Review for Test 2

1. Review for Test 2 Some Key Concepts from Unit Two: Chapters 3-5

2. Supply and Demand Supply and Demand determine prices in individual markets. Price is the mechanism that brings supply and demand together.

3. The Demand Schedule The demand schedule (demand curve) shows the relationship between a commodity’s market price and the quantity of that commodity that consumers are willing and able to purchase, other things held constant.

4. Law of Downward Sloping Demand When the price of a commodity is raised (and other things are held constant), buyers tend to buy less of the commodity. Similarly, when the price is lowered, other things being constant, quantity demanded increases. The downward slope in demand can be explained by decreasing marginal utility.

5. Substitution Effect When the price of a good rises, I will substitute other similar goods for it. For example, if the price of beef rises, I will eat more chicken and pork.

6. Income Effect As the price of a commodity rises, my income will not stretch as far as it used to. I am therefore “poorer” in a relative sense, than before the price increase.

7. Market Demand Curve The market demand curve “adds up” all the quantities demanded by individual consumers at a given price. It shows the total amount of a quantity consumers are willing and able to buy at a given price.

8. The Demand Curve P D Q

9. Moving Along Demand If the price of a product changes, consumers move along the demand curve to a new quantity. If price rises, quantity demanded falls. If price falls, quantity demanded rises. The curve itself DOES NOT MOVE. The movement is from one point to another ON THE ORIGINAL CURVE,

10. Demand for Pretzels P At a price of $10, 3 pretzels will be sold in this market. Point A on the demand curve shows this relationship. A $10 D 3 Q

11. Total Revenue Total Revenue is price times quantity. In this case, total revenue would be $30 ($10x3).

12. Demand for Pretzels P At a price of $5, 9 pretzels will be sold in this market. Point B on the demand curve shows this relationship. B $5 D Q 9

13. Moving from A to B In moving from point A to point B, we have gone down the original demand curve. As the price of pretzels fell, the quantity demanded increased. Price and quantity move in opposite directions on a demand curve.

14. Total Revenue at Point B Total Revenue at point B is $45. ($5x9) Total Revenue got larger as we moved from point A to point B because the increase in quantity was larger, in relative terms, than the decrease in price. Price fell by 1/2 ($10 to $5), but quantity tripled (3 to 9). The increase in quantity more than offset the decrease in price.

15. To find out what happens to TR To find out what happens to TR as we move along a demand curve we have to know which change is proportionately bigger, the change in quantity or the change in price. TR will move in the same direction as the change that is relatively bigger. So if quantity changes by a larger percentage than price, as it did in this example, TR will follow quantity. If the percentage change in price were bigger, TR would follow price.

16. Elasticity of Demand The elasticity of demand tells us the relationship between the percentage change in quantity and the percentage change in price as we move along a demand curve.

17. Elastic Demand When demand is elastic, the percentage change in quantity is GREATER than the percentage change in price. Total Revenue will therefore move in the SAME direction as quantity as we move along the demand curve.

18. Inelastic Demand When demand is inelastic, the percentage change in quantity is LESS than the percentage change in price. Total Revenue will therefore move in the SAME direction as price as we move along the demand curve.

19. The Demand Curve P Elasticity of demand refers to movements along the curve. D Q

20. How do we move along the curve? If we own the sort of company or agency that can control the price of its product, we can move to a new point on the demand curve by changing price. If we increase price, we expect consumers to buy less of the product. If we decrease price, we expect consumers to buy more.

21. Price and TR If demand is elastic, I can boost total revenue by dropping price because my increase in quantity will more than make up for the lower price. If demand is inelastic, I can increase total revenue by raising price because my decrease in quantity will not be large enough to undo the boost from a higher price.

22. Elastic and Inelastic Demand Changes in Price If demand is elastic, TR moves the opposite way from price. TR rises when price falls, and TR falls when price rises. If demand is inelastic, TR moves the same way as price. TR rises when price rises, and TR falls when price falls.

23. A company changes its price (moving along a stable demand curve). You observe: TR rose after the price of a product rose. You figure that demand is _________. TR fell after the price of a product rose. You figure that demand is _________. TR rose after the price of a product fell. You figure that demand is __________. TR fell after the price of a product fell. You figure that demand is __________. inelastic elastic elastic inelastic

24. Another Way to Move Along Demand In markets, with a stable demand curve, price will change when supply shifts. When supply shifts, we move along the original demand curve to a new equilibrium point.

25. Shifting Supply The shift in Supply moves us from one point to another on the old Demand P S2 S1 p2 p1 D Q q2 q1

26. We know that We know that when supply decreases, price increases and quantity decreases. We know that when supply increases, price decreases and quantity increases.

27. Supply shifts and TR What happens to TR after a shift in supply depends on the elasticity of demand. When we shift supply, we are moving along demand, so we use the same logic as before. We look at the elasticity of demand and see which is biggest, the % change in quantity or the % change in price.

28. Supply Shift and TR So, if demand is elastic, TR will increase after an increase in supply because TR moves in the same direction as quantity. (Quantity increases after a supply increase.) If demand is inelastic, TR will decrease after an increase in supply because TR moves in the same direction as price. (Price decreases after a supply increase.)

29. By the same logic Using the same logic, a decrease in supply causes TR to decrease when demand is elastic. A decrease in supply causes TR to increase when demand is inelastic.

30. You observe • TR decreases after a supply decrease. Demand is _____________ • TR increases after a supply decrease. Demand is ______________ • TR decreases after a supply increase. Demand is ______________ • TR increases after a supply increase. Demand is ___________________ elastic inelastic inelastic elastic

31. Shifting Curves Moving the entire curve

32. The position of the demand curve The position of the demand curve (e.g. where it sits in space on the graph) is affected by a number of things. If one of these factors changes, the entire demand curve will move.

33. Factors Affecting Demand • Size of market, e.g. how many consumers. • Income levels of consumers. • Prices and availability of related goods. • Tastes and preferences. • Special influences, e.g. climate and conditions.

34. For Demand to SHIFT One of these factors must change.

35. Shift versus Movement Along The demand curve does not shift when price of the product itself changes. Such a price change causes movement ALONG the original demand curve.

36. Change in Demand Demand curves will shift, as income, other prices, market size, or tastes or preferences change. "Shift" is another way of saying "change" in this case.

37. Movement along the demand curve Movement along the demand curve occurs as the good’s own price changes. P As price falls, a greater quantity is demanded. Q

38. Shifts in Demand Shifts in the demand curve take place if one of the factors behind the demand curve changes: income, prices of available goods, tastes or preferences, or special influences.

39. For Example Demand may shift outward (increase) as income rises, market size increases, the price of a substitute increases, or some special factors in the market change. P Q

40. And Demand may shift inward (decrease) as income falls, market size decreases, the price of a substitute falls, or some special factors in the market change. P Q

41. The Supply Schedule The supply schedule (or supply curve) for a commodity shows the relationship between the market price and the amount of that commodity that producers are willing and able to produce and sell, other things held constant.

42. Supply Slopes Up Supply slopes up because of the “law of diminishing returns.” To get extra output usually requires proportionally more extra input.

43. Market Supply To get market supply, sum the quantities supplied by all the individual firms at each price level.

44. Supply Shifters • Changes in costs of inputs • Technological change • Government policy • Special factors (climate, culture)

45. These factors Any of these factors can cause the firm supply curve to shift.

46. Movement along supply curve P S As price rises, all other things held constant, the quantity supplied increases. Q

47. Shift of supply curve P If the price of an input falls, the supply curve shifts out. S S’ Q

48. S S' D A shift in Supply causes a movement along the demand curve. Demand doesn't change but quantity demanded changes because of the price change.

49. S D D' A shift in Demand causes a movement along the supply curve. Supply doesn't change but quantity supplied changes because of the price change.

50. Market Equilibrium A market equilibrium comes at the place where quantity demanded equals quantity supplied. Equilibrium takes place at the intersection of the supply and demand curves.