Economics 104 Chapter 4 Review Questions Answers ANSWERS TO QUESTIONS FOR REVIEW 1 Law of Demand What is the law of demand Give two examples of how you have observed the law of demand at work in the real world How is the law of demand related to the demand curve The law of demand states that the quantity of a product demanded during a given time period varies inversely with its price other things constant Real world examples of the law of demand at work could include students buying less gasoline when the price per gallon rises or buying fewer take out pizzas when the price of pizza rises Along a downward sloping demand curve the variables price and quantity are inversely related The downward sloping demand curve is an illustration of the law of demand as the price of the good rises the quantity demanded decreases as the price of the good falls the quantity demanded increases Changes in Demand What variables influence the demand for a normal good Explain why a 2 reduction in the price of a normal good does not increase the demand for that good The demand for a normal good is determined by consumer income changes in prices of other goods consumer expectations the number or composition of consumers and consumer tastes As these variables change the demand for normal goods will change and the demand curve will shift A reduction in the price of a normal good causes a movement along the demand curve an increase in quantity demanded not an increase in demand 3 Substitution and Income Effects Distinguish between the substitution effect and income effect of a price change If a good s price increases does each effect have a positive or a negative impact on the quantity demanded The substitution effect refers to the change in a good s price relative to the prices of alternative goods A price increase makes the good more expensive so customers are more likely to buy a substitute The income effect refers to the change in the purchasing power of the consumer s income A price increase reduces purchasing power The substitution effect always creates a negative impact on the quantity demanded the income effect has a positive impact for normal goods and a negative impact for inferior goods 4 Demand Explain the effect of an increase in consumer income on demand for a good Increased income leads to greater demand for normal goods and lower demand for inferior goods For normal goods the demand curve shifts rightward when income increases For inferior goods the demand curve shifts leftward when income increases Income Effects When moving along the demand curve income must be assumed constant Yet one 5 factor that can cause a change in the quantity demanded is the income effect Reconcile these seemingly contradictory facts This question highlights the difference between nominal money income which is constant as you move along a demand curve and real income which changes whenever the nominal income or price changes Because the price falls as you move down the demand curve while nominal income is held constant real income increases leading to an increase in the quantity demanded i e the income effect 6 Demand If chocolate is found to have positive health benefits would this lead to a shift in the demand curve or a movement along the demand curve This would lead to an increase in demand a rightward shift of the demand curve because changing consumer tastes increases the demand for chocolate at every price because of the health benefits associated with consumption 7 Supply What is the law of supply Give an example of how you have observed the law of supply at work What is the relationship between the law of supply and the supply curve The law of supply states that the quantity supplied of a good is usually directly related to its price other things constant At work a student might observe a greater effort by his or her company to supply products that have been experiencing a rising price Producers try their best to produce as much as possible when a product is in great demand and thus its price is increasing Along an upward sloping supply curve the variables price and quantity are directly related As the price of a good increases a producer becomes more willing to supply the good The higher price provides the producer with a profit incentive to shift some resources from lower valued uses to the higher valued use 8 Changes in Supply What kinds of changes in underlying conditions can cause the supply curve to shift Give some examples and explain the direction in which the curve shifts Changes in the determinants of supply other than the price of the good in question can cause the supply curve to shift These determinants of supply include technology and know how the prices of resources inputs to production the prices of other goods those goods that use some of the same resources as are used to produce the good in question producer expectations and the number of producers Generally changes that lead to increases in the cost of production will decrease the supply Supply will decrease that is the supply curve will shift to the left if one of these occurs A more expensive technology has to be used due to safety regulations The price of a resource increases raising the costs of production The price of another good one that can be produced using the same resources as the good in question increases The future price of the product is expected to be higher The number of producers decreases Supply will increase that is the supply curve will shift to the right if one of these occurs A more efficient technology is discovered reducing production costs The price of a resource decreases lowering the costs of production The price of another good one that can be produced using the same resources as the good in question decreases The future price of the product is expected to be lower The number of producers increases Gasoline is a resource in the production of many goods A rise in the price of this important resource increases the costs of production and causes the supply of many products to decrease shifting their supply curves to the left Supply If a severe frost destroys some of Florida s citrus crop would this lead to a shift of the supply 9 curve or a movement along the supply curve This would lead to a leftward shift in the supply curve because output has declined and producers are now willing and able to supply less citrus at every price 10 Markets How do markets coordinate the independent decisions of buyers and