Chapter 2: Market Forces (Demand and Supply)

Question 1

The Law of Demand

Answer 1

Price and quantity demanded are inversely related. As the price of a good rises (falls) and all other things remain constant, the quantity demanded of the good falls (rises).

Question 2

Market Demand Curve

Answer 2

Indicates the total quantity of a good all consumers are willing and able to purchase at each possible price, holding the prices of related goods, income, advertising, and other variables constant.

NOTE: When we graph the demand curve for good X, we hold everything but the price of X constant.

Question 3

Market Demand Curve Direction

Answer 3

The line is always downward sloping, which reflects the law of demand.

Question 4

Change in Quantity Demanded

Answer 4

Changes in the price of a good lead to a change in the quantity demanded of that good.

This corresponds to a movement along a given demand curve.

Question 5

Movement Along a Demand Curve

Answer 5

The movement along a demand curve indicates a change in the quantity demanded.

Question 6

Demand Shifters

Answer 6

Variables, other than the price of a good, that influence demand.

Any variable that affects the willingness or ability of consumers to purchase a particular good is a potential demand shifter.

Question 7

A Shift in Demand Curve

Answer 7

Whenever advertising, income, or the price of related goods changes, it leads to a change in demand.

A rightward shift in the demand curve is called an increase in demand since more of the good is demanded at each price.

A leftward shift in the demand curve is called a decrease in demand since less of the good is demanded at each price.

Question 8

Income

Answer 8

Income affects the ability of consumers to purchase a good, changes in income affect how much consumers will buy at any price.

In graphical terms, a change in income shifts the entire demand curve.

Whether an increase in income shifts the demand curve to the right or to the left depends on the nature of the good.

Economists distinguish between two types of goods: normal and inferior goods.

Question 9

Normal Goods (Increase of Income = Increase of Demand)

Answer 9

A good for which an increase in income leads to an increase in the demand for that good (curve shifts to the right).

Conversely, a decline in income leads to a decrease in the demand for that good ( curve shifts to the left).

Question 10

Inferior Goods (Increase Income = Decrease in Demand)

Answer 10

A good for which an increase (decrease) in income leads to a decrease (increase) in the demand for that good.

Question 11

Prices of Related Goods: Substitutes and Complements

Answer 11

Changes in the prices of related goods can shift the demand curve for a good.

Question 12

Substitutes

Answer 12

Goods for which an increase (decrease) in the price of one good leads to an increase (decrease) in the demand for the other good.

Substitutes need not serve the same function.

Example: An increase in the price of Coke increases the demand for Pepsi (substitutes).

Example: televisions and patio furniture could be substitutes; as the price of televisions increases, you may choose to purchase additional patio furniture rather than an additional television.

Question 13

Complements

Answer 13

Goods for which an increase (decrease) in the price of one good leads to a decrease (increase) in the demand for the other good.

When good X is a complement to good Y, a reduction in the price of Y actually increases (shifts to the right) the demand for good X.

More of good X is purchased at each price due to the reduction in the price of the complement, good Y.

Example: If the price of beer increased, most beer drinkers would decrease their consumption of pretzels.

Question 14

Advertising and Consumer Tastes

Answer 14

An increase in advertising increases the demand of the good (shifts the demand curve to the right).

Advertising often provides consumers with information about the existence or quality of a product, which in turn induces more consumers to buy the product. These types of advertising messages are known as informative advertising.

Advertising can also influence demand by altering the underlying tastes of consumers (persuasive advertising): Trends.

Question 15

Demand Curve Shift: Advertising

Answer 15

Willing to buy more at that price and also pay more.

An increase in advertising shifts the demand curve to the right, from D1 to D2.

The impact of advertising on demand can be interpreted in two ways. Under the initial demand curve, D1, consumers would buy 50,000 units of high-style clothing per month when the price is $40. After the advertising, the demand curve shifts to D2, and consumers will now buy 60,000 units of the good when the price is $40. Alternatively, when demand is D1, consumers will pay a price of $40 when 50,000 units are available. Advertising shifts the demand curve to D2, so consumers will pay a higher price—$50—for 50,000 units.

Question 16

Population

Answer 16

Changes in the size and composition of the population can also influence demand.

Generally, as the population rises, more and more individuals wish to buy a given product, and this has the effect of shifting the demand curve to the right.

It is important to note that changes in the composition of the population can also affect the demand for a product

Example: as a greater proportion of the population ages, the demand for medical services will tend to increase.

Question 17

Consumer Expectations

Answer 17

Changes in consumer expectations can also influence demand. Applies most to durable goods.

If consumers expect future prices to be higher, they will substitute current purchases for future purchases.

Example: if consumers suddenly expect the price of automobiles to be significantly higher next year, the demand for automobiles today will increase. In effect, buying a car today is a substitute for buying a car next year.

Example: We often see this behavior for less expensive durables; consumers may stockpile laundry detergent in response to temporary sales at grocery stores.

NOTE: The current demand for a perishable product such as bananas generally is not affected by expectations of higher future prices.

Question 18

The Demand Function

Answer 18

The demand function for a good describes how much of that good will be purchased at alternative prices of the good and related goods, alternative levels of income, and alternative values of other variables that influence demand.

Considers all factors that influence demand (price and demand shifters)

Question 19

The Demand Function Equation

Answer 19

The demand function for good X may be written as

Qdx represents the quantity demanded of good X
Px the price of good X
Py the price of a related good
M income
and H the value of any other variable that influence demand, such as the level of advertising, the size of the population, or consumer expectations.

NOTE: Different products will have demand functions of different forms.

Question 20

Linear Representation of the Demand Function

Answer 20

A representation of the demand function in which the demand for a given good is a linear function of prices, income levels, and other variables influencing demand.

Demand is linear if Qdx is a linear function of prices, income, and other variables that influence demand.

The following equation is an example of a linear demand function:

NOTE: The αis are fixed numbers that the firm’s research department or an economic consultant typically estimates using market data and then provides to the manager.

Question 21

aX: Price increase

Answer 21

An increase in Px leads to a decrease in the quantity demanded of good X. This means that αx < 0.

Question 22

aY: The sign of αy will be positive or negative, depending on whether goods X and Y are substitutes or complements:

Answer 22

If αy is a positive number, an increase in the price of good Y will increase the consumption of good X; therefore, good X is a substitute for good Y.

If αy is a negative number, an increase in the price of good Y will lead to a decrease in the consumption of good X; hence, good X is a complement to good Y.

Question 23

aM: Income

Answer 23

The sign of αM also can be positive or negative depending on whether X is a normal or an inferior good:

If αM is a positive number, an increase in income (M) will increase the consumption of good X, and good X is a normal good.

If αM is a negative number, an increase in income will decrease the consumption of good X, and good X is an inferior good.

Question 24

Graph a Demand Curve from a Demand Function

Answer 24

Ascertain the value a consumer receives from a product.

Obtain the formula for a demand curve by inputting the given values of the demand shifters into the demand function but leave Px in the equation to allow for various values.

Question 25

Graph a Demand Curve: Example

Answer 25

If we do this for the demand function, where Py = $15, M = $10,000, and Ax = 2,000

Question 26

Inverse Demand Function

Answer 26

How much consumers are willing and able to pay for an additional unit of good X.

Question 27

Reservation Price

Answer 27

The highest price one will pay for a good.

Question 28

Consumer Surplus

Answer 28

The value consumers get from a good but do not have to pay for.

The amount a consumer is willing to pay for an additional unit of a good falls as more of the good is consumed.

Consumer surplus is the area above the price paid for a good but below the demand curve.

Question 29

Law of Supply

Answer 29

As the price of a good rises (falls), the quantity supplied of the good rises (falls).

Producers are willing to produce more output when the price is high than when it is low (because they know their product is in demand).

Question 30

Market Supply Curve

Answer 30

Indicates the total quantity of a good that all suppliers are willing produce at each possible price, holding input prices, technology, and other variables affecting supply constant.

The market supply curve slopes upward.

The movement along a supply curve is called a change in quantity supplied.

Question 31

Changes in Quantity Supplied

Answer 31

Changes in the price of a good lead to a change in the quantity supplied of that good.

This corresponds to a movement along a given supply curve.

Question 32

Change in Supply

Answer 32

Changes in variables, other than the price of a good, that lead to a change in supply.

This corresponds to a shift in the entire supply curve.

Question 33

Supply Curve Shifts

Answer 33

A rightward shift indicates an increase in supply as suppliers are willing to sell more of the product at each given price.

A leftward shift indicates a decrease in supply as producers sell less of the product at each price.

Question 34

Input Prices (costs of production)

Answer 34

As production costs change, the willingness of suppliers to produce output at a given price changes.

As the price of an input rises, supply decreases

This decrease in supply is depicted as a leftward shift in the supply curve.

Question 35

Technology or Government Regulations

Answer 35

Technology or government regulations that make it less costly to product an output result in a increase of supply (rightward shift)

technology or government regulations that make it more costly to product an output result in a decrease of supply (leftward shift)

Question 36

Number of Firms

Answer 36

If additional firms enter an industry, more output is available at each given price, increase in supply (rightward shift in the supply curve).

if firms exit the market, there is less output available at each given price, decrease in supply (leftward shift in the supply curve).

Question 37

Substitutes in Production

Answer 37

Technologies that are readily adaptable to produce different products.

Example: automakers can convert a truck assembly plant into a car assembly plant by altering its production facilities. When the price of cars rises, these firms can convert some of their truck assembly lines to car assembly lines to increase the quantity of cars supplied.

This has the effect of shifting the truck supply curve to the left.

Question 38

Taxes

Answer 38

An excise tax has the effect of decreasing the supply of a good.

An excise tax is a tax on each unit of output sold, where the tax revenue is collected from the supplier to the government.

For example, suppose the government levies a tax of $.20 per gallon on gasoline. Since each supplier must now pay the government $.20 per gallon for each gallon of gasoline sold, each must receive an additional $.20 per gallon to be willing to supply the same quantity of gasoline as before the tax.

An excise tax shifts the supply curve up by the amount of the tax.

NOTE: at any given price, producers are willing to sell less gasoline after the tax than before.

Question 39

Ad Valorem Tax

Answer 39

Ad valorem literally means “according to the value.”

An ad valorem tax is a percentage tax; the sales tax by the government is a well-known example.

An ad valorem tax will rotate the supply curve leftward, and the new curve will shift farther away from the original curve as the price increases.

Question 40

Producer Expectations/

Answer 40

Producer expectations about future prices can also influence current supply

In effect, selling a unit of output today and selling a unit of output tomorrow are substitutes in production.

If firms suddenly expect prices to be higher in the future and the product is not perishable, producers can hold back output today and sell it later at a higher price.

This has the effect of shifting the current supply curve to the left.

Question 41

The Supply Function

Answer 41

The supply function of a good describes how much of the good will be produced at alternative prices of the good, alternative prices of inputs, and alternative values of other variables that influence supply.

Recognizes all the factors that are potential supply shifters.

Question 42

The Suppy Function Equation

Answer 42

The supply function for good X may be written as:

Qsx represents the quantity supplied of a good
Px the price of the good
W the price of an input (such as the wage rate on labor)
P the price of technologically related goods
H the value of some other variable that affects supply (such as the existing technology, the number of firms in the market, taxes, or producer expectations).

Then the supply function for good X may be written as

Question 43

Linear Supply Function

Answer 43

A representation of the supply function in which the supply of a given good is a linear function of prices and other variables affecting supply.

Supply is linear if Qsx is a linear function of the variables that influence supply.

NOTE: The coefficients (the βis) represent given numbers that have been estimated by the firm’s research department or an economic consultant.

Question 44

Graph a Supply Curve

Answer 44

A supply curve is the relationship between price and quantity, a representative supply curve holds everything but price constant.

The information summarized in a supply function can be used to graph a supply curve.

This means one may obtain the formula for a supply curve by inserting given values of the supply shifters into the supply function but leaving Px in the equation to allow for various values.

Question 45

Inverse Supply Function

Answer 45

This curve reveals how much producers must receive to be willing to produce each additional unit of good X.

Question 46

Producer Surplus

Answer 46

The amount producers receive in excess of the amount necessary to induce them to produce the good.

Alternatively, it indicates the price firms would have to receive to be willing to produce an additional unit of a good.

Geometrically, producer surplus is the area above the supply curve but below the market price of the good.

Question 47

Competitive Market Equilibrium

Answer 47

Equilibrium in a competitive market is determined by the intersection of the market demand and supply curves.

The equilibrium price is the price that equates quantity demanded with quantity supplied.

if Qd(Pe) and Qs(Pe) represent the quantity demanded and supplied when the price is P, the equilibrium price, Pe, is the price such that Qd(Pe) = Qs(Pe) (same for equilibrium quantity).

Question 48

Equilibrium Price

Answer 48

The price of a good is determined by the interaction of market supply and demand for the good.

Question 49

Equilibrium Price and Quantity:

Answer 49