Economy: an area where people and firms produce, trade and
consume goods and services. This can vary in size- from your
local town to your country, or the globe itself.
Microeconomics and Macroeconomics
Microeconomics is the study of individual markets. For example:
studying the effect of a price change on the demand for a
good. Microeconomic decision makers are producers and
consumers (who directly operate in markets)
Macroeconomics is the study of an entire economy, as a whole.
Examples include studying the total size of the economy or the
unemployment rate, among other things. Macroeconomic decisions
are made by the government of the particular economy – a town,
state or country)
The Role of Markets in Allocating
Resources
Resource allocation: the way in which economies decide what goods
and services to provide, how to produce them and who to
produce them for.
These questions- what to produce, how to produce, and for whom to
produce – are termed ‘the basic economic questions’. In short,
resource allocation is the way in which economies solve the
three basic economics questions.
Market is any set of arrangement that brings together all the
producers and consumers of a good or service, so they may
engage in exchange. Example: a market for soft drinks.
Goods and services are bought and sold in a market at an
equilibrium price where demand and supply are equal. This is
called the price mechanism. It helps answer the three basic
economic questions. Producers will produce the good that
consumers demand the most, it will be produced in a way that
is cost-efficient, and will be produced for those who are
willing and able to buy the product. More on these topics
below:
Demand
Demand is the want and willingness of consumers to buy a good or services at a
given price. Effective demand is where the willingness to buy is
backed by the ability to pay. For example, when you want a
laptop but you don’t have the money, it is called demand. When
you do have the money to buy it, it is called effective
demand.
The effective demand for a particular good or service is
called quantity demanded.
(Individual demand is the demand from one consumer, while market
demand for a product is the total (aggregate) demand for the
product, or the sum of all individual demands of consumers).
The law of demand states that an increase in price leads to a decrease
in demand, and a decrease in price leads to an increase in demand (it’s an
inverse relationship between price and demand. However it’s
worth noting that an increase in demand leads to an increase
in price and a decrease in demand leads to a decrease in
price. The law of demand is established with respect to
changes in price, not demand, hence the difference).
This is an example of a
demand curve for Coca-Cola.
Here, a decrease in price from 80 to 60 has increased its
demand from 300 to 500.
The increase in demand due to changes in price (without changes in other
factors) is called an extension in demand. Here the extension in
demand is from A to B.
In the above example, an increase in price from 60 to 80, will
decreased the demand from 500 to 300. The decrease in demand due to
the changes in price (without changes in other factors) is called a
contraction in demand. Here the contraction in demand will be from
B to A.
In this example,
there is a rise in the demand of Coca-Cola from 500 to 600,
without any change in price. A rise in the demand for a product due to the
changes in other factors (excluding price) causes the demand curve to shift to the
right (from A to B).
In this example, there is a fall in demand of Coca-Cola from
500 to 400, without any change in price.
A fall in demand for a product due to the changes in other factors (excluding
price) causes the demand curve to shift to the left (from A to B).
Factors that cause shifts in a demand curve:
Consumer incomes: a rise in consumers’ incomes increases demand, causing a
shift to right. Similarly, a fall in incomes will shift the demand curve to the left.
Taxes on incomes: a rise in tax on incomes means less demand, causing a shift
to the left; and vice versa.
Price of substitutes: Substitutes are goods that can be used instead of a
particular product. Example: tea and coffee are substitutes (they are used for
similar purposes). A rise in the price of a substitute causes a rise in the demand
for the product, causing the demand curve to shift to the right; and vice versa.
Price of complements: Complements are goods that are used along with
another product. For example, printers and ink cartridges are complements. A
rise in the price of a complementary good will reduce the demand for the
particular product, causing the demand curve to shift to the left; and vice versa.
Changes in consumer tastes and fashion: for example, the demand for DVDs
have fallen since the advent of streaming services like Netflix, which has caused
the demand curve for DVDs to shift to the left.
Degree of Advertising: when a good is very effectively advertised (Coke and
Pepsi are good examples), its demand rises, causing a shift to the right. Lower
advertising shifts the demand curve to the left.
Change in population: A rise in the population will raise demand, and vice versa.
Other factors, such as weather, natural disasters, laws, interest rates etc. can also
shift the demand curve.
Supply
Supply is the want and willingness of producers to supply a good or services at a
given price. The amount of goods or services producers are
willing to make and supply is called quantity supplied.
(Market supply refers to the amount of goods and services all
producers supplying that particular product are willing to
supply or the sum of individual supplies of all producers).
The law of supply states that an increase in price leads to a increase in
supply, and a decrease in price leads to an decrease in supply (there is a
positive relationship between price and supply. However it’s
also worth noting that, an increase in supply leads to a
decrease in price and a decrease in supply leads to an
increase in price. The law of supply is established with
respect to changes in price, not supply, hence the
difference).
This is an example of
a supply curve for a product.
Here, an increase in price from 60 to 80, has increased its
supply from 500 to 700.
The increase in supply due to changes in price (without changes in other
factors) is called an extension in supply.
A decrease in price from 80 to 60, will decreased the
supply from 700 to 500. The decrease in supply due to changes in
price (without the changes in other factors) is called a contraction in
supply.
In this example, there is a rise in the supply of a product
from 500 to 700, without any change in price. A rise in the supply
for a product due to the changes in other factors (excluding price) causes a shift
to the right.
A fall in supply from 500 to 300, without any changes in price
is also shown. A fall in the supply for a product due to the changes in other
factors (excluding price) causes a shift to the left.
Factors that cause shifts in supply curve:
Changes in cost of production: when the cost of factors to produce the good
falls, producers can produce and supply more products cheaply, causing a shift in
the supply curve to the right. A subsidy*, which lowers the cost of production
also shifts the supply curve right. When cost of production rises, supply falls,
causing the supply curve to shift to the left.
Changes in the quantity of resources available: when the amount of resources
available rises, the supply rises; and vice versa.
Technological changes: an introduction of new technology will increase the
ability to produce more products, causing a shift to the right in the supply curve.
The profitability of other products: if a certain product is seen to be more
profitable than the one currently being produced, producers might shift to
producing the more profitable product, reducing supply of the initial product
(causing a shift to the left).
Other factors: weather, natural disasters, wars etc. can shift the supply curve left.
Market Price
The market equilibrium
price is the price at which the demand and supply curves in a
given market meet.
In this diagram, P* is the equilibrium price.
Disequilibrium price is the price at which market demand and
supply curves do not meet, which in this diagram, is any price
other than P*.
Price Changes
In this diagram, two
disequilibrium prices are marked- 2.50 and 1.50.
At price 2.50, the demand is 4 while the supply is 10. There
is excess supply relative to the demand. When the price is above the
equilibrium price, a surplus is experienced. (Surplus means ‘excess’).
At price 1.50, the demand is 10 while the supply is only 4.
There is excess demand relative to supply. When the price is below
the equilibrium price, a shortage is experienced.
(This shortage and surplus is said in terms of the
supply being short or excess respectively).
Price Elasticity of Demand (PED)
The PED of a product refers to the responsiveness of the quantity
demanded to changes in its price.
PED (of a product) = % change in quantity demanded / % change in price
For example, calculate
the price elasticity of demand of Coca-Cola from this diagram.
PED= [(500-300/300)*100] / [(80-60/80)*100]
= 66.67 / 25 = 2.67
In this example, the PED is 2.67, that is, the % change in
quantity demanded was higher than the % change in the price.
This means, a change in price makes a higher change in quantity demanded.
These products have a price elastic demand. Their values are
always above 1.
When the % change in quantity demanded is lesser than the %
change in price, it is said to have a price inelastic demand.
Their values are always below 1. A change in price makes a smaller
change in demand.
When the % change in demand and price are equal, that is value is 1,
it is called unitary price elastic demand.
When the quantity demanded changes without any changes in price itself, it
is said to have an infinitely price elastic demand. Their values are
infinite.
When the price changes have no effect on demand whatsoever, it is said to have a
perfect price inelastic demand. Their elasticity is 0.
What affects PED?
No. of substitutes: if a product has many substitute products it will have an
elastic demand. For example, Coca-Cola has many substitutes such as Pepsi and
Mountain Dew. Thus a change in price will have a greater effect on its demand (If
price rises, consumers will quickly move to the substitutes and if price lowers,
more consumers will buy Coca-Cola).
Time period: demand for a product is more likely to be elastic in the long run.
For example, if the price rises, consumers will search for cheaper substitutes.
The longer they have, the more likely they are to find one.
Proportion of income spend on commodity: goods such as rice, water
(necessities) will have an inelastic demand as a change in price won’t have any
significant effect on its demand, as it will only take up a very small proportion of
their income. Luxury goods such as cars on the other hand, will have a high price
elastic demand as it takes up a huge proportion of consumers’ incomes.
Relationship between PED and revenue and how it is helpful to
producers:
Producers can calculate the PED of their product and take a
suitable action to make the product more profitable.
Revenue is the amount of money a producer/firm generates from
sales, i.e., the total number of units sold multiplied by the
price per unit. So, as the price or the quantity sold changes,
those changes have a direct effect on revenue.
If the product is found to have an elastic demand, the producer can
lower prices to increase revenue. The law of demand states that a
price fall increases the demand. And since it is an elastic
product (change in demand is higher than change in price), the
demand of the product will increase highly. The producers get
more revenue.
If the product is found to have an inelastic demand, the producer can
raise prices to increase revenue. Since quantity demanded wouldn’t
fall much as it is inelastic, the high prices will make way
for higher revenue and thus higher profits.
Price Elasticity of Supply (PES)
The PES of a product refers to the responsiveness of its quantity
supplied it to changes in its price.
PES of a product= %change in quantity supplied / %change in price
Similar to PED, PES too can be categorized into price elastic
supply, price inelastic supply, perfectly price inelastic
supply, infinitely price elastic supply and unitary price
elastic supply. (See if you can figure out what each supply
elasticity means using the demand elasticities above as
reference, and draw the diagrams as well!)
What affects PES?
Time of production: If the product can be quickly produced, it will have a price
elastic supply as the product can be quickly supplied at any price. For example,
juice at a restaurant. But products which take a longer time to produce, such as
cars, will have a price inelastic supply as it will take a longer time for supply to
adjust to price.
Availability of resources: More resource (land, labour, capital) will make way
for an elastic supply. If there are not enough resources, producers will find it
difficult to adjust to the price changes, and supply will become price inelastic.
