Now that we have a better understanding of what GDP is and the various ways it’s calculated, let me present a scenario to you.

Suppose we have this economy, and in year 1, this economy’s GDP measured out to be $2,500. In year 2, the value of GDP rose to $5,000. Based on this information, what can you tell me about this economy?

“Well, it seems to me that this economy doubled its production going from year 1 to year 2, but it’s not that simple, is it? This is probably a trick question, otherwise you wouldn’t be asking me this, you say.

Your intuition is spot on. Since GDP is the measurement of an economy’s output one might think that if the value of GDP rose, it must mean production has risen as well, but that isn’t always the case. You have to remember that GDP is measured with money and the value of money changes over time due to inflation or deflation.

Let me show you what I mean. Pretend this economy is a one item economy; all they produce are toys. In year 1, this economy manufactured 250 toys and sold them for $10 apiece. That would give us our first year GDP value of $2,500 $(= \$10 x 250 toys). So far so good. Then let’s say that in year 2, this economy still produced 250 toys, but the price doubled to $20 apiece, doubling GDP to $5,000 $(= \$20 x 250 toys).

If GDP is supposed to be a measure of production, shouldn’t it remain the same between year 1 and year 2, since this economy produced the same number of toys each year?”

Indeed it should and therein lies the problem with what we call nominal GDP which is GDP that has not been adjusted for inflation. When we’re talking about GDP, the only thing we’re concerned about is output, but nominal GDP has prices as an added factor. The changing prices disguises any potential change in output.

Trying to compare nominal GDPs is like trying to compare distances that have been measured with a ruler that keeps on changing its mind about how long a foot is. You’re not going to get a meaningful result.

Economists realized this was a problem and the solution they came up with was a way to standardize prices across every time. That way, the value of $1 holds the same amount of weight now as it did 100 years ago. In other words, economists adjust GDP for inflation and that adjusted value is referred to as real GDP. With real GDP, we eliminate prices as a variable for change, so changes in real GDP reflect actual changes in output.

The easiest way to explain this is with an example, so follow along.

Nominal GDP and Real GDP Example
Here I have a two item economy that produces hotdogs and hamburgers. I have the quantities they produced each year along with the corresponding prices. Note how output falls going from year 3 to 4, but nominal GDP still increases, due to higher prices. The decrease in output however, is accurately captured in the real GDP, which falls from $170 to $110.

Calculating Nominal GDP
To calculate the nominal values of GDP of any given year, all we have to do is take the price of a good and multiply it by the quantity in the same year and sum those numbers up across all the goods. So to calculate nominal GDP for year 3, we take the price of hotdogs in year 3 ($5) multiply that by the number of hotdogs produced in year 3 (11 hotdogs) and add that to the price of hamburgers ($9) multiplied by the quantity of hamburgers (21 hamburgers). That gives us a nominal GDP of $244 $(= \$5 x 11 hotdogs + \$9 x 21 hamburgers) for year 3. You would repeat that process for all the other years to find their corresponding nominal GDP values.

Calculating Real GDP: Fixing Prices
Since we only have a two item economy, we can use a very simple method of calculating real GDP. The first thing that we have to do is select a reference year or a base year that we’re going to compare every other year to. (You can select any year you’d like. Just keep in mind that choosing different base years will give you different numbers.)Then we say to ourselves, “What would GDP be like if prices never changed throughout the years?” In other words, we fix the price so only output can change.

In this example, I chose year 1 as my base year. I see the price of hotdogs in year 1 is $4 and the price of hamburgers in year 1 is $6. So I’m saying to myself, “Let’s look at every other year’s GDP using year 1’s dollars.” So if I wanted to find out what the real GDP in year 4 was, I would take the prices in year 1 and multiply them by the quantities in year 4. This gives me a real GDP value of $110 $(= \$4 x 8 hotdogs + \$6 x 13 hamburgers).

Special note: The nominal GDP and the real GDP for your base year is always the same.

Calculating Real GDP: GDP Deflator
In the real world, there would be far too many things to keep track of in order to compute real GDP by fixing prices, especially if you were doing it by yourself. Instead, we calculate real GDP by using the GDP deflator, which is calculated by the Bureau of Economic Analysis (in the United States, anyway). They come up with the GDP deflator by tracking a market basket of goods and using a chain weighted technique to come up with their price index. If that sounds complicated, that’s because it is. Don’t worry, we won’t be covering that today. Instead, we’ll just be referring to this very simple formula:

$Real GDP = (Nominal GDP/GDP Deflator) x 100
From which we can derive: $GDP Deflator = (Nominal GDP/Real GDP) x 100
As well as: $Nominal GDP = (Real GDP x GDP Deflator)/100

This means that as long as you’re given at least two variables, you can always calculate the third. For example, let’s say that the base year is still year 1 and we want to use the GDP deflator in year 5 to calculate the real GDP for year 5. To do that, we simply take the nominal GDP in year 5 ($376), divide it by year 5’s GDP deflator (241) and multiply the result by 100 to get $156 $(= (\$376/241) x 100). If you know the nominal GDP and the real GDP for a given year, you can calculate that year’s GDP deflator. To get the GDP deflator of 145 $(= (\$206/\$142) x 100) in year 2, just take the nominal GDP of year 2 ($206), divide that by the real GDP of year 2 ($142) and multiply the result by 100. You can also rearrange the formula to solve for nominal GDP, as I did above. I’ll leave that exercise up to you so this post isn’t cluttered up with too many numbers.

Special note: The GDP deflator for your base year is always 100.

So you can see that the GDP deflator takes the inflation and deflation of prices across all the goods and services in an economy and compresses it into one neat little number. It allows us to tell, at a glance, how prices have been acting within the economy. If the deflator increases in value, it means that in general, prices have risen. If the deflator falls, it means that in general, prices have fell. In fact, the GDP deflator is one of the metrics some people use to measure inflation in an economy, but that’s a discussion for another time.
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Recap (tl;dr)
-Nominal GDP does not account for inflation.
-Nominal GDP can change because prices changed or because output changed or because of a combination of the two.
-Real GDP accounts for inflation and removes price as a factor.
-Changes in real GDP reflects real changes in output.
-Nominal GDP is calculated by taking prices in a given year and multiplying it with the output in the same year and summing those numbers up across all the goods and services.
-The first step to calculating real GDP is choosing a base year.
-Real GDP can be calculated by fixing base year prices or by using the GDP deflator.
-The nominal GDP and real GDP is always the same in the base year.
-The GDP deflator is always 100 in the base year.
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Reference
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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Previous economics post: Calculating GDP: Expenditures Approach

There are several different methods of calculating an economy’s GDP. Theoretically, all the different techniques should give you the same number, but that’s rarely the case due to the massive amount of data that needs to be dealt with in addition to all the points in the process where errors can creep in. That being the case, the real world results still tend to be pretty similar to each other.

Last, but not least, we arrive at the expenditures approach to calculating GDP. Conceptually, this probably the easiest method to wrap your head around. We’ll be referring back to this a lot later on down the road. This method is on the opposite end of the spectrum from the income approach. The income approach looks at all the wages, rents, interest, and profits earned by producing an item while the expenditure approach looks at all the money spent on purchasing an item. We can compute GDP by summing up the economy’s total spending in four areas: personal consumption, investment spending, government purchases, and net exports.
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Personal Consumption Expenditures (C)
This category sums up all the money that is spent by households, regular people like you and I, on goods and services. Buying groceries, buying a new car, eating out at a restaurant, all these things fall under the category of personal consumption. It’s denoted in the GDP equation by a C.
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Investment Spending (I)
When economists talk about investment, they generally aren’t referring to the financial transactions people normally think of. They’re not talking about buying and selling stocks and bonds or saving money in an account. When we talk about investment, we’re referring to the money spent by firms (businesses) on capital goods, changes to a firm’s inventory, and the construction of buildings. Investment is denoted in the GDP equation with an I. [break]
Side Note: Inventory
Remember that GDP accounts for all goods and services produced in a year, regardless of whether or not anything was sold. Changes in inventory is how the expenditures approach accounts for unsold goods (positive change in inventory) or goods sold in excess of the year’s productions (negative change in inventory) so that GDP doesn’t become understated or overstated. [break]
Side Note: Construction
All construction is counted under investment when using the expenditures approach to calculate GDP. This is because buildings are considered to be capital, even residential homes and apartments. A home owner has the option of leasing out his home and creating rental income from it, just like a factory or equipment or any other capital good.
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Government Purchases (G)
The government spends a lot of money providing public services (education, firefighters, military) and publicly owned capital (schools, parks, roads). The money they spend on these public goods, services, and capital counts towards GDP and is recorded under government purchases. Not all of the government’s spending is included here though; remember that public transfer payments are not a part of GDP. Government purchases are denoted with a G.
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Net Exports (NX)
Goods and services that are produced don’t necessarily all stay in their home country; some of it may get sent abroad. In other words, these goods and services are exported (exports is denoted with an X). Since those goods and services are produced domestically, they need to be added to GDP. At the same time, we don’t obtain all of our goods domestically, we get some of it abroad. In other words, we import goods and services (imports is denoted with an M). The three previous categories, personal consumption, investment spending, and government purchases don’t distinguish whether or not those expenditures were domestic or foreign. They’re just the total sum of expenditures in each category. To avoid overstating GDP, we have to subtract out the amount that we import. To make things simpler on ourselves and so we have fewer numbers to deal with, we lump up our international trade expenditures into one category, net exports which is defined as exports minus imports. Net exports is denoted with an NX.

Thus, the expenditures approach to GDP can easily be summed up with a simple equation: GDP = C+I+G+NX.
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Reference
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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Next economics post: Nominal GDP vs Real GDP
Previous economics post: Calculating GDP: Income Approach

There are several different methods of calculating an economy’s GDP. Theoretically, all the different techniques should give you the same number, but that’s rarely the case due to the massive amount of data that needs to be dealt with in addition to all the points in the process where errors can creep in. That being the case, the real world results still tend to be pretty similar to each other.

Another method of calculating an economy’s GDP is to use the income approach. If goods are being produced and services are being rendered, then somebody is being paid for it. If we sum up this income then add and take away a few things, we’ll have GDP.

Note: The actual methodology of the income approach goes way beyond the scope of what I’m covering here. There are many line items that I’m leaving out for simplicity’s sake. Some textbooks use a less complicated form for the income approach while others get much more advanced. Keep that in mind.

To calculate GDP this way, the first thing we need to do is figure out our national income. Since different people get paid in different ways, there are six separate categories that we have to look at: compensation of employees, rents, interest, proprietors’ income, corporate profits, and taxes on production and imports.
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Compensation of Employees
This includes all the wages and salaries that are paid out to employees, both public and private. Note that this number includes the full compensation of employees, so taxes paid by employers on the employees behalf (social security, unemployment, Medicare, etc.), health benefits, pension funding, and the like are all included in this category.[break]
Rent
This is income that is received by those who loan out their land and/or capital resources. For example, rent that a tenant pays to a landlord for an apartment or payments a farmer makes for borrowing a tractor falls under rent. Recipients of rent can either be private households or businesses. An important thing to note is that we are talking about net rent, which is rent after depreciation of the rental property. You’ll see why this is important later.[break]
Interest
Money received as payment for loans is interest. So interest paid on things like bonds, mortgages, and savings accounts all fall under this group. [break]
Proprietors’ Income
Profits made by small businesses that are sole proprietorships or partnerships or any business that isn’t incorporated (we have a separate segment for that) is considered proprietors’ income. The mom and pop shop on the corner, your favorite family restaurant, and the owner of the local landscaping company are all examples of businesses whose income would likely fall under this category. [break]
Corporate Profits
Profits made by businesses that are incorporated have their own category. There are three separate subsections to corporate profits:
-Corporate Income Tax: Because corporations are considered entities of their own, separate from their owners, they have to pay their own version of income tax based on the profits they make.
-Dividends: After paying taxes, one option that corporations have available to them is to pay out a portion or all of the left over profits to its owners, the people who own shares of the company’s stocks.
-Undistributed Corporate Profits: Whatever remains after taxes and dividend distributions are called retained earnings. This money usually gets reinvested back into the business to help the company grow.[break]
Taxes on Production and Imports
Taxes are the government’s form of “income” and this category covers a broad array of taxes, ranging from the general sales tax to customs duties. This gets a lot more detailed and complicated than what we need, so I’ll just leave it at that.
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Going from National Income to GDP
Once we sum up the value of these six categories, we’ll have what economists refer to as national income, which is the income that flows from all of a nations’ resources, whether it be located domestically or abroad. While national income is an important economic indicator in its own right, that’s not the topic of discussion; we’re looking for GDP. To get there from national income, we have to adjust for a few things.[break]
Net Foreign Factor Income
National income counts the income earned based on nationality, not based on region. So for example, the United States national income figure would include all income made by Americans both here in the States and in foreign countries. GDP is concerned only with thing that happen domestically, inside of a country, so we need to account for the income earned abroad. The net foreign factor income statistic corrects for the income made by American abroad and the income earned by foreign owned resources here in the United States. We subtract the net foreign factor income from national income as a step to calculate GDP. [break]
Consumption of Fixed Capital
Nothing lasts forever. This is especially true with capital resources; everything has a useful lifespan before it becomes obsolete or broken beyond repair and needs to be replaced. One well known accounting principle is that the cost of capital must be allocated across its useful lifespan, not when the capital was purchased. The concept of allocating the cost of capital throughout its life is called depreciation. We do this to keep profits a bit more accurate and relevant. By accounting for depreciation throughout the years rather than all at once, profits aren’t understated when the capital is purchased and aren’t overstated in the following years.

Businesses and the government set aside money specifically for the upkeep and replacement of capital The money that is spent here is part of the overall GDP, but it isn’t found anywhere in national income so it needs to be added in.[break]
Statistical Discrepancy
Like I said at the beginning, in a perfect word, the different methods used to calculate GDP would all result in the same number, but that’s hardly ever the case. To get the value of GDP that’s calculated from the income approach to match the number calculated from the expenditures approach, accountants add a “statistical discrepancy,” which is nothing more than the difference in value between the two approaches.

And with that, we have GDP via the income approach. Easy right? (Not really.) It helps to take a look at some numerical examples, which I’ll post up later.
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Recap (tl;dr)
Compensation of Employees plus Rents plus Interest plus Proprietors Income plus Corporate Profits plus Taxes on Production and Imports equals National Income

National Income less Net Foreign Factor Income plus Consumption of Fixed Capital plus Statistical Discrepancy equals Gross Domestic Product
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Next economics post: Calculating GDP: Expenditures Approach
Previous economics post: Calculating GDP: Value Added Approach

There are several different methods of calculating an economy’s GDP. Theoretically, all the different techniques should give you the same number, but that’s rarely the case due to the massive amount of data that needs to be dealt with in addition to all the points in the process where errors can creep in. That being the case, the real world results still tend to be pretty similar to each other.

One method of calculating GDP that isn’t efficient or even feasible in the real world is the value added approach. (The reason why I’m still writing about it is because I know some textbooks mention it and some professors teach it.) As its name implies, GDP is calculated by summing up all of the value that is added to a product during the production process. To calculate the value added to a good between firms, we take the price that it was sold for and subtract it from the price that it was bought at. When we sum up all of the value added over the entire production process, we have the dollar amount that the good contributed to GDP. I briefly went over this when introducing GDP in my last post. Let’s go over it again.

Value Added Example

Suppose that creating a bicycle from scratch requires five different steps from five different firms. Firm A mines the raw metal from the earth and sells it to the metal refinery for $90, so Firm A has added $90 to the value of the metal (we’ll ignore the inherent value of metal to simplify things). Firm B, the metal refinery, processes the metal it receives, purifying it and turning it into a metal that can be used for manufacturing purposes. Firm B sells the now processed metal to Firm C for $150. Because Firm B sold the metal for $150, but bought it for $90, Firm B only added $60 worth of value to the product, not the full $150. Firm C turns the metal into a functioning bike, adding $250 worth of value to the good, before selling it to Firm D for $400. Firm D distributes the bicycles to retailers at $500 a piece, adding $100 worth of value based on the service Firm D provides. Firm E, the bike shop, then retails the bicycle to a consumer for $700, which means Firm E added $200 worth of value to the bike when it provided its bike shop services (having a centralized place to peruse through many bikes, being able to talk to an expert, being able to test drive bikes before purchasing, etc.). If we sum up all the values added to this product throughout all its intermediate stages, we would come up with $700, which is the exact same price that the final form of the good sold for.

As you can see, this is a lot of work to do just to cover one product. When we introduce more goods into the economy, especially ones that have a much more complicated production process, you can easily see why the value added method isn’t used to compute an economy’s GDP. That being said, it still serves as good material to place on an exam so it doesn’t hurt to know it.
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Reference
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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Next economics post: Calculating GDP: Income Approach
Previous economics post: What is GDP?

GDP – Gross Domestic Product
-It is the monetary value of all final goods and services produced within a nation in a year.[break]
Monetary Value
-The dollar value of a good or service is what we use to measure GDP because it standardizes everything and makes it easy to track changes.
-Suppose an economy produced the following outputs in Year 1 and Year 2. In which year was GDP greater?

Year 1’s Output: 5 Soccer balls and 1,000 basketballs
Year 2’s Output: 1,000 Soccer balls and 5 basketballs

-Without the dollar amounts, it would be difficult to tell how society values soccer balls and basketballs relative to each other.
-If it’s already this difficult with just two products, imagine how much harder it will be with thousands to millions of products and services a nation produces.
-If soccer balls cost $20 each and basketballs cost $25 each, then we can tell that in Year 1, this economy’s GDP was $25,100 and in Year 2 the GDP was $20,125, so GDP in Year 1 was greater.[break]
Final Goods and Services
-GDP only tracks the value of the final goods and services and ignores the values of intermediate goods.
-The way we distinguish the difference between a final good and an intermediate good is based on who’s buying it and how it’s going to be used.
Final goods are goods and services that are bought by the final users, the people that are going to consume (use) this product or service themselves.
Intermediate goods are goods and services that are bought to be included as part of the production process for another good or service.
-Do not confuse intermediate goods with capital goods. Intermediate goods are used up in the production of something else. Capital goods are goods that assist in the production of something else; they are not used up in the production process.
-The reason why we count final goods only and not intermediate goods is to avoid multiple counting. This is easier to understand with an example.[break]
Example:
Value Added Example
-This table lists the manufacturing process for a bicycle.
-At each step of the process, value gets added to the intermediate good before it gets resold at a higher value to the next processor, before finally being sold to the end user for $700.
-According to our definition of GDP, only the final value of the bicycle ($700) should be counted.
-If we try to calculate how much the production of this bicycle adds to GDP by summing the values during the intermediate stages, we would get $1,840, which is overstating the value of this bicycle by $1,140.
-To avoid multiple counting, we can also sum up the value added at each stage of the production process, rather than looking at the final cost. (Although, theoretically these two numbers should be the same.)
-To use the value added approach, all you have to do is find the difference between what a producer sold his output for and how much he paid for his inputs. Sum up these numbers from the beginning to end of the production process and you’ll have the amount that should be added to GDP (Demonstrated in the Value Added column of the above table).[break]
Produced
-GDP only concerns itself with production.
-Transactions that don’t generate output either as a good or service (i.e. the transaction doesn’t product anything) won’t count towards GDP.
Public transfer payments are direct payments from the government that aren’t related or contingent on production. Social security payments, unemployment benefits, welfare checks, etc. are all examples of public transfer payments that do not count towards GDP.
Private transfer payments are payments made between private individuals that aren’t related to production. For example, the money you get from your grandparents for your birthday or the money you collect from your friend on a bet does not count towards GDP.
Stock market transactions are another form of financial transactions that are not included in the GDP measure. The act of buying and selling stocks in and of itself generates no output. Nothing is being created; ownerships is merely changing hands. However, the fee that you pay to your stock broker is included in GDP because he (or she) is providing you with a service.
Secondhand sales, like the last three transactions, don’t contribute to current production, so they are omitted from GDP. This is regardless of now “new” the product being resold is. You can buy a brand new car and resell it a week later; the money generated from won’t be included in GDP (unless part of it went to a broker of some sort).[break]
Within a Nation
-Anything produced within a nation’s borders counts towards that nation’s GDP regardless of who owns the production company.
-The output produced by manufacturing plants in China counts towards China’s GDP regardless if those plants are owned by Chinese companies or American companies (or Japanese companies or European companies or Australian companies or whatever).[break]
In a Year
-Unless otherwise noted, GDP refers to the output for a calendar year, so it is a very specific time frame.
-Only production that takes place in that calendar year counts towards that year’s GDP and that year’s GDP only. So production on Dec 31, 2013 will count towards 2013’s GDP while production on Jan 1, 2014 will go towards 2014’s GDP.

Fill in the Blank[break]
#1 The law of demand states that (1)_____ and (2)_____ are inversely related.

Solution Show
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#2 The difference between supply and quantity supplied is that supply refers to the entire (1)_____ while quantity supplied refers to a specific (2)_____.
Solution Show
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#3 Price ceilings are only effective if they are placed (1)_____ the equilibrium price and price floors are only effective if placed (2)_____ the equilibrium price.
Solution Show
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#4 The law of supply states that price and quantity are (1)_____ related.
Solution Show
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#5 If at the current market price of $8, quantity demanded is 8,000 and quantity supplied is 3,500, then we have a (1)_____ of (2)_____.
Solution Show
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#6 Graphically, to get a market demand curve from individual demand curves, we (1)_____ up the individual demand curves.
Solution Show
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#7 If two goods are substitutes and the price increase for one, the demand will (1)_____ for the other.
Solution Show
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#8 New sellers entering the market will cause supply to (1)_____.
Solution Show
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#9 An increase in supply will cause the market price to (1)_____ and the market quantity to (2)_____.
Solution Show
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#10 If two goods are complements and the price decreases for one, the demand will (1)_____ for the other
Solution Show
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#11 When graphing demand, economists conventionally place (1)_____ on the Y-axis and (2)_____ on the X-axis.
Solution Show
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#12 When graphing supply, economists conventionally place (1)_____ on the Y-axis and (2)_____ on the X-axis.
Solution Show
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#13 Demand for normal goods varies (1)_____ with income while inferior goods vary (2)_____ with income.
Solution Show
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#14 Graphically, to get a market supply curve from individual supply curves, we (1)_____ up the individual supply curves.
Solution Show
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#15 An increase in taxes for a good will (1)_____ supply while an increase subsidies will (2)_____ supply.
Solution Show
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#16 A decrease in demand will cause the equilibrium price to (1)_____ and the equilibrium quantity to (2)_____.
Solution Show
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Multiple Choice[break]
#1 What are might be two possible reasons a consumer buys less of a product when the price has increased?
A. Income and the price of substitute goods have changed.
B. There have been changes in taxes and subsidies.
C. The Coriolis effect and the Magnus effect.
D. The income effect and the substitution effect.
Solution Show
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#2 Which of the following are economists referring to when talking about supply?
A. The various quantities of a good or service that consumers are willing and able to purchase over a range of prices during a specified period of time.
B. The various quantities of a good or service that producers are willing and able to sell over a range of prices during a specified period of time.
C. All else equal, as price increases, quantity demanded decreases and as price decreases, quantity demanded increases.
D. All else equal, as price increases, quantity supplied increases and as price decreases, quantity supplied decreases.
Solution Show
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#3 What effect will surpluses have on the market for a good?
A. Increase supply and increase demand of the good until the equilibrium price and quantity is reached.
B. Reduce supply and reduce demand of the good until the equilibrium price and quantity is reached.
C. Put pressure on prices to fall.
D. No effect
Solution Show
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#4 Which of the following are economists referring to when talking about demand?
A. The various quantities of a good or service that consumers are willing and able to purchase over a range of prices during a specified period of time.
B. The various quantities of a good or service that producers are willing and able to sell over a range of prices during a specified period of time.
C. All else equal, as price increases, quantity demanded decreases and as price decreases, quantity demanded increases.
D. All else equal, as price increases, quantity supplied increases and as price decreases, quantity supplied decreases.
Solution Show
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#5 Which of the following will not cause the supply of corn to change?
A. The price of wheat changes.
B. The number of people buying corn changes.
C. The government subsidization of corn changes.
D. The efficiency of corn harvesting changes.
Solution Show
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#6 Which of the following will not cause the demand for blueberries to change?
A. The price of blackberries fall.
B. A blueberry diet craze sweeps the nation.
C. The price of blueberries is expected to change.
D. The price of blueberries changes.
Solution Show
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#7 Which of the following represents an increase in quantity supplied in this graph?
Demand and Supply PS Graph 1
A. S1 to S2.
B. S2 to S1.
C. Point a to point b.
D. Point b to point a.
Solution Show
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#8 You notice that the price of your favorite brand of cereal has risen. Which of the following might be a cause of the price rise?
A. The cost of producing cereal has fallen.
B. The prices of other similar cereals have risen.
C. Fewer people seem to be buying this brand.
D. The price of milk has risen.
Solution Show
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#9 What are the market effects of increasing demand and decreasing supply at the same time?
A. Price increases, quantity decreases.
B. Price is indeterminate, quantity increases.
C. Price increases, quantity is indeterminate.
D. Price decreases, quantity increases.
Solution Show
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Short Answer[break]
#1 What are the determinants of demand?
Solution Show
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#2 What are the determinants of supply?
Solution Show
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#3 What are the two endogenous variables in the demand model?
Solution Show
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#4 What do economists call the ability for markets to be able to reach the market clearing price on its own?
Solution Show
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#5 As a consumer, a rising product price makes purchasing other similar products relatively cheaper to me. What effect am I describing?
Solution Show
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#6 Find the equilibrium price and quantity. If the government instituted a market price of $5, would this be a price ceiling or a price floor? What would be the resulting surplus or shortage?
Demand and Supply PS Graph 2
Solution Show
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#7 How will improvements in production techniques affect supply? Why?
Solution Show
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#8 What is the equation of this line? Is this line more likely to be a demand curve or a supply curve?
Demand and Supply PS Graph 3
Solution Show
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#9 What is the equation of this line? Is this line more likely to be a demand curve or a supply curve?
Demand and Supply PS Graph 4
Solution Show
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#10 As a consumer, a falling product price allows me to purchase more things with my given level of income. What effect am I describing?
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#11 Computers and software are examples of what kind of goods?
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#12 Fill in the following table. What is the equilibrium price and quantity?
Demand and Supply PS Table 1
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#13 Your friend says to you, “In the market, when demand increases, price increase causing the quantity to increase. But the law of demand states that as prices go up, quantity should go down. Therefore, law of demand must be wrong.” Explain the flaw in his reasoning.
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#14 Chicken and beef are examples of what kind of goods?
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#15 What are the two endogenous variables in the supply model?
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#16 Cell phone plans and butter are examples of what kind of goods?
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#17 What effect will a change in resource prices have on supply? Why do resource prices affect supply at all?
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#18 Suppose you are hired as an economist to analyze the market L-shaped couches. You notice that every year for the past five years, more and more L-shaped couches have been sold at lower and lower prices. What might be a possible explanation for this?
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#19 Used cars are an example of what kind of goods?
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#20 How do you know if a variable is endogenous or exogenous?
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#21 What effect will a change in producer expectations have on supply?
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#22 Suppose we are at the equilibrium level for some good. If the consumers of this product have their incomes increase, what will happen to the equilibrium price?
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#23 Given the demand equation $P=-1/3Q_{D}+25 and the supply equation $P=2/3Q_{S}+4, find the equilibrium price and quantity without graphing.
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#24 Using the info above, if the government instituted a market price of $10, do we have a shortage or surplus? Of how much? Is this a price ceiling or price floor?
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#25 Graph $P=-1/3Q_{D}+25 and $P=2/3Q_{S}+4 and the price ceiling of $10. Does the information from the graph match the answers you got earlier?
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#26 Lobster is an example of what kind of goods?
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#27 What effects do a change in the prices of other goods have on supply of a good?
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#28 Identify the four complex demand and supply cases and their resulting effects on the market price and quantity.
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True/False[break]
#1 Supply curves have a positive slope.
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#2 Demand and supply curves can never be straight, otherwise we wouldn’t call them curves.
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#3 One explanation for why demand slopes downward is because of a concept called diminishing marginal cost.
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#4 Economists conventionally label the X-axis price and the Y-axis quantity when graphing demand and supply.
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#5 Demand for normal goods varies directly with income.
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#6 We can determine the market price and quantity is for a good or service just by looking at the supply curve.
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#7 All else equal, an improvement in production technology causes the equilibrium price to fall.
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Another way a market could be disturbed is through government intervention. If left alone, a market will settle at equilibrium through the rationing function of prices. However, the government sometimes thinks that the equilibrium price is unfair and will take it upon itself to influence the market through the establishment of price ceilings and price floors.

A price ceiling is a price that you cannot go above.
A price floor is a price that you cannot go below.

The easiest way to see the effects of a price ceiling or a price floor is to take a look at it graphically.

Sometimes students mix up the two when drawing and labeling them on a demand and supply graph. To help remedy this, conjure up the following image:

Imagine you are a giant in a really small room. If you tried to jump, your head would hit the ceiling. So the ceiling is a price you cannot go above. As you come tumbling back down, you would crash into the floor and come to a stop, so a price floor is a price you cannot go below. Keep that in mind.
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Price Ceilings
Suppose we’re at the equilibrium point PE and QE when all of a sudden, the government decides that the market price is too high and institutes a price ceiling, PC. (Remember, a price ceiling is a price that we cannot go above, so it’s placed below the equilibrium point.) We can immediately tell from the graph that a shortage is created as a result.

Price Ceiling Example

The price ceiling prevents the rationing function of prices from taking place. So long as there’s a ceiling, there will be a shortage.

“So what,” you might think. “I don’t see what the big deal is.” Well, let’s think about the repercussions a little bit.

We have a constant shortage on our hands, which means there isn’t enough of this product to go around, so what do we do? Do we issue things on a first come, first serve basis? Do we try to ration out the product? How do we stop counterfeiters from flooding the market with an inferior, unregulated product? How do we stop black markets from arising where the good is sold above the market price?
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Price Floors
Suppose we’re at equilibrium again at PE and QE when all of a sudden, the government decides that the market price is too low this time and decides to institute a price floor, PF. (Remember, a price floor is a price that we cannot go below, so it’s placed above the equilibrium point.) We can immediately tell from the graph that a surplus is created as a result.

Price Floor Example

The price floor prevents the rationing function of prices from taking place. So long as there’s a price floor, there will be a surplus.

Again, let’s think about the consequences of this price floor.

We have a constant surplus on our hands, which means that there’s too much of this product flooding the market, so what do we do? How will we get rid of the extra surplus? Who will pay to get rid of the extra surplus? Or will we just let the extra go to waste? How do we get the suppliers to innovate and attempt to be more efficient if they’re guaranteed a higher-than-market price? What do we do when people who would have normally been able to obtain this good that are no longer able to because of this higher price start to complain? Just a few things to think about.

Does the government actually help increase the efficiency of our economy by instituting these price ceilings and floors, or are they just good intentions with bad outcomes? We’ll look at a few case studies later to see the results.

Recap (tl;dr)
-A price ceiling is a price that you cannot go above. It only has an effect when set below the equilibrium price. Price ceilings create shortages that wouldn’t otherwise be there.

-A price floor is a price that you cannot go below. It only has an effect when set above the equilibrium price. Price ceilings create surpluses that wouldn’t otherwise be there.
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Reference
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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Next economics post: What is GDP?
Previous economics post: Market Equilibrium: Complex Cases

So it’s pretty easy to figure out what happens to the equilibrium point if we change demand or supply while one factor constant, but what happens if we change both at the same time? This is when things get a bit trickier and graphical analysis doesn’t tell us everything that we need to know.

There are four possible complex cases, where both demand and supply change at the same time:

Demand increases and supply increases
Demand increases and supply decreases
Demand decreases and supply increases
Demand decreases and supply decreases

Let me show you why they’re complex. Let’s take a look at the first case graphically.

All you know is that demand increases and supply increases, but you don’t know by how much. Let’s say that demand increases by a lot, but supply only increases by a little.
Increase in Demand, Increase in Supply 1
The end result is that the equilibrium price and quantity increases.
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Hold on though. What if demand increases by a little and supply increases by a lot?
Increase in Demand, Increase in Supply 2
This time, the equilibrium price decreases while the equilibrium quantity increases.
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What if demand and supply both increase by a similar amount?
Increase in Demand, Increase in Supply 3
Again, we have a different end result. This time, the equilibrium price stays constant while the equilibrium quantity goes up.
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In each of these cases, we increased both demand and supply, but we ended up with three different outcomes.

The more factors that we change at once, the more difficult it becomes to analyze the situation. That’s why we have simplifying assumptions like ceteris paribus to make our lives easier.

Back to the case at hand. If demand and supply increases, it’s hard to tell what happens to the equilibrium price, so the effect is unknown or indeterminate. The equilibrium quantity on the other hand increased in all three cases. In fact, the equilibrium quantity will always go up for every case where demand and supply both increase.
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There’s an easier way to see this without going through a bunch of graphs. Let’s go back to my last post where I talked about changing demand or supply while keeping the other constant.

If demand increases while supply stays constant, the equilibrium price will go up and the equilibrium quantity will go up. If supply increases while the demand stays constant, then the equilibrium price will go down while the equilibrium quantity goes up.

Note that increasing demand and increasing supply while the other is constant has opposing effects on price. That’s why when we combine the two together, we can’t tell what happens to the equilibrium price. However, we can tell what happens to the equilibrium quantity because they both move in the same direction.

You can use this technique to find out the end result of the other complex cases as well, instead of having to draw out three separate graphs every time.
Complex Cases Chart
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Recap (tl;dr)

Demand increases; supply increases: equilibrium price – indeterminate, equilibrium quantity – increases
Demand increases; supply decreases: equilibrium price – increases, equilibrium quantity – indeterminate
Demand decreases; supply increases: equilibrium price – decreases, equilibrium quantity – indeterminate
Demand decreases; supply decreases: equilibrium price – indeterminate, equilibrium quantity – decreases
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Reference
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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Next economics post: Market Equilibrium: Price Ceilings and Price Floors
Previous economics post: Market Equilibrium: Shifting Demand and Supply

So now that we know how the market will act when it’s undisturbed, let’s start mixing things up a bit and find out what happens when things start to change. For example, what if something causes demand to change? Or supply to change? Or both? This is where graphical analysis really becomes useful.
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Changes in Demand (Increase)
Suppose we’re at market equilibrium, when there’s a sudden increase in demand while supply stays constant.

Let’s walk through this step by step.

Increase in Demand

1) Demand increases. At this point, nothing else has changed yet so that increase in demand will create a shortage.

2) The shortage will cause consumers to bid up the market price, which will cause the quantity demanded to fall and the quantity supplied to rise. This will continue to happen until we hit our new equilibrium point.

3) The end result is that we now have a higher equilibrium price and a higher equilibrium quantity.
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Changes in Demand (Decrease)
The exact opposite happens if there is a decrease in demand if supply remains constant.

Decrease in Demand

1) Demand decreases. This creates a surplus in the market.

2) Producers notice the surplus building up in their inventories and begin cutting their prices. As the market price falls, the quantity supplied falls with it while the quantity demand rises. This will continue to happen until we hit our new equilibrium point.

3) The end result is that we now have a lower equilibrium price and a lower equilibrium quantity.
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Changes in Supply (Increase)
Suppose we’re at market equilibrium when there’s a sudden increase in supply while demand stays constant.

Again, we’ll go through this step by step.

Increase in Supply

1) Supply increases. At this point, nothing else has changed yet so the sudden increase in supply creates a surplus.

2) This will prompt producers to start lowering their prices so they can get rid of the surplus. As the market price goes down, the quantity supplied will decrease while the quantity demanded will increase. This will happen until we hit our new equilibrium.

3) The end result is that we now have a lower equilibrium price, but a higher equilibrium quantity.
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Changes in Supply (Decrease)
The opposite end result will occur if supply decreased instead while demand stays constant.

Decrease in Supply

1) Supply decreases, creating a shortage.

2) Consumers respond to the shortage by bidding up the market price. As the market price goes up, the quantity demanded falls while the quantity supplied rises. This will continue to happen until we hit our new equilibrium point.

3) The end result is that we now have a higher equilibrium price and a lower equilibrium quantity.
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Recap (tl;dr)
There were a lot of words and graphs up there. Here’s what you needed to get out of it.

-If demand increases while supply stays constant, the equilibrium price and quantity will go up.

-If demand decreases while supply stays constant, the equilibrium price and quantity will go down.

-If supply increases while demand stays constant, the equilibrium price will go down while the equilibrium quantity will go up.

-If supply decreases while demand stays constant, the equilibrium price will go up while the equilibrium quantity will go down.
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Reference
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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Next economics post: Market Equilibrium: Complex Cases
Previous economics post: Market Equilibrium: Putting Demand and Supply Together

Now that you understand the basics of demand and supply, let’s put them together and see what sort of magical things happen.

Earlier, I told you that by themselves, demand and supply cannot tell you what the market price for a product will be. It is only when we put the two together that we can see how buyers and sellers will interact to determine how much of a product will be put on the market and what price it will be sold for.

Market Equilibrium for Bacon Example

Taking a look at the demand and supply table, we can see that there is one price that stands out from the rest. At $6, the amount of bacon consumers are willing and able to purchase matches the amount of bacon firms are willing and able to supply. In other words, at this point and this point only, the quantity demanded matches the quantity supplied, so we say that the market is in a state of equilibrium. $6 is the equilibrium price and 10 pounds of bacon per week is the equilibrium quantity. The equilibrium point can easily be observed in the graph as well; it’s where the demand and supply curves intersect.

When we are at the equilibrium price, suppliers are producing and selling the exact amount that consumers are purchasing. Since there are neither too many goods nor too few goods in the market, economists sometimes call the equilibrium price the market clearing price. Let’s see what happens when we deviate away from this price.
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Shortages
Let’s say we’re at some price below the equilibrium price, PE. We’ll call this number P* (it can be any number as long as it’s below the equilibrium price). At every price below PE, consumers are willing and able to purchase more than producers are supplying, resulting in a shortage. The lower the price is below equilibrium, the greater the shortage. You can easily see this on a graph.

Shortage Example
At P*, consumers are demanding QD, but producers are only supplying QS. The difference between QD and QS is the shortage amount (highlighted in orange).

When a shortage occurs, there will be consumers who want the product, but are unable to get it. Some of these consumers will want the product more than others and are willing to pay a premium for the product, a price higher than the current market price to ensure that they get their hands on it (some people really love their bacon). In doing so, they’ll bid up the market price. As the market price goes up, some consumers will deem bacon too expensive and will no longer want to buy it while others simply will not be able to afford it, causing the quantity demanded to go down.

As the consumers bid up the market prices, suppliers are going to find that this product is becoming more and more profitable so they’re going to increase production, increasing the quantity supplied.

These two things will happen in conjunction with one another, driving the market price up, decreasing quantity demanded and increasing quantity supplied until we hit our equilibrium price and quantity.
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Surpluses
At every price greater than the equilibrium price PE, producers are willing and able to sell more than consumers are buying, leading to a surplus of goods. The higher the price is above equilibrium, the greater the surplus. Again, you can easily see this on a graph.

Surplus Example
At P*, consumers are only demanding QD, but producers are supplying QS. The difference between QS and QD is the surplus amount (highlighted in orange).

When there’s a surplus, suppliers will have an excess amount of goods on their hands. They’re going to need to find a place to store these extra goods. While some businesses tend to keep some extra inventory on hand, most businesses in general do not like to carry an excess surplus of goods. That’s because it costs them money to store their surpluses. They’ll need to rent out additional warehouse space, someone has to keep track of the extra inventory, security needs to be hired to so the goods don’t get stolen, so on and so forth. It’s too much of a hassle and too costly to maintain a surplus, so suppliers want to get rid of it. They’ll do so by lowering their prices. As the market price falls, producers will have less incentive to produce as much as they used to, so the quantity supplied will also fall.

As the suppliers drive down the market price, consumers are going to be more and more inclined to purchase more of the product, increasing the quantity demanded. This will continue to happen until we reach the equilibrium price, where the quantity demanded equals the quantity supplied and there is neither a shortage nor a surplus.
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Rationing Function of Prices
The ability for the market to regulate itself to find the market clearing price is known as the rationing function of prices. In a capitalistic economy, the market will revert to the equilibrium price without any assistance and will remain at equilibrium unless it’s influenced by some outside factor, like a change in demand and/or supply or through government intervention.
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Reference
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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Next economics post: Market Equilibrium: Shifting Demand and Supply
Previous economics post: Determinants (Shifters) of Supply