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Thomas Tatro's List: ECON TCO2
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The cross elasticity of demand measures how sensitive consumer purchases of one product
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The short run in microeconomics is a period of time too short to change plant capacity but long enough to use the fixed-sized plant more or less intensively. In the short run, our farmer’s plant (land and farm machinery) is fixed. But he does have time in the short run to cultivate tomatoes more intensively by applying more labor and more fertilizer and pesticides to the crop.
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The degree of price elasticity of supply depends on how easily—and therefore quickly—producers can shift resources between alternative uses. The easier and more rapidly producers can shift resources between alternative uses, the greater the price elasticity of supply.
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The simplest solution to the problem is to use the midpoint formula for calculating elasticity. This formula simply averages the two prices and the two quantities as the reference points for computing the percentages. That is,
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- • In competitive markets, prices adjust to the equilibrium level at which quantity demanded equals quantity supplied.
- • The equilibrium price and quantity are those indicated by the intersection of the supply and demand curves for any product or resource.
- • An increase in demand increases equilibrium price and quantity; a decrease in demand decreases equilibrium price and quantity.
- • An increase in supply reduces equilibrium price but increases equilibrium quantity; a decrease in supply increases equilibrium price but reduces equilibrium quantity.
- • Over time, equilibrium price and quantity may change in directions that seem at odds with the laws of demand and supply because the other-things-equal assumption is violated.
- • Government-controlled prices in the form of ceilings and floors stifle the rationing function of prices, distort resource allocations, and cause negative side effects.
QUICK REVIEW 3.3
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A price floor is a minimum price fixed by the government. A price at or above the price floor is legal; a price below it is not. Price floors above equilibrium prices are usually invoked when society feels that the free functioning of the market system has not provided a sufficient income for certain groups of resource suppliers or producers
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In brief, rent controls distort market signals and thus resources are misallocated: Too few resources are allocated to rental housing and too many to alternative uses. Ironically, although rent controls are often legislated to lessen the effects of perceived housing shortages, controls in fact are a primary cause of such shortages
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A price ceiling sets the maximum legal price a seller may charge for a product or service. A price at or below the ceiling is legal; a price above it is not. The rationale for establishing price ceilings (or ceiling prices) on specific products is that they purportedly enable consumers to obtain some “essential” good or service that they could not afford at the equilibrium price. Examples are rent controls and usury laws, which specify maximum “prices” in the forms of rent and interest that can be charged to borrowers
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Competitive markets also produce allocative efficiency: the particular mix of goods and services most highly valued by society (minimum-cost production assumed). For example, society wants land suitable for growing corn used for that purpose, not to grow dandelions. It wants diamonds to be used for jewelry, not crushed up and used as an additive to give concrete more sparkle
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We are looking for the equilibrium price and equilibrium quantity. The equilibrium price (or market-clearing price) is the price where the intentions of buyers and sellers match. It is the price where quantity demanded equals quantity supplied. The table in Figure 3.6 reveals that at $3, and only at that price, the number of bushels of corn that sellers wish to sell (7000) is identical to the number consumers want to buy (also 7000). At $3 and 7000 bushels of corn, there is neither a shortage nor a surplus of corn. So 7000 bushels of corn is the equilibrium quantity: the quantity at which the intentions of buyers and sellers match, so that the quantity demanded and the quantity supplied are equal.
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- • A supply schedule or curve shows that, other things equal, the quantity of a good supplied varies directly with its price.
- • The supply curve shifts because of changes in (a) resource prices, (b) technology, (c) taxes or subsidies, (d) prices of other goods, (e) expectations of future prices, and (f) the number of suppliers.
- • A change in supply is a shift of the supply curve; a change in quantity supplied is a movement from one point to another on a fixed supply curve.
QUICK REVIEW 3.2
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Because supply is a schedule or curve, a change in supply means a change in the schedule and a shift of the curve. An increase in supply shifts the curve to the right; a decrease in supply shifts it to the left. The cause of a change in supply is a change in one or more of the determinants of supply.
In contrast, a change in quantity supplied is a movement from one point to another on a fixed supply curve. The cause of such a movement is a change in the price of the specific product being considered.
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Market supply is derived from individual supply in exactly the same way that market demand is derived from individual demand. We sum the quantities supplied by each producer at each price. That is, we obtain the market supply curve by “horizontally adding” the supply curves of the individual producers
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The basic determinants of supply are (1) resource prices, (2) technology, (3) taxes and subsidies, (4) prices of other goods, (5) producer expectations, and (6) the number of sellers in the market. A change in any one or more of these determinants of supply, or supply shifters, will move the supply curve for a product either right or left
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The table in Figure 3.4 shows that a positive or direct relationship prevails between price and quantity supplied. As price rises, the quantity supplied rises; as price falls, the quantity supplied falls. This relationship is called the law of supply. A supply schedule tells us that, other things equal, firms will produce and offer for sale more of their product at a high price than at a low price. This, again, is basically common sense.
Price is an obstacle from the standpoint of the consumer, who is on the paying end. The higher the price, the less the consumer will buy. But the supplier is on the receiving end of the product’s price. To a supplier, price represents revenue, which serves as an incentive to produce and sell a product. The higher the price, the greater this incentive and the greater the quantity supplied
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An individual producer’s supply of corn. Because price and quantity supplied are directly related, the supply curve for an individual producer graphs as an upsloping curve. Other things equal, producers will offer more of a product for sale as its price rises and less of the product for sale as its price falls
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- • Demand is a schedule or a curve showing the amount of a product that buyers are willing and able to purchase, in a particular time period, at each possible price in a series of prices.
- • The law of demand states that, other things equal, the quantity of a good purchased varies inversely with its price.
- • The demand curve shifts because of changes in (a) consumer tastes, (b) the number of buyers in the market, (c) consumer income, (d) the prices of substitute or complementary goods, and (e) consumer expectations.
- • A change in demand is a shift of the demand curve; a change in quantity demanded is a movement from one point to another on a fixed demand curve
QUICK REVIEW 3.1
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How changes in income affect demand is a more complex matter. For most products, a rise in income causes an increase in demand. Consumers typically buy more steaks, furniture, and electronic equipment as their incomes increase. Conversely, the demand for such products declines as their incomes fall. Products whose demand varies directly with money income are called superior goods, or normal goods
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Although most products are normal goods, there are some exceptions. As incomes increase beyond some point, the demand for used clothing, retread tires, and third-hand automobiles may decrease, because the higher incomes enable consumers to buy new versions of those products. Rising incomes may also decrease the demand for soy-enhanced hamburger. Similarly, rising incomes may cause the demand for charcoal grills to decline as wealthier consumers switch to gas grills. Goods whose demand varies inversely with money income are called inferior goods
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The inverse relationship between price and quantity demanded for any product can be represented on a simple graph, in which, by convention, we measure quantity demanded on the horizontal axis and price on the vertical axis. In the graph in Figure 3.1 we have plotted the five price-quantity data points listed in the accompanying table and connected the points with a smooth curve, labeled D. Such a curve is called a demand curve. Its downward slope reflects the law of demand—people buy more of a product, service, or resource as its price falls. The relationship between price and quantity demanded is inverse (or negative).
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• We can also explain the law of demand in terms of income and substitution effects. The income effect indicates that a lower price increases the purchasing power of a buyer’s money income, enabling the buyer to purchase more of the product than before. A higher price has the opposite effect. The substitution effect suggests that at a lower price buyers have the incentive to substitute what is now a less expensive product for other products that are now relatively more expensive. The product whose price has fallen is now “a better deal” relative to the other products
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Other things equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls. In short, there is a negative or inverse relationship between price and quantity demanded. Economists call this inverse relationship the law of demand.
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- The law of demand is consistent with common sense. People ordinarily do buy more of a product at a low price than at a high price. Price is an obstacle that deters consumers from buying. The higher that obstacle, the less of a product they will buy; the lower the price obstacle, the more they will buy. The fact that businesses have “sales” to clear out unsold items is evidence of their belief in the law of demand.
- • In any specific time period, each buyer of a product will derive less satisfaction (or benefit, or utility) from each successive unit of the product consumed. The second Big Mac will yield less satisfaction to the consumer than the first, and the third still less than the second. That is, consumption is subject to diminishing marginal utility. And because successive units of a particular product yield less and less marginal utility, consumers will buy additional units only if the price of those units is progressively reduced.
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Demand is a schedule or a curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified period of time.1 Demand shows the quantities of a product that will be purchased at various possible prices, other things equal. Demand can easily be shown in table form. The table in Figure 3.1 is a hypothetical demand schedule for a single consumer purchasing bushels of corn.
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