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Midterm Reviewer for Managerial Economy

Chapter 3
 Demand is the quantity of a good or service that customers are willing
and able to purchase during a specified period under a given set of
economic conditions.
 Market demand is the aggregate of individual, or personal, demand.
Insight into market demand relations requires an understanding of the
nature of individual demand.
 Individual demand is determined by the value associated with acquiring
and using any good or service and the ability to acquire it.
 Two basic models of individual demand:
a.) Theory of consumer behavior relates to the direct demand for
personal consumption products. This model is appropriate for
analyzing individual demand for goods and services that directly
satisfy consumer desires.
b.) Utility the value or worth of a good or service, the prime determinant
of direct demand. Individuals are viewed as attempting to maximize
the total utility or satisfaction provided by the goods and services they
acquire and consume.
 Derived demand the demand is derived from the demand for the products
they are used to provide. Also called Input demand. It is related to the
profitability of using a good or service.
 Key components in the determination of derived demand are the
marginal benefits and marginal costs associated with using a given input
or factor of production.
 The amount of any good or service used rises when its marginal benefit,
measured in terms of the value of resulting output, is greater than the
marginal costs of using the input, measured in terms of wages, interest,
raw material costs, or related expenses.
 The amount of any input used in production falls when resulting
marginal benefits are less than the marginal cost of employment.
 For final consumption products, utility maximization as described by
the theory of consumer behavior explains the basis for direct demand.
For inputs used in the production of other products, profit maximization
provides the underlying rationale for derived demand.
 The market demand function for a product is a statement of the relation
between the aggregate quantity demanded and all factors that affect this
quantity.
 Q = - 500P + 250PX + 125I + 20,000Pop - 1,000,000i + 600A
Equation (3.3) states that automobile demand falls by 500 for each
$1 increase in the average price charged by domestic manufacturers; it
rises by 250 with every $1 increase in the average price of new import
luxury cars ( PX) ; it increases by 125 for each $1 increase in disposable
income per household (I); it increases by 20,000 with each additional
million persons in the population (Pop); it decreases by 1 million for
every 1 percent rise in interest rates (i); and it increases by 600 with each
unit ($1 million) spent on advertising (A).

 The demand curve expresses the relation between the prices charged for
a product and the quantity demanded, holding constant the effects of all
other variables.
 A reduction in price increases the quantity demanded; an increase in
price decreases the quantity demanded.
 Change in the Quantity Demanded Movement along a given demand
curve reflecting a change in price.
 Shift in Demand Switch from one demand curve to another following a
change in a non-price determinant of demand.
 When demand is inversely related to a factor such as interest rates, a
reduction in the factor leads to rising demand and an increase in the
factor leads to falling demand.
 Supply is the total quantity offered for sale under various market
conditions. The profit motive determines the quantity of a good or
service that producers are willing and able to sell during a given period.
 The amount of any good or service supplied will rise when the marginal
benefit to producers, measured in terms of the value of output, is greater
than the marginal cost of production.
 The amount of any good or service supplied will fall when the marginal
benefit to producers is less than the marginal costs of production.
 Factors influencing the quantity supplied of a product:
a.) The price of the product - When marginal revenue exceeds marginal cost,
firms increase the quantity supplied to earn the greater profits associated
with expanded output. Higher prices allow firms to pay the higher
production costs that are sometimes associated with expansions in
output. Conversely, lower prices typically cause producers to reduce the
quantity supplied. At the margin, lower prices can have the effect of
making previous levels of production unprofitable.
b.) The prices of related goods and services - the substitution of one output
for another can cause an inverse relation between the supply of one
product and the price of a second product, complementary production
relationships result in a positive relation between supply and the price of
a related product.
c.) Technology - An improvement in the state of technology, including any
product invention or process innovation that reduces production costs,
increases the quantity and/or quality of products offered for sale at a
given price.
d.) Changes in input prices - an increase in input prices will raise costs and
reduce the quantity that can be supplied profitably at a given market
price. A decrease in input prices increases profitability and the quantity
supplied at a given price.
e.) Weather - Temperature, rainfall, and wind all influence the quantity that
can be supplied particularly in agricultural products.
 The market supply function for a product is the relation between the
quantity supplied and all factors affecting that amount.
 Q = 2,000P – 500PSUV – 100,000W – 15,000S – 125,000E – 1,000,000i
Equation (3.8) indicates that the quantity of automobiles supplied
increases by 2,000 units for each $1 increase in the average price
charged; it decreases by 500 units for each $1 increase in the average
price of new SUVs; it decreases by 100,000 units for each $1 increase in
wage rates, including fringes; it decreases by 15,000 units with each $1
increase in the average cost of steel; it decreases by 125,000 units with
each $1 increase in the average cost of energy; and it decreases by 1
million units if interest rates rise 1 percent. Thus, each parameter
indicates the effect of the related factor on supply from domestic
manufacturers.
 The supply curve expresses the relation between the price charged and
the quantity supplied, holding constant the effects of all other variables.
 Change in the Quantity Supplied is the movement along a given supply
curve reflecting a change in price.
 These differences stem from the fact that a rise in demand involves an
upward shift in the demand curve, whereas a fall in demand involves a
downward shift in the demand curve. Conversely, a rise in supply
involves a downward shift in the supply curve; a fall in supply involves
an upward shift in the supply curve.
 Shift in Supply is the movement from one supply curve to another
following a change in a non-price determinant of supply.
 Equilibrium is the perfect balance in demand and supply.
 A surplus is created when producers supply more of a product at a given
price than buyers demand. Surplus describes a condition of excess
supply.
 A shortage is created when buyers demand more of a product at a given
price than producers are willing to supply. Shortage describes a condition
of excess demand.
 The market equilibrium price, or the market clearing price, because it
just clears the market of all supplied product.
 Surplus describes an excess in the quantity supplied over the quantity
demanded at a given market price. A surplus results in downward
pressure on both market prices and Industry output.
 Shortage describes an excess in the quantity demanded over the quantity
supplied at a given market price. A shortage results in upward pressure
on both market prices and industry output.
 Market equilibrium describes a condition of perfect balance in the
quantity demanded and the quantity supplied at a given price. In
equilibrium, there is no tendency for change in either price or quantity.
 Comparative Statics Analysis is the study of changing demand and
supply conditions.
 The role of factors influencing demand is often analyzed while holding
supply conditions constant.
 The role of factors influencing supply can be analyzed by studying
changes in supply while holding demand conditions constant.
Chapter 4
 Utility Theory is the ability of goods and services to satisfy consumer
wants is the basis for consumer demand.
 Consumer behavior theory rests upon three basic assumptions regarding
the utility tied to consumption:
a.) More is better. Consumers always prefer more to less of any good or
service. Economists refer to this as the non-satiation principle.
b.) Preferences are complete. When preferences are complete, consumers
are able to compare and rank the benefits tied to consumption. If both
provide the same amount of satisfaction or utility, the consumer is said
to display indifference between the two. Indifference implies
equivalence in the eyes of the consumer. A consumer can be indifferent
between goods and services that are distinct in a physical sense. What’s
important in the case of consumer indifference is that two products yield
the same amount of satisfaction or well-being to the consumer.
c.) Preferences are transitive. When preferences are transitive, consumers
are able to rank order the desirability of various goods and services.
 Ordinal Utility Rank ordering of preferences, for example, A is better
than B.
 Cardinal Utility Understanding of the intensity of preference, for
example, A=2B.
 Utility Function is the descriptive statement that relates well-being to the
consumption of goods and services.
 Utils Unit of utility or well-being.
 Bundles of items desired by consumers are called market baskets
because they reflect combinations of goods and services available in the
marketplace.
 Marginal Utility Added satisfaction derived from a 1-unit increase in
consumption.
 Diminishing marginal utility increases the cost of each marginal unit of
satisfaction.
 Law of Diminishing Marginal Utility As an individual increases
consumption of a given product within a set period of time, the marginal
utility gained from consumption eventually declines.
 Indifference Curves Representation of all market baskets that provide a
given consumer the same amount of utility or satisfaction.
 Indifference curves have four essential properties:
a.) higher indifference curves are better
b.) indifference curves do not intersect
c.) indifference curves slope downward
d.) indifference curves bend inward (are convex to the origin)
 Substitutes are products that serve the same purpose.
 Complements are products that are best consumed together.
 Perfect Substitutes are goods and services that satisfy the same need or
desire.
 Perfect Complements are goods and services consumed together in the
same combination.
 Budget Constraint are combinations of products that can be purchased
for a fixed amount.
 Perfect substitutes are reflected in straight-line indifference curves.
 Perfect complements are reflected in L-shaped indifference curves.
 Imperfect substitutes are reflected in U-shaped indifference curves.
 Total Budget = Spending on Goods + Spending on Service
= PyY + PxX
Solving this expression for Y:
Y = B/Py + (Px/Py)X
 The effect of a budget increase is to shift a budget constraint outward
and to the right. The effect of a budget decrease is to shift a budget
constraint inward and to the left. So long as the relative prices of goods
and services remain constant.
 As the price of goods falls, a given budget will purchase more goods.
 A fall in the price of goods or services permits an increase in
consumption and consumer welfare.
 If both prices fall by a given percentage, a parallel rightward shift in
the budget constraint occurs that is identical to the effect of an increase
in budget.
 Income Effect increase in overall consumption made possible by a price
cut, or decrease in overall consumption that follows a price increase.
 Substitution Effect change in relative consumption that occurs as
consumers substitute cheaper products for more expensive products.
 Individual Demand is the demand curve for an individual consumer
depends upon the size of the consumer’s budget consumption
preferences.
 Price– consumption Curve are market baskets that maximize utility at
different prices for a given item.
 Income– Consumption Curve is the utility-maximizing combinations of
goods and services at every income level.
 Price–consumption curves show how optimal consumption is affected
by changing prices, or movements along the demand curve. Income–
consumption curves illustrate the effects of shifts in demand due to
changing income.
 Engle Curve is a plot of the relationship between income and the quantity
consumed of a good or service. It is related to income–consumption
curves.
 If consumers have a tendency to buy more of a product as their income
rises, such products are called normal goods.
 If consumers tend to buy less of a product following an increase in
income, such products are called inferior goods.
 Given consumer preferences and budget constraint information, it is
possible to determine optimal consumption.
 Optimal Market Basket Best feasible combination of goods and services.
 The resulting optimal market basket of goods and services must satisfy
two important conditions:
a.) the optimal market basket lies on the budget line
b.) the optimal market basket reflects consideration of marginal benefits and
marginal costs
 Revealed Preference is a declared choice. It is a documented desire for a
given good or service over some other less expensive good or service.
 Marginal Rate of Substitution a change in consumption of Y (goods)
necessary to offset a given change in the consumption of X (services) if
the consumer’s overall level of utility is to remain constant.
 Utility is maximized when the marginal utility derived from each
individual product is proportional to the price paid.
 Utility is maximized when products are purchased at relative prices that
equal the relative marginal utility derived from consumption.
 Consumption Path are the optimal combinations of products as
consumption increases.
 Demand analysis focuses on measuring the sensitivity of demand to
changes in a range of important factors.
 A measure of responsiveness used in demand analysis is elasticity,
defined as the percentage change in a dependent variable, Y, resulting
from a percentage change in the value of an independent variable, X.
Elasticity = Percentage Change in Y/Percentage Change in X
 Endogenous Variables are factors such as price and advertising that are
within the control of the firm.
 Exogenous Variables are factors outside the control of the firm, such as
consumer incomes, competitor prices, and the weather.
 Point Elasticity It measures elasticity at a given point on a function.
Point Elasticity = ϵ = Percentage change in Y / Small Percentage change in X
= ɗY/Y / ɗX/X
= ɗY/ɗX / Y/X
Point elasticity measures the percentage effect on Y of a percentage
change in X at a given point on a function.
 If εX = 5, a 1 percent increase in X will lead to a 5 percent increase in
Y, and a 1 percent decrease in X will lead to a 5 percent decrease in Y.
 When εX > 0, Y changes in the same positive or negative direction as X.
Conversely, when εX < 0, Y changes in the opposite direction of changes
in X.
 Arc Elasticity is the average elasticity over a given range of a function.
Arc Elasticity = EX = Percentage Change in Y/ Large Percentage Change in X
= Change in Y/Average / Large Change in X/Average
= (Y2-Y1)/(Y2+Y1)/2 / (X2-X1)/(X2+X1)/2
= ΔY/(Y2+Y1) / ΔX/(X2+X1)
= ΔY/ΔX x (X2+X1) / (Y2+Y1)
The arc elasticity formula eliminates the problem of deciding which end
of a given range to use as a base, and measures the relation between two
variables over a range of data.
 Price Elasticity of Demand is the responsiveness of quantity demanded
to changes in the price of the product itself, holding constant the values
of all other variables in the demand function.
Point Price Elasticity = ϵp = Percentage Change in Quantity (Q) / Small
Percentage Change in Price (P)
= ɗQ/Q / ɗP/P
= ɗQ/ɗP x P/Q
Arc Price Elasticity = Ep = Percentage Change in Q/ Large Percentage Change
in P
= ΔQ/(Q2+Q1) / ΔP/(P2+P1)
= ΔQ/ΔP x (Q2+Q1)/(P2+P1)
 Three specific ranges of price elasticity:
a.) |ε P| > 1.0, defined as elastic demand.
b.) |ε P| = 1.0, defined as unitary elasticity.
c.) |ε P| < 1.0, defined as inelastic demand.
 Elastic Demand is a situation in which a price change leads to a more
than proportionate change in quantity demanded.
 Unitary Elasticity is a situation in which price and quantity changes
exactly offset each other.
 Inelastic Demand is a situation in which a price change leads to a less
than proportionate change in quantity demanded.
 Elastic Demand: When price increases, Revenue decreases.
When price decreases, Revenue increases.
 Unitary Elasticity: When price increases, Revenue remain uncharged.
When price decreases, Revenue remain unchanged.
 Inelastic Demand: When price increases, Revenue increases.
When price decreases, Revenue decreases.
 With perfectly inelastic demand, a fixed level of outputs is demanded
irrespective of price.
 With perfectly elastic demand, all output is sold at a fixed price.
 Price Elasticity and Marginal Revenue are the direct relations between
price elasticity, marginal revenue, and total revenue.
 In the range in which demand is elastic with respect to price, marginal
revenue is positive and total revenue increases with a reduction in price.
In the inelastic range, marginal revenue is negative and total revenue
decreases with price reductions.
 Optimal Price Formula states that for any downward-sloping demand
curve, maximum profits result when
P* = MC/[1 + (1/ϵp)]
 There are three major influences on price elasticity:
a.) the extent to which a good is considered a necessity
b.) the availability of substitute goods
c.) the proportion of income spent on the product
 Cross-Price Elasticity is the responsiveness of demand for one product
to changes in the price of another.
Point Cross-Price Elasticity = ϵpx = Percentage Change in Quantity of
Y (QY)/ Small Percentage Change
in Price of X (PX)
= ΔQY/ΔPX x PX/QY
Arc Cross-Price Elasticity = EPX = Percentage Change in Quantity of Y
(QY)/ Large Percentage Change in
Price of X (PX)
= ΔQY/ΔQX x (PX2+PX1)/(QY2+QY1)
 Cross-price elasticity information is especially important for firms with
a wide variety of products because meaningful substitute or
complementary relations can exist within the firm’s own product line.
Cross-price elasticity information also allows firms to measure the
degree of competition in the marketplace. If the cross-price elasticity
between a firm’s output and products produced in related industries is
large and positive, the firm may face the imminent threat of competitor
encroachment.
 Income Elasticity is the responsiveness of demand to changes in income,
holding constant the effect of all other variables.
Point Income Elasticity = ϵI = Percentage Change in Quantity (Q) / Small
Percentage Change in Income (I)
= ΔQ/ΔI + I/Q
Arc Income Elasticity = EI = Percentage Change in Quantity (Q) / Large
Percentage Change in Income (I)
= ΔQy/ΔI x (I2+I1)/(Q2+Q1)
 Countercyclical Falls with rising income, and rises with falling income.
 Noncyclical Normal Goods are products for which demand is relatively
unaffected by changing income.
 Cyclical Normal Goods are products for which demand is strongly
affected by changing income.