The Determination of Price

Question 1

Three conditions must be satisfied in order for a market to be well described by the demand-and-supply model. What are they?

Answer 1

• There must be a large number of consumers of the product, each one small relative to the size of the market.
• There must be a large number of producers of the product, each one small relative to the size of the market.
• Producers must be selling identical or “homogeneous” versions of the product.

Question 2

For the sake of this course, what is the definition of a market?

Answer 2

market

Any situation in which buyers and sellers can negotiate the exchange of goods or services.

Question 3

What is a way that individual markets differ?

Answer 3

Individual markets differ in the degree of competition among the various buyers and sellers.

Question 4

What is a perfectly competitive market?

Answer 4

Markets in which the number of buyers and sellers is sufficiently large that no one of them has any appreciable influence on the market price. This is a rough definition of what economists call perfectly competitive markets.

Question 5

What is excess demand?

Answer 5

excess demand

A situation in which, at the given price, quantity demanded exceeds quantity supplied.

Question 6

What is excess supply?

Answer 6

excess supply

A situation in which, at the given price, quantity supplied exceeds quantity demanded.

Question 7

What is an example of excess supply and how does it affect price?

Answer 7

To examine the determination of market price, let’s suppose first that the price is $100 per bushel. At this price, 95 000 bushels are offered for sale, but only 40 000 bushels are demanded. There is an excess supply of 55 000 bushels per year. Apple sellers are then likely to cut their prices to get rid of this surplus. And purchasers, observing the stock of unsold apples, will begin to offer less money for the product. In other words, excess supply causes downward pressure on price.

Question 8

What is an example of excess demand and how does it affect price?

Answer 8

Now consider the price of $20 per bushel. At this price, there is excess demand. The 20 000 bushels produced each year are snapped up quickly, and 90 000 bushels of desired purchases cannot be made. Rivalry between would-be purchasers may lead them to offer more than the prevailing price to outbid other purchasers. Also, sellers may begin to ask a higher price for the quantities that they do have to sell. In other words, excess demand causes upward pressure on price.

Question 9

What is Equilibrium price?

Answer 9

equilibrium price
The price at which quantity demanded equals quantity supplied. Also called the market-clearing price.

Equilibrium implies a state of rest, or balance, between opposing forces. The ­equilibrium price is the one toward which the actual market price will tend. Once established, it will persist until it is disturbed by some change in market conditions that shifts the demand curve, the supply curve, or both.

The price at which the quantity demanded equals the quantity supplied is called the equilibrium price, or the market-clearing price.

Question 10

What is Disequilibrium price?

Answer 10

Disequilibrium price

A price at which quantity demanded does not equal quantity supplied.

Question 11

What is Disequilibrium?

Answer 11

disequilibrium
A situation in a market in which there is excess demand or excess supply.

Whenever there is either excess demand or excess supply in a market, that market is said to be in a state of ­disequilibrium and the market price will be changing.

Question 12

What is happening below and above the equilibrium price?

Answer 12

It is clear that the equilibrium price occurs where the demand and supply curves intersect. Below that price, there is excess demand and hence upward pressure on the existing price. Above that price, there is excess supply and hence downward pressure on the existing price.3

Question 13

What can cause a shift in the demand/supply curve?

Answer 13

Changes in any of the variables, other than price, that influence quantity demanded or supplied will cause a shift in the demand curve, the supply curve, or both.

Question 14

What are the four possible shifts that can occur on a supply/demand chart?

Answer 14

There are four possible shifts: an increase in demand (a rightward shift in the demand curve), a decrease in demand (a leftward shift in the demand curve), an increase in supply (a rightward shift in the supply curve), and a decrease in supply (a leftward shift in the supply curve).

Question 15

What are comparative statics?

Answer 15

comparative statics
The derivation of predictions by analyzing the effect of a change in a single exogenous variable on the equilibrium.

With this method, we derive predictions about how the endogenous variables (equilibrium price and quantity) will change following a change in a single exogenous variable (the variables whose changes cause shifts in the demand and supply curves).

Question 16

How (in simple terms) are the methods of comparative statics employed?

Answer 16

We start from a position of equilibrium and then introduce the change to be studied. We then determine the new equilibrium position and compare it with the original one. The difference between the two positions of equilibrium must result from the change that was introduced, because everything else has been held constant.

Question 17

What is an endogenous variable?

Answer 17

endogenous variables (equilibrium price and quantity)

Question 18

What is an exogenous variable?

Answer 18

exogenous variable (the variables whose changes cause shifts in the demand and supply curves)

Question 19

What are the effects of the four possible curve shifts?

Answer 19

• An increase in demand causes an increase in both the equilibrium price and the equilibrium quantity exchanged.
• A decrease in demand causes a decrease in both the equilibrium price and the equilibrium quantity exchanged.
• An increase in supply causes a decrease in the equilibrium price and an increase in the equilibrium quantity exchanged.
• A decrease in supply causes an increase in the equilibrium price and a decrease in the equilibrium quantity exchanged.-

Question 20

What is the reasoning for AN INCREASE IN DEMAND (THE DEMAND CURVE SHIFTS TO THE RIGHT)

Answer 20

An increase in demand creates a shortage at the initial equilibrium price, and the unsatisfied buyers bid up the price. This rise in price causes a larger quantity to be supplied, with the result that at the new equilibrium more is exchanged at a higher price.

Question 21

reasoning behind “A DECREASE IN DEMAND (THE DEMAND CURVE SHIFTS TO THE LEFT).”

Answer 21

A decrease in demand creates a surplus at the initial equilibrium price, and the unsuccessful sellers bid the price down. As a result, less of the product is supplied and offered for sale. At the new equilibrium, both price and quantity exchanged are lower than they were originally.

Question 22

Reasoning behind “AN INCREASE IN SUPPLY (THE SUPPLY CURVE SHIFTS TO THE RIGHT).”

Answer 22

An increase in supply creates a surplus at the initial equilibrium price, and the unsuccessful suppliers force the price down. This drop in price increases the quantity demanded, and the new equilibrium is at a lower price and a higher quantity exchanged.

Question 23

Reasoning behind “A DECREASE IN SUPPLY (THE SUPPLY CURVE SHIFTS TO THE LEFT).”

Answer 23

A decrease in supply creates a shortage at the initial equilibrium price that causes the price to be bid up. This rise in price reduces the quantity demanded, and the new equilibrium is at a higher price and a lower quantity exchanged.

Question 24

What is absolute (or money) price?

Answer 24

The price of a product is the amount of money that must be spent to acquire one unit of that product. This is called the absolute price or money price

The amount of money that must be spent to acquire one unit of a product. Also called money price.

Question 25

What is relative price?

Answer 25

relative price
The ratio of the money price of one product to the money price of another product; that is, a ratio of two absolute prices.

Question 26

What is a n example of an increase in relative price?

Answer 26

For example, if the price of carrots rises while the prices of other vegetables are constant, we expect consumers to reduce their quantity demanded of carrots as they substitute toward the consumption of other vegetables. In this case, the relative price of carrots has increased.

Question 27

In microeconomics, when we refer to a change in price, are we referring to relative or absolute price?

Answer 27

In microeconomics, whenever we refer to a change in the price of one product, we mean a change in that product’s relative price, that is, a change in the price of that product relative to the prices of all other goods. The demand and supply of specific products depends on their relative, not absolute, prices.