Part I: Supply and Demand

Question 1

Explain the concept of costs

Answer 1

Scarcity of resources –> choice –> opportunity cost

Cost: opportunity cost; consider the example of having to choose between a job in D.C. vs a job in Richmond

• Explicit cost:* would make a higher salary in D.C. than in Richmond (but this is because of COLA)
• Implicit cost:* costs of D.C. traffic (wasted time, road rage, etc.)
• External cost:* if you move to D.C. you would leave your family/friends in Richmond (your family/friends would experience the externality of you moving to D.C.)

Question 2

Explain the concept of markets, prices, and the allocation of scarce resources

Answer 2

Many supply and demand factors jointly determine prices

Prices influence the choices of households and firms

Prices coordinate the allocation of resources

Prices are the “fingers of the invisible hand” – fingers give dexterity to the hand, and prices give dexterity to the invisible hand

Micro Theory is a rigorous exposition of the market model

Question 3

Explain (simply) the demand curve

Answer 3

Inverse relationship between the quantity demanded of a good and a change in the good’s own price

Question 4

What are the two reasons for the inverse relationship between quantity demanded and price?

Answer 4

1) substitution effect
2) income effect

Question 5

What is the substitution effect?

Answer 5

a price change changes the appeal of a good relative to all other goods

Question 6

What is the income effect, and what should it really be called?

Answer 6

a price hange alters the purchasing power for a given level of nominal income

• this should really be known as the “purchasing power effect”
• if prices change, your purchasing power changes. Your income will NOT change – only your real income aka purchasing power changes

Question 7

Explain simply a change in quantity demanded

Answer 7

Q_X^D = f (1/P_X)

this is a movement of the demand curve

• endogenous factors = movement

price = endogenous factor

• movement = responsiveness of quantity to price (an inverse relationship)

Question 8

Explain simply a change in demand

Answer 8

Q_X^D = f (P_XY)

==> a change affecting the amount purchased at any given price

• this is a shift of the demand curve
• exogenous facotrs = shift
• factors other than P_X = exogenous factors

Question 9

What are some exogenous factors that would case a change (shift) in demand?

Answer 9

Price of related goods (P_XY) – either a complement or a substitute

Nominal income (I) – what you earn in a year

Wealth – a stock of what you accumulate

Consumer tastes, i.e. individuals’ “utility functions”

Population – this is simply the number of consumers in a market; more people in a market = more demand

Demographics, e.g. Baby Boomers are old and consume more health care

Question 10

What is a linear specification of the demand curve?

Answer 10

Q_X^D = ɑ – 𝛽(P_X)

e.g. Q_X^D = 1800 – 30(P_X)

Question 11

What is the inverse demand curve?

Answer 11

inverse ==> P = f(Q)

PX= ɑ/𝛽 – (1/𝛽)Q_X^D

e.g. P_X = 60 – 1/30(Q_X^D)

Question 12

Distinguish variables and parameters

Answer 12

Variables = Q and P

Parameters = ɑ and 𝛽

Question 13

Graphical quandary: Does Q depend on P or does P depend on Q (linear demand curve vs inverse)?

Answer 13

In order to understand this, must look at the history

In the first microeconomics textbook, an example of the Boston fishing market was included. Fisherman go out and fish during the day and then sell the fish they catch that afternoon

In the short run, the fish supply is fixed for that day (can’t get any more than the fish they caught while selling at the market). Suppose one day doctors say there is a significant health improvement from eating fish, so there is a large increase in demand for fish ⇒ because supply is fixed for the day, P is a function of Q

The next day, the fisherman employ more people to catch more people in response to the higher price from yesterday (which was driven by the increase in demand) → now supply increases ⇒ Q is a function of P

Remember that in the short run all inputs are fixed, but in the long run inputs become variable

Basically, the answer to whether Q depends on P or P depends on Q is that it depends

Question 14

What is the choke price for demand?

Answer 14

The value of P where Q = 0 (vertical intercept) – this is the price at which consumers begin to “choke,” i.e. stop buying

Question 15

Conceptual, graphical, algebraic distinction in the demand model (summary)

Answer 15

• “Change in quantity demanded” vs a “change in demand”
• Movement along a demand curve vs shifts of a demand curve
• An “endogenous” response vs an “exogenous” change
• Causal relation between “variables” vs a change in a “parameter”
• (Q, P) vs (ɑ, 𝛽)

⇒ these statements are basically five ways of saying the same thing:

***A change in quantity demanded results in a movement. This is an endogenous response, which reflects the relationship between the variables Q and P. A change in demand results in a shift of the demand curve. This is an exogenous response, which reflects a change in the parameters, ɑ and 𝛽.***

Question 16

Explain simply the supply curve

Answer 16

The supply curve shows the direct (i.e. positive) response of the quantity supplied of a good to a change in the good’s own price, ceteris paribus

Question 17

What are the two reasons that the supply curve shows a direct relationship?

Answer 17

1) cost effect
2) profit effect

Question 18

Explain the cost effect

Answer 18

a higher price is required to cover the higher marginal cost of producing in the short run

Question 19

explain the profit effect

Answer 19

higher price raises the profitability of “infra-marginal” units, and total profit rises

Question 20

Explain simply a change in quantity supplied

Answer 20

Q_X^S = f (P_X)

==> the specific influence of a price change, ceteris paribus

this is a movement of the supply curve

endogenous factors = movement

price = endogenous factor

movement = responsiveness of quantity to price (an inverse relationship)

Question 21

Explain simply a change in supply

Answer 21

Q_X^S = f (… factors other than P_X…)

==> a change affecting the amount supplied at any given price

this is a shift of the supply curve

exogenous factors = shift

factors other than P_X = exogenous factors

Question 22

What are some examples of exogenous factors that would cause a change (shift) in supply?

Answer 22

• Price of a related good (P_XZ)
• Input prices (P_i)
• Technology – technological progress increases the productivity of inputs which decreases the cost of production
• Number of suppliers – if there is economic profit, more firms will enter the market
• Supply shocks, e.g. Hurricane Harvey has caused a supply shock in the oil market (there is an increase in the price of gas)

Just remember that an increase in supply is a shift right (looks like a shift down) and a decrease in supply is a shift left (looks like a shift up) – don’t get these mixed up!!

Question 23

What is the linear specification of the supply curve?

Answer 23

Q_X^S = 𝛾 + 𝛿(P_X)

e.g. Q_X^S = -200 + 20(P_X)

Question 24

What is the inverse supply curve?

Answer 24

P_X = 𝛾/𝛿 + 1/𝛿(Q_X^S)

e.g. P_X = 10 + 1/20(Q_X^S)

*** be careful with negatives!!! When in doubt, just solve out the inverse

Question 25

What is the choke price for supply?

Answer 25

the value of P where Q^S = 0 (vertical intercept)

Question 26

Conceptual, graphical, algebraic distinctions in the supply model (summary)

Answer 26

Change in quantity supplied vs change in supply

Movement along a supply curve vs shifts of a supply curve

An endogenous response vs exogenous change

Causal relations between variables vs a change in parameter

Q and P vs 𝛾 and 𝛿

Question 27

What is market equilibrium?

Answer 27

The price at which quantity demanded equals quantity supplied [intuition]

Q^D = Q^S [math]

Question 28

What is elasticity (basic definition)?

Answer 28

Elasticity is a proportional measure of the responsiveness of Q^D

Question 29

Why is elasticity proportional?

Answer 29

Elasticity is proportional because it is unit-free ==> can compare elasticities of different goods

elasticity is related to, but subtly different from, slope

Question 30

Explain elasticity as a generic concept

Answer 30

Q^D can respond to P_x as well as any other parameter in the demand model

For example, there is price elasticity, but there is also income elasticity, cross-price elasticity, etc.

One of the exogenous factors that would influence demand is tastes and preferences; this could be quantified by looking at advertising expenditures

Question 31

How is elasticity calculated?

Answer 31

In Econ 101 we used the midpoint formula to calculate a range elasticity; a more advanced way to look at elasticity is to calculate the point elasticity of demand –> “point” implies the elasticity for a very small change in P (i.e. dQ/dP), which is just the slope of a linear demand curve

⇒ it is very easy to measure demand elasticities – just calculate –𝛽 (P/Q)

Question 32

How do you interpret a price elasticity calculation?

Answer 32

Qualitative

• 𝜺^D > 1 = elastic
• 𝜺^D <1 = inelastic
• 𝜺^D = 1 = unit elastic

Quantitative

“%Δ in Q associated with a %ΔP” → for example, if 𝜺^D = 2.5 then a 1% change in price would lead to a 2.5% change in Q

Question 33

What are the determinants of price elasticity of demand?

Answer 33

1. Substitutes (Q will be more responsive if the consumer has more options)
2. Time (short run vs long run)
3. Percentage of budget

⇒ note that the reasons for the negative slope of the demand curve are the substitution effect and the income (aka “purchasing power”) effect – just like the determinants of price elasticity

Question 34

Why is the value of elasticity varied along a linear demand curve? Would it ever be possible to have a constant elasticity?

Answer 34

𝜺^D = – 𝛽 (P/Q) → if the demand curve is linear, 𝛽 is constant. As P decreases, Q increases; so the value of 𝜺^D starts large (high P, low Q) then falls throughout g

A constant elasticity is only possible for nonlinear functions (because with a nonlinear function, dP/dQ is getting smaller and P and Q are always changing, so it is possible that the changes would “cancel” each other out and result in a constant elasticity)

With linear functions, dP/dQ is constant but P and Q are changing so the demand elasticity will change along the demand curve