The Price System & the Microeconomy (market forces i.e.

demand supply)

Demand and Supply Curves

Demand: the willingness and the ability to buy a product at a certain price level over the period of time

Law of Demand: the quantity demanded is inversely proportional to price (ceteris paribus applied)

Market Demand: the total demand for a particular product in the market. To show the relationship between market demand
and the price of the product. It is calculated by adding togethr the quantity demanded of each individual at a given price

Supply: the willingness and the ability to sell a product at a certain price level over the period of time

Law of Supply: the quantity supplied is directly proportional to price (ceteris paribus applied)

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Market Supply: the total supply for a particular product in the market. To show the relationship between market supply and
the price of the product. It is calculated by adding together the quantity supplied of each individual(producer) at a given
price

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Determining the equilibrium price and quantity

In order to find the equilibrium one must evaluate both demand and supply curves of the product. The point where both the
curves intersect we can say demand and supply meets is called the equilibrium point

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Shift of the curve v/s Movement along the curve
Movement in the demand or supply curve is due to the change in price while shift in demand or supply curve is caused due to
non-price factors

Determinants of demand:
Taste and preferences
Awareness
Income
Price of other goods
Speculation
Size, age, gender or population
Distribution of income

Determinants of supply
Cost of production
Availability of resources
Climate
Technology
Government regulations
Taxes & subsidies

Shift in Demand Curve

Change in demand for a particular product at a given price. Individuals are either able to buy more or less of a product at
each price

Shift to the Right: Demand grows ; individuals can buy more at each price
Shift to the Left: Demand Shrinks ; individuals can buy less at each price

Shift in Supply Curve

Change in Supply for a particular product at a given price. Producers are either able to sell more or less of a product at each
price

Shift to the Right: Supply grows ; individuals can sell more at each price
Shift to the Left: Supply Shrinks ; individuals can sell less at each price

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Shift to the Left: Supply Shrinks ; individuals can sell less at each price

ELASTICITY OF DEMAND
Responsiveness of quantity demanded with respect to the change in given factor i.e. price, consumer income, price of
substitute etc.

Types of Elasticity:
Price Elasticity of Demand (PED)
Cross Elasticity of Demand (XED)
Income Elasticity of Demand (YED) *change = New Value - Old Value
Old value

Price Elasticity of Demand (PED)

It measures the responsiveness of a change in demand to a change* in price. It can be calculated by the following formula :
% 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 the quantity demanded is relatively unresponsive to the change in price

PED = 1 = Unitary elastic the quantity demanded is changed equally to the change in price

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PED = 1 = Unitary elastic the quantity demanded is changed equally to the change in price

PED = 0 = Perfectly inelastic the quantity demanded is unchanged with every change in price

PED = infinity = Perfectly elastic the quantity demanded is changed to high extent with the little change in price; infinite
demand

Factors influencing Price Elasticity of Demand

Necessity
Substitutes
Addictiveness
Proportion of income spent on the product
Durability of good
Peak and Off-Peak Demand

Point Price Elasticity of Demand

Measures the price elasticity of demand at a specific point on the demand curve instead of over a range of it.

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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 as consumers become less sensitive to price changes

Income elasticity of Demand (YED)

Measures the responsiveness of a change in demand to a change in income
Formula: % change in Qty Demanded
% change in consumer income

YED < 0 = Inferior Good

As income increases demand decreases as consumer switches towards better quality products/alternatives

YED > 0 = Normal Good

Demand increases as income increases as consumer buys more of a good

YED > 1 = Luxury Good

Demand increases in a bigger proportion than income

Cross elasticity of Demand (XED)

Measures the responsiveness of a change in demand of one good X, to a change in price of another good, Y.
Formula: %change in quantity demanded of product X
%change in price of product Y

XED < 0 = Complements

If Y becomes more expensive the qty demanded of both goods falls

XED < 0 = Substitutes

If Y becomes more expensive the qty demanded of X rises; consumer switches towards the alternative

XED = 0 = No Relationship
Goods have no influence on each other's demand

Interaction of Demand and Supply

Market Equilibrium
When supply meets demand

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When supply meets demand
Price has no tendency to change : Since the producers are meeting consumers' demand

Market Disequilibrium
When supply doesn’t meet demand

This happens due to two scenarios

Surplus: when supply exceeds demand
Shortage: when demand exceeds supply

Market relationship
Joint demand: when goods are complements (bought/consumed together)
Alternative demand: when goods are substitute (alternative goods)
Derived demand: when the demand for a good produces corresponding demand for another related goods
Joint supply: when increasing the supply of one good influences the supply of other

The price Mechanism / the invisible hand

Price has 3 main functions

Rationing
Signaling
Incentivizing

Rationing: price increases by default when resources are scarce

Increase in price: discourages demand, consequently rations resources. In such time it is disincentive to make the purchase.

Signaling: price acts as a signal to consumers and new firms entering the market
Price Variations: indicates where resources are needed in the market

Incentivizing: consumers can inform producers the products they desire by making choices
High prices: Encourage firms to increase their output since they can make more profit
Low demand: results in lower prices which disincentivize firms' output production

Consumer and Producer Surplus

Consumer Surplus: the difference between the price the consumer is willing and able to pay and the price they actually pay . It
is based on what consumer perceives their private benefit will be from consuming the good

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 law of Diminishing Marginal Utility
Consumer surplus generally declines with each extra unit consumed
Extra unit generates less utility. 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

Rise in demand
Rise in supply

Decreasing consumer surplus: either

Fall in demand
Fall in supply

Producer Surplus
The difference between the price the producer is willing to charge and the price they actually charge. The private benefit
gained by the producer that covers their cost. It is usually measured by the Profit

Increasing Producer Surplus: either

Rise in supply
Rise in demand

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Rise in demand

Decreasing Producer Surplus: either

Fall in supply
Fall in demand

Economic Welfare
The total benefit society receives from an economic transaction
It is calculated by adding both consumer and producer surplus together
It is important when considering the effects of government intervention

GOVERNMENT MICRO ECONOMIC INTERVENTION

Maximum & Minimum Prices

Minimum Prices
Price control set by the Government as the lowest legal price that can be set for a good or service
It is also called Price Flooring.
It is done to discourage consumption/production of goods/services

Minimum Wage -> Type of minimum price; could reduce employment but, encourages positive externalities
Positive Externalities -> Improved socioeconomic welfare and incentivizes work

Key Takeaways from Minimum Price Graph (above)

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Key Takeaways from Minimum Price Graph (above)
1)Quantity Supplied (Qs) > Quantity Demanded (Qd)
Supply -> Rises from Q* to Qs
Demand -> Reduced from Q* to Qd

2)Price Minimum is ABOVE Equilibrium ->

Makes it more profitable to sell the good; incentivizes production, and less affordable to consume (discourages consumption)
More Quantity Supplied (Qs) -> Suppliers are encouraged to supply more of their product
Less Quantity Demanded (Qd) -> Consumers are discouraged from purchasing the product, since it becomes less affordable
Main Outcome → Excess Supply (difference between Q* and Qs)

Eg. of Minimum Price) Minimum Wage

Minimum hourly wage an employer must pay an employee. It reduce poverty; increasing living standard of workers.

3)It might have perverse Outcomes (Negative Side Effects)

Unemployment Increased -> More expensive to hire workers; firms must lay off part of their workforce. Labour Costs Rise
Reward for Working Rises -> More workers are willing to supply their labor.
It will hurt Unskilled Workers -> Since firms are stricter in the abilities they demand of their employees at higher wage rates

4) Requisites to be Effective:
Minimum Wage must be ABOVE Equilibrium -> Or else employers will ignore minimum wages below the market wage
(equilibrium level)

Elasticity of Labour Demand

Inelastic Demand -> Will result in a smaller excess of unemployed workers; firms don’t respond in such extreme degree to rise in
labour costs
Elastic Demand -> Will result in a more accentuated excess of unemployed workers; firms respond adhoc to the rise in labour
costs

Minimum Price Impact on Producer & Consumer Surplus

Advantages of minimum prices

Discouragement of consumption of demerit goods
Raise in living standard of poorest
Work incentive increases

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Disadvantages of minimum prices
Informal labor
Unemployment rate rises
Decrease in wealth of consumers
Inflation

Maximum Prices
Price control set by the Government as the highest legal price that can be set for a good or service. It is also called Price
Ceiling. It is imposed I order to encourage consumption/production of goods/services; avoid goods from getting too expensive

Key Takeaways from Maximum Price Graph Above

Quantity Demanded (Qd) > Quantity Supplied (Qs)
Supply -> Falls from Q* to Qs
Demand -> Rises from Q* to Qd

2) Price Maximum is BELOW Equilibrium -> Makes it less profitable to supply the good; discourages production, and more
affordable to consume (encourages consumption)
Less Quantity Supplied (Qs) -> Suppliers are discouraged from supplying their product, since it becomes less profitable to sell
More Quantity Demanded (Qd) -> Consumers are encouraged to purchasing the product, since it becomes more affordable
3)Main Outcome -> Supply Shortage // Excess Demand (difference between Q* and Qs)
Consumers Require Rationing of the Good -> Since more consumers want the product than what is currently available
Rationing Mechanisms -> Must be put in order to fairly distribute the product’s output

Eg. of Maximum Price. Real Estate Rent Prices

Aim/Purpose -> Maintain the rent affordable for tenants (consumers)
Perverse Outcomes (Negative Side Effects)
Landlords (Suppliers) -> Unwilling to supply their real estate to the market, since prices aren’t as profitable than before the
maximum rent limit
Tenants (Consumers) -> Struggle to find available housing, since less landlords are willing to rent
Black Market Arises -> Landlords accept bribes from desperate tenants; results in extremely exclusive rent prices, since
demand accentuates significantly)

4)Requisites to be Effective:
Price Ceiling must be BELOW Equilibrium -> Or else producers will ignore price ceilings

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Advantages of maximum prices
Essential goods become affordable
Housing market
Transportation Market
Prevents monopoly exploitation
Can result welfare gains
Increase in firms efficiency

Disadvantages of maximum prices

Supply shortage / excess demand
Bribery & corruption
Informal market / Black market increases
Reduction in firms' profits
May lead to government failure

Social Costs = Private Costs + External Costs

Social Benefits = Private Benefits + External Benefits
Private Costs are the production and consumption costs of a firm, individual or the government
Private Benefits are the benefits of the production and consumption to the firm, individual or government.
External Costs are the negative side-effects on third parties for which the consumer doesn’t pay.
External benefits are the positive side-effects enjoyed by third parties.

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Buffer Stock Schemes
Markets with Supply Variations -> Experience price volatility (price equilibrium varies constantly)
Reasons -> Eg. Agriculture Industry: difficult weather conditions
Agricultural Markets -> Have their supply fixed in the short run

Government Intervenes -> Aims to reduce price volatility through the use of buffer stock schemes
Buffer Stock -> Amount of a commodity that is held to limit its price volatility
When Commodity has Production Surplus -> Product is bought and stored in the buffer stock
When Commodity has Production Shortage -> Buffer stock supplies the amount needed to cover the shortage

Key Takeaways from Buffer Stock Graph (above)

Eg. of Buffer Stock Scheme) Demand & Supply in Agricultural Market
Supply in Any Year -> Perfectly Inelastic (PES=0, vertical supply curve) Years 1-3 -> S, S1, S2
Government’s Aim -> Wants equilibrium to be at price P* and quantity Q* Year S1
Equilibrium Quantity -> Q1
Equilibrium Price -> P2
Government Buys Extra Output (Q1-Q*) -> This shifts the equilibrium price to P* Year S2
Equilibrium Quantity -> Q2
Equilibrium Price -> P1
Government Sells Buffer Stock to Cover Shortage (Q2-Q*) -> This shifts the equilibrium price to P*

Advantages of Buffer Stock

Solves Price Volatility -> Achieves to establish price stability in uncertain markets
Stable Incomes for Farmers/Workforce of Unstable Markets -> Eg. agricultural market’s profits are stabilized
Encourages Producers to Engage in Long-Term Business Plans & Deals -> Gives way to economic growth, discovery of
new industries, international competitiveness, etc.

Disadvantages of Buffer Stock

May be Arbitrary to Determine the Equilibrium Price -> Uncertainty about what the equilibrium price of a commodity
should be
Additional Costs of Operating the Buffer Stock Scheme -> Either the Government or producers will need to
contribute; may distract the Government from focusing in other responsibilities
Difficulties to Store Excess Supply -> Perishability of the produce must be considered

Taxation
Example of Average v/s Marginal Tax
Money Earned -> $100,000
Money Paid in Income Tax -> $25,000
Net Income -> $75,000

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Net Income -> $75,000
Average Rate of Taxation -> 25%
Marginal Tax Rate -> The rate of tax that you pay on your next dollar earned
May be Different from Average Rate of Taxation -> Since it depends on the next tax bracket the individual is on
Tax Rate Formula -> [(Total Tax Paid) / (Total Income)] * 100
Tax Rate Eg. -> [(21,036.75)/(100,000)] * 100 = 21.04%

Direct Taxes
Definition -> Taxes that are levied on income, wealth and profit
Payee (Recipient of Tax Payments) -> Direct taxes are paid directly to the Government
Responsibility -> Bears on the Consumer/Firm through income, inheritance, etc.
Examples -> Income Tax, Capital Gains Tax, Corporation Tax

Indirect Taxes
Definition -> Taxes which are levied on expenditure of goods and services
Collected from Sellers -> This increases the production costs of producers, thus resulting in less supply
Market Price of Good Rises -> Hence Quantity Demanded is lower (contracts)
Consumer Incidence -> The amount of tax passed from the producer to the consumer
Producer Incidence -> Portion of the tax which the producer pays
Examples -> VAT (UK), Sales Tax (USA)
Excise Duty -> Specific Tax on a particular good
Main Types
Specific/Per-Unit Tax
Ad Valorem/Value Added Tax

Specific/Per-Unit Tax -> Fixed amount of tax charger to the seller per each unit of good/service sold
The Most Common Type of Indirect tax. Largest Source of Tax Revenue for Governments

Ad Valorem/Value Added Tax -> Tax based upon the total value of a transaction, levied as a % of a good’s value

Proportional, Progressive & Regressive Taxes

Proportional: Flat or Fixed rate for all taxpayers, regardless of income. For e.g. Corporation Tax; Firms etc.

Progressive: It rises with the rise in income. High taxes for those who have higher incomes. For e.g. Income Tax

Regressive: It falls with the rise in income. People with lower incomes pay more in taxes (indirectly). For e.g. Sales
Tax

Impact v/s Incidence of a Tax

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Impact v/s Incidence of a Tax
Impact -> The individual/company on which the tax is levied on
Incidence of a Tax -> Eventual distribution of the burden of a tax

Impact of a specific tax

Impact on Elastic Product

Quantity Demanded -> Reduced from Q* to Q1
Price -> Rises from P* to Pconsumer

Impact on Inelastic Product

Quantity Demanded -> Minimally reduced from Q* to Q1
Price -> Rises sharply from P* to Pconsumer
Ineffective to Reduce Demerit Good Demand -> Since addicted consumers purchase anyways. It is great source of
revenue for Government

Incidence of a Specific Tax

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Incidence of a Specific Tax

Inelastic Product

Elastic product

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Main Takeaway -> The more inelastic a product is, the greater the burden lies on the consumer.
Scenarios for Complete Consumer Burden
NO Producer Burden -> Either because consumers absorb all the burden or producers refuse to adjust to consumers’
demands

Perfectly Inelastic Demand -> PED = ∞ ; consumers absorb all the burden since they do not respond to changes in
price; vertical demand curve

Perfectly Elastic Supply -> PES = ∞ ; consumers absorb all the burden since producers refuse to adjust to consumers’
demands; vertical supply curve

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Impact of an Ad Valorem Tax
Main Difference from Specific Tax -> Tax value rises as the price rises
Elastic Demand

Impact on Elastic Product

Quantity Demanded -> Reduced from Q* to Q1
Price -> Rises from P* to Pconsumer

Inelastic Demand

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Impact on Inelastic Product
Quantity Demanded -> Minimally reduced from Q* to Q1
Price -> Rises sharply from P* to Pconsumer

Incidence of an Ad-Valorem Tax

Taxation Graph Calculations & Formulas

Value of the Tax -> Difference between Pconsumer and PSupplier
Tax Revenue -> Q1 * Value of Tax // Q1 * (Pconsumer-Psupplier)

Producer Burden
Area -> Above Psupplier, below market/equilibrium price, left of Q1
Inelastic Market -> Producer burden is smaller; more money spent on product
Elastic Market -> Producer burden is greater; less revenue due to less sales

Consumer Burden
Area -> Below Pconsumer, above market/equilibrium price, left of Q1
Inelastic Market -> Consumer burden is greater; more money spent by consumers
Elastic Market -> Consumer burden is smaller; consumers don’t tolerate a rise in price, less demand, less sales
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Elastic Market -> Consumer burden is smaller; consumers don’t tolerate a rise in price, less demand, less sales

Deadweight Loss (DWL) -> Inefficient allocation of resources, market failure; no party enjoys the benefit
Inelastic Market -> DWL is much smaller; revenue is collected anyway since consumers still buy the product
Elastic Market -> DWL is much greater; revenue is much smaller since consumer demand contracts

Subsidies
Benefit given by the government to producers to reduce their production costs. It encourages further production.
They are financed by the Tax Revenue
Opportunity Cost -> Government revenue could have been used elsewhere; potential government failure: there may
be inefficient spending.

Impact of a Subsidy
Shift Supply Curve to the Right / Supply Expands -> Producers can supply more of their product at each given price.
Market/Equilibrium Price -> Lowered from P* to Pconsumer (see below)
Value of Subsidy Per-Unit -> Difference between P* and Pconsumer
Total Government Spending on Subsidy -> Per-Unit Subsidy * Output

Elastic Demand

Impact on Elastic Product:

Price -> Slightly reduced from P* to Pconsumer
Quantity Supplied -> Large increase from Q* to Q1

Incidence of a Subsidy

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Consumers -> Do not fully benefit from the full value of the subsidy
Producers -> Absorb some of the benefit of the subsidy for their own gain

Inelastic Demand

Greater consumer benefit

Elastic demand

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Greater producer benefit

Income & Wealth Inequality

Income v/s Wealth
Income: Flow of money. It is variable
Wealth: Stock of money or assets. Constant

Income
Money received, especially on a regular basis
Wages & Salaries -> Paid to people as a reward for the work they have carried out
Benefits -> Ways in which income can be received; pensions or tax credit
Profits -> Income that flows into businesses
Dividends -> Income distributed to shareholders of businesses
Rental Income -> Flow of income to people who own and rent/lease out their property
Interest -> Paid to people who hold money in interest-paying accounts with financial institutions

Wealth
Savings -> Held in multiple types of accounts with financial institutions
Shares -> Ownership of shares issued by limited companies
Property -> Ownership of property
Bonds -> Money held in bonds
Pension Schemes -> Wealth held in occupational pension schemes and life assurance schemes

The Gini Coefficient

A statistical measure of the degree of inequality of income in an economy
It is used for measuring income & wealth inequality
The Lower the Figure -> The more equal the distribution of income
The Bigger the Figure -> The more unequal the distribution of income

Economic Reasons for Income and Wealth Inequality

Employment -> Hard to find well-paid employment

Increase in Unemployment -> Fewer people receiving wages, more receiving state benefits
Fewer Full-Time Positions -> Part-time jobs rise, income inequality increases since wages are lower in part-time
positions

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positions

Government Policy
Wage Freezes -> The wage increase rate rises slower than inflation; seeks to reduce further inflation
Fall in Standard of Living -> Mostly seen in public sector workers

Taxation -> The Government may raise tax levels to increase public revenue, makes taxes even more regressive for
lower sectors of the economy

Distribution of Wealth:
People Who Already Hold Wealth -> Can invest, which creates even more wealth for them

The existing Concentration of Wealth -> Makes inequality a vicious cycle

Policies to Redistribute Income and Wealth

Minimum Wage:
Government can establish a minimum wage. Some workers may be unemployed since firms may not be able to pay all
workers the minimum wage which may lead to unemployed workers living off benefits

Transfer Payments:
One-way payments (in-kind benefits) in which no good, money or service is exchanged. It ensures basic living
standards for all, reduces inequality and poverty, redistributes income from the rich to the poor. Transfer payments
are not a reward for any productive effort
Revenue from Taxation -> Used to provide financial support to people
Government Provisions -> Social security, unemployment benefits and housing benefits

Progressive Income Taxes:

Where the proportion of income paid in tax increases as income increases
They are used to achieve a more equitable distribution of income. These do not only take more from a person as
their income rises but also a higher proportion of their income
There is an increase in the Marginal Rate of Taxation -> For. Income tax might start at 20% and then increase by
30%, later 40%, and later 50% as income levels rise

Inheritance & Capital Taxes:

Inheritance Tax -> A tax which is paid on the money, property and possessions of someone who has died
Capital Gains Tax -> A tax which is paid on the surplus obtained from the sale of an asset for more than was
originally paid for it
They are used by government to intervene in the economy to try to bring about a more equitable distribution of
wealth

State Provision of Essential Goods & Services:

They are used to help redistribute income & wealth
Money for Provision Funding -> Comes from the money received from taxation
It helps reduce inequality since money goes from the well-off to the less well-off
Example -> State Provision of Health Care

Public Goods -> Must be provided by the State, or they would not be provided at all

Effect of Transfer Payments on the Market

Transfer Payments -> Can be given in various forms of income support to those who struggle economically.
Unemployment Benefit -> Money paid out to unemployed workers
Side Effect -> May discourage workers from finding employment (benefits are argued to be too high)
Perverse Outcome -> Inefficient allocation of resources; labour is NOT fully employed
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Perverse Outcome -> Inefficient allocation of resources; labour is NOT fully employed

Direct Provision of Goods & Services

Public & Merit Goods -> they may not be provided or underprovided by the private sector.
Examples -> Education, Defense, State Provision of Wealth, etc.
Government Intervention -> Attempts to ensure there is an optimal level of provision of public & merit goods
E.g. Street Lighting, Police and National Defence -> Provided by the State, since otherwise they would not be
provided at all.
Redistribute Income & Wealth -> Money used to pay for provision comes from taxation.
Reduces Inequality -> Tax revenue pays for goods/services the poor are not able to afford
Tradeoff -> Increased spending = less spending elsewhere

Effects to Notice
It reduces Role of the Private Sector -> The State has no competition and is not motivated by profit.
May Lead to Less Efficiency -> Since there is a lack of incentive to reduce production costs
Solution -> The Government can pay private firms to provide goods/services
Delegate Provision to Firms -> Instead of supplying them themselves
May Result in Lower Costs -> Firms may compete to be hired by the Government

Provision of Information
Governments -> Attempt to ensure there is no information failure; must raise awareness of the advantages of
merit goods and the disadvantages of demerit goods.
Imperfect Information -> May lead to market failure
Consumers & Producers -> Require perfect information to make informed economic decisions
Example -> Second-hand car dealers must show the entire history of a car
Downsides & Challenges -> It’s expensive to regulate information provision properly

Nationalisation & Privatisation

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