MICROECONOMICS

1. Basic Economic Ideas

2. The price system
3. Microeconomics Govt. intervention
Command words used in Economics

Directive Word What it means

Calculate Work out using the information provided

Define Give the exact meaning of

Describe Give a description of, explain the main features of

Illustrate Give examples, use a diagram

Outline Describe the key points without detail

Explain the main points in detail, examine closely, separate into
Analyse
parts and show how all the parts connect and link
Compare Explain the similarities and differences between
Give clear reasons or make clear the meaning of, use examples
Explain
and explain the theory behind the question
Consider Give your thoughts about, with some justification q

Assess Show how important something is, give your judgment on

Comment upon Give your reasoned opinion on, with explanations

Criticise Give an opinion but support it with evidence

Give the important arguments for and against, often requires a
Discuss
conclusion
Discuss the importance of, judge the overall worth of, make an
Evaluate
attempt to weight up your opinions
Give reasons for and against, come to a conclusion with a
To what extent justification of which arguments are strongest and which are
weakest.
UNIT # 1
Basic Economic Ideas
& Resource Allocation
a) Scarcity, choice and  The fundamental economic problem
opportunity cost  The meaning of scarcity and the inevitability of
choices at all levels (individual, firms,
governments)
 The basic questions of what will be produced,
how and for whom
 The meaning of the term, ‘ceteris paribus’
b) Positive and normative  The distinction between facts and value
statements judgment
c) Factors of production  The rewards to the factors of production; land,
labour, capital and enterprise
d) Resource allocation in different  Decision making in market, planned and mixed
economic systems and issues of economies
transaction  The role of the factor enterprise in a modern
economy
e) Production possibility curve  Shape and shifts of the curve
 Constant and increasing opportunity costs
f) Money  Functions and characteristics in a modern
economy
 Barter, cash and bank deposits, cheques, near
money, liquidity
g) Classification of goods and  Free goods, private goods (economic goods) and
services public goods
 Merit goods and demerit goods as the outcome
of imperfect information of consumers.
Unit 1 Basic economic ideas and resources allocation
Economy is an area where goods and services are produced and consumed.

Economics is the social science that studies human behavior between

unlimited wants and limited resources with their alternative uses.

In other words, it is a social science that studies how we can make the best use of what
we have in order to satisfy our needs and wants.

Or, simply, economics is the study of the economy.

Production and Consumption

Resources are combined in the process of production to create goods and services. Goods
and services have the capacity to satisfy wants. The process through which individuals
use up goods and services to satisfy wants is known as consumption. Some goods, such
as a chocolate bar, are quickly used up to satisfy our wants and are known as consumer
perishables. Other things satisfy wants over a longer period. These are called consumer
durables. Examples of consumer durables include television sets, refrigerators and
vehicles.

BASIC ECONOMIC PROBLEM

The limitedness of resources to satisfy all human needs and wants in the society is known
as the basic economic problem, fundamental economic problem or problem of scarcity.

Form an individual to a whole society, everyone faces the problem of scarcity. The
problem of scarcity arises due to two reasons:

1. Limited nature of resources

2. Unlimited nature of wants.
The Limited Nature of Resources

Resources

Economic Resources Free Resources

Limited in supply Unlimited in supply

e.g. Air, Sunlight

Land (N) Labour (L) Capital (K) Entrepreneurship

Resources are all those materials and efforts which can be used to produce goods and
services, e.g. agricultural area , labor, machines, tools, etc.

Resources are of two types:

A. Unlimited Resources or free resources.
B. Limited resources or scarce resources

Unlimited Resources or Free Resources

Resources which are unlimited in supply e.g. sunlight and sea
water. Free resources are not of much concern to economists.

Limited resources or Scarce Resources

 Resources which are limited in their supply, e.g., agricultural area that a country can
have are limited, number of machines, buildings, oil-reserves, and labor force are
limited in supply.
 Scarce resources are also know as factors of production.
 There are four major types of factors of production, i.e., land, labor, capital and
entrepreneurship.

i. Land (natural resources):

 All natural and god-gifted resources which can be used to produce goods and services
are collectively known as land, e.g., agricultural areas, oil-reserves, gas-reserves,
rivers, lakes, minerals, coal, metals, natural forests, etc.
 If a factor owner lends its factor of production to someone else for use of specific
period, the benefit that factor owner will receive for parting with the use of factor he
owns, is known as factor reward, return of factor of production or factor income.
 Reward of land is known as rent.

ii. Labor (human resource):

All human efforts (physical or mental) used to produce goods and services are termed
as labor. Labor refers to the efforts used in the production process and is not the same
as workers.

Workers Labor
Doctor Medical service
Teacher Teaching services
Engineer Engineering services
Security guard Security services

Labor = No. of workers × average work hours

 Reward of labor is wages and salaries

 Salaries are offered to permanently appointed staff and paid usually monthly or
weekly.
 Wages are offered to the labor hired for a specific period or on task-basis.

iii. Capital (man-made resources):

 All these resources which are man-made and can be used to produce goods and
services e.g., machines, building, tools, furniture, roads and vehicles, etc.
 Reward of capital is interest.
Capital

Financial Physical Capital

Amount of money All those man-made

invested by the owner resources used to produce
goods and services
Used in
Accounting Used in
Terms Economic
Terms
iv. Entrepreneurship:
Entrepreneur is the
 Entrepreneur is the person who combines all three factors
person who
of production and takes the risk of loss.
combines all three
 Combining all factors function may be shared with factors of
managerial labor but risk-taking is exclusive function of
production and
entrepreneur. takes the risk of
 Entrepreneurship is the service of entrepreneur. loss.
 Reward for entrepreneurship is known as profit.

LAND LABOR CAPITAL ENTREPRENEURSHIP

Symbol N L K -
Definition Limited Human Man-made  combines all factors of
natural efforts resources production
resources measured in  takes the risk of loss
number of
hours
Examples  Agricultural  Medical  Roads  Sole-trader’s services
area services  Buildings  Partners’ services
 Oil  Teaching  Machines  Shareholder’s services
 Minerals services  Microsoft
 River  Banking word
services
 Labor
services
Reward Rent Wages or Interest Profit
Salary
Unlimited Nature of Wants

 Wants are all those desires which give us pleasure.

 Those desires without which we cannot live are known as needs, e.g., food, clothing,
shelter, etc.
 However, those desires which provide us pleasure but we can survive without then
are termed as wants.
 Needs are limited but wants are unlimited.

Individuals, firms or a society have diverse and wide range of wants.

 Individuals may desire better food, luxurious housing, high incomes, better working
conditions, and so on.
 Firms may desire for more and more profits, expansion, market-share, and monopoly
power.
 Society may desire or improved infrastructure, low un-employment, low inflation,
high economic growth, and high standard of living.

There is no limit of wants people, firms, and societies have.

This limited nature of resources and unlimited nature of wants leads to the existence of
basic economic problem at all levels. Scarcity means inability to satisfy all of the wants
with the given level of limited resources.

are satisfied are produced

Wants Goods & Services Resources
by by

Unlimited Limited
Basic Economic Problem (Scarcity)

Relationship between scarcity, choice, and opportunity cost

The existence of scarcity forces people, firms and societies to choose some of their wants
that can be satisfied and other wants to be left unsatisfied. Economics helps us to make
wise choices to achieve the highest possible satisfaction. Hence, economics is a science
of making best choices in order to satisfy our needs and wants.

Where there is scarcity, there is choice, and every choice has its opportunity cost. If there
is no scarcity, there is no choice and no opportunity cost, i.e., free goods.

 Choice means selection of something for consumption or production. Every “choice”

is accompanied by opportunity cost.
 Opportunity cost is the benefits of the next best alternative sacrificed due to the
current choice have been made.
Examples:
 At an individual level
An individual faces the basic economic problem if he has Rs.20 and wants to buy a
Pepsi and chips with price of Rs.15 and Rs.10, respectively. He is unable to buy both
due to his limited income; hence, is forced to make a choice. If he chooses Pepsi, the
benefit he could have from consumption of chips in his opportunity cost.

 At a firm’s level
A firm may have to choose either an advertising campaign or installment of new
machinery in the factory because it does not have enough resources to do both.
Choice of advertising campaign will have the opportunity cost of new machinery.

 At the country’s level

A society may face basic economic problem when it does not find enough resources
to develop a school network in rural areas as well as wants to strengthen its defense
system. Choice of strong national defense will lead to the sacrifice of the benefit she
could have from improved education.

 Opportunity Cost is even present between the choice of present or future.

 If a society chooses high standard of living in future, it must invest more today to
reap high in future. More investment today means less consumption and lower
standard of living in the present.
 Present consumption is the opportunity cost of investment and better future living
standards.

Problem of scarcity and its link with choice and opportunity can be best explained
through a Production Possibility Curve (PPC)
PRODUCTION POSSIBLITY CURVE

The Production Possibility Curve (PPC) is a curve that shows all

maximum possible combinations of two goods and services which a country

can produce using all available resources with efficient technique of

production at a given state of technology.

The quality and quantity of factors of production determines an economy’s

production possibilities – the goods and services it can produce with the
resources it has available. A simple economic model, known as a production
possibility curve (PPC), can be used to show the choices available and how
resources are allocated.
The PPC is sometimes called the production possibility frontier since it draws
a type of boundary between what can be produced and what cannot be
produced.
The end points of the production possibility curve represent the extreme
possibilities of what can be produced. In between these extremes, there are
many points on the production possibility curve where other combinations of
the two products can be made while maximising total output.
The points, on the production possibility curve indicate an efficient allocation
of resources. In other words, the economy is getting all it can from the
resources available given the present state of technology. It is clearly sensible
and beneficial for the economy to be producing on its production possibility
curve.
Any point within the production possibility curve shows inefficient allocation
of resources since the economy is producing less than it could from the
resources available. This applies to any other points that are located within
the production possibility curve.
Assumptions of PPC
 Suppose there are only two goods produced in a country: Guns and Roses.
 Suppose the economy is working at full employment. All available resources are
utilized to produce goods and services and quantity of resources in fixed.
 Assume that country is using best available technique of production, i.e.,
Productive Efficiency (a situation where it is impossible to produce more of one good
without sacrifice of other).
 Finally, to construct PPC and make it comprehendible, it is assumed that state of
technology will not change in the given time constraint.
 Following diagram shows the production possibility curve of a country producing
guns and roses assuming that all available resources are fully employed in the most
efficient way at present state of technology.
 If all resources are allocated in guns production the economy will be at point ‘A’.
 If all resources in roses production the economy will be at point ‘B’.
 `A curve joining ‘A’ and ‘B’ is PPC as shown below.
Guns

0 B Roses
Point ‘A’ and ‘B’ may be joined by a straight line or an inward bending curve as shown
below:
Good y Good y

A A
Hence, PPC may be of three shapes, i.e., outward bending, inward bending, or a straight
line.

Shape of PPC
There are some concerns about the shape of PPC.
 Why is PPC downward sloping?
 Why is PPC outward bending?
 Why is the PPC a straight line?
 Why is the PPC inward bending?

1. Why is the PPC downward sloping?

PPC is always downward sloping because presence of trade-off (i.e., opportunity
cost) between the two goods because of scarcity. According to basic assumption of
PPC, as a country has used all of its available resources with productive efficiency in
a given constraint of technology, it is impossible now to increase the production of
one good without losing the other. That’s why PPC will always be downward sloping.
However, scarcity does not provide any information regarding why

PPC is straight line, inward bending, or outward bending.

2. Why is the PPC outward bending?

PPC is curved or bowed outward in figure below.

Guns
a
20 c
18 23
15 d
5
10 e

10

b
0  1  2  3  4 Roses
 Slope of production possibility curve (PPC) shows opportunity cost of product
shown on x axis and outward bowed PPC shows increasing slope and thus
increasing opportunity cost. The reasons for this concave looking PPC is that
factors of production don't possess identical skills and are not equally efficient in
producing different goods. In order to increase output of a product, one has to
give up some units of the other product as resources are scarce. As we know,
factors of production don't possess uniform skills so higher and higher costs in
terms of retraining and wastage have to be incurred when resource, less suitable
to the production of a product, are allocated to its production. For example
during a busy exam series, an exam board faced with the shortage of examiners,
asks its admin and clerical staff to mark exam papers. Since admin and clerical
staff is not skilled enough to mark the exam papers, it will result in higher and
higher cost (as more and more clerks are assigned the job of marking scripts) for
the exam board in terms of retraining staff and errors in marking, resulting in a
PPC which becomes more and more steep i.e higher slope and higher
opportunity cost.
This is because the non-homogeneity of resources or imperfect mobility of resources
from one use to another. In other words, resources are specialized in their nature and
can’t be equally efficient in production of both goods. Workers who are efficient in roses
(farmers) are not equally efficient in guns (factory workers). All resources, like labor are
specialized for particular products.

- At point “a” in figure, where all available resources are employed in production
of guns, economy is using even those resources in guns which were more efficient
in roses production. If resources which were more efficient for roses and least
efficient in guns are switched to produce some of the roses, we will be at point
“c”, where a little sacrifice of guns can generate more roses, shown by
opportunity cost of 2 units.
- If we more from “c” to “d” in figure, we have to switch those resources in
production of roses, which were also efficient in production of guns.
Consequently, opportunity cost (i.e., sacrifice of guns) will be greater than
before, i.e., 3 units of guns.
- Increase in production of roses beyond the point “d”, leads to use those
resources in production of roses which were most suitable for guns, resulting
 into high opportunity cost. This non-homogeneity of resources and increasing
opportunity cost causes the PPC to be curved outward. This is known as the law
of increasing opportunity costs.

3. When is the PPC a straight line?

PPC can also be a straight line if resources are homogenous or perfectly mobile for
both goods. Straight line PPC will have constant opportunity cost. This is shown in
the following diagram.
Good Y

4 a

3 c

2 d

1 e

b
0 1 2 3 4 Good X

4. When is the PPC inward bending?

 Non-homogenous resources
 Decreasing opportunity cot
 Least suitable resources for roses are switched to roses production at first and
most suitable at the end.
Good y

20 a

10 c
d
5 e
2 b
0 1 2 3 4 Good x
(roses
PPC and opportunity cost calculations:

According to the following diagram:

Guns

20 a

15 d

10 e

b
0 2 3 4 Roses

- Opportunity cost of 4 units of roses is 20 units of guns or opportunity cost of 20

units of guns is 4 units of roses.
- Opportunity cost of 15 units of guns is 2 units of roses or opportunity cost of 2
units of roses is 5 units of guns.
- Opportunity cost of increase in roses form 2 units to 3 units is fall in production of
guns from 15 to 10 units, i.e., 5 units of guns and vice-versa.

POINTS BELOW, ON, AND BEYOND THE PPC

Points on the PPC Points below the Points beyond the

PPC PPC
According to figure a,b,d and e S U
Attainable   
Desirable   
Employment of Full-employment Unemployment –
Resources
Productive   –
Efficiency
Opportunity Cost   –
 Guns

20 a
U
15 d

10 e
S

b
0 2 3 4 Roses

Points on the PPC

- Point “a” represents the maximum production of guns if all resources are employed in
the production of guns and no roses are produced.
- Point “b” represents the maximum production of roses when no guns are produced.
- A curve joining these two extreme points (may be outward being, inward bending, or
a straight line) is the PPC.
- At any point along the curve, such as “d” and “e”, there is a trade-off between two
goods.
- The production of roses can only be expanded by taking resources away from the
production of guns.
- When an economy moves from point “d” to “e”, to have an extra unit of roses it must
sacrifice “5” units of guns (opportunity cost).

Points below the PPC

- Point “S” or any other points below the PPC show that the economy is either under-
utilizing its scarce resources (i.e., unemployment) or it is using an inefficient
technique of production.
- Economy is capable of moving to point “d” without sacrificing roses: more guns can
be produced by either employing idle resources or replacing inefficient techniques
with efficient ones. It is also possible to produce more roses without sacrificing guns,
as shown through a movement form point “S” to point “e” on the PPC.
- This movement of an economy from a point below the PPC to the any of the points
on the PPC is also known as actual economic growth.

Points beyond the PPC

- Point “U” is unattainable within the current time frame and production capacity. It
can be achieved in the long run when some of the assumptions of the PPC and
relaxed, e.g., an increase in quantity of land, labor, and capital or an improvement in
technology.

Shifts in the PPC

The production possibility curve can shift parallel inward or outward:
Good y

C
A
E

0
F B D Good x
Causes of Shifts in the PPC
There are three major causes of shifts in the PPC.
1. A change in the quantity of resources.
2. A change in the productivity (quality) of existing resources.
3. A reallocation of resources.

1. A change in the quantity of resources.

Land:
- Land may increase because of:
- Discovery of oil, metal or mineral reserves by active search.
- Eroded, water-logged land may be made usable for agricultural purposes
(Reclamation of land)
– It shifts the PPC outward.
- Land may decrease because of:
- Depletion of non-renewable natural resources e.g., oil-reserves may exhaust by
over utilization.
- Erosion caused by deforestation will reduce agricultural land.
- Water-logging may reduce agricultural usage of land.
- Natural disasters (floods, earthquakes, etc.) may reduce the quantity of land for a
country.
– it shifts the PPC inward

Labor:
Population

Dependent age group (Below 16 Working age group of Adult

years and Above 65 years) Population (16-65 years)

Active Population Inactive Population

Employed Unemployed Those who are either not

willing to work or unable
Those who are to work
Those who are willing e.g.
employed on some job
and those who are self-
and able to work but  University students
employed
have no job  Housewives
 Disables
 On training
Labour Force or Work Force or Working
Population
i. Labor may increase by:
– Increase in total population, especially in the working population.
– Change in structure of population from less dependent population to more
working population, even without an increase in total population.
– Immigration is greater than emigration.
– Increased women-participation in jobs.
– Lower school-leaving age.
– Higher retirement age.
– It shifts PPC outwards

ii. Labor may decrease by:

– Decrease in total population, especially in the working population.
– Change in structure of population from working population to more dependent,
population even without decrease in total population.
– Emigration is greater than immigration.
– Decreased women-participation in jobs.
– Higher school-leaving age.
– Lower retirement age.
– It shifts PPC inwards

Capital:
– Capital stock means total value of capital goods (buildings, factories, roads, bridges,
etc.) at a point in time.
– Investment is the total spending on capital goods and services in given period of time
usually one year (Gross investment)
– Net investment in the increase in capital stock of a country in one year.

Net Investment = Gross Investment – Depreciation

– Depreciation of capital consumption is a loss in value of an asset due to wear and

tear, obsoleteness, or just the passing of time.

Investment itself depends on various factors, including:

– Rate of return on Capital
– Interest rate
– Business optimism and pessimism
– Government policies about taxation and subsidies
– Political stability
– Technology
– Infrastructure

Example:
Suppose there is a software house having a capital stock of 10 computers at the beginning
of year 1. During year 1, the software house bought 5 new computers (gross investment),
but 2 out of existing 10 ten computers because obsolete and are discarded. In year 2,
software house will have 13 computers capital stock.

Capital Stock in year 1 = 10 computers

Gross investment in year 1 = 5 computers
Depreciation in year 1 = 2 computers
Net investment = 5 – 2 = 3 computers
Capital stock in year 2 = capital stock in year 1 + Net investment
= 10 + 3 = 13 computers

Gross Investment vs. Depreciation Net Capital PPC

Investment Stock
Gross Investment > Depreciation Shifts
>0 Increases
outward
Gross Investment = Depreciation 0 Unchanged Unchanged
Gross Investment < Depreciation Shifts
<0 Decreases
inward
Consumer goods

B Gross Investment < Depreciation

A Gross Investment = Depreciation

C Gross Investment > Depreciation

Depreciation

0 X0 Capital Goods (Gross Investment

2. Change in Quality (Productivity) of Resources:
Productivity is the efficiency of factors of productions used.
Productivity is defined as output per unit of input (per unit of time).
Output
Productivity 
Labor

Example:
If ‘5’ workers produce 10,000 goods in ‘5’ hours, then:
Q. What is total production?
Ans: 10,000
Q. What is the productivity of labor? 10,000
5 2000
Ans:   400 goods per worker per hour
5 5
Determinants of the productivity of labor:
– Wage rate
– Education and training
– Technology
– Work conditions
– Length of working hours
– Fringe benefits/perks/non-monetary benefits/non-pecuniary benefits.
– Bonuses and commissions
– Promotional opportunities
– Health

Determinants of the productivity of capital:

– Technology
– Skilled labor
– Depreciation, etc.

Determinants of the productivity of land:

– Technology
– Skilled labor
– Fertility rates, etc.
Determinants of productivity of entrepreneurship:
– Communication
– Management techniques, etc.

Improved technology makes capital more productive and increases the productive
capacity of a country. Education and training contribute to human capital (labor) and
improves their productivity. Educated and skilled labor also uses capital more efficiently.

Research and development (R&D) also contribute towards the productivity of land.
Better technique of extraction, improved methods of farming and fishing, development of
new breeds of plants and animals, and the use of fertilizers can enhance the productivity
of existing land, shifting the PPC outwards.
Better technology can also help the entrepreneurial abilities of a country. Improved
communication, transportation, and new management techniques can contribute a lot
towards the productivity of entrepreneurship. The PPC will shift outwards in this case.

3. The Reallocation of Resources:

Switching resources (land, labor, capital, etc.) from the production of one product to
another product’s is known as reallocating resources.
a. Different sectors of an economy have different levels of productivity. The
services sector is the most productive sector, but the manufacturing sector is
comparatively less productive, and the agricultural sector is the least productive
sector of an economy. When resources are reallocated from agricultural to
manufacturing and services sector, an increase in productivity leads to an outward
shift in the PPC, and vice-versa.
b. The reallocation of resources from consumer goods to capital goods will also
increase the productive capacity of a country in the future, shifting the PPC
outwards. The opposite will be true if resources are switched to more consumer
goods, as shown in the following figure.
Consumer Goods

C
Reallocation of
G resources
Yo
Y1 H

0 X0 X1 B D Capital Goods
Initially, the economy was producing at “A” with Y0 consumer goods and X0 capital
goods.

When resources are reallocated to “B”, where more capital goods (X1) and fewer
consumer goods (Y1) are produced, there will be a high rate of economic growth and the
PPC will shift outward.
Types of Shifts in PPC
– Parallel shift
– Pivotal shift
– Non-parallel shift
– Intersecting shift

1. Parallel Shift:
A parallel shift in the PPC occurs when an increase or decrease in the quantity and
quality of resources is equally suitable or disastrous for both goods, as shown in the
diagram below. Good y

C
A
E

0
F B D Good x
2. Pivotal Shift:
A pivotal shift in the PPC occurs when a change in the quantity and quality of
resources affects only one good, or affects one good more than other. This is shown
in the diagrams below.
Guns Guns

A G
E

0 B C 0 F
Roses Roses
To illustrate: A genetic breakthrough in the productivity of roses will only increase the
productive capacity of a country for roses, and have no effect on the productive capacity
of a country for guns. This will shift the PPC from AB to AC in above left diagram.
Similarly, when new gun metal reserves are discovered, it will do nothing for the
productive capacity of roses, and the PPC will shift from EF to GF in above right
diagram. The PPC will pivot outward toward the good in which its productivity has
increased.

A decline in the quantity or productivity of resources will cause an inward pivotal shift of
the PPC from KL to KM or LN, as shown in the figure below.
Guns

K
N

0 M L Roses
3. Non-parallel Shift:
Unequal suitability will lead to different rate of growth in different goods and the
PPC will shift as shown in the diagram below.
Guns
(Capital intensive)
S
W

0 R T Roses
(Labour intensive)
4. Intersecting Shift:
There may be a case in which the production capacity of one product rises and the
production capacity of the other product falls. In this scenario the PPC will shift from
XY to UV, as shown in the diagram below.

Uses and Limitations of the PPC

The PPC represents both microeconomic (the study of economics in segments) and
macroeconomic (The study of the economy as a whole) issued.

Microeconomic Issues:
The PPC shows the microeconomic issues of:
– The basic economic problem, i.e., scarcity, choice and opportunity cost.
– Productive efficiency.
– Allocative efficiency (Production according to the desires of society) but cannot do
this alone. Social Preferences are needed to determine the allocatively efficient point
on the PPC.

However, the PPC does not show the microeconomic issues of:
– The provision of merit (e.g., education and healthcare) and public goods (e.g.,
national defence, light houses, etc.)
– Externalities (e.g., noise, pollution, congestion, etc.)
– Competition, etc.

Macroeconomic Issues:
The PPC shows the macroeconomic issues of:
– Actual growth (an increase in real GDP) by a movement of the point of production
from below the PPC to on the PPC.
– Potential growth (an increase in potential GDP) by an outward shift of the PPC.
– Employment and unemployment in the economy.

However, PPC does not show the macroeconomic issues of:

– Rate of inflation (A persistent rise in the general price level)
– Balance of payments (A record of all transactions of a country with the rest of the
world)
– Even distribution of income.
ECONOMIC STRUCTURE
The term economic structure refers to the way in which an economic consists of various
sectors i.e. primary, secondary, tertiary and quaternary sector.

1. Primary Sector:
This consists of agriculture, fishing and activities such as mining and oil extraction.

2. Secondary Sector:
Secondary sector includes manufacturing activities that are found in an economic e.g.
food processing, textiles and clothing, iron and steel production, vehicle
manufacturing, and electronics, etc.

3. Tertiary sector:
This is the service sector and covers a range of diverse activities such as retailing,
transport, logistics, banking, insurance and education, etc.

4. Quaternary Sector:
A relatively new term to denote the knowledge-based part of the economy–especially
the provision of information. Typical examples are scientific research and product
development, computing, and ICT.

As economies develop their economic structure changes and there is a progression from
primary to secondary to tertiary activities. In developed economies, the tertiary sector
tends to be the principal employer.

POSITIVE AND NORMATIVE STATEMENTS

Positive Statements
Positive statements are based on facts or established principles. These statements can be
tested and verified form the information available. They can be also used in construction
and explanation of theories and concepts in economics. For example: Pakistan is
experiencing a 30% rate of inflation; this statement is positive because the data on
inflation trends can be retrieved from the government of Pakistan.
Normative Statements
Normative statements are based on opinions and cannot be tested or verified because they
are not meant to relate to a particular point, or they can be regarded as statements that are
generalized. For example: inflation should be low at any cost. Statements like these
cannot be proven and they are not a fact as they are generalized.
Normative statements usually include words like:
– Should be/out to be
– Desirable/undesirable
– Fair/unfair
– Good/better/best/bad/worse
– Harmful/beneficial
– Welfare/happiness/well-being/standard of living
– Deserves/doesn’t deserve, etc.

CLASSIFICATION OF GOODS AND SERVICES:

Product or commodity is anything that is used to satisfy needs and wants of a society.
Products are either Goods (tangible and visible) or Services (intangible and invisible).
Goods and services can be classified into two basic categories, i.e., free goods and
economic goods.

Classification of Goods and Services

Economic Goods Free Goods

- Limited in supply - unlimited in supply

- opportunity cost exists - zero opportunity
- zero price
- e.g., Air, Sunlight
Private Goods Public Goods

- excludible - non-excludible
- rival/exhaustible - non-rival/exhaustible

Merit Demerit Other Pure Public Quasi Public

Goods Goods Goods Goods Goods
e.g. e.g. e.g. High degree of Low degree of either
- Education - Cigarettes - Cars non-excludability non-excludability
- Healthcare - Alcohol - Food & non-rivalry or non-rivalry

e.g., National e.g., Public

defence & beach or Public
Light-house Park
FREE GOODS:
Free goods are those which are unlimited in supply. These have zero opportunity cost
since consumption is limited by scarcity. They have no prices – as their name indicates –
and in theory, no factors of production are required to produce them. The air we breathe
could also be seen as a free good along with water in a local river.

ECONOMIC GOODS:
Economic or scarce goods are those which are limited in supply. Virtually all goods we
consume are economic goods including food, clothing, cars, mobiles etc. except those
few which fall under the category of free goods. Economic goods are either private goods
or public goods.

Public goods:
Public goods are non-excludable and non-exhaustible (non-rivalry in consumption) and,
most times, non-rejectable as well.

- Non-excludable means no one can be stopped from the consuming the good if they
are available to anyone in the society.
- Non-exhaustible or non-rival means that they don’t exhaust when they are consumed.
- Non-rejectable means that the consumer does not have a choice of whether to
consume the commodity or not. An availability of public goods to one person does
not infringe upon the right of others to consume the same product.

There are a number of goods can be seen as public goods. Take the example of
lighthouse. Once a lighthouse is built to warn one ship at sea away from a dangerous area
of rocks, then by its very nature, this service will automatically be provided to all ships
that sail within a certain distance of the lighthouse. It is non-excludable. Equally, the fact
that other ships see the light given by the lighthouse and are warned away from the
dangerous rocks does not reduce the benefit that any one particular ship receives from
that warning. It is non-rival

Quasi-public goods
Some goods are purely public (e.g. lighthouse or national defence) and other are to
certain extent also known as quasi-public goods (e.g. public beach or public park). These
are the goods that have some but not all of the characteristics of public goods.
A good example might be a sandy seaside beach. Such a beach is available to all those
who wish to use it. It appears non-excludable. However, it is possible to think of ways of
excluding consumers. Privately owned beaches do this. Equally, the beach is non-rival up
to a point. If you are the first person on a pleasant beach on a warn sunny day, it does
very little to diminish your enjoyment of that beach as a few more people arrive to enjoy
the benefits themselves. However, there may well come a point at which that is no longer
the case. As the beach becomes crowded, space limited and other people’s conversations
and music become ever more audible, enjoyment may perceptibly reduce. Thus, the each
has something of the characteristic of non-rivalry, but not the full characteristic. It is a
quasi-public good.

Whether a good is purely public depends upon the extent to which it is non-excludable
and non-exhaustible.

PUBLIC GOODS PRIVATE GOODS

Non-excludable Excludible
Non-exhaustible Exhaustible
Free rider problem No free rider problem
Non-marketable Marketable
Benefits of public goods can be extended to Benefits of private goods can’t be extended
others at zero additional cost. to others at zero additional cost.
Non-rejectable Rejectable
Examples: National defence, light Examples: merit goods, demerit
houses, national T.V., and radio goods, and all other goods.
broadcasts
Private goods:
Private goods are those bought and consumed by individual consumers or firms for their
own benefit. Most of the goods we consume on a daily basis are private goods. Food,
cars, TV, education, cigarettes etc. all are examples of private goods regardless of
whoever is producing i.e. private or public sector. They have two important
characteristics.

a. Excludability:
It is possible to exclude some people from using a private good. This is normally
done through charging a price. If the price is not acceptable, then that good will not
 be consumed. Once a private good has been purchased by one person it cannot be
consumed by others.

b. Rivalry:
The consumption by one person reduces the availability for others, in some ways it
seems obvious that when we purchase food, clothes or a textbook then this means that
fewer of these goods are available for purchase by others.

1. Merit goods:
The state is concerned to increase in consumption of certain goods which it considers
to be highly desirable for the welfare of the citizens however consumers do not
realize the true private benefit of them. Such goods are described as merit goods.
They are special form of private goods. The best-known examples are state health and
education systems. Other examples include training, insurance, inoculation and seat
belts.

In a pure market system, consumer spending on merit goods would be determined by

the private benefits (benefit to consumers and producers) derived from them. Merit
goods have positive externalities or external benefit (benefit to the third party who are
not directly involved in production and consumption decision) so that the social
benefits (Private benefit + external benefit) derived from them consumption exceed
the private benefits.

To understand these types of goods, it is necessary to appreciate that there is

information failure to the consumer. This arises because consumers do not perceive
quite how good or bad a particular product is for them; either they do not have the
right information or they simply lack some relevant information. This is why merit
goods are provided by the government for those who are deemed to need them. With
this idea of a failure for information, a merit good is defined as a good that is better
for a person than the person who may consume the good realizes.

It is interesting to note that the example of a merit good given here, namely
education, is the same as the same as the example of the product that can be seen as
having positive externalities associated with it. People undertaking education receives
consumption and investment benefits. Most will enjoy the education and it may
stimulate lifetime interests (consumption benefit) and will increase their future
earning power (investment benefit). In addition to these private benefits, third parties
 will gain from having a more educated, inventive labor force and a more informed
population (positive externalities). However, the reason for identifying the product is
different here in case of merit goods. Here, it is not due to the external benefits that it
creates, but rather due to the unperceived private benefits to the person through
consuming the product.

2. Demerit goods:
Demerit goods, on the other hand, those products that are worse for the individual
consumer than the individual realizes. Cigarettes are taken to be a typical example
here. It is suggested that when a person makes a decision to smoke a cigarette, he or
she is not fully in possession of such information, then there would be a greater
reluctance to smoke.

In a pure market system, consumer spending on demerit goods would be determined

by the private costs (cost of consumers and producers) derived from them. Demerit
goods have negative externalities or external cost (cost to the third party who are not
directly involved in production and consumption decision) so that the social costs
(Private cost + external cost) derived from their consumption exceed the private costs.

It is interesting to note that the example of a demerit good given there, namely
smoking, is the same as the same as the example of the product that can be seen as
having negative externalities associated with it. However, the reason for identifying
the product is different. Here, it is not due to the damage done to others that the issue
arises, but rather due to the unperceived damage done to the person through
consuming the product. Like smoking if a good is demerit as well as causes negative
externality, there will be two causes of market failure associated with one product.

Merit goods, demerit goods and value judgments

It may have been noticed in the above definitions that a significant question poses itself
with regard to merit and demerit goods. Who is to say what is ‘good’ or ‘bad’ for a
person? If an individual consumer makes a presumably (suppose/take it) rational decision
to consume a product, what right has the rest of society to say that he or she is making a
‘wrong’ decision? It seems clear that if this is what is going on, we have entered the area
of value judgments. If society is able to say to consumers that they do not fully realize
what is good or bad for them, then we are accepting that ‘society knows best’ and has
some right to make such a judgment. In effect, we are allowing paternalism (a situation
where society knows best and has some right to make a value judgment) and we are
saying that it is acceptable for society to judge what is, or is not good for a person
regardless of what that person may believe.

BASIC ECONOMIC QUESTIONS

There are three basic questions that explain the process of production of goods and
services that arise due to the concept of scarcity. The three basic questions are: what to
produce, how to produce and for whom to produce.

1. What to Produce
Limited resources do not allow us to produce everything, so we have to decide what
to produce and in what quantities. We have to decide whether we have to produce
consumer goods and services or non-consumer goods and services such as military
hardware and defense systems.

The second part of this question asks: “how much of each good is to be produced?”
Society’s point of view may categorize it as:

- Socially optimum (at a point where social welfare is maximized)

- Under-production (less than socially optimum)
- Over-production (more than socially optimum)

The private Sector:

- Aims to maximize profit.

- Produces fewer necessities and more luxuries.
- Under-produces merit goods, i.e., goods whose actual private benefits is not
realized by the consumers who consume them because of imperfect knowledge:
e.g., education, healthcare, seat belts, helmets, etc.
- Over-produces de-merit goods, i.e., goods which are harmful to society but the
consumers who consume them do not realize the actual private cost of such
goods: e.g., cigarettes, alcohol, drugs, etc.
- Does not produce public goods, which are non-excludable and non-exhaustible
(non-rivalry in consumption) and, most times, non-rejectable as well.

a. The Public Sector:

- Aims for collective welfare of the society.
- Fewer luxury goods and more merit goods and public goods are provided.
- Socially optimum merit goods.
 - Socially optimum demerit goods.
- Socially optimum public goods.

2. How to Produce
The question of how to produce arises due to limited resources and unlimited wants.
We have to decide a way in which we can produce enough goods and services that
can satisfy maximum wants, and that the resources are used efficiently and to their
maximum capacity. The private and public sectors help in deciding how to produce
the goods and services.

a. The Private Sector:

- Produces efficiently
- Minimizes its costs by whichever method is the least-cost one, i.e., labor or
capital intensive.

b. The Public Sector:

- Produces inefficiently
- Prefers labor intensive methods because of employment.

3. for Whom to Produce

As we cannot satisfy all the wants because of scarcity, we have to decide which group
of people must be satisfied and which is left unsatisfied, or which goods and services
must be produced that can satisfy maximum wants. Under the private sector the
problem is solved by using the price mechanism, which decides the quantity of goods
and services to be produced and for which group these goods and services will be
produced; whereas under the public sector the decision is made through the rationing
mechanism. This concept allows more equal distribution then the price mechanism.

MEANING OF THE TERM ‘CETERIS PARIBUS’

This Latin term is widely used by economists to refer to a situation where ‘other things
remain equal’. The idea behind this to be able to simplify an actual situation by assuming
that apart from a single change of circumstances, everything else is unchanged. In this
way, economists can model one change at a time.

DECISIONS AT THE MARGIN

Like ceteris paribus, this is another tool that is used by economists to simplify a situation.
Many aspects of microeconomics involve analyzing decisions at the margin’. By this we
mean that a small change in one economic variable will lead to further (small) changes in
other variables.

Decision making characterized by weighing the additional (marginal) benefits of a

change against the additional (marginal) costs of a change with respect to current
conditions.

According to economists, for most decisions, you think in terms of additional, or

marginal, costs and benefits, not total costs and benefits. That’s because most decisions
deal with making a small, or additional, change.

To illustrate, suppose you just finished eating a burger and drinking a soda for lunch. You
are still a little hungry and are considering whether or not to order another burger. An
economists would say that in deciding whether or not to order another burger, you will
compare the additional benefits of the additional burger to the additional costs of the
additional burger. In economics, the word marginal is a synonym for additional. So we
say that you will compare the marginal benefits of the (next) burger to the marginal costs
of the (next) burger. If the marginal benefits are greater than the marginal costs, you
obviously expect a net benefit to ordering the next burger, and therefore, you order the
next burger. If, however, the marginal benefits are less than the marginal costs, you
obviously expect a net cost to ordering the next burger, and therefore, you do not order
the next burger.

Condition Action

Marginal Benefit of next burger > Marginal Cost of next burger Buy next burger

Marginal Benefit of next burger < Marginal Cost of next burger Do not buy next burger.

What you don’t consider when making this decision are the total benefits and total costs
of burgers. That’s because the benefits and costs connected with the first burger (the one
you have already eaten) are no longer relevant to the current decision. You are not
deciding between eating two burgers and eating no burgers; your decision is whether to
eat a second burger after you have already eaten a first burger.

SHORT RUN, LONG RUN AND VERY LONG RUN

The short run is a time period in which it is possible to change some inputs but not all of
them. Typically it is when labour, a variable factor of production, can be increased or
decreased to change output. So, with all other factors of production remaining the same
(ceteris paribus), a firm taking on more workers may be able to increase its output.

In the long run, it is possible for all factors of production or resources to change. So, it is
the long run, a firm may improve the quality and quantity of its capital by building a new
factory to increase its output. This will usually allow it to be more efficient since the firm
has had time to evaluate how best this can be done successfully and efficiently.

The very long run is where not only are all factors of production variable, but all other
key inputs are also variable. These key inputs can include technology, government
regulations and social consideration.

ECONOMIC SYSTEMS
A system by which an economy allocates its scarce resources in production of various
goods and services to satisfy the needs and wants of a society i.e. deal with basic
economic problem.

The problem of scarcity, which in turn requires choices to be made, is one that is
common to all economies, rich and poor. The choices that are made and which can
realistically be made are determined by the economic system of a particular country.
Traditionally, economists have recognized three distinct types of economic system –
these are the market economy, the command or planned economy and the mixed
economy.

FEATURES MARKET COMMAND MIXED

ECONOMY ECONOMY ECONOMY
Ownership of Private ownership Government Private + Public
property: ownership (government)
ownership
Motive or objective: Profit maximization Collective social Private Sector:
welfare Profit maximization.
Pubic Sector: Social
welfare
Allocative Price mechanism Rationing Private Sector: Price
mechanism: (demand and mechanism (central mechanism
supply) planning & quotas) Public Sector:
Rationing
 mechanism
Freedom of choice Yes No Private Sector: Yes
(regarding Public Sector: No
production and
consumption):
Competition: Yes No Private Sector: Yes
Public Sector: No
The role of the Minimum All economic & The government
government (in the government non-economic limites its role to the
allocation of intervention in affairs are in the provision of
resources): economic affairs. hands of necessary goods &
Only limited to government services & to
maintaining law & regulate the private
order in the country sector for social
welfare.
Variety of goods & Yes No. Private Sector: Yes
services Public Sector: No
Quality of goods and High quality Usually poor quality Private Sector: High
services: quality
Public Sector:
Usually poor quality
Response to changes Quick response to Slow or no response Private Sector:
in demand changes in Quick response
(Consumer consumers’ Public Sector: Slow
sovereignty): preferences response
Efficiency *Usually efficient Inefficient The inefficiency of
[Producing most allocation of allocation of the private sector or
desirable goods resources because resources because minimized by
(allocative of existence of of the absence of a government
efficiency) with profit motive profit motive policies.
least-cost methods *Sometimes
(productive inefficient, e.g., in
efficiency)]: the case of private
monopolies.
Shortages & The price Central planning is Private Sector: No
surpluses (shortage- mechanism clears unable to guess shortages and
demand>supply; the market and there exact quantities surpluses
Surplus = are not shortages or demanded: Public Sector:
supply>demand): surpluses. shortages & Shortages and
surpluses are surpluses are
present present
Merit goods (e.g., Under-production & Socially optimum *Private sector:
healthcare, under-consumption Under-provides
education, etc.): *Missing markets of
merit goods will be
supplied through
government
provision.
Public goods (e.g., Non-marketable Provides public The public sector
street lighting and and, therefore, goods through provides public
national defense): missing government goods.
expenditure
Demerit goods (e.g., Over-production & Fewer or not The government
alcohol, drugs, over-consumption demerit goods discourages
cigarettes, etc.): consumption by
applying high taxes
and other imposing
other legislative
actions.
Distribution of Unequal distribution Even distribution Progressive taxation
income & wealth: and welfare
payments to the
poor will reduce the
disparity between
the rich & poor.
Useless duplication Yes No May occur in the
of goods & services private sector, but
not in the public
sector
Negative More than socially Socially optimum The government
externalities (e.g., optimum level will regulate
noise, pollution, negative
congestion, etc.): externalities through
taxes and legislative
impositions.
Necessities & luxury Fewer necessities & More necessities & The public sector
goods: more luxury goods fewer luxury goods will provide
necessities, even to
those who can’t pay
for them
Private monopolies: Develop and exploit No private The government
consumers by monopolies are regulates private
 setting high prices exist in command monopolies and
economy protects consumers
from exploitation.
Existence in real No pure market No pure command All economies are
world: economy economy mixed, but their
proportion of
private & public
sectors vary from
country to country.
Other terms: Free economy, Communism,
Capitalism, free socialism, planned –
market economy, economy, centrally
lalssez faire. planned economy

DIFFICULTIES FACED BY TRANSITION ECONOMIES:

Eastern European countries, such as Poland, Ukraine, or those forming the Soviet Union,
etc., were command economies throughout the 1940s and the 1950s. However, during the
1990s these economies started transforming themselves into market-oriented economies.
These countries, while they were in a process of transition, were known as transition
economies. This transition created a lot of problems for the people living in these nations,
and also for the government itself.

1. Sharp fall in GDP:

The first immediate problem that an economy may face will be a sharp fall in its GDP
because of the reduction in its output. The fall in output of each East European
country during the transition period was because of the fact that the state-owned
businesses lost customers as the old network between businesses fell apart. This was
because it was all based on state planning–the government told each firm which other
firm would receive their output and they would be paid accordingly. They would also
be told where it should buy their inputs. During the transition period firms had to
actively seek customers, whereas before they didn’t need to do so.

2. Lack of entrepreneurial abilities:

Entrepreneurs, due to a lack of experience, may not run firms efficiently. They may
not choose the right production methods or output levels to maximize profits.
Workers’ may be dogmatic in setting minimum wage levels, and may demand wages
from firms that might be deemed as being excessive in relation to firm revenues. As a
 result the relations between a firm and the labor that is employees will deteriorate and
resource wastage will occur in nearly all industries in the country.

3. High rate of unemployment:

Due to the transition, now that there is no central planning, the factories can produce
whatever they want. They will start cutting back on investment because they do not
want to take too many risks, which will lead to reduced demand in the economy.
Furthermore, because of this, the suppliers will also cut off workers, leading to large
scale unemployment and this leads to the reduced demand which will have an impact
on the decrease in the output of the country.

One of the strengths of a planned economy is that there is virtually no unemployment.

However, during the transition many enterprises will be force out of business because
of the lack of funds and demand to support them.

Another reason was that some of the firms were forced to become efficient after the
transition, due to the competition from other firms and foreign enterprises. The easiest
way of becoming efficient for these firms was by laying-off workers and making the
remaining workforce work harder and more productively. All the countries in the
transition process found unemployment as one of the heaviest burdens they had to
bear.

In a state economy the central planning body determines the output level of each
industry and specifies the amount of resources to be allocated; consumer preferences
are given little importance. As the market economy develops, demand for certain
goods may fall, while for others it may rise rapidly. Certain industries may become
inept and shut down, while market-oriented businesses will thrive but still face a
shortage of resources. Therefore, the economy will produce inside the PPC as an
inefficient allocation of resources prevails.

4. Rise in the informal sectors:

The countries worst affected by the GDP fall may have a rise in their informal
sectors. For example, in 1988, countries like Uzbekistan and Georgia had informal
sectors that were greater than their formal sectors. This also affects GDP because the
revenue earned in the informal sector is not included in a country’s GDP.

5. High inflation:
 The transformation is also associated with high inflation. A rise in price is almost
inevitable if any economy moves towards a free-market system. In a market system
resources are allocated by price. The free market price is inevitably higher than the
old state price, since consumers have been rationed in the past, so demand will be
greater. So, when a market system is introduced, the price will rise until demand
equals supply. There is no shortage because some consumers have been priced out of
the market. Higher prices can spark a wage-price spiral. Workers will react to higher
prices of goods by demanding higher wages. If firms give higher wages, then they
must make up for the cost of increasing the price of their goods, which will, in turn,
gives rise to further wage demands. The government must then give firms money to
pay the workers and to prevent them from going bankrupt. If they don’t they will
have protests, strikes, and civil unrest to deal with; whereas if they print too much
money it will simply make it worthless.

6. Process of privatization:
In a command economy land and capital is owned by the state, whereas in a market
economy it is predominantly owned by the public sector. So the move from one type
of economy to the other involves the sale of state assets to private individuals–
privatization. This can be done through a number of ways, such as by giving property
and capital away to individuals and companies currently employing them (e.g.,
tenants of council housing could be given their accommodation). The problem with
this is that is very arbitrary and unfair way of sharing out the state-owned businesses
and capital. This would divide society into the rich and poor. The state also sell its
assets to the highest bidder and use the proceeds to reduce tax or reduce government
debt.

7. Merit, demerit, and public goods:

In addition, as consumers gain power in the allocation of resources, certain goods
which may be deemed good for society (merit goods) will be produced below the
socially optimum level whilst those reckoned as harmful (demerit goods) will be
produced in greater numbers. Due to the problems of non-excludability and non-
rivalry, public goods, although necessary, will no longer be produced in the country.

8. Negative externalities:
There may be a time gap before a new framework of government controls can be
developed to offset the disadvantages of a market economy. In this period, firms
 seeking to keep their costs low may create pollution by disputing their waste in an
unsafe manner.

9. Market imperfections:
Imperfect completion is also likely to develop like monopoly (single dominant seller),
with consequences for prices output, quality, and consumer sovereignty.

These problems are like to be faced by transitioning economies, yet the impact of these
problems can be reduced. The government primarily needs to ensure that its assets are
distributed fairly among the people. In order to avoid large income gaps among the
population, the government can maintain its net social security safety net system and
introduce tax reforms (such as VAT).

Although the transition will be quite problematic, the long-term benefits should not be
overlooked. By taking certain measures governments may be able to avert certain
difficulties, and by ensuring a healthy environment for free market operations, the
government may help the economy to immensely improve its citizen’s level of comfort.

TOPICAL PAST PAPER ESSAY QUESTIONS

Scarcity
(Nov 2011/P22/Q2/b)
Discuss whether the combination of improved technology and globalization will result in
solving the basic economic problem. (12)
(June 2010/P23/Q2/a)
With the help of examples, explain why different economic decision makers face the
problem of scarcity (08)
(Nov 2002/P2/Q2/a)
Explain the link between the basic economic problem of scarcity and opportunity cost. (08)
(June 2000/a)
What is meant by the basic economic problem of scarcity? (08)
(June 1999/a)
The study of economics centers upon the problem of scarcity. Explain what is meant by
this problem and assess whether the use of economics can solve the problem. (08)
Explain the link between opportunity cost and the production possibility curve. (08)
(June 1991/a)
Explain the concept of opportunity cost. (08)

Unit # 2
The Price System and
the micro economy
a) Demand and supply curve  Effective demand
 Individual and market demand and supply
 Factors influencing demand and supply
b) Price elasticity, income  The meaning and calculation of elasticity of
elasticity and cross-elasticities of demand
demand  The range of elasticities of demand
 The factors affecting elasticity of demand
 The implications of revenue and business
decisions of price, income and cross-elasticities
of demand
c) Price elasticity of supply  Meaning and calculation of elasticity of supply
 The range of elasticities of supply
 The factors affecting elasticity of supply
 Implications for speed and ease with which
businesses react to changed market conditions
d) Interaction of demand and  Meaning of equilibrium and disequilibrium
supply e) Market equilibrium and  Effects of changes in supply and demand on
disequilibrium equilibrium price and quantity
 Applications of demand and supply analysis
 Movements along and shifts of the demand and
supply curves
 Joint supply
 The workings of the price mechanism; rationing,
signaling and the transmission of preferences
e) Consumer and producer surplus  Meaning and significance
 How these are affected by changes in
equilibrium price and quantity
Unit 2 Demand, Supply and Equilibrium
DEMAND

Definition

Demand Refers to the quantity of a product that purchasers are

willing and able to buy at various prices per period of time, all other

things being equal

 Quantity
 Product
 Purchasers/Consumers
 Willingness
 Ability
 At various prices
 Over a certain period of time
 Quantity: This refers to the numerical quantity of a product that is being demanded.
 Product: This is a general term that simply refers to the item that is being traded. It
can be used for goods or services. We could also stretch this to include tradable items
like money or other financial assets such as shares.
 Purchasers: These are the buyers of the product and are often referred to as
‘consumers’, although they may simply be intermediaries in the supply chain, e.g.,
Nestle purchasing large amounts of cocoa to be used the production of chocolate for
sale to the final consumer. We can consider an individual’s demand for a product or
more usefully, we can aggregate this to look at the demand for the market as a whole.

 Willing to buy: Purchasers must want a product if they are going to enter into the
market with the intention of buying it.

 Able to buy: To an economist, the notional demand (speculative and not always
backed up by the ability to pay) for a product, which emerges from wanting it, must
be backed by purchasing power if the demand is to become an effective demand.
Sellers are only willing to sell a product if the purchaser has the money to pay for the
product. It is this effective demand that is of particular importance of economists.
 Various prices: Prices are crucial to the functioning of a market. Although many
things influence demand for a product, it is at the time of purchase, when we have to
hand over our money and pay the price that we really judge whether the product is
value for money – in other words, whether we really are willing and able to buy it. As
the price goes up, and provided no other changes have occurred, more and more
people will judge the product to be less worthwhile.

 Per period of time: Demand must be time related, it is of no use to say that the local
McDonald’s sold 20 Big Macs to consumers unless you specify the time period over
which the sales occurred. If that was per minute than demand is high, but if that was
per week then this would show there is little demand for Big Macs in this particular
market.

 Other things being equal: There are numerous potential influences on the demand
for a product. Understanding the connections between the various influences is very
difficult if many of these elements are changing simultaneously. This is why it is
necessary to apply the cateris paribus assumption.

Demand
 Willingness
 Willingness
 Willingness  Ability
 Ability
 Act of buying if available
Purchase

Individual Demand Market Demand Aggregate Demand

 Demand of a  Demand for a  Demand for all

product by single product in a market products by all
consumer by all consumers households in a
country

Law of demand or demand function:

If other things are held constant (i.e., cateris paribus), a higher quantity will be
demanded at lower prices and a lower quantity will be demand at higher prices. Demand
has an inverse (i.e., negative) relationship with price.

Cateris Paribus

P Qd

P Qd

Mathematical formula to derive demand curve is shown as below:

Qd = f(P)

Qd = a – bP

Demand Schedule:
A table that shows inverse relationship between price and quantity demanded is known as
demand schedule.
If a = 50 and b = 10

Then following table shows negative relationship between price (P) and quantity
demanded (Qd) of a product.

Price Qd = 50 – 10P
$3 = 50 – 10(3) = 20
$2 = 50 – 10(2) = 30

Demand Curve
A curve that shows a relationship between price and quantity demanded. Graphical
representation of a demand schedule is known as demand curve – as shown in the
diagram below.
Price

a
3
b
2
D

0 20 30 Quantity
Taking price on y-axis and quantity demanded on x-axis, a downward sloping (negative)
curve is known as a demand curve. This demand curve has been drawn as a straight line
(a linear relationship). However, it is perfectly acceptable for price and quantity
demanded to be related in a non-liner manner in the form of a type of curve.

Law of demand is only applicable when all other factors are held constant. Assuming
ceteris paribus, the law of demand holds these factors constant:

- Income of consumers.
- Fashion/taste
- Advertising
- Population
- Prices of substitutes (alternatively demanded goods which satisfy some desire, e.g.,
Pepsi & Coke).
- Prices of complements (jointly demanded goods, e.g, car & fuel, pen, & ink, etc.).
- Seasons.
- Health linkages with the use of product.
- Income Tax
- Interest rates (cost of borrowing)
- Availability of credit
- Hire purchase facilities

Changes in demand:
Demand can change:
- By movement along the same curve (change in quantity demanded).
- By shift of the whole demand curve (change in demand)
 Changes in Demand and Qd

Change in quantity demanded (Qd) Change in demand

Movement along the same Shift of the demand curve

demand curve
Due to exogenous factor
Due to endgenous factor

Rise Fall
Extension Contraction

Price Price

P0 B
Ex
te
ns
Co

io
nt

P1 b Fall Rise
ra
c
tio
n

D1
D
D0
D2
0 0
Q0 Q1 Quantity Quantity

Endogenous and Exogenous Factors:

Endogenous factor is an internal factor of given theory and can be identified by looking
at the axes; e.g., price is given on the y-axis when constructing the demand curve and
will be considered as an endogenous factor.
Exogenous factors: are those which are external factors and are not given on the axis;
e.g., income, fashion, advertising, etc., are exogenous factors for demand.

Any change in endogenous (internal) factors brings about a movement along the same
curve, but any change in exogenous factors (external i:e Non price factors) creates a shift
in the demand curve, as explained below:

1. Movement along the same curve:

All those changes in quantity demanded of a product which arise from the change in
the price of a product are known as change in quantity demanded or movement along
the same curve.

Movement along the same curve can be:

- An extension in demand.
- A contraction in demand.

Extension in Demand:
It is an increase in quantity demanded due to decrease in price, keeping all other
things constant. Extension in demand is shown by a rightward movement along the
same demand curve.
Price

Extension

5 A
4 B
D

0
15 30 Quantity

Contraction in Demand:
It is decrease in quantity demanded due to an increase in price, keeping all other factors
constant. A contraction in demand can be shown by a leftward movement along the
demand curve.
 Price

Contraction

5 B
4 A
D

0
15 30 Quantity
2. Shift of the Demand Curve:
When the demand for the product changes due to changes in any of the exogenous
factors (external factors such as income of consumers, advertising, fashion, etc.), it
causes shifts in the demand curve.
Demand curve can shift
- Rightward, i.e., rise.
- Leftwards, i.e., fall.

Rise in Demand:
Increase in demand due to some non-price factors (such as consumers’ income, fashion,
etc.) is known as rise in demand.

Price (S) Off-season Demand (D0) Peak-season Demand (D1)

5 10 20
4 20 30

Demand will rise when: Price

- Income of consumers 
- Fashion/taste  6
- Advertising  5
- Population 
4
D1
D0

0
10 20 30 Quantity
- Season  e.g., demand for
winter clothing.
- Health-friendly 
- Prices of substitutes 
- Prices of complements 
- Expectations of future income 
- Expectations of future prices 
- Income tax 
- Interest rates 
- Availability of credit 
- Hire purchase facilities 

Rise in demand can be identified by the rightward shift of the whole demand curve, as
shown in the diagram above.

Rise in demand Extension in Demand

 Quantity demanded increases  Quantity demanded increases
 Due to exogenous factors.  Due to decrease in price.
 Whole demand curve shifts rightward  Demand curve remains same–rightward
movement along the same curve

Fall in Demand:
Decrease in demand due to any of the non-price factors (like consumers’ income,
fashion, etc.) is known as a fall in demand.

Price (S) Initial Demand (D0) Demand (D1) if income falls

5 20 10
4 30 20

Demand will fall when: Price

- Income of consumers 
- Advertising 
- Population 
5
- Season (out) 
- Health-unfriendly 4
- Prices of substitutes  D0
- Prices of complements  D1

0
10 20 30 Quantity
- Expectations of future income
- Expectations of future prices 
- Income tax 
- Interest rates 
- Availability of credit 
- Hire purchase facilities 

Fall in demand can be identified by the leftward shift of the whole demand curve, as
shown in figure above.

Derivation of market demand from individual demand curves:

The market demand for a product at a certain price is obtained by summing all of the
quantities demanded by individuals at that price. The market demand curve can be
obtained through the horizontal summation of all the individual demand curves for the
product. Market demand curve is normally flatter (elastic) than individual demand
curves. For example, let us assume that there are only three consumers who demand the
product according to the following schedule:

Price Demand of Demand of Demand of Market Demand = A + B + C

A B C
5 10 15 20 10 + 15 + 20 = 45
4 20 25 30 20 + 25 + 30 = 75
Price

5
4
DMarket
DC
DB
DA

0
10 20 30 45 75
Quantity
Exceptions of the law of demand:

Law of demand (economic theory of consumer behavior) is not true for all sorts of goods
and situations. Some exceptions exist where people demand more goods and services at
higher prices and vice-versa, ceteris paribus. Examples are:

1. Speculative goods:

Speculators are those who buy assets not for investment purposes; rather, they make
profit by the difference in sale and cost of an asset for the short period of time.
Examples of speculative goods are shares and currencies.

2. When quality is judged by prices:

Sometimes the quality of your product is judged by the price it costs to the consumer.
High price is taken as an indicator of good quality and vice-versa, in this situation
demand would increase with the rise in price and vice-versa.

Price

D
In these cases:
P  Qd P1
P  Qd
P0

0
Q0 Q1 Quantity
SUPPLY

Supply is the quantities of a product that suppliers are willing and able to sell at various
prices per period of time, cateris paribus.

 Quantities: Economists often deal with numerical values and very often try to
represent information in a quantitative way.

 Product: As with demand we are using the term to refer to any item that is being
traded. It can be used for goods or services. We could also stretch this to include
tradable items like money or financial assets such as shares.

 Suppliers: These are the sellers of the product and are often referred to as
‘producers’, although they may not be manufacturers of the product, they may
simply be an intermediary in the chain or selling services. We could look at an
individual company’s supply or a product or, more usefully, we can aggregate to
look at the supply for an overall market.

 Willing and able to sell at various prices: In a market economy, companies

must gain from selling their products. They are also in the fortunate position that
in many cases they can withhold supply if the price is too low. When price rises in
the markets, it is assumed companies will be more willing and able to supply
more to the market.

 Per period of time: Supply must also be time related. It is of no use to say that
Acer supplied 200 computers unless you specify the relevant time period. Clearly
this needs to be consistent with the time period being used for demand.

 Other things being equal: There are numerous potential influences on the supply
of a product. Analyzing the connections between the various elements is very
difficult if lots of these elements are changing simultaneously. So, we assume
these other factors affecting.

Supply
 Volume of  Willingness
 Willingness
goods in  Stock
+ stock
possession  Act of selling when demanded
Sale
 Stock

Individual Supply Market Supply Aggregate Supply

 Supply of a product  Supply of a product  Supply for all

by single firm in a market by all products by all
firms firms in a country

Law of Supply

If other things are held constant, i.e., ceteris paribus, a higher quantity would be supplied
at higher prices, and vice-versa, i.e.,

Ceteris Paribus

P  Profit Margin  Qs

P  Profit Margin  Qs

Supply has a positive relationship with price.

Supply Schedule

It is a table that shows the positive relationship between the price and quantity supplied
of a product, e.g.

P Qs
10 100
11 200
Supply Curve

It is a curve that shows relationship between price and quantity supplied of a product. The
graphical representation of a supply schedule is known as a supply curve.
Price

6 A
5 B
Taking 571price of y-axis and quantity on x-axis, an upward sloping (positively sloped)
curve is known as a supply curve–as shown in the figure above.

The law of supply is only applicable when all other factors are held constant. Assuming
ceteris paribus, the law of supply holds these constant.

- Cost of production (i.e., cost of raw materials, cost of fuel, cost of rent, cost of
insurance, cost of electricity, etc.).
- Climate/weather (especially for agricultural products).
- Taxes (e.g., corporation tax, sales tax, VAT, etc.).
- Subsidies (these are grants given to privately owned firms by the government).
- Technology (which in turn influence the productivity of factors of production).
- Education and training by the government.
- Number of producers in the market.
- Price of jointly supplied good (e.g., beef and cattle hide).
- Price of alternatively supplied goods (e.g., leather jackets and leather gloves;
brown and black shoes).
- Techniques of production
 Changes in Supply
Changes in Supply and Qs

Change in quantity Supplied Change in supply

Movement along the same Shift of the whole supply

Supply curve curve

Due to exogenous factor

Due to endogenous factor

Rise Fall
Extension Contraction

Price Price

S S2 S0 S1

P1 A
ion
ns

ion
te

ct
Ex

ra

P0 B
nt

Fall Rise
Co

0 0
Q0 Q1 Quantity Quantity
Movement along the same supply curve.

All those changes in the quantity supplied of a product which arise from the change in its
market price are known as movements along the same supply curve.

A movement along the same supply curve can be:

- An extension in supply
Price
- A contraction in supply
S
Extension in Supply:
P1 b
It is increase in quantity supplied due
to an increase in the market price of

n
P0 a

io
a product, assuming all other things

ns
te
are held constant

Ex
0 Q1
Q0 Quantity
 Price
S
a
Contraction in Supply: P0

It is decrease in quantity supplied

b
due to a decrease in the market price P1
of a product, assuming all other
things are held constant.

0 Q1 Q0 Quantity

Shift of the supply curve:

When the supply of a product changes due to some exogenous factors (e.g., tax, cost of
production, etc.) It causes a shift in the supply curve.

The supply curve can shift:

- Rightward i.e., rise

- Leftward i.e., fall

Rise in Supply:

An increase in the supply of a good due to any of the exogenous (external) factors (e.g.,
reduction in tax, improvement in technology, etc.) is known as a rise in supply.

Supply will rise when: Price

S0 S1
- Cost of production falls.
- Climate is favorable.
- Taxes fall.
- Subsidies rise.
- Technology improves. Rise
- The number of producers rises.
- The price of jointly supplied
goods rises. (car & spare parts)
- The price of alternatively
0
supplied goods falls. (dell & Quantity
hp)
 Rise in Supply Extension in Supply
 Quantity supplied increases  Quantity supplied increases
 Due to Non price factors  Due to increase in price.
 Whole supply curve shifts rightward  Supply curve remains same-rightward
movement along the same curve.

Supply will fall when: Price

S2 S0
- Cost of production rises.
- Climate is unfavorable
- Taxes rise
- Subsidies fall.
- Technology declines. Fall
- The number of producers falls.
- The price of jointly supplied goods
falls.
- The price of alternatively supplied
0
goods rises. Quantity

Fall in Supply Contraction in Supply

 Supply decreases  Quantity supplied decreases
 Due to Non price factors  Due to decrease in price.
 Whole supply curve shifts leftward  Supply curve remains same-downward
movement along the same curve.

Derivation of Market Supply from Individual Supply Curves.

The market supply is the sum of all producers’ supply at a given price of a product. The
market supply curve can be derived from the horizontal summation of all producers or
sellers supply curve. For example, let us assume that there are only three suppliers in the
market who supply according to the following supply schedules:

Price Supply of Supply of Supply of Market Supply = A + B + C

A B C
10 100 200 300 100+200+300=600
15 150 250 350 150+250+350=750
 Price

SA SB SC
SMarket
12
10

0
100 300 600 800
200 Quantity
EQUILIBRIUM

`Equilibrium is a situation when there is no tendency to change. Price is the value of a

product determined by the interaction of demand and supply. Equilibrium price is a
position when quantity demanded equals quantity supplied–it is established at the point
where the demand and supply curves intersect. The equilibrium price, P0 is shown in the
diagram below.
Price

Surplus

a b

P0 E0

P2 d c

Shortage

0
Q1 Q0 Q2 Quantity
Disequilibrium positions: Quantity demanded (Qd) is either more or less than quantity
supplied (Qs). These are corrected by consumer and producer responses, which alter
prices.

If the price is greater than PO: That is when Qs is greater than Qd, this will cause a
surplus. The excess supply pushes price downwards, forcing producers to reduce their
production and to dispose unsold stocks at low prices while simultaneously encouraging
consumers to demand large quantities. Prices will fall until the equilibrium is restored at
PO as shown in the diagram above.

Similarly, if price is les the PO: Qs is less than Qd, there will be a shortage of the
commodity. In this case producers will push prices upwards and increase production
while some consumers are deprived of the good. The prices continue to rise till
equilibrium price is restored at PO, as shown in the diagram above.

Changes in equilibrium:

1. Demand
2. Demand
3. Supply
4. Supply
5. Demand& Supply
6. Demandbut Supply
7. Demand& Supply
8. Demand but Supply
Price
Demand Shifts:
S0
Demand shifts and equilibrium.
Rise E1
P1
1. Demand Rises
P0 a
- Consumers’ income increases E0 Shortage
and demand shift right to D1 D1
- Shortage at old Price P0.
D0
- Price increase
- New equilibrium at E1 (Q1, P1)
- An extension in supply. 0 Q0 Q1 Quantity
Note: When demand rises, price and quantity increases.

Price
2. Demand Falls
S0
Surplus
- Consumer’s tastes change and
demand shift left to D1. P0 b
E0
- Surplus at old price P0.
- Price decreases until S0 = D1 P1
- New equilibrium at E1 (Q1, P1) E1 Fall
D0
- A contraction in supply.
D1
Note: When demand falls, price and
quantity decreases.
0 Q0
Q1 Quantity
Supply Shifts
Price
3. Supply Rises.
S0
S1
- Subsidies are given by the
Rise
government, shifting supply
rightwards to S1. E0 Surplus
P0 c
- Surplus at old price P0.
- Price decreases until D0 = S1 P1 E1
- New equilibrium at E1 (Q1, P1)
- An extension in demand.
D0
Note: When supply rises, price falls
0 Q0 Q1
and quantity increases. Quantity
Price
4. Supply Falls. S1
S0
- Fuel costs increase, shifting Fall
supply leftwards to S1.
- Shortage at old price P0. E1
P1 c
- Price increases until D0 = S1.
P0 E0
- New equilibrium at E1 (Q1, P1) Shortage

D0
0 Q1 Q0 Quantity
 - A contraction in demand

Note: When supply falls, price rises

and quantity decreases.

Simultaneous shift of demand and supply and their effect on equilibrium

Price
According to figure:

1. D  ‘x’ to point ‘b’

a S2 S0 S1
2. D  ‘x’ to point ‘f’
3. S  ‘x’ to point ‘d’ h b

4. S  ‘x’ to point ‘h’ g x c

5. D, S  ‘x’ to point ‘c’ d
f
6. D, S  ‘x’ to point ‘g’
e
7. D, S  ‘x’ to point ‘a’
D2 D0 D1
8. D, S  ‘x’ to point ‘e’
0
Quantity
A simultaneous shift in both demand and supply may lead to an increase or decrease in
price and cause an uncertain outcome of quantity traded–or vice-versa, depending on the
relative strength of the shifts in demand and supply, as explained below.

D D
S P = Uncertain P=
Q= Q = Uncertain
S P= P = Uncertain
Q = Uncertain Q=

5. When both demand and supply rise.

When demand and supply both rise, quantity traded will definitely increase, but the
change in price is uncertain. The price may remain the same (when both demand and
supply rise equally), may increase (when the rise in demand is greater than the rise in
supply), or may fall (when the rise in supply is greater than the rise in demand), as
shown in following diagrams.
 Price Price Price

S0 S0 S0
S1 S1 Ris Ris
e

se
e S1

Ri

se
se

Ri
Ri

E0 P1 E1 P0 E0
P0 E1 P0 E0 P1 E1
D1 D1

se
Ri
D1 D0
D0 D0
6. When
0 both demand and supply fall
Q0 Q1 0 Quantity Q0 Q1 Quantity 0 Q0 Q1 Quantity
When demand and supply both fall, quantity traded definitely decreases, but the change in
price is uncertain–i.e. it may stay the same, fall, or rise, depending on the relative magnitudes
of the shifts in demand and supply, as shown in the following diagrams.

Price Price Price

S1
S1 S1
S0 S0 Fa Fa
Fa ll ll
l S0
ll al
ll

F
Fa

E1 P0 E0 P1 E1
P0 E0 P1 E1 P0 Eo
ll D0 D0
Fa
D0 D1
D1 D1
0 Quantity 0 Quantity 0
Q1 Q0 Q1 Q0 Q1 Q0 Quantity

7. When demand rises and supply fails

When demand rises but supply falls, price will always rise, but the quantity traded
may vary according to the magnitudes of the changes in demand and supply,
respectively.
Price
Price Price S1 S1
S1 S0
S0 S0
P E P1 E1 P1 E1
1 1

E0
P0 E0 P0
D1 P0 E0
D1 D1
D0 D0 D0
0 0 0
Q Quantity Quantity
 Fa
ll

Ri
se
Ri
se
Fa
ll

Ri
se

Ri
se
Fa
ll
8. When demand falls and supply rises

When demand falls and supply rises, price definitely decreases, but the quantity
traded may vary according to relative magnitudes of the changes in demand and
supply, respectively.

Price
Price Price S0 S0
S0 S1 Ris
l S1 ll e S1
F al Fa
P0 E1 P0 E0 P0 E0

E1
E0 ll
P1 P1 Fa P1 E1
e

D0 e D0
Ris

Ris
D0
D1 D1 D1
0
Q0 Quantity 0 Q1 Q0 Quantity 0
Q0 Q1 Quantity

INTERDEPENDENT MARKETS & PRICES

1. Joint Demand or Complementary Goods

Some products are jointly demanded. This means that they are complementary, in the
sense that the use of one requires the use of the other.

For example: The demand for fuel is associated with the demand for cars, and the
demand for mobile phone networks is linked to the demand for mobile phone sets.

PfuelDcars
Price of fuel Price of cars
S0
S1 S
E1
P0 E0 P1
E1 P0 E0
P1

D1
D
D0
0 0
Q0 Q1 Quantity of fuel Q0 Q1 Quantity of cars
2. Substitute Products

Subtitutes are goods which satisfy the same desire. Other things being equal, the
demand for a product will trend to vary directly with the price of its substitute.

PRiceQdWheat

The figure below explain this relationship between products and their substitutes. In
the left diagram, a decrease in the supply of rice has cause and increase in the price of
and a decrease in the quantity demanded for tea. In the right diagram, the changes in
the market for rice has caused an increase in the price of and demand for wheat, and
an extension in its quantity supplied.
Price of Rice Price of Wheat
S1
S0 S
E1
P1 E1 P1
E0 P0 E0
P0

D1
D0 D0
0 0
Q1 Q0 Q0 Q1
Quantity of Rice Quantity of Wheat

3. Demand for Several Uses

The demands for such products are the totals of the demands of various users.

For example:

- Wool will be demanded by the textile industry, carpet manufacturers, blanket

manufacturers, the hosiery industry, and many others. An increase in the
demand for wool by one industry will raise the price and affect the prices of
all other products made from wool. \
 - Copper provides a good example for a basic commodity widely used in many
different industries. A large increase in the demand for central heating
(Copper pipes) might increase prices in the electrical components industries
(printed circuits and cables)
- Nylon
- Rubber

4. Joint Supply

Joint supply occurs where the production of one product automatically leads to the
production of another.

- Lead and zinc are found in the same ore, so the extraction of one automatically
leads to the extraction of the other.
- The production of beef also results in the production of hides and the production
of mutton leads to supply of wool.
- An oil refinery produces many different fuels from crude oil, and an increased
output of any one produce, say petrol, will automatically increase the output of
the others (benzene, diesel, oil, etc.)
- Rent-a-car from does not normally supply a weekday travel without supplying a
weekend travel.

Where products are in joint supply, an increase in the demand for one of them will cause
a fall in the price of the other. This is shown in the figure below. In the left diagram, the
demand of beef increases, causing an extension in supply and the price of beef to from P0
to P1. This also increases the supply of hides as shown in the right diagram below.

Price of Beef Price of hides

S0
S S1
E1 E0
P1 P0
P0 E0 P1 E1
Ris
D1 e
D0 D
0 0
Q0 Q1 Q0 Q1
Quantity of Beef
Quantity of hides
5. Relationship between Product and Factor Markets

A change in the demand for and/or supply of a product will not only affect the market
for that product, but will also affect all involved factor markets (i.e., the markets for
the resources that produce the product). Similarly, changes in factor markets will have
effects on product markets.

These relationships can be examined by looking at two examples. If, in a country,

there is a trend towards vegetarianism, the price of vegetables will increase and the
price of meat will fall. The figure below shows how an increase in the demand of
vegetables will cause their price to rise and supply to extend, whilst the decrease in
demand of meat will cause its price to fall and supply to contract.

Price of vegetables Price of beef

S S
E1 E0
P1 P0
P0 E0 P1 E1

D1 D0
D0 D1
0 0
Q0 Q1 Q1 Q0
Quantity of vegetables Quantity of beef

If a rise in the price of vegetables leads to an increase in their profitability, the demand
for green houses, for workers in the vegetable industry processing equipment, for
vegetarian restaurants, etc. will increase as well. On the other hand, if the profitability of
meat production falls, the demand for land to grace cattle, for lorries to transport animals,
for hot dog, stalls, etc., will decrease. The figure below shows the likely effects of this on
the market for butchers.
 Price of Butchers

S
E0
W0
W1 E1

D0
D1
0
Q1 Q0
No. of Butchers
Changes in factor markets also affect product markets. For example, if the wages for
brick makers increases, then the cost of producing bricks will increase as well. This, in
turn, is likely to raise the price of bricks due to a reduction in their supply.

ECONOMIC AGENTS IN A MARKET ECONOMY

There are three main types of actors or agents in the market system. Consumers and
producers interact in the goods markets of the economy. Producers and owners of the
factors of production (land, labor, and capital) interact in the factor markets of the
economy.

1. The Consumer

In a pure free market system, it is the consumer who is all-powerful. Consumers are
free to offer their money however, they want and the market offers a wide choice of
products in return. It is assumed that consumers will allocate their scarce resources so
as to maximize their welfare, satisfaction, or utility.

2. The Firm

In a pure free market, the firms are the servants of the consumers. Their motive is to
make high profits. This means maximizing the difference between revenue and costs.

Revenues

If they fail to produce goods which consumers wish to buy, they will not be able to
sell them. Consumers will buy from companies which produce the goods they want.
Successful companies will have high revenues; unsuccessful ones will have a low or
no revenue.
 Costs

If firms fail to minimize costs, they will fail to make a profit. Other, more efficient
firms will be able to steal their market by selling at a lower price. The price of failure
will be the exit of the firm from its industry.

3. Owners of the factors of production

Owners of land, labor, and capital are motivated by the desire to maximize their
returns.

- A landlord wishes to rent his or her land at the highest possible price.
- A worker wishes to hire him or herself at a maximum wage, all other things
being equal.
- An owner of capital wishes to receive the highest rate of return on the capital
he or she owns.

These owners will search the market place for the highest possible reward, and only when
they have found it will they offer their factor for employment. Firms, on the other hand,
will seek to minimize costs. They will only be prepared to pay the owner the value of the
factor in the production process.

THE FUNCTION OF PRICES IN THE MARKET

Market prices tend to directly individuals pursuing their own interests to engage in
activities that promote the economic well-being of society. Adam Smith, the father of
economics, refers to this as the “INVISIBLE HAND”. The working of this “invisible
hand” may be explained by four important functions that the price performs in the
market.

1. Rationing

Consumer wants are infinite, but we live in a world that in scarce of resources–and,
therefore, scarce of commodities as well. Somehow, these commodities have to be
rationed among the members of society. Price acts as a rationing tool in a market
economy, and is used to distribute limited goods and services produced by scarce
resources.

a. If many consumers demand a good, but its supply is relatively low, then prices
will be high
 - Some consumers (from low income groups) may stop their consumption;
- Some (such as some from middle income groups) may reduce their
consumption;
- Some (usually from high income groups) may continue consuming the same
amount or more.

Limited supply will be rationed to those buyers prepared to pay a high enough
price.

b. If demand is relatively low and supply is relatively high, then prices will be low.
The low price ensures a large number of goods will be bought, reflecting the lack
of scarcity of the good.

2. Signal

The price of the good is a key piece of information to both buyers and sellers in the
market. Prices are determined by the transactions that take place between buyers and
sellers. They reflect market conditions and, therefore, act as a signal to those in the
market. Decisions of buying and selling are based on those signals.

- P is a signal of shortage which may arise from D or S or both.

- P is a signal of surplus which may arise from D or S or both

3. Incentive

Prices act as an incentive for buyers and sellers.

- Low prices encourage buyers to purchase more goods and services. For
consumers, this is because the amount of satisfaction or utility gained per unit
of currency spent increases relative to other goods. Higher prices discourage
buying because consumers get fewer goods per unit of currency spent.
- On the supply side, higher prices encourage suppliers to sell more to the
market. Firms may have to take on more workers and invest in new capital
equipment to achieve this. Low prices discourage production. A prolonged fall
in prices may drive some firms out of the market because it is no longer
profitable for them to supply.

4. Allocation of Resources

Allocation of Resources
The term ‘resource allocation’ refers’ to the way in which the available factors of
production are distributed among the various uses to which they might be put. There
are always insufficient resources to produce all the goods and services that could be
consumed. It is therefore necessary to allocate resources efficiently between the
various possible uses, and, in so doing, to choose what and what not to produce.

Price Mechanism

In a market there are buyers who demand goods and sellers who supply goods. The
interaction of demand and supply fixes the price at which exchange takes place. A
mechanism in which price plays the key role in the allocation of goods and services
and resources in the market is known as the ‘price mechanism’.

Example

If there is an increase in the demand for corn due to change in consumer tastes, the
demand curve for corn will shift to the right from D0D0 to D1D1 (See diagram below).
With supply remaining unchanged, the price will increase from OP0 to OP1. This
increase in the price of corn will act as a signal and incentive for producers to produce
more corn. The quantity supplied will then increase from OQ0 to OQ1.

Price

S
E1
P1
P0 E0

D1
D0
0
Q0 Q1 Quantity

At the new price, the profits of existing firms will increase in the short run. So, in the
long run, some firms will enter the industry, raising supply.
Factors market too will be affected. The demand by firms in the corn industry for
workers and equipment will rise. So, the wages for corn workers may rise. The rise in
wages (i.e., the price of labor), acts as a signal to workers. The incentive to work in
the corn industry will have risen so more workers will want jobs in corn production.
Some worker from elsewhere in the economy will enter the corn industry, motivated
by high wages. Similarly, capital-owners and land-owners will be attracted to the corn
industry.

Wages
S0
S1
E0
W0
W1 E1
Ris
e
D
0 L1
L0 Labour
Unit # 3 ELASTICITY
Definition

Elasticity is the degree of responsiveness (numerical measure) of one dependent variable

to changes in another independent variable, ceteris paribus.

Types

Elasticity is of two types:

- Elasticity of demand
- Elasticity of supply
Elasticity

Elasticity of demand Elasticity of supply

Responsiveness of Qd to the change in Responsiveness of Qs to the change in

own price Income of consumers Price of another good Own price of product

PED YED XED PES

INTERPRETING THE ELASTICITY FIGURES:

To understand the elasticity figures, there are three aspects that should be kept in mind
while interpreting them:

1. The use of percentages

2. The use of signs (positive or negative)
3. The significance of the value
The use of percentage
a. The use of percentages allows us to compare the changes in two different variables
measured in different types of units–e.g., in PEC, we measure the responsiveness of
quantity demanded (which is measured in pounds, kg, etc.) to changes in the price of
the product (which is measured in $, PKR, etc.), so the use of percentage helps
remove these differences.

b. The use of percentages removes the problems associated with the size of the units
used–e.g., if the price of a product rises from $2 to $4, there is a change of $2, but if
the same change is measured in ‘cents’, it would be 200 cents. Apparently, $2 and
200 cents might be confusing while solving problems, but the use of percentages will
remove this problem as described in the example below.

P0 P1 P %P
$2 $4 2 42
  100  100%
2
200 400 100 400  200
  100  100%
Cents Cents 200

c. Percentage change is the only suitable way to decide how big a change in price or
quantity is–e.g., if the price of a product rises by $1, is this a large increase or
small increased? We can answer only if we know what the original price was. For
a bottle of Pepsi whose original price is 20 cents, a $1 increase is a big increase
because price has increased by 500%; but in the case of a house whose original
price is $5000, an increase $1 is a small increase in price, because the price has
just increased by 0.2%. Therefore, it is the percentage or the oproportionate
increase in price that we look at when deciding how big a price rise it is.

The use of sign (positive or negative)

The sign with an elasticity number shows the relationship between two variables. For
instance, price elasticity of demand will have a negative number because quantity
demanded has a negative relationship with the price of a product. According to the
law of demand (ceteris paribus):

P  Qd

P  Qd
 The value of price elasticity of demand will always be negative, whereas price
elasticity of supply will always have a positive value since price and quantity
supplied have a positive relationship.

P  Qs

P  Qs

But, the signs have important significance when considering the values of income
elasticity of demand and cross elasticity of demand, since the signs explain the
relationship between the variables involved.

The negative sign of price elasticity of demand is usually ignored because it is

assumed to be universally understood that quantity demanded always has negative
relationship with price.

Significance of value

If we ignore the sign and just concentrate on the value of the figure, then we can
determine the elasticity of demand or supply. The five types of elasticities are:

- Elastic demand or supply (Elasticity > 1)

- Inelastic demand or supply (Elasticity < 1)
- Unitary elastic demand or supply (Elasticity = 1)
- Perfectly elastic demand or supply (Elasticity = )
- Perfectly inelastic demand or supply (Elasticity = 0)

Formula

Effect
Formula  As we know
Cause

%Qs Qs
PED  %Q   100
%P Q1

%Qs P
PES  %P   100
%P P1

%Qd
YED 
%Y
 %Qd of good ' x'
XED 
%P of good ' y'

Substituting values of %P and %Qd into the formula.

ΔQ
 100
%Qd Q1
PED  
%P ΔP
 100
P1

Q P1
PED  
Q1 ΔP

Q P1
PED  
P Q1

ELASTCITY OF DEMAND
Elasticity of demand can be defined as the degree of responsiveness of quantity
demanded (Qd or Qd) to changes in the price of a product, changes in the price of its
substitutes or complements, or changes in the incomes of consumers. The different
elasticities of demand can be categorized as follows:

1. Price elasticity of demand (PEC)

2. Income elasticity of demand (YED)
3. Cross elasticity of demand (XED)

Price Elasticity of Demand

Price Elasticity of Demand (PED) is defined as the degree of responsiveness of quantity
demanded to changes in the price of a product.

PED is always negative because price and quantity demanded have a negative
relationship. In the example below, the value of PED is –2.5, but by ingoing the sign we
can determine the type of elasticity. In this example the demand is elastic.

%Q ΔQ P1
PED   
%P P Q1
Example:

P1 = $10 Qd1 = 1000 units ΔQ P1

P2 = $12 Qd2 = 500 units PEC  
P Q1

500 - 1000 10  500 10

PED      2.5
12  10 1000 2 1000

Types of PED:

There are five types of PED that determine the elasticity of demand. These are:

1. Price elastic demand (PED > 1)

2. Price inelastic demand (PED < 1)
3. Unitary price elastic demand (PED = 1)
4. Perfectly price elastic demand (PED = )
5. Perfectly price inelastic demand (PED = 0)

1. Price elastic demand (PED > 1)

When a small proportionate change in price generates a large proportionate change in

quantity demanded, it is known as price elastic demand. In the example below, PED
is “–5”. Ignoring the negative sign, the value is greater than 1, so demand is
considered to be price elastic.

%Q
PED  1
%P

P1 = $10 Qd1 = 100 units ΔQ P1

P2 = $8 Qd2 = 200 units PEC  
P Q1

200 - 100 10 100 10

PED      5
8  10 100  2 100
 Price

10
8

0
100 200 Quantity

Relationship of price elastic demand with total revenue or total expenditure:

Revenue is the money received from the sales of goods and services. Total revenue
can be calculated using the following formula:

TR = P × Q

Total Revenue (TR) received by the seller is very important because it determines the
level of profits earned by the seller the following formula shows the calculation of
profit earned:

Profit = total revenue – total cost

Maximum total revenue (TR) or minimum total cost (TC) means more profit for the
business. Knowledge of PED would be very useful for the seller as goods whose
demand is elastic any reduction in price of product will generate proportionately
greater increase in quantity demanded, and therefore total revenue will rise and vice-
versa.

P  Q TR

P  Q TR

At “P0 = 10$

TR = A + B area

= 10 × 100 = $1000
At “P1 = 8$ Price

TR = B + C area

= 8 × 200 = $1600

Hence 10
A
8
Loss = “A’ area
B C
Gain = “C” area D

Net gain = C – A area

0
100 200 Quantity
= 800 – 200 = $600

The following diagrams show the relationship between total revenue and quantity
demanded, and the relationship between total revenue and price.
Price Total Revenue

TR

P0 TR1

P1 TR0

TR

0 0 Q0
TR0 TR1 Total Revenue Q1 Quantity

Price inelastic demand (PED < 1):

When a large proportionate change in price generates a small proportionate response in

quantity demanded, demand is said to be price inelastic.
 %Q
PED  1
%P

In the example below PED is “–0.2”. Ignoring the negative sign, the value is less than
1, so demand is price inelastic.

P1 = $10 Qd1 = 100 units ΔQ P1

P2 = $5 Qd2 = 110 units PEC  
P Q1

110 - 100 10 10 10
PED      0.2
5  10 100  5 100

Price

10

D
0
100 110 Quantity
The demand curve for inelastic demand would be steeper, as shown in above.

Relationship of price inelastic demand with total revenue or total expenditure:

For goods whose demand is inelastic: any reduction in price will generate a
proportionately smaller increase in quantity demanded; therefore, total revenue will fall,
and vice-versa. Refer to the diagram below

P  Q TR
P  Q TR
At “P0 = 10$
TR = A + B area Price
= 10 × 100 = $1000
At “P1 = 5$
TR = B + C area
= 5 × 110 = $550 P010
Hence A
Loss = “A’ area P15
Gain = “C” area B C
D
Net gain = A – C area 0
100 110 Quantity
= 500 – 50 = $450 Q0 Q1
The diagrams below show the relationship between total revenue and quantity demanded,
and the relationship between total revenue and price.
Price Total Revenue

TR

P1 TR0

TR1
P0

TR

0 TR0 0
TR1 Total Revenue Q0 Q1 Quantity
Unitary Price elastic demand (PED = 1)

When an equal proportionate change in price generates an equal proportionate response

in quantity demanded, demand is said be be unitary price elastic.

%Q
PED  1
%P

A demand curve with unitary price elasticity is shaped like a rectangular hyperbola,
as shown in the diagram below

` Pride

P0 PED = 1

P1
D

0
Q0 Q1 Quantity
 Elasticity Formula

%Q
PED 
%P

For Straight Line For Hyperbola

Uses original price and Uses average price and

original for calculation of quantity for calculation of
%age changes %age changes

Q Q
% Q   100 %Q   100
Q1 (Q1  Q 0 )/2

P P
%Q   100 %Q   100
P1 (P1  P2 )/2

Example:

P1 = $10 Qd1 = 100 units

100
P2 = $5 Qd2 = 200 units %Q  100  66.67%
100  200
2
5
%P   100  66.67%
10  5
2
66.67%
PED  1
66.67%

TR1 = 10 × 100 = $1000

TR2 = 5 × 200 = $1000
Relationship of unitary price elastic demand with total revenue or total expenditure:

Any price increase or decrease will cause the quantity demanded to change with equal
proportion; thus, there will be no change in total revenue–as shown in the diagram below.
Price

At “P0”
TR = A + B area
P0
At “P1”
A
TR = B + C area
P1
D
B C
0
Q0 Q1

Quantity

TR

P2

P1

P0

0
TR0 Total Revenue

The diagrams above show the relationship between total revenue and quantity demanded,
and the relationship between total revenue and price.
Perfectly price elastic demand (PED = infinity):

When a small proportionate change in price generates an infinite response in quantity

demanded, demand is said to be perfectly price elastic
%Q
PED   infinity
%P
The demand curve for a perfectly price elastic good is parallel to the “quantity” axis, as
shown in the diagram below.

Price

PED = 
P0

0
Q0 Q1 Quantity
Relationship of perfectly price elastic demand with total revenue or total
expenditure:

In perfectly price elastic demand, there is no or little change in the price, so total revenue
is positively related to quantity demanded. Therefore, when quantity demanded will
increase, total revenue will also increase with equal percentage–and vice-versa.

Perfectly price inelastic demand (PED = 0)

When a large percentage change in price leads to no change in quantity demanded,
demand is said to be perfectly price inelastic. The demand curve of a perfectly price
inelastic good will be parallel to the “price”, axis as shown in the diagram below.
%Q
PED   Zero
%P
Price
D

P2

P1

P0

0
Q0 Quantity
Relationship of perfectly inelastic demand with total revenue or total expenditure:
In perfectly price inelastic demand quantity demanded remains constant whereas, any
change in price causes equal proportionate change in total revenue, refer to diagram
above.

Varying PED Along the Downward Sloping Straight Line Demand Curve:
A downward-sloping straight-line demand curve has different elasticities along the same
curve. It has a high price elasticity before the mid-point, a unitary elasticity in the middle,
and a price inelasticity after the mid-point—as shown in the diagram below:
 Price

PED = 
6 a
5 b PED > 1
PED = 1
4 c
3 d
2 e PED < 1
1 f
g PED=0
0
1 2 3 4 5 6 Quantity

At Point ‘a’
Q = 1 P = -1 P1 = 6 Q1 = 0

Q P1 1 6
PED        Infinity  (Perfectly Elastic)
P Q1 1 0

At Point ‘b’
Q = 1 P = 1 P1 = 5 Q1 = 1

Q P1 1 5
PED      5 (Elastic)
P Q1 1 1

At Point ‘c’
Q = 1 P = 1 P1 = 4 Q1 = 2

Q P1 1 4
PED      2 (Elastic)
P Q1 1 2

At Point ‘d’
Q = 1 P = 1 P1 = 3 Q1 = 3
 Q P1 1 6
PED      1 (Unitary Elastic)
P Q1 1 0

At Point ‘e’
Q = 1 P = 1 P1 = 2 Q1 = 4

Q P1 1 2
PED      0.5 (Inelastic)
P Q1 1 4

At Point ‘f’
Q = 1 P = 1 P1 = 1 Q1 = 5

Q P1 1 1
PED      0.2 (Inelastic)
P Q1 1 5

At Point ‘g’
Q = 1 P = 1 P1 = 0 Q1 = 6

Q P1 1 0
PED      0 (Perfectly Elastic)
P Q1 1 6

Actually PED is a relationship between proportional, not absolute, changes in price and
quantity demanded. As price falls, people become less sensitive to price changes.

Another explanation of varying PED along the same downward sloping demand curve is
shown in diagram above. The change in quantity and change in price are both constant.
P
So remain the same whether we measure PED at any point on the demand curve.
Q
P1
However it is that will change and finally determine the value of PED. As we move
Q1
down along the curve, initial price (P1) falls and initial quantity (Q1)rises. Hence the ratio
P1
of will yield lower values with the fall in price. Consequently, there will be a
Q1
reduction in the value of PED along the curve from left to right. Refer to the diagram
above.
P  Qd  PED 
P  Qd  PED 

Relationship between Downward Sloping Demand Curve and Total Revenue:

The diagram below shows the relationship between the demand curve and total revenue
curve. The diagram shows that, at price “P0”, PED is unit elastic, and total revenue is at
its maximum. When the price is above “P0”, total revenue is rising. When the price is
below “P0”, total revenue is falling.
Price

PED > 1
(PTR)
P1 a
1
PED = 1
(TR = Maximum)
P0 d
PED < 1
(PTR)
1
g
0 Q0 Q1 Quantity

TR = Maximum

TR
0
Q0 Quantity
Constant PED along the Demand Curves:
Perfectly elastic perfect inelastic, and unit elastic demand curves are special cases where
the PED remains constant along the same demand curve.
a) Perfectly elastic demand curve:
The amount of quantity demanded is infinite at price P0, as shown in the diagram
below.
Price

PED = 
P0

0
Q0 Q1 Quantity
b) Perfectly inelastic demand curve:
Quantity demanded does not change as price changes at any point. This is shown in
the diagram below.
Price
D

P2

P1

P0

0
Q0 Quantity
c) Unitary elastic demand curve:
The percentage change in quantity demanded is the same as the percentage change in
price. Refer to the diagram below.
Pride

P0 PED = 1

P1
D
 Summary of PED types:

Price
PED = 0

PED = 
PED = –1
PED < –1 PED > –1
0
Quantity

Determinants of PED:
Price elasticity of demand is determined by the ease with which consumers can
change their demand. Some of the factors that determine that ease are:

1. The nature of good:

– Necessities  Inelastic demand
– Luxuries  Elastic demand
Goods and services which are necessities, e.g., food, clothing, etc., have inelastic
demand. Those which are termed luxuries, e.g., Lexus, Nike shoes, etc., have elastic
demand.

2. Definition of a good:
– Broadly defined  Inelastic demand
– Closely defined  Elastic demand

Broadly defined goods are inelastic in nature because they have relatively fewer close
substitutes. On the other hand, if a good or service is more closely defined, its
 potential substitutes will increase causing its demand to become elastic—e.g., on the
whole, a car would have an inelastic demand, but a Honda Civic would have an
elastic demand. This is because it is hard to find a substitute for a car but very easy to
find substitutes for a Honda Civic.

3. Number of substitutes:
– Less substitutes  Inelastic demand
– More substitutes  Elastic demand

The more substitutes for a product, the more easily consumers can shift from one
product to another, the more elastic will be the demand—e.g., in Pakistan electricity
is only available from WAPDA and there are virtually no substitutes for it; hence
demand for electricity would be inelastic in Pakistan.

4. Habit forming or consumer loyalty:

– Addictive  Inelastic demand
– Non-addictive  Elastic demand

Some goods and services are addictive in nature—e.g., alcohol, drugs cigarettes, etc.
Any rise in the prices for these products would not inhibit the use of these goods by
addicted consumers, so their demand would be inelastic. Similarly, the more a
consumer is loyal to a brand, the more inelastic its demand will be.

5. Time:
– In emergency  Inelastic demand
– More time available  Elastic demand

Some goods are demanded during an emergency—e.g, lifesaving medicines. Those

goods for which demand cannot be postponed are inelastic. However, the demand for
goods like ‘houses’ is elastic, because consumers can take their time to make
decisions before they buy these goods.

6. Proportion of income:

a small proportion of income spent on goods: inelastic demand

a large proportion of income spent on goods: elastic demand

PRICE ELASTICITY OF SUPPLY (PES)
The degree of responsiveness of quantity supplied (Qs or Qs) to changes in the price of
the product is known as elasticity of supply or price elasticity of supply (PES)
%Qs ΔQs P1
PES   
% P ΔP Q1
Price elasticity of supply is always positive because quantity supplied and price has a
positive relationship.
Example
P1 = 100 Qs1 = 1000
P2 = 200 Qs2 = 2500

1500 100
PES    1.5
100 1000

Types of PES:
There are five types of PES:
1. Price elastic supply (PES > 1)
2. Price inelastic supply (PES < 1)
3. Unitary price elastic supply (PES = 1)
4. Perfectly price elastic supply (PES = )
5. Perfectly price inelastic supply (PES = 0)

1. Price Elastic Supply (PES > 1):

When a small change in price generates a proportionately larger response in quantity
supplied, supply is said to be price elastic supply.
 %Qs
PES  1
%P
Price
S1

S0

0
Quantity supplied
The elastic supply curve originates from the y-axis regardless whether it is steep or not.
Both S0 and S1 are elastic supply curves.

2. Price Inelastic Supply (PES < 1):

When a large change in price generates a proportionately smaller response in quantity
supplied, supply is said to be price inelastic supply.
%Qs
PES  1
%P
Price
S2

S3

0
Quantity supply
An inelastic supply curve originates from the x-axis, regardless of whether it is steep
or not. Both S2 and S3 are inelastic supply curves.
3. Unitary Price Elastic Supply (PES = 1)
When a change in price generates an equally proportionate change in quantity
supplied, supply is said to be unitary price elasticity. Any curve that originates from
the origin will be unitary price-elastic supply, irrespective of the gradient that it has.
Therefore, in the diagram below, S4, S5 and S6 all are unitary price elastic.
%Qs
PES  1
%P

Price
S4
S5

S6

0
Quantity

4. Perfectly Price Elastic Supply (PES = infinity)

When a very small proportionate change in the price of the product leads to an
infinite response in quantity supplied, supply is said to be perfectly price elastic or
infinite price elastic.
%Qs
PES     Infinity
%P
 Price

PES = 
P0 S

0
Quantity

5. Perfectly Price Inelastic Supply (PES = 0)

When a change in price generates no change in quantity supplied, supply is said to be
perfectly price inelastic or to have a price elasticity of supply of zero.
%Qs
PES  0
%P
Price

PES = 0

0 Q0 Quantity
Varying Price Elasticity of Supply along the Supply Curve:
Normal upward sloping supply curves (both elastic and inelastic) have different
elasticities at different points on the curve. However, PES will be constant along unitary,
horizontal, and vertical straight-line supply curves.

Summary
Price
PES = 0
PES < 1
PES = 1

PES > 1

0
Quantity

DTERMINANTS OF PES

The extent to which the supply of a product is elastic depends upon the flexibility and
mobility of factors of production. If production can be expanded easily and quickly
and/or products can be easily brought out of storage in response to an increase in demand
(and the resulting rise in price), supply will be elastic; if not, supply will be inelastic.
Similarly, when demand (and price) falls, supply will be elastic if production can be cut
back easily and/or products can be taken off the market and stored. The factors that can
influence the degrees of responsiveness of supply to price change are as follows:
– Level of spare capacity
– Time period
– Level of employment
– Storability of a product.
– Agricultural vs. manufactured products.
– Time required to increase capacity.
– Ability to import inputs.
1. Level of Spare of Excess Capacity
When the industry is operating below full capacity
Industry can expand easily
Excess capacity by using previously unused Supply will be elastic
variable and fixed assets

When the industry is operating at full capacity:

Industry cannot
At full capacity Supply will be inelastic
expand easily

2. Time Period:
Time period is directly linked with PES. The more time the producer has to make
adjustments, the more elastic the product’s supply will be. With respect to time,
supply can be of three types:
- Momentary supply
- Short-run supply
- Long-run supply

i. Momentary Supply:
A momentary time period is that during which supply is restricted to the quantities
actually available in the market. The momentary time period is too short to change
any factors of production and, therefore, alter the supply in response to changes in
price and/or demand of the product in the market. Supply is fixed (perfectly inelastic)
during the momentary time period. An example can be of the supply of fish, fruit, and
vegetables in the local market.
Price

PES = 0

0 Q0 Quantity
ii. Short-run Supply
The short-run is a time period long enough to change one or two factors of
production—usually labour—but not enough time to change all factors of production
and, therefore, after the supply in response to changes in price and/or demand of the
product in market.
Price

SRS

0
Quantity

iii. Long-run Supply

The long run is the time period, long enough to change the quantity of all factors of
production employed and, therefore, alter the supply in response to changes in price
and/or demand of the product in the market. Supply in the long run is more elastic
than in the short run.

Price

LRS

0
Quantity
1. Level of Employment
At full employment:
No significant increase in output is possible in the short run (because idle resources
are not available and efficiency and technology can only be improved in the long
run). Supply will, therefore, be inelastic.

At below full employment:

Output can be increased easily by using the idle resources in economy. Supply will,
therefore, be elastic.

2. Storability of a Product
If the product can be stored and cheaply, supply can be stopped by adding to
inventory stocks during periods of low price. When the price rises, the quantity
offered for sale can be increased quickly and easily by drawing from inventory
stocks. Supply will therefore be elastic.

If the product cannot be stored easily and cheaply, supply will be inelastic.

3. Length of the Production Process

- Agricultural Products
These products take a considerable amount time change the supply; so, their
supply is inelastic in the short run.

- Manufactured Products
Compared to the production of agricultural products, the production process for
manufactured products is shorter; so, manufactured products have a relatively
elastic supply.

4. Time required to increase Capacity

 - If expansion takes a short time, supply will be elastic; e.g., in the garments
industry.
- If expansion takes a long time, supply will be inelastic; e.g., in the mining
industry.

5. Ability to Import Inputs

- If a country can import raw-materials, machines, etc., from abroad easily and
cheaply will be elastic, even at full-employment.
- In a closed economy, supply will be inelastic at full-employment.

INCOME ELASTICITY OF DEMAND

The degree of responsiveness of quantity demanded to changes in the income of the
consumer alone is known as income elasticity of demand (YED).

%Q ΔQ Y1
Y.E.D   
%Y ΔY Q1

In PED, the sign has no important significance, but in YED the sign is of great concern to
economists, because it defines the relationship between the variables involved. YED can
be characterized into two types, on the basis of signs:

a) Positive YED (normal goods)

b) Negative YED (inferior goods)

Positive YED (Normal Goods):

When an increase in income leads to an increase in quantity demanded or a decrease in

income leads to a decrease in quantity demanded, income elasticity of demand will be
positive because income and demand have a positive relationship. This is shown in the
example below:

Example:

Y1 = $100 Y2 = $ 110

Qd1 = 10 Qd2 = 11.5

 %Q 11.5 - 10 100
Y.E.D     1.5
%Y 110 - 100 10

The positive value of YED in the diagram below signifies that, for this good, income and
quantity demanded have a positive relationship; hence, it is classified as a normal good.

Income

Positive YED

Y1

Y0

0 Q0 Q1 Quantity

Positive YED is of three types:

i. Positive income elastic demand (YED > 1)

ii. Positive Income inelastic demand (YED < 1)
iii. Positive income unitary elastic demand (YED = 1)

i. Positive income elastic demand (YED > +1):

When a small percentage increase in income leads to a large percentage increase in
quantity demanded, or when a small percentage decrease in income leads to a large
percentage decrease in quantity demanded, demand is said to be positive income
elastic. This is shown in the diagram below. Normal goods with a positive income
elasticity of demand greater than one are sometimes referred to as superior good.
Luxuries on which consumers spend a major proportion of their income are taken as
positive income elastic goods—e.g., cars, jets, foreign holidays, etc.
Income

YED > +1

Y1

Y0
i. Positive income inelastic demand (YED < +1)

When a large percentage increase in income leads to a small percentage increase in

quantity demanded, or when a large percentage increase in income leads to a small
percentage decrease in quantity demanded, demand is said to be positive income
inelastic. This is shown in the diagram below. As long as consumers do not spend a
major proportion of their incomes on normal goods (either necessities or comforts),
their demand is considered to be positively income inelastic—e.g., regular clothing,
chocolates, fruits, etc.

YED > +1

Y1

Y0

0
Q0 Q1 Quantity

1. Positive income unitary elastic demand (YED = 1)

When a change in income leads to an equal proportionate change in quantity
demanded, demand is said to be positive income unitary elastic. This is shown in
diagram below.

Income

YED = +1

Y1

Y0

0
Q0 Q1 Quantity
2. Negative YED (Inferior Goods):
When an increase in income leads to a fall in quantity demanded, or when a decrease
in income leads to a rise in quantity demanded, income elasticity of demand will be
negative, because income and demand have an inverse relationship. This is shown in
the diagram below. The negative value of YED in the example below shows that
income and demand have a negative relationship; hence, it is an interior good.

Y1 = $100 Y2 = $ 115

Qd1 = 150 Qd2 = 120

%Q 120 - 150 100

Y.E.D     1.3
%Y 115 - 100 150

Income

Y1

Y0

Negative YED

0
Q0 Q1 Quantity

Those goods which have a negative YED are known as inferior goods. Negative YED is
of three types.

i. Negative income elastic demand (YED > –1)

ii. Negative income inelastic demand (YED < –1)
iii. Negative income unitary elastic demand (YED = –1)
i. Negative income elastic demand (YED > –1)

When a small percentage increase in income leads to a large percentage decrease in

quantity demanded (or vice-versa), demand is said to be characterized by negative
income elasticity. This is shown in the diagram below:
Income

Y1
Y0

YED >–1

0
Q1 Q0 Quantity

Inferior goods which have a negative income elastic demand include flour, rice,
shoes, etc. With a small increase or decrease in income people can shift to branded
products or back to cheap products, respectively.

ii. Negative income inelastic demand (YED < –1)

When a large percentage increase in income leads to a small percentage decrease in

quantity demanded (or vice-versa), demand is said to be characterized by negative
income elasticity. This is shown in the diagram below.
Income

Y1

Y0

YED < -1
0 Q1 Q0 Quantity
 Inferior goods which have negative income elastic demand include match boxes,
grains, etc.

iii. Negative income unitary elastic demand (YED = –1)

When a certain increase in income leads to an equal proportionate decrease in

quantity demanded (or vice-versa), demand is said to be characterized by negative
income unitary elasticity. This is shown in the diagram below.
Price

YED = -1

0 Quantity

Summary of types of YED

Price
YED > +1
YED = +1

YED < +1

YED = -1

YED > -1
YED < -1

O Quantity
CROSS ELASTICTY OF DEMAND (XED)
The degree of responsiveness of the quantity demanded of one good to changes in the
price of another good is known as cross elasticity of demand.

%Qd of good ' x' Q 2x  Q1x P1y

XED   y 
%P of good ' y' P2  P1y Q1x

The importance of the sign in XED is also very important for economists because it
defines the relationship between the two products (as we will see further in this topic).
XED is categorized into two types of the basis of signs.

- Positive XED (substitutes)

- Negative XED (complements)

Positive XED (Substitutes)

If an increase in the price of a product causes an increase in the demand for its substitutes
and a decrease in the price of a product causes a decrease in the demand for its
substitutes, demand for the good is said to be characterized by positive cross elasticity.
This is shown in the diagram below.

Price of “Y”

PY1

Positive X.E.D
PY0 (substitutes)

0 Qx0 Qx1

Substitutes are goods which are alternatively demanded and have a positive relationship
between the price of one and the demand for the other (substitute)—e.g., Pepsi and Coke,
a Honda Car and a Toyota Car, etc. This is shown in the example below.
Example

Suppose Pepsi and Coke have the following prices and demands, respectively:

P1P (price of Pepsi)  $10 Q1c (quantity of Coke)  100

P2P (price of Pepsi)  $5 Qc2 (quantity of Coke)  50

%Qd of Coke 50 - 100 10

XED     2.5
%P of Pepsi 8 - 10 100

- Positive cross elastic demand (XED > 1)

- Positive cross inelastic demand (XED < 1)
- Positive cross unitary elastic demand (XED = 1)

i. Positive cross elastic demand (XED > 1)

When a small percentage increase in the price of product “Y” leads to a large
percentage increase in the quantity demanded of product “X” (or vice-versa), demand
is said to be characterized by positive cross elasticity. This is shown in the diagram
below: Price of “Y”

XED > +1

PY1
PY0

0 Qx0 Qx1
Quantity of “X”

ii. Positive cross inelastic demand (XED <1)

When a large percentage increase in the price of product “Y” leads to a small
percentage increase in the quantity demanded of product “X” (or vice-versa), demand
 is said to be characterized by positive cross inelasticity. This is shown in the diagram
below.
Price of “Y”

XED = +1
PY1

PY0

0 Qx0 Qx1
Quantity of “X”
iii. Positive cross unitary elastic demand (XED = 1):

When an increase in the price of product “Y” leads to an equally proportionate

increase in the quantity demanded of product “X” (Or vice-versa), demand is said to
be characterized by positive cross unitary elasticity. This is shown in the diagram
below. Price of “Y”

XED > +1

PY1
PY0

0 Qx0 Qx1
Quantity of “X”

Negative XED (Complements):

When an increase in the price of a product leads to a proportionate decrease in demand

for its complement products, or any decrease in price of a product leads to a proportionate
increase in the demand for its complement products, the demand for the good is said to be
characterized by negative cross elasticity. This is shown in the diagram below.
Price of “Y”

PY1

PY0

0 Qx1 Qx0 Quantity of “X”

Complements are those goods and services which are jointly demanded (e.g., car and
tyre, bat and ball, compact discs and CD players, etc.) and are characterized by a negative
relationship between the price of one product and demand for the other (its complement).
This is shown in the example below.

Example:

Suppose a car and tyres have the following prices and demands, respectively:”

P1c (price of Car)  $10 Q1c (quantity of tyres)  100

P2c (price of Car)  $8 Qc2 (quantity of tyres)  150

%Qd of tyre 150 - 100 10

XED     2.5
%P of Car 8 - 10 100

A negative value indicates that there is a negative relationship between the price of a
car and the quantity demanded of tyres. Hence, goods and services having negative
cross elasticity of demand are complements. Negative cross elasticity and demand is
of three types:

- Negative cross elastic demand (XED > –1)

 - Negative cross inelastic demand (XED < –1)
- Negative cross unitary elastic demand (XED = –1)

i. Negative cross elastic demand (XED > –1)

When a small increase in the price of product “Y” leads to a proportionately large
decrease in the quantity demanded of product “X” (or vice-versa), demand is said to
be characterized by negative cross elasticity. This is shown in the diagram below.

Price of “Y”

XED > -1

0
Quantity of “X”

ii. Negative cross inelastic demand (XED < –1)

When a large increase in the price of product “Y” leads to a proportionately small
decrease in the quantity demanded of product “X” or vice-versa, demand is said to be
characterized by negative cross inelasticity. This is shown in the diagram below.

Price of “Y”

XED > -1

0
Quantity of “X”
iii. Negative cross unitary elastic demand (XED = –1)

When an increase is the price of product “Y” leads to an equally proportionate

decrease in the quantity demanded of product “X” (or vice-versa), demand is said to
be characterized by negative cross unitary elasticity. This is shown in the diagram
below.
Price of “Y”

XED = -1

0 Quantity of “X”

Summary of types of XED

Price of
good ‘x’
XED > +1

(Close Substitutes)
XED = +1

XED < +1

XED = -1

XED > -1
XED < -1

O Qd of good ‘y’
PRACTICAL APPLICATIONS OF ELASTICITY
- of PED
- of YED
- of XED

Practical Applications of PED and PES

Price elasticity of demand helps in many practical ways, such as:

1. The determination of total revenue (TR) of the firm.

2. Determining the price stability of a product.
3. Calculating the tax incidence on the consumers and producers.
4. Designing fiscal policy

1. Determination of total revenue (TR) of the firm.

Refer to types of PED: elastic, inelastic, unitary elastic and varying PED along the
straight linegh gggtffffffffvgg demand curve.

2. Determining the price stability of a product:

PED contributes to price fluctuations in a market. Agricultural products and raw-

materials have demand that is more inelastic when compared to the demand of
manufactured goods. Let us consider the case of a rise in the supply of primary
products and manufactured goods under two different demand conditions; this is
shown in the diagrams below.
Price Price

S2 S2 S0
S0 S1 S1

P2 E2 P2 E2
Price Price
P0 E0 P0 E0
fluctuations fluctuations
P1 E1
P1 E1
D

D
0 0
Q2 Q0 Q1 Quantity Q2 Q0 Q1 Quantity
Output Output
fluctuations fluctuations
 In the left diagram, demand is elastic for manufactured goods—it causes a relatively
small decrease in price from “P0” to “P1”. In the right diagram the demand of primary
products is inelastic. In order to attract consumers to purchase the increased supply of
primary products a large decrease in their price is required—from “P0” to “P1”. So,
for inelastic demand, an equal shift in supply will lead to a large change in price; and,
in inelastic demand, it will lead to a small change in price. Therefore, we can
conclude: the more elastic the demand, the more stable the price.

Similarly, PES contributes to price fluctuations in a market. Agricultural products and

raw-materials have a supply that is more inelastic when compared to the supply of
manufactured goods. Let us consider the case of a rise in the demand for primary
products and manufactured goods under two different supply conditions. This is
shown in the diagrams below.
Price Price

S0 (Elastic) S0 (Elastic)

E1 E1
fluctuations

fluctuations

P2 P2
Price

Price

P0 E0 P0 E0
E2 E2
P1 D1 P1 D1
D0 D0
D2 D2
0 0
Q2 Q0 Q1 Quantity Q2 Q0 Q1 Quantity
Output Output
fluctuations fluctuations

Therefore, the more elastic the supply, the more stable the price.

3. Elasticity and tax incidence

- Tax is compulsory transfer of money from the private sector to the government.
- Taxes are, broadly speaking, of two types, i.e., direct taxes and indirect taxes.
- Direct taxes are those which are levied directly on individuals and firm—e.g.,
income tax, wealth tax, etc.
 - Indirect taxes are those which are levied on goods and services rather than on
individuals or firms.
- Income tax influences the demand for all the products that consumers buy,
because they reduce disposable income (the income which consumers can spend).
- Indirect taxes from part of the costs of production; hence, they cause shifts in
supply.

Effect of direct tax (income tax)

Income Tax   Yd  D

Price

P0 E1
E2
P1

D1
D2 (After income Tax)
0 Q1 Q0 Quantity

Effect of indirect tax

When tax increases, costs of production increase as well, whereas profitability decreases
and supply falls.

Types of indirect Taxes

- Specific tax
- Ad valorem tax

Specific tax Ad valorem Tax

A fixed amount per unit Forms a fixed percentage of the price of the
product
Causes a parallel shift in the supply curve Causes a pivotal shift in the supply curve
 Price Price S1 (After
Advalorem Tax)
Per unit Per unit
S1 (After
Specific Tax)
Tax Tax
S0 (Before Tax) S0 (Before Tax)

Quantity Quantity

Example

- Suppose in indirect tax of $2 per unit is imposed on a good with an initial equilibrium
price of $5 and equilibrium quantity of 600 units. This is shown in the table below.

Price that Price that Qd Qs (before tax) Qs (after tax)

consumers pay sellers receive
after tax
$10 10 – 2 = $8 100 1100 900
$9 9 – 2 = $7 200 1000 800
$8 8 – 2 = $6 300 900 700
$7 7 – 2 = $5 400 800 600
$6 6 – 2 = $4 500 700 500
$5 5 – 2 = $3 600 600 400
$4 4 – 2 = $2 700 500 300

- After the imposition of a tax there will be a difference between the price consumers
pay and the amount sellers receive
Price that sellers receive = Price consumers pay – Per unit tax
- The new supply schedule will be according to the price that sellers receive. This is
shown in the table “Qs (after tax)”.
- The new equilibrium will be established at a price of $6 with a quantity traded of 500
units, which indicates that the incidence of tax is split between the consumers and
producers, with a burden of $1 on tax on each of them.
The effect of tax on equilibrium price and output, and the distribution of the incidence of
tax can also be explained by the diagram below:
Price
Tax paid by
Price that consumers S1 (After tax)
consumers pays
after tax S0 (Before tax)
E1
$7
Per unit
$5 E0
tax = $4
$3 a
Price that
Tax paid D
seller receives
by seller
after tax 0
40 60 Quantity

- Per unit tax is the vertical distance taken from the new equilibrium to the old
supply curve, denoted by ‘a’ in the diagram above. It is the amount of tax levied
on each unit of the product.
Per unit tax = Price that consumers pay – Price that sellers receive
- Total tax revenue is the per unit tax multiplied by the new equilibrium quantity.
- Whether the tax goes directly from the buyer’s pocket to the government (income
tax), or indirectly from the buyer’s pocket, into the seller’s hand, and then to the
government (sales tax) does not matter. Once the market reaches its new
equilibrium, buyers and sellers share the burden, regardless of how the tax is
levied.
- The person who physically pays the tax is not necessarily the person who bears
the burden of the tax.
- Because a tax creates a difference between the price that consumers pay and the
price that seller receives, the burden of a tax typically falls on both buyers and
sellers.

Tax incidence on consumers = Price consumers pay after tax – Market price before tax
Tax incidence on seller = Market price before tax – Price seller receives the tax

- The more inelastic one’s relative supply and demand, the larger the tax burden
one will bear.
 - The amount each side pays depends on the relative price elasticity of demand and
supply.
- Buyers pay the entire tax only in the case of a perfectly elastic supply or perfectly
inelastic demand.
- Sellers pay the entire tax only in the case of a perfectly elastic demand or
perfectly inelastic supply.

1. When Tax Burden is equally shared Between Consumers and Sellers:

- If PED = PES, the tax burden is shared equally. This is shown in the diagram
below.
Price
Tax paid by
Price that consumers S1 (After tax)
consumers pays
S0 (Before tax)
after tax
E1
$7
Per unit
$5 E0
tax = $4
$3 a
Price that
Tax paid D
seller receives
by seller
after tax 0
40 60 Quantity
- This rarely ever happens since elasticities are rarely ever equal.

2. When More Tax Burden is on Consumers

Price
Tax paid by
Price that S1 (After tax)
consumers
consumers pays
after tax S0 (Before tax)

$11=P1 E1
Per unit
$9=P0 b E0
tax = $3
$8=P2 a
Price that seller Tax paid
by seller D0
receives after tax
0
50 70 Quantity
3. When More Tax Burden is on Sellers

Price

Price that S1 (After tax)

consumers pays Tax paid by
S0 (Before tax)
after tax consumers

$9=P1 E1
E0
Per unit $8=P0
b
tax = $6
D0
$3=P2 a
Price that seller
receives after tax Tax paid 50 70 Quantity
by seller
4. When Entire Tax Burden is on Consumers

- If demand is perfectly inelastic

Price

Price that D0 S1 (After tax)

Tax paid
consumers by sellers S0 (Before tax)
pays
E
$9=P1
Per unit
tax = $4 $5=P0
E0

Price that D0
sellers
receive Q0 Quantity

- If supply is perfectly elastic

 Price

Price that
consumers Entire Tax paid by consumers
pays

$9=P1 E1 S1 (After tax)

Per unit E0
tax = $2 $7=P0 S0 (Before tax)
a

Price that D0
seller
receive Q1 Q2 Quantity

5. When Entire Tax Burden is on Sellers

Price

Price that Tax paid S0 (Before tax)

consumers by sellers
pay after tax
E1 E0
$8=P0 D0
Per unit
tax = $4
$4=P1 a
Price that
sellers receive
after tax Q1 Q0 Quantity

Draw the diagrams and identify the incidence of tax on:

Demand Supply Tax Incidence

Elastic Inelastic More tax burden on ?
Inelastic Elastic More tax burden on ?
Perfectly elastic – Whole tax burden on ?
Perfectly inelastic – Whole tax burden on ?
– Perfectly elastic Whole tax burden on ?
 – Perfectly inelastic Whole tax burden on ?

4. Elasticity and subsidy benefits

Subsidies are grants given by the government to firms to increase their production
and to reduce the product’s market prices. This is done so that consumers are able to
buy necessities at cheaper prices.

Types of Subsidies

- Specific subsidy
- Ad valorem subsidy

Specific Subsidy Ad valorem Subsidy

A fixed amount per unit Forms a fixed percentage of the price of the
product
Causes a parallel shift in the supply curve Causes a pivotal shift in the supply curve
Price Price S0 (before subsidy)

Per unit Per unit

S0 (before subsidy)
subsidy subsidy
S1 (after specific S1 (After specific
subsidy subsid

Quantity Quantity

Price
Price that sellers Subsidy benefit
receive after to seller S0 (Before subsidy)
Before Tax)
subsidy S1 (After specific subsidy)
a
$9
Per unit E0
$7
subsidy $5 E1
=4 $2
Price that Subsidy
consumers pay benefit to D
after subsidy Consumers
40 60 Quantity
 - When subsidies increase, the costs of production decrease, and supply increases.
- Per unit subsidy is the vertical distance from the new equilibrium to the old
supply curve.
- Total subsidy expenditure by the government is calculated by multiplying per unit
subsidy with the new equilibrium quantity.

The benefit of a subsidy is also shared between sellers and buyers according to PED
to PES—similar to tax incidence.

Demand Supply Subsidy benefits

Elastic Inelastic More subsidy benefit to sellers
Inelastic Elastic More subsidy benefit to consumers
Perfectly elastic – Whole subsidy benefit to sellers
Perfectly inelastic – Whole subsidy benefit to consumers
– Perfectly elastic Whole subsidy benefit to consumers
– Perfectly inelastic Whole subsidy benefits to sellers

Similar to how tax incidence depends on the relative elasticity of demand and supply, the
distribution of subsidy benefits also depend on the relative elasticity of demand and
supply. If the government is willing to grant a subsidy for the welfare of consumers, it
must consider the relative elasticity of demand and supply. If the government is providing
a subsidy to the product whose demand is relatively more elastic than its supply, it will be
able to achieve its aim of consumer welfare. However, it would be fairly successful when
demand is relatively more elastic than supply.

Practical Applications of YED:

It is potentially of great importance for businesses and for governments is forecasting the
future demand for a whole range of consumer goods and services. In emerging markets
like China and India, for example, as incomes increase then people demand more cars.
Production changes need to occur to satisfy this demand and governments need to build
more roads to accommodate the increased demand.

Information of YED can help sellers decide what price and promotional activities they
should undertake in order to increase their sales and profits. When the economy is
moving towards a boom, the general level of income is rising; people will prefer
purchasing normal instead of cheap inferior goods. If the YED for a normal good is
greater than 1, then demand will be expected to grow more rapidly than consumer
incomes. During this time, sellers should concentrate on promoting luxuries through
attractive displays, advertising, and other promotional activities. Similarly, sellers should
promote luxury items at the end of the year as well—when bonuses are rapid in a job-
oriented society or when crops are sold in an agrarian society. On the other hand, when a
society moves towards a slump (i.e., a recession), sellers should promote goods with
lower prices as people’s income levels are falling.

Practical Application of XED:

Cross elasticity of demand can be helpful for sellers in making decisions regarding which
goods should be promoted and what prices should be charged under different market
conditions. For example, if the price of coffee rises, tea sellers should realize that
consumers will buy more tea; in order to encourage that, they should launch more
promotional activities and advertisements to increase their sales. Increases in the price of
coffee also, to some extent, enable tea sellers to justify increasing the price of tea. The
opposite would be the case of a decrease in the price of coffee. Now the tea seller must
lower tea prices in order to stop consumers from switching their demand to coffee.

Cross elasticity of demand also helps sellers decide how and when to react to changes in
the prices of complementary goods. If car are cheaper now, tyre sellers can take
advantage of low car prices by increasing their sales of tyres through promotional
packages, discounts, etc. On the other hand, an increase in the price of cars will force tyre
manufacturers to reduce their price in order to match falling demand. Price cuts and
special offers like ‘buy one, get one free’ can prevent sales from falling.

Companies are increasingly concerned with trying to get consumers to buy not just one of
their products but a whole range of complementary ones, e.g., computer printers and
cartridges. XED will identify those products that are most complementary and help a
company introduce a pricing structure that generates more revenue. For instance, market
research may indicate that families spend most money at restaurants when special deals
are offered, even though the PED for meals is low. In this case, for example, the high
negative cross elasticity between meal prices and the demand for soft drinks (such as
Pepsi Cola and Coca-Cola) means that although the revenue from food sales may fall, the
demand for soft drinks may increase. This indicates that:
The restaurant may need to introduce a more sophisticated pricing structure by looking at
the relationships between the demand for all products and services offered.

With the knowledge of cross elasticity of demand, a firm can react effectively when the
price of its substitutes or complements change. This way it can maximize its profits by
raising revenue and keeping costs to a minimum.

-
Unit # 4
Government Microeconomic
Intervention
a) Maximum and minimum prices  Meaning and effect on the market
b) Taxes (direct and indirect)  impact and incidence of taxes
 specific and volarem taxes
 average and marginal rates of taxation
 proportional, progressive and regressive taxes
 the Canons of Taxation
c) Subsidies  impact and incidence of taxes
 specific and volarem taxes
 average and marginal rates of taxation
 proportional, progressive and regressive taxes
 the Canons of Taxation
d) Transfer payments  meaning and effect on the market
e) Direction provision of goods  meaning and effect on the market
and services
f) Nationalism and privatization  meaning and effect on the market
Unit # 4 Government Microeconomic Intervention
CONSUMER SURPLUS
The difference between maximum price consumers are

willing to pay and the price that they actually pay.

Example:
The following table shows the maximum amounts a consumer is willing to pay for given
quantities.

Quantity Maximum willing to pay

1 100
2 80
3 50
4 30
5 20

Suppose the consumer buy ‘4’ units at the price of $30 each. What will be their consumer
surplus?

i) for ‘4’ units

ii) of the ‘4th’ unit?

Quantity Willingness to Price in $’s Consumer Total consumer

pay Surplus of surplus
each unit
1 100 30 100 – 30 = +70 70
2 80 30 80 – 30 = +50 70+50=120
3 50 30 50 – 30 = +20 70+50+20=140
4 30 30 30 – 30 = 0 70+50+20=0=140
5 20 30 - -

(i) CONSUMER SURPLUS FOR FOUR UNITS:

Willingness to pay = 100 + 80 + 50 + 30 = 260

 Actual expenditure = 4 × 30 = 120
Consumer Surplus = 260 – 120 = 140

(ii) CONSUMER SURPLUS FOR THE FOURTH UNIT:

Willingness to pay = 30
Actual expenditure = 30
Consumer Surplus = 30 – 30 = 0
 Consumer surplus can never be negative

Graphically

The height of the demand curve measures how much buyers in the market value each unit.

- Total area below the demand curve up to a certain quantity shows the willingness to pay.

Price Price

Willingness to pay Actual consumer expenditure

a a
E0 E0
P0

D0 D0

0 0
Q0 Quantity Quantity
- Q0
- The price indicates the amount they actually pay for each unit.
- The area quantified as price multiplied by quantity represents actual consumer
expenditure.
- The difference between these two—the triangular area below the demand curve but above
the price paid—is a measure of the total consumer surplus up to a given quantity.
Price Price

Consumer Surplus Consumer Surplus

a a
X E0 E0
P0 P0

D0 D0
DETEMINANETS OF CONSUMER SURPLUS
a) PRICE:

As the price of the product decreases, consumer surplus increases.

P  CS

P  CS
Price

a
X
P0 E0
Z
E1
P1
m
D0

0
Q0 Q1 Quantity
Price Consumer Surplus
OP0 aE0P0
OP1 aE1P1

b) PRICE ELASTICITY OF DEMAND:

The more inelastic the demand curve, the greater the consumer surplus. This is illustrated in
the following diagrams.
n
PED Consumer
Surplus Price
Elastic aE0P0 Y
a
Inelastic nE0P0 X
Perfectly Elastic Zero P0 E0
Perfectly Inelastic Infinity

D0 (Elastic)
D1 (Inelastic)
0
Q0 Quantity
 Price Price
D0 (Perfectly Inelastic)

Infinite
E0 Consumer Surplus
P0 D0 (Perfectly P0 E0

Elastic)

0 Q0 0 Q0
Quantity Quantity

PRODUCER SURPLUS:

It is the difference between the minimum amount that the sellers are willing to accept for the
given units of the product and what they actually receive through the market.

Producer surplus is not the same as profit.

It is the difference between the minimum amount that the sellers are willing to accept for the
given units of the product and what they actually receive through the market.

Producer surplus is not the same as profit.

Producer surplus represents the gains received by all parties connected to the production of a
good (such as raw-material suppliers, workers, landlords, etc). Profit, however, is only received
by the owners of the firm producing the good.

Example:

The following table shows the minimum amounts that sellers are willing to accept for the given
quantities:

Suppose the market price is $70; producer surplus will be:

Quantity Willingness Price in $’s Producer Total producer surplus
to accept Surplus of
each unit
1 30 70 70 – 30 = 40 40
2 40 70 70 – 40 = 30 40 + 30 = 70
3 50 70 70 – 50 = 20 40 + 30 +20 =90
4 60 70 70 – 60 = 10 40 + 30 +20+10=100
5 70 70 70 – 70 = 0 40 + 30 +20+10+0=100

Graphically

- The height of the supply curve measures the minimum amount the seller is willing to
accept in the market for each unit.
- The total amount below the supply curve up to a certain quantity shows the minimum
amount that the seller is willing to accept for that given quantity.

Price Price

S0 S0

E0 E0
P0

b b Total Revenue
Willing to accept

0 Q0 0 Q0
Quantity Quantity

- The price indicates the amount the seller actually receives for each unit.
- The area quantified by price multiplied by quantity represents the actual revenue received
by the seller.
- The difference between these two—the triangular area above the supply curve but below
the price received—is a measure of the total producer surplus up to a given quantity.

Price Price

S0 S0
Producer Surplus Producer Surplus
E0 E0
P0 P0
A A
b b
DETERMINANTS OF PRODUCER SURPLUS
c) PRICE

As the price of the product increased, producer surplus increases.

P  PS
P  PS 
Price

S0
P1
C E1
P0
E0
A
b

0
Q0 Q1 Quantity
Price Producer Surplus
OP0 bE0P0
OP1 bE1P1

d) PRICE ELASTICITY OF SUPPLY:

The more inelastic the supply curve, the greater the producer surplus. This is shown
in the following diagram.
Price
PES Producer S0 (Inelastic)
Surplus S0 (Elastic)
Elastic bE0P0
P0
E0
 Inelastic 0bP0E0r
Perfectly Elastic Zero

In case perfectly elastic dully producer surplus will be zero and in case of perfectly
inelastic it will be equal to total consumer expenditure.

Price Price
S0 (Perfectly Inelastic

Producer surplus = Zero

P0 E0 S0 (Perfectly
P0 E0
Elastic
Producer surplus

0 Q0 0
Quantity Q0 Quantity

TOTAL SURPLUS

Price

Consumer Surplus
S0

E0
P0
Producer
Surplus b
D

0
Q0 Quantity
Total Surplus = Consumer Surplus + Producer Surplus
EFFICIENCY AND MARKET EQUILIBRIUM
Economic efficiency means a situation where net social welfare is maximized.

- The supply curve reflects producer’s opportunity cost. Each point along the supply
curve indicates the minimum price for which the units of a good could be produced
without a loss to the seller. Assuming no other third parties are affected by the
production of this good, then the height of the supply curve represents the opportunity
cost of society of producing and selling the good.
- Each point along the demand curve indicates how consumers value an extra unit of
the good—that is, the maximum amount the consumer is willing to pay for the extra
unit. Again, assuming that no one third parties are affected, the height of the demand
curve represents the benefit of society of producing and selling the good.
- Any time the consumer’s valuation of a unit (the benefit) exceeds the producer’s
opportunity cost, selling the unit is consistent with economic efficiency. The trade
will result in mutual gain to both parties.
- Any time the consumer’s valuation of a unit (the benefit) is less than the producer’s
opportunity cost, selling the unit is not consistent with economic efficiency. The trade
will not result in mutual gain for both parties.

Hence:

When only the buyers and sellers are affected by production and exchange, competitive
market forces will automatically guide a market toward an equilibrium level of output
where all units that create more benefit (the buyer’s valuation shown by the height of the
demand curve) than cost (opportunity cost of production shown by the height of the
supply curve) are produced. This maximizes the total gains from trade—the combined
area represented by consumer and producer surplus.
 Government Microeconomic Intervention

Financial Intervention Regulations Direct Provision

Price Controls Nationalization

Taxes Subsidies :P

Maximum Minimum
Direct Indirect Price Limit Price Limit
Taxes Taxes

By Law By Stock By Guaranteed

Purchase Scheme Price Scheme

FINANCIAL INTERVENTION:
Financial tools, such as taxes and subsidies, are frequently used by governments to
influence production and the prices of a wide range of goods and services in the market.
For example, demerit goods are usually subject to high rates of indirect taxation. By
contrast, subsidies, involving a direct payment by the government to a producer, make the
price paid by consumers less than it should be. Typically, subsidies are paid for goods
and services that benefit the community and that might not be provided in a free market.
These payments can be in the form of a partial subsidy, as in the case of staple food
products and public transport, or total, as in the case of free school meals for children
from low-income families.

Taxes – direct and indirect

A tax can be defined as a compulsory transfer of money on private individuals and

organizations by the government to raise revenue to finance expenditure on public goods
and services.

Canons of Taxation

Adam Smith, the leading classical economist, set out his so-called canons of taxation.
These state that a ‘good’ tax is one that is:
  Equitable — those who can afford to should pay more
 Economic—the revenue should be greater than the costs of collection
 Transparent—tax payers should know exactly what they are paying
 Convenient—it should be easy to pay.

Tax Systems

In collection taxes and in the development of taxation systems, governments should be

aware of the impact a tax has on the various income groups in the economy. This is
entirely consistent with the equity aspect of canons of taxation.

The relationship between taxation and income varies for different types of tax. Three
relationships can be identified: progressive, regressive, and proportional. The significance
of this classification is important for the standpoint of equity. As incomes increase,
people clearly pay more tax in absolute terms, what is more relevant is the percentage of
income paid in tax.

Progressive Tax Proportional Tax Regressive Tax

Progressive taxes are those A proportional tax is one in Regressive taxes are those
that, when income rises, which increases in income that, as income rises, the
the proportion of total are matched by proportion of total income
income paid in tax proportionally equal paid in tax falls.
increases increases in the amount
paid in tax. The tax rate is,
therefore, constant

In a progressive tax system In a proportional tax In a regressive tax system

the marginal rate will be system the marginal rate the marginal rate will be
greater than the average will be equal to the average lesser than the average rate
rate and ART will be rate and both ART and and ART will be falling,
rising, resulting in a more MRT will be constant; resulting in a more unequal
equal distribution of therefore, there will be no distribution of income.
income. effect on overall
distribution of income.

E.g.,: Income Tax E.g.: VAT and GST E.g.: Professional tax in
Pakistan
 Rate of Tax Rate of Tax
Rate of Tax

Progressive Tax
Proportional Tax

Regressive Tax

0 0
0 Income Income
Income
Example Example Example
Y1 = 1000 Y1 = 1000 Y1 = 1000
Rate of Tax =10% Rate of Tax =10% Rate of Tax =10%
Tax Revenue = $100 Tax Revenue = $100 Tax Revenue = $100
Y2 = $2000 Y2 = $2000 Y2 = $2000
Rate of Tax = 15% Rate of Tax = 10% Rate of Tax = 8%
Tax Revenue = $300 Tax Revenue = $200 Tax Revenue = $160

The average of taxation (ART) is defined as the average percentage of total income that
is paid in taxes. All forms of taxation are included in the calculation. It is dearly more
equitable for the poorest income groups to have a low average tax rate; by contrast,
higher earners should have a higher average tax rate.

Tax
ART   100
Income

The marginal rate of taxation (MRT) is different. I signifies the proportion of an

increase in income which is paid in taxes to the government. In a progressive tax system
the marginal rate will be greater than the average rate resulting in a more equal
distribution of income.

Change in Tax
MRT   100
Change in Income
Types of Taxes

Direct Taxes Indirect Taxes

Those taxes which are levied on Those taxes which are levied on
individuals’ and firms’ incomes and expenditure on goods and services and
wealth and for which the burden can’t be for which the burden can be passed on to
passed on to others. consumers.
E.g. E.g.
- Income tax - General sales tax (GST)
- Wealth tax - Value added tax (VAT)
- Corporation tax - Tariff/custom duties
- Inheritance tax - Motor vehicle tax
- Capital gain tax
Advantages Disadvantages
1 Revenue:
The government collects revenue from
direct taxes for its spending on –
infrastructure such as the building of
roads, hospitals, airports, etc.
2 Certain: Uncertainty of Revenue
Revenue from direct taxes is certain and Revenue collection from indirect taxes is
state authorities can plan their linked to product sales in the coming
expenditures for the coming year on the year, therefore, it lacks certainty. Actual
revenue they expect from direct taxes. revenue might be far below or far above
expectations.
3 Redistribute Income from Rich to Redistribute Income from Poor to
Poor Rich
Direct taxes are usually progressive in Indirect taxes are usually regressive in
nature–the rate of taxation rises with nature, i.e., as income rises, the rate of
increases in income. Therefore, more tax taxation falls. Therefore, the poor bears a
is collected from the rich, and the poor greater burden of the tax than the rich.
are exempted from income tax payments. The poor become poorer and rich
Even if the poor earn below a certain become richer in a regressive tax system;
level, they might be subsidized by the so, inequalities/disparities between the
government. Direct taxes, therefore, rich and poor increase in a system of
reduce inequality (the gap between the indirect taxation.
rich and poor)
4 Deflation in Nature Inflationary in Nature
Increased direct taxes (e.g., income tax) Indirect taxes (e.g., GST) usually form
reduce disposable income and, therefore, part of the price of a product. Therefore,
reduce spending in the economy. Lower any increases in indirect taxes will
 aggregate demand will bring the price increase the prices of goods, causing
level down, thus reducing inflationary inflation in the economy
pressure.
5 No Tax Burden Tax Burden
The burden of direct taxes cannot be The burden of indirect taxes can be
passed over to others. passed to consumers in the form of
higher prices.
6 According to ability to pay No according to ability to pay
7. Not Avoidable Avoidable
Anyone who earns an income beyond the Anyone who does not buy a product will
tax-exempted level (e.g., Rs.150,000 per not pay the tax on that product.
annum in Pakistan in 2006) has to pay Therefore, indirect taxes are avoidable.
income tax. It cannot be avoided.
Disadvantages Advantages
1 Expensive to collect: Cheaper to collect from a company that
High cost of collection, keeping records, might charge it to consumers by raising
pursuit of defaulters, etc. their product’s price
2 Discourage Savings Do not discourage savings
e.g.,Incometax↑disposable
income↓Consumption↓.Savings↓
3 Narrow Tax base Wider Tax base
Direct taxes have a very narrow tax base. Since these taxes are levied on goods and
Very few people fall in the tax net of services, all people will pay them,
direct taxes; for example, income taxes irrespective of their age, sex and income.
are only levied on those who are either Indirect taxes have a far wider base than
employed or running a business, and direct taxes.
earning income beyond the tax-exempted
level. Those of old age, children,
housewives, and the unemployed, along
with people who are earning below the
minimum taxable limit will not pay
income tax.
4 Disincentive to work No Disincentive to Work
Direct taxes (e.g., income tax) As indirect taxes are on goods and
discourage work. This is because they services, they do not discourage workers.
reduce the willingness and incentives of
workers to work overtime because a
major part of their extra income would
have deducted as tax.
5 Disincentive to Enterprise Not disincentive to Enterprise
Similar to “disincentive to work”, direct
 taxes discourage businessmen from
putting in their best efforts into their
work.
6. Can’t be Used to Discourage Demerit Are Used to Discourage Demerit goods
Goods E.g., A high tax on cigarettes will
discourage their consumption
7. Cannot Discourage Imports Directly Can discourage Imports Directly
E.g., tariff/duties will make imports
expensive, forcing people to switch their
demand to local substitutes  balance of
payments deficit would be corrected.

Governments have decision to take regarding their tax regimes, the most important being
achieving the right balance between direct and indirect taxes. A trend in many economies
has been to collect increasing revenues from indirect taxes on expenditure since these can
usually be collected quickly, are less liable to evasion and corruption, and do not interfere
with the work incentive problem. Those economies that are compliant with their strategy
are therefore supporting a regressive tax system – one that will not be well-liked by low
and middle-income earners. This is particularly the case in developing and emerging
economies, where it is easier to levy indirect rather than direct taxes as a means of
establishing a secure tax regime.

Purposes of taxation
1. To collect revenue

To collect revenue for the government developed countries depend mainly on direct
taxes while developing countries depend mainly on indirect taxes.

2. To redistribute income

The government can reduce income inequality in four ways:

- Progressive tax system whereby the higher the income earned, the higher the
taxes paid.
- Higher indirect taxes on luxuries (e.g., cars and liquor)
- Negative income tax (only in the United States and the United Kingdom). If the
household earns less than the minimum level of income, the government gives a
 subsidy so that they have a subsistence-level income. It is an income maintenance
scheme. The amount paid is related to the level of income.

3. To combat inflation

This is cone by imposing higher direct taxes, especially income tax, which will cause
disposable income to fall. When this happens, demand pull inflation will fall, thereby
controlling inflation.

4. To correct an adverse balance of payments

By imposing tariffs, the price of the imported goods will rise and (assuming demand
is elastic) this will cause a fall in demand for the imported good.

5. To check consumption of goods which are considered undesirable

An example of high indirect taxes on cigarettes and liquor.

6. To protect local/infant industries

By imposing higher custom duties on imported goods. This causes the price of
imported goods to rise and (assuming that demand is elastic), therefore, demand for
imported goods will fall.

EFFECTS OF AN INDIRECT TAX ON CONSUMERS, SELLERS, THE

GOVENRMENT, AND EFFICIENCY:
Price
S1 (After tax)

a S0 (Before tax)
E1
P1
E0 Dead weight loss
Po
P2 c

D0
b
0 Q1 Q0 Quantity

Before After
 Tax Tax
Supply curve S0 S1
Price that consumer pays OP0 OP1
Price that sellers receive OP0 OP2
Quantity Traded OQ0 OQ1
Consumer surplus a P0 E0 a P1 E1
Producer surplus b P0 E0 b P2 c
Per unit tax – E1c
Total tax revenue – P1 E1 c P2
Reduction in consumer – P1 E1 E0 P0
surplus
Reduction in production – P0 E0 c P2
surplus
Tax from consumer surplus – P0 P2 E2 f
Tax from production surplus – P0 f c P 2
Dead weight loss – E1 c E0 = (E1 f E0 + f
c E0 )
The above diagram illustrates the effects of the imposition of an indirect tax. The initial
demand curve is D0 Supply curve is S0 and old equilibrium point is E0 (with old
equilibrium price P0 and old equilibrium quantity Q0). The triangular area that is below
the demand curve but above old equilibrium price P0 represents the old consumer surplus
(aP0E0). The area above the old supply curve S0 but below old equilibrium price
quantifies the producer surplus (bP0E0). The amount per unit that the consumers pay and
the sellers receive for the good is P0. As the indirect tax is imposed, the costs of
production for suppliers increase, causing the supply curve to shift leftwards to S 1,
decreasing the quantities that suppliers are willing to sell for every given price. The new
equilibrium point is E1 (with new equilibrium price P1 and new equilibrium quantity Q1).
As can be observed, the equilibrium price increased, but the equilibrium quantity
decreased. The consumers now pay a higher price of P1 per unit. However, at a quantity
of Q1, the producers receive an amount of P2 per unit (as determined by the price per unit
charged for quantity. Q0 according to the old supply Curve S0). The new consumer
surplus is aP1E1; so, the reduction in producer surplus is represented by the area P0E0cP2
The tax per unit is the vertical difference between the supply curves. In this case, that
would be the difference between OP1 and OP2 , which is E1c. The total tax revenue for
the government is calculated as (tax per unit × new equilibrium quantity). Thus, total tax
revenue is quantified by the rectangular area P1E1cP2. Part of this rectangular area which
lies above new equilibrium pace P1 represents the burden of the tax on the consumer
(P0P1E1f) whereas the part of it which lies below the new equilibrium price P1 represents
the burden of tax on the producer (P0fcP2). The triangular area E1cE0 represents the dead
weight loss due to the imposition of the indirect tax. It is important to note that the
deadweight loss comprises of a loss in consumer surplus of E1fE0 and a loss in producer
surplus of fcE0. The burden of the tax incidence is being shared between consumers and
producers. However, the distribution of that burden depends on the price elasticities of
demand and supply.
Subsidies
Another form of government intervention in the market is through the provision of
subsidies. These are direct payments made by government to the producers of goods and
services. When paid to a producer, a subsidy has the opposite effect of an indirect tax – it
is the equivalent of a fall in costs for the producer and results in a rightward shift in the
market supply curve. A reduction in a subsidy payment will lead to a shift to the left in
the supply curve.
Purposes of subsidy
 to keep down the market prices of essential goods
 to encourage greater consumption of merit goods to contribute to a more equitable
distribution of income.
 to provide services that would not be provided by the free market
 to raise producers’ income, especially in the case of farmers
 to provide an opportunity for exporters to sell more good
 to reduce dependence on imports by paying subsidies to domestic producers to
close substitutes.

EFFECTS OF THE PROVISION OF A SUBSIDY ON CONSUMERS, SELLERS,

THE GOVERNMENT, AND EFFICIENCY:

A government normally intervenes in a market if it senses that the equilibrium price and
quantity determined by the price mechanism has resulted in a misallocation of resources.
A subsidy is a payment made by the government to a firm or household. In most cases,
these payment are made to a firm to reduce the cost of the labor or capital it employs.
Price

Addition in
a consumer surplus S0
c S1
P2
E0 Dead Weight
P0 Loss
P1 E1 Addition producer
surplus

b D0
0 Q0 Q1 Quantity
 Before After
Subsidy Subsidy
Supply curve S0 S1
Price that consumers pays OP0 OP1
Price that sellers receive OP0 OP2
Quantity traded OQ0 Oq1
Consumer surplus aP0E0 aP1E1
Producer surplus bP0E0 bP2c
Per unit Subsidy - E1c
Subsidy expenditure - P1E1cP2
Addition in consumer
- P1E1E0P0
surplus
Addition in production
- P0E0cP2
surplus
Dead weight loss - E1cE0

The above diagram illustrates the effects of the provision of a subsidy. The initial demand
curve is D0. Supply curve is S0, and old equilibrium point is E0 (with old equilibrium
price P0 and old equilibrium quantity Q0). The triangular area that is below the demand
curve but above old equilibrium price P0 represents the old consumer surplus (aP0E0).
The area above the old supply curve S0 but below old equilibrium price quantifies the
producer surplus (bP0E0). The amount per unit that the consumers pay and the sellers
receive for the good is P0. As the subside is provided, the costs of production for
suppliers decrease, causing the supply curve to shift rightwards to S1, increasing the
quantities that suppliers are willing to sell for every given price. The new equilibrium
point is E1 (with new equilibrium price P1 and new equilibrium quantity Q1). As can be
observed, the equilibrium price decreased, but the equilibrium quantity increased. The
consumers now pay a lower price of P1 per unit. However, at a quantity of Q1, the
producers receive an amount of P2 per unit (as determined by the price per unit charged
for quantity Q0 according to the old supply curve S0). The new consumer surplus is
aP1E1; so, the addition to consumer surplus is represented by the area P1E1E0P0. The new
producer surplus is bP2c; so, the addition in producer surplus is represented by the area
P0E0cP2. The Subsidy per unit is the vertical difference between the supply curves. In
this case, that would be the difference between OP1 and OP2, which is E1c. The total
subsidy expenditure for the government is calculated as subsidy per unit × new
equilibrium quantity). Thus, subsidy expenditure is quantified by the rectangular area
P1E1cP2. The triangular area E1cE0 represents the dead weight loss due to the provision of
the subsidy.

It is clear that both consumer and producer surpluses will be impacted by subsidizing the
good. However, the extent to which each will be affected depends on the respective
elasticity of the demand and supply curve. The more inelastic the demand curve, the
greater the consumer’s gain from a subsidy. When demand is perfectly inelastic the
consumer gains most of the benefit from the subsidy, since the entire subsidy is passed
onto the consumer through a lower price. When demand is relatively elastic, the main
effect of the subsidy is to increase the equilibrium quantity traded rather than to lower the
market price. The above diagrams show the impacts of prices and the respective surpluses
of both agents when price elasticity of demand differs.

Advantages:

The benefits of subsidizing goods are vast.

 The obvious benefit is that subsidizing the good reduces the price of the good,
allowing more consumers to be able to afford the good or service. Moreover, if
the good is a necessity, as in the case of most agricultural goods, then it is
mandatory for the government to ensure that the good is available to most
citizens. Subsidizing those particular agricultural goods will raise the standard of
living for lower-tier consumers.
 Producers of agricultural commodities are likely to benefit from subsidies as well.
They are likely to earn higher revenue, as government payments to firms are
likely to increase. Farmers or other people employed in the agricultural sector are
likely to earn little income without the government incentivizing them through
subsidies.
 Subsidies also support lower-income groups, allowing them to afford basic
necessities which they would otherwise not be able to.
 Also, if a country imports agricultural goods, subsidizing local producers would
help them compete with foreign competitors and, thus, would also benefit the
balance of payments of the country.

Disadvantages:
While farm subsidies may have benefits, such as stabilizing the agricultural development
of a nation, the potential negatives of farm subsidies should be taken into consideration as
well.

 Critics of farm subsidies argue that they drive down international prices for
agricultural products, causing of exacerbating poverty in countries struggling to
establish a strong export economy.
 They (export subsidies) may also encourage inefficiency by causing the firms to
rely more on subsidies than on efficient cost-reducing techniques that will help
them make a bigger profit. The farmers would still receive the subsidy offered by
the government, even though their agricultural produce reaps no profits.
 Farm subsidies also control the normal market cycle. Raising incomes while
prices are rising will eventually raise commercial and industrial costs, causing the
final products to lose their competitiveness in the international market.
 It is not only interfering with the workings of the market mechanism but has
opportunity cost implications.
 Another problem is that subsidies are so-called ‘blanket’ or lump sum payments
and, unlike taxes on consumers, cannot easily be linked to incomes and the ability
to pay.

Transfer Payments

Transfer payments are payments from tax revenue that are received by certain members
of the community without any production activity. They are not made through the
market, as no production takes place. Like a progressive taxation system, their function is
to provide a more equitable distribution of income. The main recipients are vulnerable
groups such as the elderly, the disabled, the unemployed and the very poor. Payments
tend to transfer income from those able to work and pay taxes to those unable to work or
in need of assistance.

Examples include:

- old age pensions

- unemployment benefits m housing allowing a food coupons
- child benefits.

The extent to which transfer payment can be paid is heavily dependent on how much tax
is collected and how many people have paid tax. In developing economies this is affected
by all sorts of problems. Pakistan has a growing elderly population, yet it has a low tax
base. Pension and social security coverage is limited to the formal sector and therefore,
only covers a small percentage of the population.

Advantage

 necessary to protect the most vulnerable groups in the community

 less poverty
 more equitable distribution of income

Disadvantages

 act as a disincentive to accepting work, so increasing the unemployment rate

 output in the economy is less than it might be
 inefficiency

PRICE CONTROLS:
The government can control market prices by:
- Setting maximum price limit (price ceiling)
- Setting minimum price limit (price floor)

1. Maximum price limit (price ceiling)

Objective:
To protect consumers from exploitation by sellers. Usually, in the case of
commodities that are necessities, the government sets a maximum price limit in the
market.

The effects of a maximum price limit:

- As long as the market price is below or equal to the maximum price limit, it will
be ineffective and the government will not interfere in the market.
- If the market price tends to cross the maximum price limit, the government takes
administrative actions to make it effective.
Price Price Price

S
S
S E0
E0 P0 g h
Pmax
P0 E0
Shortage
D D
D
0 0 0
Q0 Quantity Q0 Quantity Q1 Q2 Quantity
 Price

Consumer
surplus S
k Welfare loss
Total
Consumer Producer
Surplus after P0 E0
surplus
price ceiling transferred to
Pmax
consumers g h
Producer surplus
after price ceiling D
b
0 Q1 Q0 Q2 Quantity

Shortage
 Before effective After effective
maximum price maximum price
limit limit
Price that consumer pays
OP0 OPmax
and sellers receive
Quantity demanded (Qd) OQ0 OQ2
Quantity supplied (Qs) OQ0 OQ1
Shortage – Q1Q2=gh
Quantity traded OQ0 OQ1
Consumer expenditure =
OP0E0Q0 O PmaxgQ1
Sellers revenue (TR)
Consumer Surplus a P0 E0 a Pmaxgk
Producer Surplus b P0 E0 b Pmaxg
Producer surplus converted
– P0jgPmax
to consumer surplus
Dead weight loss – kgE0

The above diagram illustrates the effects of the imposition of an effective maximum
price. The demand curve is D, supply curve is S, and equilibrium point is E0 (with
equilibrium price P0 and equilibrium quantity Q0). The triangular area that is below the
demand curve but above old equilibrium price P0 represents the old consumer surplus
(aP0E0) The area above the old supply curve S0 but below old equilibrium rice quantifies
the producer surplus (bP0E0). Originally, the amount per unit that the consumers pay and
the sellers receive for the good is P0. As the maximum price limit is imposed, the new
price that consumers pay and sellers receive decreases to Pmax. (Note that the equilibrium
price remains unchanged. It’s just that the market price is forced to be Pmax or lower). At
the maximum price Pmax, the quantity demanded increases to Q2 and the quantity that
sellers are willing to supply decreases to Q1. The difference between Q1 and Q2 of gh
represents the shortage of stock to satisfy effective demand. The quantity traded,
therefore, is only equal to Q1. The new consumer surplus is aPmaxgk. The new producer
surplus is bPmaxg. The amount of producer surplus converted to consumer surplus as a
result of the price ceiling is represented by the area P0jgPmax. The triangular area kgE0
represents the dead weight loss due to the imposition of the price ceiling.

Advantages:

Some of the people will get the product at a lower price.

Disadvantages:

1. Shortages and black markets will develop.

Because the quantity demanded will exceed quantity supplied, some people will not
be able to buy the product. Frustrated by the shortage, consumers will make under-
the-table (black market) payments to secure their purchases.

2. The future supply will decline

The below-equilibrium price will discourage entrepreneurs from producing the

product, and private investment will flow elsewhere.

3. The quality will deteriorate

When producers are not allowed to raise their prices, they will use quality reductions
to incur lower costs. Eventually, the quality of the product will reflect the controlled
price. A cheaper product will be of inferior quality to an expensive one.

4. Non-price methods of rationing will become more important.

Because price no longer rations (distributes) the goods, other forms of competition
will develop. Sellers will favor friends, people of influence, and relatives, etc.

Discrimination will become more prevalent in the rationing process.

2. Minimum price limit (price floor)

Objective:

Sometimes the prices are adjusted too low to benefit the suppliers of the product, so
the government feels the need to interfere in the market by setting minimum prices—
for example, though minimum wage laws for agricultural products. The government
imposes price floors in an effort to artificially increase the prices that farmers receive.

The effects of a minimum price limit:

 As long as the market price is above or equal to the minimum price limit, it will
be ineffective and the government will not interfere in the market.
  If the market price tends to cross the minimum price limit, the government will
take administrative actions to make it effective.
Price Price Price

S
S S
P0 E0 Surplus
Pmin g
E0 P0 h
E0 D
D
D
0 0 0
Q0 Quantity Q0 Quantity Q1 Q2 Quantity

(Not Effective) (Not Effective) (Effective)

Types of minimum price limits

- By law
- By Stock purchase or buffer stocks
- By guaranteed price scheme

a. Minimum price limit by law

Total surplus minimum price
Producer transferred to
P0 limit (Price
Surplus consumer E0
flooring)
after price surplus
flooring Producer surplus
after price
k D
flooring
0 b Q1 Q0 Q2 Quantity

Surplus
Before effective After effective
minimum price minimum price
limit limit
Price that consumer pays
OP0 OPmin
and sellers receive
Quantity demanded (Qd) OQ0 OQ1
Quantity supplied (Qs) OQ0 OQ2
Shortage – Q1Q2=gh
Quantity traded OQ0 OQ1
Consumer expenditure =
OP0E0Q0 O PmingQ1
Sellers revenue (TR)
Consumer Surplus aP0 E0 a Pmingk
Producer Surplus bP0 E0 b Pming
Producer surplus converted
– P0jgPmin
to consumer surplus
Dead weight loss – kgE0

The above diagram illustrates the effects of the imposition of an effective minimum price
by law. The demand curve is D, supply curve is S, and equilibrium point is E0 (with
equilibrium pride P0 and equilibrium quantity Q0). The triangular area that is below the
demand curve but above old equilibrium pride P0 represents the old consumer surplus
(aP0E0). The area above the old supply curve S0 but below old equilibrium price
quantifies the producer surplus (bP0E0). Originally, the amount per unit that the
consumers pay and the sellers receive for the good is P0. As the minimum price limit is
imposed, the new price that consumers pay and sellers receive increases to P min. (Note
that the equilibrium price remains unchanged. It’s just that the market price is forced to
be Pmin or higher.) At the minimum price Pmin, the quantity demanded decreases to Q1 and
the quantity that sellers are willing to supply increases to Q2. The difference between Q1
and Q2 of gh represents the surplus of stock left unsold after satisfying effective demand.
The quantity traded, therefore, is only equal to Q1. The new consumer surplus is aPming.
The new producer surplus is OPmingkb. The amount of consumer surplus converted to
producer surplus as a result of the price ceiling is represented by the area P 0jgpmin. The
triangular area kgE0 represents the dead weight loss due to the imposition of the price
floor.

Advantages:

- Benefits some of the sellers who will sell the product at a higher price.

Disadvantages:

- A price floor reduces the quantity of the good exchanged and reduces the gains
from trade.
- Non-price factors will play a larger role in the rationing process, but this time
buyers will be in a position to be more selective. Buyers will purchase from
sellers willing to offer them non-price favors—better service, discounts on other
products, or easier credit terms, for example.
- Sellers will only benefit from the price increase if demand is inelastic.

b. Minimum price limit by stock purchase schemes:

- The government sets a lower limit on the price of the product and allows free
forces to operate unless and until the price of the product remains above or equal
to the minimum price limit.
- However, if the market price falls below the limit, the government will buy
surplus stocks and store them to resell them the market during periods of shortage
when the market price starts rising.

Price

a
Government Purchase
S
Surplus
g h
Pmin Effective minimum
price limit by stock
purchase scheme
P0 E0

k D
0 b Q1 Q0 Q2 Quantity
 Before
After minimum
minimum price
price limit by
limit by stock
stock purchase
purchase
Price that consumer pays OP0 OPmin
Price that seller receives OP0 OPmin
Quantity demanded (Qd) OQ0 OQ2
Quantity supplied (Qs) OQ0 OQ1
Surplus – Q1Q2=gh
Quantity traded OQ0 OQ1
Consumer expenditure OP0E0Q0 O PmingQ1
Government expenditure of
– ghQ2Q1
stock purchase
Sellers revenue OP0E0Q0 OPminhQ2

The above diagram illustrates the effects of the imposition of an effective minimum price
through stock purchase schemes. The demand curve is D, supply curve is S, and
equilibrium point is E0 (with equilibrium price P0 and equilibrium quantity Q0).
Originally, the amount per unit that the consumers pay and the sellers receive for the
good is P0, and the revenue that the sellers receive (calculated as price per unit × quantity
sold) is quantified by the region OP0E0Q0. As the minimum price limit is imposed, the
new price that consumers pay and sellers receive increases to Pmin. (Note that the
equilibrium price remains unchanged. It’s just that the market price is forced to be Pmin,
the quantity demanded decreases to Q1 and the quantity that sellers are willing to supply
increases to Q2. The difference between Q1 and Q2 of gh represents the surplus of stock
left unsold after satisfying effective demand. The quantity revenue (ghQ2Q1) is paid for
by the government as it purchases the surplus stock so that it can maintain the minimum
price.

The stock purchase system is usually unsuccessful when the minimum price limit is too
high. The government ends up buying more often and in larger quantities than they are
able to sell, increasing storage and purchase costs. However, stock purchase is a more
common practice for agricultural products than for any other types of goods.

c. Minimum Price Limit by guaranteed price scheme

- Another way to support producers and consumers is through a guaranteed price
scheme.
- In a guaranteed price scheme the government ensures a certain price or revenue to
sellers for a given output, and allows them to sell their product in the market at
whatever price they can sell.
- The difference between market price (price that consumers pay in this case) and
guaranteed price will be paid by the government as a subsidy. This is shown in the
diagram below.

Price
a

g h
Pmin Guaranteed
minimum price limit
P0 E0

Pmkt k

D
0 b Q1 Q0 Q2 Quantity

Before After
guaranteed guaranteed
minimum price minimum price
limit limit
Price that consumer pays OP0 OPmin
 Price that seller receives OP0 OPmkt
Quantity demanded (Qd) OQ0 OQ2
Quantity supplied (Qs) OQ0 OQ1
Surplus – –
Quantity traded OQ0 OQ2
Consumer expenditure OP0E0Q0 O PmktkQ2
Government subsidy
– PmktPminhk
expenditure
Sellers revenue OP0E0Q0 OPminhQ2

The above diagram illustrates the effects of the imposition of an effective guaranteed
minimum price. The demand curve is D, Supply curve is S and equilibrium point is E0
(with equilibrium P0 and equilibrium quantity Q0). Originally the amount per unit that the
consumers pay and the sellers receive for the good is P0 and the revenue that sellers
receive (calculated as price per unit × quantity sold) is quantified by the region OP 0E0Q0.
As the minimum price limited is imposed, the new price that consumers pay increases to
Pmin, and the new price that sellers receive is the market price Pmkt. (Note that the
equilibrium price remains unchanged. It’s just that the minimum price guaranteed to
sellers is Pmin and the price actually prevailing in the market is Pmkt.) AT the market price
Pmkt, the quantity demanded by consumers increases to Q2 and the quantity that sellers are
willing to supply decreases to Q1. However, the price that suppliers are willing to accept
for quantity Q2 is price Pmin. The government pays that price to the suppliers (since they
are guaranteed it), so the quantity supplied and traded at the guaranteed minimum price
limit is Q2. The consumer expenditure on the good is equal to (market price per unit ×
quantity traded), which is quantified by the area OPmktkQ2. The government pays the
producers the guaranteed amount of PmktPminhk in the form of a subsidy. The revenue that
sellers receive now is the addition of consumer expenditure and the government subsidy,
equaling OPminhQ2.
PRIVATIZATION

Privatization means transferring the ownership of assets from the public to the private
sector.

Forms of privatization

1. Denationalization:

Privatization of ownership—sales of assets or shares. In this case, the government

may retain some shares in the enterprise and act as a regular to ensure that public
interest is protected.

2. Franchising:

Gives the private sector a right to operate a particular service/activity for a given
length of time. May be exclusive or competitive.

3. Privatization of production:

The government of buys goods and services instead of producing them.

4. Privatization of financing:

The government relies on consumer charges rather than tax revenue to subsidize
operations; e.g., independent school fees.

5. Deregulation:

The liberalization of regulation to promote competition through the removal of

barriers to entry (e.g., telecommunications, the financial industry, airlines, etc.)

Arguments of privatization

These include:

1. Raising revenue for the government

The revenue gained from the sale makes it possible for the government to reduce its
need to borrow and to cut tax rates without reducing its own spending. Extra
 government revenue may also be received in the form of higher corporation tax
receipts if the privatized concerns become more profitable.

2. The removal of political interference

In the private sector, decisions are made on the grounds of efficiency and profit.
Politicians may make decisions to further their own political ends and not those of the
industry in question.

3. Increased competition

It is argued that the private sector has the spur of competition since inefficiency is
punished with bankruptcy. A failed firm will go out of business and the resources will
be reallocated in line with consumer demand, whereas state enterprises cannot go
bankrupt because the government guarantees their borrowings.

A private sector firm may have to compete in financial markets for funds, and has to
persuade banks and other financial institutions or its shareholders that its plans are
viable.

Greater competition may also be created in the product market if an industry, which
was run as a monopoly under state ownership is split into competing parts, for
example, telecommunication firms operating in completion with each other.

4. Increased efficiency

Managers of a privatized firm will be freed from political control and interference.
They will be able to charge prices they regard as commercially appropriate and make
investments they think will produce the right return. The stock market may also put
pressure on private sector firms to be more efficient. If they are not performing well,
their share price will fall and they will run the risk of being taken over by another
firm.

5. Wider share ownership

The broadening of share ownership may be another aim of privatization. The idea is
to shift ownership away from the state and institutions towards individuals.
6. Cost-push inflation may be reduced

Private sector managers may be more reluctant to concede to wages rises not matched
by higher productivity, and may be less willing to accent inefficient labour.

Arguments against privatization

1. Long term loss of revenue

Whilst selling off profitable assets raises revenue for the government in the short
term, it leads to a loss of future profits for these industries. If the loss of profit is
greater than any rise in corporation tax resulting from the privatization, the
government borrowing requirements may be larger in the future.

2. Competition in product markets may not be increased

If a public sector monopoly is replaced by a private sector monopoly then, other

things being equal competition will not increase.

3. Market forces may not ensure greater efficiency

Privatization firms, if they have a high degree of monopoly power, are likely to be
able to earn supernormal profits, even if they are inefficient. The stock market may
also fail to put pressure on the firms to become efficient. The stock market may also
fall heavily on retained profits for their investment finance, and their large size is
likely to prevent other firms from being able to take them over.

4. The loss of potential revenue from the sale of a privatized concern that has been
sold too cheaply

It is thought that, in the past, some state concerns were sold off too cheaply. Evidence
for this was provided by the sharp rise in the price of shares, which occurred the day
after the shares were sold in many former state concerns. Whilst this provided a
speculative gain for the purchasers, there was a corresponding