CB2 Business Economics Past Exam Questions & Solution PDF

0 CB2 BUSINESS ECONOMICS PAST EXAM QUESTIONS & SOLUTION  1 CB2- BUSINESS ECONOMICS SYLLABUS 1. Economic Models and Recent historical applications...

0 CB2 BUSINESS ECONOMICS PAST EXAM QUESTIONS & SOLUTION  1 CB2- BUSINESS ECONOMICS SYLLABUS 1. Economic Models and Recent historical applications → 10% 2. Microeconomics → 45% → behaviour of consumer; firms, markets 3. Macroeconomics → 45%  relationship between govt, mkt, firms 100%  govt policies  international made Paper Pattern  26 MCQ of 1.5 marks each 39  Approximate 10 short answer questions (2-6 marks each) 41  2 long questions (10 each) 20 100 marks We take references from ‘Economics for Business’ by John Sloman, Dean Garatt, & Jon Guest. EXHAUSTIVE NOTES PREPARED BY CT7 ALL INDIA RANK 1 SHIVANGEE AGARWAL  2 INDEX CHAPTER PAGE TOPIC NO. NO. 1. Economic Concepts and Systems 1.1 Economics and Global Issues 6 1.2 What Economists study 9 1.3 Different Economic Systems 15 2. Supply and Demand (1) 2.1 Demand 19 2.2 Supply 22 2.3 Price and output determination 24 3. Supply and Demand (2) 3.1 Price elasticity of demand (PED) 29 3.2 Other elasticities 37 3.3 The time dimension 40 3.4 The control of prices 45 3.5 Indirect taxes and subsidies 47 4. Background to Demand 4.1 The marginal utility theory 50 4.2 The timing of costs and benefits 54 4.3 Indifference Analysis 55 4.4 Demand under conditions of risk and uncertainty 63 4.5 Behavioural economics 68 5. Background to supply 5.1 The short run theory of production 81 5.2 Costs in the short run 85 5.3 The long run theory of production 88 5.4 Costs in the long run 92 5.5 Revenue 94 5.6 Profit maximisation 97 6. Perfect competition and Monopoly 6.1 Alternative market structures 101 6.2 Perfect competition 102 6.3 Monopoly 109 6.4 The theory of contestable markets 115  3 7. Monopolistic Competition and Oligopoly 7.1 Monopolistic competition 118 7.2 Oligopoly 121 7.3 Game theory 129 8. Pricing Strategies 8.1 Cost based pricing and limit pricing 133 8.2 Price discrimination 134 8.3 Price discrimination in Financial Services 138 8.4 Multiple product pricing 139 8.5 Pricing and the product life cycle 141 9. Market Failure and Government Intervention 9.1 Efficiency under perfect competition 144 9.2 The case for government intervention 148 9.3 Forms of government intervention 155 9.4 Government failure and the case for the market 161 9.5 Competition policy 164 9.6 Economics of the Environment 170 10. The Macroeconomic Environment 10.1 An overview of key macroeconomic issues 178 10.2 The circular flow of income 180 10.3 Measuring national income and output 182 10.4 The AD-AS model 185 11. Macroeconomic Objectives 11.1 The business cycle 187 11.2 Unemployment and the labour market 190 11.3 Inflation and the AD-AS model 196 12. International Trade and Payments 12.1 The advantages of trade 202 12.2 Arguments for restricting trade 210 13. Balance of Payments and Exchange rates 13.1 The Open Economy 217 14. The Financial System and The Money Supply 14.1 The definition, role and evolution of the financial system 224 14.2 The financial system 230 14.3 The history and consequences of banking crises 239  4 14.4 The meaning and functions of money 242 14.5 Bitcoin and other Cryptocurrencies 242 15. The Money Market and the Monetary Policy 15.1 The Supply of Money 244 15.2 The Money Market Model 248 15.3 Monetary policy 253 16. Main Strands of Economic Thinking 261 17. Classical and Keynesian Theory 17.1 Classical theory 266 17.2 The Keynesian revolution 270 17.3 Background to Keynesian theory 274 17.4 The determination of national income 281 17.5 The simple Keynesian analysis of unemployment and inflation 286 17.6 Keynesian Analysis of the Business Cycle 289 18. Relationship between the Goods and Money Markets 18.1 The effects of monetary changes on national income 294 18.2 The monetary effects of changes in the goods market 302 18.3 The IS-MP model 305 19. Monetarist and New Classical Schools, and Keynesian Responses 19.1 The Monetarist school 313 19.2 The new classical school 315 19.3 The EAPC and the inflation unemployment relationship 318 19.4 Inflation and unemployment: the monetarist perspective 321 19.5 Central banks and inflation targeting 325 19.6 The Keynesian response 332 20. Supply Side Policy 20.1 Approaches to supply side policy 336 20.2 Supply side policies in practice: market-oriented policies 338 20.3 Supply side policies in practice: interventionist policies 342 21. Demand Side Policy 21.1 Fiscal policy and the public finances 346 21.2 The use of fiscal policy 350 21.3 The policy making environment 356 22. Exchange Rate Policy 22.1 Alternative exchange rate regimes 358 22.2 Fixed exchange rates 365  5 22.3 Freely floating exchange rates 367 22.4 Exchange rate systems in practice 372 23. Global Harmonisation and Money Union 22.1 Globalisation and the problem of instability 376 22.2 European economic and monetary union (EMU) 379 24. Summary on debates on Theory and Policy 24.1 A timeline revisited 385 24.2 The macroeconomic environment and debates 386 24.3 An emerging consensus up to the crisis of 2008 389 24.4 The financial crisis and the search for a new consensus 390  6 1.1 ECONOMICS AND GLOBAL ISSUES COVID-19 and the global health emergency The COVID-19 pandemic dominated our lives during 2020 and 2021 and beyond. People and governments struggled to cope with illness and death, and the damage to lives and livelihoods. The impact on developing countries was particularly harsh. According to the World Bank, in 2020 alone the pandemic may have pushed around 100 million people into extreme poverty. Everyone was faced with choices and these affected behaviour. Most of these had an economic dimension. In- deed, economics studies the choices we make as individuals, firms, societies or governments. INDIVIDUAL CHOICES People had to decide whether to follow the rules and advice about behaviour (e.g. whether to wear a face mask or socially distance). Some decided to follow lockdowns; others were ready to break or bend the rules. Econom- ics studies people’s behaviour – and how it impacts on economic decisions and the economy. For example, early on in the pandemic, many people stockpiled various items, such as hand sanitiser, toilet rolls and dried foods. This caused many shops to run out, which only further encouraged panic buying. Some shops responded by raising prices to increase their profit margins. The lockdowns affected firms’ profits. Some sectors were particularly hard hit, such as hospitality, leisure and tourism. Many suppliers found that their sales revenues had dried up as they were forced to close down, while others adjusted by trying to sell more online. Firms had to choose whether to give up or carry on. On the plus side, some of their costs had fallen, such as heating and lighting and staff costs; we call these ‘varia- ble costs’. Other costs, however, such as rent, rates and interest charges generally did not fall; we call these ‘fixed costs’. Profits would have become losses if the government had not provided substantial support, which was still not enough to prevent many firms going out of business. Some managed to defer fixed costs, but these would have to be paid later – another difficult choice whether or not to give up. And the pandemic hastened the move to online sales and away from the High Street, leading to the demise of many large chains of shops such as Arcadia, Laura Ashley and Debenhams. Others, such as John Lewis, closed a number of branches. Across the UK, some 17 500 chain-store outlets were permanently closed in 2020. In con- trast, sales of online retailers such as Boohoo and Asos boomed.  7 As far as employees were concerned, some were easily able to work from home with a separate room to work in and a good Internet connection. They also saved money on commuting costs. Others with childcare responsibili- ties and shared working spaces and/or devices struggled to work efficiently from home. Some found their in- comes constant or even rising; others saw a fall or had to rely on furlough money from the government. Most had little power in such a situation and had to accept the wages determined by the changing market environment. Then vaccines began to be rolled out. Most people embraced getting jabbed to protect them and their loved ones. Others were suspicious for various reasons. But here was a classic problem in economics: what we do for our-selves often has spillover effects on others. If we are not protected, we are more likely to catch the disease and pass it on to others, even if we only get infected mildly or are largely asymptomatic. Many actions we take affect others – either beneficially or adversely. These can be as simple as whether to wear a face mask. So should the government constrain our actions? This is another key choice that has to be made and economists can help analyse these choices and identify their costs and benefits. GOVERNMENT CHOICES The pandemic did not just affect individuals and firms; it had major effects on whole economies. With many firms being forced to shut down, even if only temporarily, and some sectors, such as public transport, facing a collapse in demand, economies around the world went into recession – economic growth was negative. The UK was particularly badly hit at first, partly from the choice made by the government to delay locking down. National output (known as ‘gross domestic product’ or ‘GDP’) fell by nearly 10 per cent in 2020. Unem- ployment rose. The government responded by massively increasing spending by supporting individuals through the furlough scheme, whereby 80 per cent of the wages of those temporarily laid off were covered by the government and distributed through their employers. Other support was given to businesses and to the self-employed. This prevented unemployment from rising much further. Other longer-term measures for recovery included large-scale spending on physical infrastructure, such as public transport, roads, green energy and broadband, and on public services, such as health and education. In the USA, President Biden introduced a $3 trillion programme of infrastructure spending to boost a green recovery. This followed a $1.9 trillion programme of support for vulnerable people and businesses to survive the pandemic But the massive support came at a cost. Government spending on support schemes plus a decline in tax reve- nues meant that government borrowing soared. In the UK, annual public-sector net borrowing rose from 2.6 per cent of GDP in 2019 to nearly 17 per cent in 2020, so adding to the total stock of public-sector debt, pushing it up from 84.4 per cent in 2019 to just over 100 per cent in 2020 – and forecast to rise to nearly 110 per cent by 2023. The government has to finance the borrowing through paying interest from taxes (or even more borrowing). So the government was faced with a choice about when to start raising taxes or cutting government spending to reduce the level of borrowing. This was a hard choice and the plan, announced in the 2021/22 Budget, was to raise taxes on business profits (‘corporation tax’) and to freeze income tax thresholds from April 2023. Similar dilemmas were faced by governments around the world. The general approach was to spend now and pay later – an easy choice at the time, but a difficult one later, especially for governments facing re-election.  8 It was not just governments that were trying to keep their economies going. Central banks, such as the Federal Reserve in the USA, the European Central Bank for the eurozone and the Bank of England for the UK, were also playing their part. The general approach was to create more electronic money, through a process of ‘quantita- tive easing’. If there was more money circulating through the banking system, people would borrow and spend more, helping to boost businesses. But when you turn on the ‘money tap’ like this, you have to choose how much money to create and when to turn the tap off. Too little money and the recession may persist; too much money and prices may be pushed up by soaring spending. This ‘inflation’, as it is called, creates other problems for the economy, and central banks are keen not to let it go above 2 per cent per annum. Give some other examples of choices that governments had to make during the pandemic. To what extent were they economic choices? Getting all these economic choices right was a hard thing for individuals, businesses and governments. Economists had a crucial role in analysing the effects of these choices and advising on the best courses of action. The Environment and the Global Climate Emergency So can economists play a central role in addressing the climate emergency? The answer is ‘yes’ at many levels. Climate scientists can model the causes and effects of global warming. However, to address the problem and cut emissions to reach carbon neutrality and stop global warming – or at least limit it to 1.5°C above pre-industrial levels, which is the objective of the Intergovernmental Panel on Climate Change (IPCC) – then choices have to be made. As we saw when looking at the coronavirus pandemic in the context of vaccination, people’s actions affect oth- ers. Perhaps nowhere is this more crucial than with the environment. When people burn fossil fuels in their boilers or their cars, or buy goods which have travelled half way across the world on fossil-fuel hungry ships and planes, this affects others; not just themselves. At an individual level, therefore, people need to think and behave ‘green’. But what are the mechanisms for achieving this? Apart from education and developing greater social responsibility, pricing is key. If renewable energy were cheaper and fossil fuels were more expensive, then people would be more willing to switch to low- carbon consumption. Indeed, pricing is a central issue in economics. But how can prices be altered? They can be reduced by government subsidies and raised by taxes. There are other methods too by which pricing can be used. One of these is emissions trading. This is where permits to emit CO2 are allocated or auctioned to businesses, which can then trade them in markets. Low emitters will not have to pay so much, thereby giving them a cost advantage over high emitting companies, which will require more permits and hence have to pay more. Economists have played a key role in developing emissions trading in markets such as the EU Emissions Trading Scheme (EU ETS). THE ISSUE OF FAIRNESS One of the key issues in economics is how to achieve a fair distribution of income and wealth, both today and over time. One area where this is vitally important is the environment. How can the world fairly share the costs and benefits of creating a low-carbon economy? If it fails, politicians will face a backlash from people who see their jobs and incomes under threat. Young people will blame the old for taking more than their fair share and degrading the environment in the process. The problem is that change normally involves gainers and losers – a central dilemma in economics. Green investment may create jobs in alternative  9 energy generation but result in jobs being lost in coal mining and heavy industry. And when there are groups of losers, populist politicians can use the resulting anger to drive wedges in society and turn people against tack- ling climate change – something that is easier if they can deny its existence. International Action: We live in an interdependent world. Actions in one part of the globe affect lives in oth- ers. If the rich countries are big carbon emitters, this affects people in poor countries too. Their lives may be more vulnerable to climate change and its impact on the weather and harvests. Economists play a large role in studying the trading between nations and how economic power affects patterns of trade and investment. Multinational companies often drive intensive farming and mining in developing countries, and the effects on the environment in these countries can be devastating. Rainforests are cut down for mining, ranching or grow- ing monocrops, such as palm oil plantations. And not only is the devastation confined to these countries: as well as hugely diminishing biodiversity, they contribute to global warming as the ‘lungs of the world’ are destroyed. From 2010 to 2019, in Brazil’s Amazon basin 16.6 billion tonnes of CO2 were released into the atmosphere from burning or destroying forest, or replacing it with plantations. Yet only 13.9 billion tonnes were drawn down through photosynthesis and new growth. Actions by the global community can help but very often there are international games being played, with coun- tries often unwilling to commit to carbon-reducing measures unless they can be convinced that other countries are playing their part too. Economists study these types of ‘games’. Indeed there is a major branch of economics called ‘game theory’, which looks at effective ways of incentivising people, firms and governments to behave in co-operative ways. 1.2 WHAT ECONOMISTS STUDY Problem of Scarcity: Human wants > What actually can be produced. ↓ To deal with this Efficiency - Fully & efficiently employed resources. Fair Allocation- Rational choice and fair allocation of resources. ↓ leads to Full Potential output achieved and increased over time  10 Economic Systems: (i) Command- state makes decision (ii) Free Market Economies – market forces (demand/supply) (iii) Mixed – mixture of the above two Some key terms Production: Is the transformation of inputs into outputs by firms in order to earn profits (or meet some other objectives). Consumption: is the art of using goods and services to satisfy wants. This will normally involve purchasing the goods and services. Firms uses three categories of inputs, resources and factors of production to produce outputs, normally goods & services. These are: 1. Labour: all forms of human input (both mental and physical) into production (human resources) 2. Land and raw materials: all naturally occurring resources e.g. oil, cotton (natural resources) 3. Capital: manufactured resources, e.g. factories, computers. Scarcity: is the excess of human wants over what can be produced to fulfill these wants. Since resources are scarce, choice have to be made between different alternatives, e.g. consumers must choose which goods & ser- vices to consume, while firms must choose which goods/services to produce. Macroeconomics: is concerned with the economy as a whole and studies economic aggregates, such as na- tional income, unemployment and general level of prices. Aggregate demand: the total level of spending in the economy, by consumers, firms and the government. Aggregate supply: the total amount of output (goods & services) in the economy. Microeconomics: is concerned with individual parts of the economy (e.g. households, firms and industries) and the way they interact to determine the pattern of production and distribution of goods and services. Inflation: refers to a general rise in the level of prices throughout the economy. The rate of inflation refers to percentage increase in level of prices over a 12 months period. Recession: is a period where national output falls, i.e. economic growth is negative. According to official defini- tion, a recession occurs if output declines for two or more consecutive years. Balance of Trade: A part of Balance of Payments (records a country’s transactions with rest of the world), which is export of goods and services minus imports of goods and services. If Export>Imports → Trade Surplus; If Imports > Exports → Trade Deficit.  11 Unemployment: The number of people of working age who are actively looking for a job/work but are cur- rently without a job. Demand–side policy seeks to influence the level of spending and hence aggregate demand. For example, the government might try to boost spending by:  cutting taxes  increasing government spending  reducing interest rates. It will also indirectly affect output, employment and prices. Supply–side policy seeks to influence the level of production directly and were aggregate supply. For exam- ple, the government might:  introduce tax incentives for investments or for people to work harder.  introduce new training schemes.  build new motorways. Opportunity Cost: Firms and consumes both face choices between activities, e.g. producing or consuming dif- ferent types of goods. The opportunity cost of an activity is measured in terms of next best alternatives fore- gone. Ex- the opportunity cost of putting some money into your pension scheme is the current spending you do without. Rational choice: is one that involves weighing up the benefit of an activity against its opportunity cost. Rational decision making: involves weighing up marginal benefit of an activity and marginal cost. Marginal Cost: For a firm, it is the additional cost of producing one more unit of output. For an individual, it is additional cost of a little bit more of a particular activity. Marginal Benefit–For a firm, it is the additional benefit of producing one more unit of output. For an individ- ual, it is additional benefit of a little bit more of a particular activity. If MB > MC,  Firm would increase profit by increasing output by one unit, or  Individual would increase ‘net total benefit’ by doing a little more of a particular activity (consume one more unit of good). Economic Efficiency: A situation where each good is produced at the minimum cost and where individual people and firms get the maximum benefit from their resources. Efficiency in:  Production  Consumption Allocative  Specialisation and Exchange Efficiency  12 Productive Efficiency: A situation where firms are producing the maximum output for a given amount of in- puts, or producing a given output at the least cost. Allocative Efficiency: A situation where the current combination of goods produced and sold gives the maxi- mum satisfaction for each consumer at their current level of income. Note: that a redistribution of income would lead to a different combination of goods that was allocatively efficient. Equity: A distribution of income that is considered to be fair and just. Note that an equitable distribution is not the same as an equal distribution and that different people have different views on this. Production Possibility Curve: A curve showing all possible combination of two goods that a country can pro- duce within a specified time period with all its resources fully and efficiency employed. Increasing opportunity cost of production: When additional production of one good involves ever increasing sacrifices of another. Investment–The production of items that are not for immediate consumption. Barter Economy: An economy where people exchange goods and services directly with one another without any payment of money. Workers to be paid with bundles of goods. Market: Interaction between buyers and sellers. Full Employment of Resources and Growth Because scarcity exists, societies are concerned that their resources should be used as fully as possible and over time their national output should grow. Why grow? If output grows, then more of our wants can be satisfied. Individuals and society can be made better off. The achievement of growth and full use of resources is not easy. Furthermore, attempts by government to stimulate growth and employment can result in inflation and rising imports. Economics have often experienced cycles where periods of growth alternate with periods of recession. This is called ‘Business Cycles’, which lasts for a few months or few years. Main Microeconomic Choices Because resources are scarce, choices have to be made. Three main categories of choices that must be made are:  What goods and services are going to be produced and in what quantities, since there are not enough resources to satisfy all human wants. Ex- how many cars, how much wheat etc.  How are things going to be produced? What resources are going to be used and in what quantities? What techniques are going to be used?  For whom are things going to be produced? How will country’s income will be distributed. What will be the wages of shop workers MPs, footballers, etc.  13 Circular Flow of Income  Firms pay income to households in return for use, of factors of production owned by households.  Households spend their incomes on goods and services produced by firms – this represents income of firms.  Circular flow of income → goods & services.  Microeconomic questions – How, what and for whom.  Macroeconomic questions – Total size. Production Possibility Curve Units of Food (in millions) Units of Clothing (in millions) 8.0 0.0 7.0 2.2 6.0 4.0 5.0 5.0  14 4.0 5.6 3.0 6.0 2.0 6.4 1.0 6.7 0.0 7.0 This table gives the maximum possible combinations of food and clothing that can be produced in a given pe- riod of time. Two assumptions–  Only two types of goods (foods & clothing) are produced using all resources (land, labour, and capital)  There is only one type of food and one type of clothing. With all resources devoted to only food, the country can make 8 million of food and no clothing. By producing 7 million of food, it could release enough amount of resources to produce 2.2 million of clothing. The curve shows all combinations of the two goods that can be produced with all the nation’s wealth and re- sources fully and efficiently employed. For example, production can take place at point x, but cannot take place at point w: the nation doesn’t have enough resources to do the same. Microeconomic and PPC If a country chooses to produce more of clothing, it would have to sacrifice the production of some food. This sacrifice of food is the opportunity cost of extra clothing. The fact that to produce more of one good involves producing less of other good is illustrated by the downward sloping nature of curve. For example: At point y country is producing 5 million of food and clothing. To move to point Z (extra 0.6 mil- lion of clothing) it will have to reduce food by 1 million. Thus, the opportunity cost of the 0.6 million of clothing would be 1 million units of food forgone. Increasing opportunity cost: As country produces more of one good it has to sacrifice, ever – increasing amount of other. The reason is that different factors of production have different properties. Thus, if a country concentrates more on the production of one good, it has to start using resources that are less suitable – re- sources that would have been better suited to producing other goods (growing marginal cost).It is because of the increase in opportunity costs that the PPC is bowed outward rather than being a straight line (concave to origin).  15 Macroeconomic and PPC There is no guarantee that country uses resources fully, or they have been using it in the most efficient way possible. The nation may thus be producing at a point inside the curve – for ex point v i.e. less of both the goods. By using its resources to the full, the nation could move out onto the curve: to point x or y. It could produce more clothing and more food.  Microeconomic issue – combinations of goods produced.  Macroeconomic issue – total amount produced is as much as it could be. Over time production possibility of nation are likely to increase. Investment in new plant & machinery, discov- ery of new materials, technological advancements. The growth in potential output is illustrated as - 1.3 DIFFERENT ECONOMIC SYSTEMS Centrally Planned or Command Economy–An economy where all economic decisions are taken by central authorities. Free Market Economy: An economy where all economic decisions are taken by individual households and firms, with no government intervention.  16 Mixed Economy: An economy where economic decisions are made partly by the government and partly through market. In practice all economics are mixed. Informal Sector: The parts of the economy that involve production and/or exchange, but there are no money payments. Ex-activities taking place in home like cooking, cleaning etc. Subsistence Production: When people produce things for their own consumption. Ex– people growing their own food. Input – Output Analysis: This involves dividing the economy into sectors, where each sector is a user of inputs from and a supplier of outputs to other sectors. The technique examines how these inputs and outputs can be matched to the total resources available in the economy. Price Mechanism: The system is a market economy whereby changes in price in response to change in de- mand and supply have the effect of making demand equal to supply. Equilibrium: A position of balance. A position from which there is no inherent tendency to move away. Equilibrium Price: The price where the quantity demanded equals quantity supplied: price where there is no shortage or surplus. Mixed Market Economy: A market economy where there is some government intervention. Relative Price: The price of one good compared with another. Allocation of Resources and Distribution of Output- Command Economy:  It plans the allocation of resources between current consumption and future investment. The amount of resources if chooses to denote to investment will demand on its broad macroeconomic strategy: the importance it attaches to growth as opposed to current consumption.  At microeconomic level, it plans the output of each industry and firm, the techniques that will be used and the labour and other resources required by each industry and firm(planned demand = planned supply).  Distribution of goods / output to consumers according to aim of government. (i) Judgement of people’s needs. (ii) Give more to those who produce more (incentive to work hard).  Distribute directly by rationing.  Distribute money incomes and allow individuals to decide how to spend it. Free Market Economy: Individual are free to make their own economic decisions. Consumers are free to decide what to buy with their income. Firms are free to choose what to sell and which methods to use. These are reflected on price which changes continuously to reach an equilibrium.  17 Advantages & Disadvantages of Command Economy  The larger and more complex the economy, the greater the task of collecting and analysing the informa- tion essential to planning – increases the cost and bureaucracy.  If there is no system of prices, or if prices are set arbitrarily by the state, planning is likely to involve in- efficient use of resources. E.g. – How can a rational decision be made between an oil-fired and coal-fired furnace if prices of oil and coal do not reflect their relative scarcity.  It is difficult to device appropriate incentives for workers to encourage them to be more productive without reduction in quality.  Complete state control over resource allocation would involve a considerable loss of individual liberty. (i) No choice for workers: where to work. (ii) No choice for consumers: what to buy.  If production is planned and consumers are free to spend money income as they wish, there will be a problem if the wishes of consumers change. Free Market Economy  No need of complex, costly bureaucracies to coordinate economic decisions.  Economy responds quickly to changing demand and supply conditions.  (a) Firms combine factors of production efficiently to increase profits (b) More efficiently workers work, higher their wages. (c) Consumers carefully decide what to buy to achieve greater value of money. These help to minimize central economic problems (private gain results in social good).  Power and property may be unequally distributed(e.g.-unions, landlords, big business houses)  Competition between firms is often limited.  Consumers and firms may not have full information about costs and benefits → bad decisions.  Rather than responding to consumer wishes, firms may attempt to persuade consumers by advertising.  Free markets may lead to macroeconomic instability like: falling output, rising unemployment.  Practices of some firms may be socially undesirable. Interdependence of Goods and Factor Markets  18 Goods Market:  Demand for goods rises.  This creates shortage.  This causes the price of that good to rise.  This eliminates the shortage by reducing demand and encouraging firms to produce. Factor Market:  An increase in supply of goods (Sg) creates increased demand of factors of production (inputs).  This causes shortage of inputs.  This causes their prices to rise.  This eliminates their shortage by reducing demand and encouraging suppliers of input to supply more. Opposite direction: Sf ↑ →Pf ↓→ COP ↓ → Surplus → Pg↓ → Dg ↑ (Sg>Dg) (Sf : Inputs and raw materials discovered) In all cases of changes in demand and supply, the resulting changes in price act as both signals and incentives. A fall in demand is signalled by a fall in price. This then acts as an incentive for supply to fall as goods are now less profitable to produce. Mixed Economy: Because of problems of two extremes, most countries are mixed economies. In this economy, the government can control,  Relative price of goods/inputs (by taxing/subsidizing/direct price control).  Relative income (income taxes, welfare payments).  The pattern of production /consumption by the use of legislation (making it illegal), by direct provision (education, defence) etc.  The macroeconomic problems by use of taxes and government expenditure, the control of bank lending and interest rates, control of foreign exchange rates.  19 2.1 DEMAND Price Taker : A person or firm with no power to be able to influence market price. The Law of Demand: The quantity of good demanded per period of time will fall as price rises and will rise as price falls, other things being equal (ceteris paribus). Income Effect: The effect of change in price on quantity demanded arising from consumer becoming better or worse off as a resort of price change. Substitution Effect: The effect of change in price on quantity demanded arising from consumer switching to or from alternative (substitutive) products.  Price of good rises, people feel poorer, purchasing power falls (real income ↓) – Income Effect (size of fall in Qd demands on proportion of income spent on good).  Price of good rise, good will now cost more than alternative or substitute good, hence people will switch to these – Substitution Effect (size of fall in Qd depends on closeness to substitute good). Quantity Demanded: The amount of good that a consumer is willing and able to buy at a given price over a given period of time. Demand Curve: A graph that shows the relationship between the price of a good and the quantity of the good demanded over a given time period.  Price on vertical axis  Quantity demanded on horizontal axis  Downward sloping (law of demand)  Can refer to an individual consumer or market as whole. Substitute Goods: Goods which consumers consider to be alternatives to each other. For example,Coke, Pepsi. As price of one ↑, demand for other ↑. Complementary Goods: Are pair of goods which are consumed together. For example, bread and butter. As price of one ↑, demand for other ↓.  20 Normal Goods: Goods for which demand rises as people’s income rises. Inferior Goods: Goods for which demand falls as people’s income rise, e.g. no-name grocery store products. Econometrics: The science of applying statistical techniques to economic data in order to identify and test economic relationships. The demand for potatoes (monthly) Price (pence per kg) A’s demand (in kgs) B’s demand (in kgs) Total Market Demand (in kgs) 20 28 16 44 40 15 11 26 60 5 9 14 80 1 7 8 100 0 6 6 A and B are demand schedules for two individuals. To obtain the market demand schedule, we simply add the quantity demanded of all individuals present in a market. This is the horizontal summation of quantity de- manded at all prices. The quantity demanded are for a period of time (month) and not a point of time. Demand Equations: We represent relationship between demand for a good and the determinants of demand in form of equality called demand equation. Qd = a - bP This is a simple demand equation which related quantity demanded to just one determinant which is price based on ceteris paribus (assuming other determinants remain constant). If a changes alone, there will be a parallel shift in the demand curve.  21 If b changes alone, the slope of the curve will change. Qd = a - bP + bPs – ePc Qd → Quantity demanded of god P→ Price of good (P↑ Qd ↓) Y→ Income of consumer (Y↑ Qd ↑) Ps→ Price of substitute good (Ps↑ Qd ↑) Pc→ Price of complementary good (Pc↑ Qd ↓) Estimated demand equations:Surveys can be conducted to show how demand depends on each one of a number of determinants, while the rest are held constant. Using statistical techniques called regression analy- sis, a demand equation can be estimated. Other Determinants of demand: 1. Consumer tastes 2. The number and price of substitute goods. 3. The number and price of complementary goods. 4. Consumers income. 5. The distribution of income. 6. Expectation of future price earnings. Movements along and shifts in the demand come: A demand curve shows how quantity demanded varies with price, other things remaining equal. A change in price will lead to movement along the existing demand curve. However, if any of other determinants of demand changes, then demand curve will itself shift.  22 A change in demand refers to shift in demand curve, which occurs when a determinant other than price changes. A change in quantity demanded refers to Movement along a demand curve, which occurs when there is a change in its own price (other things remaining constant). 3.2 SUPPLY Supply Curve: A graph showing the relationship between the price of a good and the quantity of the good sup- plied over a given period of time. Substitutes in Supply: These are two goods where an increased production of one means directing resources away from producing the other. E.g.– carrots and potatoes. Goods in Joint Supply: These are goods where the production of one lead to the production of the other. E.g.– refining code oil to produce petrol, other goods fuels are produced as well like diesel. Relation between price and quantity supplied: When the price of a good rises, the quantity supplied will also rise. The three reasons are – 1. Short term -  As firm supply more they are likely to find that beyond a certain level of output, costs rise more and more rapidly. Hence, producers will need to get a higher price if they are to be persuaded to produce ex- tra output.  The higher the price of a good, the more profitable it becomes to produce. Firms will thus be encour- aged to produce more of it by switching from producing less profitable goods. 2. Long term -  Given time, if price of goods remains high, new producers will be encouraged to step up in production. Total market supply thus rises. The supply of Potatoes (monthly) Price of potatoes(pence/kg) Farmer X’s supply(tonnes) Total Market Supply(tonnes:000s) a 20 50 100 b 40 70 200 c 60 100 350 d 80 120 530 e 100 130 700  23 Market supply curve of potatoes (monthly) Determinants that influence supply:  The Cost of Production: (Cost of production increases, the supply decreases) (a) Change in input prices: costs of production will rise if wages, raw material prices, rents, interest rates or any other input prices rise. (b) Change in technology: technological advances can fundamentally alter the costs of production. Con- sider, for example, how the microchip revolution has changed production methods and information handling in virtually every industry in the world. (c) Organisational changes: various cost savings can be made in many firms by reorganising production. (d) Government policy: costs will be lowered by government subsidies and raised by various taxes. Gov- ernment regulation may also increase costs; examples include minimum wages and obligations for employers to provide and contribute to employee pensions.  The profitability of alternative products (substitutes profitability↑ S↓).  The profitability of goods in joint supply(petrol ↑diesel↑).  The aim of producers - (a) Profit maximisation (b) Sales maximisation  Expectations of future price changes. (Price expectation ↑S↓ (now))  The number of suppliers.  Nature, random shocks and other unpredictable events.  24 Movements and shifts in the supply curve: Changes in quantity supplied: The term used for a movement along the supply curve to a new point. It occurs when there is a change in price. Change in supply: The term used for a shift in the supply curve. It occurs when a determinant other than price changes. Supply Equations: Qs = C + dP Simple supply equation, relating quantity supplied to price of the good. As price increases quantity supplied increases. Qs = C + dP – eA + fJ Qs→ Quantity supplied P→ price of own good (P↑ Qs↑) A→ profitability of substitute good (A↑ Qs↓) J→ Profitability of good in joint supply (J↑ Qs↑) Example: Qs= 300 + 80P – 20A + 30J 2.3 PRICE AND OUTPUT DETERMINATION Marketing Clearing: A market clears when supply matches demand, leaving no shortage or surplus. The price at which demand equals supply is the equilibrium price or market clearing price. Equating demand and supply equations: Demand equation of a bicycle insurance - 100–P  25 Supply equation of a bicycle insurance - P–25 (No. of policies sold in a year) Qd = 100–P (Quantity in 000s) Qs = P–25 Equating the two, 100–P = P–25 Or, 2P = 125 Or, P = ₹ 62.5 Hence quantity demanded or supplied can be calculated as, Qd = 100 – 62.5 = 37.5 Hence 37500 policies per year. Equilibrium occurs where the demand and supply curves intersect. At any price above the equilibrium price, a surplus of supply over demand will arise. This leads to a drop in price which will increase the quantity demanded and reduce the quantity supplied. These changes will restore equilibrium. Similarly, Any price < equilibrium price leads to shortage An increase in Price leads to a decrease in Qd and increase in Qs which restores equilibrium.  26 Movement to new equilibrium: Equilibrium price and quantity will change as demand / supply curve shifts. 1. Suppose there is an increase in supply of bicycle insurance policies following decrease in cost of production. 2. Suppose there is a decrease in bicycle insurance policy supply due to increase cost of production. 3. Suppose there is an increase in demand for bicycle and hence bicycle insurance due to rise in income of consumers  27 4. Suppose there is a decrease in bicycle insurance policies demanded by consumers following decrease in income. 5. Both supply and demand curve can shift together Demand increases and supply falls. Increase in demand < Fall in supply. Hence, price rises and quantity falls. Identification Problem Both demand and supply depend on price, and yet their interaction determines price. For this reason, it is diffi- cult to identify just what is going on when price and quantity change, and to identity just what the demand and supply curves look like. In (2) above demand curve has not shifted. The change in equilibrium price and quantity demanded is entirely due to shift in supply curve. If we are certain about this, then we can identify the position of demand curve. In (5) above both demand and supply curves have shifted, and new equilibrium is achieved.  28 The problem is when supply curve shifts, we often cannot know whether or not the demand curve has shifted and if so by how much, and vice versa. Hence, it is difficult to identify just what is causing the change in price and quantity. Financial & Non– Financial Incentives Incentives drive the way individuals and businesses behave even when we don’t see that the incentive exists. Shortage of good → Market price↑ → opportunity cost ↑ → incentive to consume less ↓ Also, there is incentive for firms to produce more ↑ as the good is now profitable. This is financial incentive. Other e.g.– wage, tax relief an investment to businesses. Non-financial incentives also play an important role, when we look at what motivates people making decisions. When we give charity, buy presents for our family etc, we are reacting to non-financial incentives. Incentives may be ‘perverse’ or undesirable. E.g. – Making cars safer may encourage people to drive faster. In- creasing top rates of income tax may encourage high earners to workless. Hence, incentives need to be appreciative and not undesirable. Partial Equilibrium The type of equilibrium we studied is known as ‘partial equilibrium’. It is partial because what we are doing is examining just one tiny bit of economy at a time: just one market (e.g. that for onions). It is even partial within the market for onions because we are assuming that price is the only thing that changes the balance of demand and supply: nothing else changes. In other words, when we refer to equilibrium price and quantity we are as- suming that all other determinants of both demand and supply are held constant. If another determinant does change, there would be a new partial equilibrium as price adjustments and both demand and supply responds.  29 3.1 PRICE ELASTICITY OF DEMAND (PED) Price Elasticity of Demand: The responsiveness of quantity demanded to a change in price. Here D’ is more elastic demand curve than D, in other words given change in price, there will be a larger change in quantity demanded along D’ than D. The effect of shift in supply curve on price depends on responsiveness of demand to change in price. Formula: The percentage (proportionate) change in quantity demanded divided by percentage (proportionate) change in price. %ΔQd PED = %ΔP The Sign: As a rise in price causes quantity demanded to fall and a fall in price causes quantity demanded to increase, there is a negative relation between the two. Hence, PED is always negative. %ΔQd %ΔQd PED = or %ΔP %ΔP The Value: Ignoring the negative sign and just the value of PED tells us about the elasticity of curve.  30 Elastic: A change in price causes a proportionately larger charge in quantity demanded. Hence E>I. Customers are very sensitive to change in price. A PED of -2.5 tells that 1 percentage change in price (rise) will lead to 2.5% fall in quantity demanded. Inelastic: A change in price causes a proportionately small charge in quantity demanded. Hence E1 (elastic) (2) Point Elasticity– The measurement of elasticity at a point on a curve. Here, ΔQ P PED = × ΔP Q Since we are measuring at a point, we want to know how quantity demanded reacts to infinitesimally small change in price. dQ P Hence, PED   dP Q dP Where, is differential calculus term for the rate of change in quantity with respect to change in price. dQ dQ dP ( is the slope of demand curve at a particular point). Mathematically is the slope of the tangent to dP dQ the demand curve at the point. Using calculus to calculate price elasticity of demand, Let Qd = 60-15P+P2. Hence slope is given by, (differentiating w.r.t. P) dQ = -15+2P dP  35 Let say at price of 3, dQ = –15+(2x3) = –9 dP Thus PED at price 3 is, dQ P 3 =   9  (Qd= 60-(15X3) + (3x3) = 24) dP Q 24 = –9/8 (elastic) Elasticity of a straight - line demand curve A straight - line demand curve has different elasticises at each point on it. Equation of a straight line is, Q = a –bP dP dQ Where -b is the inverse of the slope of the demand curve ( ) i.e.. dQ dP dQ P Hence, PED   dP Q dQ  b dP P So, PED  b  Q 10 1 Let Q= 50-5P (and so slope is   b  5 ) 50 5 PED at n, -5 × (8/10) = –4 (elastic) at m, -5 × (6/20) = –1.5  36 at l, -5 × (4/30) = –0.67 (inelastic) at k, –5 × (2/40) = –0.25 at a, PED is – and at b, PED is 0. mid-point, (–5) × (5/25) = –1 Advertising and its effect on demand curves Advertisers try to do these two things –  Shift the demand curve to the right, and  Make it less price elastic. D1 is the original demand curve and D2 is the demand curve after advertising effect. (1) Shifting demand curve to right.  Advertising bring people’s attention → market grows → demands curve shifts right.  Increases people’s desire for product → people will be prepared to pay higher price for each unit pur- chased. (2) Making demand curve less elastic Advertising creates brand loyalty →allows time to raise price above its rivals, with no significant effect on sales (fall) [substitution effect lessens as consumer believes there is no close substitute]. In the diagram, the rightward shift allows an increased quantity (Q2) to be sold at original price (P1). If de- mand is also made highly inelastic, the firm can raise its price and still have a substantial increase in sales. Thus, price is raised to P2 and sales will be Q3 – still above Q1. Total gain in revenue is shown by shaded region.  37 3.2 OTHER ELASTICITIES Price elasticity of supply (PES) The responsiveness of quantity supplied to a change in price. General formula is given by, % Qs PES  % P The effect on price and quantity of a shift in the demand curve will depend on price elasticity of supply. Determinants  The amount by which costs rise as output rises. The less the additional cost of producing additional output, the more firms will be encouraged to produce for a given price, the more elastic supply will be. E.g. - more spare capacity, readily get extra supplies of raw materials etc.  Time period – (i) Immediate: highly inelastic (cannot change supply immediately) (ii) Short run: some inputs can be increased. Supply can change somewhat (other inputs remain fixed) (iii) Long run: sufficient time for all inputs to be changed and for new firms to enter the market or for some to exit. Supply is likely to be more elastic. Measurements: Using arc elasticity formula, %Qs Qs / average Qs PES   %P P / average P Using point elasticity formula, dQs P PES   dP Q  A vertical supply curve has zero elasticity.  A horizontal supply curve has infinite elasticity. When two supply curves cross, the steeper one will have lower price, elasticity of supply.  38 Any straight-line supply curve starting at the origin, will have elasticity equal to 1, irrespective of its slope. S2 is more elastic than S1 All are unit elastic supply curve Supply Equation, Qs = a +bp If supply curve passes through the origin, Qs  bP  as a  0 ....................(1) dQs P  PES   (point elasticity of supply) dP Q dQs But, b dP  39 dQs P P  PES    b dP Qs Qs P =b (as Qs = bP from (1)) bP =1 Income Elasticity of Demand (IED) This measures the responsiveness of demand to a change in consumers income (Y). Formula, YED = percentage (proportionate) change in demand divided by percentage (proportionate) change in income %ΔQd YED = %ΔY Determinants:  The degree of ‘necessity’ of goods – (i) Basic goods – low income elasticity of demand (ii) Luxury goods – high income elasticity of demand  Normal goods (demand increases as income increase) – (i) If figure is positive and greater than 1 – share of consumers income spent on the good increases as in- come increases. (ii) If figure is positive and less than 1 – share of consumers income spent on the good falls, as income in- creases. (iii) If the figure is negative – demand for some goods decreases as people’s income rise above a certain level. For example – supermarket’s value lines, bus journeys, etc. these are called inferior goods (de- mand decreases as income increases). Such goods have negative IED. IED is an important concept to firms considering future size of market for their product. Cross Price Elasticity of demand (CED) It is a measure of responsiveness of demand for one product to a change in price of another (substi- tute/complement). It enables us to predict, how much the demand curve of first product will shift when the price of demand of second product changes.  40 Formula, %ΔQDA CEDAB = %ΔPB If good B is a substitute of good A – A’s demand will rise as B’s price will rise. Hence CEDAB will be positive. If good B is a complement good to A– A’s demand will fall as B’s price will rise. Hence CEDAB will be negative. Determinant: ‘Closeness’ of substitute or complement - The closer it is, the bigger the effect on first good of a change in price of other good. Firms need to know the cross–price elasticity of demand for their product of a change in their rival’s product or of a complementary product. These are vital for production planning. 3.3 THE TIME DIMENSION SHORT -RUN AND LONG RUN ADJUSTMENTS 1. Response of Supply to an increase in Demand. 2. Response of Demand to an increase in Supply.  41 As equilibrium moves from a to b to c, there is a large short run price change (P1 to P2) and a small short run quantity change (Q1 to Q2), but a small long run price change (P1 to P3) and a large long run quantity change (Q1 to Q3)(longer the time period, greater the elasticity of supply and demand). * People’s actions are influenced by their expectations –People respond not just to what is happening now, but what they anticipate will happen in future. Speculation: where people make buying or selling decisions based on their anticipation of future prices. Speculators: People who buy (or sell) commodities or financial assets with the intention of profiting by selling them (or buying them back) at a later date for a higher (lower) price. Speculation is often based on current trend in prices. If prices are currently rising, it will reach a peak and then fall or go on rising.  Sometimes people with take advantage of expected price rise purely to make money and have no inten- tion of keeping the item they have bought.  Similarly, people will take advantage of expected price reductions by selling something now only to buy it later.  In extreme cases, speculators need not part with the money. Nevertheless, speculators on average tend to gain rather than lose. The reason is that speculation tends to be self- fulfilling. In other words, the actions of speculators tend to bring about the very effect on prices that they had antic- ipated. For example, if speculators believe that the price of Barclays shares is about to rise, they will buy some. But by doing this they will contribute to an increase in demand and ensure that the price will rise; the prophecy has become self-fulfilling. The speculators on average tend to gain rather than lose. The reason is that speculation tends to be self- fulfill- ing. The actions of speculators tend to cause the very effect that they anticipated. (i) Stabilising – reduce price fluctuations (ii) Destabilising – aggravate them Stabilising speculation This happens when speculators (buyers or suppliers) believes that a change in price is only temporary. 1. Initial Price Fall (speculators believe that fall in price to P2 is only temporary.  42 First there is an initial fall in price. This shifts the demand curve from D1 to D2. The equilibrium shifts a to b and the price falls to P2. People believe that the fall in price is only temporary and suppliers hold back. Expected price to rise again: Supply shifts from S1 to S2. Buyers increase their purchase (to take advantage of the fall in price). The demand curve shifts from D2 to D3. The new equilibrium is at point c and price rises to P3 (towards P1). 2. Initial Price Rise (speculators believe that rise in price to P2 is only temporary) At first there is an initial rise in price. This shifts the demand curve from D1 to D2. This leads to a rise in price from P1 to P2. Now that the price is higher, the supplier brings their goods into the market and the supply curve shifts from S1 to S2. The consumers hold back until the price falls so the demand curve shifts from D 2 to D3. The new equilibrium is at point c and the price falls back to P3 (towards P1). Actions of speculators tend to reduce price fluctuations. For example, farmers. Destabilising Speculation This happens when speculators (suppliers or buyers) believe that a change in price heralds similar changes to come. 1. Initial Fall in Price (speculators believe that the fall in price to P2 signifies a trend)  43 At first there is a fall in price. The demand curve shifts from D1 to D2 which leads to a fall in price from P1 to P2. Speculators believe that a fall in price heralds further price fall. The suppliers decide to sell now before there is a further reduction in price. This leads to the supply curve shifting from S 1 to S2. Consumers wait for a further fall in price and so the demand curve shifts from D2 to D3. The new equilibrium is at point c and the price falls to P3. 2. Initial Rise in Price (speculators believe that the rise in price to P2 signifies a trend) There is an initial rise in demand from D1 to D2 which leads to a rise in price from P1 to P2. Suppliers wait until the price rises again, so the supply curve shifts from S1 to S2. The consumers buy now before there is rise in prices. The demand curve shifts from D2 to D3 and price rises to P3. The new equilibrium is at point c. Actions of speculators tends to make price movements larger. For example, real estate. Risk Uncertainty  Probability of an outcome is known.  Probability of an outcome is not known.  Lesser the probability of a desirable outcome,  Odds are not known or roughly known. greater is the risk involved.  Gamble on toss of a coin.  Gambling on stock exchange. In both cases the outcome may or may not happen. Short selling (shorting): where investors borrow an asset, such as shares, oil contracts or foreign currency. Sell the asset, hoping the price will soon fall; then buy it later and return it to the lender. Assuming the price has fallen, the short seller will make a profit of the difference (minus any fees). There is always a danger, that the price may have risen, in which case the short seller will make a loss. One way of reducing uncertainty is by deal- ing in futures or forward markets.  44 Futures or forward markets: A market in which contracts are made to buy or sell at some future date at a price agreed today. Future Price: A price agreed today at which an item (e.g. commodities) will be exchanged at some set due in the future. Spot price: The current market price. For example, Sellers → agree to sell 10kg wheat in 6months- time (farmer)@ ₹ 160. After 6 months – 1. If the spot price may fall to ₹ 140, the seller will gain. 2. If the spot price rises to ₹ 180, the seller will make a loss. Buyers → agree to buy 10kg wheat after 6 months- time (flour millers) @ ₹ 160. After 6 months – 1. If the spot price falls to ₹ 140, the buyer will make a loss. 2. If the spot price rises to ₹ 180, the buyer will make a profit. Forward price is determined by demand and supply. Speculators operate in future market who never actually handle the commodities themselves. They are neither producer nor users of commodities. They merely speculate. They may be individuals or financial institutions. For example : suppose coffee price is ₹ 1,300 per 10 kg on 1st October. The speculator believes that the spot price will increase in the future. He will buy 10 kgs of 6 months coffee futures. Now on 1 st February the price of coffee increases, he will sell 10 kgs of 2 month coffee futures at ₹ 1500 per 10 kgs. Speculators in future market thus incur risks, unlike sellers and buyers of commodities, for whom the future market eliminates risk. Stock holding as a way of reducing the problem of uncertainty –Suppliers can reduce the problem of uncer- tainly by holding stocks. During plantation, farmers are not sure or are uncertain about the price of produce when they take it to market. By storing they can choose the time of selling.  When prices are low, the stocks can be bought.  When prices are high, stocks can be sold.  45 3.4 THE CONTROL OF PRICES Minimum Price (Floor Price) A price floor set by the government or some other agency. The price is not allowed to fall below this level (although it is allowed to rise above it). Reasons–  To protect farmer’s incomes, prevents price from falling below a level.  In case of wages (price of labour), minimum wage legislation can be used to prevent workers wage rate from falling below a certain level.  To create surplus (in times of plenty) which can be stored in preparation of possible future shortage.  To deter consumption of a particular goods. (Black market might develop without such support). Various methods to deal with surplus:  The government could buy the surplus and store it, destroy it, or sell it in abroad.  Supply could be artificially lowered by restricting producers to particular quotas.  Demand could be raised by advertising. Cost to government in buying the surplus is shown in shaded region (abcd).  46 Maximum price (Price Ceiling) A price ceiling set by government or some other agency. The price is not allowed to rise above this level (al- though it is allowed to fall below it). Government might impose maximum price for basic food stuffs, such as bread, or utilities such as water, or maxi- mum rental levels on property because they believe that market price or rents are too high for many people. Government might adopt the process of rationing. Rationing: Where the government restricts the amount of a good that people are allowed to buy.  By queuing  By ration coupons Problems: 1. A major problem is likely to be emergence of illegal markets(underground or shadow markets), where people ignore government’s price and / or quantity controls and sell illegally at whatever price equates illegal demand and supply. Customers unable to buy enough in legal markets , may well be prepared to pay very high prices. 2. Another problem is that it reduces quantity produced. To minimise this –  direct government production, or by giving subsidies or tax relief to firms.  reduce demand by production of alternatives or lowering people’s income. Price gouging: Where sellers raise their prices by an amount considered to be excessive, to take advantage of a crisis such as a war, natural disaster or pandemic. Significant price rises during a crisis are often referred to as price gouging. The practice invokes very negative responses from many consumers who consider the actions as unethical.  47 3.5 INDIRECT TAXES AND SUBSIDIES Indirect Tax: A tax on expenditure of goods. These taxes are not directly paid by the consumers, but indirectly via the sellers of the good. Specific Tax: An indirect tax of a fixed sum per unit sold. E.g. – tax per litre of oil. Ad Valorem Tax: An indirect tax of a certain percentage of the price of good. E.g. – VAT. Supply curve will –  Shift parallelly leftwards (upwards) in case of specific tax.  Swing upwards, at zero price. No tax hence no shift. This is the case of ad valorem tax. At higher prices the gap between old and new supply curve will widen. To be persuaded to produce same quantity Q1, as before imposition of tax, firms must now receive a price which allows them fully to re coup the tax they have to pay (P1 + tax). Effect of tax →↑ price and ↓ quantity. As demand curve is downward sloping, price will not rise to P1 + tax, but only to P2. Thus, burden of tax is distributed to consumers and producers both. Consumer’s burden → P2 – P1 Producer’s burden → P1 + tax – P2 Government Receives→ Tax The effect of the tax is to raise price and reduce quantity. Price will not rise by the full amount of the tax, how- ever, because the demand curve is downward sloping. Thus the burden or incidence of such taxes is distributed between consumers and producers. Consumers pay to the extent that price rises. Producers pay to the extent that this rise in price is not sufficient to cover the tax.  48 Incidence of an Indirect Tax Size of tax is some in all cases, increase in supply curve in same. But rise in price and decrease in quantity is dif- ferent. Total Tax Revenue = Tax per unit * Q2 (total shaded region) Consumer’s share of Tax on good → The proportion of revenue from a tax on a good that arises from an in- crease in the price of good. [(P2 – P1) × Q2]. Producer’s share of a tax on good → The proportion of the revenue from a tax on the good that arises from a reduction in the price to the producer (after payment of tax)[{P1 – (P2 – tax)}× Q2]  49  Less elastic demand & supply (1&3) → Q falls less, hence tax revenue of government ↑  Less elastic demand, more elastic supply (1&4) → Price will rise more, and hence consumer’s share of tax will be larger.  More elastic demand, less elastic supply – Price will rise less, and hence the producer’s share will be larger. Cigarettes, petrol, alcohol → major target for indirect taxes (Demand is large and fairly inelastic). Effect of Subsidising Products Effects subsidy on price and Quantity A subsidy is the payment by the government to a producer or consumer. In this supply curve shifts downwards by amount of subsidy (specific subsidy). Initial equilibrium is at ‘a’ with Po and Qo. Government introduces subsidy of amount (a-b) per unit. Firms are now willing to supply same Qo for lower price P2 because government is paying (Po – P2) via subsidy. Hence, supply curve shifts downwards parallel. New equilibrium → ‘d’ with P1and Q1. Price does not fall by full amount of subsidy. Extent to which effect of subsidy is passed to consumer depends on elasticity of demand and supply curves (PED and PES). Less elastic demand and more elastic supply → consumer’s subsidy share will be greater (i.e. price fall will be greater). Cost of subsidy to taxpayer → per unit subsidy → quantity sold after = (P3 – P1) x Q1.  50 4.1 MARGINAL UTILITY THEORY Rational Consumer: A person who weighs up the costs and benefits to them of each additional unit of a good purchased. Attempt to get best value for money, given limited income of consumer. We assume that consumers behave rationally. Total Utility: The total satisfaction a consumer gets from the consumption of all the units of a good consumed within a given period of time. Marginal Utility: The extra satisfaction gained from consuming one extra unit of a good within a given period of time. We consider that utility is measurable and that util is an imaginary unit of satisfaction from consumption of a good. Principle of Diminishing marginal utility: As more units of a good are consumed, additional units will pro- vide less additional satisfaction than previous units. Jolly’s utility from consumption of chocolate (daily) Packets of TU MU Chocolate (units) (units) 0 0 - 1 7 7 2 11 4 3 13 2 4 14 1 5 14 0 6 13 -1  51  Mu curve slopes downwards (principle of diminishing MU).  TU curves starts at the origin (zero consumption yields zero utility).  TU curves reaches a peak when MU is zero. When MU is zero, there is no addition to TU.  Mu can be derived from the TU curve. It is the slope of the line joining two adjacent quantities on the curve. TU MU  Q People’s utility schedule might change: We assume ceteris paribus, where everything else remains constant. However, people’s consumption pattern might change. It might depend on other things consumed. Each time consumption of other goods change (substitutes or complements) the curve will shift. Tastes change, circum- stances change and consumption pattern changes. Optimum level of consumption: One Commodity (simplest case) We can measure utility with money. MU becomes the amount of money a person would be prepared to pay to obtain one more unit. If Jolly is prepared to pay ₹ 10 for a packet of chocolate, then MU from that one pack will be ₹ 10 (MU = ₹ 10). Consumer surplus: The excess of what a person would have been prepared to pay for a good (i.e. the utility) over what person actually pays. Marginal Consumer Surplus: The excess of utility from the consumption of one more unit of a good (MU) over the price paid: MCS = MU – P Total consumer surplus: The excess of a person’s total utility from the consumption of a good (TU) over the total amount that person spends on it (TE). TCS = TU – TE Rational consumer behaviour : The attempt to maximise total consumer surplus.  52 Consumer buys 5 units of good at price ₹ 2. Total Expenditure, TE = 2*5 = ₹ 10 Total Consumer Surplus, TCS = ₹ 2*5*0.5 = ₹ 5 Total Utility, TU = TE + TCS = ₹ 15 If MU>P, consumer should buy more. TCS is maximised where the MU of a good is equal to price (P) paid for that good, i.e. people should consume a good up to the point where MU = P An Individual’s Demand Curve It will be same as MU curve of that good, whose utility is measured in money. This figure shows marginal utility curve of a particular good for a particular person. If price is P 1, person would consume Q1, where MU = P1. Thus, a is a point on demand curve. If price falls to P2, he will consume Q2, MU = P2. Thus, b would be the second point on demand curve and c will be the third point. As long as an individual seeks to maximise consumer surplus, and hence consume where P = MU, then demand curve will be along the same line as MU curve. Market demand curve is the horizontal summation of all individual demand curve hence MU curve. If there are close substitutes of a good, it is likely to have elastic demand, MU will diminish slowly as consump- tion of this increases. ↑ P coffee, ↓Q coffee, their desire for tea ↑.MU curve of tea thus shifts right. Weakness of one commodity model –  The interdependence of changes in consumption of different goods.  The dependence of consumption on income (Marginal utility of money diminishes as income increases. It doesn’t remain the same).  53 Optimum Combination of Goods consumed Given limited income, we make choices. The optimum ‘bundle’ of goods needs to be chosen. The rule of a rational consumer behaviour is known as the equi–marginal principle(of consumption). Con- sumers will maximize total utility from their incomes by consuming that combination of goods where. MU A PA  MU B PB If last unit of good A consumed gives three times utility as last unit of good B, and good A costs only twice as that of good B, consumer will substitute B with A. As consumption of A ↑, the MU A↓ and as consumption of B ↓, MUB ↑(Diminishing Marginal Utility). To maximize utility, this substitution will continue until ratio of marginal utilities equals ratio of prices of two goods. To derive demand curve from above analysis– For any given income and given prices for good A and all other goods, the quantity a person will demand for good A will be, that satisfies the equation MU A PA   1 MU B PB If PA falls, MU A PA  MU B PB QA↑ and QB ↓ (also for other goods) This continues until again the equation (1) is satisfied. This way we get second point at P and Q. Further price changes of good A, will change the quantity consumed of A. Hence, we get points on the demand curve of good A. If price of other goods (other than A) changes or marginal utility of any good changes (including A), then again there will be a shift in the demand curve for good A, as equation (1) is satisfied. Water-Diamond Paradox Water which is so essential to life, has such a low market value whereas diamonds which is relatively so trivial has so high market value. Water being so essential has a high total utility: high ‘value in use’. But for most of us given that we consume so much already, it has low marginal utility.  54 Diamonds on the other hand, although they have a much lower total utility, have much higher MU. There are very few diamonds in the world. Thus, people having few of them. They are valuable at the margin. Also, MU of water is low because its supply is plentiful as compared to diamonds. MU determines price (not TU). Hence, as MU ↑, price of good ↑. In desert MU of water will be high. Hence, you will be prepared to pay more. 4.2 THE TIMING OF COSTS AND BENEFITS There may be significant delays between the point in time the costs are incurred and benefits received. This is called inter temporal choice. E.g. - car, mobile phone, consumer durables. The cost of consumer durables is im- mediate but the benefits are received over a period of time. The cost of smoking cigarettes is paid over a period of time but the benefit is received immediately. Optimum choice of consumption with inter-temporal choice People are impatient most of the time. They prefer to consume the things they like immediately, rather than waiting till a later date. They would also prefer to delay any costs until later. For example, U Monday: u (₹ 500Monday) > u (₹ 500Tuesday) and U Tuesday: u (₹ 500Tuesday) = U Monday: u (₹ 500Monday) Person’s point of view on Monday (U Monday): The utility from receiving money on Monday is more than receiv- ing on Tuesday. Exponential Discounting: A method of reducing future benefits and cost to a present value. The discount rate depends on just how much less from the consumer’s perspective, future utility and cost (from a decision made today) are then gaining the utility/incurring the costs today. Present value: The value a person places today on a good that will not be consumed until some point in the future. Discount factor: The value today of deciding to consume a good one period in the future as a proportion of the value when it is actually consumed. To capture the impatience, method of weighting future costs and benefits is developed. Exponential discounting - multiplying future cost & benefit with a number ₹ 10 (Buy product). (ii) DF = 0.4 ∴PV of Benefit = ₹ 20 × 0.4 = ₹ 8 < ₹ 10 (do not Buy). (iii) DF = 0.9 (after 2 months) PV of Benefit = ₹ 20 × 0.9 × 0.9 = ₹ 16.20 > ₹ 10 (Buy). 4.3 INDIFFERENCE ANALYSIS Utility cannot be measured in absolute sense. We cannot really say, that MU of one good exceeds other by how much. Indifference analysis involves merely ranking various combination of goods in order of preferences. No measurement of utility is required. Indifference Curve: A line showing all those combination of two goods between which a consumer is indiffe- rent, i.e., those combinations that give same level of utility. Indifference set: A table showing the same information as an indifference curve. Indifference Set Pears Oranges Points 30 6 a 24 7 b 20 8 c 14 10 d 10 13 e 8 15 f 6 20 g  56 As consumer moves from a to b, 6 units of Pears are satisfied for one orange. Hence, slope of IC is –6/1 = –6 ignoring negative sign → 6. Marginal rate of substitution: The amount of one good (Y) that a consumer is prepared to give up in order to obtain one extra unit of another good (X). i.e. ΔY/ΔX. ⸫MRS = 6. From point e to f, slope is –2/2 = –1 (MRS = 1) Hence, slope of curve decreases as we move down the curve. Diminishing marginal rate of substitution: The more a person consumes of good X and less of good Y, the less additional Y will that person be prepared to give up in order to obtain an extra unit of X i.e. ∆Y/∆X dimi- nishes. As consumer consumes more oranges and fewer pears, his MU from oranges will diminish while that from pears will increase. He will be prepared to give up fewer and fewer pears for each additional orange. MRS dimi- nishes. 6 MU pears = MU oranges MU oranges  6 MU pears This is same as MRS (ΔY/ΔX), MU X  MRS  (ignoring negative sign) MU Y Hence, the Indifference curve is downward sloping and convex to origin. The curvature and slope of indifference curves: Although indifference curves for two goods are normally bowed in towards the origin, the slope and curvature can vary. This provides some information about consum- er preferences. For example, if the indifference curve is relatively steep, then the MRS remains large along the whole length of the line. The consumer has a stronger preference for the good on the horizontal axis over the good on the vertical axis. If the indifference curve is relatively flat, the reverse is true. The more curved or bow- shaped the curve, the more complementary the two goods are in consumption. The lower the curvature (i.e. closer it is to being a straight line) the more substitutable the two goods are in consumption. Budget line A graph showing all the possible combinations of two goods that can be purchased at given prices and for a given budget. Indifference map: A graph showing a whole set of IC. The further away a particular curve is from the origin, the higher the level of satisfaction it represents.  57 I2 gives better utility than I1. I3 gives more utility then I2 and so on. The actual choice will depend on people’s income. Combination of goods you are able to buy depends on the income available to the consumer and the prices of the goods. Budget = ₹ 30 Units of good X Units of good Y 0 30 0*2+30*1 5 20 5*2+20*1 10 10 10*2+10*1 15 0 15*2+0*1  58 A change in Income As income increases (hence budget) budget line will shift outwards, parallel to old one.More can now be pur- chased. Increase in income leads to movement from point m to Effect on budget line due to fall in price of good X point n (more can now be purchased of both goods) (figure 2) A change in price Slope of the line is PX/PY (ignoring negative sign) Figure 2 - If Px falls to ₹1 and PY remains at ₹1, the budget line will join 30 on Y axis and 30 on X axis. The line pivots outwards on point a. If PY would have changed, the line would pivot on point b. The Optimum consumption –point The consumer will like to consume around the highest IC. This is curve I3 at point t, curves I4 and I5 are not achievable, as they lie above the budget line B(Infeasible region).Consumer could consume along I 1 and I2 but these will give less utility than point t. The optimum consumption point is where the budget line touches (tangential) the highest possible IC. Hence, both will have the same slope.  59 PX Slope of budget line = PY MUX Slope of IC → MRS = MUY PX MU X ⸫Optimum consumption point,  PY MU Y (Same as equal marginal principle) The objective is to maximize total utility subject to budget constraint, Max TU  X,Y  Subject to budget constraint, PX × X + PY × Y Effect of change in Income The corresponding optimum points (r, s, t) are shown. The line joining these points are called Income- Consumption Curve. A line showing how a person’s optimum level of consumption of two goods changes as in- come changes (assuming price of goods is constant). If money income increases when prices are held constant, the real income will increase. If prices fall for same amount of money income, we can buy more. Hence, real income increases. Both will have different effect on budget line. Provided relative prices of two goods remain the same (i.e. fall or rise by same percentage), the budget line will shift parallelly outwards (inwards). Real Income- Income measured in terms of how much it can buy. Money income ↑ 10%, Price ↑ by 8% ⸫ Real income ↑ 2%  60 Income elasticity e of demand and income consumption curve In above figure, as income rises, demand for both goods rises. Thus, both have positive income elasticity of de- mand – normal goods. If income – consumption curve becomes flatter at higher levels of income, it would show increasing proportion of income spent on X. Flatter the curve, IED of X ↑. The effect of change in Price As PX decreases (money income remaining the same and PY remaining the same), budget line will pivot out- wards (round point a). The new optimum point will be k. The line joining j and k is called Price-Consumption Curve. A line showing how a person’s optimum level of consumption of two goods changes as prices of one good changes (assuming that income and price of other good remain constant). Composite goods – extending the analysis to more than two goods One limitation of indifference curve analysis so far is that it has only been possible to examine choices between two goods. In reality, consumers choose between many goods. How can we extend the diagrammatic analysis to examine these situations while keeping the two-dimensional diagrams that make it easier to visualise the theory? The answer is to consider the consumer’s choice between one particular good and a combination of all other goods. This combination is called a composite good. Therefore, in the diagrams, we measure units of good X on the horizontal axis and units of the composite good on the vertical axis. A unit of the combined or composite good is defined so that the price is £1 per unit. This might seem a little strange but it means that the vertical axis not only measures units of the composite good, it now also measures the consumer’s expenditure on all other goods. For example, if the consumer purchases 10 units of the compos- ite good, they must also be spending £10 on all other goods. Another useful implication of drawing the diagram this way is that the vertical axis can illustrate both the con- sumer’s budget/income and their expenditure on good X. For example, in the Figure, the intercept of the budget line on the vertical axis shows the total expenditure on all other goods when the consumer does not purchase any of good X (i.e. £100). Remember, we assume that the consumer spends all of their income – they do not save. Therefore, the intercept also shows that the consumer’s total income/budget is £100.  61 At the optimum point a, in Figure, the consumer purchases 75 units of the composite good and QX1 units of good X. Unless the price of X is £1, the horizontal axis does not illustrate the expenditure on good X. However, if the consumer is spending £75 on all other goods, they must be spending £25 on good X. Travelling downwards along the vertical axis from the intercept tells us the consumer’s expenditure on the good X. Deriving individual demand curve Taking expenditure on all other goods except of good (good X) which we want to produce a demand curve on Y axis. Assuming income, tastes and prices of all other goods held constant. As PX will change the budget line will pivot on the point where it intersects Y axis. Price-consumption curve is drawn to show Qd of good X as price changes. Then this price – quantity relation can be transferred to the de- mand curve. Deriving demand curve for good X from Price-Consumption Curve  62 a, b, c, d on demand curve in lower diagram corresponds to points on the price-consumption curve (Note P2 is half of P1, P3 is one third of P1 and P4 is one quarter of P1). Income and Substitution Effects of Price Change A NORMAL GOOD: Price of good X rises. Substitution Effect: We draw new budget line B1A, parallel to B2 showing new price ratio (higher price of X). Being tangential to I1, the utility of consump- tion remains same. There is no change in real in- come (exclude income effect). Movement from f to g (QX1 to QX2) is merely due to relative changes in price of X and Y. Income Effect: In reality budget line shifted to B2, consumer is forced to consume on a lower IC I2: real income has fallen. Thus, movement from QX2 to QX3 is due to Income effect. Both these affects reinforce each other (reduction in QX)(Both are negative, P ↑ QX ↓). As both effects are ↑, price elasticity of demand ↑. AN INFERIOR GOOD: Price of inferior good X rises Substitution Effect: PX rises, the substitution effect