Review for Test 2 Some Key Concepts from Unit Two: Chapters 3-5
Supply and Demand Supply and Demand determine prices in individual markets. Price is the mechanism that brings supply and demand together.
Law of Downward Sloping Demand When the price of a commodity is raised (and other things are held constant), buyers tend to buy less of the commodity. Similarly, when the price is lowered, other things being constant, quantity demanded increases. The downward slope in demand can be explained by decreasing marginal utility.
Substitution Effect When the price of a good rises, I will substitute other similar goods for it. For example, if the price of beef rises, I will eat more chicken and pork.
Income Effect As the price of a commodity rises, my income will not stretch as far as it used to. I am therefore “poorer” in a relative sense, than before the price increase.
Market Demand Curve The market demand curve “adds up” all the quantities demanded by individual consumers at a given price. It shows the total amount of a quantity consumers are willing and able to buy at a given price.
The Demand Curve P Elasticity of demand refers to movements along the curve. D Q
Moving Along Demand If the price of a product changes, consumers move along the demand curve to a new quantity. If price rises, quantity demanded falls. If price falls, quantity demanded rises. The curve itself DOES NOT MOVE. The movement is from one point to another ON THE ORIGINAL CURVE,
Elasticity of Demand The elasticity of demand tells us the relationship between the percentage change in quantity and the percentage change in price as we move along a demand curve.
Demand for Pretzels P At a price of $10, 3 pretzels will be sold in this market. Point A on the demand curve shows this relationship. A $10 D 3 Q
Total Revenue Total Revenue is price times quantity. In this case, total revenue would be $30 ($10x3).
Demand for Pretzels P At a price of $5, 9 pretzels will be sold in this market. Point B on the demand curve shows this relationship. B $5 D Q 9
Moving from A to B In moving from point A to point B, we have gone down the original demand curve. As the price of pretzels fell, the quantity demanded increased. Price and quantity move in opposite directions on a demand curve.
Total Revenue at Point B Total Revenue at point B is $45. ($5x9) Total Revenue got larger as we moved from point A to point B because the increase in quantity was larger, in relative terms, than the decrease in price. Price fell by 1/2 ($10 to $5), but quantity tripled (3 to 9). The increase in quantity more than offset the decrease in price.
We can calculate this elasticity % change in price is 5/7.5*100% = 66.67 (midpoint convention) % change in q is 6/6*100% = 100% Price Q 10 3 5 9 Ed = 100%/66.67% = 1.5 Elastic demand
To find out what happens to TR To find out what happens to TR as we move along a demand curve we have to know which change is proportionately bigger, the change in quantity or the change in price. TR will move in the same direction as the change that is relatively bigger. So if quantity changes by a larger percentage than price, as it did in this example, TR will follow quantity. If the percentage change in price were bigger, TR would follow price.
In a shoving match the biggest person usually wins. So whichever effect is bigger, price change or quantity change will determine the direction of total revenue.
Elastic Demand When demand is elastic, the percentage change in price is LESS than the percentage change in quantity. Total Revenue will therefore move in the OPPOSITE direction as price as you move along the demand curve (and the same direction as quantity).
If demand is elastic: Ed = % change in q % change in p ____________ > 1 (elastic) % change in p is smaller than % change in q for elastic demand. So price loses the shoving match and TR moves opposite from price.
Inelastic Demand When demand is inelastic, the percentage change in price is GREATER than the percentage change in quantity. Total Revenue will therefore move in the SAME direction as price as we move along the demand curve (and the opposite direction as quantity).
If demand is inelastic, Ed = % change in q % change in p ____________ < 1 (inelastic) % change in p is biggest for inelastic demand. So price wins the “shoving match” and TR moves the same way as price for inelastic demand.
Quick Way to Remember Elastic demand: Price and TR move in opposite directions. Inelastic demand: Price and TR move in same direction. If you are given a shift in supply as a starting point, stop and figure out what will happen to price after the supply shift and apply the rules above.
How do we move along the curve? If we own the sort of company or agency that can control the price of its product, we can move to a new point on the demand curve by changing price. If we increase price, we expect consumers to buy less of the product. If we decrease price, we expect consumers to buy more.
Price and TR If demand is elastic, I can boost total revenue by dropping price because my increase in quantity will more than make up for the lower price. If demand is inelastic, I can increase total revenue by raising price because my decrease in quantity will not be larger enough to undo the boost from a higher price.
You observe: TR rose after the price of a product rose. You figure that demand is _________. TR fell after the price of a product rose. You figure that demand is _________. TR rose after the price of a product fell. You figure that demand is __________. TR fell after the price of a product fell. You figure that demand is __________. inelastic elastic elastic inelastic
Another Way to Move Along Demand In markets, with a stable demand curve, price will change when supply shifts. When supply shifts, we move along the original demand curve to a new equilibrium point.
Shifting Supply The shift in Supply moves us from one point to another on the old Demand P S2 S1 p2 p1 D Q q2 q1
We know that We know that when supply decreases, price increases and quantity decreases. We know that when supply increases, price decreases and quantity increases.
Supply shifts and TR What happens to TR after a shift in supply depends on the elasticity of demand. When we shift supply, we are moving along demand and price will change, so we figure out the direction of the price change and use the same rules as before.
Special case: When Ed = 1 When demand has unitary elasticity, an increase or decrease in price has no effect on total revenue. (TR stays the same.)
You observe • TR decreases after a supply decrease. Demand is _____________ • TR increases after a supply decrease. Demand is ______________ • TR decreases after a supply increase. Demand is ______________ • TR increases after a supply increase. Demand is ___________________ (price inc) elastic (price inc) inelastic (price dec) inelastic (price dec) elastic
Shifting Curves Moving the entire curve
The position of the demand curve The position of the demand curve (e.g. where it sits in space on the graph) is affected by a number of things. If one of these factors changes, the entire demand curve will move.
Factors Affecting Demand • Size of market, e.g. how many consumers. • Income levels of consumers. • Prices and availability of related goods. • Tastes and preferences. • Special influences, e.g. climate and conditions.
For Demand to SHIFT One of these factors must change.
Shift versus Movement Along The demand curve does not shift when price of the product itself changes. Such a price change causes movement ALONG the original demand curve.
Change in Demand Demand curves will shift, as income, other prices, market size, or tastes or preferences change. "Shift" is another way of saying "change" in this case.
For Example Demand may shift outward (increase) as income rises, market size increases, the price of a substitute increases, or some special factors in the market change. P Q
And Demand may shift inward (decrease) as income falls, market size decreases, the price of a substitute falls, or some special factors in the market change. P Q
The Supply Schedule The supply schedule (or supply curve) for a commodity shows the relationship between the market price and the amount of that commodity that producers are willing and able to produce and sell, other things held constant.
Supply Slopes Up Supply slopes up because of the “law of diminishing returns.” (We have referred to this as “low hanging fruit.”) To get extra output usually requires proportionally more extra input.
Market Supply To get market supply, sum the quantities supplied by all the individual firms at each price level.
Supply Shifters • Changes in costs of inputs • Technological change • Government policy • Special factors (climate, culture)
These factors Any of these factors can cause the firm supply curve to shift.
Movement along supply curve P S As price rises, all other things held constant, the quantity supplied increases. Q
Shift of supply curve P If the price of an input falls, the supply curve shifts out. S S’ Q
S S' D A shift in Supply causes a movement along the demand curve. Demand doesn't change but quantity demanded changes because of the price change.
S D D' A shift in Demand causes a movement along the supply curve. Supply doesn't change but quantity supplied changes because of the price change.
Market Equilibrium A market equilibrium comes at the place where quantity demanded equals quantity supplied. Equilibrium takes place at the intersection of the supply and demand curves.
Graphical Representation of Equilibrium . . 5 . S P Surplus . . . 4 . Equilibrium 3 . . . 2 Shortage . . 1 D . . . . Q 5 15 20 10