AP Micro - Unit 2

law of demand

• inverse relationship exists between price and quantity demanded

• as price decreases, quantity demanded increases

demand curve

• downward slope labeled D on Price v. Quantity plot

• why?

  • Diminishing marginal utility

  • income effect (consumers aware of % that good is of their income)

  • substitution effect (consumers will find alternative if price is not ideal)

• Market demand

  • horizontal sum of individual demands

what if demand increases/decreases?

vs

what if quantity demanded inc/dec?

• demand curve shifts right/left respectively

• if quant. demand. inc or dec, there is a move along the curve

determinants of demand (what causes right/left shifts)

• TRIBE

• Tastes/preferences (of consumers)

• Price of related goods

  • substitutes (inc. in pepsi price drives inc. demand for coke)

  • complements (dec. in hot dog price drives inc. in quantity demanded for hot dog which in turn drives inc. in demand for buns)

  • unrelated goods (one price change does not affect the other)

• Income

  • Normal good (superior goods, as income increases demand increases)

  • Inferior goods (as income increases demand decreases)(ex. Spam, Thrift clothes)

• Number of Buyers (population)

• Expectations (pregnancy drives demand for baby products)

law of supply

• a direct relationship exists between price and quantity supplied

• as price increases, quantity supplied increases (to capitalize on that higher price)

supply curve

• upward trend labeled S on a price v. quantity plot

increase in supply v. quantity-supplied

• in supply: shift left/right

• in quant. supp.: move along the curve

Determinants of supply

• ROTTEN

• Resource Prices

  • price of resources dec. leads to increase in supply

• Price of other goods

  • price of good 1 inc. leads to quantity supp. of good 1 to inc., and the shift in resources needed to accomplish that leads to decrease in supply of good 2

• Technology

  • more tech = more supply

• Taxes and subsidies

  • more taxes = less supply

  • subsidy = more supply

• Expectations

• Number of Sellers

price elasticity of demand

• how much more or less will consumers buy a good as price changes

• measures responsiveness to price changes

• % change in quantity demanded / % change in price = Ed

• where in both % change values should be absolute value

price elasticity of demand is…

• inelastic from 0 to 1

  • necessities like insulin, changing price won’t really change quantity demanded

• elastic from 1 to infinity

  • luxuries

• unit elastic at 1

  • quantity change = price change, a 10% inc or dec will lead to a 10% inc or dec in the other

  • businesses could opt to switch to a more inelastic good to allow for price raises and more revenue

two extreme cases in price elasticity of demand

• vertical line = perfect inelastic demand, consumers willing to pay anything

• horizontal line = perfect elastic demand, consumers will only purchase at one specific price, will stop buying entirely if price changes

determinants of price elasticity of demand

• Need v. Want

• Substitutability

  • More subs = more elastic

• Percentage of income

  • higher % = more elastic

• Time

  • more time = more elastic

  • If an executive only has so many days to book a flight to Paris, will be willing to pay more for it (more inelastic due to less time)

total revenue

• Price * Quantity = TR

• TR - Total Cost = Profit

• TR = consumer expenditure (synonyms)

Total Revenue Test for Elasticity

• based on quant. demanded v. TR parabola (right of vertex = inelastic and left of it = elastic, vertex = unit elastic)

• If price and TR move together, inelastic demand

• if quantity and TR move together, elastic demand

• if TR doesn’t move, unit elastic

price elasticity of supply

• Es = % change in quant. supplied / % change in price

• measures how much quantity supplied can change in response to a price change

determinants of price elasticity of supply

• Input Substitutability

  • More subs (more ways and means of producing a good) = more elastic, more can be supplied after a price increase

  • ex, if the price of oil increases, my company only has one source of it, so I can’t just switch to a source that’s easier to extract or cheaper to produce, quantity supplied cannot increase that much

• Time

  • Less time = inelastic

  • ex, less time means less strategizing, must use expensive resources available

cross-price elasticity of demand

Exy = % change in quantity demanded of X / % change in price of Y

• Tests whether goods are related or not

• positive = goods are substitutes (magnitude = more/less sub.)

• negative = goods are complementary (magnitude = more comp. or less comp.)

• zero/near-zero = unrelated

Income Elasticity of Demand

Ei = % change in quantity demanded / % change in income

• positive = goods are normal (superior)

• negative = goods are inferior

• magnitude matters

market demand and supply graph

S and D lines intersecting on a Q v. P plot, with dashed lines towards axis where market equilibrium is (intersection)

surplus

• when quantity supplied is higher than quantity demanded, when price is too high, two separate points on S and D lines that leads to two Qd values

• price must be lowered

shortage

• Price falls below market equilibrium, two points on Qd axis, Qs < Qd

• Must raise price

Market equilibrium (what determines)

• Equilibrium price and quantity (location of it)

• Indeterminate (either equil. price or equil. quantity may be)

• rationing function of prices (market will move itself to equilibrium, prices ration out goods and shortages/surpluses occur when priced wrong)

• changes in demand/supply (as opposed to changes in Qd and Qs)

welfare economics

• study of economic wellbeing

• market equil. will maximize the welfare of buyers and sellers

• consumer surplus and producer surplus

consumer surplus

• price buyer is willing to pay minus market price

• “upwards” triangle formed beneath demand curve by highest price willing to pay, lowest price willing to pay, and point where consumer surplus is zero

• area of this triangle = surplus of all consumers

producer surplus

• market price minus price producer is willing to sell at\

• “downward” triangle formed above supply curve by highest price willing to sell, lowest price, and where producer surplus is zero

• area is surplus of all producers

Market efficiency

• consumer surplus + producer surplus = total surplus

• free markets maximize efficiency (total surplus) at equilibrium

drawing single / double shifts

• always start with P v. Q plot, labeled S and D lines, and market equilibrium with dashed lines to axes (P1 and Q1)

• single shifts: draw the new line, label the old one 1 and new one 2, draw new equilibrium with P2 and Q2

• double shifts: move each line equal distance, new equilibrium is one formed by D2 and S2 curves, one value (P or Q) should be indeterminate, since we can’t know which shift had a greater effect on that value (label this one X1,2)

taxation, general effects

• When a tax is levied on a good…

  • Price paid by buyer increases

  • Price received by producer decreases

  • Both end up with less money

• Must fit within S and D curve, drives a wedge between price buyers pay and that sellers receive

• quantity sold decreases (occurs left of equilibrium)

tax distortion on a graph

A = consumer surplus

F = producer surplus

B + D = tax revenue (size of tax (vertical) * quantity of good sold (horizontal))

C + E = Deadweight loss (DWL, fall in total surplus) (c for consumer and e for producer)

ABC = consumer surplus without tax

what determines size of DWL?

• elasticity of supply and demand

• more elastic (flatter line) = more loss

tax incidence

• How is tax split between buyers and sellers?

  • The steeper (more inelastic) curve pays more

  • notice larger DWL triangle for the steeper curve when the tax distortion is applied to the graph

price controls

• enacted when policymakers believe market price is unfair to buyers or sellers

• price ceiling: legal maximum, benefits consumers

• price floor: legal minimum, benefits producers

• two types: binding (effects equilibrium), non-binding (no effect)

effects of non-binding ceiling/floor

• equilibrium already above the floor / below the ceiling, all is well

effects of binding floor / ceiling

• ceiling: equi. price is above the ceiling, price must be lowered, but this creates a shortage, Qs < Qd, and non-price-rationing (long lines, discrimination, not everyone gets the good now)

• floor: equil. price below the floor, must increase, but this creates a surplus, Qs > Qd, and non-price rationing (companies bribing others to sell their product)

price control effect on total surplus

• binding price floor

  • consumer surplus = A

  • producer surplus = BDF (floors help prod.)

  • DWL = CE

• binding price ceiling

  • Producer surplus = F

  • consumer surplus = ABD (ceilings help consum.)

  • DWL = CE

international trade (two types of attitudes)

• closed economy (autarchy) (no trade at all)

• open economy (trades freely)

tariffs and effects

• tax on foreign goods that are sold domestically

• raises price of imported goods by amount of tariff

• decreases domestic consumer surplus

• increases domestic producer surplus

• government gets tariff revenue

• creates DWL, total surplus falls

tariff on a graph

two other trade mechanisms

• import quota

  • limit on quantity of imports

• export subsidy

  • lowers domestic cost of production

both tariffs and quotas….

• Raise domestic price

• Reduce imports

• Reduce domestic consum. surplus

• Increase domestic prod. surplus

• Reduce total surplus (create DWL)