UNIT II: THE MARKET ECONOMY
AP Content Summary
II.
The nature and functions of product markets (55-65%)
A.
Supply and demand
1. Market equilibrium
2. Determinants of supply and demand
3. Price and quantity controls
4. Elasticity
a. Price, income, and cross-price elasticities of demand
b. Price elasticity of supply
5. Consumer surplus, producer surplus, and market efficiency
6. Tax incidence and deadweight loss
Straight from the horse’s mouth:
“A well-planned AP course requires an analysis of the determinants of supply and demand and
the ways in which changes in these determinants affect equilibrium price and output. In
particular, the course helps students make the important distinction between movements along the
curves and shifts in the curves. The course also emphasizes the impact of government policies
such as price floors and ceilings, excise taxes, tariffs, and quotas on the free market price and
quantity exchanged. The concepts of consumer surplus and producer surplus should also be
introduced. Students are expected to comprehend and apply the concepts of price, cross-price,
income elasticities of demand, and the price elasticity of supply.”
Primary and Supporting Concepts:
Module
(Krugman)
5
Chapter
(McConnell)
3
Concepts
Demand (D)
-
6
3
6, 7, 8, 9
3
46, 47, 48
6
49, 50
3
50
4, 17
Determinants of Demand
Change in Demand versus Change in Quantity Demanded
(QD)
Law of Demand
Supply (S)
- Determinants of Supply
- Change in Supply versus Change in Quantity Supplied (QS)
- Law of Supply
Equilibrium (E)
- Laws of Supply and Demand (relationships)
- Shortages and Surplus (Law of Market Forces)
- Ceilings and Floors
Elasticity
- Price, income, and cross-price elasticities of demand
- Price elasticity of Supply
Market Efficiency
- Consumer Surplus, Producer Surplus
- Market Efficiency
Tax Incidence
- Deadweight loss
Topic 1:
Demand:
Read Krugman’s module 5 & 7
Objectives:
1. Explain the role of price in a market economy
2. Define and illustrate demand through schedules and graphs.
3. Distinguish between change in demand and change in quantity demanded.
4. Explain the inverse relationship between price and quantity demanded.
5. Identify and explain the variable which causes a change in demand.
6. Illustrate and explain the changes in quantity demanded given a price
change.
Concepts to memorize:
Market
Law of Demand
Diminishing Marginal Utility
Substitution Effect
Normal Goods
Substitute Goods
Change in D versus Change in QD
Demand Schedule
Demand
Income Effect
Demand Curve
Inferior Goods
Complimentary Goods
Key Conceptual Questions:
1. What is the difference between demand and quantity demanded?
2. What is the difference between change in demand and change in quantity
demanded? (use graphs to aid you)
3. What determinants cause a change in demand?
Topic 2:
Supply
Read Krugman’s module 6 & 7
Objectives:
1. Explain the role of price in a market economy.
2. Define and illustrate supply through schedules and graphs.
3. Distinguish between change(s) in supply and change(s) in quantity supplied.
4. Explain the direct relationship between price and quantity supplied.
5. Identify and explain the variables that cause a change in supply.
6. Illustrate and explain the changes in quantity supplied given a price change.
Concepts to memorize:
Quantity Supplied
Supply Schedule
Substitution
Change in Price of a Substitute
Productivity
Law of Supply
Supply
Supply Curve
Market Supply
Complement in Production
Change in Price of a Complement
Key Conceptual Questions:
1. What is the difference between supply and quantity supplied?
2. What is the difference between change in supply and change in quantity supplied?
(use graphs to aid you)
3. What determinants cause a change in supply?
Topic 3:
Equilibrium and Market Efficiency
Read Krugman’s module 6, 7, 8, 9
Objectives:
1. Explain the role of price in a market economy.
2. Explain the concept of equilibrium price and quantity.
3. Illustrate graphically equilibrium price and quantity.
4. Explain and graph the effects of changes in demand and supply on equilibrium price and quantity,
including simultaneous changes in demand and supply.
5. Define and illustrate surpluses and shortages.
6. Define affects of surpluses and shortages on prices and quantities.
7. Interpret and/or compute equilibrium price and quantities from graphs, mathematics equations, and/or
data.
8. Define price ceilings and price floors, and provide examples.
9. Graph and explain the consequences of government-set prices.
Concepts to memorize:
Market Equilibrium
Surplus/Excessive Supply
Marginal benefit
Market Efficiency
Price Ceiling
Rent Ceiling
Black Market
Equilibrium Price
Shortage/Excessive Demand
Marginal Cost
Obstacles to Efficiency
Price Floor
Production Quota
Search Activity
Equilibrium Quantity
Subsidies
Minimum Wage Law
Key Conceptual Questions:
1. Why will the market-clearing (equilibrium) price be set at the intersection of supply and demand-- and
not at a higher or lower price?
2. How do market prices and equilibrium quantities respond to
a. change in demand?
b. change in supply?
c. simultaneous increases in supply and demand?
d. simultaneous decreases in supply and demand?
e. an increase in demand and a decrease in supply?
f. decrease in demand and an increase in supply?
3. What is the function of price and to what extent does it provide those functions in an efficient and
equitable manner?
4. What is an effective price ceiling? What is an effective price floor? Why are they created and what are
the effects of each?
5. Assume the fast food industry is an example of a competitive market currently in equilibrium. (i) Draw
a market supply and demand graph to show the current equilibrium and; (2) illustrate and explain
the immediate results of imposing a price ceiling on fast food good
6. What are black markets? Why do these occur?
7. How can wage rates, interest rates and exchanges rates be analyzed within the supply and demand
framework?
8. What happens when prices are set by law above or below the market equilibrium level?
Topic 4:
Elasticity
Read Krugman’s module 46, 47, 48
Objectives:
1. Define, explain, calculate, and interpret the price elasticity of demand.
2. Explain the meaning of elastic, inelastic, and unitary price elasticity of demand.
3. Recognize graphs of perfectly elastic and perfectly inelastic demand.
4. Use the total revenue test to determine whether elasticity of demand is elastic,
inelastic, or unit elastic.
5. List four major determinants of price elasticity of demand.
6. Explain cross elasticity of demand and how it is used to determine substitute or
complementary products.
7. Define income elasticity and its relationship to normal and inferior goods.
8. Calculate and explain the price elasticity of supply.
Concepts to memorize:
Elastic
Total Revenue
Income Elasticity
Mid-Point Method
Inelastic
Total Revenue Test
Normal Goods
Unit elastic
Cross Elasticity
Inferior Goods
Key Conceptual Questions:
1. What is price elasticity of demand and what factors determine its size?
2. How is total revenue related to the price elasticity of demand?
3. What is the income elasticity of demand?
4. What is the price elasticity of supply?
5. Assume that the short run demand for cigarettes is relatively, but not perfectly,
inelastic. The Indiana legislature often debates whether to place a per unit tax on
cigarettes in order to both increase the states tax revenues and to decrease
cigarette smoking. Use supply and demand analysis to describe the impact of a
proposed per unit tax on: (i) the price paid by consumers for cigarettes; (ii) the
quantity sold. Evaluate the short run goals of the Indiana legislature. Now if the
demand for cigarettes became more elastic, explain how each of the following
will differ from your previous answers: (i) the price and quantity sold of
cigarettes and (ii) the government’s tax revenues.
Topic 5:
Tax incidence and deadweight loss
Read Krugman’s module 50
Objectives:
1. Identify and explain tax burdens and deadweight loss
2. Describe the effects of taxes, who pays the taxes, and why they create inefficiencies.
3. Differentiate between the benefits-received and ability-to-pay principles of taxation.
4. Explain the relationship between the elasticities of demand and supply and the
efficiency loss of a particular tax.
Concepts to memorize:
Deadweight Loss
Taxable income
Progressive Tax
Benefits Principle
Producer Surplus
Tax Incidence
Marginal Tax Rate
Proportional Tax
Ability-to-pay
Excess Burden
Average Tax Rate
Regressive Tax
Consumer Surplus
Key Conceptual Questions:
1. How does the imposition of a tax affect a market? What determines the
distribution of the tax burden between buyers and sellers?
2. Explain the burden of taxation given elasticity information.