Question

If an economy has fully flexible prices and demand unexpectedly increases, you would expect that the economy’s real GDP would tend to: a. Increase. b. Decrease. c. Remain the same.

Short answer

a. Increase.

Step-by-step solution

Understanding Flexible Prices

In an economy with fully flexible prices, prices adjust quickly to changes in demand and supply. This means that if demand increases, prices can rise to meet this new level of demand.

Analyzing the Effects of Increased Demand

When demand increases unexpectedly in a flexible-price economy, consumers are willing to pay more. Firms, eager to capitalize on the increased willingness to pay, produce more goods, increasing the real GDP.

Linking Increased Production to Real GDP

As firms increase production to meet higher demand, the total output, or real GDP, of the economy increases because more goods and services are being produced and sold.

Conclusion

With prices increasing and firms responding by producing more, the economy's real GDP tends to increase in response to an unexpected rise in demand.

Key concepts

Flexible Prices

In an economy where prices are fully flexible, the prices of goods and services can quickly adjust to changes in both demand and supply. This flexibility allows the market to efficiently allocate resources, ensuring that supply meets demand.

Flexibility in prices means that when the demand for a product increases, its price can rise promptly without any significant delay. This immediate price adjustment is crucial because it signals to producers that there is a higher demand in the market, prompting them to increase production. Likewise, if demand falls, prices can decrease, signaling producers to scale down production.

This concept of flexible prices is essential in understanding how markets operate efficiently. When prices can move freely in response to market conditions, resources are directed towards their most valued uses, contributing to optimal economic outcomes.

Real GDP

Real GDP, or Real Gross Domestic Product, measures the total value of all goods and services produced in an economy, adjusted for price changes or inflation. By considering only the value of goods and services produced, real GDP provides a clear picture of an economy's physical output and production levels.

Unlike nominal GDP, which can be affected by changes in price or inflation, real GDP provides a more accurate representation of an economy's size and how it is growing over time. Economists use real GDP to gauge how changes in production and consumption influence overall economic growth.

For example, when an economy experiences an increase in production due to increased demand, as firms respond by producing more, real GDP reflects this rise in economic activity. This measurement is vital because it tells us how efficiently an economy is operating and producing goods based on its capacity and resources.

Demand and Supply

The concepts of demand and supply form the foundation of economics, explaining how prices and quantities of goods and services are determined in a market economy. **Demand** refers to the quantity of a product that consumers are willing and able to purchase at a given price, while **supply** represents the quantity that producers are willing to sell at a particular price.

These two forces interact in a market setting to establish the equilibrium price and quantity.

• **When demand increases:** Prices typically rise, motivating producers to supply more to meet the higher demand.
• **When demand decreases:** Prices generally fall, signaling producers to reduce output.
• **When supply increases:** Prices may drop, encouraging consumers to buy more.
• **When supply decreases:** Prices can rise, prompting consumers to buy less or find alternatives.

The balance of demand and supply ensures that the resources are allocated efficiently in the economy. When prices are flexible, any shift in demand or supply can be quickly adjusted by changes in price, ensuring that markets remain in equilibrium.