Chapter 2 Economics (AS Level) PDF

CHAPTER 2 : THE PRICE SYSTEM AND THE MICROECONOMY (AS LEVEL) 2.1 Demand and supply curves  CONTENT 2.1.1 effective demand 2.1.2 individual and market demand and supply 2.1.3 determinants of demand 2.1.4 determinants of supply 2.1.5 causes of a shift in the demand curve (D) 2.1.6 causes of...

CHAPTER 2 : THE PRICE SYSTEM AND THE MICROECONOMY (AS LEVEL) 2.1 Demand and supply curves  CONTENT 2.1.1 effective demand 2.1.2 individual and market demand and supply 2.1.3 determinants of demand 2.1.4 determinants of supply 2.1.5 causes of a shift in the demand curve (D) 2.1.6 causes of a shift in the supply curve (S) 2.1.7 distinction between the shift in the demand or supply curve and the movement along these curves  2.1.1 EFFECTIVE DEMAND Definition of Demand Demand is defined as the ability and willingness to buy specific quantities of goods in a given period of time as a particular price, ceteris paribus. Demand differs from desire, want, wish and the like. More desire and wants for a product will not cause producers to produce that product and place in the market. The person who desires or wants to have a product must have the ability to buy and willing to pay for that product; only then is that desire called a demand.  2.1.1 EFFECTIVE DEMAND Demand = willingness to buy + ability to buy [ Consumer must have the money to buy the product] Desire, want and wish =only the desire, without the ability to purchase the product  2.1.1 EFFECTIVE DEMAND Law of Demand The law of demand states that the higher the prices of a product, the lower the quantity demanded of that product and the lower the price of a product, the higher the quantity demanded, ceteris paribus. Based on the law of demand, negative relationship exists between price and the quantity demanded.  2.1.1 EFFECTIVE DEMAND Demand Schedule and Demand Curve The demand schedule for a product is a list of the quantity that a buyer is willing to buy at different prices at one particular time. Price (RM) Quantity (unit) 5 2 4 4 3 6 2 8 1 10 Individual demand schedule for ‘Pilot’ pens  2.1.1 EFFECTIVE DEMAND The demand schedule can be shown in a diagram to show how we obtain a demand curve. The demand curve is a line on a graph showing the inverse relationship between the quantities demanded of a product and its price. The demand curve shows the relationship between the quantities of ‘Pilot’ pens demanded and its price, provided that everything else is constant. The demand curve must slope downwards due to the inverse relationship between price and quantity demanded (according to the law of demand). 2.1.1 EFFECTIVE DEMAND Demand Curve  2.1.2 INDIVIDUAL AND MARKET DEMAND AND SUPPLY Individual demand Market demand The relationship between the quantity of a The relationship between total quantity of a product demanded by single individual and its product demanded (by adding all the quantities price. demanded) by all consumers in the market and its price. Thus, market demand is the combination of individual demands. Individual demand 1 + Individual demand 2 = Market demand Market Demand = ∑ Individual Demand  2.1.2 INDIVIDUAL AND MARKET DEMAND AND SUPPLY Let us take the example of the ‘Pilot ‘pens. Table 1.0 shows both the individual demand and market demand for the pens. Price (RM) Individual 1 Individual 2 Market Demand 5 2 4 6 4 4 5 9 3 6 6 12 2 8 7 15 1 10 8 18 Market demand schedule for ‘Pilot’ pens  2.1.2 INDIVIDUAL AND MARKET DEMAND AND SUPPLY Based on the given information, in Table 1.0, plot the demand curve in a diagram to show the individual demand and the market demand. We have assumed that the market consists of only two individuals: 1 and 2. The market demand curve is a horizontal summation of individual demand curves. We add the individual demands to obtain the market demand.  2.1.3 DETERMINANTS OF DEMAND i. Internal Factors a) Price of goods The price of the product depends on the cost of production, which in turn will determine the quantity that will be purchased by the consumer. The higher the price, the lower the demand.  2.1.3 DETERMINANTS OF DEMAND ii. External Factors a) Price of related goods The demand for a product is also affected by a change in the price of related goods. Related goods fall into two categories. i. Substitute goods are goods or services that can be used in place of another product or service. ▪ For example, a bus ride versus an LRT ride; Tea versus coffee; apples versus oranges and so on. ▪ A change in the price of a substitute product affects the demand for the product in the same direction in which the price changes.  2.1.3 DETERMINANTS OF DEMAND ▪ Demand for a product will increase, if the price of a substitute product rises, vice versa. ▪ When the price of coffee increase, for example the quantity demanded for coffee will fall and people will look for an alternative. Thus, the demand for tea, for example, will increase. ii. Complementary goods are goods that are used in conjunction with another product. ▪ For example, a disk and a computer; pen and ink and bread and butter. ▪ The change in the price of a complementary product affects the demand for the product in the opposite direction to the price change. ▪ Demand for the product will decrease, if the price of complementary goods rises, and vice versa. ▪ For example, when the price of pens increases, the quantity demanded for pens will fall and the demand for ink will also decrease as both goods are used together.  2.1.3 DETERMINANTS OF DEMAND b.) Consumers’ income Other things being equal, when income increases, consumers’ demand for more good and services will increase. Good that increase in demand as income increase as normal goods, such as cars, shirts and books. Goods that decrease in demand as income increases are inferior goods, such as low-grade potatoes and used cars.  2.1.3 DETERMINANTS OF DEMAND c.) Consumers’ fashion tastes and preferences. Tastes and fashions of consumers change significantly. If a product becomes more fashionable, the demand for it will increase and if the same product becomes outdated, the demand for it will fall. As tastes and fashions change, demand will also change. For example, change in music, fashion trends or recreation. d.) Population or number of buyers. Demand depends on the size of the total population or the number of buyers in the market. A larger population with a high rate of growth creates a greater demand for goods and services.  2.1.3 DETERMINANTS OF DEMAND e.) Expectation about future prices. The higher the expected future price of a product, the higher the current demand for that product, and vice versa. For example, when the government plans to increase the price of sugar the following week, the present demand for sugar will immediately increase-consumers would want to store for future use due to the expected price hike. If consumers expect the price of cars to fall next year, the present demand for cars this year will decrease, because consumers will wait for the price to fall.  2.1.3 DETERMINANTS OF DEMAND f.) Advertisement Advertised goods normally have a higher demand because of awareness. Consumers will only buy goods and services when they are aware of the existence of those product. Advertisement will attract people to the goods and services. For example, soft drinks advertisements in Malaysia which carry endorsements by celebrities attract many consumers to buy the product. g.) Festive season and climate During festive seasons, different products will be in high demand. For example, during Chinese New Year, the demand for mandarin oranges will be greater..  2.1.3 DETERMINANTS OF DEMAND h.) Level of taxation The higher the taxes, the lower the purchasing power of consumers and vice versa. This will lead to a decrease in demand. For example, if the government reduces income tax by 10% consumers will have more money to spend on goods and services. This increases the demand for goods and services. i.) Supply of money in circulation The larger the supply of money in circulation, the greater the demand for goods and services, because consumers have more money to spend.  CHANGES IN QUANTITY DEMANDED VS. CHANGES IN DEMAND Changes in determination of demand influence consumers’ purchasing plans. This causes a movement or shift in the demand curve. a) Changes in Quantity Demanded If the price of products changes and other factors are constant, there will be movement along the demand curve. a) Upwards movement - decrease in quantity demanded (contraction) b) Downward movement - increase in the quantity demanded (Expansion).  CHANGES IN QUANTITY DEMANDED VS. CHANGES IN DEMAND When the price is at $20, the quantity demanded is 10 units. When the price increases to $30 the quantity demanded falls from 10 units to 5 units. The movement along the demand curve $20 and 10 units (point b) to $30 and 5 units (point a) illustrates the change in quantity demanded  CHANGES IN QUANTITY DEMANDED VS. CHANGES IN DEMAND b.) Changes in Demand If the price of a product is constant and other factors (Determinants of demand) change, there will be a shift of the demand curve. i. Demand curve shifts to right if (increase in demand D0 to D1): Price of substitute goods increases. Price of complement goods decreases. Income increases (Normal goods) Expected future price increases Number of buyer increase.  CHANGES IN QUANTITY DEMANDED VS. CHANGES IN DEMAND b) Demand curve shifts to left if (decrease in demand D1 to D0): Price of substitute goods decreases. Price of complement goods increases. Income decreases (Normal goods) Expected future price decreases Number of buyers decrease.  SUPPLY Definition of Supply Supply refers to the amount of a good or service firms or producers are willing and able to sell at a given price. Law of Supply The law of supply states that there is a direct relationship between price and quantity supplied. When the price of the commodity rises, quantity supplied of that commodity rises. In other words, the higher the price of the product, the more the firm will supply because more is the profit.  SUPPLY Supply schedule and supply curve The supply schedule for a product is a list of the quantity supplied at different prices, assuming ' influences are constant. The supply schedule represents a functional relationship between price and quantity supplied. It assumes that other supply determinants constant , such as the state of technology, government policies and the price of related goods, are a Table 1.1 shows the quantity of 'Pilot' pens supplied at each price level.  SUPPLY Price (RM) Quantity (unit) 5 10 4 8 3 6 2 4 1 2 The above supply curve shows the relationship between the quantities of ‘Pilot’ pens supplied and its price, provided that everything else is constant. The supply curve slopes upwards.  Individual Supply and Market Supply Individual Supply Market Supply The relationship between the quantity of a The relationship between total quantity of a product supplied by single seller and its price. product supplied (by adding all the quantities supplied) by all sellers in the market and its price. Thus, market supply is the combination of individual supply. Individual supply 1 + Individual supply 2 = Market supply Market supply = ∑ Individual Supply  Individual Supply and Market Supply Let us take the example of the ‘Pilot’ pens. Table 1.2 shows both the individual supply and market supply for the pens. Price (RM) Individual 1 Individual 2 Market Supply 5 10 8 18 4 8 7 15 3 6 6 12 2 4 5 9 1 2 4 6 Individual Supply and Market Supply  2.1.4 DETERMINANTS OF SUPPLY i. Internal Factors a) The price of the good itself: Changes in the price of the commodity will lead to changes in quantity supplied of that commodity. For instance, a rise in the price of good X will lead to a rise in quantity supplied of good X. This is because good X is now more profitable, and producers supply more of it.  2.1.4 DETERMINANTS OF SUPPLY ii. External Factors a) Price of related goods The supply of a product can be influenced by the price of related goods: i. Substitute goods. Supply of a product will decrease when there is an increase in the price of substitute product, e.g. Pepsi and Coco-cola. If the price of Pepsi increase, the quantity supplied will increase (as per the law of supply) and the quantity of Coco-cola will decrease.  2.1.4 DETERMINANTS OF SUPPLY i. Complementary goods An increase in the price of a product will increase the supply of a complementary good, e.g. Pen and ink. When the price of pens increases, the quantity supplied for pens will increase and the supply of ink will also increase, since both complementary goods. b) Weather / climatic conditions: The supply of agricultural products is affected by changes in weather conditions. A favorable climatic condition may bring bumper (abundant) harvest so that producers supply more of the agricultural products. On the other hand, an unfavorable season which results in a poor harvest may cause quantity supplied to fall.  2.1.4 DETERMINANTS OF SUPPLY c) Changes in the prices / costs of factors of production: Movement in wages, prices of raw materials, fuel and power, rents, interest rates and other factor prices affects the cost of production. For instance, increase in wages paid to workers increases the cost of production and reduces the profits of firms. Hence, firms will supply less goods. d) Government policy Taxes – Taxes will decrease the supply of goods and services because taxes discourage producers from producing extra which increases the cost of production. Subsidies- Subsidies will increase supply as subsidies encourage producers to produce more.  2.1.4 DETERMINANTS OF SUPPLY c) Changes in the prices / costs of factors of production: Movement in wages, prices of raw materials, fuel and power, rents, interest rates and other factor prices affects the cost of production. For instance, increase in wages paid to workers increases the cost of production and reduces the profits of firms. Hence, firms will supply less goods. d) Government policy Taxes – Taxes will decrease the supply of goods and services because taxes discourage producers from producing extra which increases the cost of production. Subsidies- Subsidies will increase supply as subsidies encourage producers to produce more. CHANGE IN QUANTITY SUPPLIED VS. CHANGE IN SUPPLY Price Price s0 SS s1 Quantity Quantity ❖ Movement along supply curve ❖ Shift in the supply curve ❖ Price changes and other factors are ❖ Occurs when there are changes in constant other factors but the price remains ❖ Downward movement  Decrease in constant quantity supplied (Contraction) ❖ Increase in Supply (S0 → S1) ❖ Upward movement  Increase in ❖ Decrease in Supply (S1 → S0) quantity supplied (Expansion) CHANGE IN QUANTITY SUPPLIED CHANGE IN SUPPLY Thank you CHAPTER 2 : THE PRICE SYSTEM AND THE MICROECONOMY (AS LEVEL) 2.2 Price elasticity, income elasticity and cross elasticity of demand  CONTENT 2.2.1 definition of price elasticity, income elasticity and cross elasticity of demand (PED, YED, XED) 2.2.2 formulae for and calculation of price elasticity, income elasticity and cross elasticity of demand 2.2.3 significance of relative percentage changes, the size and sign of the coefficient of: price elasticity of demand, income elasticity of demand, cross elasticity of demand  CONTENT 2.2.4 descriptions of elasticity values: perfectly elastic, (highly) elastic, unitary elasticity, (highly) inelastic, perfectly inelastic 2.2.5 variation in price elasticity of demand along the length of a straight-line demand curve 2.2.6 factors affecting: price elasticity of demand, income elasticity of demand, cross elasticity of demand. 2.2.7 relationship between price elasticity of demand and total expenditure on a product 2.2.8 implications for decision-making of price elasticity, income elasticity and cross elasticity of demand  Elasticity ▪ Elasticity of demand is a measure of how much the demand for a product change when there is a change in one of the factors that determine demand. ▪ There are three elasticities of demand to consider: Price elasticity of Income Elasticity Cross Elasticity of demand (PED) of demand (YED) demand (XED)  Definition of PED a) Price elasticity of demand [PED] Price elasticity of demand is a measure of how much the quantity demanded of a product change when there is a change in the price of the product. It is usually calculated by using the following equation:  Definition of PED Example A publishing firm discovers that when they lower the price of one of their monthly magazines from $5.00 to $4.50, the number of magazines that are bought by customers each month rises from 200,000 to 230,000. With this information, we can calculate the price elasticity of demand for the magazine in question: Definition of PED  THE RANGE OF VALUES OF PED i. Perfectly Inelastic Demand o If PED is equal to zero, then a change in the price of a product will have no effect on the quantity demanded at all. o Since zero divided by anything is zero, no matter what the percentage change in price, the PED value will be zero. o A demand curve with a PED value of zero is shown in Figure 1 and, in this case, demand is said to be perfectly inelastic it is completely unresponsive to price changes. o Whether price is P1, P2 , or any other price, the quantity demanded will be Q.  THE RANGE OF VALUES OF PED In reality, perfectly inelastic demand is quite rare and typically only applies to certain critical medical treatments, where consumers have no choice but to purchase the product regardless of the price. Figure 1 A perfectly inelastic demand curve  THE RANGE OF VALUES OF PED ii. Perfectly Elastic Demand o A PED value of infinity is best explained by using a diagram and the situation is shown in Figure 2. In this case, demand is said to be perfectly elastic. o At the price P1 , the demand curve goes on for ever and so the quantity demanded is infinite. o However, if price is raised above P1 , even by the smallest amount, demand will fall to zero, an infinite change. o Since infinity divided by anything is infinity, no matter what the percentage change in price, the PED value will be infinity.  THE RANGE OF VALUES OF PED In practice, perfectly elastic demand is not found in real-world markets because consumers typically have alternatives and preferences, and prices can't change instantaneously. Figure 2 A perfectly elastic demand curve  THE RANGE OF VALUES OF PED iii. Inelastic demand o The value of PED is less than one and greater than zero. o If a product has inelastic demand, then a change in the price of the product leads to a proportionally smaller change in the quantity demanded of it. This means that if the price is raised, the quantity demanded will not fall by much in comparison, and so the total revenue gained by the firm (the number of units sold the price of the product) will increase.  THE RANGE OF VALUES OF PED Examples 1) There are several cases of pharmaceutical firms like Nostrum, Pfizer and Flynn hiking up prices of essential medicines, in some cases, life saving AIDS and cancer drugs, given patent protection and a profit motivated business objective. 2) Rail Fares in the UK rise yearly yet train operators repeatedly report large increases in revenue. With a lack of good substitutes and the necessity of getting to and from work, the demand for rail travel at peak times in the UK is significantly price inelastic. 3) The Apple iPhone is a proven case of price inelastic demand given immense brand loyalty. In 2017, Apple crossed the $1,000 price mark for the first time with its iPhone X, yet made record revenue in 2018 despite little to no unit sales growth. 4) Other examples; Cigarettes, Alcohol, Fuel, UK Hospital Parking and Champions League Final Airfares.  THE RANGE OF VALUES OF PED Example When the price of a carton of strawberry yoghurt is raised from $1 to $1.20, the firm finds that quantity demanded per week falls from 12,000 cartons to 10,800 cartons. Thus a 20% increase in price is causing a 10% fall in the quantity demanded. We can work out the PED by using the equation:  THE RANGE OF VALUES OF PED ▪ As we can see, the PED is 0.5, less than one, so the demand for the yoghurt is inelastic. ▪ Before the price increase, the total revenue gained by the firm was 12,000 x $1 = $12,000. ▪ After the increase, the total revenue becomes 10,800 x $1.20 = $12,960. ▪ The firm has increased revenue by raising the price. ▪ This is shown in Figure 3. Thus, if a firm has inelastic demand for its product and wishes to increase total revenue, it should raise the price of the product.  THE RANGE OF VALUES OF PED Goods like gasoline often exhibit inelastic demand because they are necessities, and consumers have limited short-term alternatives. Figure 3 The demand for strawberry yoghurt  THE RANGE OF VALUES OF PED iv. Elastic demand o The value of PED is greater than one and less than infinity. o If a product has elastic demand, then a change in the price of the product leads to a greater than proportionate change in the quantity demanded of it. This means that if price is raised, the quantity demanded will fall by more in comparison, and so the total revenue gained by the firm (the number of units sold x the price of the product) will fall.  THE RANGE OF VALUES OF PED Example When the price of a hot dog is raised from $2 to $2.10, a hot dog seller finds that quantity demanded per week falls from 200 hot dogs to 180 hot dogs. Thus a 5% increase in price is causing a 10% fall in the quantity demanded. We can work out the PED by using the equation:  THE RANGE OF VALUES OF PED As we can see, the PED is 2, greater than 1, so the demand for the hot dog is elastic. Before the price rise, the total revenue gained by the hot dog seller was 200 x $2 = $400. After the increase, the, total revenue becomes 180 x $2.10 = $378. The seller has caused a fall in revenue by raising the price. This is shown in Figure 4. Thus, if a firm has elastic demand for its product and wishes to increase total revenue, it should not raise the price of the product.  THE RANGE OF VALUES OF PED Goods and services with readily available substitutes and many alternatives typically exhibit elastic demand because consumers can easily adjust their consumption in response to price changes. Figure 4 The demand for hot dogs  THE RANGE OF VALUES OF PED v. Unit elastic demand o If price is raised by a certain percentage, then the quantity demanded will fall by the same percentage, and so PED is equal to 1. o A curve that has unit elasticity at every point is shown in Figure 5. o It is known as a rectangular hyperbola. o The rectangular hyperbola is drawn in such a way that price times quantity at any point is constant. This means that the total of the “revenue boxes” always have the same area and if the revenue does not change when price changes, then PED must be unity.  THE RANGE OF VALUES OF PED In practice, there is no product that has a unitary elasticity of demand Figure 5 A rectangular hyperbola, where PED =1 at every point Test Yourself ! Test Yourself !  Total Revenue and PED Elasticity Explanation Elastic Demand A reduction in price will increase the firm’s total revenue. An increase in price will decrease the firm’s total revenue. Example: o For example, a good has an elastic PED of -2.5. o When the good’s price is £5, 20 units are sold, giving a total revenue of £100. o When price falls to £4, demand rises to 30 units and total revenue increases to £120. Total Revenue and PED  Total Revenue and PED Elasticity Explanation Inelastic Demand A reduction in price will reduce the firm’s total revenue. An increase in price will increase the firm’s total revenue. Example o For example, a good has an inelastic PED of -0.5. o When the good’s price is £5, 20 units are sold, giving a total revenue of £100. o When price falls to £4, demand rises to 22 units and total revenue falls to £88. Total Revenue and PED  Total Revenue and PED Elasticity Explanation Unitary Demand In cases of unitary demand, changes in price do not lead to changes in total revenue. Total revenue remains constant, regardless of whether the firm reduces or increases the price. Total Revenue and PED  PED and a downward-sloping linear demand curve ▪ It might be assumed that PED is the same throughout the entire length of the demand curve. This is not correct. Ed = Lower Segment Upper segment Point Quantity Price Ed = Lower Segment Elasticity Upper segment A 0 10 Perfectly Elastic B 15 7 2.3 Elastic C 25 5 1 Unitary Elastic D 40 2 0.25 Inelastic E 50 0 0 Perfectly inelastic  PED and a downward-sloping linear demand curve Price ($) Ed = Lower Segment Upper segment 3 10 A 2 7/3 = 2.3 7 B 5/5 = 1 3 5 C 2/8 = 0.25 2 0/8 = 0 2 D E Quantity (Unit) 0 15 25 40 50  Factors affecting price elasticity of demand Factors Explanation The number of close ▪ The more close substitutes there are for a given good or service the substitutes more price elastic demand will be. ▪ Therefore, as the price increases, quantity demanded will decrease proportionately more than the price increase. ▪ Consumers will switch to substitute products instead. ▪ The fewer close substitutes here are for a given good or services the more price inelastic demand will be. ▪ Therefore, as the price increases, quantity demanded will decrease proportionately less than the price increase. ▪ Consumers will find it difficult to switch to cheaper substitutes.  Factors affecting price elasticity of demand Factors Explanation The percentage of ▪ The greater the proportion of income a given price change takes, the income more price elastic demand will be. ▪ Demand for an expensive item that take up a large proportion of income is likely to be more responsive to a price change - price elastic demand. Luxury or necessity ▪ Luxuries will have more price elastic demand, as when the price of luxuries increase, individuals will decrease their consumption markedly realizing consumption is not necessary. ▪ In this sense, the proportionate decrease in quantity demand is greater than the rise in price.  Factors affecting price elasticity of demand Factors Explanation Luxury or necessity ▪ Necessities will have more price inelastic demand as when the price of necessities increase, individuais will not decrease their consumption markedly realising consumption is necessary. ▪ In this sense, the proportionate decrease in quantity demand is less than the rise in price.  Factors affecting price elasticity of demand Factors Explanation Addictive nature of the ▪ If the good in question is addictive or habit forming such as stamp good/habit forming good collecting, demand for it will be price inelastic. ▪ This is because even when the price of these goods increase, an individual may not be able to stop themselves from consuming it due to its addictive or habit forming nature. ▪ In this sense if the price of the good increases, the proportionate decrease in quantity demand is less than the rise in price.  Factors affecting price elasticity of demand Factors Explanation Time period ▪ In the long run demand for goods and services tends to become more price elastic. ▪ This is because more substitutes enter the market over time allowing consumers to switch their consumption more easily if prices are rising for other goods or services. ▪ In this sense, overtime, if the price of the good increases, the proportionate decrease in quantity demand will be greater than the rise in price. Test Yourself! Test Yourself!  Definition of YED b) Income elasticity of demand [YED] Income elasticity of demand measures the degree of responsiveness of quantity demanded to a change in income of consumers. Income elasticity of demand is calculated as follows: The major question then, is "when income rises/decreases a certain percent, does quantity demanded change proportionally, proportionally more, or proportionally less?"  Definition of YED Before we dive into the math, let's define some terms: ▪ A normal good is a good that, when income increases, demand also increases. This is the case for most goods. ▪ An inferior good is the opposite: when income increases, demand decreases. Some examples of this are things like ramen noodles and bus tickets. When income increases, we may move to better ramen or a taxi.  Definition of YED Example Take an example. A person has an increase in annual income from $60,000 per year to $66,000. She then increases her annual spending on holidays from $2,500 to $3,000. With this information, we can calculate her income elasticity of demand for holidays. The classification of goods in relation to income The classification of goods in relation to income The classification of goods in relation to income The classification of goods in relation to income Test Yourself! Using Table 8.4: 1. Calculate the YED when rooms rent for 400 rupees. 2. Calculate the YED when rooms rent for 1000 rupees. 3. Explain whether guest house rooms are normal or inferior goods. 4. Explain whether guest house rooms are necessity or superior goods.  Definition of XED c) Cross elasticity of demand [XED] Cross elasticity of demand is a measure of how much the demand for a product change when there is a change in the price of another product. It is usually calculated by using the equation below:  Definition of YED Example The owners of a pizza stand find that when their competitor, a hamburger stand, lowers the price of a burger from $2 to $1.80, the number of pizza slices that they sell each week falls from 400 to 380, because of the lower priced burger. With this information, we can calculate the cross elasticity of demand for the pizza slices from the stand. Sign of XED Test Yourself! Thank you CHAPTER 2 : THE PRICE SYSTEM AND THE MICROECONOMY (AS LEVEL) 2.3 Price Elasticity of Supply  CONTENT 2.3.1 definition of price elasticity of supply (PES) 2.3.2 formula for and calculation of price elasticity of supply 2.3.3 significance of relative percentage changes, the size and sign of the coefficient of price elasticity of supply 2.3.4 factors affecting price elasticity of supply 2.3.5 implications for speed and ease with which firms react to changed market conditions  2.3.1 Definition of Price Elasticity of Supply (PES) ▪ Price elasticity of supply is a measure of how much the supply of a product changes when there is a change in the price of the product. ▪ It is usually calculated by using the equation below. ▪ Since there is always a direct relationship between price and quantity supplied, the PES coefficient will always be positive.  2.3.1 Definition of Price Elasticity of Supply (PES) Example A publishing firm realizes that they can now sell their monthly magazine for $5.50 instead of $5.00. In light of this, they increase their supply from 200 000 to 230 000 magazines per month. With this information, we can calculate the price elasticity of supply for the magazine in question  2.3.3 Significance of Relative Percentage Changes, the Size and Sign of the Coefficient of Price Elasticity of Supply i. Perfectly Inelastic supply curve ▪ If PES is equal to zero, then a change in the price of a product will have no effect on the quantity supplied at all. ▪ Since zero divided by anything is zero, no matter what the percentage change in price, the PES value will be zero. ▪ A supply curve with a value of zero is shown in Figure 1 and, in this case, supply is said to be perfectly inelastic- it is completely unresponsive to price changes. Whether price is P1, P2, or any other price, the quantity supplied will be Q.  2.3.3 Significance of Relative Percentage Changes, the Size and Sign of the Coefficient of Price Elasticity of Supply In the very short run, sometimes known as the immediate time period, it is impossible for firms to increase their supply straight away, no matter what happens to price, and so the supply curve would look like the one in Figure 1, until new factors of production could be employed. Thus, a perfectly inelastic supply curve is a possibility. Figure 1 A perfectly inelastic supply curve  2.3.3 Significance of Relative Percentage Changes, the Size and Sign of the Coefficient of Price Elasticity of Supply ii. Perfectly Elastic Supply ▪ A PES value of infinity is best explained by using a diagram and the situation is shown in Figure 2. ▪ In this case, supply is said to be perfectly elastic. ▪ At the price P1, the supply curve goes on forever and so the quantity supplied is infinite. However, if price falls below P1, even by the smallest amount, supply will fall to zero, an infinite change. Since infinity divided by anything is infinity, no matter what the percentage change in price, the PES value will be infinity. 2.3.3 Significance of Relative Percentage Changes, the Size and Sign of the Coefficient of Price Elasticity of Supply Figure 2 A perfectly elastic supply curve  2.3.3 Significance of Relative Percentage Changes, the Size and Sign of the Coefficient of Price Elasticity of Supply Normal products have values between zero and infinity and we will now look at those values. The range of values of PES is normally split into three categories: Elasticities Explanation Inelastic supply ▪ The value of PES is less than one and greater than zero. ▪ If a product has inelastic supply, then a change in the price of the product leads to a less than proportionate change in the quantity supplied of it, and so the value of PES is greater than zero and less than one. ▪ Curve S3 has a PES value of less than one along its entire length. This is because the percentage change in price is always greater than the percentage change in quantity supplied. For mathematical reasons, it is correct to say that any straight- line supply curve starting from the x-axis has a PES value less than one.  2.3.3 Significance of Relative Percentage Changes, the Size and Sign of the Coefficient of Price Elasticity of Supply Elasticities Explanation Elastic supply ▪ The value of PES is greater than one and less than infinity. ▪ If a product has elastic supply, then a change in the price of the product leads to a greater than proportionate change in the quantity supplied of it, and so the value of PES is greater than one and less than infinity. ▪ Curve S4 has a PES value of greater than one along its entire length. This is because the percentage change in quantity supplied is always greater than the percentage change in price. For mathematical reasons, it is correct to say that any straight- line supply curve starting from the y-axis has a PES value greater than one.  2.3.3 Significance of Relative Percentage Changes, the Size and Sign of the Coefficient of Price Elasticity of Supply Elasticities Explanation Unit elastic supply ▪ The value of PES is equal to one. ▪ If a product has unit elastic supply, then a change in the price of the product leads to a proportionate change in the quantity supplied of it and so the value of PES is equal to one. ▪ In Figure 3, curves S1 and S2 have a PES value of one along their entire length. This is because the percentage change in price is always equal to the percentage change in quantity supplied. For mathematical reasons, it is correct to say that any straight- line supply curve, passing through the origin, has an elasticity of supply of one.  2.3.3 Significance of Relative Percentage Changes, the Size and Sign of the Coefficient of Price Elasticity of Supply S1-S2 = Unit elastic supply S3 = Inelastic supply S4 = Elastic supply Figure 3 Supply curves with different values of PES  2.3.4 Factors Affecting Price Elasticity of Supply Factors Explanation Time periods ▪ The elasticity of supply tends to be greater in the long run than in the short run because it is easier to increase the amount produced when the firm has more time in which to do it. ▪ It may be difficult to change quantities supplied in response to a price increase in the short run. This is obvious if one considers agricultural products. ▪ Suppose that the price of an agricultural product rises unexpectedly. There is little that farmers can do to supply more agricultural products because it takes time to grow them. Thus, the supply of agricultural products tends to be inelastic in the short run. ▪ However, supply is elastic in the long run since the long run offers opportunities to expand output that are not available instantaneously.  2.3.4 Factors Affecting Price Elasticity of Supply Factors Explanation Availability of ▪ If a firm wishes to expand production, it will need more resources. If the economy is resources already using most of its scarce resources, then firms will find it difficult to employ more, and therefore, output will not rise. Hence, supply of most goods will be inelastic. ▪ If, however, there is unemployment of resources, firms can easily raise output, and in this case, supply is elastic. Technology Modern methods of production expand output and thus the supply tends to be elastic. advancements The number of outputs produced in a given period of time is lower when old methods of production are used.  2.3.4 Factors Affecting Price Elasticity of Supply Factors Explanation Perishability ▪ There are perishable products such as agricultural products (e.g., Fruits and vegetables) and supply tends to be inelastic. Changes in price do not affect supply much because seller cannot store perishable products for long periods of time. ▪ In case of less perishable such as manufactured products (e.g., cars, shoes, and canned food), the supply is more elastic. If sellers expect a price increase in another two months, they may store these products for future sale. Thank you CHAPTER 2 : THE PRICE SYSTEM AND THE MICROECONOMY (AS LEVEL) 2.4 The Interaction of Demand and Supply  CONTENT 2.4.1 definition of market equilibrium and disequilibrium 2.4.2 effects of shifts in demand and supply curves on equilibrium price and quantity 2.4.3 relationships between different markets: joint demand (complements), alternative demand (substitutes), derived demand, joint supply 2.4.4 functions of price in resource allocation; rationing, signaling (transmission of preferences) and incentivizing  2.4.1 Definition of Market Equilibrium and Disequilibrium ▪ Market equilibrium is a situation when quantity demanded (Qd), and quantity supplied (Qs) are equal and there is no tendency for price or quantity to change. QDD = QSS ▪ When a market is in equilibrium, the quantity sellers are willing to sell balances exactly with the quantity buyers are willing to buy. ▪ The price at the point of equilibrium is known as the equilibrium price, while the quantity at the point of equilibrium is known as the equilibrium quantity 2.4.1 Definition of Market Equilibrium and Disequilibrium 2.4.1 Definition of Market Equilibrium and Disequilibrium QUESTION  2.4.1 Definition of Market Equilibrium and Disequilibrium Price Quantity Quantity Market Condition Market Prices Demanded Supplied 5 2 10 SURPLUS Falls 4 4 8 SURPLUS Falls 3 6 6 EQUILIBRIUM Equilibrium 2 8 4 SHORTAGE Rises 1 10 2 SHORTAGE Rises A market will not be in equilibrium if the quantity demanded is not equal to the quantity supplied.  2.4.1 Definition of Market Equilibrium and Disequilibrium SURPLUS (QSS > QDD) 6 5 SS 4 Price ($) E 3 P* 2 1 SHORTAGE (QDD > QSS) DD 0 Q* 2 4 6 8 10 Quantity (Unit) 2.4.1 Definition of Market Equilibrium and Disequilibrium  2.4.2 Effects of Shifts in Demand and Supply Curves on Equilibrium Price and Quantity Assume supply is constant Price ($) Increase in Demand Change in demand -DD curve shifts to the SS right -Equilibrium price and P2 quantity increase P* P1 DD1 DD Decrease in Demand DD2 -DD curve shifts to the left -Equilibrium price and Q1 Q* Q2 Quantity (unit) quantity decrease  2.4.2 Effects of Shifts in Demand and Supply Curves on Equilibrium Price and Quantity Assume demand is constant Increase in Supply Change in Supply Price ($) SS2 -SS curve shifts to the right SS -Equilibrium price decreases and P2 quantity increases SS1 P* P1 DD Decrease in Supply -SS curve shifts to the left Q1 Q* Q2 Quantity (Unit) -Equilibrium price increases and quantity decreases  2.4.2 Effects of Shifts in Demand and Supply Curves on Equilibrium Price and Quantity SUPPLY AND DEMAND BOTH INCREASE Case 1: Same Price ($) magnitude DD1 -Equilibrium price is SS constant and quantity increases SS1 P* DD Q* Q1 Quantity (unit) QUESTION  2.4.2 Effects of Shifts in Demand and Supply Curves on Equilibrium Price and Quantity SUPPLY AND DEMAND BOTH INCREASE Case 2: Different Magnitude Price ($) DD1 -Equilibrium price SS increases and quantity increases SS1 P1 P* DD Q* Q1 Quantity (unit)  2.4.2 Effects of Shifts in Demand and Supply Curves on Equilibrium Price and Quantity SUPPLY AND DEMAND BOTH INCREASE Case 3: Different Price ($) Magnitude DD1 SS -Equilibrium price decreases SS1 and quantity increases P* Both DD and SS increase P1 ➔ Equilibrium quantity increase ➔ Equilibrium price is uncertain DD Q* Q1 Quantity (unit)  2.4.3 Relationships Between Different Markets The relationship between two products (substitutes and complements) is now extended to show how market conditions change when there is a change in the price of either of them. The special cases of derived demand and joint supply are also introduced below. i. Alternative demand ▪ a substitute is an alternative good. Example Well-known brand of sweet chilli sauce and an own-label brand from a supermarket. A rise in price of one product will lead to an increase in demand and a rise in price of the substitute product. 2.4.3 Relationships Between Different Markets Figure 1: An increase in the price of a substitute  2.4.3 Relationships Between Different Markets ii. Joint demand ▪ A complement is in joint demand, meaning that it is consumed with another product. ▪ An example is a replica football shirt and shorts. ▪ Here, an increase in supply will see the price of one product fall prompting an increase in demand for the complement Figure 2: A fall in the price of a complement  2.4.3 Relationships Between Different Markets iii. Derived demand ▪ Derived demand applies where something is required because it is needed for the production of other goods and services. ▪ A typical example is labour, a factor of production. A hotel business demands labour in order to provide accommodation and food for its visitors. If there is an increase in demand for the hotel’s services, the demand for hotel workers will also increase. Therefore, the demand for hotel workers is derived from the demand for the hotel’s services. 2.4.3 Relationships Between Different Markets Figure 3: Derived demand  2.4.3 Relationships Between Different Markets iv. Joint supply ▪ Joint supply occurs when two goods are produced together but for different purposes. ▪ An example is the case of soya bean processing in the US where the crop is first processed for human consumption and the remainder is made into animal feed. ▪ Figure 4 shows how an increase in demand for processed soya for humans leads to an increase in supply and a fall in price of the animal feed. QUESTION 2.4.3 Relationships Between Different Markets Figure 4: Joint supply  2.4.4 Functions of Price in Resource Allocation; Rationing, Signaling (Transmission Of Preferences) And Incentivizing a) Rationing ▪ In other situations, the price system can ration (limit) products in the market. The process of rationing is automatic. Example o A producer may wish to limit the supply of products so that they remain exclusive in the market. o Exclusive products are likely to have a high price, such as designer jewellery or an upmarket sports car. o A form of rationing will take place because of the products’ high price. o Demand is limited and ensures that it is in line with the quantity supplied to the market.  2.4.4 Functions of Price in Resource Allocation; Rationing, Signaling (Transmission Of Preferences) and Incentivizing b) Signalling and the transmission of preferences- Prices also act as a signal to both producers & consumers. ▪ A rise in the quantity demanded results in an increase in price, signaling to (telling) producers that they should put more of their products onto the market. ▪ In turn, if consumers withhold their demand, prices can be expected to fall. This signals to producers that less should be produced. ▪ The price mechanism works in such a way that the outcome is a new equilibrium position with consumers’ demand equal to producers’ supply. ▪ The price mechanism allows the wants of consumers to be made known to producers.  2.4.4 Functions of Price in Resource Allocation; Rationing, Signaling (Transmission Of Preferences) And Incentivizing ▪ This is called the transmission of preferences and is automatic. If consumers do not buy a particular product because it is not liked or it is too expensive, then the message is transmitted back to producers. o If they wish to stay in business, producers should react by either improving the product, reducing its price or both.  2.4.4 Functions of Price in Resource Allocation; Rationing, Signaling (Transmission Of Preferences) And Incentivizing c) The provision of incentive ▪ Price also acts as an incentive to buyers and sellers. Low prices and special offers such as discounts generally encourage consumers to buy more goods. This is because consumers get more satisfaction from consuming a product when they think they are getting a good deal. ▪ Higher prices can stop consumers purchasing a good; however, they can encourage suppliers to produce more for the market in a way that low prices can discourage their willingness to supply. If low prices persist, suppliers may well decide to exit a market. Thank you CHAPTER 2 : THE PRICE SYSTEM AND THE MICROECONOMY (AS LEVEL) 2.5 Consumer and producer surplus  CONTENT 2.5.1 meaning and significance of consumer surplus 2.5.2 meaning and significance of producer surplus 2.5.3 causes of changes in consumer and producer surplus 2.5.4 significance of price elasticity of demand and of supply in determining the extent of these changes  2.5.1 Meaning and Significance of Consumer Surplus CONSUMER SURPLUS : ▪ The difference between the maximum price consumer’s willing to pay and the price that they actually pay. ▪ Consumer surplus is the extra benefit consumers gain when they pay less for a product or service than they are willing to. Example If you're willing to pay $100 for a concert ticket but pay only $60, your consumer surplus is $40. You want to buy a $50 shirt, but you find it on sale for $30. Your consumer surplus is $20 ($50 -$30) because you gained $20 in value by paying less than your maximum willingness to pay. ▪ In this image, it is clear that the car salesman had no idea what the woman’s willingness to pay was. ▪ Had he known, he would probably have sold that car for at least $2,000 more.  2.5.1 Meaning and Significance of Consumer Surplus Example The following table shows the maximum amount a consumer is willing to pay for given quantities Suppose the consumer buy 3 units at the price of $50 each. What will be their consumer surplus? (Actual Price =$ 30) QUANTITY MAXIMUM WILLING TO PAY 1 100 Willingness to pay = $50 2 80 Actual Price =$ 30 3 50 Consumer surplus = $ 20 4 30 Consumer surplus can never be negative. 5 20 2.5.1 Meaning and Significance of Consumer Surplus Total area below the demand curve up to a certain quantity shows the willingness to pay. 2.5.1 Meaning and Significance of Consumer Surplus ▪ The price indicates the amount they actually pay for each unit. ▪ The area quantified as price multiplied by quantity represents actual consumer expenditure. ▪ The difference between these two--the triangular area below the demand curve but above the price paid--is a measure of the total consumer surplus up to a given quantity. 2.5.1 Meaning and Significance of Consumer Surplus  2.5.1 Meaning and Significance of Consumer Surplus Determinant of consumer surplus. a.) Price : As the price of the product decreases, consumer surplus increase. Price Consumer surplus  2.5.1 Meaning and Significance of Consumer Surplus Determinant of consumer surplus. b.) Price elasticity of Demand : ▪ The more inelastic the demand curve, the greater the surplus. PED Consumer surplus Elastic aEoP0 Inelastic nEoPo  2.5.1 Meaning and Significance of Consumer Surplus PED Consumer surplus Perfectly Elastic Zero Perfectly Inelastic Infinity  2.5.2 MEANING AND SIGNIFICANCE OF PRODUCER SURPLUS PRODUCER SURPLUS ▪ It represents the difference between the market price and the minimum acceptable price for the producer. Example Imagine a company that manufactures smartphones. The company is willing to sell each smartphone for a minimum price of $300 to cover its production costs and make a reasonable profit. In the market, the current price for their smartphones is $400. Producer Surplus = Market Price - Minimum Price Producer Surplus = $400 - $300 = $100  2.5.2 MEANING AND SIGNIFICANCE OF PRODUCER SURPLUS - = Market price Willingness Producer surplus to accept  2.5.2 MEANING AND SIGNIFICANCE OF PRODUCER SURPLUS Determinant of Producer surplus. b.) Price elasticity of Supply: ▪ The more inelastic the supply curve, the greater the surplus. 2.5.2 Meaning and Significance of Producer Surplus  Producer and consumer surplus Price of concert ticket SS 80 Consumer Surplus (CS) = area above equilibrium price and below 60 demand curve CONSUME R Producer Surplus (PS) = area SURPLUS below equilibrium price and above 40 supply curve PRODUCER SURPLUS Total Surplus (TS) = CS + PS 20 0 1 2 3 4 Quantity of concert ticket Thank you