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Macroeconomics

Basic Economic Concepts1

Contents:

 Introduction to macroeconomics
 Opportunity cost and the Production Possibilities Curve
 Comparative advantage and the gains from trade
 Demand
 Supply
 Markets

About this unit

In this unit, you'll learn fundamental economic concepts like scarcity, opportunity cost, and
supply and demand. You will learn things like the distinction between absolute and comparative
advantage, how to identify comparative advantage from differences in opportunity costs, and
how to apply the principle of comparative advantage to determine the basis on which mutually
advantageous trade can take place between individuals and/or countries.

Introduction to Macroeconomics:

If you want to sum up what economics means, you could do so with the
following statement:

Individuals and societies are forced to make choices because most


resources are scarce.

Economics is the study of how individuals and societies choose to allocate


scarce resources, why they choose to allocate them that way, and the
consequences of those decisions.

Scarcity is sometimes considered the basic problem of economics. Resources


are scarce because we live in a world in which humans’ wants are infinite but
the land, labor, and capital required to satisfy those wants are limited. This
1
Source: khanacedemy.org
conflict between society’s unlimited wants and our limited resources
means choices must be made when deciding how to allocate scarce resources.

Any economic system must provide society with a means of making choices
that answer three basic questions:

 What will be produced with society’s limited resources?


 How will we produce the things we need and want?
 How will society’s output be distributed?

Key Terms
Term Definition
the study of how individuals and societies choose to
economics allocate scarce resources.

the fact that there is a limited amount of resources to


scarcity satisfy unlimited wants.

also called the factors of production; these are the


land (natural resources such as minerals and oil),
labor (work contributed by humans), capital (tools,
equipment, and facilities), and entrepreneurship (the
capacity to organize, develop, and manage a
economic business) that individuals and businesses use in the
resources production of goods and services.

graphical and mathematical tools created by


economists to better understand complicated
models processes in economics.
Term Definition
ceteris paribus a Latin phrase meaning "all else equal".

some entity making a decision; this can be an


individual, a household, a business, a city, or even
agent the government of a country.

rewards or punishments associated with a possible


incentives action; agents make decisions based on incentives.

an agent is "rational" if they use all available


information to choose an action that makes them as
rational decision well off as possible; economic models assume that
making agents are rational.

analytical thinking about objective facts and cause-


and-effect relationships that are testable, such as how
positive analysis much of a good will be sold when a price changes.

unlike positive analysis, normative analysis is


subjective thinking about what we should value or a
course of action that should be taken, such as the
normative importance of environmental factors and the
analysis approach to managing them.

the study of the interactions of buyers and sellers in


microeconomics the markets for particular goods and services

the study of aggregates and the overall commercial


output and health of nations; includes the analysis of
factors such as unemployment, inflation, economic
macroeconomics growth and interest rates.
Term Definition
measures such as the unemployment rate, rate of
inflation, and national output that summarize all
markets in an economy, rather than individual
markets; economic aggregates are frequently used as
economic measures of the economic performance of an
aggregates economy.

Models and graphs


Economics is a social science. This means that economists, in their study of
human interactions, use models to simplify, analyze, and predict human
behavior. Models include graphs and mathematical models.

The purpose of these graphs and mathematical models is to simplify the


many interactions that occur in an economy. In their use of models,
economists usually make the assumption, when analyzing the effect of a
particular change on a market or on a nation’s economy, that all else is held
constant. The term we use for “all else equal” is the Latin expressions, ceteris
paribus.

Another assumption economists make is that economic agents are rational


and have an incentive to make decisions that are always in their own self-
interest. While in reality human beings often act irrationally, by assuming
people, businesses, governments, and other agents are rational decision-
makers, and by assuming ceteris paribus, economists attempt to establish
laws and make predictions about how human interactions will affect society.
When thinking about economic problems, we can use either positive analysis
or normative analysis. Positive analysis is objective, fact-based, and cause-
and-effect thinking about problems. When economists disagree it is typically
due to different normative analysis. When using normative analysis, the focus
is on what should happen or how desirable one action is compared to a
different action.

The study of economics is sometimes broken down into two


disciplines: microeconomics and macroeconomics. Microeconomics
examines the interactions of buyers and sellers in individual markets for
goods and services, the competitive structure of markets, and the markets for
resources. Macroeconomics examines the interactions and behavior of entire
nations' economies, such as why recessions occur, what causes economic
growth, and how countries can benefit from specialization and trade.

Common Misperceptions
 Economics is not the study of stock markets, money, or how to run a
business. Although many new students believe they will be learning about
these concepts, economics is a social science that seeks to better understand
and predict human interactions; unlike business and finance, which focus on
how to manage a business organization and invest money in a way to earn the
highest return for investors.

 One essential assumption made in most economic analysis is that all


humans are rational and will make choices based on what is always in their
best interest. In the real world, obviously, people, businesses, and even entire
societies can be highly irrational.
 Just because a decision is "irrational" in the economic sense, that
doesn't mean that it is inherently wrong, bad, or lesser than what an
economist would call a "rational" decision. In fact, the field of Behavioral
Economics seeks to understand better the many reasons humans choose to
make economically "irrational" choices in their decision making.

 One of the four economic resources that societies must decide how to
allocate is capital. When people use the word capital in everyday
conversation, many people are referring to money or “financial capital.” In
economics, capital is defined as the already-produced goods (tools,
machinery, equipment, and physical infrastructure) that are used in the
production of other goods or services. A robot on a car factory floor is
defined as capital in economics; money you borrow to start your own
business is not.

Discussion questions
 Victorian historian Thomas Carlyle once called economics the "dismal
science" because he believed it obsessively focused on the scarcity of
resources. What does the field of economics provide society that other
sciences such as chemistry, biology and physics cannot?

 Using at least three key terms from this lesson, explain how scarcity
affects you in your everyday life.

 What are the three basic economic questions? How have different
societies that you know about or have studied in other classes attempted to
answer these questions?
Opportunity cost and the PPC
The Production Possibilities Curve (PPC) is a model used to show the
tradeoffs associated with allocating resources between the production of two
goods. The PPC can be used to illustrate the concepts of scarcity, opportunity
cost, efficiency, inefficiency, economic growth, and contractions.

For example, suppose Carmen splits her time as a carpenter between making
tables and building bookshelves. The PPC would show the maximum amount
of either tables or bookshelves she could build given her current resources.
The shape of the PPC would indicate whether she had increasing or constant
opportunity costs.

Key terms
Term Definition
(also called a production possibilities frontier) a
graphical model that represents all of the different
production combinations of two goods that can be produced; the
possibilities PPC captures scarcity of resources and opportunity
curve (PPC) costs.

the value of the next best alternative to any decision


you make; for example, if Abby can spend her time
either watching videos or studying, the opportunity
cost of an hour watching videos is the hour of
opportunity cost studying she gives up to do that.

efficiency the full employment of resources in production;


efficient combinations of output will always be on the
Term Definition
PPC.

the underemployment of any of the four economic


inefficient use resources (land, labor, capital, and entrepreneurial
(under- ability); inefficient combinations of production are
utilization) of represented using a PPC as points on the interior of
resources the PPC.

an increase in an economy's ability to produce goods


and services over time; economic growth in the PPC
growth model is illustrated by a shift out of the PPC.

a decrease in output that occurs due to the under-


utilization of resources; in a graphical model of the
PPC, a contraction is represented by moving to a
point that is further away from, and on the interior of,
contraction the PPC.

when the opportunity cost of a good remains constant


as output of the good increases, which is represented
as a PPC curve that is a straight line; for example, if
constant Colin always gives up producing 2 fidget spinners
opportunity every time he produces a Pokemon card, he has
costs constant opportunity costs.

increasing when the opportunity cost of a good increases as


opportunity output of the good increases, which is represented in a
costs graph as a PPC that is bowed out from the origin; for
example Julissa gives up 222 fidget spinners when
she produces the first Pokemon card, and 444 fidget
Term Definition
spinners for the second Pokemon card, so she has
increasing opportunity costs.

(also called technology) the ability to combine


economic resources; an increase in productivity
causes economic growth even if economic resources
have not changed, which would be represented by a
productivity shift out of the PPC.

Key model

The Production Possibilities Curve (PPC) is a model that captures scarcity


and the opportunity costs of choices when faced with the possibility of
producing two goods or services. Points on the interior of the PPC are
inefficient, points on the PPC are efficient, and points beyond the PPC are
unattainable. The opportunity cost of moving from one efficient combination
of production to another efficient combination of production is how much of
one good is given up in order to get more of the other good.

The shape of the PPC also gives us information on the production technology
(in other words, how the resources are combined to produce these goods).
The bowed out shape of the PPC in Figure 111 indicates that there are
increasing opportunity costs of production.

We can also use the PPC model to illustrate economic growth, which is
represented by a shift of the PPC. Figure 222 illustrates an agent that has
experienced economic growth. Combinations that were once impossible, such
as 6 iPads and 4 watches, are now on the new PPC, thanks to the increase in
resources or technology.

Key Equations and Calculations: Calculating


opportunity costs:
To find the opportunity cost of any good X in terms of the units of Y given
up, we use the following formula:
Opportunity cost of each unit of good X = (Y1-Y2) \ (X1-X2)
units of good Y.
Solution:

For example, suppose we knew that the following table represented all of the
possible combinations of iPads and Apple Watches that could be produced.

Number of Apple Watches Number of iPads


0 5
2 4

4 3

6 2

8 1

10 0
If a producer is producing 666 Apple Watches and 222 iPads, but wants to
make one more iPad, they can instead produce 444 Apple Watches
and 333 iPads:
{Opportunity cost of one iPad}: (6-4)\(3-2) Apple Watches

=2÷1 Apple Watches

=2 Apple Watches

Note that opportunity costs are always expressed in terms of the good that is
given up.

We can use the same procedure if given a graph. Figure 3 shows a PPC that
has been created from our table. The two points used in this formula are the
two efficient points indicated in the graph in Figure 3.

Common Misperceptions
 Not all costs are monetary costs. Opportunity costs are expressed in
terms of how much of another good, service, or activity must be given up in
order to pursue or produce another activity or good. For example, when you
head out to see a movie, the cost of that activity is not just the price of a
movie ticket, but the value of the next best alternative, such as cleaning your
room.
 Going from an inefficient amount of production to an efficient amount
of production is not economic growth. For example, suppose an economy can
make two goods: chocolate donuts and cattle prods. But half of their donut
machines aren’t being used, so they aren’t fully using all of their resources.
Graphically, that would be represented by a combination of goods in the
interior of their PPC. If they then put all of those donut machines to work,
they aren’t acquiring more resources (which is what we mean by economic
growth). Instead, they are just using their resources more efficiently and
moving to a new point on the PPC.
 On the other hand, if this economy is making as many donuts and cattle
prods as it can, and it acquires more donut machines, it has experienced
economic growth because it now has more resources (in this case, capital)
available. This would be represented in a PPC graph as a shift outward of the
entire PPC curve.

Discussion Questions
 How would you show with a PPC that a country has constant
opportunity costs of production?
 Using a correctly labeled PPC model, show an economy that has
increasing opportunity costs that can produce cattle prods and chocolate
donuts that is underutilizing its labor.
[Got it, thanks!]

Using our example earlier of an economy producing chocolate donuts and


cattle prods, suppose a lot of the cattle prod workers were laid off. Point A in
Figure 4 would represent an inefficient amount of production due to
underutilization of this labor.
Lesson summary: Comparative advantage and gains
from trade
Absolute advantage describes a situation in which an individual, business or
country can produce more of a good or service than any other producer with
the same quantity of resources.

The United States, for example, has a skilled workforce, abundant natural
resources, and advanced technology. Because of these three things, the US
can produce many goods more efficiently than potential trading partners,
giving it an absolute advantage in the production of goods from corn to
computers, to maple syrup and cars. This does not, however, mean that the
US does not benefit from trading for these goods with other nations.

Comparative advantage describes a situation in which an individual,


business or country can produce a good or service at a lower opportunity cost
than another producer.

For example, because it has an abundance of maple trees, Canada can


produce maple syrup at a very low opportunity cost in relation to avocados, a
fruit for which its climate is less suited.

Mexico, on the other hand, with its ample sunshine and warm climate. can
grow avocados at a much lower opportunity cost in terms of maple syrup
given up than Canada.

Specialization
Production specialization according to comparative advantage, not absolute
advantage, results in exchange opportunities that lead to consumption
opportunities beyond the PPC. Trade between two agents or countries allows
the countries to enjoy a higher total output and level of consumption than
what would have been possible domestically.

Canada and Mexico can each specialize in the good they have a comparative
advantage in and exchange with one another. This lets both countries enjoy
more maple syrup and avocados than they could have enjoyed without trade.
Mexico will export avocados and import maple syrup; this way Mexicans can
enjoy their tasty breakfasts and Canadians will enjoy delicious guacamole!

Comparative advantage and opportunity costs determine the terms of trade


for exchange under which mutually beneficial trade can occur.

In order for Canadians to benefit from trade with Mexico, they must be able
to import avocados at a lower opportunity cost than it would cost them to
grow domestically. Likewise, Mexico must get maple syrup more cheaply (in
terms of avocados given up) than it could have produced it for domestically.
The terms of trade refer to the trading price agreed upon by two agents,
which when beneficial, will allow both countries to enjoy gains from trade.

Key terms
Term Definition
the ability to produce more of a good than another
entity, given the same resources. For example, in a
single day, Owen can embroider 10 pillows and
absolute Penny can embroider 15 pillows, so Penny has
advantage absolute advantage in embroidering pillows.

comparative the ability to produce a good at a lower opportunity


advantage cost than another entity. For example, for every
Term Definition
pillow Owen embroiders his opportunity cost
is 2 scarves knitted, while Penny must
forego 3 scarves for every pillow she embroiders, so
Owen has comparative advantage in embroidering
pillows.

when an individual or a country allocates most or all


of its resources towards the production of a particular
good or service. For example, Sal (an individual)
specializes in producing educational videos, and
Bangladesh (the country) specializes in producing
specialization textiles.

the exchange of goods, services or resources between


trade one economic agent and another

international the exchange of goods, services, or resources between


trade one country and another

the ability of two agents to increase their consumption


possibilities by specializing in the good in which they
have comparative advantage and trading for a good in
gains from trade which they do not have comparative advantage

the price of one good in terms of the other that two


countries agree to trade at; beneficial terms of trade
terms of trade allows a country to import a good at a lower
(also called opportunity cost than the cost for them to produce the
“trading price”) good domestically, thus the country gains from trade.
Key Graphical Models
PPCs can be used to determine opportunity costs, comparative advantage,
and who should specialize in which good (as in Figure 1).

Figure 1: Countries A and B's production possibilities before trade

The gains from trade can be shown in a PPC by drawing a line originating at
the point on the axis on which an agent is specializing its production (in the
good it has a comparative advantage in) out to a point on the opposite axis
beyond what it could have achieved without trade.

Assuming terms of trade are beneficial (e.g. offering each agent a lower
opportunity cost than could be achieved without trade) an individual or
country will be able to consume at a point beyond its PPC through
specialization and trade (as in Figure 2).
Figure 2: Countries A and B's potential gains from trade

Common Misperceptions
 A country that has an absolute advantage in producing all goods still
stands to benefit from trade with other countries, since the basis of the gains
for trade is comparative advantage, not absolute advantage.

 It is not possible for an individual or country to have a comparative


advantage in all goods. There will be some other individual or country that
can produce some things at lower opportunity costs.

 "Self-sufficiency" is not necessarily a trait to be strived for in the global


economy. Individuals or nations who try to produce everything for
themselves are likely to end up poorer than those that engage in
specialization and trade.
Discussion questions
1. In what circumstances might a country NOT benefit from trade with
another country? 
[Hide explanation]

If two countries have identical opportunity costs for two goods, then the
countries do not stand to gain from trade with one another for the goods in
question.

2. Economist Russell Roberts once wrote, "Self-sufficiency is the road to


poverty." Discuss how the principle of specialization and trade based on
comparative advantage supports this claim.

3. The table below shows the production possibilities of two countries,


Tonju and Emria, of two goods, smartphones and apples, given a fixed
amount of resources.

4. Smartphones Apples
Tonju 39 13
Emria 48 24
 a. Which country has the absolute advantage in smartphones and which
has the absolute advantage in apples?

 b. Calculate Tonju’s opportunity cost of smartphones in terms of apples

 c. If the two countries were to specialize and trade with one another,
which country would import smartphones?

 d. Assume the countries decide to specialize and trade and settled on a


trading price of 2.5 smartphones per apple. Explain why the country that
specializes in apples would experience gains from trade.
[Hide explanation]
 a. Emria has an absolute advantage in smartphones because it can
produce 484848 smartphones compared to just 393939 in Tonju. Emria also
has an absolute advantage in apples, since it can produce 242424 apples
compared to just 13 in Tonju

 b. Tonju can produce 393939 smartphones or 131313 apples. To


determine the opportunity cost we can divide the number of apples it can
produce by the number of smartphones it could have produced with the same
resources. 393939 smartphone = 13=13equals,
13 apples. 111 smartphone = \dfrac{13}{39}=3913equals, start fraction, 13,
divided by, 39, end fraction apples. For each smartphone Tonju produces it
gives up just \dfrac {1}{3}31start fraction, 1, divided by, 3, end fraction of
an apple

 c. Emria will import smartphones. Tonju can produce smartphones at a


lower opportunity cost than Emria (\dfrac{1}{3}31start fraction, 1, divided
by, 3, end fraction apple per smartphone compared to Emria’s 1/2, end
fraction apple per smartphone). Therefore, Tonju will specialize in and export
smartphones and Emria will import smartphones

 d. Emria, which has a comparative advantage in apples


(222 smartphones per apple compared to Tonju’s 333 smartphones per apple)
will gain from trade because by exchanging apples with Tonju, Emria will
receive 2.52.52, point, 5smartphones for every apple it give up instead of
just 222 smartphones, which it would get if it tried to produce smartphones
domestically.
Lesson summary: Demand and the determinants of
demand

About this unit


In this unit, you'll learn fundamental economic concepts like scarcity, opportunity cost, and supply
and demand. You will learn things like the distinction between absolute and comparative advantage,
how to identify comparative advantage from differences in opportunity costs, and how to apply the
principle of comparative advantage to determine the basis on which mutually advantageous trade
can take place between individuals and/or countries.

Lesson summary: Demand and the


determinants of demand
In a competitive market, demand for and supply of a good or service
determine the equilibrium price.

The law of demand


Markets have two agents: buyers and sellers. Demand represents the buyers
in a market. Demand is a description of all quantities of a good or service that
a buyer would be willing to purchase at all prices.

According to the law of demand, this relationship is always negative: the


response to an increase in price is a decrease in the quantity demanded.

For example, if the price of scented erasers decreases, buyers will respond to
the price decrease by increasing the quantity of scented erasers demanded. A
market for a good requires demand and supply.

The determinants of demand


What influences demand besides price? Factors like changes in consumer
income also cause the market demand to increase or decrease. For example, if
the number of buyers in a market decreases, there will be less quantity
demanded at every price, which means demand has decreased.
For instance, if scented erasers are normal goods, then when buyers have
more income they will buy more scented erasers at every possible price; this
would also shift the demand curve to the right.

Key Terms
Term Definition
all of the quantities of a good or service that buyers
would be willing and able to buy at all possible prices;
demand is represented graphically as the entire demand
demand curve.

a table describing all of the quantities of a good or


service; the demand schedule is the data on price and
demand quantities demanded that can be used to create a
schedule demand curve.

a graph that plots out the demand schedule, which


shows the relationship between price and quantity
demand curve demanded

all other factors being equal, there is an inverse


relationship between a good’s price and the quantity
consumers demand; in other words, the law of demand
is why the demand curve is downward sloping; when
price goes down, people respond by buying a larger
law of demand quantity.

quantity the specific amount that buyers are willing to purchase


demanded at a given price; each point on a demand curve is
Term Definition
associated with a specific quantity demanded.

change in a movement along a demand curve caused by a change


quantity in price; a change in quantity demanded is a movement
demanded along the same curve

when buyers are willing to buy a different quantity at


all possible prices, which is represented graphically by
change in a shift of the entire demand curve; this occurs due to a
demand change in one of the determinants of demand.

changes in conditions that cause the demand curve to


shift; the mnemonic TONIE can help you remember
determinants of the changes that can shift demand (T-tastes, O-other
demand goods, N-number of buyers, I-income, E-expectations)

a good for which demand will increase when buyers’


normal good incomes increase.

a good for which demand will decrease when buyers’


inferior good incomes increase.
goods that can replace each other; when the price of a
substitute good increases, the demand for its substitute will
goods increase.

goods that tend to be consumed together; when the


complement price of a good increases the demand for its
goods complement will decrease.

Key Graphical Model


Figure 1: A model showing an increase in demand

The demand curve shows all of the quantities that a buyer is willing to
purchase at all possible prices. In Figure 1, the curve D_1D1D, start subscript,
1, end subscript represents a buyer that would be willing to nothing when the
price is \$9$9dollar sign, 9, 222 units when the price is \$7$7dollar sign,
7, 666 units with the price is \$3$3dollar sign, 3, and 999 units if the price
was \$0$0dollar sign, 0.

A movement along a curve, such as moving from point AAA to


point BBB occurs when price changes, is a response to an increase in price.
In this case, this movement is caused by an increase in price from \$3$3dollar
sign, 3 to \$7$7dollar sign, 7.

The curve D_2D2D, start subscript, 2, end subscript represents a higher


demand for this good, which would happen if a determinant of demand
changed. For example, an increase in the number of buyers of this good
would cause the increase in demand shown in this graph. A movement from
point BBB to point XXX would only occur if demand increased.

Common misperceptions

Change in demand vs. change in quantity demanded


 A change in demand and a change in quantity demanded are not the
same thing. Demand changes only when one of the determinants of demand
change (recall the elements of the mnemonic TONIE). For instance, rising
consumer incomes (one of the determinants) will increase demand for new
cars, a normal good, which would shift the entire demand curve to the right.
More cars will be demanded at every price when demand increases.

 Price is not a determinant of demand, thus a change in price does not


cause demand to increase or decrease. If the price of new cars changes,
ceteris paribus, there will be a change in the quantity demanded and a
movement along the demand curve.

How a price change affects quantity demanded for a


good and demand for related goods
 A change in the price of a good will cause the quantity demanded for
that good to change, but a change in the demand for related goods
(complements and substitutes) causes the demand curve to shift.
 For example, when the price of hot dogs falls three things happen:
Quantity demanded for hot dogs increases, demand for hot dog buns (a
complement) increases, and demand for hamburgers (a substitute) decreases
Discussion Questions
 How would you describe to a friend the difference between an increase
in demand versus an increase in quantity demanded?
 What are the five determinants of demand?
 How would you show a decrease in the demand for Concert Tickets
using a graph? 

[Thanks! Got it!]

Lesson summary: Supply and its determinants

The law of supply


The law of supply states that there is a positive relationship between price
and quantity supplied, leading to an upward-sloping supply curve. Sellers like
to make money, and higher prices mean more money!
For example, let’s say that fishermen notice the price of tuna rising. Because
higher prices will make them more money, fishermen spend more time and
effort catching tuna. As a result, as the price rises, the quantity of tuna
supplied increases.

The determinants of supply


Factors that influence producer supply cause the market supply curve to shift.
For example, one of the determinants of supply in the market for tuna is the
availability and the price of fishing permits. If more fishing permits are made
available and the permit fee is lowered, we can expect more fisherman to
enter the market; as a result, the supply of tuna will likely increase. Now, at
every price, a greater quantity of tuna will be supplied to the market.

Key Terms
Term Definition
a schedule or a curve describing all the possible
quantities that sellers are willing and able to produce, at
all possible prices they might encounter in a particular
period of time; supply is represented in a graphical
supply model as the entire supply curve.

law of supply all other factors being equal, there is a direct


relationship between a good’s price and the quantity
supplied; as the price of a good increases, the quantity
supplied increases; similarly, as price decreases, the
quantity supplied decreases, leading to a supply curve
Term Definition
that is always upward sloping.

the amount of a good or service that sellers are willing


to sell at a specific price; quantity supplied is
quantity represented in a graphical model as a single point on a
supplied supply curve.

change in
quantity a movement along a supply curve resulting from a
supplied change in a good’s price

a movement or shift in an entire supply curve resulting


change in from a change in one of the non-price determinants of
supply supply

changes in non-price factors that will cause an entire


supply curve to shift (increasing or decreasing market
supply); these include 1) the number of sellers in a
market, 2) the level of technology used in a good’s
production, 3) the prices of inputs used to produce a
good, 4) the amount of government regulation,
subsidies or taxes in a market, 5) the price of other
determinants goods sellers could produce, and 6) the expectations
of supply among producers of future prices.

Key Graphical Models


The supply curve demonstrates the relationship between a good’s price and
the quantity producers are willing and able to supply. The upward sloping
line demonstrates this direct relationship: as the price rises, the quantity
supplied increases; as price decreases, quantity supplied decreases.

Figure 1: An upward sloping supply curve

Common Misperceptions
 You may often hear people say, incorrectly, that higher prices lead to
“more supply” and that lower prices lead to “less supply.” However, this is an
incorrect use of the terms. Higher prices will result in an increased quantity
supplied and lower price will result in a decrease in quantity supplied. Only a
change in a non-price determinant of supply causes a good's supply to
increase or decrease.

Discussion questions
1. How would producers of a good, such as candy canes, adjust their
current supply if they expect its price to rise in the future? 
[Hide explanation]

If businesses expect future prices to be higher, they will most likely withhold
current supply, which would reduce the market supply. If prices are expected
to fall in the future, they would benefit from increasing supply today in order
to sell while the price is still relatively high.

In the candy cane market, producers would withhold supply in the summer
and early fall because they expect prices to rise around the holiday season.
Towards the end of the holiday season, when they expect candy cane prices
to fall in the future, they’ll supply as much as they can while prices are still
high.

2. How will increased regulation of producers by the government affect a


good’s supply? What other government interferences in a market can
influence the level supply of a good? 
[Hide explanation]

Increased government regulations cause producers costs to rise, reducing the


supply of the regulated good. Other government interventions that affect
supply are subsidies (payments from the government to producers, which
increase supply) and taxes (payments from producers to the government,
which decrease supply)

3. In a correctly labelled graph, show an increase in the supply of a good.


In another, correctly labelled graph, show an increase in the quantity supplied
of a good. Explain why these two are different.

Lesson summary: Market equilibrium, disequilibrium,


and changes in equilibrium
In a competitive market, demand for and supply of a good or service
determine the equilibrium price.

Equilibrium
MARKETS: Equilibrium is achieved at the price at which quantities
demanded and supplied are equal. We can represent a market in equilibrium
in a graph by showing the combined price and quantity at which the supply
and demand curves intersect.

For example, imagine that sellers of squirrel repellant are willing to


sell 500units of squirrel repellant at a price of \$5$5dollar sign, 5 per can. If
buyers are willing to buy 500 units of squirrel repellent at that price, this
market would be in equilibrium at the price of \$5$5dollar sign, 5 and at the
quantity of 500 cans.

Disequilibrium
Whenever markets experience imbalances—creating disequilibrium prices,
surpluses, and shortages—market forces drive prices toward equilibrium.

A surplus exists when the price is above equilibrium, which encourages


sellers to lower their prices to eliminate the surplus.

A shortage will exist at any price below equilibrium, which leads to the price
of the good increasing.

For example, imagine the price of dragon repellent is currently \$6$6dollar


sign, 6 per can. People only want to buy 400400400 cans of dragon repellent,
but the sellers are willing to sell 600600600 cans at that price. This creates a
surplus because there are unsold units. Sellers will lower their prices to attract
buyers for their unsold cans of dragon repellant.
Changes in equilibrium
Changes in the determinants of supply and/or demand result in a new
equilibrium price and quantity. When there is a change in supply or demand,
the old price will no longer be an equilibrium. Instead, there will be a
shortage or surplus, and price will subsequently adjust until there is a new
equilibrium.

For example, suppose there is a sudden invasion of aggressive unicorns.


There will be more people who want to buy unicorn repellent at all possible
prices, causing demand to increase. At the original price, there will be a
shortage of unicorn repellant, signaling sellers to increase the price until the
quantity supplied and quantity demanded are once again equal.

We can summarize the changes in equilibrium with the following table:

Change Change in P* Change in Q*


Supply increases ↑(shifts right) P ↓ Q↑

Supply decreases ↓shifts left P↑ Q ↓

Demand increases ↑shifts right P↑ Q ↑

Demand decreases  ↓shifts left P ↓ Q ↓

Demand Increases, Supply


increases P ↕ indeterminate Q ↑

Demand Increases, Supply


decreases P ↑ Q↕indeterminate

Demand decreases, Supply


increases P ↓ Q ↕indeterminate

Demand decreases, Supply P ↕indeterminate Q ↓


Change Change in P* Change in Q*
decreases

Key Terms
Term Definition
an interaction of buyers and sellers where goods,
market services, or resources are exchanged

when the quantity demanded of a good, service, or


shortage resource is greater than the quantity supplied

when the quantity supplied of a good, service, or


surplus resource is greater than the quantity demanded

in a market setting, an equilibrium occurs when price


has adjusted until quantity supplied is equal to quantity
equilibrium demanded

in a market setting, disequilibrium occurs when


quantity supplied is not equal to the quantity
demanded; when a market is experiencing a
disequilibrium, there will be either a shortage or a
disequilibrium surplus.

the price in a market at which the quantity demanded


equilibrium and the quantity supplied of a good are equal to one
price another; this is also called the “market clearing price.”

equilibrium the quantity that will be sold and purchased at the


quantity equilibrium price
Key Graphical Models - The market model
Consider the market for giant shiny salamander stickers, given in Figure 111.
Currently, the equilibrium price of these stickers is \$5$5dollar sign, 5, and
the equilibrium quantity is 3.

Figure 1: The market for salamander stickers

Changes in Supply
Suppose the price of glitter, which is used to make giant shiny salamander
stickers, increases so that it now costs the seller \$2$2dollar sign, 2 more per
sticker to produce them. This will cause the supply of this good to decrease.
To see the impact a decrease in supply will have on the equilibrium price and
quantity, grab the interactive supply curve and shift it to the left until the
price is \$2$2dollar sign, 2higher at every level of output (the new supply
curve should start at \$4$4dollar sign, 4).

What change did you notice? If you adjusted the graph correctly, you should
see the equilibrium price increases to \$6$6dollar sign, 6, and the equilibrium
quantity in this market decreases to 222 stickers.

Now instead, suppose someone invents a new way to produce shiny


salamander stickers so there is less waste and fewer resources are needed to
produce them. This would result in an increase in the supply of shiny
salamander stickers. To see the impact an increase in supply will have on the
equilibrium price and quantity, grab the interactive supply curve and drag it
to the right so that at every quantity the price is \$2$2dollar sign, 2 lower (the
new supply curve should start at \$0$0dollar sign, 0).

How did you do? If you adjusted the graph correctly, you should see the
equilibrium price decreases to \$4$4dollar sign, 4 and equilibrium quantity
increases to 444stickers.

Changes in demand
Suppose a famous, trendsetting actress starts wearing giant shiny salamander
stickers, which makes them instantly the must-have accessory. This would
cause the demand for this good to increase. To see the impact on equilibrium
price and quantity in the market from an increase in demand, grab the
demand curve Figure 222 and shift it to the right to represent an increase in
demand.
Figure 2: The market for salamander stickers

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Changes in both demand and supply


When both supply and demand change at the same time, the impact on
equilibrium price and quantity cannot be determined for certain without
knowing which changed by a greater amount.

Suppose shiny salamander stickers fall out of popularity, and therefore the
demand for them decreases. At the same time, the price of glitter goes up,
which leads to a decrease in supply.

On the one hand, the decrease in demand should make price decrease and


quantity demanded decrease.On the other hand, the decrease in supply should
also make price __increase and quantity demanded decrease. That means we
know for certain that the quantity of giant shiny salamander stickers will
decrease. But what will happen to price?
In Figure 3, we see a decrease in supply and a decrease in demand. The effect
on quantity is easy to determine (quantity will definitely decrease). On the
other hand, it is hard to tell if the equilibrium price has increased, decreased,
or stays the same. Because we cannot say which of these has happened with
certainty, we say that the price change is indeterminate or ambiguous.

Figure 3: The market for giant shiny salamander stickers

Of course, when modeling changes in a graph it is possible to see changes in


both equilibrium price and quantity when shifting both demand and supply
(depending on how much each curve shifts). In the interactive graph below,
move both demand and supply in different directions. Each time, move the
equilibrium point to the new intersection of demand and supply. Try to create
new equilibria at which:

 Price is higher and quantity is higher


 Price is higher and quantity is lower
 Price is lower and quantity is higher
 Price is lower and quantity is lower

Figure 4: The market for salamander stickers

Common Misperceptions
 When showing an equilibrium price and quantity, it is important to
clearly label these on the appropriate axis, not just the interior of the graph.
Remember that the point on either axis represents the market price and the
market quantity, not a point in the middle of the graph.
 When both supply and demand change at the same time, we will not be
able to make a statement about what happens to both price and quantity, one
of these will be uncertain.

Discussion Questions
1. When both supply and demand increase at the same time, why can't we
tell what will happen to the equilibrium price?
2. Can you think of an example of a good in your own life for which there
was a shortage?
3. What happened to the price of that good?
4. Using a correctly labeled graph, show the impact on equilibrium price
and quantity in the market for pumpkin spiced lattes if the cost of producing
them increases. 
[Hide explanation]

An increase in the cost of production causes a decrease in supply, and


increase in equilibrium price, and a decrease in equilibrium quantity, as in
Figure 555.

Figure 5: Pumpkin spiced lattes following an increase in production costs