Chapter 2 - Supply and demand

Question 1

There are four key assumptions underlying the supply and demand model. Name these assumptions.

Answer 1

The supply and demand model assumes that (a) supply and demand are in a single market, (b) all goods in the market are identical, (c) all goods sell for the same price and everyone in the market has the same information, and ( d) there are many consumers and producers in the market (price takers).

Question 2

Complements and substitutes of a given good affect the demand for that good. Define complements and substitutes

Answer 2

A complement is a good that is purchased and used in combination with another good. A substitute is a good that can be used in place of another good.

Question 3

What simplifying assumption do we make to build a demand curve? Why is the demand curve downward sloping?

Answer 3

We assume that there is no change in any other factors that may also affect how much of a good a consumer buys. The downward slope reflects the fact that consumers demand less of a good as its price increases.

Question 4

What is the difference between a change in quantity demanded and a change in demand?

Answer 4

A change in quantity demanded is a movement along the demand curve that occurs because of a change in the good’s own price, while a change in demand reflects a shift of the entire demand curve caused by a change in a determinant of demand other than the good’s price.

Question 5

What form do inverse supply and demand equations take? Why do economists often represent supply and demand using the inverse equations?

Answer 5

The inverse demand curve expresses the price of a product as a function of quantity demanded. The inverse supply curve expresses the price of a product as a function of quantity supplied. Expressing price as a function of quantity makes the demand and supply choke prices more explicit.

Question 6

Why is the supply curve upward-sloping?

Answer 6

The upward slope of the supply curve reflects the fact that holding all else equal, producers supply more of a good as its price increases.

Question 7

What is the difference between a change in quantity supplied and a change in supply?

Answer 7

A change in quantity supplied is a movement along the supply curve that occurs because of a change in the good’s own price, while a change in supply reflects a shift of the entire supply curve caused by a change in a determinant of supply other than the good’s price.

Question 8

Define market equilibrium. What is true of the quantity supplied and demanded at the market equilibrium?

Answer 8

The market equilibrium occurs at the intersection of supply and demand curves for a good. At equilibrium, the quantity supplied by producers equals the quantity demanded by consumers.

Question 9

What happens when price is below the equilibrium price?Why?

And what happens when the price is above the equilibrium price?

Answer 9

When the market price is too low, there is excess demand (shortage) for a good because consumers demand more of the good than producers are willing to supply at the relatively low price. Buyers who cannot find the good available for sale will bid up the price

If the price is higher than the equilibrium price, there is excess demand (surplus). - To eliminate the difference, the suppliers must attract more buyers, i.e. lower their prices

Question 10

In what direction will price and quantity move as a result of a demand shift?

Answer 10

A demand shift causes equilibrium price and quantity to change in the same direction. More specifically, an outward shift in demand increases both price and quantity, while an inward shift in demand decreases price and quantity.

Question 11

In what direction will price and quantity move as a result of a supply shift?

Answer 11

A supply shift causes equilibrium price and quantity to change in opposite directions. More specifically, an outward shift in supply decreases price but increases quantity; an inward shift in supply increases price but decreases quantity.

Question 12

Why is the direction of change of either price or quantity unknown when both supply and demand shift?

Answer 12

When both supply and demand shift, the direction of change in either quantity or price is determined by the relative magnitudes and directions of the shifts.

Question 13

What happens to equilibrium price when supply and demand shift in the same direction? What happens to equilibrium quantity in the same situation?

Answer 13

If supply and demand both increase, quantity increases; if both supply and demand decrease, quantity decreases. The effect on price is unknown: It depends on the relative magnitudes of the supply and demand shifts.

Question 14

What is the difference between an elasticity and slope?

Answer 14

The slope of a supply or demand curve relates changes in the level of prices to changes in the level of quantity demanded or supplied. Elasticity represents the responsiveness of quantities to prices. More specifically, we express elasticity as the percentage change in quantity for a given percentage change in price.

Two big problems with using just slopes of demand and supply curves to measure price responsiveness:

1. Slopes depend on the units of measurement
2. Cannot be compared across different products

Question 15

We learned that economists have special terms for elasticities of particular magnitudes. Name the magnitudes for the following: inelastic, elastic, unit elastic, perfectly elastic, and perfectly inelastic.

Answer 15

The magnitude of each is as follows: inelastic E < l, elastic E > l, unit-elastic E = l , perfectly elastic E = 0, and perfectly inelastic E = oo.

Remember it is the absolute value we look at

if |E|>1 - a 1% change in price leads to a larger than 1% effect on quantity i.e. elastic

if |E|<1 - a 1% change in price leads to a less than 1% change in quantity i.e. inelastic

if |E|=1 - unit elastic, a 1% change is causing a 1% change in quantity

if |E|=0 - perfectly inelastic
if |E|=∞ - perfectly elastic

Question 16

Using the concept of income elasticity of demand, describe normal, luxury, and inferior goods

Answer 16

Normal goods have positive income elasticities; luxury goods have income elasticities greater than 1; and inferior goods have negative income elasticities.

Question 17

Using the concept of cross-price elasticity of demand, describe substitutes and complements.

Answer 17

When a good has a positive cross-price elasticity with another good, that good is a substitute for the other good. When a good has a negative cross-price elasticity with another good, that good is a complement for the other good.

Question 18

What does the price elasticity reveal?

Answer 18

The price elasticity of demand reveals whether total expenditures will increase or decrease with prices. In particular, total expenditures increase with prices if demand is inelastic, decrease with prices if demand is elastic, and stay constant if demand is unit-elastic.

Question 19

What does it mean when a good is elastic?

Answer 19

A 1% change in price leads to a larger than 1% effect on quantity i.e. elastic

Elasticity - the ratio of the percentage change in one value to the percentage change in another

Question 20

What do we use the inverse demand curve for?

Answer 20

Graphs

Question 21

How do we calculate elasticity?

Answer 21

For direct demand = slope*P/Q

For indirect demand: 1/slope *P/Q

Question 22

What is a market?

Answer 22

In the strictest sense - defined by the specific product being bought or sold, a particular location and a point in time

In practice - broadly defined (place where producers and consumers meet for transactions)

A broadly defined market makes the assumptions of the supply and demand model less likely to hold

Question 23

Name 5 five things that can influence demand

Answer 23

• Price
• The number of consumers
• Consumer income or wealth
• Consumer tastes
• Prices of other goods

Question 24

Why is price treated differently from the other factors that affect demand?

Answer 24

1. Price is typically one of the most important factors that influence demand
2. Prices can usually be changed frequently and easily
3. Of all the factors that influence demand, price is the only one that also exerts a large, direct influence on the other side of the market - on the quantity of the good that producers are willing to supply  link between both sides of the market

Question 25

Name 4 things that can influence supply

Answer 25

Price

Suppliers’ cost of production

The number of sellers

Sellers’ outside options (other markets, prices of other related goods)

Question 26

What determines the size of price and quantity changes?

Answer 26

Slopes of the curves
If the demand curve shifts, then the slope of the supply curve determines whether the shift leads to a relatively large equilibrium price change and a relatively small equilibrium quantity change and vice versa
If the supply curve shifts, it is the slope of the demand curve that matters

Relatively flat supply curve - shift in demand will result in relatively small increase in equilibrium price and relatively large increase in equilibrium quantity

Relatively steep supply curve - shift in demand will result in relatively large increase in equilibrium price and relatively small increase in equilibrium quantity

Relatively flat demand curve - shift in supply will result in relatively small decrease in equilibrium price and relatively large increase in equilibrium quantity

Relatively steep demand curve - shift in supply will result in relatively large decrease in equilibrium price and a relatively small increase in equilibrium quantity

Question 27

What does a steep curve imply?

Answer 27

Steeper curves mean that price changes are correlated with relatively small quantity changes

When demand curves are steep - implies that consumers are not very price-sensitive and won’t change their quantity demanded much in response to price changes

Steep supply curves - producers’ quantities supplied are not particularly sensitive to price changes

Question 28

Describe the relationship between markets and elasticities

Answer 28

Markets with large-magnitude price elasticities of demand could be those where there is a lot of ability to substitute. Relatively small increases in price result in relatively large drops in quantity demanded

Markets with less price-responsiveness demand have elasticities that are small in magnitude. Relatively large increases in price result in relatively small decreases in quantity demanded.

Markets with large price elasticities of supply would be those where it is easy for suppliers to vary their amount of production as price changes. Relatively small increases in price result in relatively large increases in quantity supplied.

Markets with low price elasticities of supply have quantities supplied that are fairly unresponsive to price changes. Relatively large increases in price result in relatively small increases in quantity supplied.

The more narrowly defined the goods are (and so the more substitute products there are), the more elastic the demand tends to be

Question 29

What variables affect the elasticity of supply and demand?

Answer 29

What variables affect the elasticity of demand?

1. Availability of close substitutes
2. Breadth of the market
3. Type of product ‒ Necessity or luxury item
4. Percentage of income spent on the good
5. Time horizon of the analysis

What variables affect the elasticity of supply?

1. The ease at which production capacity can be expanded
2. Time horizon of the analysis

Question 30

Describe perfectly inelastic and perfectly elastic demand and supply

Answer 30

Perfectly inelastic -> vertical demand or supply curve, infinite slope, a change in price will result in 0% change in quantity demanded or supplied. Any shift in the market’s demand or supply curve will result in a change only in the market equilibrium price, not quantity

Perfectly elastic -> horizontal demand or supply curve, slope is zero, any change in price will result in an infinitely large change in quantity demanded or supplied.