Unit 1 - How Markets Work

AN INTRODUCTION TO ECONOMICS

By Kevin Bucknall BSc(Econ), PhD

Copyright © Kevin Bucknall

Module 2881 The Market System, Unit 1: “Markets: How They Work”

The course is the GCEAdvanced Level in Economics, following the Edexcel syllabus. This is a course in the UK, normally taken in grade 12 and it is most commonly used for selecting students for university entrance. This is a series of teaching notes I used until I stopped teaching recently. If you spot any errors, please email me and let me know. I maintain a few email addresses for different purposes; currently they are [email protected] and [email protected]. If you receive no reply it may mean that somewhere along the line a spam-trap has nabbed your message. You can try sending it again, but try taking out any words that you thing a spam-trap might not like. An alternative explanation is that hotmail thought it was spam and deleted it after a few days when I was on holiday or something and was not checking my junk-mail box regularly. Converting my files to PDF format resulted in some strange errors appearing - I corrected all that I noticed but if I missed any and you spot them, please email me!

Now down to business. If you want good marks, these notes should be read and reread until you really know them. Practise drawing the diagrams until you can do them from memory without making mistakes. It is a good idea to revise something and practise drawing diagrams every day. 1-1. INTRODUCTION POSITIVE AND NORMATIVE THINKING Positive economics deals with what is; normative thinking deals with what ought to be and is value-laden All sciences and fields of learning try to be positive and deal with facts and models based on facts. You should try to be positive i.e. scientific in your statements, especially when writing essays and in the exam room. Words like "ought", or "should" or “as a nation we must” are all normative statements and you should do your best to avoid them. Try not to say things like “It would be better if…”, or “the government should….” “it would be a good thing for X to do Y”. Many policy prescriptions you might wish to make are normative, e.g., “The economy would be better off if we….” and it can raise an examiner’s hackles. You might get away with a general statement such as “Some advocate…”, “It has been suggested that…” or “Many believe that….” as these sound less normative. Note the words used in an otherwise scientific study can themselves carry a normative feeling, e.g. "freedom", "democracy", "efficiency", or "welfare" are all Copyright Kevin Bucknall ©

Chap 1 - 1

words to many people; whereas words such as "inequitable", "exploitation", "unsound", "interference", "fascist", or "police-state" seem "bad" to many people.

OPPORTUNITY COST

We live in a world of scarcity, in the sense that we can never have everything that we might like. As a result we must make choices, for instance whether to buy this or that, whether to eat this or that, whether to walk in the park or go to a movie, or whether to produce this or that. Every time we make a choice to do something we automatically exclude something else that we did not do - we have given it up. We call this the “opportunity cost”.

Definition - “Opportunity cost is the best forgone alternative”, i.e. it is what we gave up to get what we did. The opportunity cost of buying new pair of shoes might be a lunch forgone. The opportunity cost of buying a new shirt might be not going to the cinema. The opportunity cost of taking a part-time job might be not being able to hang out in the mall with your friends. For a producer The opportunity cost of buying plastic packaging material might be the cardboard he did not buy. NB there can be many alternatives foregone, but only one will be the opportunity cost you cannot add them up and say they are all the opportunity cost, because it must be a choice between them. Opportunity cost can be thought of as: 1. The cost in pounds (represents a real thing given up); or 2. The cost in time. Opportunity cost is important 1. We use it whenever we are deciding what to do, for example shall we hire a couple of videos - or buy a pizza instead. 2. It always arises with budget allocations. At some point in your life you may have to draw up a budget and allocate money for different purposes. You will be forced to weigh up what is really needed in your tennis club, computer society, your country or whatever. 3. It lies behind the cost curves that we draw. How does this work?

Chap 1 - 2

Consider two producers, A and B Producer A might have to pay £20 a ton to get the iron ore to make into motor cars. Producer A sees the cost as £20, but we see it as the way of making sure he gets the resources, rather than letting B get them! So the opportunity cost really does stand behind the cost curves we draw. Similarly in consumption: if something costs £10, you have to pay £10 to buy it. That £10 is not only the price of the object, it is also the amount you have to pay to get the resources, raw materials, labour etc. that went into making it. This prevented these resources from going into making something else. After you buy the item it will be reordered by the shopkeeper and replaced on the shelf. S/he orders from a wholesaler who in turn orders more from the producer. The producer then buys the raw materials etc. to make another of whatever you bought! In this way, resources keep on going into making whatever people demand. 4. This is how the price mechanism really works – that is, how it allocates resources to wherever the demand is the greatest.

THE PRODUCTION FRONTIER OR PRODUCTION POSSIBILITY CURVE What is it? It shows us the maximum that a country can produce. There is clearly a limit to this at any one time - just like there is a limit to the weight that you can lift over your head or eat at any time. We assume two goods (I will use apples and bananas or A and B) for ease of explanation – but it is true of any number of goods. Drawing the diagram – we start with the maximum amount of good A we can produce if all our resources are devoted to producing A which gives us a point on the vertical axis; then we do the same for the case if we only produce B to give us a point on the horizontal axis. Then we join the two positions with a straight line. Once we have drawn the line, we do not have to have all apples or all bananas but we can chose somewhere along it. Any point on it represents a mix of the two goods that people wish to buy. At the point selected above, people consume 0A1 apples and 0B1 bananas.

Chap 1 - 3

Apples

A1

ppc1

0

B1

Bananas

[DIGRESSION: DRAWING THE CURVES You should practise drawing all the diagrams regularly – several times each day is a good idea. In the end, they need to be second nature to you so that you can recall and correctly draw the appropriate diagram whenever you want. It is most important to be able to this so that you can quickly gain good marks. The wrong diagram, a mislabelled one, or one lacking labels, more or less dooms you to fail. It shows that you do not really understand what you are saying and examiners hate that. Labels, by the way, are the words on the diagram, like “apples”, “bananas” or “ppc 1” in this diagram. When tutoring, I would draw each diagram again in front of the student, and explain the importance of getting it right (and remind them of this now and then later). It is important to see how a diagram is built up as they are really easy to do, but to be suddenly presented with a complicated finished product can be a bit daunting. For this reason, I have put in a sensible order of drawing the diagram for the first few times I present them. It is just about impossible to get a good mark in economics without drawing diagrams, so start practicing without delay! END OF DIGRESSION] The way the diagram of the production possibility curve is drawn.

1

2

Apples

3

Apples

Apples

A1

ppc1

0

Bananas

0

Bananas

ppc1

0

.

Chap 1 - 4

B1

Bananas

We usually draw the production function curved , to reflect the law of diminishing returns. Some factors of production are better at producing A and not as good at B, as you might imagine. Some land is simply better at growing bananas than apples, just as some of your friends are better at doing maths, swimming or playing the guitar than others. So as we move down the production possibility curve and get more bananas, we can expect to get a few less bananas than we might expect; perhaps we used to give up 5 apples to get 5 more bananas, but as we slide down the curve we will get, say, only 4 more bananas, then only 3 more, or 2 more, as we keep sliding down. The line curves in at each end to show this as in the diagram below.

Apples

A1

0

B1

Bananas

[Digression. It is unlikely in my view that you will be asked why the production frontier is curved as opposed to a straight line, but if you do, the reasoning above and the diagram in this bracketed section explains it. In the diagram below you can easily see that with a straight line, we would get more apples if producing our maximum amount of apples. That is the same as saying we could produce more if we were not subject to the law of diminishing returns. It is clear that with a straight line production frontier A4B4, we could have either 0A4 of apples (at point 04) or 0b4 of bananas (at point B4). However, because of diminishing returns we are on the curved production frontier A3B3 and if we only produce apples, the most we can have is at point A3; similarly, if we only produce bananas the most we could have is at point B3. The gap A3 to A4 represents the “lost” apples as returns continue to diminish as we keep on switching land from bananas.

.

Chap 1 - 5

Apples A4 A3 A2 A1 0

B2B1 B3 B4

Bananas

You can see the small part where land is equally suitable for apples or bananas, between A1 and A2 for apples and B1 and B2 for bananas. In this small area, returns do not diminish. End of digression]

The way the diagram of the straight and curved production possibility curves are drawn. Apples

1

Apples

2

Apples

3

A4

A4

A3

0

Bananas

Apples

4

0

Apples

Bananas B4 5

0

Apples

A4

A4

A4

A3

A3

A3

A1

A2 A1

0

B3 B4 Bananas

0

B1 B3 B4 Bananas

Chap 1 - 6

0

Bananas

B4

6

B2B1 B3 B4 Bananas

It is common to use straight line production frontiers in books because they are easier to draw and manipulate.

What happens if we swivel the curve? If society learns to get better at producing Apples alone, it would swivel the curve out along the vertical axis of apples. This reflects the fact that we can get more output from the resources and factors of production that we have. The swivel that gives us more apples reflects a productivity increase in apples, but not in bananas. Apples

ppc2 A2

A1 ppc1

0

B1

Bananas

After the productivity increase in the apple growing industry, society can increase production of apples from 0A1 to 0A2.

The way the diagram of the increased productivity in apple orchards is drawn.

1 Apples

2

Apples

A1 ppc1

0

Bananas

Apples

3

0

Bananas

4

Apples

ppc2

ppc2 A2

A1 ppc1

ppc1

0

Bananas

0

B1

.

Chap 1 - 7

Bananas

What if we move the whole curve out? If a country has learned to get better at producing everything, this would physically move the production frontier upwards and outward, which is economic growth.

Apples ppc 2 (4 year's time)

A2 A1

ppc1 (now)

0

B1B2

Bananas

We return to the subject of economic growth in the unit “Managing the economy”.

The way the diagram of economic growth is drawn.

1

Apples

2

Apples

3

Apples

A1

ppc1 (now)

0

Bananas

0

Bananas

5

4 Apples

Apples ppc 2 (4 year's time)

ppc 2 (4 year's time)

A2 A1

A1

ppc1 (now)

0

B1

ppc1 (now)

Bananas

0

B1B2

Bananas

Chap 1 - 8

0

B1

Bananas

SPECIALISATION AND FOREIGN TRADE If people specialise they are more productive – if you are like me, you probably could not make a good pair of shoes, do brain surgery or advise on investing for pensions! We tend to do what we are best at. Imagine the result if we did what we are worst at! Countries are the same – if they concentrate on what they are best at, they produce more and better goods or services. As a rule of thumb, countries that follow a protectionist policy (protecting their industries from foreign competition) are trying to do what they are worst at, or at least not trying to do what they could be best at. Most economists would probably think that protectionism is not exactly a good idea. Two concepts of “advantage”

Absolute advantage – this means a country can produce more of almost everything than another, i.e., it is a wealthy country. The USA can produce more than Egypt for instance – clearly, the USA has an absolute advantage over Egypt. It is of no particular interest as an idea: the rich are just rich! Comparative advantage – this means that a country is better at producing something, but not necessarily everything, than another. For instance, Sweden is better at making marine engines than the UK, but we are better at organising financial markets and insurance. All countries are better at doing a few things more than others. Comparative advantage is the one that matters in economics and it is the main reason why countries trade with each other. We do not simply buy pineapples from tropical countries because it is too cold to grow them here. We could in fact grow them under glass and with heating, but we clearly lack a comparative advantage in the pineapple producing business. Hawaii on the other hand has a strong comparative advantage in that area. The gains from trade If a country tries to produce everything for itself, it will stay poor. Examples: China under Mao Zedong and Russia under Stalin both followed such a policy and the people suffered a very low standard of living as a result. The message is that trade helps the people in a country to gain wealth! The gains from trade consist of: Comparative advantage – we do what we are best at and thus produce more. We then exchange our surplus with other countries for something we are less good at. Both the other countries and our country do better and enjoy higher living standards as a result. Economies of scale – if we specialise we can follow a system of mass production, and lower our costs. We can then exchange the surplus with other countries. Economies of scale are examined in Unit 2.

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Chap 1 - 9

We can gain wider consumer choice - e.g., we can drive Volvos, Renaults or BMW’s, as well as locally-made Fords!

Chap 1 - 10

1-2. DEMAND AND SUPPLY: INTRODUCTION (Abbreviations: S = “supply”; D = “demand”; Y = “income”; r = “rate of interest”) Demand The lower the price, the more will be demanded; the higher the price the less will be demanded. Think! If Nike trainers were £5 a pair, would you buy more than if they were £200 a pair? It seems probable! In economics, “demand” means demand is backed by money – it is not just a need or a desire, but people do have the money to buy and are prepared to buy. What determines the D curve? i.e., why is it where it is and not somewhere else?

Price

D ?? D ?? 0

Quantity

There are four main personal determinants of demand Income. Taste. Prices of other goods. Expectations about future prices of this good or service. AND some other market determinants Income distribution - if you think of all the other people in your house and you, if you suddenly got all the total income and savings and the others had none, there would be a different pattern of demand from what it is now. They probably do not eat lunch every day if they have no money. It is the same in society in general: change the income distribution and a new pattern of demand curves follows. Wealth distribution (as opposed to income distribution). If 10% of the population have 90% of the wealth, probably more Porsche motor cars will be demanded than if we all have the same rather lowish amount!

Chap 1 - 11

Population size - the larger the population, the bigger the demand, ceteris paribus. That is a Latin tag meaning “all other things remaining the same” and you might come across it in a lot of economics books. Population age distribution - if there are many old people, important demands in society will be for medicines, hip replacement operations and Zimmer frames but fewer Beastie Boys CDs, or prams.

The interest rate. This is especially important for house purchases, motor cars, long-life consumer goods often on a credit card, or hire purchase generally. A higher rate of interest means more to repay, so people tend to borrow less.

What can cause a shift in the demand curve? (= a new curve) A change in any of the above determinants of demand will do it! If demand increases, overall, more of the good/service is bought at any unchanged (the same) price. You can see this in the diagram below, where at P1 an amount OQ1 is demanded, but after demand increases to D2, at the same price an large amount is demanded, i.e., OQ2. It is easy to remember what “an increase in demand” means; there must be a new curve and it will move upwards and to the right..

Price S P1 D2 D1 0

Q1

Chap 1 - 12

Q2

Quantity

The way the diagram of a shift in demand is drawn. (shown not moving to equilibrium, so you can see that more is demanded at the same price)

Price

1

Price

2

3

Price

Price S1

S1

P1 D1 0

0

Quantity

S1

P1 D1 D2

D1

D1

Quantity

4

0

Q1Quantity

0

Q1Quantity

If demand decreases, the demand curve shifts the other way. Again we have a new curve, as in the diagram below.

Price

P1 D1 D2 0

Q2

Q1

Quantity

Supply

What is the supply curve? The supply curve is a curve showing the quantity that will be offered on the market at any price.

Price S

P1

0

Q1 Quantity

Chap 1 - 13

Imagine: in your classroom, if I offer to buy each T shirt for £500, almost everyone will sell to me; but if I offer £1 each, probably few if any would be willing; but if I were to offer £7, more would sell but probably not everyone. That is why the supply curve slopes upward!

What determines the supply curve, i.e. why is it where it is and not somewhere else? The price, quantity, and quality of inputs used. These consist of things like machinery, equipment, staff and workers, raw materials, and fuel. These are collectively known as “the factors of production”, and are often summarised as land, (L) labour (N) and capital (K) plus a remainder term, R.

Land and labour are quite straightforward; land is what it says but can include things like diamonds or oil that are found there; labour mostly means workers but does include managers too. Capital means machinery and equipment, and “social overhead capital” like roads, bridges and docks. [Digression: The whole production of the nation can be summed up as O = f(L, N, K) + R or put into words, “output is a function of (is in some as yet undefined way caused by) land, labour, capital, and a few other things”. You will need this later; I am just sowing a few seeds.]

The really interesting one is “R”, which covers things in both labour and capital: The labour component of “R”:

This consists of things like entrepreneurial ability, the managerial methods in use, labour motivation and how good it is, labour skills, the strength of the trade union and its attitudes, the bonus and other incentive systems in force, the quality of the education system, and the retraining facilities available in society. The capital component of “R”: This consists of things like the level of technology, the adequacy of factory organisation, and economies of scale. They can obviously affect output if they are good or bad. The level of knowledge and technology available (it can appear separately, or be included in the remainder term, “R”, as above). Maybe the weather, e.g. floods can destroy crops, effect transport, reduce supply, and raise price.

Chap 1 - 14

Joint supply - if we increase the number of sheep to supply an increased demand for mutton, it automatically increases the wool supply. So the price of related good can be a determinant of supply. Examiners like questions on joint supply, but it is not often encountered in the world in which we live.

The productivity of the factors of production – this is closely related to technology; but it can also be how hard workers are prepared to work, motivation, and incentives systems etc. (it too can appear separately, or be included in the remainder term, R, as above). The size and number of firms in the industry, including the marketing conditions. War and social unrest.

What can cause an increase or decrease in supply? (a shift in the curve) Like demand, it needs a change in one or more of the determinants. For supply these include things like: A change in the price of a factor of production. A change in the productivity of a factor. New technology invented. The discovery of a new raw material or fuel. More worker enthusiasm. This occurs often in war time, because of patriotism.

An increase in supply = the curve shifts downward and to the right (more is supplied at the unchanged price) e.g., if labour productivity increases or someone finds a new cheap source of materials.

Chap 1 - 15

Price S1

S2

P1

0

Q1

Q2

Quantity

A decrease in supply is the opposite; the supply curve shifts up and to right:

Price S2 S1 P1

0

Q2

Q1 Quantity

And you will notice that less is supplied at the price P1.

Time Periods And Supply

Three time periods matter: the very short run (Vsr) (or “momentary supply”), the short run (SR) , and the long run (LR).

They have different slopes to their curves and different elasticities (more later!).

Chap 1 - 16

The very short run. This is defined as the time when no change can be made in any of the factors of production – the supply curve is vertical. Examples are the fruit and vegetables that appear in the wholesale market each day. The short run. This is defined as the period in which the variable factors can be altered but not the fixed factors, i.e. we can make some changes. Fixed factors = those that do not vary with output - such as factory building, transport fleet, office staff, and the bill for heating and lighting the premises. Variable factors = those that vary directly with output - such as raw materials, the energy used, the petrol in the trucks, and the wages of some unskilled workers who might be taken on when needed, perhaps part-time. The supply curve we usually draw is the short run one. The long run Is defined as the period when all factors can be varied i.e., the producer can do any changes s/he wants. This means a flatter curve, possibly even downward sloping sometimes.

How the supply curve can vary with the time period we are considering:

Price

S vsr

S short run

S long run S long run 0

Quantity

The flatter the curve, the more elastic it is (“quantity stretches more”). Producers will only make changes that help them produce more or reduce costs. BUT NOTE that all the curves are drawn on the one diagram; this means the scale is the same for all; if you draw each in a separate diagram, the flatter one (S long run) is not necessarily the most elastic, as the horizontal axis might be on a much wider scale. If this seems incomprehensible to you, Do Not Worry! Just remember to put them all on the same diagram.

Chap 1 - 17

1-3. THE DETERMINATION OF PRICE

We have looked at demand and supply separately, we now put them together. When I started in economics, I had to chant: "price is determined by supply and demand!” It certainly made it stick in my mind and might help you.

Let's draw the supply and demand curves on the same diagram:

Price S

D P1

0

Q1 Quantity

Guess where the equilibrium price will be? Right! Where the two curves cross!!

What Do We Mean By Equilibrium? "Equilibrium" is the state of affairs in which there is no tendency to change. At P1, the equilibrium price, all who wish to sell have done so, and all who wish to buy have done so – there are no unsatisfied buyers or sellers. If we take any other price, we can see that this is not so – look at the diagram below. At the Set Price, which is above equilibrium. Q. What do we see? A. More is supplied than is demanded; the amount demanded is only OQd but the amount supplied is OQs. The result will be that stocks build up on the shelf or in the factory. There are unsatisfied sellers. You can see all this in the diagram.

Chap 1 - 18

Price S

D Set Price P1

Qd

0

Q1 Qs

Quantity

The way the diagram of an increase in demand raising price is drawn.

1 Price

Price

2

Price

3 S

D1 0

Quantity

0

Quantity

D1 0

Quantity

5

4

Price

Price

S

S Set price P1

P1 D2

D1

D1 0

Q1

Quantity

0

QdQ1 Qs

Quantity

The way the diagrams are built up should be reasonably clear by now. If you have any worries, check back and examine those supplied earlier. Although diagrams vary, you should see the general principles are: 1. Draw the axes and label them immediately (“one axis, two axes”). 2. Put in the first curve and label it. 3. Add the second curve and label it. 4. Draw the equilibrium position – preferably using dotted lines.

Chap 1 - 19

5. Make the necessary changes, such as shift a curve inwards or outwards by drawing a new curve and labelling it. 6. Draw the new equilibrium position – preferably using dotted lines. And finally you compare the new equilibrium position with the first one, using your own words but trying to get in the necessary jargon phrases such as “increase in demand”, or “economic growth”, whatever is relevant to the question you are tackling. Remember that you should practise drawing the diagrams regularly. Henceforth I shall not be supplying the series of pictures showing how the diagrams are built up, as you should be able to follow the above principles for yourself. Before long, it will become second nature to examine a finished diagram and work out how it was built up.]

Q. If we take any price below equilibrium, what do we see? Look at the next diagram.

Price S

D P1 Set Price

0

Qs Q1 Qd

Quantity

At the set price, below the equilibrium level of P1, the quantity supplied (OQs) is a lot less than the quantity demanded (OQd). We will experience shortages and unsatisfied consumers who wish to buy but are unable to do so.

Increases and Extensions of Supply And Demand We know that the word "increase" extensions?

means a shift of the

curve – but what about

"Extensions" are movements along an existing curve.

Questions are often set to see if you know the difference between an ”increase” and an “extension”.

Chap 1 - 20

[A digression: if a line crosses two others, an increase in one curve always extension of the other! The diagram here shows that.

means an

For supply and demand: With an increase in demand we slide up an unchanged supply curve.

Price S P2 P1 D2 D1 0

Quantity

Q1Q2

It’s clear that an increase in demand goes with an extension of supply.

And we can see an increase in supply goes with an extension of demand, as we slide down an unchanged demand curve:

Price S1 S2 P1 P2 D1

0

Q1

Chap 1 - 21

Q2 Quantity

Decreases and contractions of supply and demand A decrease means a new curve, which shifts backwards; a contraction means sliding back along an unchanged curve. A contraction of demand following a decrease in supply

Price D

S2 S1

P2

P1 0

Quantity

Q2 Q1

A contraction of supply following a decrease in demand

Price S P1 P2 D1 D2 0

Q2Q1

Quantity

NOTE that we start on demand curve D1 and supply curve S1 to ascertain the equilibrium price and quantity; then we look at D2 and S2 to get the second equilibrium position.

Reminder: In economics, at this level we always start in equilibrium, then we alter something, and move to the new equilibrium position. We then compare the two equilibrium positions.

Chap 1 - 22

This is one of the hoary old trick questions. "Demand increases, so price rises. The rise in price means fewer can afford the good, so demand decreases and prices fall again." Do you agree with this statement?

Q. What do you think? At first glance it might seem to make sense. But it is in fact false! Why is it false? You draw the diagram now on a piece of paper. First increase the demand curve and you will see the price rise as we extend up the supply curve. Then think about the new equilibrium. Why on earth should it change? It is an equilibrium position! That was why you learned the definition of equilibrium a little while ago – to be able to detect fallacies in argument.

This is a proposition in logic, designed to test if you really understand supply and demand. You should try to get the words “extension” and “increase” in to show you can use them properly and you definitely need a diagram.

Chap 1 - 23

1-4. THE CONCEPT OF ELASTICITY: MEASURING THE RESPONSIVENESS OF DEMAND AND SUPPLY (very popular with examiners) ELASTICITIES Elasticities are a sort of measure of supply and demand. If demand increases, and we ask how much does supply extend, we need more than an answer like "quite a lot"!! Government may be trying to raise tax to get a certain amount of revenue for instance. The question is “How much will quantity change, a lot or a little?”

WE START WITH THE ELASTICITY OF DEMAND

Three broad types of elasticity of demand 1. Price elasticity = the usual one, it deals with 1 good. 2. Cross elasticity = a special one, it deals with 2 goods. 3. Income elasticity = a special one and it deals with changes in incomes.

1. Price Elasticity of Demand Definition: "Price elasticity of demand is a measure of the responsiveness of quantity demanded to a small change in price". Learn this by heart!

the

[In simpler terms, “is the proportional change in quantity greater or lesser than the change in price?” As an example, if the price was 20 and it falls by 2, the fall is 10% (2 times 100, all divided by 20); and if quantity then increases from 100 to 200, the increase is 100%. We can see that the increase in Q is greater (100% compared with 10%) – i.e., stretches out a lot – it is elastic!]

How do we actually measure price elasticity? Price elasticity of demand is measured by the percentage change in Qd, divided by the percentage change in price:

%

Chap 1 - 24

it

So the price elasticity of demand is

Q = P

=

Q

xP P

(to divide by fraction = invert and multiply)

x P

(gather the change terms all on side for neatness)

(if this shuffling makes you unhappy, just remember that 3 x 4 is the same as 4 x 3) In the example above, the percentage change in Q was 100 and the percentage change in price was 10 so the elasticity is 100 divided by 10 = 10.0 - in the world in which we live this is actually very high! (Anything over 2 in the real world is pretty high.)

Logically the answer can have only 1 of 3 results: <1, = 1, or >1 (< stands for “less than”; > stands for “more than”; if we are looking at “<” left to right, we see it goes little to big!) Depending on whether in the fraction, the top is smaller than the bottom, equal to the bottom, or less than the bottom!

What does each possible answer mean? a] If the answer is greater than 1 (e.g., 1.62) the demand curve is elastic. It means that a small change in price led to big change in quantity (Q stretched a lot which means that it is elastic); graphically the curve tends to look flat when compared with an inelastic curve. But remember all curves must have the same scale and axis or else be on the same diagram.

Examples of demand curves which are price elastic: Dell computers (one brand of many substitutes); Foreign travel by cheap airlines.

Chap 1 - 25

b] If the answer is less than 1 the demand curve is inelastic e.g., 0.75 People do not respond so much to price cuts and although they buy more, they do not buy a lot more. Examples: Salt, bread, sets of cutlery (essentials; no substitutes).

c] If the answer just happens to equal 1 it is “unit elastic” = a special case and rarely seen, except perhaps for a small part of a large demand curve! The answer would work out at exactly 1.0 – and the curve is asymptotic; this means that it approaches but never quite reaches the axes.

Reminder: if you draw one rather flat demand curve in one diagram, demand is actually relatively elastic etc because we do not know the scale – don’t worry about it, it’s technical! Just remember to say “relatively inelastic” or “relatively elastic” in the exam room!

What do the different elasticity demand curves look like?

Price

D elastic

D inelastic D unit elastic 0

Quantity

The importance of the elasticity concept It allows us to get precise answers, not be vague. We need it for certain questions e.g., if a hairdresser is considering increasing her price for a basic cut from £20 to £25, will profits rise or fall?

Answer: if the demand for her skills is elastic, profits must fall.

Chap 1 - 26

What determines price elasticity? The number of substitutes - the greater the substitutes, the more elastic the good - a small price rise means consumers switch to another brand. THIS IS THE MAIN DETERMINANT! The proportion of income - the greater the proportion of income going on good, the more elastic it tends to be. Salt is relatively inelastic and very cheap – would you consume a £2’s worth a year? Luxuries and necessities - luxuries tend to be more elastic (airfares, foreign travel); necessities more inelastic (electricity). Some economists do not like this “luxuries” point because what constitutes a luxury alters too much and in addition they can be personal to different individuals. Time - the longer the time, the more elastic demand tends to be, probably because

o More substitutes become available , the good or service is copied by others, new manufacturers can enter, imports be made etc. o

Habits change only slowly, so we adjust to new prices slowly.

o Capital may need to wear out to make change, e.g., if the price of petrol rises, drivers have to wait until it is time to buy a new and smaller car in order to reduce petrol consumption.

Q. For the hairdresser earlier who is considering a price rise, I asked earlier what would happen to her profit if she charged more. Assume she is very good and her clients see no real substitute? A. The demand curve for here services is inelastic so profit would rise! Q. But consider what would happen if she were just another high street hair dresser?

Draw the diagram for me now!

Another example of the importance of elasticity: if the government raises the tax on cigarettes, will government revenue rise or fall? And by how much? The government normally wishes to raise more revenue – although there are health benefits if people reduce cigarette consumption, which saves on National Health Service expenditure too. If the government raises tax by 5% and demand is inelastic, the quantity will fall as price rises, but it will fall by less than 5%, so revenue will increase. If the government imposes an indirect tax, it pushes up the supply curve by the exact amount of tax.

Chap 1 - 27

If the tax is absolute e.g., £1 each item, it pushes the curve up parallel. The original producer faces no change in supply conditions, but £1 is added to each quantity.

S2 Price S1

X

P2 P1

Q1 Quantity

o

When we draw the diagram for the imposition of indirect tax: We start at the original equilibrium, and add the tax. We will then see a new equilibrium and compare this with the original; P1Q1 becomes P2Q2. There is a rise in price - but by less than the whole tax - and there is a fall in quantity.

Price

S2 P2 P1

B C D

0

S1

A D

Q2 Q1 Quantity

The increase in tax is DB, but the price only goes from P1 to P2 = CB The government revenue is the quantity sold times the tax per unit = OQ2 multiplied by BD Note that the supplier works on the original S1 curve – the S2 curve merely includes the government tax.

Chap 1 - 28

If the indirect tax is ad valorem (e.g., 10%) it pushes up the supply curve at an increasing rate Q. Why? A. Because 10% of £1 is only 10P, but 10% of £10 is £1!

Price

S2

S1 P2 P1

0

Q1 Quantity

A subsidy is just a negative tax e.g., government gives producer some money (subsidy) rather than a producer or consumer giving money to the government (tax).

Subsidy questions are not usually as interesting as tax ones! For a subsidy, we show at a new supply curve below and to right of original one. In this

Price

P1 P2

0

S1 S2 A B

Q1 Quantity

Chap 1 - 29

Let’s draw the diagram for putting on a subsidy.

Price S1 A

P3 P1 P2

S2 B D

0

Q1 Q2 Quantity

We start, as ever, in the initial equilibrium position, P1Q1 on the curves S1 and D1. The subsidy goes on and the new supply curve is S2. What is the size of the total subsidy i.e., the cost to the government? The subsidy is AB a unit in the diagram above. The quantity sold after the subsidy is imposed is OQ2. So the subsidy the government pays is 0Q2 times BA. Which is also equal to the area P2B times AB. This area is P2BAP3.

Note that the supplier works off the original supply curve – there has been no change in the determinants of his or her supply. But consumers work off S2, including the subsidy, which is what appears in the market. Notice that consumption rises from 0Q1 to 0Q2 – which is the point of the subsidy: more is produced and consumed.

The limits of price elasticity of demand Perfectly elastic = horizontal line; this means that consumers will demand an infinite amount at that price! It is merely a limit and it cannot be reached. Perfectly inelastic = vertical line; this means that consumers will pay any amount at all, such as £1, or £1 million, or £1 trillion…. to buy the good or service. Again this is unreasonable, it’s merely a limit.

Chap 1 - 30

2. Cross Elasticity of Demand

Definition: "Cross elasticity of demand is a measure of the responsiveness of the quantity demanded of one good or service to a small change in price of another". Learn this! It is virtually the same as the definition of price elasticity earlier – go on, compare them now! Cross elasticity measures substitutes and complements (note the spelling; it is not “compliments”) If the supply of beef increases so the equilibrium price falls, it may induce some people to switch from eating chicken or pork to eating the now cheaper beef. The fall in price of beef causes a decrease in quantity demanded of chicken or pork.

% %

Note the “A” and “B” difference: we are dividing the percentage change in the quantity of A by the change in the price of B. If the price of beef fell and the quantity of chicken fell the answer will be positive, because two negatives make a positive, so any items with a positive cross elasticity are substitutes. If the price of heating oil falls it may induce some to install oil generated central heating in houses. We see that a fall in the price of A means an increase in the quantity of generators, so the answer is negative (one plus and one minus) so these two goods are complements. Cross elasticity does not seem to be used much in economics, except in exams!

3. Income Elasticity of Demand Now this is most important! Incomes keep increasing over time, so the demand pattern for various goods and services keeps changing. Definition: "Income elasticity of demand is a measure of the responsiveness of the quantity demanded of a good or service to a small change in income". Learn!

Income elastic: a given change in income leads to a greater than proportionate increase in demand for the good or service. Examples of income elastic goods: foreign travel, good wines, smart motor cars, eating in restaurants, and currently well-regarded brands, e.g., Adidas sportswear of Parmigiani Fleurier watches.

Chap 1 - 31

Income inelastic: a given change in income leads to a less than proportionate increase in demand for the good or service. Examples: bread, staple foods generally, cheap stores, and all lowly-regarded brands. Income neutral elastic : should it just happen that, say, a 5% increase in income leads to a 5% increase in demand for a good or service, then it is income neutral elastic. This is not really an interesting case, merely a bit strange. Oddly enough,. Pizza Hut in Australia claimed in the 1990s that they were like this: in a recession some people stopped eating out so stopped going to Pizza Hut, but other people switched from “proper” restaurants to Pizza Hut which cancelled things out, so the company did not suffer! Income negative elastic: this is most interesting! This happens when an increase in income causes a fall in demand. Really it indicates that we dislike this product but for some reason we must consume it at the time. When we can afford not to consume it, then we stop buying it. Examiners like this concept! Examples are scarce, but it is suggested that probably potatoes were like this in Ireland during the Nineteenth century. Currently, the demand for mealies (sweet corn) in some African countries may be income negative elastic. It is a rare event anyway. Negative income elasticity means it is an “inferior good”.

Chap 1 - 32

THE ELASTICITY OF SUPPLY Definition: the responsiveness of the quantity supplied to a small change in price. It is measured by:

% % The measure roughly indicates the slope of the supply curve; the steeper the more inelastic. BUT unit elastic supply is any straight line that cuts through the origin! (Just remember this, and do not worry! If you are a mathematician, you may already see why.)

Price

S1

S2

0

Quantity

Supply periods and time: (covered briefly earlier)

Price

S very short run

S short run

S long run

S long run

0

Quantity

Very short run = totally inelastic supply = fixed supply (e.g., the amount in a wholesale vegetable market on one day; all the works of dead painters). Short run = perhaps moderately inelastic.

Chap 1 - 33

Long run = more elastic; or even negative elasticity (it slopes downward).

Why is supply more elastic in the long run? Because the company can alter both the fixed and variable factors (i.e., all the factors of production). It can also find new or cheaper sources of raw materials, improve the training of labour, and introduce new technology or better machines. This allows the company to obtain more output without needing much increase in price. The downward sloping supply curve in the long run is already familiar to you: computers, scanners, TV sets, DVD players and discs, CD players and discs….. Most if not all of the products of modern hi-tech industry fall into this category. As the years go by, they get better and a lot cheaper. Elasticity of supply is probably a bit less interesting to economists than the elasticities of demand - and it is easier to learn as there is less of it!

Chap 1 - 34

1-5. DEMAND AND SUPPLY: APPLICATIONS TO ANY MARKET ARE POSSIBLE

Popular ones that examiners use to set a question about include: Housing. Foreign Exchange. Labour and wages. Agricultural products or raw material production, like tin or coal. But the analysis is virtually identical in each case!

Be prepared to handle: The concept of equilibrium The determinants of supply and of demand An increase in demand and a decrease in demand An extension of both demand and supply The elasticity of demand and supply Minimum price fixing Maximum price fixing Applying an indirect tax (which shifts S curve up and to right).

An example of foreign exchange. You must use a diagram or two! The value of a currency is determined by the supply and demand for it – just like any other good or service, it is the normal equilibrium diagram you need. The supply of £’s comes from the UK importing goods and services from abroad. We pay in pounds to a bank, which uses them to buy the US $ etc. that we need to pay the foreign supplier. If we import more, we increase the supply of pounds on the market, thus putting pressure on the pound to fall in value. Similarly, if we export, we buy the pounds back, thereby increasing the demand for pounds. You could usefully practice drawing diagrams to fit these scenarios. They are the standard increase in supply and decrease in supply diagrams, but with “Quantity of £” on the horizontal axis and “Price of £ in $” on the vertical one.

Chap 1 - 35

An example of the labour market. If the UK allows more migrants in, this increases the supply of labour. Because many migrants are relatively young males, they add more to the supply of labour than they take out in social security benefits. The increase in the supply of labour puts pressure on to lower wages, especially for the unskilled or semi-skilled. It is difficult for many migrants to find more professional work unless their English is good; they tend to end up in the unskilled sector, even if they have skills and abilities, until their language skill improves sufficiently and this can take many months or years. The result is the normal diagram for an increase in supply, in this case of labour. You need the quantity of labour on the horizontal axis and wages on the vertical. Go on, draw it now!

You must use diagrams to answer questions about price or wages. Many markers glance at the diagrams first and if they are correct, he or she is immediately disposed to give you a good mark and a decent pass! If your diagrams are clear and correct, they might also give you the benefit of the doubt if they have trouble with your handwriting or standard of grammatical English. In the exam room in economics it is virtually impossible to get a good mark without diagrams.

Chap 1 - 36

1-6 LET’S RECAP AND SHOW THE MARKET MECHANISM WORKING IN ALL ITS GLORY IN A PERFECT WORLD In a perfect world, a market system will give a perfect result – resources will be allocated exactly to where people need them to produce what the people need. Think supply and demand curves for two goods, both in equilibrium; assume people spend all their money (as this is easier to imagine how it works). Then increase the demand for one good (which means you must reduce demand for the other, because they are spending all their money by assumption). First we look at the goods market – let’s assume they are bread and milk; we start in equilibrium, then we will increase the demand for one good and see what happens. Secondly, we examine the factor market which lies below the goods market. That consists of those resources that are used to produce the bread and milk. We use the labour market as the factor of production. We have simplified the model by using two goods and one factor to show the perfect workings of the market. With any number of goods and services and more factors we can still get this perfect resource allocation. (The whole of Unit One in this course is devoted to this market solution. Unit Two will explain why we may not in fact attain this perfection.) Abbreviations used: MC = marginal cost AC = average cost P = price Q = quantity MR = marginal revenue Lab = labour AR = average revenue PPC = production possibility curve (production frontier)

Chap 1 - 37 Copyright Kevin Bucknall, May 2007.

We start with the market for goods or services (bread and milk) in equilibrium

Bread

Milk

And we can see the factor market for these goods. Again we are in equilibrium, using labour as the example. These are the people who make the bread and produce the milk Bread workers

Milk workers

Chap 1 - 38 Copyright Kevin Bucknall, May 2007.

THEN, WE CHANGE SOMETHING AND ALTER THE EQUILIBRIUM LEVELS: let’s increase the demand for bread and reduce the demand for milk. We start as usual in equilibrium, on the demand curve for bread, “D” and increase it to “D1”. The demand for milk falls, from D to D1, as people switch to consuming more bread and away from milk.(On the assumption that all income is spent, if people spend more on bread they must spend less on milk!)

Bread

Milk

You can see that the price of bread rises (people demand it more) and the price of milk falls (less demand) As a result of more bread being demanded by the people, we get an increase in the demand for bread workers and a fall in the demand for milk workers – and we will reach a new equilibrium in the factor market. Again, demand increases from “D” to “D1” for the bread workers, and falls from “D” to “D1” for the milk workers. Bread workers

Milk workers

Bread

Milk

Chap 1 - 39 Copyright Kevin Bucknall, May 2007.

You can see that wages rise where demand for the product has increased, and fall where the product is less in demand than previously. We can put changes in goods/services market and factor markets together into one diagram, one directly above the other and read it vertically to see what happens to the factors of production in both industries as demand changes.

We see, as the demand for a good or service increases, this sucks factors into that industry – but where do they come from? They come from the contracting industry, where the demand for a good or service has decreased – the factors of production (land, capital and workers) have to leave that industry (in the real world, if there is unemployment, they might be drawn into work).

Chap 1 - 40 Copyright Kevin Bucknall, May 2007.

Workers might simply be dismissed – which really annoys people, upsets the trade unions, and might have a political fallout with loss of support for the government. Or the firms may take advantage of “natural wastage” – that is to say, as people voluntarily leave, they are not replaced. Who leaves? Several groups may be involved: · · · · · ·

old workers who are retiring because of age. those who get ill and retire those resigning and moving to a better job as part of a career move. those who move to a new area of the country, following their spouse, to get to a better climate or school area for instance. those who migrate to a different country. those who die.

And as s for Capital, e.g., trucks, or warehousing facilities cause little upset – things have no feelings! They may be sold or leased to other companies to use. Land is similar to capital, it can be transferred to several other uses fairly easily.

The above diagrams demonstrate the way the market mechanism (price mechanism) operates. This was first spotted by Adam Smith in the Wealth of Nations as early as 1776 but the diagrams came later. Understanding this system led to the phrase “the consumer is king” as the next sentence explains. Resources (land, labour and capital) flow from where they are not in demand, or demand is falling, to where they are in demand, or demand is rising. So the price mechanism is well-regarded as a good (but by no means perfect) way of allocating resources to society’s demands. Later, in Unit 2 “Why markets fail” you will learn what can, and actually does, go wrong with this apparently brilliant market system.

A reminder: are you revising something and practising drawing a few diagrams each day?

Chap 1 - 41

1-7 CONSUMER AND PRODUCER SURPLUS We know that there is an equilibrium market price at which both consumers buy and suppliers sell. But what about the consumers and producers who are not themselves exactly at that equilibrium price? They receive a benefit. We can see from the demand curve that the first consumer, buying at 1 on the quantity axis, would be willing to pay P1, which is much more than the market price he or she has to pay (P Mkt). So the column above Pmkt is a sort of surplus that the first buyer enjoys!

Price This triangle is the consumer surplus

P1

P Mkt D1 0

1 23

Q1

Quantity

Similarly, for the second buyer, at 2 on the quantity axis; and the same goes for the third and subsequent buyers until we get out to Q1 and P Mkt. All these early consumers would pay more but do not have to do so – and they gain a lot of extra enjoyment as a result. Eventually the whole triangle above P Mkt is filled in; and the filled in bit of this triangle, indicated by an arrow, is the consumer surplus.

For producers, we have an analogous argument. Some would be willing to supply more cheaply than the equilibrium price, P Mkt. In the diagram below, we can see from the supply curve that the supplier of the first unit would be happy to do this at a price well below P Mkt. The column above quantity 1 up to P Mkt is again a sort of extra or surplus – which in this case belonging to the producers.

Moving to quantity 2, again we can see a column, but a bit smaller than for quantity 1. And as we move out towards Q1, the triangle above the supply curve but below P Mkt is filled in. The arrow again points to it. This is “the producers’ surplus”.

Chap 1 - 42

Price S1 This triangle is the producer surplus

P Mkt

P1 0

12 3

Q1

Quantity

The two triangles thus make up the total consumer surplus and the producer surplus.

Price S1 Consumer surplus

P Mkt Producer surplus

D 0

Q1

Quantity

Use of the concept With indirect taxation, the imposition of a tax (or if there already is such a tax, an increase or decrease in such a tax) may impinge more on consumers than producers or vice versa! “Who gains the most (or who loses the most)?” is the question. This may be called “the incidence of taxation”, “the tax burden”, or a question may be asked, such as “who bears the brunt of the tax?” The answer as to who gains or loses the most depends on the elasticities involved.

Chap 1 - 43

Let us assume that an indirect tax on a good increases. If demand is highly inelastic (consumers will pay almost any high price without reducing consumption much) then the increase must largely fall on these consumers – they are simply willing to pay! We know they are prepared to do so because the demand curve is relatively inelastic and that is what inelastic demand means. Cigarettes probably fall into this category, as do all addictive drugs. Think of a vertical demand curve: if we increase the tax, the supply curve just moves up; there is no change in the quantity demanded; suppliers still receive the old price (reading off their supply curve S1; the gap between S1 and S2 is all tax and goes to the government not to the supplier). There is clearly no loss of producer surplus as their situation has not changed at all - and consumers pay all the difference:

Price

Perfectly inelastic D S2 S1

0

Quantity

It can be proved, but you can take it on trust, that if the elasticity of demand is lower than the elasticity of supply, the consumer loses more than the supplier! In other words, it is the relative elasticities that count .

The usual supply and demand situation divides the incidence of tax (who pays it, or more of it) between suppliers and consumers – and of course the incidence falls heavier on the side which is relatively inelastic.

You may get a question about the incidence of tax – or one about imposing (or increasing) an indirect tax. A reminder: in introductory economics we nearly always use “static equilibrium analysis” which means we start in equilibrium, change something, and analyse the result. Who then bears the burden of tax when an indirect tax increases? See the diagram below.

Chap 1 - 44

Price S2 P2 P1

B

S1 A

C D

0

D

Q2 Q1 Quantity

We start on the curves S1 and D, with the equilibrium price P1 and quantity Q1. Then we add a tax (or increase an existing tax!) which shifts the supply curve up to S2, by the amount of the tax. Any tax per unit shifts the supply curve up vertically; the tax is the line BD in the diagram above. Having made our change, we look at the result: consumers pay BC of the tax, and producers pay CD of it. The distance CD is smaller than the distance BC, the consumer pays more of the tax, and we also know that the elasticity of supply must be greater than the elasticity of demand!

We can also look at the areas and see the changes in both surpluses: The consumer surplus reduces by ABC The producer surplus reduces by ACD In Unit 4, “Industrial economics”, we again use the concept of surpluses in our monopoly diagram. We can show the deadweight loss of monopoly, as well as the loss of consumer surplus and the increase in the producer surplus that results from the monopolist being able to set the quantity that he or she produces which results in the most profitable price possible. More of this later!

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Chap 1 - 45