Chapter 2: Economic Systems & Resource Allocation

Basic Economic Questions

What to Produce (guns vs. butter)

How to Produce (labor-intensive vs. capital-intensive technology)

For Whom to Produce (rich vs. poor)

Economic SystemsEconomic Systems

Tradition & Custom Economy

Command & Control Economy– Central Planning

Market Economy– Pure vs. Mixed– Competitive vs. Non-competitive

Market System

Network of buyers & sellers who transact in the market

Buyers “demand” goods & services

Sellers “supply” goods & services

Advantage of Market Economy

Free interactions between buyers & sellers

Full information to make decisions

Free to choose between alternatives

DemandDemand

Definition: quantities of a good or service consumers are able to buy at various prices

Law of Demand: price and quantity are negatively related

Movement along demand is caused by a price change

Demand Schedule

Demand for PepsiPrice Quantity Demanded

$1.50 1,500

$2.00 1,000

$2.50 500

Demand LineDemand Line

Price

Quantity

D

D

1.50

2.00

1000 1500

A

B

Shift in Demand

Shift in demand is caused by a change in

– Consumer income & tastes– Consumer expectations (price, income)– Number of consumers– Price of related goods (substitute, complementary)

Increase in Demand

Price

Quantity

D

D

2.00

1500 2000

A

B

D’

D’

C

Supply

Definition: quantities of a good or service producers are able to sell at various prices

Law of Supply: price and quantity supplied are positively related

Movement along supply is caused by a price change

Supply Schedule

Supply for Pepsi

Price Quantity Supplied

$1.50 500

$2.00 1,000

$2.50 1,500

Supply Line

Price

Quantity

S

S

1.50

2.00

500 1000

A

B

Shift in Supply

Shift in supply is caused by an change in

– production cost & technology– number of firms– price of related goods– price expectations

Increase in Supply

Price

Quantity

S

S

1.50

500 1000

S’

S’

A

B

C

EquilibriumEquilibrium

A condition at which the independent plans of buyers and sellers exactly coincide in the marketplace.

At equilibrium: Demand = Supply to determine equilibrium price & quantity

Market Equilibrium

Equilibrium in Pepsi Market

Price Quantity Demanded Quantity Supplied

$1.50 1,500 500

$2.00 1,000 1,000

$2.50 500 1,500

Demand-Supply Interaction

Price

Quantity

D

D

1.50

2.00

1000 1500

Equilibrium

B

500

2.50S

SShortage

Surplus

Stability

Shortage: at a price below equilibrium quantity demanded > quantity supplied

Surplus: at a price above equilibrium quantity supplied > quantity demanded

Price adjustments eliminate shortages & surpluses

Increase in Demand:

Price

Quantity

D

D

P

P’

Q Q’

A

D’

D’

B

S

S

Higher PriceLarger Quantity

Increase in Supply:

Price

Quantity

S

S

P’

P

Q Q’

S’

S’

A

B

D

D

Lower PriceLarger Quantity

Increase in Demand & Supply:

Price

Quantity

D

D

D’

D’

S

S

A

S’

S’

B

P

P’

Q Q’

Here:Higher PriceLarger Quantity

Market: Command Economy

Price

Quantity

D

D

P’

P

Q Q’

A

S

D’

D’

B

C

Shortage=ACif price is fixed