Capitalism. and the Market System. AP Macroeconomics Unit 2. Adam Smith and the Free Market. Security Stability Equity. Efficiency Growth Freedom 4-3

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1 Adam Smith and the Free Market Krugman Module 4, pp Module 5, pp Module 6, pp Module 7, pp Capitalism 4-2 and the Market System ECONOMIC GOALS Efficiency Growth Freedom 4-3 Security Stability Equity 1

2 CAITALISM AT WORK The Four Fundamental uestions... What will be produced? How will the goods be produced? Who will get the goods and services? How do we get MORE? A Macroeconomics 4-4 Traditional Economy Economic decisions based on custom Make what has always been made Do the same work parents did Barter: trade without money 4-5 EARLY ECONOMISTS Wealth is Gold Gold is Limited Whoever has the most Gold, Wins MERCANTILISTS 4-6 2

3 Wealth is NOT Gold Wealth is GOODS. ADAM SMITH CAITALISM Whoever Dies with the Most Toys, Wins. -Gordon Gekko Wall Street, ADAM SMITH It is not from the benevolence of the butcher, the brewer, and the baker that we expect our dinner, but from their regard to their own self-interest The Wealth of Nations 1776 Smith s Free Market SELF-INTEREST MARKETS RIVATE ROERTY COMETITION FREEDOM OF CHOICE NO GOVERNMENT INTERFERENCE 4-9 3

4 CAITALISM Other characteristics Specialization and Interdependence Investment in Technology and Capital Use of Money Financial capital A Macroeconomics 4-10 Smith s Free Market Other Characteristics Specialization and Trade Division of Labor Mass roduction Interdependence 4-11 Smith s Free Market Other Characteristics Investment in Technology and Capital Technological Innovation and Roundabout roduction

5 Smith s Free Market Other Characteristics Use of Money roblem of Barter: Coincidence of Wants Means of Exchange Measure of Value Store of Value 4-13 roduction ossibility Frontier Capital Goods Increased Resources Trade Technology 4-14 Consumer Goods COMETITION AND THE INVISIBLE HAND 4-15 The Case for the Market System Efficiency Growth Freedom 5

6 Trade 4-16 Absolute and Comparative Advantage FUNDAMENTAL ECONOMIC CONCET Trade is Good! 4-17 A ARABLE FOR THE BENEFITS OF TRADE Imagine an economic system with only two goods, potatoes and cows and only two people, Scrooge McDuck and Grunkle Stan What should each person produce? Why should these people trade?

7 Scrooge McDuck Cows otatoes Grunkle Stan Cows otatoes What is the opportunity cost of each good for each individual? Who has the Comparative Advantage for each good? Cows 8 4 A If there is no trade, Scrooge chooses this production and consumption.? Cows 12 6 B If there is no trade, Stan chooses this production and consumption otatoes otatoes (ounces) The roduction ossibilities Frontiers Copyright 2003 Southwestern/Thomson Learning 4-21 COMARATIVE ADVANTAGE Differences in the opportunity costs answer these questions: OC = L/G The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. 7

8 What is total possible production for both goods if they specialize in producing the good with the lowest cost? Cows OC = 24/12 If there is no trade, OC(c) = 2 otatoes OC = 32/8 12 Scrooge chooses If there is no trade, OC(c) = 4 otatoes 8 this production and Stan chooses consumption. this production and consumption. 6 B OC = 8/32 4 A OC(p) = 1/4 Cow OC = 12/24 OC(p) = 1/2 Cow Cows Stan has the Comparative Advantage in Cows 0 otatoes Scrooge has the Comparative Advantage in otatoes The roduction ossibilities Frontiers otatoes (ounces) Copyright 2003 Southwestern/Thomson Learning GAINS FROM TRADE! Cows 12 8 With trade, Scrooge s possibilities Shift to the right! Cows 12 With trade, Stan s possibilities Shift to the right! otatoes otatoes (ounces) If each specializes in what they do best and trades, their possibilities increase, and their F shift to the right Copyright 2003 Southwestern/Thomson Learning B 32 Comparative Advantage and Trade Benefits of Trade Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage

9 ALICATIONS OF COMARATIVE ADVANTAGE Should the United States trade with other countries? Each country has many citizens with different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off. Imports goods produced abroad and sold domestically Exports goods produced domestically and sold abroad 4-25 roduction ossibilities for Two Countries 4-26 Absolute Advantage The comparison of producers according to total productivity. The producer that can produce more of BOTH goods is said to have an absolute advantage. Trade is NOT based on Absolute Advantage, only Comparative Advantage!

10 roduction ossibilities for Two Countries Will these two countries gain from trade if 100 units of malaria medicine are traded for 200 cotton shirts? To find out: 1. Calculate the opportunity costs of production for each country 2. Determine the comparative advantage for each country 3. Determine if the terms of trade are mutually beneficial 4-28 roduction ossibilities for Two Countries Cotton Shirts (C) Bangladesh 750C = 250M 1C = 1/3M United States 1000C =1000M 1C = 1M Bangladesh has a comparative advantage in Cotton Shirts Malaria Medicine (M) 250M = 750C 1M = 3C 1000M =1000C 1M = 1C 4-29 The United States has a comparative advantage in Malaria Medicine. roduction ossibilities for Two Countries Bangladesh United States TERMS OF TRADE are mutually beneficial if the RELATIVE RICE is between the two country s opportunity costs. Cotton Shirts (C) 750C = 250M 1C = 1/3M 1000C =1000M 1C = 1M The Relative rice of Medicine must be greater than 1 Shirt but less than 3 Shirts. Malaria Medicine (M) 250M = 750C 1M = 3C 1000M =1000C 1M = 1C Conversely, the rice of Cotton Shirts must be greater than 1/3 Medicine but less than 1 Medicine

11 Interdependence and the Gains from Trade Interdependence occurs because people are better off when they specialize and trade. atterns of production and trade are based on differences in opportunity costs. Gains from trade are based on comparative advantage, not absolute advantage. Trade makes everyone better off because it allows people to specialize. The principle of comparative advantage applies to countries as well as people Markets and Competition A market is a group of buyers and sellers of a particular product. A competitive market is one with many buyers and sellers, each has a negligible effect on price. A perfectly competitive market: all goods exactly the same Large numbers of buyers & sellers so that no one can affect market price In this chapter, we assume markets are perfectly competitive. 32 Demand The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises. The reasons for this: Diminishing Marginal Utility Substitution Effect Income Effect 33 11

12 The Demand Schedule Demand schedule: A table that shows the relationship between the price of a good and the quantity demanded. Example: Helen s demand for lattes. Notice that Helen s preferences obey the Law of Demand. rice of lattes uantity of lattes demanded CHATER 4 34 rice of Lattes $6.00 Demand Schedule & Curve uantity of Lattes rice of lattes uantity of lattes demanded Market Demand versus Individual Demand The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price. Suppose Helen and Ken are the only two buyers in the Latte market. ( d = quantity demanded) rice Helen s d Ken s d + 8 = = = = = = = Market d

13 The Market Demand Curve for Lattes $ d (Market) Demand Curve Shifters The demand curve shows how price affects quantity demanded. Non-price determinants of demand are things other than the good s price that effect buyers willingness and ability to purchase a good Changes in them shift the D curve 38 Demand Curve Shifters: Tastes Income More or Less Buyers Expectations particularly future prices Related Goods rices Substitutes same direction Complements opposite direction CHATER

14 Summary: Variables That Affect Demand Variable rice A change in this variable causes a change along the D curve Tastes shifts the D curve Income shifts the D curve More/less buyers shifts the D curve Expectations shifts the D curve Related goods shifts the D curve 40 Supply The quantity supplied of any good is the amount that sellers are willing and able to sell. Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises. The reasons for this: Increasing Costs or - Diminishing Marginal Utility Total Revenue is equal to rice X uantity 41 The Supply Schedule Supply schedule: A table that shows the relationship between the price of a good and the quantity supplied. Example: Starbucks supply of lattes. Notice that Starbucks supply schedule obeys the Law of Supply. rice of lattes uantity of lattes supplied

15 Starbucks Supply Schedule & Curve $ rice of lattes uantity of lattes supplied Market Supply versus Individual Supply The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price. Suppose Starbucks and Jitters are the only two sellers in this market. ( s = quantity supplied) rice Starbucks Jitters + 0 = = = = = = = Market s The Market Supply Curve $ S (Market)

16 Supply Curve Shifters The supply curve shows how price affects quantity supplied. Non-price determinants of supply change businesses willingness and ability to produce products for sale in the market. Changes in Non-price determinants shift the S curve 46 Supply Curve Shifters: Government Subsidies and Taxes Other rofit Opportunities Number of Sellers Investment Costs of roductions wages, interest, rent Expectations particularly future profits Related Goods rices CHATER 4 47 Summary: Variables That Affect Supply Variable rice Government Other rofit Opportunities No. of sellers Investment A change in this variable causes a movement along the S curve shifts the S curve shifts the S curve shifts the S curve shifts the S curve Cost of Resources shifts the S curve Expectations shifts the S curve 48 16

17 Supply and Demand Together $6.00 D S Equilibrium: has reached the level where quantity supplied equals quantity demanded 49 Equilibrium price: The price that equates quantity supplied with quantity demanded $6.00 D S D S $ Equilibrium quantity: The quantity supplied and quantity demanded at the equilibrium price $6.00 D S D S $

18 Surplus: when quantity supplied is greater than quantity demanded $6.00 D Surplus S Example: If = $5, then D = 9 lattes and S = 25 lattes resulting in a surplus of 16 lattes CHATER 4 52 Surplus: when quantity supplied is greater than quantity demanded $6.00 D Surplus S Facing a surplus, sellers try to increase sales by cutting price. This causes D to rise and S to fall which reduces the surplus. CHATER 4 53 Surplus: when quantity supplied is greater than quantity demanded $6.00 D Surplus S Facing a surplus, sellers try to increase sales by cutting price. This causes D to rise and S to fall. rices continue to fall until market reaches equilibrium

19 Shortage: when quantity demanded is greater than quantity supplied $6.00 D Shortage S Example: If = $1, then D = 21 lattes and S = 5 lattes resulting in a shortage of 16 lattes 55 Shortage: when quantity demanded is greater than quantity supplied $6.00 D Shortage S Facing a shortage, sellers raise the price, causing D to fall and S to rise, which reduces the shortage. 56 Shortage: when quantity demanded is greater than quantity supplied $6.00 D S Facing a shortage, sellers raise the price, causing D to fall and S to rise. rices continue to rise until market reaches equilibrium. Shortage

20 Three Steps to Analyzing Changes in Equilibrium To determine the effects of any event, 1. Decide whether event shifts S curve, D curve, or both. 2. Decide in which direction curve shifts. 3. Use supply-demand diagram to see how the shift changes eq m and. A Macroeconomics 58 EXAMLE: The Market for Hybrid Cars price of hybrid cars S 1 1 D quantity of hybrid cars EXAMLE 1: A Change in Demand EVENT TO BE ANALYZED: Increase in price of gas. STE 1: D curve shifts because STE 2: price of gas affects demand for D shifts right hybrids. because SSTE curve 3: high gas price makes does hybrids not shift, The shift because causes price an more attractive of increase relative gas does in price to other not cars. affect and quantity cost of of producing hybrid cars. hybrids S 1 D 1 D

21 EXAMLE 1: A Change in Demand Notice: When rises, producers supply a larger quantity of hybrids, even though the S curve has not shifted. 2 1 S 1 Always be careful to distinguish b/w a shift in a curve and a movement along the curve. 1 2 D 1 D 2 61 Terms for Shift vs. Movement Along Curve Change in supply: a shift in the S curve occurs when a non-price determinant of supply changes (like technology or costs) Change in the quantity supplied: a movement along a fixed S curve occurs when changes Change in demand: a shift in the D curve occurs when a non-price determinant of demand changes (like income or # of buyers) Change in the quantity demanded: a movement along a fixed D curve occurs when changes EXAMLE 2: A Change in Supply EVENT: New technology reduces cost of producing hybrid cars. STE 1: S curve shifts because STE 2: event affects cost of production. S shifts right D because curve does not shift, STE because 3: event reduces cost, production The shift causes makes production technology is price not to more profitable one fall of the at factors and quantity any given that price. affect to rise. demand S 1 D 1 S

22 EXAMLE 3: A Change in Both Supply and Demand EVENTS: price of gas rises AND new technology reduces S 1 S 2 production costs STE 1: Both curves shift. STE 2: Both shift to the right. 2 1 STE 3: rises, but effect on is ambiguous: If demand increases more than supply, rises. 1 2 D 1 D 2 64 EXAMLE 3: A Change in Both Supply and Demand EVENTS: price of gas rises AND new technology reduces S 1 production costs S 2 STE 3, cont. But if supply increases more than demand, falls D 1 2 D 2 CHATER 4 65 CONCLUSION: How rices Allocate Resources One of the Ten rinciples from Chapter 1: Markets are usually a good way to organize economic activity. In market economies, prices adjust to balance supply and demand. These equilibrium prices are the signals that guide economic decisions and thereby allocate scarce resources

23 CHATER SUMMARY A competitive market has many buyers and sellers, each of whom has little or no influence on the market price. Economists use the supply and demand model to analyze competitive markets. The downward-sloping demand curve reflects the Law of Demand, which states that the quantity buyers demand of a good depends negatively on the good s price. 67 CHATER SUMMARY Besides price, demand depends on buyers incomes, tastes, expectations, the prices of substitutes and complements, and # of buyers. If one of these factors changes, the D curve shifts. The upward-sloping supply curve reflects the Law of Supply, which states that the quantity sellers supply depends positively on the good s price. Other determinants of supply include input prices, technology, expectations, and the # of sellers. Changes in these factors shift the S curve. CHATER 4 68 CHATER SUMMARY The intersection of S and D curves determine the market equilibrium. At the equilibrium price, quantity supplied equals quantity demanded. If the market price is above equilibrium, a surplus results, which causes the price to fall. If the market price is below equilibrium, a shortage results, causing the price to rise

24 CHATER SUMMARY We can use the supply-demand diagram to analyze the effects of any event on a market: First, determine whether the event shifts one or both curves. Second, determine the direction of the shifts. Third, compare the new equilibrium to the initial one. In market economies, prices are the signals that guide economic decisions and allocate scarce resources