Demand and Supply Review for AP Economics
The review questions for this study guide can be found at:
Main Topics: Law of Demand, Income and Substitution Effects, Demand Curves, Determinants of Demand
For many years now, you have understood the concept of demand. On the surface, the concept is rather simple: people tend to purchase fewer items when the price is high than they do when the price is low. This is such an intuitively appealing concept that your typical consumer cares little about the rationale and still manages to live a happy life. As someone knee-deep in reviewing to take the AP exams, you need to go "behind the scenes" of demand. Intuition will take you only so far: you need to know the underlying theory of what is perhaps the most widely understood, and sometimes misunderstood, economic concept.
Law of Demand
Let's get this part out of the way. The Law of Demand is commonly described as: "Holding all else equal, when the price of a good rises, consumers decrease their quantity demanded for that good." In other words, there is an inverse, or negative, relationship between the price and the quantity demanded of a good.
"Holding all else equal "? Economic models—demand is just one of many such models—are simplified versions of real behavior. In addition to the price, there are many factors that influence how many units of a good consumers purchase. In order to predict how consumers respond to changes in one variable (price), we must assume that all other relevant factors are held constant. Say we observed that last month, the price of orange juice fell, consumer incomes rose, the price of apple juice increased, and consumers bought more orange juice. Was this increased orange juice consumption because the price fell, because incomes rose, or was it because apple juice became more expensive? Maybe it increased for all of these reasons. Maybe for none of these reasons. It is impossible to isolate and measure the effect of one variable (i.e., orange juice prices) on the consumption of orange juice if we do not control (hold constant) these other external factors. At the heart of the Law of Demand is a consumer's willingness and ability to pay the going price. If the consumer becomes more willing, or more able, to consume a good, then either the price has fallen, or one of these external factors has changed. We spend more time on these demand "determinants" a little later in this chapter. Income and Substitution Effects
One of the important things behind the scenes of the Law of Demand is the economic mantra "only relative prices matter." I'm sure you have heard the stories from your parents or grandparents about how the price of a cup of coffee "back in the good old days" was just a nickel. Today you might get the same coffee for $1.75. These prices are simply money (or absolute, or nominal) prices, and when it comes to a demand decision, a money price alone is near useless. However, if you think about the money price in terms of: (1) what other goods $1.75 could buy, or (2) how much of your income is absorbed by $1.75, then you're talking relative (or real) prices. These are what matter. The number of units of any other good Y that must be sacrificed to acquire the first good X, measures the relative price of good X.
Let's keep things simple and say that you divide your $10 daily income between apple fritters at today's prices of $1 each and chocolate chip bagels at $2 each. These are the money prices of your labor and of these two yummy snacks.
Today at the price of $1, the relative cost of a fritter is one-half of a bagel (see Table 6.1). Relative to your income, it amounts to one-tenth of your budget.
Tomorrow, when the price doubles to $2 per fritter, two things happen to help explain, and lay the foundation for, the Law of Demand.
- The relative price of a fritter has risen to one bagel and the relative price of a bagel has fallen from two fritters to one fritter. Since fritters are now relatively more expensive, we would expect you to consume more bagels and fewer fritters. This is known as the substitution effect.
- Relative to your income, the price of a fritter has increased from one tenth to one fifth of your budget. In other words, if you were to buy only fritters, today you can purchase 10 but tomorrow the same income would only buy you 5. This lost purchasing power is known as the income effect.
- Substitution effect: the change in quantity demanded resulting from a change in the price of one good relative to the price of other goods.
- Income effect: the change in quantity demanded resulting from a change in the consumer's purchasing power (or real income).
When the price of fritters increased, both of these effects caused our consumer (you) to decrease the quantity demanded, thus predicting a response consistent with the Law of Demand.
"How would a consumer react if the prices of fritters and bagels, and daily income had all doubled?"
Since the price of fritters, relative to the price of bagels, and relative to daily income, has not changed, the consumer is unlikely to alter behavior. This is why we say that only relative prices matter.
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