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2009Micro Economics
ECONOMICS
COURSE OVERVIEW
Welcome to GCD and First year economics. This course covers the basic theory of microeconomics and macroeconomics. Microeconomics deals with the theory of demand and supply, elasticity, the theory of costs of production and the theory of the firm. Macroeconomics deals with subjects, which you may be more familiar with like economic growth, inflation, unemployment, exchange rates etc. As it is quite an intensive course over 12 weeks it is very important that you do extra reading after classes and attend all lectures and tutorials. This manual and the class PowerPoint slides are compiled using the book “Essentials of Economics” by John Sloman. This book is in the library and has a very good website.www.booksites.net/sloman. I will also use other material which I will reference as we go along.
Moodle will be used to post any extra notes, links to interesting sites and articles and other material, which will be of help you. It is your responsibility to check the moodle site for any uploads.
I would encourage you to ask questions during class if you do not understand something as it is very likely that others could have the same problem. Posing questions are a great way of understanding the material more deeply and it also makes classes more interesting for all. During class I will also give out short questions and quizzes, which you should attempt. You learn most by taking the time and effort to really understand the material.
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RECOMMENDED TEXTBOOK
Essentials of Economics. By John Sloman (2007) – Sixth Ed (any edition will cover the majority of the same material). Prentice Hall
Every student will be expected to consult this text. The text itself will provide a very useful supplement to the lecture notes. This text has an excellent online website. It explains the material very well and also has very good online multiple choice questions.
READING LIST
The use of a core text is designed to make the best use of your time and effort. However to enhance your understanding you are also encouraged to read widely around the key topic areas. The following texts and magazines, used selectively, will greatly add to your understanding of the subject.
Books & magazines.
These are some of the important texts and magazines in the subject area and related areas:Krugman,P &Wells,R (2006) Economics. WorthNagle, Sean (2005) Economics. 3rd EditionO’ Leary, J (2007) Make that Grade: Economics 3rd Edition. Gill & MacmillanSloman & Sutcliff (2000) Economics Workbook. Prentice HallTurley, G., & Maloney, M., (2006). Principles of Economics: An Irish Textbook- Second edition. Gill and Macmillan.Useful magazines and newspapers include: The Economist, Business Week, Business & Finance, The Financial Times, Sunday Business Post.
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Topic 1
An Introduction to Economics
Learning outcomes from this topic:
When this topic is finished you should1. Know the principles that underlie the economics of individual choice.2. Be able to look at a problem through the lens of the economist.3. Be able to draw the PPC and interpret graphs.4. Be able to distinguish between the different economic systems.
What is economics all about and why study economics?
Economics is a very useful subject to study for many reasons. It explains many of the areas that touch our lives. This is true from a personal level, for example it helps answer questions such as Will I get a good job on qualifying, how much can I expect to earn, is my rent likely to rise, what will happen to the value of my American trust fund? And many more. It is also a very useful subject when trying to make business decisions such as:How much will I charge for my product, how can I become more efficient in my production, should I move to a larger premises or stay in this one, how will a tax on my product affect my profit, should I hire more people or stay with the staff I have? And many more.Economics theory will not answer all these questions definitively but the knowledge of economics will allow you to make a more rational and informed decision.
On this course of economics I want you to think like economists. As we go through the course I will draw attention to how economists would look at a situation as opposed to accountants or social workers.
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Parts of economics are very theoretical and involve many diagrams and graphs. These are meant to help you in your understanding of the subject not be an obstacle to understanding. Apart from helping your understanding, understanding graphs and really knowing how to use these graphs and diagrams to explain the theory will give you a great sense of achievement. Even after many years of studying economics I still see new things in graphs and diagrams that enhance my understanding of the subject. As W.B Yeats is supposed to have said,
Education is Not the Filling of a Pail, but the Lighting of a Fire".
So enjoy studying economics, I want to create a “community of learners” where we all learn and where you participate in classes as much as I do. Ask questions, listen to the news, query what is happening, and argue with what the book says. Never be afraid to voice your own opinions but be able to back up what you say with the theory.
Most economists on the news use basic first year economics to illustrate their points of view, so after 12 weeks you should be in a position to listen and assess what any economist is saying and be able to agree or disagree with him using the knowledge learnt here.
The structure of the classes:
I will run through the material first using PowerPoint. These will follow this manual and will be on moodle. I will also use the overhead projector to go through any graphs. I will give out questions /crosswords/ multiple choice questions as we go through the course also so keep these as they will be useful to revise.
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The economic Problem:
Economics as mentioned above looks at many different areas of life. Many people think economics is about money, and it is often dealing with issues such as pay, profit, GDP (Gross Domestic Product), earnings per share etc however it is not just about money, it is mainly concerned with The production of goods and services in the economyThe consumption of goods and services in the economy.
While these two issues are important the overriding concept which makes a problem and economic problem is the issue of scarcity. Scarcity is the excess of human wants over what can actually be produced. Because of scarcity, various choices have to be made between alternatives.
It is fair to say that in general people would like more money than they have. Because of this people behave in certain ways. I come to work. You go to college probably in the expectation of getting a better job, people shop for bargains, etc. It studies people as consumers buying the goods they themselves want, it studies producers as suppliers supplying what people want, and it studies how governments influence consumption and production through taxes, laws, subsidies etc. Economics studies anything to do with the process of satisfying peoples wants,
Individual Choice: the core of economics: (Krugman)Every economic issue involves choices. You chose to come to class today instead of staying in bed or working or going to the cinema. I choose to work here and not somewhere else, I go to the shop on my way home and but a bottle of French wine and not a bottle of Italian wine….
There are four principles that underlie the Economics of Individual Choice: We will look at each of these:
1 Scarcity:
Resources are scarce: Money, time, are just two examples. Because these are scarce, individuals make choices. Cash rich time poor was a catch phrase in Ireland over the last few years. This is why spars and centra can charge more. People with lots of money value their time so they will pay above the norm to save time.The other resources that are scarce are often referred to as the factors of production. These are anything that can be used to make something else.The factors of production are scarce i.e. Land, Labour, Capital and Enterprise. The price or the rewards of the factors of production are: Land – rent, Labour – wages, Capital – interest, Enterprise – profit.
Individuals make choices but society also must make choices. In a free market economy, the choices of society are arrived at by adding together the choices of all individuals in society. For example, the choice by Irish people to shop in local stores and not big supermarkets is made by looking at the individual choices of all the Irish shoppers. Sometimes individual choices can make for poor societal decisions.
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For example, in Ireland during the property boom many farmers sold off plots of land for development, each individual farmer had a great incentive to do this because the price of farmland was so high, but if all farmers did this then what about the beauty of the countryside? Should the government step in and stop this, maybe the government could buy up land and make it open space for all to enjoy? Economics looks at the allocation of resources. Different individuals have different opinions on how resources should be allocated. Try to form your own opinions, there is no right or wrong opinion but there are implications for every action, so think through the effect your opinion will have on you and society.
Economists working for government make decision based on how they will affect society.
2. Opportunity Cost
Economic concepts are often best understood by looking at examples.
Supposing I have one night free and I decide to take a class at my local school. I can take a golf class or a music appreciation class. If I chose the golf I cannot do the music. The opportunity cost of doing the golf is the enjoyment I would have derived from the music. If the golf class was €100 and the music class was free, then the opportunity cost of doing golf would be the enjoyment of the music and whatever you could have bought with the €100.
Supposing you were in college with Tiger Woods, the famous golf player. Who has the higher opportunity cost of first year college? Why? Does this explain why many top athletes leave college early?
We are forced to choose between alternative uses. In choosing, a cost is incurred. We call this the opportunity cost, which is the cost in terms of the alternatives foregone.
3. “How much” decisions at the margin.
Choices are often of the type “either-or”. Will I go to college or get a job? Other questions are about how much. How much time should I spend studying economics rather than maths? How many people should I employ?
Imagine you own a factory which makes handmade scarves. You employ knitters to knit these. You currently employ 10 knitters. You pay each one €50 per day. How would you decide if you should employ an 11th knitter?
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Decisions about whether to do a bit more or a bit less of an activity are marginal decisions. The study of such decisions is known as marginal analysis.
4. People usually exploit opportunities to make themselves better off.
Imagine it costs €30 to park your car in Dublin for a day, and you heard that a garage in central Dublin would change the oil in your car for €20 and keep your car all day. What would happen?
People change their behavior in response to incentives. We assume in economics that people are rational. They make choices that give them the best value for money. In the above example, a rational person will get their oil changed rather than pay €30. Not every single person will do that, some might be so rich they take the first space they see, but generally we would expect to see the oil changing garage full all the time. So in economics try not to always look for the exception to the rule, assume the majority of people will be rational.
Production Possibility Frontier
The production possibility curve shows the microeconomic issues of choice and opportunity cost.
The (PPF) shows all possible combinations of two goods that can be produced using the available technology and all available resources.
EXAMPLE
Only bottles and bananas are produced. Consider the following production possibilities:
This example is very simplistic where we assume a country only produces two products using all available resources, in other words all labour is working at full capacity, all machinery is working to full capacity, all land is fully utilised and all entrepreneurs are fully utilised also. However even though this is very unrealistic the concept is important.
Possible combinations Bottles Banana kg
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a 9 0b 8 5c 6 10d 3 13e 0 15
At point a only bottles are produced At point e only bananas are produced At all other points some combination of the two goods is produced.
Let us now illustrate the information in a diagram
Combinations of the two goods which are found inside the curve are said to be attainable but inefficient (resources are being used inefficiently or some resources are lying idle)
All points outside the curve are unattainable
Points along the curve represent attainable and efficient combinations – this locus of points forms the production possibility frontier.
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Production possibility curve
02468
10121416
0 2 4 6 8 10
bottles
bana
na
2009Micro Economics
Moving from one point on the PPF to another involves an opportunity cost e.g. point a to point b involves giving up one bottle for five kgs of bananas. The opportunity cost of five kgs of bananas is one bottle.
The opportunity cost varies with the quantity of the goods produced. The first five kgs cost one bottle; the second five pounds cost two bottles and so on.
Regardless of which good we consider, the opportunity cost of producing that good increases as we produce more of it, causing the production possibility frontier to be concave. (As we move down the frontier, resources, which are more productive in producing bottles, are diverted to the production of bananas)
Resources and technology determine the PPF. If either of these changes, so does the position of the PPF.
There are three fundamental questions in economics, which require explanation.
They are:
What?What goods are to be produced and in what quantities? This is an ‘allocation’ problem
How? How should these goods and services be produced? Should production be labour intensive or capital intensive? This is the ‘production’ problem.
For whom? Who shall receive these goods and services? This is the problem of ‘distribution’
The Difference between Microeconomics and MacroeconomicsIt is difficult to see the difference before you have studied either, so we will answer this question at the end of the course. .But just a tasterMicroeconomics focuses on the individual decision-making units whereas macroeconomics concentrates on the economic system as a whole.
Microeconomics deals with specific units and markets – a consumer, a firm, and the market for beef, a state monopoly etc.
Macroeconomics is concerned with aggregates - national output, the general price level etc.
Economics is considered to be a social science i.e. a classified body of knowledge that studies various aspects of human behaviour.
Economic methodology is more akin to the natural sciences than the social sciences.
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There are two methods of economic analysis:
Deductive Method: A certain proposition or hypothesis is taken as being true and then a process of logical deduction or rational reasoning is applied to it so as to develop certain conclusions or theories. e.g. Hypothesis – as the price falls, more people will buy that good, so we can develop certain conclusions e.g. if the price of brand X washing powder falls, while the prices of competing brands remain stable then demand for brand X will increase.
Inductive Method: Economists draw conclusions from the known facts of economic life. Data is collected on production, consumption, employment, wages etc. Economists examine and analyse this data to find meaningful trends and relationships e.g. economists examine the sales graph of a good when price is raised or lowered to see if it behaves according to the normal law of demand.
The inductive method is most useful when used in conjunction with the deductive method. This means an economic theory developed by the deductive method can be checked against the known facts i.e. inductive method.
Economic research is not conducted under laboratory conditions. The economic environment is constantly changing. An economist’s response to this is that a model does not have to mirror reality in order to be valid. The most important criterion for success in terms of modelling is the predictive power of the model.
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Classifications
In economics theory we often need to classify items into different groupings. For example different firms are classified often based on the degree of competition they face.Supposing you wanted to divide this class into 2 groups- male/females. I did the easy one.4 groups8 groupsWhat classifications would work?
ECONOMIC SYSTEMSThis is done at the beginning of chapter 1 in Essentials of economicsThe main criteria used to establish the type of economic system a country falls into depends on the amount of government interference/ control in the working of the economy. (What, how and for whom to produce)
Cuba Ireland USA
Command economy Mixed economy Free market economy
High government interference low government interference
There are three types of economic systems:
Centrally Planned Economy – the government or a central planning board makes decisions and choices about resource allocation. Closest example is China.
Free Market Economy – decisions and choices about resource allocation are left to free market forces of supply and demand and the workings of the price mechanism. The price mechanism is the system in a market economy whereby price changes act as a mechanism whereby demand and supply are balanced. In other words prices will rise and fall until demand equals supply.
The Free Market Economy is commonly associated with a pure capitalist system, where land and capital are privately owned. While no market is “completely free” the closest example is the USA.
Mixed Economies – decisions and choices are made partly by free market forces of supply and demand and partly by the government. Examples are the western European countries.
Characteristics of a Centrally Planned Economy
A central planning board makes all or most decisions about resource allocation.
No private profit
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Individual consumer unable to influence the production system
Communist economies are command economies
Economic efficiency depends on the accuracy of the government’s plan
People only have limited freedom but in return they have greater security and social solidarity
Communist economies in practice generally have a small free market sector.
Characteristics of the Free Market System
1. Self interest .The consumer and the four factors of production want to maximise their return.
2. Prices and markets. Interaction of supply and demand determines price, and changes in these will alter society’s use of resources.
3. Limited government involvement. Adam Smith (18th Century economist) was the first key advocate for a free enterprise (Laissez-Faire) economy. He did however see a limited role for government in a purely capitalist system in areas such as defence, issuing of currency, etc.
4. Private Property. Individuals have the right to own, control and dispose of the means of production such as land, buildings, machinery, etc.
Advantages of a Free Market System
Individuals and Firms have the freedom to make their own decisions
Eliminates need for complex bureaucracies
Encourages innovation and entrepreneurship
Competition is good for customers providing more choice and lower prices
Greater efficiency of the factors of production
Disadvantages of a Free Market System
All resources are only available at the prevailing price –this implies that necessities may be unavailable to some sectors of society
Unsatisfactory, socially unacceptable distribution of income may result as weaker sections of society may be neglected…. i.e. the rich get richer and the poor get poorer.
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Some undesirable goods may be produced e.g. drugs
Competition may be eliminated by monopolies
May result in socially irresponsible behaviour by some firms such s environmental pollution.
Some desirable products may not be produced e.g. public bus service
Competition may lead to a waste of resources
Private wealth may be maximised at the expense of others
Some vital services not provided e.g. Police, fire service
Health and Education may not be provided in adequate quantities
REASONS WHY THE GOVERNMENT SHOULD USEFULLY INTERVENE IN A FREE MARKET ECONOMY
Restricts the unfair use of economic power by monopolies
Redistributes wealth
Provided goods and services private enterprise is reluctant or unable to provide in sufficient quantities or at an acceptable price e.g. third level education
To provide socially desirable but unprofitable goods and services e.g. public parks
To provide services which would be unsuitable for private enterprise e.g. legal system
To remove socially undesirable consequences of private production e.g. pollution
Manage inflation rates, unemployment rates etc.
Provide health and education
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Problem Sheet 1
The Production Possibility Curve
Assume a nation puts all its resources into the production of either food or clothing. Given its available resources it can produce the following combinations of each:Units of food-millions Units of clothing millions8 07 2.26 45 54 5.63 62 6.41 6.70 7
Plot the production possibility curve. This curve introduces the concept of choice and opportunity costs.
Fill in the following table showing the amount of clothing foregone for every unit of food produced.Food Clothing foregone1 to 24 to 57 to 8
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What you should know now!!!
You should be able to explain what the production possibility curve shows and how it explains the concept of opportunity costs.
Why does the opportunity cost increase as specialisation increases? You should be able to distinguish between the three different economic systems. You should
know the advantages and disadvantages of each.
In answering questions from past papers try to do the following:
Define in your own words the main word/concept/theme in the question.
Draw a diagram if you can. Give some examples.
Some examples of exam questions on this area are as follows;
(a) Compare and contrast the free market economy with the command economy.(b) Write a brief note on the command economy, the mixed economy and the free-market economy. In your
answer list some of the characteristics of each and give examples of countries, which fit into each system.
(c) Draw a production possibility frontier and list some circumstances, which will cause the production possibility frontier to shift outwards.
We will go through how to answer these questions in class. You should try them yourself before then. Remember if you do write them out I will correct them for you.
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TOPIC 2MARKETS, DEMAND AND SUPPLY
(Ref: Chapter 1)
Learning outcomes from this topic:
When this topic is finished you should1. Know the difference between demand and supply and be able to draw the graphs confidently.2. Know what shifts the demand curve and the supply curve.3. Be able to explain the effects of price restrictions on equilibrium.4. Apply demand and supply concepts to current issues
In economics we are consumers, you and I, we shop and buy goods, we form households. House holders= consumers = we demand goods.
Firms produce goods they are producers. Firms supply goods
So when you look at a question, for example, is it good or bad for Irish people if the price of pharmaceuticals rises? (In Ireland we produce pharmaceuticals):
The answer should start with: it depends if you are a consumer or a producer…….
Before we begin to put a formal structure on the theory of demand and supply let us pause for thought and think about the following:
Map out the chain of events which occur if Irish people start to demand a lot more fresh cheese?
.
Map out the chain of events which you think would occur if farmers had a very good coffee harvest due to excellent weather conditions?
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THE DEMAND CURVE
Imagine you owned a shop selling homemade chocolate. As an experiment you charge a different price for a box of chocolate each week for 10 weeks. As you lower the price week by week, will you sell more or less boxes?
The quantity demanded of a good refers in economics to the amount of a good a person (consumer) is willing and able to buy at a given price.
The general, and in most cases “normal” relationship between price and quantity changes is frequently illustrated by graphing the anticipated amounts of a good that people can be expected to buy, in a given time period, at a series of different prices within a given price range. This produces a demand curve.
Bear in mind that the demand curve is a simple two-dimensional graph. It shows the relationship between just two variables - the price of a good and the quantity of that good that we believe is likely to be purchased over a given time period. In order to carry out the experiment we hold everything else that could affect people’s decision to buy chocolate constant. “ceteris paribus” means we hold everything else constant.
Take the example of the boxes of chocolate above. Supposing the following tables shows the results of your experiment:
Price in Euro Quantity demanded (in boxes per week)12 010 58 106 154 202 250 30
If we plot these figures we get the demand curve:
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In textbooks the demand curve is drawn as a straight line; however it is probably more realistic that the demand curve would be a ‘curve’. Why???
This example illustrates the general shape of the demand curve and the normal relationship between price and quantity demanded of a product. If all other influences remain constant, we would expect the quantity demanded to rise as price falls and to fall as price rises.
Supposing you owned a cinema and over a year you carried out an experiment whereby on every Saturday night over the year you raised the entry fee by 50 cent. Starting with week 1 up to week 52 chart how the numbers going to the cinema would change?i.e. the demand for cinema tickets.
Do you think the demand curve for the theatre would be the same?
Use and Importance of Demand CurvesThe price-quantity relationship is one of the most important things we need to know when considering sales of products. A firm must know the likely result of a change in price, because any alteration in quantity demanded will affect the total sales revenue. (Sales revenue = price X quantity)
Governments also need to know the probable effects of any change in a tax imposed on products. Because such a tax will influence price, the price-quantity relationship is, again, an important issue. If a government is considering an increase in a tax such as value added tax (VAT), which influences a very wide range of goods, it needs to know what extra total revenue it can expect to gain from the tax increase. It cannot assume that quantities consumed of all goods affected will remain the same; it must take into account the probable changes in quantity demanded that would result from the changes in price.
It is a convention (general rule) in economics that price per unit is measured on the vertical (often called the Y) axis, while quantity in units per period of time is measured along the horizontal X-axis. It is common to label the axes simply “Price” and “Quantity”.
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So the law of demand states that as a general rule as prices increase quantity demanded falls. Can you think of any situations when this might not be true?
When we did the example earlier with the chocolate we changed the price and saw what happened to quantity demanded, assuming that all other factors, which affect demand, remained unchanged as we carried out the experiment. These ‘other factors’ are anything, which would affect the amount of goods consumers buy. In our example we used chocolate to illustrate our point. We would have reached the same conclusion if we had used a different product. As prices rise, quantity demanded falls for all goods. (there are a few exceptions).Do the following with your neighbour.Pick any good you have bought over the last week. Mars bar, premier milk, eggs, etc.
List the things, factors that affected this decision. Put another way, what could have altered the amount of these goods you bought?
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Factors influencing demand
Price of the good itself (p)
Consumer income (y): as income rises demand for most goods rise. Any good whose demand rises as consumer income rises is called a ‘Normal Good’. There are some goods however that demand falls for these goods, as people get richer. These goods are called ‘Inferior goods’. Examples of inferior goods are: unbranded goods, bus tickets, mince meat. As people get richer they will often buy less of these goods.
The price of substitute goods ( ) : in the case of tea for example if the price of coffee which is a competing/substitute good increased then the demand for tea might also rise as people switch to tea.
The price of complementary goods ( ): complementary goods are goods where the pair of goods completes each other. i.e. Camera and film, car and petrol, toothbrush and toothpaste. If the price of a camera increases then that will affect the demand for film.
Advertising. (A)
Tastes (t)
Population (Pop)
Expectations (e)
We can summarise the above factors which determine demand in the following equation.
When drawing the demand curve we hold all determinants of demand constant except prices. In economic theory, any determinant, which is held constant when deriving a curve, will cause that curve to shift when that variable subsequently changes.
In summary, a change in price itself will cause a movement along a demand curve; a change in any other factor will cause a shift in the demand curve.
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Supply
When studying demand we looked at the various amounts of a good the consumers will demand at various prices. When we study supply we look at the various amounts of a good, firms will supply at various prices. When thinking about supply, imagine you own a firm or small business, the supply curve represents how much you would supply at various prices. Remember we assume you have choices to make as to where you can use your resources.
Imagine you own a small factory with a few ovens. You can use the factory to supply any type of food you want. Supposing you decide to supply pizza and other products. As the price of pizzas rise (in other words, shops are willing to pay you more for the pizzas you make) what choices will you make regarding your business?
DemandConsumers
Supply Firms
To derive the supply curve, imagine you are a firm supplying the boxes of chocolate to the shop. As the price goes up in the shop you will be inclined to make (supply/sell) more chocolate. At very low prices you would be inclined to supply very little and would prefer to make something, which is more profitable. However at very low prices, consumers will want a lot of chocolate and demand will be high, but firms will not want to supply that much and supply is low.
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Using a numerical example: let’s assume that the following is found to represent the supply decisions of a firm.
Price in Euro Quantity supplied (in boxes per week)12 2510 208 156 104 52 00 0
Supply curve
0
5
10
15
0 10 20 30
Quantity
Pric
e
Notice how the supply curve has a positive slope and usually does not pass through the origin, why?
When deriving the above supply curve we held all other determinants of supply constant.
Factors influencing Supply
Price of the good itself (p)
Technology (t): As new technology are developed supply increases at all prices.
Costs of production (c) these include the price of raw materials, labour costs.
Government taxes and subsidies (Gov t &s) on producers: if the government imposes a per unit tax on suppliers then firms will generally supply less of this product and move into the production of
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goods that are not taxes. The firm will of course try to pass the tax onto the consumer by raising prices but this is not always possible.
The profit available on goods in alternative supply (alternative profit): if a farmer supplies carrots and the profit on turnips increases, the farmer will switch out of carrot production into turnip production.
The profit available on goods in joint supply: if lamb becomes very profitable, then farmers will supply more lamb, which will automatically lead to an increase in the supply of wool.
This relationship between quantity supplied and the various determinants of supply is often written as follows:
A change in price of the good itself will cause a movement along the supply curve; a change in any of the other factors will cause a shift in the supply curve.
We have now looked at the demand curve and the supply curve in isolation from each other. In the market economy trade takes place at the equilibrium price. This equilibrium price is determined by the interaction of demand and supply. Using our simple example of chocolate, what will the equilibrium price and quantity be???
NB. From now on, you will never really need to draw a demand or supply curve on their own, the demand curve and the supply curve should both be drawn on the same graph. Equilibrium price and quantity should be shown by lines as the following graph illustrates.
DEMAND AND SUPPLY COMBINED
P = DP = D
P = S P = S
Equilibrium Q Quantity
In the above diagram, equilibrium is at P, where demand equals supply. In the chocolate example this would be at a price of €7. Usually a process of trial and error on the part of the shopkeeper finds this price. If the shopkeeper sets the price too low, at €4, demand for the chocolate will be 20 but supply is only 5, there is now excess demand. The shopkeeper will sell out of chocolate very quickly and the price will go up. As price goes up, demand falls and supply rises along the respective curves.
At €7 the excess demand no longer exists and there will be no need for the shopkeeper to change prices any more. This is called the price mechanism. The price adjusts to reflect excess demand.
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Excess demand
Excess Supply
P
D
SPRICE
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If the price is set too high, at €10, the firms will supply 20 boxes of chocolate, but demand will only be 5 boxes, there will be excess supply and prices will fall until such time that the excess supply is gone and equilibrium is achieved.
Equilibrium occurs when quantity demanded equals quantity supplied.
PRICE AND MARKET EQUILIBRIUM
The equilibrium price is the price at which quantity demanded equals quantity supplied.
The equilibrium condition is as follows:Equilibrium occurs when quantity demanded equals quantity supplied.Qd = Qe = QsWhere: Qe = equilibrium quantity
Example1
Qd = 3,875, – 250PQs = -1,000, + 400P
Solve for price and quantityQd = Qs
3,875 – 250P = -1,000 + 400PSolving for the unknown P, we get 3,875 – 250P = -1000 + 400P4,875 = 650PP = 7.5
If P= 7.5, then we can solve for the unknown Qe. This is solved by substituting P=7.5 into either the demand or supply equation, since, in equilibrium, the quantity demanded equals the quantity supplied.
Qe = 3,875 – 250 (7.5) = 3,875 – 1,875 = 2,000
The equilibrium price is 7.5 and equilibrium quantity is 2,000
Example 2Calculate equilibrium price and quantity for the following two equations.
Qd = 150 – PQs = -50 + PQd = Qs150 – P = -50 + P
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200 = 2P100 = PEquilibrium Price equals 100
To calculate equilibrium quantity we substitute P=100 into the above equationsQe = 150 – 100 = -50 + 100 = 50Qe = 50The equilibrium price equals 100 and the equilibrium quantity equals 50.
PRICE CONTROLS
Price controls are government regulations whereby the government interferes with the market and decides the price that must be charged for a good.
Two common types of price controls are: Price ceilings sometimes called maximum price. This benefits the consumer by lowering
the price the consumer must pay for the good.
Price floors, sometimes called a minimum price. This benefits the producer by increasing the price above equilibrium.
Price Ceilings
- A price ceiling is a maximum price on a good or service legislated by the government. For example governments might legislate for maximum prices for certain necessities, such as pharmaceuticals, to ensure that the poor have access to them.
- When a price ceiling is implemented the supplier cannot charge above this ‘maximum’ price. Its purpose is to help and protect consumers.
- In order to make certain products, such as necessities, more affordable, the government sets a price below the high equilibrium price. Imposing a price ceiling does this.
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- If there was no price control the market would settle at a price P . The government then introduces a maximum P* (price ceiling) which firms cannot exceed. This will lead to excess demand of AB.
P = DP = D
P = S P = S P* A B Ceiling price
Q Quantity
Price Floors
- A price floor is a minimum price legislated by government on a good or service.
- When a price floor is implemented the consumer is not legally permitted to purchase the good or service below this price.
- The purpose of a price floor is to help producers.
- If governments set a minimum price above the equilibrium price there will tend to be excess supply in the market resulting in unsold stocks.
- The figure below shows the effect of a price floor on price and on quantity demanded and supplied.
- The price floor P*, results in excess supply of AB
P* A BPrice floor
Q Quantity
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Excess Supply
P0
D
SPRICE
Excess Supply
P0
D
SPRICE
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Factors that Affect Demand (i.e. determinants of demand)
As explained earlier:
If the price of the good itself changes i.e. P there will be a movement along the demand curve
Price
P = P1 to P2
D = Q1 to Q2
There is a movement from A to B
Quantity
If any of the factors change i.e. income, price of substitutes, price of complementary goods, advertising, population, tastes there will be a shift in the demand curve.
Shift to the left = less is demandedShift to the right = more is demanded
Price Less More
Quantity
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P2
P1
Q2 Q1
B
A
D1
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Factors that cause a shift in the demand curve.
a) A change in the price of substitute goods Substitute goods = both goods serve the same purpose. An example would be Pepsi and Coke.If the price of coca cola rises what effect will this have on the demand for PEPSI? The demand for pepsi will go up.Shift in demand curve for Pepsi to the right
b) A change in the price of complementary goods Complementary goods are goods that are in joint demand; you can’t have one without the other.An example is golf clubs and golf balls. If the price of golf clubs rises the demand for golf balls will fall because less people will buy clubs and hence there will be less demand for golf balls. This would cause a shift in the demand curve for golf balls to the left.List some other examples of substitute and complementary goods:
c) Income: Income is usually denoted by the letter y.
When income rises, the demand for some goods rise and the demand for some goods fall. Goods for whom demand rises as income increases are called Normal goods. Inferior goods are goods that demand falls for as income rises.
Normal goods: Most goods are normal. Steak, meals in good restaurants, branded goods. Positive income effect: Y = D and vice versa.Shift in the demand curve to the right
Inferior goods: examples; unbranded products, mince meat, bus tickets Negative income effect = Y = D. An example is cheap wine, which would be the inferior good in relation to expensive wine
Normal and inferior goods relate to how demand for these goods is affected by income not price.
If you won the lotto of €5 million, list two goods you would buy more of12And two goods you would buy less of.
3
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4
d) T Taste
Tastes will differ for a good e.g. there is a change in taste towards iPods now compared with walkmans. The demand curve for iPods will shift to the right while the demand for walkmans will shift to the left.
e) E Expectations
The consumer thinks that the price will rise in the future, the demand will increase now and there will be a shift in the demand curve to the right
f) Advertising: advertising a good usually increases demand and shifts the demand curve to the right.
g) Populations: As more Chinese people settle in Ireland the demand for Chinese food would increase.
REMEMBERIf the price of the good changes there will be a movement along the demand curve. If any of the other factors change there will be a shift in the demand curve. This shift could be to the right or to the left; it depends on what has altered and the type of good being analysed.
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Factors that affect Supply (Determinants of Supply)
If there is a change in the price of the good itself, there will be a movement along the supply curve
PRICE
B P = P1 to P2
P1 S = 100 to 200= movement A to B
100 200 Q
If any of the factors other than P change i.e. P1…n = selling price of other goods to which the producer would switch his production, C = costs of production, T= technological change, taxation = unplanned events, there will be a shift in the supply curve.
Shift to the left = less is suppliedShift to the right = more is supplied
Price
More
Quantity
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P2
A
S1
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S2
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Factors that cause a shift in the supply curve.
P2….n Selling Price of other goods to which the producer could switch his productionExampleA manufacturer is producing chairs and the price of tables increases, so tables become more profitable, he will switch his production to tables. There will be a shift in the supply curve for chairs to the left.
C Cost of ProductionIf the cost of producing CD players increases e.g. cost of raw material = supply of CD players = shift to the left.
T Technological breakthroughIf there is a technological breakthrough e.g. a more efficient way to produce a product, the supply curve will shift to the right.
Taxation if the government Impose a per unit tax on a good the supply will shift to the left.
U Unplanned eventsNokia has planned to deliver 2000 cell phones to a shop in Dublin. The cell phones are ready but the trucks, which they have ordered to transport the phones, have not arrived. Supply curve shifts to the ___________?????
Summary
As mentioned earlier:
Determinants of Supply
The quantity supplied of a good will be influenced by The price of the good, The selling price of other goods to which the producer would switch his
production, Costs of production, Technological breakthrough, Taxation Shocks. A frost or drought
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If the price of the good changes there will be a movement along the supply curve.
If any of the other factors change there will be a shift in the supply curve.
The Effects of Changes in Demand and Supply on Price/Output Equilibrium.
Question;
From an initial equilibrium position of demand equal to supply, illustrate and explain the effect on equilibrium price and quantity of each of the following?
1. An increase in population2. An increase in labour costs3. An improvement in technology4. A per unit tax imposed by the government.5. A subsidy given to producers of €16. A minimum price is imposed by the government on your product.
We will do these in class.Remember demand or supply will not shift unless one of the factors which affect them changes.
WORK THROUGH THESE, I WILL COVER THEM IN CLASS AND I WILL ALSO PUT THE ANSWERS ON MOODLE.
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WORK SHEET
Q1 IN A COMPETITIVE MARKET AN INCREASE IN CONSUMER INCOME WILL LEAD TO:
a) An increase in equilibrium price and quantity for a normal good.b) A rise in equilibrium price and quantity for an inferior good.c) A rise in equilibrium price and a fall in quantity for a normal goodd) A rise in equilibrium price and a fall in quantity for an inferior good.
Q2 An increase in market supply and an increase in market demand will result in
a) A decrease in equilibrium price and an increase in equilibrium quantityb) A decrease in equilibrium price - the change in equilibrium quantity is indeterminatec) An increase in equilibrium quantity and the change in price is uncleard) None of the above
Q3 On a number of occasions OPEC has succeeded in driving up the price of crude oil. It has been done by:
a) Increasing the demand for oilb) Increasing the supply of oilc) Restricting the supply of oild) All of the above
Q4 The “law of demand” states that:
a) The demand curve slopes down from left to rightb) The quantity demanded increases as prices fallsc) There is a negative relationship between price and quantity demandedd) All of the above
Q5 A price ceiling is:a) Set above the equilibrium priceb) Set below the equilibrium pricec) Is commonly referred to as a minimum priced) Both (a) and (c) above
Q6 Other things being equal, the effects of a decrease in the price of apple juice would best be represented by which of the following:
a) A rightward shift in the demand curve for apple juice
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b) An increase in the quantity demanded of apple juicec) A leftward shift in the demand curve for apple juiced) A decrease in the quantity demanded of apple juice.
Question 7
Using demand and supply analysis examine the effect of each of the following events on the market price and quantity of rice.
(i) An increase in income.
(ii) A government subsidy is placed on the good.
(b) Using the following demand and supply functions:
Demand: Q =100 - 2PSupply: Q = - 24 + 2P
1. Calculate the equilibrium price and quantity.
2. Calculate the changes in price and quantity if the government impose a 2-unit tax on the product.
3. Calculate the tax revenue received by the government.
Sample Exam questionQUESTION 4(c) Using demand and supply analysis examine the effect of each of the following events on the
market equilibrium price and quantity of houses.
(i) An increase in income.
(3 marks)
(ii) An increase in the amount of land rezoned for houses.
(3 marks)
(iii) An increase in interest rates coupled with a downturn in the economy.
(3 marks)
(d) Using the following demand and supply functions:
Demand: Q = 80-4P
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Supply: Q = - 18 + 3P(i) Calculate the equilibrium price and quantity.
(4 marks)
(ii) If the government imposed a price ceiling of €10 on the good, how would the market react? Draw a diagram to illustrate your answer.
(3 marks)
(iii) Calculate the tax revenue received by the government if a €2 tax is imposed on the good. Use the demand and supply equations given above.
(4 marks)
Total (20 marks)
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WORKSHOP 1
Markets, Supply and Demand
1. The following passage refers to the operation of a free-market economy. Delete the words (in italics) which are incorrect.
In a totally free-market economy, the quantities of each type of good that are bought and sold, and the amounts of factors of production (labour, land and capital, enterprise) that are used, are determined by the decisions of individual households and firms through the interaction of demand and supply.
In goods markets, households are suppliers / demanders and firms are suppliers / demanders. In labour markets, households are suppliers / demanders and firms are suppliers / demanders.
Demand and supply are brought into balance by the effects of changes in price. If supply exceeds demand in any market (a surplus), the price will rise / fall / stay the same. This will lead to a rise in the quantity both demanded and supplied / a fall in the quantity both demanded and supplied / a rise in the quantity demanded but a fall in the quantity supplied / a rise in the quantity supplied but a fall in the quantity demanded. If, however, demand exceeds supply in any market (a shortage), the price will fall / rise / stay the same. This will lead to a fall / rise in the quantity demanded and a fall / rise in the quantity supplied. In either case the adjustment of price will ensure that demand and supply are brought into equilibrium, with any shortage or surplus being eliminated.
2. How will the market demand curve for a `normal' good shift (i.e. left, right or no shift) in each of the following cases?
(a) The price of a substitute good falls..............................................................left / right / no shift
(b) Population rises...........................................................................................left / right / no shift
(c) Tastes shift away from the good..................................................................left / right / no shift
(d) The price of a complementary good falls....................................................left / right / no shift
(e) The good becomes more expensive.............................................................left / right / no shift
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3. How will the market supply curve of a good shift (i.e. left, right or no shift) in each of the following cases?
(a) Costs of producing the good fall..................................................................left / right / no shift
(b) Alternative products (in supply) become more profitable............................left / right / no shift
(c) The price of the good rises..........................................................................left / right / no shift
(d) Firms anticipate that the price of the good is about to fall............................left / right / no shift
4. How will the following changes affect the market price of wheat flour (assuming that the market is initially in equilibrium)? In each case, sketch what happens to the demand and/or supply curves and, as result, what happens to the equilibrium price.
(a) People consume more bread. (b) The discovery of a new cheaper way of milling flour.
(c) The prices of other grains rise. (d) Rice and potatoes fall in price.
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Workshop1
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5. The diagram below shows the demand for and supply of petrol. The market is initially in equilibrium at point x.
There is then a shift in the demand and/or supply curves, with a resulting change in equilibrium price and quantity.
To which equilibrium point (a, b, c, d, e, f, g or h) will the market move from point x after each of the following changes?
The market for petrol
(a) A rise in the cost of refining petrol.
(b) A fall in bus and train fares.
(c) A fall in the price of crude oil and an increase in the price of cars.
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(d) A rise in tax on petrol and a reduction in tax on cars.
6. The demand and supply schedules for wheat in a free market are as follows:
Price per tonne 120 160 200 240 280 320 360 400
Tonnes demanded per week 725 700 675 650 600 550 500 425Tonnes supplied per week 225 300 400 500 600 750 1000 1300
(a) Draw the demand and supply curves on the following diagram:
(a) . .What is the equilibrium price? ………………………………………………………………
(b) .Suppose the government fixes a maximum price of £200 per tonne. What will be the effect?
...........................................................................................................................................
(d) Suppose that supply now increases by 150 tonnes at all prices.
Price per tonne 120 160 200 240 280 320 360 400
Tonnes demanded per week 725 700 675 650 600 550 500 425(old) Tonnes supplied per week 225 300 400 500 600 750 1000 1300
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(new) Tonnes supplied per week ... ... ... ... ... ... .... ....
(e) How much will price change from the original equilibrium (assuming that the government no longer fixes a maximum price)? How much more will be sold?
Change in price ..................................................................................................................
TOPIC 3ELASTICITY
(Ref: Chapter 2)
ELASTICITY
Learning outcomes from this topic:
When this topic is finished you should1. Be able to define the different elasticity measures and calculate each one2. Know exactly what elasticity is and how it is a useful concept for business people and the
government.3. Be able to make the linkages between price changes, elasticity and company profits.
Using a demand and supply curve answer the following question.
Is a good harvest good or bad news for a farmer? The correct answer is “it depends”, it could be yes or it could be no.With your neighbour, do the flowing:One of you answers yes and the other no. Together draw diagrams to justify each answer. To start draw a generic demand and supply to get the idea of what will happen if the harvest is good. Then adapt to the question posed.
We know from demand and supply that quantity demanded depends on various factors, the most important from an elasticity point of view being own price (i.e. the price of the good being studied), income, and the price of related goods (substitutes and complements).
We also know from demand and supply that as the price increases demand for that good falls; Elasticity measures the extent of that fall.
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There are three elasticities, which we will study under the heading of elasticity of demand. (Elasticity of supply is done later). These three elasticities are:
Own price elasticity of demand. This is sometimes referred to as just “price elasticity of demand”.
Income elasticity of demand. Cross price elasticity of demand.
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PRICE ELASTICITY OF DEMANDWe have already seen that there is a relationship between price, sales revenue and quantity changes. This is most important for practical studies of price and sales movements, and we need to have a precise way of measuring and analysing the various possible relationships. Price elasticity of demand (Ped) is the responsiveness of quantity demanded to a change in its own priceIt is the relationship between a proportional change in quantity demanded and a proportional change in price, so that Ped = proportional change in quantity demanded ÷ proportional change in price.Ped = Proportionate in quantity demanded/ proportionate in price
Price elasticity of demand = /
Example
Price Quantity Demanded10 520 2
Using the formula above where equals the change in quantity demanded and equals
the change in price:
= -3 / ½ (5 + 2) 10/ ½ (10 + 20) = - 1.28 Ped = -1.28
As explained earlier, for the great majority of goods a rise in price (positive figure) leads to a reduction in quantity demanded (negative figure) and a fall in price (negative figure) leads to an increase in quantity demanded (positive figure).
Thus when working out price elasticity of demand we either divide a negative figure by a positive or a positive figure by a negative. Either way we end up with a negative figure.
Because own price elasticity of demand is always negative economists often ignore the negative sign and just concentrate on the value of the figure, this tells us whether demand is elastic or inelastic.
-2 -1 0 1 2 3
Page 44Inelastic goods (ignore sign)
Elastic goods have elasticity in this range. Ignore sign
This reads: the change in quantity demanded divided by the mid-point of quantity, all over the change in price over the mid-price.
Inelastic goods
Elastic goods have elasticity in this range
2009Micro Economics
When the calculation of price elasticity of demand produces a result that is more than 1, i.e. when the proportional change in quantity is greater than the proportional change in price, we say that demand is price elastic. i.e. if price increased by 1% quantity demanded falls by more than 1%.
When the calculation of price elasticity of demand produces a result, which is less than 1, i.e. when the proportional change in quantity is less than the proportional change in price, we say that demand is price inelastic. i.e. if price increased by 1% quantity demanded falls by less than 1%.
When the calculation of price elasticity of demand produces a figure of 1, i.e. when the proportional change in quantity is equal to the proportional change in price, we say that demand has unitary elasticity.
The demand for fish is likely to have a price elasticity of around 0.9, washing powder about 0.3, and eggs around 0.02. These demand elasticity’s are price inelastic but fish is clearly much more price-sensitive than eggs. Notice that while the demand for washing powder as a product is price inelastic, the elasticity of a particular brand is likely to be very elastic. Maybe around 1.3.
Value of Elasticity
The value of elasticity may be anything between zero and infinity.
(i) Price Elasticity of Demand Ped= 0, i.e. perfectly inelastic demand (e.g. Drugs) (i.e. no change in Quantity Demanded no matter how much price changes)
D
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(ii) Price Elasticity of Demand =1, i.e. unit elasticity of demand (i.e. any percentage change in price causes the SAME percentage change in quantity demanded.
D
(iii) Price Elasticity of Demand = (i.e. infinity) i.e. perfectly elastic, so at the given price there is an infinite amount demanded but any change in price causes Quantity Demanded to fall to Zero.
D
(iv) Price Elasticity of Demand < 1, relatively inelastic demand (e.g. cigarettes) (i.e. any percentage change in price causes a SMALLER percentage change in Quantity Demanded.)
D
(v) Price Elasticity of Demand 1 relatively elastic demand (i.e. any percentage change in price causes a BIGGER percentage change in Quantity Demanded.)
D
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P
Q
P
Q
P
Q
P
Q
Visually, a relatively inelastic good is shown as having a steep demand curve
The relatively elastic demand curve has a flatter demand curve
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SUMMARY
P P P P P
Q Q Q Q Q
Elastic > 1Proportionate change in quantity demanded > proportionate change in price
Inelastic < 1Proportionate change in quantity demanded < proportionate change in price
Unit Elasticity =1Proportionate change in quantity demanded = proportionate change in price
Perfectly Inelastic = 0 No change in quantity demanded as a result of a change in price
Perfectly Elastic = (Infinity)No change in price as a result of a change in quantity demanded
One important feature of price elasticity of demand is that it changes as you move along the demand curve; so most goods have an inelastic price range (at low prices) and an elastic price range (at high prices). This is fairly obvious because if we know that for an inelastic good, as prices rise total revenue rises then why would firms not just continually increase prices? The answer is……………………
Consider the demand curve shown in the next page.
At point A, Ped = 1, so that here demand is neither elastic nor inelastic. Here, revenue remains the same at both prices because the change in price produces exactly the same proportional change in quantity demanded.
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D DD D
D
ELASTIC INELASTIC UNIT ELASTIC
PERFECTLY INELASTIC
PERFECTLY ELASTIC
2009Micro Economics
At point B, however, Ped is greater than 1, so that demand is price elastic.
A reduction in price at B results in a more than proportional increase in quantity demanded, so that there is an increase in total revenue. A firm in this position will increase revenue by reducing price but lose revenue if it increases price.
At point C, the position is completely reversed and Ped is less than 1, so that demand is price inelastic. A reduction in price here results in a less than proportional increase in quantity demanded, so that there is a fall in total revenue. A firm in this position will lose revenue by reducing price but gain revenue by increasing price.
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The point of greatest possible revenue on any linear demand curve is where price elasticity is at unity (where Ped = 1).
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The Relationship between Price Elasticity of Demand and Total Revenue (NB). This is very important because it illustrate how elasticity is useful.Qd = quantity demanded
ELASTIC Price = Qd by a larger proportion so TR Price = Qd by a larger proportion so TR
INELASTICPrice = Qd by a smaller proportion so TR Price = Qd by a smaller proportion so TR
UNIT ELASTICPrice = Qd by the same proportion so TR no change.Price =Qd by the same proportion so TR no change.
Influences on Price Elasticity of DemandWe have seen that the price elasticity of demand can be expected to change as price changes, so that the products own price can normally be regarded as an influence on its elasticity. The important point, really, is whether buyers are likely to pay much attention to the price when deciding whether to buy, or if other influences are more important. These may include current fashion or social attitudes, strong habits (even addiction, in some cases such as tobacco smoking) or the need to buy in order to achieve some other desired objective, such as buying petrol in order to drive to work.
If the product price is only a relatively small amount compared with normal income then price is likely to be less important than the other influences affecting demand, which is thus likely to be price inelastic. Toothbrushes, matches, shoe polish, are all examples of products likely to be price inelastic. Here, high relative price changes at normal price levels are unlikely to weigh heavily with consumers, because annual spending on these items is only a very small part of total income. Other influences, e.g. social attitudes (smoking), the move away from coal fires (matches), health issues are likely to be much more important.
We must also be careful to distinguish between the demand elasticity for the class or product and that for a particular brand of the product. My decision whether or not to buy household soap is not likely to be greatly influenced by a 10% rise in its price, but when I am actually making my purchase I am quite likely to compare the prices of two brands and choose the cheaper, assuming that I do not think that one is superior in quality to the other. Thus, demand for a product can be price inelastic, whereas demand for a specific brand of the product can be price elastic.
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Factors Influencing Demand Elasticity1. Availability of Substitute Goods
The easier it is to switch away from a good the more elastic will its demand be.
Let’s assume that Pepsi and coke are close substitutes. If the price of coke rises we would expect the quantity demanded of coke to decrease a lot as people switch to Pepsi. Hence coke would be seen as elastic. Note that it is for this very fact that advertisements for coke are so strongly brand orientated. Notice also that most goods, which are heavily advertised, are those goods, which have many substitutes.
The stronger the relationship between the substitutes, the more elastic the demand. In this case because Pepsi is a strong substitute for Coke, if the price of Coke goes up, the demand for Coke will be very elastic, as consumers switch to Pepsi.
2. Complementary Goods Given two complimentary goods, the demand for the less important of the two goods in joint demand will be inelastic. For example lamb and mint sauce, if the price of lamb does not change but the price of mint sauce increases in price, the demand for mint sauce will be inelastic, as consumers are more concerned about the price of the more important good, lamb changing its price.
3. Proportion of income spent on the productThe greater the proportion of income spent on the good the more elastic will its demand be. The smaller the proportion of income, which you spend on a good, the more inelastic your demand will be. For example, if you spend .01% of your income on matches and the prices of matches increases by 10%, it will have very little impact upon demand for matches i.e. demand will be inelastic.
4. Whether the commodity is a luxury or a necessityPrice elasticity of demand for luxuries is relatively elastic as it is not necessary that we possess luxuries however demand for necessities is relatively inelastic as people must buy these products even when price increases.
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FURTHER DEMAND ELASTICITIES
The general concept of elasticity can be applied to any of the influences on demand. If you think about the concept, you will realise that it is simply the ratio of a proportional change in quantity demanded to the proportional change in the influence considered to be responsible for that quantity movement. The only limiting element in using elasticity is that the influence must be capable of some sort of precise measurement or evaluation. This makes it difficult to produce a definite calculation for, say, changes in taste or fashion, as this is very difficult to measure. The most commonly used elasticities, in addition to the products own price, and are those for income and for other prices of related goods.
Income Elasticity of Demand (Yed)
Negative Positive
Inferior goods Zero Normal goods
Income elasticity possible values
Income elasticity of demand (Yed) is the responsiveness of quantity demanded due to a change in income.This relates to the proportionate or percentage change in quantity demanded to the proportionate or percentage change in disposable income of customers for the product.
This may be positive or negative, because there may be an increase in demand following an income increase or a fall in demand. If the income and quantity changes are in the same direction, then the figure for Yed is positive. If the changes are in the opposite directions to each other, then the figure carries the negative sign (). A rise in income usually leads to a rise in demand, but demand for some goods may fall. In the 1950s, in Ireland, demand for motorcycles fell as incomes rose and people bought cars. As we saw earlier, such goods are known as inferior goods.
Notice that we are referring here to “disposable income”, i.e. the income left to the consumer after compulsory deductions have been taken. The most important of these are income tax and National Insurance contributions. We may also include contributions to pension schemes or to trade unions or professional bodies, where membership is necessary for employment.
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Yed = Proportionate change in quantity demanded / Proportionate change in income
Income elasticity of demand = /
Summary
Yed is positive for normal goods. A goods for whom demand rises as income rises. If income increases by 1% and quantity demanded rises by 0.5% we say that good is normal but a necessity where as if income rises by 1% and quantity demanded rises by 3% we say that good is a luxury good.
Yed is negative for inferior goods. If income rises by 1% and quantity demanded falls by 2% we say that good is an inferior good.Yed 0 = Normal Good
Yed = 0 - 1 = necessity
Yed 1 = Luxury Good
Yed < 0 = inferior good
Yed = 0 = this implies the good is income neutral; income has no effect on the demand for the good. For example salt.
Income elasticity of Demand is normally positive because when income rises people consume more of most goods.
If Income Elasticity of Demand is greater than one then Yed is said to be income elastic, i.e. a small change in income causes a bigger change in quantity demanded e.g. luxury goods and services.
If income elasticity of demand is less than one then Yed is said to be income inelastic, i.e. a change in income causes a smaller change in quantity demanded. E.g. some necessities
INFLUENCES ON INCOME ELASTICITY OF DEMAND
The following influences are likely to increase a product’s income elasticity of demand:
Degree of “necessity" of the good. In a developed country, the demand for luxury goods expands rapidly as peoples income rise, whereas the demand for basic goods such as bread only rises slowly. Thus items such as cars and foreign holidays have a high income elasticity of demand, items such as potatoes and bus journeys have a low income elasticity of demand.
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Association with a higher living standard than that currently enjoyed is likely to lead to rising demand when incomes do rise.
In general, the more highly priced durable goods (household machines, motor vehicles, etc.) and services are more likely to be income elastic than the staple items of food and clothing. We do not usually buy twice as much of these if we receive double our former income. On the other hand, our spending on holidays may increase by far more than double. Increased spending on motor transport is also associated with rising incomes. Although we have been considering income rises, very similar comments apply to income reductions. Holidays and motorcars are often the first things to be sacrificed in the face of a sudden drop in income.
Income elasticity of demand is an important concept to firms considering the future size of the market for their product. If the product has a high income elasticity of demand, sales are likely to expand rapidly as national income rises, but may also fall significantly if the economy moves into recession. (Sloman,J 1997)
CROSS PRICE ELASTICITY OF DEMAND
Cross price elasticity of demand is the responsiveness of quantity demanded for (good X) due to a change in the price of another good (good Y). Where goods X and Y are either substitutes or complements.
Cross price elasticity of demand = Proportionate change in quantity demanded for x / Proportionate change in price of y
Cross price elasticity of demand =
SUBSTITUTE GOODS If two products are substitutes for each other, we can expect a rise in the price of one to lead to a rise in the demand for the other i.e. a positive relationship
Proportionate in quantity demanded for x / Proportionate in price of y.Example Coke Pepsi
P assume price of Pepsi stays the same.QD Qd = +/+ = +
COMPLEMENTARY GOODS
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If, however, the two products are linked together, e.g. golf clubs and golf balls, then a rise in the price of one leads to a fall in the demand for the other, i.e. a negative relationship.
Proportionate in quantity demanded for x / Proportionate in price for y
ExampleGolf Clubs Golf BallsP assume price of golf balls stay the same.QD Qd = +/ =
Influences on Cross Price Elasticity of Demand
The more close substitutes a product has, the more likely it is to react to changes in price of any of those substitutes. The demand for coach travel reacts to changes in rail fares, and the link became closer in Ireland when motorways cut down the times of road journeys between the major cities and long-distance coaches became more directly comparable with inter-city trains. Brands of goods are normally much more cross elastic with each other than the good itself is with other goods. We are not unduly influenced by other price movements when we decide how much soap to buy, but we are much more ready to switch to a competing brand when there is a rise in the price of the brand we normally buy.
In the same way, the intensity of negative cross elasticity depends on how closely products are associated with each other. For people in Ireland, the demand for suntan lotion is likely to fall if the price of “package holidays in the sun” rises.
THE IMPORTANCE OF ELASTICITY CALCULATIONS
The calculation of elasticities is not just of academic interest. Anyone, including the business manager and the members of government who wish to predict accurately the effect of changes in price or income on revenue and on quantities bought, need to have a clear idea of elasticity and their calculation. If a business manager thinks that a price rise will always increase sales revenue, then he or she needs to be reminded that this is far from being true. A price rise when demand is price elastic will, as you have seen, reduce total sales revenue.
Governments making changes in income or expenditure taxes must be able to calculate their effects on demand. If they do not, then their predictions about the results of the tax change are likely to prove badly out of line with reality.
A government wishing to increase its tax revenue will tend to choose goods the demand for which is price inelastic - tobacco for example, or petrol. If, however, it goes on increasing the tax, the time will
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eventually come when demand becomes price elastic and any further increase will result in a reduction in sales revenue and a fall in tax receipts. Price elasticity of demand can also change as a result of other influences. If, for example, there is a long-term trend away from smoking, we can expect demand for cigarettes to become price elastic at lower price levels in the future.
If governments wish to influence consumer demand by price changes, they are likely to try to make demand more price elastic by ensuring that suitable substitutes are available for the target product. For instance, if they wish to reduce consumption of leaded petrol, they must encourage the availability and demand for unleaded petrol, and ensure that vehicle engines can be converted easily and cheaply to unleaded petrol. They may wish to support any tax changes by changes in the law, perhaps requiring all new vehicles to be adapted to use unleaded fuel.
Try the following question, which came up in last year’s exam:
(d) Imagine you are the new health minister in government. You are very anti smoking and want to implement new laws and policies to try and prevent young people from starting to smoke. Your economist friend has told you that cigarettes are very inelastic goods. What does this mean and how would it help you in drawing up your policies. In your answer suggest some policy options.
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Price Elasticity of Supply
Price elasticity of supply is the responsiveness of supply to a change in price
Price elasticity of supply = Proportionate in quantity supplied / Proportionate in price
Price elasticity of supply:
Price elasticity of supply is generally positive
Elasticity of Supply is normally positive because suppliers will want to supply more at a higher price because that increases their revenues.
Zero Elasticity of Supply (Perfectly Inelastic Supply)
Proportionate in quantity supplied / Proportionate in price = 0 i.e. no change in supply as a result of a change in price.
Price
Quantity
Infinite Elasticity of Supply (Perfectly Elastic Supply)
Proportionate in quantity supplied / Proportionate in price = infinity. The extreme cases are often difficult to explain because they are so rare.
Price
S
Quantity
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UNIT ELASTICITY OF SUPPLY
Proportionate in quantity supplied / Proportionate in price = 1
PRICE
Quantity
Factors Which Affect Elasticity of Supply
Cost ConditionsWhen P = QS, costs per unit affect how much supply will increase. If it costs more per unit to S, then supply will not be very responsive to an increase in price = inelastic.
Time PeriodThe shorter the time period the less elastic the supply will be e.g. if you are selling vegetables in a particular season and price increases, then supply will be inelastic as you may not be able to grow vegetables in a hurry.
Storage CostsWhen prices falls, supply falls, but if it costs a lot to store the product whose supply you have reduced, then supply may be inelastic.
Perish abilityThe higher the perish ability, the more inelastic the supply will be. e.g. if the price of butter decreases, then the supply of butter should fall, the supply will be inelastic in this case i.e. supply of butter will be reduced by only a small amount, otherwise it will go off.
Alternative Goods that could be producedIf it is easy for a firm to switch to produce other goods elasticity of supply will be greater.
Cost of attracting factors of production and laying them offThe cheaper and easier it is to get extra factors means a higher elasticity of supply.
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Elasticity and the Profit Maximising Firm
Profit Maximising FirmProfit ( ) = TR – TCTotal Revenue (TR) = P * Q (Price Quantity)TC = Total Costs
What will the profit maximising firm do, if demand for his product is elastic, inelastic, unit elastic??
P P
Elastic > 1 TR TR
Inelastic < 1 TR TR
Unit Elastic = 1 TR no TR no
Elastic Profit maximising firm will P to increase sales revenue, by P the Qd, which means TC, what happens to profit is inconclusive.
Inelastic Profit maximising firm will P to maximise sales revenue, by P, the QD TC since firm is supplying less profit
Unit Elastic Profit maximising firm will P. There will be no change in total revenue but Qd = TC = Profit
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ELASTICITY AND THE GOVERNMENT
The government has two main objectives
Increase total revenue Social policy provision
If the government taxes a good, the supply curve shifts to the left = P and if they subsidise a good the supply curve shifts to the right = P
It is necessary to tax and subsidise to fulfil the objectives above.
Elasticity and Taxation
ElasticIf P, by a larger proportion = TR. The only time, the government will tax goods which have an elastic demand will be when it is part of social policy e.g. fur coats
InelasticThere are two categories of goods with an inelastic demand.Category A Goods we feel we need – cigarettes and alcoholCategory B Goods we need – milk and bread
Tax category A because if P, Q by a smaller proportion = TR.
ElasticThe government will generally not subsidise goods that have an elastic demand, however an example of a good they may subsidise is the theatre, thereby making it more widely available to a wider range of people.
InelasticWhich category will the government subsidise??They will not subsidise cigarettes and alcohol but they may subsidise category B above.
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PRACTICAL SIGNIFICANCE OF INCOME ELASTICITY OF DEMAND
A. If a firm is selling a normal good, when income increases, demand for normal goods increase, so firms will produce more normal goods. Normal goods have a positive income effect. (Vice versa if income of the community falls).
B. If a firm is selling a luxury good, when incomes increases, demand for luxury goods increases, so firms produce more luxury goods. Luxury goods have a high positive income effect. (Vice versa if income of the community falls).
C. If firm is selling an inferior good, when income increases, demand for inferior goods decreases, so firms produce less inferior goods. Inferior goods have a negative income effect. (Vice- versa if income of the community falls).
D. If a firm is selling a necessity and the income of the community increases, the demand for necessities will not change that much. The firm will not alter his production. Necessities have a low income elasticity of demand.
When incomes rise people do not merely increase their demands for the good they consumed formerly but change to new products.
They may enrich their lives by more varied diets or more sophisticated consumer goods.
Entrepreneurs and governments must predict these requirements and form opinions as to the likely elasticity of demand for various goods and services as income rises.
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WORKSHOP 2
Markets in Action
1. (a) The price elasticity of demand measures the responsiveness of the quantity demanded / price to a change in the quantity demanded / the quantity supplied / price.
[Delete wrong words.]
(b) Give the formula for price elasticity of demand.
........................................................................................................................................................
2. In the mid 1990s, the government in the UK announced that for every 10 per cent rise in the price of cigarettes, the demand is likely to fall by 6 per cent. If this information is correct, what is the value of the price elasticity of demand for cigarettes?
................................................................................................................................................................
3. In each of the following pairs, tick which of the two items is likely to have the more elastic demand. Give reasons for your answer.
(a) Petrol (all brands) Esso petrol
.......................................................................................................................................................
.......................................................................................................................................................
(b) Holidays abroad Bread
.......................................................................................................................................................
.......................................................................................................................................................
(c) Salt Clothing
.......................................................................................................................................................
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.......................................................................................................................................................
5. The following diagram shows two demand curves that cross at a price of P1.
Which of the following statements are true?
(a) Curve D1 is inelastic and curve D2 elastic. .……………………………………. True / False
(b) Demand is more elastic between P0 and P1 along curve D2 than along curve D1.. True / False
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(d) For any given change in price there will be a larger proportionate change in quantity along curve D1 than along curve D2.
……..………………………….…….. True / False
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6. Fill in the rest of the following table:
Quantity demanded
(000s)
Price(£)
Total consumer
expenditure
Elastic or inelastic demand
Price elasticity of demand
7
9
11
13
13
11
9
7
………..
………..
………..
………..
……….
……….
……….
……….
……….
……….
7. (a) What is the formula for income elasticity of demand?
…………………………………………………………………………………………………
(b) Which of the following would you expect to have a demand which is elastic with respect to income? (There are more than one.)
(i) Flour Yes / No / Possibly
(ii) Ready-prepared meals for the microwave Yes / No / Possibly
(iii) Paté de foie Yes / No / Possibly
(iv) Socks Yes / No / Possibly
(v) Designer jeans Yes / No / Possibly
(vi) Electricity Yes / No / Possibly
(vii) Bus journeys Yes / No / Possibly
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(viii)Insurance Yes / No / Possibly
TOPIC 4THE SUPPLY DECISION
(Ref: Chapter 3)
Learning outcomes from this topic:
When this topic is finished you should1. Be able to explain the law of diminishing returns to someone who knows no economics.2. Be able to distinguish between the short run and the long run.3. List and understand the various different reasons for economies and diseconomies of scale.4. Be able to derive, explain and draw the different curves: AC,MC etc
This topic is made up of loads of individual theories that build on each other. I will bring in separate exercises to class to allow you to get practice in working through these problems, so while it can be a little daunting initially all will be revealed before the end.
General background. Objectives of the Firm
We assume in this course that firms aim to maximise profits. Why does a firm not produce more and more product and therefore profits would continue to increase? As output increases costs also increase and hence profit is uncertain. Generally if a firm can increase its profits by producing more, it will normally do so.
Profit = Total Revenue – Total Cost
Profit = TR –TC
If a firm is considering producing more of a good, it will ask the question, is the money I make from this good (the marginal revenue) more than the cost of making it (marginal cost). If the answer is yes then the good will be made and production will rise. A firm will continue to produce a good so long as the MR >MC. This is a rational decision.
As a firm produces more of a good, the cost per unit of production changes.
3 key decisions the firm must make are:How much output/ quantity of product to supplyHow to produce that output (choice of production technique/technology
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How much of each input to demand.
ProductionProduction essentially involves the transformation of inputs/factors of production (land, labour, capital and enterprise) into outputs.
This relationship can be described in the form of a production function.A production function demonstrates the relationship between the amount of input used and the amount of output generated.
i.e. TP = f (L, Lb, K, E)where TP=Total Product (i.e. Total Output) L=Land Lb=Labour K=Capital E=Enterprise
In this topic there are four areas studied:
Production in the short run. (The law of diminishing returns)
Production in the long run.
Costs in the short run Costs in the long run (economies and diseconomies of scale)
Production in the Short Run
The short run covers a period of time where there is at least one factor of production, which does not change. It is fixed. It is usually assumed to be capital.
ExampleClock production per week
Table1.(1) No. Of workers
(2) K
(3) Total Product (TP)
(4) Average Product(AP)
(5)Marginal Product(MP)
0 2 0 01 2 100 100 1002 2 320 160 2203 2 630 210 310
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4 2 1040 260 410***5 2 1400 280 3606 2 1740 290 3407 2 1960 280 2208 2 1840 230 -120
Diminishing returns set in after the 4th worker is employed. Diminishing returns can be defined as: Diminishing returns set in when output starts to increase at a decreasing rate or when marginal product starts to decrease.
The Marginal Product of labour is the change in total output when an additional unit of labour is added.
= Change
- Normally by adding workers the division of labour will increase productivity/increase marginal returns.
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- Increasing marginal returns implies that an additional unit of a variable factor adds more to the total product than the previous unit.
- However from Table 1. Above you will notice that eventually MP begins to decline or diminish. This is what the British economist, David Ricardo, referred to as the law of diminishing returns.
** Very important economic theory- the law of diminishing returns states that when additional units of a variable input (labour) are added to fixed inputs after a certain point, the marginal product of the variable input declines
The average product of labour equals TP of labour divided by the number of units of labouri.e. = TP/ L
- If MP is above AP then AP rises- If MP = AP then AP is constant- If MP is below AP then AP falls
If total output or product is 100 units when 5 workers are employed, then AP will equal 100/5=20
Production in the Long Run
The long run is a period of time in which all the factors of production can be varied in quantity.
The long run production function shows the quantities of output produced from a combination of inputs.
Three possible relationships between inputs and outputs may exist in the long run production function:
i) Increasing returns to scale…where the increase in output is proportionally greater than the increase in inputs. For example, if a firm doubled all labour and capital and land, output would increase by more than double.
ii) Constant returns to scale…. where the increase in output matches the increase in inputs
iii) Decreasing returns to scale. …Where the increase in output is proportionally smaller than the increase in inputs.
COSTS
It is very important that you understand costs because we use the cost curves again in all diagrams in the next chapter.
-The firm must understand and appreciate cost behaviour not least because of its obvious impact on profitability.
- Economists employ a definition of costs that helps model decisions about what to produce and how much to produce and whether to exit or enter an industry.
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(Profit) = TR (Total Revenue) – TC (Total Cost)
Average Costs = TC/ Q = unit costs of production
Average Revenue = TR/Q =P.Q/Q=P. Average revenue is another word for price
Average Fixed Costs = TFC/Q = unit fixed costs
Average Variable Costs = TVC/Q = unit variable costs
Marginal costs are the change in total costs necessary to produce one additional unit of output. = TC / Q
Example Output Total costs MC AC
1 1000 1000600
2 1600 800200
3 1800 600
Marginal Revenue is the change in total revenue when an extra unit of output is sold = TR / Q
Fixed Cost = costs which do not vary within a wide range of output. They can change eventually e.g. rent or rates.
Variable Costs vary directly with the level of output e.g. raw materials, electricity to propel machinery
Short run period – This is the period when the quantity used of at least one of the factors of production is fixed.
Long run period – long enough to allow an alteration in the quantity used of all of the factors of production
The Relationship Between Average Cost and Marginal Cost
This is a relationship, which holds true in the long run and short run.
If MC < AC, AC is falling
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If MC > AC, AC is rising
If MC = AC, AC is unchanged
When MC = AC, AC is at a minimum
Normal Profit is being earned when total revenue is just sufficient to cover all costs.
Supernormal profit is being earned when total revenue is greater than all costs incurred.
Losses are incurred when less than normal profit is being earned.
Short – run costs.
Remember the short run is the period when the quantity used of at least one of the factors of production is fixed.
STC=SFC &SVC
If the factor of production is fixed in the short run then the costs are as well.
In the Clock example discussed earlier, labour is the only variable input, the others are fixed.
As labour is the only variable input, wage is the variable cost.
Table 2
Short – Run Costs (per week) for Clocks Ltd
(1)
Labour
(2)
Q
(3)
SFC
(4)
SVC
(5)
STC
(6)
SMC
(7)
SAFC
(8)
SAVC
(9)
SATC
0 0 100 0 100
1 100 100 200 300 2.00 1.00 2.00 3.00
2 320 100 400 500 0.91 0.31 1.25 1.56
3 630 100 600 700 0.65 0.16 0.95 1.11Page 71
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4 1040 100 800 900 0.49 0.10 0.77 0.87
5 1400 100 1000 1100 0.56 0.07 0.71 0.79
6 1740 100 1200 1300 0.59 0.06 0.69 0.75
7 1960 100 1400 1500 0.91 0.05 0.71 0.76
From the above data plot the following curves:
STC
SVC
On a separate graph plot:
SAFC
SAVC
SATC
SMC
Be able to explain the shape of each one.
STC =SVC + SFC
SMC = STC/ Q
SAFC = SFC/Q
SAVC =SVC/Q
SATC =SAFC & SAVC
Why is the Short Run Average Cost Curve U-shaped?
. Law of Diminishing Marginal Returns
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This law states that as increasing quantities of a variable factor of production are combined with a fixed factor of production, a stage will eventually be reached where marginal returns begin to decline.
Long-Run Costs: Some important economics concepts
Economies of scale, Average costs are falling as output rises.
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The long run can be defined as a period of time, which is long enough to vary all factors of production
Economies of scale: When an increase in the factors of production results in a more than proportionate increase in the level of output. For example, if all inputs double, output would increase by more than double. If all inputs double cost double, so if output increases by more than double average costs would fall.
Example:Stages Total costs € Output Average cost TC/Q1 100 50 22 Costs double 200 120 1.66
(Average Costs as Q)
Diseconomies of scale – when an increase in the factors of production results in a less than proportionate increase in the level of output (Average Costs as Q)
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Diseconomies of scale set in when all economies of scale have been exhausted and average costs begin to rise as output increases.Firms would always try to avoid this happening but sometimes they fail and AC rise.
Economies of scale are good for a firm. They increase the opportunity to make more profits.
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Economies of Scale
Internal – within the firm itself
Technical – increase in the use of machinery, labour economiesMarketing – bulk buying, economies in distributionFinancial – lower rates of interest
External – outside the firm but within the industryTechnical schools may train workers in skills, which means firms do not have to train staff initially, which lowers the costs of production
Establishment of marketing boards - instead of each firm having to have its own marketing department, if an industry is large enough, a marketing body for the whole industry may be set up e.g. Irish Tourist Board.
Diseconomies of Scale
Internal – within the firm itself
As firms increase in size, they are more difficult to manage
It is difficult to control stocks
Staff morale falls, as workers feel like mere cogs in a wheel
External- outside the firm within the industry
Scarcities of raw material may occur, which may hamper the development of the industry, thus leading to rising costs.
The inability of the infrastructure to keep pace with the increasing demands of the firm.
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Profit Maximising Output Level: MC=MR
To maximise profit it is necessary that TR be greater than TC by as large an amount as possible.
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- To maximise the difference between TR and TC it is necessary that MC and MR are equal.
P**
Q^ Q**
Q** is where the profit maximising firm will operate. This is where MC=MR.
EXPLAIN IN YOUR OWN WORDS WHY Q ^ IS NOT THE PROFIT MAXIMISING POINT?
IF YOU CAN DO THIS YOU ARE WELL ON THE WAY TO THINKING LIKE AN ECONOMIST!!
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MR
MC
Price
Quantity
Explain here!!
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- Therefore the challenge facing the firm is to produce the level of output at which MC =MR.
MR= TR/Q
Table 3.Total revenue, marginal revenue, total cost and marginal cost.
(1)Q(Tons)
(2)TR(£00)
(3)MR(£00)
(4)TC(£00)
(5)MC(£00)
(6)MR-MC(£00)
(7)Output decision
0 0 361 33 33 50 14 19 Increase2 63 30 62 12 18 Increase3 90 27 73 11 16 Increase4 114 24 82 9 15 Increase5 135 21 92 10 11 Increase6 153 18 105 13 5 Increase7 168 15 119 14 1 Increase8 180 12 144 25 -13 Decrease9 189 9 171 27 -18 Increase
The Output decision of the firm in the short run
2 conditions required for short- run equilibriuma) Produce a level of output where MR=SRMCb) A firm will produce at this level of output if and only if PSAVC
Output decision of the firm in the long run.
Once again 2 conditions are required for long run equilibriuma) Produce at a level of output where MC=MRb) Firm will produce in the long run if P LAC
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WORKSHOP 3
The Supply Decision
1. (a) Complete the following table of costs for a firm. (Note: enter the figures in the MC column between outputs of 0 and 1, 1 and 2, 2 and 3, etc.)
Output TC (£) AC (£) MC (£)
0
1
2
3
4
5
6
7
8
9
10
55
85
110
130
…….
…….
280
…….
…….
610
…….
…….
…….
…….
…….
40
42
…….
…….
…….
…….
…….
…….
…….
…….
…….
…….
…….
90
110
…….
150
(b) How much is total fixed cost at:
(i) an output of 0?.................................................................................................................
(ii) an output of 6?.................................................................................................................
(c) How much is average fixed cost at:
(i) an output of 5?.................................................................................................................
(ii) an output of 10?...............................................................................................................
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(d) How much is total variable cost at an output of 5?..................................................................
(e) How much is average variable cost at an output of 10?..........................................................
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2. (a) Referring to the data from question 1, draw the firm’s average and marginal cost curves on the following diagram. (Remember to plot MC mid-way between the quantity figures.)
(b) Mark on the diagram the output at which diminishing returns set in.
(c) Assume that the firm is a price taker and faces a market price of £60 per unit.
Draw the firm’s AR and MR curves on the above diagram
(d) How much will it produce in order to maximise profit?..........................................................
(e) Shade in the amount of profit it makes.
(f) Calculate how much profit this is .....................................................................................
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..........................................................................................
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3. The following is a list of various types of economies of scale:
(i) The firm can benefit from the specialisation and division of labour.(ii) It can overcome the problem of indivisibilities.
(iii) It can obtain inputs at a lower price.(iv) Large containers/machines have a greater capacity relative to their surface area.(v) The firm may be able to obtain finance at lower cost.
(vi) It becomes economical to sell by-products.(vii) Production can take place in integrated plants.
(viii) Risks can be spread with a larger number of products or plants.
Match each of the following examples for a particular firm to one of these types of economy of scale.
(a) Delivery vans can carry full loads to single destinations. ……..
(b) It can more easily make a public issue of shares. ……..
(c) It can diversify into other markets. .….....
(d) Workers spend less time having to train for a wide variety of different tasks, andless time moving from task to task. .….....
(e) It negotiates bulk discount with a supplier of raw materials. .….....
(f) It uses large warehouses to store its raw materials and finished goods. .….....
(g) A clothing manufacturer does a deal to supply a soft toy manufacturer with offcutsfor stuffing toys. .….....
(h) Conveyor belts transfer the product through several stages of the manufacturingprocess. ……..
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This page consists of three multiple-choice questionsIn each case, circle the correct answer.
4. If, at the current level of output, a firm’s average cost is greater than its marginal cost, then:
A. An increase in output must raise average its cost still further above marginal cost.
B. A reduction in output would raise average cost.
C. The firm is producing beyond its minimum average cost level.
D. The marginal cost curve is downward sloping at the current level of output.
E. Average fixed cost must be constant.
5. A firm discovers that if it either increases or reduces output, its short-run average cost increases. It follows that:
A. The firm is maximising profit at its present output.
B. The firm is maximising its marginal cost at its present at its present output.
C. The firm is producing at the point where marginal cost equals average cost.
D. Diseconomies of scale are present.
E. Total costs are at a minimum.
6. The information in the following table relates to a firm’s average and marginal costs of operating each of three plants (X, Y and Z). Each plant has a U-shaped average cost curve.
Plant Plant X Plant Y Plant ZAverage cost (£)Marginal cost (£)
1616
1413
1416
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The firm is a price taker, selling its product for £15 per unit. In order to maximise profit, the firm in the long run will:
A. Expand production at plant X, shut down plant Y and reduce production at plant Z.
B. Expand production at plant X, reduce production at plant Y and shut down plant Z.
C. Shut down plant X, expand production at plant Y and reduce production at plant Z
D. Shut down plant X, reduce production at plant Y and expand production at plant Z
E. Reduce production at plant X, expand production at plant Y and shut down plant Z.
Costs and Production A few more examples
Question OneFill in the missing Columns
Number of workers Total Product Average product Marginal product0 01 102 263 404 525 606 657 678 67
Sketch the three curve and state when diminishing returns set in.
Question 2
Fill in the missing columns
Output Total Costs
Fixed costs
Variable costs
Average fixed costs
Average variable costs
Marginal Costs
0 3001 5402 6803 7504 9525 12006 1602
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TOPIC 5MARKET STRUCTURES
(Ref. Chapter 4)Some extra graphs will be given out with this section.
All book references refer to Sloman 3rd edition.
Learning outcomes from this topic:
When this topic is finished you should1. Know the difference between the different market structures2. Be able to justify why a particular industry is in a particular market
structure.3. Be able to confidently draw the various diagrams to illustrate how
market structures operate and how much profit each market structure can make.
4. Be able to manipulate the graphs to reflect changes in costs or taxes.
CLASSIFYING MARKETSMarkets can be classified according to:
Number of firms Freedom of entry to and exit from the industry Nature of the product Nature of the demand curve
THE FOUR MARKET STRUCTURES Perfect Competition Monopoly Monopolistic Competition
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Oligopoly
Why do we study market structures?
1. The market structure under which a firm operates will affect its conduct, which in turn affects its performance.
2. It enables appropriate strategies to be developed in accordance with industry conditions
3. It facilitates effective future planning
4. It aids decisions regarding production and output
PROFIT MAXIMISING RULES
The first issue to deal with is the Basic Profit Maximising Rules underlying ALL market structures.
These are the rules, which must be followed in order to find the quantity, and price, which maximises profit in all market structures.
The second issue is to deal with each of the market structures separately and:
Explain the assumptions
Illustrate the price and quantity which is consistent with supernormal profits (SUPERNORMAL PROFIT), normal profits and a loss
Basic Profit Maximising Rules which apply to all Market Structures
Short Run Long Run_____________
MC = MR MC = MR
MC must cut MR from below MC must cut MR from below
AR AVC AR AC
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The relationship between MR and MC tells us whether profit is rising or falling
The relationship between AR (Price) and AC tells us what type of profit we are earning.
AR > AC = supernormal profit
AR < AC = LOSS
AR = AC = normal profit
Explanation of Normal Profit
Normal profit is a cost of production; it is the minimum amount necessary in order for production to take place.
EXAMPLE 1
AR for a bar of chocolate = 40 cent
AC for a bar of chocolate Land = 10 cent Labour = 20 cent Capital = 5 cent Enterprise = 5 cent Total AC = 40 cent
In this case, AR = AC therefore normal profit is being earned.
What decision will the firm take in the short run and the long run??
Example 2AR = € 310.00AFC = € 85.00AVC = € 270.00AC = € 355.00
IN THE SHORT RUN AR = P AVC (AR MUST BE GREATER THAN OR EQUAL TO AVC)
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In the above diagram, so long as price are above P2 the firm can continue in business in the short run because it is covering its average variable costs. The firm is not making a profit though and hence this is not a good place for the firm to be. Once price rise to P3 the firm is making a normal profit and is
OK. If the price rises above P3 the firm would be making a supernormal profit, i.e. a profit over and above that which is necessary to keep the firm in the industry.
In the Long run AR AC (AR must be greater than or equal to AC)
In the above example if prices fell below P2 the firm would have to shut down.
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Examples
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PERFECT COMPETITION
The theory of perfect competition is based on a number of key assumptions relating to the firm and industry.
Assumptions of Perfect Competition include:
1. Homogenous goods – goods are identical in that one seller’s product cannot be distinguished from another’s. An example of such product would be carrots.
2. Many competitive sellers who are price takersThe individual firm takes its price from the market. It has no power to influence that market through its own individual actions. The product’s price is the sae for each buyer and seller
3. Perfect knowledge. Customers are aware of the prices charged by each firm and firms are aware of the actions of their competitors.
4. Freedom of entry or exit of sellers in the marketplace.
Perfectly Elastic Demand CurveIf the firm in a perfectly competitive market were to attempt to raise prices its demand would collapse.
Therefore at the firm’s price or market price the firm will be faced with a perfectly elastic (horizontal) demand curve. (See below)
. Price
Demand = price=AR=Marginal revenue
Quantity demanded The demand curve is perfectly elastic; the price remains the same even though the quantity can
change.
In all market structure diagrams the AR curve is the demand curve. Average revenue is just another name for price.
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Only in Perfect Competition is the AR curve also the MR curve. The reason for this is that the price is the same regardless of the output. See diagram above
IN PERFECT COMPETITION AR =MR=PRICE
Example
Price Quantity P * Q = TR MR AR = TR/Q
100 1 100 --- 100 100 2 200 100 100100 3 300 100 100
In Perfect Competition price is lower and output higher than in monopoly. In Perfect Competition, resources are used efficiently and consumers benefit with lower prices
Output decision in the short run.
Firm will strive to produce at a level of output where SMC =MR and where AR is greater than AC
In the short run price must cover AVC otherwise it will not remain in business. (As explained earlier)
. In the short run firms in a PC market can make supernormal profits where AR>ATC.
Here the firm is only making normal profit as AR = ATC
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Draw diagram to explain this here.
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Here the firm is failing to cover its ATC and AVC and will not be able to remain in business.
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This firm is making a supernormal profit in the short run. The supernormal profit is shown by the fact that the price achieved P is greater than the Average cost of producing Q.
Here the firm is making just normal profits because the price received for Q goods is the same as the AC for Q goods.When P=AC the firm is making normal profits.
2009Micro Economics
In the above situation the firm is making a loss because it is not covering its average costs. If this is a firm in the short run the firm could remain in the industry if the firm was covering its average variable costs. In the long run the firm could not sustain a loss and should exit the industry.
Output in the Long run
In the long run unless ARATC, the firm will not be able to remain in business.
If ATC exceeds AR then the firm will have no option but to exit the industry.
As firms exit the industry supply is reduced and prices will rise thereby allowing existing firms to achieve normal profit i.e. where AR=AC.
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If firms are earning short run supernormal profit (super normal profits) this will attract new entrants who are aware of this supernormal profit.
This influx of new entrants will result in an increase in supply which will push prices down and a new equilibrium will be reached where AR = AC.This can be shown easily using demand and supply.
In the long run the firm will make just normal profits because if it were making supernormal profits, new firms would be attracted into the industry. Since there are no barriers to entry, new firms could enter and this would push prices down, gradually eliminating any supernormal profits. If the firm were making a loss, firms would exit the industry and hence prices would rise.
A good way of testing yourself in economics is to try and draw the diagrams you have studied. Remember that the labelling of the diagrams is extremely important. Test yourself below.
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Perfectly competitive firm in long run equilibrium.
A perfectly competitive firm making a supernormal profit in the short run.
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MONOPOLY
Monopoly means single (sole) supplier, dominant firms are more usual than absolute monopolists
The monopolist can choose the price to charge or the quantity to sell.
They can earn supernormal profits
In order to earn supernormal profits in the long run, there must be barriers to entry.
Examples of barriers to entry include economies of scale, the government might grant a company the sole right to supply a good or service, patents or copyright brand loyalty, ownership of outlets, etc.
Under a monopoly there are no close substitutes in the marketplace.
Under conditions of monopoly the consumer has no choice from whom to purchase and as such the demand curve facing the monopolist (i.e. the AR curve), is the total market demand for the product.
THE MONOPOLIST DEMAND CURVE IS DOWNWARD SLOPING AND MR IS BELOW AR
EQUILIBRIUM OUTPUT IS WHERE MC=MR
SUPERNORMAL PROFIT CAN PERSIST IN THE LONG RUN
Short run equilibrium: In monopoly situations the short run equilibrium and the long run equilibrium are the same.
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The firm should produce at a level where MR = MC. The demand curve in the monopoly diagram above shows the price that corresponds to that
output.
When a monopoly firm is in profit maximising equilibrium, its marginal cost is always less than the price it charges for its output.
The shaded area shows the firm’s SUPERNORMAL PROFIT.
Unlike perfect competition it is quite possible for the monopolist to earn SUPERNORMAL PROFIT in the long run due to barriers to entry.
It is important to note that supernormal profit is not guaranteed for a monopolist as cost, demand and environmental conditions will have a big impact on costs and revenue.
Figure A shows a situation where the monopolist is only earning normal profit i.e. producing at an output level Qm where AR=AC and MC =MR
Figure shows a situation where ATC exceeds AR and the monopolist is making a loss.
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Economic profits and supernormal profits are the same thing. Different books and economics prefer different terms. A bit confusing I know!
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Figure A
Figure B
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ADVANTAGES OF MONOPOLY
Economies of scale Profits may be used for investment Promise of high profits encourages risk taking
DISADVANTAGES OF MONOPOLY
High prices/low output in the short run High prices/ low output in long run Lack of incentive to innovate Inefficiency
Monopoly versus Perfect Competition
Figure C compares the profit- maximising position for an industry under monopoly with that under perfect competition. We will assume that they both face the same demand curve and the same cost curve. Page 130.
The monopolist will produce Q1 at price P1, whereas the under perfect competition it would be Q2 at price P2.
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Figure C
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Under perfect competition production will be where AR = MC = MR
Under monopoly production will be where MR = MC
Therefore we can see that a monopolist will charge a higher price and produce less than what happens in perfect competition.
In the long run because of barriers to entry the monopolist is able to keep prices high and still receive supernormal profit whereas in perfect competition freedom of entry eliminates supernormal profit and forces firms to produce at the bottom of their LRAC curve. The effect is to keep long run prices down in perfect competition.
THE THEORY OF CONTESTABLE MARKETS
- Theory argues that what is crucial in determining price an output is not whether an industry is actually a monopoly or competitive but whether there is a real threat of competition.
- As a monopolist is protected with high barriers to entry then it can make supernormal profit in the long run because of the absence of competition.
- If, however another firm could take over from it with little difficulty it will behave much more like a competitive firm.
If there is relative ease of entry into some markets with a high degree of concentration, these markets are referred to as contestable.
- A perfectly contestable market is where there is free and costless entry and exit.
Existing firms in contestable markets are unlikely to be in a position to make supernormal profits in the long run. If existing firms were earning supernormal profit, this would attract new firms into the market, making it more competitive and leading to falling prices, and the removal of supernormal profit.
The threat of this competition is greater the lower are the entry and exit costs to and from the industry.
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MONOPOLISTIC COMPETITION
- A pure monopoly is an industry with a single firm in which there are no close substitutes and entry of new firms is blocked.
- Monopolistic competition however deals with firms that differentiate their products in industries with many producers and freedom of entry.
- Monopolistic competition has elements of both monopoly and perfect competition.
- Monopolistic Competition assumes the market structure is characterised by: a) Many profit maximising firms competing. b) Freedom of entry and exit c) Firms supplying differentiated products to the marketplace.
- Products in this marketplace are not perfect substitutes i.e. quality, price, features, design, etc; differentiate one product from the next.
- Under monopolistic competition the firm will need to decide upon the exact variety of product to produce and how much to spend on advertising for it. The firm will then become involved in non-price competition (i.e. competing in terms of advertising and/or product development).
- As products are differentiated the firm is not a price taker as in perfect competition, but has market power to decide its own price.
- Therefore each firm has a downward sloping demand curve and not a perfectly elastic (horizontal) demand curve, as is the case in perfect competition.
- Given the assumption of freedom of entry, supernormal profit (where AR>AC) can only exist in the short run under monopolistic competition. Monopolistic competition in the short run is the same as monopoly. However the supernormal profits are eroded away in the long run as more firms enter the industry.
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- As supernormal profit is earned other firms will be attracted to the marketplace and now consumers will have more choice and the firm will only be able to earn normal profit in the
-
--
- long run
- In monopolistic competition there is under utilisation of capacity in the long run. Because of this excess capacity it may result in higher costs and higher prices than perfectly competitive firms, but consumers can benefit from a greater diversity of products.
- In a pure monopoly situation (discussed earlier) the monopolist can earn supernormal profit in the long run because of barriers to entry, which prevent competitors entering the marketplace.
OLIGOPOLY
An oligopoly is where a few large firms between them share a large proportion of the industry.
An oligopoly is an industry characterised by:
1. A relatively small number of firms
2. Moderate to high entry barriers.
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3. Oligopolists may produce a homogeneous product (e.g. oil) or there may be Product differentiation (e.g. electronic appliances or cars)
4. Firms production decisions are interdependent i.e. the actions of one firm affect Other firms in the industry.
5. Each firm has enough market power to prevent it being a price taker, but also each firm is subject to enough rivalry to prevent it seeing the market demand curve as its own.
The behaviour of oligopolies is strategic, in that they take explicit account of the impact of their decisions on competing firms and of the reactions they expect from competing firms.
The problem with the Oligopoly market structure has to do with the degree of uncertainty i.e. firms are unsure of how competitors will respond to their actions but must try to anticipate.
One way to reduce this uncertainty and to maximise joint profits is to collude either formally or informally.
A cartel agreement is an agreement that allows the participants to coordinate their output and pricing decisions to earn monopoly profits.
Price cartel is created when a group of oligopoly firms combine to agree on a price at which they will sell their product to the market
Each oligopoly firm would increase its profits if all the big firms in the market charge the same price as a monopolist would and split the output between them. This is called collusion, which can be operated through the above cartel agreement.
Collusive Oligopoly is where oligopolies agree (formally or informally) to limit competition between them. They may set output quotas, fix prices, limit product promotion, or agree not to ‘poach’ each other’s markets.
Non- Collusive Oligopoly is where oligopolies have no agreement between themselves, formal, informal or tacit.
Tacit collusion – where oligopolies avoid engaging in price-cutting, excessive advertising etc. There may be unwritten ‘rules’ of collusive behaviour such as price leadership. It occurs when all firms realise that one of them is initiating a price change that will be of benefit to them all and so follow the leader and change their own.
EQUILIBRIUM OF INDUSTRY UNDER COLLUSIVE OLIGOPOLY The cartel will maximise profits if it acts like a monopoly i.e. where the members behave as if they were a single firm. The total market demand curve and MR curve is shown and we can see that the cartel’s MC curve is the sum of the MC curves of the members of the cartel.
Profits are maximised at Q1 where MC = MR. The cartel must therefore set a price of P1 (at which Q1 will be demanded)
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Having agreed on the cartel price, the members may compete against each other using non-price competition, to gain as big a share of Q1 as possible. Alternatively the cartel may decide to divide the market between the in terms of quotas in output.
Success of the cartel depends on:
- Whether it consists of most or all of the producers of the good – it must consist of all of the producers
- If there are close substitutes for the products – there should be no close substitutes
- The ease with which the supply can be regulated – it must be possible to regulate supply
- Whether producers can agree on their individual shares of the total restricted supply to the market – there must be agreement on individual shares
The weakness of the cartel is the incentive for an individual firm to increase output. If every firm did this, excess supply would occur forcing down the price.
NON - COLLUSIVE OLIGOPOLY: GAME THEORY (SEE ALSO PAGE 150-151 IN TEXT)
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As was mentioned previously non-collusive oligopoly is where oligopolies have no agreement between themselves, formal, informal or tacit.
As such non-collusive oligopolies will have to work out a price strategy. This strategy will then depend on their attitudes towards risk and the assumptions they make a about the behaviour of their rivals.
Game theory is the study of alternative strategies that oligopolies may choose to adopt, depending on their assumptions about their rivals’ behaviour.
They can adopt a low risk ‘maximin’ strategy of choosing the policy that has the least- bad worst outcome, or a high-risk maximax’ strategy of choosing the policy with the best possible outcome, or some compromise. Either way, a ‘Nash’ equilibrium is likely to be reached which is not in the best interests of the firm collectively. It will also entail a lower level of profit than if they had colluded.
Non–Collusive Oligopoly:
Take for example a small number of firms supplying differentiated products to a particular market.
The model makes the following assumptions regarding behaviour:
1. If one firm lowers its price, competitors will regard this as a threat (to market share) and respond by lowering their prices to a similar amount.
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The kinked demand curve
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2. If one firm raises price the response of competitors will be to keep their prices constant.
- The response by competitors implies a kinked demand curve facing the individual firm.
PriceThere is a price above which competitors would not follow price changes. At this price a kink (K) occurs in the demand curve.
If the P above the kink competitors will not follow. Demand becomes elastic for the individual firm in question as consumers move to the now relatively cheaper competitors.
If the P below the kink, competitors will follow, now all firms are charging the same price, so demand for the individual firm in question will be inelastic.
This model has been criticised because you cannot predict where the kink would occur, therefore you could not predict the price.
PRICE DISCRIMINATION
The single price monopolist charges the same price to all customers no matter whom they are or where they are.
The price discriminating monopolist however charges different prices to different customers for the same product, which are not related to cost. Example…cinema charging different prices for afternoon and evening shows.
Factors necessary for price discrimination to take place include:1. It must be possible to divide consumers into separate groups. E.g. students and old age
pensioners who travel by train.
2. The market must be separated so the product cannot be resold.
Third Degree and First Degree Price Discrimination.
Third degree price discrimination occurs when the firm divides consumers into groups and charges different prices for each group (e.g. weekend flights and weekday flights)
First-degree price discrimination occurs when every consumer is charged the maximum price that he/she can afford. Here the monopolist is seeking to capture some or the entire consumer surplus.
Note: consumer surplus is the difference between the maximum price the consumer would be willing to pay rather than go without the item and the price actually paid.
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SUMMARY
THE CHARACTERISTIC DIFFERENCES BETWEEN MARKET STRUCTURES
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3rd degree price discrimination
First degree price discrimination occurs when the firm can secure all the consumer surplus for itself by charging each customer the highest possible price that customer is willing to pay.
2009Micro Economics
Perfect Competition
Monopolistic competition
Oligopoly Monopoly
Number of firms
Very Many Many Few One
Type of product
Homogenous(undifferentiated)
Differentiated
Undifferentiated or differentiated
Unique
Barriers to entry
No No Yes Yes
Pricing Strategy
Price taker Price maker Interdependent Price maker
Long-run profits
Normal Normal Possibility of supernormal profit
Possibility of supernormal profit
Examples Carrots Restaurants Oil, Electrical appliances
Rail transport, Prescription Drugs
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WORKSHOP 4
Market Structures
1. It is usual to divide markets into four categories. In ascending order of competitiveness these are (fill in the missing three):
1. monopoly.
2. ..........................................................................................................................................
3. ..........................................................................................................................................
4. ..........................................................................................................................................
2. To which of the above four categories do the following apply to the member firms? (There can be more than one market category in each case.)
(a) Firms face a downward sloping demand curve. ....................................................................
(b) New firms can freely enter the industry. .................................................................................
(c) Firms produce a homogeneous product. ................................................................................
(d) Firms are price takers. ............................................................................................................
(e) Firms face an elastic demand (but less than infinity) at the profit-maximising output.
..........................................................................................................................................
(f) Firms will produce where MR = MC if they wish to maximise profits. .................................
(g) There is perfect knowledge on the part of consumers of price and product quality.
..........................................................................................................................................
3. In which of the four categories would you place each of the following? (It is possible in some cases that part of the industry could be in one category and part in another: if so name both.)
(a) A village post office.................................................................................................................
(b) Restaurants in large town ........................................................................................................
(c) Banks.......................................................................................................................................
(d) Hi-fi manufacturers .................................................................................................................
(e) Producers of barley .................................................................................................................
(f) Water supply ...........................................................................................................................
(g) Local buses .............................................................................................................................
(h) The market for foreign currency .............................................................................................
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4. The following diagram shows the cost curves of a firm under perfect competition.
a) How much will the firm produce in order to maximise profits at a priceof £8 per unit? ......................................
b) What will be its average cost of production at this output?.......................................................
c) How much (supernormal) profit will it make?..........................................................................
d) How much will the firm produce in order to maximise profits at a priceof £5 per unit? .......................................
e) How much (supernormal) profit will it make?..........................................................................
f) How much will the firm produce in order to maximise profits at a price
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of £4 per unit? .......................................
g) What will be its profit position now?........................................................................................
h) Below what price would the firm shut down in the short run?..................................................
i) Below what price would the firm shut down in the long run?...................................................
5. A monopolist is faced with the following cost and revenue curves:
(a) What is the maximum-profit output?
..............................................................(b) What is the maximum-profit price?
..............................................................
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(c) What is the total revenue at this price and output?
..............................................................(d) What is the total cost at this price and output?
..............................................................(e) What is the level of profit at this price and output?
..............................................................(f) If the monopolist were ordered to produce 300 units, what would be the market price?
..............................................................(g) How much profit would now be made?
..............................................................(h) If the monopolist were faced with the same demand, but average costs were constant at £60
per unit, what output would maximise profit? ..........................................................................
(i) What would be the price now?................................................................................................
(j) How much profit would now be made?...................................................................................
(k) Assume now that the monopolist decides not to maximise profits, but instead sets a price of £40. How much will now be sold? ...........................................................................................
(l) What is the marginal revenue at this output? ..........................................................................
(m) What does the answer to (l) indicate about total revenue at a price of £40?...........................
(n) What is the price elasticity of demand at a price of £40? (You do not need to do a calculation to work this out: think about the relationship between MR and TR.)
............................
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6. Which of the following are characteristics of oligopoly? (a) There are just a few firms that dominate the industry. ..................................................Yes/No(b) There are few if any barriers to the entry of new firms into the industry. .....................Yes/No(c) The firms may produce either a homogeneous or a differentiated product. ..................Yes/No(d) The firms face downward sloping demand curves. .......................................................Yes/No(e) There is little point in advertising because there are so few firms. ................................Yes/No(f) Oligopolists tend to take into account the actions and reactions of other firms. ............Yes/No
7. Under which of the following circumstances is collusion likely to break down?(a) There is a reduction in barriers to international trade. ..................................................Yes/No(b) The market becomes more stable. ...............................................................................Yes/No(c) One of the firms develops a new cost-saving technique. .............................................Yes/No(d) One of the firms becomes dominant in the industry. ...................................................Yes/No(e) The number of firms in the industry decreases. ...........................................................Yes/No
8. The table below shows the annual profits of two paint manufacturers. At present they both charge £5.00 per litre for gloss paint. Their annual profits are shown in box A. The other boxes show the effects on their profits of one or the other, or both firms reducing their price to £3.50 per litre.
Durashine’s price£5.00 £3.50
£5.00Supasheen’
s
A£6 million each
C£2 million for
Supasheen£8 million for Durashine
price£3.50
B£9 million for Supasheen
£3 million for Durashine
D£4 million each
(a) Which of the two prices should Durashine charge if it is pursuing(i) a maximax strategy? ....................................................................................£5.00/£3.50
(ii) a maximin strategy? .....................................................................................£5.00/£3.50
(b) Which of the two prices should Supasheen charge if it is pursuing
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(i) a maximax strategy? ....................................................................................£5.00/£3.50(ii) a maximin strategy? .....................................................................................£5.00/£3.50
(c) Why is this known as a dominant strategy game?
..........................................................................................................................................
(d) Assume now that the `game' between Supasheen has been played for some time with the result that they both learn a `lesson' from it. What are they likely to do?
BUSINESS ECONOMICS
TEST 1 MARKETS, DEMAND AND SUPPLY
Please note: All questions must be attempted.
TRUE OR FALSE
1. The Production possibility Frontier (PPF) shows all possible combinations of two goods which can be produced using the available technology and some resources.
Answer_________2. All points outside the PPF curve are unattainable
Answer_________
3. Moving from one point on the PPF to another involves an opportunity cost
Answer_________
4. A mixed economy is one where decisions and choices are made by the government or a central planning board
Answer_________
5. Price and Quantity demanded are positively related Answer_________
6. A change in price will normally cause a movement along the demand curve. Answer_________
7. For normal goods the demand curve is positively sloped. Answer_________
8. Necessities are goods with perverse demand curves Answer__
_______
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9. Consumer surplus is the difference between what the consumer would have been willing to pay for units of a good and what the manufacturer is willing to accept for the good
Answer_________
10.Substitute goods are positively related Answer_________
11.Cds and cd players are examples of substitute goods Answer_________
12.An inferior good has a negative income effect Answer_________MULTI CHOICE QUESTIONS
13. An increases in the price of a normal good will cause:a shift in the demand curve to the lefta shift in the demand curve to the righta movement upwards along the demand curvea movement downwards along the demand curve Answer______14 . An increase in income will normally cause; a) A shift in the demand curve to the leftb) a shift in the demand curve to the rightc) a movement upwards along the demand curved) a movement downwards along the demand curve Answer______
15. A reduction in the firm’s cost of production will cause; a) a shift in the supply curve to the right b) a shift in the supply curve to the left c) a movement upwards along the demand curve d) a movement downwards along the demand curve Answer________
16. Opportunity cost is:a) the lowest average cost of production.b) cost of producing an extra unit of output.c) average cost and marginal cost added together.d) the cost of alternatives foregone.
Answer______
17. Excess demand will cause;a) prices to fallb) prices to increasec) none of the above Answer____
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18. Excess supply will cause; a) downward pressure on priceb) upward pressure on pricesc) none of the above Answer_____
19. When the government introduces a price ceiling this will normally lead to: a) excess supply b) excess demand c) very high pricesd) none of the above
Answer______
20. If Qd = 120 - P and Qs = -40 + P then:
a) Price equals 80 and equilibrium quantity equals 40b) Price equals 40 and equilibrium quantity equals 80c) Price equals 120 and equilibrium quantity equals 40d) Price equals 40 and equilibrium quantity equals 120
Answer_________
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BUSINESS ECONOMICS
TEST 2ELASTICITY
TRUE OR FALSE
1. A 15% rise in price of good X and a subsequent 10% fall in quantity demanded would mean price elasticity of demand for good X is inelastic
Answer_________
2. Price elasticity of demand for substitute goods is negative
Answer_________
3. Storage costs affect elasticity of supply
Answer_________ Price
Demand
Quantity
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4. The above demand curve is perfectly inelastic
Answer_________
Price Supply
Quantity
5. The above supply curve is perfectly elastic
Answer_________
6. If demand is elastic a rise in price will lead to a fall in total revenue
Answer_________
7. The higher the perisability of a good the more inelastic supply will be.
Answer_________
8. Given two complementary goods, the demand for the less important of the two goods in joint demand will be inelastic.
Answer_________
9. Cigarettes is an example of an inferior good Answer_________
10. A good with few or no substitutes is likely to have a relatively steep demand curve Answer_________
11. If demand for a good is unit elastic the firm will raise price to maximize profit
Answer_________
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MULTI CHOICE QUESTIONS
12. Price elasticity of demand measures:a) The rate of change of salesb) The responsiveness of demand to a change in pricec) The amount of sales at a specific priced) The responsiveness of price to a change in demand
Answer______ 13 . For what could price elasticity of demand be used?
a) Calculating a person’s disposable incomeb) Calculating the rate of inflationc) Estimating changes in a company’s sales revenued) None of the above Answer______
14. If good X is an inferior good then an increase in income will lead to;a) An increase in demand for good Xb) A fall in demand for good X b) A shift in the demand curve of good X to the right c) A movement along the demand curve for good X d) A movement downwards along the demand curve Answer________
15. The demand curve for a product is elastic when:a) The amount of income spent on the product is smallb) There are many substitutesc) Quantity demanded is unresponsive to a change in priced) The demand curve is completely vertical
Answer______
16. Cross elasticity of demand measures:
a) The responsiveness of supply to a change in demand b) The responsiveness of demand (Good X) due to a change in the price of another
Good (Good Y) c) How two demand curves intersect with a supply curve d) None of the above
Answer____
17.All of the following factors influence demand elasticity except; a) Costs of production
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b) Availability of substitute goodsc) Whether the good is a luxury or necessityd) Durability of the product Answer_____
18. If the price of apples increases from 10 cent to 15 cent and the quantity demanded then falls from 100 to 80, the price of elasticity of demand equals
a) 1b) 20c) 0.55d) 0.2
Answer _____
19. If income elasticity of demand equals zero for the good then the good would be:a) A normal good b) A luxury goodc) An inferior goodd) A necessity good
Answer _____
20. If good x has a price elasticity of demand equally to 3.5 then it is considered a) Elasticb) Inelasticc) Very elasticd) Very inelastic Answer _____
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Answers to some economics multiple choice questions from past exams
JANUARY 2003
(a) If good X is a normal good, an increase in consumer income will lead to:
(I) A rise in equilibrium price and quantity
(ii) A fall in equilibrium price and quantity
(iii) A fall in equilibrium price and an increase in output
(iv) None of the above
(b) Which of the following statements is true?
(i) If the price elasticity of demand is -3, a fall in price will result in total revenue rising
(ii) The income elasticity of demand will only be zero in the case of inferior goods
(iii) The cross price elasticity of demand for complementary goods will always be positive
(iv) None of the above
(c) Diminishing marginal returns occur:
(i) Only in the short run due to the existence of a fixed factor
(ii) Can occur in the short run and in the long run
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(iii) Cause average costs to fall as output rises
(iv) None of the above
(d) Consumer surplus is measured by:
(i) The price which the consumers are willing to pay for the good
(ii) The difference between the price which the consumers are willing to pay for the good and the market price
(iii) Total expenditure by consumers
(iv) Total expenditure by consumers minus profit
(e) Firms will make maximum profit when
(i) Sales revenue is maximized
(ii) Marginal revenue is equal to marginal cost
(iii) Total costs are at a minimum
(iv) None of the above
(f) Suppose country A has a freely floating exchange rate. If the inflation rate in country A were greater that the inflation rate in other countries (with whom it trades) you would expect to see the currency of country A:
(i) Appreciate
(ii) Depreciate
(iii) Remain unchanged
(iv) None of the above
(g) Which of the following is not considered a macro economic goal of government?
(i) Full employment
(ii) Low inflation
(iii) Steady growth
(iv) High corporate tax rates
(h) Which of the following set of variables is an injection into the circular flow diagram:
(i) Exports, taxes and investment
(ii) Government expenditure, exports and investment.
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(iii) Investment, imports and subsidies
(iv) Imports savings and taxes
(i) Recessions can be caused by:(i) A contraction in aggregate demand
(ii) An adverse shift in aggregate supply
(iii) Both of the above
(iv) Neither of the above
(j) The government wants to increase national output by €300million. The economics advisors provide the following information: mps =0.2Y, mpm = 0.2Y,
=200, = 300, =100By how much should the government increase it’s spending on goods and services?
(i) €250 million
(ii) €300 million
(iii) €120 million
(iv) None of the above
(a) If good X is an inferior good then an increase in income will lead to:
(i) A rise in equilibrium price and quantity
(ii) A fall in equilibrium price and quantity
(iii) A fall in equilibrium price and an increase in output
(iv) None of the above
(b) The law of demand states that:
(i) The demand curve slopes down from left to right
(ii) The quantity demanded increases as prices fall
(iii) There is a negative relationship between price and quantity demanded
(iv) All of the above
(c) The head of a train company claims that a 40% increase in ticket prices would not lead to any change in amount spent on train tickets. This must imply that demand elasticity is:
(i) Inelastic
(ii) Elastic
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(iii) Equal to - 1
(iv) Zero
(d) In a perfectly competitive market firms will maximise profits when:
(i) Marginal revenue equals marginal costs
(ii) Price equals marginal cost
(iii) Average revenue equals marginal cost
(iv) All of the above
(e) Oligopoly is a market in which there are:
(i) A large number of firms producing differentiated products
(ii) A large number of firms producing identical products
(iii) A small number of firms producing similar or identical products
(iv) None of the above
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(f) Which of the following is not a valid answer to the question “Why is real GNP an imperfect measure of living standards”?
(v) It excludes leisure
(vi) It does not take account of environmental costs
(vii) It does not take account of inflation
(viii) It does not take account of income distribution
(g) “Crowding out” occurs when?
(v) Foreign interests buy government securities
(vi) An increase in taxation results in a lower level of consumption spending
(vii) Government borrowing forces up interest rates and reduces the level of private investment spending
(viii) None of the above
(h) Which of the following set of variables are leakages from the circular flow model:
(v) Exports, taxes and investment
(vi) Government expenditure, exports and investment.
(vii) Investment, imports and subsidies
(viii) Imports savings and taxes
(i) The money multiplier is:(v) The ratio of bank deposits to liabilities
(vi) The amount of money in circulation
(vii) The amount of money the banking system creates with each pound of reserves
(viii) None of the above
(j) The government wants to increase national output by €600million. The economics advisors provide the following information: mps = 0.3Y, mpm = 0.2Y, =200, = 300, =100By how much should the government increase it’s spending on goods and services?
(v) €250 million
(vi) €300 million
(vii) €120 million
(viii) None of the above
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