Download Price Theory Handout #2

Price Theory Handout #2
Perfect competition: a situation in which there are so many buyers and sellers that no single buyer or seller
can unilaterally affect the price on the market.
Imperfect competition: a situation in which a single buyer or seller has the power to influence the price on
the market.
Quantity demanded (Qd): the total amount of a good that buyers would choose to purchase under given
conditions. The given conditions include the price of the good and the determinants of demand.
Determinants of demand: anything that affects the quantity demanded of a good, except for the price of the
good.
Demand: the relationship between the price and quantity demanded of a good, when everything else is held
constant. The demand for a good depends on consumers’ willingness and ability to pay for the good at
different prices.
The Law of Demand: when the price of a good rises, and everything else remains the same, the quantity of
the good demanded will fall. That is,
↑P → ↓Qd
Ceteris Paribus: the "everything else remains the same" or "other things equal" assumption.
Normal good: any good for which the law of demand holds. (Note: this is different from the book’s
definition of normal.)
Demand Curve: a graphical representation of the relationship between price and quantity demanded for a
particular good. It is a curve or line, each point of which is a price-Qd pair.
Quantity supplied (Qs): the total amount of a good that sellers would choose to produce and sell under
given conditions. The given conditions include the price of the good and the determinants of supply.
Determinants of supply: anything that affects the quantity supplied of a good, except for the price of the
good.
Supply: the relationship between price and quantity supplied of a good, while holding everything else
constant.
Law of Supply: when the price of a good rises, and everything else remains the same, the quantity of the
good supplied will also rise. In short,
↑P → ↑Qs
Supply Curve: a graphical representation of the relationship between price and quantity supplied for a
particular good (ceteris paribus). It is a curve or line, each point of which is a price-Qs pair.
Market equilibrium: an equilibrium price P* and equilibrium quantity Q*, which occur where the market
clearing condition holds.
Market clearing condition: Qd = Qs.
Short-side rule: When there is a disequilibrium price, the actually quantity that gets sold on the market is
Qd or Qs, whichever is smaller.
Price ceiling: a maximum price mandated by the government.
Price floor: a minimum price mandated by the government.
Shortage or excess demand: the difference between Qd and Qs when Qd > Qs because of a price ceiling (or
below-equilibrium price).
Surplus or excess supply: the difference between Qd and Qs when Qd < Qs because of a price floor (or
above-equilibrium price).
Consumer Surplus (CS): the extra (excess) value individuals receive from consuming a good over what
they pay for it, in monetary terms. The area below the demand curve, above the price that occurs, and left
of the quantity that actually gets sold.
Producer Surplus (PS): the extra (excess) value producers get for a good in excess of the opportunity costs
they incur by producing it, in monetary terms. The area above the supply curve, below the price that occurs,
and left of the quantity that actually gets sold.
Total Surplus: CS + PS.
Dead-weight loss (DWL): the reduction in the total surplus that results from a policy that prevents mutually
beneficial trades from occurring. The area below demand, above supply, and between the market
equilibrium quantity and the actual quantity that gets sold.
Transfer: the portion of the total surplus that moves from CS to PS, or from PS to CS, when a policy such
as a price control displaces the market outcome.
Elasticity: the degree of responsiveness of one variable to another, in terms of percentage changes.
Price elasticity of demand: the percentage change in quantity demanded divided by the percentage change
in price. That is,
Ed = |%Qd/%P|
Alternative formula for price elasticity of demand, at a point on the curve (Q d, P), when m is the slope of
the demand curve (remember that m will be negative for any good that obeys the law of demand):
Ed = |(1/m)(P/Qd)|
Elastic demand: when Ed > 1
Unit elastic demand: when Ed = 1
Inelastic demand: when 1 > Ed > 0
Tax incidence: the study of how the burden of a tax is distributed over different groups.