Economics notes: Unit 1 - How Markets Work

CONTENTS OF ENTIRE BOOK

Unit 1 Markets: How They Work.......................................................................................... 1Positive and normative thinking ................................................................................................1Opportunity cost ........................................................................................................................1The production frontier or production possibility curve ............................................................3Specialisation and foreign trade..................................................................................................6Demand and supply: an introduction..........................................................................................8The elasticity of demand...........................................................................................................20The elasticity of supply.............................................................................................................30Demand and supply: applications to any market are possible..................................................32The market mechanism working...............................................................................................34Consumer and producer surplus...............................................................................................39

Unit 2 Markets : Why Markets Can Fail.............................................................................43What does market failure mean?..............................................................................................44Reason 1 - Monopoly elements or market dominance.............................................................47Oligopoly..................................................................................................................................51Imperfect competition or monopolistic competition................................................................54Reason 2 - externalities, social cost and private costs..............................................................58Reason 3 - public goods............................................................................................................64Reason 4 - merit goods.............................................................................................................65Reason 5 - demerit goods.........................................................................................................66Reason 6 - information failures................................................................................................67Reason 8 - factor immobility....................................................................................................70Other issues and market problems exist: The distribution of income and wealth....................................................................................75Economies of scale...................................................................................................................79Price fixing by government or one of its bodies.......................................................................84

Unit 3: Managing the Economy.............................................................................................90Why is the government involved in the economy....................................................................90How can government try to manage the economy?..................................................................92Inflation.....................................................................................................................................95Unemployment.......................................................................................................................100The balance of payments........................................................................................................106Gross domestic product (GDP)...............................................................................................110Economic growth....................................................................................................................113Aggregate demand..................................................................................................................120Aggregate supply....................................................................................................................122Altering the level of national income.....................................................................................123Macroeconomic policy – what the government does or tries to do........................................128The multiplier.........................................................................................................................136The interest rate and the level of investment..........................................................................136Money and monetary policy...................................................................................................138Fiscal policy............................................................................................................................146Supply side economics...........................................................................................................152The Phillips curve...................................................................................................................158

Unit 4: “The Theory of Production & Costs”....................................................................164The growth of firms................................................................................................................164The external growth of firms:.................................................................................................167Multination corporations.........................................................................................................169

An introduction to production theory and costs......................................................................170Cost curves..............................................................................................................................175The different possible market conditions................................................................................178Perfect competition.................................................................................................................179Monopoly................................................................................................................................184Imperfect competition or monopolistic competition..............................................................188An introduction to efficiency..................................................................................................192An introduction to price discrimination..................................................................................196Pricing strategies.....................................................................................................................199Game theory............................................................................................................................201Oligopoly - the kinked demand curve.....................................................................................203

Unit 5A: Labour Markets....................................................................................................207The supply of labour...............................................................................................................207The demand for labour............................................................................................................210Determining the equilibrium wage.........................................................................................214The effects of trade unions......................................................................................................217Differences in earnings...........................................................................................................222Labour participation, unemployment and ageing...................................................................229An introduction to the distribution of income and wealth......................................................233

Unit 6, The UK in the Global Economy: “Globalisation and Protection”.......................236An introduction to globalisation and protection.....................................................................236Trade protection and trade liberalisation................................................................................238Trading blocs and the world trade organisation (WTO).........................................................242The balance of payments........................................................................................................247The European monetary union (EMU)...................................................................................255Public expenditure in the UK..................................................................................................258Inward foreign investment by multinational corporations......................................................264External shocks and the global economy................................................................................266

Module 2881 The Market System, Unit 1:“Markets: How They Work”

The course is the GCE Advanced Level in Economics, following the Edexcel syllabus but if you arefollowing a different syllabus then you can simply select the parts of this book that you can use. Economicsis economics! The GCE A level is normally taken in the UK in the Sixth Form (grades 11 and 12) and it ismost commonly used for selecting students for university entrance.

This is a series of teaching notes I used until I stopped teaching recently. If you spot any errors, please emailme and let me know. I maintain a few email addresses for different purposes; currently theyare:[email protected] and [email protected]. If you receive no reply it may meanthat somewhere along the line a spam trap has nabbed your message. You can try sending it again, but trytaking out any words that you thing a spam trap might not like. An alternative explanation is that Hotmailthought it was spam and deleted it after a few days when I was on holiday or something and was notchecking my junk mail box regularly. Converting my files to PDF format resulted in the occasional strangeerror appearing. I corrected all that I noticed but if I missed any and you spot them, please email me!

Now down to business. If you want good marks, these notes should be read and reread until you really knowthem. Practise drawing the diagrams until you can do them from memory without making mistakes. It is agood idea to revise something and practise drawing diagrams for a short period every day.

1-1. INTRODUCTION

POSITIVE AND NORMATIVE THINKING

Positive economics deals with what is; normative thinking deals with what ought to be and is value-laden.All sciences and fields of learning try to be positive and deal with facts and models based on facts. Youshould try to be positive i.e. scientific in your statements, especially when writing essays and in the examroom.

Words like "ought", or "should" or “as a nation we must” are all normative statements and you should doyour best to avoid them. Try not to say things like “It would be better if…”,or “the government should….”“it would be a good thing for X to do Y”. Many policy prescriptions you might wish to make are normative,e.g., “The economy would be better off if we….” and it can raise an examiner’s hackles. You might getaway with a general statement such as “Some advocate…”, “It has been suggested that…” or “Many believethat….” as these are positive statements and sound less normative. Note that the words used in an otherwisescientific study can themselves carry a normative feeling, e.g. "freedom", "democracy", "efficiency", or"welfare" may all seem to be “good words to many people; whereas words such as “inequitable”,“exploitation”, "unsound", "interference", "fascist", or "police state" seem "bad" to many people.

OPPORTUNITY COST

We live in a world of scarcity, in the sense that we can never have everything that we might like. As a resultwe must make choices, for instance whether to buy this or that, whether to eat this or that, whether to walkin the park or go to a movie, or whether to produce this or that. Every time we make a choice to do some-thing we automatically exclude something else that we did not do we have given it up. We call this the“opportunity cost”.

Definition “Opportunity cost is the best forgone alternative” i.e. it is what we gave up to get what we did. The opportunity cost of buying new pair of shoes might be alunch forgone.

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· The opportunity cost of buying a new shirt might be not going to the cinema.· The opportunity cost of taking a part-time job might be not being able to hang out in the mall with

your friends.

For a producerThe opportunity cost of buying plastic packaging material might be the cardboard he did not buy.

NB there can be many alternatives foregone, but only one will be the opportunity cost you cannot add themup and say they are all the opportunity cost, because it must be a choice between them.

Opportunity cost can be thought of as:

1. The cost in pounds (represents a real thing given up); or2. The cost in time.

Opportunity cost is important

1. We use it whenever we are deciding what to do, for example shall we hire a couple of videos or buy a piz-za instead.

2. It always arises with budget allocations. At some point in your life you may have to draw up a budget andallocate money for different purposes. You will be forced to weigh up what is really needed in your tennisclub, computer society, your country or whatever.

3. It lies behind the cost curves that we draw. How does this work?

Consider two producers, A and B. Producer A might have to pay £20 a ton to get the iron ore to make intomotor cars. Producer A sees the cost as £20, but we see it as the way of making sure he gets the resources,rather than letting B get them! So the opportunity cost really does stand behind the cost curves we draw.

Similarly in consumption: if something costs £10, you have to pay £10 to buy it. That £10 is not only theprice of the object, it is also the amount you have to pay to get the resources, raw materials, labour etc. thatwent into making it. This prevented these resources from going into making something else.

After you buy the item it will be reordered by the shopkeeper and replaced on the shelf. S/he orders from awholesaler who in turn orders more from the producer. The producer then buys the raw materials etc. tomake another of whatever you bought! In this way, resources keep on going into making whatever peopledemand.

4. This is how the price mechanism really works – that is, how it allocates resources to wherever the de-mand is the greatest.

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Apples

A1

PPC1

Bananas00 B1

THE PRODUCTION FRONTIER OR PRODUCTION POSSIBILITY CURVE

What is it?It shows us the maximum that a country can produce. There is clearly a limit to this at any one time justlike there is a limit to the weight that you can lift over your head or eat at any time. We assume two goods(I will use apples and bananas as these easily can be represented by A and B) for ease of explanation –but it is true of any number of goods.

Drawing the diagram – we start with the maximum amount of good A we can produce if all our resourcesare devoted to producing A which gives us a point on the vertical axis; then we do the same for the case ifwe only produce B to give us a point on the horizontal axis. Then we join the two positions with a straightline. Once we have drawn the line, we do not have to have all apples or all bananas but we can chose some-where along it. Any point on it represents a mix of the two goods that people wish to buy. At the point se-lected above, people consume 0A1 apples and 0B1 Bananas.

Apples

A1

PPC1

Bananas00 B1

[DIGRESSION: DRAWING THE CURVESYou should practise drawing all the diagrams regularly – several times each day is a good idea. In the end,they need to be second nature to you so that you can recall and correctly draw the appropriate diagramwhenever you want. It is most important to be able to this so that you can quickly gain good marks.The wrong diagram, a mislabelled one, or one lacking labels, more or less dooms you to fail. It showsthat you do not really understand what you are saying and examiners hate that. Labels, by the way, are thewords on the diagram, like “apples”, “bananas” or “ppc 1” in this diagram.

When tutoring, I would draw each diagram again in front of the student, and explain the importance of get-ting it right (and remind them of this now and then later). It is important to see how a diagram is built up asthey are really easy to do, but to be suddenly presented with a complicated finished product can be a bitdaunting. For this reason, I have put in a sensible order of drawing the diagram for the first few times Ipresent them. It is just about impossible to get a good mark in economics without drawing diagrams, sostart practicing without delay!

Warning! It may seem easy, but it helps you much less if you download diagrams from the Internet and pastethem into essays. It is more valuable for you to draw them, and learn them, for yourself. END OF DIGRES-SION]

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0

Apples

Bananas0

Apples

Bananas

PPC1

0

Apples

Bananas

PPC1A1

B1

Apples

Bananas00 B1

A1

Equilibrium pointwhere ppc is justtangent to theprice line AB

A

B

PPCA2

B2

The way the diagram of the production possibility curve is drawn.

0

Apples

Bananas0

Apples

Bananas

PPC1

0

Apples

Bananas

PPC1A1

B1

We usually draw the production function curved , to reflect the law of diminishing returns. Some factors ofproduction are better at producing A and not as good at B, as you might imagine. Some land is simply bet-ter at growing bananas than apples, just as some of your friends are better at doing maths, swimming orplaying the guitar than others. So as we move down the production possibility curve and get more bananas,we can expect to get a few less bananas than we might expect; perhaps we used to give up 5 apples to get 5more bananas, but as we slide down the curve we will get, say, only 4 more bananas, then only 3 more, or 2more, as we keep sliding down.

The line curves in at each end to show this as in the diagram below.

Apples

Bananas00 B1

A1

Equilibrium pointwhere ppc is justtangent to theprice line AB

A

B

PPCA2

B2

[Digression. It is unlikely in my view that you will be asked why the production frontier is curved as op-posed to a straight line, but if you do, the reasoning above and the diagram explains it. In the diagram youcan easily see that if we had a straight line production possibility curve (like AB) we could produce the max-imum amount of apples at the end of it, that is, at A, and have no bananas at all. But as diminishing returnsdo exist, we are actually on the curved A2B2. The maximum apples possible are at A2 (not A which wecould reach if we were on the straight line ppc ). As diminishing returns put us on the curve not the straight,the difference between A2 and A is the quantity of apples lost because of diminishing returns, End of digres-sion]

It is common to use straight line production frontiers in text books because they are easier to draw and ma-nipulate, so they often look like the diagram below.

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Apples

A1

PPC1

Bananas00 B1

Apples

Bananas0

A1

A2

B

Apples

A1

PPC1

Bananas00 B1

What happens if we swivel the curve? If society learns to get better at producing Apples alone, it wouldswivel the curve out along the vertical axis of apples. This reflects the fact that we can get more outputfrom the resources and factors of production that we have. The swivel that gives us more apples reflectsa productivity increase in apples, but not in bananas.

Apples

Bananas0

A1

A2

B

After the productivity increase in the apple growing industry, withe same quantity and quality of factors ofproduction, society can increase the output of apples from 0A1 to 0A2, that is, by the distance A1 to A2.

If we swivel it the other way, and push out B , we would get a productivity increase in bananas, but not inapples.

What if we move the whole curve out? If a country has learned to get better at producing every-thing, this would physically move the production frontier upwards and outward, which is economic growth.

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Apples

A

Bananas00 B

ppc1 =now

ppc2 =4 years time

A1A2

B1B2

Apples

A

Bananas00 B

ppc1 =now

ppc2 =4 years time

A1A2

B1B2

We return to the subject of economic growth in the unit “Managing the economy”.

SPECIALISATION AND FOREIGN TRADE

If people specialise they are more productive – if you are like me, you probably could not make a good pairof shoes, do brain surgery or advise on investing for pensions! We tend to do what we are best at. Imaginethe result if we did what we are worst at!

Countries are the same – if they concentrate on what they are best at, they produce more and better goods orservices. As a rule of thumb, countries that follow a protectionist policy (protecting their industries fromforeign competition) are trying to do what they are worst at, or at least not trying to do what they could bebest at. Most economists would probably think that protectionism is not exactly a good idea.

Two concepts of “advantage”

Absolute advantage – this means a country can produce more of almost everything than another, i.e., it is awealthy country. The USA can produce more than Egypt for instance – clearly, the USA has an absoluteadvantage over Egypt. It is of no particular interest as an idea: the rich are just rich!

Comparative advantage – this means that a country is better at producing something, but not necessarilyeverything, than another. For instance, Sweden is better at making marine engines than the UK, but we arebetter at organising financial markets and insurance. All countries are better at doing a few things more thanothers.

Comparative advantage is the one that matters in economics and it is the main reason why countries tradewith each other. We do not simply buy pineapples from tropical countries because it is too cold to growthem here. We could in fact grow them under glass and with heating, but we clearly lack a comparative ad-vantage in the pineapple producing business. Hawaii on the other hand has a strong comparative advantagein that area.

The gains from trade

If a country tries to produce everything for itself, it will stay poor. Examples: China under Mao Zedong andRussia under Stalin both followed such a policy and the people suffered a very low standard of living as aresult. The message is that trade helps the people in a country to gain wealth!

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The gains from trade consist of:

· Comparative advantage – we do what we are best at and thus produce more. We then exchange oursurplus with other countries for something we are less good at. Both the other countries and ourcountry do better and enjoy higher living standards as a result.

· Economies of scale – if we specialise we can follow a system of mass production, and lower ourcosts. We can then exchange the surplus with other countries. Economies of scale are examined inUnit 2.

· We can gain wider consumer choice e.g., we can drive Volvos, Renaults or BMW’s, as well as lo-cally-made Fords!

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Price

D

Quantity0

1-2. DEMAND AND SUPPLY: INTRODUCTION

(Abbreviations: S = “supply”; D = “demand”; Y = “income”; r = “rate of interest”)

At the equilibrium price, the quantity demanded just equals the quantity supplied. There are unsatisfied con-sumers who could not buy at that price even though they were willing. What do we mean by equilibrium?Equilibrium is the state of affairs in which there is no tendency to change. How do we show this equilibriumprice? We use demand and supply curves.

DemandWhat is the demand curve? It is a curve showing the quantity that will be bought on the market at differentprices.

The lower the price, the more will be demanded; the higher the price the less will be demanded. Think! Ifall Nike trainers were £2 a pair, would you buy more than if they were £200 a pair? It seems probable!

Price

D

Quantity0

In economics, “demand” means demand is backed by money – it is not just a need or a desire, but people dohave the money to buy and are prepared to buy.

Supply

What is the supply curve? The supply curve is a curve showing the quantity that will be offered on the mar-ket at different prices. We believe that higher prices cause more people to sell. Imagine: in your classroom,if I offer to buy each T shirt for £500, almost everyone will sell to me; but if I offer £1 each, probably few ifany would be willing If however I were to offer £7, more would sell but probably not everyone. That is whythe supply curve slopes upward.

So the demand curve is drawn sloping down-ward, left to right. Examine the one here - at ahigh price, high up on the price axis, little is de-manded as we trace a line down to the quantityaxis. But at a lower price, a greater quantity isdemanded.

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Price

Quantity0

SS

Price

D

P

Quantity0 Q

S

Price

Quantity0

SS

Let’s put both the demand and supply curves on the same diagram .

Price

D

P

Quantity0 Q

S

Guess where the equilibrium price will be? Right! Where the two curves cross! As said earlier, at the equi-librium price, the quantity demanded just equals the quantity supplied. There are no unsatisfied consumerswho could not buy at that price even though they were willing and everyone who wanted to sell at that pricecould do so. This happy situation happens at the intersection of D and S with price P and quantity Q.

When I started in economics, I had to chant along with the rest of the class: "price is determined by supplyand demand!” It certainly made it stick in my mind and might help you too!

Let us return and look at demand in more detail (We’ll look at supply later too)9

Price

Quantity0

D here? Or why not here?

D D

What determines the D curve? i.e., why is it where it is and not somewhere else?

Price

Quantity0

D here? Or why not here?

D D

1. There are four main personal determinants of demand

· Income· Taste· Prices of other goods or service· Expectations about future prices of this good or service

2. AND several other market determinants

· Income distribution - if you think of all the other people in your house and you as you are now, thenif you suddenly got all the total income and savings and the others had none, there would be a dif-ferent pattern of demand from what it is now. They probably do not eat lunch every day if they haveno money. It is the same in society in general: change the income distribution and a new pattern ofdemand curves follows.

· Wealth distribution (as opposed to income distribution). If 10% of the population have 90% ofthe wealth, probably more Porsche motor cars will be demanded than if we all have the same ratherlowish amount!

· Population size - the larger the population, the bigger the demand, ceteris paribus. That is a Lat-in tag meaning “all other things remaining the same” and you might come across it in a lot of eco-nomics books.

· Population age distribution - if there are many old people, important demands in society will be formedicines, hip replacement operations and Zimmer frames but fewer Beastie Boys CDs, or prams.

· The interest rate. This is especially important for house purchases, motor cars, long-life consumergoods often on a credit card, or hire purchase generally. A higher rate of interest means more to re-pay, so people tend to borrow less.

What can cause a shift in the demand curve? (= a new curve)10

Price

Quantity0

D1

P

Q1

D2

Q2

Price

Quantity0

D1

P1

Q1

SD2

Q2

P2

A change in any of the above determinants of demand will do it!

If demand increases, overall, more of the good/service is bought at any unchanged (the same) price. You cansee this in the diagram below, where at P1 an amount OQ1 is demanded, but after demand increases to D2,at the same price an large amount is demanded, i.e., OQ2. It is easy to remember what “an increase in de-mand” means; there must be a new curve and it will move upwards and to the right.

Price

Quantity0

D1

P

Q1

D2

Q2

The effects of an increase in demand are usually analysed using the equilibrium positions determined by theintersection of demand and supply.

Price

Quantity0

D1

P1

Q1

SD2

Q2

P2

You can see that the increase in demand means we move from the equilibrium position P1Q1 to the newequilibrium position P2Q2. More is demanded - we shift from the position Q1 to the position Q2, so the dif-ference (OQ2 minus OQ1) is Q1Q2.

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Quantity

Price

D1

Quantity

Price

D1

S1

Quantity

Price

D1

S1

P1

Q1 Quantity

Price

D1

S1

P1

Q1

D2

Q2

Price

Quantity0

D2

P

Q2

D1

Q1

The way the diagram of a shift in demand is drawn,(shown not moving to the new equilibrium, soyou can see that more is demanded at the same price)

Quantity

Price

D1

Quantity

Price

D1

S1

Quantity

Price

D1

S1

P1

Q1 Quantity

Price

D1

S1

P1

Q1

D2

Q2

The way the diagrams are built up should be reasonably clear by now. If you have any worries, checkback and examine those supplied earlier. The general principles are:

1. Draw the axes and label them immediately (“one axis, two axes”).2. Put in the first curve and label it.3. Add the second curve and label it.4. Draw the equilibrium position – preferably using dotted lines.5. Make the necessary changes, such as shift a curve inwards or outwards by drawing a new curve and la-belling it.6. Draw the new equilibrium position – preferably using dotted lines.7. And finally you compare the new equilibrium position with the first one, using your own words but tryingto get in the necessary jargon phrases such as “increase in demand”, or “economic growth”, whatever isrelevant to the question you are tackling.

Henceforth I shall not be supplying the series of pictures showing how the diagrams are built up, as youshould be able to follow the above principles for yourself. Before long, it will become second nature to ex-amine a finished diagram and work out how it was built up.

If demand decreases, the demand curve shifts the other way, downward and to the left. Again we have anew curve, as in the diagram below.

Price

Quantity0

D2

P

Q2

D1

Q1You will notice that less is bought at any given price, such as P.

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Price

Quantity0

D2

P2

Q2

SD1

Q1

P1

Price

Quantity0

S?? S??

Again, a decrease in demand is usually analysed by determining the new equilibrium position and the com-paring it with the original one. For this we need to put the supply curve in.

Price

Quantity0

D2

P2

Q2

SD1

Q1

P1

As you can see, if demand decreases, then less is bought (as you might imagine!) and the quantity demandedfalls from Q2 to Q1; price also falls, in this case from P1 to P2

Let us look at supply in more detail

What determines the supply curve, i.e. why is it where it is and not somewhere else?

Price

Quantity0

S?? S??

The answer is, the price, quantity, and quality of inputs used. These consist of things like machinery,equipment, staff and workers, raw materials, and fuel. These are collectively known as “the factors ofproduction”, and are often summarised as land, (L) labour (N) and capital (K) plus a remainder term, R.

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· Land - is what it says but can include things like diamonds or oil that are found there.

· Labour mostly means workers, but also includes managers.

· Capital means machinery and equipment. A subset of this is“social overhead capital” - like roads,bridges and docks.

[Digression: The whole production of the nation can be summed up as: O = f(L, N, K) + Ror put into words, “output is a function of (= is in some as yet undefined way caused by) land, labour, capi-tal, and a few other things”. You will need this later; I am just sowing a few seeds.]

· The remainder term “R”, which covers things in both labour and capital is the really interesting one

The labour component of “R”. This consists of things like entrepreneurial ability, the managerial methods inuse, labour motivation and how good it is, labour skills, the strength of the trade union and its attitudes, thebonus and other incentive systems in force, the quality of the education system, and the retraining facilitiesavailable in society.

The capital component of “R”. This consists of things like:

The level of technology, knowledge about what technology is available, the adequacy of factory organi-sation, and economies of scale. They can obviously affect the supply curve, or the output possible, if theyare good or bad.

· Maybe the weather, e.g. floods can destroy crops, effect transport, reduce supply, and raiseprice.

· Joint supply - if we increase the number of sheep to supply an increased demand for mutton, it auto-matically increases the wool supply. So the price of related good can be a determinant of supply.Examiners like questions on joint supply, but it is not often encountered in the world in which welive.

· The productivity of the factors of production – this is closely related to technology; but it can also behow hard workers are prepared to work, motivation, and incentives systems etc. (it too can appearseparately, or be included in the remainder term, R, as above).

· The size and number of firms in the industry, including the marketing conditions.

· War and social unrest.

What can cause an increase or decrease in supply?(a shift in the curve)

Like demand, it needs a change in one or more of the determinants. For supply these include things like:· A change in the price of a factor of production.· A change in the productivity of a factor.· New technology invented.· The discovery of a new raw material or fuel.· More worker enthusiasm. This occurs often in war time, because of patriotism.

An increase in supply = the curve shifts downward and to the right (more is supplied at the unchangedprice) - e.g., if labour productivity increases or someone finds a new cheap source of materials.

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Price

Quantity0

SS1 SS2

P1

Q1 Q2

Price

Quantity0

SS1 SS2

D

P1P2

Q1 Q2

Price

Quantity0

SS1 SS2

P1

Q1 Q2

You will notice that the quantity supplied at the unchanged price P1 increases - well, that’s what an increasein supply does!

And if we put in a demand curve we can see both the equilibrium positions and work out that an increase insupply means a fall in price and an increase in the quantity purchased.

Price

Quantity0

SS1 SS2

D

P1P2

Q1 Q2

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Price

Quantity0

SS2 SS1

P1

Q2 Q1

Price

Quantity0

SS2 SS1

D

P2P1

Q2 Q1

A decrease in supply is the opposite; the supply curve shifts up and to the left:

Price

Quantity0

SS2 SS1

P1

Q2 Q1

Again, less is supplied at any chosen price; we move from a supply of OQ1 to the smaller quantity OQ2.

The new and old equilibrium positions need both a supply curve and a demand curve.

Price

Quantity0

SS2 SS1

D

P2P1

Q2 Q1

More analysis! A decrease in supply means a fall in the quantity supplied and an increase in price. Work outfor yourself the old and new quantities and prices - good practice!

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Price

Quantity0

S short runfairly inelastic

Falling long run S curve(modern hi tech goods for exampleget cheaper over time)

S long runhigh elasticity

S very short runtotally inelastic

S short run closeto unit inelastic

Time Periods And Supply

Three time periods matter:

· the very short run (VSR) (or “momentary supply”),· the short run (SR) , and· the long run (LR).

They have different slopes to their curves and different elasticities (more later!).

The very short run. This is defined as the time when no change can be made in any of the factors of produc-tion – the supply curve is vertical. Examples are the fruit and vegetables that appear in the wholesale marketeach day.

The short run.This is defined as the period in which the variable factors can be altered but not the fixed factors, i.e. we canmake some changes.

· Fixed factors = those that do not vary with output such as factory building, transport fleet, officestaff, and the bill for heating and lighting the premises.

· Variable factors = those that vary directly with output such as raw materials, the energy used, thepetrol in the trucks, and the wages of some unskilled workers who might be taken on whenneeded, perhaps part-time.

The supply curve we usually draw is the short run one.

The long runIs defined as the period when all factors can be varied i.e., the producer can do any changes s/he wants. Thismeans a flatter curve, possibly even downward sloping sometimes.

How the supply curve can vary with the time period we are considering:The flatter the curve, the more elastic it is (“quantity stretches more”). Producers will only make changesthat help them produce more or reduce costs.

Price

Quantity0






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Quantity

Price

D1

S1

P1

Q1

D2

Q2

P2The shift of D1 to D2 isan increase in demand

The sliding up the unchangedS curve is an extension of supply

NOTE that all the curves are drawn on the one diagram; this means the scale is the same for all; if you draweach in a separate diagram, the flatter one (S long run) is not necessarily the most elastic, as the horizontalaxis might be on a much wider scale. If this seems incomprehensible to you, Do Not Worry! Just rememberto put them all on the same diagram.

Remember that you should practise drawing the diagrams regularly!

Increases and Extensions of Supply And Demand

We know that the word "increase" means a shift of the curve – but what about extensions?

"Extensions" are movements along an existing curve.

Questions are often set to see if you know the difference between an ”increase” and an “extension”.

[A digression: if a line crosses two others, an increase in one curve always means an extension of the other!The diagram here shows that.

For supply and demand:

With an increase in demand we slide up an unchanged supply curve.

Quantity

Price

D1

S1

P1

Q1

D2

Q2

P2The shift of D1 to D2 isan increase in demand

The sliding up the unchangedS curve is an extension of supply

We see two upwardsloping lines that cross asingle line. The upwardsloping lines reflect anincrease (or decrease)and we slide down (orup) the single line.

It’s clear that an increase in de-mand goes with an extension ofsupply.

18

Price

Quantity0

SS1 SS2

D

The shift of S1 to S2 isan increase in supply

Sliding down the unchangedD curve is an extension of demand

P1P2

S1 S2

Price

Quantity0

SS2 SS1

D

The shift of S1 to S2 isa decrease in supply

Sliding up the unchanged D curveis a contraction of demand

P2P1

S2 S1

NOTE that we start on demand curve D1 and supply curve S1 to ascertain the equilibrium price andquantity; then we look at D2 to get the second equilibrium position.

Reminder: In economics, at this level we always start in equilibrium, then we alter something, and move tothe new equilibrium position. We then compare the two equilibrium positions for the analysis.

And we can see an increase in supply goes with an extension of demand, as we slide down an unchangeddemand curve:

With an increase in supply we slide down an unchanged demand curve

Price

Quantity0

SS1 SS2

D

The shift of S1 to S2 isan increase in supply

Sliding down the unchangedD curve is an extension of demand

P1P2

S1 S2

Decreases and contractions of supply and demand

A decrease means a new curve, which shifts backwards; a contraction means sliding back along an un-changed curve.

A contraction of demand following a decrease in supply :

Price

Quantity0

SS2 SS1

D

The shift of S1 to S2 isa decrease in supply

Sliding up the unchanged D curveis a contraction of demand

P2P1

S2 S1

19

Price

Quantity0

S

D1

|The shift of D1 to D2 isa decrease in demand

P1P2

S1 S2

D2

Sliding down the unchangedS cuve is a contraction of supply

A contraction of supply following a decrease in demand

Price

Quantity0

S

D1

|The shift of D1 to D2 isa decrease in demand

P1P2

S1 S2

D2

Sliding down the unchangedS cuve is a contraction of supply

Here is one of the hoary old trick questions. "Demand increases, so price rises. The rise in price meansfewer can afford the good, so demand decreases and prices fall again." Do you agree with this statement?

Question: what do you think?

At first glance it might seem to make sense. But it is in fact false!

Why is it false? You draw the diagram now on a piece of paper. First increase the demand curve andyou will see the price rise as we extend up the supply curve.

Then think about the new equilibrium. Why on earth should it change? It is an equilibrium position!That was why you learned the definition of equilibrium a little while ago - to be able to detect fallaciesin argument.

This is a proposition in logic, designed to test if you really understand supply and demand. You shouldtry to get the words “extension” and “increase” in to show you can use them properly and you definitelyneed a diagram.

1-4. THE CONCEPT OF ELASTICITY: MEASURING THERESPONSIVENESS OF DEMAND AND SUPPLY (very popular with examiners)

ELASTICITIES

Elasticities are a sort of measure of supply and demand.

If demand increases, and we ask how much does supply extend, we need more than an answer like"quite a lot"!! Government may be trying to raise tax to get a certain amount of revenue for instance.The question is “How much will quantity change, a lot or a little?”

20

WE START WITH THE ELASTICITY OF DEMAND

Three broad types of elasticity of demand

1. Price elasticity = the usual one, it deals with 1 good.2. Cross elasticity = a special one, it deals with 2 goods.3. Income elasticity = a special one and it deals with changes in incomes.

1. Price Elasticity of Demand

Definition: "Price elasticity of demand is a measure of the responsiveness of the quantity demandedto a small change in price". Learn this by heart!

[In simpler terms, “is the proportional change in quantity greater or lesser than the change in price?”As an example, if the price was 20 and it falls by 2, the fall is 10% (2 times 100, all divided by 20); andif quantity then increases from 100 to 200, the increase is 100%.

We can see that the increase in Q is greater (100% compared with 10%) - i.e., it stretches out a lot - itis elastic!]

How do we actually measure price elasticity?

Price elasticity of demand is measured by the percentage change in Qd, divided by the percentage changein price:

%∆Qd

%∆P

So the price elasticity of demand is:

∆QQ

------------∆PP

= ∆Q x ∆P Q P

= ∆Q x Q∆P P

(to divide by fraction invert and multiply)

(gathering the change terms all on side for neatness. Ifthis shuffling makes you unhappy, just remember that3 x 4 is the same as 4 x 3)

21

Price

Unit elastic D(not well drawn!)

Quantity0

Inelastic D

Elastic D

In the example above, the percentage change in Q was 100 and the percentage changein price was 10 so the elasticity is 100 divided by 10 = 10.0 In the world in which welive this is actually very high! (Anything over 2 in the real world is pretty high.)

Logically the answer can have only 1 of 3 results: <1, = 1, or >1

(< stands for “less than”; > stands for “more than”; if we are looking at “<” left to right, the way we read,we see it goes little to big so it is easy to remember!)

When we look at the fraction, we find that the answer is less than 1 if the top is smaller than the bottom,equal to 1 if the top and bottom are the same, or more than 1 if the top is greater than the bottom.

What does each possible answer mean?a] If the answer is greater than 1 (e.g., 1.62) the demand curve is elastic.

It means that a small change in price led to big change in quantity (Q stretched a lot which means thatit is elastic); graphically the curve tends to look flat when compared with an inelastic curve. Butremember all curves must have the same scale and axis or else be on the same diagram.

Examples of demand curves which are price elastic:

Dell computers (one brand of many substitutes); foreign travel by cheap airlines.

b] If the answer is less than 1, e.g., 0.75, the demand curve is inelastic People do not respond somuch to price cuts and although they buy more, they do not buy a lot more.

Examples:Salt, bread, sets of cutlery (essentials; no substitutes).

c] If the answer just happens to equal 1 it is “unit elastic” (unity = 1), a special case and rarely seen,except perhaps for a small part of a large demand curve! The answer would work out at exactly 1.0 andthe curve is asymptotic; this means that it approaches more and more closely but never quite reaches theaxes.

Reminder: if you draw one rather flat demand curve in one diagram, demand is actually onlyrelatively elastic etc because we do not know the scale - don’t worry about it, it’s technical!Just remember to say “relatively inelastic” or “relatively elastic” in the exam room! If youdraw them on one diagram then you are on safer ground if you just say “elastic”.

What do the different elasticity demand curves look like?Price

Unit elastic D(not well drawn!)

Quantity0

Inelastic D

Elastic D

[The unit elastic de-mand is not drawn well- I am a rotten artist Ifear.]

22

The importance of the elasticity concept

It allows us to get precise answers, not be vague.

We need it for certain questions e.g., if a hairdresser is considering increasing her price for a basic cut from£20 to £25, will profits rise or fall?

What determines price elasticity?

· The number of substitutes - the greater the substitutes, the more elastic the good - a small pricerise means consumers switch to another brand. THIS IS THE MAIN DETERMINANT!

· The proportion of income - the greater the proportion of income going on good, the more elasticit tends to be. Salt is relatively inelastic and very cheap - would you consume a £2’s worth a year?

· Luxuries and necessities - luxuries tend to be more elastic (airfares, foreign travel); necessitiesmore inelastic (electricity). Some economists do not like this “luxuries” point because whatconstitutes a luxury alters too much and in addition they can be personal to different individuals.

· Time - the longer the time, the more elastic demand tends to be, probably because

· More substitutes become available , the good or service is copied by others, new manufac-turers can enter, imports be made etc.

· Habits change only slowly, so we adjust to new prices slowly.· Capital may need to wear out to make change, e.g., if the price of petrol rises, drivers have

to wait until it is time to buy a new and smaller car in order to reduce petrol consumption.

Q. For the hairdresser earlier who is considering a price rise, I asked earlier what would happen to her profit if shecharged more. Assume she is very good and her clients feel that there is no real substitute?

A. The demand curve for her services is inelastic so profit would rise!

Q. But consider what would happen if she were just another high street hair dresser?

Draw the diagram for me now!

Another example of the importance of elasticity: if the government raises the tax on cigarettes, willgovernment revenue rise or fall? And by how much?

The government normally wishes to raise more revenue - although there are health benefits if peoplereduce cigarette consumption, which saves on National Health Service expenditure too.If the government raises tax by 5% and demand is inelastic, the quantity will fall as price rises, but itwill fall by less than 5%, so revenue will increase.

If the government imposes an indirect tax, it pushes up the supply curve by the exact amount of tax.

If the tax is absolute e.g., £1 each item, it pushes the curve up parallel. The original producer faces nochange in supply conditions, but £1 is added to each quantity.

23

Price

Quantity0

SS2 SS1

P1

Q1

P2

Price

Quantity0

SS2 SS1

D

P2P1

Q2 Q1

Price

Quantity0

SS2 SS1

D

P2P1

Q2 Q1

C

BA

When we draw the diagram for the imposition of indirect tax: we start at the original equilibrium, andadd the tax.

Price

Quantity0

SS2 SS1

P1

Q1

P2

When we look at the market equilibrium, we start with a supply and demand curve and see the originalequilibrium. We then add the tax, which pushes up the supply curve and look at the new equilibriumposition, to see what changes the tax has made.

Price

Quantity0

SS2 SS1

D

P2P1

Q2 Q1

We can see that the original equilibrium position P1Q1 becomes P2Q2 once the tax is imposed. Thereis a rise in price - but by less than the whole tax - and there is a fall in quantity.

Price

Quantity0

SS2 SS1

D

P2P1

Q2 Q1

C

BA

The increase in tax per unit is AC, but the price only goes from P1 to P2 = BC; and BC is less than AC(price rises but by less than the whole amount of tax per unit)

Note that the supplier workson the original S1 curve - theS2 curve merely includes thegovernment tax.

24

What about the change in government revenue? This is the quantity now sold (OQ2 at the newequilibrium position = the number of units) times the tax per unit (AC). This is the area bounded byP2CAP3 in the diagram below.

If the indirect tax is ad valorem (proportional not absolute, e.g., 10%) it pushes up the supply curveat an increasing rate

Q. Why?

A. Because 10% of £1 is only 10P, but 10% of £10 is £1!

[Not very well drawn =my inadequacy as an artist]

Price

Quantity0

SS2 SS1

D

P2P1

Q2 Q1

C

BAP3

Price

Quantity0

S2

S1

D

P2P1

Q2 Q1

C

BA

25

Price

Quantity0

SS2 SS1

D

P2P1

Q2 Q1

C

BA

Price

Quantity0

S2

S1

D

P2P1

Q2 Q1

C

BA

Price

Quantity0

SS2 SS1

D

P2P1

Q2 Q1

C

BA

The government revenue is the quantity now sold (OQ2 at the new equilibrium position = the number ofunits) times the tax per unit (AC). This is the area bounded by P2CAP3.

If the indirect tax is ad valorem (proportional not absolute, e.g., 10%) it pushes up the supply curveat an increasing rate

Q. Why?

A. Because 10% of £1 is only 10P, but 10% of £10 is £1!

Price

Quantity0

S2

S1

D

P2P1

Q2 Q1

C

BA

26

Price

Quantity0

SS1 SS2

D

P1

P2

Q1

Price

Quantity0

SS1 SS2

D

P1P2

Q1

A

B

Q2

A subsidy is just a negative tax e.g., government gives producer some money (subsidy) ratherthan a producer or consumer giving money to the government (tax).

Subsidy questions are not usually as interesting as tax ones!

Let’s draw the diagram for putting on a subsidy.

Price

Quantity0

SS1 SS2

D

P1

P2

Q1

We start, as ever, in the initial equilibrium position, P1Q1 on the curves S1 and D1. The subsidy goeson, the size of it is P1 to P2, and the new supply curve is S2. You can see that the unchanged quantity,Q1, is now cheaper at price P2- but we have not yet examined the new equilibrium position to see theresults of the change.

What is the total amount of the subsidy, i.e., the cost to the government? We need to look at the newequilibrium position, which will be at P2Q2, below.

Price

Quantity0

SS1 SS2

D

P1P2

Q1

A

B

Q227

Price

Quantity0

SS1 SS2

D

P1P2

Q1

A

B

Q2

P3

C

D

Price

Quantity0

Perfectly inelastic demand

Perfectly elastic demand

The subsidy is AB for each unit in the diagram above.The quantity sold after the subsidy is imposed is OQ2.

So how much does the subsidy cost the government, and ultimately the tax payer?

Price

Quantity0

SS1 SS2

D

P1P2

Q1

A

B

Q2

P3

C

D

The subsidy the government pays is the new quantity sold, (0Q2) times the subsidy amount per unit ofBA.We know that BA is the same as CD because the curve shifts parallel.We know that the suppliers continue with curve S1, so they require price 0P3 for quantity 0Q2 (Notethat the supplier works off the original supply curve - there has been no change in the determinants ofhis or her supply.)We see that consumers pay the rectangle 0Q2CP2.We see that the government pays the rectangle P2CDP3 - this is the subsidy cost to the tax payer.And together these add up to the total expenditure of 0Q2DP3.Notice also that consumption rises from 0Q1 to 0Q2 - which is the point of the subsidy: more is pro-duced and consumed.

The limits of price elasticity of demand

Perfectly elastic = a horizontal line; this means that consumers will demand an infinite amount at thatprice! It is merely a limit and obviously it cannot be reached.

Perfectly inelastic = vertical line; this means that consumers will pay any amount at all, such as £1, or £1million, or £1 trillion…. to buy the good or service. Again this is unreasonable, it’s merely a limit. Theylook like this:

Price

Quantity0


Perfectly elastic demand

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2. Cross Elasticity of Demand

Definition: "Cross elasticity of demand is a measure of the responsiveness of the quantity demanded ofone good or service to a small change in price of another". Learn this! It is virtually the same as thedefinition of price elasticity earlier - go on, compare them now!

Cross elasticity measures substitutes and complements (note the spelling; it is not “compliments”)

If the supply of beef increases so the equilibrium price falls, it may induce some people to switch fromeating chicken or pork to eating the now cheaper beef. The fall in price of beef causes a decrease inquantity demanded of chicken or pork.

%∆Qd of good A

%∆P of good B

Note the “A” and “B” difference: we are dividing the percentage change in the quantity of A by thechange in the price of B.

If the price of beef fell and the quantity of chicken fell the answer will be positive, because two negativesmake a positive, so any items with a positive cross elasticity are substitutes.

If the price of heating oil falls it may induce some to install oil generated central heating in houses. Wesee that a fall in the price of A means an increase in the quantity of generators, so the answer is nega-tive (one plus and one minus) so these two goods are complements.

Cross elasticity does not seem to be used much in economics, except in exams.

3. Income Elasticity of Demand

Now this is most important! Incomes keep increasing over time, so the demand pattern for various goodsand services keeps changing. This matters for new firms looking to move into the market and producesomething: the market for what goods or services is likely to grow the fastest? That’s the area to be in! Itmatters for existing firms looking to diversify, or be concerned about the prospects for the future in thearea they produce and sell in.

Definition: "Income elasticity of demand is a measure of the responsiveness of the quantity demandedof a good or service to a small change in income". Learn!

Income elastic: a given change in income leads to a greater than proportionate increase in demand forthe good or service. Examples of income elastic goods: foreign travel, good wines, smart motor cars,eating in restaurants, and currently well-regarded brands, e.g., Adidas sportswear or Rolex watches.

Income inelastic: a given change in income leads to a less than proportionate increase in demand forthe good or service. Examples: bread, staple foods generally, cheap stores, and all lowly-regardedbrands. If our income happens to double (lucky us!) we do not spend twice as much on such items.

Income neutral elastic: should it just happen that, say, a 5% increase in income leads to a 5% increase indemand for a good or service, then it is income neutral elastic. This is not really an interesting case,merely a bit strange. Oddly enough, Pizza Hut in Australia claimed in the 1990s that they were like this:in a recession some people stopped eating out so stopped going to Pizza Hut, but other people switchedfrom “proper” restaurants to Pizza Hut which cancelled things out, so the company did not suffer!

Income negative elastic: this is most interesting! This happens when an increase in income causes a fallin demand. Really it indicates that we dislike this product but for some reason we must consume it atthe time. When we can afford not to consume it, then we stop buying it. Examiners like this concept!

29

Price

Quantity

Price

Quantity0ll ll ll l l ll l ll l

l

l

l

x x

xx

1 2 3 4 5 1 2 3 4 5

S S

Price

Quantity0

S

S

Examples are scarce, but it is suggested that probably potatoes were like this in Ireland during the Nine-teenth century. Currently, the demand for mealies (sweet corn) in some African countries may be in-come negative elastic. It is a rare event anyway. Negative income elasticity means that it is an “inferiorgood”.

THE ELASTICITY OF SUPPLY

Definition: the responsiveness of the quantity supplied to a small change in price. It is measured by:

%∆Qs%∆P

The measure roughly indicates the slope of the supply curve; the steeper the more inelastic. Why isthis only “roughly”? Because it depends on the scale of the diagram - for instance both the diagramsbelow have the same elasticity, but because the horizontal scale is not the same the slopes look differ-ent. That is why we have to draw two different elasticities on the same diagram where the scale is thesame.

Price

Quantity

Price

Quantity0ll ll ll l l ll l ll l

l

l

l

x x

xx

1 2 3 4 5 1 2 3 4 5

S S

BUT unit elastic supply is any straight line that cuts through the origin! (Just remember this, and donot worry! If you are a mathematician, you may already see why.)

Price

Quantity0

S

S

30

Price

Quantity0






Supply periods and time: (covered briefly earlier)

Price

Quantity0






Very short run = totally inelastic supply = fixed supply (e.g., the amount in a wholesale vegetablemarket delivered each morning; all the works of dead painters or sculptors).

Short run = perhaps moderately inelastic.

Long run = more elastic; or even negative elasticity (it slopes downward).

Why is supply more elastic in the long run?

Because the company can alter both the fixed and variable factors (i.e., all the factors of production). Itcan also find new or cheaper sources of raw materials; improve the training of labour; and introducenew technology or better machines. This allows the company to obtain more output without needingmuch increase in price.

The downward sloping supply curve in the long run is already familiar to you: computers, scanners,TV sets, digital cameras, DVD players and discs, CD players and discs….. Most if not all of the prod-ucts of modern hi-tech industry fall into this category. As the years go by, they get better and a lotcheaper.

Elasticity of supply is probably a bit less interesting to economists than the elasticities of demand - andit is easier to learn as there is less of it!

31

Quantity of pounds ininternational markets

Value of thepound in $

D1

S1

($)P1

Q10

1-5. DEMAND AND SUPPLY: APPLICATIONS TO ANY MARKET ARE POSSIBLE

Popular ones that examiners often like to set a question about include:· Housing· Foreign exchange· Agricultural products or raw material production, like tin or coal (often inelastic S and D so fluc-

tuations are common)

But the analysis is virtually identical in each case! You need to mention supply and demand very early inyour answer and then use supply and demand analysis, drawing the curves you need.

Be prepared to handle:

· The concept of equilibrium· The determinants of supply and of demand· An increase in demand and a decrease in demand· An increase in supply and a decrease in supply· An extension of both demand and supply· The elasticity of demand and supply· Minimum price fixing (examined in Unit 2)· Maximum price fixing (examined in Unit 2)· Applying an indirect tax (which shifts S curve up and to right).

An example of foreign exchange

You must use a diagram or two!

The value of a currency is determined by the supply and demand for it - just like any other good orservice, it is the normal equilibrium diagram you need.

The supply of £’s comes from the UK importing goods and services from abroad. We pay in pounds toa bank, which uses them to buy the US $ etc. that we need to pay the foreign supplier. If we import more,we increase the supply of pounds on the market, thus putting pressure on the pound to fall in value.Similarly, if we export, we buy the pounds back, thereby increasing the demand for pounds.

You could usefully practice drawing diagrams to fit these scenarios. They are the standard increase insupply and decrease in supply diagrams, but with “Quantity of £” on the horizontal axis and “Price of £in $” on the vertical one. We have to value the pound in some other currency, such as US$.



D1

S1

($)P1

Q10

32



D1

S1

($)P1

Q10

S2

($)P2

Q2

If the UK increases its imports, this puts more pounds on the international markets as we pay for theextra imports. This means an increase in the balance of trade deficit. This increase in supply then putspressure on the value of the pound, which falls.



D1

S1

($)P1

Q10

S2

($)P2

Q2

If foreign holders of pounds, largely banks but also others such as large international companies aswell as international speculators, decide the pound is overvalued and about to fall, they might sell. Theresults are the same: the increase in supply reduces the value of the pound. This may be termed “selfjustifying expectations”.

An example of the labour market.

If the UK allows more migrants in, this increases the supply of labour. Because many migrants arerelatively young males, they add to the supply of labour, normally producing more than they take outin social security benefits.

The increase in the supply of labour puts pressure on to lower wages, especially for the unskilled orsemi-skilled. It is difficult for many migrants to find more professional work unless their English isgood; they tend to end up in the unskilled sector, even if they have skills and abilities, until their lan-guage skill improves sufficiently and this can take many months or years.

The result is the normal diagram for an increase in supply, in this case of labour. You need the quantityof labour on the horizontal axis and wages on the vertical. Go on, draw it now!

Remember! You must use diagrams to answer questions about price or wages. Many markers glance atthe diagrams first and if they are correct, he or she is immediately disposed to give you a good mark anda decent pass! If your diagrams are clear and correct, they might also give you the benefit of the doubtif they have trouble with your handwriting or standard of grammatical English. In the exam room ineconomics it is virtually impossible to get a good mark without diagrams.

33

1-6 LET’S RECAP AND SHOW THE MARKET MECHANISM WORKING IN ALL ITSGLORY IN A PERFECT WORLD

In a perfect world, a market system will give a perfect result - resources will be allocated exactly towhere people need them to produce what the people demand.

Think supply and demand curves for two goods, both in equilibrium; assume people spend all theirmoney (as this is easier to imagine how it works). Then increase the demand for one good (which meansyou must reduce demand for the other, because they are spending all their money by assumption).

First we look at the goods market - let’s assume they are bread and milk; we start in equilibrium, thenwe will increase the demand for one good and see what happens.

Secondly, we examine the factor market which lies below the goods market. That consists of thoseresources that are used to produce the bread and milk. We use the labour market as the factor of production.

We have simplified the model by using two goods and one factor to show the perfect workings of themarket. With any number of goods and services and more factors we can still get this perfect resourceallocation.

(The whole of Unit One in this course is devoted to this market solution. Unit Two will explain why wemay not in fact attain this theoretical perfection.)

Abbreviations used:

MC = marginal costAC = average costP = priceQ = quantityMR = marginal revenueLab = labourAR = average revenuePPC = production possibility curve (production frontier)

34

Price

D

P

Quantity0 Q

S

Price

D

P

Quantity0 Q

S

Bread Milk

Wage

D

W

Quantityof labour

0 Qlab

S

Wage

D

W

0 Qlab

S

Bread workers

Quantityof labour

Milk workers

We start with the market for goods or services (bread and milk) in equilibrium

Price

D

P

Quantity0 Q

S

Price

D

P

Quantity0 Q

S

Bread Milk

And we can also examine the factor market for these goods; in this case we will use the people who makethe bread and produce the milk (Unit 4 covers labour markets in detail). Again we start in equilibrium.(The two diagrams below do not have to look exactly the same as the two above; they just have to benormal supply and demand curves.)

Wage

D

W

Quantityof labour

0 Qlab

S

Wage

D

W

0 Qlab

S

Bread workers

Quantityof labour

Milk workers

35

Price

D1

P1

Quantity0 Q1

S

Price

D1

P1

Quantity0 Q1

S

Bread Milk

D2

D2

Q2Q2

P2

P2

Wage

D1

W1

Quantityof labour

0 Qlab1

S

Wage

D1

W1

0 Qlab1

S

Bread workers

Quantityof labour

Milk workers

D2

D2

W2

W2

Qlab2 Qlab2

THEN, WE CHANGE SOMETHING AND ALTER THE EQUILIBRIUM POSITIONS

let’s increase the demand for bread and reduce the demand for milk. (On the assumption that all in-come is spent, if people spend more on bread they must spend less on milk.) We start as usual in equi-librium, on the demand curve for bread, “D1” and increase it to “D2”. People switch to consumingmore bread and away from milk, so the demand for milk falls, from D1 to D2.

Price

D1

P1

Quantity0 Q1

S

Price

D1

P1

Quantity0 Q1

S

Bread Milk

D2

D2

Q2Q2

P2

P2

You can see on the left that the price of bread rises (people demand it more) and on the right the price ofmilk falls (less demand).

Because of this change in the demand pattern, we get an increase in the demand for workers to producemore bread and a fall in the demand for milk workers - and we will reach a new equilibrium in the factormarket.

Again, demand increases from “D” to “D1” for the bread workers, and falls from “D” to “D1” for themilk workers.

Wage

D1

W1

Quantityof labour

0 Qlab1

S

Wage

D1

W1

0 Qlab1

S

Bread workers

Quantityof labour

Milk workers

D2

D2

W2

W2

Qlab2 Qlab2

You can see on the right that wages rise where demand for the product has increased (bread), and onthe left they fall where the product is less in demand than previously (milk).

36

Price

D1

P1

Quantity0 Q1

S

Price

D1

P1

Quantity0 Q1

S

Bread Milk

D2

D2

Q2 Q2

P2

P2

Wage

D1

W1

Quantityof labour

0 Qlab1

S

Wage

D1

W1

0 Qlab1

S

Bread workers

Quantityof labour

Milk workers

D2

D2

W2

W2

Qlab2 Qlab2

We can put changes in goods/services market and factor markets together into one diagram, one directlyabove the other and read it vertically to see what happens to the factors of production in both industriesas demand changes.

Price

D1

P1

Quantity0 Q1

S

Price

D1

P1

Quantity0 Q1

S

Bread Milk

D2

D2

Q2 Q2

P2

P2

Wage

D1

W1

Quantityof labour

0 Qlab1

S

Wage

D1

W1

0 Qlab1

S

Bread workers

Quantityof labour

Milk workers

D2

D2

W2

W2

Qlab2 Qlab2

We see, as the demand for a good or service increases (top left hand side), this sucks factors into thatindustry - but where do they come from?

They come from the contracting industry, where the demand for a good or service has decreased (topright hand side) - the factors of production (land, capital and workers) have to leave that industry (inthe real world, if unemployment already existed, some of the unemployed might be drawn into work).

Where demand for a good or service falls, the workers might simply be dismissed - which reallyannoyspeople, upsets the trade unions, and might have a political fallout with loss of support for the government.

Or the firms may take advantage of “natural wastage”; that is to say that is to say, as people voluntarily leave,they are not replaced.

Trace the lines downfrom the equilibriumpositions in the goodsmarket to the corre-sponding equilibriumin the labour marketfor the workers need-ed to produce thequantity in the top di-agrams

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Who leaves? Several groups may be involved:

· old workers who are retiring because of age· those who get ill and retire· those resigning and moving to a better job as part of a career move· those who move to a new area of the country, following their spouse, to get to a better climate

or school area for instance· those who migrate to a different country· those who die

Unemployed people are naturally very upset and social problems can emerge which the governmentmay have to deal with. But with capital, e.g., trucks, or warehousing facilities, shifting the use of thesecauses little upset - things have no feelings! They may be sold or leased to other companies to use.

Land is similar to capital, it can often be transferred to several other uses fairly easily.

The above diagrams of resources moving from declining sectors to expanding ones and stoppingin equilibrium demonstrate the way the market mechanism (price mechanism) operates.

This was first spotted by Adam Smith in the Wealth of Nations as early as 1776 although the diagramsdid not come until later. Understanding how an economic system works in this fashion led to the phrase“the consumer is king” as the next sentence explains.

Resources (land, labour and capital) flow from where they are not in demand, or demand is falling, towhere they are in demand, or demand is rising. So the price mechanism is well-regarded as a good (butby no means perfect) way of allocating resources to society’s demands.

Later, in Unit 2 “Why markets fail” you will learn what can, and actually does, go wrong with thisapparently brilliant market system.

A reminder: are you revising something and practising drawing a few diagrams each day?

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Price

Quantity0

D

P mkt

Q

P1

1 2 3

This triangle is theconsumer surplus

Price

Quantity0

P mkt

P1

This triangle is theproduce surplus

S

1 2 3 Q1

1-7 CONSUMER AND PRODUCER SURPLUS

We know that there is an equilibrium market price at which both consumers buy and suppliers sell. Butwhat about the consumers and producers who are not themselves exactly at that equilibrium price? Theyreceive a benefit.

For consumers, we can see from the demand curve that the first consumer, buying at 1 on the quantityaxis, would be willing to pay P1, which is much more than the market price he or she has to pay (P mkt).So the column above P mkt is a sort of surplus that the first buyer enjoys!

Price

Quantity0

D

P mkt

Q

P1

1 2 3


Similarly, for the second buyer, at 2 on the quantity axis; and the same goes for the third and subsequentbuyers until we get out to Q1 and P Mkt. All these early consumers would pay more but do not have todo so - and they gain a lot of extra enjoyment as a result. Eventually the whole triangle above P Mkt isfilled in; and the filled in bit of this triangle, indicated by an arrow, is the consumer surplus.

For producers, we have an analogous argument. Some would be willing to supply more cheaply thanthe equilibrium price, P Mkt. In the diagram below, we can see from the supply curve that the supplierof the first unit would be happy to do this at a price well below P Mkt. The column above quantity 1 upto P Mkt is again a sort of extra or surplus - which in this case belonging to the producers.

Moving to quantity 2, again we can see a column, but a bit smaller than for quantity 1. And as we moveout towards Q1, the triangle above the supply curve but below P Mkt is filled in. The arrow again pointsto it. This is “the producers’ surplus”.

Price

Quantity0

P mkt

P1

This triangle is theproduce surplus

S

1 2 3 Q1

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Price

Quantity0

P mkt

P1

This triangle is theproducer surplus

S

1 2 3 Q1


D

Price

Quantity0


S1

S2

P1

P2

If we put the two diagrams together, we can see that both the triangles thus make up the total con-sumer surplus and the producer surplus.

Price

Quantity0

P mkt

P1

This triangle is theproducer surplus

S

1 2 3 Q1


D

Use of the concept

With indirect taxation, the imposition of a tax (or if there already is such a tax, an increase or decreasein such a tax) may impinge more on consumers than producers - or vice versa! “Who gains themost (or who loses the most)?” is the question. This may be called “the incidence of taxation”, “the taxburden”, or a question may be asked, such as “who bears the brunt of the tax?”

The answer as to who gains or loses the most depends on the elasticities involved.

Let us assume that an indirect tax on a good increases. If demand is highly inelastic (consumers willpay almost any high price without reducing consumption much) then the increase must largely fall onthese consumers - they are simply willing to pay!We know they are prepared to do so because the demand curve is relatively inelastic and that is whatinelastic demand means. Cigarettes probably fall into this category, as do all addictive drugs.

Think of a vertical demand curve: if we increase the tax, the supply curve just moves up; there is nochange in the quantity demanded; suppliers still receive the old price (reading off their supply curve S1;the gap between S1 and S2 is all tax and goes to the government not to the supplier). There is clearlyno loss of producer surplus as their situation has not changed at all - and consumers pay all the difference:

Price

Quantity0


S1

S2

P1

P2

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Price

Quantity0

S1

S2

P1

P2

Demand

AC

B

D

Q1Q2

It can be proved, but you can take it on trust, that if the elasticity of demand is lower than the elasticityof supply, the consumer loses more than the supplier! In other words, it is the relative elasticities thatcount.

The usual supply and demand situation divides the incidence of tax (who pays it, or more of it) betweensuppliers and consumers - and of course the incidence falls heavier on the side which is relativelyinelastic.You may get a question about the incidence of tax - or one about imposing (or increasing) an indirecttax.

A reminder: in introductory economics we nearly always use “static equilibrium analysis” which meanswe start in equilibrium, change something, and analyse the result.

Who then bears the burden of tax when an indirect tax increases? See the diagram below.

Price

Quantity0

S1

S2

P1

P2

Demand

AC

B

D

Q1Q2

We start on the curves S1 and Demand, with the equilibrium price P1 and quantity Q1.

Then we add a tax (or increase an existing tax!) which shifts the supply curve up to S2, by the amountof the tax. Any tax per unit shifts the supply curve up vertically; the tax is the line BD in the diagramabove.

Having made our change, we look at the result: consumers pay BC of the tax, and producers pay CDof it. The distance CD is smaller than the distance BC, the consumer pays more of the tax, and wealso know that the elasticity of supply must be greater than the elasticity of demand!

We can also look at the areas and see the changes in both surpluses:The consumer surplus reduces by ABC.The producer surplus reduces by ACD.

In Unit 4, “Industrial economics”, we again use the concept of surpluses in our monopoly diagram. Wecan show the deadweight loss of monopoly, as well as the loss of consumer surplus and the increase inthe producer surplus that results from the monopolist being able to set the quantity that he or she pro-duces which results in the most profitable price possible. More of this later!

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Economics notes: Unit 1 - How Markets Work

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Transcript of Economics notes: Unit 1 - How Markets Work