Section 1 Micro Economics

Markets
The nature of markets
Market: where buyers and sellers come together to carry out an economic transaction.

Product markets: Goods and services are being bought and sold

Factor markets: Factors of production are being bought and sold

Financial markets: (Foreign exchange market) International currencies are traded

Stock markets: Shares in companies are bought and sold

Demand

The law of demand

Demand: is the total amount of goods and services that consumers are willing and able to
purchase at a given price in a given time period.
The Law of Demand: states that "as the price of a product falls, the quantity demanded of the
product will usually increase, ceteris paribus".

The demand curve

Demand curve: represents the relationship between the price and the quantity demanded of a
product, ceteris paribus.

Figure 1.1 - A demand curve

The non-price determinants of demand (factors that change demand or shift the demand curve)
 The non-price determinants of demand (shifting) for normal & inferior goods:

1. Income: As income rises

o demand for normal goods rises, demand curve shifts to the right

o demand for inferior goods falls, demand curve shifts to the left (when income gets
to certain level, demand will become zero and so the demand curve disappears)

2. Taste & Preferences: Change in tastes in favor (i.e. advertising campaign) demand
curve shifts to the right

3. Price of substitutes and complements:

o As price of substitutes increases (movement along the curve) the demand shifts to
the right

o As price of complements increases (movement along the curve) the demand shifts
to the left

4. Demographic changes: if population grows, the demand for most products will increase,
thus the demand curves shift to the right?more will be demanded at each price level

Movements along and shifts of the demand curve

Movement along the demand curve:

A change in price of the good itself leads to a movement along the existing demand curve
(price is the axes), while a change in any other determinants of demand will always lead to a
shift of the demand curve to either left or to the right.

Figure 1.2 - Movement along and a shift of the demand curve

Supply
 The law of supply
Supply: is the total amount of goods and services that producers are willing and able to purchase
at a given price in a given time period.
The law of supply: states that "as the price of a product rises, the quantity supplied of the
product will usually increase, ceteris paribus".

price rises but costs do not change profitability increases supply more (increase
profits)

The supply curve

Supply curve: represents the relationship between the price and the quantity supplied of a
product, ceteris paribus.

Figure 1.3 - The supply curve

The non-price determinants of supply (factors that change supply or shift the supply curve)
The non-price determinants of supply (shifting):

1. Changes in costs of factors of production: Increase in costs of production supply

shifts to the left

o land

o labor

o capital

o entrepreneurship (human capital or intellectual capital)

2. State of technology: Improvements in technology supply shifts to the right (natural

disasters may move the technology backwards supply shifts to the left)
3. Price of relating product (joint/competitive supply): if producer could produce another
product with higher profit, due to limited resources, the supply for the existing product
decreases.

4. Expectations: if demand for the product is likely to rise supply increases (ready to
supply more in the future and gain higher profit)

5. Indirect taxes & subsidies:

o Indirect taxes increase costs supply shifts left

o Subsidies reduce costs supply shifts right

6. Number of firms in the market: more firms producing supply shifts to the
right more are being supplied at each price level

Movements along and shifts of the supply curve

Movements along the supply curve:

A change in price of the good itself leads to a movement along the existing supply curve
(price is the axes), while a change in any other determinants of supply will always lead to a
shift of the demand curve to either left or to the right.

Figure 1.4 - Movement along and shift of the supply curve

Market equilibrium

Equilibrium and changes to equilibrium

Market equilibrium: is where the supply equals to the demand.
 Figure 1.5 - Market equilibrium

Calculating and illustrating equilibrium using linear equations

The market is in equilibrium at Pe, when the amount of that product consumers wish to buy, Qe,
is equal to the amount of coffee producer wish to sell.

Figure 1.6 - Excess in supply and demand at different price levels

Excess supply: More is being supplied than demanded at P1 in order to eliminate the
surplus, producer must lower the price

Excess demand: More is being demanded than supplied at P2 in order to eliminate

this shortage, producer must raise the price

Changes in determinants cause changes in equilibrium

 Figure 1.7 - A change in equlibiurm due to a change in determinants

When theres a change in determinants of demand/supply other than the price of the
product, it would lead to a shift of a curve.

When Demand shifts to D1, Qe is the quantity supplied, but Q2 is the quantity demanded,
there is excess demand (of xxx units).

Due to price mechanism (see below), the price will rise until Pe1, where the new
equilibrium quantity, is both demanded and supplied.

The role of the price mechanism

Resource allocation
Price mechanism: moves market into equilibrium.

Scarce resources are allocated and reallocated in response to changes in price.

Price signals are given to producers what consumers wish to buy

Price changes as a result of change in equilibrium.

A higher price would provide incentives to firms to produce more, since there is a larger
profit.

Opportunity cost: is the next best alternative forgone. When a choice is made, there is an
opportunity cost.
Market efficiency

Consumer surplus
Consumer surplus: is the extra satisfaction gained by consumers from paying a price that is
lower than that which they are prepared to pay.
 Producer surplus
Producer surplus: is the excess of actual earnings that a producer makes from a given quantity of
output, over and above the amount the producer would be prepared to accept for that output.

Figure 1.8 - Consumer and producer surplus

Allocative efficiency
Allocative efficiency happens when competitive market is in equilibrium, where resources are
allocated in the most efficient way from societys point of view.

Social surplus (consumer + producer surplus) is maximized.

Marginal social benefit = Marginal social cost

Price elasticity of demand (PED)

Price elasticity of demand: measures the responsiveness of quantity demanded to a change in
price, along a given demand curve.
Elasticity of demand refers to price elasticity of demand. It refers to the quantity
demanded of a commodity in response to a given change in price. Price elasticity is always
negative, which indicates that the customer tends to buy more with every fall in the price. The
relationship between the price and the demand is inverse.

Proportionate change in the quantity demanded

for product X
Price elasticity of demand = -------------------------------------------------------------------
Proportionate change in the price of X

(Q2 Q1) / Q1
 EDp = ------------------------
(P2 P1) / P1

Where Q1 is the quantity demanded before price change, Q2 is quantity demanded after
price change, P1 is the price before change, and P2 is the price after change.

Figure 2.1 - Price elastic demand

Price inelastic demand (greater than One)
This is with reference to situations where a larger change in price will result in smaller change in
the quantity demanded. In this case E < 1. Hence it is called inelastic demand. Many
commodities which are necessaries of life will have inelastic demand as they are essential
requirements.

Figure 2.2 - Price inelastic demand

Unit elastic demand

This is a case in which the change in price will result in exactly equal change in the quantity
demanded. If both are equal then E = 1 and the elasticity is said to be unitary.

%change in P = %change in Qd
 Total revenue will not change when price changes (same revenue box)

Figure 2.3 - Unit elastic demand

Perfectly elastic demand, demand is zero at all but one price.
This is a condition in which a very small change in price will result in infinitely large response in
the demand. A small rise in price may result in the contraction of demand even to zero and a
small drop in price may result in contraction of demand even to zero and a small drop in price
may result in extension of demand to unimaginable quantity. Hence this type of elasticity is
called perfectly or infinitely elastic demand.

Figure 2.4 - Perfectly elastic demand

Perfectly inelastic demand, demand is constant at any price.
This is a case in which the response in demand to change in price is almost nil. Even a large fall
in price will not induce the quantity of demand to be more, nor a large rise in price will prevent
the consumers from buying less. The demand is inert to the changes in prices and the quantity
remains the same whatever be the change in price.
 Figure 2.5 - Perfectly inelastic demand
Determinants of PED:

1. Number and closeness of substitutes: more substitutes available & closer higher PED

2. Degree of necessity (and how widely it is defined): lower the degree of

necessity higher PED; the more vague it is defined, i.e. food higher PED

o As it is more narrowly defined more subjective

3. Time period considered: more time to consider higher PED

o Inelastic in the short term, elastic in the long term

4. Income spent: the higher the income spent higher PED

Applications of price elasticity of demand

Applications of PED:

1. Governments: if inelastic (low) PED less consequence if P impose more indirect

tax

2. Firms: if inelastic (low) PED more revenue if P price of the product ris

Cross price elasticity of demand (XED)

Cross price elasticity of demand and its determinants

Cross elasticity of demand refers to the quantity demanded of a commodity in response to
a change in the price of a related good, which may by substitute or complementary.

Proportionate change in the quantity demanded

for product X
Cross elasticity of demand = -------------------------------------------------------------------
 Proportionate change in price of product Y

(Q2x Q1x) / Q1x

EDc = ------------------------
(P2y P1y) / P1y
Where Q1x is the quantity demanded before change, Q 2x is quantity demanded after change, P y is
the price before change, and P2y is the price after change in the case of product Y.

Cross price elasticity of demand: measures the responsiveness of a demand for one good to a
change in price of another good.
Determinants of XED:

Substitute goods: positive value of XED

Complementary goods: negative value of XED

The absolute value of XED depends on the closeness of the relationship between the two
goods. (Two goods are unrelated if XED =0)

Applications of cross price elasticity of demand

Applications of XED:

1. Firms on substitutes goods: low positive value?the better?increase price of the product

2. Firms on complementary goods: high negative value?the better?increase price of the

product

Income elasticity of demand (YED)

Income elasticity of demand: measures the responsiveness of demand to a change in consumers
income.
Income elasticity of demand refers to the quantity demanded of a commodity in response
to a given change in income of the customer.

Income elasticity is normally positive, which indicates that the consumer tends to buy
more and more with every increase in income.

Proportionate change in the quantity demanded

for product X
Income elasticity of demand = -------------------------------------------------------------------
Proportionate change in Income

(Q2 Q1) / Q1
EDi = ------------------------
(I2 I1) / I1
 Where Q1 is the quantity demanded before income change, Q2 is quantity demanded after
Income change, I1 is the income before change, and I2 is the income after change.

Determinants:

Normal goods: positive value of YED

Inferior goods: negative value of YED

Necessities: Income inelastic of demand

Luxuries: Income elastic of demand

Applications of income elasticity of demand

Application:

1. Firms: can predict the effect of a business cycle on sales

Price elasticity of supply (PES)

Price elasticity of supply and its determinants

Price elasticity of supply: measures the responsiveness of quantity supplied to a change in price
along a given supply curve.

The value will always be positive

Price elastic supply (less than infinity).

Figure 2.6 - Price elastic supply

Price inelastic supply (greater than zero).
 Figure 2.7 - Price inelastic supply

Unit elastic of supply

Here, the percentage change in quantity supplied is equal to the percentage change in price. If the price is
increased by 10%, supply is also increased by 10%

Mathematically, any straight-line supply curve passing through the origin is unit elastic of
supply.

Figure 2.8 - Unit elastic supply

Perfectly elastic supply, only supplied at a certain price level.

Here, any quantity can be supplied at a given price and there is no need to increase the price. The firm can
even stop the supply completely. Hence this type of elasticity is called perfectly or infinitely elastic
supply
 Figure 2.9 - Perectly elastic supply
Perfectly inelastic supply, supply is constant at any price level.
Here, supply remains constant irrespective of the changes in price. The firm is completely insensitive to
price change.

The shape of the supply curve is a vertical line parallel to the y axis.

Here, if there is an increase in demand, the price will be higher. The higher the demand, the higher the
price. The lower the demand, the lower the price. This phenomenon is very rare and may be found in,
perhaps, a very very short period. Ex. Perishable goods. Economists call such a short period as market
period.

Figure 2.10 - Perfectly inelastic supply

Determinants of PES:

1. Time period considered: longer the time period considered the more elastic (time to
increase the factors of production, such as capital)

2. Mobility of factors of production: higher the mobility of factors of production the

more elastic (easier to change to another production with less costs when price rises)
3. Unused capacity: if more capacity productive resources not being fully used the
more elastic (increase output easily without great costs)

4. Ability to store stocks: if able to store high level of stocks the more elastic (able to
react to price increases with swift supply increases)

Applications of price elasticity of supply

Commodities: are raw materials in the primary production. (i.e. cotton & coffee)

Inelastic PED, PES, & YED.

Higher degree of necessity, takes time to grow/harvest to increase Qs, few or no

substitutes

Manufactured products & service relatively high (elastic) PED, PES, YED.
Indirect taxes

Specific (fixed amount) taxes and ad valorem (percentage) taxes and their impact on markets
Aim of imposing indirect taxes:

1. To raise tax revenues Government spending

2. Internalize externalities Achieve socially optimal level of output

Types of indirect tax:

Specific tax: is where a fixed amount of tax is imposed upon a product.

Shifts supply curve vertically upward by the amount of the tax

i.e. A tax of $1 per unit supply shifts $1 unit upward

Figure 3.1 - The effect of a specific tax on the supply curve

 2. Ad valorem tax: is where the tax is a percentage of the selling price.

Gap between S & S+tax gets bigger

i.e. A percentage tax of 20%?at $5, tax $1; at $10, tax $2

Figure 3.2 - The effect of ad valorem tax on the supply curve

When either specific taxes or valorem taxes are imposed, the market will shrink in size (decrease
in quantity), thus possibly lower the level of employment in the market, since firms might
employ fewer people. (Curve shifts up because it increases costs of production.)

Figure 3.3 - Shift in supply curve due to indirect tax

Consequences of imposing an indirect tax:

1. Producer: revenue falls (from P1xQ1 to P2xQ2)

2. Consumer: price of the product rises (from P1 to P2)

3. Government: receives tax revenue [(P2-P3)xQ2]

 Figure 3.4 -The effect of an indirect tax

Tax incidence and price elasticity of demand and supply

Figure 3.5 - Distribution of the tax burden

Forward diagonal lines: Tax burden on consumers
Backward diagonal lines: Tax burden on producers
Vertical lines: Deadweight loss (loss of consumer & producer surplus)

Tax incidence differs depending on the PED & PES of the product:

Tax incidence on producer: (P1-P3)xQ2

Tax incidence on consumer: (P2-P1)xQ2

Price of the product: rises from P1 to P2

PED & PES (of a product)

 Figure 3.6 - Effect of an indirect tax on an elastic demand curve

After the tax is imposed, the producer would like to raise the price up to P1 and pass on
all the tax to consumers

However, there is excess supply, and by market mechanism, price has to fall and a new
equilibrium P2Q2 is formed

At price P2, quantity Q2 is both demanded and supplied

P2-P1 Tax incidence on consumer

P1-P3 Tax incidence on producer

If a good with inelastic demand is taxed, the tax burden can be easily passed on to the consumer
(PED is less than PES)

Figure 3.7 - Effect of an indirect tax on an inelastic demand curve

P2-P1 Tax incidence on consumer
P1-P3 Tax incidence on producer

Subsidies
 Impact on markets
Subsidy: is an amount of money per unit of output paid by the government to a firm.
Aim of providing subsidies:

1. Lower the price of essential goods to consumers ? government hopes that consumption
will increase

2. Guarantee the supply of products ? that government thinks is necessary for the economy.
i.e. power source

o OR provide employment to solve economic & social problems.

3. Enable producers to compete with overseas trade ? thus protecting home industry

When subsidies are provided, the market will expand in size (increase in quantity), thus
possibly raise the level of employment in the market, since firms might employ more people.

Figure 3.8 - Effect of a subsidy on the supply curve

Supply curve shifts down because a subsidy reduces costs of production.
Consequences of providing a subsidy:
1. Producer: revenue increases

Figure 3.9 - Effect of a subsidy on the producer

 2. Consumer: price of the product decreases

Change in consumer expenditure ? may increase or fall, depending on relative saving and
extra expenditure

Figure 3.10 - Effect of a subsidy on the consumer

3. Government: expenditure increases (take money away from other areas of expenditure or
raise taxes)

Figure 3.11 - Effect of a subsidy on the government

Price controls

Price ceilings (maximum prices): rationale, consequences and examples

Price ceilings (maximum prices): is a situation where government sets a maximum price, below
the equilibrium price to prevent producers from raising the price above it.

Set to protect consumers

Usually in markets of necessity or merit goods (good that would be underprovided if the
market were allowed to operate freely)

I.e. Maximum food price controls during food shortage?ensure low-cost food for the
poor.
 I.e. Maximum rent controls?ensure affordable accommodation for those on low incomes.

Figure 3.12 - A price ceilling

If maximum price is imposed at Pmax, Q2 will be demanded because price has fallen, but
only Q1 will be supplied. ?excess demand

Eventually consumption will fall from Qe to Q1, even though it is at a lower price

Consumer expenditure (firms revenue) will decrease

Consequences of maximum price:

1. Shortages: leads to forming of black market/underground parallel market (where product

is sold at a higher price, somewhere between Pe and Pmax.)

2. Non-price rationing mechanisms: Long queues or reservations can determine the order
in which consumers are served.

3. Welfare impacts: Producer surplus decreases, consumer surplus increase

4. Inefficient resource allocation: allocatively inefficient

Impacts on stakeholders:

1. Consumers: lower prices, but have to go through non-price rationing mechanisms

2. Producers: lower selling price revenue decreases

3. Government: increase spending on solving the consequences subsidize or direct

provision to shift the supply curve to right reduce government expenditure in other
areas opportunity cost

Price floors (minimum prices): rationale, consequences and examples

 Price floors (minimum prices): is a situation where the government sets a minimum price, above
the equilibrium price to prevent producers from reducing the price below it.

Set to protect producers of goods & services that government thinks are important. i.e.
agricultural products

To protect workers by setting minimum wage ensure workers earn enough to lead a
reasonable existence

Figure 3.13 - A price floor

If minimum price is imposed at Pmin, only Q1 will be demanded since the price has
risen, but Q2 will now be supplied. excess supply

Consumption will fall from Qe to Q1

Consumer expenditure (firms revenue) will decrease.

Consequences of minimum price:

1. Surpluses: producer will be tempted to get around the price controls and sell their excess
supply for a lower price, somewhere between Pmin & Pe.

2. Disposal of the surplus by the government

3. Welfare impact: producer surplus increases, consumer surplus decreases

4. Inefficient resource allocation: allocatively inefficient

Impacts on stakeholders:

1. Consumers: higher prices

2. Producer: higher selling price less cost-conscious inefficiency & waste of resources
OR producing more of protected product than other products that they could produce more
efficiently

3. Government: increase spending on solving the consequences store, destroy or selling

the surplus abroad (dumping harm other domestic industries angry reaction from foreign
governments) OR increase demand by advertising or restricting supplies of imports through
protectionist policies (thus increase demand for domestic products)

The meaning of market failure

Market failure as a failure to allocate resources efficiently

Market failure: occurs when the condition for the market is allocatively inefficient, resulting in
an over-allocation of resources or an under-allocation of resources.

More (or less) is sold at a lower (or higher) price than is socially desirable.

Marginal private benefits: is the extra benefit to the entity consuming or producing one
additional unit.
Marginal social benefits: is the private benefit to the entity plus the spill-over benefits to third
parties of consuming or producing one additional unit.
Marginal private costs: is the extra costs to the entity consuming or producing one additional
unit.
Marginal social costs: is the private costs to the entity plus the spill-over costs to third parties of
consuming or producing one additional unit.

Types of market failure

The meaning of externalities

Externality: is an unintended side effect that result from production or consumption of a good,
affecting the third parties.

When this is externality, the market does not achieve a social optimum where MSB=MSC

Negative externalities also called spill-over costs or social costs

Positive externalities also called spill-over benefits or social benefits

 Figure 4.1 - Social equilibrium

Social equilibrium: occurs at Ps, Qs

Internalizing an externality: is a government action to achieve socially desirable equilibrium
for the economy.

Negative externalities of production and consumption

Negative externalities of production: is a harmful side effect to the society due to the
production by a firm.
i.e. Factory releasing poisoning materials that are harmful to the area; Power house burning fossil
fuels, releasing greenhouse gases that would cause global warming.

Figure 4.2 - A negative externality of production

There is a misallocation of resources: too much is being produced at a too low price than
is socially desirable.

There is a welfare lost to society of the extra units from Qp to Qs because MSC is greater
than MSB (shaded area)

Negative externalities of consumption: is a harmful side effect to the society due to the
consumption by an individual.
i.e. Smokers giving passive smoking to other people, causing them to get illnesses.
 Figure 4.3 - A negative externality of consumption

This is a misallocation of resources: too much is being consumed at a too high price than
is socially desirable.

There is welfare lost to society of the extra units from Qp to Qs because MSC is greater
than MSB (shaded area)

Demerit goods: are goods that the government thinks are bad both for the consumer and the
society. They are over-provided by the market and will be over-consumed.

They are examples for negative externalities of consumption

Internalizing a negative externality:

1. Market based policies: Taxation & tradable permits increase private costs to
firms MPC shifts up towards the point of socially desirable equilibrium

2. Government regulations: Banning stops the consumption or production completely;

Restricting outputs increase private costs for firms to meet the standard MPC shifts up
towards the point of socially desirable equilibrium

3. Publicity campaign provide education on demerit goods OR fund negative advertising

on demerit goods less consumption shifts MPB to left towards the point of socially
desirable equilibrium