microeconomics.pdf

6 72 95 Principles of 23 Prepared by 51 Prof. Dr. Mohamed Abdelwahed Mohamed Othman Prof. Dr. Gamal Mahmoud Attia Obaid Pro...

6 72 95 Principles of 23 Prepared by 51 Prof. Dr. Mohamed Abdelwahed Mohamed Othman Prof. Dr. Gamal Mahmoud Attia Obaid Prof. Dr. Mahmoud Abdelaziz Touny Abdelaal Department of Economics & Foreign Trade Faculty of Commerce and Business Administration Helwan University 2023  ‫الناشر‬ ‫جهاز نصر وتوزًع الكثاب اجلامعي‬ 6 ‫جامعة حموان‬ 72 ‫© حقوق الثألٌف حمفوظة لممؤلفني‬ 95 ‫حفظ الترجمة‬ 23 Publisher 51 Agency of Publishing & distributing the university book Helwan University © Copyright reserved for the authors 2023  PREFACE These notes of microeconomics principles are directed to students of the first year of college of commerce. They give students some knowledge about principles of microeconomics. These notes are given to students to simplify the material given to them. Beside these notes a number of references are recommended to students to complete their 6 knowledge of this subject. 72 The first two chapters are written by Professor Dr. 95 Mohamed Abdelwahed while chapters 5 & 6 are written by Professor Dr. Gamal Attia, and the other chapters (3, 4, 7, 8) 23 are written by Professor Dr. Mahmoud Touny. We hope that these notes, in addition to lectures and 51 other material recommended, will meet the objective of teaching this course. The Authors Sept. 2023  1 Table of Contents Subject Page Chapter (1): The Economic Problem and Economic Systems 2 Chapter (2): The Production Possibility Frontier and Its 20 Applications ……………………………………. Chapter (3): Demand and Supply in a Market System ……… 42 6 Chapter (4): Demand and Supply Elasticities ………………. 79 72 Chapter (5): The Consumer Equilibrium …………………… 105 Chapter (6): Theories of Production and Costs ……………… 122 95 Chapter (7): Perfect Competition ……………………………. 144 23 Chapter (8): Monopoly ……………………………………… 175 References …………………………………………………… 193 51 About the Authors ………………………………………….. 196  6 72 The Economic Problem 95 and Economic Systems 23 51  3 The Economic Problem and 1.1 Definition of Economics: Why do we study economics? 6 72 There are many reasons for studying economics. Economics is essential to understanding the world in which you live and 95 work. What determines the prices of the goods and services on which you spend your income? Why do some people earn 23 so much and others so little? Why do some jobs pay high wages while other jobs pay low wages? How do firms 51 operating in different market environments decide what quantities to produce of their product outputs, what prices to charge for these outputs, and what quantities of labor and capital inputs to employ? Therefore, the ultimate goal of economic science is to improve the living conditions of people in their everyday lives. As you embark on your study of economics, you will hear the comment that there are as many definitions of Chapter (1) The Economic Problem and Economic Systems  4 economics as there are economists. Adam Smith (1723–90) who considered being the founding father of modern Economics defined economics as an inquiry into the nature and causes of the wealth of nations. John Stuart Mill (1806– 73) viewed economics as ‘the practical science of the production and distribution of wealth’. Alfred Marshall declared economics to be ‘the study of mankind in the ordinary business of life. Modern economists define 6 economics as the study of how man allocates scarce resources, which have alternative uses, to achieve given ends 72 or goals. For example, Paul A. Samuelson and William D. Nordhaus define economics as the study of how societies use 95 scarce resources to produce valuable commodities and distribute them among different people. Behind this 23 definition are two key ideas in economics: that goods are scarce and that society must use its resources efficiently. 51 From the previous discussion, we can conclude a good definition of economics as "economics is a social science that studies how individuals, governments, firms, and nations make choices on allocating scarce resources to satisfy their unlimited wants". Economics is a social science as it deals with human behavior in society. Economics recognizes that resources are scarce. The economy is the mechanism through Chapter (1) The Economic Problem and Economic Systems  5 which these scarce resources are organized for the production of goods and services. These goods and services satisfy the needs and want of the different groups (individuals, firms, and governments) in the economy. 1-2 The Economic Problem There are two facts constituting the economic problems, and provide a foundation for the field of economics. The two facts are: (1) the unlimited or society's material wants, and (2) the 6 limited or scarce economic resources. These two facts will be 72 indicated as follows: (1) Unlimited Wants: 95 We indicate this title under the following sub-titles: 23 1- Definition of Material Wants: Material wants mean that the desires of consumers, 51 businesses and units of governments to obtain and use various goods and services that provide utility. These material wants include: (A) Goods which are tangible products and satisfy wants. They include a wide range of products that fill the bill in this respect such as meat, houses, sweaters, shirts, sweets, cars, toothpaste, books, 'radio, cinema, television, computer, and other products. Clearly, we Chapter (1) The Economic Problem and Economic Systems  6 can classify these goods under: (1) necessities such as food, shelter and clothing, and (2) luxuries such as perfumes, yachts and mink coats. Of course, what is a necessity to somebody may be a luxury to someone else, and what is a necessity today may have been a luxury a few years ago. Also we can divide goods, according to their production, to: (1) consumer goods which directly satisfy wants such as pizza, ice cream, hamburger.., and (2) capital goods which 6 satisfy wants indirectly by permitting production of consumer goods. 72 (B) Services which are intangible and satisfy wants as 95 much as products such as repairing cars, haircut, legal advice, teaching, transportation, and other services. 23 In fact, we buy many goods for the services they render such as cars, refrigerators and washing machines. 51 Therefore, the differences between goods and services are often less than they seem to be Also, material wants mean the desires of businesses and units of governments - in addition to consumers indicated above - to obtain and use various goods and services that seek to satisfy. Businesses want plant buildings, trucks, machinery, warehouses, communication systems, and other materials that help them accomplish their Chapter (1) The Economic Problem and Economic Systems  7 production objectives. Lastly, government, that reflects the collective wants of its citizenry or objectives of its own, seeks schools, universities, highways, hospitals, bridges, military hardware, and railway stations. (2).Characteristics of Material Wants : As a whole, the material wants are insatiable or unlimited mean that material wants for goods and services cannot be completely satisfied. However, wants for a particular good or 6 service can be satisfied, which means that, over a short period of time we can get enough ice cream or oranges. But for the 72 whole goods, we cannot fill all the list of our wants. 95 In addition, over a period of time wants multiply so that as one fills some of the wants on the list he adds new ones. The rapid introduction of new products, going on 23 nowadays, whets appetites, and advertising encourages people to demand items they might not otherwise consider 51 buying. To conclude, over time, society has innumerable unfulfilled material wants. Some of these wants have biological roots such as food, shelter and clothing, and others influenced by the conventions and customs of the society. Over time, wants change and multiply, fueled by development of new products and advertising and sales Chapter (1) The Economic Problem and Economic Systems  8 promotion. The overall objective of all economic activity is to satisfy the various, diverse and developed material wants. (2) Scarce Resources This title is indicated under the following sub-titles: 1- Definition of Economic Resources: Economic resources mean all natural, human, and manufactured resources that go into the production of goods 6 and services. These include types of labor, land and mineral 72 resources, tools, factory and farm buildings and all equipment, and machinery used to produce manufactured goods and agricultural products, transportation and communication facilities. 95 2- Types of Resources: 23 Economic resources can be dividend into the following four 51 types: A. Land: Land refers broadly to natural resources. It means all natural resources (endowments or gifts of nature( usable in the productive process. These include land used for agriculture (farming), underpinning houses, factories, and roads, energy resources (such as oil) and non-energy resources (such as gold, copper, iron ore and sand), water Chapter (1) The Economic Problem and Economic Systems  9 resources, and environmental resources (such as clean air and drinkable water). B. Labour Labour refers broadly to human resources. It includes all physical and mental talents of human being that are available and usable in producing goods and services, This includes time spent in production by workers, teachers, machinist, clerks, professors, and others. It is the most crucial 6 input for developed and developing countries. 72 C. Capital Capital (investment goods) is all manufactured aids or 95 durable goods of an economy, produced to produce other goods. It includes all tools, machines, equipment, roads, 23 computers, trucks, hammers, steel mills, transportation, distribution facilities, factories, and storages used in 51 producing goods and services and getting them to final consumer. This process of producing investment or capital goods is known as investment. The accumulation of specialized capital goods (or investment goods) is important to economic development. Chapter (1) The Economic Problem and Economic Systems  10 Here, it is preferable to raise two related points: (1) Capital goods are different from consumer goods in that the consumer goods satisfy material wants directly, while capital goods satisfy wants indirectly by facilitating production of consumable goods, and (2) Capital is different from money. Business men often talk about money as "money capital" which means money available to buy equipment, machinery, and other productive facilities. Clearly, money produces nothing, and thus it is not 6 considered an economic resource. In short, real capital (tools, 72 machinery, and other productive equipment) is an economic resource, but money (financial capital) is not an economic resource. 95 d. Entrepreneurial Ability: 23 This classified as a special human resource under the label "entrepreneurial ability" or "enterprise". The 51 entrepreneur can perform four functions: 1- The entrepreneur combines the resources of land, labour, and capital to produce a good or service. That is, he (she) combines resources be in what is hoped it will be profitable project. In short, he (she) is the driving force behind production. Chapter (1) The Economic Problem and Economic Systems  11 2- The entrepreneur is an innovator who introduces new products, new productive techniques, and new forms of business organization. 3- The entrepreneur makes basic business policy decisions, especially the non-routine decisions which set the course of a business enterprise. 4- The entrepreneur is a risk bearer. In a capitalistic system, he has no guarantee of 6 profit. The payment for his efforts may be profits or 72 losses. Clearly, the entrepreneur risks not only effort, and business reputation, but also firm's invested funds. 3- Resource Payments 95 The previous resources (or factors of production or 23 inputs) are provided to business institutions in exchange for money income. The income accruing to land is called rental 51 income, while capital takes interest income. Entrepreneur takes profits which may be a negative figure (losses). Labor takes wages which include salaries and various wage and salary supplements in the form of bonuses, commissions, and others. 4- Relative Scarcity Economic resources are scarce or limited in supply. Earth contains limited amounts of resources to use in Chapter (1) The Economic Problem and Economic Systems  12 producing goods and services. Since the scare or limited resources resulted in limited output, society will not be able to produce and consume all the goods and services it might want. Clearly, resources are scare or limited in comparison with material wants. 1.3 Solving Economic Problem To solve economic problem, the field of economics should intervene through its theories and tools at the micro 6 and macro levels. Therefore, economics is defined as "the social science concerned with the problem of using or 72 managing scarce resources (the means of producing) to attain the greatest or maximum fulfillment of society's unlimited 95 wants (the goal of producing)". Economics is concerned with "doing the best with what we have". Clearly, because wants 23 are virtually unlimited in comparison with resources which are scarce, all of society's material wants cannot be satisfied. The next best thing is to accomplish the greatest possible 51 satisfaction of these wants. To understand how economics field helps to solve economic problems, the following sub- titles offered: 1.3.1 The Three Questions of Economic Organization In the context of solving economic problem, all economies (developing or developed) must confront and solve three important economic problems. Each economy Chapter (1) The Economic Problem and Economic Systems  13 must determine what goods are produced, how these goods are made, and for whom they are produced. These three economic questions can be explained, in more details, as follows: 1. What goods are produced and in what quantities? An economy must determine how much of the selected goods and services it will make and when they will be produced? Clearly, each society must choose goods and services to produce and direct scarce resources to make 6 them. What are the possible goods and services that 72 society choose today and delay for tomorrow? Societies must decide which goods and services will produce today. for present generation (consumption goods) and 95 for future generation (investment or capital goods). This question would not be raised if societies have no 23 economic problem (scarce or limited resources and unlimited wants). 51 2. How are commodities and services are produced? An economy must determine what production technique it will use (labour-intensive production or capital- intensive production)? Clearly, economies must decide: who will do the production and with what resources? Will farms and factories use much labour or capital to produce? This question raised because each country must use the technique of production which is appropriate to its scare resources. It must use the labor- Chapter (1) The Economic Problem and Economic Systems  14 intensive production technique if it has abundant labour and scare capital. The reverse is true for countries that have abundant capital and scarce labour. Also, this question would not be raised if there is no economic problem. 3. For whom are goods and services produced? This question is concerned with the distribution of income and wealth in the society. Clearly, it is related to: who gets the fruits of economic activities? How is the national product distributed among households? Is the 6 distribution of income and wealth fair and equitable? 72 Are many people poor and a few rich? All these question would not be raised if there is no economic 95 problem. 1.3.2 Economic Systems 23 Since different economies are organized through different economic systems (command, market and mixed 51 economies) economics studies various mechanisms that an economy can use to allocate its scarce resources. There are three different ways of organizing an economy: 1- Command Economy: This is the first extreme, where government makes most economic decisions about production and distribution. In this system Chapter (1) The Economic Problem and Economic Systems  15 (Soviet Union during most of the twentieth century) the government owns resources or factors of production (land, labour and capital), owns and direct all industries and farms working in the economy. Clearly, government choose and prefer the goods and services must produced for the society and direct to them the scarce resources. This will be achieved by making decisions at the top of the hierarchy giving economic commands to those further down the ladder. In the command system, government answers the key 6 economic questions through its ownership of resources 72 and its power to enforce decisions. 2- Market Economy: This is the second extreme, where 95 most economic questions are settled by market mechanism such as the United States and Western 23 Europe and many other economies around the world. It is a system in which individuals and private firms 51 make decisions about production and consumption conducted by the market through prices, profits and utilities. In this system, firms or businessmen produce the goods and services that yield the highest profits (the what) by using the least costly technique of production (the how). In this system (market economy), consumption is determined by individual's decisions about how to spend their Chapter (1) The Economic Problem and Economic Systems  16 wages, rents, interests and profits generated by their resources (the for whom). This extreme case of market system resulted from the classical model of laissez- faire or invisible-hand economy in which the government keeps its hands off economic decisions. Clearly, in this system market direct resources toward goods and services which maximize profits of producers, satisfactions of consumers, and payments of resource owners. 6 This conducted through the signals of prices resulted from the 72 market. 3- Mixed Economy: This system collects elements of 95 market and command systems. In reality, there is contemporary economy falls completely into either 23 command and market economies. Rather, all economies (societies) are mixed economies. 51 Nowadays, in all economies, most decisions are made in the marketplace. However, government a key role in conducting (overseeing) the functioning of the market. Clearly, in this prevailed system operating in reality, governments regulate economic life, produce defense, police, educational, health services and control pollution. All this occurred next to the market job of directing resources toward economic activities. Chapter (1) The Economic Problem and Economic Systems  17 1.4 Economics and Efficiency: Since society's resources are limited in comparison with its unlimited wants, it must use its limited resources efficiently. Therefore, economics known (as a discipline of education in its intervention to solve economic problem) is & science of efficiency. Clearly, it requires to get the maximum amount of useful goods and services produced with its available resources. 6 To reach this situation of efficiency, society must achieves both full employment and full production as 72 follows: 95 1. Full Employment: It means that all available resources should be employed. Clearly, all labour force should employed and society should provide 23 employment for all who are willing and able to work. Also all capital equipment or arable land should not sit 51 idle. This should occur in the light of considering Society's laws and customs, such as laws of restricting children work and productivity requirements. 2. Full Production: It means that all employed resources should be used to make the most valued contributions to the gross domestic product (GDP) or output. If society fails to achieve full production, economists say that society' resources are unemployed. Clearly, full Chapter (1) The Economic Problem and Economic Systems  18 employment of all employment resources is not sufficient to realize efficiency. So, this should be combined with realizing full production. Full production implies that two types of efficiency are realized: A. Allocative Efficiency: It means that resources are directed to goods and services most wanted by society. For instance, society wants resources appointed to food, not hamburgers, Also, 6 resources should be directed to produce goods and 72 services in which realize the maximum production. For example, arable lands of Upper Egypt should be devoted to produce sugar cane and other traditional 95 crops, and arable lands of Lower Egypt should be devoted to produce rice and other traditional crops. 23 Also, accountants should be directed to work in firms' marketing and financial departments. In short, 51 allocative efficiency means that resources are apportioned among firms and industries to get the certain mix of products society wants the most. B. Productive Efficiency: It means that the least costly production technique are used to produce wanted goods and services. It requires to produce an amount of goods and services by the least cost possible. In short, productive efficiency means that each good or Chapter (1) The Economic Problem and Economic Systems  19 service should be produced in the least costly fashion (using advanced tools to lower costs in stead of using manual tools). In summary, Full production means producing the right goods (allocative efficiency) in the right way (productive efficiency). 6 72 95 23 51 Chapter (1) The Economic Problem and Economic Systems  6 72 The production 95 possibility frontier and its applications 23 51  21 Chapter (2) The production possibility frontier and its applications In Chapter 1, we learned that individuals and societies should make trade-offs every day. For instance, you may frequently have to decide between spending more time studying to get 6 better grades or going to a party with your friends. The more 72 time you study, the less time you have for your friends. Similarly, a society has to determine how to allocate its 95 resources. The decision to build new roads will mean there is less money available for new schools, and vice versa. 23 2.1 The Production Possibilities Frontier 51 Production possibilities frontier (PPF) reflects country's available resources and technologies. Since resources are limited, an economy cannot have an unlimited output of goods and services. Therefore, choices must be made on which goods and services to produce and which to forgo. To analyze production possibilities frontier, some assumptions should be set as follows: Chapter (2) The Production Possibility Frontier and Its Applications  22 1. Efficiency: This means that the economy is operating at full employment and realizing full production. 2. Fixed Resources: This means that the available supplied of resources (or factors of production) are fixed in both quantity and quality. However, these resources can be shifted or reallocated, within limits, among different uses. For instance, unskilled labor can work on a farm, at a fast food restaurant, or in a gasoline station. 6 3. Fixed Technology: This means that technology does 72 not change (constant) during the course of analysis. Clearly, we look at the economy of analysis during a 95 very short period of time or at a specific point in time. Of course, it would not be realistic to rule out 23 technological advances and resource changes over a relatively long period of time. 51 4. Two Goods: It is assumed that the economy of analysis producing only two products: machines reflecting capital goods and wheat reflecting consumption goods. This assumption is undertaken to simplify our analysis. It is clear from the assumption above that a choice must be made along alternatives (necessity of choice). Since resources are scare or limited, machines and wheat that the economy can produce are limited. Limited resources (inputs) Chapter (2) The Production Possibility Frontier and Its Applications  23 mean limited outputs. Clearly, since resources are limited in supply and fully employed, any increase in the production of wheat will shift resources away from the production of machines to the production of wheat. The reverse is true in case of increasing machines. The above proposition and assumptions can be indicated by the following production possibilities table and curve as follows: 1. Production Possibilities Table: 6 72 The following hypothetical table records the alternatives available production that economy can implement to achieve 95 its efficient objective of producing machines or (and) wheat (as shown in Table 2.1). 23 At alternative A, the economy would devote all its resources to produce 15 million units of machines (capital goods). In contrast, at alternative F, all available resources 51 would go to wheat production to produce 5 million tons (consumption goods). At alternatives (B-E) the economy directs all available resources to produce both machines and wheat. As we move from alternative A to F, the production of wheat sets up by shifting resources away from machines production. In moving from alternative A to alternative F, society chooses more of consumption goods (more now) to satisfy Chapter (2) The Production Possibility Frontier and Its Applications  24 present generation at the expense of capital goods (much more later) of the future generation Also, in moving from alternative F toward A, society chooses to forgo current consumption. This sacrifice of current consumption frees resources from the production of consumption goods to be transferred to produce capital goods. For example, choice (A) reflects the productive level, in which 15 million units of machines and none of the wheat good is produced. This, of course, means that all resources 6 and production capacities are entirely directed to the 72 production of machine, while there are no productive elements employed in the production of the other commodity 95 (wheat). In contrast, the latter choice (F) illustrates a completely 23 different situation, where the economy directs all its productive capacity to produce the only commodity (wheat). 51 In this case, 5 units of a commodity (wheat) are produced, while no other unit is produced of a commodity (machine). It is unlikely that society will choose either of these extreme outcomes because it is human nature to enjoy variety. If this society decides to spend some of its resources producing consumer goods and some of its resources making capital goods, its economy will end up with a combination of Chapter (2) The Production Possibility Frontier and Its Applications  25 both (machine) and (wheat) that can be placed somewhere along the production possibilities curve between points A and F. Group B for example, includes the production of 14 units of a commodity (machine) and one unit of a commodity (wheat). In group D, the economy produces 9 units of a commodity (machine) and 3 units of a commodity (wheat). Because of the problem of scarcity, the increase in production from one commodity must be at the expense of 6 the quantity produced from the other. That is, there is a 72 sacrifice and an opportunity cost to be calculated. Table 2.1 95 Alternative Production Possibilities 23 Machines Wheat ( In Opportunity Possibilities (in Million Million Cost Units) tons) 51 A 15 0 - B 14 1 1 C 12 2 2 D 9 3 3 E 5 4 4 F 0 5 5 Chapter (2) The Production Possibility Frontier and Its Applications  26 Clearly, at any point in time, a full-employment, full- production economy must sacrifice some of wheat (product X) to produce more of machines (product Y). The scarce resources prohibits the economy from having more of both machines and wheat. 2. Production Possibilities Curve Here, figures recorded in the above table (2.1) can be depicted by using the following graph: 6 72 95 23 51 Every point on the production possibilities curve reflects some maximum output of the two products. i.e., Chapter (2) The Production Possibility Frontier and Its Applications  27 points lying on the production possibilities mean that society using its resources in efficient way (following full employment and full production). Clearly points (A to F) are attainable and reflect achieving efficiency. In other words, using the maximum production capacity of the economy, i.e., using all factors of production and the technical level available, the maximum quantity that can be produced is those points on the production possibility curve such as points A, B, C, D, E, F. These points can be 6 defined as optimal production points, as these different 72 groups show the maximum amount that can be produced from the two commodities. So, each point along the PPC represents 95 a possible set of outcomes that the society can choose if it uses all of its resources efficiently. Clearly, whenever society 23 is producing on the production possibilities frontier, the only way to get more of one good is to accept less of another. 51 Since an economy operates along the frontier it will be efficient at any point. At any combination of both goods along the production possibilities curve, the society is using all of its resources in the most productive way possible. But what about the point (Z) and any other points that might be located under the curve (inside the PPC)? These points represent outcomes inside the Chapter (2) The Production Possibility Frontier and Its Applications  28 production possibilities frontier, which indicate inefficient use of the society’s resources. Consider, for example, the resource of labor. If employees spend many hours on social media instead of doing their jobs, the output of both goods will drop and will no longer be efficient. As long as the workers use all of their time efficiently, they will produce the maximum amount of goods. Therefore, points within the curve, such as point Z in figure (2-2), are not optimal, 6 characterized by a lack of optimal utilization of productive resources, which may indicate some unexploited economic 72 resources or inefficient exploitation of available resources. 95 However, this economy can move from a point within the curve to a point on the curve by exploiting untapped 23 resources or optimizing the available resources. For example, it is possible to move from point (Z) to point (K) located on 51 the (PPC). This transition involves the production of more (wheat) while maintaining the same amount of product (machine). On the other hand, it is possible to move from point (Z) to an optimal point of production such as point (B). This transition increases the production of (machine) while maintaining the same quantity of product (wheat). Finally, the quantity produced of both goods can be increased by moving to the points on the curve between (K) and (B). Thus, Chapter (2) The Production Possibility Frontier and Its Applications  29 the non-optimal production points are those within the curve, and the quantity of one product can be increased without reducing the production of the other product or increasing the quantity of both goods by moving from a point within the curve to a point on the edge. 6 72 95 23 Figure 2-2: Non-optimal production points 51 Notice that some combinations of the two goods cannot be produced. This is because resources within the society are scarce and limited. In our example, the society would enjoy point (M), but given the available resources and technology, it cannot produce at that output level. Points beyond the production possibilities frontier are desirable but not feasible, given the resources and technology that the society has available. Since the maximum possible Chapter (2) The Production Possibility Frontier and Its Applications  30 production of goods and services must be on the curve, external points such as point (M) are desirable productivity points (where there are larger quantities of goods) but this point is outside the frontier, therefore it is unattainable under the current resources and the technical level. i.e., points lying inside the curve (Z) are attainable, but are not as desirable as points on the curve because they are not efficient. Clearly, at these points (inside the curve) economy 6 failed to achieve full employment and full production. On the 72 other hand, points lying outside the production possibilities curve (W or M) would be superior to any point on the curve, 95 but are not attainable because of the limited current supplies of resources and technology. The production restriction of 23 limited resources prohibits production of any combination of consumption and capital goods lying outside the production 51 possibilities frontier. 2.2 Law of Increasing Opportunity Costs Opportunity cost means that the amount of other products which must be forgone or sacrificed to obtain. some amount of any given product. For example, the amount of machines (Y) which must forgone or given up to get another unit of Chapter (2) The Production Possibility Frontier and Its Applications  31 wheat (X) is the opportunity cost or the cost of that unit of wheat (X). In moving from possibility A to B in table (2-1) the cost of 1 unit of wheat is 1 unit of machines, but as we move from B to F, the sacrifice or cost of machines involved in getting each additional unit of wheat increases. This reflected on the graph by concavity which reflects increasing opportunity costs. 6 Clearly, since our society produces only two goods, the 72 trade-offs that occur along the production possibilities frontier represent the opportunity cost of producing one good 95 instead of the other. The production possibilities frontier shows the opportunity cost of one good as measured in terms 23 of the other good. When a society moves from point B to point C, it gives up 2 units of machine good (capital good) to 51 get 1 additional unit of wheat good (consumer good). That is, at point C, the opportunity cost of 1 unit of wheat good is 2 units of machine good. Also, moving from point C to point D refers to increasing the production of what good by one unit (from 2 to 3) at the expense of decreasing the output of machine good by 3 units (from 12 to 9) which represents the opportunity cost in that case (see table 2-1 and figure 2-1). Chapter (2) The Production Possibility Frontier and Its Applications  32 Since resources tend to be specialized if they are diverted from one use to another their marginal contribution falls. In other words, opportunity cost increases. This is why the PPC is usually concave to the origin showing an increasing slope. Not all resources are perfectly adaptable for use in making both goods. Some workers are good at making consumer goods, and others are not so good. When society tries to make as many consumer goods (wheat) as possible, it 6 will be using both types of workers. That is, to get more consumer goods (wheat), society will have to use workers 72 who are increasingly less skilled at making productive goods. In that case, society will give up small quantities of 95 productive goods. But as our society continues to increase the production of consumer goods, it will be at the expense 23 of the more skilled labor movement in productive goods production, resulting in the sacrifice of larger quantities of 51 productive goods. For example, to produce one extra unit of consumer goods, the society can move from point A to point B (give up one unit of productive goods) and from the point, B to point C (give up two units of productive goods), and from point C to point D (give up three units of productive goods) and so on... Therefore, the production possibilities curve is bowed outward. A bowed-out production Chapter (2) The Production Possibility Frontier and Its Applications  33 possibilities frontier reflects the increasing opportunity cost of production. If opportunity cost remains constant when resources are transferred from one use to another the PPC will be straight-lined with a constant slope. 2.3 Applications of the Production Possibility Curve: The production possibility curve is of much importance in 6 explaining some of the basic facts of human life like the 72 problems of unemployment, technological progress, economic growth, and economic efficiency. (1) Unemployment: 95 Now we were to relax the assumption of full employment of 23 resources. Such a situation is depicted in Figure 2-2 where the economy is represented by a point (such as Z) inside the 51 PPC. This situation implies either idle resources or inefficient use of resources within the economy. The economy can attain the full employment level by utilizing its resources fully and efficiently and thus move to a point on the frontier of PPC. At the level of full employment, the economy can have more consumer goods at point K, more capital goods at point B, or more of both the goods between B and K. Chapter (2) The Production Possibility Frontier and Its Applications  34 (2) Economic Growth: Economic growth may happen when there is an increase in resource quantity and quality or through a technological upgrade. The production possibility curve in that case shifts outwards, and therefore the economy can reach point M. In this case, this economy can produce more goods which are called "economic growth". Factors that could cause the production possibility curve to move outwards are: 6 - Discovery of new natural resources; 72 - Growth in population; - Technological progress; 95 - Improvements in labor productivity. Figure (2-3) illustrates shifts in the production possibility 23 curve. When more resources are available for the production of both goods, the entire PPC shifts upward and outward. 51 This makes a point like outside the PPC possible (such as point M in figure 4). Figure (2-3a) shows the shift of the PPC to the right due to increasing available resources or technological development, thereby increasing the quantities produced. Note that Figure (2-3a) shows a balanced growth in which the maximum quantities of the two commodities were increased simultaneously (growth in both sectors). Chapter (2) The Production Possibility Frontier and Its Applications  35 Figure (2-3b) shows the shift of the PPC to the interior due to the low quantity of available resources, which may be due to: - The depletion of some of the available natural resources of the society (Excessive extraction rates of renewable or non-renewable resources); - The economic damage caused by war or severe natural disasters. 6 - Large scale net migration of people out of a country; 72 - A fall in productivity of labor resources. Thus the productive potential of this society was reduced and the PPC move inward. 95 23 Figure (2-3c) shows an uneven growth, with an increase in the maximum possible production of the commodity (P 51 wheat), while the maximum quantity produced from (S machine) remained constant. Assuming that technology upgrading takes place in the production of productive goods and with the existing resource available, consumer goods can be produced more as much compared to before. This will cause a shift at the consumer goods axis as shown in Figure (2-3c). Chapter (2) The Production Possibility Frontier and Its Applications  36 Now, assuming that there is growth in the total workforce utilized in the production of capital goods. In that case, the maximum production of (S machine) has increased, while the maximum quantity produced from commodity (P wheat) has remained unchanged (Figure 2-3d). 6 72 95 23 51 Figure (2-3): Shifts of the production possibility curve. (3) Present Goods versus Future Goods: An economy that allocates more resources in the present to the production of capital goods than to consumer goods will Chapter (2) The Production Possibility Frontier and Its Applications  37 have more of both kinds of goods in the future. It will thus experience higher economic growth. This is because consumer goods satisfy the present wants while capital goods satisfy future wants. Figure (2-4a) shows the lesser outward shift of the present PPC to the future PPC when fewer capital goods are produced in the future. On the other hand, Figure (2-4b) shows that the outward shift of the economy’s future production possibility curve from the present PPC is greater 6 when more capital goods are produced in the future. 72 95 23 51 Figure 2-4: Present Goods Vs. Future Goods Therefore, to expand our production possibilities in the future, we must devote fewer resources to producing consumer goods and more resources to accumulating capital and developing technologies so that we can produce more Chapter (2) The Production Possibility Frontier and Its Applications  38 consumption goods in the future. Some consumption must be given up today so that more capital goods can be produced. The opportunity cost of more future consumption is the loss of current consumption. This idea can also apply to different pairs of goods or services such as public vs private goods, agricultural vs non- agricultural goods, consumption vs investment, etc. (4) The PPC and comparative advantage 6 While every society must choose how much of each good it 72 should produce, it does not need to produce every single good it consumes. Often a country decides how much of a good to 95 produce based on how expensive it is to produce the good versus buying it from a different country. 23 Suppose two countries, the United States and Brazil, need to 51 decide how much they will produce of two crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce a lot of sugar cane per acre but not much wheat. On the other hand, the United States can produce a lot of wheat per acre but not much sugar cane. Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the United States. The reverse is also true; the United States has a lower opportunity cost of Chapter (2) The Production Possibility Frontier and Its Applications  39 producing wheat than Brazil. It might be easiest to understand this relationship by taking a look at figure (2-5) below. 6 72 Figure 2-5: The PPC and comparative advantage 95 This graph shows two images. Both images have Y axes labeled sugar cane and X axes labeled wheat. In the image 23 (a), Brazil’s sugar cane production is nearly double the production of its wheat. In image (b), the United States sugar 51 cane production is nearly half the production of its wheat. When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. In our example, Brazil has a comparative advantage in sugar cane, and the United States has a comparative advantage in wheat. Take a look at the PPFs of the two countries. If Brazil devoted all of its Chapter (2) The Production Possibility Frontier and Its Applications  40 resources to producing wheat, it would be producing at point A. If however, it devoted all of its resources to producing sugar cane instead, it would be producing a much larger amount, at point B. By moving from point A to point B, Brazil would give up a relatively small quantity in wheat production to obtain a large production in sugar cane. The opposite is true for the United States. If the United States moved from point C to point D and produced only sugar cane, 6 its choice would result in a large opportunity cost in terms of 72 sacrificed wheat production. When countries engage in trade, they specialize in the 95 production of the goods that they have a comparative advantage in and trade part of that production for goods they 23 do not have a comparative advantage in. In this case, that would mean that the United States would export wheat to 51 Brazil, and Brazil would export sugar cane to the United States. With trade, goods are produced where the opportunity cost is lowest, so total production increases, benefiting both trading parties. (5) A division of labor and PPC: A division of labor refers to how production can be broken down into separate tasks, enabling machines to be developed Chapter (2) The Production Possibility Frontier and Its Applications  41 to help production, and allowing labor to specialize in a small range of activities. No single person produces the good alone. The actions of each individual in the production process must be coordinated. For example, in the process of producing cars, there will be a high degree of labor specialization. Some workers will design the cars, some will work on testing cars, some will work on marketing, some workers will work on different sections of the assembly line, and so on. Therefore, 6 narrow specialization of tasks within a production process so that each worker can become a specialist in doing one thing 72 leads to increase production efficiency. In modern industries, division of labor is a major motive force for economic 95 growth. Adam Smith [1723-1790] in his book "Wealth of Nations" proposes that the division of labor is one of the 23 major elements that contribute to economic growth. As a result, division of labor and specialization, can considerably 51 improve productive capacity, and shift the PPC outwards. Chapter (2) The Production Possibility Frontier and Its Applications  6 72 Demand and Supply in 95 a Market System 23 51  43 Chapter (3) Demand and Supply in a Market System Introduction: In chapter 1, we learned about the free market economy. In a free market economy, the concepts of demand and supply are essential tools in determining the prices of goods and services. The price system will determine how resources, 6 products, and services are distributed. Distribution is made 72 based on wants and the ability to pay. Anyone who has wants and is willing to pay will obtain what is required. 95 In a market system, there is no central body responsible for 23 making decisions on production and utilization. Instead, each individual has the freedom in making a purchase decision that 51 can provide maximum satisfaction, and producers have the freedom to sell based on the needs to maximize profit. A complex market system will regulate the decisions of both parties to determine market equilibrium. In this chapter, we will look at the operation of the market system through the concept of demand and supply. We will also try to understand the factors involved in changing the market. Before discussing how buyers and sellers behave, Chapter (3) Demand and Supply in a Market System  44 let’s first consider more fully what we mean by the terms market. A market refers to the convergence of the desires of a group of buyers and sellers of a particular good or service. The buyers as a group determine the demand for the product, and the sellers as a group determine the supply of the product. Markets take many forms. Some markets are highly organized, such as the markets for many agricultural 6 commodities. In these markets, buyers and sellers meet at a 72 specific time and place to exchange goods. However, other markets of some goods are less organized as sellers and 95 buyers of the good are not necessarily met at a specific place. They can exchange the goods through other means such as 23 through the internet. We can illustrate the interactions of market forces (Demand and supply) in the market through 51 chart 1. Chapter (3) Demand and Supply in a Market System  45 6 72 Chart 1: Market forces 95 The Demand: 23 In economic analysis, the concept of demand is used to describe, analyze and predict the behavior of buyers in the 51 market Demand refers to the "different quantities of a particular commodity that the consumer is willing and able to purchase at different price levels over some time." We should distinguish between effective demand and ineffective demand. Effective demand is the desire to buy supported by the purchasing power (the ability to buy). Ineffective demand, however, refers to just the desire to acquire a commodity. Chapter (3) Demand and Supply in a Market System  46 Demand schedule and demand curve Demand can be described by using tables or curves that relate the quantity of a product required and can be afforded by consumers in a particular period at various price levels, while other variables remain unchanged. Demand is a table showing the quantities required by the consumer of a commodity at different levels of prices of this commodity. Table (1) indicates the demand schedule of a specific 6 commodity through a specific period. 72 Table 1: Demand schedule Point Price (P) Quantity Demanded (Qd) $ 95 KG A 10 2 23 B 9 4 C 8 6 D 7 8 51 E 6 10 F 5 12 From table (1), it is clear that as the price of the good goes down, the quantity demanded by the consumer rises. For example, when the price of the commodity decreases from $10 to $9, the quantity demanded increases from 2 KG to 4 KG, and when the price decreases from $9 to $8, the quantity demanded increases from 4 KG to 6 KG and so on. Note that Chapter (3) Demand and Supply in a Market System  47 the demand table shows the relationship between the price of a good and the quantity demanded, holding constant everything else that influences how much of the good consumers want to buy. The demand curve is a graphical representation of the relationship between the price of the commodity and the quantity demanded of it. Because a lower price increases the quantity demanded, the demand curve slopes downward. 6 Figure (1) represents the demand curve for the data 72 represented in table (1). Note that the price of the good is on the vertical axis, and the quantity demanded is on the 95 horizontal axis. 23 51 Figure 1: The demand curve Chapter (3) Demand and Supply in a Market System  48 A demand curve with a negative slope indicates an inverse relationship between the quantity demanded and the price level. When price increases, demand quantity decreases, and when price decreases, demand quantity increases. This inverse relationship is referred to as "the Law of Demand". The law of demand points out an inverse relationship between the price of the commodity and the quantity demanded when all other factors affecting the demand are fixed. 6 72 95 23 51 Figure 2: The law of demand Chapter (3) Demand and Supply in a Market System  49 Market Demand versus Individual Demand The demand curve in Figure 1 shows an individual’s demand for a product. To analyze how markets work, we need to determine the market demand, the sum of all the individual demands for a particular good or service. Table 2 shows the demand schedules for the previous example of the two individuals in this market (X and Y). We can calculate the quantity demanded in a market at each price by summing up 6 the quantity demanded by each consumer. 72 Table 2: The market demand Point (P) 95 (Qd) of X (Qd) of Y Market $ KG KG Demand A 10 2 3 5 23 B 9 4 5 9 C 8 6 7 13 51 D 7 8 9 17 E 6 10 11 21 F 5 12 13 25 Thus, the market demand curve is found by adding horizontally the individual demand curves. For example, at a price of $8, X demands 6KG and Y demands 7KG, so the market quantity demanded, in that case, is 13KG. Chapter (3) Demand and Supply in a Market System  50 Figure 3: The market demand Shifts in the Demand Curve 6 Because the market demand curve holds other things 72 constant, it need not be stable over time. If something happens to alter the quantity demanded at any given price, the 95 demand curve shifts. There are some factors affecting the demand for a certain good that cause the demand curve to 23 shift to the right (increasing demand) or the left (decreasing demand). Many variables can shift the demand curve. Here 51 are the most important. 1) Consumer income: Normal goods: A lower income means that you have less to spend in total, so you would have to spend less on most goods. If the demand for a good falls when income falls, the good is called a normal good. In this Chapter (3) Demand and Supply in a Market System  51 case, the demand curve will shift to the right. Increasing income on the other hand leads to an increase in the demand for the normal good and then the entire demand curve shifts to the right. Example: Increasing consumer income leads to increased demand for meat. Inferior good: Not all goods are normal goods. If the demand for a good rises when income falls, the good 6 is called an inferior good. Increased income results in 72 reduced demand for the inferior good and then the entire demand curve shifts to the left, as the consumer t, ends to buy another (normal) good that he was unable 95 to buy before increasing his income. Examples of inferior goods are low-quality clothing 23 and third-class train ticket. 51 2) Prices of related goods: The Complementary goods: When a fall in the price of one good raises the demand for another good, the two goods are called complements. Complements are often pairs of goods that are used together, such as gasoline and automobiles, computers, and software. High gasoline prices (as a complementary Chapter (3) Demand and Supply in a Market System  52 commodity), resulting in lower demand for cars (original commodity). Therefore, the demand curve for cars shifts to the left. The substitute goods: they satisfy similar desires. When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. Substitutes are often pairs of goods that are used in place of each other, such as chicken & meat. 6 Increasing the price of meat leads to an increase in the 72 demand for chicken, therefore the demand curve for chicken moves to the right. 3) Consumer tastes: 95 The most obvious determinant of your demand is your tastes. 23 Consumers' reluctance from a commodity due to changing tastes leads to reduced demand for this commodity. On the 51 other hand, if consumer tastes tend to favor a commodity, demand for it increases and the demand curve will shift to the right. 4) Consumer expectations: Your expectations about the future may affect your demand for a good or service today. If the consumer expects the price Chapter (3) Demand and Supply in a Market System  53 of the commodity to rise, the current demand for it will increase. Also, if the consumer expects a decrease in a commodity price, the current demand will fall. Also, If you expect to earn a higher income next month, you may choose to save less now and spend more of your current income and thus your demand for many goods will increase. 5) Number of consumers: Market demand depends also on the number of these buyers. 6 Increasing the number of consumers leads to increased 72 demand for various goods and services. 6) Advertising campaigns: 95 A successful advertising campaign leads to an increase in the 23 demand for the product and thus the demand curve shifts to the right. 51 7) Income tax: An increase in income tax will reduce the disposable income of people as people have less money to spend and this results in a decrease in demand for most goods. Chapter (3) Demand and Supply in a Market System  54 Table 3 and figure 4 clarify what happens to the demand if income increases or decreases for a normal good. An increase in income for a normal good leads to an increase in the quantity demanded at each price which results in shifting the demand curve to the right. On the other hand, a decrease in income leads to a decrease in the quantity demanded at each price and thus shifting the demand curve to the left. In general, any change that raises the quantity demanded at 6 any given price shifts the demand curve to the right. Any 72 change that lowers the quantity demanded at any given price shifts the demand curve to the left. 95 Table 3: Changes in demand 23 Point (P) (Qd1) (Qd2) (Qd3) $ Before After After changes in income income income increases decreases 51 A 10 2 4 1 B 9 4 6 2 C 8 6 8 3 D 7 8 10 4 E 6 10 12 5 F 5 12 14 6 Chapter (3) Demand and Supply in a Market System  55 6 72 Figure 4: Shifts of the demand curve 95 Shifts in the Demand Curve versus Movements along the Demand Curve: 23 It is important to understand the difference between these terms: shifts of the demand curve and movement along the 51 demand curve. The demand curve illustrates the relationship between price and quantity at a certain point of time only; with the assumption that other factors remain unchanged. However, it cannot show the relationship for a longer period due to the changes in other demand determinants. As illustrated in figure (5-a), Movement along the demand curve indicates the changes in demanded quantity caused by Chapter (3) Demand and Supply in a Market System  56 changes in commodity price. For example, when the price changes from P1 to P2, the quantity demanded changes from Q1 to Q2 and therefore we move along the demand curve from point A to point B. However, shifts in the demand curve are caused by changes in other determinant variables (such as prices of related goods, consumer preferences, and income). The right shift of the demand curve indicates an increase in demand while the 6 shift to the left indicates a decrease in demand quantity 72 (figure 5-b). 95 23 51 Figure 5: Shifts in the demand curve and movements along the demand curve Chapter (3) Demand and Supply in a Market System  57 The supply: As we clarified before, the market not only consists of buyers but also sellers or producers. Therefore, we will now look at the behavior of sellers in the market. In economic analysis, the behavior of sellers (or producer) in the market is illustrated using the concept of supply. The supply expresses the quantity of a commodity that producers (or sellers) are willing and able to sell at various prices during a certain 6 period. A supply schedule is a table that shows the 72 relationship between the price of a good and the quantity supplied. The supply curve shows the graphic representation 95 of the relationship between the price and the quantity supplied. 23 When the price of a commodity is high, selling it is profitable, and so the quantity supplied increases. By contrast, when the 51 price of this commodity is low, the business is less profitable, so sellers produce less of it. At a low price, some sellers may even choose to shut down, and their quantity supplied falls to zero. This relationship between price and quantity supplied is called the law of supply. The law of supply indicates that when the price of good rises, the quantity supplied of that good also rises, and when the price falls, the quantity supplied Chapter (3) Demand and Supply in a Market System  58 falls as well assuming other factors affecting the supply are unchanged. Therefore, we can say that there is a positive relationship between price and quantity supplied. The positive relationship between the price and quantity supplied can be explained by two reasons. Firstly, the price increase may cause an increase in profit, therefore, the firm will be encouraged to increase production. Secondly, increasing the price of a commodity may encourage new 6 producers to enter the market and thus increases the market 72 supply. Table 4 shows the quantity supplied of a specific good at 95 various prices. At a price of $5 or below, there is not any seller ready to supply any quantity at all (this price is not 23 profitable for anyone). As the price rises, the quantity supplied increases gradually. This is the supply schedule, a 51 table that shows the relationship between the price of a good and the quantity supplied, holding other factors affecting the supply constant. Chapter (3) Demand and Supply in a Market System  59 Table 4: Supply schedule Point Price (P) Quantity supplied (Qs) $ KG A 10 10 B 9 8 C 8 6 D 7 4 E 6 2 F 5 0 The graph in Figure 6 uses the numbers from table 5 to 6 illustrate the law of supply. The curve relating to price and 72 quantity supplied is called the supply curve. The supply curve slopes upward because, other things equal, a higher price 95 means a greater quantity supplied. 23 51 Figure 6: Supply curve Chapter (3) Demand and Supply in a Market System  60 Determinations of supply: Some factors affect the supply of a commodity rather than the price which can shift the supply curve to the right (increase) or the left (decrease). These factors are: 1) Prices of inputs: Production inputs mean all raw material, fuel, machinery, equipment, and labor used to produce a good or service. High 6 input prices increase production costs and assuming the 72 commodity price is stable, producers will be forced to reduce their production as a result of lower profits which reduces the 95 supply of that commodity (shift of the supply curve to the left). Conversely, supply increases when input prices 23 decrease (lower production costs) resulting in the shift of the supply curve to the right. 51 2) Technical progress: Technological advances increase productivity and decrease costs of production and thus increase the supply of goods (shifting the supply curve to the right). Chapter (3) Demand and Supply in a Market System  61 3) Prices of other goods: The correlation of goods in the production process influences the supply of a particular good when a price change for related good occurs. The correlation of goods in the production process can be divided into two; Substitute goods in production: These are goods that can be produced using the same set of resources. 6 Examples include wheat and maize, small cars, and 72 large cars. The rise in the price of corn, assuming that the price of wheat and all the other factors are constant makes maize more profitable than wheat. In that case, 95 farmers tend to grow maize and reduce wheat production (reduce wheat supply) shifting the wheat 23 supply curve to the left, and vice versa if corn prices fall. Complementary goods in production: These are goods 51 jointly produced in a production process. There is a direct correlation between the price of one of the two products integrated into production and the supply of the other product. For example, oil and natural gas production & leather and meat. An increase in the price of meat leads to an increase in the quantity supplied, as Chapter (3) Demand and Supply in a Market System  62 well as an increase in the supply of leather, and then moves the supply curve of the leather to the right. 4) Producer expectations: If a firm expects the price of the good to rise in the future, it will put some of its current production into storage and supply less to the market today shifting the supply curve to the left, and vice versa. 6 5) Number of producers: 72 Usually, the increase in the number of producers of a commodity leads to an increase in supply, and then the supply 95 curve shifts to the right, and vice versa if the number of producers falls. 23 6) Taxes and subsidies: 51 Changes in government policy related to tax and subsidies will also influence the supply curve. If the government imposes a tax on the producer, this represents an extra cost on the producer and thus makes the producer decrease the supply of that good (shifts the supply curve to the left). On the other hand, granting the producer a subsidy enhances the Chapter (3) Demand and Supply in a Market System  63 producer to increase the supply of that good, and thus the supply curve shifts to the right. 6 72 95 Figure 7: Shifts of the supply curve 23 Shifts in the supply curve versus Movements along the 51 Supply Curve: Changes in the quantity supplied (increase or decrease) is due to the change in the price of the commodity itself which results in moving from one point to another on the same supply curve. Figure (8-a) shows the change in the quantity supplied since a price drop from $9 to $7 reduces the quantity Chapter (3) Demand and Supply in a Market System  64 supplied from 8 to 4 units and then moves from point B to point D. On the other side, a change in supply (increase or decrease) is due to the change in other factors affecting the supply other than the price of the commodity itself. Increasing supply shifts the supply curve to the right whereas decreasing supply is expressed by shifting the supply curve to the left. 6 72 95 23 Figure 8: Shifts in the supply curve versus Movements along the 51 Supply Curve: Individual Supply and Market Supply Like market demand, market supply will also be obtained by summing up the quantity supplied by all sellers at various price levels. Assuming there are only two sellers in the market, table 5 displays how to get the market supply by Chapter (3) Demand and Supply in a Market System  65 summing up the quantity supplied by the two sellers at each price. Table 5: Individual Supply and Market Supply (P) (Qs1) of (Qs2) of Market $ Seller 1 Seller 2 supply 10 10 11 21 9 8 9 17 8 6 7 13 7 4 5 9 6 6 2 3 5 72 5 0 1 1 95 23 51 Figure 9: Derivation of the market supply curve Market Equilibrium Previously, we analyzed supply and demand separately. But to show how both interact in determining price and quantity, we need to draw the demand and supply curves in one Chapter (3) Demand and Supply in a Market System  66 diagram. The market equilibrium is determined when the quantity demanded of the commodity is equal to the quantity supplied at a certain market price. The particular quantity and price are known as equilibrium quantity and equilibrium price. From the table, market equilibrium is achieved when the commodity price = $ 8 (equilibrium price). Quantity demanded = Quantity supplied = 13 units (Equilibrium quantity) 6 From the graph, the equilibrium is determined at the 72 intersection point of the demand curve and the supply curve (point C). The equilibrium quantity = 13 units and the 95 equilibrium price = $ 8. At the equilibrium price, the quantity of the good that buyers are willing and able to buy exactly 23 balances the quantity that sellers are willing and able to sell. 51 Table 3: Market equilibrium Point P Qd Qs ($) (KG) (KG) A 10 5 21 B 9 9 17 C 8 13 13 D 7 17 9 E 6 21 5 F 5 25 1 Chapter (3) Demand and Supply in a Market System  67 6 72 Figure 10: Market equilibrium 95 Shortages and Surpluses 23 In the previous section, we have seen how supply and demand together determine a market’s equilibrium, which in turn 51 determines the price of the good and the amount of the good that buyers purchase and sellers produce. But how does the market respond when it is not in equilibrium? Suppose first that the market price is above the equilibrium price, as in Figure 11. At a price of $9, the quantity of the good supplied (17 units) exceeds the quantity demanded (9 units). There is a surplus of goods. Suppliers are unable to Chapter (3) Demand and Supply in a Market System  68 sell all they want at the going price. A surplus is sometimes called a situation of excess supply. 6 72 95 Figure 11: Surplus (Excess supply) Suppliers try to get rid of this surplus and increase sales by 23 reducing the price of the goods, and this moves the price toward its equilibrium level. Falling prices, in turn, increase the 51 quantity demanded and decrease the quantity supplied. These changes represent movements along the supply and demand curves. Prices continue to fall until the market reaches equilibrium. Suppose now that the market price is below the equilibrium price, as in Figure 12. In this case, the price is $7, and the quantity demanded (17 units) exceeds the quantity supplied (9 Chapter (3) Demand and Supply in a Market System  69 units). There is a shortage of the good in the market. Consumers are unable to buy all they want at that price. A shortage is sometimes called an excess demand. A shortage occurs whenever the quantity supplied is less than the quantity demanded. As the market price increases in response to the shortage, sellers increase the quantity that they offer. At the same time, as the price rises, buyers will demand a smaller quantity. Therefore, an increase in price causes the quantity 6 demanded to fall and the quantity supplied to rise. Once again, these changes represent movements along the supply and 72 demand curves, and they move the market toward equilibrium. 95 23 51 Figure 12: Shortage (Excess demand) Chapter (3) Demand and Supply in a Market System  70 Thus, regardless of whether the price starts too high or too low, the interactions between buyers and sellers automatically push the market price toward the equilibrium price. Once the market reaches its equilibrium, all buyers and sellers are satisfied, and there is no upward or downward pressure on the price. How quickly equilibrium is reached varies from market to market depending on how quickly prices adjust. In most free markets, surpluses and shortages are only temporary because 6 prices eventually move toward their equilibrium levels. 72 Changes in Market Equilibrium Due to changes in Demand and Supply 95 The equilibrium price and quantity depend on the position of the 23 supply and demand curves. When some event shifts one of these curves, the equilibrium in the market changes, resulting in a new 51 price and a new quantity exchanged between buyers and sellers. Three main cases can occur. The first case is related to changes in demand whereas the supply conditions do not change. The second case is that some factors change the supply whereas the demand side does not change. The third case is that some conditions change both supply and demand sides. Firstly: Changes in demand with constant supply: Chapter (3) Demand and Supply in a Market System  71 There are two possibilities for changing demand: increasing demand or decreasing demand due to changes in other factors affecting demand other than price. Assuming that there is an increase in consumer income increases the demand for the regular commodity, and thus the demand curve shifts right from D1 to D2. This will result in a change of equilibrium point from E1 to E2 and an increased equilibrium price from P1 to P2 as well as an increase in the equilibrium quantity from Q1 to Q2 6 (figure 13-a). 72 In the case of decreasing demand the demand curve shifts to the left from D1 to D3, the equilibrium point will change from E1 95 to E3 and the equilibrium price will drop from P1 to P3 and the equilibrium quantity will decrease from Q1 to Q3 (figure 13-b). 23 51 Figure 13: A Change in Market Equilibrium Due to a Shift in Demand Secondly: Changes in supply with constant demand: Chapter (3) Demand and Supply in a Market System  72 Also, we can distinguish between two cases here; increasing the supply or decreasing the supply due to the change in other factors affecting the supply other than the price. Assuming that there has been a decline in the prices of factors of production (such as lower prices of raw materials), resulting in an increased supply of the commodity, which means that the supply curve shifts to the right from S1 to S2. This leads to a change in the equilibrium point from E1 to E2 and lowers the equilibrium 6 price from P1 to P2 and increases the equilibrium quantity from Q1 to Q2 (figure 14-a). In the case of decreasing supply (for 72 example, as a result of an increase in workers' wages), the supply curve shifts to the left from S1 to S3, the equilibrium 95 point will change from E1 to E3, and the equilibrium price rises from P1 to P3, and the equilibrium quantity decreases from Q1 23 to Q3 (figure 14-b). 51 Chapter (3) Demand and Supply in a Market System  73 Figure 14: A Change in Market Equilibrium Due to a Shift in Supply Thirdly, changes in both supply and demand sides: There are four possibilities for changing supply-demand together which are: - Increase of demand with increasing supply. - Decease of demand with decreasing supply. - Increase of demand with decreasing supply. 6 - Decrease of demand with increasing supply. 72 We will analyze the effect of increasing demand with increasing supply, and you can analyze the remaining three possibilities. 95 - The effect of an increase in demand and supply 23 simultaneously: Assuming that some factors led to increased demand for the 51 commodity (i.e. an increase in consumers' incomes), while at the same time other factors led to increased supply of goods (such as technological progress in the production of this commodity). This will result in a shift of both the demand curve and the supply curve to the right. The final effect on the equilibrium price and equilibrium quantity will depend on the ratio of increase in both demand and supply. Chapter (3) Demand and Supply in a Market System  74 There are three possibilities here: the percentage increase in demand is greater than the percentage increase in supply, the percentage increase in demand is equal to the percentage increase in supply, or the percentage increase in demand is less than the percentage increase in supply. If the percentage increase in demand is greater than the percentage increase of supply, both the equilibrium price and the equilibrium quantity will increase (figure 15-a). 6 If the percentage increase in demand is less than the percentage 72 increase in supply, the equilibrium price will fall and the equilibrium quantity will increase (figure 15-b). 95 23 51 Chapter (3) Demand and Supply in a Market System  75 Figure 15: Increase of both demand and supply sides 6 Finally, if the percentage increase in demand is equal to the 72 percentage increase of supply, the equilibrium quantity will increase but the equilibrium price will not change (figure 15-c). 95 The inevitable consequence of increasing both demand and supply is to increase the equilibrium quantity, while the 23 equilibrium price depends on the relative increase of both demand and supply. 51 Mathematical representation of Demand and supply Both demand and supply curves can be represented by equations for the straight line in the following formulas: Demand equation: Qd = a – b P Supply equation: Qs = c + d P Chapter (3) Demand and Supply in a Market System  76 Where Qd represents the quantity demanded, Qs represents the quantity supplied, P is the price, and a, b, c, and d are the equation constants. By equaling the quantity demanded with the quantity supplied we can calculate both the equilibrium quantity and the equilibrium price. Example: 6 Assuming that the equations of the demand and supply of 72 a commodity take the following formulations: Qd = 50 - 3 P 95 Qs = -14 + 5 P 23 Calculate both the equilibrium price and the equilibrium quantity. 51 The answer: The equilibrium condition: Qs = Qd -14 + 5 P = 50 – 3 P 8P = 64 Pe = 64/8 = 8 (Equilibrium price) Substitute in the demand equation (or supply equation): Chapter (3) Demand and Supply in a Market System  77 Qe = 50 – 3 (8) = 50 – 24= 26 (Equilibrium quantity). Identifying Excess Demand or Excess Supply: Excess demand exists when the quantity demanded is greater than the quantity supplied. Alternatively, excess supply exists when the quantity supplied is greater than the quantity demanded. In both cases, the market is not in equilibrium. 6 72 95 23 51 Figure 6: Excess demand and excess supply Example: In the previous example; 1. Determine the amount of excess demand or supply if the price is $12. 2. Determine the amount of excess demand or supply if the price is $6. The answer: Chapter (3) Demand and Supply in a Market System  78 1) Insert the presumed price of $12 into the demand function to find Qd = 50 - 3(12) = 14. Insert a price of $12 into the supply function to find Qs = -14 + 5(12) = 46. Because the quantity supplied is greater than the quantity demanded at the $12 price, there is an excess supply equal to 46 − 14 = 32. 2) Insert the presumed price of $6 into the demand function to find Qd = 50 - 3(6) = 32. Insert a price of $6 into the 6 supply function to find Qs = -14 + 5(6) = 16. Because quantity demanded is greater than quantity supplied at 72 the $6 price, there is an excess demand equal to 32 − 16 = 16. 95 23 51 Chapter (3) Demand and Supply in a Market System  6 72 Demand and Supply Elasticities 95 23 51  80 Chapter (4) Demand and Supply Elasticities In general, elasticity is simply a measure of how sensitive one variable is to a change in the value of another variable. We often need to measure how sensitive the quantity demanded or supplied is to changes in the independent variables that affect them. The concept of elasticity of demand and supply