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What types of questions does the supply and demand model help answer?
- How the markets are doing
- In markets where this model is applicable, it allows us to make clare predictions about the effects of external shocks on prices and market out comes
- This model is precisely accurate in perfectly competitive markets in which all suppliers and buyers are price takers. It is not accurate otherwise.
What type of market needs to be in place for the supply and demand model to work?
This model is precisely accurate in perfectly competitive markets in which all suppliers and buyers are price takers. It is not accurate otherwise.
What is the demand curve?
- The demand curve is a concise summary of the answer to the question: What happens to the quantity demanded as the price changes, when all other factors are held constant?
- It shows the quantity demanded at each possible price, holding other factors that influence purchases constant.
What is the definition of "demand curve"?
Its a graph showing how the demand for a commodity or service varies with changes in its price.
What are the five factors of demand?
Price of the product - consumers demand more of a good when its price is lower, holding other things constant.
Income - when a consumers income rises that consumer will often buy more of many goods.
Price of related goods - Substitute: different brands of essential the same good that are close to substitute Compliment a good that is used with a good under consideration.
Tastes and information - Consumers do not purchase goods they dislike. Firms devote significant resources to trying to change consumer tastes through advertising. Information about characteristics and the effect s of a good has an impact on consumer decisions.
Government regulations Governments may ban, restrict or subsidize goods or services.
What is the law of demand?
Consumers demand more of a good when its price is lower, holding other things constant.
Discuss the factor of demand - price of related goods... What are the two possibilities?
Substitute: different brands of essentially the same goods are close substitutes
Buyers decide how much of different goods to purchase based, in part, on relative prices. As the price of one good changes, it changes relative to the prices of others goods, given that the other prices do not change. This induces buyers to alter the mix of goods
Compliment: A good that is used with the good under consideration.
What is the law of demand?
The law of demand states that there is an inverse relationship between quantity demanded of a commodity and it’s price, other factors being constant. In other words, higher the price, lower the demand and vice versa, other things remaining constant.
How does the graphical presentation of demand curve look?
It's a reverse function, (P is a function of Q)
How do you determine the demand if there are more than one consumer/demand for the product?
- The overall demand is composed of
- the demand of many individual consumers.
The total quantity demanded at a given price is the sum of the quantity each consumer demands at that price.
- We can generalize this approach to
- look at the total demand for three or four or more consumers, or we can apply it to groups of consumers rather than just to individuals.
Therefore.... The demand for consumer 1+ The demand for consumer 2 = Total quantity demanded
What is elasticity?
The price elasticity of demand (or simply the demand elasticity) is the percentage change in quantity demanded, Q, divided by the percentage change in price, p.
What are the two measures of elasticity?
Arc Price Elasticity
the arc elasticity is the elasticity of one variable with respect to another between two given points. It is the ratio of the percentage change of one of the variables between the two points to the percentage change of the other variable.
- (q/average Q)/(p/average P)
- It is an elasticity that uses the average price and average quantity as the denominator for percentage calculations.
In the formula (∆Q/Avg Q) is the percentage change in quantity demanded and (∆p/Avg p) is the percentage change in price.
- Point elasticity measures the effect of a small change in price on the quantity demanded.
- In the formula, we are evaluating the elasticity at the point (Q, p) and ∆Q/∆p is the ratio of the change in quantity to the change in price.
- Point elasticity is useful when the functional form of the demand curve is available.
What is Point Elasticity?
Point elasticity measures the effect of a small change in price on the quantity demanded.In the formula, we are evaluating the elasticity at the point (Q, p) and ∆Q/∆p is the ratio of the change in quantity to the change in price.Point elasticity is useful when the functional form of the demand curve is available.
What is Arc Price Elasticity ?
the arc elasticity is the elasticity of one variable with respect to another between two given points. It is the ratio of the percentage change of one of the variables between the two points to the percentage change of the other variable.(q/average Q)/(p/average P)It is an elasticity that uses the average price and average quantity as the denominator for percentage calculations.In the formula (∆Q/Avg Q) is the percentage change in quantity demanded and (∆p/Avg p) is the percentage change in price.
If the shape of the linear demand curve is downward sloping, elasticity
varies along the demand curve.
The higher the price, the more elastic the demand curve.
What is Income Elasticity?
is the percentage change in the quantity demanded divided by the percentage change in income Y.
◦Normal goods have positive income elasticity, such as avocados.
◦Inferior goods have negative income elasticity, such as instant soup.
What is cross-price elasticity?
the percentage change in the quantity demanded divided by the percentage change in the price of another good
- ◦Complement goods have negative
- cross-price elasticity, such as cream and coffee.
- ◦Substitute goods have positive
- cross-price elasticity, such as avocados and tomatoes.
What is the supply curve?
supply curve, in economics, graphic representation of the relationship between product price and quantity of product that a seller is willing and able to supply. Product price is measured on the vertical axis of the graph and quantity of product supplied on the horizontal axis.
- ◦is a concise summary of the answer to the question: What happens to the quantity supplied as the price changes, when all other
- factors are held constant?
- ◦shows the quantity supplied at each possible price, holding other factors that
- influence firms’ supply decisions constant.
What are factors of supply?
- Own price - typically suppliers want to supply more of their goods if the price is higher
- Cost of production - when teh cost of production input increases, companies want to supply less at a given price holding other factors constant
- Technological change - if tech advances allow a company to produce at a lower cost, the company wants to supply more at a given price holding all other factors constant
- Government regulations - may ban, restrict, tax or subsidize goods or services
What is the market equilibrium?
Where the demand curve and supply curve meet.
- The market is in equilibrium when all
- market participants are able to buy or sell as much as they want (no participant wants to change his/her behavior). In other words, quantity supplied equals quantity demanded. This is often referred to as market clearing condition.
What are types of government intervention?
- Price controls
- Limits on who can buy (i.e. cigarettes)
- Restriction of imports
- Government purchase of goods
What is a price ceiling?
Government intervention where a binding ceiling price (regulated price is below the market clearing price) is established.
A price ceiling is a government-imposed price control or limit on how high a price is charged for a product. Governments intend price ceilings to protect consumers from conditions that could make necessary commodities unattainable
What is a price floor?
A price floor is a government- or group-imposed price control or limit on how low a price can be charged for a product. A price floor must be greater than the equilibrium price in order to be effective.
What is the effect of sales taxes?
The specific sales tax causes the equilibrium price consumers pay to rise, the equilibrium price that firms receive to fall, and the equilibrium quantity to fall.
Does it matter who gets taxed?
- ◦It doesn’t matter whether the specific tax is
- collected from firms or consumers.
◦The market outcome is the same regardless of who is taxed.
Are taxes fully passed to consumers?
Full pass-through can occur but partial pass-through is more common.
◦The degree of the pass through depends on the shapes of the S and D curves.
◦Perfectly elastic demand – no pass through.
◦Perfectly inelastic demand – full pass through.
What is the consumer preference/utility function?
In economics, utility is a representation of preferences over some set of goods and services. Preferences have a (continuous) utility representation so long as they are transitive, complete, and continuous.Utility is usually applied by economists in such constructs as the indifference curve, which plot the combination of commodities that an individual or a society would accept to maintain a given level of satisfaction. Individual utility and social utility can be construed as the value of a utility function and a social welfare function respectively.
To explain consumer behavior... economists assume that consumers have...
a set of tastes or preferences that they use to guide them in choosing between goods. These tastes differ substantially among individuals.
What are three properties of consumer preference?
when a consumer faces a choice between two bundles of goods and only one of the following is true. The consumer might prefer the first bundle to the second, or the second bundle to the first, or be indifferent between the two bundles.
More is better:
- Transivity: ◦if a is strictly
- preferred to b and b is strictly preferred to c, it follows that a must be strictly preferred to c. Transitivity applies also to weak preference and indifference relationships.
◦all else being the same, more of a good is better than less. This is a nonsatiation property
What is Transivity?
Transivity: ◦if a is strictlypreferred to b and b is strictly preferred to c, it follows that a must be strictly preferred to c. Transitivity applies also to weak preference and indifference relationships.
What are three properties of indifference curves?
- 1. Bundles on indifference curves farther than the origin are preferred to those on indifference curves closer to the origin.
- 2. There is an indifference curve through every possible bundle
3. Indifference curves cannot cross
4. Indifference curves slope downward.
Can indifference curves cross?
Indifference curves slope ___
Indifference curves farther away from the origin...
are preferred to those on indifference curves closer to the origin.
What is Marginal Utility?
Marginal utility is the slope of the utility function as we hold the quantity of the other good constant
In economics, the marginal utility of a good or service is the gain from an increase, or loss from a decrease, in the consumption of that good or service.
What is Marginal rates of Substitution?
- The MRS depends on the negative of the ratio of the marginal utility of one good to the
- marginal utility of another good.
In economics, the marginal rate of substitution is the rate at which a consumer is ready to give up one good in exchange for another good while maintaining the same level of utility. At consumption levels, our marginal rates of substitution are identical.
MRS shows the rate at which ....
consumer can substitute one good for another while remaining on the same indifference curve.
What is MRS?
Marginal Rate of Substitution
What are types of preference? (indifference curves)
- Perfect Substitutes
- Perfect Complements
- Imperfect Substitutes
What is the budget constraint?
A budget constraint represents all the combinations of goods and services that a consumer may purchase given current prices within his or her given income. Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices. Both concepts have a ready graphical representation in the two-good case.
What is Opportunity Set?
- all the bundles a consumer can buy,
- including all the bundles inside the budget constraint and on the budget
What does the slope of the budget line look like?
Negative slope, like the demand curve
If Lisa's MRT is -1/2 for pizza/burritos, we can infer...
she can "trade" an extra pizza for half of a burrito, or equivalently she has to give up two pizzas to obtain an extra burrito
Where does a consumers optimal bundle lie?
The optimal bundle must lie on an indifference curve that touches the budget line but does not cross it. (where MRS=MRT)
Point e is where: MRS = MRT or
It's the consumers optimal bundle.
What is the production process?
Production is a process of combining various material inputs and immaterial inputs (plans, know-how) in order to make something for consumption (the output). It is the act of creating output, a good or service which has value and contributes to the utility of individuals.
What is the Production Function?
The maximum quantity of output that can be produced with different combinations of inputs (factors of production), given current knowledge about technology and organization
What is Short Run production?
A period of time that is short enough such that at least one input cannot be varied. In the short run, inputs are a combination of fixed input and variable inputs.
In economics, it is the concept that within a certain period of time, in the future, at least one input is fixed while others are variable. The short run is not a definite period of time, but rather varies based on the length of the firm's contracts. For example, a firm may have entered into lease contracts which fix the amount of rent over the next month, year or several years. Or the firm may have wage contracts with certain workers which cannot be changed until the contract renewal.
What is Long Run production?
a period of time that all inputs can be varied. In the long run, all inputs are variable.
the long run is the conceptual time period in which there are no fixed factors of production, so that there are no constraints preventing changing the output level by changing the capital stock or by entering or leaving an industry.
q = f(L, K)
is a production function for a firm that uses only labor and capital as production inputs. This production function suggests that in order to produce q units of output, the company needs to have L units of labor and K units of capital.
What is Marginal Product of Labor ?
MPL = ∆q/∆L
Shows a change in total output resulting from using one extra unit of labor, holding other factors (capital) constant)
In economics, the marginal product of labor (MPL) is the change in output that results from employing an added unit of labor.
What is the Average Product of Labour?
APL = q/L
Shows the ratio of output to the amount of labor used to produce that output.
If MPL > APL
then average product must rise with extra labor.
If MPL < APL
then average product must fall with extra labor
If MPL = 0,
- then the product curve reaches its peak (maximum
What is The Law of Diminishing Marginal Returns?
- If a company keeps increasing an input, holding all other inputs and technology constant, the corresponding increases in output
- will eventually become smaller (diminish).
What is fixed cost?
cost associated with fixed input and thus does not vary with the level of output. Examples: expenditures on land, office space, production facilities, and other overhead expenses.
In economics, fixed costs, indirect costs or overheads are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month, and are often referred to as overheadcosts.
What are Variable costs?
- cost associated with variable input
- and thus will change as the quantity of output changes.
A corporate expense that varies with production output. Variable costs are those costs that vary depending on a company's production volume; they rise as production increases and fall as production decreases.
What are total costs? TC
The sum of fixed and variable costs
What is Marginal Cost?
Marginal cost (MC = ΔC/Δq) is the amount by which a firm’s cost changes if the firm produces one more unit of output.
In economics and finance, marginal cost is the change in the totalcost that arises when the quantity produced has an increment by unit. That is, it is the cost of producing one more unit of a good.
Marginal cost also equals the change in variable cost
from a one-unit increase in output because…fixed cost is fixed; MC = ΔVC/Δq = w(ΔL/Δq) = w/MPL
- ◦Goes up, then MC must goes down. When the production
- is really effective, it is less costly to produce more.
◦Goes down, then MC must goes up. When the production is really ineffective (diminishing marginal return), it is more costly to produce more.
The production function determines
the shape of the
- marginal cost, average variable
- cost, and average cost curves.
As output increases, variable cost ____
increases more than proportionally because of diminishing marginal returns.
If MC < AVC
- then average variable cost must fall with
- additional output.
If MC > AVC
then average variable cost must rise with additional output.
If MC = AVC
then average variable cost is at its minimum.
In the long run, labor and capital are ___.
- The firm can substitute one input for another while continuing to produce the same
- level of output.
What is isoquant?
In economics, an isoquant (derived from quantity and the Greek word iso, meaning equal) is a contour line drawn through the set of points at which the same quantity of output is produced while changing the quantities of two or more inputs.
What are some properties of Isoquants?
The farther the isoqunt from the origin, the greater the level of output.
Isoquants do not cross
Isoquants slope downards
The slope of the isoquant shows the ability of a firm to replace one input with another while holding output constant.
The farther an isoquant is from the origin, the greater the
level of output.
The slope of an isoquant shows the ability of a firm to
replace one input with another while holding output constant.
What is the marginal rate of technical substitution?
The rate at which one factor has to be decreased in order to retain the same level of productivity if another factor is increased. The marginal rate of technical substitution shows the tradeoffs between factors, such as capital and labor, that a firm must make in order to keep output constant. The marginal rate of technical substitution is different than the marginal rate of substitution (MRS). MRTS focuses on producer equilibrium, while MRS focuses on consumer equilibrium.
What is Constant Returns to Scale ?
A production function exhibits constant returns to scale if doubling inputs exactly doubles the output.
Production process with neither economies nor diseconomies of scale: the output of the process increases or decreases simultaneously and in step with increase or decrease in the inputs. A plant with a constant returns to scale is equally efficient in producing small batches as it is in producing large batches.
What is Increasing returns to scale?
A production function exhibits increasing returns to scale if doubling inputs more than doubles the output.
Increasing returns to scale exists if a firm increases ALL resources--labor, capital, and other inputs--by a given proportion (say 10 percent) and output increases by more than this proportion (that is more than 10 percent).
What is Decreasing Returns to Scale ?
•A production function exhibits decreasing returns to scale if doubling inputs less than doubles output.
A property of a production function such that changing all inputs by the same proportion changes output less than in proportion. Example: a function homogeneous of degree less than one. Also called simplydecreasing returns. Not to be confused with diminishing returns, which refers to increasing some inputs while holding other inputs fixed. Contrasts with increasing returns and constant returns.
What are returns to scale?
In economics, returns to scale and economies of scale are related but different terms that describe what happens as the scale of production increases in the long run, when all input levels including physical capital usage are variable (chosen by the firm).
There are constant, increasing and decreasing returns to scale.
What is Isocost?
An isocost represents all combinations of inputs that have the same total cost.
The isocost line is combined with the isoquant map to determine the optimal production point at any given level of output. Specifically, the point of tangency between any isoquant and an isocost line gives the lowest-cost combination of inputs that can produce the level of output associated with that isoquant.
What are some properties of Isocosts?
Isocost lines that are farther from the origin have higher costs than those closer to the origin.
The slope of each isocost line with capital on the vertical axis is –w/r, the rate at which the firm can trade capital for labor in input markets
Isocost lines that are farther from the origin have
higher costs than those closer to the origin.
The firm minimizes its cost by using the combination of inputs on the
isoquant that is tangent to the isocost line
In the long run, returns to scale determine the shape of
the production function
increasing returns to scale =
◦decreasing average cost at low levels of output.
constant returns to scale =
- ◦constant average cost at intermediate
- levels of output
decreasing returns to scale =
- ◦increasing average cost at high levels of
The long-run average cost is always
equal to or below the short-run average cost because any input combination in the short run is also available in the long run.
What is Economies of Scope ?
An economic theory stating that the average total cost of production decreases as a result of increasing the number of different goods produced.
What is production allocation?
- If there are more than 2 production functions, for example two plants of different size, then production allocation across these
- two production functions should be such that MCA = MCB.
- For Example: A company has 2 production plants that have in the following marginal
- cost functions.
Plant 1: MC1=0.4Q1
Plant 2: MC2=2+0.2Q2
How much should this firm produces with each process if it wants to produce 4 units of output? What about 8 units of output?