Managerial Economics (Midterm Examination Review)

MASTERING KEY IDEAS

A. Markets have two sides. One side of a market is the demand side.

1. State the law of demand. - The law of demand states that the quantity purchased varies
inversely with price. In other words, the higher the price, the lower the quantity demanded.
This occurs because of diminishing marginal utility. The law of diminishing marginal utility
states that all else equal, as consumption increases, the marginal utility derived from each
additional unit declines. Marginal utility is the incremental increase in utility that results from
the consumption of one additional unit. "Utility" is an economic term used to represent
satisfaction or happiness. In simple terms, the law of diminishing marginal utility means that
the more of an item that you use or consume, the less satisfaction you get from each
additional unit consumed or used.

That is, consumers use the first units of an economic good they purchase to serve their most
urgent needs first, then they use each additional unit of the good to serve successively lower-
valued ends.2

Key Takeaways

 The law of demand is a fundamental principle of economics that states that at a higher
price, consumers will demand a lower quantity of a good.
 Demand is derived from the law of diminishing marginal utility, the fact that
consumers use economic goods to satisfy their most urgent needs first.
 A market demand curve expresses the sum of quantity demanded at each price across
all consumers in the market.
 Changes in price can be reflected in movement along a demand curve, but by
themselves, they don't increase or decrease demand.
 The shape and magnitude of demand shifts in response to changes in consumer
preferences, incomes, or related economic goods, not usually to changes in price.

2. Draw a demand curve. Label each axis.

This curve generally moves downward from the left to the right. This
movement expresses the law of demand, which states that as the price of a
given commodity increases, the quantity demanded decreases as long as all
else is equal.
Note that this formulation implies that price is the independent variable, and quantity is the
dependent variable. In most disciplines, the independent variable appears on the horizontal
or x-axis, but economics is an exception to this rule.

For example, if the price of corn rises, consumers will have an incentive to buy less corn and
substitute other foods for it, so the total quantity of corn that consumers demand will fall.

3. Describe why the law of demand holds. - Because buyers have finite
resources, their spending on a given product or commodity is limited as well,
so higher prices reduce the quantity demanded.
 The law of demand holds that the demand level for a product or a resource will decline as
its price rises, and rise as the price drops.
 Conversely, the law of supply says higher prices boost supply of an economic good while
lower ones tend to diminish it.
 A market-clearing price balances supply and demand, and can be graphically represented
as the intersection of the supply and demand curves.
 The degree to which changes in price translate into changes in demand and supply is
known as the product's price elasticity. Demand for basic necessities is relatively inelastic,
meaning it is less responsive to changes in their price.

B. Movements along a demand curve are called changes in quantity demanded, while shifts
to new demand curves are called changes in demand.
1. Explain the differences between a change in quantity demanded and a change in
demand. A change in quantity demanded refers to a movement along a fixed demand
curve -- that's caused by a change in price. A change in demand refers to a shift in the
demand curve -- that's caused by one of the shifters: income, preferences, changes in
the price of related goods and so on. The change in quantity demanded is that change
in demand means rightward or leftward shift in the demand curve and change in
quantity demanded means movement along the demand curve.

2. Define the following terms:

a. Normal good- normal goods are products and services that see a rise in
demand when incomes rise
b. Inferior good- Inferior goods are products and services that see a decrease
in demand as incomes rise.
c. Substitute- A substitute good is a good that serves the same purpose as
another good for consumers.
d. Complement- A complementary good is a good that adds value to another
good when they are consumed together

3. Graphically illustrate the difference between an increase in quantity demanded and an

increase in demand.
4. Graphically illustrate the difference between a decrease in quantity demanded and a
decrease in demand.

5. List the changes that would shift the demand curve rightward. - It's is caused by
other factors other than price. The rightward shift in demand curve can be caused by
any of the following factors:

1. A positive change in consumer tastes and preference. For example, consuming a

particular product can reduce body cholesterol level.
2. Increase in consumer's income will increase demand making demand curve to shift
rightwards.
3. Consumers future expectations about price increase. If consumers expect the price is
going to increase in a future date, they'll consumer more at the moment causing a
rightward shift of the demand curve.
4. Increase in price of substitutes. Increase in price of other substitutes, let's say butter,
people will switch to consuming margarine which will cause its demand to increase.
This also happens when price of complementary goods decreases. For example, if
price of gasoline decreases, people are more likely to demand more automobiles.
5. Increase in number of consumers. This might be as a result of advertisements to
potential customers who were unaware of the product.

6. List the changes that would shift the demand curve leftward.
 1. Change in Taste and Preferences
 2. Population Decrease

C. Markets have two sides. One side of a market is the supply side.
1. State the law of supply. - The law of supply relates price changes for a product with
the quantity supplied. In contrast with the law of demand the law of supply
relationship is direct, not inverse. The higher the price, the higher the quantity
supplied. Lower prices mean reduced supply, all else held equal.
- Higher prices give suppliers an incentive to supply more of the product or
commodity, assuming their costs aren't increasing as much. Lower prices result in a
cost squeeze that curbs supply. As a result, supply slopes are upwardly sloping from
left to right.

2. Draw the supply curve. Label each axis.

3. Explain why the supply curve is usually upward-sloping. - The supply curve
slopes upward because as a product's price rises, the business would tend to be
more willing to make it. Also, since businesses are efficient and would exhaust the
cheapest production inputs first, the cost of production tends to rise as output
increases.
- The supply curve slopes upward, that is as the price increases quantity supplied
increases. This happens because higher prices offer higher profits. Thus, it
encourages the produce to invest more, produce more and thus earn larger profits.
4. Explain why the law of supply does not always hold. - The law of supply does not
always hold true. At some point, all of the resources required to produce the good
or service in question will be used, and no more will be available. At this point, the
supply curve will turn completely vertical, as production is maxed out. This is
referred to as inelastic supply. Also, in monopoly, Monopoly is a situation where there
is only a single seller of a commodity. Thus, he is the price maker and has control
over the prices. In such a case, the law of supply may not apply as he may not be
willing to increase the supply even if the prices are high.

D. Movements along a supply curve are called changes in quantity supplied, while shifts to
new supply curves are called changes in supply.
1. Explain the differences between a change in quantity supplied and a change in supply.
- A change in supply refers to a shift in the entire supply curve, which can happen due
to factors such as changes in production costs or taxes. A change in quantity supplied,
on the other hand, refers to movement along the curve due to changes in price.

2. Define the following terms:

a. Relevant resource- An economic factor required to achieve the desired
outcomes. Also called factors of production, there are four main economic
resources: land, labor, capital, and entrepreneurship ability. Land, quite
literally, is any natural resource involved in the production process, including
what is on the surface.
b. Technology- Technology, for economists, is anything that helps us produce
things faster, better or cheaper. When you think of technology there's a good
chance you think of physical things like big machines or fast computers. But
when economists talk about technology, they're thinking more broadly about
new ways of doing things.
c. Tax- Taxes are mandatory contributions levied on individuals or corporations
by a government entity—whether local, regional, or national.
d. Subsidy- A subsidy is a direct or indirect payment to individuals or firms,
usually in the form of a cash payment from the government or a targeted tax
cut.
3. Graphically illustrate the difference between an increase in quantity supplied and an
increase in supply.

4. Graphically illustrate the difference between a decrease in quantity supplied and a

decrease in supply.
5. List the changes that would shift the supply curve rightward.- Supply shifters include
prices of factors of production, returns from alternative activities, technology, seller
expectations, natural events, and the number of sellers. If a firm has lower costs of
production, such as labour, it will be able to supply more of a product at any given
price therefore causing a shift to the right. Another cause of a shift of the supply curve
to the right could be favourable weather conditions.

6. List the changes that would shift the supply curve leftward.

E. Market adjustment will eliminate shortages and surpluses.

1. Define the following terms:
a. Surplus
b. Shortage
c. Equilibrium price An equilibrium price, also known as a market-clearing
price, is the consumer cost assigned to some product or service such that
supply and demand are equal, or close to equal.
d. Equilibrium quantity Equilibrium quantity refers to the quantity of a good
supplied in the marketplace when the quantity supplied by sellers exactly
matches the quantity demanded by buyers.
2. State what will happen to price when there is a surplus. A surplus exists when the
price is above equilibrium, which encourages sellers to lower their prices to
eliminate the surplus.

3. State what will happen to price when there is a shortage. A shortage will exist at
any price below equilibrium, which leads to the price of the good increasing.

F. A change in a factor of demand or a factor of supply (or both) will change the point of
market equilibrium in a predictable way.
1. Explain what will happen to equilibrium price and equilibrium quantity in the
following cases:
a. Demand rises and supply is constant. An increase in demand, all other things
unchanged, will cause the equilibrium price to rise; quantity supplied will increase.
b. Demand falls and supply is constant. A decrease in demand will cause the equilibrium
price to fall; quantity supplied will decrease.
c. Demand is constant and supply rises. If there is an increase in the supply of goods and
services while demand remains the same, prices tend to fall to a lower equilibrium
price and a higher equilibrium quantity of goods and services.
d. Demand is constant and supply falls. If there is a decrease in the supply of goods and
services while demand remains the same, prices tend to rise to a higher
equilibrium price and a lower quantity of goods and services.
e. Demand rises by more than supply rises. If the increase in demand is greater than the
increase in supply, the equilibrium price will rise, and the equilibrium quantity
will increase. The demand curve will shift to the right, intersecting the supply curve
at a higher price and a higher quantity.
f. Demand rises by the same amount that supply rises. If the increase in both demand
and supply is exactly equal, there occurs a proportionate shift in the demand and
supply curve. Consequently, the equilibrium price remains the same. However, the
equilibrium quantity rises.
g. Demand rises by less than supply rises.
h. Demand rises by more than supply falls. An increase in demand and a decrease in
supply will cause an increase in equilibrium price, but the effect on equilibrium
quantity cannot be detennined
i. Demand rises by the same amount that supply falls. When the demand rises by the
same amount as the fall in supply, then we see that there is rightward shift in the
demand curve and there is leftward shift in the supply curve. This will lead to
increase in equilibrium price of the good.
j. Demand rises by less than supply falls. If the increase in demand is more than the
decrease in supply, the equilibrium quantity increases. If the increase in demand is
less than the decrease in supply, the equilibrium quantity decreases. In both cases,
equilibrium price increases.
k. Demand falls by more than supply rises.
l. Demand falls by the same amount that supply rises. When demand shifts to the left
and supply shifts to the right, then the eqilibrium price will decrease and the
equilibrium quantity will remain same.
m. Demand falls by less than supply rises.
n. Demand falls by more than supply falls.
o. Demand falls by the same amount that supply falls.
p. Demand falls by less than supply falls.

G. Price elasticity of demand measures the responsiveness of quantity demanded of a product

to a change in the price of that product.
1. State the (midpoint) formula for calculating price elasticity of demand. This average
is calculated in the ( Q 2 + Q 1 ) / 2 and the ( P 2 + P 1 ) / 2 portions of the elasticity
formula. This is where the midpoint method gets its name. The average is the
midpoint between the old value and the new value.

Midpoint elasticity = (Change in the value of B / Average of initial and final value of B) /
(Change in the value of A / Average of initial and final value of A)
PED = (Q2 - Q1) / [(Q2 + Q1) / 2] / (P2 - P1) / [(P2 + P1) / 2]

2. Describe elastic demand. An elastic demand is one in which the change in quantity
demanded due to a change in price is large.
3. Describe inelastic demand. An inelastic demand is one in which the change in
quantity demanded due to a change in price is small.
4. Describe unit elastic demand. Unit elastic demand is referred to as a demand in
which any change in the price of a good leads to an equally proportional change
in quantity demanded. In other words, the unit elastic demand implies that the
percentage change in quantity demanded is exactly the same as the percentage change
in price.
5. Explain when demand would be perfectly elastic. - when the demand for the
product is entirely dependent on the price of the product. This means that if any
producer increases his price by even a minimal amount, his demand will disappear.
Customers will then switch to a different producer or supplier.
6. Explain when demand would be perfectly inelastic.- a small increase or decrease in
the price of a product will have no effect on the quantity that is demanded or
supplied of that product. If a 1% change in the price of a product, there will be less
than 1% change in the quantity demanded or supplied.
7. Explain how price elasticity of demand affects the relationship between price and
total revenue. When demand is inelastic (price elasticity ), price and total revenue
have a positive relationship, which means that as price rises, total revenue rises as
well. When demand is elastic (price elasticity ), price and total revenue have a
negative relationship, meaning that price rises lead to lower total revenue.

H. There are major determinants of price elasticity of demand.

Price elasticity of demand

The concept of price elasticity of demand describes how a change in price affects the quantity
demanded. Because of the law of demand, it is calculated as the percentage change in
quantity demanded divided by the percentage change in price.

Price Elasticity of Demand (PED) = % change in quantity demanded / % change in price

The greater the price elasticity of demand, the more responsive is the quantity demanded to
price changes. The good is said to have elastic demand if the price elasticity of demand is
greater than one. Demand is perfectly elastic when the quantity demanded falls to zero as the
price rises. When the price of an elastic good rises, there is a quantity effect, in which fewer
units are sold, lowering revenue.

The lower the demand elasticity, the less responsive the quantity demanded is to price
changes. The good is said to have inelastic demand if the price elasticity of demand is less
than one. Demand is described as perfectly inelastic when the quantity demanded does not
respond to a change in price. Increased revenues will result from raising the price of an
inelastic good because each unit will be sold at a higher price.

When a change in price is accompanied by a proportional change in the quantity demanded,

the good is said to be unit elastic. This indicates that if the price changes by X percent, the
quantity demanded changes by X percent. As a result, if the demand price elasticity equals
one, the good is unit elastic. When a good has a unit elastic demand, the quantity and price
effects cancel each other out.

1. List the factors that tend to increase price elasticity of demand. - (1) availability of
substitutes, (2) if the good is a luxury or a necessity, (3) the proportion of income
spent on the good, and (4) how much time has elapsed since the time the price
changed. If income elasticity is positive, the good is normal.
2. List the factors that tend to decrease price elasticity of demand.
Factors affecting price elasticity of demand

1. Total number of substitutes

If a product has several substitutes or brands, the elasticity of demand for that product will be
high because consumers will switch from one brand to another based on price changes.
Chocolates, for example, are an excellent example of substitutes. Chocolates are available in
a variety of brands for consumers to choose from.

2. Product price in relation to earnings

When a person spends a small percentage of their available income on a good, their price
elasticity of demand is low. As a result, a change in the price of a good has very little impact
on the consumer’s willingness to buy it. When a good accounts for a significant portion of a
consumer’s income, the consumer is said to have a more elastic demand.

3. Substitution costs

In some cases, switching from one brand to another can have a significant impact. For
example, if a cable service has a deposit lock-in period, an existing customer cannot switch
to another service, even if it is cheaper, without losing the deposit. As a result, demand is
inelastic.

4. Loyalty to a brand

Consumers can be devoted to a particular brand. In such cases, a change in the product’s
price has no impact on the demand for that product. As a result of brand loyalty, demand is
inelastic.

The amount of time that has passed since a price change.

Consumers are more elastic over longer periods of time because they will find acceptable and
less expensive substitutes after a price increase of a good.

I. Cross elasticity of demand measures the responsiveness of the quantity demanded of one
good to a change in the price of another good.
1. State the formula for calculating cross elasticity of demand.

2. Explain how cross elasticity of demand is used. - Cross elasticity of demand

evaluates the relationship between two products when the price in one of them
changes. It shows the relative change in demand for one product as the price of the
other rises or falls.

J. Income elasticity of demand measures the responsiveness of the quantity demanded of a

good to a change in income.
1. State the formula for calculating income elasticity of demand.
2. Explain how income elasticity of demand is used.

K. Price elasticity of supply measures the responsiveness of quantity supplied of a good to a

change in the price of that good.
1. State the formula for calculating price elasticity of supply.

2. Describe elastic supply. - A good or service has an elastic

supply when the percentage change in the quantity
supplied exceeds the percentage change in price. In most
cases, the provider can respond quickly to a price change.
3. Describe inelastic supply. Supply whose percentage change is less than a
percentage change in price. For example, if the price of a commodity drops twenty-
five percent and supply decreases by only two percent, supply is said to be inelastic.
(See elasticity.)
4. Describe unit elastic supply. Unit elastic supply is referred to as a supply that is
perfectly responsive to price changes. In other words, any change in the price of a
good with unit elastic supply results in an equally proportional change in quantity
supplied.
5. Explain when the supply would be perfectly elastic. If a small change in the price of
an item results in an infinite change in the quantity supplied, the supply is
considered perfectly elastic. This means that suppliers are willing and able to supply
an unlimited quantity of the good at a specific price.
6. Explain when supply would be perfectly inelastic. Perfectly inelastic supply is when
the PES formula equals zero. That is, there is no change in quantity supplied when
the price changes. Examples include products that have limited quantities, such as
land or a painting from deceased artists
7. Explain how price elasticity of supply changes over time. The price elasticity of
supply is greater when the length of time under consideration is longer because over
time producers have more options for adjusting to the change in price. When
applied to labor supply, the price elasticity of supply is usually positive but can be
negative.

L. The laws of supply and demand determine who pays a tax.

1. Describe the conditions under which consumers will pay the full tax. When the
demand is perfectly inelastic in nature,or the supply is perfectly elastic in nature,
the entire tax burden will fall on the consumers. This is because, when the demand is
perfectly inelastic, any increase in price due to taxes, will not bring any decrease in
quantity demanded.
2. Describe the conditions under which producers will pay the full tax. When the
demand is more elastic than the supply, than producers are going to pay more of the
tax. And when the demand is horizontal, or perfectly elastic, the producers are
going to pay all of that tax.

1. Explain how the government can maximize tax revenues. Increase the tax rate on
those products, particularly sugary beverages, which consumers still buy and
consume even when there is an increase in price. The products may include soft
drinks, juices, alcohol, and even cigarettes because the demand for these does not
really change despite the change in price. In this way, the government could
maximize tax revenue.