1

Diagrams
Diagrams are
an excellent
way to show
analytical skills
To secure L2
marks,
diagrams are
expected, what
more for L3
marks
Please explain your
diagrams
Caution: Do not just
draw conclusions
from your diagrams
but explain how you
arrive at those
conclusions
Caution: Diagrams
not explained will
not be given credit at
the A levels
Diagrams must be
completely labelled
and contextualised
If more than one
market is involved,
like market for
apples and market
for oranges, please
label on the
diagram which
market you are
analysing explicitly
and clearly
Accuracy in
illustration expected
Microeconomic diagrams
Industrys level of analysis
Price mechanism
An Example: Corn Industry under perfect competition
Price
Quantity
SS
DD
P
Q 4 12
Figure 1: Market for Corn
A
E
B
20
10
5
0
Qd = Qs
Price adjustment process
Explain how shortages and surpluses
are eliminated via the price
mechanism
Explain what shifts the demand
curve (TIPSEY) and what shifts the
supply curve (ecoping)
Explain how shifts in demand curve
and supply curve will lead to
changes in equilibrium price and
equilibrium quantity
Note: For simplicity, increase in
demand is reflected by a rightward
shift of the demand curve while
increase in quantity demanded is
reflected by a movement along the
demand curve
Inflationary gap
MLC
J-curve
Demand-supply analysis
Analyse shifts in
demand curve or
supply curve first
After analysing the
change in the position
of demand or supply
curve, then provide
refinement if needed
elasticity of
demand or supply
concepts
2
Price Elasticity of demand measures
the extent of MOVEMENT along the
demand curve!!
Important Note:
Price
Qty
0
P1
Q1
D
P0
Q
0
Price
Qty 0
D
Q
1
Q
0
Price-elastic demand and TR Fig 2(a)
price
0
quantity
D
P
1
Q
1
P
0
Q
0
When P falls to
P
1
, Qd
increases more
than
proportionately
, and in turn
TR rises.
S0
S1
Price-inelastic demand & TR Fig 2(b)
price
0
quantity
D
P
1
Q
1
When P falls to P
1
,
Qd increases less
than proportionately
and in turn, TR falls.
P
0
Q
0
S0
S1
When demand curve shifts to the right
from D1 to D2, the extent of increase
in price depends on the price elasticity
of supply. The more inelastic the
supply curve (S1 is more inelastic in
supply compared to S2), the greater
the extent of increase in price (from
R0 to R1 for S1 as compared to R0 to
R2 for S2.)
When demand curve shifts to
the right, the extent of
increase in quantity supplied
depends on the price elasticity
of supply. The more inelastic
the supply curve (S1 is more
inelastic in supply compared
to S2), the smaller the extent
of increase in quantity
supplied (from Q0 to Q1 for
S1 as compared to Q0 to Q2
for S2.)
PES is relevant when the
demand curve shifts
PED is relevant when the supply curve shifts
Income elasticity of demand
The sign of income
elasticity of demand will
affect the direction of shift
in demand curve e.g. For
normal goods, the YED is
positive, then when
income increases, the
demand for the good shifts
to the right. For inferior
goods, YED is negative
(elaborate)
The value of income
elasticity of demand will
affect the extent of shift in
demand curve e.g. For
necessities or non-luxury,
the YED is positive and
less than one, this means
that when income
increases, the shift to the
right in demand curve is
less than proportionate to
the increase in income.
Elaborate on the value for
non-necessities and
luxuries (YED>1)
3
Cross elasticity of demand
The sign of cross elasticity
of demand will affect the
direction of shift in
demand curve e.g. For
substitutes, the CED for
coke with respect to the
price of pepsi is positive,
then when the price of
pepsi increases, the
demand curve for coke
shifts to the right. For
complements, CED is
negative (elaborate)
The value of cross elasticity
of demand reflects for
instance, the degree of
substitutability between the
two goods and hence the
extent of shift in demand
curve. The higher the value of
positive CED, the more
substitutable the two goods
are, hence the greater the shift
in the demand curve for coke
when the price of pepsi
increases. Elaborate on the
value for goods with negative
CED
Tax incidence
Do you know
that the incidence
of taxes depend
on the relative
price elasticity of
demand and price
elasticity of
supply?
Subsidy to producers
Before subsidy:
Original equilibrium
price without subsidy
is OP2 and
equilibrium quantity
is OQ2
After subisdy: New
price paid by
consumers after
subsidy is OP1 and
equilibrium quantity
is OQ1. Price
received by producers
is OP1. Total subsidy
given by government
is P1P3 times OQ1
What is the
incidence of subsidy?
Consumers and Producers Surplus with Price Controls
Equity vs Efficiency
Q
e
Quantity
of X
Price ($)
P
e
Ss
Dd
P
min
Q
1
A
B
C
D
E
O
Minimum Price Original consumers surplus =
area (A + B + C).
New consumers surplus =
area A.
Consumers experience a loss of
area (B + C).
Original producers surplus
= area (D+ E).
New producers surplus
= area (B + D).
Producers experience a gain of
area B but a loss of area E.
The total change in surplus
= change in consumers surplus +
change in producers surplus
= (B + C) + (B E)
= (C + E).
Refer to pg 13
Consumers and Producers Surplus with Price Controls
Equity vs Efficiency
Maximum Price
Q
e Quantity
of drugs
Price ($)
P
e
Ss
Dd
P
max
Q
1
O
Original consumers surplus
= area (A + B).
New consumers surplus
= area (A + D).
Change in consumers surplus
= area (D B).
* Consumers can experience a net loss
or gain depending on the relative size
of area
B and D.
Original producers surplus
= area (C + D + E).
New producers surplus
= area E.
Producers experience a loss of area
(C + D).
The total change in surplus
= change in consumers surplus
+ change in producers surplus
= (D B) + ( )( C+ D)
= (B + C).
Pb
Refer to pg 13
Application to Labour Market : Wage Determination
Price of labour = Wage
Rate
Quantity of
Labour
0
Supply Supply
Demand Demand
W
e
Q
e
4
Why does the wage gap between high skilled and low skilled
workers exist?
Basics first:
Explain the POSITION of the demand curve RELATIVE to
the supply curve for each market
Refinements:
PED & PES for each market
WR
Q
LSL
WR
Q
HSL
0
Low skilled
labour e.g.
rubbish
collectors
High skilled labour
e.g. surgeons
0
W0
Q0
D
S
W1
Q1
D
S
0
P
L
Q
L
P
L
Q
L 0
Market for high
skilled labour
Market for low
skilled labour
d1 d3
s1
s3
W
1
Why has the wage gap been widening in
developed countries like Singapore?

Basics:

Shifts in demand and supply curves for labour in each

market

Refinements

Extent of shifts in demand/supply curves

s2
s4
d2
d4
W
2
W
3
W
4
Application to interest rate determination:
Loanable Funds Theory
The equilibrium
interest rate is
determined by
the supply and
demand for
loanable funds
Application to interest rate determination:
Liquidity Preference Theory
The equilibrium
interest rate is
determined by
the supply and
demand for
money
M/P
real money
balances
r
interest
rate
Md
r
1
M/P
How the Central Bank raises the interest rate
To increase r, the
central bank
reduces money
supply (money
supply is
assumed to be
determined by the
central bank)
M/P
real money
balances
r
interest
rate
Md
r
1
r
2
M1/P
M2/P
5
Cost curves Short-Run Cost
Total fixed cost is the
same at each output
level.
Total variable cost
increases as output
increases.
Total cost, which is the
sum of TFC and TVC also
increases as output
increases.
Cost Curves and Their Shapes
Quantity of Output
(bagels per hour)
Costs
$3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
0 1 4 3 2 7 6 5 9 8 14 13 12 11 10
ATC
AVC
AFC
Typical Cost Curves for a Firm
Quantity of Output
Costs
$3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
0 1 4 3 2 7 6 5 9 8 14 13 12 11 10
MC
ATC
AVC
U-Shaped Long-Run Average
Total Cost
Quantity of
Cars per Day
0
Average
Total
Cost
Internal Economies
of scale
Long run ATC
Internal Diseconomies
of scale
Constant
returns to
scale
Does the AC always rise as output increases?
Yes in the short run (SRAC comprises of AFC and
AVC. AFC falls throughout as output increases but
AVC falls then rises due to law of diminishing returns
(LDMR explains why MC and AVC curve are U-
shaped). Elaborate
However, in the long run, LRAC is subjected to internal
EOS and internal diseconomies of scale
In some industries, where IEOS are extremely significant,
LRAC falls throughout the entire market demand but in
others, LRAC rises quickly as diseconomies of scale sets in
early relative to market demand. There are some industries
where the LRAC curve is saucer-shaped. Are you able to
provide examples of industries that exhibit the following
shapes of LRAC?
6
Minimum Efficient Scale (MES)
Minimum efficient scale (MES) is the smallest
level of output at which a firm can minimise
long run average costs.
MES can be important in determining the
structure of an industry, e.g. where the MES
is:
large relative to the size of the market, the industry
will tend to be more concentrated;
small relative to the size of the market, the industry
will tend to be more competitive.
External Economies of Scale
Quantity of
Cars per Day
0
Average
Total
Cost
LRAC2
External
Economies of Scale
LRAC1
External Diseconomies of Scale
Quantity of
Cars per Day
0
Average
Total
Cost
LRAC1
External
Diseconomies of
Scale
LRAC2
Firms level of analysis /
Market structures
fig
O
P
e
S
D
The PC Industry The PC Firm
$
Output
O
Perfect competition
Total Revenue of a Firm in Perfect Competition
$
TR
O
Q
D = AR = MR
$
Output O
7
PC firm
Conditions for profit-maximisation
MR > MC MR > MC MC > MR
Profit-max
condition is
MC=MR and MC
curve cuts MR
from below
(rising MC)
fig
O
$
PC Firm
Output
O
PC Industry
P
Output
S
D
P
e
MC
AR
Q
e
AC
AC
Short-run equilibrium of industry and firm in perfect
competition
Short-run equilibrium of industry and firm in perfect
competition
D = AR = MR
fig
O O
P P
Q
S
1
D
LRAC
P
L
P
1
QL
S
e
AR
1
D
1
AR
L
D
L
Q
Long-run equilibrium in perfect competition Long-run equilibrium in perfect competition
New firms enter due
to lack of entry barriers
Supernormal profits
In the short run
Normal profits
in the LR
Industry Firm
MC
Q
1
LR Equilibrium
In the LR, the equilibrium for the PC firm
is at the output level where
In the LR, the firm is operating at its
minimum efficient scale at q*
p
LRAC
LRMC
MR =
AR
p*
q*
LRAC = LRMC = MR = AR
Firm in imperfect market
structure
Conditions for profit-maximisation: MC=MR
M
R
>

M
C
M
C
>

M
R
Supernormal profit
$
Q O
MC
AC
Q
m
AR
AC
AR
Monopoly making supernormal profits
MR
8
$
Q O
MC ( = supply in
perfect competition)
Q
M
MR
P
M
P
C
Q
C
Comparison of monopoly with perfect competition
D = AR
Deadweight Loss
$
Q O
MR
Q
M
P
M
P
C
Q
C
MC (S)
perfect competition
MC
monopoly
AR = D
Comparison of PC and Monopoly with significant IEOS Comparison of PC and Monopoly with significant IEOS
The less price elastic the demand
the greater the difference between
price and MC and hence, the
greater the allocative inefficiency
$ $
Quantity Quantity
AR
MR
MR
AR
MC MC
Q* Q*
P*
P*
P*-MC
The more elastic is
demand, the less the
markup.
Quantity
MR
q
B
D = AR MRPPD
Quantity
MR
q**
BB
0
First degree or perfect price discrimination (PPD)
Price
P**
E
MC
qPPD
Profit-max output
under PPD is qPPD
where MC=MRPPD;
No single price as
price varies along the
demand curve;
TR under PPD is
OECqPPD
Under a single-
priced
monopolist,
profit-max
output is q**
and price is P**.
TR is
OP**Bq**
Quantity
MR
q
ATC
A
B
D=MRPPD
Quantity
MR
**
ATC
AA
BB
0
Benefits of first degree or perfect price discrimination
makes it possible to cover costs when the average cost of
production is higher than the average revenue from selling the
good at all units of output
C
Price
P**
E
MC
qPPD
F
G
Second Degree P.D.
7
AR = Dd
Price
Qty
100 200 300
8
6
Additional revenue by the
monopoly = loss of
consumer surplus
MR
MC
9
fig
O O O
MR
X
MR
Y MR
T
MC
D=AR
Y
5
7
1000 2000 3000
(a) Market X (b) Market Y
(c) Total
(markets X + Y)
9
D=AR
X
Profit-maximising output under
third degree price discrimination
$
Q O
AC
MR
AR D
P
s
Q
s
MC
Short Run Equilibrium in Monopolistic Competition
$
Q O
LRAC
MR
L
AR
L
D
L
P
L
Q
L
LRMC
Long Run Equilibrium in Monopolistic Competition
Normal Profits in the LR for MPC firm
due to lack of barriers to entry
MPC LR Equilibrium
P
q
A
Price
Output
0
.
AR2
MR2
MC
ATC
AR1
MR1
MC = MR
MC = MR
Normal Profits in
the LR for MPC
firm due to lack of
barriers to entry
Assume existing
firm is making
supernormal
profits initially.
New firms will
enter in the long
run and existing
firms demand will
fall AR and MR
curves shift left
from AR1 to AR2
and MR1 to MR2
normal profits
only in the LR
$
Q O
LRAC
MR
L
AR
L
D
L
P
L
Q
L
LRMC
Long Run Equilibrium in Monopolistic Competition
Q
O
Excess
Capacity
$
Q O
P
1
Q
1
MC
2
MC
1
MR
D = AR
E.g. As long as MC varies between MC
1
and MC
2
but the profit maximising output
and price remain unaltered
Oligopoly- Kinked demand curve firms have a
tendency to avoid price competition
10
Relationship between
PED and MR and total
revenue
Quantity
MR
q
B
D=AR
Quantity
MR
q**
BB
0
Profit-max output level vs revenue max output level
Price
P**
E
MC
Q1
Total revenue
maximising
output level is
MR=0
Total revenue
maximising
output level is at
Q1 and price at
P1
Profit-max
output condition
is MC=MR and
MC is rising.
Profit-max
output level is
q** and price is
P**.
P1
Basic Conditions
Consumer Demand Production
Elasticity, substitutes Technology,
Location, seasonality etc. Scale
economies etc.
Structure
Numbers of buyers and sellers, barriers to entry, product
differentiation, vertical integration, diversification
Conduct
Advertising, R&D, pricing behaviour, plant investment, legal
tactics, product choice, collusion, merger and contracts
Performance
Price, production efficiency, allocative efficiency, equity, quality,
technical progress, profits
Government Policy
Regulation, antitrust,
barriers to entry, taxes
and subsidies,
investment incentives,
employment incentives,
macroeconomic policies
Source: Carlton &Perloff (2004)
STRUCTURE, CONDUCTAND PERFORMANCE
Market failure
Market Failure & Efficiency
Efficiency Concepts: Allocative Efficiency
An Example: Corn Industry under perfect competition
Societys total benefits =
Area OAEQ
Societys total costs =
Area OBEQ
Societys Net benefit is
maximised = Area AEB
Sum of CS and PS is
maximised.
Socially Optimal Outcome
Price
Quantity
SS = MSC
DD = MSB
P
Q 4 12
Figure 1: Market for Corn
A
E
B
20
10
5
P=MC, MSB = MSC
0
Page 8
Qd = Qs
A
E
E
1
Quantity
0
MPB = MSB
MPC

Q

R
MSC = MPC + MEC Costs/Benefits
Welfare Loss
to Society
Market Failure
Sources of Market Failure:
Negative
externalities
ignored due to
self-interest
motive
11
Methods by which governments
intervene
Usage of cars
Price of using cars
MPC
MSC = MPC + MEC
P
1
P
2
Figure 2: External Cost and the use of Taxation
Q
s
Q
1
P
3
A
E
C
B
MPB = MSB
MPC curve will reflect
the marginal private cost
derived from using the
car. MPC includes cost of
petrol, maintenance cost
etc.
MSC curve will reflect
both MPC & MEC of
using the car.
MEC includes costs of
pollution, congestion etc.
imposed on third parties
arising from usage of cars
MPC1 (MPC+specific tax) D
Page 4
After implementing quota
The producer surplus is
area EDO
This is because the
government receives
P2CDE in the form of
COE revenue from the
producer
2.3 Government Regulation & Legislation
Output Controls Licensing & Quotas
Methods by which governments
intervene
Refer to pg 12
P
0
DD
COE/quota
P
1
P
2
Q
1
Q
2
E
A
B
C
D
Quantity of new cars
SS
Methods by which governments
intervene
Government Subsidies
to Consumers
Taxes and Subsidies
Government Subsidies to
Producers
Figure 5
S
1
=
MPC
D
1
=
MPB
Q
P
Q
1
Q
2
D
2
=
MSB
S
2
= MPC
+ subsidy
H
G
F
P
2
P
1
P
3
Figure 4
MPC= MSC
MSB=MPB + MEB
= MPB + Direct Subsidy
MPB
Quanti
ty
P
Q
2
Q1 0
C
B
P
2
P
1
A P
3
Page 7
65
B
A
Quantity of big macs
Price
0
Dd1/perfect
info
Ss

Z
Welfare Loss
to Society
Dd0/imperfect info
Y

Positive Externalities: Page 12 of lecture notes

C
Overconsumption of demerit goods
due to lack of information and hence
resulting in underestimation of
personal costs and overestimation of
personal benefits (personal well-being
argument)
66
B
A
Quantity of health
screenings
Price
0
Dd0/imperfect
info
Ss

Y
Welfare Loss
to Society
Dd1/perfect info
Z

Positive Externalities: Page 12 of lecture notes

C
Underconsumption of merit
goods due to lack of
information and hence
resulting in underestimation
of personal benefits (personal
well-being argument)
12
Market Failure
Sources of Market Failure:
Imperfect
Competition
Page
18
2. Productive efficiency
p
LRAC
LRMC
MR =
AR
P1
Q
1
Price taking firm achieves
Productive Efficiency in the long
run
This is because
P=AR=MR (price taker) &
MR=MC (profit-max at q1) &
Normal profits in LR only
Output produced at MES
since perfectly elastic demand
curve tangent to lowest point on
LRAC curve
Market Failure
Sources of Market Failure:
Imperfect
Competition
Page
18
2. Productive Inefficiency
MR
AR
Price
Output
MES
Q2
LRAC
MC
This is because
P=AR>MR (price setter)
&
MR=MC (profit-max at
q2) &
Normal profits in LR
Output produced is
less than that at MES
since downward sloping
demand curve tangent to
falling portion of LRAC
curve
Market Failure
Sources of Market Failure:
Imperfect
Competition
Page
18
2. Productive Inefficiency
P
Q3
A
Price
Output
0
AR
MR
MC
LRAC
MES
This is because
P=AR>MR (price setter) &
MR=MC (profit-max at Q3)
Supernormal profits in LR
Output produced is less
than that at MES
Monopoly/Oligopoly
making supernormal profit
in the long run is
productively inefficient
Market Failure
Sources of Market Failure:
Imperfect
Competition
Page
18
2. Productive efficiency
P
q
A
Price
Output
0
AR
MR
MC
LRAC
MES
This is because
P=AR>MR (price setter) &
MR=MC (profit-max at q)
Supernormal profits in LR
Output produced
coincides with output at
MES
2
1
Q1 Q
$
AC
AC + lump-sum tax
MC = MSC
O
a
b
Methods by which governments
intervene
This will cause profits
to fall from Area 1+2
to Area 1 alone.
P1
AC
Area 2 represents the
amount of tax paid to
the government.
2.1.3 Taxes & Subsidies to correct for Monopoly Power :
Objective - To reduce excessive monopoly profit
Page 8
Methods by which governments
intervene
Q
$
MC =
MPC
AR = MSB MR
MC - subsidy
Q
2
P
2
Q
1
P
1
Figure 7
To produce at societys
optimal level of output,
the government can
impose a per-unit
subsidy which shifts
both MC and AC
downwards.
2.1.3 Taxes & Subsidies to correct for Monopoly Power :
Objective - To regulate monopoly output
Page 9
13
2.3. Government Regulation & Legislation Monopoly
Methods by which governments
intervene
2.3.2 Pricing Regulation (MC or AC Pricing)
Refer to pg 11
Profit-maximising output
level is at Oqm and price
is at OPm where MC=MR
Average cost pricing (AC
pricing) output level is at
Oqf and price is at Opf
(AR=AC)
Marginal cost pricing
(MC pricing) output level
is at Oqs and price is at
Ops (AR=MC)
PPC
Opportunity cost
Attainable vs
unattainable production
Productive efficiency
Unemployment vs full
employment
Do you know what are
the assumptions of the
PPC?
Do you know how to use
the following concepts to
explain the PPC
Opportunity cost
Attainable vs
unattainable
production
Productive efficiency
Unemployment vs full
employment
Macroeconomic diagrams
Macroeconomic diagrams
14
Circular flow in a 4 sector economy
Use AD/AS model if the question
focuses on effects of the economy in
general and/or if the question focuses
on inflation
Use Y=AE model if the
question focuses on multiplier
and impact changes in
autonomous spending on NY
only
AD0
Y
0
P0
AS Increase in aggregate
demand leads to rightward
shifts of AD curve
elaborate
General
AS3
Increase in cost of production leads to upward shift of AS curve
elaborate
Potential growth as reflected by outward shift of vertical portion of AS
curve increase in full employment level of national income
accompanied by fall in general price level from PL1 to PL increase
in potential growth and dampening of inflation
General price
level
Marginal efficiency of investment
Effectiveness
of a fall in
interest rates on
increasing the
level of
investment
depends on the
interest
elasticity of
MEI
15
Do you know
how to explain
the tariff
diagram?
Do you know
the assumptions
behind the tariff
diagram?
Tariff diagram
In the very short run,
when the Marshall-
Lerners condition is not
met (that is, when the sum
of PEDx and PEDm is less
than one), a depreciation of
the exchange rate will
worsen balance of trade
and hence current account
and in turn, BOP.
In the longer run, when
the Marshall-Lerners
condition is met, that is,
when the sum of PEDx and
PEDm is greater than one,
the depreciation of the ER
will eventually improve
BOT and hence current
account and in turn,
Balance of payments.
Trade-off between higher
growth and higher inflation
General price level
Real National Income
AS
Yf
AD0
P0
Y0
AD 1
Y1
P1
Assuming that the economy
is operating at less than full
employment, a shift in the
AD curve to AD1 as a result
of a change in any or all of
the factors affecting AD
would increase RNY from
Y0 to Y1 accompanied by
an increase in GPL from P0
to P1. Hence, actual growth
will be achieved and
unemployment reduced but
at a cost of higher inflation
(a trade-off between macro
objectives).
Using AD/AS model to
explain why RNY increases
when AD increases
General
price
level
Real National Income
AS
Yf
AD0
P0
Y0
The increase in AD from AD0 to AD1 will
cause a shortage at the initial GPL P0.
The shortage will cause an upward
pressure on the GPL. Since each AS
curve is drawn for a given cost of
production (COP) and assuming no
change in COP, the increase in GPL will
increase the profit margin for
producers. Producers will then have the
incentive to step up on production. The
increase in production will increase RNY
from Y0 to Y1. This means that when
GPL increases, there be a movement
along AS curve. There will also be a
movement along AD1 curve when GPL
increases and this is in part due to
income effect. When GPL increases
real purchasing power of households
falls and ability to consume falls, hence
the movement along AD1 curve as GPL
increases. (Note the movement along AD is
also due to international trade and interest
rate effect but this is not required at H2.)
AD 1
Y1
P1
Be prepared
Please be prepared for
cross-topical questions
Please also be
prepared for questions
that combine both
microeconomic and
macroeconomic issues
All the best!