03 Supply and Demand Flashcards
Substitutes
A good for which demand will increase if the price of a related good increases.
Complements
Two goods are complements if an increase in the price of one good leads to a decrease in the demand for the other (or a demand in the price of one good leads to an increase in the demand for the other).
Shortage
Implies that the quantity demanded is greater than the quantity supplied, indicating that the price is below equilibrium price.
Reservation price
A limit on the price of a good or service.
Demand curve
Illustrates the quantity buyers would purchase at each possible price, has a negative slope (consumers buy less at high price, more at lower price) (lower prices bring more buyers into market, lower prices cause existing buyers to buy more)
Motivation of buyers and sellers
Buyers want to benefit from the good, sellers want to make a profit
Market price balances two forces
Value buyers derive from the good
The cost to produce the good
The substitution effect
Buyers switch to substitutes when price goes up
The income effect
Buyers’ overall purchasing power goes down
The Low-Hanging Fruit Principle
Explains the upward sloping supply curve
Supply curve
Illustrates the quantity of a good that sellers are willing to offer at each price (if price is more than op cost, offer more)
Equilibrium
A system is in equilibrium when there is no tendency for it to change
Results from interaction of buyers and sellers
The equilibrium price
The price at which the supply and demand curves, no tendency to change price or quantity (quantity supplied equals quantity demanded)
The equilibrium quantity
The quantity at which the supply and demand curves intersect
The market equilibrium
Occurs when all buyers and sellers are satisfied with their respective quantities at the market price
Price ceiling
A maximum allowable price, set by law (e.g. rent controls)
If the controlled price is below equilibrium then..
Quantity demanded increases
Quantity supplied decreases
A shortage results, excess demand
Price floor
A minimum allowable price, set by law (e.g. minimum wage prevents employers offering low wages)
If the controlled price is above equilibrium then…
Quantity demanded decreases
Quantity supplied increases
A surplus results, excess supply
Incentive principle: excess demand
Each supplier has an incentive to increase the price in order to sell more
A change in the quantity demanded….
Results from a change in the price of a good
If buyers are willing to buy more at each price then…
Demand has increased (move the entire demand curve to the right) (less = decrease in demand)
When price goes up…
Quantity supplied goes up
Sellers move to a new, higher quantity supplied
Supply increases when…
Sellers are willing to offer more for sale at each possible price (moves entire supply curve to right)
Supply decreases when…
Sellers are willing to offer less for sale at each possible price (moves entire supply curve to left)
Causes of shifts in demand
Price of complementary goods Price of substitute goods Income: normal or inferior goods? Preferences Number of buyers in the market Expectations about the future
Normal good
A good for which demand increases when income rises and for which demand decreases when income falls.
Inferior good
A good for which demand decreases when income rises and for which demand increases when income falls.
Causes of shifts in supply
Change in the price of an input A change in technology Weather Number of sellers in the market Expectation of future price changes
Supply and Demand Shifts Rule One
An increase in demand will lead to an increase in both equilibrium price and quantity
Supply and Demand Shifts Rule Two
A decrease in demand will lead to a decrease in both equilibrium price and quantity
Supply and Demand Shifts Rule Three
An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity
Supply and Demand Shifts Rule Four
A decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity
Buyer’s surplus
Buyer’s reservation minus the market price
Seller’s surplus
Market price minus the seller’s reservation price
Total surplus
= Buyer’s surplus + seller’s surplus
No cash on the table..
When surplus is maximised
No opportunity to gain from additional sales or purchases
Efficiency Principle
The socially optimal quantity maximises total surplus for the economy from producing and selling a good
Economic efficiency
All goods are produced at their socially optimal level
Efficiency Principle: equilibrium price and quantity are efficient if..
Sellers pay all the costs of production
Buyers receive all the benefits of their purchase
Efficiency
Marginal cost equals marginal benefit
Production is efficient if total surplus is maximised
Equilibrium Principle
A market in equilibrium leaves no unexploited opportunities for individuals
BUT it may not exploit all gains achievable through collective action
Seller’s reservation price
The smallest dollar amount for which a seller would be willing to sell an additional unit, which is generally the same as their opportunity cost of producing an additional unit.
Cost of production affects the supply of a product
An increase in input prices will cause a decrease in supply (shift leftward)
A decrease in input prices will increase supply (shift right)
Supply increase
Then the equilibrium price will decrease, causing the quantity demanded to increase.
Feature of free markets
Individual incentives will lead markets to their respective equilibrium prices and quantities
Buyer’s reservation price
The largest dollar amount the buyer would be willing to pay for a good.
Change in price and change in demand
A change in price leads to a change in quantity demanded, which is represented by movement along a demand curve; a change in demand is a shift in the entire curve.
A socially optimal outcome…
Maximises total economic surplus
Centralised economy
An individual or a small group of individuals make its economic decisions (decide what, how, and for whom to produce.)
