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UMB / Economics / ECON econ 200 / What does the law of supply state?

# What does the law of supply state? Description

##### Description: ECON200 Midterm 1 Study guide Chapters 2-6
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ECON200 MIDTERM 1 STUDY GUIDE

## What does law of supply states?

CHAPTER 2: SPECIALIZATION AND EXCHANGE

Production Possibilities Frontier (PPF)

∙ Production Possibilities Frontier (PPF) is a line or a curve  which shows all the possible combinations of outputs that  can be produced with a given amount of resources.

5 Attainable  points

Good 1 4

3

Unattainable with given resources

2 Attainable but

1 inefficient

0 1 2 3 4 5 6 7 8  Good 2

∙ If the economy operates on the PPF, it is using its resources  efficiently.

## In economics, what are the effects of tax?

∙ Opportunity cost is the amount of a good that must be given  up in order to gain an amount on another good. Here, the  opportunity cost of 5th unit of good 1 is 2 units of good 2 if  we were initially producing 2 units of good 1.

∙ Opportunity cost is represented by the slope of the PPF.  Here, the slope is -0.6 which means that we must sacrifice  0.6 units of good 1 to gain 1 unit of good 2. [Opportunity  cost/slope calculate between points (2,4) and (5,2)]

∙ In general, as more and more resources are shifted towards  one good, the opportunity cost of producing an additional  unit of the good increases. This is because no resource is

equally efficient in producing both the goods. Due to this, the PPF is concave to the origin most of the times.

## Why elasticity of demand is always negative?

∙ PPF is concave to the origin. If you want to learn more check out What is the function of scientific notations?

∙ PPF can shift due to:

o A change in resources – An increase in resources shifts  the PPF to the right and a decrease in resources shifts  the PPF to the left.

Inc. in resources  Dec. in

resources

o A change in technology – An improvement in

technology for a good rotates the PPF of the good  outwards and vice-versa.

Improvement in  technology for good on x axis If you want to learn more check out What makes delusions different from hallucinations?

∙ Absolute advantage – The ability to produce more of a good  or a service than others with the same amount of resources. ∙ Comparative advantage – The ability to produce a good or  service at a lower cost than others.

∙ A country can have a comparative advantage without having the absolute advantage.

∙ A country must have comparative advantage at something  and no country can have comparative advantage at  anything. Don't forget about the age old question of What are the types of advertising media?
If you want to learn more check out What are the roles of t cells?

∙ Specialization is spending all our time and resources on  producing one good or service.

∙ Specialization increases total production even though  resources and technology remain constant.

∙ When a country specializes, it only produces one good. In  order to obtain the other good, it must trade with another  country which specializes in that good.

∙ Gains from trade – Enhancement in output when producers  specialize and exchange goods and services.

∙ If a country specializes and trades with another country, its  consumption possibilities increases beyond the PPF even  without increase in resources or technology. Therefore, trade  is beneficial for all.

∙ PPF however doesn’t tell how much trade should be done. It  is based on the consumer preferences and the costs.

CHAPTER 3: MARKETS We also discuss several other topics like What are the three main classes of membrane proteins?

∙ Market – It refers to the buyers and sellers who exchange  goods and services. We also discuss several other topics like How are stars and planets contained within galaxies?

∙ Market economy – An economy in which private individuals  make the decisions.

COMPETITIVE MARKET

∙ Competitive market – A market in which price-taking buyers  and sellers exchange a standardized good or service and  everyone has perfect knowledge about the market. ∙ Features of this market:

o Price-taker – A buyer or seller can’t affect the market  price because there are lots of buyers and sellers  exchanging a standardized good or service.

o Standardized good – A good for which any two goods  have the same features and are interchangeable.  o The price is constant and there is full information  about the price and features of the good which is sold. o There are no transaction costs which means there is  no extra cost when buyers and sellers agree to

exchange goods.

∙ Very few markets in real world are perfectly competitive.

DEMAND

∙ Quantity demanded- The amount of a good that buyers will  purchase at a given price during a given period of time. ∙ Law of demand states that all else equal, quantity demand  rises as price falls.

∙ Demand schedule – A table showing different quantities of a  good that consumers are willing and able to purchase at  different prices during a given period of time.

∙ Demand curve – A graphical representation of different  quantities of a good that consumers are willing and able to  purchase at different prices during a given period of time.

Price

Quantity Demanded

∙ Non-price determinants of Demand

o Price of related goods- Related goods are of two  types:

 Substitute goods – Goods which can be used in  place of another to satisfy a particular want. If

price of a substitute good increases, demand for  the good we are looking at increases and vice

versa.

 Complementary goods – Goods which are used  together to satisfy a particular want. If price of a  complementary good rises, demand for the good  falls and vice-versa.

o Income of consumers- If a good is a normal good,  then its demand increases as income increases and  vice-versa. If it is an inferior good, then its demand  decreases as income increases and vice-versa.

o Consumer preferences- Consumers have likes and  dislikes which influence their purchases. For goods  towards which they develop a liking, they will demand  more of it and vice-versa.

o Expectations of future prices- If consumers expect  the price of a good to fall in the future, they will

demand less of it now in the hope of buying it in the  future for a lower price. If they expect the price to rise  in the future, they will buy more of it now.

o Number of buyers- More number of buyers in the  market mean more demand for a good.

∙ When the price of the good changes, there is a movement along the same demand curve.

Price

Quantity Demanded

∙ When a non-price determinant of demand changes, the  whole demand curve shifts to the right when demand  increases and to the left when demand falls.

Price Demand rises

Demand falls

Quantity demanded

SUPPLY

∙ Quantity supplied – The quantity of a good or service that  producers will offer for sale during a given price during a  given period of time.

∙ Law of Supply – It states that all else equal, quantity supplied rises as its price increase and vice-versa.

∙ Supply schedule – A table showing different quantities of a  good supplied at different prices during a given period of  time.

∙ Supply curve- A graphical representation of different  quantities of a good supplied at different prices during a  given period of time.

Price

Quantity Supplied

∙ Determinants of Supply:

o Price of related goods – If the price of a related good  falls, the producers would like to increase the supply of  the given good since there is more opportunity of  earning profits from this good than the related good  whose price has fallen.

o Price of inputs – If the price of inputs rises, cost of  production of the good increases which decreases the  profit margin. Hence, supply falls.

o Technology – Improved technology increases the  efficiency of a producer by enabling him to produce  goods with fewer resources. Hence, it increases supply  and vice-versa.

o Expectations – If producers expect the price of a good  to increase in the future, they will reduce the supply  now and wait.

o Number of sellers – More sellers mean more supply  and vice-versa.

∙ When price of a good changes, there is a movement along  the same supply curve.

Price

Quantity Supplied

∙ When a non-price determinant of supply changes, the entire  supply curve shifts to the right when supply increases and to the left when supply decreases.

Price Supply falls Supply rises

Quantity Supplied

EQUILIBRIUM

∙ The situation in which quantity supplied equals quantity  demanded is called market equilibrium.

∙ Equilibrium price – The price at which quantity supplied  equals quantity demanded.

∙ Equilibrium quantity – The quantity that is supplied and  demanded at equilibrium price.

Equilibrium price

Equilibrium quantity

∙ When the quantity supplied is greater than quantity  demanded, we have a surplus or excess supply. In such a  situation, producers want to get rid of their stock so they  reduce the prices to attract more customers until it becomes equal to the equilibrium price.

∙ When the quantity demanded is greater than quantity  supplied, we have a shortage or excess demand. In such a  situation, there are more consumers than the supply of the  good so producers increase the price till it reaches  equilibrium. At this price, some consumers will go away due  to increased price and other consumers who stayed back will get the product.

∙ Market equilibrium changes whenever either supply and/or  demand curves shift.

Demand Supply

Effect

Increase Same

Q inc. P inc.

Decrease Same

Q dec. P dec.

Same Increase

Q inc. P dec.

Same Decrease

Q dec. P inc.

Increase Increase

Q inc. P ???

Increase Decrease

Q ??? P inc.

Decrease Increase

Q ??? P dec.

Decrease Decrease

Q dec. P???

CHAPTER 4: ELASTICITY

∙ Law of Demand tells us about the inverse relationship  between quantity demanded and price, but it doesn’t  tell us by how much quantity demanded changes due to a  change in price of the good. This information can be  obtained by calculating the elasticity.

∙ Elasticity - measure of how much producers and  consumers react to a change in the market conditions. ∙ Types of elasticity:

o Price elasticity of demand: How much quantity  demanded changes due to a change in price

o Price elasticity of supply: How much quantity  supplied changes due to a change in price

o Cross-price elasticity of demand: How demand  changes due to a change in price of related good o Income elasticity of demand: How much demand  change due to a change in consumer’s income

∙ Price elasticity of demand = % change in quantity  demanded

% change in price

∙ Mid-point formula for calculating elasticity:

(Q2 – Q1)/[( Q2 + Q1 ) /

2]

(P2 – P1)/[( P2 + P1 ) / 2]

∙ Elasticity of demand is always negative due to the inverse  relationship between quantity demanded and price.  However, the negative sign isn’t written sometimes. ∙ Elasticity of demand is:

o Elastic if > 0

o Inelastic if < 0

o Unitary if = 1

o Perfectly elastic if = infinite

o Perfectly inelastic if = 0

∙ An elastic demand curve is flatter than an inelastic  demand curve.

Price Price

Quantity

Quantity

ELASTIC

INELASTIC

∙ On a demand curve, the elasticity changes at every point.  The demand is elastic above a certain point and  inelastic below that point. At that point, the demand  is unit elastic.

Elastic

Price Unit-elastic

Inelastic

Quantity

∙ Determinants of price elasticity of demand:

o Availability of substitutes

o Degree of necessity

o Cost relative to income

o Scope of the market

∙ Total Revenue – The total amount a firm receives from the  sale of a given quantity of goods and services.

Total Revenue = Price per unit x Number of

units sold

∙ The type of elasticity of demand for a good  effects the total revenue a firm gets when its  price changes.

∙ An increase in price effects total revenue in two ways (these effects are opposite when price  decreases):

o Price effect – An increase in total revenue due to  selling of the product at a higher price.

o Quantity effect – A decrease in total revenue due to  selling fewer units of the product.

∙ When price effect is greater than quantity effect, the total  revenue increases due to an increase in its price.

∙ When quantity effect is greater than price effect, the total  revenue decreases due to an increase in its price.

∙ Price elasticity of supply = % change in quantity supplied

% change in price

∙ Price elasticity of supply =

(Q2 – Q1)/[( Q2 +  Q1 ) / 2]

(P2 – P1)/[( P2 + P1 ) / 2]

∙ Determinants of price elasticity of supply:

o Availability of inputs

o Flexibility of production process

∙ Cross-price elasticity of demand = % change in  quantity demanded of good 1

%  change in price of good 2

∙ In case of substitute goods, cross-price elasticity is positive. ∙ For complementary goods, cross-price elasticity is negative. ∙ Income elasticity of demand = % change in quantity  demanded

% change in income

∙ If a good is a luxury, income elasticity is positive and >1 ∙ If a good is a necessity, income elasticity is positive and <1 ∙ If a good is normal, income elasticity is positive. ∙ If a good is inferior, income elasticity is negative.

CHAPTER 5: EFFICIENCY

∙ Willingness to pay – The maximum price that consumers are  willing to pay for a good or service.

∙ Willingness to sell – The minimum price a producer is willing  to accept in return for a good or service.

∙ Surplus – A way of measuring who benefits from transactions and by how much. It is the difference between the price at  which a buyer/seller is willing to trade and the actual price.

∙ Consumer surplus – It is the benefit a consumer gets from  purchasing a good, measured by the difference between the  willingness to pay and the actual price.

∙ Producer surplus – It is the benefit a producer gets from  selling a good, measured by the difference between the  willingness to sell and the actual price.

∙ Total surplus- Combined benefits that everyone receives  from participating in an exchange of goods and services. ∙ When there is surplus, both buyers and sellers gain as both  gain surplus.

∙ Efficient Market – A situation in which no exchange can make one person better off with someone else becoming worse off. ∙ At equilibrium, the market is efficient.

∙ An intervention, which takes the market away from  equilibrium can benefit either producers or consumers, but it decreases total surplus. Hence, the market becomes  inefficient.

∙ Deadweight loss – A loss of total surplus when the quantity  of a good is exchanged below the equilibrium quantity. ∙ A missing market is the one in which some exchanges don’t  happen for any reason. It could be missing because of public  policy which bans some goods or due to some tax which  makes goods costly to produce.

CHAPTER 6: GOVERNMENT INTERVENTION

∙ Equilibrium in a perfectly competitive market is  efficient (total surplus is maximum).

∙ If the government intervenes in a perfectly  competitive market, it will become inefficient.  ∙ Reasons to intervene:

o Changing the distribution of surplus

o Encouraging or discouraging surplus

o Correcting market failures

∙ Types of intervention:

o Price controls:

 Price ceiling

 Price floor

o Quantity control

o Taxes

o Subsidies

∙ Price ceiling – max legal price at which the good can be  sold.

S

S

P

P

Pnew

D  Qs Q Qd

D

Q

∙ If there is a price ceiling in the market, the new price falls  below the equilibrium market price. At this price, quantity  demanded is more than the quantity supplied and hence  there is a shortage of the good in the market.

∙ Producer surplus falls as producers are selling fewer goods at a lower price.

∙ The policy of price ceiling helps increase consumer surplus,  but decreases producer surplus by a greater number. Hence,  total surplus decreases and deadweight loss occurs.

∙ Due to price ceiling, goods must be rationed as there is a  shortage.

∙ Rent-seeking behavior is when rationing is done via bribing. ∙ Non-binding price ceiling doesn’t affect the market as the  price ceiling is set above the market equilibrium price.

∙ Price floor is a minimum legal price at which a good can be  sold.

S

P

D  Q

S

Pnew

P

D

Qd Q

∙ If there is a price floor in the market, the new price becomes  more than the equilibrium price and at that price, quantity  demanded is less than quantity supplied. This creates an  excess of the good in the market.

∙ Consumer surplus falls as they buy less of the good at a  higher price.

∙ The policy of price floor helps increase producer surplus, but  decreases consumer surplus by a greater amount, so total  surplus falls and deadweight loss occurs.

∙ Due to excess supply, the government can buy the good  from producers who couldn’t sell their good to the  consumers.

∙ Price floor is said to be non-binding when the price fixed is  under the original market equilibrium price. In this case, the  market is not affected by the price floor.

TAX AND SUBSIDY

∙ Tax has two effects:

o They discourage production and consumption of a good if it’s taxed.

o They increase government revenue.

∙ When a tax is levied on sellers, decreases the supply but  doesn’t affect the demand. Therefore, the equilibrium price  increases and quantity falls.

∙ When tax is levied on buyers, it has the same effect.  Demand falls while supply is the same. Therefore,  equilibrium price and quantity both fall. The tax amount is  payed by the buyer to the government.

∙ Tax wedge is the difference in the amount paid by buyers  and the amount received by the sellers. It is equal to the tax.

∙ Government tax revenue = Tax * Quantity after tax  (source:thismatter.com)

∙ Deadweight loss occurs due to a tax as the number of  transactions falls.

∙ The person (consumers or producers) whose curve (demand  or supply) is more inelastic bears the burden of the tax. ∙ Statutory incidence of tax – The person who is legally  responsible for paying the tax.

∙ Economic incidence – The person who bears the incidence of  tax. It doesn’t depend on the statutory incidence. ∙ Subsidy – It’s a requirement that government pay an extra  amount to producers or consumers of a good.

∙ A subsidy to sellers increases supply and doesn’t affect the  demand. So, equilibrium price falls and quantity increases. ∙ Subsidies also cause Deadweight loss because of  overproduction or overconsumption of the good.

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