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