AP econ unit 2

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Demand

Relationship between price levels and quantities consumers are willing and able to buy

Law of demand

As price decreases quantity demanded increases (and vice versa) assuming ceteris paribus

Requirements for demand

Consumer must be willing able and wanting to buy

Quantity demanded

Specific amount demanded at a particular price (a point on the curve)

Demand curve

Downward-sloping curve showing inverse relationship between price and quantity demanded

Market demand

Total demand from all consumers in a market

Change in demand

Shift of the entire curve caused by consumer based non-price factors

Change in quantity demanded

Movement along the curve caused by price change only

Substitution effect

When the price of a good rises consumers switch to substitutes

Income effect

When prices fall consumers’ purchasing power rises increasing quantity demanded

Law of diminishing marginal utility

Additional satisfaction decreases with each additional unit consumed

Determinants of demand

Factors that cause the demand curve to shift

Price of related goods

Changes in prices of substitutes or complements affect demand

Substitute goods

Goods used in place of one another—if price of A rises demand for B increases

Complement goods

Goods used together—if price of A rises demand for B decreases

Change in income

Increased income raises demand for normal goods and reduces demand for inferior goods

Normal goods

Goods for which demand increases as income rises

Inferior goods

Goods for which demand decreases as income rises

Consumer tastes and preferences

Trends or cultural shifts that change consumer desire for goods

Consumer expectations

Future expectations of price or income affecting current demand

Number of consumers

More consumers in market increases overall demand

Supply

Relationship between price levels and quantities producers are willing and able to sell

Law of supply

As price increases quantity supplied increases (and vice versa) assuming ceteris paribus

Quantity supplied

Specific quantity offered at a particular price (a point on the curve)

Supply curve

Upward-sloping curve showing positive relationship between price and quantity supplied

Change in supply

Shift of the entire curve due to producer based non-price factors

Change in quantity supplied

Movement along the curve caused by price change only

Determinants of supply

Factors that cause shifts in supply

Technology improvement

Increases productivity → shifts supply right

Input or capital costs

If production costs increase → supply shifts left

Seller expectations

Expectations about future market conditions shift supply

Government action

Taxes decrease supply subsidies increase supply

Number of suppliers

More sellers increase total supply

Prices of other goods

If another product becomes more profitable supply of current good decreases

Ceteris paribus

Assumption that all other variables are held constant while one changes

Subsidy

Government payment to producers to encourage production

Excise tax

Tax on production or sale that decreases supply

Market equilibrium

Point where quantity demanded equals quantity supplied

Equilibrium price (market clearing price)

Price where supply and demand intersect

Surplus

Quantity supplied exceeds quantity demanded at a given price (price too high)

Shortage

Quantity demanded exceeds quantity supplied at a given price (price too low)

Disequilibrium

Any price where quantity demanded ≠ quantity supplied

Market forces

Automatic adjustments that push prices toward equilibrium

Increase in demand

Shifts demand curve right → higher equilibrium price and quantity

Decrease in demand

Shifts demand curve left → lower equilibrium price and quantity

Increase in supply

Shifts supply curve right → lower equilibrium price higher quantity

Decrease in supply

Shifts supply curve left → higher equilibrium price lower quantity

Double shifters

When both curves shift one variable (price or quantity) is indeterminate

Indeterminate outcome

When both demand and supply shift and direction of one variable cannot be determined without more data

Increase in demand & increase in supply

Price indeterminate quantity increases

Increase in demand & decrease in supply

Price increases quantity indeterminate

Decrease in demand & increase in supply

Price decreases quantity indeterminate

Decrease in demand & decrease in supply

Price indeterminate quantity decreases

Elasticity

How sensitive a quantity is to a change in price

Law of Demand says that

Consumers will buy more as price goes down and less as it goes up

Price Elasticity of Demand (Ed)

% change in quantity demanded ÷ % change in price

Meaning of Price Elasticity of Demand

A measure of consumer responsiveness to a change in price

Inelastic Demand

Quantity demanded is insensitive to price changes

Characteristics of Inelastic Demand

Few substitutes

Elastic Demand

Quantity demanded is sensitive to price changes

Characteristics of Elastic Demand

Many substitutes

Elasticity Coefficient < 1

Inelastic demand

Elasticity Coefficient > 1

Elastic demand

Elasticity Coefficient = 1

Unit elastic

Perfectly Inelastic Demand

Elasticity = 0

Perfectly Elastic Demand

Elasticity = ∞

Relatively Inelastic

Elasticity less than 1

Relatively Elastic

Elasticity greater than 1

Determinants of Elasticity

Availability of substitutes

Total Revenue Test

Shows how changes in price affect total revenue

Inelastic (Revenue Test)

Price increase causes total revenue to increase

Elastic (Revenue Test)

Price increase causes total revenue to decrease

Unit Elastic (Revenue Test)

Price changes but total revenue remains constant

Cross-Price Elasticity of Demand (Exy)

% change in quantity of X ÷ % change in price of Y

Positive Cross-Price Elasticity

Goods are substitutes

Negative Cross-Price Elasticity

Goods are complements

Income Elasticity of Demand (Ei)

% change in quantity ÷ % change in income

Positive Income Elasticity

Normal goods

Negative Income Elasticity

Inferior goods

Ei > 1

Luxury goods

0 < Ei

Normal goods

Ei = 0

Unrelated goods

Ei < 0

Inferior goods

Price Elasticity of Supply (Es)

% change in quantity supplied ÷ % change in price

Meaning of Price Elasticity of Supply

Shows how sensitive producers are to price changes

Inelastic Supply

Producers cannot easily change production

Elastic Supply

Producers can easily change production

Determinants of Es

Time

Inelastic vs Elastic Supply Table

Inelastic = hard to produce

Elastic = easy to produce

low cost inputs

Price Control

A legal restriction on how high or low a market price may go

Price Ceiling

Maximum price sellers can charge (below equilibrium)

Goal of Price Ceiling

Helps consumers by keeping prices affordable

Effect of Price Ceiling

Creates shortage (Qd > Qs)

Inefficiencies from Price Ceiling

Inefficient allocation

Price Floor

Minimum price buyers must pay (above equilibrium)

Goal of Price Floor

Helps sellers by keeping prices high

Effect of Price Floor

Creates surplus (Qs > Qd)

Common Price Floor Examples

Minimum wage and farm price supports

Inefficiencies from Price Floor

Wasted resources