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* Chapter 3

Demand, Supply, and Prices

*Demand- the desire to own something and

the ability to pay for it
*Both must be present
*Law of Demand- when a good’s price is
lower, consumers will buy more of it. When
the price is higher, consumer will buy less
of it

*Chapter 3 Section 1:

Fundamentals of Demand

*Law of Demand results from two
overlapping patterns:
*Substitution effect
*Income Effect

*Chapter 3 Section 1:

Fundamentals of Demand

*Substitution effect- takes place

when a consumer reacts to the rise
in the price of one good by
consuming less of that good and
more of a substitute good
*Can also apply to a drop in prices

*Chapter 3 Section 1:

Fundamentals of Demand

*Income effect- if the price for the good

goes up and you cannot afford to buy as
much of it, but don’t consumer another
good in its place
*Ex: movie tickets

* Remember demand is judged on how much of
an item we buy and not on how much money
we spend on an item

*Chapter 3 Section 1:

Fundamentals of Demand

*Demand schedule- table that lists the

quantity of a good that a person will
purchase at various prices in a market

*Chapter 3 Section 1:

Fundamentals of Demand

*Market Demand Schedule- quantities
demanded at various prices by all
consumers in the market

*Chapter 3 Section 1:

Fundamentals of Demand

*Demand Curve- graphic representation of a
demand schedule
*Vertical axis- lowest prices at the
bottom, highest prices at the top
*Horizontal axis- lowest quantity on the
left, highest quantity on the right
*Limitations:
*Cannot predict market changes

*Chapter 3 Section 1:

Fundamentals of Demand

*Shifts in demand are not always connected
to price
*Ceteris paribus-all other things held
constant
*Demand schedule assumes everything
but price remains constant
*Demand schedules and demand curves
are only accurate if ceteris paribus
remains true

*Chapter 3 Section 2:
Shifts in Demand

*When we drop the ceteris paribus

rule- we no longer move along the
demand curve, instead the entire
curve shifts

*Chapter 3 Section 2:
Shifts in Demand

* Non-price determinants- factors that can lead
to the shifting of demand up or down

* Income
* Consumer expectations
* Demographics
* Consumer taste
* Advertising

*Chapter 3 Section 2:
Shifts in Demand

*Income:
*Normal goods- goods that consumers

demand more of when their income
increases
*Inferior goods- goods that you would buy
in smaller quantities, or not at all, if
your income were to rise and you could
afford something better
*Shift to the right = increase in demand
*Shift to the left= decrease in demand

*Chapter 3 Section 2:
Shifts in Demand

* Consumer expectations:

* Expectations about the future

* Could be the future of that particular item

* Demographics

* The statistical characteristics of populations
* Age
* Race
* Gender
* Occupation
* Income levels

*Chapter 3 Section 2:
Shifts in Demand

* Population:

* Changes in population of a market effect the
demand in that market

* Consumer taste and advertising:

* Advertising and publicity play a role in demand

*Chapter 3 Section 2:
Shifts in Demand

* Price of Related Goods:

* Complements: two goods that are bought and

used together
* Substitutes: goods that are used in place of one
another

*Chapter 3 Section 2:
Shifts in Demand

*Elasticity of Demand- the way

consumers react to price changes
*How drastically buyers will cut
back or increase their demand for
a good when the price rise or falls

*Chapter 3 Section 3:
Elasticity of Demand

*Inelastic- if you buy the same amount or

just a little less of a good after a large
price increase
*Relatively unresponsive to price changes
*Elastic- if you buy much less of a good
after a small price increase
*Very responsive to price changes

* Increases and decreases

*Chapter 3 Section 3:
Elasticity of Demand

*Elasticity of the good-Percentage of

change in the quantity of the good
demanded divided by the percentage
of change in the price of the good

*Because of the law of demand- elasticity
is always negative

* For simplicity- this negative is dropped

*Chapter 3 Section 3:
Elasticity of Demand

*Elasticity of demand changes at different
price levels
*Less than 1= inelastic
*Greater than 1= elastic
*Elasticity = 1- unitary elastic

* Percentage change in quantity demand is

exactly equal to percentage change in price

*Chapter 3 Section 3:
Elasticity of Demand

*Factors Affecting Elasticity
*Availability of substitutes

*Lack of good substitutes tends to make
a good inelastic

*Relative importance

*How much of your budget you spend on
the good

* Larger percentage more likely to be elastic

*Chapter 3 Section 3:

Elasticity of Demand

*Factors Affecting Elasticity Cont.
*Necessity versus luxury

* The more of a necessity – the more inelastic

* Can change person to person
*Change over time

* Demand can sometimes become more elastic
over time

*Chapter 3 Section 3:
Elasticity of Demand

* Elasticity helps us measure how consumers

respond to price changes for different products

* Elasticity of demand determines how a change in
prices will affect a firm’s total revenue or
income
* Total Revenue- amount of money the company
receives by selling its goods

* Price
* Quantity sold

*Chapter 3 Section 3:
Elasticity of Demand

*A firm could lose revenue by

increasing its price- depends on the
demand and elasticity of the product
*If demand is inelastic- typically
can increase in price= increase in
revenue

*Chapter 3 Section 3:
Elasticity of Demand

*Supply- Amount of a good or service that is
available
*Law of Supply- producers offer more of a
good or service as its price increases and
less as its price falls
*Quantity supplied- how much of a good or
service a producer is willing and able to
sell at a specific price

*Chapter 3 Section 4

Fundamentals of Supply

*Producers may also be called a supplier,

company or owner
*Whoever supplies a product to market
*Price increase is also an incentive for new
firms to enter the market to earn their own
profits
*Individual firms and firms changing their
level of production and firms entering or
exiting the market- combine to create the
law of supply

*Chapter 3 Section 4

Fundamentals of Supply

*If a firm is already earning a profit for a

good or service, then an increase in the
price- ceteris paribus- will increase the
firm’s profits
*The search for profit drives the suppliers
decision
*One benefit of the economic system of the
United States is the markets are open to
new suppliers

*Chapter 3 Section 4

Fundamentals of Supply

*Supply schedule- relationship between

price and quantity supplied for a specific
good or service
*How much of a good or service a supplier
will offer at various price

* 2 variables

* Price number supplied

* Very specific set of conditions
* Other factors could change the supply
schedule

*Chapter 3 Section 4

Fundamentals of Supply

*When a factor other than price

changes- a new supply schedule must
be made
*Market supply schedule- all firms in
a particular market
*Also reflects the law of supply

*Chapter 3 Section 4

Fundamentals of Supply

*Market supply curve- graph of market

supply schedule
*Elasticity of supply- measures how firms
will respond to changes in the price of a
good or service
*Elasticity is greater than 1- supply is very
sensitive to price change
*Elasticity less than 1= supply is inelasticnot very sensitive to price change
*Elasticity = to 1 –unitary elastic

*Chapter 3 Section 4

Fundamentals of Supply

*Key factor is time- how long does it take

supply to change their output
*Supply become more elastic over time

*Chapter 3 Section 4

Fundamentals of Supply

*Marginal product of labor- change in output
from hiring one more worker
*Adding extra workers can result in
specialization
*Increasing marginal returns- when adding
more to the output than the previous
worker

*Chapter 3 Section 5
Costs of Production

* Increasing marginal returns- when adding a worker

adds more to the output than the previous worker
* Diminishing marginal returns- produce less and less
output from each additional unit of labor
* Happens because workers have a limited amount
of capital- any human-made resource used to
produce other things

*Negative marginal return- when adding one
more worker decreases output

*Chapter 3 Section 5
Costs of Production

* Production Costs: Fixed Costs and Variable
Costs

* Fixed Cost- cost that doesn’t change, no matter
how much of a good is produced

* Cost of a building
* Property taxes
* Etc.

*Chapter 3 Section 5
Costs of Production

* Variable Costs- costs that rise or fall depending
on the quantity produced

* Labor
* Materials
* Electricity
* Etc

* Total Cost= Fixed Costs + Variable Costs

*Chapter 3 Section 5
Costs of Production

* Marginal Cost- additional cost of producing one
more unit
* Firms basic goal = to maximize profit

* Profit = total revenue – total cost

* Marginal Revenue- additional income from
selling one more unit of a good

* Ideal output- stop when marginal revenue=

marginal costs
* Any other quantity will generate less profit

*Chapter 3 Section 5
Costs of Production

* Average cost= total cost divided by quantity
produced
* Operating cost- the cost of operating the
facility

* Includes variable costs but not fixed costs
* If operating costs are lower than total revenuefactory will stay open (at least temporarily)

* Eventually if firm is losing money they will change
their fixed costs (selling property, etc.)

*Chapter 3 Section 5
Costs of Production