Professional Documents
Culture Documents
Basic
Definitions
Social
Science
and
Economics
Social
Science
is
defined
as
a
branch
of
science
that
studies
the
society
and
human
behavior
in
it,
including
anthropology,
communication
studies,
criminology,
economics,
geography,
history,
political
science,
psychology,
social
studies,
and
sociology.
Economics
is
the
branch
of
social
science
that
deals
with
the
production
and
distribution
and
consumption
of
goods
and
services
and
their
management.
It
is
the
study
of
how
scarce
resources
are
allocated
to
fulfil
unlimited
wants.
Microeconomics
and
Macroeconomics
Economics
is
usually
divided
into
two
main
branches:
Microeconomics,
which
examines
the
economic
behaviour
of
individual
actors
such
as
businesses,
households,
and
individuals,
with
a
view
to
understand
decision
making
in
the
face
of
scarcity
and
the
allocation
consequences
of
these
decisions.
Macroeconomics,
which
examines
an
economy
as
a
whole
with
a
view
to
understanding
the
interaction
between
economic
aggregates
such
as
national
income,
employment
and
inflation.
Economic
growth
is
the
increase
of
per
capita
gross
domestic
product
(GDP)
or
other
measure
of
aggregate
income.
It
is
often
measured
as
the
rate
of
change
in
GDP.
Economic
growth
refers
only
to
the
quantity
of
goods
and
services
produced.
Economic
development
typically
involves
improvements
in
a
variety
of
indicators
such
as
literacy
rates,
life
expectancy,
and
poverty
rates.
It
is
a
measure
of
welfare
in
the
economy.
Human
Development
Index
(HDI)
is
one
of
the
most
commonly
used
development
measure.
Sustainable
development
is
a
pattern
of
resource
use
that
aims
to
meet
human
needs
while
preserving
the
environment
so
that
these
needs
can
be
met
not
only
in
the
present,
but
also
for
future
generations.
Economic
development
that
meets
the
needs
of
the
present
without
compromising
the
ability
of
future
generations
to
meet
their
own
needs.
Free
Goods
and
Economics
Goods
Free
goods
are
what
is
needed
by
the
society
and
is
available
without
limits.
The
free
good
is
a
term
used
in
economics
to
describe
a
good
that
is
not
scarce.
A
free
good
is
available
in
as
great
a
quantity
as
desired
with
zero
opportunity
cost
to
society.
Economics
goods
are
consumable
item
that
is
useful
to
people
but
scarce
in
relation
to
its
demand,
so
that
human
effort
is
required
to
obtain
it.
4
Factors
Examples
Papa
Johns
Pizza
Land:
Retail
Locations/Kitchens/Stores
Labor:
Hourly
and
Salaried
Workers,
per
diem
delivery
drivers.
Capital:
Ovens,
Boxes,
Utensils
(pans,
spatulas,
etc.),
Point
of
Sales
equipment,
Ingredients,
etc.
Entrepreneur:
Papa
John
Schnatter,
Founder
CEO
Coca-Cola
Softdrinks
Land:
Factories,
Bottling
Plants,
Floor
Space
at
the
Retail
Market
Labor:
Hourly
and
Salaried
Workers
Capital:
Ingredients,
Bottling
Supplies
(Aluminum
&
Plastic),
Packaging,
Delivery
Vehicles,
etc.
Entrepreneur:
John
Pemberton,
Founder.
Today;
CEO
and
Board
of
Directors
3
Basic
Questions
Examples
What
to
produce:
Automobiles;
SUVs,
sports
cars,
sedans,
coupes?
How
to
Produce:
Factory,
USA
or
Overseas?
Union
or
Non-Union
For
Whom
to
Produce:
How
expensive
do
you
make
the
vehicle?
Chevrolet,
Buick
or
Cadillac
What
to
produce:
TAG
Heuer;
Timepieces
How
to
Produce:
Factory
and
handmade,
Switzerland
For
Whom
to
Produce:
sports,
casual
and
dress
watches
and
customers
What
to
produce:
New
Era
Hats
How
to
Produce:
Factory,
USA
or
Overseas?
Union
or
Non-Union
For
Whom
to
Produce:
MLB
Hats,
NFL
Hats,
NBA
Hats,
NHL
Hats,
Casual
Hats,
Comic
Hats
Section
1:
Microeconomics
1.1
Competitive
markets:
demand
and
supply
(some
topics
HL
only)
1.2
Elasticity
1.3
Government
intervention
(some
topics
HL
extension,
plus
one
topic
HL
only)
1.4
Market
failure
(some
topics
HL
only)
1.5
Theory
of
the
firm
and
market
structures
(HL
only)
The
purpose
of
this
section
is
to
identify
and
explain
the
importance
of
markets
and
the
role
played
by
demand
and
supply.
The
roles
played
by
consumers,
producers
and
the
government
in
different
market
structures
are
highlighted.
The
failures
of
a
market
system
are
identified
and
possible
solutions
are
examined.
The
concepts
learned
here
have
links
with
other
areas
of
the
economics
syllabus;
for
example,
elasticity
has
many
applications
in
different
areas
of
international
trade
and
development.
What
is
Market
Market
is
a
place
where
buyers
and
sellers
meet.
In
economics,
the
concept
of
a
market
is
any
structure
that
allows
buyers
and
sellers
to
exchange
any
type
of
goods,
services
and
information.
The
exchange
of
goods
or
services
for
money
is
a
transaction.
Features
of
a
market
Market
participants
consist
of
all
the
buyers
and
sellers
of
a
good
who
influence
its
price.
There
are
two
roles
in
markets,
buyers
and
sellers.
The
market
facilitates
trade
and
enables
the
distribution
and
allocation
of
resources
in
a
society.
Markets
allow
any
tradable
item
to
be
evaluated
and
priced.
A
market
emerges
spontaneously
or
is
constructed
deliberately
by
human
interaction
in
order
to
facilitate
the
exchange
of
goods
and
services
What
is
demand?
Demand
is
defined
as
want
or
willingness
of
consumers
to
buy
goods
and
services.
In
economics
willingness
to
buy
goods
and
services
should
be
accompanied
by
the
ability
to
buy
(purchasing
power)
and
is
referred
to
as
effective
demand.
Law
of
demand
The
law
of
demand
is
an
economic
law
that
states
that
consumers
buy
more
of
a
good
when
its
price
decreases
and
less
when
its
price
increases,
ceteris
paribus.
It
states
that
when
price
increases,
the
amount
demanded
will
fall
and
when
prices
fall,
the
amount
demanded
will
rise.
Rationale
of
the
law
of
demand
There
are
two
reasons
for
a
fall
in
demand
when
the
prices
increase.
Income
effect:
People
feel
poorer.
As
the
price
of
a
good
rises
the
purchasing
power
of
people
to
buy
that
good
will
fall.
This
is
known
as
income
effect.
Substitution
effect:
Some
people
might
shift
to
cheaper
alternatives/substitutes
once
the
price
of
a
good
rise,
thus
leading
to
a
fall
in
demand
for
that
good.
Shift
in
the
demand
curve
Usually
demand
curves
are
drawn
based
on
the
assumption
except
for
price
all
other
factors
remain
the
same.
But
there
might
be
instances
when
demand
may
be
affected
by
factors
other
than
price.
This
will
result
in
the
change
in
demand
although
the
price
will
remain
the
same.
This
change
in
demand
may
cause
the
demand
curve
to
SHIFT
inwards
or
outwards.
Shift
of
demand
curve
OUTWARDS
shows
an
increase
in
demand
at
the
same
price
level.
It
is
known
as
INCREASE
IN
DEMAND.
Shift
of
demand
curve
INWARDS
shows
that
less
is
demanded
at
the
same
price
level.
It
is
known
as
a
FALL
IN
DEMAND.
Factors
affecting
demand
Change
in
peoples
income:
More
the
people
earn
the
more
they
will
spend
and
thus
the
demand
will
rise.
A
fall
in
income
will
see
a
fall
in
demand.
Changes
in
population:
An
increase
in
population
will
result
in
a
rise
in
demand
and
vice
versa.
Change
in
fashion
and
taste:
Commodities
or
which
the
fashion
is
out
are
less
in
demand
as
compared
to
commodities
which
are
in
fashion.
In
the
same
way,
change
in
taste
of
people
affects
the
demand
of
a
commodity.
Changes
in
Income
Tax:
An
increase
in
income
tax
will
see
a
fall
in
demand
as
people
will
have
less
money
left
in
their
pockets
to
spend
whereas
a
decrease
in
income
tax
will
result
in
increase
of
demand
for
products
and
services
because
people
now
have
more
disposable
income.
Change
in
prices
of
Substitute
goods:
Substitute
goods
or
services
are
those
which
can
replace
the
want
of
another
good
or
service.
For
example
margarine
is
a
substitute
for
butter.
Thus
a
rise
in
butter
prices
will
see
a
rise
in
demand
for
margarine
and
vice
versa.
Change
in
price
of
Complementary
goods:
Complementary
goods
or
services
are
demanded
along
with
other
goods
and
services
or
jointly
demanded
with
other
goods
or
services.
Demand
for
cars
is
affected
the
change
in
price
of
petrol.
Same
way,
demand
for
DVD
players
will
rise
if
the
prices
of
DVDs
fall.
Advertising:
A
successful
advertising
campaign
may
affect
the
demand
for
a
product
or
service.
Climate:
Changes
in
climate
affects
the
demand
for
certain
goods
and
services.
Interest
rates:
A
fall
in
Interest
rate
will
see
a
rise
in
demand
for
goods
and
services.
What
is
Supply?
Supply
refers
to
the
amount
of
goods
and
services
firms
or
producers
are
willing
and
able
to
sell
in
the
market
at
a
possible
price,
at
a
particular
point
of
time.
Law
of
Supply
It
states
that
when
the
price
of
a
commodity
rises,
the
supply
for
it
also
increases.
The
higher
the
price
for
the
good
or
service
the
more
it
will
be
supplied
in
the
market.
The
reason
behind
it
is
that
more
and
more
suppliers
will
be
interested
in
supplying
those
good
or
service
whose
prices
are
rising.
In
this
diagram
the
equilibrium
price
is
P*
and
the
quantity
supplied
Qe.
However,
the
prices
have
been
increased
to
P2.
As
the
price
has
increased
it
will
lead
to
more
suppliers
entering
the
market
and
supply
increasing
to
Qs.
At
the
same
time,
a
increase
in
price
to
P1
will
lead
to
a
fall
in
demand
(as
per
the
law
of
demand)
i.e.
Qd.
This
will
create
an
excess
supply
situation.
Now
the
suppliers
will
find
it
difficult
to
sell
their
goods
and
they
will
have
to
reduce
their
price
to
attract
more
consumers.
This
will
go
on
till
the
price
again
reaches
its
initial
level
i.e.
P*.
Hence
the
situation
is
self
righting
if
the
prices
are
raised
without
any
external
reason.
Similarly,
in
the
figure
below
We
can
see
that
the
prices
have
been
artificially
reduced
from
P*
to
P1.
This
leads
to
a
fall
in
supply
from
Q*
to
Qs
(as
per
law
of
supply).
As
the
prices
fall
from
P*
to
P1,
people
can
afford
to
buy
more
of
that
good
and
demand
increase
from
Q*
to
Qd.
Again
an
excess
demand
situation
is
created.
In
order
to
get
the
most
out
of
this
situation
the
suppliers
will
start
increasing
their
price.
On
the
other
hand
demand
will
start
falling
as
the
prices
increase.
This
will
all
continue
till
the
prices
settle
at
equilibrium
price
i.e.
Pe.
Hence
we
can
say
that
equilibrium
is
self-righting
Movement
to
a
new
equilibrium
The
equilibrium
price
remains
unchanged
till
the
demand
and
supply
curves
retain
their
position.
The
moment
there
is
a
shift
in
any
of
the
components,
a
new
equilibrium
will
be
formed.
Supply
Equilibrium price
Equilibrium quantity
Increase
Decrease
Unchanged
Unchanged
Unchanged
Unchanged
Increase
Decrease
Rise
Fall
Rise
Rise
Rise
Fall
Rise
Fall
If
there
is
a
shift
in
demand,
it
will
lead
to
a
movement
along
the
supply
curve
and
a
new
equilibrium
point
will
be
achieved.
In
figure
1,
There
is
equilibrium
at
point
E,
where
the
price
is
Pe
and
quantity
supplied
is
Qe.
There
is
a
shift
in
demand
from
D1
to
D2.
At
price
Pe,
it
will
lead
to
a
'excess
demand'
situation
(F).
In
order
to
cope
with
excess
demand
the
suppliers
will
start
increasing
the
price
and
more
will
be
supplied.
On
the
other
hand
as
the
prices
increase,
demand
will
start
to
fall.
This
phenomenon
will
continue
till
a
new
equilibrium
stage
is
reached
at
point
G.
Now
the
Price
will
be
P1
and
quantity
supplied
at
that
point
will
be
Qe1.
Hence
it
has
resulted
in
an
increase
in
price
and
quantity
demanded.
The
opposite
will
happen
if
there
is
a
shift
of
demand
curve
to
the
left.
The
price
and
quantity
demand
will
fall.
In
figure
2,
the
equilibrium
point
is
E
with
Pe
as
the
equilibrium
price
and
Qe
as
the
quantity
demanded.
Now
there
is
a
rightward
shift
in
supply
curve
to
S2
i.e.
supply
increases.
This
will
lead
to
a
excess
supply.
Producers
will
find
it
difficult
to
find
consumers
and
will
have
to
reduce
their
prices
to
clear
their
inventories.
As
the
prices
fall,
more
people
will
be
interested
in
buying
the
product.
This
will
continue
till
equilibrium
is
achieved
at
G.
There
will
a
price
fall
from
Pe
to
Pe1
and
Qe
to
Qe1.
The
result
is
lower
equilibrium
price
and
lower
equilibrium
quantity.
Price
Elasticity
of
demand
The
responsiveness
of
quantity
demanded,
or
how
much
quantity
demanded
changes,
given
a
change
in
the
price
of
goods
or
service
is
known
as
the
price
elasticity
of
demand.
Negative
sign
The
mathematical
value
which
is
derived
from
the
calculation
is
negative.
A
negative
value
indicates
an
inverse
relationship
between
price
and
the
quantity
demanded.
However,
the
negative
sign
is
ignored.
Range
of
PED
The
value
of
PED
might
range
from
0
to
?
Lets
take
a
look
at
various
types
of
PED.
Perfectly
Inelastic
demand
In
this
case
the
PED
=0
That
means,
any
change
in
price
will
not
have
any
effect
on
the
demand
of
the
product.
Or
in
other
words,
the
percentage
change
in
demand
will
be
equal
to
zero.
It
is
hypothetical
situation
and
does
not
exist
in
real
world.
Perfectly
elastic
demand
In
this
case
the
PED
=?
The
demand
changes
infinitely
at
a
particular
price.
Any
change
in
price
will
lead
to
fall
of
demand
to
zero.
It
is
hypothetical
situation
and
does
not
exist
in
real
world.
However
Normal
goods
have
value
of
PED
between
0
and
?.
These
can
be
classified
as
Inelastic
demand
When
a
product
has
a
PED
less
than
1
and
greater
than
0,
it
is
said
to
be
have
an
inelastic
demand.
The
percentage
change
in
demand
is
less
than
the
percentage
change
in
price
of
the
product.
Demand
for
a
product
is
said
to
be
ELASTIC
if
the
percentage
change
is
demand
is
more
than
the
percentage
change
in
price.
The
value
of
PED
is
more
than
1.
When
there
is
a
smaller
percentage
change
in
quantity
demanded
as
compared
to
the
percentage
change
in
its
price,
the
product
is
said
to
price
INELASTIC.
The
value
of
PED
is
less
than
1.
Applications
of
Price
Elasticity
of
Demand
Examine
the
role
of
PED
for
firms
in
making
decisions
regarding
price
changes
and
their
effect
on
total
revenue.
Firms
give
a
lot
of
importance
to
PED
while
setting
prices
for
their
products.
A
firm
will
be
more
willing
to
increase
the
price
of
a
product,
which
has
a
more
inelastic
demand
because
it
will
lead
to
an
overall
increase
in
their
revenue.
With
an
increase
in
price
of
the
product,
the
demand
will
not
fall
in
the
same
proportion
and
this
end
up
in
more
revenue
for
the
firm.
On
the
other
hand
a
firm
seeking
to
increase
its
revenue
and
having
elastic
demand
for
its
product
should
not
increase
its
prices
because
it
will
lead
to
a
fall
in
their
revenue.
As
the
price
increase
there
will
be
a
more
than
proportionate
fall
in
sales,
thus
pulling
down
the
overall
revenue
of
the
firm.
Explain
why
the
PED
for
many
primary
commodities
is
relatively
low
and
the
PED
for
manufactured
products
is
relatively
high.
The
PED
for
primary
commodities
is
relatively
low
due
to
the
fact
that
they
have
very
few
substitutes
whereas
manufactured
products
have
a
relatively
high
PED
because
of
the
existence
of
many
substitutes.
For
example,
the
PED
for
cow
leather
(primary
commodity)
is
relatively
lower
than
a
genuine
cow
leather
shoe
(manufactured
product).
The
reason
being
there
is
no
or
very
few
substitutes
for
leather
as
a
raw
material
for
producing
shoes.
However,
leather
shoe
may
have
many
substitutes
in
the
form
of
sheep
leather
and
other
types
of
artificial
leather
shoes
available
in
the
market.
Examine
the
significance
of
PED
for
government
in
relation
to
indirect
taxes.
PED
hold
a
lot
of
significance
for
government
while
deciding
indirect
taxes
on
goods
and
services.
Government
uses
taxes
to
reduce
the
use
of
demerit
goods
in
the
economy.
For
example
they
might
increase
taxes
on
cigarettes.
Cigarettes
are
habit
forming
or
addictive
and
have
inelastic
demand,
thus,
even
a
high
increase
in
indirect
taxes
will
not
lead
to
a
fall
in
the
consumption
of
cigarette
smoking.
Thus
overall
revenue
of
government
will
increase
without
drastically
harming
the
cigarette
manufacturing
industry
and
employment.
Moreover,
it
might
lead
to
some
fall
in
cigarette
consumption
due
to
increased
prices.
Cross
price
elasticity
of
demand
(XED)
Cross
elasticity
of
demand
is
the
effect
on
the
change
in
demand
of
one
good
as
a
result
of
a
change
in
price
of
related
to
another
product.
In
economics,
it
is
denoted
by
the
symbol
XED.
The
formula
for
cross
elasticity
of
demand
is
In
XED
it
is
important
to
have
the
positive/negative
sign
in
front
of
the
value.
If
the
value
of
XED
is
positive,
this
means
that
the
two
goods
being
considered
are
substitute
goods.
Close
substitutes
have
high
positive
value.
Example:
butter
and
margarine.
If
two
goods
are
complements,
an
increase
in
the
price
of
one
will
lead
to
a
reduction
in
the
demand
for
the
otherthe
XED
is
negative.
Very
close
complements
have
a
lower
negative
value.
If
two
goods
are
unrelated,
a
change
in
the
price
of
one
will
not
affect
the
demand
for
the
other
the
XED
is
zero.
The
Income
Elasticity
of
Demand
(YED)
measures
the
rate
of
response
of
quantity
demand
due
to
a
raise
(or
lowering)
in
a
consumers
income.
Normal
goods:
an
increase
in
income
leads
to
an
increase
in
consumption,
demand
shifts
to
the
right.
Thus
YED
is
positive
for
normal
goods.
Inferior
goods:
Income
elasticity
is
actually
negative
for
inferior
goods,
the
demand
curve
shifts
left
as
income
rises.
As
income
rises,
the
proportion
spent
on
cheap
goods
will
reduce
as
now
they
can
afford
to
buy
more
expensive
goods.
For
example
demand
for
cheap/generic
electronic
goods
will
fall
as
people
income
rises
and
they
will
switch
to
expensive
branded
electronic
goods.
Distinguish,
with
reference
to
YED,
between
necessity
(income
inelastic)
goods
and
luxury
(income
elastic)
goods.
Basic
or
necessity
goods
have
a
low
income
elasticity
i.e.,
0
<
?
<
1.
Quantity
demanded
will
not
increase
much
as
income
increases
(income
elasticity
for
food
=
0.2)
Luxury
goods
have
high
income
elasticity
i.e.
?
>
1.
Quantity
demanded
rises
faster
than
income.
For
restaurant
meals
income
elasticity
is
higher
than
for
food,
because
of
the
additional
restaurant
service.
In
different
types
of
economies,
the
demand
for
goods
and
services
are
determined
by
the
income
elasticity.
As
economies
grow,
firms
will
want
to
avoid
producing
inferior
goods.
The
reason
being
as
income
increases
more
and
more
people
will
switch
from
inferior
goods
to
superior
goods.
Elasticity
=
0:
if
the
supply
curve
is
vertical,
and
there
is
no
response
to
prices.
Elasticity
=
?:
if
the
supply
curve
is
horizontal.
Supply
is
price
elastic
if
the
price
elasticity
of
supply
is
greater
than
1,
unit
price
elastic
if
it
is
equal
to
1,
and
price
inelastic
if
it
is
less
than
1.
Supply
is
Price
Elastic
when
the
percentage
change
in
quantity
supplied
is
more
than
the
percentage
change
in
Price
of
the
commodity.
PES
is
more
than
1.
Supply
is
Price
Inelastic
when
the
percentage
change
in
quantity
supplied
is
less
than
the
percentage
change
in
Price
of
the
comoditity.
PES
is
less
than
1.
Perfectly
price
elasticity
of
supply
Infinite
price
elasticity
of
Supply
Price
Elasticity
of
Supply
Price
elasticity
of
supply
is
a
measure
of
the
responsiveness
of
quantity
to
a
change
in
price.
In
other
words,
it
the
percentage
change
in
supply
as
compared
to
the
percentage
change
in
price
of
a
commodity.
Factors
affecting
Price
Elasticity
of
Supply
Time:
In
the
short
run
firms
will
only
be
able
to
increase
input
of
labor
to
increase
supply
of
commodities
may
not
be
able
to
increase
the
supply
in
response
to
the
price
change
but
the
supply
change
will
be
little
because
other
factors
of
production
may
not
be
increased
in
the
same
proportion
and
may
limit
the
supply.
However,
in
the
long
run
a
firm
will
increase
the
input
of
all
factors
of
production
and
thus
the
supply
becomes
more
price
elastic.
Availability
of
resources:
If
the
economy
already
using
most
of
its
scarce
resources
then
firms
will
find
it
difficult
to
employ
more
and
so
output
will
not
be
able
to
rise.
The
supply
of
most
of
goods
and
services
will
therefore
be
price
inelastic.
Number
of
producers:
More
producers
mean
that
the
output
can
be
increased
more
easily.
Thus
supply
is
more
elastic.
Ease
of
storing
stocks:
If
goods
can
be
stocked
with
ease
and
have
a
long
shelf
life,
the
supply
will
be
elastic,
otherwise
inelastic.
For
example
perishable
goods
such
as
fresh
flowers,
vegetables
have
comparatively
inelastic
supply
because
it
is
difficult
to
store
them
for
longer
periods.
Increase
in
cost
of
production
as
compared
to
output:
In
cases
where
there
is
a
significant
increase
in
cost
of
production
when
output
is
increased,
supply
is
inelastic.
This
is
because
suppliers
will
have
to
have
to
do
a
significant
investment
in
order
to
increase
the
output.
It
will
take
time
and
some
suppliers
may
be
hesitant
in
doing
so.
Improvement
in
Technology:
In
industries
where
there
is
a
rapid
improvement
in
technology,
the
PES
of
such
goods
will
be
more
elastic
as
compared
to
industries
where
there
is
not
much
improvement
in
technology.
Stock
of
finished
goods:
In
industries
where
there
are
high
inventories/stocks
of
finished
goods,
the
suppliers
can
easily
supply
more
as
the
price
rises.
Thus,
the
PES
for
these
goods
will
be
elastic.
Consumer
Surplus
Consumer
surplus
measures
the
difference
between
total
benefit
of
consuming
a
given
quantity
of
output
and
the
total
expenditures
consumers
pay
to
obtain
that
quantity.
the
shaded
area
OCDE;
total
expenditures
are
given
by
the
rectangle
OBDE.
The
difference,
shown
by
the
triangle
BCD,
is
consumer
surplus.
Producer
Surplus
Producer
surplus
can
be
defined
as
The
difference
between
the
amount
that
a
producer
of
a
good
receives
and
the
minimum
amount
that
he
or
she
would
be
willing
to
accept
for
the
good.
The
difference,
or
surplus
amount,
is
the
benefit
that
the
producer
receives
for
selling
the
good
in
the
market.
Producers'
surplus
exists
when
actual
price
exceeds
the
minimum
price
sellers
will
accept.
Here,
total
revenue
is
given
by
the
rectangle
OBDE,
and
total
costs
are
given
by
the
area
OADE.
The
difference,
shown
by
the
triangle
ABD
is
producer
surplus.
Community
Surplus
is
the
welfare
of
society
and
it
is
made
up
of
a
consumer
surplus
plus
a
producer
surplus.
It
exists
when
it
is
impossible
to
make
someone
better
off
without
making
someone
else
worse
off.
When
the
consumer
surplus
is
equal
to
producer
surplus
It
exists
when
the
market
is
in
equilibrium,
with
no
external
influences
and
no
external
effects.
Market
is
said
to
be
socially
efficient
and
community
surplus
is
at
its
maximum.
Allocative
Efficiency
Allocative
efficiency
is
when
resources
are
allocated
in
the
most
efficient
way
from
society's
point
of
view.
In
other
words
the
market
is
said
to
be
socially
efficient.
Allocative
efficiency
exisists
where
Community
Surplus
(consumer
surplus
and
producer
surplus)
is
maximized.
At
equilibrium
where
demand
is
equal
to
suppy,
community
surplus
is
maximised.
Indirect
taxes
An
indirect
tax
is
a
tax
collected
by
an
intermediary
i.e.
seller,
from
the
person
who
bears
the
ultimate
economic
burden
of
the
tax
i.e.
consumer.
It
is
imposed
on
expenditure.
In
simple
terms,
it
is
a
tax
which
is
imposed
on
goods
and
services
sold.
It
is
usually
added
to
the
cost
of
the
good
or
service
and
charged
from
the
ultimate
consumer.
The
seller
will
then
file
a
return
to
the
government
on
all
the
taxes
he
has
collected
from
the
consumer.
Examples
are
sales
tax
and
excise
duty
Reasons
for
imposing
taxes
The
main
reasons
for
government
imposing
taxes
can
be
To
generate
Government
revenues:
excise
duties
on
beers,
wines
and
spirits
are
price
inelastic
in
demand,
so
tax
price
increases
by
levying
specific
alcohol
and
tobacco
taxes
raise
consumer
expenditures
as
a
whole
on
these
categories
and
therefore
taxation
revenues;
To
discourage
consumption:
Government
might
use
taxes
to
discourage
consumption
of
certain
demerit
goods
such
as
cigarettes.
To
alter
the
pattern
of
consumption:
Government
might
use
direct
taxes
a
a
mean
to
alter
the
consumption
patter
of
its
population.
Certain
goods
can
be
made
more
price
attractive
through
lower
taxes
while
goods
which
have
high
marginal
social
cost
can
be
made
expensive
through
taxation.
Distinction
between
specific
and
ad
valorem
taxes
Specific
tax
is
a
flat
rate
of
tax
whereas
ad
valorem
tax
is
a
percentage
tax.
Ad
valorem
literally
the
term
means
according
to
value.
It
is
imposed
on
the
basis
of
the
monetary
value
of
the
taxed
item.
A
specific
tax
is
when
specific
amount
is
imposed
upon
a
good,
for
example
$10
on
each
mobile
phone
sold;
whereas
ad
valorem
tax
is
expressed
as
a
percentage
of
the
selling
price
e.g.
12%
of
the
sales.
The
amount
of
specific
tax
changes
in
the
same
proportion
as
the
quantity
sold
increase,
whereas,
in
ad
valorem
the
tax
collected
is
more
at
higher
prices
then
at
lower
prices.
Consequences
of
imposing
indirect
tax
Imposition
of
tax
results
in
three
economic
observations.
Incidence:
Incidence
of
tax
means
the
party
who
actually
pays
the
tax.
Government
revenue:
the
amount
of
tax
government
will
receive
as
revenue
Resource
allocation:
the
amount
of
fall
in
quantity
demanded
and
produced
created
by
the
tax.
If
the
tax
does
not
change
the
products
price
or
factor
prices,
the
burden
falls
on
the
owner
of
the
firmthe
owner
of
capital.
If
prices
adjust
by
a
fraction
of
the
tax,
the
burden
is
shared.
The
incidence
of
tax
will
be
shared
between
the
consumers
and
producers,
depending
on
the
price
elasticity
of
demand
(PED)
for
that
product
(which
we
will
discuss
later).
If
we
assume
that
the
burden
is
equally
shared
by
both
the
consumers
and
the
producers
then
the
size
of
square
CYZPe
is
equal
to
PeZXP1.
This
means
the
incidence
of
tax
is
equally
distributed
by
both
the
consumer
and
producer.
Government
revenue
Putting
taxes
on
goods
and
services
generates
revenue
for
the
government.
Figure
below
shows
the
shaded
region
as
tax
revenue
for
government
i.e.
CYXP1.
The
implication
will
be
a
fall
in
output
from
Qe
to
Q1
and
thus
the
consumption
and
production
of
the
commodity
will
fall.
Tax
incidence
and
price
elasticity
of
demand
and
supply
Incidence
of
indirect
taxes
on
consumers
and
firms
differs,
depending
on
the
price
elasticity
of
demand
and
on
the
price
elasticity
of
supply.
Lets
study
individual
cases.
Scenario
1:
When
PED
is
greater
than
PES
Where
PED
is
greater
than
PES,
it
implies
that
consumers
are
more
sensitive
to
price
changes
as
compared
to
suppliers.
Thus
the
incidence
of
tax
will
be
more
on
the
suppliers
because
if
too
much
burden
of
tax
is
passed
on
to
the
consumers
then
the
demand
will
fall
drastically.
Therefore,
this
time
the
price
paid
by
buyers
barely
rises;
sellers
bear
most
of
the
burden
of
the
tax.
Scenario
3
:
PED
is
equal
to
PES
In
this
case
both
the
producer
and
consumer
will
share
equal
burden
of
tax.
What
are
subsidies?
A
subsidy
is
a
form
of
financial
assistance
paid
by
the
government
to
a
business
or
economic
sector.
Why
subsidies
are
given?
Subsidies
might
be
given
to
Lower
the
cost
of
necessary
goods
which
might
affects
a
major
part
of
population.
Example,
subsidies
given
to
essential
food
items
and
oil
(in
India).
Guarantee
the
supply
of
merit
goods,
which
the
government
thinks
consumers
should
consume.
Help
domestic
firms
become
more
competitive
in
the
international
market,
also
known
as
protectionism.
Effect
of
subsidy
Subsidy
reduces
the
cost
of
production.
Thus
the
supply
curve
for
the
product
shifts
vertically
downwards
by
the
amount
of
subsidy
provided.
Impact
of
subsidies
on
Producers
Subsidies
are
monetary
benefits
provided
to
the
producer
by
the
Government
on
account
of
production
of
certain
commodity.
Subsidies
lead
to
increase
in
producer
revenue.
Due
to
subsidy
the
supply
curve
(S-subsidy)
will
shift
vertically
downwards
by
the
amount
of
subsidy.
This
reduces
the
cost
of
production
and
more
is
now
being
supplied
at
every
price.
Through
the
diagram,
we
can
see,
initially
the
market
was
at
equilibrium
with
Qe
being
supplied
&
demanded
at
Price
(Pe).
Government
provides
subsidy
WZ
per
unit.
Producers
lower
their
prices
to
P1
Increase
output
till
a
new
equilibrium
is
reached
at
Q1
The
producer
will
however
not
pass
all
the
subsidy
benefit
to
the
consumer.
Initial
producer
revenue
was
OPeXQe
which
now
increases
to
ODWQ1.
Impact
of
subsidies
on
Government
Government
will
end
up
paying
a
subsidy
of
P1DWZ.
Obviously,
this
will
involve
an
opportunity
cost.
Government
will
have
to
forego
investments
in
other
sectors
of
the
economy
in
order
to
provide
subsidy.
At
the
end
of
the
day,
the
burden
usually
lies
on
the
taxpayer.
Scenario
2:
When
PED
is
inelastic
relative
to
PES
Consumption
of
the
product
is
increased
and
so
is
the
revenue
of
the
producer.
The
consumer
benefit
from
a
relatively
large
price
fall,
but
their
demand
is
relative
inelastic,
their
consumption
does
not
increase
by
a
great
amount.
For
the
price
that
the
ceiling
is
set
at,
there
is
more
demand
(Q2)
than
there
is
at
the
equilibrium
price.
There
is
also
less
supply
(Q1)
than
there
is
at
the
equilibrium
price,
thus
there
is
more
quantity
demanded
than
quantity
supplied
i.e.
shortage.
Impact
of
Price
ceiling
Inefficiency:
Inefficiency
occurs
since
at
the
price
ceiling
quantity
supplied
the
marginal
benefit
exceeds
the
marginal
cost.
This
inefficiency
is
equal
to
the
deadweight
welfare
loss.
Existence
of
black
market:
Due
to
demand
exceeding
the
supply,
there
will
be
buyers
who
will
be
willing
to
purchase
the
good
at
a
higher
price.
This
will
lead
to
existence
of
black
market.
How
can
government
correct
this
situation?
Subsidies
may
be
offered
to
the
firms
to
encourage
the
production
of
such
goods.
However
it
involves
an
opportunity
cost
to
the
government
as
they
might
have
to
divert
funds
from
other
activities.
Government
may
also
consider
the
option
of
producing
the
goods
by
themselves.
Government
may
also
release
previously
stored
inventory
of
such
goods
to
ensure
that
there
is
no
shortage
in
the
market,
however,
it
might
not
be
possible
for
all
the
goods,
for
example,
perishable
goods.
All
these
options
will
lead
to
the
shift
of
supply
curve
to
the
right
and
thus
forming
a
new
equilibrium
at
Pmax
Minimum
Prices
or
Price
Floor
A
minimum
allowable
price
set
above
the
equilibrium
price
is
a
price
floor.
With
a
price
floor,
the
government
forbids
a
price
below
the
minimum
Price
Floors
are
minimum
prices
set
by
the
government
for
certain
commodities
and
services
that
it
believes
are
being
sold
in
an
unfair
market
with
too
low
of
a
price
and
thus
their
producers
deserve
some
assistance.
Government
might
set
Minimum
prices
To
raise
incomes
for
producers
such
a
farmers
and
protect
them
from
frequent
fluctuations
in
the
commodity
market.
To
protect
workers
and
ensure
that
they
get
a
enough
wages
to
sustain
a
reasonable
standard
of
living.
Examples
of
price
floors
In
many
countries
governments
assist
farmers
by
setting
price
floors
in
agricultural
markets.
Setting
Minimum
wages
for
certain
occupations
is
also
an
example
of
price
floors.
Consequences
of
a
price
floor
As
seen
from
the
diagram.
The
equilibrium
price
for
a
particular
good
is
Pe
and
the
Quantity
demanded
is
Qe.
The
government
thinks
that
it
is
too
low
for
that
good
thus
they
set
up
a
minimum
price
for
a
good
Pmin.
This
will
lead
to
a
fall
in
demand
to
Q1
and
increase
in
supply
to
Q2,
thus
creating
excess
supply
or
surplus.
Government
can
eliminate
the
surplus
by
buying
the
excess
supply
at
the
minimum
price.
This
will
result
in
the
shifting
of
demand
curve
to
the
right,
thus
creating
a
new
equilibrium
at
Pmin.
The
Government
may
store
it
or
sell
it
abroad.
However,
both
these
options
have
consequences.
Buying
the
surplus
and
storing
it
will
cost
an
opportunity
cost
for
the
government
as
they
have
to
divert
funds
from
other
important
areas
and
exporting
it
other
countries
may
be
considered
as
dumping.
What
is
Market
Failure?
In
a
market
where
there
is
equilibrium,
the
resources
are
allocated
in
the
best
possible
manner
and
there
is
'allocative
efficiency'.
Allocative
efficiency
is
when
situation
where
Marginal
cost
is
equal
to
Marginal
revenue.
However,
this
is
not
possible
in
the
real
world.
Market
failure
exists
when
the
resources
are
not
allocated
efficiently.
Community
surplus
is
not
maximized
and
thus
there
is
market
failure.
From
a
community's
point
of
view,
producer
surplus
is
not
equal
to
consumer
surplus.
Market
failure
is
thus
caused
by
Abuse
of
monopoly
power
Lack
of
public
goods
Under
provision
of
merit
goods
Overprovision
of
demerit
goods
Environmental
degradation
Inequality
in
distribution
of
wealth
Immobility
of
factors
of
production
Problems
of
information
Short
termism
Externalities
Externalities
are
a
loss
or
gain
in
the
welfare
of
one
party
resulting
from
an
activity
of
another
party,
without
there
being
any
compensation
for
the
losing
party.
This
activity
can
be
due
to
consumption
or
production
of
a
good
or
service.
If
the
third
party
suffers
due
to
this
activity
then
it
is
known
as
negative
externality.
When
the
third
party
gains
from
this
activity
is
it
known
as
positive
externality.
Marginal
Private
Benefit
is
the
benefit
which
is
derived
by
private
individuals
in
the
consumption
of
a
good
or
service.
Marginal
Private
Cost
is
the
cost
of
producing,
specifically
marginal
costs,
which
are
incurred
by
private
individual
while
producing
a
good
or
service.
Marginal
Social
Cost
is
the
total
cost
to
society
as
a
whole
for
producing
one
further
unit,
or
taking
one
further
action,
in
an
economy.
This
total
cost
of
producing
one
extra
unit
of
something
is
not
simply
the
direct
cost
borne
by
the
producer,
but
also
must
include
the
costs
to
the
external
environment
and
other
stakeholders.
The
market
demand
and
supply
curves
therefore
reflect
the
MPB
and
MPC
accruing
to
buyers
and
sellers.
When
there
is
no
externality
then
the
intersection
MPB
(demand)
curve
and
MPC
(supply)
curve
determine
the
equilibrium
price.
The
price
and
quantity
reflected
at
this
point
are
socially
optimum
level
of
production
or
consumption
and
the
market
is
said
to
have
allocative
efficiency.
i.e.
MPC=MPB.
At
this
point
the
consumer
surplus
is
equal
to
the
producer
surplus.
However,
this
is
usually
not
the
case
in
real
world.
The
production
or
consumption
of
goods
and
services
do
produce
externalities
and
thus
the
concept
of
Marginal
social
benefits
and
Marginal
social
costs
comes
into
being.
MSB=MPB+Externality
MSC=MPC+Externality
Types
of
Externalities
Externalities
can
result
either
from
consumption
activities
or
from
production
activities
There
are
four
types
of
Externalities
1.
Negative
externality
of
Production
2.
Negative
externality
of
Consumption
3.
Positive
externality
of
Production
4.
Positive
externality
of
Consumption
Negative
Production
Externalities
Negative
production
externalities
are
the
side-effects
of
production
activities.
As
a
result
an
individual
or
firm
making
a
decision
does
not
have
to
pay
the
full
cost
of
the
decision.
Pollution
created
by
firms
due
to
production
activities
is
an
example
of
negative
production
externality.
In
an
unregulated
market,
producers
don't
take
responsibility
for
external
costs
that
exist--these
are
passed
on
to
society.
Thus
producers
have
lower
marginal
costs
than
they
would
otherwise
have
and
the
supply
curve
is
effectively
shifted
down
(to
the
right)
of
the
supply
curve
that
society
faces.
Because
the
supply
curve
is
increased,
more
of
the
product
is
bought
than
the
efficient
amount--that
is,
too
much
of
the
product
is
produced
and
sold.
Since
marginal
benefit
is
not
equal
to
marginal
cost,
a
deadweight
welfare
loss
results.
The
diagram
illustrates
negative
production
externality.
The
supply
curve
given
by
MPC
reflects
the
firms
private
costs
of
production
and
the
marginal
social
cost
curve
given
by
MSC
represents
the
full
cost
of
production
to
society.
The
vertical
difference
between
MPC
and
MSC
represents
negative
externality.
Therefore
for
each
level
of
output,
Q1,
social
costs
given
by
MSC
are
greater
than
the
firms
private
costs
by
the
amount
of
externality.
The
optimal
production
quantity
is
Q*,
but
the
negative
externality
results
in
production
of
Q1.
The
deadweight
welfare
loss
is
shown
in
blue.
Corrective
Negative
Production
externalities
In
order
to
correct
negative
externality
of
production
and
to
bring
down
the
production
to
the
optimal
level,
government
can
intervene
through
the
following
options:
Legislation
and
regulations
Government
can
pass
legislations
to
prevent
or
reduce
the
effects
of
production
externalities.
These
legislations
will
lower
the
quantity
of
goods
produced
and
bring
it
closer
to
the
optimal
quantity
Q*
by
shifting
the
MPC
curve
upward
towards
the
MSC
curve.
It
might
include
legislations
to
Limit
the
emission
of
pollutants
by
setting
limits
to
the
extent
of
pollutants
produced
by
a
firm.
Limit
the
production
to
a
certain
level.
Force
polluting
units
to
install
technologies
which
reduce
emissions.
Putting
Taxes
Government
may
impose
a
tax
on
the
firm
either
on
per
unit
of
production
or
per
unit
of
pollutants
emitted.
These
will
lead
to
a
shift
of
MPC
curve
upwards
towards
the
MSC
curve
and
thus
reducing
output
and
bringing
it
closer
to
socially
optimal
level
i.e.
Q*.
The
diagram
below
shows
the
impact
of
taxes
Tradable
permits
Tradable
permits
are
a
cost-efficient,
market-driven
approach
to
reducing
greenhouse
gas
emissions.
A
government
must
start
by
deciding
how
many
tons
of
a
particular
gas
may
be
emitted
each
year.
It
then
divides
this
quantity
up
into
a
number
of
tradable
emissions
entitlements
-
measured,
perhaps,
in
CO2-equivalent
tons
-
and
allocates
them
to
individual
firms.
This
gives
each
firm
a
quota
of
greenhouse
gases
that
it
can
emit
over
a
specified
interval
of
time.
Then
the
market
takes
over.
Those
polluters
that
can
reduce
their
emissions
relatively
cheaply
may
find
it
profitable
to
do
so
and
to
sell
their
emissions
permits
to
other
firms.
Those
that
find
it
expensive
to
cut
emissions
may
find
it
attractive
to
buy
extra
permits.
Trading
would
continue
until
all
profitable
trading
opportunities
had
been
exhausted.
Tradable
permits
will
result
in
firms
to
lower
the
quantity
of
goods
produced
so
that
it
equals
Q*
and
to
raise
the
price
of
the
goods.
In
negative
consumption
externality,
the
MPB
is
not
reflecting
social
benefit
and
thus
MSB
lies
below
MPB.
The
vertical
difference
between
MPB
and
MSB
is
the
negative
externality.
The
optimal
level
of
consumption
is
where
MSB=MSC
i.e.
Q*.
However
the
negative
externality
is
being
ignored
and
thus
there
is
an
over
consumption
of
the
goods
at
Q1.
Correcting
negative
consumption
externalities
Advertising:
Government
can
using
persuasive
advertising/awareness
campaigns
to
alert
the
consumers
and
influence
them
reduce
their
consumption.
This
will
lead
to
a
shift
of
MPB
curve
to
the
left
thus
reducing
the
gap
between
socially
optimal
level
of
consumption
Q*
and
Q1.
Legislations
and
regulations:
Government
can
also
pass
legislations
or
impose
fines
on
certain
activities
which
create
nuisance
for
the
societies.
Many
countries
already
have
banned
smoking
in
public
places.
Imposing
indirect
taxes:
By
putting
taxes
on
the
production
of
goods
that
cause
negative
consumption
externalities,
government
can
reduce
the
supply.
By
putting
taxes,
the
supply
curve(MSC)
will
shift
upwards
to
MSC+tax.
This
will
reduce
the
gap
between
Q*
and
Q1.
Positive
Production
externalities
These
are
positive
externalities
created
due
to
production
of
certain
goods
and
services.
Examples
include,
when
firms
train
their
employees
which
result
in
better
manpower
or
invest
in
research
and
development
and
succeed
in
developing
new
technologies
which
benefits
the
society.
Due
to
the
fact
that
positive
externality
is
produced,
the
MSC
lies
below
the
MPC.
The
diagram
below
illustrates
positive
production
externalities.
As
we
can
see
that
the
social
optimal
level
of
production
of
these
goods
should
be
Q*
,
however
there
is
under-allocation
of
resources
and
thus
there
is
output
is
at
Q1.
Corrective
positive
production
externalities
Subsidies
can
be
provided
to
firms,
which
produce
these
goods.
The
effect
will
be
the
lowering
of
MPC
and
thus
the
MPC
will
more
downward
to
MSC.
This
will
increase
the
output
to
a
level
Q2
near
to
the
socially
optimal
level
Q*.
The
price
will
also
fall
from
P1
to
P2.
As
the
diagram
illustrates,
the
MSB
lies
above
the
MPB
and
the
difference
between
the
two
consists
of
positive
externality.
The
socially
optimal
level
is
where
MSB=MSC
i.e
Q*,
however,
due
to
under-allocation
of
resources
the
output/consumption
is
at
Q1.
Corrective
Positive
consumption
externalities
Subsidies
By
giving
subsidies
to
the
producers
of
the
good
with
the
positive
externality
will
result
in
increasing
supply
and
shifting
the
supply
curve
downwards.
This
will
lead
to
MSC
curve
shifting
to
MSC+subsidy
which
means
high
output/consumption
at
socially
optimal
level
Q*
and
at
lower
prices
from
P1
to
P*.
Advertising
Through
positive
advertising
government
can
persuade
consumers
to
increase
their
consumption
and
thus
lead
to
a
shift
of
MPB
to
the
right
i.e.
increase
in
demand.
If
the
MPB
curve
shifts
enough,
it
will
coincide
with
MSB
and
Q*
will
be
produced
and
consumed.