AP Microeconomics Graphs Review

In this review we will cover every graph that is required to be known for the AP microeconomics exam. Graphs are very important in microeconomics as they allow economists to show how various economic variables interact. You will be expected to understand and intrepret these graphs on the AP microeconomics exam.

Producution Possibilities Curve

What it shows: The Production Possibilties Curve compares the production rates of two commodities that share the same factors of production (input resources).  The Production Possibilities Curve shows the specified production level of one commodity that results given the production level of the other. It assumes the maximum possible efficient use of the resources for a maximum possible production of both commodities. A period of time is specified as well as the production technologies. Either commodity compared can be a good or a service.

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The above graph is an example of a Production Possibilities Curve. The graph is showing the rates of varying production of Guns and Butter. The various points For an economy to increase the quantity of one good produced, production of the other good must be sacrificed. Here, butter production must be sacrificed in order to produce more guns. Production Possibility curve's represent how much of the latter must be sacrificed for a given increase in production of the former.

Point A: This point demonstrates economic inefficiency. Given the amount of resources in the economy, more guns and butter could be produced with increased efficiency.

Point B: An efficient production of guns and butter with more guns being produced than butter.

Point C: An efficient production of butter and guns with more butter being produced than guns.

Point D: An efficient production of butter and guns with an equal amount of guns and butter produced.

Point X: A resource constrained production of guns and butter. This point cannot be achieved without adding more input resources to the economy.

Opportunity Cost and the Production Possibilties Curve

If there is no increase in productive resources, increasing production of a first good entails decreasing production of a second, because resources must be transferred to the first and away from the second. Points along the curve describe the trade-off between the goods. The sacrifice in the production of the second good is called the opportunity cost (because increasing production of the first good entails losing the opportunity to produce some amount of the second). Opportunity cost is measured in the number of units of the second good forgone for one or more units of the first good.

In the context of a PPF, opportunity cost is directly related to the shape of the curve (see below). If the shape of the PPF curve is straight-line, the opportunity cost is constant as production of different goods is changing. But, opportunity cost usually will vary depending on the start and end point. In the diagram on the right, producing 10 more packets of butter, at a low level of butter production, costs the opportunity of 5 guns (as with a movement from A to B). At point C, the economy is already close to its maximum potential butter output. To produce 10 more packets of butter, 50 guns must be sacrificed (as with a movement from C to D). The ratio of opportunity costs is determined by the marginal rate of transformation.

Increasing butter from A to B carries little opportunity cost, but for C to D the cost is great.

Shape

The production–possibility frontier can be constructed from the contract curve in an Edgeworth production box diagram of factor intensity. The example used above (which demonstrates increasing opportunity costs, with a curve concave from the origin) is the most common form of PPF. It represents a disparity in the factor intensities and technologies of the two production sectors. That is, as an economy specializes more and more into one product (e.g., moving from point B to point D), the opportunity cost of producing that product increases, because we are using more and more resources that are less efficient in producing it. With increasing production of butter, workers from the gun industry will move to it. At first, the least qualified (or most general) gun workers will be transferred into making more butter, and moving these workers has little impact on the opportunity cost of increasing butter production: the loss in gun production will be small. But the cost of producing successive units of butter will increase as resources that are more and more specialized in gun production are moved into the butter industry.

If opportunity costs are constant, a straight-line (linear) PPF is produced. This case reflects a situation where resources are not specialised and can be substituted for each other with no added cost. Products requiring similar resources (bread and pastry, for instance) will have an almost straight PPF, hence almost constant opportunity costs. More specifically, with constant returns to scale, there are two opportunities for a linear PPF: firstly, if there was only one factor of production to consider, or secondly, if the factor intensity ratios in the two sectors were constant at all points on the production-possibilities curve. With varying returns to scale, however, it may not be entirely linear in either case.

With economies of scale, the PPF would appear inward, with opportunity costs falling as more is produced of each respective product. Specialisation in producing successive units of a good determines its opportunity cost (say from mass production methods or specialization of labor).

     

A common PPF: increasing opportunity cost         An inverted PPF: decreasing opportunity cost                   A straight line PPF: constant opportunity cost

Supply & Demand

Demand Curve

The demand curve is the graph depicting the relationship between the price of a certain commodity, and the amount of it that consumers are willing and able to purchase at that given price. It is a graphic representation of a demand schedule. The demand curve for all consumers together follows from the demand curve of every individual consumer: the individual demands at each price are added together.

Demand curves are used to estimate behaviors in competitive markets, and are often combined with supply curves to estimate the equilibrium price (the price at which sellers together are willing to sell the same amount as buyers together are willing to buy, also known as market clearing price) and the equilibrium quantity (the amount of that good or service that will be produced and bought without surplus/excess supply or shortage/excess demand) of that market. In a monopolistic market, the demand curve facing the monopolist is simply the market demand curve.

An example of a demand curve shifting

Shift of a Demand Curve

The shift of a demand curve takes place when there is a change in any non-price determinant of demand, resulting in a new demand curve. Non-price determinants of demand are those things that will cause demand to change even if prices remain the same—in other words, the things whose changes might cause a consumer to buy more or less of a good even if the good's own price remained unchanged. Some of the more important factors are the prices of related goods (both substitutes and complements), income, population, and expectations. However, demand is the willingness and ability of a consumer to purchase a good under the prevailing circumstances; so, any circumstance that affects the consumer's willingness or ability to buy the good or service in question can be a non-price determinant of demand. As an example, weather could be a factor in the demand for beer at a baseball game.

When income rises, the demand curve for normal goods shifts outward as more will be demanded at all prices, while the demand curve for inferior goods shifts inward due to the increased attainability of superior substitutes. With respect to related goods, when the price of a good (e.g. a hamburger) rises, the demand curve for substitute goods (e.g. chicken) shifts out, while the demand curve for complementary goods (e.g. tomato sauce) shifts in (i.e. there is more demand for substitute goods as they become more attractive in terms of value for money, while demand for complementary goods contracts in response to the contraction of quantity demanded of the underlying good).

Demand shifters

  • Changes in disposable income
  • Changes in tastes and preferences - tastes and preferences are assumed to be fixed in the short-run. This assumption of fixed preferences is a necessary condition for aggregation of individual demand curves to derive market demand.
  • Changes in expectations.
  • Changes in the prices of related goods (substitutes and complements)
  • Population size and composition

Changes that increase demand

Some circumstances which can cause the demand curve to shift out include:

  • increase in price of a substitute
  • decrease in price of complement
  • increase in income if good is a normal good
  • decrease in income if good is an inferior good

Changes that decrease demand

Some circumstances which can cause the demand curve to shift in include:

  • decrease in price of a substitute
  • increase in price of a complement
  • decrease in income if good is normal good
  • increase in income if good is inferior good

Factors affecting market demand

Market or aggregate demand is the summation of individual demand curves. In addition to the factors which can affect individual demand there are three factors that can affect market demand (cause the market demand curve to shift):

  • a change in the number of consumers,
  • a change in the distribution of tastes among consumers,
  • a change in the distribution of income among consumers with different tastes.

Supply and Demand at Equilibrium

Equilibrium is defined to the price-quantity pair where the quantity demanded is equal to the quantity supplied, represented by the intersection of the demand and supply curves.

Market Equilibrium:

A situation in a market when the price is such that the quantity that consumers wish to demand is correctly balanced by the quantity that firms wish to supply.

Comparative static analysis:

Examines the likely effect on the equilibrium of a change in the external conditions affecting the market.

Changes in market equilibrium:- Practical uses of supply and demand analysis often center on the different variables that change equilibrium price and quantity, represented as shifts in the respective curves. Comparative statics of such a shift traces the effects from the initial equilibrium to the new equilibrium.

Demand curve shifts:

When consumers increase the quantity demanded at a given price, it is referred to as an increase in demand. Increased demand can be represented on the graph as the curve being shifted to the right. At each price point, a greater quantity is demanded, as from the initial curve D1 to the new curve D2. In the diagram, this raises the equilibrium price from P1 to the higher P2. This raises the equilibrium quantity from Q1 to the higher Q2. A movement along the curve is described as a "change in the quantity demanded" to distinguish it from a "change in demand," that is, a shift of the curve. there has been an increase in demand which has caused an increase in (equilibrium) quantity. The increase in demand could also come from changing tastes and fashions, incomes, price changes in complementary and substitute goods, market expectations, and number of buyers. This would cause the entire demand curve to shift changing the equilibrium price and quantity. Note in the diagram that the shift of the demand curve, by causing a new equilibrium price to emerge, resulted in movement along the supply curve from the point (Q1, P1) to the point Q2, P2).

If the demand decreases, then the opposite happens: a shift of the curve to the left. If the demand starts at D2, and decreases to D1, the equilibrium price will decrease, and the equilibrium quantity will also decrease. The quantity supplied at each price is the same as before the demand shift, reflecting the fact that the supply curve has not shifted; but the equilibrium quantity and price are different as a result of the change (shift) in demand.

The movement of the demand curve in response to a change in a non-price determinant of demand is caused by a change in the x-intercept, the constant term of the demand equation.

Supply curve shifts:

When technological progress occurs, the supply curve shifts. For example, assume that someone invents a better way of growing wheat so that the cost of growing a given quantity of wheat decreases. Otherwise stated, producers will be willing to supply more wheat at every price and this shifts the supply curve S1 outward, to S2—an increase in supply. This increase in supply causes the equilibrium price to decrease from P1 to P2. The equilibrium quantity increases from Q1 to Q2 as consumers move along the demand curve to the new lower price. As a result of a supply curve shift, the price and the quantity move in opposite directions.

If the quantity supplied decreases, the opposite happens. If the supply curve starts at S2, and shifts leftward to S1, the equilibrium price will increase and the equilibrium quantity will decrease as consumers move along the demand curve to the new higher price and associated lower quantity demanded. The quantity demanded at each price is the same as before the supply shift, reflecting the fact that the demand curve has not shifted. But due to the change (shift) in supply, the equilibrium quantity and price have changed.

The movement of the supply curve in response to a change in a non-price determinant of supply is caused by a change in the y-intercept, the constant term of the supply equation. The supply curve shifts up and down the y axis as non-price determinants of demand change.

Price Floor 

A price floor is a government- or group-imposed limit on how low a price can be charged for a product. For a price floor to be effective, it must be greater than the equilibrium price.

A price floor can be set above the free-market equilibrium price. In the first graph at right, the dashed green line represents a price floor set below the free-market price. In this case, the floor has no practical effect. The government has mandated a minimum price, but the market already bares a higher price.

An effective price floor, causing a surplus (supply exceeds demand).

By contrast, in the second graph, the dashed green line represents a price floor set above the free-market price. In this case, the price floor has a measurable impact on the market. It ensures prices stay high so that product can continue to be made.

An effective price floor, causing a surplus (supply exceeds demand).

A price floor set above the market equilibrium price has several side-effects. Consumers find they must now pay a higher price for the same product. As a result, they reduce their purchases or drop out of the market entirely. Meanwhile, suppliers find they are guaranteed a new, higher price than they were charging before. As a result, they increase production.

Taken together, these effects mean there is now an excess supply (known as a surplus) of the product in the market. To maintain the price floor over the long term, the government may need to take action to remove this surplus.

Price ceiling

A price ceiling is a government-imposed limit on the price charged for a product. Governments intend price ceilings to protect consumers from conditions that could make necessary commodities unattainable. However, a price ceiling can cause problems if imposed for a long period without controlled rationing. Price ceilings can produce negative results when the correct solution would have been to increase supply. Misuse occurs when a government misdiagnoses a price as too high when the real problem is that the supply is too low. In an unregulated market economy price ceilings do not exist. Students may incorrectly perceive a price ceiling as being on top of a supply and demand curve when in fact, an effective price ceiling is positioned below the equilibrium position on the graph.

                                    

Non-binding price ceiling

Binding Versus Non-Binding price ceilings

A price ceiling can be set above or below the free-market equilibrium price. For a price ceiling to be effective, it must differ from the free market price. In the graph at right, the supply and demand curves intersect to determine the free-market quantity and price. The dashed line represents a price ceiling set above the free-market price, called a non-binding price ceiling. In this case, the ceiling has no practical effect. The government has mandated a maximum price, but the market price is established well below that. In contrast, the solid green line is a price ceiling set below the free market price, called a binding price ceiling. In this case, the price ceiling has a measurable impact on the market.

Consequences of Binding Price Ceilings

A price ceiling set below the free-market price has several effects. Suppliers find they can't charge what they had been. As a result, some suppliers drop out of the market. This reduces supply. Meanwhile, consumers find they can now buy the product for less, so quantity demanded increases. These two actions cause quantity demanded to exceed quantity supplied, which causes a shortage—unless rationing or other consumption controls are enforced. It can also lead to various forms of non-price competition so supply can meet demand.

Reduction in quality

To supply demand at the legal price, the most obvious approach is to lower costs. However, in most cases, lower costs means lower quality. During World War II, for example, food sellers operating under ceilings reduced portion size and used less expensive ingredients (e.g., more fat, flour, etc.). It can also be seen in decreased maintenance of rent controlled apartments.

Some scholars, however, doubt that price ceilings necessarily drive quality down in the case of an oligopoly. They argued that with few competing firms selling under a price ceiling, a company at the lower end of the market must find ways to achieve better quality without raising price.

Black markets

DiscriminationIf somebody cannot obtain needed goods because a price ceiling reduces the quantity, they may turn to the black market. Those who—by luck or good management—obtain goods in short supply can profit by illegally selling at a higher price than the free market allows. The black market price is higher than the free market price because the quantity is less than in a free market transaction, where more sellers could afford to sell the product. People are sometimes forced to buy at these higher prices when a shortage happens and there is no other place to obtain these.

If there is a shortage, sellers may discriminate among customers. In the case of rent control in New York City, landlords have given rent-controlled apartments to celebrities over less-wealthy, non-famous people.

 

Pricing, quantity, and welfare effects of a binding price ceiling

Perfectly Competitive Firm

Perfectly Competitive Product Market Structure

Imperfectly Competitive Product Market Structure

Negative and Positive Externalities

Monopoly

Consumer and Producer Surplus

Effects of Taxes

Labor Market

Monopolistic Competition

perfectly competitive labor market

Lorenz Curve