Microeconomics: Demand, Supply, Elasticity, and Market Equilibrium

  • 2.3 Competitive Markets: Supply

    • Explains the law of supply.

    • Individual supply represents how much a seller is willing and able to sell per price during a specific period.

    • A producer's supply can be shown via a supply schedule (table of quantities supplied at various prices).

    • Ceteris Paribus: other factors that may affect supply are assumed to be constant.

    • Willing means the seller wants to sell, and able means that it possesses the resources and technology to produce it.

    • A supply schedule and supply curve don't show how many chocolate bars producers will sell or the prices they'll get. It shows how many chocolate bars they can produce if the price were 5, $4 and so on.

    • The law of supply states the positive correlation between price and quantity supplied ceteris paribus.

  • Market Supply

    • Market supply shows the total quantity of a good that all sellers are willing and able to offer at different prices.

    • Market supply is the sum of all individual firms' supplies of the good.

    • Market supply illustrates the law of supply (i.e., the positive relationship between price and quantity supplied).

    • In perfectly competitive markets, firms are "price takers", so their actions do not affect market supply.

  • Non-Price Determinants of Supply and Shifts of the Supply Curve

    • The variables, other than price, that can influence supply.

    • Changes in the non-price determinants of supply cause shifts of the supply curve.

    • If more is supplied = the curve shifts to the right. If less is supplied = the curve shifts to the left.

    • Rightward shift = increase in supply. Leftward shift = decrease in supply.

    • Increased resource prices causes a decrease in supply i.e. leftward shift.

    • Improved technology = rightward shift in the supply curve i.e. increase in supply.

    • Government intervention through taxes decreases supply, and subsidies increases supply.

    • With other goods X and Y, a fall in the price of X produces a rightward shift in the supply for Y, while an increase in the price of X produces a leftward shift in the supply for Y.

    • Change # of Sellers: If the # of sellers increases, supply increases and the market supply curve shifts to the right.

    • Producers expectations: expectations that the prices of their outputs will rise in the future influence supply decisions today; prices expected to increase = decrease in supply (shift to the left).

  • Movements Along a Supply Curve vs. Shifts of a Supply Curve

    • A change in price produces a change in quantity supplied, which is shown as a movement along the supply curve.

    • A change in non-price determinant of supply leads to a change in supply, which is represented by a shift in the entire supply curve.

  • 2.4 Market Equilibrium: Combining Demand and Supply

    • Equilibrium price is where supply and demand intersect, also called the "market-clearing price".

    • Equilibrium quantity is the quantity bought and sold at the equilibrium price.

    • At prices above equilibrium, quantity supplied exceeds quantity demanded, creating surpluses.

    • At prices below equilibrium, quantity demanded exceeds quantity supplied, creating shortages.

    • Firms selling at above equilibrium price have unsold inventories pushing them to reduce prices.

    • Shortages lead to competing buyers bidding prices up toward equilibrium as producers increase quantity.

    • Market forces drive prices toward equilibrium where supply equals demand.

  • Changes in Market Equilibrium

    • Demand curve shifts as consumer tastes, incomes, expectations, or prices of related goods change.

    • Supply curve shifts due to input costs, technology, government regulations, or number of sellers changing.

    • Changes in both demand and supply curves leads to a new equilibrium

    • Change in demand and supply can be analyzed qualitatively and quantitatively with specific values.

  • 2.5 The Role of Prices in a Competitive Market

    • Prices have 3 important functions:

      • Transmitting information (to consumers and producers)

      • Rationing scarce resources (allocating) to its best uses

      • Providing incentives to affect the allocation of resources

    • Prices provide critical signals about relative scarcities and consumer valuations.

    • Prices act as an incentive to produce more of goods society values most highly.

  • 2.6 Consumer Surplus and Producer Surplus

    • Consumer surplus (CS) is the difference between the highest price consumers are willing to pay and the actual market price.

    • Consumer surplus is the area below the demand curve and above the market price.

    • Producer surplus (PS) is the difference between the lowest price firms are willing to accept and the actual market price

    • Producer surplus is the area above the supply curve and below the market price.

    • In perfectly competitive markets, total surplus (CS + PS) is maximized at the equilibrium price and quantity.

    • Total surplus measures the net benefit to society from the production and consumption of a good.

    • Efficiency is achieved in competitive markets when resources are allocated in such a way that maximizes total surplus; this allocation is called allocative efficiency

    • Efficiency implies that it is impossible to reallocate resources in such a way as to make at least one person better off without making another person worse off.

    • There are no positive externalities nor existence of public goods for efficiency to be achieved.

  • 2.7 Government Intervention

    • Price controls: setting maximum or minimum prices legislatively; usually creates surpluses or shortages.

    • Reasons for intervention:

      • Correct market failure (inefficient allocation of resources due to externalities or public goods)

      • Achieve greater equity (fairness in the distribution of resources)

      • Promote other social goals (e.g., environmental protection, public health)

    • Government can also intervene via price controls.

    • Price ceiling: a legislated maximum price that sellers are allowed to charge. Its set below the equilibrium. Examples are rent control, or energy price controls.

      • Effects of Price Ceilings: Shortages, Non-price rationing (waiting lines, favoritism), Inefficient resource allocation (underproduction), Black markets

    • Price floor: a legislated minimum price that sellers are allowed to charge. Its set above the equilibrium. Examples are agriculture price supports and minimum wage.

      • Effects of Price Floors: Surpluses, Disposal problems (government buys surplus), Inefficient resource allocation (overproduction).

  • Indirect Taxes

    • Taxes imposed on spending on goods and services.

    • Specific taxes are a fixed amount of tax per unit sold.

      • Effects of Specific Taxes: Increased price to consumers, decreased price to producers, decreased quantity traded, tax revenue for government, allocative inefficiency (over or under allocation of resources)

    • Ad valorem taxes are a fixed percentage of the price of the good or service.

      • Incidence of Tax: refers to the division of a tax between consumers and producers.

    • Subsidies

      • Payments from the government to firms to lower costs and encourage increased production.

      • Effects of Subsidies: Lower price to consumers, increased price to producers, increased quantity traded, subsidy costs for government, allocative inefficiency.

  • 2.8 International Trade

    • World price is where supply and demand intersect, determining exports and imports.

    • Domestic and world prices determine trade flows and impacts.

    • Without trade, the domestic price and quantity are determined by domestic supply and demand.

      • With trade, if the world price is above the domestic price, the country will export the good.

      • With trade, if the world price is below the domestic price, the country will import the good.

    • Arguments For Trade Restrictions (Protectionism):

      • Infant industry argument (protecting new industries until they are able to compete globally)

      • National security argument (protecting industries essential for national defense)

      • Promote greater equity in the distribution of income (redistributing income from richer to poorer households)

      • Generate government revenue (tariffs)

  • Methods of Trade Restriction

    • Tariffs are taxes on imported goods, increasing price, decreasing quantity, and generating revenue.

    • Quotas are quantity limits on imports, restricting supply and raising domestic price.

    • Effects of Tariffs and Quotas: Higher price, lower quantity consumed, redistribution of income from consumers and foreign producers to domestic producers and government, welfare loss (inefficient use of resources)

  • Exchange Rates

    • the value of one currency expressed in terms of another currency.

    • Factors that cause exchange rates to change. High interest rates, increased investment from abroad.

    • Increased exports lead to increased exports of the currency.

  • HL Only

    • 2.9 Elasticity

    • Price elasticity of demand (PED) measures the responsiveness of quantity demanded to a change in price.

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

    • Determinants of PED: number and closeness of substitutes, the degree to which the good is a necessity, length of time, proportion of income spent on the good

    • PED > 1 = elastic

    • PED < 1 = inelastic

    • PED = 1 = unit elastic

    • PED = 0 = perfectly inelastic

    • PED = infinity = perfectly elastic

    • Along a straight-line demand curve, PED varies from elastic to inelastic.

    • The more elastic the demand, the more the tax falls on the producer.

      • PED and Total Revenue (TR): TR = Price x Quantity. Reduction in price will raise TR if Demand is elastic, and lower TR if Demand is inelastic

      • Implications of PED for Government: For example, A good like cigarettes with a low PED can be taxed to raise government revenue

  • Income Elasticity of Demand (YED)

    • Measures the responsiveness of demand to a change in income.

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

    • YED > 0 = normal good

    • YED < 0 = inferior good

    • YED > 1 = income elastic

    • YED < 1 = income inelastic

    • Knowledge of YED helps firms predict how demand will shift as economic conditions change.

  • Cross-Price Elasticity of Demand (XED)

    • Measures the responsiveness of demand for one good to a change in the price of another good.

    • XED = (% Change in Quantity Demanded of Good A) / (% Change in Price of Good B)

    • XED > 0 = substitutes

    • XED < 0 = complements

    • XED = 0 = unrelated goods

    • Helps firms understand relationships between different products and pricing strategies.

  • Price Elasticity of Supply (PES)

    • Measures the responsiveness of quantity supplied to a change in price.

    • PES = (% Change in Quantity Supplied) / (% Change in Price)

    • Determinants of PES: time, mobility of factors of production (land, labor, capital), unused capacity/stocks, ease of storage, ability to increase production at a low cost, the degree to which the good is a necessity

    • PES > 1 = elastic

    • PES < 1 = inelastic

    • PES = 1 = unit elastic

    • PES = 0 = perfectly inelastic

    • PES = infinity = perfectly elastic

    • PES is generally higher in the long run than in the short run, as firms have more time to adjust production.

    • Knowledge of PES helps firms make production decisions and respond to changing market conditions.