Chapter 4: Demand, Supply, and Market Equilibrium

Definition of Markets

A market is any arrangement that allows buyers and sellers to exchange goods, services, or resources. Markets can be physical (like a grocery store) or virtual (like online platforms).

• Key Point: Markets facilitate the interaction of demand and supply, determining prices and quantities traded.

• Example: The housing market, where buyers and sellers negotiate prices for homes.

Law of Demand, Demand Schedule, and Demand Curve

The Law of Demand states that, ceteris paribus (all else equal), as the price of a good increases, the quantity demanded decreases, and vice versa.

• Demand Schedule: A table showing the quantity demanded at various prices.

• Demand Curve: A graphical representation of the demand schedule, typically downward sloping.

• Example: As the price of coffee rises, fewer cups are purchased.

Individual Demand and Market Demand

Individual demand refers to the quantity of a good a single consumer is willing to buy at each price. Market demand is the sum of all individual demands at each price.

• Key Point: Market demand is found by horizontally summing individual demand curves.

Factors Affecting Demand & Demand Curve Shifts

Factors other than price can shift the demand curve:

• Income changes (normal vs. inferior goods)

• Prices of related goods (substitutes and complements)

• Tastes and preferences

• Expectations about future prices

• Number of buyers

• Example: An increase in consumer income shifts the demand curve for new cars to the right.

Law of Supply, Supply Schedule, and Supply Curve

The Law of Supply states that, ceteris paribus, as the price of a good increases, the quantity supplied increases, and vice versa.

• Supply Schedule: A table showing the quantity supplied at various prices.

• Supply Curve: A graphical representation of the supply schedule, typically upward sloping.

Individual Supply and Market Supply

Individual supply is the quantity a single seller is willing to offer at each price. Market supply is the sum of all individual supplies at each price.

• Key Point: Market supply is found by horizontally summing individual supply curves.

Factors Affecting Supply & Supply Curve Shifts

Factors other than price can shift the supply curve:

• Input prices

• Technology

• Expectations about future prices

• Number of sellers

• Example: A decrease in the cost of raw materials shifts the supply curve to the right.

Market Equilibrium

Market equilibrium occurs where quantity demanded equals quantity supplied. The corresponding price is the equilibrium price (), and the quantity is the equilibrium quantity ().

• Equation:

Market Disequilibrium: Surplus and Shortage

Disequilibrium occurs when the market price is not at equilibrium:

• Surplus: Quantity supplied exceeds quantity demanded () at prices above equilibrium.

• Shortage: Quantity demanded exceeds quantity supplied () at prices below equilibrium.

• Formulas:

(when )

(when )

Changes in Market Equilibrium

Shifts in demand or supply curves lead to new equilibrium prices and quantities.

• Example: An increase in demand (shift right) raises both equilibrium price and quantity.

Simultaneous Shifts (Double Shifts)

When both demand and supply shift, the effect on equilibrium price and quantity depends on the magnitude and direction of each shift.

• Key Point: The outcome for price or quantity may be indeterminate without more information.

Chapter 5: Consumers and Incentives

The Buyer's Problem

Consumers aim to maximize their satisfaction (utility) given their preferences, budget, and prices.

• Three Pillars of Rational Decision:

  • Preferences

  • Budget constraint

  • Prices of goods and services

Budget Constraint: Graphs, Intercepts, and Rotations

The budget constraint shows all combinations of goods a consumer can afford given their income and prices.

• Equation:

• Intercepts: Maximum quantity of one good if all income is spent on it.

• Rotations: Changes in price rotate the budget line; changes in income shift it parallel.

Total Benefit, Marginal Benefit, and the Equal Marginal Principle

• Total Benefit (TB): The total satisfaction from consuming a certain quantity.

• Marginal Benefit (MB): The additional benefit from consuming one more unit.

• Equal Marginal Principle: Consumers maximize utility when the marginal benefit per dollar is equal across all goods.

• Equation:

Optimizing Consumption: Allocating Budgets Using MB/P

Consumers allocate their budget so that the last dollar spent on each good provides the same marginal benefit.

• Key Point: If , buy more of good 1 and less of good 2.

Opportunity Cost Calculations and Relative Prices

The opportunity cost of a good is the value of the next best alternative forgone.

• Equation: (units of good Y per unit of good X)

Deriving the Demand Curve from Buyers’ Decisions

The demand curve reflects the quantities a consumer will buy at different prices, based on their optimization process.

Consumer Surplus

Consumer surplus is the difference between what consumers are willing to pay and what they actually pay.

• Individual:

• Market:

• Key Point: Graphically, consumer surplus is the area between the demand curve and the market price, up to the quantity purchased.

Demand Elasticities

Elasticity measures responsiveness of quantity demanded to changes in price, income, or prices of other goods.

• Price Elasticity of Demand (): Percentage change in quantity demanded divided by percentage change in price.

• Equation (definition):

• Arc/Midpoint Formula:

• Cross-Price Elasticity (): Measures how quantity demanded of good X responds to price changes in good Y.

• Equation (definition):

• Arc/Midpoint Formula:

• Income Elasticity (): Measures how quantity demanded responds to changes in income.

• Equation (definition):

• Arc/Midpoint Formula:

Interpretation of Elasticities

• Price Elasticity: If , demand is elastic; if , demand is inelastic; if , demand is unit elastic.

• Cross-Price Elasticity: Positive for substitutes, negative for complements.

• Income Elasticity: Positive for normal goods, negative for inferior goods; greater than 1 for luxury goods.

• Extreme Cases: Perfectly elastic demand (horizontal curve), perfectly inelastic demand (vertical curve).

Relationship Between Price Elasticity of Demand and Revenue

• Key Point: When demand is elastic, a price decrease increases total revenue; when inelastic, a price decrease reduces total revenue.

• Equation:

Chapter 6: Sellers and Incentives (Sections 6.1 and part of 6.2)

Sellers in the Perfectly Competitive Market (Price Takers)

In a perfectly competitive market, sellers are price takers: they accept the market price as given and cannot influence it.

• Key Point: Each seller's output is small relative to the market, so individual decisions do not affect the market price.

Profit Maximization and Its Ingredients

Firms maximize profit, which is the difference between total revenue and total cost.

• Equation:

• Key Ingredients: Market price, cost structure, and output decision.

Relevant Formulas Summary Table

Additional info: Some distinctions (such as between demand and quantity demanded, or supply and quantity supplied) are considered technicalities for this exam, but are important in broader economic analysis.