The review questions for this study guide can be found at:
Demand, Supply, Market Equilibrium, and Welfare Analysis Review Questions for AP Economics
Demand
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.
Example:
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.
The Demand Curve
The residents of small midwestern town love to quench their summer thirsts with lemonade. Table 6.2 summarizes the townsfolk's daily consumption of cups of lemonade at several prices, holding constant all other factors that might influence the overall demand for lemonade. This table is sometimes referred to as a demand schedule.
The values in Table 6.2 reflect the Law of Demand: "Holding all else equal, when the price of a cup of lemonade rises, consumers decrease their quantity demanded for lemonade." It is often quite useful to convert a demand schedule like the one above into a graphical Representation, the demand curve (Figure 6.1).
Quantity Demanded versus Demand
The Law of Demand predicts a downward (or negative) sloping demand curve (Figure 6.1) If the price moves from $1 to $1.25, and all other factors are held constant, we observe a decrease in the quantity demanded from 60 to 40 cups. It is important to place special emphasis on "quantity demanded." If the price of the good changes and all other factors remain constant, the demand curve is held constant and we simply observe the consumer moving along the fixed demand curve. If one of the external factors change, the entire demand curve shifts to the left or right.
Determinants of Demand
So what are all of these factors that we insist on holding constant? These determinants of demand influence both the willingness and ability of the consumer to purchase units of the good or service. In addition to the price of the product itself, there are a number of variables that account for the total demand of a good like lemonade. These are:
Demand represents the consumer's willingness and ability to pay for a good. Income is a major factor in that "ability" to pay component. For most goods, when income increases, demand for the good increases. Thus, for these normal goods, increased income results in a graphical rightward shift in the entire demand curve. There are other inferior goods, fewer in number, where higher levels of income produce a decrease in the demand curve.
Example:
When looking to furnish a first college apartment, many students increase their demand for used furniture at yard sales. Upon graduation and employment in their first real job, new graduates increase their demand for new furniture and decrease their demand for used furniture. For them, new furniture is a normal good while used furniture is an inferior good.
- An increase in demand is viewed as a rightward shift in the demand curve. There are two ways to think about this shift.
- At all prices, the consumer is willing and able to buy more units of the good. In Figure 6.2 below you can see that at the constant price of $1, the quantity demanded has risen from two to three.
- At all quantities, the consumer is willing and able to pay higher prices for the good.
Of course the opposite is, true of a decrease in demand, or leftward shift of the demand curve. In Figure 6.2 you can see that at the constant price of $1, the quantity demanded has fallen from two to one.
- Price of Substitute Goods
Two goods are substitutes if the consumer can use either to satisfy the same essential function, therefore experiencing the same degree of happiness (utility). If the two goods are substitutes, and the price of one good X falls, the consumer demand for the substitute good Y decreases.
Example:
Mammoth State University (MSU) and Ivy Vine College (IVC) are considered substitute institutions of higher learning in the same geographical region. Ivy Vine College, shamelessly (wink, wink) seeking to increase its reputation as an "elite" institution, increases tuition while Mammoth State's tuition remains the same. We expect to see, holding all else constant, a decrease in quantity demanded for IVC degrees, and an increase in the overall demand for MSU degrees. (See Figures 6.3 and 6.4.)
- Price of Complementary Goods
Two goods are complements if the consumer receives more utility from consuming them together than she would receive consuming each separately. I enjoy consuming tortilla chips by themselves, but my utility increases if I combine those chips with a complementary good like salsa or nacho cheese dip. If any two goods are complements, and the price of one good X falls, the consumer demand for the complement good Y increases.
Example:
College students love to order late night pizza delivered to their dorm rooms. The local pizza joint decreased the price of breadsticks, a complement to the pizzas. We expect to see, holding all else constant, an increase in quantity demanded for breadsticks, and an increase in the demand for pizzas.
We have different internal tastes and preferences. Collectively, consumer tastes and preferences change with the seasons (more gloves in December, fewer lawn chairs); with fashion trends (increased popularity of tattoos, return of bell-bottoms); or with advertising (low-carb foods). A stronger preference for a good is an increase in the willingness to pay for the good, which increases demand.
The future expectation of a price change or an income change can cause demand to shift today. Demand can also respond to an expectation of the future availability of a good.
Example:
On a Wednesday, you have reason to believe that the price of gasoline is going to rise $.05 per gallon by the weekend. What do you do? Many consumers, armed with this expectation, increase their demand for gasoline today. We might predict the opposite behavior, a decrease in demand today, if consumers expect the price of gasoline to fall a few days from now. Demand can also be influenced by future expectations of an income change.
Example:
One month prior to your college graduation day you land your first full-time job. You have signed an employment contract that guarantees a specific salary, but you will not receive your first paycheck until the end of your first month on the job. This future expectation of a sizeable increase in income often prompts consumers to increase their demand for normal goods now. Maybe you would start shopping for a car, a larger apartment, or several business suits.
Example:
For years, auto producers have been promising more alternative fuel cars, but so far these cars are relatively difficult to find on dealership lots. Suppose the "Big 3" promise widespread availability of affordable electric and hydrogen fuel cell cars in the next 12 months. This expectation of increased availability in the future will likely decrease the demand of these cars today.
An increase in the number of buyers, holding other factors constant, increases the demand for a good. This is often the result of demographic changes or increased availability in more markets.
Example:
When the Soviet Union fractured and the Russian government began allowing more foreign investment, corporations such as Coca-Cola, IBM, and McDonald's found millions of new buyers for their products. Globally, the demand for colas, PCs, and burgers increased.
Supply
Main Topics: Law of Supply, Increasing Marginal Costs, Supply Curves, Determinants of Supply
Fred and Wilma, Woodward and Bernstein, Ross and Rachel, Bill and Monica, Mercedes and Benz, Ben and Jerry, Sex Symbol and Economist. What do they have in common? They are all famous, or infamous, partners. If there are three words that you need to have in your arsenal for the AP exams, they are "Demand and Supply," or "Supply and Demand" if you are the rebellious type. The previous section has covered the demand half of this duo and so it stands to reason that we should spend a little time studying the other side. Unlike demand, few of us have ever had up close and personal experience as suppliers. Lacking such personal experience with supply, it is helpful to try to put yourself in the shoes of someone who wishes to profit from the production and sale of a product. If something happens that would increase your chances of earning more profit, you increase your supply of the product. If something happens that will hurt your profit opportunities, you decrease your supply of the product.
Law of Supply
Drumroll, please. The Law of Supply is commonly described as: "Holding all else equal, when the price of a good rises, suppliers increase their quantity supplied for that good." In other words, there is a direct, or positive, relationship between the price and the quantity supplied of a good.
Again, we insist on qualifying our law with the phrase, "Holding all else equal." Similar to the demand model, the supply model is a simplified version of real behavior. In addition to the price, there are several factors that influence how many units of a good producers supply. In order to predict how producers respond to fluctuations in one variable (price), we must assume that all other relevant factors are held constant. Before we talk about these external supply determinants, let's examine what is happening behind the scenes of the Law of Supply.
Increasing Marginal Costs
The more you do something (e.g., a physical activity), the more difficult it becomes to do the next unit of that activity. Anyone who has run laps around a track, lifted weights, or raked leaves in the yard understands this. If you were asked to rake leaves, as more hours of raking are supplied, it becomes physically more and more difficult to rake the next hour. We also include the opportunity cost of the time involved in the raking, and you surely know that time is precious to a student. If you have a paper to write or an exam to cram for, raking leaves for an hour comes at a dear cost. In terms of forgone opportunities, the marginal cost of raking leaves rises as you postpone that paper or study session.
When we discussed production possibilities in Chapter 5, we addressed a key economic concept: as more of a good is produced, the greater is its marginal cost.
- As suppliers increase the quantity supplied of a good, they face rising marginal costs.
- As a result, they only increase the quantity supplied of that good if the price received is high enough to at least cover the higher marginal cost.
The Supply Curve
A small town has a thriving summer sidewalk lemonade stand industry. Table 6.3 summarizes the daily quantity of lemonade cups offered for sale at several prices, holding constant all other factors that might influence the overall supply of lemonade. This table is sometimes referred to as a supply schedule.
The values in this table reflect the Law of Supply: "Holding all else equal, when the price of a cup of lemonade rises, suppliers increase their quantity supplied for lemonade." Remember those profit opportunities? If kids can sell more cups of lemonade at a higher price, they will do so. It is often quite useful to convert a supply schedule like the one in Table 6.3 into a graphical representation, the supply curve (Figure 6.5).
Quantity Supplied versus Supply
The Law of Supply predicts an upward (or positive) sloping supply curve (Figure 6.5). When the price moves from $1 to $1.25, and all other factors are held constant, we observe an increase in the quantity supplied from 100 cups to 120 cups. Just as with demand, it is important to place special emphasis on "quantity supplied." When the price of the good changes, and all other factors are held constant, the supply curve is held constant; we simply observe the producer moving along the fixed supply curve. If one of the external factors changes, the entire supply curve shifts to the left or right.
Determinants of Supply
Lemonade producers are willing and able to supply more lemonade if something happens that promises to increase their profit opportunities. In addition to the price of the product itself, there are a number of variables, or determinants of supply, that account for the total supply of a good like lemonade. These factors are:
If the cost of sugar, a key ingredient in lemonade, unexpectedly falls, it has now become less costly to produce lemonade and so we should expect producers all over town, seeing the profit opportunity, to increase the supply of lemonade at all prices. This results in a graphical rightward shift in the entire supply curve.
- An increase in supply is viewed as a rightward shift in the supply curve. There are two ways to think about this shift.
- At all prices, the producer is willing and able to supply more units of the good. In Figure 6.6 you can see that at the constant price of $1, the quantity supplied has risen from two to three.
- At all quantities, the marginal cost of production is lower, so producers are willing and able to accept lower prices for the good.
- Of course the opposite is true of a decrease in supply, or leftward shift of the supply curve. In Figure 6.6 you can see that at the constant price of $1, the quantity supplied has fallen from two to one.
- Technology or Productivity
A technological improvement usually decreases the marginal cost of producing a good, thus allowing the producer to supply more units, and is reflected by a rightward shift in the supply curve. If kids all over town began using electric lemon squeezers rather than their sticky bare hands, the supply of lemonade would increase.
A per unit tax is treated by the firm as an additional cost of production and would therefore decrease the supply curve, or shift it leftward. Mayor McScrooge might impose a 25 cent tax on every cup of lemonade, decreasing the entire supply curve. A subsidy is essentially the anti-tax, or a per unit gift from the government because it lowers the per unit cost of production.
A producer's willingness to supply today might be affected by an expectation of tomorrow's price. If it were the 2nd of July, and lemonade producers expected a heat wave and a 4th of July parade in two days, they might hold back some of their supply today and hope to sell it at an inflated price on the holiday. Thus today's quantity supplied at all prices would decrease.
Firms can use the same resources to produce different goods. If the price of a milkshake were rising and profit opportunities were improving for milkshake producers, the supply of lemonade in a small town would decrease and the supply of milkshakes would increase.
When more suppliers enter a market, we expect the supply curve to shift to the right. If several of our lemonade entrepreneurs are forced by their parents to attend summer camp, we would expect the entire supply curve to move leftward. Fewer cups of lemonade would be supplied at each and every price.
The review questions for this study guide can be found at:
Demand, Supply, Market Equilibrium, and Welfare Analysis Review Questions for AP Economics
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