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Supply and Demand.

Chapter 1

1) supply curve - the relationship between the quantity of a good that producers are willing to sell and the price of the good.

2) demand curve - the relationship between the quantity of a good that consumers are willing to buy and the price of the good.

3) substitutes - two goods for which an increase in the price of one leads to an increase in the quantity demanded of the other.

4) complements - two goods for which an increase in the price of one leads to a decrease in the quantity demanded of the other.

5) equilibrium (or market-clearing) price - price that equates the quantity supplied to the quantity demanded.

6) market mechanism - tendency in a free market for price to change until the market clears.

7) surplus - situation in which the quantity supplied exceeds the quantity demanded.

8) shortage - situation in which the quantity demanded exceeds the quantity supplied.

9) elasticity - percentage change in one variable resulting from a 1-percent increase in another.

Positive analysis deals with explanation and prediction.

Normative analysis deals with what ought to be.

A perfectly competitive market is characterized by the fact that there is a “going market price” which all buyers pay and all sellers receive, and no one player in the market can individually affect the price.

A corner solution exists if a customer buys in extremes, & buys all of one category of good & none of another. MRS is not necessarily equal to Pa/Pb.

For a corner solution, it is only necessary that the MRS exceed the price ratio.

In a non-competitive market, a single firm is large enough to affect the price of the product.

The real price of a good in year Z in terms of base year B dollars is:

Real price in year Z= (CPI B /CPI Z )*Nominal price of good in year Z.

Cartels - groups of producers who act collectively.

Chapter 2

Elasticities provide a useful way of summarizing the response of one economic variable to a change in another variable.

The elasticity of demand is defined as the percentage change in quantity demanded that results from a one-percent change in price.

Elastic- a one-percent increase in its price will cause the quantity demanded to fall by more than one percent.

Inelastic – a one-percent increase in its price causes the quantity demanded to fall by less than one percent.

Supply and Demand analysis is only appropriate for competitive markets.

Supply Curve

Q s =c+dP

(c = intercept, d = slope)

?P/?Q s =1/d

d=?Q s /?P

Demand Curve

Q D =a-bP

?Q D /?P=-b

The own-price elasticity of demand is defined in general as

E p =(P/Q)(?Q/?P)

E p =-b(P/Q)

Since the demand elasticity is always less than zero ( demand curves slope down), the distinction between elastic and inelastic demand depends on whether E p is less than or greater than -1.

The income elasticity of demand is the percentage change in the quantity demanded in response to a one-percent change in income:

E I =(?Q/?I)(I/Q)

The cross-price elasticity of demand is the percentage change in the quantity demanded of one good in response to a one-percent change in the price of a related good:

E QxPy =(P y /Q x )(?Q x /?P y )

The cross-price elasticity of demand is positive if the two goods are substitutes and it is negative if the two goods are complements.

The price elasticity of supply is the percentage change in the quantity supplied in response to a one-percent change in price:

E s =(P/Q)(?Q s /?P)

E s =d(P/Q)

The elasticity of supply is a positive number: a supple curve is inelastic if E s >1 and it is inelastic if 0<Es<1.

For non-durable goods, short-run demand is less elastic than long-run demand.

For durable goods, the short-run demand is more elastic.

The term price-ceiling is used when the government sets a price in the market that is below the equilibrium price. When the government sets a price that is above the equilibrium price it is called a price floor. Price ceilings create situations of excess demand, while price floors create excess supply.

Chapter 3.

There are 3 steps involved in the study of consumer behavior

1) consumer preferences

2) budget constraints

3) given preferences & limited incomes, what amount and type of goods will be purchased?

An indifference curve maps out all of the market baskets that yield the same amount of utility to the consumer. The slope of the indifference curve at a point is called the marginal rate of substitution (MRS).

Indifference curves cannot cross. - violates assumption that more is better.

If the indifference curve is sloped upward, they would violate the assumption that more is preferred to less.

Three basic preference assumptions are required in order to use indifference curves in a consistent manner:

•  completeness

•  transitivity

•  more is better.

The budget constraint describes the rate at which the consumer is able to trade, given market prices and the level of the consumer's income. We assume that the consumer will always spend all of his or her income.

Utility-maximization is achieved when the budget constraint is tangent to an indifference curve. At this tangency point, the marginal rate of substitution between the two goods is equal to the ratio of the prices.

MRS= - ?C/?F

Budget constraints.

The slope of the budget line is - Pf/Pc

P F F+P C C=I

C=I/P C – (P F /P C )F

MRS= P F /P C

Market basket (or bundle) - List with specific quantities of one or more goods.

Utility - a numerical score representing the satisfaction that a consumer gets from a given market basket.

Marginal Utility

Every market basket on an indifference curve gives the same utility. Utility is simply a measure of the satisfaction that an individual gets from consuming a particular market basket.

MRS=MU F /MU C =P F /P C

Ordinal utility function - utility function that generates a ranking of market baskets in order of most to least preferred.

Cardinal utility function - utility function describing by how much one market basket is preferred to another.