Econ test 1

production possibilities curve

A curve showing the different combinations of two goods or services that can be produced in a full-employment, full-production economy where the available supplies of resources and technology are fixed.

2.13 (a). Explain how allocative efficiency is related to the concepts of consumer surplus and producer surplus.

Allocative efficiency is achieved when a society has allocated the "right" amount of resources for the production of a certain good and when the quantity of that good being produced is at the amount mostly wanted by society. This is also achieved at market equilibrium, when consumer surplus and producer surplus are maximized. Therefore, in order to achieve allocative efficiency, maximum consumer surplus and producer surplus (social surplus) must be maximized. If there is an unbalanced amount of either consumer surplus or producer surplus, then allocative efficiency cannot be achieved.

2.6 (a). You observe that over a period of some years the price of strawberries has increased, and the quantity of strawberries consumers buy has also increased. Using diagrams, explain whether this violates the law of demand.

An increase in the price of strawberries and an increase in the quantity of strawberries that consumers buy violates the law of demand because the law of demand states that there is a negative causal relationship between the price of goods and the quantity demanded over a certain time period. Therefore as the price of a good increases, quantity demanded falls; and as the price falls, quantity demanded increases, ceteris paribus. As shown on the graph, more people are willing and able to buy strawberries at point B for a lower price as opposed to a higher price at point A.

Determinants of Demand

Anything other than price of the current item that influences consumer buying decisions, including income, tastes and preferences, price of related items (substitutes and complements), number of consumers in the market, and expected future price.

Determinants of Supply

Anything other than price of the current item that influences production decisions, including cost of raw materials, cost of labor, level of technology used to produce, number of producers in the market, price of related products, and expected future price.

2.7 (a). In the standard demand and supply analysis, an increase in demand, ceteris paribus, leads to a larger equilibrium quantity supplied, and yet supply does not change. Using a diagram, explain how this is possible.

Due to the shift in the demand curve, the new equilibrium price will be higher to accommodate for the excess demand. Now that the price is raised, producers have an incentive to supply more, thus the increase in quantity supplied. Meanwhile the supply curve remains. The shift in demand changes the price, which according to the law of supply, has a positive causal relationship with quantity supplied. The shift in demand leads to a change in price, which leads to movement along the supply curve that affects quantity supplied; however the supply curve never actually moves itself.

2.4 (a). 'Quantity supplied increases as price increases. Yet as supply increases, price falls.' Using diagrams, explain whether these two statements contradict each other.

On a supply curve, quantity supplied is affected by price. However the actual supply curve is only affected by non-price determinants of supply. Statement 1 refers to a movement along the supply curve, as shown in Figure 1 from point A to B. As stated by the law of supply, an increase in price causes an increase in quantity supplied. However, statement 2 is referring to a market, which is depicted by a graph of both the supply and demand curve, as shown in figure 2. When supply increases, the supply curve shifts to the right. This lowers the equilibrium price and increases the equilibrium quantity. Since the demand curve cannot allow for the new equilibrium quantity at the same price, the price must lower. Since the first statement refers to movement along the supply curve, and the second refers to movement of the curve itself, the two statements do not contradict one another.

2.10 (a). Using the production of possibilities model, explain how scarcity, choice and opportunity costs are related to each other.

Scarcity leads to choice and choice leads to opportunity costs. Because human wants are infinite and factory inputs are finite, scarcity occurs. The opportunity cost is the benefit foregone by not choosing the the next best alternative. The PPC reflects scarcity, choice and opportunity costs. It shows all possible combinations of two goods that can be produced in the economy when factory inputs are fully and efficiently employed. Scarcity is the unattainable points outside the PPC. In the figure below, the opportunity cost of producing one more butter is the production of another gun.

2.1 (a). Explain the meaning of the law of demand, and using examples and diagrams, distinguish between movements along and shifts of the demand curve.

The law of demand states that as the price of a good increases, quantity demanded falls and vice versa (ceteris paribus). It is a negative causal relationship between the price of a good and its quantity demanded over a particular time period (c.p). Movements along the demand curve happen whenever the price of a good changes, ceteris paribus. This is referred to a change in quantity demanded. From the graph below, the change from a to b is an increase in quantity demanded. A shift of the demand curve happens when there is any change in a non-price determinant (change in consumer tastes/preferences, change in income of consumers, change in price of substitutes or complementaries) of demand. This is called a change in demand. For example, if there is an increase in number of buyers, the demand curve shifts right and is an increase in demand.

2.2 (a). Explain the meaning of the law of supply, and using examples and diagrams, distinguish between movements along and shifts of the supply curve.

The law of supply states that as the price of a good increases, the quantity of the good increases as well and vice versa. There is a positive causal relationship between the price of a good and the quantity of a good supplied over a particular time period. Ceteris paribus. A movement along the supply curve is caused by a change in price, and is called a change in quantity supplied. In the figure, the movement from a to b shows quantity supplied increases. Shifts in the supply curve are caused by changes in non price determinants of supply (change in technology, number of firms, price of "inputs" resources, taxes or subsidies to firms, firm expectations about prices, joint supply, competitive supply, and shocks). It is a change in supply. A rightward shift means that for a given price, supply increases and more is supplied; a leftward shift means that for a given price, supply decreases and less is supplied.

2.12 (a). Assuming a fall in the market supply of oil, analyse the role of the price mechanism in reallocating resources.

because there is scarcity, choices will be made. Assuming that the economy is producing on its PPC, it must answer the questions of what to produce and how to produce. The answers to these two questions will determine the reallocation of resources. This reallocation involves opportunity cost, since in order to produce more of one good, there must be a sacrifice of another. This decision is made by demanders and suppliers based on price, which acts both as a signal and incentive. for example, With the fall in the market supply of oil, the price increases to adjust to the new equilibrium (or until the shortage disappears). This signals the buyers that oil is more expensive, and acts as an incentive for them to buy less oil, ceteris paribus. In turn, the quantity of oil demanded decreases, as defined by the Law of Demand, again, ceteris paribus. Sellers are signaled to produce more oil because of the increase in its price, ceteris paribus, as shown by the Law of Supply.

profit=

revenue - cost

What is demand?

the willingness and ability of producer to produce different quantities of a good at different prices during a specific time period