LAST MINUTE REVISION

GUIDE
Balakumar.R.J
UNIT -2- ALLOCATION OF RESOURCES; HOW MARKETS WORKS AND MARKET FAILURE

CONTENTS

 Market and mixed economic system

 Demand and supply
 PED and PES
 Market failure
 Private and social costs and benefits
 Private and public expenditures
 Exploitation and conservation of resources

MARKET ECONOMIC SYSTEM

An economic system where all the economic activities are owned and controlled by private individual
and there is no government intervention
FEATURES OF MARKET ECONOMY

 Private property
 Freedom of choice
 Self-interest ( profit motive)
 Price mechanism
 Limited role of government

ADVANTAGES OF MARKET ECONOMY

 More competition
 Lower prices and better quality
 Wide variety of choices
 Efficient allocation of resources
 Better methods of production
 consumer sovereignty

DISADVANTAGES OF MARKET ECONOMY

 No provision of public goods

 Under provision of merit goods
 Over provision of demerit goods
 Monopoly power
 Imperfect information
 Inequality
 Ignores social cost

6 | Page
MIXED ECONOMIC SYSTEM
An economic system where public and private sector exists side by side and operate for the welfare of
the people.
FEATURES OF MIXED ECONOMY

 Both private and public sector exists

 Profit and welfare motive
 Price mechanism and price fixation
 Freedom of choice
 Major role of the government

ADVANTAGES OF MIXED ECONOMY

 Provision of public goods and merit goods by government

 Demerit goods controlled
 Monopoly power controlled
 Equality of incomes
 Private sector encouraged by profit motive
 Tax revenue for government
 Price mechanism and fixation helps both producers and consumers

DISADVANTAGES OF MIXED ECONOMY

 Heavy taxes reduce incentives to work hard or make profits

 Less efficient private sector can limit the choice
 Excessive control over business activity can add costs and discourage enterprise
 More government power can lead corruption

DIFFERENCE BETWEEN MARKET AND MIXED ECONOMY

MARKET ECONOMY MIXED ECONOMY

Resource allocation Private sector allocates Private and public sector
resources allocates resources
Motive Profit motive only Profit motive and welfare
motive
Price Price mechanism Price mechanism with
government control
Role of government No or limited role Major role of government

7 | Page
DEMAND
Demand is the desire, willingness and ability to buy a product. The law of demand is more will be
demanded at lower price than higher price, other things remains constant.
FACTORS AFFECTING DEMAND FOR GOODS AND SERVICES

 Price of the product

 Income of the people
 Price of related goods ( substitute goods and complementary goods)
 Subsitute goods are goods which can be used instead of others ( Tea and Coffee)
 Complementary goods are those goods which have joint demand( DVD and DVD
player)
 Expected future price
 Taste and fashions
 Advertising
 Population

CHANGES IN DEMAND

 Extension of demand:-
Increasing quantity
demanded due to
decreasing price
 Contraction of demand: -
Decreasing quantity of
demand due to
increasing price.

CHANGES IN DEMAND

 Increasing demand:- Shift

of demand curve to the
right due to changes in
non-price factor
 Decreasing
demand:- Shift of demand
curve to the left due to
changes in non-price factor

8 | Page
SUPPLY
Supply is the total quantity of goods and services that a supplier is willing and able to sell at a given
price. The law of supply is, more will be supplied at higher price than lower price, other things remains
constant.
FACTORS AFFECTING SUPPLY OF GOODS AND SERVICES

 Price of the product Costs of production Improvement in technology Taxation( a compulsory

 payment imposed by government from the people and businesses) Subsidy ( a financial
 assistance given by the government usually to domestic producer) Natural disasters and
 weather conditions Number of suppliers




CHANGES IN SUPPLY

 Extension of supply:-
Increasing quantity
supplied due to
increasing price
 Contraction of supply: -
Decreasing quantity
supplied due to
decreasing price.

. CHANGES IN SUPPLY

 Increasing supply:- Shift of

supply curve to the right due
to changes in non-price
factor Decreasing supply:-
 Shift of supply curve to the
left due to changes in non-
price factor

9 | Page
EQUILIBRIUM PRICE AND DISEQUILBRIUM PRICE

EQUILIBRIUM PRICE DISEQUILIBRIUM PRICE

A price determined by market forces Prices fixed by government (minimum and
A price where demand and supply are equal maximum price)
No shortages or surplus Prices where demand and supply are not equal
Shortages exists when government fix maximum
price and surplus exists when government fix
minimum price
Minimum price:- A price fixed by government above the equilibrium price in order to help producers
Maximum price: - A price fixed by government below the equilibrium price in order to help consumers.

EFFECTS OF CHANGES IN DEMAND AND SUPPLY ON EQUILIBRIUM PRICE AND QUANTITY

EFFECTS OF INCREASING DEMAND

 Increase price
 Increase quantity

10 | Page
P

D1
EFFECTS OF DECREASING DEMAND
P
 Decreasing price
 Decreasing quantity P1

Q1 Q Q

P D
EFFECTS OF INCREASING SUPPLY D
 Reduce price S1
 Increase quantity
P
P1

Q Q1 Q

EFFECTS OF DECREASING SUPPLY

 Increase price
 Decrease quantity

11 | Page
PRICE ELASTICITY OF DEMAND

The responsiveness of quantity of demand due to change in price. It can be calculated using a
formula.

OR

Example 1:- A price of rice increases from MVR 5 per kg to MVR 7 per kg. As a result, quantity
demand decreases from 250 kg to 230 kg. Calculate the price elasticity of demand.

OR

Note that the value of price elasticity of demand is always negative. Because the law of demand
states that increasing the value of price decreases the value of quantity and vice versa. But when
describing the elasticity, the negative sign is ignored.

12 | Page
Example 2:- Calculate the price elasticity of demand when the price increases from 15 to 30.

PRICE QUANTITY DEMANDED QUANTITY SUPPLIED

10 250 35
15 230 60
30 170 95
45 50 120

Example 3:- Calculate the price elasticity of demand

P 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝

𝑷𝑬𝑫
D 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐩𝐫𝐢𝐜𝐞
𝟐𝟎
𝑷𝑬𝑫
𝟓𝟎
10 𝑷𝑬𝑫 𝟎 𝟒
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝑶𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒑𝒓𝒊𝒄𝒆
5 𝐏𝐄𝐃 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑷𝒓𝒊𝒄𝒆 𝒙
𝑶𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚
𝟏𝟎
𝟏𝟎
𝐏𝐄𝐃 𝒙
𝟓 𝟓𝟎
Q 𝐏𝐄𝐃 𝟎 𝟒
50 60

13 | Page
TYPES OF PRICE ELASTICITY OF DEMAND

 Elastic demand [P E D > 1]

Percentage change in quantity demanded is more than the percentage in price. Elasticity is more
than one. Example: Demand for Air conditioner is elastic. In this case firm’s revenue will increase if
there is a fall in its price.

When demand is price elastic a decrease in price would increase the revenue and rise in price would
decrease the total revenue. So producers fix lower price if the demand is elastic.

 Inelastic demand [P E D < 1 ]

Percentage change in quantity demanded is less than the percentage change in price. Elasticity is
less than one. Example: - The demand for petrol is inelastic. In this case firm’s revenue will increase
if there is a rise in price.

Demand curve takes a steep slope. Elasticity < 1

 When demand is price inelastic an increase in price would increase the revenue and a decrease in
price reduces total revenue. So producers fix higher price for the goods which have inelastic demand
in order to earn maximum revenue.

14 | Page
 Perfectly (Infinitively) elastic [P E D = ∞]

At the price Op, people are prepared to buy all that they can obtain. They would buy an infinite
amount if it were obtainable. Demand is said to be perfectly elastic. In this case, the more the
individual firm produces the more revenue will be earned.

If producer set a price above the existing price the demand becomes zero.

Demand curve will be parallel to the X axis. Elasticity = ∞

 Perfectly inelastic demand [P E D = 0]

Demand is said to be perfectly inelastic when the quantity demanded does not respond to any change
in price. The more the price rises, the bigger will be the level of consumer expenditure.

Demand curve will be parallel to the Y axis. Elasticity = 0

15 | Page
 Unitary Elastic Demand [P E D =1]

Unitary elastic demand means percentage change in quantity demanded is equal to the percentage
change in price. Elasticity is equal to one. In this case total consumer expenditure remains constant.

Demand curve will be rectangular hyperbola in shape. Elasticity = 1

When demand is unitary elastic, a rise in price or fall in price has no effect on total revenue

FACTORS AFFECTING PRICE ELASTICITY OF DEMAND

 Availability of substitutes
 Income spent on the goods
 Time period
 Habit forming goods
 Luxury or necessary good

PRACTICAL IMPORTANCE OF PRICE ELASTICITY OF DEMAND

 Helpful to Producers
 Important to Monopolists
 Helpful to the government
 Important in international trade
 Consumer expenditure

16 | Page
PRICE ELASTICITY OF SUPPLY

The term price elasticity of supply refers to the way in which the quantity supplied responds to a
change in price. In other words it is the rate of change or responsiveness in supply due to change in
price

-OR-

OR

TYPES OF PRICE ELASTICITY OF SUPPLY

 Elastic Supply [P E S > 1 ] Inelastic

 supply[P E S < 1 ] Perfectly elastic
 supply [P E S =∞ ] Perfectly inelastic
 supply [P E S = 0 ] Unitary elastic
 supply [P E S =1 ]

17 | Page
FACTORS AFFECTING PRICE ELASTICITY OF SUPPLY

Supply is elastic when firms can easily and quickly change the amounts supplied in response to a
change in price. Supply is inelastic when the quantity supplied cannot be easily and quickly changed
when price changes. Following factors determine the elasticity of supply.

 Whether or not there is any excess capacity

 Storage facilities
 Availability of resources
 The level of stocks
 Manufactured goods and agricultural products

USEFULNESS OF PRICE ELASTICITY OF SUPPLY

 A supplier will be willing to supply more into the market when prices are higher. This is
because they can generate more revenue.
 A good’s supply tends to be elastic if it can be supplied easily into the market and inelastic if it
cannot be easily supplied into the market.
 So, a producer has to try to find some ways to make those goods which have inelastic supply
to elastic.
 This can be done through storage facilities, excess capacities and easy supply of raw
materials. As a result, the firm can sell more and generate more revenue.

18 | Page
MARKET FAILURE
This occurs when the market economy fails to allocate the resources efficiently

REASONS FOR MARKET FAILURE

 No provision of public goods

 Under provision of merit goods
 Over provision of demerit goods
 Monopoly power
 Imperfect information
 Inequality
 Ignores social costs

GOVERNMENT INTERVENTION TO CORRECT MARKET FAILURE

 Taxation
 Subsidies
 Regulation

PRIVATE AND SOCIAL COSTS AND BENEFITS

 PRIVATE COST: - This is the cost to an individual or to a firm regarding an economic activity.
Eg. Cost of buying cigarettes, illness caused by cigarettes.

 PRIVATE BENEFIT: - This is the benefit to an individual or to a firm regarding an economic

activity. Eg, salary gained by teaching

 EXTERNAL COST:- This is the cost or negative effects to third parties other than producers
and consumers regarding an activity Eg illness and smell to non-smokers due to smoking

 EXTERNAL BENEFIT: - This is the benefit or positive effects to third parties other than
producers and consumers regarding an activity. Eg. Jobs available

 EXTERNALITIES: - It can also be defined as the effects to third parties.

 SOCIAL BENEFIT: - Social benefits include the sum of private benefits and external benefits.
Eg benefits to the country of having high qualified and educated citizens.

 SOCIAL COST: - Social costs are the sum of private cost and external costs. Eg pollution
and global warming due to factories and cancer and other dangerous diseases caused due to
smoking

19 | Page
PRIVATE EXPENDITURES AND PUBLIC EXPENDITURES

PRIVATE EXPENDITURES PUBLIC EXPENDITURES

ADVANTAGES  High quality  Cheap
 Efficiency  Everyone can benefit
 Fast and accurate  Inequality reduces
 services
 Lower quality
DISADVANTAGES  Expensive
 Everyone cannot afford  Opportunity costs
Inequality rises

EXPLOITATION AND CONSERVATION OF RESOURCES

EXPLOITATION CONSERVATION
ADVANTAGES  Employment and  Positive
 income environmental
 Economic growth impact
 Living standard  Future
Better allocation of employment,
resources income and
economic growth
Environmental impact
DISADVANTAGES   Slow down current
Fall in future growth,  rate of growth
 employment and Fall in employment
income due to lack of  and income
resources Fall in current
living standard.

20 | Page