Econ 208 Laws & Definitions

Law of Demand

The price of the product and the quantity demanded are related negatively, other things being equal. (As price increases, quantity demanded decreases)

Four Laws of Supply & Demand Shocks

1. A positive demand shock causes an increase in both equilibrium price and equilibrium quantity

2. A negative demand shock causes a decrease in both equilibrium price and equilibrium quantity.

3. A positive supply shock causes a decrease in the equilibrium price and an increase in the equilibrium quantity.

4. A negative supply shock causes an increase in the equilibrium price and a decrease in the equilibrium quantity

Law of Diminishing Marginal Utility

• The utility that any consumer derives from successive units of a particular product is assumed to diminish as total consumption of the product increases

• Marginal utility falls as the level of consumption rises

Quantity Demanded 

The amount of a product that consumers desire to purchase in some time period.

Influences: 

Quantity demanded is influenced

by

• Product’s price

• Prices of other products

• Tastes

• Information

• Income

• Government rules and regulations

• Other factors

Demand

The entire relationship between the quantity demanded and the price of a commodity, other things being equal.

Substitutes

Goods that can be used in place of another good to satisfy similar needs or desires

Complements

Goods that tend to be consumed together

Movements Along the Demand Curve

Changes in quantity demanded caused by a rising/falling price.

Shifts in the Demand Curve

Changes in demand are caused by all factors except the price. Shifts left signal a decrease in demand and shifts right signal an increase.

Factors include:

• income

• taste

• distribution of income

• population

• expectations about the future

Quantity Supplied

The amount of a commodity that producers wish to sell in some time period. 

Supply Curve

Economic hypothesis: the price of the product and the quantity supplied are positively related

Factors that cause movements:

• price of inputs 

• price of other products

Factors that cause shifts: 

• technology

• government taxes or subsidies

• expectations about the future

• number of suppliers

Equilibrium Price

the price at which quantity demanded equals quantity supplied

Disequilibrium

When demand does not equal supply → excess demand/supply

Economic Shocks

Anything other than the price that changes

demand or supply

Elasticity

(% change in Quantity demanded) / (% change in Price)

** Know how to calculate

Price Elasticity of Demand

Demand is elastic when quantity demanded is relatively responsive to a change in the product’s own price.

→ n > 1

Demand is inelastic if quantity demanded is relatively unresponsive to changes in price.

→ n < 1

Demand elasticity tends to be high when there are many close substitutes. The availability of substitutes is determined by:

• how specifically the product is defined

• the length of the time interval (short run vs. long run)

• whether the good is a necessity or a luxury

Availability of Substitutes

• Products with close substitutes tend to have elastic demands

• Products with no close substitutes tend to have inelastic demands.

• Narrowly defined products have more elastic demands than do more broadly defined products

Short-Run and Long-Run

The response to a price change (the measured price elasticity of demand) will tend to be greater the longer the time span.

• A short-run demand curve shows the immediate response of quantity demanded to a change in price.

• A long-run demand curve shows the response of quantity demanded to a change in price after enough time has passed to develop or switch to substitute products

Perfect Elasticity

Horizontal demand curve, elasticity is infinite.

• If the price increases even slightly above p*, demand falls to zero

Perfect Inelasticity

Vertical demand curve, elasticity is zero.

• If the price goes up, the quantity demanded is unchanged (essential goods).

Revenue

Any shock that changes the equilibrium price will affect the industry’s revenue.

• With elastic demand, a higher price reduces revenue.

• With inelastic demand, a higher price increases revenue.

Supply Elasticity

Price elasticity of supply is a measure of the responsiveness of quantity supplied to a change in the product’s own price.

Factors:

• the technical ease of substitution in production

• the nature of production costs

• the time span (short run vs. long run)

Income Elasticity of Demand

n_{y =} (% change in quantity demanded) /

(% change in income)

If n_y > 0, the good is said to be normal.

If n_y < 0, the good is said to be inferior.

Normal Goods

If income elasticity is positive but less than one, demand is income inelastic.

If income elasticity is positive and greater than one, demand is income elastic.

Inferior Goods

Inferior goods have a negative income

elasticity because an increase in income

leads to a reduction in quantity demanded

Cross Elasticity of Demand

n_xy = (% change in quantity demanded of good x) / (% change in price of good y)

• If n_xy > 0, then X and Y are substitutes.

• If n_xy < 0, then X and Y are complements

Price Floor

The minimum permissible price set by the

government for a particular good or service.

Ex: minimum wage

• set below equilibrium: no effect

• set above equilibrium: raise the price and lead to excess supply (surplus)

Price Ceilings

The maximum price at which a certain good or service can be exchanged.

Ex: rent controls

• set below equilibrium: lower the price and lead to excess demand (shortage)

• set above equilibrium: no effect

Budget constraint (budget line):

The bundles of goods that can be bought if the entire budget is spent on those goods at given prices.

B = (Y/P_B) - (P_Z/P_B)Z

• Slope of the Budget line: change is B / change in Z

Bundle of goods:

• a list of quantities of different goods

Opportunity set:

• all the consumption bundles the consumer can afford.

Preferences

How a consumer ranks any two bundles of goods.

Three Assumptions

1. Completeness → can rank any 2 bundles 

2. Transitivity → preferences over bundles are consistent

3. More is Better

Utility

A set of numerical values that reflect the relative rankings of various bundles of goods.

• Ordinal utility: ranking bundles comparatively 

• Cardinal utility: countable/measurable utility 

• Total utility: the total satisfaction resulting from the consumption of a given commodity by a consume

• Marginal utility: the additional satisfaction obtained by a consumer from consuming one additional unit of a commodity.

Utility Maximizing

The utility obtained from the last dollar spent on each product is equal. 

When MU_x/MU_y = P_x/P_y

Substitution Effect

The change in the quantity of a good that a consumer demands when the good’s price changes

• The substitution effect increases the quantity demanded of a good whose (relative) price has fallen and reduces the quantity demanded of a good whose (relative) price has increased.

Income Effect

The change in the quantity of a good a consumer demands because of a change in income

• For a normal good, consumers buy more of a product that has fallen in price.

• For an inferior good, consumers buy fewer units when its price falls.

Income and Substitution Effects with an Inferior Good

If a good is inferior, the income effect and the substitution effect move in opposite directions.