ECO401 Introduction to Economics PDF

ECO401 – INTRODUCTION TO ECONOMICS Lesson No. Topics Page No. Lesson 01 Introduction to Economics ……………………………………………. 01 Lesson 02 Introduction to Economics (Continued)………………………………....

ECO401 – INTRODUCTION TO ECONOMICS Lesson No. Topics Page No. Lesson 01 Introduction to Economics ……………………………………………. 01 Lesson 02 Introduction to Economics (Continued)………………………………. 04 Exercises 07 Lesson 03 Demand, Supply and Equilibrium Analysis……………...…………….... 10 Lesson 04 Demand, Supply and Equilibrium Analysis (Continued)……………..… 13 Lesson 05 Demand, Supply and Equilibrium Analysis (Continued)……………….. 16 Exercises 19 Lesson 06 Elasticities ……………………………………………………………... 26 Lesson 07 Elasticities (Continued)… ………………………………………............ 32 Lesson 08 Elasticities (Continued)……………………… ………………................. 34 Exercises 37 Lesson 09 Consumer Behavior: Consumption Side Analysis………………………. 40 Lesson 10 Consumer Behavior: Consumption Side Analysis (Continued)…………. 42 Lesson 11 Consumer Behavior: Consumption Side Analysis (Continued)…………. 44 Lesson 12 Consumer Behavior: Consumption Side Analysis (Continued)…………. 46 Exercises 48 Lesson 13 Producer Behavior: Production Side Analysis 53 Lesson 14 Producer Behavior: Production Side Analysis (Continued)……………... 56 Lesson 15 Producer Behavior: Production Side Analysis (Continued)……………... 58 Lesson 16 Producer Behavior: Cost Analysis………………………..……………... 60 Lesson 17 Revenue and Profit Maximization Analysis……………………………... 63 Exercises 66 Lesson 18 Profit Maximization Analysis (Cont) and Market Structures……………. 71 Lesson 19 Market Structures (Continued)…………………….…………………… 74 Lesson 20 Market Structures (Continued)…………………….…………………… 76 Lesson 21 Market Structures (Continued)…………………….…………………… 78 Lesson 22 Market Structures (Continued)…………………….…………………… 81 Exercises 84 Lesson 23 Market Structures (Cont) and Welfare Economics……………………… 90 Lesson 24 Welfare Economics (Continued)……………………………………….. 93 Exercises 96 Lesson 25 Introduction To Macroeconomics ……………………………….…….. 103 Lesson 26 Introduction To Macroeconomics (Continued)……………………..….. 106 Lesson 27 Introduction To Macroeconomics (Continued)…………..…………….. 110 Exercises 113 Lesson 28 Macroeconomic Data and National Income Accounting……………….. 117 Lesson 29 Macroeconomic Data and National Income Accounting (Continued)…... 120 Macroeconomic Equilibrium: The Determination of Equilibrium Lesson 30 124 Income………………………………………………………………… Macroeconomic Equilibrium: The Determination of Equilibrium Lesson 31 128 Income (Continued)……………………………………………………. Macroeconomic Equilibrium: The Determination of Equilibrium Lesson 32 133 Income (Continued)……………………………………………………. Exercises 136 Lesson 33 The Four Big Macroeconomic Issues And Their Inter-Relationships ….. 142 The Four Big Macroeconomic Issues And Their Inter-Relationships Lesson 34 148 (Continued)… …………………………………………………………  The Four Big Macroeconomic Issues And Their Inter-Relationships Lesson 35 152 (Continued)… ………………………………………………………… The Four Big Macroeconomic Issues And Their Inter-Relationships Lesson 36 154 (Continued.)… ………………………………………………………… The Four Big Macroeconomic Issues And Their Inter-Relationships Lesson 37 158 (Continued)… ………………………………………………………… The Four Big Macroeconomic Issues And Their Inter-Relationships Lesson 38 161 (Continued)… ………………………………………………………… The Four Big Macroeconomic Issues And Their Inter-Relationships Lesson 39 165 (Continued)… ………………………………………………………… The Four Big Macroeconomic Issues And Their Inter-Relationships: Lesson 40 170 Bilateral Relationship among the “Big Four” and Fiscal Policy…………. Exercises 177 Lesson 41 Fiscal Policy, Money and Banking……………………………………… 185 Lesson 42 Money, Central Banking and Monetary Policy………..………………… 189 Lesson 43 Money and Goods Market Equilibrium: IS-LM Framework…………..... 193 Exercises 198 Lesson 44 International Trade And Finance…………………….…………………. 203 Lesson 45 Problems of Lower Income Countries (LICs)………………...………… 207 Exercises 212 Introduction to Economics –ECO401 VU Lesson 1 INTRODUCTION TO ECONOMICS WHAT IS ECONOMICS? Economics is not a natural science, i.e. it is not concerned with studying the physical world like chemistry, biology. Social sciences are connected with the study of people in society. It is not possible to conduct laboratory experiments, nor is it possible to fully unravel the process of human decision- making. “Economics is the study of how we the people engage ourselves in production, distribution and consumption of goods and services in a society.” The term economics came from the Greek for oikos (house) and nomos (custom or law), hence "rules of the household. Another definition is: “The science which studies human behavior as a relationship between ends and scarce means which have alternative uses.” BRANCHES OF ECONOMICS Normative economics: Normative economics is the branch of economics that incorporates value judgments about what the economy should be like or what particular policy actions should be recommended to achieve a desirable goal. Normative economics looks at the desirability of certain aspects of the economy. It underlies expressions of support for particular economic policies. Normative economics is known as statements of opinion which cannot be proved or disproved, and suggests what should be done to solve economic problems, i-e unemployment should be reduced. Normative economics discusses "what ought to be". Examples: 1-A normative economic theory not only describes how money-supply growth affects inflation, but it also provides instructions that what policy should be followed. 2- A normative economic theory not only describes how interest rate affects inflation but it also provides guidance that what policy should be followed. Positive economics: Positive economics, by contrast, is the analysis of facts and behavior in an economy or “the way things are.” Positive statements can be proved or disproved, and which concern how an economy works, i-e unemployment is increasing in our economy. Positive economics is sometimes defined as the economics of "what is" Examples: 1- A positive economic theory might describe how money-supply growth affects inflation, but it does not provide any instruction on what policy should be followed. 2- A positive economic theory might describe how interest rate affects inflation but it does not provide any guidance on whether what policy should be followed. We the people: includes firms, households and the government. Goods are the things which are produced to be sold. Services involve doing something for the customers but not producing goods. FACTORS OF PRODUCTION Factors of production are inputs into the production process. They are the resources needed to produce goods and services. The factors of production are: Land includes the land used for agriculture or industrial purposes as well as natural resources taken from above or below the soil. Capital consists of durable producer goods (machines, plants etc.) that are in turn used for production of other goods. Labor consists of the manpower used in the process of production. Entrepreneurship includes the managerial abilities that a person brings to the organization. Entrepreneurs can be owners or managers of firms. © Copyright Virtual University of Pakistan 1 Introduction to Economics –ECO401 VU Scarcity does not mean that a good is rare; scarcity exists because economic resources are unable to supply all the goods demanded. It is a pervasive condition of human existence that exists because society has unlimited wants and needs, but limited resources used for their satisfaction. In other words, while we all want a bunch of stuff, we can't have everything that we want. Rationing is a process by which we limit the supply or amount of some economic factor which is scarcely available. It is the distribution or allocation of a limited commodity, usually accomplished based on a standard or criterion. The two primary methods of rationing are markets and governments. Rationing is needed due to the scarcity problem. Because wants and needs are unlimited, but resources are limited, available commodities must be rationed out to competing uses. ECONOMIC SYSTEMS There are different types of economic systems prevailing in the world. Dictatorship: Dictatorship is a system in which economic decisions are taken by the dictator which may be an individual or a group of selected people. Command or planned economy: A command or planned economy is a mode of economic organization in which the key economic functions – for whom, what, how to produce are principally determined by government directive. In a planned economy, a planning committee usually government or some group determines the economy’s output of goods and services. They decide about the optimal mix of resources in the economy. They also decide how the factor of production needs to be employed to get optimal mix. Free market/capitalist economy: A free market/capitalist economy is a system in which the questions about what to produce, how to produce and for whom to produce are decided primarily by the demand and supply interactions in the market. In this economy what to produce is thereby determined by the market price of each good and service in relation to the cost of producing each good and service. In a free economy the only goods and services produced are those whose price in the market is at least equal to the producer’s cost of producing output. When a price greater than the cost of producing that good or service prevails, producers are induced to increase the production. If the product’s price falls below the cost of production, producers reduce supply. Islamic economic system: This system is based on Islamic values and Islamic rules i-e zakat, ushr, etc. Islam forbids both the taking and giving of interest. Modern economists, too, have slowly begun to realize the futility of interest. The Islamic economic principles if strictly followed would eliminate the possibility of accumulation of wealth in the hands of a few and would ensure the greater circulation of money as well as a wider distribution of wealth. Broadly speaking these principles are (1) Zakat or compulsory alms giving (2) The Islamic law of inheritance which splits the property of an individual into a number of shares given to his relations (3) The forbiddance of interest which checks accumulation of wealth and this strikes at the root of capitalism. Pakistan case: A mixed economy In Pakistan, there is mixed economic system. Resources are governed by both government and individuals. Some resources are in the hand of government and some are in the hand of public. Optimal mix of resources is decided by the price mechanism i-e by the market forces of demand and supply. Pakistan economy thus consists of the characteristics of both planned economy and free market economy. People are free to make their decisions. They can make their properties. Government controls the Defence. CIRCULAR FLOW OF GOODS & INCOME There are two sectors in the circular flow of goods & services. One is household sector and the other is the business sector which includes firms. Households demands goods & services, Firms supply goods & services. An exchange takes place in an economy. In monetary economy, firms exchange goods & services for money. Firms’ demands factors of production and households supply factors of production. Firms pay the payment in terms of wages, rent, etc. This is circular flow of goods. On the other hand, © Copyright Virtual University of Pakistan 2 Introduction to Economics –ECO401 VU household gives money to firms to purchase the goods & services from firms, and firms’ gives money to households in return for factors of production. DISTINCTION BETWEEN MICRO & MACRO ECONOMICS Micro Economics: The branch of economics that studies the parts of the economy, especially such topics as markets, prices, industries, demand, and supply. It can be thought of as the study of the economic trees, as compared to macroeconomics, which is study of the entire economic forest. Microeconomics is a branch of economics that studies how individuals, households, and firms make decisions to allocate limited resources typically in markets where goods or services are being bought and sold. It also examines how these decisions and behaviors affect the supply and demand for goods and services, which determines prices, and how prices, in turn, determine the supply and demand of goods and services. Macro Economics: The branch of economics that studies the entire economy, especially such topics as aggregate production, unemployment, inflation, and business cycles. It can be thought of as the study of the economic forest, as compared to microeconomics, which is study of the economic trees. Macroeconomics, involves the "sum total of economic activity, dealing with the issues of growth, inflation, and unemployment and with national economic policies relating to these issues” and the effects of government actions (e.g., changing taxation levels) on them. © Copyright Virtual University of Pakistan 3 Introduction to Economics –ECO401 VU Lesson 02 INTRODUCTION TO ECONOMICS (CONTINUED) COST & BENEFIT ANALYSIS Rational choice is the choice based on pure reason and without succumbing to one’s emotions or whims. Consumers can decide about the rational decision by using cost and benefit analysis. Rational choice is a general theory of human behavior that assumes individuals try to make the most efficient decisions possible in an environment of scarce resources. By "efficient" it is meant that humans are "utility maximizers" - for any given choice a person seeks the most benefit relative to costs. Consumers can make about the rational decision by using cost and benefit analysis. Consumers want to maximize their level of satisfaction relative to their cost. Rational choice is also the optimal choice. Optimum means producing the best possible results (also optimal). Equity in economics means a situation in which every thing is treated fairly or equally, i.e. according to its due share. So if the lives of all individuals are deemed to have equal value, equity would demand that all of them have equal financial net worth. Nepotism means doing unfair favors for near ones when in power. Rational choice is the choice based on pure reason and without succumbing to one’s emotions or whims. Barter trade is a non-monetary system of trade in which “goods” not money is exchanged. This was the system used in the world before the advent of coins and currency. HOW CONSUMER DECIDES ABOUT OPTIMAL CHOICE The consumers decide about the optimal choice by using the cost and benefit analysis which maximizes the benefit relative to the cost. Example: Benefit Cost Net Benefit (Salary) (Transportation) = Benefit – Cost Job A (Lahore) 15,000 1,000 14,000 Job B (Gujranwala) 20,000 7,000 13,000 Since net benefit of job A is greater so the rational choice is job A which is in Lahore. HOW PRODUCERS DECIDE ABOUT OPTIMAL CHOICE Assume that a firm which is thinking to open a new production line of car manufacturing. Rational decision involves the cost and benefit of that car’s production. Costs will be additional labor employed, additional raw material and additional parts & components that have to be bought. Benefits will be additional revenue that the firm will get by selling the additional number of cars. It will be profitable to invest if revenue is greater than the cost. OPPORTUNITY COST The opportunity cost of a particular choice is the satisfaction that would have been derived from the next best alternative foregone; in other words, it is what must be given up or sacrificed in making a certain choice or decision. Example: Let’s take the decision to buy the book or not, if you will not buy the book then you will be involved in many other activities. In the following table, opportunity Cost of buying the book and not giving charity = 20 SU, which is the benefit derived from giving charity. You will buy the book if the benefit from other alternatives is less than the benefit derived from buying of book. © Copyright Virtual University of Pakistan 4 Introduction to Economics –ECO401 VU Benefit Derived in Cost Satisfaction Unit Book 200 10 Clothes 200 5 Charity 200 20 MARGINAL COST AND MARGINAL BENEFIT Marginal cost is the increment to total costs of producing an additional unit of some good or service. There are other broader definitions as well. Marginal benefit is the increment to total benefit derived from consuming an additional unit of good or service. There are other broader definitions as well. PRODUCTION POSSIBILITY FRONTIER (PPF) Production possibility frontier (PPF) is the curve which joins all the points showing the maximum amount of goods and services which the country can produce in a given time with limited resources, given a specific state of technology. A production possibilities frontier represents the boundary or frontier of the economy's production capabilities. That's why it's termed a production possibilities frontier (or PPF). As a frontier, it is the maximum production possible given existing (fixed) resources and technology. Table: Choice & Opportunity cost revisited: The law of increasing opportunity cost Rice Cotton Opportunity Cost (Bags) (Bushels) of Additional Unit A 0 10 B 1 9 1 C 2 7 2 D 3 4 3 E 4 0 4 This table represents the alternative combinations of rice and cotton for a hypothetical economy which is producing only 2 goods. At point A only cotton is produced, rice is not produced. In order to produce one unit of rice, we have to give up one unit of cotton (10-9=1). So the opportunity cost is 1 at point B. further in order to produce next unit of rice, we have to give up 2 units of cotton (9-7=2). So the opportunity cost of next additional unit is 2 and so on. This table shows that opportunity cost is increasing with each additional unit. It means we have to give up higher and higher units of cotton in order to produce each additional unit of rice. This is the principle of increasing opportunity cost. If opportunity cost decreases with each additional unit produced, then it is the principle of decreasing opportunity cost. And if opportunity cost remains constant with each extra unit produced, it is the principle of constant opportunity cost. The law of increasing opportunity cost is what gives the curve its distinctive convex shape. Points on the PPF show the efficient utilization of resources. Points inside the PPF show inefficient use of resources. Points outside the PPF show that some of the resources are unemployed or not utilized. PPF curve shifts upward due to technological advancements. If there is improvement in technology to produce the output, then total output will increase and PPF will shift outward. OPPORTUNITY COST & PRODUCTION POSSIBILITIES The production possibilities analysis, which is the alternative combinations of two goods that an economy can produce with given resources and technology, can be used to illustrate opportunity cost-- the highest valued alternative foregone in the pursuit of an activity. The PPF showed in the video lecture slide shows the principle of increasing opportunity cost. © Copyright Virtual University of Pakistan 5 Introduction to Economics –ECO401 VU PPF AND ITS RELATIONSHIP WITH MACROECONOMICS In the graph of PPF, Points within the PPF are inefficient and it is the rare possibility in the real world. Inefficient means that it may not be using its available resources. May be some workers are unemployed creating the macro economic problem of unemployment or may be capital is not using properly. Points outside the PPF are unattainable since the PPF defines the maximum output produced at the given time period so there is no possibility to produce output outside the PPF. Here in PPF, we are not concerned with the combinations of goods which is a micro economic issue rather we are concerned with the overall output produced which is a macroeconomic issue. Economic growth is an increase in the total output of a country over time. It is the long-run expansion of the economy's ability to produce output. When GDP of a country is increasing it means that country is growing economically. Economic growth is made possible by increasing the quantity or quality of the economy's resources (labor, capital, land, and entrepreneurship). © Copyright Virtual University of Pakistan 6 Introduction to Economics –ECO401 VU EXERCISES Could production and consumption take place without money? If you think they could, give examples. Yes. People could produce things for their own consumption. For example, people could grow vegetables in their garden or allotment; they could do their own painting and decorating. Alternatively people could engage in barter: they could produce things and then swap them for goods that other people had produced. Must goods be at least temporarily unattainable to be scarce? Goods need not be unattainable to be scarce. Because people’s incomes are limited, they can not have everything they want from shops, even though the shops are stocked full. If all items in shops were free, the shelves would soon be emptied! If we would all like more money, why does the government not print a lot more? Could it not thereby solve the problem of scarcity ‘at a stroke’? The problem of scarcity is one of a lack of production. Simply printing more money without producing more goods and services will merely lead to inflation. To the extent that firms cannot meet the extra demand (i.e. the extra consumer expenditure) by extra production, they will respond by putting up their prices. Without extra production, consumers will be unable to buy any more than previously. Which of the following are macroeconomic issues, which are microeconomic ones and which could be either depending on the context? a) Inflation. b) Low wages in certain service industries. c) The rate of exchange between the dollar and the rupee. d) Why the price of cabbages fluctuates more than that of cars. e) The rate of economic growth this year compared with last year. f)The decline of traditional manufacturing industries. a) Macro. It refers to a general rise in prices across the whole economy. b) Micro. It refers to specific industries c) Either. In a world context, it is a micro issue, since it refers to the price of one currency in terms of one other. In a national context it is more of a macro issue, since it refers to the exchange rate at which all Pakistanis goods are traded internationally. (This is certainly a less clear–cut division that in (a) and (b) above.) d) Micro. It refers to specific products. e) Macro. It refers to the general growth in output of the economy as a whole. f) Micro (macro in certain contexts). It is micro because it refers to specific industries. It could, however, also help to explain the macroeconomic phenomena of high unemployment or balance of payments problems. Assume that you are looking for a job and are offered two. One is more unpleasant to do, but pays more. How would you make a rational choice between the two jobs? You should weigh up whether the extra pay (benefit) from the better paid job is worth the extra hardship (cost) involved in doing it. How would the principle of weighing up marginal costs and benefits apply to a worker deciding how much overtime to work in a given week? The worker would consider whether the extra pay (the marginal benefit) is worth the extra effort and loss of leisure (the marginal cost). Would it ever be desirable to have total equality in an economy? The objective of total equality may be regarded as desirable in itself by many people. There are two problems with this objective, however. The first is in defining equality. If there were total equality of incomes then households with dependants would have a lower income per head than households where everyone was working. In other words, equality of incomes would not mean equality in terms of standards of living. © Copyright Virtual University of Pakistan 7 Introduction to Economics –ECO401 VU If on the other hand, equality were to be defined in terms of standards of living, then should the different needs of different people be taken into account? Should people with special health or other needs have a higher income? Also, if equality were to be defined in terms of standards of living, many people would regard it as unfair that people should receive different incomes (according to the nature of their household) for doing the same amount of work. The second major problem concerns incentives. If all jobs were to be paid the same (or people were to be paid according to the composition of their household), irrespective of people’s efforts or skills, then what would be the incentive to train or to work harder? If there are several other things you could have done, is the opportunity cost the sum of all of them? No. It is the sacrifice involved in the next best alternative. What is the opportunity cost of spending an evening revising for an economics exam? What would you need to know in order to make a sensible decision about what to do that evening? The next best alternative might be revising for another exam, or it might be taking time off to relax or to go out. To make a sensible decision, you need to consider these alternatives and whether they are better or worse for you than studying for the economics exam. One major problem here is the lack of information. You do not know just how much the extra study will improve your performance in the exam, because you do not know in advance just how much you will learn and you do not know what is going to be on the exam paper. Similarly you do not know this information for studying for other exams. Make a list of the benefits of higher education. The benefits to the individual include: increased future earnings; the direct benefits of being more educated; the pleasure of the social contacts at university or college. Is the opportunity cost to the individual of attending higher education different from the opportunity costs to society as a whole? Yes. The opportunity cost to society as a whole would include the costs of providing tuition (staffing costs, materials, capital costs, etc.), which could be greater than any fees the student may have to pay. On the other hand, the benefits to society would include benefits beyond those received by the individual. For example, they would include the extra profits employers would make by employing the individual with those qualifications. There is a saying in economics, ‘There is no such thing as a free lunch’. What does this mean? That there is always (or virtually always) an opportunity cost of anything we consume. Even if we do not incur the cost ourselves (the ‘lunch’ is free to us), someone will incur the cost (e.g. the institution providing the lunch). Are any other (desirable) goods or services truly abundant? Very few! Possibly various social interactions between people, but even here, the time to enjoy them is not abundant. Under what circumstances would the production possibility curve be (a) a straight line; (b) bowed in toward the origin? Are these circumstances ever likely? a) When there are constant opportunity costs. This will occur when resources are equally suited to producing either good. This might possibly occur in our highly simplified world of just two goods. In the real world it is unlikely. b) When there are decreasing opportunity costs. This will occur when increased specialization in one good allows the country to become more efficient in its production. It gains ‘economies of scale’ sufficient to offset having to use less suitable resources. Will economic growth necessarily involve a parallel outward shift of the production possibility curve? No. Technical progress, the discovery of raw materials, improved education and training, etc., may favour one good rather than the other. In such cases the gap between the old and new curves would be widest where they meet the axis of the good whose potential output had grown more. Which of the following are positive statements, which are normative statements and which could be either depending on the context? a) Cutting the higher rates of income tax will redistribute incomes from the poor to the rich. © Copyright Virtual University of Pakistan 8 Introduction to Economics –ECO401 VU b) It is wrong that inflation should be reduced if this means that there will be higher unemployment. c) It is wrong to state that putting up interest rates will reduce inflation. d) The government should raise interest rates in order to prevent the exchange rate falling. e) Current government policies should reduce unemployment. a) Positive. This is merely a statement about what would happen. b) Normative. The statement is making the value judgment that reducing inflation is a less desirable goal than the avoidance of higher unemployment. c) Positive. Here the word ‘wrong’ means ‘incorrect’ not ‘morally wrong’. The statement is making a claim that can be tested by looking at the facts. Do higher interest rates reduce inflation, or don’t they? d) Both. The positive element is the claim that higher interest rates prevent the exchange rate falling. This can be tested by an appeal to the facts. The normative element is the value judgment that the government ought to prevent the exchange rate falling. e) Either. It depends what is meant. If the statement means that current government policies are likely to reduce unemployment, the statement is positive. If, however, it means that the government ought to direct its policies towards reducing unemployment, the statement is normative. © Copyright Virtual University of Pakistan 9 Introduction to Economics –ECO401 VU Lesson 03 Demand, Supply & Equilibrium Analysis GOODS MARKET AND FACTORS MARKET Goods/product/commodity markets: Markets used to exchange final good or service. Product markets exchange consumer goods purchased by the household sector, capital investment goods purchased by the business sector, and goods purchased by government and foreign sectors. A product market, however, does NOT include the exchange of raw materials, scarce resources, factors of production, or any type of intermediate goods. The total value of goods exchanged in product markets each year is measured by gross domestic product. The demand side of product markets includes consumption expenditures, investment expenditures, government purchases, and net exports. The supply side of product markets is production of the business sector. Factors markets: Markets used to exchange the services of a factor of production: labor, capital, land, and entrepreneurship. Factor markets, also termed resource markets, exchange the services of factors, NOT the factors themselves. For example, the labor services of workers are exchanged through factor markets NOT the actual workers. Buying and selling the actual workers are not only slavery (which is illegal) it's also the type of exchange that would take place through product markets, not factor markets. More realistically, capital and land are two resources and are legally exchanged through product markets. The services of these resources, however, are exchanged through factor markets. The value of the services exchanged through factor markets each year is measured as national income. Assumption is a belief or feeling that something is true or that something will happen, although there is no proof. Economists make frequent use of assumptions in putting forward their theories. Perfect competition refers to a situation in which no firm or consumer is big enough to affect the market price. DEMAND ANALYSIS Shortage: A shortage is a situation in which demand exceeds supply, i.e. producers are unable to meet market demand for the product. Shortages cause prices to raise prompting producers to produce more and consumers to demand less. Surplus: A surplus is a situation of excess supply, in which market demand falls short of the quantity supplied; i.e. the producers are unable to sell all the produced goods in the market. Surpluses cause prices to fall prompting producers to supply less and consumers to demand more. Price Mechanism: The price mechanism is a signaling and rationing device which prompts consumers and producers to adjust their demand and supply, respectively, in response to a shortage or surplus. Shortages cause prices to rise, prompting producers to produce more and consumers to demand less. Surpluses cause prices to fall prompting producers to supply less and consumers to demand more. In either case, the price mechanism attempts to clear the shortage or surplus in the market. Normal goods are goods whose quantity demanded goes up as consumer income increases. Inferior goods are goods whose quantity demanded goes down as consumer income increases. Giffen goods are the sub category of inferior good. It is a rare type of good seldom seen in the real world, in which a change in price causes quantity demanded to change in the same direction (in violation of the law of demand). In other words, an increase in the price of Giffen good results in an increase in the quantity demanded. The existence of a Giffen good requires the existence of special circumstances. First, the good must be an inferior good. Second, the income effect is greater than the substitution effect. A Giffen good is most likely to result when the good is a significant share of the consumer's budget. Margarine is a Giffen good as compared to butter. Substitution effect: It is one of two reasons for law of demand and the negative slope of the market demand curve. The substitution effect occurs because a change in the price of a good makes it relatively higher or lower © Copyright Virtual University of Pakistan 10 Introduction to Economics –ECO401 VU than the prices of other goods that might act as substitutes. A higher price means that a good is more expensive relative to other goods, while a lower price means it's less expensive. Or more simply we can say that if price of any good increases, people reduce its consumption and substitute any other good whose price is not increased. This is substitution effect. Income effect: It is also one of two reasons for the law of demand and the negative slope of the market demand curve. The income effect results because a change in price gives buyers more real income, or the purchasing power of the income, even though money or nominal income remains the same. This causes changes in the quantity demanded of the good. Or more simply we can say that when price of any good increases, consumer’s real income falls and its purchasing power also decreases. This is income effect. Price effect: Price effect is the addition of income and substitution effect. Price effect = Income effect + Substitution effect Substitutes are goods that compete with one another or can be substituted for one another, like butter and margarine. Compliments are goods that go hand in hand with each another. Examples are left shoe and right shoe, or bread and butter Cash crops are the crops which are not used as food but as a raw material in factories e.g. cotton. DEMAND Demand is the quantity of a good that buyers wish to purchase at each conceivable price. Law of demand: The law of demand states that holding all other factors constant, if the price of a certain commodity rises, its quantity demanded will go down, and vice-versa. Other factors are income, population, tastes, prices of all other goods etc. Demand schedule: A demand schedule is a table (sometimes also referred to as a graph) which shows various combinations of quantity demanded and price. Price Quantity demanded Quantity demanded (Individual) (Market) 5 3.5 3500 4 4.5 4500 3 6.0 6000 2 8.0 8000 1 11.0 11000 Demand curve: A demand curve is a graph that obtains when price (one of the determinants of demand) is plotted against quantity demanded. Price (P) Demand Curve Quantity Demanded (Q) Demand function: A demand function is an equational representation of demand as a function of its many determinants. © Copyright Virtual University of Pakistan 11  Introduction to Economics –ECO401 VU Qd = f ( Pg , T , Psi … Psn , Pci … Pcm , Y , B , Pge t+1 ) Where, Pg = Price of the good, T = Tastes, Psi … Psn = Prices of substitute goods, Pci … Pcm = Prices of complimentary goods, Y = Income, B = Income Distribution, Pge t+1 = Future prices Equation of demand function is Qd= a – b P Shifts in the demand curve: Shifts in the demand curve plotted in P-Qd space are caused by changes in any determinant of demand other than the price of the good itself. Movements along the curve correspond to the changes in the variable on the vertical axis. FACTORS SHIFTING DEMAND CURVE: Factors Changing Effect on Direction of Effect on Effect on Demand Demand Shift in Demand Equilibrium Equilibrium Curve Price Quantity Increase in income Increase Rightward Increase Increase (normal good) Decrease in Decrease Leftward Decrease Decrease income(normal good) Increase in income Decrease Leftward Decrease Decrease (inferior good) Decrease in Increase Rightward Increase Increase income(inferior good) Increase in price of Increase Rightward Increase Increase Substitute Decrease in price of Decrease Leftward Decrease Decrease substitute Increase in price of Decrease Leftward Decrease Decrease complement Decrease in price of Increase Rightward Increase Increase complement Increase in taste and Increase Rightward Increase Increase preference for good Decrease in taste and Decrease Leftward Decrease Decrease preference for good Increase in number of Increase Rightward Increase Increase consumers Decrease in number of Decrease Leftward Decrease Decrease consumers MARKET DEMAND CURVE Market demand curve is a graphic representation of a market demand which shows the quantities of a commodity that consumers are willing and able to purchase during a period of time at various alternative prices, while holding constant everything else that effects demand. The market demand curve for a commodity is negatively sloped, indicating that more of a commodity is purchased at a lower price. © Copyright Virtual University of Pakistan 12 Introduction to Economics –ECO401 VU Lesson 04 DEMAND, SUPPLY & EQUILIBRIUM ANALYSIS (CONTINUED) SUPPLY Supply is the quantity of a good that sellers wish to sell at each conceivable price. Law of supply: The law of supply states that the quantity supplied will go up as the price goes up and vice versa. As output increases, cost will also increase. Higher prices means more profit so firms will produce more of that product whose price has increased. New producers will also emerge in the market. And total supply will also increase. Supply schedule: A supply schedule is a table (sometimes also referred to as a graph) which shows various combinations of quantity supplied and price. Price Quantity supplied Quantity supplied (Individual) (Market) 5 75 7500 4 70 7000 3 60 6000 2 40 4000 1 10 1000 Supply curve: A supply schedule is a table which shows various combinations of quantity supplied and price. Graphical illustration of this table gives us the supply curve. Price (P) Supply Curve Quantity Supplied (Q) Supply function: A supply function is an equational representation of supply as a function of all its determinants. Quantity Supplied = f (Price) QS = f ( Pg , Cg , a1 … an , j1 … jm , R , A , Pge t+1 ) Where, Quantity Supplied = Qs, Price of the goods = Pg, Profitability of alternative goods = a1…..an, Profitability of the goods jointly supplied = j1….jm, Nature and Other Random Shocks = R, Aims of Producers = A, Expected Price of good = Pge at some future time = t+1 A supply equation is QS = c + d P PROBLEMS OF IDENTIFICATION OR DETERMINANTS OF SUPPLY Problems of identification arise when we can not determine that the change in the equilibrium quantities is either caused by a change in demand or by changes in both demand and supply. Determinants of supply are: Costs of production Profitability of alternative products (substitutes in supply) Profitability of goods in joint supply © Copyright Virtual University of Pakistan 13 Introduction to Economics –ECO401 VU Nature and other random shocks Aims of producers Expectations of producers Determinants in the context of supply of butter: A reduction in the cost of producing butter. A reduction in the profitability of producing cream or cheese. An increase in the profitability of skimmed milk. If weather conditions are favorable, grass yields and hence milk yields are likely to be high. If butter producers expect the price to rise in near future, they may decide to release less to the market now. FACTORS SHIFTING SUPPLY CURVE Factors Changing Supply Effect on Direction of Effect on Effect on Supply Shift in Supply Equilibrium Equilibrium Curve Price Quantity Increase in resource price Decrease Leftward Increase Decrease Decrease in resource price Increase Rightward Decrease Increase Improved technology Increase Rightward Decrease Increase Decline in technology Decrease Leftward Increase Decrease Expect a price increase Decrease Leftward Increase Decrease Expect a price decrease Increase Rightward Decrease Increase Increase in number of Increase Rightward Decrease Increase suppliers Decrease in number of Decrease Leftward Increase Decrease suppliers EQUILIBRIUM Equilibrium is a state in which there are no shortages and surpluses; in other words the quantity demanded is equal to the quantity supplied. Equilibrium price is the price prevailing at the point of intersection of the demand and supply curves; in other words, it is the price at which the quantity demanded is equal to the quantity supplied. Equilibrium quantity is the quantity that clears the market; in other words, it is it is the quantity at which the quantity demand is equal to the quantity supplied. Demand Curve Price (P) Supply Curve Qd = Qs Quantity (Q) ALGEBRAIC REPRESENTATION OF EQUILIBRIUM If we have following demand and supply function Qd = 100 – 10 P Qs = 40 + 20 P © Copyright Virtual University of Pakistan 14 Introduction to Economics –ECO401 VU In equilibrium, Qd = Qs Therefore, 100 - 10P = 40 + 20P 20P + 10P = 100 - 40 30P = 60 P = 60/30 P=2 Putting the value of price in any of demand and supply equation, Q = 100 – 10x2 (or 40 + 20x2) Q = 100 – 20 Q = 80 The equilibrium price is 2 and the equilibrium quantity is 80 © Copyright Virtual University of Pakistan 15 Introduction to Economics –ECO401 VU Lesson 05 DEMAND, SUPPLY & EQUILIBRIUM ANALYSIS (CONTINUED) EQUILIBRIUM CAN SHIFT IF Demand Curve Shifts. Supply Curve Shifts. Both Shift. This gives rise to eight possibilities. These eight possibilities can be summarized as following: D Æ , S ~, PÇ QÇ D~,SÆ, PÈ QÇ DÆ,SÆ, P? QÇ DÅ,S~, PÈ QÈ D~,SÅ, PÇ QÈ DÆ,SÅ, PÇ Q? DÅ,SÆ, PÈ Q? DÅ,SÅ, P? QÈ The symbol “Æ” or “Ç” shows increase and the symbol “Å” and “È” shows a decrease while the symbol “~” shows that the particular thing remains same. NOTE: (Graphical illustration of all these possibilities is given in the video lecture) Points to note in these 8 possibilities: 1. Whenever the demand curve shifts the new equilibrium is obtained by moving along the supply curve. 2. Whenever supply curve shifts, the new equilibrium is obtained by moving along the demand curve. 3. Whenever both demand and supply curves shifts, we will move first on the demand curve and then along the supply curve. THE MARKET FOR BUTTER Question: What will happen to the equilibrium price and quantity of butter in each of the following cases? a. A rise in the price of the margarine. D Æ , S Å b. A rise in the demand for milk. S Æ; D Å ( if milk is a substitute ) c. A rise in the price of bread. D Å d. A rise in the demand of bread. D Æ e. An expected rise in the price of butter in near future. S Å D Æ f. A Tax on butter production. S Å g. An invention of a new, but expensive, process of removing all cholesterol from butter , plus the passing of law which states that all producers must use this process. D Æ S Å GOVERNMENT’S ROLE IN PRICE-DETERMINATION & EQUILIBRIUM ANALYSIS Identification problem is the problem of how to identify demand & supply curve. This problem arises when both price and quantity. Government can impact on equilibrium by two fundamental ways. The government may intervene in the market and mandate a maximum price (price ceiling) or minimum price (price floor) for a good or service. PRICE CEILING: A price ceiling is the maximum price limit that the government sets to ensure that prices don’t rise above that limit (medicines for e.g.). © Copyright Virtual University of Pakistan 16 Introduction to Economics –ECO401 VU If a price ceiling is placed below the market-clearing price, as Pc, the market-clearing or equilibrium price of Pe becomes illegal. At the ceiling price, buyers want to buy more than sellers will make available. In the graph, buyers would like to buy amount Q4 at price Pc, but sellers will sell only Q1. Because they cannot buy as much as they would like at the legal price, buyers will be out of equilibrium. The normal adjustment that this disequilibrium would set into motion in a free market, an increase in price, is illegal; and buyers or sellers or both will be penalized if transactions take place above Pc. Buyers are faced with the problem that they want to buy more than is available. This is a rationing problem. PRICE FLOOR: A price floor is the minimum price that a Government sets to support a desired commodity or service in a society (wages for e.g.). Price ceilings are not the only sort of price controls governments have imposed. There have also been many laws that establish minimum prices, or price floors. The graph illustrates a price floor with price Pf. At this price, buyers are in equilibrium, but sellers are not. They would like to sell quantity Q2, but buyers are only willing to take Q3. To prevent the adjustment process from causing price to fall, government may buy the surplus, If it does not buy the surplus, government must penalize either buyers or sellers or both who transact below the price floor, or else price will fall. Because there is no one else to absorb the surplus, sellers will. © Copyright Virtual University of Pakistan 17 Introduction to Economics –ECO401 VU RATIONING & SUPPLY SHOCKS (ALTERATION OF EQUILIBRIUM PRICE BY THE GOVT) There are two ways for this: 1. Through Tax : Tax (to be paid by the producer) will increase the Supply Price, Supply Curve shifts left ward, Price increases & quantity decreases. 2. Through Subsidy : Subsidy (given to the producer) will decrease the Supply Price, Supply Curve shifts rightward, Price decreases & quantity increases. SOCIAL COST Social cost is the cost of an economic decision, whether private or public, borne by the society as a whole. MARGINAL SOCIAL COST Marginal social cost is the change in social costs caused by a unit change in output. © Copyright Virtual University of Pakistan 18 Introduction to Economics –ECO401 VU EXERCISES Asif and Aasia’s “monthly” demand schedules for potatoes are given. Roughly draw these demand schedules on the same graph. Assume that there are 200 consumers in the market. Of these, 100 have schedules like Asif’s and 100 have schedules like Aasia’s. Complete the Total market demand (“monthly”) column in the table below? Price Asif Aasia Total market demand (pence (Qd in (Qd in (kg) per kg) kg) kg) 20 28 16 4400 40 15 11 2600 60 5 9 1400 80 1 7 800 100 0 6 600 100 90 80 70 60 Price in Rs/kg 50 40 Asif’s 30 demand Aasia’s 20 demand 10 0 0 5 10 15 20 25 30 Quantity demanded (kg per month) Assuming that demand does not change from month to month, how would you plot the annual market demand for potatoes? The amount demanded would be 12 times higher at each price. If the scale of the horizontal axis were unaltered, the curve would shift way out to the right. A simple way of showing the new curve, therefore, would be to compress the scale of the horizontal axis. (If each of the numbers on the axis were multiplied by 12, the curve would remain in physically the same position.) At what price is their demand the same? The two curves cross at a price of Rs50 per kg and at a demand of 10 kg per month. What explanations could there be for the quite different shapes of their two demand curves? One explanation could be that Asif is quite happy to eat rice, pasta or bread instead of potatoes. Thus when the price of potatoes goes up she switches to these other foods, and switches to potatoes when the price of potatoes comes down. Aasia, by contrast, may not see these other foods as close substitutes and thus her demand for potatoes will be less price sensitive. © Copyright Virtual University of Pakistan 19 Introduction to Economics –ECO401 VU Do all these the determinants of demand affect both an individual’s demand and the market demand for a product? All except the distribution of income in the economy. You are given a market demand curve for apples. Assume that the price of apples increases by 20 per cent at each price – due, say, to substantial increases in the prices of other substitute fruits. Plot the new demand curve for apples. Is the new curve parallel to the old one? See below. As you can see, the curves are not parallel. A constant percentage increase in quantity demanded gives a bigger and bigger absolute increase as quantity increases. 100 90 80 70 Price (Rs per kg) 60 50 40 New 30 demand 20 Old demand 10 0 0 100 200 300 400 500 600 700 800 900 Quantity demanded (kg per month) The price of lamb meat rises and yet it is observed that the sales of lamb meat increase. Does this mean that the demand curve for lamb meat is upward sloping? Explain. No not necessarily. For example, the price of substitutes such as beef or chicken may have risen by a larger amount. In such cases the demand curve for lamb meat will have shifted to the right. Thus although a rise in the price of lamb meat will cause a movement up along this new demand curve, more lamb meat will nevertheless be demanded because lamb meat is now relatively cheaper than the alternatives. A demand function is given by Qd = 10000 – 200P. Draw this in P-Qd space. What is it about the demand function equation that makes the demand curve in P- Qd space (a) downward sloping; (b) a straight line? a) The fact is that the 200P term has a negative sign attached to it. This means that as P rises, Qd falls. b) The fact is that there is no P to a power term. The demand curve thus has a constant slope of – 1/200. A demand function is given by Qd = a + bY, where Y is total income. If the term “a” has a value of – 50 000 and the term “b” a value of 0.001, construct a demand schedule with respect to Y. Do this for incomes between Rs100 million and Rs300 million at Rs50 million intervals. © Copyright Virtual University of Pakistan 20 Introduction to Economics –ECO401 VU Y (in Rs Qd (in 000s) millions) 100 50 150 100 200 150 250 200 300 250 Now use this schedule to plot a demand curve with respect to income. Comment on its shape. The curve will be an upward-sloping straight line, crossing the horizontal axis at –50 000. It would rise by 100 000 units for each Rs100 million rise in income. 300 Demand 250 Income (Rs millions 200 150 100 50 0 0 50 100 150 200 250 300 Quantity demanded Market dem and (with respect to income) What are the reasons which cause the market supply of potatoes to fall? Examples include: The cost of producing potatoes rises. The profitability of alternative crops (e.g. carrots) rises. A poor potato harvest. Farmers expect the price of potatoes to rise (short-run supply falls). For what reasons might the supply of leather rise? Examples include: The cost of producing leather falls. The profitability of producing mutton and chicken decreases. The price of beef rises (goods in joint supply). A long-running industrial dispute involving leather workers is resolved. Producers expect the price of leather to fall (short-run supply increases). This question is concerned with the supply of gas for home and office heating in winters. In each case consider whether there is a movement along the supply curve (and in which direction) or a shift in it (left or right). (a) New gas fields start up in production. (b) The demand for home heating rises. (c) The price of electric heating falls. (d) The demand for CNG for cars (produced in joint supply) rises. (e) New technology decreases the costs of gas production. (a) Shift right. (b) Movement up along (as a result of a rise in price). (c) Movement down along (as a result of a fall in price resulting from a fall in demand as people switch to electric heating). (d) Shift right (more of a good in joint supply is produced). (e) Shift right. © Copyright Virtual University of Pakistan 21 Introduction to Economics –ECO401 VU A supply function is given as Qs = c + dP, where “c” is 500 and “d” is 1000. Draw the schedule (table) and graph for equation for prices from Rs1 to Rs10. What is it in the equation that determines the slope of the supply ‘curve’? 10 9 Supply 8 7 6 Price 5 4 3 2 1 0 0 2000 4000 6000 8000 10000 Quantity supplied P (in Qs Rs) (units) 1 1500 2 2500 3 3500 4 4500 5 5500 6 6500 7 7500 8 8500 9 9500 10 10500 The graph is an upward sloping straight line crossing the horizontal axis at 500 units. The slope is given by the value of the d term: i.e. the slope is 1/1000 (for every Re1 increase in price, quantity supplied increases by 1000 units). Explain the process by which the price of houses would rise if there were a shortage. People with houses to sell would ask a higher price than previous sellers of similar houses (probably with the advice of an estate agent). Potential purchasers would be prepared to pay a higher price than previously in order to obtain the type of house they wanted. With a typical upward sloping market supply curve and downward sloping market demand curve, what would happen to equilibrium price and quantity if the demand curve shifted to the left? Both price and quantity will fall. You should be able to label two demand curves (e.g. D1 and D2), two equilibrium points (e.g. e1 and e2) corresponding prices Pe2 and Pe1 (Pe2 < Pe1), and quantities Qe2 and Qe1 (Qe2 > Qe1). What will happen to the equilibrium price and quantity of butter in each of the following cases? You should state whether demand or supply (or both) have shifted and in which direction. (In each case assume ceteris paribus.) (a) A rise in the price of margarine; (b) A rise in the demand for yoghurt; (c) A rise in the price of bread; (d) A rise in the demand for bread; (e) An expected rise in the price of butter in the near future; (f) A tax on butter production; (g) The invention of a new, but expensive, process for © Copyright Virtual University of Pakistan 22 Introduction to Economics –ECO401 VU removing all cholesterol from butter plus the passing of a law which states that all butter producers must use this process. a) Price rises, quantity rises (demand shifts to the right: butter and margarine are substitutes). b) Price falls, quantity rises (supply shifts to the right: butter and yoghurt are in joint supply). c) Price falls, quantity falls (demand shifts to the left: bread and butter are complementary goods). d) Price rises, quantity rises (demand shifts to the right: bread and butter are complementary goods). e) Price rises, quantity rises or falls depending on relative sizes of the shifts in demand and supply (demand shifts to the right as people buy now before the price rises; supply shifts to the left as producers hold back stocks until the price does rise). f) Price rises, quantity falls (supply shifts to the left). g) Price rises, quantity rises or falls depending on the relative size of the shifts in demand and supply (demand shifts to the right as more health-conscious people start buying butter; supply shifts to the left as a result of the increased cost of production). Are there any factors on the supply side that influence house prices? Yes. Although they are usually less important than demand-side factors, they are, nevertheless important in determining changes in house prices. The two most important are the expectations of the construction industry. If house building firms (contractors) are confident that demand will continue to rise, and with it house prices, they are likely to start building more houses. The resulting increase in the supply of houses (after the time taken to build them) will help to dampen the rise in prices. The other major supply-side factor is the expectations of house owners. If people think that prices will rise in the near future and are thinking of selling their house, they are likely to delay selling and wait until prices have risen. This (temporary) reduction in supply will help to push up prices even further. Draw a supply and demand diagram with the price of labour (the wage rate) on the vertical axis and the quantity of labour (the number of workers) on the horizontal axis. What will happen to employment if the government raises wages from the equilibrium to some minimum wage above the equilibrium? Firms’ demand for labour will shrink at the new higher wage rate. The supply of workers will rise as more workers would be willing to work (and work more hours) at the higher wage rate. There will thus be unemployment (a surplus of workers) at the minimum wage set. All economies have black markets in goods; whether this poses a serious problem is another matter. What would be the effect on black-market prices of a rise in the official price? Other things being equal, there would probably be a fall in the black-market price. A rise in the official price would cause an increase in the quantity supplied and a reduction in the quantity demanded and hence less of a shortage. There would therefore be less demand for black-market products. Will a system of low official prices plus a black market be more equitable or less equitable than a system of free markets? More equitable if the supplies at official prices were distributed fairly (e.g. by some form of rationing). If, however, supplies were allocated on a first-come, first-served basis, then on official markets there would still be inequity between those who are lucky enough or queue long enough to get the product and those who do not get it. Also, the rich will still be able to get the product on the black market! Think of some examples where the price of a good or service is kept below the equilibrium (e.g. rent controls). In each case consider the advantages and disadvantages of the policy. Two examples are: Rent controls. Advantages: makes cheap housing available to those who would otherwise have difficulty in affording reasonable accommodation. Disadvantages: causes a reduction in the supply of private rented accommodation; causes demand to exceed supply and thus some people will be unable to find accommodation. Tickets for a concert. © Copyright Virtual University of Pakistan 23 Introduction to Economics –ECO401 VU Advantages: allows the price to be advertised in advance and guarantees a full house; makes seats available to those who could not afford the free-market price. Disadvantages: causes queuing or seats are being only available to those booking well in advance. Primary and secondary schooling is free in state schools in most countries. If parents are given a choice of schools for their children, there will be a shortage of places at popular schools. What methods could be used for dealing with this shortage? What are their relative merits? Some form of rationing (selection) will have to be applied. This could be done on the basis of ability. If the objective is to have schools that cater for the full range of abilities, then this objective will not be met. If the objective is to recruit the most able children, then selection by ability is consistent with this goal. An alternative is to select by geographical location, with the students living nearer to the school being given preference over those living further away. This is the system used by most state schools. It could well disadvantage children with particular needs, however, for whom the school would be particularly suitable. Other methods include the ‘sibling’ rule, whereby children who have older brothers or sisters already at the school are given preference. This, however, could lead to children living nearer the school being deprived of a place. Under what circumstances would making a product illegal (a) cause a fall in its price; (b) cause the quantity sold to fall to zero. a) Where the shift in demand was greater than the shift in supply (perhaps because of very ‘law abiding’ consumers, or where consumers faced harsher penalties than suppliers. b) Where the penalties were very harsh and the law was strictly enforced, and/or where people were very law abiding. Can you think of any examples where prices and wages do not adjust very rapidly to a shortage or surplus? For what reasons might they not do so? ƒ Many prices set by companies are adjusted relatively infrequently: it would be administratively too costly to change them every time there was a change in demand. For example a mail order company, where all the items in its catalogue have a printed price, would find it costly to adjust prices very frequently, since that would involve printing a new catalogue, or at least a new price list. ƒ Many wages are set annually by a process of collective bargaining. They are not adjusted in the interim. Why do the prices of fresh vegetables fall when they are in season? Could an individual farmer prevent the price falling? Because supply is at a high level. The increased supply creates a surplus which pushes down the price. Individual farmers could not prevent the price falling. If they continued to charge the higher price, consumers would simply buy from those farmers charging the lower price. If you were the owner of a clothes shop, how would you set about deciding what prices to charge for each garment at the end of season sale? You would try to reduce the price of each item as little as was necessary to get rid of the remaining stock. The problem for shop owners is that they do not have enough information about consumer demand to make precise calculations here. Many shops try a fairly cautious approach first, and then, if that is not enough to sell all the stock, they make further ‘end of sale’ reductions later. The number of owners of CD players has grown rapidly and hence the demand for CDs has also grown rapidly. Yet the prices of CDs have fallen. How could this come about? The costs of manufacturing CDs may have fallen with improvements in technology and mass- production economies. Competition from increased numbers of manufacturers may have increased supply of CDs and driven prices down. The advent of copying tracks from the internet reduces the demand for CDs. This change in demand has further compounded the fall in price. Explain in words what is happening in the following diagram. © Copyright Virtual University of Pakistan 24 Introduction to Economics –ECO401 VU T h e p r ic e m e c h a n is m : t h e e f f e c t o f t h e d i s c o v e r y o f r a w m a t e r ia l s F a c to r M a rk e t Si ↓ Si ↑ s u rp lu s Pi ↓ u n t il D i = S i ( S i > D i) Di ↑ G o o d s M a rk e t Sg ↓ Pi ↓ Sg ↑ s u rp lu s Pg ↓ u n t il D g = S g (S g > D g) Dg ↑ The new discovery of raw material i means an increase in the supply i. This causes a surplus (excess supply) in the market for i, causing the price of i to fall until the same is removed (lower Pi causes demand to increase and supply to fall). The reduction in Pi also reduces the cost of producing good g (we can assume good g uses the factor i intensively), causing the supply of good g to increase beyond demand. The surplus in the market for good g drives the price of g down until the excess is cleared. The diagram illustrates interdependence between goods and factor markets. Can different factor markets be interdependent also? Give examples. Yes. A rise in the price of one factor (e.g. oil) will encourage producers to switch to alternatives (e.g. coal). This will create a shortage of coal and drive up its price. This will encourage increased production of coal. Similarly an increase in the population (and consequently size of the labour force) of a country will depress the price of labour (wages). This will cause producers to shift to more labour intensive production and reduce production methods which are capital (or machine) intensive. As a result the demand for capital will fall reducing its rental price. © Copyright Virtual University of Pakistan 25 Introduction to Economics –ECO401 VU Lesson 06 ELASTICITIES IMPORTANCE OF ELASTICITY IN OUR TODAY’S LIFE There is much more importance of the concept of elasticity in our life. ƒ The firm which uses advertising to change prices uses the concept of elasticity of demand of its product. ƒ Mostly firms set the prices of their product by viewing at the elasticity of demand of their product. ƒ The government collects revenues by imposing taxes. The good tax imposed by the government on the products is one for which either demand is inelastic or the supply is inelastic. ƒ So if the government wants to put tax burden on the consumers then it will choose the product to tax with low price elasticity of demand. ƒ And if government wants to panelize the producers then it must choose the product with low price elasticity of supply. ELASTICITY Elasticity is a term widely used in economics to denote the “responsiveness of one variable to changes in another.” In proper words, it is the relative response of one variable to changes in another variable. The phrase "relative response" is best interpreted as the percentage change. TYPES OF ELASTICITY There are four major types of elasticity: Price Elasticity of Demand Price Elasticity of Supply Income Elasticity of Demand Cross-Price Elasticity of Demand Price Elasticity of Demand: Price elasticity of demand is the percentage change in quantity demanded with respect to the percentage change in price. Price elasticity of demand can be illustrated by the following formula: PЄd = Percentage change in Quantity Demanded Percentage change in Price Where Є = Epsilon; universal notation for elasticity. If, for example, a 20% increase in the price of a product causes a 10% fall in the Quantity demanded, the price elasticity of demand will be: PЄd = - 10% = - 0.5 20% Price Elasticity of Supply: Price elasticity of supply is the percentage change in quantity supplied with respect to the percentage change in price. Price elasticity of supply can be illustrated by the following formula: PЄs = Percentage change in Quantity Supplied Percentage change in Price If a 15% rise in the price of a product causes a 15% rise in the quantity supplied, the price elasticity of supply will be: PЄs = 15 % = 1 15 % © Copyright Virtual University of Pakistan 26 Introduction to Economics –ECO401 VU Income Elasticity of Demand: Income elasticity of demand is the percentage change in quantity demanded with respect to the percentage change in income of the consumer. Income elasticity of demand can be illustrated by the following formula: YЄd = Percentage change in Quantity Demanded Percentage change in Income If a 2% rise in the consumer’s incomes causes an 8% rise in product’s demand, then the income elasticity of demand for the product will be: YЄd = 8% =4 2% Cross-Price Elasticity of Demand: Cross price elasticity of demand is the percentage change in quantity demanded of a specific good, with respect to the percentage change in the price of another related good. PbЄda = Percentage change in Demand for good a Percentage change in Price of good b If, for example, the demand for butter rose by 2% when the price of margarine rose by 8%, then the cross price elasticity of demand of butter with respect to the price of margarine will be. PbЄda = 2% = 0.25 8% If, on the other hand, the price of bread (a compliment) rose, the demand for butter would fall. If a 4% rise in the price of bread led to a 3% fall in the demand for butter, the cross-price elasticity of demand for butter with respect to bread would be: PbЄda = - 3% = - 0.75 4% WHY WE USE PERCENTAGE CHANGE RATHER THAN ABSOLUTE CHANGE IN ELASTICITY? 1. By using percentage changes and proportions we can avoid the problem of comparison in two different quantitative variables i-e Qd is measured in units and Price is measured in rupees. So by calculating percentages we can avoid the problem of unit conversion into rupees. 2. It helps us avoid that of what size of units to be changed i-e A jump from Rs.2 to Rs.4 could be described as a 100% increase or as an increase of Rs.2. but by using percentages we can avoid this problem because both gives the same answer. 3. It also helps how to define big or small changes. By looking at Rs.2 or Rs.4, we can’t say that it is a big change or a small change. But if we translate it in the form of percentages then it becomes 100% which is a big change. ELASTIC AND INELASTIC DEMAND Slope and elasticity of demand have an inverse relationship. When slope is high elasticity of demand is low and vice versa. When the slope of a demand curve is infinity, elasticity is zero (perfectly inelastic demand); and when the slope of a demand curve is zero, elasticity is infinite (perfectly elastic demand). Unit elasticity means that a 1% change in price will result in an exact 1% change in quantity demanded. Thus elasticity will be equal to one. A unit elastic demand curve plots as a rectangular hyperbola. Note that a straight line demand curve cannot have unit elasticity as the value of elasticity changes along the straight line demand curve. © Copyright Virtual University of Pakistan 27 Introduction to Economics –ECO401 VU Elastic demand curve Inelastic demand curve TOTAL REVENUE AND ELASTICITY Total revenue (TR) = Price x Quantity (P x Q) Elastic demand means when price of any product increases, its demand decreases more than the increase in price. As price increases total revenue decreases in case of elastic demand. Inelastic demand of any product means that if price of that product increases there is very small effect on its quantity demanded. As price increases, total revenue also increases in case of inelastic demand. For example, flour is the basic necessity of life for all people. Its demand is inelastic. As the price of flour increases, its quantity demanded does not decrease much because people have to use flour in all situations whether its price is high or low. EXAMPLE OF 2 FIRMS Firm 1: (Inelastic demand curve) For inelastic demand curve, firm increases its prices but quantity demanded does not change as much. Increase in price is greater while the decrease in quantity is smaller. So firm will earn more revenues by increasing prices. So TR increases as the price increases. © Copyright Virtual University of Pakistan 28 Introduction to Economics –ECO401 VU Price 10 F Inelastic demand curve 6 T 0 90 100 Quantity Demanded Є = percentage change in Qd Percentage change in P = 90 – 100 ÷ 10 – 6 100 6 = - 0.15 In the above figure, Elasticity for firm 1 is equal to -0.15; it is less than 1 (ignoring minus sign) which shows that the demand curve is inelastic. Firm 2: (Elastic demand curve) For elastic demand curve, firm does not increase its prices. Because as prices increases, quantity demanded decreases much larger. Decrease in quantity demanded is greater than the increase in prices. So firm will earn less revenue. So TR decreases as price increases. Price 10 Elastic demand curve 7 U Z 6 0 40 100 Quantity Demanded Є = percentage change in Qd Percentage change in P = 40 – 100 ÷ 7 – 6 100 6 = - 3. 6 In the above figure elasticity for firm 2 is -3.6; it is greater than 1 (ignoring minus sign) which shows that the demand curve is elastic. ELASTICITY BETWEEN TWO POINTS Elasticity can also be calculated between two points. Figure: © Copyright Virtual University of Pakistan 29 Introduction to Economics –ECO401 VU Price 10 Elastic demand curve 8 K L 6 0 8 16 Quantity Demanded In this figure, elasticity from point K to L is -4. ЄKL = percentage change in Qd Percentage change in P = 16– 8 ÷ 6 – 8 8 8 = -4 Since absolute value is greater than 1 so it is elastic. Similarly we can also calculate for inelastic demand curve. Arc Elasticity Arc elasticity measures the “average” elasticity between two points on the demand curve. The formula is simply (change in quantity/change in price)*(average price/average quantity). To measure arc elasticity we take average values for Q and P respectively. Point Elasticity Point elasticity is used when the change in price is very small, i.e. the two points between which elasticity is being measured essentially collapse on each other. Differential calculus is used to calculate the instantaneous rate of change of quantity with respect to changes in price (dQ/dP) and then this is multiplied by P/Q, where P and Q are the price and quantity obtaining at the point of interest. The formula for point elasticity can be illustrated as: Є=∆Q x P ∆P Q Or this formula can also be written as: Є= dQ x P dP Q Where d = infinitely small change in price. If elasticity = zero then demand curve will be vertical. If elasticity is infinity then the demand curve will be horizontal. POINT ELASTICITY FOR QUADRATIC DEMAND FUNCTION The quadratic demand function is Qd = 60 – 15P + P2 Assume different values of price e-g from 0 to 10. Put these values in this equation and find out the quantity demand. Here we take price from 0 to 3. © Copyright Virtual University of Pakistan 30 Introduction to Economics –ECO401 VU P 60 -15P P2 Qd = 60 – 15P + P2 0 60 0 0 60 1 60 -15 1 46 2 60 -30 4 34 3 60 -45 9 24 Then draw a figure, plot prices on vertical axis and quantity on horizontal axis. The resulting curve will be downward sloping curve. 7 6 5 4 3 2 1 0 0 20 40 60 80 To find the point elasticity of demand from this quadratic equation, differentiate it with respect to price, Qd = 60 – 15P + P2 dQ/dP = -15 + 2P IF P=3 then dQ/dP = -15 + 2(3) = -15 + 6 = -9 And Qd = 60- 15(3) + (3)2 = 24 The formula of elasticity = (dQ / dP) (P/Q) = -9 (3/24) = -1.125 Its absolute value (ignoring minus sign) is greater than one so it is point elastic. © Copyright Virtual University of Pakistan 31 Introduction to Economics –ECO401 VU Lesson 07 ELASTICITIES (CONTINUED) INELASTIC DEMAND 0< Є < 1 Price rises: As P increases, Q decreases Percentage change in P > percentage change in Q Now TR = P x Q TR will also increase Price falls: As P decreases, Q increases Percentage change in P > percentage change in Q Now TR = P x Q TR will also decrease ELASTIC DEMAND Є > 1 Price rises: As P increases, Q decreases Percentage change in P < percentage change in Q Now TR = P x Q TR will also decrease Price falls: As P decreases, Q increases Percentage change in P < percentage change in Q Now TR = P x Q TR will also increase UNIT ELASTIC DEMAND Є = 1 Price rises: As P increases, Q decreases Percentage change in P = percentage change in Q. Now TR = P x Q TR will remain unchanged. Price falls: As P decreases, Q increases Percentage change in P = percentage change in Q. Now TR = P x Q TR will remain unchanged. TABLE OF UNITARY ELASTICITY P Q TR 2.5 400 1,000 5 200 1,000 10 100 1,000 20 50 1,000 40 25 1,000 The curve of unitary elastic demand will be a hyperbola. DETERMINANTS OF PRICE ELASTICITY OF DEMAND 1. Number of close substitutes within the market - The more (and closer) substitutes available in the market the more elastic demand will be in response to a change in price. In this case, the substitution effect will be quite strong. 2. Percentage of income spent on a good - It may be the case that the smaller the proportion of income spent taken up with purchasing the good or service the m