Chapter 2: Demand and Supply Analysis

Question 1

The three dimensions of a market

Answer 1

Commodity: the product bought and sold

Geography: the location in which purchases are being made

Time: the period of time during which transactions are occurring

Question 2

Market demand curve

Answer 2

A curve that shows us the quantity of goods that consumers are willing to buy at different prices

Question 3

Derived demand

Answer 3

Demand for a good that is derived from the production and sale of other goods

Question 4

Direct demand

Answer 4

Demand for a good that comes from the desire of buyers to directly consume the good itself

Question 5

Law of demand

Answer 5

The inverse relationship between price of a good and quantity demanded when other factors that influence demand or held fixed

Question 6

Market supply curve

Answer 6

A curve that shows us the total quantity of goods that their suppliers are willing to sell at different prices.

Question 7

Law of supply

Answer 7

The positive relationship between price and quantity supplied, when other factors that influence supply are held fixed

Question 8

Factors of production

Answer 8

resources such as labor and raw materials that are used to produce a good

Question 9

(market) equilibrium

Answer 9

a point at which there is no tendency for the market price to change as long as exogenous variables remain unchanged.

Question 10

excess supply

Answer 10

a situation in which the quantity supplied at a given price exceeds the quantity demanded

Question 11

excess demand

Answer 11

a situation in which the quantity demanded at a given price exceeds the quantity supplied.

Question 12

PRICE ELASTICITY OF DEMAND [PED]

Answer 12

a measure of the rate of percentage change of quantity demanded with respect to price, holding all other determinants of demand constant.

WHAT DOES IT MEASURE: the sensitivity of the quantity demanded to price.

FORMULA:

εₚ = (%∆ in Quantity) / (%∆ in Price)

[note: it is ε subscript Q,P]

Question 13

Perfectly Inelastic Demand [ε=0]

Answer 13

[When price elasticity of demand = 0]
(demand curve is a straight vertical line): |

When quantity demanded is completely insensitive to price.

Question 14

Inelastic Demand [-1<ε<0]

Answer 14

[When price elasticity of demand is between 0 and -1]
(slope of the demand curve is greatly decreasing): \

When quantity demanded is RELATIVELY insensitive to price.

[ie gasoline, utilities, etc]

Question 15

(Unit Elastic) Unitary Elastic Demand [ε=-1]

Answer 15

[When price elasticity of demand is -1]
(slope of the demand curve is basically 1)

Percentage increase in quantity demanded is equal to percentage decrease in price.

Question 16

Elastic Demand [-∞<ε<-1]

Answer 16

[when price elasticity of demand is between -1 and -∞]
(slope of the demand curve is approaching a flat line)

Quantity demanded is relatively sensitive to price

[ie if water bottles are $3 each, I will only buy one, but if it goes down to $1/bottle, I’ll buy 2 or 3]

Question 17

Perfectly Elastic Demand [ε= -∞]

Answer 17

[when price elasticity of demand is -∞]
(slope of the demand curve is a horizontal line): ––

Any increase in price results in quantity demanded decreasing to zero, and any decrease in price results in quantity demanded increasing to infinity.

Question 18

Linear Demand Curve

Answer 18

A demand curve in the form:

Q = a - bP

Q = quantity demanded

a = positive constant; embodies the effects of all the factors (e.g. income, prices of other goods) other than price that affect demand for the good

b = positive coefficient that reflects how the price of the good affects the quantity demanded.

P = price of good demanded

Question 19

Inverse demand curve

Answer 19

an equation for the demand curve that expresses price as a function of quantity.

P = (a/b) - (1/b)Q

(a/b) = choke price, or the price when the quantity demanded falls to 0.

Question 20

Choke Price

Answer 20

(a/b) in an inverse demand curve

The price at which the quantity demanded falls to 0.

Question 21

Formula for Price Elasticity of Demand f/ linear demand curve

Answer 21

εₚ = (∆Q/∆P) ✖️ (P/Q)

εₚ = -b✖️(P/Q)

*Midpoint (M): εₚ = -1; Q =a/2 & P=a/2b
*Elastic Region: -∞ < εₚ < -1
*Inelastic Region: -1 < εₚ < 0

The formula tells us that for a linear demand curve, the price elasticity of demand varies as we move along the curve.

Question 22

Elastic Region of the Demand Curve

Answer 22

Area between the choke price a/b (where Q=0) and a price of a/2b at the midpoint M of the demand curve, the price elasticity of demand is between -∞ and -1.

*Price Elasticity of Demand: -∞ < εₚ < -1

*Quantity: 0 < Q < (a/2)
*Price: (a/2b) < P < (a/b)

Question 23

Inelastic Region of the Demand Curve

Answer 23

Area for prices between a/2b and 0, the price elasticity of demand is between -1 and 0.

*Price Elasticity of Demand: -1 < εₚ < 0

*Quantity: (a/2) < Q < a
*Price: 0 < P < (a/2b)

Question 24

Constant Elasticity Demand Curve

Answer 24

General formula:

Q = aP^-b

A demand curve of the form Q = aP^-b, where a and b are positive constants. The term -b is the price of elasticity of demand (εₚ) along this curve

Question 25

Total Revenue

Answer 25

(Selling price) ✖️ (quantity of product sold)

Question 26

What happens to Total Revenue if: (elastic demand)

Answer 26

If the demand is elastic, the quantity reduction will outweigh the benefit of a higher price => TR will FALL.

[elastic means the quantity demanded is relatively sensitive to price]

Question 27

What happens to Total Revenue if: (Inelastic demand)

Answer 27

If the demand is INELASTIC, the quantity reduction will not be too severe => TR will go UP!

[inelastic means the quantity demanded is relatively INSENSITIVE to price]

Question 28

3 Factors that determine a product’s Price Elasticity of Demand

Answer 28

(from pg 49 in textbook): Here are some factors that determine a product’s price elasticity of demand–the extent to which demand is relatively sensitive or insensitive to price:

1) good substitutes exist
2) when consumer’s expenditure is large
3) when good is a necessity

In more detail:

*Demand tends to be more price elastic when good substitutes exist for a product.
––(or demand tends to be less price elastic when the product has few or not very satisfactory substitutes) [ie travel options for leisure travelers b/c fly, drive, bus, etc]

*Demand tends to be more price elastic when a consumer’s expenditure on the product is large.
––(either in absolute terms or as a fraction of total expenditures) [ie for refrigerators and automobiles where the gain from carefully evaluating the purchase and paying close attention to the price is greater than it is when the item does not entail a large outlay of money]

*Demand tends to be less price elastic when consumers see the product as being a necessity. [ie rice, eggs, milk–you’re gonna buy them anyways because you eat them everyday]

Question 29

INCOME ELASTICITY OF DEMAND

Answer 29

The ratio of the percentage change of quantity demanded to the percentage change of income, holding price and all other determinants of demand constant.

ε (subscript Q, I) but we’ll call εₗ, I because income as opposed to p for price

εₗ = ((∆Q/Q)✖️100%) / (∆I/I)✖️100%)

Or,

εₗ = (∆Q/∆I) ✖️ (I/Q)

Question 30

Cross Price Elasticity of Demand [CPED]

Answer 30

The ratio of the percentage change of the quantity of one good demanded with respect to the percentage change in the price of another good.

ε (subscript Qᵢ, Pⱼ) = ((∆Qᵢ/Qᵢ) ✖️ 100%) / ((∆Pⱼ/Pⱼ) ✖️ 100%)

Or

εᵢⱼ = (∆Qᵢ / ∆Pⱼ) ✖️ (Pⱼ/ Qᵢ)

If CPED or εᵢⱼ > 0, a higher price for good j increases the quantity of good i demanded.

Question 31

Demand Substitutes

Answer 31

Two goods are related in such a way that if the price of one increases, demand for the other increases.

CPED > 0 ==> substitutes

if the εᵢⱼ or CPED (cross price elasticity of demand) > 0, a higher price for good j increases the quantity of good i demanded —> i and j are substitutes

Question 32

Demand COMPLIMENTS

Answer 32

Two goods related in such a way that if the price of one increases, demand for the other decreases.

CPED < 0 ==> compliments

if the εᵢⱼ or CPED (cross price elasticity of demand) < 0, a higher price for good j decreases the quantity of good i demanded –> i and j are compliments

Question 33

Price Elasticity of SUPPLY [PES]

Answer 33

The percentage change in quantity supplied for each percent change in price, holding all other determinants of supply constant.

It measures the sensitivity of the quantity supplied to price.

ε (Subscript Q^s, P) = ((∆Q^s/Q^s) ✖️ 100%) / ((∆P/P) ✖️ 100%)

εₛ = (∆Q^s/∆P) ✖️ (P/Q^s)

Question 34

What does the Price Elasticity of Supply measure?

Answer 34

It measures the sensitivity of quantity supplied to price

Question 35

Long-Run Demand Curve

Answer 35

Demand curve that pertains to the period of time in which consumers can fully adjust their purchase decisions to changes in price

Question 36

Short Run Demand Curve

Answer 36

The demand curve that pertains to the period of time in which consumers cannot fully adjust their purchase decisions to changes in price

Question 37

Long-run supply curve

Answer 37

the supply curve that pertains to the period of time in which producers can fully adjust their supply decisions to changes in price

Question 38

Durable Goods

Answer 38

Goods, such as automobiles or airplanes, that provide valuable services over many years

Question 39

Short-Run supply curve

Answer 39

the supply curve pertains to the period of time in which sellers cannot fully adjust their supply decisions in response to changes in price

Question 40

Nondurable goods

Answer 40

goods that are immediately consumed in one use or have a lifespan of less than three years