AP Micro Unit 2 - Supply and Demand

Market

* A system that brings together producers that supply goods and consumers that demand them

Demand

* The desire for a good or service, as well as the willingness and ability to pay for it

Law of Demand

• As the price of a good increases, the quantity demanded decreases

• As the price of a good decreases, the quantity demanded increases

Substitution Effect

* When the price of a good increases, consumers will usually buy less of that good and more of a substitute good that is similar but cheaper

Income Effect

• When the price of a good increases, a consumer’s purchasing power decreases because they can buy less of the good with the same amount of income

  • A consumer will buy less of the good and more of other, cheaper goods to make their income stretch further

• When the price of a good decreases, a consumer’s purchasing power increases as they can now buy more of the good with their same income

Determinants of Demand

• INSECT

• Income

  • changes in consumers’ income

• Number of consumers

  • change in consumer population in the market

• Substitute

  • availability of substitutes

• Expectation

  • expectations about the future

• Complement

  • availability of complements

• Taste

  • changes in tastes and preferences

Supply

* The quantity of a good or service a producer is willing and able to offer for sale at a given price in a given time period

Law of Supply

• As the price of a good increases, the quantity supplied increases

• As the price of a good decreases, the quantity supplied decreases

Determinants of Supply

• Resource costs

  • cost of the resources used to produce

• Taxes and subsidies

  • government actions

• Technology/Productivity

  • advances in technology

• Expectations

  • expectations for future market conditions

• Number of Sellers/Producers

  • number of sellers in the market

Price Elasticity of Demand (PED)

• Measure a consumer’s sensitivity to price changes

• %ΔQd / %ΔP

  • Percent change in Quantity Demanded divided by percent change in Price

• We use absolute value of the PED Coefficient (what we solve for)

Perfectly Inelastic Demand

• Demand coefficient of 0

• Quantity demanded does not change regardless of price changes

• Examples: necessities of food, water, and shelter; insulin, etc.

• Doesn’t realistically exist

Relatively Inelastic Demand

• Demand coefficient between 0 and 1

• Quantity demanded is slightly responsive to price changes

• Examples: gasoline

Unit Elasticity of Demand

• Demand coefficient of 1

• Quantity demanded is exactly proportional to price changes

• Examples: Luxury goods

Relatively Elastic Demand

• Demand coefficient greater 1 but less than infinity

• Quantity demanded is highly responsive to price changes

• Examples: Leisure activities (concerts)

Perfectly Elastic Demand

• Demand coefficient of infinity

• Quantity demanded becomes infinite as the price approaches zero and becomes zero as the price increases

• Examples: product with many substitutes

• Doesn’t realistically exist

Total Revenue

• Measure of the amount of money a business brings in

• TR = P * Q

Total Revenue Test

• Connect TR to price elasticity by defining rules for how TR responds to price changes under certain elasticities

• Elastic Demand

  • When P increases, TR will decrease

  • When P decreases, TR will increase

• Inelastic Demand

  • When P increases, TR will increase

  • When P decreases, TR will decrease

• Unit Elastic Demand

  • Increase or decrease in P will not affect TR

Price Elasticity of Supply (PES)

• Measurement of how responsive firms are to a change of a good or service in the market

• %ΔQs / %ΔP

  • Percent change in Quantity Supplied divided by percent change in Price

• Big factor is time - time to adjust production or retrieve resources

  • Think about short run vs long run

Perfectly Inelastic Supply

• Supply coefficient of 0

• Quantity supplied does not change regardless of price changes

• Examples: monopoly goods

Relatively Inelastic Supply

• Supply coefficient between 0 and 1

• Quantity supplied is not very responsive to price changes

• Examples

  • Supply for a company that has a large fixed cost

Unit Elasticity of Supply

• Supply coefficient of 1

• Quantity supplied is exactly proportional to price changes

Relatively Elastic Supply

• Supply coefficient between 1 and infinity

• Quantity supplied is very responsive to price changes

• Examples

  • Type of supply that a firm can quickly increase production of in response to higher prices

Perfectly Elastic Supply

• Supply coefficient of infinity

• Quantity supplied becomes infinite as the price increases

• Examples

  • Type of supply that has an unlimited number of suppliers (commodities)

Income Elasticity of Demand

• Measure of the sensitivity of quantity demanded to changes in income

• %ΔQd / %ΔI

  • Percent change in Quantity Demanded divided by percent change in Income

• Can show if a good in normal or inferior

Normal Good

• A good that increases in quantity demanded when income increases

  • Higher quality products that, when we have more income, we buy more readily

• Positive Coefficient

Inferior Good

• A good that decreases in quantity demanded when income increases

  • Lower quality products that, when we have more income, we change what we buy

• Negative Coefficient

Sticky Good

• A good that has no change in quantity demanded when income changes

• Coefficient of 0

Cross-Price Elasticity of Demand

• Describes the sensitivity quantity demanded for one good to the price of another good

• Determines if two goods are substitutes or complements or neither

• %ΔQda / %ΔPb

  • Percent change in Quantity Demanded of good A divided by percent change in Price of good B

  • Positive Coefficient - substitutes

  • Negative Coefficient - complements

  • Coefficient of 0 - no relation to each other

Market Equilibrium

• A condition in a market where the quantity supplied equals the quantity demanded at an optimal price level

• Point where everything supplied is consumed

• Where Qd = Qs

• Occurs from voluntary exchange

• This is allocative efficiency

Voluntary Exchange

* The act of consumers and firms are mutually benefitting in the marketplace, as utility and profits are maximized

Consumer Surplus

• The difference between the total amount that consumers are willing and able to pay for a good or service and the total amount they actually pay

• Shaded triangle above the equilibrium price

Individual Consumer Surplus

* Difference between a buyer’s maximum price and what the market price is

Total Consumer Surplus

• All the individual consumer surpluses added together

• Shaded triangle above the equilibrium price

Producer Surplus

• The difference between the total amount firms are willing and able to sell a good or service for and the total amount they actually receive when selling it

• Shaded triangle below the equilibrium price

Individual Producer Surplus

* Difference between a seller’s minimum price and the market equilibrium price

Total Producer Surplus

• All the individual producer surpluses added together

• Shaded triangle below the equilibrium price

Market Disequilibrium

• A state at which the quantity demanded does not equal the quantity supplied

• Usually caused by a price above or below the equilibrium price

• Consumer or Producer surplus will lose out in disequilibrium

Shortage

• Quantity demanded is higher than quantity supplied

• Too many people want a good compared to how many firms are willing to sell it

Surplus

• Quantity supplied is higher than quantity demanded

• Too many firms are willing to sell a good, but not many people want to or are able to purchase it

When there is disequilibrium, in the long run, the market will shift towards…

market equilibrium

Deadweight Loss

• Lost surplus

• Triangle shaded that is not the Consumer Surplus or the Producer Surplus

Double Shift

* Both the supply and demand shift

Government power in microeconomics

• Has power over markets

• Can control prices with price ceilings and price floors

• Can impact the price of goods through excise (aka per-unit) taxes

Price Ceiling

• A price maximum set by the government - firms cannot sell above the price ceiling

• Only effective below the market equilibrium

• Examples:

  • Rent control

Price Floor

• A price minimum set by the government - firms cannot sell below the price floor

• Only effective above market equilibrium

• Examples:

  • Minimum wage

Excise Tax

• AKA per-unit tax

• A tax on every item produced

Lump Sum Tax

• Independent of quantity

• Doesn’t increase in size as quantity increases - it’s a fixed price

Tax Incidence

• Both producers and consumers share part of the excise tax

• Based on elasticity of demand and supply, consumers or producers may carry more of the burden

  • Elasticities are equal - consumers and producers equally pay

  • Demand is more inelastic - consumers pay more

  • Demand is more elastic - consumers pay less

Public Policy

* The laws and regulations that govern economic activity

Quotas

• A government-imposed limit on production levels

• Limits the amount of a particular good that can come into a country from somewhere else

• Trade barrier to protect domestic industries that produce similar goods

Tariffs

• A tax on foreign goods coming into a country

• Effort to reduce the amount of a particular good coming into a country by raising the price of the good