AP Microeconomics Unit 2
Unit 2, Lesson 1: Demand
1. Definition of Demand
Demand is the willingness and ability to purchase a good or service at different prices.
Consumers make choices based on price, income, and preferences.
2. Law of Demand
As the price of a good increases, the quantity demanded decreases (and vice versa).
This creates an inverse relationship between price and quantity demanded.
3. Demand Curve
A downward-sloping curve that shows the relationship between price and quantity demanded.
Movement along the curve happens when the price of the good changes.
4. Determinants of Demand (Factors that Shift the Curve)
When these factors change, the entire demand curve shifts, not just the quantity demanded:
Income:
Normal Goods – Demand increases as income rises (e.g., new cars, restaurants).
Inferior Goods – Demand decreases as income rises (e.g., instant noodles, used cars).
Prices of Related Goods:
Substitutes – A rise in the price of one increases demand for the other (e.g., Coke & Pepsi).
Complements – A rise in the price of one decreases demand for the other (e.g., peanut butter & jelly).
Tastes and Preferences: Trends and cultural shifts can increase or decrease demand.
Expectations: If people expect prices to rise, they may buy more now.
Number of Buyers: More buyers increase demand, fewer buyers decrease it.
5. Changes in Demand vs. Changes in Quantity Demanded
Change in Quantity Demanded → Movement along the curve (caused by a price change).
Change in Demand → Shift of the curve (caused by non-price factors like income, and tastes).
Key Takeaway:
Demand is influenced by multiple factors, not just price. A change in price moves along the demand curve, while a change in other factors shifts the entire curve.
Unit 2, Lesson 3: Price Elasticity of Supply
1. Definition of Price Elasticity of Supply (PES)
Measures how much quantity supplied changes in response to price changes.
2. Interpreting PES Values
Elastic Supply (PES > 1): Quantity supplied changes more than the price change (e.g., mass-produced goods).
Inelastic Supply (PES < 1): Quantity supplied changes less than the price change (e.g., rare goods like beachfront property).
Unit Elastic Supply (PES = 1): Quantity supplied changes proportionally to price.
Perfectly Inelastic Supply (PES = 0): Supply stays the same regardless of price (e.g., fixed number of stadium seats).
Perfectly Elastic Supply (PES = ∞): A tiny price change leads to an infinite change in supply.
3. Determinants of Price Elasticity of Supply
Substitutes:
If a firm can easily switch production to another good, supply is more elastic (e.g., a farmer switching between corn and soybeans).
If production is highly specialized with no substitutes, supply is inelastic (e.g., unique handcrafted goods).
Timeframe:
Short Run: Supply is inelastic because firms cannot adjust quickly (e.g., factories need time to increase production).
Long Run: Supply is more elastic because firms have time to expand capacity (e.g., new factories can be built).
Income Share (Cost of Production):
If production costs are low relative to price, supply is more elastic because firms can easily increase output.
If production costs are high, supply is inelastic since expanding production is expensive.
Luxury vs. Necessity:
Luxury goods tend to have more elastic supply because firms can adjust production based on demand.
Necessities often have inelastic supply since production is harder to change (e.g., basic food crops).
Narrowness of Market:
Broad markets (e.g., “food”) tend to have inelastic supply since changing total production is difficult.
Narrow markets (e.g., “organic strawberries”) have more elastic supply because specific production adjustments can be made.
4. Importance of PES in Economics
Helps businesses and policymakers predict how supply reacts to price changes.
Used to analyze industries (e.g., why housing prices are hard to control).
Helps governments design tax policies by understanding supply reactions.
Lesson 4: Cross-Price Elasticity of Demand
Definition: Measures how the quantity demanded of one good responds to a price change in another good.
Formula:
Interpretation:
Positive Value: Indicates that the goods are substitutes (e.g., tea and coffee).
Negative Value: Indicates that the goods are complements (e.g., printers and ink cartridges).
Zero: Indicates that the goods are unrelated.
Application: Understanding cross-price elasticity helps businesses and policymakers anticipate how changes in the market for one product can affect related products.
Lesson 5: Income Elasticity of Demand
Definition: Measures how the quantity demanded of a good responds to changes in consumer income.
Formula:
Interpretation:
Positive Value (>1): The good is a luxury item; demand increases more than the income increase.
Positive Value (<1): The good is a necessity; demand increases, but less proportionally to income.
Negative Value: The good is an inferior good; demand decreases as income increases.
Application: Income elasticity helps businesses and economists understand how changes in the economy (like a recession or boom) might affect the demand for various goods and services.
Percent change= change in priceaverage of two goods
Positive XED (>0): Goods are substitutes (e.g., Coke and Pepsi).
Negative XED (<0): Goods are complements (e.g., peanut butter and jelly).
XED = 0: Goods are unrelated (e.g., shoes and milk).
Unit 2 Lesson 8
1. Price Ceilings:
Definition: A legal maximum price set below the equilibrium price, preventing prices from rising to their natural market level.
Example: Rent control policies that cap the amount landlords can charge tenants.
Consequences:
Shortages: Quantity demanded exceeds quantity supplied, leading to insufficient availability of the good or service.
Black Markets: Illegal markets may emerge where goods are sold at higher prices.
Reduced Quality: Producers may lower the quality of goods or services to cut costs.
Binding Price Ceiling: Set below equilibrium price → creates a shortage
2. Price Floors:
Definition: A legal minimum price set above the equilibrium price, preventing prices from falling to their natural market level.
Example: Minimum wage laws that set the lowest legal hourly wage for workers.
Consequences:
Surpluses: Quantity supplied exceeds quantity demanded, leading to excess supply.
Unemployment: In the case of minimum wage, employers may reduce hiring due to higher labor costs.
Waste of Resources: Excess goods may go unsold, leading to inefficiencies.
Binding Price Floor: Set above equilibrium price → creates a surplus
3. Deadweight Loss:
Definition: The loss of total surplus (consumer and producer surplus) that occurs when the market is not in equilibrium due to interventions like price ceilings or floors.
Implication: Represents the lost welfare or the benefits that could have been achieved in a free market setting.
4. Taxation:
Impact on Markets:
Supply and Demand Shifts: Taxes can shift supply curves (for production taxes) or demand curves (for consumption taxes), leading to new equilibrium prices and quantities.
Tax Incidence: Determines how the burden of a tax is divided between consumers and producers, depending on the relative elasticities of supply and demand.
Consequences:
Increased Prices for Consumers: Consumers may pay higher prices due to the tax.
Reduced Producer Revenue: Producers may receive less revenue after taxes are deducted.
Deadweight Loss: Similar to price controls, taxes can lead to a loss of total surplus, indicating market inefficiency.
5. Subsidies:
Definition: Financial assistance provided by the government to encourage the production or consumption of a particular good or service.
Impact on Markets:
Lower Prices for Consumers: Subsidies can make goods or services more affordable.
Increased Producer Revenue: Producers receive additional income, encouraging higher production levels.
Consequences:
Market Distortions: Subsidies can lead to overproduction or overconsumption of certain goods.
Budgetary Costs: Subsidies require government funding, impacting public budgets.
1⃣ Benefits of Trade
Trade allows countries to specialize in producing goods where they have a comparative advantage.
This leads to greater efficiency and increased total surplus (consumer + producer surplus).
Consumers gain access to cheaper goods and a wider variety of products.
Example: If the U.S. specializes in technology and trades with Brazil, which specializes in coffee, both countries benefit.
2⃣ World Price vs. Domestic Price
World Price (Pw): The price of a good in the international market.
Domestic Price (Pd): The price of the good in a country without trade.
If Pw < Pd, the country imports the good.
If Pw > Pd, the country exports the good.
The equation for Trade Decision:
Example: If the world price of steel is $500 per ton, but the domestic price is $700 per ton, the country will import steel.
3⃣ Imports and Their Effects
Occurs when Pw < Pd
Winners: Consumers (pay lower prices).
Losers: Domestic producers (must lower prices or reduce production).
Total surplus increases because consumer gains exceed producer losses.
Example: Suppose the U.S. domestic price for sugar is $3 per pound, but the world price is $2 per pound. If the U.S. allows free trade, it will import sugar, reducing the price for consumers.
4⃣ Exports and Their Effects
Occurs when Pw < Pd
Winners: Domestic producers (sell at a higher price).
Losers: Domestic consumers (must pay higher prices).
Total surplus increases because producer gains exceed consumer losses.
Example: If the world price of wheat is $10 per bushel, but the domestic price is $7 per bushel, the country will export wheat to foreign buyers willing to pay more.
5⃣ Tariffs (Taxes on Imports)
A tariff is a tax imposed on imported goods, raising their price.
Effects of a tariff:
Higher prices for consumers (reducing demand).
More domestic production (since foreign goods are less competitive).
Fewer imports (lower quantity traded).
Government collects tax revenue.
Deadweight loss (DWL) arises due to inefficiencies.
Tariff Revenue Formula:
Example: If the U.S. imposes a $2 per unit tariff on imported cars and 10 million cars are imported, the government collects: 2 x 10,000,000= 20,000,000 dollars
Deadweight Loss (DWL) from Tariff:
6⃣ Quotas (Limits on Imports)
A quota is a legal limit on the quantity of a good that can be imported.
Effects of quotas:
Higher domestic prices (fewer imports mean lower supply).
Benefits domestic producers (less foreign competition).
No government revenue (unlike tariffs).
Example: If the U.S. sets a quota of 500,000 imported cars per year, the supply of cars decreases, increasing prices for consumers.
7⃣ Deadweight Loss from Trade Restrictions
Both tariffs and quotas create deadweight loss (DWL) by reducing the efficient level of trade.
The formula for DWL:
Example: A tariff increases the price of a product by $3 per unit, reducing imports by 100,000 units.
8⃣ Arguments for Trade Restrictions
Protect Domestic Jobs: Prevents unemployment due to foreign competition.
National Security: Avoids reliance on other countries for essential goods.
Infant Industry Protection: Helps new industries grow by shielding them from competition.
Unfair Trade Practices: Prevents dumping (foreign firms selling below cost).
Protecting Consumers: Some imports may have lower safety standards.
Example: The U.S. imposed tariffs on Chinese solar panels to protect American solar panel manufacturers from low-cost imports.
Unit 2 Lesson 7
1⃣ Market Equilibrium Recap
Equilibrium occurs when quantity demanded (QD) = quantity supplied (QS).
Equilibrium price (P*) is where supply and demand curves intersect.
Equilibrium quantity (Q*) is the quantity exchanged at P*.
Any disruption causes disequilibrium, leading to shortages or surpluses.
2⃣ Disequilibrium: Surplus and Shortage
Surplus (Excess Supply):
Occurs when price is above equilibrium (P > P*).
QS > QD → More goods produced than demanded.
Solution: Sellers lower prices to clear excess supply.
Shortage (Excess Demand):
Occurs when price is below equilibrium (P < P*).
QD > QS → More demand than supply.
Solution: Sellers raise prices until equilibrium is restored.
3⃣ Changes in Demand and Supply Affect Equilibrium
Factors shifting demand (D) or supply (S) change equilibrium price and quantity.
Increase in Demand (D → D₂)
Rightward shift of demand curve.
Results: ↑ P* (higher price), ↑ Q* (higher quantity).
Example: A rise in consumer income increases demand for normal goods.
Decrease in Demand (D → D₁)
Leftward shift of demand curve.
Results: ↓ P* (lower price), ↓ Q* (lower quantity).
Example: A decline in population reduces demand for housing.
Increase in Supply (S → S₂)
Rightward shift of supply curve.
Results: ↓ P* (lower price), ↑ Q* (higher quantity).
Example: Improved technology lowers production costs.
Decrease in Supply (S → S₁)
Leftward shift of supply curve.
Results: ↑ P* (higher price), ↓ Q* (lower quantity).
Example: A natural disaster disrupts crop production.
5⃣ Equilibrium Adjustment Process
When demand or supply shifts, the market gradually moves toward a new equilibrium:
Shortage or surplus emerges.
Prices adjust due to competition.
New equilibrium price and quantity are reached.