The Basic Economics Problems

Learning focus: 1. Wants, resources and scarcity 2. Choice and Opportunity cost 3. Free goods and economic goods 4. Consumer goods and capital (producer) goods 5. Basic economic problems and economic systems

What are wants? Wants are human desire for things. (goods and services). Wants can be material or non-material What are resources? Resources are things that can satisfy wants. Characteristic of wants: Human wants are unlimited. We always prefer to have more goods and services. When our basic wants are satisfied, other wants will appear. Characteristic of resources: Resources on earth are limited in supply. Types of resources: They include natural resources, human resources and man-made resources. What is scarcity? Scarcity is a situation which we do not have enough resources to satisfy all our wants. Scarcity is a relative concept. Relative to our human wants, resources are not enough or insufficient to satisfy all our wants. Since resources are limited but wants are unlimited, we have to make choice. Attention: Don't say resources cannot satisfy all our wants. Should say resources are insufficient to satisfy all our wants. (Scarcity) is a (noun). (Scarce) is an (adjective). Don't write as (scare).

The concept of scarcity: 1. 2. A resource is scarce if we want more of it, that is, more of it is preferred. Scarcity is a relative concept: relative to our unlimited wants, the limited resources available are insufficient (not enough) to satisfy all human wants. We have to compare wants with the level of resources to know whether the problem exists or not. Limited is not equivalent to insufficient. A resource that is in fixed supply may not be scarce. Sea water on earth is fixed in supply but by no means scarce as we do not want more of it.

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Even the quantity supplied of good is large the problem of scarcity may still exist since our wants for them may be even greater.

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Even the richest man in the world has to face the problem of scarcity. No one can escape the problem of scarcity.

Definition of opportunity cost: Opportunity cost is expressed in terms of the highest valued option forgone.

The concept of opportunity cost: When scarcity exists, we can't have everything we want. We have to make choice out of a number of options. Inevitably, we have to forgo (give up) some of the options. Opportunity cost indicates the real cost of our choice. Cost is NOT all other options forgone but the highest valued option forgone. You cant add up the value of all forgone options, simply because even you dont choose the selected option, you are not allowed to have all the rest, but just one of them. However in some cases, you have to add up several options to be the opportunity cost. It is because the options are not mutually exclusive.See case 4)

Explanation: Among the forgone options, the one with the highest value is the opportunity cost of our choice of the best option. The opportunity cost must be among the forgone options. If it is not one of the forgone options, it can not be the opportunity cost.

Example 1 : cost is not all other options forgone: The following items are the options available for you to choose from and they are ranked according to the buyers order of preference and you have money to buy one of them only: B 1st (selected) C 2nd (forgone) A 3rd (forgone) D 4th (forgone)

B has the highest value among all options To choose B, the Opportunity Cost is C D has the lowest value among all options (lowest) B is the selected option To choose C, the Opportunity Cost is B C has the highest value among the forgone options. (highest) To choose A, the Opportunity Cost is B (highest) To choose D, the Opportunity Cost is B (highest)

Concepts: 1. We choose the highest valued option among all available options 2. 3. Our opportunity cost is the highest valued option among those forgone options. We choose the option which costs us the least to minimize the cost of our choice.

Steps: 1. List out all the available options 2. 3. 4. Rank the options and prepare a priority list according to our preference. Try one option at a time to compare the relative cost of each possible option To choose the one with the lowest (least) cost to choose the one with the (highest) value. This is a very difficult concept. Most students confuse them easily. They don't know the different between the value of the option and the cost of choosing the option.

When will cost change? Cost is the highest valued option forgone. Cost will change when there is a change in the value of this "highest valued forgone option" or this "highest valued forgone option" is replaced by another option. No choice, No cost: If there is no choice, there won't be any forgone option and that there is no "highest valued option forgone". The opportunity cost of choosing A is to forgo B. Don't say the opportunity cost of A is B.

Example 2: Cost changes when the value of the highest valued option forgone changes. Suppose Tom has $20 to spend on one of the three following options for lunch. First choice: $20 a Hamburger (highest value of the three options) Second choice : $20 a bowl of noodles (Highest valued option forgone) (value higher than the chicken leg but lower than the Hamburger) Third choice : $20 a chicken leg (lowest value of the three options) His opportunity cost of choosing the Hamburger is losing the opportunity to choose the bowl of noodles. The bowl of noodles has the highest value among the forgone options ( noodles and chicken leg are the forgone options) Q1. In case a cockroach is found in the bowl of noodle, will the opportunity cost of choosing the Hamburger change? Ans. Yes, cost changes when the value of the highest valued option forgone changes. The bowl of noodles is the highest valued option forgone and its value changes. The cost of eating the hamburger is lower than before. (The cost is lower, not the value is lower) Q2. In case the Hamburger is not very tasty. Will the opportunity cost (of choosing a hamburger) change? Ans. No. Change in the value of the selected option will not affect its cost. The value of the highest valued option forgone is not affected. The cost is still the bowl of delicious noodles. Attention: 1. Cost changes only if there is a change in the highest valued option forgone. (the highest valued option forgone is replaced by another option or there is a change in value of this highest valued option) A change in the value of the selected option changes will not affect cost. Don't mix up the value of your choice with the cost of your choice.

2. 3

Example 3: Opportunity cost in form of Implicit cost : Suppose a man owns an apartment worth $2 million. He could sell it for money and then puts the money into a bank to receive 5% interest. Alternatively, he could rent out the apartment at $8000 a month. What is his opportunity cost (in a year) if he chooses to living in his own apartment? () The interest would be $100,000 = $2,000,000 x 5% (highest valued option forgone) The rental income would be $96,000 = $8,000 x 12 (lowest valued option forgone) Attention: Living in your own flat incurs positive opportunity cost. The cost is to give up the rental income from the property.

Example 4 : total cost of attending an English course: In some cases, you have to add up several things (forgone options) as the opportunity cost. It depends whether the options are mutually exclusive. John plans to attend an English course. There are eight hours of lessons in each month and the course fee is $600 per month. Alternatively, he can use his time working as a part-time waiter and earns $50 per hour. What is John's cost of attending the course in a month?

If he changes his mind by not attending the English course, he can save the $600 course fee and he can earn $400 ($50 x 8 hours) as well. The school fee and the income from the part-time job are not mutually exclusive. His cost of attending the English course is $600 + $400 = $1,000. Example 5: Opportunity cost shows the comparative costs / comparative advantage: Mrs. Lee is a retired person. Mrs. Lee's daughter, Susan, is a lawyer. Mrs. Lee does the housework in her daughter's house and receives no money for it. The cost to Mrs. Lee is nothing (or the value of leisure). The cost to Susan is the income forgone as a lawyer. The cost to Mrs. Lee of doing the housework is lower than Susan the lawyer. (given that the leisure value is lower than the income of a lawyer)

1. 2. 3.

What is a good? A good is something at least someone wants it. Some is better than none. It can satisfy wants. Types of goods: 1. Free goods 2. Economic goods or scarce goods Definition of free goods: A free good is a good whose quantity is sufficient to satisfy all out wants. More of it is not preferred. Definition of economic goods: An economic good is a good whose quantity is insufficient to satisfy all our wants. More of it is preferred. Note: the phrase 'some is better than none' applies to both free goods and economic goods Features of a free good: 1. 2. 3. 4. Quantity available is sufficient (enough) for satisfying all human wants. More of it is not preferred. No one is willing to pay a price for it. Opportunity cost in production is zero

Features of an economic good: 1. 2. 3. 4. Quantity available is insufficient (not enough) for satisfying all human wants. More of it is preferred. People are willing to pay a price for it. Opportunity cost in production is greater than zero.

Remarks: 1. A free good must be free of charge as no one is willing to pay for it. 2. 3. A good with a positive price must be an economic good. A good that is free of charge may not be a free good. A free of charge good can be an economic good.

Examples of free goods: Air on earth, sea water at the sea side and sand in the desert are examples of free goods. Examples of economic goods: Television sets, air conditioners, cars and bread are examples of economic goods.

Example of an economic good that is free of charge: In Hong Kong, many TV programmes are broadcast to viewers free of charge. They are by no means free goods. These programmes require positive cost of production. Resources used to produce them are scarce in supply and have alternative uses. Therefore, TV broadcast is an economic good.

Remarks: A good can be an economic good in one situation and a free good in another situation. Air on earth is a free good. Air underwater or in outer space is an economic good. Types of goods: 1. Consumer goods 2. Capital goods (=producer goods) Definition of Consumer goods: A consumer good is produced (made) for consumption or satisfying consumer's wants directly.

Definition of Capital goods: (producer good): A capital good is produced (made) for production or producing other goods. Capital goods are man-made resources.

Remarks: The definition of a consumer good or a capital good depends on its usage. An air-conditioner at home is a consumer good but it is a capital good in a restaurant. An apple is a consumer good if it is for immediate consumption. It is a capital good if it is used as raw material for producing apple pies in a cake shop.

The three basic Economic problems: 1. What to produce and in what quantity? What goods should be produced with the resources and how many/much should be produced?

2.

How to produce? What kind of production method should be used in production? (more workers less machines or more machines less workers.) For whom are the goods produced? How to distribute the goods produced to the consumers? Who can enjoy the goods produced?

3.

Types of economic system: 1. Traditional economy 2. Market economy 3 Planned economy 4. Mixed economy 1. a. The Traditional Economy: Rigid () rules and customs dominate their activities and behaviour. Their life and methods of production are primitive () , resulting in a low efficiency ( )and low standard of living. There is an authority (e.g. chief of the clan, village or community) in interpreting the rules, customs and makes final decisions. There is only a simple division of labour by heritage and customs. A sexual division of labour is common. As a result, the 3 basic problems of what, how and for whom to produce are solved by traditions. There are ways to allocate resources, to distribute income and products, to stabilize prices but NOT the way to help the economy to grow and develop. 2. The Market (Capitalist) Economy: A market economy is an economy mainly relies on market mechanism (price mechanism) to distribute resources and products. a. Private Property Rights: These rights include the rights to use and to control a property; right to exclude others from using that property; right to sell and transfer; right to get any benefits from the property. These rights had to be protected by laws. Without private property right, exchange is meaningless.

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Decentralized Decision-making with Self-interest: Reliance on Price Competition: With scarcity, there is competition everywhere. A market economy relies on a free market with a price to direct the exchanges of goods and services. Price is the guiding signal for exchange. In a market economy, the 3 basic problems are solved by a freely competitive market

e.

3.

The Command or Planned Economy: In a command economy, there is a central authority, usually the government, to direct the allocation of resources, the distribution of income and goods. The government becomes a huge organization with numerous ranks of officials called bureaucrats () or comrades () in a socialist economy. The 3 basic economic problems are to be solved by the central authority. The Mixed Economy: All economies at present are mixed. They differ in the extent of their degree of reliance on functions of the market.

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Demand, Supply and Price

Learning focus: 1 Concept of Demand: 2 Individual Demand: 3 Demand Schedule & Demand Curve: 4 Quantity demanded and Demand: 5 Market Demand: 6 Law of Demand: 7 Concept of Supply: 8 Individual Supply: 9 Supply Schedule & Supply Curve 10 Quantity supplied and Supply: 11 Market Supply: 12 Law of Supply: 13 Concept of Market price: 14 Equilibrium price & quantity: 15 Excess Demand & Excess Supply:

Concept of Demand: 1. It refers to both the ability to pay and a willingness to buy on the part of the consumer (s).

2.

Demand is a flow concept. It refers to our demand in a given period. The length of the time period is very important. It can be a day, a week etc. There are many factors affecting our demand. In order to explore the effect of price on quantity demanded, economists like to assume other factors unchanged so as to make the analysis easier. In Latin, the term 'ceteris paribus' means 'holding other factors constant or unchanged'. Demand is a plan of purchase. It shows the quantities someone is (willing & able to buy) at all prices.

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Individual demand: An individual demand refers to the quantities of a good that a consumer is willing to buy and able to buy at all prices within a period of time, ceteris paribus.

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Individual Demand Schedule & Individual Demand Curve: 1. Individual Demand can be shown by an individual demand schedule An individual demand schedule of a consumer is a table showing the quantities of a good that a consumer would buy at all different prices within a time period, ceteris paribus.

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Individual Demand can be shown by an individual demand curve An individual demand curve shows the relationship between price and quantity demanded in a graph. Each single point on the demand curve represents one quantity demanded and one price. Along the curve, there are many quantities and prices. A Demand Schedule for a Good of a Consumer:
Price ($ per unit ) Quantity demanded 30 2 25 4 20 6 15 8 10 10 5 12

A Demand Curve for a good of a consumer (within a period of time) Price 30

20

10

10

12 Quantity

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Demand and Quantity demanded Demand is NOT the same as Quantity demanded. Demand: 1. 2. Demand is a plan of purchase. Demand refers to the quantities of a good that a consumer is willing and able to buy at all level of prices in a given period of time. Demand is expressed by the whole demand schedule. There are many quantities and prices. Demand is represented by the whole demand curve.

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Quantity demanded: 1. Quantity demanded is only part of the whole plan of purchase. 2. Quantity demanded refers to the quantity of a good that a consumer is willing and able to buy at a particular price in a given period of time. Quantity demanded is expressed by one row of the demand schedule with one quantity and one price. Quantity demanded is represented by a single dot on the demand curve.

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Market Demand: A market demand refers to the total individual demand of all the consumers in the market.

Case Study: The following example gives a demand schedule in a market consisting of only 2 consumers, Tom & Mary. Plot and name the market demand curve in the graph. A Demand Schedule of A Market Consisted of Only 2 Consumers Price ($ per unit) Tom 25 20 15 10 1 2 3 4 0 1 2 3 Quantity Demanded Mary Market (Tom's+ Mary's)

Demand Curve For Tom Demand Curve For Mary Price 30 Price
n

Market Demand Curve

Price

20

10

4 0

4 0

Quantity

Quantity

Quantity

The market demand curve is obtained by summing up the individual demand curves of the good in the market horizontally.

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Law of Demand: The law of demand states that price and quantity demanded of a good are inversely related ceteris paribus. The law of demand states that if other factors being constant, when price of a good decreases, its quantity demanded increases; and price (of a good) increases, its quantity demanded decreases. The market demand curve also slopes downward from left to right . The slope implies that price and quantity demanded are inversely related, ceteris paribus. Demand shows the relationship between price and quantity demanded. The law of demand shows their inverse relationship. Examples: A supermarket puts forward a discount sale. It shows the law of demand. A restaurant puts forward tea time special set meal. It shows the law of demand. Summary: Demand is wants (our desire) + willing and able to buy. Demand is a flow. It is the quantity to be purchased within a day, a week, a month etc. It is NOT the quantity to be purchased now. Quantity demanded is a single point on the demand curve. ( a quantity at a price) Demand is represented by the whole demand curve. (all quantities at all level of prices) The downward sloping demand curve shows the law of demand. It is downward sloping because price and quantity demanded are inversely related. Individual demand is the purchase plan of a consumer. Market demand is the total demand of all consumers in the market.

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Concept of Supply: 1. Supply refers to both the ability to sell (provide) and the willingness to sell by the supplier(s). Supply is a flow concept. Supply is a flow concept. It refers to our supply in a given period. The length of the time period is very important. It can be a day, a week etc. There are again many factors affecting the supply of a firm. Economics hold the ceteris paribus condition in order to analyze the relationship between price and quantity supplied by a firm or a producer. Ceteris paribus means other factors being constant. Supply is a plan of sales (not production). It shows the quantities supplied at all different prices. (a producer may not be the seller, goods produced need not be sold immediately)

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Individual supply: An individual demand refers to the quantities of a good a supplier is willing to sell and able to sell at all prices within a period of time, ceteris paribus.

Individual Supply Schedule & Individual Supply Curve 1. Individual supply can be shown by a supply schedule: An individual supply schedule is a table showing the quantities of a good that a firm or supplier would produce (sell) at all different prices within a time period, ceteris paribus. Each column of the table (schedule) represents one price and one quantity. The whole schedule shows many prices and many quantities. Supply can be shown by a supply curve: An individual supply curve shows the relationship between price and quantity supplied in a graph. Each single point on the supply curve represents one quantity supplied and one price. Along the curve, there are many quantities and prices.

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A Supply Schedule for a Good of an Individual Firm: 20 30 Price per unit 10 ($ ) 2 4 6 Quantity Supplied

40 8

50 10

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A Supply Curve for a good of a supply Price 50

40

30

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12 Quantity

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Supply and Quantity Supplied: Supply is NOT the same as Quantity supplied. Supply: 1. 2. Supply is a plan of sales. Supply refers to the quantities of a good that a seller is willing and able to sell at all level of prices in a given period of time. Supply is expressed by the whole supply schedule. There are many quantities and prices. Supply is represented by the whole supply curve.

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Quantity supplied: 1. Quantity supplied is only part of the whole plan of sales.

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Quantity supplied refers to the quantity of a good that a seller is willing and able to sell at a particular price in a given period of time. Quantity supplied is expressed by one row of the supply schedule with one quantity and one price.

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Quantity supplied is represented by a single dot on the supply curve.

Market Supply: It refers to the sum of supply for a good by all the individual producers or firms in the market. The example below gives a supply schedule in a market consisting of only 2 sellers, Tom and Mary. Plot and name the market supply curve in the graph. Price ($ per unit) 25 20 15 10 Quantity Supplied Tom 4 3 2 1 Mary 3 2 1 0 Market (Tom's + Mary's)

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The market supply curve is obtained by summing up the individual supply curves in the market horizontally. Supply Curve For Tom Supply Curve For Mary Market Supply Curve Price Price Price 30

20

10

4 0

4 0

Quantity

Quantity

Quantity

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Law of Supply: The law of supply states that price and quantity supplied of a good is positively related ceteris paribus. The law of supply states that if other factors being constant, when price of a good increases, quantity supplied increases and price of a good decreases, quantity supplied decreases.

The market supply curve slopes upward from left to right . The slope implies that price and quantity supplied are positively related, ceteris paribus. Supply shows the relationship between price and quantity supplied. The law of supply shows their direct relationship. Concept of Market Price: With demand and supply in a market, the interaction between market demand and market supply together will determine the market price of a good. Concept of market equilibrium: Market equilibrium means the market is in a stable condition. There is no tendency for price or quantity transacted to change. All goods produced can be sold out and all the consumers can get the quantity they want to buy. The intersection point of the demand curve and the supply curve is called the equilibrium (E*). The price is called equilibrium price (Pe) and the quantity called equilibrium quantity (Qe). In short, market equilibrium refers to a state when the market quantity demanded equals the market quantity supplied.

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Equilibrium Price and Quantity in a Market: The Market Demand & Supply Schedule of a Good: Price ($ per unit) Quantity Demanded Quantity Supplied 60 50 40 30 20 10 200 400 600 800 1000 1200 800 700 600 500 400 300

Plot the market demand & market supply curves in the graph. Label S with the supply curve and D with the demand curve and mark E , P and Q in the diagram. The Demand & Supply Curves of a Good:

60 50 40 30 20 10

200

400

600

800

1000

1200

From the market demand and supply curves above, it is found that there is a point at which the quantity demanded is equal to the quantity supplied. The point is called an equilibrium point. The price is called the equilibrium price which is $_______ . The equilibrium quantity is ________ units . At equilibrium, the quantity demanded equals to the quantity supplied. The quantity transacted is an equilibrium quantity.

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Excess Demand (Shortage ) and Excess Supply (Surplus ) Whenever the market price is above the equilibrium price, the quantity supplied will be ___________ than the quantity demanded, there is a surplus in the market, i.e. an excess supply. In this case, the quantity transacted is the quantity ___________. Whenever the market price is below the equilibrium price, the quantity demanded will be __________ than the quantity supplied , there is a shortage in the market, i.e. an excess demand. In this case, the quantity transacted is the quantity ___________. Questions for discussion: 1. What is the difference between shortage and scarcity in economics? Scarcity occurs if the quantity demanded is greater than the quantity supplied at zero price. i.e. wants > the quantity available. Shortage occurs if the quantity demanded is greater than the quantity supplied at a controlled maximum price set below equilibrium price but above zero ( Pe > P > 0). It is also known as excess demand.

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Change in Demand and Supply

Learning focus: 1. Change in quantity demanded and change in demand 2. Change in demand and factors affecting demand 3. Change in quantity supplied and change in supply 4. Change in supply and factors affecting supply 5. The effects of changes in demand and supply on quantity and price 6. Techniques of drawing graphs. Change in Quantity Demanded and Change in Demand Change in Quantity Demanded: a movement along the same Demand Curve : Whenever the price changes, a consumer will change its quantity demanded accordingly. According to the law of demand, when the price rises, the quantity demanded will fall. Such a change can be expressed by a movement along a demand curve. The demand curve does not move. Other factors being constant, a change in the price of a good will cause a change in its quantity demanded.

P 15 11 D 0 90 120 Q

For example, the price of apples determines the quantity demanded of apples. Other factors being constant, when the price of apples decreases from $15 to $11, quantity demanded of apples rises from 90 units to 120 units.

Change in Demand : a Shift of a Demand Curve: A change in demand refers to a change in the plan of purchase. The demand curve shifts. (It shifts to the right = an increase in demand; It shifts to the left = a decrease in demand) A change in other factor (other than its own price) will lead to a change in demand.

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The example below gives a demand schedule and an increase in demand. A Demand Schedule showing a change in demand: Price ($/unit) 30 25 20 15 10 5 Original Quantity Demanded 200 400 600 800 1000 1200 New Quantity Demanded 400 600 800 1000 1200 1400

A shift of the Demand Curve P 30

20

10

400

800

1200

1600

The new demand curve is on the ________ of the original demand curve. It is an increase in demand.

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What is the difference between 'a change in quantity demanded' (Qd) and 'a change in demand'? A change in quantity demanded (Qd) must be caused by a change in price of itself. It is shown on the graph by a movement along the same demand curve. A change in demand is caused by a change in some other factors (including the price of related goods) but not related to the price of itself. It is indicated on the graph by a shift of the demand curve to the right (increase) or to the left (decrease)

Factors affecting Demand (factors leading to a change in demand; a Shift of Demand Curve): 1 Income: The effect of income on the demand for a good depends on whether the good is a normal good or an inferior good. a. Normal goods The demand for a normal good is positively related to the income of consumers. Inferior goods The demand for an inferior good is negatively related to the income of consumers. Whether it is an inferior good depends on the level of income of the consumer but not the good itself. 2. Prices of Related Goods: When the price of a good ( X ) rises, it will affect the demand for a related good ( Y ). It depends whether it is a complement or a substitute. Complement: Two goods are said to be complements if people prefer to consume them together. They are in joint demand. The demand for one good is negatively related to the price of its complement. For example, a car and gasoline are complements. Substitutes: Two goods are said to be substitutes if one good can replace the other good. They are in competitive demand. The demand for one good is positively related to the price of its substitutes. For example, beef and pork are substitutes.

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c.

Derived demand: It means that the demand for a good comes from the demand for another good. The demand for factors of production or raw materials is known as "derived demand". The demand for labour derives from the demand for products produced by the labour. If two goods are complements, a rise in price of good X will lead to a fall in demand of good Y. (They are in joint demand relationship.) If two goods are substitutes, a rise in price of good X will lead to an increase in demand of good Y. (They are in competitive demand relationship) Students usually get confused here. They don't know whether they are talking about good X or good Y price of good X affects quantity demanded of X price of good Y affects quantity demanded of Y price of good Y affects demand for X. price of good X affects demand for Y. demand and quantity demanded

3.

Taste: It refers to the subjective choice of consumers. It may be affected by our knowledge, friends, education, culture and advertising.

Weather and climate: We may demand different goods on different seasons or weather, e.g. the demand for umbrella, increases during in wet season. Expectations of Future Price: Consumers would change their demand if they expect the future price changes. People tend to buy in advance if they predict price to rise in the near future. They tend to defer their purchase if they expect a fall in price in the near future. Size of Population: A larger population would mean more consumers. The market demand increases.

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AttentionA big sales or a seasonal discount is not a factor affecting demand. Since people will buy more as a result of a reduction in price, ( a discounted price) it actually means an increase in quantity demanded. It is not an increase in demand.

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Change in Quantity Supplied and Change in Supply Change in Quantity Supplied : a movement along the same Supply Curve :

Whenever the price changes, a seller will change its quantity supplied accordingly. According to the law of supply, when the price rises, the quantity supplied will rise too. Such a change can be expressed by a movement along a supply curve. The supply curve does not move. Other factors being constant, a change in the price of the good will cause a change in its quantity supplied. For example, the price of apples determines the quantity supplied of apples. Other P 15 11 S

Q 0 90 120 factors being constant, when the price of apples increases from $11 to $15, quantity supplied of apples rises from 90 units to 120 units.

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Change in Supply : a Shift of a Supply Curve: A change in supply refers to a change in the plan of sales. The supply curve shifts. (It shifts to the right = an increase in supply; It shifts to the left = a decrease in supply) (It shifts down = an increase in supply; It shifts up = a decrease in supply) A change in other factor (other than its own price) will lead to a change in supply. A supply schedule showing a change in supply: Price per unit Original Quantity Supplied 10 200 15 400 20 600 25 800 30 1000 A shift of the Supply Curve P 30

New Quantity Supplied 400 600 800 1000 1200

20

10

400

800

1200

The new supply curve is on the ______ of the original supply curve. It is an increase in supply. Be careful, if the supply curve shifts up, it means a decrease in supply; if the supply curve shifts down; it means an increase in supply.

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What is the difference between 'a change in quantity supplied' and 'a change in supply'? A change in quantity supplied (Qs) must be caused by a change in price of itself. It is shown on the graph by a movement along the same supply curve. A change in supply is caused by a change in some other factors (including the price of related goods) but not related to the price of itself. It is indicated on the graph by a shift of the supply curve to the right (increase) or to the left (decrease) Factors affecting Supply (factors leading to a change in supply; a Shift of Supply Curve): 1. Prices of factors of production If the prices of factors of production increase, the production cost of a good will increase. The profit of the producer will fall and the supply of the good will decrease. The supply of a good is negatively related to the prices of the factors of production.

2.

Prices of related goods The supply of a good is affected by the price of a related good. The effects on the supply depend on whether the two goods are in joint supply or in competitive supply. Joint supply Two goods are said to be in joint supply if they are produced in the same production process. If the production of one good increases, the supply of the other good in joint supply will increase. If the price of a good increases, the supply of the other good in joint supply will increase too. Beef and hide are examples of goods in joint supply. (Hide is the by-product of beef)

a.

b.

Competitive supply Two goods are in competitive supply if they use same or similar factors of production. If two goods are in competitive supply, using more resources on the production of one good, the supply of the other good in competitive supply will decrease.

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If the price of a good increases, the supply of the other good in competitive supply will decrease. Residential buildings and commercial buildings are examples of goods in competitive supply.

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Technological progress It means a larger quantity of a good can be produced by the same amount of inputs. Supply increases as a result.

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Weather and climate Weather and climate affect the supply of some goods. For instance, a warm climate favours the growth of agricultural products and will increase the supply of these good.

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Tax and subsidy It refers to the tax imposed and subsidy given by the government If the government imposes a sales tax on a certain good, the cost of providing such good will increase (supply curve shifts up) and the supply will decrease. On the contrary, if the government offers a subsidy on a certain good (supply curve shifts down), the supply of the good will increase.

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Number of producers In general, the larger the number of producers, the greater the supply of a good is. Price expectation by sellers If producers expect the price of a good to rise (fall) in the future, they will decrease (increase) the supply of the good immediately.

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Technique of drawing graphs. Each diagram should have a title Use pens of two different colors in your diagram. One for the original curve and the other for the new curve. Use arrows to show the shifting of curves, change in price and quantity. Label P P1 P2 , Q1 Q2 , D1 S1 , D2 S2, E E' etc. Demand changes but supply remains unchanged If demand increases, demand curve shifts to the right from D1 to D2. Equilibrium changes from E1 to E2, equilibrium price increases from P1 to P2, equilibrium quantity increase from Q1 to Q2. Given supply unchanged, an increase in demand will increase both the equilibrium price and quantity. On the contrary, a decrease in demand will decrease both the equilibrium price and quantity.

demand increases

demand decreases

30

Supply changes but demand remains unchanged If supply increases, supply curve will shifts to the right from S1 to S2. Equilibrium will change from E1 to E2, equilibrium price will fall from P1 to P2 and equilibrium quantity will rise from Q1 to Q2. Given demand unchanged, an increase in supply will lead to a decrease in the equilibrium price but an increase in equilibrium quantity. On the contrary, a decrease in supply will lead to an increase in the equilibrium price but a decrease in equilibrium quantity.

supply increases

supply decreases

Supply and demand change at the same time If demand and supply increase at the same time, equilibrium quantity must increase but the direction of equilibrium price is uncertain: If demand increase is equal to supply increase, equilibrium price will not change. If demand increase is greater than supply increase, equilibrium price will rise. If demand increase is smaller than supply increase, equilibrium price will fall.

demand increase is equal to supply increase And the price doesnt change

demand increase is greater than supply increase

demand increase is smaller than supply increase

31

Supply and demand change at the same time If demand and supply decrease at the same time, equilibrium quantity must decrease but the direction of equilibrium price is uncertain: If demand decrease is equal to supply decrease, equilibrium price will not change. If demand decrease is greater than supply decrease, equilibrium price will ______. If demand decrease is smaller than supply decrease, equilibrium price will ______.

demand decrease is equal to supply decrease And the price doesnt change

demand decrease is greater than supply decrease

demand decrease is smaller than supply decrease

Supply and demand change at the same time If demand increases but supply decreases, equilibrium price must increase but the direction of equilibrium quantity is uncertain: If demand increase is equal to supply decrease, equilibrium quantity will not change. If demand increase is greater than supply decrease, equilibrium quantity will ______. If demand increase is smaller than supply decrease, equilibrium quantity will ______.

demand increase is equal to supply decrease

32

demand increase is greater than supply decrease

demand increase is smaller than supply decrease

Supply and demand change at the same time If demand decreases but supply increases, equilibrium price must decrease but the direction of equilibrium quantity is uncertain: If demand decrease is equal to supply increase, equilibrium quantity will not change. If demand decrease is greater than supply increase, equilibrium quantity will ______. If demand decrease is smaller than supply increase, equilibrium quantity will ______.

demand decrease is equal to supply increase

demand decrease is greater than supply increase

demand decrease is smaller than supply increase

33

Elasticity of Demand and Supply

Learning focus: 1. Concept of elasticity 2. Price elasticity of demand 3. Elasticity of demand & total revenue of supplier 4. Factors affecting price elasticity of demand 5. Price elasticity of supply 6. Factors affecting price elasticity of supply 7. Extreme cases of elasticity

Concept of Elasticity: Elasticity refers to the response of a variable to a change in another variable. The two variables may be of different units of measurement. So, the changes of the two variables are expressed in the form of a percentage change in order to compare their rates of change.

Definition of elasticity of demand: The price elasticity of demand refers to the (percentage) change in quantity demanded due to a (percentage) change in price faced by a consumer.

Concept of elasticity of demand: Price changes will cause a change in the quantity demanded. Price elasticity of demand shows the degree of response of the quantity demanded of a consumer to a change in price. By measuring the ratio of the percentage change in quantity demanded to the percentage change in the market price of any good, we can know the sensitivity of quantity demanded to a price change by the value of elasticity of demand.

34

Calculation:
Ed = % change in quantity demanded % change in price

Since price and quantity demanded are inversely related, the value of % change in quantity demanded over the % change in price must be negative. To avoid confusing and to focus on the responsiveness of the change in quantity demanded to a change in price, we ignore the sign and take the absolute value. Arc elasticity of demand: By arc elasticity, percentage change is measured by the change relative to the average of its initial values (P1 and Q1)and new values (P2 and Q2). The formula is: % change in quantity demanded =

(Q 2 Q1) 100% 1 (Q1 + Q 2 )

2

% change in price =

(P2 P1) 100% 1 (P1 + P 2 ) 2

Price elasticity of demand =

% change in quantity demanded % change in price (Q2 Q1 ) 1 (Q1 + Q 2) Ed = 2 ( P2 P1 ) 1 (P1 + P 2) 2 Ed =
Ed = (Q2 Q1 ) ( P1 + P2 ) ( P2 P1 ) (Q1 + Q2 )

Attention: This way of calculation is different from the way you use in mathematics.

35

Values of elasticity range from 0 to infinity () Five levels of elasticity of demand: 1. a. b. c. d. 2. a. b. c. 3. a. b. c. Perfectly elastic : a very small percentage change in price leads to an infinite percentage change in Ed is equal to infinity. Demand curve is a horizontal line. Quantity demanded is extremely sensitive to price. Elastic : the percentage change in price is smaller than the percentage change in quantity demanded, Ed is larger than one but less than infinity. Quantity demanded is sensitive to price. Unitarily elastic : the percentage change in price is exactly equal to the percentage change in quantity demanded. Ed is equal to one Total revenue or spending P x Q = TR will not change when Ed = 1 Area of the rectangle will not change. Inelastic : the percentage change in price is greater than the percentage change in quantity demanded. Ed is smaller than one but greater than zero. Quantity demanded is insensitive to price. Perfectly inelastic : Quantity demanded remains unchanged no matter how large the change in price. Quantity demanded doesnot respond to price change. Ed is zero Demand curve is a vertical line

4. a. b. c. 5. a. b. c.

36

Example: Points A B Price ($) 12 8 Quantity demanded (units/ period) 60 100

Arc elasticity of demand (Between A & B)

12 8

A B D 60 100 Q

Rate of change in quantity demanded

= (100 60) 40 1 = = (100 + 60) 80 2 2 (8 12) 4 2 = = (12 + 8) 10 5 2

Rate of change in price

=

1 2 = - 1.25 2 5

and the absolute value is 1.25

The arc elasticity of demand tells us the rate of change in quantity demanded between a given price range, here between $12 and $8. In this case, when there is 40% change in price, (between $12 to $8), on the average the consumer will change its quantity demanded by a rate of 50%. The ratio of change in quantity demanded to a change in price is 1.25 : 1 Because it is greater than 1, it belongs to elastic demand.

37

Properties of a Straight-line Demand Curve On a straight-line demand curve, each point on it bears different value of elasticity of demand. At the mid-point of the curve, the elasticity of demand is equal to 1. or in absolute value equal to 1 It is unitarily elastic At any point higher than the mid-point, its elasticity is greater than 1, in absolute value. It is elastic
Y-intercept = Ed = Ed > 1 Mid point: Ed= 1 Ed < 1 D Q X-intercept = Ed = 0

At any point lower than the mid point, its The value of price elasticity of demand makes up of elasticity of demand is smaller than 1, again in two components: the slope and the position. absolute value. It is inelastic At the Y-intercept, Q is zero
pEd = (Q2 Q1 ) P 1 ( P2 P ) Q1 1

In general, other factors the same, the flatter the slope, the higher the value and the more elastic it is. The steeper the slope, the lower the value and the more inelastic it is.

P/Q will be infinite = The position on the demand curve also affects the elasticity of demand = It is perfectly elastic elasticity of demand. In general, it is more elastic to the top left hand portion and it is less elastic or more inelastic to the bottom right portion. At the X-intercept, P is zero
Ed = (Q2 Q1 ) P1 ( P2 P1 ) Q1

P/Q will become zero elasticity of demand = 0 It is perfectly inelastic

38

Critical thinking: Ed is elastic when % change in price < % change in quantity demanded Why can't we say the change in price is smaller than the change in Quantity demanded? 5 2 7 = 2/6 = 33.33% 100 10 110 = 10/105 =9.52% Example 2 increases more in absolute terms. Example 1 increases more in percentage. The rise in absolute value is misleading.

Relationship among price, elasticity of demand and total revenue: (FAQ)

Price

Elasticity of demand

Total revenue

Total Revenue received by suppliers = Price Quantity transacted = P x Qt = TR

In case of elastic demand condition, a cut in price will increase total revenue:
When the demand is elastic, it means the percentage change in quantity demanded is greater than the percentage change in price. Since a cut in price will lead to a loss in revenue and a rise in quantity demanded will lead to a gain in revenue. It follows that the cut in price leading to a loss in revenue is smaller than the gain in revenue due to the increase in quantity demanded. Gain is greater than loss. There is a net increase in total revenue.

39

P A 12 10 C B D1

Between point A & B, The elasticity of demand is _________,is elastic Between point A & C, The arc elasticity of demand is _______,is inelastic

D2 0 20 22 35 Q

Total Revenue and Elastic Demand Curve When demand is elastic, a decrease in price will increase ( D1 ) total revenue. At point A, TR = $ 12 20 units = $ 240 At point B, TR = $ _______ ______ units = $____ Total Revenue and Inelastic Demand Curve When demand is inelastic, a decrease in price will decrease ( D2 ) total revenue. At point A, TR = $ 12 20 units = $ 240 At point C, TR = $ _______ ______ units = $____

In case of unitarily elastic demand condition, any change in price will not affect total revenue: A unitarily elastic demand implies that the percentage change in quantity demanded is the same as that of price. The total revenue at any price level is the same. Most students overlook the fact the total revenue does not change in case of unitarily elastic demand. Ed >1 ____________________________ <1 ____________________________ =1 ____________________________ =0 ____________________________ = ____________________________ Price
40

Price

TR

TR

Ed

unchanged unchanged

Diagrams Inelastic Demand with an Increase in Price

Inelastic Demand with a Decrease in Price

Elastic Demand with an Increase in Price

Elastic Demand with a Decrease in Price

Unitarily Elastic Demand with an Increase in Price

Unitarily Elastic Demand with a Decrease in Price

41

FaF Factors affecting Price Elasticity of Demand

1.

Presence of substitutes If a good has many close substitutes at a similar price range, the demand for it tends to be more elastic. In response to an increase in price, consumers may switch to its substitutes. Proportion of expenditure spent on the good The demand for a good which taking up a small proportion of a consumers total expenditure tends to be inelastic. As the consumer may think that the amount of expenditure does not affect much. Demand for necessity The demand for necessities tends to be inelastic. Habit forming product The demand of some products like cigarettes, alcohol or drugs is inelastic Information available to the consumers The less informed the consumer is, the more inelastic the demand will be, e.g. tourists. Time to adjust consumption habit The longer the time, consumer has more time to adjust his consumption habit and to find replacement.

2.

3.

4.

5.

6.

Definition of elasticity of supply: The price elasticity of supply refers to the (percentage) change in quantity supplied due to a (percentage ) change in price. Concept of elasticity of supply: We know that when price changes, the quantity supplied will change too. Price elasticity of supply shows the degree of response of the quantity supplied to a change in price. By measuring the ratio of the percentage change in quantity supplied to the percentage change in the market price of any good, we can know the sensitivity of quantity supplied to a price change by the value of elasticity of supply.

42

Calculation:
Es = % change in quantity supplied % change in price

Arc elasticity of supply: By arc elasticity, percentage change is measured by the change relative to the average of its initial values (P1 and Q1)and new values (P2 and Q2). The formula is: % change in quantity supplied =

(Q 2 Q1) 100% 1 (Q1 + Q 2 )

2

% change in price =

(P2 P1) 100% 1 (P1 + P 2 ) 2

Price elasticity of supply =

% change in quantity supplied % change in price (Q2 Q1 ) 1 (Q1 + Q 2) Es = 2 ( P2 P1 ) 1 (P1 + P 2) 2 Es = Es = (Q2 Q1 ) ( P1 + P2 ) ( P2 P1 ) (Q1 + Q2 )

Attention: This way of calculation is different from the way you use in mathematics.

43

Values of elasticity range from 0 to infinity () Five levels of elasticity of supply: 1. a. b. c. d. 2. a. b. c. d. 3. a. b. c. 4. a. b. c. d. 5. a. b. c. Perfectly elastic : a very small percentage change in price leads to an infinite percentage change in quantity supplied Es is equal to infinity. Supply curve is a horizontal line. Quantity supplied is very sensitive to price. Elastic : the percentage change in price is smaller than the percentage change in quantity supplied, Es is larger than one but less than infinity. Quantity supplied is sensitive to price. Supply curve passing through the positive portion of the vertical axis Unitarily elastic : the percentage change in price is exactly equal to the percentage change in quantity supplied. Es is equal to one Supply curve passing through the origin Inelastic : the percentage change in price is greater than the percentage change in quantity supplied. Es is smaller than one but greater than zero. Quantity supplied is insensitive to price. Supply curve passing through the positive portion of the horizontal axis Perfectly inelastic : Quantity supplied remains unchanged no matter how large the change in price. Quantity supplied doesnot respond to price change. Es is zero Supply curve is a vertical line

44

Example: Points Price Quantity supplied

A B

12 18

400 600

P 18 A 12 0

Q 400 600

Arc elasticity of supply between A and B =1 It belongs to unitarily elastic supply Rate of Change in quantity supplied
= (600 400) 200 2 = = (400 + 600) 500 5 2 (18 12) 6 2 = = (12 + 18) 15 5 2
2 2 =1 5 5

Rate of Change in price

=

Elasticity of supply =

S1 S2 S3 S4 S5 S6 0 Q

P P2

S7 S8

P1 0 Q1 Q

Which of the above supply curves show an elastic supply, inelastic supply and unitarily elastic supply?

45

Factors affecting Price Elasticity of Supply: 1. Flexibility of production capacity If the existing production capacity can be expanded or adjusted easily, the supply is more elastic. Mobility of factors of production If the factors of production could be moved from one industry to another, the supply of the resulting products becomes more elastic. Production Time The longer the time used in production, the less elastic the supply will be. Even price has increased a lot, quantity of output cannot be raised immediately. Entry to the industry The easier the entry to an industry, the more elastic the supply will be because there could be more competitors with easy entry into the industry.

2.

3.

4.

46

Extreme cases of elasticity:

Perfectly inelastic demand
Perfectly elastic demand

Perfectly inelastic supply

Perfectly elastic demand

Unitarily elastic demand A B A B

Unitarily elastic supply

P A Same Same 0 B D Q

P S1 S2 S3

47

Market intervention
Learning focus: 1. Maximum price control (price ceiling) 2. The effects of maximum price control 3. Non-price allocation 4. Minimum price control (price floor) 5. The effects of minimum price control 6. The effects of minimum price control on total revenue under different demand elasticity 7. Quantity control: Quota 8. The effects of a quota 9. The effects of a quota on total revenue under different demand elasticities 10. Applications of price control 11. Per unit (sales) Tax 12. The effects of a per unit sales tax 13. Tax burden & incidence 14. Per unit Subsidy 15. The effects of a per unit subsidy 16. Share of benefit under subsidy 17. Numerical applications of per unit tax Price Ceiling (maximum price control): Price ceiling refers to the maximum price set by an authority usually the government on any good or service. All sellers are not allowed to sell the good at a price higher than the ceiling price. Aim In general, the government thinks that a controlled price allows the relatively low-income groups to have a chance to buy the good or service.

48

P
Price ceiling

Not allowed

Excess demand

D Qd Q

Qs Qt

Qe

Pe = equilibrium price Qe = equilibrium quantity Qs = quantity supplied Qd = quantity demanded Qt = quantity transacted To be effective, maximum price control (price ceiling) should be set below the equilibrium price. If not, you are forbidding someone to go somewhere he does not want to go. It won't make any sense. Effects of maximum price control: a lower market price; a smaller amount of quantity transacted ; a reduction in the total revenue of the suppliers. a shortage or excess demand at the ceiling price ; non-price competition / Non-price Methods of Rationing (not using price as a criteria of distribution) A price ceiling may give rise to a black market because the regulated price is different from the original equilibrium price. Black market is operating with price competition.

1. 2. 3. 4. 5.

6.

49

Non-price methods of allocation: A price ceiling leads to a shortage which has to be solved by some other methods of allocation other than price. These means are called non-price methods of allocation. 1. On First-come, First-served Basis It is usually undertaken in the form of a queue. By Sellers' Preference By Ability By Needs By Ballot / lucky draw

2. 3. 4. 5.

Price Floor (minimum price control): Price floor refers to the minimum price set by an authority (usually the government) on any good or service. All sellers are not allowed to sell the good at a price lower than the price floor. Aim In general, the government uses a floor price to protect the gain of the suppliers. The minimum wage law in many developed nations is a good example to protect the interest of the workers or the labour union. In some countries, a minimum price policy on agricultural products is introduced to protect the interest of the farmers.
P
Price floor Excess supply

Pe

E
Not allowed

D 0 Qd Qt Qe Qs Q

To be effective, minimum price control price floor should be set above the equilibrium price. Here, quantity demanded is the quantity transacted as transaction is always at the short side of the market.

50

Effects of minimum price control: 1. a higher market price ; 2. a smaller amount of quantity transacted if the government does not buy up the surplus ; a surplus or excess supply at the floor price ; a change in the total revenue depending also on the elasticity of demand. Ed > 1, TR; Ed < 1,TR

3. 4.

Quantity control (Quota) : A quota is a limitation on the quantity supplied by sellers. It may be a legal restriction on the amount of imports decided by the importing nation. To be effective, quota should be set below the equilibrium quantity. When a quota is imposed, the supply curve will become vertical.
Excess supply

P
New Price P2

Pe

D 0 Q2 Q Qt
d

Qe

Qs

Effects of a quota: For example, if a quota is imposed at Q2 , the new market price becomes ___________. The maximum amount of transaction is limited by the quota restriction. Quantity transacted decreases to ____________. The total revenue of the suppliers / exporters changes from ___________ to ____________. Do you know what causes the total revenue to increase/ decrease in this case? It depends on ___________________________. If the demand is ____________ total revenue will increase. If the demand is ____________ total revenue will decrease.

51

Effect of a quota on total revenue under elastic demand:

Excess supply

P
New Price P2

GAIN P
e

E LOSS D

Q2 Q Qt
d

Qe

Qs

Total revenue decrease from 0 Pe E Qe to 0 P2 E' Q2 Effect of a quota on total revenue under inelastic demand:
Excess supply

P
New Price P2

E' GAIN E

LOSS

D Qe Qs

Q2 Q Qt
d

Total revenue increase from 0PeEQe to 0P2E'Q2

52

Applications of price and quantity control: Question 1: price ceiling and price floor Quantity demanded / price/ unit $ period 120 4400 140 4200 160 4000 180 3800 200 3600

Quantity supplied / period 3200 3600 4000 4400 4800

The original equilibrium price is _______ and equilibrium quantity is ______ units and the total revenue is _____. Note: first determine whether the control is an effective one before concluding an excess demand or and excess supply. A maximum price control is set at $140, the excess ________ is _____ units. The quantity transacted is ______ units. The total revenue is ____. In any case, total revenue must increase/decrease). If a maximum price control is set at $180, (ineffective), there is no excess demand and the quantity transacted is still 4000 units. A minimum price control is set at $200, the excess ________ is _____ units. The quantity transacted is ________ units. The total revenue is _________. Total revenue (increases / decreases) and it proves that demand is (elastic / inelastic). If a minimum price control is set at $120, (ineffective), there is no excess demand and the quantity transacted is still 4000 units. Question 2: Quota price/ unit $ 200 250 300 350 400 450

Quantity demanded / period 2100 2000 1900 1800 1700 1600

Quantity supplied / period 1500 1600 1700 1800 1900 2000

When the quota is set at 1700 units, the market price will be ____________ . Old total revenue was $350 x 1800 = _________ New total revenue is $400 x 1700 = _________ Total revenue (increases / decreases) __________. and it imples that the demand is

53

Meaning of a Tax A tax is a legal payment levied by the government either on a person, a company or on any goods and services. What is an indirect tax? An indirect Tax is a sales tax levied on goods and services by the government. The burden of the tax can be shifted to the consumer. The amount of indirect tax is usually collected from the consumer on behalf of the government by the seller. It is then paid to the government. When there is an indirect tax on commodity, supply decreases A Per Unit Sales Tax : It is a fixed amount of tax added to every unit of goods supplied.

An Ad Valorem Sales Tax : It is based on a fixed percentage of the price of a good supplied. The Effect of a Per Unit Sales Tax: When a per unit sales tax is levied on a good, supply decreases, the supply curve will shift up by the amount of the per unit tax. The new and previous supply curves are parallel to each other. The equilibrium price increases but equilibrium quantity decreases.

In general, the suppliers will try to shift part of or the whole amount of the tax to the consumers by asking for a higher price the final market price still depends on the interaction of demand and supply. As the market price is increased, consumers pay part of the indirect tax indirectly to the government.

Tax Burden

(Tax Incidence)

It refers to the bearing of the tax burden by the consumers and producers. Owning to the difference in elasticity of demand and supply, the tax burden of the consumer and the supplier may be different.

54

per unit tax

S+t S

E' tax = t P2 P1 C S E D 0 Q2 Q1 Qt

tax = t

P2 - P1 = unit tax paid by consumers t - (P2-P1) = unit tax paid by sellers Qt or Q2 = new quantity transacted C = total tax paid by consumers (P2-P1) x Q2 S.= total tax paid by producers [t - (P2-P1)] x Q2 t x Qt = total tax revenue

: 1. 2. Q1 3. E' P2 Q2, t x Qt = 4. P1 P2P2 - P1 5.

55

How is the tax burden distributed between consumers and supplier? Elasticity of demand > elasticity of supply Technique of drawing curves: a flatter demand curve OR a steeper supply curve Result: the consumer bears less tax burden than the seller.

per unit tax

S+t S tax = t E D

E' tax = t P2 P1 C S

Q2 Q1 Qt

Elasticity of demand < elasticity of supply Technique of drawing curves: a steeper demand curve OR a flatter supply curve Result: the consumer bears more tax burden than the seller.

per unit tax

S+t S

E' P2 tax = t P1 C S E D 0 Q2 Q1 Qt

tax = t

56

Perfectly Elastic demand: Technique of drawing curves: a horizontal demand curve Result: the consumer bears no tax burden, the seller bears all tax burden.

per unit tax

S+t S tax = t

P2 P1 tax = t 0 S

E' E D

Q2 Qt

Q1

Perfectly Elastic supply: Technique of drawing curves: a horizontal supply curve Result: the consumer bears all tax burden, the seller bears no tax burden.
P per unit tax

P2 tax = t C P1 0

E' E D Q2 Qt Q1

S+t S tax = t Q

57

Perfectly inelastic demand: Technique of drawing curves: a vertical demand curve Result: the consumer bears all tax burden, the seller bears no tax burden.

P D

per unit tax

S+t S tax = t

P2 tax = t C P1 0

E'

E Q Qt

Perfectly inelastic supply: Technique of drawing curves: a vertical supply curve Result: the consumer bears no tax burden, the seller bears all tax burden.
P S+t S P2 P1 tax = t S E' = E tax = t per unit tax

D tax = t 0 Q Qt Q

58

Subsidy: A subsidy is an amount given to the producers or suppliers in an industry by the government. When there is a subsidy on commodity, supply increases, supply curve shifts downward. It may be given in the form of a lump-sum basis or in a per unit basis. In Hong Kong, the government gives subsidies to public medical services, education and social welfare allowance. Per unit Subsidy: A per unit subsidy is an amount given to the producers or suppliers in an industry by the government, on a per unit basis For a unit subsidy, producers get the subsidy on each unit of goods produced and sold. The Effect of A Subsidy: When there is a per unit subsidy on commodity, supply increases, supply curve shifts downward vertically by the amount of the subsidy. The equilibrium price decreases but equilibrium quantity increases. As the market price is decreased, consumers get part of the subsidy indirectly from the government. The new and previous supply curves are parallel to each other.

59

Share of benefit of the subsidy: It refers to the share of subsidy (money given by the government) enjoyed by the consumers and producers. Owning to the difference in elasticity of demand and supply, the benefit of the consumer and the supplier may be different.

per unit subsidy

S S-s

Subsidy = s

P1 P2

S C

E E' D

Subsidy = s

Q1 Q2 Q
t

P1- P2 = unit tax paid by consumers s - (P1 - P2) = unit tax paid by sellers Qt or Q2 = new quantity transacted C = total subsidy given to consumers (P1-P2) x Q2 S= total subsidy given to sellers [s - (P1 - P2)] x Q2 s x Qt = total tax revenue Seller gets revenue : P2 x Q2 from the market. In addition, he gets (s x Q2) from the government. : Q1 E' P2 Q2, s x Qt =

P1 P2P1- P2

60

How is the subsidy benefit distributed? Elasticity of demand > elasticity of supply Technique of drawing curves: a flatter demand curve OR a steeper supply curve Result: the consumer enjoys less subsidy than the seller.

per unit subsidy

S S-s subsidy = s

subsidy = s

P1 P2

S C

E E' D

Q1 Q2 Qt

Elasticity of demand < elasticity of supply Technique of drawing curves: a steeper demand curve OR a flatter supply curve Result: the consumer enjoys more subsidy than the seller.

per unit subsidy

S S-s

P1 Subsidy = s P2

S C

E E' D

Subsidy = s

Q1 Q2 Qt

61

Perfectly Elastic demand: Technique of drawing curves: a horizontal demand curve Result: the consumer enjoys no subsidy, the seller enjoys all subsidy.

per unit subsidy

S S-s

Subsidy = s

S P2 P1 E E' D

Subsidy = s

Q1

Q2 Qt

Perfectly Elastic supply: Technique of drawing curves: a horizontal supply curve Result: the consumer enjoys all subsidy, the seller enjoy no subsidy.

P per unit subsidy

P1 Subsidy = s P2 0

E C E' D Q1 Q2 Qt

S S-s Subsidy = s Q

62

Perfectly inelastic demand: Technique of drawing curves: a vertical demand curve Result: the consumer enjoys all subsidy, the seller enjoys no subsidy.

per unit subsidy D

S S-s Subsidy =s

P1 Subsidy =s C P2 0

E' Q Qt

Perfectly inelastic supply: Technique of drawing curves: a vertical supply curve Result: the consumer enjoys no subsidy, the seller enjoys all subsidy.

P S-s

per unit subsidy Subsidy = s

Subsidy = s

S P2 P1

E' = E D Subsidy = s

Q Qt

63

Numerical applications of per unit tax: Question 1: price/ unit $ Quantity demanded / period 5 4400 6 4200 7 4000 8 3800 9 3600 10 3400

Quantity supplied / period 3200 3600 4000 4400 4800 5200

A per unit tax of $3 is imposed, the supply curve shifts up vertically by $3. The new schedules of demand and supply are as follow:

price/ unit $ 5 6 7 8 9 10

Quantity demanded / period 4400 4200 4000 3800 3600 3400

Quantity supplied / period

3200 3600 4000 4400 4800 5200

At each level of quantity supplied, price increases by $3. At 3200 units, the original price was $5 and now it is $8. At 3600 units, the original price was $6 and now it is $9 and so on. The whole supply schedule moves down 3 rows for $3. The new equilibrium price is $9 as compared with the old equilibrium price of $7. The consumer's share of the tax burden is $2 and the seller's share of the tax burden is $1. The consumer bears more tax burden. It means with the price range of $7 to $9, the price elasticity of demand is less than the price elasticity of supply. Total tax revenue is $3 x 3600 = $10,800. Consumer bears $7,200. Seller bears $3,600.

64

Production and Stages

Learning focus: 1. Meaning of production 2. Stages of production Meaning of production: Production refers to the creation of value. It includes manufacturing of goods or provision of services. Production includes: 1. a change in form of resources, e.g. from wheat to flour, flour to cake. 2. a change in place, e.g. from warehouse to the retail outlets. 3. the provision of services, e.g. personal service financial service and social service Stages of production: Primary production , Secondary production , Tertiary production Definition of primary production: Primary production refers to the extraction of resources from nature without any processing or the use of natural resources directly from nature. Examples: e.g. mining: extract raw material from nature e.g. lumbering: cutting of wood from the forest e.g. farming: use of natural resources directly from nature e.g. fishing : catching fish from the sea or rearing fish in cages or in fish ponds e.g. keeping livestock: Definition of secondary production: Secondary production refers to the turning of raw materials into finished or semi-finished products. It is also known as manufacturing of goods. Examples: garment (clothes making) , toys, watches and clocks, building and construction , generation of gas or power (electricity).

65

Definition of tertiary production: Tertiary production refers to the provision of services. Tertiary production includes: 1. Personal services: e.g. medical services 2. Commercial services: e.g. transport services, finance services. 3. Social services e.g. social welfare service, education services, police

Interdependence of the stages of production: One stage depends on the other two stages. Primary production provides food and raw materials Secondary production provides consumer goods and producer goods Tertiary production provides services

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Division of labour
Learning focus: 1. Meaning of division of labour: 2. Types of division of labour: 3. Meaning of productivity: 4. Advantages of division of labour: 5. Defects of division of labour: 6. Limitations of division of labour: Meaning of division of labour: Division of labour means specialization of work. Workers are specialized in doing one job or part of a job. Types of division of labour: simple division of labour complex division of labour regional division of labour Definition of simple division of labour: Simple division of labour refers to division of labour by occupation or profession . e.g. farmers for farming, fishermen for fishing. / doctors for medical services Definition of complex division of labour: Complex division of labour refers to division of labour by stages of production. Different people perform different tasks of the same industry. For example, in a garment factory, some workers do the cutting work; some workers do the sewing work. Definition of regional division of labour:

Regional division of labour refers to division of labour by place or territory. Different regions or country produces different things. For example, New Zealand produces milk, China produces silk.

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Meaning of productivity: Productivity of labour: (average labour productivity) It refers to the average output per man hour.

total output total man hours Labour refers to the human efforts in production including mental and physical contribution of workers. [You can say a worker or two workers. You can't say a labour or two labours.]
Average labour productivity = How does division of labour increase productivity? 1. Practice makes perfect. An individual worker becomes more skillful after practicing the same task again and again. He can produce better and more output. Choosing the right person on the right job: People have different talents and skills and they may suit different jobs. It can reduce production time: Workers don't have to switch between tasks of different rhythms () and production time is saved. It enables the use of machines: It is easier to design machines to work with labour to do a simple task. Use of machine can enhance productivity of workers.

2.

3.

4.

Advantages of division of labour: 1. a. b. Advantage to the firms Division of labour raises productivity and lowering average production cost. Economize the use of tools or capital: Each worker works on one piece of tool at one time. One single tool is enough instead of keeping the whole set of tools. This reduces the waste of leaving some tools idle while a worker is working with another piece of tool. c. It can reduce training time: It needs less time to train a worker for a single task than the whole process. It is easier for an individual to learn a single task than the whole process.

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2.

Advantage to the consumers: Consumers can enjoy cheaper products: division of labour reduces production cost and this will help to lower prices.

3. a.

Advantages to the workers: The right job is assigned to the right person : (simple division of labour) each worker is allowed to perform task that he can master best and he devotes to his interest.

b.

It may raise income of workers: Division of labour enhances efficiency and raises productivity. At a result, there is higher output or income. If the workers can have a share of the increased income, their income may be higher. However, if most incomes go into the pocket of the employer, wages of workers may not increase.

c.

By the same token, people can enjoy more leisure time () and higher standard of living:

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Defects of division of labour: 1. Defects to the firm: Extreme degree of interdependence is undesirable. Problem in one of the stages will affect the whole production line. Defects to the consumers: Products are over standardized and less choice to the consumers: Mechanization under division of labour implies standardization in design and style such that consumers will have less choice.

2.

3. a.

Defects to the workers: Job becomes boring or monotonous: (for complex division of labour) Workers will find it boring by repeating the same job. That will reduce efficiency and productivity or causing deterioration in quality.

b.

There is a lack of craftsmanship/ individual idea / personal style: For complex division of labour, traditional craftsmanship will be replaced by machines.

c.

Higher chance of being unemployed: For complex division of labour, each worker knows only one single skill of the whole production process. It is easily replaced by other workers or machines. That will increase their chance of being unemployed.

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4. a.

Defects to the whole economy: Over reliance on the exports of a few products: Under regional division of labour, some countries may specialize in a few products only. They may rely too much on the exports of them. Over reliance on the imports of a few products : Under regional division of labour, some countries may rely too much on the imports of some products. If such imports become unstable, the importing country will be hard hit.

b.

Limitations of DOL: 1. Nature of product: The nature of product may not allow the practice of division of labour. If it requires individual skills or creative ideas, division of labour is not applicable. e.g. painting. Size of the market: Division of labour increases output. If the size of the market is too small to absorb the extra output, division of labour becomes unnecessary. Means of transport and cost of transport: Efficient transport network can facilitate transactions and regional division of labour. If the transport network cannot meet the demand and regional division of labour is restricted. Moreover, if transport cost is higher than the gain from trade that trade will not occur.

2.

3.

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Factors of Production
Learning focus: 1. Meaning and types of factors of production a. Land: definition, characteristics & functions b. Capital: definition, function, types, formation and depreciation c. Labour: definition, supply and factors affecting supply, productivity and factors affecting productivity, wage payment methods d. Entrepreneur and entrepreneurship: definition and functions 2. Factor (occupational / geographical) mobility:

Meaning of factors of production: Factors of production are inputs in the process of production. Resources used for production are called factors of production. There are 4 factors of production under 3 main types: 1. Natural resources: Land 2. Human resources: Labour and Entrepreneurship 3. Man made resources: Capital Definition of land: (as a factor of production) In economics, land does not confine to continents above sea level. Land includes all natural resources in its original form that can be used in production. Land as a concept in economics includes the fertility of soil, minerals or power resources buried underground, wild animals on earth, birds in the sky, fish in the sea, sunshine, sea water, land and ocean, mountains and rivers as long as they are productive. In short, all things on earth capable of producing things in its natural form are examples of land. (Bad land is not land as a factor because it is non-productive.) Characteristics of land: 1. The supply of land is fixed as all natural resources on earth are fixed. (2003:16 Answer B The supply of land may change over time.)??? 2. Land is geographically immobile: you cannot move land from it original position without changing its natural form. 3. Land is a gift of nature. There is no cost of producing land. It exists before the existence of men. We cannot create/ produce land. (Once man-made elements are added to land, it is not in its natural form. We call that capital). For example, a piece of reclaimed land, a factory building are capital but not land, fish in the sea is part of the land but fish in a seafood restaurant is capital.

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Function of land: It provides space and raw materials for production Definition of capital: Capital is a man-made resource used for production. Capital usually means capital goods. These include machines, equipment, tools, plant and factory buildings, raw materials are also included. Capital also includes money capital and unsold stock or inventory produced as well as semi-finished goods kept. Function of capital: It can increase the productivity of other factors or improving the quality of other factors. For example: Workers use machines in production to increase productivity. Adding of fertilizers can improve the quality and productivity of land.

Types of capital: 1. Fixed capital: durable assets in production. It forms will not change after production. e.g. a screwdriver. 2. Working capital: raw materials used in production. e.g. wood 3. Liquid capital: it refers to capital that can be converted into cash easily. Shares and demand deposits at bank are liquid capital. Real estate and machines are less liquid capital. Formation of capital: The production of capital goods is called capital formation. The production of machines, tools or equipment are examples of capital formation.

Depreciation: (also known as capital consumption) Capital goods are subject to wear and tear. The value of capital goods will decrease over time. After certain time of operation, the machine requires frequent repairing and replacement of spare parts . There is a decrease in quantity of output and deterioration of quality of output. Definition of labour: Labour refers to the human effort - both physical (muscle power) and mental (intellectual power) effort - put in production. (labour is not worker)

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Supply of labour: Labour is measured in terms of man-hours , but NOT the number of workers. The total supply of labour is measured by the total number of man-hours provided by all the workers. Factors affecting the supply of labour. 1. Size and composition of population: age and sex distribution 2. The proportion of the working population:( The percentage of population that works): The number of students, housewives and retired people in the population will affect the working population. 3. The average number of working hours: legal limit on the hours of work, public holidays tax structure that affect the incentive to work, the religion and custom of the population. (time spent of worshiping god) Meaning of productivity: Productivity of labour: (average labour productivity) It refers to the output per man hour. Productivity of a worker: (average productivity of worker) It refers to the output per worker Average labour productivity

total output total man hours

total output total workers

Average worker's productivity =

Factors affecting productivity of labour: 1. Education and training 2. Method of organizing and management efficiency 3. Quantity and quality of capital used with the labour 4. Better payment method employed 5. Better working environment.

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Factor income of labour: wage Different payment methods: 1. Time rate 2. Piece rate 3. Bonus 4. Commission 5. Profit sharing Meaning of various payment methods: 1. Wages are paid according to the time of work done by a worker. Time rate includes monthly wage, weekly wage, daily wage, and hourly wage.

2. Piece rate are wages paid to workers according to the quantity of output produced. More output means higher wages.

3. Bonus is paid to a worker if the company earns extra profit. It is an amount paid by the employer as a reward for good performance of workers leading to the profit.

4. Commission is an amount of money paid to the worker for the business done or quantity of goods sold. It may be on a per unit basis or on a percentage basis. Even though the business does not make any profit, the employer has to paid the agreed commission as promised.

5. Profit sharing is a way to share a percentage of the profit with the worker. If the company performs well, the worker can share good profit with the boss. Workers will have high working incentive. In case of a loss, the worker cannot get any.

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Advantages and disadvantages of different system: To compare time rate with piece rate: Advantages Piece Rate To the employers piece rate can encourage workers to work harder with minimum supervision as workers have high incentive to work too. To the workers piece rate is fair to the more efficient workers. Time Rate To the employers time rate is easier for the firm to administer and it costs the least. To the employees time rate gives a stable income to them. Bonus, Commission and Profit Sharing To the employers workers paid under time rate may get lazy and extra cost of supervision is needed.

Disadvantages To the employers workers paid under piece rate care only about quantity. Extra cost has to be spent of quality control of output.

To the employers all three have the common advantage of raising the working incentive of workers.

To the employees workers' income becomes unstable.

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Definition of an entrepreneur: An entrepreneur is the one who owns the business. He provides capital for the business. He sets up the business and makes final decision for it. He manages, organizes and controls other factors of production. He may not participate directly in production but he must bear the risks.

Definition of entrepreneurship: Entrepreneurship is the organizing factor in the process of production. It includes the skills of decision making, management, organization and risk taking. Functions of an entrepreneur: 1. He provides capital for production. 2. He owns and controls the firm or business. 3. He bears business risk. 4. He manages the business. 5. He makes final decision and important decision for the firm 6. He organizes other factors of production. What is risk taking? The return of an entrepreneur is profit. Profitability depends on the performance of the business and there is no guarantee for a profit. It may make a loss if performs badly. That is why an entrepreneur bears risk in production. Functions of an entrepreneur in a large modern company: In a large modern company, shareholders of the company are the owners of the firm. They are responsible for providing capital and taking business risks. For management and decision making, the shareholders will appoint certain directors in to the board of directors which compose of some professional managers who are performing these functions. Though they are the employees of the company, they supply the skills of an entrepreneur known as entrepreneurship.

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Factor mobility: Factor mobility can be further divided into occupational mobility and geographical mobility. Types of mobility: Occupational mobility refers to the movement of a production factor from one industry to another. Geographical mobility refers to the movement of a production factor from one location to another. Mobility of different factors: Mobility of land: Land is occupationally mobile but geographically immobile. Mobility of capital: Occupational mobility of capital: Money (liquid) capital is highly mobile occupationally as money can be invested into different occupations. Fixed capital is less mobile than money capital. Machines designed for a special usage are occupational immobile. Working capital includes stocks, semi-finished product and raw materials. Their occupational mobility varies. Stocks and semi-finished product usually have definite use with low level of mobility. Raw materials have a higher mobility as they can be used in different industries. Geographical mobility of capital: Capital has higher geographical mobility than the other factors. Fixed capital, working capital and liquid capital can be easily moved from one place the another. Among the three, liquid capital has the highest geographical mobility. For working capital and fixed capital, if they are light enough, they are geographically mobile too. In general plant and factory are less mobile than equipment and tools while stocks and raw materials are more mobile. In countries without exchange control, money capital has high geographical mobility too. If capital is moved from one country to another, the relative policies about flow of capital, investment environment, legal system and other related facilities are also important.

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Mobility of entrepreneur: An entrepreneur is occupationally mobile as his skill and experience can be applied to different businesses. He is also geographically mobile as most countries welcome them for investment. Factors affecting occupational mobility of labour: 1. license or professional membership: Professional like accountants need the recognition of the professional association. This reduces their occupational mobility.

2. Age of workers: workers of higher age are reluctant to change occupation and their occupational mobility is in general low. 3 Special skills an talent: People have special talents and skills are unlikely willing to change occupation as the opportunity cost of changing job is high.

4. Period of training: The longer the education, training and experience needed, the lower the occupational mobility. 5. Labour union: Labour unions are formed by workers of same occupation. Their aim is to protect the interest of members and to restrict the competition from non-members. This reduces occupational mobility. 6. Income level: The higher income group tends to have lower occupational mobility as the opportunity cost of changing job for them is too high. 7. Income differences: Great income differences attract people to change job.

Factors affecting geographically mobility of labour: 1. Means of transport, costs of transport ( money and time): Efficient means and cost of transport will increase geographical mobility of labour. 2. Government policy: Tightening of emigration and immigration rules will reduce geographical mobility of labour. 3. Cultural and language differences. 4. Income differences: 5. Economic and political factors:

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Business ownership
Learning focus: 1. Definition of a firm 2. Meaning of ownership 3. Private and public enterprises 4. Examples of public enterprises 5. Public corporation 6. Sole proprietorship: meaning, features and advantages and disadvantages 7. Partnership: meaning, features (general & limited partners), advantages and disadvantages 8. Limited company: meaning, features (private & public company) 9. Formation of limited company 10 Types of limited company 11. Advantages and disadvantages of limited company 12. Methods of raising capital: shares and bonds 13. Types of shares: preference shares and ordinary shares Definition of a firm: A firm is also known as an enterprise. It is a planning unit of production where people make production decisions. Meaning of ownership: Ownership of a property includes the rights to control, to use, to derive income from, to sell, to dispose of the property. For example, you can use you desk in our school but you can't sell it for money because you are not the owner. You are granted the permission to use it.

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Private and public enterprises: Individual ownership is called private ownership A firm under private ownership is called a private enterprise. Government ownership is called public ownership A firm under public ownership is called a public enterprise. Public enterprises: Public enterprises usually do not aim to make profits. They provide goods and services at reasonable prices.

Examples of public enterprises: Group A: Government departments: The Water Supplies in Hong Kong, the Postal Services in Hong Kong, Radio Television Hong Kong Group B: Government Agencies: The Hong Kong Housing Authority, The Hospital Authority. Public corporation: A public corporation is set up by statute and is wholly owned by the government. The government only owns shares of the company but it is run independently as a private business by the Board of Directors appointed by the government. We call it a public corporation. It aims at profits. Examples: the Kowloon Canton Railway Corporation. The Airport Authority Hong Kong, Remarks: The Mass Transit Railway Corporation Limited (MTRC) was a public corporation but with some shares issued and sold to the public. It is now difficult to tell whether it is a public enterprise or a private enterprise.

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Private enterprises:
Private Enterprises Sole-proprietorship General Partnership Partnership Limited Partnership Limited Company Private Limited Company Public Limited Company

Listed Public Limited Company

Non-listed Public Limited Company

Meaning of sole proprietorship: A firm under the control of one single owner is called a sole proprietorship() The person who owns the sole proprietorship is called a sole proprietor. () A sole proprietor provides all the capital, makes major and final decisions, bears all the risks, enjoys all the profits and suffers all the losses. Features of a sole proprietorship: 1. One single owner: The sole proprietor can enjoy all profits solely. 2. Unlimited liability (responsibility): The owner is fully responsible for the firm's debts. If the firm goes bankrupt, the owner has to use his private property to repay the debt of the firm and there is no upper limit on his responsibility. 3. No separate legal status: The sole proprietorship and the sole proprietor are regarded as one single legal entity (). There is no separate legal status between the owner and the firm. If the sole proprietorship breaks the law, the owner should personally be responsible for the offence. 4. Lack of business continuity: If the owner retires, goes bankrupt or dies, the firm must end.

5. Transfer of business: A sole proprietor can sell the assets and business of the firm. The new sole proprietorship can carry on the business in the original name or a new name but it should not be regarded as the same old sole proprietorship.

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6. Small size business: A sole proprietorship formed by one single person usually has limited amount of capital and the size is in general small. Advantages of a sole proprietorship: (in general) 1. Easy to establish: The procedures of setting up a sole proprietorship are simple and the cost is relatively low. 2. High incentive to work: The sole proprietor is solely responsible for all losses and he alone enjoys all profits that he has high incentive to manage the firm well. 3. High efficiency in operation and flexible decision making: He alone makes all decision. He does not need to discuss with other owners to make decisions. He can make prompt (/) and quick decision. 4. Close relationship with employees: A sole proprietorship is usually small in size that it can develop a close relationship with employees by increasing the morale () and productivity. 5. Close relationship with customers: The owner is in direct contact with customers and he can understand the needs of customers better. 6. Lower profits tax rate: (compare with limited company) The profit tax rate is 1% lower than the limited companies. 7. Keeping the accounts confidential: (compare with limited company) The owner can keep the firm's accounts secret.

Disadvantages of a sole proprietorship: 1. Limited source of capital: The capital of a single person is limited. For this reason, the source of capital of a sole proprietorship is limited too. It relies mainly on the past profits accumulated and personal assets of the sole proprietor. 2. Unlimited liability: (compare with limited company) The responsibility of the sole proprietor to the firm's debt is not limited to the investment. The owner's private property may be used to repay the debt. 3. No separate legal status: (compare with limited company) The sole proprietorship and the sole proprietor are regarded as one single legal entity. If the firm breaks the law, the owner is personally liable for the offence .

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4. Low continuity: (compare with limited company) The firm cannot continue with the retirement, the bankruptcy, or the death of the sole proprietor. 5. Small in size: A sole proprietorship may be too small to enjoy economies of scale. Suitability of sole proprietorship: Sole proprietorship is most suitable for businesses which require efficient, small-scale production with a low set-up cost. For example, hairdressing, retailing and professional services such as private clinics. Meaning of a partnership: Partnership is the relation which subsists between persons carrying on a business in common with a view of profit. (Excluding limited company) A partnership consists of 2 to 20 owners who put their capital together and run a business under contract. Owners of the partnership are called partners. Types of partners: There are two types of partners: namely general partners and limited partners General partners Every (general) partner in a firm is liable jointly with the other (general) partners for all debts and obligations of the firm incurred while he is a partner. Thus, a general partner bears unlimited liability to the firm's debt. A general partner has to use his own property to repay the debt of the firm. Limited partners A limited partner bears limited liability to debt. His responsibility is limited to the amount he has invested only. Types of partnership: There are two types of partnership: namely general partnership and limited partnership General partnership: In a general partnership, all partners (owners) are general partners Limited partnership: In a limited partnership, some partners are general partners and some partners are limited partners. There is at least one general partner in a limited partnership to take up the unlimited liability.

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Features of a general partnership: 1. Number of partners: A partnership can have a minimum of TWO and a maximum of TWENTY partners. 2. No separate legal status: (compare with limited company) Partners and the partnership are regarded as a single legal entity. The partnership has no separate legal identity. All partners are fully liable for the act of the firm legally. If the firm breaks the law, the owner is personally liable for the offence (). 3. Each partner's decision is binding on all other partners: Each general partner can enter into contracts with outside parties in the name of the firm. All other partners are legally responsible for the act of other partners. 4. Unlimited liability: Partners have unlimited liability. If the partnership goes bankrupt (), each partner is fully liable for its debts. Partners have to use their personal property to repay the debts of the partnership and there is no upper limited on the amount liable. 5. Admission and withdrawal of partners and transfer of shares: Partners may agree among themselves on the admission and withdrawal of partners. The consent () of all partners is required for the admission of new partners, the withdrawal of existing () partners. (1) (2) A person who is admitted as a partner into an existing firm does not thereby become liable to the creditors of the firm for anything done before he became a partner. A partner who retires from a firm does not thereby cease to be liable for partnership debts or obligations incurred before his retirement.

6. Low continuity: (compare with limited company) If any of the general partners withdraws, goes bankrupt or dies, the partnership will be dissolved. If it likes to carry on business in the old firm's name, it has to be reorganized again. 7. Small size business: A partnership formed by partners usually has limited amount of capital and the size is in general small. (Compared with sole proprietorship, a partnership has more source of capital. But compared with limited company, a partnership has less source of capital.)

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Features of a limited partnership: 1. Some partners in the limited partnership are general partners and they have the same obligations () as the general partners in a general partnership. 2. Some partners in the limited partnership are limited partners (or sleeping partners) who enjoy limited liability. If the business fails, the responsibility of the limited partners is limited to the amount they have invested. They don't have to use their personal property to repay the debts of the partnership. 3. There must be at least one general partner in the limited partnership with unlimited liability. 4. The rights of a limited partner are restricted. They do not manage the firm, they cannot withdraw their capital nor dissolve the partnership and the limited partnership will not end if a limited partner retires, goes bankrupt or is dead. 5. Members of a limited partnership need to register with the Companies Registry ( ) Advantages of a partnership: A partnership has most advantages over a sole proprietorship. In the following, the bracket indicates the advantages relative to a sole proprietorship or a limited company: 1. High incentive: (compare with limited company) Partners are collectively responsible for all losses and they share all profits. They have high incentive to manage the firm well to keep cost low and to increase revenue so as to raise profits. 2. Close relationship with employees: (compare with limited company) A partnership is usually small in size that partners can develop a close relationship with employees by increasing the morale and productivity. 3. Close contact with customers: (compare with limited company) The owners are in direct contact with customers and they can understand the needs of customers better. 4. Easy to set up: (compare with limited company) 5. Lower profits tax rate: (compare with limited company) The tax rate is 1% lower than the limited companies. 6. Keeping the accounts confidential: (compare with limited company) The partnership can keep the firm's accounts secret.

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7. Wider sources of capital (compare with sole proprietorship only) A partnership has greater capital resources than a sole proprietorship as there are more owners to contribute capital. 8. Share risk of loss: (compare with sole proprietorship only) Partners can share the losses among themselves

9. Greater extent of division of labour: (compare with sole proprietorship only) Partners can have a variety of skills. Each partner can share the workload and specialize in different areas. Disadvantage of partnership: 1. No separate legal identity: (compare with limited company) The partnership is regarded as one single entity with the partners. All partners are fully and legally liable for the act of the firm. 2. Each partner's decision is binding on all other partners: If one partner makes an error, other partners will have to bear the consequences. 3. Unlimited liability: (compare with limited company) Partners have unlimited liability. If the partnership goes bankrupt, each partner is fully liable for its debts. Partners have to use their personal property to repay the debts of the partnership and there is no upper limited on the amount liable. 4. Lack of continuity: (compare with limited company) If any of the general partners withdraws, goes bankrupt or dies, the partnership will be dissolved. If it likes to carry on business in the old firm's name, it has to be reorganized again. 5. Limited capital resources: The capital of partners is limited in compared with a limited company though the source of capital is wider than a sole proprietorship. 6. Low flexibility in decision making: (compare with sole proprietorship) Partners may have difference opinions. They may spend a long time discussing problems before they make decisions. Remarks: In Hong Kong, lawyers and doctors must operate in form of sole-proprietorship or partnership and they bear unlimited liability as professionals. They cannot operate in form of limited companies. However, they can insure against their risk with an insurance company.

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Meaning of a limited company: A limited company is also known as a joint-stock company or a corporation. It is a legal person on its own. It is an enterprise which enjoys separate legal entity from its shareholders. A limited company aims at profit. It is managed by some professional directors making use of money provided by some inexperienced investors.

Features of a limited company: 1. Issue shares: A limited company can raise capital by selling shares to investors. Investors will become the owners or shareholders of the company. 2. Separation of ownership and management : The role of the shareholders, as owners, is to contribute capital to the company. The shareholders do not participate in the running of the business. The shareholders can exercise their rights () in the annual general meeting by voting the board of directors. () The board of directors elected by shareholders are responsible for running the business with the help of some professional managers employed. 3. Separate legal entity of the company: The limited company enjoys a legal status separated from it shareholders. It is regarded by law as an independent legal person. () It can own property ( ), sign contracts (), enter into agreement (), sue () somebody or be sued () by somebody in its own name (). Shareholders are not personally liable for the act of the company. 4. Limited liability: Shareholders, owners, enjoy limited liability. Their maximum loss is limited to the amount invested (). They don't have to use their personal property to repay the debts of the limited company. (Note : It is not the liability of the company that is limited, it is the liability of the shareholders that is limited)

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Types of limited company: 1. Private limited company 2. Public limited company listed 3. Public limited company not listed There are two types of limited company, namely private limited company and public limited company. There are two types of public limited company, namely listed public limited company and non-listed public limited company. All limited companies that are not private limited companies are public limited companies. Features of a Private limited company: 1. The number of shareholders should not exceed 50 but should have at least ONE. 2. The transfer of shares is restricted. It cannot offer its shares to the public. If shares are transferred, the directors of the company have to approve the transfer with the consent of the present shareholders. Transfer of shares is restricted to present shareholders.

3. A private limited company need not reveal its financial status to the public. Features of a Public limited company: 1. There is no upper limit on the number of shareholders but there should have at least ONE.

2. The transfer of shares of a public limited company is not restricted to the present shareholders. In case the public limited company is a listed company (), with the approval of the Securities and Futures Commission of Hong Kong ( ) and the HKEx ()*., Shares can be traded in the stock exchange. 3. A public limited company needs to disclose its financial status and must also be made known to the public. * The Hong Kong Exchanges and Clearing Limited (HKEx) is the holding company of the Stock Exchange of Hong Kong Limited, the Hong Kong Futures Exchange Limited and the Hong Kong Securities Clearing Company Limited.

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Advantages of a limited company over a sole proprietorship or a partnership: 1. Limited liability: Shareholders' liability is limited to the amount they have invested. They don't need to repay debt of the company with their own properties. 2. Separate legal entity: A limited company is an independent legal person. It can manage its affairs in its own name. 3. Wider sources of capital: A limited company can have wider source of capital. To raise more capital, it can invite more shareholders to join the company. 4. Stable sources of capital: Shareholders are not allowed to request refund of capital. Also, the amount of dividend is determined by the Board of Directors who will assess the future development needs before deciding the amount of dividend to be distributed. 5. Longer continuity: As an independent legal person, its existence will not be affected by the leaving of the shareholders and hence it has higher degree of continuity. 6. Specialization: Management and ownership are separated in a limited company. This allows professional decision making and raising the quality of management and production efficiency. 7. Enjoy economies of scale: Large source of capital implies a large firm size which can enjoy economies of scale. Disadvantages of a limited company over a sole proprietorship or a partnership: 1. Higher set-up cost: In Hong Kong, you need extra documents for registration as a limited company and it takes a longer time to establish. 2. Lower flexibility in decision making: A limited company with a larger size may have complicated organization. This may slow down its response to changes and management efficiency. 3. Higher profits tax rate: The profit tax rate is higher than a sole-proprietorship and a partnership

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4. Lack of financial privacy: () A private limited company has to disclose financial information to the shareholders only. A listed public limited companies have to disclose their business performance and financial status to the public. They can't keep financial secrecy. A summary financial report of a listed company shall contain all the information and particulars included in the company's balance sheet and profit and loss account as they appear in the relevant financial documents. 5. Difficult to develop close relationship with customers and employees: Limited companies usually are large in size. It is difficult for them to develop close relationship with employee and they are not ready to offer individual service to customers. Methods of raising capital: Borrowing: from other company, bank or issue bonds or debentures Issue shares: preference shares / ordinary shares Meaning of bonds : 1. A bond is a kind of borrowing. 2. A limited company can issue debentures (bonds) to raise capital in the form of a long term loan called bonds. 3. The limited company gives the bond holder a fixed rate of interest. () 4. The holder of the company bonds is the creditor () but not the owner. 5. Bond holders don't have voting right in the business. 6. In case of liquidation(), bond holders have a higher priority () of getting back their money than the shareholders. 7. Bond holders bear credit risk () of non payment, i.e. the borrower refuses or fails to pay back the money. 8. Government may also issue bonds. In Hong Kong, the Hong Kong Monetary Authority issues some short term bills called the Exchange Fund Bills. ( )

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Meaning of shares : A share is a certificate issued by the limited company indicating the ownership of the company. Shareholders () are the owners of the limited company. There are two types of shares: Ordinary share holders have voting right Preference share holders have no voting right. Ordinary share holders get variable dividends () depending on the performance of the company. Preference share holders get fixed dividends ()even when the company is performing well. When the company earns no profit or making a loss, both ordinary share holders and preference share holders cannot get any dividend. In case of liquidation (), preference share holders can get back their investment prior to the ordinary share holders. In case of liquidation, share holders have lower priority than the bond holders in getting back their investment. In all cases, the government has the highest priority, then the employees, then the creditors, then the preference share holders, and finally the ordinary share holders. Share holders bear business risk , i.e. the profit or loss of the company.

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Preference shares Rate of dividend There is a fixed rate of dividend Priority in getting dividend Priority in getting back capital Voting rights Preference shareholders will receive a dividend before ordinary shareholders When the company winds up, preference shareholders will get back their capital before ordinary shareholders. Preference shareholders do not have voting rights in shareholders' meetings.

Ordinary shares There is no fixed rate of dividend Ordinary shareholders are the last to receive a dividend Ordinary shareholders are the last to get back their capital Ordinary shareholders have voting rights in shareholders' meeting.

Identity Returns

Bonds Bondholders are creditors of the firm. Bondholders get fixed interest Even the company makes no profits, it still has to pay interest to the bondholders.

Priority in getting back capital Voting rights

Ordinary shares Shareholders are owners of the firm. Shareholders get dividend Ordinary shareholders get variable dividend preference shareholders get fixed dividend When the company winds up, Shareholders are the last to get bondholders will get back their back their capital capital before shareholders. Bondholders do not have voting Ordinary shareholders have rights voting rights in shareholders' meeting.

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Short run and Long run

(law of diminishing marginal returns and economies of scale)
Learning focus: 1. Fixed factor and variable factor 2. Short run and long run 3. Law of diminishing marginal returns 4. Economies of scale and diseconomies of scale Factors of production can be classified as fixed factor and variable factor: Definition of a fixed factor: A fixed factor is a factor which quantity does not vary with the level of output. Definition of a variable factor: A variable factor is a factor which quantity varies with the level of output. Identification of factors under different situations: Temporary changes: The variable factors whose quantities change with output while the fixed factors whose quantities do not change with output. As everything has to restored to original after a temporary market changes Persistent changes: Once the factory has increased the employment of all its factors, they all become variable factors. Production period can be classified as short run and long run: In the short run, there are both fixed factor and variable factors. A firm can vary it variable factors to change its output level. The existence of a fixed factor is enough to identify it to be in the short run. In the long run, time is long enough to allow the fixed factor in the short run to change in quantity. The short run fixed factor becomes variable factor in the long run.

Definition of short run: The short run is a production period in which there is at least one fixed factor. (Some fixed and some variable factors)

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Definition of long run: The long run is a production period in which all factors of production are variable factors. (There is no fixed factor.) How short is the short run? ? In the short run, time is not long enough for the firm to vary the quantity of some factors of production. Therefore, there are both fixed factors and variable factors. How long is the long run? ? In the long run, time is long enough for a firm to vary the quantity of all factors of production. The fixed factor in the short run becomes variable factor in the long run. Note: Never use the period of time to identity the case as short run or long run.

Input output relationship in the short run:

Total product, average product and marginal product: Definition of total product (TP): Total product is the total output produced by all the factors of production employed. Definition of average product (AP): Average product is the total product divided by the quantity of variable factors input.
Average Product Total Product Quantity of variable factors

Definition of marginal product (MP):

Marginal product is the change in the total product as a result of the employment of an additional unit of variable factor. Marginal product increases initially but decreases eventually and even becomes negative. MPn = TPn - TPn-1

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Example: Suppose several farmers are working on a piece of land. Farmers are the variable factor and land is the fixed factor. Fill in the values
Land Farmers Total output of farmer ( TP) Average Output of farmer(AP) Marginal Output of farmer(MP)

1 1 1 1 1

1 2 3 4 5

20 50 90 120 130

We observe that marginal product starts to decline when the 4 unit of farmer is employed. The above case satisfies the law of diminishing marginal returns. **Beware of the words such as "when" or "after". They mean differently. Reason for increasing marginal product at first: At first, there is excess capacity of the fixed factor. Marginal output increases as we can take advantage of the unused capacity of fixed factor.

Reason for decreasing marginal product eventually: At the end, the fixed factor is fully used and further increase in variable factor input will lead to a decrease in marginal product. Variable cost and fixed costs Variable costs are the costs of employing variable factors. These costs vary when output charge. Fixed costs are the costs of employing fixed factors. These costs do not vary when output changes. In the short run Variable costs Fixed costs =0 >0 >0 >0 In the long run Variable costs Fixed costs =0 >0 =0 =0

Production cost incurred When output = 0 When output > 0

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Measurement of production costs Total cost (TC) It is equal to the sum of total fixed cost (TFC) and total variable cost (TVC), which are the costs of using all the fixed factors and all the variable factors TC = TFC + TVC Average cost (AC) It is the cost per unit of output produced Average Cost = Total Cost Unit of output

Marginal cost (MC) It is the change in total cost that results from producing an additional unit of output. (extra cost paid for an additional unit of output produced) MPn = TPn - TPn-1 Note: All total, average and marginal concepts can be applied to variable cost and fixed cost. e.g. AC = AFC + AVC, MC = MFC +MVC Definition of the law of diminishing marginal returns : The law of diminishing marginal returns states that in the short run, as more quantities of variable factor are added to a given amount of fixed factor, holding technology constant, the marginal product will eventually decrease. marginal product average product Examination technique: In the public exam, you are required to find the marginal product with a bit of calculation. It may be the case that the total product is given or the average product is given. In some cases, you have to explain with figures. If there is no fixed factor in the production, it must be in the long run. Law of diminishing marginal returns will not apply. Internal and external economies of scale Internal economies of scale is advantage enjoyed by a firm whoen the firm itself enlarges the scale of production External economies of scale is advantages enjoyed by a firm when other firms or the industry enlarge(s) the scale of production

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Cost-output relationship in the long run

Economies of scale: At the beginning, when the scale of production increases, a firm can enjoy many advantage. In the long run, firm can expand to increase the size to enjoy a lower average cost of production. The benefits from expansion are called economies of scale. When the long run average cost is at a minimum, that scale of production is called optimal scale .
Cost $

LAC

Q1

Possible sources of internal economies of scale: 1. Managerial economies: When a firm expands, it can employ specialists and experts for different departments. It can apply division of labour by employing more workers. This improves the firm's efficiency and reduces the average costs. 2. Financial economies: A large firm can raise capital more easily than a small firm and raise funds at a lower average cost. It can enjoy lower interest rate, longer repayment term and less collaterals needed. It may also issue shares and thus need not pay interest. That reduces average cost. 3. Marketing economies: Large firms can afford to spend money on advertising and delivery . The average cost of advertising and delivery decreases as the quantity of goods increases. 4. Purchasing economies: Large firms can purchase raw materials and fuels at a lower cost. They can enjoy larger discount and longer credit terms because they buy goods in large quantity.

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5. Technical economies: A large firm can afford to buy better machines since the cost can be spread over a larger output. It can more fully utilize the machines that productivity can be raised. 6. Risk diversification: Large firms can spread risk by diversifying its products and developing new markets. 7. Research and development: (R & D) Large firms can spend large amounts of money on research and development. This brings innovations , lowering average cost as well as exploring new markets.

Possible sources of external economies of scale: 1. More workers would be attracted to the industry, employed and trained. As a result, more experienced and qualified workers will be available for this industry. This lowers the firms cost of recruiting and training workers. 2. As the demand for back-up, transport and communication services increases, corresponding services would be developed. This lowers the firms cost of using these services. 3. Since more firms advertise their products, more people will know about the industry and its products. This lowers the firms cost of marketing.

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Diseconomies of scale: If the firm expands further in size that leads to a rise in average cost of production. The situation is called diseconomies of scale. Possible sources of internal diseconomies of scale: 1. Management diseconomies: As a firm gets too large, organization becomes complicated. Communication between members of the firm becomes difficult. Time and resources are wasted and decision errors are committed. 2. Financial diseconomies: A very large firm needs huge amount of capital for expansion. Over borrowing may lead to high interest rate as the lending institutions may think that part of the loan is unsecured. 3. Marketing diseconomies: A firm that has grown too large will find it difficult to expand its market share. Market share expansion can only be done by spending a lot of money on advertising and cost increases. Further increase in the sales of the firm may require exploration of overseas markets. 4. Purchasing diseconomies The supply of resources is limited. When a firm continuously increases its use of these resources, the firm may have to purchase them from more expensive sources or use costlier substitutes. Possible sources of internal diseconomies of scale: 1. Excessive expansion of an industry causes a drastic increase in the demand for factor inputs like labour, land, factories, raw materials and machines, etc. This may greatly raise input prices likes wages, rent and prices of raw materials and machines, etc. 2. Increasing concentration of business activities in a district leads to a substantial increase in traffic in that area. The resulting congestion raises transport costs. Hence, the firm suffers a higher average cost of transportation. Diseconomies of scale can be explained by the law of diminishing marginal returns. Do you agree? No. Because the law of diminishing marginal returns is exist in the short run only while diseconomies of scales exist in the long run only.

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Expansion of firms
Learning focus: 1. Types of expansion 2. Motives of expansion 3. Methods of expansion Types of expansion: 1. Internal expansion: It refers to a firm expanding within its existing framework, such as buying new offices, factories or extending more branches. 2. External expansion (Integration): () It means a firm expanding by combining with other firm/ firms. Integration refers to the combination of firms. A. Horizontal integration: It refers to the combination of firms producing the same product, or operating the same stage in the industry. e.g. (bank with bank) (a garment factory with another garment factory) B. Vertical integration: It refers to the combination of firms operating at different stages of production. There are two types of vertical integration 1. Backward vertical integration: It refers to combining with a firm of a preceding production stage. e.g. (Garment making + Cloth making) 2. Forward vertical integration: It refers to combining with a firm of a next production stage. e.g. (Cloth making + Garment making) C. Lateral integration: It refers to the combination of firms producing related but not competitive products. e.g. (clocks and watches) (private cars and lorries manufacturers) (cake and bread) D. Conglomerate integration: It refers to the combination of firms in completely different types of production / unrelated businesses. e.g. (supermarket and mobile phone network service)

Motives of integration: Motives of horizontal integration:

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Note : horizontal internal expansion horizontal integration 1. It can enjoy economies of scale: Average cost of production decreases as the size of firm grows bigger. 2. It can enlarge the market share and turn competitors into partners. 3. It ensures more efficient use of resources and can avoid duplication of facilities. Branches under the same firm can share the resources. 4. It can promote the brand name as a bigger firm. Motives of vertical integration: (vertical internal expansion vertical integration) 1. It ensures steady supply of raw material (for backward vertical integration). 2. It ensures steady market for its output (for forward vertical integration). 3. It enables more flexibility in resources usage as they need the same supportive branches like the accounts department and personnel department. 4. It can promote the brand name as a bigger firm. Motives of lateral integration: (lateral internal expansion lateral integration) 1. It can diversify risk of investment into another line of business. 2. It enables more flexibility in resources usage as they require similar inputs and technology. 3. It can promote the brand name as a bigger firm. Motives of conglomerate integration: (conglomerate internal expansion conglomerate integration) 1. It can diversify risk of investment into another line of business. 2. It enables more flexibility in resources usage as they need the same supportive branches like the accounts department and personnel department. 3. It can promote the brand name as a bigger firm. General motives for expansion:

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1. It enables more flexibility in resources usage. 2. It can promote the brand name as a bigger firm. Methods of integration: 1. Takeover One firm buys up the controlling share of another firm. The original firm be taken over is still trading in the same status. e.g. Hongkong Bank acquired controlling shares of Hang Seng Bank 2. Merger : A firm absorbs another firm by purchasing all its assets. The firm being merged is dissolved. e.g. The Hong Kong Telecom was merged by the PCCW . (Pacific Century CyberWorks Limited.) 3. Consolidation : Two firms dissolve to form a new firm. e.g. Hutchison Whampoa was formed by merging Hutchison and Whampoa. 4. Cartel: Some independent firms in the business come together to make an agreement on the price and quantity of goods. The agreement is a loose one. e.g. The Organization of Petroleum Exporting Countries (OPEC)

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Market Structure
Learning focus: 1. Concept of market 2. Concept of market structure 3. Perfect and imperfect competition a. Perfect competition b. Monopoly c. Oligopoly d. Monopolistic competition 4. Features of different market structure 5. Price competition and non-price competition What is a market? A market is an institution () that enables buyers and sellers to have contact for transactions (). What is market structure? Market structure is the set of conditions under which buyers and sellers interact in the market. Different relationships between buyers and sellers will lead to different market structure. These conditions include the number of buyers and sellers, the nature of goods, the ease of entry and exit of firms and the information flow in the market. We can classify the market structure into two categories: 1. Perfect competition 2. Imperfect competition Forms of Market Structure: Perfect Competition Monopolistic Competition Imperfect Competition Oligopoly Monopoly

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Conditions for perfect competition: 1. 2. There are large number of (numerous) buyers and sellers. No firm in the market is large enough to have sufficient influence on the market price. Therefore all firms are selling the good at the same price. Sellers are price takers who take the market price for granted. All firms are selling homogeneous product / or identical product. Firms can enter and exit the market freely without any restrictions or barriers. Flow of information in this market in free and perfect. Every piece of information is known to all participants. The market is transparent.

3. 4. 5.

Remarks: There is nothing perfect in this world and this market structure is just for analysis only. There is no perfect competitive market in the real world. We can classify imperfect competition into three categories: 1. Monopoly 2. Oligopoly 3. Monopolistic Competition What is a monopoly? When there is only one seller of the product in market the market structure is called a monopoly. The seller is called a monopolist.

Features of a monopoly market: 1. There is only one single seller in the market 2. 3. There is no other firm selling the same product. There are entry barriers of various forms to prevent new firms from entering the market. There is imperfect flow of information.

4.

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Formation of monopoly: 1. Government franchise: The government grants a franchise to a private firm to become the only legal supplier of a certain good or service in a place. The Kowloon Motor Bus Company Limited is an example of franchise. Rights to operate bus services on certain routes have been granted to the company for a period of time but the bus company has to pay some money for the franchise. Economies of Scale or Natural monopoly: Some businesses require huge capital investment and they have to produce in large scale to benefit from economy of scale. It is difficult for a new firm to compete with the existing firm. The firm enjoying economies of scale with established market network can drive away new firms easily. Public ownership: The government owns certain important resources or properties that are not available to private firms. The Water Supplies Department is the sole supplier of water in Hong Kong. Cartel: Suppliers of the same product form an organization. They make agreements on the quantity and price of the product. Trademark and copyright: They are given to protect technological innovation and intellectual property rights.

2.

3.

4.

5.

Behaviour of a monopolist: 1. It is a price searcher. It searches for the best price for its output. Usually, price is higher but quantity is lower than the other market because of the inelastic elasticity of demand The monopolist will employ non-price competition such as advertising to compete with some potential rival firms which produce substitutes. For example, Town Gas and China Light and Power Company Limited are competing in the fuel/power supplies market.

2.

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What is an Oligopoly: An oligopoly is a market structure in which there are only a few dominate sellers. The action of each single seller will affect the profits of the other firms and it will lead to immediate reaction of other firms. Each firm has certain degree of monopoly power in the market. Firms in such market are called oligopolists. Example of an oligopoly : ATV, TVB and the Cable TV Features of an oligopoly: 1. There are only a few dominating firms (the market can have hundreds of sellers) 2. Firms are selling differentiated product. Though the product seems the same superficially, due to non-price competition, the product is different from the view point of consumers. Non price competition includes packaging, after sale service, free gift and brand name. See behaviour of an oligopoly. 3. There are entry barriers for new firms 4. Flow of information in the market is imperfect. Behaviour of oligopolists: 1. They are price searchers who are able to charge different prices for their products. 2. They employ different form of non-price competition, such as advertising, packages, brand name, design or gifts to compete with other firms. Price is sticky as they are quite reluctant to cut their price as it may lead to a price war among them. They try the best to avoid cut throat competition. Firms in the market may form a cartel to take joint action to protect their interest. Products in an oligopolistic market are usually inelastic in demand. Firms can increase their incomes ( total revenue) by raising price and reducing quantity together.

3.

4.

What is monopolistic competition? Monopolistic competition refers to a market with many sellers providing similar (heterogeneous) products. For example, retail stores and fashion shops. Features of monopolistic competition: 1. Large number of buyers and sellers. 2. The products are differentiated but highly similar to each other and hence each seller has a certain amount of monopolistic power in the market. Sellers are free to enter or leave the market. There is no entry barrier of any form. The flow of market information is imperfect.

3. 4.

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Behaviour of firms in monopolistic competition: 1. The firms use non-price competition such as advertising, packaging, brand name, design and free gifts to attract more customers. The term product differentiation refers to the nature of the products from the viewpoint of the buyers. It refers to the physical property of the products as well as the services provided during the process of exchange like pre-sale and after-sale services. In a market of monopolistic competition refers to a market where some of the characteristics of monopoly and perfect competition are present. They are selling slightly different products and services and their prices vary. Usually, styles, brand names, materials used, packaging and immediate and after sale services vary too.

2.

3.

Price competition and non-price competition: Price competition means firms competing with one another in terms of price. A firm reduces the price a good to attract more consumers. Non price competition means competing with the other firms in terms of other means. A firm may employ all other means to attract more consumers instead of reducing price. In a market of perfect competition, there is only price competition. However, it seems that price is the same for all price takers and we may wrongly think that there is no price competition at all. In fact, a single price is the result of severe competition under perfect competition. No more reduction is possible.

Note: Price competition occurs in market of perfect competition. Both price competition and non-price competition occurs in market of imperfect competition. A seller in a monopoly, an oligopoly or monopolistic competition is a price searcher A seller in a perfectly competitive market is a price taker In 2005 HKCEE, price searcher and price taker were not acceptable features in the marking scheme. Avoid using them.

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