The Market

1
The Market

• Supply Demand all that

2
The Big Picture
P
P

Q
Q
Demand
Supply
P
Equilibrium Price Quantity
Q
The Market
3
Demand

• Analysis based on individuals' behavior, then
  summing of individuals into aggregate demand at
  various prices
• Explanations
• Verbal quantity demanded changes inversely
  w/price
• Simple graph downward sloping curve of P vs Q
• Graphic derivation from preferences
• Mathematical specification D f(P)
• Axiomatic derivation

4
Indifference Curves - I
Two space defines various combinations of Q1
Q2 that you might choose. Some (Q1, Q1) you
prefer to others, some you prefer less, some
alternatives leave you indifferent. An
indifference curve is defined by set of
combinations among which you are indifferent.
I1 lt I2 lt I3
Quant. of Good 2 Dem. (Q2)

higher levels of preference higher levels of
utility
P1
q
q'
q"
O
Quantity of Good 1 Demanded (Q1)
NB under usual assumptions 1. Q1 and Q2 are
infinitely divisible, so infinite of smooth
curves 2. curves are open, I.e., you always
prefer MORE of everything
5
Indifference Curves - II
I1 lt I2 lt I3
Quant. of Good 2 Dem. (Q2)

P1
q
q'
q"
O
Quantity of Good 1 Demanded (Q1)
NB if you drop the assumption that you always
prefer MORE of everything, then at some point
curves close, and MORE would mean a lower level
of utility
6
Budget Line - I
Available budget (money) M with prices of Q1
P1, Q2 P2 so, total expenditure M
P1Q1P2Q2 which defines the budget line.
Q2

q2
If all M spent on Q2 then you would be at q2. If
all M spent on Q1 then you would be at q1.
NB if you spend less than M, you will be at some
point under the budget line in the space defined
by 0,q1,q2.
q1
Q1
O
If you rewrite M P1Q1P2Q2 as Q2 (1/ P2)M -
(P1 / P2) Q1 you can see that the slope of the
line P1/ P2 (and is negative)
7
Budget Lines - IIIf income (M) increases, budget
line shifts right
Q2

M' P1Q1P2Q2
MP1Q1P2Q2
P1
Q1
O
If M' gt M, then line shifts right.
8
Budget Lines - IIIIf P1 increases, budget line
intercept shifts left
Q2

If P1 increases, max Q1 falls (Change in P1 would
have no effect on vertical intercept if all M
spent on Q2)
Q1
O
If P1ltP1, then intercept shifts left.
If P2/P1 changes, slope changes
9
Utility Maximization
I3
Q2
MP1Q1P2Q2
Q1
q
O
To Maximize utility you will want to be on
highest possible I. Highest possible I will be
that which is tangent to budget line.
10
Graphic Derivation of Demand CurveDemand Curve
shows what happens to quantity demanded as price
changes. So we raise P1 and see what happens to Q1
I1 lt I2 lt I3
P1"

P1'
P1'
P1
P1
P1"
q
q" q'
q
q'
q"
O
Quantity of Good 1 Demanded (Q1)
As price rises, P1lt P1'lt P1, quantity demanded
falls, q to q to q and the combinations of P1
and q define a demand curve for Q1.
11
Mathematical Specificationof Demand Curves

• D f(P)
• dD/dP lt 0
• ?D/?P lt 0
• Linear Demand Functions
• D a - bP
• D 300 - 20P

12
Axiomatic Derivation

• Subset of Assumptions
• A gt B, A lt B, A B
• axiom of transitivity
• axiom of asymmetry
• comparability
• egotism, no one else's consumption matters to you
• continuity (continuous curves, eg., indifference
  curves
• insatiability (no maximium, always want more)

13
Utility

• Indifference Curves defined by
• preference - further from origin prefered
• utility - further from origin, higher utility
• Utility satisfaction derived from consumption
• Utility derived from "utilitarians" - Eng.
  Philos.
• all action taken with view to utility to be
  derived
• measured by "utils"???cardinality
• law of diminishing marginal utility (maybe!)
• Utility functions U f(x1, x2, .... xn)

14
Problem w/utility

• Cardinality
• ? you can compare utility for different people
• interpersonal comparisons
• Law of Diminishing Mar. Utility
• ? how much utility depended upon how much you
  have
• Cardinality Law of Diminishing Utility
• ? total social utility would increase through
  redistribution of money from rich to poor
• ? a political problem! Solution shift to
  ordinality( )
• ? utility theory replaced by preference theory

15
Supply

• Analysis based on each firm's behavior, then
  summing of firms into aggregate supply at various
  prices
• Explanations
• Verbal quantity supplied changes directly
  w/price
• Simple graph upward sloping curve of P vs Q
• Graphic derivation from costs profit
  maximization
• Mathematical specification S f(P)
• Axiomatic derivation

16
Costs
Marginal cost (MC)
Price, costs

average cost
price given marginal revenue (MR)
quantity produced
Profit Maximization occurs where MC MR
17
Derivation of Supply Curve
Marginal cost (MC) S
Price, costs

P3
P2
P1
quantity produced
q1
q2
q3
Profit Maximization occurs where MC MR
18
Mathematical Specification

• S f(P)
• dS/dP gt 0
• ?S/?P gt 0
• Linear Supply Functions
• S a bP
• S 300 20P

19
Axiomatic Derivation

• Subset of axioms
• Existence of Production
• There exists some attainable element x that can
  be transformed into y
• Neutrality of Transformations
• any two transformations T are indifferent???their
  inputs are indifferent and their outputs are
  indifferent
• Convexity
• Production set Yj is convex

20
Change in Technology

• Improvements in Technology that lower costs of
  production, shift MC curve down, and Supply curve
  to Right

MC/S
MC'/S'
Supply shifts to the right
marginal cost shifts down
21
Equilibrium

• Shapes of S D guarantee "equilibrium", i.e.,
  tendency to return to price that equalizes them

Supply
P
excess supply
equilibrium price
Demand
Q
equilibrium quantity
22
--END--