The Price System & the Microeconomy

Demand & Supply Curves

Effective Demand

• Definition -> The quantity of a good or service an individual is willing and able to purchase over a range of prices over a
period of time.

o Desire for a Product -> Must be backed up with the ability to pay for it

• Important Note -> You must distinguish an individual’s demand for a product from the desire or need for a product

o Eg. an Individual wants a Ferrari but can’t Afford It -> Economics states that he does not have a demand for it

o Reason -> Individual may be willing but is not able to; hence, Effective Demand is not met

Demand

• Individual Demand -> Relationship between individual demand and the price for a product

• Law of Demand -> For most goods and services, the quantity demanded is inversely proportional to its price.

• Demand Curve -> Curve showing the relationship between the quantity of products individuals are willing and able to buy
over a range of prices over a period of time.

o Assuming Ceteris Paribus -> All other factors affecting demand are held constant

o Illustrates the Law of Demand -> Relationship between demand and price

E.g. Demand for Tomatoes by Individual “Tom”

• Assuming Ceteris Paribus -> All other factors affecting Tom’s demand for tomatoes remain constant
• Absence of the Supply Curve -> We cannot determine the quantity demanded and the price

Market Demand

• Definition -> The total demand for a particular product in the market

• Purpose -> Shows the relationship between market demand and the price of a product

• Calculation -> Adding together the quantity demanded of each individual at any given price** **

Supply

• Definition -> The quantity of a good a producer is willing and able to offer for sale over a range of prices, over a given period
of time

• Determining the Equilibrium Price and Quantity -> One must evaluate both demand and supply curves of a product.

• Individual Supply -> Relationship between an individual producer’s supply and the price for a product

• Law of Supply -> For most goods and services, the quantity supplied is directly proportional with its price.

o If Price Rises -> Quantity Supplied Rises

o If Price Falls -> Quantity Supplied Falls

• Supply Curve -> Curve showing the relationship between the quantity of a product producers are willing and able to offer for
sale over a range of prices, over a period of time

o Assuming Ceteris Paribus -> All other factors affecting supply are held constant

• Illustrates the Law of Supply -> Relationship between supply and price

Law of Supply Explanation

• Higher Prices -> Producers are willing to supply more because it is likely more profitable

• Lack of Demand Curve -> We cannot determine the quantity supplied and at what price

** **

Market Supply

• Definition -> The total supply for a particular product in the market

• Purpose -> Shows the relationship between market supply and the price of a product

• Calculation -> Adding together the quantity supplied of each individual producer at each price** **

Shift of the Curve v/s Movement Along Curve.

• Price -> Moves along the given curve (either supply or demand curve)

• Determinants of Demand/Supply -> Bring about changes in the whole curve when these conditions change

• Movement Along Curve is NOT the Same as Shift in Curve

• Movement Along Curve -> Either contractions or extensions of demand/supply

• Shift in Curve -> Movement of the whole curve due to changes in the determinants

Determinants of Demand

• Price is NOT the Only Factor -> Other factors affect an individual’s demand for a good/service

• Conditions of Demand -> Affect how much an individual will demand at each price

o Produce Shifts in Demand -> Either to right or left

1) Income
• Normal Good -> Good whose demand rises as income rises, and falls as income falls; most goods and services

• Inferior Good -> Good whose demand falls as income rises, and rises as income falls

o Reason -> Consumers usually opt for cheaper alternatives when their income is reduced

▪ Eg. McDonald’s -> The least “well-off” opt for fast food over real meals due to them being cheaper

Type of Good Income Relationship Income Rises Income Falls Example

Normal Direct relationship Demand rises Demand falls Most goods

Inferior Inverse relationship Demand falls Demand rises Fast food (eg. McDonald’s)

2) Price of Other Goods

• Goods are Usually Related to One Another -> Either as A)Substitutes or B)Complements

• A) Substitutes -> Goods that are alternative to one another ; they can replace each other

o Example -> Coffee v/s Tea

o If Price of Tea Rises -> Tea’s demand is reduced, since individuals opt for coffee ; Coffee’s demand rises

o If Price of Tea Falls, -> Opposite happens

• B) Complements -> Goods that are consumed together

o Example -> Gas Fuel and Car

o If Price of Cars Rises -> Car’s demand will fall

▪ Fuel’s Demand Falls Too -> Since fuel’d demand is likely inversely related to the price of cars
Good Good A & B Price of A Rises Price of A Falls Example
Relationship

Substitutes They can replace each Good A’s demand falls ; Good A’s demand rises Coffee v/s
other; alternatives Good B’s demand rises ;Good B’s demand falls \n Tea

Complements They are consumed Good A’s demand falls ; Good A’s demand rises Car and Gas
together \n Good B’s demand falls ;Good B’s demand rises Fuel

3) Tastes & Preferences

• Individuals -> Unlikely to consume products they do not like

• The More Attractive a Good Is -> The greater the demand is likely to be

Advertising -> Can influence individual’s tastes and preferences, hence influence the demand of a product

4) Speculation

• Individuals -> May buy products hoping their price will rise, thus can profit when reselling it

• Speculative Products -> Houses, Shares, Antiques, etc.

• High Speculation of Rising Prices -> Demand is likely to rise

5) Size, Age, Gender or Population

• Population Size -> Generally directly proportional with demand for most goods and services

• Age and Gender Fluctuations -> Influences the behaviour of demand for goods and services that have a specific demographic

o Example -> Products targeted to the young or elderly, or focused on either males or females
6) Distribution of Income

• Income Equality -> Demand for normal goods should increase

• Income Inequality -> Demand for luxury goods (rich) and inferior goods (poor) should increase

o Influence on Inferior and Luxury Goods -> Will depend on the nature of the change in distribution

Determinants of Supply

• Price is NOT the Only Factor -> Other factors affect an individual producer’s supply for a good/service

• Conditions of Supply -> Affect how much an individual producer will supply at each price

o Produce Shifts in Supply -> Either to right or left

1) Costs of Production

• Rise in Costs -> Supply curve should fall

o Reason -> Producers can offer less for sale at each price

• Examples -> Cost of chips for making phones, salaries of office workers

2) Availability of Resources

• More Availability -> Supply curve should rise

• Eg. More Copper Deposits are Discovered -> Tech industries can produce more electronic chips

3) Climate

• Does NOT Affect All Goods -> Only affects industries that are concerned with the weather

o Example -> Agriculture

• Bad Weather Conditions -> Supply curve should fall

o Reason -> It reduces the ability to produce more crops

• Other Industries Impacted -> Construction, tourism, etc.

4) Technology

• Improvements in Technology -> Supply curve should rise

• Reduction in Costs of Production -> Lets firms produce more at each given price

o Eg. New Machinery -> Might significantly increase tech industries’ ability to produce electronic chips

5) Government Regulation

• Government’s Purpose/Aim -> Health and safety, consumer welfare, legislation, etc.

o Main Goal -> Protect employees from being exploited; equal pay and minimum wage

• High Regulation -> Supply curve should fall

o Reason -> Usually rises the costs of production or reduces efficiency of FOPS

6) Taxes & Subsidies

• Indirect Taxes -> Supply curve should fall

o Reason -> Increases the costs of production for producers

• Subsidies -> Supply curve should rise

o Reason -> Reduces the costs of production for producers; producers can supply more output at lower prices

Determinants of Demand & Supply

Conditions of Demand Conditions of Supply

1) Income 1) Costs of Production

2) Price of Other Goods // Relationship of Goods 2) Resource Availability

3) Tastes & Preferences // Advertising 3) Climate Weather

4) Speculation 4) Technology

5) Size, Age, Gender or Population 5) Government Regulation

6) Income Distribution 6) Taxes & Subsidies

Shifts in the Demand Curve

• If Any of the Conditions of Demand Change -> Demand curve will shift according to the nature of the condition affected

• Shift in Demand Curve -> Individuals are either able to purchase more or less of a product at each price

o Shift to the Right -> Demand Grows ; individuals can buy more of a product at each price

o Shift to the Left -> Demand Shrinks ; individuals can buy less of a product at each price

** **
Demand Condition Being Rise in Demand // Shift to the Right Fall in Demand // Shift to the Left
Assessed

1) Income Normal Goods: Rise in Income; Inferior Normal Goods: Fall in Income; Inferior
Goods: Fall in Income Goods: Rise in Income

2) Relationship of Goods Substitute’s price rises; Complement’s Substitute’s price falls; Complement’s
price falls price rises

3) Tastes & Preferences More Advertising // Product becomes Less Advertising // Product becomes less
more Attractive Attractive

4) Speculation High Speculation that Good’s price will High Speculation that Good’s price will fall
Rise

5) Population Increase in Good’s Target Population \n Fall in Good’s Target Population

6) Income Distribution More even distribution of income (Income Less even distribution of income (Income
Equality) Inequality)

Shifts in the Supply Curve

• If Any of the Conditions of Supply Change, the Supply curve will shift according to the nature of the condition affected

• Shift in Supply Curve -> Producers can purchase more or less of a product at each price.

o Shift to the Right -> Supply Grows; individuals can buy more of a product at each price.
o Shift to the Left -> Supply Shrinks; individuals can buy less of a product at each price \n

Supply Condition Being Rise in Supply // Shift to the Right Fall in Supply // Shift to the Left
Assessed

1) Costs of Production Lower Wages // Cheaper Raw Higher Wages // Expensive Raw
Materials Materials

2) Resource Availability Discovery of Ore Deposits Trade Embargoes

3) Climate Weather Optimum Weather Conditions Bad Weather Conditions

4) Technology Improvements in Technology N/A

5) Government Regulation Minimum Government Regulation Excessive Government Regulation

6) Taxes & Subsidies Less Taxes; More Subsidies More Taxes; Less Subsidies

Price Elasticity, Income Elasticity & Cross Elasticity of Demand

Price of Elasticity of Demand

• Definition -> Measures the responsiveness of a change in demand to a change in price

• Formula -> PED = (%Change in Quantity Demanded) / (%Change in Price)

• PED > 1 = Price Elastic -> The change in price leads to an even bigger change in demand
** **

• PED < 1 = Price Inelastic -> Demand is relatively unresponsive to a change in price

** **

• PED = 1 = Unitary Elastic -> Change in demand is equal to the change in price** **

• PED = 0 = Perfectly Inelastic -> Demand does not change when price changes** **

• PED = ∞ = Perfectly Elastic -> Demand falls to zero when price changes; infinite change in demand** **

Type of PED PED Value Shape

Perfectly Elastic PED = ∞ \n Horizontal Line

Elastic PED > 1 Less Steep Curve

Unitary Elastic PED = 1 Hyperbola

Inelastic PED < 1 More Steep Curve

Perfectly Inelastic PED = 0 Vertical Line

Eg. Price of Bread Increases

• Increase in Price -> 15%

• Decrease in Quantity Demanded -> -20%

• PED -> -20% / 15% = -1.33

• Ignore Whether Value is Positive or Negative -> Solely consider the magnitude

• Magnitude = 1.33 -> 1.33 > 1, so PED is relatively price elastic

Factors Influencing Price Elasticity of Demand

1. Necessity -> Determines whether a good’s demand is more likely to respond to a change in price

o Necessary Goods -> Relatively Inelastic Demand, since even though prices rise consumers still need to consume those
goods

o Luxury Goods -> Relatively Elastic Demand, since they are not necessary

2. Substitutes -> The amount of substitutes a good has can influence the elasticity

o Several Substitutes -> Relatively Elastic Demand

o Eg. Market for Bread -> Relatively Inelastic Demand, since there are less substitutes for bread

3. Addictiveness -> More addictive goods have Relatively Inelastic Demand, since consumers are addicted to them

o Eg. Cigarettes -> Consumers continue demanding them, even if price increases

4. Proportion of Income Spent on the Good -> Influences consumers capability to afford the product, hence its demand

o Smaller Proportion -> Relatively Inelastic Demand

o Greater Proportion -> Relatively Elastic Demand

5. Durability of the Good -> A good’s duration determines how much consumers are willing to wait to buy another one
o Longer Durability -> Relatively Elastic Demand

6. Peak and Off-Peak Demand -> During peak times, demand for tickets is Relatively Inelastic

Factor Being Assessed Elastic PED Inelastic PED

1) Necessity Luxury Goods; eg. travelling Necessary Goods; eg. food/electricity

2) Substitute Availability Several Substitutes; eg. phones Fewer Substitutes; eg. bread

3) Addictiveness Less Addictive More Addictive

4) Proportion of Income Greater Proportion; eg. car Smaller Proportion; eg. magazine

5) Durability Longer Durability; eg. washing machine Shorter Durability; eg. food

6) Peak and Off-Peak Off-Peak times Peak times

Point Price Elasticity of Demand

• Definition -> Measures the price elasticity of demand at a specific point on the demand curve instead of over a range of it**

**

• As Price Rises -> Point PED becomes more elastic, as consumers become more sensitive to price changes

• As Price Falls -> Point PED becomes more inelastic

Income Elasticity of Demand

• Definition -> Measures the responsiveness of a change in demand to a change in income

• Formula -> YED = (%Change in Quantity Demanded) / (%Change in Income)

• YED < 0 = Inferior Good -> As income increases, demand decreases; consumers switch to better quality alternatives; inferior
good demand is reduced

• YED > 1 = Luxury Good -> As income increases, an even bigger increase in demand occurs; luxury good demand increases

YED Value Type of Good Interpretation

YED < 0 Inferior Good Demand decreases as Income increases ; consumers switch to better quality alternatives

YED > 0 Normal Good Demand increases as Income increases ; consumers can buy more of the good

YED > 1 Luxury Good Demand increases in a bigger proportion than income

Cross Elasticity of Demand

• Definition -> Measures the responsiveness of a change in demand of one good, X, to a change in price of another good, Y

• Formula -> XED = (%change in X’s Quantity Demanded) / (%change in Y’s Price)

• XED < 0 = Complements -> If Y becomes more expensive, the quantity demanded of both goods falls

• XED > 0 = Substitutes -> If Y becomes more expensive, the quantity demanded of X rises; consumers switch to the alternative

• XED = 0 = No Relationship -> Goods have no kind of relationship or influence on each other’s demand
XED Feature Interpretation Application

Greater Magnitude (farther Stronger relationship Degree of change between demands of both
from 0) between goods goods is much more significant

Smaller Magnitude**(closer to Weaker relationship Degree of change between demands of both

0)** \n between goods goods is less significant

Positive Sign (+) Substitutes If Good Y becomes more expensive; demand of

Good X rises

Negative Sign (-) Complements If Good Y becomes more expensive, demand of

both goods falls

XED = 0 No Relationship (between Variations in Good Y’s price have no effect in Good
both Goods) X’s demand

Type of Formula Sign (+ or -) Purpose

Elasticity

PED PED = (%ΔQd) / (%ΔPrice) Must be ignored Optimising prices for revenue and taxation

YED YED = (%ΔQd) / (%ΔIncome) Must be Determining type of Good (inferior, normal or
Considered luxury)
Type of Formula Sign (+ or -) Purpose
Elasticity

XED YED = (%Δ Good X’s Qd) / (%Δ Must be Determining relationship between goods
Good Y’s Price) Considered (complements or substitutes)

Price Elasticity of Supply

Price Elasticity of Supply

• Definition -> Measures the responsiveness of a change in supply to a change in price

• Formula -> PES = (%change in Quantity Supplied) / (%change in Price)

• PES > 1 = Elastic Supply -> Firms can increase supply quickly at little cost \n

• PES < 1 = Inelastic Supply -> Supply will be expensive for firms, hence can not variate quickly \n

• PES = 0 = Perfectly Inelastic Supply -> Supply is fixed, hence any change in demand won’t change the current supply

• PES = ∞ = Perfectly Elastic Supply -> Any quantity demanded can be met without changing the price

Type of PES PES Value Shape

Perfectly Elastic PES = ∞ Horizontal Line

Type of PES PES Value Shape

Elastic PES > 1 Less Steep Curve

Inelastic PES < 1 More Steep Curve

Perfectly Inelastic PES = 0 Vertical Line

Eg. the Price of Wheat Increases

• Increase in Price -> 15%

• Decrease in Quantity Demanded -> 20%

• PES -> 20% / 15% = 1.33

• Ignore Whether the Value is Positive or Negative -> Solely consider the magnitude

• Magnitude = 1.33 -> 1.33 > 1, so PES is relatively price elastic

Factors Influencing Price Elasticity of Supply

1. Time Scale -> Determines whether a good’s supply is more likely to respond to a change in price

o Short Run -> Price Inelastic Supply, since producers cannot quickly increase supply

o Long Run -> Price Elastic Supply

2. Spare Capacity -> Availability of resources determines whether producers can supply more or less of their product

o Full Capacity -> Price Inelastic Supply, since there is no spare resources left to increase supply

o Spare Resources -> Price Elastic Supply, since there are lots of spare and unemployed resources
3. Level of Stocks -> Amount of storage determines whether producers can allow themselves to increase supply

o Storable Goods -> Price Elastic Supply, since firms can allow themselves to stock additional supply

o Perishable Goods -> Price Inelastic Supply,s since firms cannot stock them for long

4. Flexibility of Factors of Production -> Determines whether producers can reallocate their resources to where extra supply is
needed

o Flexible FOPS -> Price Elastic Supply

o Fixed FOPS -> Price Inelastic Supply

5. Market Barriers of Entry -> Determines the accessibility that producers have to enter a brand new market/industry

o Higher Entry Barriers -> Price Inelastic Supply; producers struggle to enter into the product’s market

▪ Lower Entry barriers -> Price Elastic Supply

Factor Being Assessed Elastic PES Inelastic PES

1) Time Scale Long Run Short Run

2) Spare Capacity Spare Resources Full Capacity

3) Level of Stocks Storable Goods Perishable Goods

4) Flexibility of Factors of Production Flexible FOPS Fixed FOPS

Factor Being Assessed Elastic PES Inelastic PES

5) Market Barriers to Entry Lower Entry Barriers Higher Entry Barriers

Interaction of Demand and Supply

Market Equilibrium

• Definition -> When supply meets demand; shown by P* Qd in the graph below

• Price has No Tendency for Change -> Since producers are meeting consumers’ demand

• Market Disequilibrium -> Whenever supply is not equal to demand; 2 scenarios: 1)Surplus or 2)Shortage

o Surplus -> Occurs when supply exceeds demand; excess supply (blue line in graph)

o Shortage -> Occurs when demand exceeds supply; excess demand red line in graph)

** **

Relationships Between Different Markets

Market Definition Example

Relationship

1) Joint When goods are complements (goods that **Gas Fuel & Car:**Increase in Car demand is
Demand are bought together) likely to lead to an increase in the demand for gas
fuel \n
Market Definition Example
Relationship

2) Alternative When goods are substitutes (goods that are **iPhone v/s Samsung:**Increase in iPhone
Demand alternatives for each other) demand is likely to lead to a fall in the demand for
Samsung phones \n

3) Derived When the demand for a good produces a **PC’s & Microchips:**Increase in PCs’ demand is
Demand corresponding demand for another related likely to lead to an increase in the demand for
good microchips \n

4) Joint Supply When increasing the supply of one good **Lamb Supply & Wool Supply:**Increase in Lamb
influences the supply of another good supply is likely to lead to an increase in the supply
of wool \n

The Price Mechanism // The Invisible Hand

• Price has 3 Main Functions -> Rationing, Signalling, and Incentivising

• A)Rationing -> Price increases by default when resources are scarce

o Increase in Price -> Discourages demand, consequently rations resources

o Eg. Plane Ticket Rise as Seats are Sold -> Because spaces are running out

o Disincentive to Purchase the Tickets -> Results in rationing the tickets

• B)Signalling -> Price acts as a signal to consumers and new firms entering the market

o Price Variations -> Indicate where resources are needed in the market
• C)Incentivising -> Consumers can inform producers the products they desire by making choices

o High Prices -> Encourage firms to increase their output, since they can make more profit

o Low Demand -> Results in lower prices, which disincentivize firms’ output production

Consumer and Producer Surplus

Consumer Surplus

• Definition -> The difference between the price the consumer is willing and able to pay and the price they actually pay

• Basis -> What the consumer perceives their private benefit will be from consuming the good

** **

• Location in Graph -> Area above market price and below the demand curve

• Law of Diminishing Marginal Utility -> Consumer surplus generally declines with each extra unit consumed

o Extra Unit -> Generates less utility than the one already consumed

o Main Outcome -> Consumers are willing to pay less for extra units

• Inelastic Demand Curves -> Have larger consumer surplus, since consumers are willing to pay much higher prices to consume
the good

• Increasing Consumer Surplus -> Either a)Rise in Demand or b)Rise in Supply

• Decreasing Consumer Surplus -> Either b)Fall in Demand or b)Fall in Supply

Producer Surplus

• Definition -> The difference between the price the producer is willing to charge and the price they actually charge
• Basis -> The private benefit gained by the producer that covers their cost

• Measurement -> Profit** **

• Location in Graph -> Area below the market price and above the supply curve

• Increasing Producer Surplus -> Either a)Rise in Supply or b)Rise in Demand

• Decreasing Producer Surplus -> Either a)Fall in Supply or b)Fall in Demand

Economic Welfare

• Definition -> The total benefit society receives from an economic transaction

• Calculation -> Area of producer and consumer surplus added together

• Importance -> When considering the effects of Government Intervention