Supply and Demand

Question 1

Three fundamental questions of economics

Answer 1

“What goods and services are produced?”, “How (i.e. with what input factors) are goods and services produced?”, and “Who (i.e. which consumers) gets goods and services?”

Price signalling helps answer the three fundamental questions of microeconomics. An increase in the price of a good decreases the production of that good, changes the input prices of the factors to produce good, and makes it harder for poor people to purchase it.

Question 2

Theoretical Economics vs. Empirical Economics

Answer 2

Theoretical economics builds models; the “theory” is that a particular model is accurate. Empirical economics tests those models – those theories – by seeing if they accurately describe reality.

Question 3

Positive vs. Normative Economics

Answer 3

Positive – study of the way things are

Normative – study of the way things should be

Positive statements describe what is (or isn’t), rather than what should be (or shouldn’t be). Describing how a price is set or who would receive a good is a simple factual statement.

Words like “bad”, “unfair”, and “ought” all indicate human judgments about what should be. These are normative statements.

Question 4

Equity

Answer 4

How you slice up that pie of goods & services

Question 5

Efficiency

Answer 5

maximize size of economic pie (producing as many goods and services as possible)

Question 6

Market failure

Answer 6

market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. Market failures can be viewed as scenarios where individuals’ pursuit of pure self-interest leads to results that are not efficient– that can be improved upon from the societal point of view.

Question 7

What determines the quantity & price of a good?

Answer 7

Supply and demand jointly determine the quantity of each good produced, and the price at which it is sold.

Question 8

Market

Answer 8

everyone who wants to buy a certain good and everyone who wants to sell that same good

Question 9

Buyers determine…

Answer 9

The buyers alone determine the market demand for that good.

Question 10

Sellers determine…

Answer 10

The sellers alone determine the market supply for that good.

Question 11

Perfectly competitive market

Answer 11

there are so many buyers and sellers that no single buyer or seller can influence the price of the good unilaterally. If there are many sellers of a good, then any seller who charges a higher price will not attract any buyers, and the price of actual goods sold will remain unchanged.

Question 12

In a perfectly competitive market, are the sellers price takers or price makers?

Answer 12

We call these sellers price takers because they take the market price as given.

Question 13

Quantity demanded

Answer 13

the amount of a good or service that buyers are willing and able to buy at a specific price. It is usually negatively related to price.

Question 14

Law of demand

Answer 14

The negative relationship between quantity demanded and price. As price rises, quantity demanded falls.

Question 15

Demand

Answer 15

Demand is the set of all quantities demanded over the range of all possible prices. It describes the entire relationship between price and quantity demanded, and is graphically represented as the demand curve.

Question 16

Quantity supplied

Answer 16

the amount of a good or service that sellers are willing and able to sell at a specific price. It is usually positively related to price.

Question 17

Law of supply

Answer 17

The positive relationship between quantity supplied and price; think of sellers entering the market only when they can profitably sell their good.

Question 18

Supply

Answer 18

the set of all quantities supplied over the range of all possible prices. It describes the entire relationship between price and quantity supplied, and is graphically represented as the supply curve

Question 19

Market equilibrium

Answer 19

At this price, buyers demand exactly as much as sellers supply. The price is the equilibrium price, often designated P∗, and the quantity is the equilibrium quantity, often designated Q∗; intersection of supply and demand curves

Question 20

Market clearing price

Answer 20

If all the buyers and sellers gathered together in a single marketplace, and buyers purchased as much as they were willing and able to at the equilibrium price, then each buyer and seller would finish their business and go home for the day. There would be nobody left in the market trying fruitlessly to buy or sell additional goods at that price. Thus, this market is said to have cleared.

Question 21

Excess demand (supply shortage)

Answer 21

Below the market equilibrium. At this price, quantity demanded exceeds quantity supplied. Buyers would be delighted to buy cheap gasoline, but many sellers are going to close up shop. This is a shortage.

Question 22

Excess supply (surplus)

Answer 22

Above the market equilibrium. At this price, quantity supplied exceeds quantity demanded. Sellers would be delighted to provide expensive gasoline, but many buyers are going to cut back on purchases. This is a surplus.

Question 23

Law of supply and demand

Answer 23

When the market price is below the equilibrium price, the market price will rise. When the market price is above the equilibrium price, the market price will fall.

Putting two and two together, we see that market forces will always push the market price toward the market-clearing price, and once it arrives there, there is no further pressure to move. This is the law of supply and demand, and it is one of the most powerful concepts in economics. Adam Smith called this equilibrium-seeking behavior the Invisible Hand of the market.

Question 24

Which axis does price go on?

Answer 24

Y-axis/vertical axis, always.

Question 25

Inward vs. outward shift

Answer 25

Inward = left, outward = right

Question 26

Explain what happens when there’s a shift in the demand curve (say, the price of beef goes up, what happens to the pork market?)

Answer 26

What is the relationship between beef and pork? They’re substitutes

As the price of beef goes up, people will want to shift towards pork

So that’s an outward demand shift for pork

We start initially in equilibrium (e1), then suddenly people want more pork so the entire demand curve shifts out & we move along the supply curve

For every price of pork, people want more

But there is a constraint to how high producers can raise the price before demand falls away (at point e2 = new equilibrium, producers have higher price, consumers are okay with it & they are at equilibrium again)

Question 27

Explain what happens when there’s a shift in the supply curve

Answer 27

Let’s say there’s a drought & the price of hogs rises – so the cost to producers has gone up

Therefore, producers will raise prices – causing an inward shift to the supply curve (looks like it shifts up, when its really shifting left)

At every quantity, the producers needs a higher price to justify higher input costs

Causes excess demand, prices rise until a new equilibrium has been met

This time, we move along the demand curve

Question 28

What happens when you introduce a price floor that’s above the market equilibrium? (i.e. minimum wage)

Answer 28

A new equilibrium is found where the minimum wage intersects with the demand curve; the price rises (because the minimum wage is higher than the market equilibrium price) & then labor demanded falls (because firms can’t afford to have as many workers). More workers want to work at this higher wage, so we’re left with a market with excess supply = unemployment.

Question 29

What happens when you introduce a price ceiling above the market equilibrium?

Answer 29

Nothing, because both consumers and producers are already happy where they are. There’s no constraint/bind on either party.

Question 30

Summarize why the government introduced a gasoline price ceiling in the 1970’s.

Answer 30

In the 1970’s – gas was really cheap, then OPEC formed (cartel) - and they got together and raised the price of gasoline in the 70’s

Before 1973, we’re at equilibrium point e1 (low price, high quantity)

Then, OPEC formed and decided to lower supply – so it raised the price (enough to overcome the quantity they lose by lowering supply); now we’re at e2

So, the government implemented a gas ceiling to interfere with OPEC’s impact.

Question 31

How did consumers & producers react to the 1970’s price ceiling?

Answer 31

Consumers are now ready to get gas (high demand)

Gas stations can only sell a little bit of gas because they are still facing taxes from OPEC – so they lowered their supply. Suddenly, you have a massive excess demand.

Question 32

Negative implications of the 1970’s gas ceiling?

Answer 32

Low efficiency – I would be willing to pay more to get more gas, the gas station would be willing to sell more gas at a higher price but because of the price ceiling, that can’t happen - the ‘size of the pie’ is not getting maximized

Allocation problems – when there’s excess demand, who gets the gas?

In the perfectly competitive equilibrium of e2, it’s not an issue. People who are WTP at that market price get it & others don’t. Since the market can’t adjust to that equilibrium, so now… it’s who has the time to sit there and wait in line to get gas. People are sitting there in line could be engaged in more productive activities.

The pie is being shrunk – wasting time & gas

Equity is also an issue - Poor people liked the lower prices, but again created massive inefficiencies. An example of an efficiency-equity tradeoff. Typically, if we want to distribute the pie differently then the pie will shrink (generally)

Question 33

Efficient outcome

Answer 33

An efficient outcome is a outcome in which all trades that both parties want to make are made.

Question 34

Perfectly inelastic demand

What is the slope?

Answer 34

Inelastic demand – demand is not at all sensitive to price

Demand curve is perfectly vertical; slope is 0.

The quantity demand will be the same at any price

Question 35

Perfectly inelastic demand - what happens when supply shifts?

Answer 35

When the price rises, they’ll sell the same quantity at a higher price. There’s no wiggle/waggle - because consumers will just accept the higher price.

Question 36

Perfectly inelastic demand - examples

Answer 36

Consumers will buy the same of something no matter what because there’s no substitute. Example: Insulin

Question 37

Perfectly elastic demand

Answer 37

Demand where people are willing to pay the given price; Very price sensitive

If the price is raised by 1 cent more, they won’t buy any of it. If the price is lowered by 1 cent less, they’ll buy an infinite amount.

Perfectly horizontal demand curve; slope is negative infinity.

Question 38

Perfectly elastic demand - examples

Answer 38

Fast food restaurants - many substitutes; people are very price sensitive.

Question 39

The equation for the elasticity of demand

Answer 39

Percent change in quantity demanded over percent change in price, or change in Qd/Qd divided by change in P/P

Question 40

Elasticity of demand

Answer 40

When the price gets higher, consumers want less – how rapidly they want less is the shape of the demand curve

Question 41

Elasticity of supply

Answer 41

When the price goes up, how rapidly they want to supply more as price changes is the shape of the supply curve; it’s positive (positive slope)

Question 42

Tax incidence

Answer 42

Who bears the burden of taxation?

Statutory tax incidence - whoever pays the check bears the burden. If I pay my income tax, the tax is on me. If the gas station pays the gas tax, then the burden is on them

Question 43

Economic incidence

Answer 43

Whoever sends the check in is not necessarily the person who bears the burden of the tax because the market will adjust. The difference in somebody’s resources before & after a tax is imposed

Question 44

Why is economic incidence not equal to statutory incidence?

Answer 44

Because of the market reaction to a tax

When a tax is imposed on producers in a competitive market, they’ll raise their price to some extent - so their incidence will be lower than the check that they sent to the government.

If a tax is levied on consumers, they’ll buy less & the price will be lowered – so their incidence will be lower than the check that they sent to the government

Question 45

Consumer tax burden =

Answer 45

Price post tax – price pre tax + tax payment (per unit)

Question 46

Producer tax burden =

Answer 46

Price pre tax – price post tax + tax payment (per unit)

Question 47

Total economic burden =

Answer 47

a.k.a the “tax wedge”; includes consumer and producer tax burden.

Generally, the tax burden is shared on both sides of the market regardless of who pays them.

Question 48

Why is the side of the market on which the tax is imposed is irrelevant?

Answer 48

Imagine the $0.50 is all on the consumers – you are bearing the tax totally. Well, the market will react.

As a consumer, only WTP to $1.00 and my demand curve will shift inwards by $0.50. Producers will have to move up the supply curve – they’ll have to cut the price to $1.30 and 90 billion gallons being sold

Either way, if tax is levied on producers or consumers they still reach a quantity of 90 billion gallons. The burden on consumers vs. producers is the same burden as last time.

CTB = $1.50 - $1.00 = -$0.30 burden

PTB = $1.50 - $1.30 = -$0.20 burden

Question 49

Why economic incidence is determined by elasticities? (stuck vs. slippery)

Answer 49

Stuck parties bear taxes; more slippery parties avoid taxes. If you’re stuck, if you have to buy that insulin, you have to bear that tax. If you’re slippery, if you can just go next door to someone else, then you likely won’t bear the tax.

Negotiating power

As curves get more elastic, the incidence is going to be borne by the other party. As the demand curve gets more elastic, suppliers bear more incidence. As the supply curve gets more elastic, consumers bear more incidence.

Question 50

Who bears the tax burden if there is perfectly inelastic demand?

Answer 50

The full burden is on the consumer. They can do this because demand isn’t affected by changes in price

Question 51

Who bears the tax burden if there is perfectly elastic demand?

Answer 51

Producers have to bear the entire tax, but if they raise the price nobody will buy anything (very price sensitive)

Question 52

Correlation vs causality

Answer 52

Correlation – two variables move together vs. Causality - a change in one variable causes the other one to move

Question 53

How do you estimate the slope of the demand curve from changes in supply?

Answer 53

A shift of the supply curve causes movement of the equilibrium along the demand curve, which enables us to estimate the slope of the demand curve, and consequently the price elasticity of demand.

Question 54

How do you estimate the slope of the supply curve from changes in demand?

Answer 54

A shift of the demand curve causes movement of the equilibrium along the supply curve, which enables us to estimate the slope of the supply curve, and consequently the price elasticity of supply.

Question 55

How do you estimate the slope of the supply or demand curve from changes in both the supply and demand?

Answer 55

You can’t. You have to isolate a shift in either the supply or the demand curve. A shift of both the demand and supply curves causes movement of the equilibrium of both original curves, which enables us to estimate neither the slope of the original demand curve nor the slope of the original supply curve, and consequently neither the price elasticity of demand nor the price elasticity of supply.

Question 56

Name 3 elements of microeconomics

Answer 56

Microeconomics is about trade-offs, the study of scarcity, and constrained optimization. Economics is a quasi-science, not a real science because economic models do not perfectly explain real-world phenomena, they only approximate them.

Question 57

What do consumers maximize?

Answer 57

Consumers maximize utility subject to budget constraints.

Question 58

What do producers seek to maximize?

Answer 58

Producers maximize profits subject to marketplace constraints.

Question 59

Another term for “excess supply of labor”?

Answer 59

Unemployment

Question 60

Efficiency is a concept analogous to making the economic “pie”…

Answer 60

…as big as possible. Efficiency is about not preventing economic transactions from happening, thereby growing the size of the economy. This is like growing the pie. Dividing the pie equally is a concept analogous to equity.

Question 61

Do price ceilings always result in excess demand?

Answer 61

No. If a price ceiling is nonbinding – that is, if a price ceiling is established above the equilibrium price – then the equilibrium will not change in response to the price ceiling.

Question 62

What makes a price ceiling binding?

Answer 62

In order for a price ceiling to be binding, it must be below the free-market equilibrium price. If the price ceiling were imposed above the free-market equilibrium price, the market would continue on as though nothing had happened.

Question 63

What are revealed preferences? How did economists try to use revealed preferences to gauge how much people value their own life?

Answer 63

Revealed preferences uses observations about the choices people make to estimate their underlying preferences. In this case, the amount people choose to pay for safety features reveals how much they value lowering their risk of death, and therefore how much they value death itself.

Question 64

What goods have perfectly inelastic demand?

Answer 64

If a good has no substitutes, then consumers in the market for that good have no option but to buy it at whatever price it is offered.

Question 65

Demand curve

Answer 65

measures the willingness of consumers to buy the good

Question 66

Supply curve

Answer 66

measures the willingness of producers to sell the good

Question 67

Supply and demand curves can shift when there are

Answer 67

– shocks to the ability of producers to supply
– shocks in consumer tastes
– shocks to the price of complement/substitute goods. A rise in the price of a substitute good for good X raises the demand for the X.

Question 68

What kinds of interventions in market can lead to disequilibrium?

Answer 68

– for example, imposing a minimum wage means that more people will want to work than employers want to hire at the minimum wage. This creates unemployment.

Question 69

Cost of government interventions? In terms off efficiency/equity?

Answer 69

The cost of these interventions is found in reduced efficiency (trades that are not made); there may be benefits in greater equity.

Question 70

Explain the difference between a movement along the demand (supply) curve and a shift of the demand (supply) curve

Answer 70

If you’re moving along the curve, it’s due to a change in price. If you shift the demand curve, it means at any price, the demand is different - i.e. different input prices, changes in consumer preferences, changes in substitutable markets, etc.

Question 71

Describe factors that shift supply and demand curves

Answer 71

Price of a Commodity - As already discussed, the movement in a demand curve occurs due to a simple change in the price of goods. This may usually occur because of the changes in supply conditions. The factors that affect the demand are assumed to be held constant. Therefore, a change in the price of a commodity leads to a movement along the demand curve and is referred to as a change in quantity demanded.

Income of Consumers -If something happens to alter the quantity demanded at a given price, a shift in a demand curve occurs. Lower income means that a person has less to spend, so he is likely to spend less on most of the goods. Change in the level of income of the consumers causes a shift in the demand curve because their purchasing power overall changes.

Expectation of Consumers - For example, if consumers will expect to earn higher income next month, they may be willing to spend more of their current savings purchasing the ice cream. Also, if they believe that the price of an ice cream would drop tomorrow; they will be reluctant to purchase it at today’s price. This ultimately causes a shift in the demand curve.

Price of Related Goods - A change in the price of related goods affects the demand for a certain product and causes a demand curve to shift. There are two kinds of related goods, complementary and substitute goods. When the demand of one good reduces due to the fall in a price of another good, the two goods are known as substitutes. Whereas, when the demand for one good increases due to fall in a price of another good, the two goods are known as complements.

If the price of Popsicle falls, the law of demand says that people will purchase more popsicles as compared to ice creams because they have the same characteristics and satisfy similar desires of consumers. Therefore, a change in the price of related goods causes a shift in the demand curve rather than a movement along the demand curve because this factor externally affects the demand curve.

Consumer Preferences - The most obvious determinant of demand is the consumer preference and a change in a consumer preference causes a shift in the demand curve. If people like ice cream, they purchase more of it. With the passage of time, economists have become more interested in explaining consumer preferences and taste. The development in neuroscience has made it more evident as to why people make decisions and this has come into the realm of economics, which helps economists examine what happens when the preferences of consumers change.

The Size of the Population and its Structure - A large population size, keeping other things equal, shows a higher demand for all goods and services. Therefore, more consumer base means there will be more consumption and more demand, which will externally affect the demand curve and hence, will cause it to shift. Moreover, changes in the way a consumer population is structured also leave an impact on the demand. For example, goods and services required by elderly in European countries, where there is more ageing population, will increase the demand of those goods and services as a result.

Question 72

“what’s wrong” with excess supply or excess demand

Answer 72

Leads to inefficient outcomes, market failure, etc.

Question 73

How does elasticity affect consumers’ response to a shift in the price?

Answer 73

The elasticity affects consumers’ response to a shift in price: if the elasticity is between 0 and -1, then firms can raise revenues by raising the price (since consumers will still buy the good in significant quantities); if elasticity < -1, then raising the price results in a decline in from revenue.

Question 74

What could you observe in order to estimate an elasticity of demand?

Answer 74

Accurately estimating an elasticity requires a shift along the supply curve (e.g., a tax on suppliers).

Question 75

Perfectly inelastic demand is correlated to a good with substitutes or no substitutes? What about perfectly elastic demand?

Answer 75

Perfectly inelastic demand is characteristic of a good with no substitutes; perfectly elastic demand is a good with perfect substitutes

Question 76

Which equation should you use when you have a table of quantities and prices and want to figure out the demand and supply equations?

Answer 76

Qd−Q1d=[(Q2d−Q1d)/(p2−p1)]*(p−p1)

Question 77

Elasticity of demand equation

Answer 77

% change in quantity/% change in price

Question 78

Revenue equation

Answer 78

R = p * q(p)

Question 79

What is the elasticity of demand if our revenues remain unchanged given an infinitesimal change in our prices?

Answer 79

For revenues to remain unchanged when we change prices by x% , quantities must change by −x% (locally).

ϵD=% change in quantity% change in price=−x%x%=−1

Question 80

What is the elasticity of demand if by raising our prices by 8% we will lose half of our customers?

Answer 80

=-50/8=-6.25

Question 81

What are all possible values for elasticity of demand if raising the price of our product led to a decrease in revenues?

Answer 81

Revenues are R=p⋅q(p) . When we raise prices, there are two forces opposing each other for revenues: higher prices will increase revenue but also detract the quantity demanded. Algebraically, dRdp=q+p⋅dqdp=q(1+ϵD) .

For dRdp

Question 82

What are all possible values for elasticity of demand if a positive shock to the supply resulted in higher quantity sold but market price remained the same?

Answer 82

negative infinity

Question 83

What are all possible values for elasticity of demand if cutting prices will have no effect on the number of units we sell?

Answer 83

0

Question 84

True or False In the short run, a profit-maximizing firm chooses its input mix by setting MRTS=−w/r .

Answer 84

In the short run, firms cannot adjust K , so they cannot choose the input mix this way.

Question 85

True or false - In the long run, a profit-maximizing firm chooses its input mix by setting MRTS=−w/r .

Answer 85

This may or may not be true. Depending on the production function, production may be at a corner solution, and the firm may choose production to remain at the corner solution.

Question 86

The short run marginal cost curve is __________ due to the law of diminishing marginal returns.

Answer 86

eventually increasing

The law of diminishing marginal returns means that the marginal cost curve will eventually be increasing. However, at low levels of the input, there can be increasing marginal returns to an input, and MC may decrease at first.

Question 87

If a firm has U-shaped marginal cost, then AVC=MC at the point where AVC is minimized.

Never? Sometimes? Or Always?

Answer 87

Always