Microeconomics

Demand and Supply

Market: Where buyers and sellers come together to carry out economic transactions. Product Market: Where goods and services are bought and sold. Factor Market: Where the factors of production are bought and sold.

Demand Demand is the quantity of a good or service that consumers are willing and able to purchase at a given price in a time period. The effective demand is the amount they are able and willing to buy. When dealing with demand, the following assumptions are made: I. II. III. The consumer wants utility (satisfaction), which comes from goods and services. The more goods and services consumers get, the more satisfied. Consumers gain less satisfaction from every additional good.

The Law of Demand

As the price of a product falls, the quantity demanded of the product increases, ceteris paribus. In simpler terms, the demand curve slopes downwards. Ceteris paribus: all other things remain equal (unchanged). This is when one variable is changed, and other factors are held constant. The law of demand can be represented as a demand schedule, which shows the relationship between price and demand usually in the form of a table. Drawn graphically, price is on the y-axis and quantity demanded is on the xaxis. As price drops, quantity demanded increases for the following reasons:

Income effect: when price falls, real income rises, which increases the consumers purchasing power (ability to buy goods). With increased real income, the consumer can buy more.

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Microeconomics Substitution effect: when the price of a product falls, it will become more attractive to consumers than other products, which may lead them to substitute other products by it. Non-Price determinants of demand

A change in price causes a movement along the demand curve. A change in any other factor results in a shift in the demand curve. Income: there are two types of products when considering income. Normal goods: Obey the law of demand. As income rises, the demand curve shifts to the right. Inferior goods: Demand falls as income rises. This is because consumers substitute it for better products at a higher price. The demand curve shifts to the left. At certain income levels, demand will be zero. Price of other goods: There are three possible relationships between products: Substitutes: If two products are substitutes, the change in the price of one will lead to a change in demand for the other. If the is a fall in price of good a, there will be an increase in demand for good b and vice versa. Complements: these are products often purchased together. If the price of a good falls, it will be demanded more, and the complements will have an increase in demand. Unrelated goods: Nothing happens. Taste and preference: Generally, trends change. Marketing may be used to shift the demand curve to the right. This could also be change in seasons (winter-summer) Size of the population: as the population grows, the overall demand increases since there are more people. Change in age structure: as the age structure changes, some goods will have increased demand, while other goods will have a fall in demand. Change in income distribution: if income is more equally distributed, there may be an increase in demand for basic necessities.

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Microeconomics Government policies and taxes: Governments may place regulations on goods and services that harm consumers. Supply Supply is the willingness and ability of producers to produce a quantity of a product at a given price at a given time period. The law of supply: as the price of a product increases, the supply increases, ceteris paribus. Non-Price determinants of supply Cost of factors of production: If factors of production become more expensive, costs rise, leading to a lower supply. Price of other goods the firm can produce: if the price of a product rises due to high demand, firms may start producing it instead of their own products. Technology: if better producing technology is available, firms will produce more goods. Expectations: producers expecting an increase in demand may increase supply, and vise versa. Government intervention: governments may introduce taxes, which will raise prices and cause a fall in supply. It can also introduce subsidies, which will reduce costs and increase supply. Market Equilibrium Equilibrium: market equilibrium occurs when quantity demanded and quantities supplied are equal as the amount sought by buyers is equal to the amount produced by sellers. Markets remain in equilibrium unless affected by a change in the determinants of demand and supply. The equilibrium point is self-righting, and the variables will return to the market-clearing price unless affected by a change in the determinants of demand and supply. Resources are allocated in response to changes in price. An increase in price due to an increase in demand will lead to an increase in supply and the amount of resources allocated will increase.

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Market Efficiency: Consumer and producer Surplus

Consumer surplus: the satisfaction gained by consumers from paying a price lower than that they are prepared to pay. Graphically represented, this is the area above the market price. Producer surplus: the excess earnings produces gains from a given quantity of output that would be above the amount the producer would accept for that output. Graphically represented, this happens if the producer sells at the market price above what he would expect (area under market price) As a graph, this is what

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Allocate Efficiency Allocative efficiency: When the market is in equilibrium, it is socially efficient. At this state, total economic welfare can be maximized, so the resources are allocated in the most efficient way from societys point of view. (Marginal benefit = marginal cost) The sum of consumer and producer surplus is known as community surplus. Perhaps consumers would prefer lower costs, and producers would like higher costs, it is the point that benefits them all.

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Microeconomics An industrys supply is determined by the costs of production. If the supply cost equals the cost to society, this would be equal to the marginal social cost (MSC). The demand is measured by the utility (benefits) consumptions brings consumers. If the benefit to the market equals the benefit to society, this would be equal to the marginal social benefit (MSB). A free market would lead to maximum community surplus, which leads to allocative efficiency, as the marginal social costs would equal the marginal social benefits. Elasticity

Elasticity is a measure of responsiveness. In economics, it used to find the responsiveness of demand or supply to a change in their determinants. Elasticity of Demand The elasticity of demand measures the responsiveness of demand to a change in one of its determinants including price, income, and the price of other goods. Price Elasticity of Demand (PED) Price elasticity of demand measures the change in quantity demanded after a change in price.

The sign (+ or ) is not important.

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PED 0: perfectly inelastic demand. Demand does not change at all prices.

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PED between 0 and 1: inelastic demand. The percentage change in demand is smaller than the percentage change in price. In this case, an increase in prices would increase revenue.

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PED 1: Unit elastic demand. The percentage change in demand is equal to the percentage change in price. Revenue does not change. In this case, the change in demand is opposite the change in price.

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PED between 1 and infinity: elastic demand. The percentage change in demand is greater than the percentage change in price. In this case, an increase in price would decrease revenue.

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PED Infinity: perfectly elastic demand. At a given price level, demand is infinite. Any small change in price will reduce demand to zero.

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Factors affecting the elasticity of demand: From Tutor2U: The number of close substitutes the more close substitutes there are in the market, the more elastic is demand because consumers find it easy to switch The cost of switching between products there may be costs involved in switching. In this case, demand tends to be inelastic. For example, mobile phone service providers may insist on a12 month contract. The degree of necessity or whether the good is a luxury necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand. The proportion of a consumers income allocated to spending on the good products that take up a high % of income will have a more elastic demand The time period allowed following a price change demand is more price elastic, the longer that consumers have to respond to a price change. They have more time to search for cheaper substitutes and switch their spending. Whether the good is subject to habitual consumption consumers become less sensitive to the price of the good of they buy something out of habit (it has become the default choice). Peak and off-peak demand - demand is price inelastic at peak times and more elastic at off-peak times this is particularly the case for transport services. The breadth of definition of a good or service if a good is broadly defined, i.e. the demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change.

Cross Elasticity of Demand (XED) Cross elasticity of demand is a measure of how a change in the price of a product affects the demand for another. It can be used to find the relationship between products.

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Positive XED: the goods are substitutes. The demand for substitutes increase when the price of another good increases. The higher the value, the closer the substitutes. Negative XED: the goods are complements. The demand for complementary goods increases when the price of another decreases. The lower the value, the closer the complements. Unrelated goods have an XED of 0. Income Elasticity of Demand (YED) Income elasticity of demand is a measure of how a change income affects demand. It can be used to determine if a good is inferior or normal. Positive YED: Normal good. Demand increases as income rises. Negative YED: Inferior good. Demand decreases as income rises. YED value between 0 and 1: income inelastic good. The good is a necessity. YED value greater than 1: income elastic good. An Engel curve shows the relationship between income and the demand for a product over time.

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Elasticity of supply

Price elasticity of supply (PES) is a measure of the change in supply according to a change in price.

PES 0: Perfectly inelastic supply. A change in price will have no affect on supply. Possible in the short term where all factors of production are fixed.

PES Infinity: Perfectly elastic supply. True in international trade where there is a fixed world price.

PES less than 1: Inelastic supply. A change in price will lead to a smaller change in supply.

PES greater than 1: Elastic supply. A change in price will lead to a greater change in supply.

PES 1: Unit elastic supply. A change in price leads to an equal, opposite change in supply.

A supply curve from the origin has a PES value of 1. A supply curve from the x axis has a PES value of less than 1. A supply curve from the y axis has a PES value of more than 1. Factors affecting the elasticity of supply: Cost of increasing output: If buying capital is expensive, it will not be worth increasing output. The existence of unused capacity and the mobility of the factors of production can lower the cost of increasing output. Time period: the longer the time period, the more elastic the supply. Ability to store stock: Storing stock makes reacting to changes in price easier.

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Raw materials (commodities) have inelastic demand because they have few substitutes and are always needed for production. Commodities also have inelastic supply as the factors of production cannot easily be mobalised.

Indirect taxes, subsidies, and price controls. Indirect tax: tax imposed on expenditure added to the selling price of a product. Indirect taxes raise production costs and shift the supply curve upwards by the amount of the tax. There are two types of indirect taxes: Specific taxes: a fixed amount of tax per unit. Percentage taxes: the tax is a percentage of the selling price. The tax increases are price increases. Firms usually pass the tax onto consumers by raising prices. This may cause an excess supply. The prices would usually drop to a new equilibrium level in this case. Taxes are usually placed on inelastic goods since the change in demand will be smaller than the change in price, meaning that a large revenue will be gained without causing large unemployment. Subsidy: a subsidy is a form of financial assistance provided by the government to a firm. Governments provide subsidies to: 1. Lower the price of essential goods to increase consumption. 2. Guarantee the supply of necessities or to maintain the industries creating them. 3. To enable domestic firms to compete with foreign firms on the basis of price. The supply curve will shift vertically downwards by the amount of the subsidy, therefore lowering prices and increasing the amount supplied at every price level. Subsidies increase the income gained by firms. Opportunity costs arise when subsidies are provided. Taxpayer money is used to provide subsidies, yet it is the taxpayers (citizens) that consume the tax too.

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Firms may become inefficient, as they do not compete fairly in a free market with foreign companies. Subsidies may negatively affect producers from other countries are domestic goods become more attractive due to their lower prices. Price Controls Price controls are restrictions set by the government on the prices of goods and services. This can be set by using maximum and minimum price controls.

Maximum price controls This happens when a government sets a maximum price below the equilibrium price. Maximum prices are set to make products affordable to consumers, especially if the necessities. Maximum price controls may be imposed to increase consumption Setting a price lower than the equilibrium price increases demand and decreases supply, thus consumption will fall. To cater for the excess demand, black markets may emerge. Also, shopkeepers may start dealing selectively. To remove the shortage, a new equilibrium needs to be set at the maximum price. 1. Subsidies can be provided to producers to increase supply (shift it to the right) 2. The government can produce its own goods. 3. If the product is durable, the government could use a buffer stock system: buying stock and releasing it when needed, essentially increasing the supply. These measures impose an opportunity cost on the government. Minimum price controls

This happens when governments set a minimum price above the equilibrium price.

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Microeconomics Minimum price levels are set to raise income for producers and to provide workers with a minimum wage to improve their living conditions.

Setting a higher price reduces demand, as per the law of demand, which means that there will be an excess supply of the good. To eliminate the excess supply, a new equilibrium is needed at the minimum price. this can be done by shifting the demand curve to the right. The government could shift demand by buying the excess products. The excess can be stored, destroyed, or sold abroad. However, storage is expensive, selling products abroad at low prices can be seen as dumping by foreign governments, and destroying the excess stock is wasteful. A solution to this would be to completely not provide the goods or services, and pay the producers the amount they would earn if they did supply their products. To avoid the method above, quotas could be placed on producers to prevent them from producing in excess, or supply can be increased by marketing or limiting consumer choice (by making domestic goods more attractive than imported goods, or banning imported goods completely). The disadvantage of minimum price controls is that firms would become less cost-conscious and more wasteful/ inefficient. Market Failure

Market failure is a situation where there allocation of goods and services by the free market is not efficient. According to the theory of Pareto efficiency, a market is failing if it is still conceivable to make a market participant better-off without making another worse-off. An economy is efficient if resources are used to maximize production. In a state of economic efficiency, no more output can be made without increasing input, and production is done at the lowest cost. There are several types of market failure.

Lack of public goods Public goods are goods that would not be provided at all in a free market, even though they are of benefit to society.

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Public goods are not provided in a free market because they are nonexcludable and non-rivalrous.

A good is non-rivalrous if the consumer does not prevent others from consuming the good. (the cost of providing it to an additional individual is zero) A good is non-excludable if consumers who have not paid for it have access to it. Governments may choose to provide public goods by themselves, or completely subsidise private firms to provide the good. Under-supply of merit goods Merit goods are goods that will be underprovided by the market. These are goods that are needed, not wanted, by consumers. These goods benefit individuals and society as a whole. All public goods are merit goods. Governments may choose to provide merit goods by themselves, or completely subsidise private firms to provide the good. Over-supply of demerit goods A demerit good is a good or service whose consumption is considered unhealthy and socially undesirable. To prevent their consumption, governments may ban them completely. Less harmful demerit goods may be taxed instead of complete bans. The existence of externalities

An externality is the cost or benefit incurred by a third, uninvolved party due to production or consumption. If the effect on the third party is negative, it is a negative externality. In this case, the cost to community is greater than the cost of production paid by the firm. This is a misallocation of resources and is socially inefficient; therefore there is a welfare loss equal to the externality.

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Microeconomics If the effect on the third party is positive, it is a positive externality. In this case, the marginal private cost is greater than the marginal social cost. The marginal social cost (MSC) is equal to the marginal private cost (MPC), plus or minus any costs/benefits incurred by society from production. The marginal social benefit (MSB) is equal to the marginal private benefit (MPB), plus or minus any costs/benefits incurred by society due to consumption. If MSC equals MSB, there will be no externalities. In this case, the social benefit is maximized (community surplus). If this is not achieved, then the market is failing. Negative externalities of consumption: consumption that affects third parties negatively. In this case, governments can completely ban the goods or tax them. If the demand is inelastic, this may not change demand. Education about the risks of consumption may remain the only option. Positive externalities of consumption: consumption that benefits society. To increase the consumption of these goods, subsidies could be provided to increase demand and make MSB=MSC. Since this is expensive, marketing may be used to increase demand, or the consumption could be made mandatory. Market failure due to common-access resources: resources, such as natural resources, may not be non-excludable. They might be exploited, thus the resources will be depleted and society will incur a negative externality. This is market failure. Sustainability: the consumption of the current generation do not affect the consumption by future generations negatively. Poverty and economic growth may affect sustainability. People living in poverty may exploit natural resources to earn an income and grow economically. This consumption is not sustainable if resources are depleted. The extraction and burning of fossil fuels is creates negative externalities due to their negative effect on nature. The consumption of fossil fuels is market failure on a global level. To reduce the externalities, consumption and production may be regulated and renewable-energy sources can be used. International cooperation is needed to solve the issue of global warming since pollution is not restricted by national borders.

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