econ ppt 2

Microeconomics

1

Markets

What is a market and how does it work to allocate resources in an economy?

How do governments intervene in the market?

2

What factors influence market

structure?

Number of Firms

Barriers to Entry

Homogeneous or

Heterogeneous Product

Market Power/Consume

r Sovereignty

3

PerfectCompetition

Oligopoly MonopolisticCompetition

Monopoly

Market Structure: Number of Firms

Small & many Large & fewSmall & many

One & largeRelatively

4

PerfectCompetition

Oligopoly MonopolisticCompetition

Monopoly

Market Structure: Barriers to Entry

None High Relatively low Very High

5

PerfectCompetition

Oligopoly MonopolisticCompetition

Monopoly

Nature of goods: Homogeneous or Heterogeneous

“Identical” Both Similar “Unique”

6

PerfectCompetition

Oligopoly MonopolisticCompetition

Monopoly

Market Structure: Market Power/Consumer Sovereignty

Very high Low High Very low

7

PerfectCompetition

Oligopoly MonopolisticCompetition

Monopoly

Market Structure: Examples

Agriculture Cars Restaurants,books, clothing

Post Office, water & electricity

8

Monopolistic C

ompetition

Many Buyers

Similar products

Many Sellers

Advertising & branding

9

Perfect C

ompetition

Many Buyers

Identical products

Many Sellers

Price drives decisions

10

Monopoly

Many buyers

No close substitutes

One seller

Immense power

11

Oligopoly

Many buyers

Product requires

high production

costs

A few large sellers

Tendency to collude

12

A market is any situation or place that enables the buying and selling of goods and services and factors of production. A market may be a physical location (a street market), it may also be a virtual one (internet buying and selling) or a national one (the market for teachers or doctors). Triple A

Markets exist when buyers and sellers interact. This interaction determines market prices and thereby allocates scarce good and services.

What is a market? 13

Buying and selling is fundamental.

The Supply & Demand Model

Supply and Demand Model

Law of Demand

Law of Supply

Equilibrium Price and Quantity

14

The intersection of demand and supply is the goal that every seller want to achieve.

Demand

A schedule (curve) that shows the quantity of a good that consumers are able and willing to buy at a certain price during a specified period of time.

15

Higher the price less peoplewould buy.

+Change in Quantity Demanded

Movement along the demand curve

16

Law of Demand

• Demand falls

Price Rises •Demand rises

Price Falls

17

Why Does Demand Rise when Prices Fall?

More

Buyers Income

Effect Substitute

Effect

This is cheap!

I am richer!

I will switch to this product!

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Three important factorsTo effect demand

Determinants of Demand: Price

Price • Increase or decrease in in

price level

Increase or decrease in the quantity demanded• Movement along price

curve

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Determinants of Demand: Non-price

Non-Price• Change in factors other

than price that influence demand

Increase or decrease in Demand• Rightward or leftward shift

or the Demand Curve

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D e te rm in a n ts o f D e m a n d

T – consumers’ tastes and preferences

O – other goods (complements and substitutes)

E – expectations of future incomes or prices

I – income

S – size of the market (number of firms)

S - special events or circumstances 21

+Change in Demand

22

Movements versus Shifts

Change in Quantity Demanded

Change in Demand

23

Veblen Goods (HL Extension)

A “show-off” good Price Increases Demand

Increases

24

Giffen Goods (HL Extension)

Essential inferior good Price Increases Demand

Increases

25

Expectations (HL Extension)

Price Falls

Consumer expects further

price falls

Purchase delayed

Fall in quantity

demanded

26

Exceptions to the Law of Demand (HL Extension)27

Supply

A schedule (curve) showing how much of a product producers will supply at each of a series of prices over a specific period of time.

28

Law of Supply

• Supply falls

Price Falls •Supply rises

Price Rises

29

Why Does Supply Rise when Price Rises?

Suppliers want

to sell more New suppliers

enter market

I can make more profit!

I can make a profit!

30

Determinants of Supply: Price

Price • Increase or decrease in in

price level

Increase or decrease in the quantity supplied• Movement along Supply

Curve

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+Change in Quantity Supplied

32

Determinants of Supply: Non-price

Non-Price• Change in factors other

than price that influence supply

Increase or decrease in Supply• Rightward or leftward

shift in the Supply Curve

33

Determinants of Supply

S – subsidies and taxes

T – technology

O – other related goods

R – resources

E – expectations

S - special events or circumstances 34

+Change in Supply

35

Movements Versus Shift

Change in Quantity Supplied Change in Supply

36

Equilibrium Price and Quantity

Marketing Clearing

Price

Suppliers obtain their

highest price

Demanders obtain their

lowest prices

All goods are sold

Quantity Supplied = Quantity

Demanded

37

+Equilibrium

38

Functions of Supply and Demand Interactions

Prices

Incentive for Suppliers

Provides a Rationing Function

Signaling Function for Suppliers

39

+Consumer and Producer Surplus

Consumer surplus is when people are able to buy a good for less than they would have been

willing to pay.

Producer surplus is the difference between the

minimum price a producer would accept to supply a given

quantity of a good and the price actually received.

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+Consumer Surplus

Price

Quantity

D

Po

Qo

A + B = Maximum Willingness to Pay for Qo

What is paid

Consumer Surplus

A

B

+

Minimum Amount Needed to Supply Qo

Producer Surplus

Price

Quantity

Po

Qo

What is paid

Producer Surplus

S

+Consumer and Producer Surplus

Price

Quantity

Po

Qo

S

Producer Surplus

Consumer Surplus

D

+

Original Consumer Surplus

Change in Consumer Surplus: Price Increase

Quantity

New Consumer Surplus

Loss in Surplus: Consumers paying more

Loss in Surplus: Consumers buying less

Price

D

Po

Qo

P1

Q1

Price Ceilings

Price Ceiling

• Maximum (low) price to protect consumers

• Many suppliers opt out of market

Excessive Demand

• Supply does not equal demand

• Under-allocation of resources

Shortages

• Informal markets (Black market)

• Queuing and rationing

45

Price Floor

Price Floor

• Minimum (high) price to protect producers and low income earners

Excessive Supply

• Supply does not equal demand

• Unemploy-ment

Surpluses

• Inefficiencies• Over-

allocation of resources

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+Price Ceiling & Price Floor

47

+Disadvantages

Possible Solutions

Increase Supply

Negative Consequences

of Price Ceilings

Shortages

Provide subsidies

Expensive

Opportunity Costs

Releases stockpiles

No stockpiles

Expensive Opportunity

CostsGovernment provision

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+Disadvantages

Possible Solutions

Increase Demand

Negative Consequences of Price Floors

Surpluses

Destroy or stockpile

Expensive/Wasteful

Opportunity Costs

Export surplus and/or impose

tariffs Upset trading partners

Advertise

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Buffer stock manager sets a price band from highest and lowest

price

Buys stock in times of surplus

Sells stock in times of shortage

Price Support/Buffer Stock SchemesGovernments intervene when there are extreme price fluctuations brought about by seasons factors (agricultural products) and/or economic factors (commodities).

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+Loss in Efficiency Too High a Price (Price Floor)

Price

Quantity

Po

Qo

S

D

QL

New Consumer Surplus

PH

New Producer Surplus

Lost Consumer Surplus

Lost Producer Surplus

Price Floor

+

New Producer Surplus

New Consumer Surplus

Loss in Efficiency Too Low a Price (Price Ceiling)

Price

Quantity

Po

Qo

S

D

QL

PL

Lost Consumer Surplus

Lost Producer Surplus

Price Ceiling

Commodity Price Agreements

A buffer stock scheme involving several countries

E.g UNCTAD OPEC

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MicroeconomicsElasticities

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Elasticities

How sensitive is a buyer to a change in price?

How sensitive is a buyer when another product changes price?How sensitive is a buyer to changes in their own income?How sensitive is a supplier to a change in price?55

ElasticitiesPrice

elasticity of

demand PED

Cross elasticit

y of demand

XED

Income elasticit

y of demand

YED

Price elasticit

y of supply PES

56

Price Elasticity of Demand (PED)

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

57

Range of PED values•Demand not sensitive or responsive to changes in pricePED < 1

Inelastic demand

•A proportional sensitivity or responsiveness to a change in pricePED =1

Unit elasticity

•Demand sensitive or responsive to change in price

PED > 1

Elastic demand

58

Range of PED values• Not sensitive or

responsive to changes in pricePED < 1

Inelastic demand

• A proportional sensitivity or responsiveness to a change in price

PED =1

Unit elasticity

• Sensitive or responsive to change in price

PED > 1

Elastic demand

59

Price Inelastic Demand60

Price Elastic Demand61

Range of PED62

Extreme Cases

PED = 0

Perfectly inelastic

PED = ∞

Perfectly

elastic

63

Perfectly Elastic Demand64

Perfectly Inelastic Demand65

Unit Elastic Demand66

Determinants of PED

P – proportion of income spend on good

A – availability of substitutes

C– closeness of substitutes

T – time available for adjustment

T – type of good: necessity or luxury67

Determinants of PEDIncome

• Inelastic demand

A large proportion of income

• Elastic demandA small

proportion of income

68

Determinants of PEDSubstitutes

• Inelastic demand

Very close substitutes

• Elastic demand

No close substitutes

69

Determinants of PEDSubstitutes

• Inelastic demand

Substitutes available

• Elastic demandNo

substitutes available

70

Determinants of PESTime

• Inelastic supplyShort run = all

but one input can be changed

• Elastic supplyLong run = all inputs can

be changed

71

Determinants of PESSpare Capacity

• Inelastic supplyNo spare

capacity

• Elastic supply

Space capacity available

72

Practical Implications of ElasticityImpact on Total Revenue of Firms

Tax Incidence

73

Impact on Total Revenue of Firms

Total revenue is the amount paid by buyers and received by sellers of a good. TR = P x Q

With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.

With an elastic demand curve, an increase in price leads to a increase in quantity that is proportionately smaller. Thus, total revenue decreases.

Governments levy taxes to raise revenue for public projects

Critics of taxation argue that:

Taxes discourage market activity.

When a good or service is taxed, the quantity sold is smaller.

Taxation

Indirect Tax Specific Tax76

Indirect Tax Ad Valorem Tax77

Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

How this burden is shared depends on elasticity.

Tax Incidence

+Tax and Relatively Inelastic Demand

TR = .25 X 200 m = 50 m

+Tax and Relatively Inelastic Demand

+Tax and Relatively Inelastic Demand

Price for Buyers = .35

Price for Sellers= .2 (150m X .2)

(150m X .15)

(150m X .35)

+Tax and Relatively Inelastic Demand

Price for Buyers = .35

Price for Sellers = .25

Before Tax Buyers paid .25After Tax Buyers pay .35 Buyers contribute 15 m to Revenue (150 X .1)

+

Buyers spend = 52.5 m

(150m items x .35)

Sellers receive

30 million

(150 m items x .20)

Govt. Revenue =

22.5m

(150 items x .15 tax

Buyers have contributed 15 m

150 m items x .1

Before the tax they paid .25 now they pay .35 on 150 m items. They pay

a higher price of .1 per item

Sellers must contribute

7.5 m

150 items x .5 to make up the tax revenue shortfall

The Money Trail

+Tax and Relatively Elastic Demand

+Tax and Relatively Elastic Demand

Summary

The incidence of a tax refers to who bears the burden of a tax.

The incidence of a tax does not depend on whether the tax is levied on buyers or sellers.

The incidence of the tax depends on the price elasticities of supply and demand.

The burden tends to fall on the side of the market that is less elastic.

Total Revenue and Price Elastic Demand87

Total Revenue and Price Inelastic Demand88

Some Practical Applications of PED

With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

89

Market Failure

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Market Failure

What is market failure and why does it occur?

How effectively can governments intervene to correct market failure?

91

What is market failure?

At times markets fail to

allocate resources efficiently

provide goods beneficial to

society

stop production and consumption of harmful goods

92

Sources of Market Failure

ExternalitiesMerit and Demerit Goods

Public Goods

Abuse of Monopoly

Power

93

Positive Externalities

Third parties benefit from the production

of goods and services

Third parties benefit from the

consumption of goods and services

Negative Externalities

Third parties bear spillover costs of the production of goods

and services

Third parties bear spillover cost of the

consumption of goods and services

94

Negative Production Externality95

Negative Consumption Externality96

Tax and Negative Production Externality97

Tax on Producers and Negative Consumption Externality98

Advertising to Shift Demand and Reduce Negative Consumption Externality99

Correcting Negative

Externalities of Production

Legislation & Regulation

Tradable PermitsTax

100

Correcting Negative

Externalities of Consumption

Legislation & Regulation

AdvertisingTax firm

101

Positive Production Externality102

Positive Consumption Externality103

Correcting Positive

Externalities of Consumption

Legislation

AdvertisingSubsidies

104

Correcting Positive Externalities of

Production

Subsidy

105

106

Extension of Property Rights to Correct

Negative Externalities

Internalize Externality

Market-based Appeal

Offending Firms and third parties

monitor progress

The Environment & Sustainable Development

107

What is Sustainable Development?

The present use of resources in satisfying the needs of the economy should not lessen or limit future generations’ use of resources in satisfying needs.

108

+ International Cooperation on Environmental Issues

Reduction of Global Pollution

Accountability

Assigning blame

Cost estimation

Setting appropriate costs

Method

Debate on most efficient methods

Trade-offs

Striking balance between growth &

environmental impact

109

Tradable Permits

Government set a ceiling for total

emissions

Permits Issued and firms fined if they exceed limit

Permits may be resold to other

firms

110

Advantages of of Tradable Permits• Disincentive for inefficient firms• Incentives to firms to reduce

pollution

Disadvantages of Tradable Permits• Heavy polluters may simply

buy permits and perpetuate the problem

• Pollution levels do not reduce

111

Public, Merit & Demerit Goods

112

Public Goods

• Non-Excludable• Non-rivalrous• Free riders

Merit Goods

• Merit goods are under-consumed and underprovided

Demerit Goods

• Demerit goods are overconsumed and overprovided

113

• Positive externalities

• Lack of income • Lack of knowledge

Merit Goods

• subsidies• government

provision• advertising• regulation

Solutions114

• Negative externality

• Lack of knowledge and/or apathy

Demerit Goods

• tax• advertising• regulation

Solutions115

• inefficiencies • higher prices

Monopoly Power

• legislation and regulation

• government ownership

Solutions116

Typical Examination Question

Questions on the Theory of Demand and Supply

1. Explain the function of prices.

2. Explain the function of markets.

3. The basic economic problems is scarcity. Explain how a market economy (or command economy) allocates resources.

4. Evaluate the consequences of price controls.

5. Evaluate the view that it is best to allow primary commodity prices to be determined purely through the free interaction of market forces.

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Typical Examination Question

Questions on Elasticity

1.Define cross elasticity of demand (or the other elasticities ) and using diagrams, explain its impact.

2.Explain why price elasticity of demand and the price elasticity of supply tends to be low on primary commodities and how this impacts price stability.

118

Typical Examination Question

Questions on Market Failure1. Explain the differences between merit goods, demerit goods and

public goods.

2. Evaluate the view that governments should always intervene in markets for such goods as cigarettes and alcohol.

3. With the aid of a diagram, explain how the application of a flat rate tax (a specific/fixed amount) could reduce pollution.

4. Using an appropriate diagram, explain how negative externalities (or positive externality) are a type of market failure.

5. Evaluate the measures that a government might adapt to correct market failure arising from negative (or positive) externalities.

119

Resources

Phil Holden has an excellent set of youtube videos on all aspects of markets.

Teaching Tools for Microeconomics from John Stosel is a little dated but still another excellent source of video clips on markets. This is produced by ABC News.

Paul Solman has produced a series of video clips designed to accompany Economics by Paul Samuelson. They are excellent for the IB Course. The DVD can be obtained from McGraw-Hill.

The National Council on Economic Education has produced a two volumes of student activities: Advanced Placement Economics: Microeconomics Student Activities Workbook, 3rd Edition, and Advanced Placement Economics: Macroeconomics Student Activities Workbook, 3rd Edition. Though they are designed for Advanced Placement students many of the data sets helps IB students understand key concepts. These activities are especially good for students who are more mathematically minded.

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