ECO 240 – 2, Price Theory The Basic Decision-Making

Units in the Economy:

Reading :
Firms and Households

SLO Chapter 2
BD Chapter 4
LCR Chapters 4 & 5

Firms and Households
A firm is an organization that
transforms resources into
products. Firms are the primary
producing units in a market
economy.
Households are the consuming
units in an economy.
The Entrepreneur
The entrepreneur is the person
who organizes, manages, and
assumes the risks of a firm,
taking a new idea or a new
product and turning it into a
successful business.

Markets Labour Markets

Product Factor
Labour markets are the input
Product or output markets are markets in which households
the markets in which goods and supply work for wages to firms
services are exchanged. that demand labour.
Input or Factor markets are the
markets in which resources used to
produce products are exchanged.

1
 Capital Markets Land Markets

Capital markets are the

Land markets are the input
input markets in which
markets in which
households supply their
households supply land or
savings, for interest or for
other real property in
claims to future profits, to
exchange for rent.
firms that demand funds in
order to buy capital goods.

The Circular Flow

The Circular Flow
Output
Markets
Supply (Goods & Demand
A circular flow diagram Services)
describes the interaction of House
firms and households in Firms holds
markets for outputs and
inputs. Input Markets:
Labor (wages)
Demand Capital (interest) Supply
Land (rent)

Demand in the Product Determinants of Household

Markets
The quantity demanded represents
the amount of a product that a
household buy in a given time
period at the current market price.
A household’s decision about
what quantity of a product to
demand depends on a number
of factors...
Demand:

PRICE of the product

INCOME available

Amount of accumulated WEALTH

PRICES OF RELATED PRODUCTS

TASTES and PREFERENCES

EXPECTATIONS with respect to future
income, wealth, and prices

2
 The Demand Schedule
A demand schedule is a table
or chart showing how much
of a given product a
household would be willing
to buy at different prices.
The Demand Curve
The demand curve is a graph
illustrating how much of a given
product a household would be
willing to buy at different prices.
Demand curves are usually derived
from demand schedules.

Demand Curve
The Law of Demand
Price
$15.00 There is a negative, or inverse,
relationship between the quantity
of a good demanded and its price.
$10.00
The demand curve is downward
$7.50
sloping / negatively sloped.
Assumption: Other things remain
$3.50 constant
$ .50
01 3 7 25 30
Quantity demanded

Determinants of Household Demand when the Income as a Determinant of

assumption is dropped
Demand
1) Income and Wealth Normal Goods: Goods for

Income: The total of all which demand goes up when
earnings received by a household income rises and for which
in a given period of time demand goes down when

Wealth: The total value of what income falls
a household owns less what it Inferior Goods: Goods for
owes which demand falls when income
rises.

3
 Prices of Other Goods and Services as
Determinants of Demand Other Determinants of
Household Demand:
Substitutes: Goods that serve to
replace for one another; when the • Tastes and Preferences -
price of one increases, demand for These are quite subjective and
the other goes up - Perfect tend to change over time.
substitutes are identical products.
Complements: Goods that “go
• Expectations - With respect to
together”. When the price of one
future income, wealth, prices,
increases, demand for the other
and availability.
goes down.

Demand for Phone Calls - A Change in

Changes in Quantity Demanded vs. Quantity Demanded
Changes in Demand:
Price
Change in quantity
Important Distinction!! $15.00
demanded is caused by a

Changes in quantity demanded imply change in price resulting to
movement along a demand curve other $10.00 movement along a demand
things remain constant. curve.

Changes in demand imply a shift in $7.50
the entire demand curve due to e.g. $3.50
income changes, etc... D
$ .50
01 3 7 25 30
Quantity demanded

Demand for Phone Calls - A Change in Changes in Demand

Demand - Income Changes -

$15.00 A change in demand is Income increases

caused by a change in a P P
demand factor other than
$10.00 price e.g. income, future
expectations, tax policy,
$7.50 etc.. – demand curve shifts

$3.50 D2 D1 D2
D2 D1
$ .50 D1 Q Q
Demand for inferior good Demand for normal good
01 3 7 25 30 shifts left shifts right
Quantity demanded

4
 Changes in Demand From Household to Market
- Prices of Related Goods -
Demand
P Price of
hamburger rises
Demand for a good or service
P
can be defined for an
P
Q
individual household, or for a
Quantity of group of households that
hamburger
demanded falls make up a market.
D1 D2
D2 Q D1
Demand for complement Demand for substitute Q
good (catsup) shifts left good (chicken) shifts right

Deriving market demand from the

Market Demand individual demand curves:
- Defined - P
P
DB DC
$3.50
Market demand represents DA $3.50
the sum of all the quantities $1.50 $1.50
0
of a good or service 0 0
4 8 Qd 3 Qd 4 9 Qd
demanded per period by all Price Market Demand
the households buying in the
$3.50
market for that good or
service. $1.50
0
8 20 Qd

Supply in Output Markets Quantity Supplied

A firm’s decision about The quantity supplied

what quantity of a product represents the number of
to supply depends on a units of a product that a
number of factors... firm would be willing and
able to offer for sale at a
particular price during a
given time period

5
 Factors Determining Firm
Supply:

PRICE of the product

COST of producing the product
- Prices of required inputs
- Technologies used to
produce the product

PRICES of RELATED products
The Law of Supply
There is a positive, or direct,
relationship between the
quantity of a good supplied
and its price. The supply
curve is positively sloped.

The Supply Schedule and

Supply Curve Supply Curve
Price
$4.00 S
A supply schedule is a
table, or chart, showing how
$3.00
much of a product firms will
supply at different prices. $2.25

A supply curve is the graphical $1.75

$1.50
representation of a supply
schedule.
0 10 20 30 40 50
Quantity demanded (1,000s)

Changes in Quantity Supplied A Change in the Quantity Supplied

vs. Changes in Supply: P
S
$4.00
IMPORTANT DISTINCTION ! Change in quantity
supplied from 10 to 20
$3.00 caused by a change in

Changes in quantity price from $1.75 to
supplied imply movement $2.25 $2.25
along a supply curve other $1.75
$1.50
things remain constant.

Changes in supply imply a
0 10 20 30 40 50
shift in the entire supply curve. Quantity demanded (1,000s)

6
 Changes in Quantity Supplied vs.
A Shift in Supply
Changes in Supply:
Price S1
$4.00 P
S2 P S1
S S2

$3.00
Change in supply caused
$2.25 by a change in a supply
factor other than price
$1.75
$1.50
Q Q
An increase in the An increase in
0 10 20 30 40 50
Quantity demanded (1,000s) quantity supplied supply

From Individual Firm to Market Market Supply

Supply
The sum of all the quantities
The supply of a good or of a good or service supplied
service can be defined for per period by all the firms
an individual firm, or for a selling in the market for that
group of firms that make up good ormarket
As with service.
demand, market
a market or an industry. supply is the horizontal
summation of the individual
firms’ supply curves.

From Individual Firm to Market

Supply Market Equilibrium
Firm A’s supply Firm B’s supply
P SA P SB
3.00
An equilibrium is the
3.00

1.75
condition that exists when
1.75
quantity supplied is equal to
10,000 30,000 Q 5,000 10,000 Q quantity demanded.
P SA+B
3.00 At equilibrium, there is no
Market 1.75 tendency for the market price
Supply to change.
Curve 25,000 65,000Q

7
 The market for beans in
Market Equilibrium equilibrium:
P
P S
S

$2.50
E
PE

D D
QE Q Bushels of beans
0 35
(1,000s)

At a price of $1.75 there is Excess

Excess Demand Demand in the bean Market:
P
S
Excess Demand exists
when quantity demanded
exceeds quantity supplied
$2.50
at the current price which is
below the market clearing $1.75
price (EQM price). D
Q
0 25 35 50

At a price of $3.00 there is Excess

Supply in the Bean Market:
Excess Supply
P
S
Excess supply is the
condition that exists when $3.00
quantity supplied exceeds $2.50
quantity demanded at the
current price.
D
0
Q
22 35 40

8
 Changes in Equilibrium Changes in Equilibrium
- Demand Shifts/Supply is Constant - - Supply Shifts/Demand is Constant -

P P S1 S2
S P S P S1
S2

P1
P2 P1 P2
P2 P1
P1 D2 P2 D1 D
D2 D
D1
Q1 Q2 Q Q 2 Q1 Q Q1 Q2 Q Q 2 Q1 Q
Increase in Demand Decrease in Demand Increase in Supply Decrease in Supply

Changes in Equilibrium Changes in Equilibrium

- Supply & Demand both Increase (or Decrease)
- Demand & Supply Move Opposite -
-

P S1 P S2 S1
P S2 P
S2 S1
S1 P1 S2
P2

P
D2 P D1 D2 D1
? ? P1 P2
D1 D1
D2 D2
Q1 Q2 Q Q -? Q
Q2 Q1 Q Q
Q -?
Increase in Demand Decrease in Demand Demand Increases Demand Decreases &
& Supply & Supply & Supply Decreases Supply Increases