Economics Study Guide PDF

ECONOMICS STUDY GUIDE Christopher Fava JUNIOR COLLEGE UNIVERSITY OF MALTA i  To Paula, Nicholas, Elizabeth and Sarah ii Brief Contents 1 The Basic Economic Problem 1 2 Demand, Supply and Price Determination 5...

ECONOMICS STUDY GUIDE Christopher Fava JUNIOR COLLEGE UNIVERSITY OF MALTA i  To Paula, Nicholas, Elizabeth and Sarah ii Brief Contents 1 The Basic Economic Problem 1 2 Demand, Supply and Price Determination 5 3 Elasticity 17 4 Application of Elasticities 26 5 Consumer Behaviour 39 6 Theory of the Firm 44 7 Profit-Maximisation 63 8 Perfect Competition 67 9 Monopoly 75 10 Imperfect Competition 94 11 Labour Market 101 12 Market Failure 108 13 International Trade 116 14 National Income Accounting 121 15 Consumption 133 16 Investment 137 17 Government and Fiscal Policy 152 18 Money and Monetary Policy 165 19 Inflation 178 20 Unemployment 188 21 International Trade 199 22 Economic Growth 212 iii Contents 1 The Common economic problem facing all societies 1 1.1 The Economic Problem 1 1.2 Economic Choice 1 1.3 Opportunity Cost 1 1.4 Normative Economics and Pure/Positive Economics 2 1.5 The Production Possibilities Curve 2 1.6 The Socially Optimum Level of Output 4 2 Demand, Supply and Price Determination 5 2.1 Demand 5 2.1.1 Individual’s demand curve and market demand curve 5 2.1.2 Movements along the demand curve 5 2.1.3 Shifts in the demand curve 5 2.1.4 Application – The main factors influencing demand for tourism 7 2.1.5 Exceptional demand curves 8 2.1.6 Consumers’ Surplus 9 2.2 Supply 10 2.2.1 Individual firm’s supply and market supply 10 2.2.2 Movements along the supply curve 10 2.2.3 Shifts in the supply curve 10 2.2.4 Producers’ Surplus 12 2.3 The determination of the market equilibrium price 13 2.3.1 Changes in the market equilibrium price 14 2.3.2 The significance of the ‘ceteris paribus’ condition 15 2.4 Conclusions 15 3 Elasticity 17 3 Concept of Elasticity 17 3.1.1 Price Elasticity of Demand 17 3.1.2 The difference between Point and Arc Elasticity 17 3.1.3 Interpretation of the value 17 3.1.4 Determinants of Price Elasticity of Demand 19 iv 3.1.5 Who requires knowledge of Price Elasticity of Demand? 19 3.1.6 Elasticity of Demand along a linear, negatively sloped Demand Function 20 3.2.1 Income Elasticity of Demand 20 3.2.2 Determinants of Income Elasticity of Demand 21 3.2.3 The Importance of Income Elasticity of Demand 21 3.3.1 Cross-price Elasticity of Demand 22 3.3.2 Determinants of Cross-price Elasticity of Demand 23 3.3.3 The Importance of Cross-price Elasticity of Demand 23 3.4.1 Price Elasticity of Supply 23 3.4.2 Factors or determinants of Price Elasticity of Supply 24 3.4.3 The Importance of Price Elasticity of Supply 25 4 Application of Elasticities 26 4.1 Taxation 26 4.1.1 The effect of a specific tax on the market equilibrium price and output 26 4.1.2 The Incidence of Taxation 27 4.2 Subsidy 29 4.3 Maximum Price Legislation 30 4.3.1 The Effect of Maximum Price Controls on Consumers’ and Producers’ surpluses 31 4.3.2 Application of maximum price legislation – Rent Controls 33 4.4 Minimum Price Legislation 34 4.4.1 The Effect of Minimum Price Controls on Consumers’ and Producers’ surpluses 34 Application of Minimum Price Legislation – The Role of the Common Agricultural 4.4.1.1 35 Policy 4.4.1.2 Application of Minimum Price Legislation – Minimum Wage Legislation 38 5 Consumer Behaviour 39 5.1 Utility Theory 40 5.2 Marginal Utility and the Individual’s Demand Curve 40 5.3 The Utility Maximising Choice 40 The Effect of a change in the Product’s Own Price – the Substitution and Income 5.4 41 Effects 5.5 The Relationship between Marginal Utility and Price Elasticity of Demand 43 5.6 The Paradox of Value 43 v 6 The Theory of the Firm 44 6.1 Introduction 44 6.1.1 Production with a Single Variable Factor Input – The Law of Variable Returns 45 6.1.2 Profit-maximisation and input choice 48 6.2 The Costs of Production – Economic Costs versus Accounting Costs 48 6.2.1 Fixed Costs 49 6.2.2 Variable Costs 50 6.2.3 Total Costs 51 6.2.4 Marginal Cost 51 6.2.5 Average Total Cost 52 6.2.6 Average Fixed Cost 52 6.2.7 Average Variable Cost 53 6.2.8 The Relationship between (i) AP and AVC, and (ii) MP and MC 54 6.2.9 The Derivation of the Short-run Average Total Cost Curve 55 6.3 Costs of Production in the Long-run – Derivation of the LRAC Curve 56 6.3.1 Economies of Scale 58 6.3.2 Diseconomies of Scale – Limits to Growth 60 Distinction between Increasing Returns to Scale and (i) Economies of Scale and (ii) 6.3.3 60 increasing returns 6.3.4 Distinction between Movements Along and Shifts in the LRAC curve 61 6.4 The Survival of Small Firms 61 7 Profit-maximisation or Loss-minimisation 63 7.1 The Profit-maximising or loss-minimising Rule 63 7.2 Distinction between Normal Profit and Abnormal Profit 65 7.3 Losses and When to go out of Business 65 7.4 The Role of Profits 66 8 Perfect Competition 67 8.1 Characteristics of Perfect Competition 67 8.2 Difficulties in satisfying the assumption of Perfect Competition 68 8.3 The Relevance or Usefulness of the Perfectly Competitive Model 69 8.4 Industries close to the Perfectly Competitive Model 69 8.5 Output Decisions under Perfect Competition 70 vi 8.6 Deriving the Perfectly Competitive Firm’s Short-run and Long-run Supply Curve 71 8.7 Long-run Equilibrium under Perfect Competition 71 8.8 Perfect Competition and Economic Efficiency 73 8.9 Perfect Competition and the Internet 73 9 Monopoly 75 9.1 Introduction – Defining Monopoly 75 9.2 Measures of Monopoly Power 75 9.3 Monopoly Power based on Restriction of Entry 75 9.4 Pricing and Output Decisions under Monopoly 79 The Relationship between Average Revenue, Marginal Revenue, and Price 9.4.1 79 Elasticity of Demand under Monopoly 9.4.2 Price and Output Choice for a Profit-maximising Monopolist 81 9.4.3 Monopoly in the short run and long run equilibrium 84 9.5 Contrasting a Perfectly Competitive Industry and a Monopolist 85 9.5.1 Possible Disadvantages of a Monopolist 85 9.5.2 Possible Advantages of a Monopolist 86 9.6 Price Discrimination 87 9.6.1 The Necessary Conditions for Discriminating Monopolist 87 9.6.2 Discrimination in the Public Interest 89 9.7 Public Policy towards Monopoly 90 9.8 Conclusion 93 10 Imperfect Competition 94 10.1 Monopolistic Competition 94 10.2 Oligopoly 95 10.2.1 Collusion 95 10.2.1.1 Formal Collusion 96 10.2.1.2 Informal (or Tacit) Collusion 96 10.2.2 Competition – Price Competition and Non-price Competition 97 10.2.3 Collusion versus Competition: The Prisoners’ Dilemma 97 10.2.4 Price Rigidity – Kinked Demand Curve Model 98 10.2.5 Saucer-shaped Average Variable Cost Curve Theory 99 10.2.6 Long-run Behaviour under Oligopoly 100 vii 11 Labour Market 101 11.1 Profit-maximisation in relation to Labour Factor Input 101 11.2 Wage Determination 103 11.3 Transfer Earnings and Economic Rent 104 11.4 The Role of Trade Unions in Wage Determination 105 11.5 The Role of a Monopsonist Employer in Wage Determination 106 12 Market Failure 108 12.1 Introduction – Market Failure Defined 108 12.1.1 Failure associated with the Non-provision of Public Goods 108 12.1.2 Failure associated with the Under-provision of Merit Goods 109 12.1.3 Failure associated with Demerit Goods 109 12.1.4 Failure associated with Externalities 109 12.1.5 Failure associated with Market Structure 110 12.1.6 Failure associated with the Market Mechanism – Asymmetric Information 110 12.2.1 Measures associated with Public Goods 111 12.2.2 Measures associated with Merit Goods 111 12.2.3 Measures associated with Demerit Goods 111 12.2.4 Measures associated with Externalities 112 12.2.5 Measures associated with Market Structure 114 12.2.6 Measures associated with Asymmetric Information 115 13 International Trade 116 13.1 Absolute Advantage and Comparative Advantage 116 13.2 The Case against Trade 118 13.2.1 Economic Arguments in favour of Protectionism 118 13.2.2 Political and Social Arguments in favour of Protectionism 119 13.3 Problems with Import Controls 119 13.4 Methods of Protectionism 120 14 National Income Accounting 121 14.1 Introduction 121 14.2 Circular Flow of Income and Expenditure 121 14.3 Aggregate Demand and Supply (An Analogy with Microeconomics) 122 viii 14.4 The Interaction of AD and AS - Equilibrium 124 14.5 Significance of National Income Statistics 125 14.6 Measuring National Income 125 14.6.1 The Expenditure Method 126 14.6.2 The Output Method 127 14.6.3 The Income Method 128 The Distinction between National Income, Personal Income, and Disposable 14.6.3.1 128 Personal Income 14.7.1 Problems associated with the Measurements of Economic Activity 129 17.7.2 Problems associated with the Interpretation of the Accounts 130 14.7.3 Difficulties in using GDP per head to compare International Standards of Living 131 14.8 Conclusion 132 15 Consumption 133 15.1 Introduction 133 15.2 Distinction between ‘Average’ and ‘Marginal’ propensities to consume and to save 133 15.3 Distinction between Movements Along and Shifts in the Consumption Function 134 15.4 Other Views on the Determinants of Consumption 136 16 Investment 137 16.1 Definition 137 16.2 Distinction between Planned Investment and Realised Investment 137 16.3 The Paradox of Thrift 139 16.4 The Effect of Investment 139 16.5 The Determinants of Investment – The Interest Rate 141 16.5.1 Discounting to Present Value 142 16.5.2 The Investment Decision 143 16.5.3 The Determination of the Discount Rate 144 16.5.4 Real versus Nominal Discount Rate 144 16.6 The Marginal Efficiency of Capital Theory 144 16.7 Other Factors Influencing Investment 146 16.8 The Accelerator Theory 148 16.9 Conclusion 151 ix 17 Government and Fiscal Policy 152 17.1 Taxation 152 17.1.1 Why Taxation? 152 17.1.2 Principles of Taxation 152 17.1.3 Direct and Indirect Taxes 153 17.1.4 Progressive, Regressive, and Proportional Taxes 153 17.1.5 Possible Advantages and Disadvantages of a Progressive Tax 154 17.1.6 The Case for Indirect Taxation 155 17.1.6.2 The Case against Indirect Taxation 156 17.2 Government Expenditure 157 17.2.1 Recurrent Expenditure 157 17.2.2 Capital Expenditure 157 17.2.3 Interest Payments on the National Debt 157 17.3 Budget 157 17.4 Fiscal Policy 158 17.4.1 Discretionary Fiscal Policy 158 17.4.1.1 The Government Spending Multiplier 158 17.4.1.2 The Tax Multiplier 158 17.4.1.3 The Balanced Budget Multiplier 159 17.4.2 Non-discretionary Fiscal Policy 159 17.4.3 Some Problems associated with the Operation of Fiscal Policy 160 17.5 Welfare Gap – Problems with State Pension Provision 163 17.6 Conclusion 164 18 Money and Monetary Policy 165 18.1 Introduction 165 18.1.1 Functions of Money 165 18.1.2 Characteristics of Money 165 18.2 Demand for Money 166 18.3 The Rate of Interest 167 18.3.1 Determination of the Rate of Interest 167 18.3.2 Shifts in the Money Demand and Supply Curves – Changes in the rate of interest 168 18.4 Measuring the Supply of Money 169 18.5 Money Creation and the Money Multiplier 170 x 18.5.1 Critique of the Simple Model 172 18.6 Monetary Policy 172 18.6.1 Monetary Policy - Definition 172 18.6.2 Fiscal and Monetary Policies are complementary 173 18.6.3 The Tools or Instruments of Monetary Policy 173 18.6.3.1 Reserve Requirements 173 18.6.3.2 Open Market Operations 174 18.6.3.3 Standing Facilities 174 18.7 Limitations of Monetary Policy 175 18.8 The European Central Bank 176 18.9 Conclusion 176 19 Inflation 178 19.1 Introduction 178 19.2 How is it measured? 178 19.2.1 What is the Retail Price Index (RPI)? 178 19.2.2 The Construction of the RPI 178 19.2.3 Why are Data presented on a Quarterly Basis? 179 What Practical Uses does the RPI have for a Ministry of Finance Official, a Central 19.2.4 179 Banker, and a Trade Unionist? 19.2.5 Indices other than the RPI 180 19.3 Main Causes of Inflation 180 19.3.1 Monetarists Theory of Inflation 180 19.3.2 Keynesian Theories of Inflation 181 19.3.2.1 Demand-pull Inflation 181 19.3.2.2 Cost-push or Supply-side Inflation 180 19.3.2.3 Imported Inflation 183 19.4 The Effects of Inflation 183 19.5 Can Inflation be Defeated? Counter Inflationary Policies 185 19.5.1 Tightening of Monetary Policy 185 19.5.2 The Use of Fiscal Policy in controlling: 185 19.5.2.1 Demand-pull Inflation 185 19.5.2.2 Cost-push Inflation 185 19.5.3 Exchange Rate Policy 185 xi 19.5.4 Prices and Incomes Policy 186 19.5.5 Long-term Policies to Control Inflation – Supply-side Policies 186 20 Unemployment 188 20.1 Definition of Unemployment 188 20.2 Unemployment Figures 188 20.3 The Costs of Unemployment 189 20.3.1 Costs to the Unemployed and their Dependents 189 20.3.2 Costs to Taxpayers 189 20.3.3 Costs to the Economy as a Whole 189 20.4 Causes of Unemployment and Policies for Unemployment 189 20.4.1 Frictional Unemployment 189 20.4.2 Structural Unemployment 190 20.4.3 Seasonal Unemployment 191 20.4.4 Real-wage Unemployment 191 20.4.5 Demand-deficient or Cyclical Unemployment 192 20.5 The Natural Rate of Unemployment 193 20.6 Long-term Unemployment 193 20.7 Causes of the Rise in the Female Activity Rate 194 20.8 The Government’s Role as Employer of the Last Resort 194 20.9 The Phillips Curve 195 20.9.1 The Break-down of the Phillips Curve 196 20.9.2 Adaptive Expectations and the Phillips Curve 196 20.9.3 Rational Expectations – The New Classical Model 197 21 International Trade 199 21.1 The Balance of Payments 199 21.1.1 The Current Account 199 21.1.2 The Capital and Financial Account 199 21.1.3 Balance in the Balance of Payments 200 21.1.4 Causes of a Current Account Deficit 201 21.1.5 Policies to deal with a Current Account Deficit 201 21.1.6 The Effect of a Devaluation of the € on exports, output and employment 202 21.1.6.1 Factors to consider when analysing the Effects of a Depreciation 203 xii 21.2 The Exchange Rate 204 21.2.1 Definition of Exchange Rate 204 21.2.2 The Demand and Supply Curves for Currencies 204 21.2.3 Types of Exchange Rates 205 21.2.3.1 A Flexible or Freely Floating Exchange Rate System 205 21.2.3.2 A Fixed Exchange Rate System 206 21.2.3.3 The Managed Floating Exchange Rate System 207 21.2.3.4 Flexible versus Fixed Exchange Rates – Advantages and Disadvantages 207 21.2.4 Malta Joins the Economic and Monetary Union 207 21.2.4.1 Advantages of the Euro 209 21.2.4.2 Disadvantages of the Euro 209 21.2.4.3 Malta’s Journey to the Euro and Beyond 210 22 Economic Growth 212 22.1 Definition 212 22.2 The Sources of Economic Growth 212 22.3 Economic Growth and Public Policy 213 22.4 The Pros and Cons of Growth 213 22.5 Summary: No Right Answer 213 xiii List of Figures 1.1 Production Possibility Curve 3 2.1(a) Movements along a stationary demand curve 6 2.1(b) Shifts of the demand curve 6 2.2 Exceptional demand curve 8 2.3 Consumers’ Surplus 9 2.4(a) Movements along a stationary supply curve 11 2.4(b) Shifts of the supply curve 11 2.5 Producers’ Surplus 12 2.6 Price Determination 13 2.7(a) A price rise caused by an increase in demand 14 2.7(b) A price rise brought about by a fall in supply 14 2.7(c) A price cut following a fall in demand 14 2.7(d) A decline in price due to an increase in supply 14 3.1(a) Price Elastic Demand 18 3.1(b) Price Inelastic Demand 18 3.2 Exceptional Demand Functions 18 3.3 Engel Curve 21 3.4(a) Close Substitutes 22 3.4(b) Remote Substitutes 22 3.4(c) Close Complements 22 3.4(d) Remote Complements 22 3.5 Exceptional Supply Functions 24 3.6 The effect of an increase in demand on P and Q depending on PES 25 4.1 The effect of a per-unit tax on Pe, Qe and consumers’ and producers’ 27 surpluses 4.2(a) PED > PES 28 4.2(b) PED < PES 28 xiv 4.3(a) PED = 0 28 4.3(b) PES = ∞ 28 4.4(a) PED = ∞ 29 4.4(b) PES = 0 29 4.5 The effect of a per-unit subsidy when PED < PES 30 4.6 The effect of a maximum price 31 4.7 The effect of a maximum price on consumers’ and producers’ welfare 32 4.8 The effect of rent controls 33 4.9 The effect of fixing a minimum price 34 4.10 The downward trend in agricultural prices 35 4.11 The effect of price fluctuation on farmers’ incomes 36 4.12 The effect of a support price 37 4.13 The effect of a minimum wage legislation 38 5.1 Relationship between TU and MU 39 5.2 Deriving the Individual’s demand curve 40 6.1 Relationship between TP, MP and AP 47 6.2 Fixed Costs 49 6.3 Relationship between TP and VC 50 6.4 The TFC, TVC, and TC curves 51 6.5 Relationship between TVC, TC and MC 52 6.6 Relationship between TFC and AFC 53 6.7 Relationship between TVC and AVC 54 6.8 Relationship between productivity and costs 55 6.9 Cost curves 56 6.10 The derivation of the LRAC curve 57 6.11 The long run average cost envelope curve 58 7.1(a) Marginal Analysis 64 7.1(b) TR and TC Analysis 64 7.2(a) AC>AR>AVC 66 xv 7.2(b) AC>ARATC 70 8.1(b) ATC>AR 70 8.2 AR=ATC 70 8.3 Deriving the firm’s supply curve 71 8.4(a) Entry of new firms 72 8.4(b) Firm’s LR equilibrium 72 9.1 Natural Monopoly 77 9.2(a) Range of Monopoly output and price 80 9.2(b) Total revenue curve for a Monopolist 80 9.3(a) Marginal Analysis 83 9.3(b) TR and TC Analysis 83 9.4 A loss-minimising Monopolist 84 9.5 Comparison between perfect competition and monopoly 85 9.6 Monopolist exploiting economies of scale 86 9.7 Price discrimination in two separate markets 88 9.8 Spreading the load 89 9.9 Price Capping 91 10.1(a) Short-run equilibrium under monopolistic competition 94 10.1(b) Long-run equilibrium under monopolistic competition 94 10.2 Perceived kinked demand function facing the oligopolist 99 10.3(a) Determination of the profit-maximising price 100 10.3(b) Adjustments in output following changes in demand 100 11.1(a) Labour Market 102 11.1(b) Individual firm’s marginal analysis 102 11.1(c) Positive difference between TR and Total Wage Bill 102 11.2 Wage differentials between different categories of workers 104 11.3(a) Elastic Supply – transfer earnings > economic rent 105 11.3(b) Inelastic Supply – economic rent > transfer earnings 105 xvi 11.4 The effect of a monopsonist employer 107 12.1 An attempt to curb negative externalities 113 12.2 An attempt to stimulate positive externalities 114 14.1 The Circular Flow of Income 121 14.2(a) Movements along the AD function 122 14.2(b) Shifts of the AD function 122 14.3(a) Movements along the AS function 123 14.3(b) Shifts of the AS function 123 14.4 Convergence towards equilibrium 124 14.5(a) The effect of an increase in AD 125 14.5(b) The effect of an increase in AS 125 15.1(a) Linear Consumption Function 134 15.1(b) Non-linear Consumption Function 134 15.2(a) Shifts in the Consumption Function 135 15.2(b) Pivots in the Consumption Function 135 16.1 Unplanned Changes in Inventories 138 16.2 An unsuccessful attempt to increase saving 139 16.3 Different MPCs resulting into different sized multipliers 140 16.4 The determination of investment 142 16.5 Investment opportunities for a firm 145 16.6 Comparison between MEC and r 146 16.7 Shifts in the MEC curve 146 17.1 Laffer Curve 155 17.2 Non-discretionary Fiscal Policy (Automatic Stabilisers) 160 17.3(a) Deflationary Gap 162 17.3(b) Inflationary Gap 162 18.1(a) Active Balances 167 18.1(b) Idle Balances 167 18.1(c) Demand for Money Curve – Liquidity Preference Curve 167 xvii 18.2 Rate of Interest Determination 168 18.3(a) The effect of an increase in the DM 169 18.3(b) The effect of a change in the SM 169 19.1 Demand-Pull Inflation 182 19.2 Cost-Push Inflation 183 20.1 Real-wage Unemployment 191 20.2 Demand-deficient Unemployment 192 20.3 Original Phillips Curve 195 20.4 Phillips Curve 195 20.5 Outward Shift in the Short-run Phillips Curve 196 20.6 Non-accelerating Inflationary Rate of Unemployment (NAIRU) 197 21.1 Convergence towards Equilibrium 204 21.2 Depreciation of the € 205 21.3 Maintenance of a Fixed Exchange Rate 206 xviii List of Tables 3.1 Price Elasticity of Demand 18 4.1 The effect of a 10c per-unit tax 26 4.2 The effect of a 15c subsidy 29 4.3 The effect of a price floor on consumers’ surplus and producers’ surplus 35 5.1 Principle of equi-marginal utility 37 5.2 The change in consumption following a rise in the price of Good Y 37 6.1 Production with a single variable factor 45 6.2 The relationship between (i) AP and AVC, and (ii) MP and MC 54 6.3 Types of internal economy of scale 59 6.4 Types of external economy of scale 60 7.1 Profit-maximisation output and price 63 9.1 The relationship between AR and MR under monopoly 80 9.2 The various strands of privatisation 92 10.1 Payoff Matrix for Pricing Game 97 10.2 Payoff Matrix for Prisoners’ Dilemma 97 11.1 Profit-maximisation in relation to Labour 101 11.2 Wage and Employment levels under a Monopsonist Employer 107 13.1 Production totals before specialisation 116 13.2 Production totals after specialisation 116 13.3 Production totals before specialisation 116 13.4 Opportunity cost of producing one product in terms of the other 117 13.5 Production totals after complete specialisation 117 13.6 Production totals after partial specialisation 117 13.7 Arguments for protectionism 119 14.1 The Computation of NI through the Expenditure method 126 14.2 The Computation of GDP using the Output method 127 14.3 The value added concept 127 14.4 Factor incomes in GDP 128 14.5 Computation of disposable, personal income 128 Marginal and Average Propensities to Consume and to Save along a Linear 15.1 133 Consumption Function 16.1 Distinction between Planned Investment and Realised Investment 138 xix 16.2 Present Value of €1 paid in the future 143 16.3 Potential Investment Projects and Expected Rates of Return 145 16.4 The Accelerator Theory 149 17.1 A Progressive Tax 153 17.2 A Regressive Tax 154 17.3 The effect of a tax dependent on income on the multiplier 159 18.1 Monetary Aggregates 169 18.2 Banks’ creation of money 171 18.3 Monetary Policy Instruments, Targets, and Objective 173 19.1 Calculation of a Retail Price Index 178 21.1 The Maastricht Convergence Criteria 208 xx UNIT 1 – The Basic Economic Problem facing all Societies 1.1 The economic problem The economic problem is that wants are unlimited. On the other hand, resources needed to satisfy our wants are scarce compared with people’s wants. Scarcity has a very specific meaning and does not simply mean rare (as many people often assume). To the economist, something is scarce if society desires more of it than is currently available. By this definition, most goods and services are scarce. The economic problem is evident on different levels. On a personal level, for example, we want more clothes, entertainment, etc but our income is limited. Furthermore, on a business level, the firm may be enticed to hire more resources but is limited with its sales receipts. Similarly, on a national level, out is its revenue the government has to finance social security, education and so on. Finally, on an international level, all countries aspire to improve their health institutions, for example, but their resources are limited. 1.2 Economic choices What we can do is to make the most of what we have. Because there are insufficient resources to produce all that is desired, society is forced to make choices. The choices are:  What output will be produced?  How shall the output be produced?  For whom shall the output be produced? Economics is the study of how people make the best use of their resources to satisfy their wants. In fact, the aim of any economic activity is to convert economic resources into goods and services to the citizen. In other words, we must economise. Indeed, ‘economics’ is derived from a Greek word meaning ‘the management of a household’. 1.3 Opportunity Cost Therefore, economics is really concerned with the problem of choice. Because all output is created from scarce resources, it follows that these resources have alternative uses. In choosing which goods and services will be produced from scarce resources, society also chooses which goods and services it will do without. For example, in deciding to work overtime, a worker forgoes leisure time; similarly, if extra capital is required to build more houses, then there will be less left for producing sport centres. The next most desired alternative sacrificed is referred to as the opportunity cost of what is produced. In fact, Economics is often referred to as a social science as it studies how people act. The subject matter is the human being. Economic goods are created from scarce resources and are scarce relative to the demand for them. Economic goods have an opportunity cost. 1 Free goods are not created from scarce resources and are so plentiful that nobody will give anything for them. Air and sand in a desert are two examples. Some goods such as state education are available without direct charge to consumers but they are still created from scarce resources. Therefore, in providing them, the alternatives that those resources could have produced are foregone so they are economic goods and not free goods. Put differently, if there is an opportunity cost, then the goods are not free goods even if no charge is made for them. Thus, economics is portrayed as a ‘science of choice.’ However, any choice betrays specific interests and favors particular agendas. There is a power struggle over the sharing of values governing the ‘best’ choice. Who decides what is best? Whose interests are served? 1.4 Normative Economics and Pure or Positive Economics Normative statements are matters of opinion which cannot be proved or disproved by reference to the facts, since they are based on value judgements. Normative statements can easily be recognised because they often contain verbs such as ‘should’ or ‘ought’. Example: Should production be in the hands of private enterprise or of the State? Positive economics deals exclusively with facts. The accuracy of positive statements can be checked against the facts and they can be proved correct or incorrect. Positive economics is not concerned with the goodness or badness of these facts nor is it concerned with their improvement. In other words, it is completely objective in its approach. Example: The use of contraceptives can control the population. 1.5 The Production Possibilities Curve/Frontier/Boundary (PPC) A Production Possibilities Curve (PPC) depicted in Figure 1.1 shows the maximum output of two goods (such as wine and wheat) that an economy is capable of producing given all its present quantity and quality of resources. The term ‘possibilities’ shows the multiplicity of possible combinations. All points on the curve (e.g. A, B and C) represent points at which the economy is operating at full productive capacity. 2  Wine (Units of Points on the PPC Output) Point inside the PPC Point outside the PPC Y3 A 80 B Y2 95 C E Y1 D 0 x1 x2 x3 Wheat (Units of Output) FIGURE 1.1: Production Possibility Curve Production combinations inside the curve (to the left of the curve), such as point D in Figure 1.1, mean that some resources are not being utilized. Put differently, they indicate that there are unemployed resources in the economy. A move from a combination inside the PPC to a combination on the PPC would mean that the economy has employed previously idle resources. The economy can move from point A to point B, for example, produce 100 additional units of wheat by producing less (e.g. 80 units) less of wine. Thus, the opportunity cost of producing 100 more units of wheat is 80 units in terms of wine. If this country were to produce an additional 100 units of wheat, that is, move from point B to point C along the PPC, it would have to give up again some units of wine; for example, 95 units of wine must be foregone. Therefore, once resources are used productively efficient, the economy can produce more of one good - by transferring workers from the production of one good to the other - but only at the expense of producing less of the other. There is a trade-off between one good and another. For example, governments should choose between any two goods. The opportunity cost of producing more of, for example, capital goods is to provide fewer social services. Note that along a concave PPC, the opportunity cost of one good in terms of the other increases as the country produces more of either goods. In other words, ever increasing amounts of one product have to be sacrificed for each additional unit of the other. Production is subject to the Law of Diminishing Returns. Given at least one fixed factor input, the marginal product of the variable input diminishes. Hence to increase the output of any one product by the same increment, larger and larger increases of the variable input are required, resulting into an increasing cost in terms of the other product foregone. Production combinations outside the curve (to the right of the curve), such as point E, are unattainable for the economy given its present quantity and quality of productive 3 resources. The economy cannot achieve any production combination outside the curve as resources are scarce. However, economic growth makes it possible to produce more of both goods at the same time; for example, produce more units of wine without having to produce less units of wheat. This occurs when a society acquires new resources (i.e. an increase in quantity) and/or when society improves its quality of resources. An increase in quantity may mean a larger labour force or an increased capital stock. The development and use of new machinery (capital) increases workers’ productivity. An improvement in the quality results from technological innovation, the discovery and application of new, efficient production techniques. An economy could best accelerate its future economic growth by choosing to produce more capital goods than consumer goods. Whatever the cause, if society’s ability to produce output increases, this will be represented by an outward movement of the entire PPC. However, if a new invention was put into use to the production of a sole product, then, the PPC would pivot. Governments and world organizations should focus on sustainable development or growth, that is, a form of growth that will not harm the welfare of future generations. In other words, it is a form of development which leaves future generations with at least as much capital and environmental wealth as the current generation inherited. 1.6 The Socially Optimum Level of Output For an economy to be efficient, it must get the maximum level of output from its resources. In addition, goods must be produced in combinations that match people’s willingness to pay for them. Therefore, although all points on the PPC are productively efficient, not all involve the most efficient allocation of resources from society’s point of view. The optimum allocation of resources occurs when productive and allocative efficiencies occur simultaneously. The socially desirable level of output occurs when the marginal rate of transformation (MRT) is equal to the marginal rate of substitution (MRS). Diagrammatically it occurs where the slope of the PPC is equal to the slope of the indifference curve. 4 UNIT 2 – Demand, Supply and Price Determination 2.1 Demand Demand is the amount of a good or service consumers are both willing and financially able to buy at a given price during a period of time. Demand in economics needs to be effective demand, i.e. wants backed up by the financial ability to buy the goods and services desired. Many of us might want a sports car or a swimming pool, but we cannot afford them. So, in the economic sense, we have no demand for such things since there is no effective ability to pay. The law of demand says that if other things do not change, the quantity demanded of a commodity will be smaller at higher market prices and larger at lower market prices. Demand is influenced by utility. The utility of a good or service is the satisfaction people get from consuming or using it. However, the utility is not constant. The law of diminishing marginal utility states that the extra (marginal) units consumed of any good or service usually yield less and less additional utility. Because our resources are limited, we resent having to pay the same price when we obtain less satisfaction from each extra unit. So to buy more, we have to be enticed by a lower price. 2.1.1 Individual’s demand curve and Market demand curve An individual’s demand is one buyer’s demand for a good. Market demand, on the other hand, is the total amount demanded by each consumer at that price. A market demand curve is the horizontal summation of all the individual demand curves. It shows the amount of a good demanders are both willing and able to buy at different prices during a specific period of time. Keeping all other things constant, price and quantity demanded generally vary inversely. 2.1.2 Movements along the demand curve (Changes in the quantity demanded) The demand curve tells us what happens to quantity demanded when price changes and there is no change in other things or factors influencing demand (ceteris paribus). If price changes (due to variations in supply), other things remaining the same (ceteris paribus) we move along a stationary demand curve to change quantity demanded as in Figure 2.1(a). A change in the product’s own price (caused by a change in supply) never shifts the demand curve for that good. An increase in price (brought about by a fall in supply) causes a contraction in demand whereas a decrease in price (due to an increase in supply) results in an expansion (or extension) in demand. 2.1.3 Shifts in the demand curve (Variations in demand) If something other than price changes (so that the ceteris paribus condition is violated) then there is a change in demand and the demand curve shifts as in Figure 2.1(b). An increase in demand is shown by a rightward shift in the demand curve as from D 1 to D 3 in Figure 2.1(b); it means that more is now demanded at each and every price or consumers are prepared to pay a higher price for the same quantity or a combination of both. 5  P P2 P1 P3 D1 Quantity Q2 Q1 Q3 FIGURE 2.1(a): Movements along a stationary demand curve P D2 D1 D3 Quantity Q2 Q1 Q3 FIGURE 2.1(b): Shifts of the demand curve A decrease in demand is illustrated by a leftward shift in the demand curve from D 1 to D 2. It means that less is now demanded at each and every price or demanders are prepared to pay a lower price for the same quantity or a combination of both. A demand curve is drawn assuming that all factors influencing demand are being held constant except price. A change in demand or a shift in the demand curve is always caused by a change in at least one of the conditions of demand. The conditions of demand refer to those factors held constant, and include: 1. the real disposable income of consumers Ceteris paribus, an increase in disposable income, i.e. income available for spending will lead to an increase in demand for normal goods and services. However, in the case of inferior good, an increase in consumer incomes leads to a decrease in demand. 2. the price of substitutes or goods in competitive demand Ceteris paribus, a rise in the price of one good will lead to a contraction in the quantity of that good demanded and an increase in the demand for its substitutes. Examples include pizza and hamburgers, public transport and private transport, and butter and margarine. 6 3. the price of complements or goods in joint demand Ceteris paribus, a rise in the price of one good will lead to contraction in the quantity of that good demanded and a decrease in the demand (inward shift of the demand curve) for the complement. Examples include printer and print cartridges, private transport and fuel. 4. consumer tastes and fashion For certain products, such as clothes, changes in fashions can bring about marked changes in demand. The more fashionable a good becomes, the more demand for it will increase, assuming that other things remain unchanged. 5. advertising A successful advertising campaign intended to stimulate demand shifts the demand curve rightwards. 6. expectations about the economy In the stock exchange, bulls buy shares when they anticipate a price rise and make a profit by selling at a higher price. 7. the population size and structure 8. religious beliefs Members of certain faiths may be forbidden to eat certain foods such as pork. A change in one of the above mentioned conditions affects the level of demand at all prices and results in a shift in the demand curve. The following factors, for example, bring about a fall in demand and consequently the demand curve shifts leftwards: A decrease in real income in the case of normal goods; An increase in the price of a complement; A decrease in the price of a substitute; An adverse change in consumers tastes; A reduction in advertising for this good; A decrease in the population 2.1.4 Application - The main factors influencing demand for tourism At a particular price there is a particular quantity demanded. The term quantity demanded makes sense only in relation to a particular price. Price per night depends on many factors including (a) value of the € vis-à-vis other currencies (b) indirect taxation and (c) type of accommodation.  Changes in Real Disposable income (Employment) N.B. Disposable Income = Money Income - Taxation Real Income = Disposable income adjusted for the rate of inflation For example, the adverse economic situation prevailing in a number of European countries influenced tourism negatively.  Changes in tastes e.g. preferences for long destinations  Changes in weather e.g. a relatively warm summer in Europe may encourage intra- country tourism in Europe. 7  Changes in the price of other goods in: (a) competitive demand e.g. price offered by Malta’s competitors (b) joint demand/complements e.g. price of air flights  Changes in advertising The intensification and broadening of marketing efforts increase the number of tourists  Changes in expectations about the economy - favourable expectations are likely to increase the number of tourists  Population size and Structure- larger populations result into more travelling  The availability of credit - the easier it is for consumers to obtain credit and the lower the interest paid for it, the more likely consumers are to borrow from banks to travel. 2.1.5 Exceptional Demand Curves In some cases demand might vary directly with price as in Figure 2.2 below: P D P2 P1 P3 Quantity Q3 Q1 Q2 FIGURE 2.2: Exceptional Demand Curve Veblen Goods/Goods with a snob appeal The economist Thornstein Veblen used the phrase ‘conspicuous consumption’ to describe the consumption of items that are valued just because of their high value. If prices are reduced, the buyers’ satisfaction from possessing them goes down, and the quantity demanded goes down. Thus, some goods are purchased for ostentatious purposes and as their price rises so does their attractiveness because they provide a means of displaying superior wealth. Goods with uncertain product quality/Consumer ignorance There are many goods for which we do not know the quality and thus we judge the quality by the price. If consumers believe that the price of a good reflects its quality then quantity demanded might increase as price increases. In other words, consumer ignorance might provide an explanation for exceptional demand curves. 8 Giffen goods The demand for a Giffen good rises when the price rises. The term ‘Giffen good’ is derived from the economist Sir Robert Giffen (1837-1910) who noticed this phenomenon while studying how the Irish peasants had behaved during the potato famine in the 1840s. He is credited with the idea of suggesting that in subsistence economies, if the price of basic foodstuffs such as bread and potatoes increases, quantity demanded will also increase. One possible reason for this is that as price rises the higher price makes it impossible for consumers to purchase better quality foodstuffs. They therefore substitute the poorer quality foodstuffs despite the fact that the price of these has increased. 2.1.6 Consumer surplus Consumer surplus is the difference between the maximum a consumer would pay for a good and the price actually paid. Consumer surplus is shown by the area above the price line and below the demand curve in Figure 2.3. P Consumers’ Surplus P1 D Quantity Q1 FIGURE 2.3: Consumers’ Surplus 9 2.2 Supply Supply is the amount of a good that producers in an industry are both willing and able to sell at a given price during a period of time. 2.2.1 Individual Supply and Market Supply An individual supply curve shows the quantity that one firm is willing and able to sell at different prices. A market supply curve is the total amount that will be supplied by all the firms in the industry at different prices during a period of time. The market supply curve is therefore the horizontal summation of all individual firms’ supply curves. In other words, we simply add the amount that every firm is willing and able to supply at each and every price. The supply curve has a positive slope or slopes upward from left to right. In other words, firms are willing and able to supply more at higher prices than at lower prices. There are two main reasons for this:  An increase in output requires a greater quantity of inputs, such as raw materials and labour. Higher prices are needed to cover a rise in marginal cost given that output is subject to diminishing marginal returns.  It is assumed that firms produce for profit, and at higher prices it becomes more profitable to expand output. Thus, higher prices also provide an incentive to boost supply in terms of higher profits. 2.2.2 Movements along the supply curve (A change in quantity supplied) As long as the ceteris paribus condition is satisfied, we can move along a single stationary supply curve, merely changing quantity supplied as in Figure 2.4(a). In other words, a change in price (due to variations in demand) results in a movement along a supply curve, resulting in a change in the quantity supplied. A change in the price of a good never shifts the supply curve for that good. An increase in price causes an expansion (or extension) in the quantity supplied. Conversely, a decrease in price results in a contraction in quantity supplied. 2.2.3 Shifts in the Supply Curve (A change in supply) A supply curve is drawn assuming that all factors influencing supply are being held constant, except price. But, if something other than the price of the product changes, then an entirely new supply curve results. We say there is a change in supply, and the supply curve shifts. For example, a leftward shift in the supply curve from S 1 to S 3 in Figure 2.4(b) indicates that suppliers are prepared to sell the same quantities at a higher price per unit following for example an increase in the price of factor inputs. If however, consumers are unprepared to pay higher prices, then, at each and every price suppliers would be prepared to supply less units in an attempt to reduce costs. 10  P S P2 P1 P3 Quantity Q3 Q1 Q2 FIGURE 2.4(a): Movements along a stationary supply curve P S3 S1 S2 Quantity Q3 Q1 Q2 FIGURE 2.4(b): Shifts of the supply curve The conditions of supply refer to those factors held constant and include: 1. The price of factor inputs or factors of production A change in costs will change the level of profit available from producing any particular commodity. For example, a rise in costs independently of any increase in output following a rise in wage rates will reduce profits and lead some firms to supply the same quantities at a higher price per unit and/or to cut back on output while other firms will cease production altogether. So, a rise in costs of production will lead to a decrease in supply, depicted by a leftward shift in the supply curve. However, a rise in costs accompanied by an equivalent rise in productivity will not affect the supply curve. For example, a five per cent increase in wages which is accompanied by a five per cent increase in productivity will leave average labour costs unchanged and therefore the supply curve will not move. 2. The price of other goods a) in competitive supply (i.e. alternative products the firm could make) Ceteris paribus, a fall in the price of a good in competitive supply results in an increase in the supply of the other. For example, farmers are likely to supply less tonnes of potatoes if the price of tomatoes rises (due to an increase in the demand for tomatoes). 11 b) in joint supply Some goods are jointly supplied. This simply means that it is impossible to supply one good without supplying the other good. Thus, ceteris paribus, a rise in the price of one good will lead to an increase in the supply of the other. For example, a rise in the price of chicken breasts results into not only in a rise in the quantity supply of chicken breasts but also into a larger supply of chicken wings. 3. Government taxes and subsidies on the firm Ceteris paribus, if the government increases the tax load on the firm, it will be, in effect, increasing the costs of production. This will have the effect of decreasing the amount supplied by firms at every given price. A subsidy has exactly the opposite effect. It represents a payment to suppliers in addition to any revenue received from sales. 4. The state of technology Ceteris paribus, if the state of technology alters such that more can be usefully produced from a given set of resources than before, then firms will supply more to the market at every given price. 5. The expectations of future price changes Ceteris paribus, if firms foresee a fall in the future price of the good, they will reduce their planned output at every given price. 6. Weather or Unforeseen circumstances Ceteris paribus, unfavorable weather conditions will lead to a poor harvest and a decrease in supply. 7. The number of firms in the industry Ceteris paribus, as new firms enter the industry, the industry’s supply curve shifts outwards. 2.2.4 Producers’ surplus Producers’ surplus is the difference between the minimum price a producer would accept to supply a given quantity of a good and the price actually received. The area of producers’ surplus is that above the supply curve and below the price as illustrated in Figure 2.5 below: P S Producers’ Surplus P1 Q1 Quantity FIGURE 2.5: Producers’ Surplus 12 2.3 The Determination of Market Price In free or uncontrolled market, prices are determined by the interaction of demand and supply. At P e in Figure 2.6, the quantity that suppliers are willing to supply is equal to the quantity that demanders are willing to buy. At P e there are neither disappointed buyers (excess demand) nor disappointed producers (excess supply). Both buyers and suppliers fulfill their plans simultaneously. At any other price, either consumers or suppliers are disappointed. At a disequilibrium price, the quantity actually sold is determined by the lesser of the quantity demanded or quantity supplied. The market equilibrium price (P e ) is that price at which there is no reason for anything to change unless disturbed by an outside shock. It is often referred to as market clearing price as it is the price at which the market clears. P S Excess Supply P2 Pe P1 Excess Demand D 0 Quantity FIGURE 2.6: Price Determination If price is greater than equilibrium price, such as P 2 in Figure 2.6, there is excess supply/surplus. It is a buyers’ market - a situation where buyers can buy what they want to buy at that price but sellers cannot sell all they want to sell. In other words, producers are ‘disappointed’ as they are prepared to sell more than consumers are willing to buy. The typical producer will find that s/he is experiencing an increase in the level of stocks. An appropriate response would be for the typical producer to reduce the level production and, as a consequence, reduce the price at which the output is offered until equilibrium is achieved. At prices below the equilibrium, as at P 1 in Figure 2.6, there is an excess demand or a shortage since consumers want to buy more than producers are willing to sell. A shortage is a situation where sellers can sell what they want to sell at that price but buyers cannot buy all they want to buy. The typical producers will find that s/he is experiencing a decrease in the level of stocks. An appropriate response would be for a typical producer to increase the level of production and, as a consequence, increase the price until equilibrium is achieved. 13 2.3.1 Changes in market equilibrium price In competitive markets, prices are determined by demand and supply. It follows that changes in the market equilibrium price must be due to changes in demand or supply, or both. It is very important to be clear about the causes of changes in price, otherwise it is impossible to predict the effects on equilibrium quantity. P P S2 S1 S1 P2 e2 P2 e2 e1 P1 e1 P1 Excess Excess Demand Demand D1 D1 D2 0 Q1 Q2 Quantity 0 Q2 Q1 Quantity FIGURE2.7(a): A price rise caused by an FIGURE 2.7(b):A price rise brought about by increase in demand a fall in supply P P S1 S1 S2 Excess Excess Supply Supply e1 e1 P1 P1 P2 e2 P2 e2 D1 D2 D1 0 Q2 Q1 Quantity 0 Q1 Q2 Quantity FIGURE 2.7(c): A price cut following a fall FIGURE 2.7(d):A decline in price due to an in demand increase in supply 14 For example, an increase in the market equilibrium price caused by an increase in demand as in Figure 2.7(a) results into a rise in equilibrium quantity whereas a price rise brought about by a fall in supply as shown in Figure 2.7 (b) results into a decline in equilibrium quantity. Similarly, one cannot draw conclusions about the impact of a price cut unless the cause is known. If price falls following a fall in demand as in Figure 2.7(c), equilibrium quantity falls. However, if price has been lowered following an increase in supply as illustrated in Figure 2.7(d), then, the quantity traded would increase from Q 1 to Q 2. In our examination of markets, we are mostly interested in the effects of a change in price on the quantity bought and sold. Having learnt ‘the law of demand’ (that is, more is demanded at lower prices than at higher prices, ceteris paribus), an increase in price is, generally, automatically associated with a fall in the quantity demanded, and vice versa. But it is important to remember that the effect of a change in price depends on the cause. It is possible for different causes of a price change to have different effects on the quantity traded. 2.3.2 The significance of the ‘ceteris paribus’ condition ‘Ceteris paribus’ is a Latin term that means ‘all other things remaining the same’. All successful attempts to understand the world use this device. By changing one factor at a time and holding all other relevant factors constant, we can isolate/separate the factor of interest (e.g. product’s our price or income or price of substitute product) and investigate its impact on another variable (e.g. quantity bought and sold) in the clearest possible way. Therefore, ‘ceteris paribus’ enables us to understand what would happen to the so-called dependent variable if only one factor were to change. In formulating economic theory, therefore, the concept of ceteris paribus helps us simplify reality by focusing on two variables that interest us. For example, if we were to determine the effect of a fall in the price of CDs on their consumption, we should have to assume that all other factors remain constant. In the laboratory sciences, such as chemistry and physics, experiments are performed that actually hold all the other relevant factors constant, except for the one under investigation. However, in economics, we usually observe the outcomes of many factors varying simultaneously. As a result, it may be difficult to sort out the effect of a change in any one factor as other relevant factors may be changing at the same time. For example, if consumers’ income were to fall or the price of competitive goods to fall, then, it would be quite difficult to estimate the effect of cheaper CDs on their quantity traded. 2.4 Conclusions 1. If demand or supply conditions change, it will push the system into disequilibrium. In other words, equilibrium prices change only if there has been a change in a condition of demand and/or supply. 2. There are forces at work automatically moving the market price towards equilibrium. 3. It follows that products whose conditions of demand and supply are inherently unstable are subject to greater price fluctuations than those with more stable demand and supply 15  conditions. For instance, goods for which demand varies according to the time of the year will display price instability. 4. It is possible for different causes of a rise in price to have different effects. The effect of a rise in price on equilibrium output depends on the cause. 5. The functions of the price mechanism The price mechanism is a system in a market economy where prices respond to shortages and surpluses. Shortages cause prices to rise; surpluses cause prices to fall. The price mechanism ensures convergence towards equilibrium. An efficient price mechanism fulfills the following functions: The signalling function – a rise in price caused by an increase in demand acts as a signal. Suppliers will produce more of that product whose price has risen. The incentive function – a price rise brought about by an increase in demand provides also an incentive for firms to shift/reallocate resources into producing goods and services whose relative price has rise, and to demand more resources such as specialised labour in order to increase production. This may bid up wages and other input prices, causing households to switch their supply of labour into industries where relative wages are rising. The rationing function – as the price of a commodity rises, the price mechanism performs a rationing function as the available supply is rationed out by price. 6. Society’s Welfare At the market equilibrium price, society’s welfare i.e. the summation of consumers’ and producers’ surpluses is at its greatest. Any price control results into an unequal shift of surplus from one group to another. Such net loss in society’s welfare is referred to as deadweight loss. 16 UNIT 3 – Elasticity 3 Concept of elasticity Elasticity measures how one dependent variable responds to a change in another independent variable. Elasticity of demand, for example, refers to the responsiveness or sensitivity of quantity demanded of Good X to a change in its own price, income, price of other goods (e.g. substitutes and complements), advertising, population, etc. 3.1.1 Price elasticity of demand Price elasticity of demand is a numerical value measuring the responsiveness of quantity demanded of, for example, Good X to a change in its own price (caused by variations in supply alone). It is calculated by the following formula: Percentage change in quantity demanded of Good X Percentage change in price of Good X 3.1.2 The difference between POINT and ARC Elasticity The point elasticity of demand is defined as the price elasticity at a particular point on the demand curve. For example, suppose that the price of Commodity X rises from €10 to €11 and as a result its quantity demanded falls from 100 to 95 units per week. Therefore, point (or unit) elasticity is calculated as follows: = (∆Q ÷ Q) ÷ (∆P ÷ P) or (∆Q ÷ ∆Q) × (P ÷ Q) = (-5 ÷ 100) ÷ (1 ÷ 10) = -0.5 The arc elasticity uses the average of the old and new values (rather than the original values) for both price and quantity. The value will always lie somewhere halfway between the point elasticities calculated at the lower and the higher prices. = (∆Q ÷ ∆P) × (P1 +P2 ÷ Q1 + Q2) = (-5 ÷ 1) × (21 ÷ 195) = -0.54 3.1.3 Interpretation of the value The sign shows the type of relationship there is between the two variables (in this case, between price and quantity demanded). PED is normally negative but a positive sign indicates a Giffen good. The absolute size indicates the strength of the relationship between the two variables. The value may vary from 0 to ∞ - the larger (smaller) the value, the more (less) sensitive are consumers to a change in price. 17 TABLE 3.1: Price Elasticity of Demand Numerical Description Explanation value P.E.D = 0 Perfectly QD remains unchanged despite any change in price as shown by inelastic demand function D5 in Figure 3.2. P.E.D < 1 Inelastic QD varies less-than-proportionately along demand function D2 in Figure 3.1(b), i.e. the proportionate change in the QD is less than the proportionate change in price which brought it about. Consumers’ total expenditure or sellers’ total revenue increases (decreases) if price rises (falls). P.E.D = -1 Unitary The % change in QD is equal to the % change in price along a Elastic rectangular hyperbola as illustrated by D4 in Figure 3.2. Total expenditure remains unchanged despite any change in price. P.E.D > 1 Elastic Along demand curve D1 in Figure 3.1(a), the % change in QD is more than the % change in price, i.e. QD varies more-than-proportionately. Consumers’ total expenditure or sellers’ total revenue goes down (up) if price increases (decreases). P.E.D = ∞ Perfectly In the case of D3 in Figure 3.2, a price rise causes demand to Elastic disappear. P of X P of X P2 P2 P1 P1 P3 P3 D1 D2 Q2 Q1 Q3 Q2 Q1Q3 Quantity D of X Quantity D of X FIGURE 3.1(a): Price Elastic Demand FIGURE 3.1(b): Price Inelastic Demand Price D3 D4 D5 Quantity demanded FIGURE 3.2: Exceptional Demand functions 18 3.1.4 Determinants of price elasticity of demand 1. The number and closeness of substitute/competitor goods Ceteris paribus, demand for a good is more (less) price elastic, the larger (fewer) the closeness of substitutes. When there are few close substitutes available for any particular product, demand will tend to be less elastic and therefore less responsive to changes in price. Thus, price elasticity depends on the width of definition. The less (more) defined is the product, the fewer (larger) are the substitutes available and hence the lower (bigger) the price elasticity of demand. Thus, demand for the commodity as a whole is less elastic than the demand for a particular brand of a commodity. For example, demand for food in general is less elastic than demand for any particular type of food such a pasta. 2. The proportion spent on the commodity relative to income Ceteris paribus, demand for a good is more (less) price elastic, the larger (smaller) the proportion spent on a good relative to income. For example, spending on electricity accounts for a larger proportion than matches and would therefore expect demand for cereals to be more price elastic than demand for matches. Thus, the degree of consumers’ sensitivity to a change in price depends on product’s price. High- (low-) priced products take a larger (smaller) proportion of a household’s income and hence the larger (smaller) is the price elasticity of demand. 3. Degree of necessity Ceteris paribus, demand for a good is more (less) price elastic, the lesser (higher) the degree of necessity. Similarly, the degree of consumers’ sensitivity depends on the number of uses the commodity has. Ceteris paribus, demand for a good is more (less) price elastic the fewer (larger) the number of uses the commodity has. For example, electricity has many uses and this is one reason why demand for electricity tends to be price inelastic. Likewise, price elasticity of demand depends of the degree of addiction or habit forming. Ceteris paribus, demand for a good is more (less) price elastic, the lesser (larger) the degree of addiction. For example, demand for cigarettes is generally said to be price inelastic. 4. Time period The longer the time-period involved, the greater the elasticity of demand is likely to be. This is because it takes time to adjust to a change in price. If the price of gas rises, people may be unable to switch immediately to alternative household systems because they are ‘locked in’ to their existing investments in gas-fired appliances. However, the opposite may be true in certain circumstances: some consumers might react to a sudden increase in the price of cigarettes by giving up smoking altogether, and then gradually drift back to their old habits. 3.1.5 Who requires knowledge of price elasticity of demand? Because price elasticity of demand (P.E.D.) determines the effect of price changes on quantity demanded it is an extremely useful concept. So who requires knowledge of price elasticity of demand? 19 1. The Business Sector Those involved in the business sector would find knowledge of P.E.D. useful if they were considering a price change for their commodity. If demand is inelastic, a rise in price results into an increase in profitability because revenue will rise and, with less being sold, output will be reduced and costs will fall. However, if demand is elastic, the manufacturer should lower his or her price to increase revenue. The effect on profit depends on the proportionate change in costs and revenue following a price change. If the latter is greater than the former, then, profit will rise. 2. The Government Knowledge of price elasticity of demand would be useful if it was decided to influence consumption through the use of taxes or subsidies. For example, indirect taxes might be used to discourage the consumption of certain demerit goods and to increase government’s revenue. On the contrary, subsidies might be used to encourage the consumption of merit goods. Knowledge of price elasticity of demand would provide an indication of how successful the policy is likely to be. In the case of subsidies, it would be useful in providing an estimate of the likely cost of the subsidy. 3. Trade Unions Trade unions would find it useful to have an estimate of price elasticity of demand for the products their members produce. Demand for workers following a rise in wages depends on the P.E.D. of the product they produce. Demand for labour tends to be wage inelastic if demand for the commodity they produce/provide is also price inelastic. 3.1.6 Elasticity of Demand along a linear Demand curve Even if the demand curve is a straight line, price elasticity of demand varies along its entire length. Price elasticity of demand rises as we move up the demand curve i.e. at higher price levels. The higher (lower) the price of a good, the more (less) price elastic is demand. High- (low-) priced products represent a higher (lower) proportion of households’ incomes and hence the more (less) elastic is demand. 3.2.1 Income elasticity of demand (YED) Income elasticity of demand (YED) is a numerical value measuring the degree of consumers’ responsiveness to a given change in income, ceteris paribus. It is equal to the percentage change in demand divided by the percentage change in income. If YED is negative, the product is an inferior good. If YED is positive and less than 1, the product is a necessity. If YED is positive and greater than 1, the product is a superior or luxury good. An Engel curve shows the amount of a good demanded at different levels of income. Almost all goods are normal at sufficiently low levels of income and are inferior at sufficiently high levels of income. In Figure 3.3 below, at income levels above Y2, the good becomes an inferior one. 20  Income Y2 Y1 Quantity demanded FIGURE 3.3: Engel Curve 3.2.2 Determinants of YED 1. Degree of necessity Demand for basic goods such as bread and soap in developed countries rises at a slower rate than income. Conversely, quantity demanded for superior goods such as dishwashers rises more than proportionately as income rises. 2. The level of income of consumers Poor people will respond differently from rich people to a rise in their incomes. For example, for a given rise in income, poor people may buy proportionately more food than rich people. 3. The rate at which the desire for a good is satisfied as consumption increases The more (less) quickly people become satisfied once they get the product, the less (more) responsive is demand to changes in incomes. 3.2.3 The importance of YED Since YED provides information about how varies as income changes, the concept is potentially of great importance in planning both in business organizations and governments. If the YED for a normal good exceeds unity, then demand for that product will grow more rapidly than consumer incomes during normal periods of economic growth – hence considerably greater productive capacity may be required. However, during a recession, when incomes fall, firms producing this sort of product will be extremely vulnerable, given the large reduction in demand that might be expected. If the YED is negative then firms producing such inferior goods will see their sales decline steadily over time as the economy grows. However, they may be the sort of business to benefit from the hard times of recession. The concept of YED can contribute to an understanding of the patterns of specialization and development. During 70s, a number of countries such as South Korea, Hong Kong, Singapore and Taiwan switched their resources from agricultural to manufactured goods such as cars, TVs, video players, cameras, hi-fi) in anticipation of the higher demand for such income-elastic luxuries. Knowledge of YED is also useful in developing a marketing strategy. For instance, at times of a boom, products can be promoted as being luxurious and stylish, whereas during a recession, certain products can be marketed as being economical. 21 3.3.1 Cross-price elasticity of demand (CED) Cross-elasticity of demand (CED) is a numerical value measuring the degree of responsiveness of demand for good A to a change in the price of good B. It is equal to the percentage change in the demand for commodity A divided by the percentage change in the price of good B.  If CED is positive, the two goods are in competitive demand, i.e. are substitutes.  If CED is negative, the two goods are in joint demand, i.e. are complements.  If CED is zero, the two products are unrelated, i.e. are independent goods. The better are the substitutes or complementary goods, the bigger will be the value of the cross- price elasticity. Price of 2nd Rates by Public hand cars transport +ve, low XED +ve, high XED P2 P2 P1 P1 0 Q1 Q2 Qty. of new cars 0 Q1 Q2 Qty. of new cars FIGURE 3.4(a): Close Substitutes FIGURE 3.4(b): Remote Substitutes Price Garage of fuel rental P2 P2 P1 P1 -ve, high XED -ve, low XED 0 Q2 Q1 Qty of new Cars 0 Q2 Q1 Qty of new cars FIGURE 3.4(c): Close Complements FIGURE 3.4(d): Remote Complements 22 3.3.2 Determinants of Cross-price Elasticity of Demand (CED) Closeness of a substitute or a complement. The better are the substitutes or complementary goods, the bigger will be the value of the cross- price elasticity as in Figure 3.4(a) and (c). For example, the demand for new cars more responsive to a change in the price of second-hand cars than it is to a change in the rates charged by public transport. 3.3.3 The importance of CED Many companies are concerned with the impact that rival pricing strategies will have, ceteris paribus, on the demand for their own product. Substitutes are characterized by a positive CED: the higher the numerical value, the greater the degree of substitutability between these alternatives in the eyes of the consumer. In such cases there is a high degree of interdependence between suppliers, and the dangers of a rival cutting price are likely to be very significant indeed. Furthermore, firms are increasingly concerned with trying to tie consumers to buy not just one of their products but a whole range of complementary ones, for example computer printers and print cartridges. CED will identify those products that are most complementary and help a company introduce a pricing structure that generates more revenue. For instance, market research may indicate that families spend most money at the cinema when special deals are offered on ticket prices, even though the PED for ticket prices is low. In this case, the high negative cross elasticity between ticket prices and the demand for food, such as ice cream and popcorn, means that, although the revenue from ticket sales may fall, this may be compensated for by increased sales of food. 3.4.1 Price elasticity of supply (PES) Price elasticity of supply (PES) is a numerical measure of the responsiveness of supply to any given change in the price of the commodity caused by variations in demand alone. It is calculated by dividing the percentage change in the quantity supplied by the percentage change in product’s own price. Since rising prices generally lead to an increase in the quantities that firms plan to sell, the PES value tends to be positive. The degree of suppliers’ responsiveness may vary from zero to infinity - the higher (lower) the numerical value, the more (less) responsive or elastic supply is said to be to price changes. If supply, for example, is said to be price inelastic, then, quantity supplied varies less-than-proportionately. The supply of paintings by Picasso is completely or perfectly price inelastic like S1 in Figure 3.5 below as no matter how much price rises following an increase in demand, no more paintings can ever be produced. Conversely, supply is said to be completely price elastic as S2 when changes in demand have no impact on the market equilibrium price – suppliers adjust supply immediately as thus there is no reason for the price to vary as neither shortages nor surpluses would develop.