IB Microecon Notes Demand/Supply

Demand/Supply/Markets

Non-price determinant of Demand - Income

• For normal economic goods, when real consumer income rises, consumers will demand a greater quantity of goods

• Real income could be affected by increase in income, price decreases etc.

Law of diminishing marginal utility

As an individual consumers additional units of a good, the additional satisfaction decreases

Substitution effect

When the price of a product falls relative to other products, there is an incentive to purchase more of the product, since marginal utility/price ratio has been improved.

Conversely, as the price of a good increases, the substitution effect increases as consumers are more inclined to purchase cheaper substitutes to maximize utility.

Difference between demand and quantity demanded

Quantity demanded is the willingness and ability to purchase a quantity of good/service at a certain price over a given time period (a specific point)

Quantity demanded changes when price changes, and is shown by movement along the same demand curve

A shift in the demand curve is attributed to non-price factors where the whole relationship between price and quantity demanded is changes

Law of diminishing marginal returns

A short run law of production stating that as more and more units of the variable factor (usually labor) are added to a fixed factor (usually capital), there is a point beyond which total product continues to rise but at a diminishing rate (and marginal cost starts to increase)

Change in Equilibrium and Market forces

• equilibrium is affected by any non-price determinant of demand of demand or supply

• This leads to a shift of either curve and excess demand/excess supply

• In order to eliminate excess demand/supply, it is necessary for price to rise/fall until the quantity demanded once again equals quantity supplied

Price Mechanism of markets

• The price mechanism of markets has 3 significant functions (1) signalling (2) rationing (3) incentivizing

  1- prices are set by the actions of consumers and producers, and reflect changing circumstances in market. Signalling those in the market to act in a certain way

  2- if there is excess demand, prices will become relatively high, so the low supply will be rationed to those willing/able to pay the higher price

  3- manages demand and supply through opposing and balancing incentives. High price acts as a disincentive for consumers and incentive for producers, and vice versa

Consumer Surplus

• difference between how much a consumer is able and willing to pay for a good and how much they actually pay

Producer surplus

Difference between how much a producer is able and willing to sell a good for and how much they actually sell it for

Allocative efficiency

Achieved when just the right amount of goods and services are produced from society’s point of view so that scarce resources are allocated in the best possible way. It is achieved when, for the last unit produced, price (P) is equal to marginal cost (MC) or more generally, if marginal social benefit (MSB) = Marginal social cost (MSC)

Inelastic PED

0<PED<1 , a change in the price of a good or service leads to a proportionately smaller change in the quantity demanded of the good or service in the opposite direction

Elastic PED

PED>1, a change in the price of a good or service leads to a proportionately larger change in the quantity demanded of the good or service in the opposite direction

PED non price determinants

1. Degree of Necessity (and how broadly it is defined

2. Absolute value of product and how much income consumer uses to purchase good

3. Availability and degree of substitutes

4. Time frame purchase decision has to be made in

5. Primary VS manufactured commdity

Impacts of Indirect tax on market

1- indirect tax causes supply curve to shift up

2 - higher price causes excess supply

3 - price has to fall until new equilibrium

(Note that the equilibrium price ≠ original price + tax)

Indirect tax when PED = PES

Burden of tax imposed is shared equally between consumers and producers

Indirect Tax when PED > PES

burden of tax will be greater on producers than consumers

Producers cannot pass on a lot of the burden of the tax because demand is very elastic and too many consumers would stop buying the product

Therefore, producers bear most of the burden of the tax, and the price for consumers only rises a little

Indirect tax when PED<PES

Burden of tax imposed will be greater on consumers of the product than on producers

Producers can pass on a lot of the burden of the tax, because demand is fairly inelastic and so consumers are not very responsive to the increase in price

Price Elasticity of Supply (PES)

A measure of the responsiveness of the quantity supplied of a good or service to a change in its price.

%∆QTY supplied ÷ %∆ Price

Elastic PES

PES > 1, change in the price of a good or service leads to a proportionally larger change in the quantity supplied of the good or service (in the same direction)

Price Inelastic Supply

PES<1 Where a change in the price of a good or service leads to a proportionately smaller change in the quantity supplied of the good or service in the same direction.