Question

The demand curve shows that price and quantity demanded are inversely related. Briefly explain the two justifications for this relationship (the income and substitution effects). The supply curve shows a positive relationship between price and quantity supplied. What role does the loss of increasing opportunity cost play in this relationship? What role does profit play in this relationship?

Answer 1

The demand curve is negatively sloped that shows the inverse relationship between price and quantity demanded. That is when price increases, quantity demand will be decreased or vice-versa.

Incom effect: When people have more income, they increase their demand. That is demand increases by increasing income or vice versa.

Substitution effect: People tends to substitute costly gods with cheaper goods. That is when the price of one good is increased, demand for that is decreased and demand for a substitute good is increased.

The inverse relation between price and quantity demand shows that substitution effect dominates the income effect.

The supply curve shows there is a positive relationship between price and quantity supplied. When opportunity cost of production increases, production becomes costly so supply decreases. It shifts the supply curve to the left and price is increased. When the price is increased and quantity supply is increased, total revenue is increased. Profit=total revenue-total cost, so profit is increased.