Microeconomics Flashcards
AICPA BAR
Fundamental Law of Demand
The price of a product (or service) and the quantity demanded of that product (or service) are inversely related. As the price of the product increases (decreases), the quantity demanded decreases (increases).
Quantity demanded is inversely related to price for two reasons
Substitution Effect: substitute one similar good (price increased) for another
Income Effect: Purchase more with lower price when income remains constant
Factors That Shift Demand Curves (Factors Other Than Price)
Changes in Wealth
Changes in the Price of Related Goods:
Changes in Consumer Income
Changes in Consumer Tastes or Preferences for a product
Changes in Consumer Expectations
Changes in the Number of Buyer Served by the Market
The Fundamental Law of Supply
Price and quantity supplied are positively related
Factors That Shift Supply Curves
Changes in Price Expectation of the Supplying Firm
Changes in Production Costs (Price of Inputs)
Changes in the Price or Demand for Other Goods
Changes in Subsidies (Positive) or Taxes (Negative)
Changes in Production Technology
Market equilibrium
Demand = supply
Price elasticity of demand
The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price
Ep = % change in quantity demanded / % change in price
The price elasticity of demand is usually negative
Price Inelasticity (Absolute Price Elasticity of Demand < 1.0)
* Price Inelasticity = 0, perfect inelastic demand curves are vertical.
2. Price Elasticity (Absolute Price Elasticity of Demand > 1.0)
3. Unit Elasticity (Absolute Price Elasticity of Demand = 1.0)
Price Elasticity Effects on Total Revenue
Effects of Price Elasticity on Total Revenue (Negative Relationship)
Effects of Price Inelasticity on Total Revenue (Positive Relationship)
Effects of Unit Elasticity on Revenue (No Effect)
Price Elasticity of supply
The price elasticity of supply is calculated the same way as the price elasticity of demand, except that we now measure the change in quantity supplied.
Ep = % change in quantity supplied / % change in price.
Price Inelasticity (Supply < 1.0)
Quantity supplied is insensitive to price changes
*Perfectly inelastic supply curve is vertical.
Price Elasticity (Supply > 1.0)
Unit Elasticity (Supply = 1.0)
Cross Elasticity
Ce = % change in number of units of X demanded (supplied) / % change in price of Y
Substitute Goods: Positive Coefficient
Complementary Goods: Negative Coefficient
Income Elasticity of demand
The income elasticity of demand measures the percentage change in quantity demanded for a product for a given percentage change in income
Ie = % change in number of units of X demanded (supplied) / % change in income
If the income elasticity of demand is positive (e.g., demand increases as income increases), the good is a normal good.
As income goes up, demand for inferior goods decreases
Inflation and Effect of Inflation on Prices
Inflation: a sustained increase in the general prices of goods and services. As the price level rises, the value of money (purchasing power) declines.
Monetary assets (cash, A/R) will be hurt by inflation and the loss of purchasing power.
Monetary liabilities (such as fixed and long-term debt) will benefit from increasing price levels because they will be repaying that with inflated currency.
Nonmonetary assets and liabilities (e.g., a building, land, machinery, etc.) will fluctuate with inflation and provide reduced variability when price levels change.
Effect of inflation on investments
Debt investments: Fixed-rate debt loss value due to inflation; Floating rate debt is less sensitive to inflation
Equity investments: Unless dividends adjust to changes in price levels, inflation will erode the dividend payments; Higher price cause customers buy fewer goods and hurt company’s profit and stock price.
Alternative Investments: Nonmonetary assets including real estate, commodities, hedge funds and private equity investments; Effectively hedge against inflation
Effect of inflation on issuing debt
In the inflation environment, floating rate debt instruments are more attractive to investors.
Principle payment will be lower in real terms regardless couple is fixed or variable
Future expense with inflation
If entities can raise sales price, they may keep profit margin.
If entities cannot raise sales price, inflation will erode their profit margin.
