Unit 2 Microeconomics

• What is demand and effective demand?

  Demand is the want and willingness of consumers to buy a product. Effective demand requires the ability to pay as well.
• What is the law of demand?

  The law of demand states that if the price of a good or service increase, the demand decreases and vice versa, ceteris paribus (all other things remain unchanged)
• What is quantity demanded?

  The amount of good or service consumers are willing and able to buy.
• What is the difference between individual and market demand?

  Individual demand is the demand of one consumer while the market demand is the total demand for the product from all the consumers who are willing and able to buy.
• When does contraction and extension happen?

  When prices are increased, the quantity demanded contracts

  when prices are decreased, the quantity demanded extends
• What is an increase and decrease in demand?

  An increase in demand means consumers demand more of the product at every price than they did before. (shift right)

  
  

  A decrease in demand means consumers demand less of the product at every price than they did before. (shift left)
• What are the factors that increase demand?

  - increase in consumer income: inferior goods demand falls, normal goods demand increases.

  - decrease on tax on income --> more disposable income

  - rise in the price of substitutes

  - fall in the price of complementary goods

  - changes in trend / fashion in favor of product

  - rise in population

  - increased advertisement

  - other (external, seasonal) factors.
• what are the factors that decrease demand?

  - decrease in consumer income:

  - increase in tax on income --> less disposable income

  - fall in the price of substitutes

  - increase in the price of complementary goods

  - changes in trend, habit, fashion in favor of other products

  - fall in population

  - decreased advertisement

  - other (external, seasonal) factors.
• What is supply?

  Supply is the amount of good or service that producers and willing to make and sell at different prices.
• What is quantity supplied?

  Supply is the amount of good or service that producers and willing and able to make and sell at different prices.
• What is the law of supply?

  Ceteris Paribus, an increase in price causes an extension (increase) in quantity supplied and a decrease in price causes a contraction (decrease) in quantity supplied.
• What is market supply?

  the sum of all individual supply curves of producers competing to supply that product
• What is extension and contraction in supply?

  Extension: when prices rise, the quantity supplied extends (shifts up)

  
  

  Contraction: when prices rise, the quantity supplied contracts (shifts down).
• What are increases and decreases in supply?

  Increase in supply is when producers are willing and able to supply more of the product than they were before at all possible prices. (shifts right)

  
  

  Decrease in supply is when producers are willing and able to supply less of the product than they were before at all possible prices. (shifts left)
• What are the factors that cause an increase in supply?

  - other products become less profitable

  - fall in the cost of production

  - increase in resources

  - technological advancements

  - subsidies, tax reduction/exemptions on profit

  - rise in business optimism and expectations of profit

  - global factors (weather)
• What are the factors that cause a decrease in supply?

  - other products become more profitable

  - rise in the cost of production

  - decrease in resources

  - technological failures

  - tax on profit increases

  - fall in business optimism and expectations of profit

  - global factors (weather for agriculture, war, natural disaster, politics)
• What is market equilibrium and price equilibrium.

  state where the market supply and market demand are equal. there is no pressure to change market price.

  price equilibrium is the price where quantity supplied = quantity demanded.
• What is shortage and surplus?

  Both occur when market is at disequilibrium.

  Shortages / excess demand occur when quantity demanded by consumers exceed what will firms supply (below mkt price)

  --> price must rise

  
  

  Surplus / excess supply occurs when firms supply more than demand. (above mkt price) --> price must fall
• What changes cause an increase in market price and what causes a decrease?

  Decrease in demand & Increase in supply = decrease in mkt price

  
  

  Increase in demand & Decrease in supply = increase in mkt price.
• What is the price elasticity of demand (PED)?

  the responsiveness of consumer demand to changes in price of a good or service.

  
  

  If a small change in price causes a relatively big change in the quantity demanded by consumers, demand for the product is price elastic (flatter line) qty demand > price

  
  

  If a small change in price causes only a relatively small change in quantity demanded by consumers, demand for the product is price inelastic (steeper line) qty demand < price
• How do we calculate PED?


  % change in quantity demanded / % change in price

  
  

  to calculate % change: (final -original / original) x 100
• How can we tell price elasticity from values?

  when PED is > 1, it is elastic. %change in qty d> %change in p

  if PED is 3, it means for every 1% change in price there is a 3% change in qty demanded.

  when PED < 1, it is inelastic

  if PED is 0.3, it means for every 1% change in price there is a 0.3% change in qty demanded.

  
  

  theories

  PED = 0, perfectly inelastic, (vertical line)

  PED = infinity, perfectly elastic (horizontal line)

  unitary elastic: PED = 1. %change in qty = %change in p
• What are the factors that affect PED?

  1. if the product is a necessity, it is usually more price inelastic than goods that satisfy human wants

  - Veblen (luxury) goods are elastic

  
  

  2. number of substitutes

  - the higher the number of substitutes, the more elastic

  - the lower the number of substitutes, the more inelastic

  
  

  3. time period consumer have to search for substitutes

  - the longer they have to find substitutes, the more likely they'll find it, more elastic (e.g. television), do not need to purchase item frequently

  - in long run, elastic,

  - in short run, inelastic

  
  

  4. the cost of switching to a different supplier

  if cost is expensive, more inelastic

  if cost is cheaper, more elastic

  
  

  5. Proportion of consumer's income spent on the product

  - small proportion of income, price inelastic

  - large proportion of income, price elastic

  
  

  6. addictive or non-addictive
• What is the significance of PED?

  Allows firms to optimise pricing and promotional strategies for thie products to achieve their sales, profit, revenue

  
  

  If demand is price elastic for a product, consumers will spend less on the product if its price increases because they will find a cheaper alternative. Firms will lose revenue if they increase this market price when their product is price elastic.

  
  

  Price elastic: firms will decrease price to increase revenue

  
  

  Firms may use advertising and other promotional strategies to not lose demand when increasing prices. (coupons, gifts)

  
  

  If demand is price inelastic for a product, consumers will demand and spend the same quantity, hence it is more profitable to increase price and the firm will gain more revenue.

  
  

  Price inelastic: firms will increase price to increase revenue

  
  

  Total revenue: price x quantity.

  
  

  The knowledge of PED is relevant to govt. seeking to use taxes to increase public revenue and dissuade consumers buying harmful products. Tax on cigarettes (useless) because inelastic demand. But for products with elastic demand, taxes are effective in decreasing qty consumed.
• What is the price elasticity of supply (PES)?

  the measure of responsiveness of quantity supplied to a change in price.
• What is price supply elastic and supply inelastic ?

  Price supply elastic means a small change in price causes a relatively big change in quantity supplied. (flatter slope)

  %change in qty s > % change in p. PES > 1

  
  

  Price supply inelastic means a small change in price causes a relatively minor change in quantity supplied. (steeper gradient)

  %change in qty s < % change in p. PES < 1

  
  

  
  

  Perfectly inelastic: PES = 0

  
  

  Perfectly elastic (everchanging): PES = infinity

  
  

  unitary elastic: PES = 1. %change in qty = %change in p
• How do we calculate PES?

  PES= %change in qty supplied / % change in price

  
  

  % change = (final - original/original) x 100
• What are the factors that affect PES?

  1. the availability of stock of finished goods and services

  - more stock, elastic

  -less stock, inelastic

  
  

  2. degree of unused or spare production capacity

  - more spare production capacity, elastic

  - less spare capacity, inelastic

  
  

  3. time period required to adjust the scale of production

  - more time (long run), price supply elastic

  -less time (short run), price supply inelastic

  
  

  4. mobility and availability of factors of production

  -if FOP is easier to employ / more mobility, elastic

  - harder to employ and less mobility, inelastic
• What is the PES in the short run, the long run and in any given moment?

  At any given moment in time, the supply is fixed, and the PES is perfectly inelastic. They are unable to respond immediately to changes in demand.

  
  

  In the short run, most products are relatively price inelastic because they can only increase supply by using any spare production capacity like working longer hours.

  
  

  In the long run, firms can obtain FOP to expand production. Most products become elastic.
• What is the significance of PES?

  A high price elasticity is desirable for many firms because they want to expand their supply as quickly and efficiently as possible in response to increasing demand and price of their products. Increased demand means higher sales, and more customers. Higher price means more profit.

  
  

  some firms are unable to reduce supply when demand falls, especially agriculture and farming sector.
• How could firms take action to improve the PED?

  -increasing storage to keep stocks of its products

  -investing in additional and spare productive capacity

  - employing latest production equipment and processes

  -employee training in new set of skills for more mobility.

  
  

  the more difficult and the longer it takes to increase supply in response to increasing demand, the less impact it will have on sales and the more impact it will have on market price.
• What is market failure?

  occurs when the free market system fails to produce outcomes in terms of prices and quantities that are socially and economically desirable.

  
  

  This results in an inefficient use of resources (misallocation of resources) and a reduction in social and economic welfare.
• How do markets fail?

  -1. Public goods will not be provided as they have the following characteristics:

  - They are socially and economically desirable

  - Once provided, it is impossible to exclude others from benefitting form them just because they have not paid for them.

  - The consumption of these services does not reduce the amount available for others.

  - As it is impossible to charge for public goods, private sector firms will not supply them because it will not be profitable.

  
  

  2. Too few merit goods will be provided and consumed

  - Merit goods are beneficial for the individual consumer and the society.

  - Supplying them to the population is expensive. Private firms will only do so if they can charge high prices to cover their costs.

  - Private firms will only provide these for those who can afford it. Low-income people will not get these services.

  - Therefore, merit goods are underprovided and underconsumed.

  
  

  3. Demerit goods will be oversupplied and overconsumed

  - Demerit goods are harmful for the individual consumer and society.

  - Private firms will supply these goods if it is profitable to do so to consumers who are willing and able to pay for them.

  - Therefore, more demerit goods will be provided in a free market than is socially or economically desirable.
• What are more ways markets can fail?

  4. Some firms may exploit their consumers and employees

  - Large firms like monopolies and oligopolies can restrict output and raise prices.

  - They usually provide essential goods and services, so consumers have no choice but to pay the high prices.

  - This leaves consumers with less income to spend on other goods and services thus lowering their living standards.

  - Sometimes large firms exploit their workers by paying them low wages and poor working conditions to increase their profits.

  
  

  5. Factor immobility obstructs the ability of firms to allocate resources efficiently

  - Factor immobility occurs when it is difficult to move labour and capital to different productive uses based on consumer demand.

  - This stops the free market from allocating resources to their most efficient uses.

  
  

  6. Goods with external costs will be over-provided

  - Extenal costs are when the production or consumption of a good or service creates a cost to the third party who are not involved in the transaction. This results in over-provision of such products.

  
  

  7. Goods with external benefits will be under-provided

  - Extenal benefits are when the production or consumption of a good or service creates a benefit to the third party who are not involved in the transaction. This results in under-provision of such products.
• What are negative and positive externalities?


  Negative externality occurs when the production or consumption of a good creates and external cost. This leads to over-production/consumption and lowers economic welfare.

  
  

  Positive externalities occur when the production or consumption of a good creates external benefits
• What are social costs and social benefits?

  Social cost = Private cost ( cost of factors of production) + external cost (cost to third party).

  
  

  Social benefit = Private benefit ( benefit to the consumer/producer) + external benefit (benefit to third party).

  
  

  If social costs are > than social benefits, there is uneconomic use of resources. Society would be better off if these resources were allocated to another use (to achieve higher economic welfare).

  
  

  If social benefits are > than social costs, there is economic use of resources. Society would be better off if more resources were used to produce these goods and services.
• What are some government intervention to correct market failure?

  1. Direct provision of goods and services. Some examples are:

  - Govts. can directly provide public and merit goods to the people "free of charge" so that low-income people can access these too.

  - They operate state-owned enterprises to provide essential services like electricity eg. DEWA

  - They also fund research organisations to develop new products and technologies eg. Technology to generate clean renewable energy.

  - These enterprises are created by a process called nationalization which means that the govt. takes over a private sector firm.

  
  

  2. Regulations are legal rules made by the government to control the forces of demand and supply in certain markets. This produces outcomes that are socially and economically more desirable. Failure to comply with these leads to paying substantial fines to the government. Some such regulations are:

  
  

  - Ban or restrict the consumption and production of demerit goods. (cigarette tax)

  - Establish some basic standards for product safety and quality.

  - Protect animal welfare and the natural environment eg. ban testing on animals for cosmetics.
• Maximum and minimum prices

  3. Price controls are maximum or minimum prices set by the government on certain goods and services.

  - A maximum price is a price cap on a product. Firms cannot legally increase their prices above this cap.

  This is imposed when large firms exploit their consumers by charging high prices to maximise their profits.Firms that exploit their consumers have the following features: Demand for their product is inelastic as they sell necessities with no/few substitutes. Markets are either monopolies or oligopolies. So are able to charge high prices.

  
  

  This law applies to markets which provide essential goods and services (eg. electricity), or to make goods more affordable to lower income people

  
  

  - A minimum price is a price floor on a product. Firms cannot legally decrease their prices below the price set.

  
  

  This is imposed to increase prices of demerit goods or on goods produced by firms that pollute or create high external costs to reduce their consumption.

  
  

  People and the economy are better off without these goods.

  
• indirect taxes and subsidies

  4. Indirect taxes are imposed on demerit goods and other goods that create negative externalities.

  
  

  The aim of this policy is not just to gain revenue but to reduce the consumption/production of these goods.

  
  

  Since the demand for most of these products is inelastic, this policy is not very effective in reducing consumption/production of these goods.

  
  

  5. Subsidies are grants given by the govt. to producers. These result in lower COP. Subsidies are given to firms that produce goods which create external benefits. The aim is to increase production/consumption of these goods/services.
• What are problems created by government intervention?

  1. Govt intervention may take a long time to agree and even longer to implement.

  
  

  2. Price controls may encourage smuggling and black markets.

  
  

  3. Taxes and subsidies distort prices - they can be too high or too low to correct the market failure.

  
  

  4. Regulations increase COP so fewer goods/services are produced at higher prices.

  
  

  5. Public sector organisations can be inefficient and provide poor quality goods as their main objective is not to maximise profits.

  
  

  6. Govt intervention can cause conflict of interest - direct provision of merit goods leads to higher taxes to pay for these services.

  
  

  7. Govt intervention is often based on their political agendas rather than what is best for society.