ap economics: module 46 terms

the law of demand

explains the downward sloping demand curve; inverse relationship between price and quantity demanded of a good

the law of demand in terms of opportunity costs

as the price of good 1 falls, people don’t have to give up as much of good 2 to buy one more unit of good 1 (lower opportunity cost). it becomes more attractive to buy good 1, causing quantity demanded to increase.

substitution effect

of a change in the price of a good, is the change in the quantity of that good demanded as the consumer substitutes the good that has become relatively cheaper for the good that has become relatively more expensive

if a good absorbs a small amount of the consumer’s income, the _____ explains the demand curve’s slope

substitution effect

if a good accounts of a large share of the consumer’s income, the _______ explain the demand curve’s slope

substitution and income effects

real income

income that’s adjusted to reflect its true purchasing power

• changes in real income → substitution and income effects

money/nominal income

income that isn’t adjusted to reflect its true purchasing power

income effect

of a change in the price of a good, is the change in the quantity of that good demanded that results from a change in the consumer’s purchasing power when the price of the good changes

2 things to know about the distinction between the substitution and income effects

1. income effect → unimportant for a majority of g/s (doesn’t change consumption); most market demand curves are downward sloping solely due to the substitution effect

2. whenever the income effect matters, it usually reinforces the substitution effect

how income effect reinforces substitution effect

when price goes up for a good that takes up a large part of income, consumers of that good become poorer due to a lower PP → for all NORMAL goods, that decrease in real income leads to a decrease in QD, reinforcing the substitution effect that would have already occurred w/ an increase in price

normal goods

demand and income are positively related

inferior goods

cheaper/knockoffs, demand and income are negatively related

t or f: for inferior goods, the income effect reinforces the substitution effect

f: doesn’t reinforce it, the two effects work in opposite directions for inferior goods

• substitution: price increase → QD decrease

• income: price increase → real income decrease → QD increase for inferior goods

t or f: the substitution effect works in the same direction for normal and inferior goods

t

total effect of a change in price

combination of income and substitution effects

Giffen goods

goods that are so inferior that an increase in price leads to an increase in quantity demanded

• income effect exceeds the substitution effect

• upward sloping demand curve (goes against LOD)

• little/no substitutes, usually can be addictive

in general the income effect is (greater/smaller) than the substitution effect

smaller (increase in price will almost always decrease Qd)

elasticity

used to measure the responsiveness of one variable to changes in the other

price elasticity of demand

measures the responsiveness of Qd to changes in price; the ratio of the % change in Qd to the % change in price

• Ed = %ΔQd/%ΔP

• drop the negative sign at the end → we use absolute values for this elasticity (negative is implied due to law of demand)

how to calculate the percent change of a variable (X)

%ΔX = 100 * ((New value of X - Old value of X)/Old value)

• new minus old over old → N-OOO

as Ed increases, responsiveness of Qd ____

increases

• elastic demand: high Ed, responsive

• inelastic demand: low Ed, less responsive

arc/midpoint method

a technique for calculating the % change by dividing the change in a variable by the average/midpoint of the initial and final values of that variable

• %ΔX = 100 * ((New X - Old X)/avg. of X)

• avg. of X = (initial X + final X)/2

reasons why demand slopes downward

1. law of demand

2. law of diminishing marginal utility

law of diminishing marginal utility

explains the downward sloping demand curve; as you consumer more of a product, you get less utility out of it

2 effects that explain the law of demand

1. substitution effect

2. income effect