Section 2 ReviewBobby Bautista (Excluding Theory of Firm)

Demand Diagrams• Market: Where Consumers and Producers come together to

establish an equilibrium price and quantity for a good or service.

• Demand: The willingness and ability to purchase a quantity of a good or service at a certain price over a given time period.

• Law of Demand: States that as price of good or service rises, the quantity of demand decreases.

• Ceteris Paribus: Let all other things remain equal

• Demand Curve: Graphical representation of law of demand. Usually downwards-sloping curve illustrating inverse relationship between price and quantity demanded.

Demand Diagrams

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Supply Diagrams• Supply: Willingness and ability of a producer to produce a

quantity of a good or service at a certain price over a given time period.

• Law of supply: States that as the price of a good rises, the quantity supplied increases.

• Supply Curve: Graphical representation of the law of supply. Upward-sloping curve illustrating the direct relationship between price and quantity supplied.

Supply Diagrams

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Impact of Tax• Specific Tax: A fixed amount of tax charged on each unit. A

specific tax will shift the supply curve vertically upwards by the amount of the tax.

• Ad-Valorem Tax: Tax that is levied as a percentage of selling prices. Eg VAT

Specific TaxAd-Valorem Tax

Tax Revenue• Calculated by taking the tax per unit and multiply by the

number of units being bought and sold in the market.

Impact of Subsidies• Payment made to firms or consumers designed to encourage

increase in output. Subsidy will shift the supply curve to the right and therefore lower the equilibrium price in a market.

Impact of Subsidies • Some of the subsidy will benefit the consumer and some will

benefit the firm.

Price• Equilibrium Price: The market clearing price. It occurs where

demand is equal to supply.

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Price• Maximum Price: Known as a ceiling price. It is a price set by

the government, above which the market price is not allowed to rise. It may be set to protect consumers from high prices, and it may be used in markets for essential goods, such as rice or house rentals.

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Excess Demand

Price• Minimum Price: Known as a floor price. I is a price set by the

government, below which the market price is not allowed to fall. It may be set to protect producers producing essential products from facing prices that are felt to be too low, such as many agricultural products in the European Union.

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Excess Demand

Excess Supply

Elasticity• Price elasticity of demand: Measure of the responsiveness of

the quantity demanded of a good or service to a change in its price.

• Elastic Demand: A change in the price of a good or service will cause a proportionately larger change in quantity demanded.

• Inelastic Demand: A change in price of a good or service will cause a proportionately smaller change in quantity demanded

Elasticity• Determinants of Elasticity:• Availability of close substitutes in the market• Luxury or Necessity • Proportion of income spent on good/service• Addictive nature• Given Time Period.• Utility

0 – Perfect Inelastic – Price no Effect

Under 1 – Inelastic – Price small effect

1 – Unitary - % Change in price & % Change in demand are same

Over 1 – Elastic – Demand very sensitive

Infinity – Perfectly Elastic – infinite amount is demanded at one price but nothing at slightly higher price

Elasticity• Cross Elasticity of Demand: Measure of the responsiveness of

the demand for a good or service to a change in the price of a related good.

• Substitute goods: Goods that can be used instead of each other, such as butter and margarine. Substitute goods have positive XED.

• Complement Goods: Goods which are used together, such as DVD player and DVDs. Complement goods have a negative PED.

• = % change in Quantity demanded of Good X / % Change in Price of good Y

Elasticity• Income Elasticity of Demand: measure of responsiveness of

demand for a good to a change in income.

• Normal Good: As income rises, demand increases. + YED

• Inferior Good: As income rises, demand decreases. – YED

• Calculated = % Change in Quantity Demanded / % Change in Real Income

Elasticity• Price Elasticity of Demand: Measure of the responsiveness of

the quantity supplied of a good or service to a change in its price.

• Determinants of PES• Time Period• Substitutability of factors of production • Level of spare capacity within firm• Level of Stocks Available.

Elasticity• Effect of Time: • Very Short run – No changes possible other than use of stocks• Short – At least one factor fixed• Long run – All factors now variables

• Effect of Substitutability:• Labor – The more skilled & specialized labor employed, the lower

the supply elasticity. Longer training period = Lower elasticity • Materials – If materials are in short supply on long delivery

periods and which are very specialized, then the supply elasticity will be low.

Elasticity• Indirect Tax: an expenditure tax on a good or service. An

indirect tax is shown as an upward shift in supply curve, where vertical distance between two supply curves represents amount of tax.

Tax on Elastic good Tax on Inelastic Good

Elasticity• Incidence/ Burden of Tax: Refers to the amount of tax paid by

the producer or the consumer. If the demand for a good is inelastic, the greater incidence the tax falls on the consumer. If demand for good is elastic, the greater incidence of tax falls on producer.

Tax Burden

Market Failure• Market Failure: The failure of the markets to produce at the

socially efficient level of output.

• Positive Externalities: Beneficial effects that are enjoyed by a third party when a good or service is produced or consumed.

• Negative Externalities: Bad effects that are suffered by a third party when a good or service is produced or consumed.

Market Failure• Public Goods: Goods or Services that would not be provided at

all by the market. They have the characteristics of non-rivalry and non-diminishability, for example Flood Barriers.

• Merit Goods: Goods or services considered as beneficial for people and that would be under-provided by the market and so under-consumed, for example Education and Health Care.

• Demerit Goods: Goods or Services considered to be harmful to people and that would be over-provided by the market and so over-consumed, for example Alcohol and Cigarettes.

Externalities

Government Response• Direct Provision of goods and services:• Government Providing good or service themselves.

• Extension of Property Rights:• Giving people more right of ownership over their immediate

environment.

• Taxes and Subsidies

Government Responses• Tradeable Pollution Rights:• Involves allowing companies to pollute a certain amount, but

then creating a market for the permits.

• Regulation, legislation and direct controls• Involves setting legal limits or regulations to prevent negative

externalities or perhaps reduce their impact.

Positive Externality

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Positive Externality of Production

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Positive Externality of Consumption

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Negative Externality

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