Transcript Principles of Microeconomics
Perfectly Competitive Supply: The Cost Side of The Market
Introductory Microeconomics
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Example 6.1. How should Leroy divide his time between… …picking apples… …and writing pulp fiction?
Note: Pulp magazines (or pulp fiction; often referred to as “the pulps”) were inexpensive fiction magazines. They were widely published from the 1920s through the 1950s. The term pulp fiction can also refer to mass market paperbacks since the 1950s. (from Wikipedia )
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Example 6.1. How should Leroy divide his time between…
A men's magazine will pay Leroy 10 cents per word to write fiction articles. He must decide how to divide his time between writing fiction, which he can do at a constant rate of 200 words per hour, and harvesting apples from the trees growing on his land, a task only he can perform. His return from harvesting apples depends on both the price of apples and the quantity of apples he harvests.
For each hour Leroy spends picking apples, he loses the $20 he could have earned writing pulp fiction. He should thus spend an additional hour picking as long as he will add at least $20 worth of apples to his total harvest.
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Example 6.1. How should Leroy divide his time between…
Earnings aside, Leroy is indifferent between the two tasks. The amount of apples he can harvest depends on the number of hours he devotes to this activity: Hours 1 2 3 4 5 Total bushels 8 12 15 17 18 Additional bushels 8 4 3 2 1
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Example 6.1. How should Leroy divide his time between…
For example, if apples sell for $2.50 per bushel: Hours Total bushels 1 2 3 4 5 8 12 15 17 18 Additional bushels 8 4 3 2 1 $ for the additional hour 20 = 8x2.5
10 = 4x2.5
7.5 = 3x2.5
5 = 2x2.5
2.5 = 1x2.5
Leroy would earn $20 for the first hour he spent picking apples, but would earn only an additional $10 if he spent a second hour. Leroy will devote only the first hour to picking apples. That is, a total of 8 apples.
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Example 6.1. How should Leroy divide his time between…
If the price of apples then rose to $5 per bushel: Hours Total bushels 1 2 3 4 5 8 12 15 17 18 Additional bushels 2 1 8 4 3 $ for the additional hour 40 = 8x5 20 = 4x5 15 = 3x5 10 = 2x5 5 = 1x5 It would pay Leroy to devote a second hour to picking, which would mean a total of 12 bushels of apples.
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Example 6.1. How should Leroy divide his time between…
Once the price of apples reached $6.67 per bushel Hours Total bushels 1 2 3 4 5 8 12 15 17 18 Additional bushels 2 1 8 4 3 $ for the additional hour 53.36 = 8x6.67
26.68 = 4x6.67
20.00 = 3x6.67
13.34 = 2x6.67
6.67 = 1x6.67
Leroy would devote a third hour to picking apples, for a total of 15 bushels.
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Example 6.1. How should Leroy divide his time between…
If the price rose to $10 per bushel Hours Total bushels 1 2 3 4 5 8 12 15 17 18 Additional bushels 2 1 8 4 3 $ for the additional hour 80 = 8x10 40 = 4x10 30 = 3x10 20 = 2x10 10 = 1x10 Leroy would devote a fourth hour to picking apples, for a total of 17 bushels.
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Example 6.1. How should Leroy divide his time between…
If the price rose to $20 per bushel Hours Total bushels 1 2 3 4 5 8 12 15 17 18 Additional bushels 2 1 8 4 3 $ for the additional hour 160 = 8x20 80 = 4x20 60 = 3x20 40 = 2x20 20 = 1x20 Leroy would devote a fifth hour to picking apples, for a total of 18 bushels.
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Example 6.1. How should Leroy divide his time between…
Leroy's individual supply curve for apples relates the amount of apples he is willing to supply at various prices.
P ($/bu) 20.00
Leroy's supply curve for apples 10.00
6.67
5.00
2.50
8 12 15 17 18 Q (bu/day)
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Example 6.1. How should Leroy divide his time between…
Marginal cost can be computed: Hours 1 2 3 4 5 Total bushels 8 12 15 17 18 Additional bushels 8 4 3 2 1 Marginal cost (of an additional bushel) $2.5=$20/8 5=20/4 6.67=20/3 10=20/2 20=20/1 The perfectly competitive firm’s supply curve is its marginal cost curve.
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Market Supply The quantity that corresponds to any given price on the market supply curve is the sum of the quantities supplied at that price by all individual sellers in the market.
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Example 6.2.
If the supply side of the apple market just like Leroy, what would the market supply curve for apples look like?
P ($/bu) 20.00
consisted of 100 suppliers Market supply curve for apples 10.00
6.67
5.00
2.50
8 12 15 17 18 Q (100s of bu/day)
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Reasons for upward sloping supply
1.
2.
The Fruit Picker's Rule
(Always pick the low-hanging fruit first). When fruit prices are low, it might pay to harvest the low hanging fruit but not the fruit growing higher up the tree, which takes more effort to get to. But if fruit prices rise sufficiently, it will pay to harvest not only the low-hanging fruit, but also the fruit on higher branches.
Differences among suppliers in opportunity cost
People facing unattractive employment opportunities in other occupations may be willing to pick apples even when the price of apples is low. Those with more attractive options will pick apples only if the price of apples is relatively high.
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Supply and opportunity cost At what price would Andy Lau worth his while to pick apples?
consider it
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Profit-Maximizing Firms and Perfectly Competitive Markets Definition. The
profit
earned by a firm is the total revenue it receives from the sale of its product minus all costs—explicit and implicit—incurred in producing it.
Definition. A
profit-maximizing firm
primary goal is to maximize the difference between its total revenues and total costs.
is one whose Definition. A
perfectly competitive market
in which no individual supplier has significant influence on the market price of the product.
is one
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Profit-Maximizing Firms and Perfectly Competitive Markets Definition. A
price taker
is a firm that has no influence over the price at which it sells its product.
Laundry Art reproduction
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Price setters Microsoft operating systems Intel microprocessors
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Price setter vs. price taker Generic USB MP3 player: price taker Apple iPod: Price setter
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Factor of production Definition. A
factor of production
in the production of a good or service.
is an input used
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Fixed factor of production Definition. A
fixed factor of production
is an input whose quantity cannot be altered in the short run.
Example: Transmission tower for a student radio station.
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Variable factor of production Definition. A
variable factor of production
is an input whose quantity can be altered in the short run.
Example: Music library for a student radio station.
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Example 6.3. Louisville Slugger uses two inputs: labor (e.g., woodworkers)… and capital (e.g., lathes, tools, buildings) A lathe is a tool which spins a block of material to perform various operations such as cutting, sanding, knurling, or deformation with tools that are applied to the workpiece to create an object which has symmetry about an axis of rotation. … to transform raw materials (e.g., lumber) …into finished output (baseball bats).
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The short-run production function Total number of employees per day 0 1 2 6 7 3 4 5 Total number of bats per day 0 40 100 130 150 165 175 181 Note that output gains begin to diminish with the third employee. Economists refer to this pattern as the
law of diminishing returns
, and it always refers to situations in which at least some factors of production are fixed.
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Some Important Cost Concepts Suppose the lease payment for the Louisville Slugger’s lathe and factory is $80 per day. This payment is both a
fixed cost
(since it does not depend on the number of bats per day the firm makes) and, for the duration of the lease, a
sunk cost
. FC = rK
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Some Important Cost Concepts The company’s payment to its employees is called
variable cost
, because unlike fixed cost, it varies with the number of bats the company produces. VC = wL
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Some Important Cost Concepts The firm’s
total cost
costs: is the sum of its fixed and variable Total cost = Fixed Cost + Variable Cost TC = FC + VC TC = rK + wL
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Some Important Cost Concepts The firm’s
marginal cost
is the change in total cost divided by the corresponding change in output. MC = D TC/ D Q MC = D VC/ D Q
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Example 6.4.
If Louisville slugger pays a fixed cost of $80 per day, and to each employee a wage of $24/day, calculate the company’s output, variable cost, total cost and marginal cost for each level of employment.
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Example 6.4.
Employees per day 0 1 2 3 4 5 6 7 Bats per day 0 40 100 130 150 165 175 181 Fixed Cost ($ per day) 80 80 80 80 80 80 80 80 Variable Cost ($/day) 0 24 48 72 96 120 144 168 Total Cost ($/day) 80 104 128 152 176 200 224 248 Marginal Cost ($/bat) 0.6
0.4
0.8
1.2
1.6
2.4
4.0
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Choosing Output to Maximize Profit If a company’s goal is to maximize its profit, it should continue to expand its output as long as the marginal benefit from expanding is at least as great as the marginal cost.
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Example 6.5.
Suppose the wholesale price of each bat (net of lumber and other materials costs) is $2.50. How many bats should Louisville Slugger produce?
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Example 6.5.
If we compare this marginal benefit ($2.50 per bat) with the marginal cost entries shown in table, we see that the firm should keep expanding until it reaches 175 bats per day (6 employees per day).
Employees per day 0 6 7 1 2 3 4 5 Bats per day 0 40 100 130 150 165 175 181 Fixed Cost ($ per day) 80 80 80 80 80 80 80 80 Variable Cost ($/day) 0 24 48 72 96 120 144 168 Total Cost ($/day) 80 104 128 152 176 200 224 248 Marginal Cost ($/bat) 0.6
0.4
0.8
1.2
1.6
2.4
4.0
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Example 6.5.
To confirm that the cost-benefit principle thus applied identifies the profit-maximizing number of bottles to produce, we can calculate profit levels directly: Employees per day 0 1 2 3 4 5 6 7 Output (bats/day) 0 40 100 130 150 165 175 181 Total revenue ($/day) 0 100 250 325 375 412.50
437.50
452.50
Total cost ($/day) 80 104 128 152 176 200 224 248 Profit ($/day) -80 -4 122 173 199 212.50
213.50
204.50
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Choosing Output to Maximize Profit When the law of diminishing returns applies (that is, when some factors of production are fixed), marginal cost goes up as the firm expands production beyond some point.
Under these circumstances, the firm's best option is to keep expanding output as long as marginal cost is less than price.
The profit maximizing output level for the perfectly competitive firm: P = MC
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Note on Example 6.5. Note in Example 6.5 that if the company's fixed cost had been any more than $293.50 per day (say, 300), it would have made a loss at every possible level of output.
Employees per day 0 1 2 3 6 7 4 5 Output (bats/day) 0 40 100 130 150 165 175 181 Total revenue ($/day) 0 100 250 325 375 412.50
437.50
452.50
Total cost ($/day) 300 324 348 372 396 420 444 468 Profit ($/day) -300 -224 -98 -47 -21 -7.5
-6.5
-15.6
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Note on Example 6.5. As long as it still had to pay its fixed cost, however, its best bet would have been to continue producing 175 bats per day, because a smaller loss is better than a larger one.
If a firm in that situation expected conditions to remain the same, it would want to get out of the bat business as soon as its equipment lease expired.
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A Note on the Firm’s Shut-Down Condition It might seem that a firm that can sell as much output as it wishes at a constant market price would always best in the short run by producing and selling the output level for which price equals marginal cost.
do But there are exceptions to this rule.
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A Note on the Firm’s Shut-Down Condition Suppose, for example, that the market price of the firm’s product falls so low that its revenue from sales is smaller than its variable cost at all possible levels of output.
The firm should then cease production for the time being.
By shutting down, it will suffer a loss equal to its fixed costs. But by remaining open, it would suffer an even larger loss.
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A Note on the Firm’s Shut-Down Condition P = market price of the product Q = number of units produced and sold PxQ = total revenue from sales Shutdown rule: Cease production if PxQ is less than VC for every level of Q.
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Average Variable Cost and Average Total Cost Suppose that the firm is unable to cover its variable cost at any level of output—that is, suppose that PxQ < VC for all levels of Q.
Then P < VC/Q for all levels of Q, since we obtain the second inequality by simply dividing both sides of the first one by Q.
The firm’s short-run shut-down condition may thus be restated a second way: Discontinue operations in the short run if the product price is less than the minimum value of its average variable cost (AVC).
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Short-run shut-down condition (alternate version):
P < minimum value of AVC
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Profitability
Average total cost:
ATC = TC/Q. Profit = total revenue – total cost = PxQ – ATCxQ = (P – ATC) Q A firm can be profitable only if the price of its product price (P) exceeds its ATC.
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A Graphical Approach to Profit-Maximization For Louisville Slugger, we have Employe es per day 0 1 2 3 4 5 6 7 Bats per day 0 40 100 130 150 165 175 181 Variable Cost ($/day) 0 24 48 72 96 120 144 168 Avg Variable Cost ($/day) 0 0.6
0.48
0.554
0.64
0.727
0.823
0.927
Total Cost ($/day) 80 104 128 152 176 200 224 248 Avg Total Cost ($/bat) Marginal Cost ($/bat) 2.6
1.28
1.169
1.173
1.21
1.28
1.37
0.6
0.4
0.8
1.2
1.6
2.4
4.0
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A Graphical Approach to Profit-Maximization Properties of the cost curves: The upward sloping portion of the marginal cost curve (MC) corresponds to the region of diminishing returns.
The marginal cost curve must intersect both the average variable cost curve (AVC) and the average total cost curve (ATC) at their respective minimum points.
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Price = Marginal Cost: The Maximum-Profit Condition In earlier examples, we implicitly assumed that the firm could employ workers only in whole number amounts.
Under these conditions, we saw that the profit maximizing output level was one for which marginal cost was somewhat less than price (because adding yet another employee would have pushed marginal cost higher than price).
But when output and employment can be varied continuously, the maximum-profit condition is that price be equal to marginal cost.
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Example 6.6.
For the bat-maker whose cost curves are shown in the next slide, find the profit-maximizing output level if bats sell for $0.80 each. How much profit will this firm earn? What is the lowest price at which this firm would continue to operate in the short run?
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$/bat 1.40
1.32
1.20
1.00
0.80
0.60
0.48
0.40
0.28
Example 6.6.
80 100 130 150
MC ATC AVC
Price Bats/day The cost-benefit principle tells us that this firm should continue to expand as long as price is at least as great as marginal cost.
If the firm follows this rule it will produce 130 bats per day, the quantity at which price and marginal cost are equal.
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$/bat 1.40
1.32
1.20
1.00
MB 0.80
0.60
MC 0.48
0.40
0.28
Example 6.6.
80 100 130 150
MC ATC AVC
Price Bats/day Suppose that the firm had sold some amount less than 130—say, only 100 bats per day. Its benefit from expanding output by one bat would then be the bat's market price, 80 cents. The cost of expanding output by one bat is equal (by definition) to the firm’s marginal cost, which at 100 bats per day is only 40 cents.
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$/bat 1.40
1.32
1.20
1.00
MB 0.80
0.60
MC 0.48
0.40
0.28
Example 6.6.
80 100 130 150
MC ATC AVC
Price Bats/day So by selling the 101st bat for 80 cents and producing it for an extra cost of only 40 cents, the firm will increase its profit by 80 – 40 = 40 cents per day.
In a similar way, we can show that for any quantity less than the level at which price equals marginal cost, the seller can boost profit by expanding production.
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$/bat MC 1.40
1.32
1.20
1.00
MB 0.80
0.60
0.48
0.40
0.28
Example 6.6.
80 100 130 150
MC ATC AVC
Price Bats/day Conversely, suppose that the firm were currently selling more than 130 bats per day—say, 150— at a price of 80 cents each.
Marginal cost at an output of 150 is 1.32 per bat. If the firm then contracted its output by one bat per day, it would cut its costs by 1.32 cents while losing only 80 cents in revenue. As a result, its profit would grow by 52 cents per day.
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Example 6.6.
The same arguments can be made regarding any quantities that differ from 130. Thus, if the firm were selling fewer than 130 bats per day, it could earn more profit by expanding; and that if it were selling more than 130, it could earn more by contracting. So at a market price of 80 cents per bat, the seller maximizes its profit by selling 130 units per week, the quantity for which price and marginal cost are exactly the same.
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Example 6.6.
Total revenue = PxQ = ($0.80/bat)x(130 bats/day) = $104 per day. Total cost = ATCxQ = $0.48/bat x 130 bats/day = $62.40/day So the firm’s profit is $41.60/day.
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Example 6.6.
Profit is equal to (P – ATC)xQ, which is equal to the area of the shaded rectangle.
$/bat
MC ATC AVC
0.80
0.48
Profit = $41.60/day Price Bats/day 130
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Example: The Holiday Store at Tung Lung Island Why does the store open only on holidays?
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SUPPLY AND PRODUCER SURPLUS The economic surplus received by a buyer is called consumer surplus. The analogous construct for a seller is producer surplus, the difference between the price a seller actually receives for the product and the lowest price for which she would have been willing to sell it (her reservation price, which in general will be her marginal cost).
Producer surplus sometimes refers to the surplus received by a single seller in a transaction, sometimes to the total surplus received by all sellers in a market or collection of markets.
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Example 6.7. Calculating Producer Surplus How much do sellers benefit from their participation in the market for cashews?
Price ($/lb) 12 10 8 6 4 2 0 2 4 6 8 S 12 16 20 D 24 Quantity (1000s of lbs/day)
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Example 6.7. Calculating Producer Surplus For all cashews sold up to 8,000 pounds per day, sellers receive a surplus equal to the difference between the market price of $8 per pound and their reservation price as given by the supply curve.
Total producer surplus received by buyers in the cashew market is the area of the shaded triangle between the supply curve and the market price Price ($/lb) 12 10 8 6 4 2 0 2 4 6 8 S 12 PS= (1/2)(8,000 lbs/day)x($8/lb) = $32,000/day 16 20 D 24 Quantity (1000s of lbs/day)
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Producer surplus Producer surplus is the highest price sellers would pay, in the aggregate, for the right to continue participating in the cashew market.
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Supply is all about marginal cost.
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Does demand ever affect supply?
P S D Q
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Example 6.8.
Is the cost of a ticket to the NBA finals so high because the salaries of NBA players (such as YAO Ming) is so high?
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Example 6.8.
Partly. But then why are the wages of NBA players so high? Because so many people are willing to pay so much to be able to watch them.
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Example 6.8.
But a starving person would be willing to pay even more for food than for watching an NBA game. Food is cheap and NBA games are expensive because many people can produce food, but only few have the skills to play in the NBA.
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Shaquille O’Neal: NBA star extraordinaire. Earnings from basketball-related activities during last championship season: $25,000,000.
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Does demand ever affect supply?
Supply depends on costs and costs always depend on demand. In many (perhaps most) cases the prices of the inputs required to produce a product will not be much affected by the demand for that product.
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Does demand ever affect supply?
The demand for bicycles will have no significant effect on the price of steel, an input for making bicycles, because the steel used in making bicycles is only a tiny fraction of the total amount of steel sold.
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Does demand ever affect supply?
So for most markets, we can assume that a shift in the demand curve will not lead to a shift in the supply curve. Assume this independence, unless otherwise stated.
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