1. Supply and Demand

1.1 Price Elasticity of Demand

1.1.1 Total revenue test

1.1.2 Elastic, inelastic and unit elastic demand

1.1.3 Determinants of price elasticity: Substitutability, proportion of income

1.2 Price Elasticity of Supply

1.2.1 Factors influencing elasticity: Availability of inputs, production time

1.2.2 Comparison of short-run and long-run elasticity

1.3 Other Elasticities

1.3.1 Cross-price elasticity: Substitutes and complements

1.3.2 Income elasticity: Normal and inferior goods

1.4 Market Equilibrium and Consumer and Producer Surplus

1.4.1 Equilibrium price and quantity determination

1.4.2 Calculating consumer and producer surplus

1.4.3 Welfare economics: Maximizing total surplus

1.5 Market Disequilibrium and Changes in Equilibrium

1.5.1 Effects of shifts in supply and demand

1.5.2 Price floors (e.g. minimum wage) and price ceilings (e.g. rent control)

1.6 Effects of Government Intervention in Markets

1.6.1 Taxes: Impact on consumers, producers and deadweight loss

1.6.2 Subsidies: Benefits and inefficiencies

1.6.3 Quantity controls (e.g. quotas)

1.7 International Trade and Public Policy

1.7.1 Effects of imports and exports on domestic markets

1.7.2 Tariffs and quotas: Costs and benefits

1.7.3 Free trade vs. protectionism

1.8 Demand

1.8.1 Law of demand and reasons for downward slope

1.8.2 Determinants of demand: Income, tastes, prices of related goods

1.8.3 Normal vs. inferior goods

1.9 Supply

1.9.1 Law of supply and reasons for upward slope

1.9.2 Determinants of supply: Input costs, technology, expectations

1.9.3 Short-run vs. long-run adjustments

2. Imperfect Competition

2.1 Oligopoly and Game Theory

2.1.1 Collusion and cartels: Benefits and challenges

2.1.2 Characteristics of oligopolies: Few large firms, barriers to entry

2.1.3 Strategic behavior: Nash equilibrium and dominant strategies

2.2 Introduction to Imperfectly Competitive Markets

2.2.1 Comparison of market structures: Monopoly, oligopoly, monopolistic competition

2.2.2 Causes and implications of market power

2.3 Monopoly

2.3.1 Sources of monopoly power

2.3.2 Price-setting behavior and inefficiency

2.3.3 Graphical representation of monopoly pricing

2.4 Price Discrimination

2.4.1 Conditions for price discrimination

2.4.2 Examples of first, second, and third-degree price discrimination

2.5 Monopolistic Competition

2.5.1 Characteristics: Product differentiation and many sellers

2.5.2 Short-run profit and long-run equilibrium

2.5.3 Excess capacity and inefficiency

3. Factor Markets

3.1 Introduction to Factor Markets

3.1.1 Derived demand: Factors of production

3.1.2 Marginal product of labor (MPL) and capital

3.1.3 Value of marginal product (VMP)

3.2 Changes in Factor Demand and Supply

3.2.1 Determinants of factor demand: Productivity, prices of goods

3.2.2 Determinants of factor supply: Population, preferences

3.3 Profit-Maximizing Behavior in Factor Markets

3.3.1 Marginal revenue product (MRP) = Marginal resource cost (MRC)

3.3.2 Hiring decisions in competitive and imperfect markets

3.4 Monopsonistic Markets

3.4.1 Characteristics of monopsony

3.4.2 Wage determination and inefficiency

4. Market Failure and the Role of Government

4.1 Socially Efficient and Inefficient Market Outcomes

4.1.1 Allocative efficiency: Marginal benefit equals marginal cost

4.1.2 Causes of market failures: Externalities, public goods

4.2 Externalities

4.2.1 Positive externalities: Subsidies and government intervention

4.2.2 Negative externalities: Taxes, regulations, and tradable permits

4.2.3 Graphical analysis of externalities

4.3 Public and Private Goods

4.3.1 Characteristics: Excludability and rivalry

4.3.2 Free-rider problem and under-provision of public goods

4.4 Government Intervention in Different Market Structures

4.4.1 Regulation of monopolies: Price caps and subsidies

4.4.2 Antitrust policies: Promoting competition

4.5 Inequality

4.5.1 Measurement of income inequality: Lorenz curve and Gini coefficient

4.5.2 Causes of inequality: Education, skills, inheritance

4.5.3 Government redistribution policies

5. Production, Cost and the Perfect Competition Model

5.1 The Production Function

5.1.1 Relationship between inputs and outputs

5.1.2 Short-run vs. long-run production

5.1.3 Law of diminishing marginal returns

5.2 Short-Run Production Costs

5.2.1 Fixed variable and total costs

5.2.2 Marginal cost (MC), average total cost (ATC), and average variable cost (AVC)

5.2.3 Cost curves and their relationships

5.3 Long-Run Production Costs

5.3.1 Economies of scale, diseconomies of scale, and constant returns

5.3.2 Long-run average cost curve (LRAC)

5.4 Types of Profit

5.4.1 Accounting profit vs. economic profit

5.4.2 Normal profit and its role in resource allocation

5.5 Profit Maximization

5.5.1 MC = MR rule for maximizing profit

5.5.2 Loss minimization in the short run

5.6 Firms’ Short-Run Decisions

5.6.1 Shutdown decision: Comparing price to AVC

5.6.2 Sunk costs and decision-making

5.7 Perfect Competition

5.7.1 Characteristics of perfect competition

5.7.2 Short-run vs. long-run equilibrium

5.7.3 Efficiency of perfectly competitive markets

6. Basic Economic Concepts

6.1 Scarcity

6.1.1 Definition and examples of scarcity

6.1.2 Unlimited wants vs. limited resources

6.1.3 Implications for individuals and societies

6.2 Resource Allocation and Economic Systems

6.2.1 Types of systems: Command, market and mixed economies

6.2.2 How different systems address fundamental economic questions

6.2.3 Examples of real-world economies

6.3 Production Possibilities Curve (PPC)

6.3.1 Trade-offs and opportunity cost

6.3.2 Efficiency, inefficiency and unattainable points

6.3.3 Economic growth and shifts in the PPC

6.4 Comparative Advantage and Trade

6.4.1 Difference between absolute and comparative advantage

6.4.2 Specialization and mutual gains from trade

6.4.3 Calculation of opportunity costs

6.5 Cost-Benefit Analysis

6.5.1 Rational decision-making using marginal analysis

6.5.2 Marginal benefits vs. marginal costs

6.5.3 Applications to individual and business decisions

6.6 Marginal Analysis and Consumer Choice

6.6.1 Marginal utility and diminishing marginal returns

6.6.2 Optimal allocation of resources

6.6.3 Budget constraints and consumer equilibrium

Law of demand and reasons for downward slope

Topic 2/3

Revision Notes
Flashcards
Past Paper Analysis
Questions
Videos

Your Flashcards are Ready!

15 Flashcards in this deck.

Law of Demand and Reasons for Downward Slope

Introduction

The Law of Demand is a fundamental principle in microeconomics, illustrating the inverse relationship between the price of a good and the quantity demanded by consumers. This concept is pivotal for students preparing for the College Board AP Microeconomics exam, as it underpins various market dynamics and consumer behavior theories.

Key Concepts

Understanding the Law of Demand

The Law of Demand states that, ceteris paribus (all other factors being equal), as the price of a good or service decreases, the quantity demanded increases, and vice versa. This relationship creates a downward-sloping demand curve when plotted on a graph with price on the vertical axis and quantity demanded on the horizontal axis.

Demand Curve Representation

The demand curve visually represents the Law of Demand. Mathematically, it can be expressed as:

Q_d = a - bP

Where:

Q_d = Quantity demanded
P = Price of the good
a and b = Constants representing the intercept and slope of the demand curve, respectively

The negative slope of the demand curve ( $-b$ ) signifies the inverse relationship between price and quantity demanded.

Substitution Effect

The substitution effect occurs when a change in the price of a good causes consumers to substitute it with another good. If the price of a good decreases, it becomes relatively cheaper compared to its substitutes, leading consumers to purchase more of it. Conversely, if the price increases, consumers may switch to alternative products.

Income Effect

The income effect refers to the change in consumers' purchasing power due to a change in the price of a good. When the price of a good falls, consumers effectively have higher real income, allowing them to buy more of the good. If the price rises, their real income decreases, and they may purchase less.

Price Elasticity of Demand

Price Elasticity of Demand (PED) measures the responsiveness of quantity demanded to a change in price. It is calculated as:

PED = \frac{\% \text{ Change in Quantity Demanded}}{\% \text{ Change in Price}}

If PED > 1, demand is elastic; if PED = 1, demand is unitary elastic; and if PED < 1, demand is inelastic. Elasticity affects the steepness of the demand curve and the total revenue for producers.

Shifts vs. Movements Along the Demand Curve

A movement along the demand curve occurs when a change in price leads to a change in quantity demanded, adhering to the Law of Demand. In contrast, a shift in the demand curve happens when a non-price factor changes, such as consumer preferences, income, or the prices of related goods, altering the overall demand at every price level.

Non-Price Determinants of Demand

Several factors can shift the demand curve, including:

Income: An increase in income can increase demand for normal goods and decrease demand for inferior goods.
Consumer Preferences: Changes in tastes or trends can make a good more or less desirable.
Prices of Related Goods: Substitutes and complements affect demand based on their price movements.
Expectations: If consumers expect prices to rise in the future, current demand may increase.
Number of Buyers: An increase in the population or the number of buyers boosts demand.

Applications of the Law of Demand

The Law of Demand is applied in various real-world scenarios, such as:

Pricing Strategies: Businesses use demand analysis to set optimal prices for their products.
Taxation Policies: Governments assess how taxes on goods will affect consumption and revenue.
Market Predictions: Economists forecast how changes in market conditions will influence demand.

Limitations of the Law of Demand

While the Law of Demand is a robust economic principle, it has certain limitations:

Giffen Goods: These are inferior goods for which demand increases as the price increases, violating the Law of Demand.
Veblen Goods: These goods are perceived as more desirable when their prices are higher, such as luxury items.
Assumption of Ceteris Paribus: The law assumes all other factors remain constant, which is rarely the case in real markets.

Graphical Representation and Analysis

Graphing the Law of Demand involves plotting price (P) on the vertical axis and quantity demanded (Q_d) on the horizontal axis. The resulting demand curve typically slopes downward from left to right, reflecting the inverse relationship between price and quantity.

For example, consider the demand function:

Q_d = 50 - 2P

At a price of $10, the quantity demanded is:

Q_d = 50 - 2(10) = 30

At a price of $20, the quantity demanded is:

Q_d = 50 - 2(20) = 10

This demonstrates that as the price increases from $10 to$ 20, the quantity demanded decreases from 30 to 10 units, adhering to the Law of Demand.

Empirical Evidence and Real-World Examples

Empirical studies consistently support the Law of Demand. For instance, during sales promotions, when prices drop, consumers purchase more products. Similarly, if fuel prices rise significantly, consumers may reduce their gasoline consumption or switch to more fuel-efficient vehicles.

Another example is the housing market. When mortgage rates decrease, the cost of borrowing falls, leading to increased demand for homes. Conversely, rising mortgage rates can dampen housing demand.

Conclusion

The Law of Demand is a cornerstone of microeconomic theory, providing insights into consumer behavior and market dynamics. Understanding its principles, applications, and limitations is essential for students preparing for the College Board AP Microeconomics exam and for analyzing real-world economic scenarios.

Comparison Table

Aspect	Law of Demand	Exceptions
Definition	Inverse relationship between price and quantity demanded.	Giffen and Veblen goods exhibit direct relationships.
Demand Curve Slope	Downward sloping.	Upward sloping for certain luxury or inferior goods.
Substitution Effect	Consumers switch to cheaper substitutes when price rises.	Not applicable in exceptions like Veblen goods.
Income Effect	Lower prices increase real income, boosting demand.	May decrease demand for inferior Giffen goods despite lower prices.
Price Elasticity	Affects the steepness of the demand curve.	Elasticity can vary; some goods may have inelastic or unitary demand.

Summary and Key Takeaways

The Law of Demand illustrates an inverse relationship between price and quantity demanded.
Substitution and income effects drive the downward slope of the demand curve.
Price elasticity influences how sensitive demand is to price changes.
Non-price factors can shift the demand curve, altering overall demand.
Exceptions like Giffen and Veblen goods challenge the traditional Law of Demand.

Examiner Tip

Tips

To master the Law of Demand for the AP exam, remember the acronym **S.I.P.**: **S**ubstitution effect, **I**ncome effect, and **P**rice elasticity. Use this to analyze how different factors influence demand. Additionally, practice drawing and interpreting demand curves to reinforce your understanding of movements versus shifts.

Did You Know

While the Law of Demand holds true for most goods, there are intriguing exceptions. For example, **Giffen goods** defy the law by showing increased demand as prices rise, typically seen in staple foods like bread in impoverished regions. Additionally, **Veblen goods** such as luxury cars and designer handbags become more desirable as their prices increase, as higher prices can signal exclusivity and status.

Common Mistakes

Students often confuse movements along the demand curve with shifts of the demand curve. For instance, increasing the price of a good leads to a movement upward along the demand curve (a decrease in quantity demanded), not a shift of the curve itself. Another common error is neglecting the **ceteris paribus** condition, leading to incorrect conclusions when other factors change simultaneously.

FAQ

What is the Law of Demand?

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

What causes the downward slope of the demand curve?

The downward slope is primarily caused by the substitution effect and the income effect, which lead consumers to buy more as prices fall and less as prices rise.

What is price elasticity of demand?

Price elasticity of demand measures how responsive the quantity demanded is to a change in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price.

Can the Law of Demand have exceptions?

Yes, exceptions like Giffen goods and Veblen goods do not follow the traditional Law of Demand, displaying direct relationships between price and quantity demanded.

What is the difference between a movement along the demand curve and a shift of the demand curve?

A movement along the demand curve is caused by a change in the price of the good, leading to a change in quantity demanded. A shift of the demand curve occurs when a non-price factor changes, altering demand at every price level.

How do income changes affect demand?

Income changes can shift the demand curve. An increase in income typically increases demand for normal goods and decreases demand for inferior goods, while a decrease in income has the opposite effect.