1. Explain why price and quantity move to the equilibrium price and quantity in a market economy.
If price is above the equilibrium price, there is excess supply (quantity supplied exceeds quantity demanded). Sellers cannot sell all of the good that they would like. Some sellers will lower price. As price falls, the law of demand says consumers will increase quantity demanded; the law of supply says producers will decrease quantity supplied. Thus, if price is above equilibrium the excess supply causes the price to fall. As price moves towards equilibrium, buyers and sellers change their actions and the quantity exchanged adjusts to the equilibrium quantity.
If price is below the equilibrium price, there is an excess demand (quantity demanded exceeds quantity supplied). Buyers cannot purchase all of the good they would like. Some buyers will offer to purchase the good at a higher price. As price rises, quantity demanded falls and quantity supplied increases. Thus, if price is below equilibrium, excess demand will result in an increase is price. As price moves toward equilibrium, buyers and sellers change their actions and the quantity exchanged adjusts to the equilibrium quantity.
2. What is marginal benefit and how does it relate to the law of demand?
Marginal benefit is the benefit a consumer receives by consuming an additional unit of a good or service. The price the consumer is willing to pay for this additional unit measures the marginal benefit he or she derives from its consumption. Generally, marginal benefit falls as an individual consumes successive units of a good. Because marginal benefit falls as successive units are consumed, the individual will be willing to pay less for each successive unit. Thus, the law of demand, which states that there is an inverse relation between price and quantity demanded, is based upon the idea of diminishing marginal benefit.
3. Explain the difference between an explicit and an implicit cost.
An explicit cost is a direct money outlay. For example, if I go to a movie and the ticket is $5.00, my explicit cost of attending the movie is the $5.00 I spend on the ticket. An implicit cost does not involve a money outlay, but instead is concerned with the nonmonetary cost associated with an action. For example, if I could have earned an "A" on my economics exam by spending my time studying instead of watching the movie, the "A"I sacrifice is the implicit cost of attending the movie.
4. The price of hamburgers is $1.85 per burger. Kate's marginal cost of producing the next burger is $0.75. Will Kate plan to increase production? Why or why not?
Yes, Kate will plan to increase production. The marginal cost tells Kate the cost of producing an additional hamburger. The price is the revenue that can be earned by producing an additional hamburger. In this case, it costs only $.75 to produce the additional hamburger; however, the additional hamburger will generate $1.85 in revenue. Thus, if Kate produces an additional hamburger, profits will increase by $1.10.
5. Explain the law of supply and its relationship to marginal cost.
Marginal cost is the cost of producing an additional unit of a good or service. Generally, marginal cost rises on each successive unit produced. Because of this, a producer is willing to increase production only if he or she receives a higher price for the additional units produced. If price falls, the cost of producing the good will be more than the price the seller receives, and he or she will cut back production. The law of supply says that there is a direct relation between price and quantity supplied. As can be seen, it is marginal cost and the principle of increasing marginal cost that underlies this law.