Chapter 3 Flashcards
All economic systems must address:
What should be produced?
How should it be produced?
For whom will it be produced?
The market for any good or service consists of
All buyers and sellers of that good or service.
The demand curve
A schedule or graph showing the quantity of a good that buyers wish to buy at each
price
As price of a good or service goes down
The quantity that consumers wish to buy will increase.
As the price of a good or service increases
The quantity consumers wish to buy will decrease.
Why do buyers purchase a greater quantity at lower prices and vice-versa?
Substitution effect
Income effect
Buyer’s reservation price
Substitution effect
The change in the quantity demanded of a good that results because buyers switch to substitutes when the price of the good changes
the price of the good changes relative to other prices
Income effect
The change in the quantity demanded of a good that results because of a change in real income of purchasers arising from the price change
all prices change in the same way
Buyer’s reservation price
The largest money amount the buyer would be willing to pay for a unit of a good
If the reservation price (benefit) exceeds the market price (cost)
The consumer will purchase the good
The supply curve
A curve or schedule that tells us the quantity of a good that sellers wish to sell at each price
Seller’s reservation price
The smallest money amount for which a seller would be willing to sell an additional unit (generally equal to marginal cost)
Opportunity costs
Giving up your highest valued alternatives
Market Equilibrium
All buyers (consumers) and sellers (producers) are satisfied with their respective quantities at the prevailing market price at the intersection of demand and supply in the market equilibrium price and equilibrium quantity
Equilibrium price
Is the price at which a good will sell.
Equilibrium quantity
Is where the quantity supplied and quantity demanded are equal. There is no tendency for the system to change.
Excess Supply
The amount by which quantity supplied exceeds quantity demanded when the price of a good exceeds the equilibrium price
Excess Demand
The amount by which quantity demanded exceeds quantity supplied when the price of a good lies below the equilibrium price
Price Ceiling
A maximum allowable price, specified by law
Price Floor
A minimum allowable price, specified by law
Change in demand
A shift of the entire demand curve:
a demand change at the same price
Change in quantity demanded
A movement along the demand curve that occurs in response to a price change
Change in the quantity supplied
A movement along the supply curve that occurs in response to a price change
Change in supply
A shift of the entire supply curve: a supply change at the same price
Complements
Two goods are complements in consumption if an increase (decrease) in the price of one
causes a leftward (rightward) shift in the demand curve for the other
E.g. tennis racquets and tennis balls; gin and tonic; printers and printer paper; pop-corn
and cinema tickets
Due to substitutes
Two goods are substitutes in consumption if an increase (decrease) in the price of one causes a rightward (leftward) shift in the demand curve for the other
E.g. Wine and beer; long distance bus and train usage; airline tickets and car ferry tickets
Normal Good
Demand curve shifts rightwards when the incomes of buyers increase and leftwards when the incomes of buyers decrease (fresh pizza?)
Inferior Good
Demand curve shifts leftwards when the incomes of buyers increase and rightwards when the incomes of buyers decrease (frozen pizza?)
Shifts in Supply
Prices of inputs and/or their substitutes
Technological change: producing more with the same input prices
Number of firms in the market
Expected future prices
Weather (farming)
Buyer’s Surplus
The difference between the buyer’s reservation price and the price actually paid
Seller’s Surplus
The difference between the price received by the seller and his or her reservation price
Total Surplus
The difference between the buyer’s reservation price and the seller’s reservation price
Price Elasticity of Demand explanation
A measure of the responsiveness of the quantity demanded of a good to a change in the price of that good
The percentage change in the quantity demanded that results from a 1 percent change in its price
Price elasticity of demand equation
Percentage change in quantity demanded/percentage change in price
When Price Elasticity of Demand is
> 1 : Elastic
=1 : Unit Elastic
<1 : Inelastic
Point Elasticity of Demand
Midpoint approach is an approximation to the value of elasticity at all points between the upper and lower point on the demand curve
Demand curve could be “curved” rather than straight
This makes the mid-point approach less accurate in looking at effects of a small price change
Perfect elastic demand
Demand is perfectly elastic with respect to price if price elasticity of demand is infinite
Perfect inelastic demand
Demand is perfectly inelastic with respect to price if price elasticity of demand is zero
Determinants of Demand Price Elasticity
Substitution Possibilities (+)
Budget Share (+)
Time (+)
Total Expenditure equation
Total Expenditure = P x Q
Total expenditure as function of price
For a good whose demand curve is a straight line, total expenditure reaches a maximum at the price corresponding to the midpoint of the demand curve.
Cross-Price Elasticity demand
The percentage change in quantity demanded of one good in response to a 1 percent change in the price of another good
Substitute Goods
Cross-Price Elasticity of demand is positive
Complement Goods
Cross-Price Elasticity of demand is negative
Income Elasticity of Demand
Is the percentage change in quantity demanded in response to a 1 percent
change in income
Price Elasticity of Supply
The percentage change in the quantity supplied that occurs in response to a 1 percent change in price
Price elasticity of supply equation
(P/Q) * (1/slope)
Determinants of Supply Elasticity
Flexibility of inputs (+)
Mobility of inputs (+)
Input substitutes (+)
Time (+)
Perfectly elastic supply
Supply is perfectly elastic with respect to price if elasticity is infinite
Perfectly inelastic supply
Supply is perfectly inelastic with respect to price if elasticity is zero
