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Introduction to Microeconomics Prepare by James M.

Kenani
Economics Economics: is a social science that studies how human beings coordinate their wants and desires, given the decision-making mechanism, social customs, and political realities of the society. Economy: a well functioning system for coordinating productive activities that create the goods and services that people want and get them to people who want them. The three central coordination problems any economy must solve: 1. What, and how much, to produce 2. How to produce it 3. For whom to produce it Scarcity - Scarcity exists because individuals want more than can be produced Scarcity means the goods available are too few to satisfy individuals desires - The degree of scarcity is constantly changing - the quantity of goods, services and usable resources depends on technology and human action. Example: A household faces many decisions. It must decide which members of the household do which tasks and what each member gets in return: Who cooks dinner? Who does the laundry? In short, the household must allocate its scarce resources among its various members, taking into account each members abilities, efforts, and desires. A society also faces many decisions like households. A society must decide what jobs will be done and who will do them. It needs some people to grow food, other people to make clothing, and still others to design computer software. Once society has allocated people (as well as land, buildings, and machines) to various jobs, it must also allocate the output of goods and services that they produce. It must decide who will eat bread and who will eat potatoes. It must decide who will drive a Porsche and who will take the bus. Economic Reasoning Economic reasoning, decisions are often made by comparing marginal costs and marginal benefits. - Marginal cost is the additional cost over and above costs already incurred - Marginal benefit is the additional benefit above and beyond what has already accrued

The economic decision rule: If the marginal benefits of doing something exceed the marginal costs, do it. MB > MC Do it! If the marginal costs of doing something exceed the marginal benefits, dont do it. MC > MB Dont do it!

Opportunity Cost Opportunity cost is the benefit forgone of the next-best alternative to the activity you have chosen Opportunity cost is the basis of cost/benefit economic reasoning

Examples of opportunity cost: 1. Individual decisions The opportunity cost of college includes: - Items you could have purchased with the money spent for tuition and books - Loss of the income from a full-time job 2. Government decisions The opportunity cost of money spent on the farm subsidies is less spending on health care or education or infrastructure development. Economic Systems Societies are organized through different economic systems that can be summarized in the following two systems: Market Economies (laissez faire) and Command Economies. Market Economy: an economy in which production and consumption are the results of decentralized decision by many firms (producers) and individuals (consumers). There is no central authority to tell people what to produce or where to ship it. Each individual producer makes what he or she thinks will be most profitable: each consumer buys what he or she chooses. A market force is an economic force that is given relatively free rein by society to work through the market The invisible hand is the price mechanism that guides our actions in a market. The invisible hand is an example of a market force. If there is a shortage, prices rise If there is a surplus, prices fall

Command Economy: an economy in which there is a central authority making decisions on production and consumption. Command economies have been tried, most notably in the Soviet Union between 1917 and 1971. This didnt work well. Producers in the Soviet Union routinely found themselves unable to produce because they did not have crucial raw materials, or succeed

in producing or found that consumers did not want their products, while consumers were unable to find necessary items. Note that the above two economic systems are the extremes. In reality, we can find neither a pure laissez faire economy nor a pure command one; rather all societies are mixed economies that combine both the free market approach and the command approach.

The Invisible Hand Theory (Adam Smith 1776 Book: An Inquiry into the Nature of the Wealth of Nations) According to the invisible hand theory, a market economy, through the price mechanism, will allocate resources efficiently - Prices fall when quantity supplied is greater than quantity demanded - Prices rise when the quantity demanded is greater than the quantity supplied - Efficiency means achieving a goal as cheaply as possible The invisible hand usually leads markets to allocate resources efficiently. Nonetheless, for various reasons, the invisible hand sometimes does not work. Economists use the term market failure to refer to a situation in which the market on its own fails to allocate resources efficiently. Sometimes government intervenes in the economy to correct this market failure. There are two broad reasons for this intervention (1) Promotion of efficiency and (2) Promotion of equity. That is, most policies aim either to enlarge the economic pie or to change how the pie is divided. One possible cause of market failure is an externality. An externality is the impact of one persons actions on the well-being of a bystander. The classic example of an external cost is pollution. If a chemical factory does not bear the entire cost of the smoke it emits, it will likely emit too much. Here, the government can raise economic well-being through environmental regulation. Another possible cause of market failure is market power. Market power refers to the ability of a single person (or small group of people) to unduly influence market prices. For example, suppose that everyone in town needs water but there is only one kiosk. The owner of the kiosk has market powerin this case a monopolyover the sale of water. The well owner is not subject to the rigorous competition with which the invisible hand normally keeps self-interest in check. A goal of many public policies, such as the income tax and the welfare system, is to achieve a more equitable distribution of economic well-being. To say that the government can improve on markets outcomes at times does not mean that it always will. Public policies are made not by angels but by a political process that is far from perfect. Sometimes policies are designed simply to reward the politically powerful. Sometimes they are
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made by well-intentioned leaders who are not fully informed. One goal of the study of economics is to help you judge when a government policy is justifiable to promote efficiency or equity and when it is not. What happens in society can be seen as a reaction to, and interaction of: - Economic forces - Social forces - Historical forces - Social, cultural, and political forces influence market forces - Political and social forces often work together against the invisible hand

Microeconomics and Macroeconomics Economic theory is divided into two parts: Microeconomics and Macroeconomics. Economics can study the decisions of individual households and firms or can study the interaction of households and firms in markets for specific goods and services. Economics can study the operation of the economy as a whole - which is just the sum of the activities of all these decision makers in all these markets. Microeconomics is the study of how households and firms make decisions and how they interact in specific markets. A microeconomist might study the effects of rent control on housing in Lilongwe City, the impact of foreign competition on the Japanese auto industry, or the effects of compulsory school attendance on workers earnings. Microeconomics studies such things as: - The pricing policy of firms - Households decisions on what to buy - How markets allocate resources among alternative ends Macroeconomics is the study of economy wide phenomena. A macroeconomist might study the effects of borrowing by the Government (Capital Hill), the changes over time in the economys rate of unemployment, or alternative policies to raise growth in national living standards. Macroeconomics studies such things as: - Inflation - Unemployment - Economic growth

Microeconomics and macroeconomics are closely intertwined. Because changes in the overall economy arise from the decisions of millions of individuals, it is impossible to understand macroeconomic developments without considering the associated microeconomic decisions.

Economic Institutions - To apply economic theory to reality, you've got to have a sense of economic institutions - Economic institutions are laws, common practices, and organizations in a society that affect the economy - Economic institutions differ significantly among nations - They sometimes seem to operate differently than economic theory predicts Economic Policy Options Economic policies are actions (or inactions) taken by the government to influence economic actions Objective policy analysis keeps value judgments separate from the analysis Subjective policy analysis reflects the analysts views of how things should be

Objective Policy Analysis To distinguish between objective and subjective analysis, economics is divided into two categories - Positive economics and Normative economics. Consider these two statements you might hear: John: Minimum wage laws cause unemployment James: The government should raise the minimum wage Notice that John and James differ in what they are trying to do. John is speaking like a scientist: he is making a claim about how the world works. James is speaking like a policy adviser: he is making a claim about how he would like to change the world. Johns statement is positive. Positive statements are descriptive. They make a claim about how the world is. Jamess statement is normative. Normative statements are prescriptive. They make a claim about how the world ought 1. Positive economics: describes the way the economy actually works. 2. Normative economics: prescribes about the way the economy should work. A key difference between positive and normative statements is how we judge their validity. We can, in principle, confirm or refute positive statements by examining evidence. An economist
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might evaluate Johns statement by analyzing data on changes in minimum wages and changes in unemployment over time. By contrast, evaluating normative statements involves values as well as facts. Jamess statement cannot be judged using data alone. Deciding what is good or bad policy is not merely a matter of science. It also involves our views on ethics, religion, and political philosophy. The Art of economics is using the knowledge of positive economics to achieve the goals determined in normative economics Tens Principles underlining Economics HOW PEOPLE Make decisions Principle 1: People face tradeoffs Principle 2: The cost of something is what you give up to get it Principle 3: Rational people think at the margin Principle 4: People respond to incentives How people interact Principle 5: Trade can make everyone better off Principle 6: Markets are usually a good way to organize economic activity Principle 7: Governments can sometimes improve market outcomes How the economy as a whole works Principle 8: A countrys standard of living depends on its ability to produce goods and services Principle 9: Prices rise when the government prints too much money Principle 10: Society faces a short-run tradeoff between inflation and unemployment

Production Possibilities Frontier


Scarcity implies the existence of tradeoffs. These tradeoffs can be illustrated quite nicely by a production possibilities frontier/curve. Production Possibilities Frontier (PPF) is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

For simplicity, it is assumed that a firm (or an economy) produces only two goods (this assumption is needed only to make the representation feasible on a two-dimensional surface such as a graph on paper or on a computer screen). When a production possibilities curve is drawn, the following assumptions are also made: 1. there is a fixed quantity and quality of available resources, 2. technology is fixed, and 3. there are no unemployed nor underemployed resources Simple example: Suppose that a student has four hours left to study for exams in two classes: microeconomics and calculus. The output in this case is the exam score in each class. The assumption of a fixed quantity and quality of available resources means that the individual has a fixed supply of study materials such as textbooks, study guides, notes, etc. to use in the available time. A fixed technology suggests that the individual has a given level of study skills that allow him or her to translate the review materials into exam scores. A resource is unemployed if it is not used. Idle land, factories, and workers are unemployed resources for a society. Underemployed resources are not used in the best possible way. Society would have underemployed resources if the best brain surgeons were driving taxis while the best taxi drivers were performing brain surgery. If there are no unemployed or underemployed resources, efficient production is said to occur.

The table below represents possible outcomes from each various combinations of time studying each subject:

Number of hours spent studying calculus 0 1 2 3 4

Number of hours spent studying economics 4 3 2 1 0

Calculus grade

Economics grade

0 30 55 75 85

60 55 45 30 0

Notice that each additional hour spent studying either calculus or economics results in smaller marginal improvements in the grade. The reason for this is that the first hour will be spent studying the most essential concepts. Each additional hour is spent on the "next-most" important topics that have not already been mastered. (It is important to note that a good grade on an economics examination requires substantially more than four hours of study time.) This is an example of a general principle known as the law of diminishing returns. The law of diminishing returns states that output will ultimately increase by progressively smaller amounts as additional units of a variable input (time in this case) are added to a production process in which other inputs are fixed (the fixed inputs here include the stock of existing subject matter knowledge, study materials, etc.). To see how the law of diminishing returns works in a more typical production setting, consider the case of a restaurant that has a fixed quantity of capital (grills, broilers, fryers, refrigerators, tables, etc.). As the level of labor use increases, output may initially rise fairly rapidly (since additional workers allow more possibilities for specialization and reduces the time spent switching from task to task). Eventually, however, the addition of more workers will result in progressively smaller increases in output (since there is a fixed amount of capital for these workers to use). It is even possible that beyond some point workers may start getting in each others way and output may decline ("too many cooks may spoil the broth....". In any case, the law of diminishing returns explains why your grade will increase by fewer points with each additional hour that you spend studying. The points in the table above can be represented by a production possibilities curve (PPC) such

as the one appearing in the diagram below. Each point on the production possibilities curve represents the best grades that can be achieved with the existing resources and technology for each alternative allocation of study time. Let's consider why the production possibilities curve has this concave shape. As the Figure 2 below indicates, a relatively large improvement in economics grade can be achieved by giving up relatively few points on the calculus exam. A movement from point A to point B results in a 30-point increase in economics grade and only a 10-point reduction in calculus grade.

The marginal opportunity cost of a good is defined to be the amount of another good that must be given up to produce an additional unit of the first good. Since the opportunity cost of 30 points on the economics test is a 10-point reduction in the score on the calculus test, we can say that the marginal opportunity cost of one additional point on the economics test is approximately 1/3 of a point on the calculus test. (If in doubt, note that if 30 points on the economics exam have an opportunity cost of 10 points, each point on the economics test must cost approximately 1/30th of 10 points on the calculus test - approximately 1/3 of a point on the calculus test).

Now, let's see what happens a second hour is transferred to the study of economics. The diagram above illustrates this outcome (a movement from point B to C). As this diagram indicates, transferring a second hour from the study of mathematics to the study of economics results in a smaller increase in economics grade (from 30 to 45 points) and a larger reduction in calculus grade (from 75 to 55). In this case, the marginal opportunity cost of a point on the economics exam has increased to approximately 4/3 of a point on the calculus exam. The increase in the marginal opportunity cost of points on the economics exam as more time is devoted to studying economics is an example of the law of increasing cost. This law states that the marginal opportunity cost of any activity rises as the level of the activity increases. This law can also be illustrated using the table below. Notice that the opportunity cost of additional points on the calculus exam rises as more time is devoted to studying calculus. Reading from the bottom of the table up to the top, you can also see that the opportunity cost of additional points on the economics exam rises as more time is devoted to the study of economics.
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Number of hours spent studying calculus 0 1 2 3 4

Number of hours spent studying economics 4 3 2 1 0

Calculus grade

Economics grade

Opportunity Cost of 1 pt on calc. exam

Opportunity Cost of 1 pt on econ. exam

0 30 55 75 85

60 55 45 30 0 1/6 2/5 3/4 3 6 5/2 4/3 1/3

One of the reasons for the law of increasing cost is the law of diminishing returns (as in the example above). Each extra hour devoted to the study of economics results in a smaller increase in the economics grade and a larger reduction in the calculus grade because of diminishing returns to time spent on either activity. A second reason for the law of increasing cost is the fact that resources are specialized. Some resources are better suited for some types of productive activities than for other types of production. Suppose, for example, that a farmer is producing both wheat and corn. Some land is very well suited for growing wheat, while other land is relatively better suit for growing corn. Some workers may be more adept at growing wheat than corn. Some farm equipment is better suited for planting and harvesting corn. The diagram below illustrates the PPC curve for this farmer.

At the top of this PPC, the farmer is producing only corn. To produce more wheat, the farmer must transfer resources from corn production to wheat production. Initially, however, he or she will transfer those resources that are relatively better suited for wheat production. This allows wheat production to increase with only a relatively small reduction in the quantity of corn produced. Each additional increase in wheat production, however, requires the use of resources that are relatively less well suited for wheat production, resulting in a rising marginal opportunity cost of wheat.

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Let's suppose that this farmer either does not use all of the available resources, or uses them in a less than optimal manner (i.e., either unemployment or underemployment occurs). In this case, the farmer will produce at a point that lies below the production possibilities curve (as illustrated by point A in the diagram below). This point A is feasible but not efficient of using resources.

Points above the production possibilities cannot be produced using current resources and technology. In the diagram below, point B is not obtainable (we cannot talk of about efficiency) unless more or higher quality resources become available or technological change occurs. Point C is feasible attainable and efficient.

An increase in the quantity or quality of resources will cause the production possibilities curve to shift outward (as in the diagram below). This type of outward shift could also be caused by technological change that increases the production of both goods.

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In some cases, however, technological change will only increase the production of a specific good. The diagram below illustrates the effect of a technological change in wheat production that does not affect corn production.

Specialization and trade


In The Wealth of Nations, Adam Smith argued that economic growth occurred as a result of specialization and division of labor. If each household produced every commodity it consumed, the total level of consumption and production in a society will be small. If each individual specializes in the productive activity at which they are "best," total output will be higher. Specialization provides such gains because it:

allows individuals to specialize in those activities in which they are more talented, individuals become more proficient at a task that they perform repeatedly, and less time is lost switching from task to task.

Increased specialization by workers requires a growth in trade. Adam Smith argued that growing specialization and trade was the ultimate cause of economic growth. Adam Smith and David Ricardo argued that similar benefits accrue from international specialization and trade. If each country specializes in the types of production at which they are best suited, the total amount of goods and services produced in the world economy will increase. Let's examine these arguments a bit more carefully. There are two measures that are commonly used to determine whether an individual or a country is "best" at a particular activity: absolute advantage and comparative advantage. These two concepts are often confused. An individual (or country) possesses an absolute advantage in the production of a good if the individual (or country) can produce more than can other individuals (or countries). An individual (or country) possesses a comparative advantage in the production of a good if the individual (or country) can produce the good at the lowest opportunity cost.

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Let's examine an example illustrating the difference between these two concepts. Suppose that the U.S. and Japan only produced two goods: CD players and wheat. The diagram below represents production possibilities curves for these two countries.

Notice that the U.S. has an absolute advantage in the production of each commodity. To determine who has a comparative advantage, though, it is necessary to compute the opportunity cost for each good. (It is assumed that the PPC is linear to simplify this discussion.) CDS APPORTUNITY COST 200/100 in US 100/75 in JAPAN WHEATS APPORTUNITY COST 100/200 in US 75/100 in JAPAN

CD WHEAT

The opportunity cost of one unit of CD players in the U.S. is 2 units of wheat. In Japan, the opportunity cost of one unit of CD players is 4/3 of a unit of wheat. Thus, Japan possesses a comparative advantage in CD player production. The U.S. however, has a comparative advantage in wheat production since the opportunity cost of a unit of wheat is 1/2 of a unit of CD players in the U.S., but is 3/4 of a unit of CD players in Japan. If each country specializes in producing the good in which it possesses a comparative advantage, it can acquire the other good through trade at a cost that is less than the opportunity cost of production in the domestic economy. If each country produces only those goods in which it possesses a comparative advantage, each good is produced in the global economy at the lowest opportunity cost. This results in an increase in the level of total output.

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A Model of a Competitive Market Supply and Demand Supply and Demand are the two words that economists use most often and forces that make market economies work. They determine the quantity of each good produced and the price at which it is sold. Competitive Markets Competitive market: a market in which there are many buyers and many sellers so that each has a negligible impact on the market price. Perfectly competitive markets are defined by two primary characteristics: (1) the goods being offered for sale are all the same, and (2) the buyers and sellers are so numerous that no single buyer or seller can influence the market price. Because buyers and sellers in perfectly competitive markets must accept the price the market determines, they are said to be price takers. Not all goods and services, however, are sold in perfectly competitive markets. Some markets have only one seller, and this seller sets the price. Such a seller is called a monopoly. Electricity Supply company, for instance, may be a monopoly. Residents of your town probably have only one supplier (ESCOM) from which to buy this service. Some markets fall between the extremes of perfect competition and monopoly. One such market, called an oligopoly, has a few sellers that do not always compete aggressively. Airline routes are an example. If a route between two cities is serviced by only two or three carriers, the carriers may avoid rigorous competition to keep prices high. Another type of market is monopolistically competitive; it contains many sellers, each offering a slightly different product. Because the products are not exactly the same, each seller has some ability to set the price for its own product. An example is the software industry. Many word processing programs compete with one another for users, but every program is different from every other and has its own price. We assume in this chapter that markets are perfectly competitive.

Demand
The demand for a good or service is defined to be the relationship that exists between the price of the good and the quantity that buyers are willing and able to purchase in a given time period, ceteris paribus. One way of representing demand is through a demand schedule such as the one appearing below: Price $1 $2 $3 $4 Quantity Demanded 100 80 60 40
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$5

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Note that the demand for the good is the entire relationship that is summarized by this table. We can write this relationship between quantity demanded and price as an equation: QD QD P or this demand relationship may also be represented graphically as illustrated in the figure below. Note that the demand curve in that figure, labeled D, slopes downward: Consumers are usually ready to buy more if the price is lower.

Both the demand schedule and the demand curve indicate that, for this good, an inverse relationship exists between the price and the quantity demanded when other factors are held constant. This inverse relationship between price and quantity demanded is so common that economists have called it the law of demand. Law of demand: states that, ceteris paribus (other things equal), the quantity demanded of a good falls when the price of the good rises. As noted above, demand is the entire relationship between price and quantity, as represented by a demand schedule or a demand curve. A change in the price of the good results in a change in the quantity demanded, but does not change the demand for the good. As the diagram below indicates, an increase in the price from $2 to $3 reduces the quantity of this good demanded from 80 to 60, but does not reduce demand.

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Market demand and Individual Demand


The market demand consists of the total quantity demanded by each individual in the market. Conceptually, the market demand curve is formed by computing the horizontal summation of the individual demand curves for all consumers. The diagram below illustrates this process. This diagram illustrates a simple case in which there are only two consumers, Person A and Person B. Notice that the total quantity demanded in the market is just the sum of the quantities demanded by each individual. In this diagram, Person A wished to buy 10 of this commodity and person B wishes to buy 15 units when the price is $3. Thus, at a price of $3, the total quantity demanded in the market is 25 (=10+15) units of this commodity.

Of course, this example is highly simplified since there are many buyers in most real-world markets. The same principle though would hold: the market demand curve is derived by adding together the quantities demanded by all consumers at each and every possible price.

Change in Demand Shift of Demand Curve


A change in demand occurs only when the relationship between price and quantity demanded changes. The position of the demand curve changes when demand changes. If the demand curve becomes steeper or flatter or shifts to the right or the left, we can say that demand has changed. Figure below illustrates a shift in the demand for a good (from D to either D or D). Notice that a rightward shift in the position of the demand curve is said to be an increase in demand since a larger quantity is demanded at each price. Similarly, any change that reduces the quantity demanded at every price shifts the demand curve to the left.

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Movement along the Demand Curve A movement along the demand curve is a change in the quantity demanded of a good resulting from the change in that goods price. The figure shows the decrease in demand from 80 units to 60 units along the demand curve resulting from the changes in price from $2 to $3.

Determinants of demand
Let's examine some factors that might be expected to change demand for most goods and services. These factors include: Price The change in price causes the movement along the demand curve. Other things equal, when the price of a good rises, the quantity demanded of the good falls. The quantity demanded is therefore negatively related to the price. This relationship between price and quantity demanded is true for most goods in the economy and, in fact, is so pervasive that economists call it the law of demand.
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Tastes and Preferences The most obvious determinant of your demand is your tastes. If you like ice cream, you buy more of it. However, peoples tastes cannot be explained because tastes are based on historical and psychological forces that are beyond the realm of economics. Economists do, however, examine what happens when tastes change. The prices of related goods When the price of frozen yogurt falls, the law of demand says that you will buy more frozen yogurt. At the same time, you will probably buy less ice cream. Because ice cream and frozen yogurt are both cold, sweet, creamy desserts, they satisfy similar desires. When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. Suppose that the price of computers falls. According to the law of demand, you will buy more computers. Yet, in this case, you will buy more software as well, because computers and software are often used together. When a fall in the price of one good raises the demand for another good, the two goods are called complements. Complements are often pairs of goods that are used together, such as gasoline and automobiles and skis and ski lift tickets.

Income A lower income means that you have less to spend in total, so you would have to spend less on someand probably mostgoods. If the demand for a good falls when income falls, the good is called a normal good. If the demand for a good rises when income falls, the good is called an inferior good. An example of an inferior good might be bus rides. As your income falls, you are less likely to buy a car or take a cab, and more likely to ride the bus. The number of consumers The market demand curve consists of the horizontal summation of the demand curves of all buyers in the market, an increase in the number of buyers would cause demand to increase. As the population rises, the demand for cars, TVs, food, and virtually all other commodities, is expected to increase. A decline in population will result in a reduction in demand. Expectations of future prices and income Your expectations about the future may affect your demand for a good or service today. For example, if you expect to earn a higher income next month, you may be more willing to spend some of your current savings buying computers. As another example, if you expect the price of cars to fall next month, you may be less willing to buy cars cone at months price.

International effects
When international markets are taken into account, the demand for a product includes both domestic and foreign demand. An important determinant of foreign demand for a good is the exchange rate. The exchange rate is the rate at which the currency of one country is converted
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into the currency of another country. Suppose, for example, that one dollar exchanges for MK250. In this case, the dollar value of one Kwacha is $.004. Notice that the exchange rate between dollars and Malawi Kwacha is the reciprocal of the exchange rate between Kwacha and dollars. Thus, an increase in the exchange value of the Malawi Kwacha (appreciation) results in a reduction in the demand for Malawian goods and services. The demand for Malawian goods and services will rise, however, if the exchange value of the Kwacha declines (depreciation/devaluation).

Supply
The supply curve shows the quantity of a good that producers are willing to sell at a given price, ceteris paribus (holding constant any other factors that might affect the quantity supplied). The supply curve is thus a relationship between the quantity supplied and the price. We can write this relationship as an equation: Qs = Qs(P) Or we can a supply schedule as the illustrated below. Price $1 $2 $3 $4 $5 Quantity Supplied 20 40 60 80 100

Note that the supply for the good is the entire relationship that is summarized by this table or can be represented by graph as shown below:

Note that the supply curve slopes upward: In other words, the higher the price, the more that firms are able and willing to produce and sell. For example, a higher price may enable current firms to expand production by hiring extra workers or by having existing workers work overtime (at greater cost to the firm). Likewise, they may expand production over a longer period of time by increasing the size of their plants.

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Just as there is a "law of demand" there is also a "law of supply." The law of supply states that ceteris paribus (other things equal), the quantity supplied of a good rises when the price of the good rises. The law of supply indicates that supply curves will be upward sloping (as in the diagram below).

To understand the law of supply, it's helpful to remember the law of increasing cost. Since the marginal opportunity cost of supplying a good rises as more is produced, a higher price is required to induce the seller to sell more of the good or service.

Change in Supply Shift of Supply Curve


Whenever there is a change in any determinant of supply, other than the goods price, the supply curve shifts. As Figure below shows, any change that raises quantity supplied at every price shifts the supply curve to the right. Similarly, any change that reduces the quantity supplied at every price shifts the supply curve to the left.

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Movement along the Supply Curve A movement along the supply curve is a change in the quantity supplied of a good resulting from the change in that goods price. The figure shows the increase in supply from 40 units to 60 units along the supply curve resulting from the changes in price from $2 to $3.

Market supply
The market supply curve is the horizontal summation of all individual supply curves. The derivation of this is equivalent to that illustrated above for demand curves.

Determinants of supply
The factors that can cause the supply curve to shift include: Price When the price of a commodity is high, selling it is profitable, and so the quantity supplied is large. As a seller, you work long hours, buy many machines, and hire many workers. By contrast, when the price of is low, your business is less profitable, and so you will produce less. At an even lower price, you may choose to go out of business altogether, and your quantity supplied falls to zero. Input Prices An increase in the price of resources reduces the profitability of producing the good or service. This reduces the quantity that suppliers are willing to offer for sale at each price. Thus, an increase in the price of labor, raw material, capital, or other resource, will be expected to change in supply of a good.

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Technology Technological improvements and changes that increase the productivity of labor result in lower production costs and higher profitability. Supply increases in response to this increase in the profitability of production. Expectations The amount of good you supply today may depend on your expectations of the future. For example, if you expect the price of a good to rise in the future, you will put some of your current production into storage and supply less to the market today. The number of producers An increase in the number of producers results in an increase of the good in the market. This may shift market supply curve. Prices of related goods and services The supply decision for a particular good is affected not only by the price of the good, but also by the price of other goods and services the firm may produce. For example, an increase in the price of corn may induce a farmer to reduce the supply of wheat. In this case, an increase in the price of one product (corn) reduces the supply of another product (wheat). It is also possible, but less common, that an increase in the price of one commodity may increase the supply of another commodity. To see this, consider the production of both beef and leather. An increase in the price of beef will cause ranchers to raise more cattle. Since beef and leather are jointly produced from cows, the increase in the price of beef will also be expected to result in an increase in the supply of leather.

International effects
In our increasingly global economy, firms often import raw materials (and sometimes the entire product) from foreign countries. The cost of these imported items will vary with the exchange rate. When the exchange value of a Kwacha rises (appreciates), the domestic price of imported inputs will fall and the domestic supply of the final commodity will increase. A decline in the exchange value of the Kwacha will raise the price of imported inputs and reduce the supply of domestic products that rely on these inputs.

The Market Mechanism (Equilibrium)


The next step is to put the supply curve and the demand curve together as illustrated in figure below. This is now the price that sellers receive for a given quantity supplied, and the price that buyers will pay for a given quantity demanded.

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It can be seen that the market demand and supply curves intersect at a price of $3 and a quantity of 60. This combination of price and quantity represents an equilibrium (market clearing) point where the quantity demanded equals the quantity supplied. At this price, each buyer is able to buy all that he or she desires and each firm is able to sell all that it desires to sell. Once this price is achieved, there is no reason for the price to either rise or fall (as long as neither the demand nor the supply curve shifts). If the price is above the equilibrium, a surplus occurs (since quantity supplied exceeds quantity demanded). This situation is illustrated in the figure below. The presence of a surplus would be expected to cause firms to lower prices until the surplus disappears (this occurs at the equilibrium price of $3).

Surplus

If the price is below the equilibrium, a shortage occurs (since quantity demanded exceeds quantity supplied). This possibility is illustrated in the diagram below. When a shortage occurs, producers will be expected to increase the price. The price will continue to rise until the shortage is eliminated when the price reaches the equilibrium price of $3.

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S
Shortage

Changes in Market Equilibrium


Let's examine what happens if demand or supply changes. First, let's consider the effect of an increase in demand. As the figure below indicates, an increase in demand results in an increase in the equilibrium levels of both price and quantity.

A decrease in demand results in a decrease in the equilibrium levels of price and quantity (as illustrated below).

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An increase in supply results in a higher equilibrium quantity and a lower equilibrium price.

Equilibrium quantity will fall and equilibrium price will rise if supply falls (as illustrated below.)

Price ceilings and price floors


A price ceiling is a legally mandated maximum price. The purpose of a price ceiling is to keep the price of a good below the market equilibrium price. Rent controls and regulated gasoline prices during wartime and the energy crisis of the 1970s are examples of price ceilings. As the diagram below illustrates, an effective price ceiling results in a shortage of a commodity since quantity demanded exceeds quantity supplied when the price of a good is kept below the equilibrium price. This explains why rent controls and regulated gasoline prices have resulted in shortages.

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A price floor is a legally mandated minimum price. The purpose of a price floor is to keep the price of a good above the market equilibrium price. Agricultural price supports and minimum wage laws are example of price ceilings. As the diagram below illustrates, an effective price floor results in a surplus of a commodity since quantity supplied exceeds quantity demanded when the price of a good is kept below the equilibrium price.

Elasticity of Supply and Demand We have seen that the demand for a good depends not only on its price but also on consumer income and on the prices of other goods. Likewise, supply depends both on price and on variables that affect production cost. For example, if the price of coffee increases, the quantity demanded will fall and the quantity supplied will rise. Often, we want to know how much the quantity supplied or demanded will rise or fall. How sensitive is the demand for coffee to its price (if price increases by 10 percent, how much will the quantity demanded change)? How much will it change if income rises by 5 percent? We use elasticities to answer these questions. Elasticity: a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants. It tells us what the percentage change in the quantity demanded for a good will be following a 1-percent increase in the price of that good.

Price elasticity of demand


The most commonly used elasticity measure is the price elasticity of demand, defined as:

E p %Q / %P
Price elasticity of demand (Ed) =

or

Price elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price.

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Example: If the Consumer Price Index were 200 at the beginning of the year and increased to 204 by the end of the year, the. Percentage change-or annual rate of inflation-would be 4/200 = .02, or 2 percent.) Thus we can also write the price elasticity of demand as follows? Q / Q PQ Ep P / P QP Price elasticity of demand is usually a negative number. When the price of a good increases, the quantity demanded usually falls. Thus Q (the change in quantity for a change in price) is
P

negative, as is Ep. Sometimes the magnitude of the price elasticity is referred in its absolute size (ie Ep = -2, as Ep = 2 in magnitude). Demand is said to be:

Elastic when Ed > 1, Unit elastic when Ed = 1, and Inelastic when Ed < 1.

When demand is elastic, a 1% increase in price will result in a greater than 1% reduction in quantity demanded. If demand is unit elastic, quantity demanded will fall by 1% when the price rises by 1%. A 1% price increase will result in less than a 1% reduction in quantity demanded when demand is inelastic. For example, when the price elasticity of demand for a particular good is 2, we say that demand is elastic and knows that a 1% increase in price will cause quantity demanded to fall by 2%. One extreme case is given by a perfectly elastic demand curve, as appears in the figure below. Demand is perfectly elastic only in the special case of a horizontal demand curve. The elasticity measure in this case is infinite (notice that the denominator of the elasticity measure equals zero). Consumers have bigger power. Consumers will buy as much as they want at a single price. Any slight price increase will lead to drop of demand to zero.

At the other extreme, a vertical demand curve is said to be perfectly inelastic. Such a demand curve appears in figure below. Note that the price elasticity of demand equals zero for a perfectly
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inelastic demand curve since the % change in quantity demanded equals zero. Producer has a bigger power. Consumers will buy a fixed quantity at any price.

Elasticity along a Linear Demand Curve Price elasticity of demand is the change in quantity associated with a change in price Q / P times the ratio of price to quantity (P / Q). But moving down along the demand curve Q / P may change, and the price and quantity will always change. Therefore, the price elasticity of demand must be measure at a particular point on the demand curve and will generally change as we move along the curve. This principle is easiest to see for a linear demand curve-that is, a demand curve of the form: Q = a - bP As an example, consider the demand curve Q=8-2P For this curve, Q / P is constant and equal to -2 (a P of 1 results in a Q of -2).

More generally, we can note that elasticity declines continuously along a linear demand curve. The top portion of the demand curve will be highly elastic and the bottom is highly inelastic. In between, elasticity gradually becomes smaller as price declines and quantity rises. At some point,
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demand changes from being elastic to inelastic. The point at which that occurs, of course, is the point at which demand is unit elastic. This relationship is illustrated in the diagram below.

Arc Elasticity
Suppose that we wish to measure the elasticity of demand in the interval between a price of $4 and a price of $5. In this case, if we start at $4 and increase to $5, price has increased by 25%. If we start at $5 and move to $4, however, price has fallen by 20%. Which percentage change should be used to represent a change between $4 and $5? To avoid ambiguity, the most common measure is to use a concept known as arc elasticity in which the midpoint of the interval is used as the base value in computing elasticity. Under this approach, the price elasticity formula becomes:

where:

Let's consider an example. Suppose that quantity demanded falls from 60 to 40 when the price rises from $3 to $5. The arc elasticity measure is given by:

In this interval, demand is inelastic (since Ed < 1).


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Elasticity and Total Revenue


The concept of price elasticity of demand is extensively used by firms that are investigating the effects of a change in the prices of their commodities. Total revenue is defined as: Total Revenue = Price x Quantity When the price declines, quantity demanded by consumers rises. The lower price received for each unit of output lowers total revenue while the increase in the number of units sold raises total revenue. Total revenue will rise when the price falls if quantity rises by a large enough percentage to offset the reduction in price per unit. In particular, we can note that total revenue will increase if quantity demanded rises by more than one percent when the price falls by one percent. Alternatively, total revenue will decline if quantity demanded rises by less than one percent when the price declines by one percent. If the price falls by one percent and quantity demanded falls by one percent, total revenue will remain unchanged (since the changes will offset each other). A careful observer will note that this comes down to a question of the magnitude of the price elasticity of demand. As defined above, this equals:

price elasticity of demand (Ed) = Using the logic discussed above, we can note that a reduction in price will lead to:

an increase in total revenue when demand is elastic, no change in total revenue when demand is unit elastic, and a decrease in total revenue when demand is inelastic.

In a similar manner, an increase in price will lead to:


a reduction in total revenue when demand is elastic, no change in total revenue when demand is unit elastic, and an increase in total revenue when demand is inelastic.

The diagram below illustrates the relationship that exists between total revenue and demand elasticity along a linear demand curve.

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As this diagram illustrates, total revenue increases as quantity increases (and price decreases) in the region in which demand is unit elastic. Total revenue falls as quantity increases (and price decreases) in the inelastic portion of the demand curve. Total revenue is maximized at the point at which demand is unit elastic. Does this mean that firms will choose to produce at the point at which demand is unit elastic? This would only be the case if they had no production costs. Firms are assumed to be concerned with maximizing their profits, not their revenue. The optimal level production can be determined only when we consider both revenue and costs. This topic will be extensively addressed in future chapters.

Determinants of price elasticity of demand


The price elasticity of demand is likely to be relatively high when:

The presence of close substitutes for a commodity, Demand for narrowly defined commodity is more elastic than the demand for broadly defined commodity. The increase of commoditys share in the consumer's budget, Time frame of the analysis.

Other Demand Elasticities


In addition to the price elasticity of demand, there are also other elasticities that describe the behavior of buyers in a market.

Income elasticity of demand


The income elasticity of demand is a measure of how sensitive demand for a good is to a change in income. Income elasticity of demand is measured as:

EI

Q / Q IQ or I / I QI

Most goods are normal goods meaning that higher income raises quantity demanded. Because quantity demanded and income moves in the same direction, normal goods have positive income elasticities. A few goods, such as bus rides, are inferior goods: higher income lowers the quantity demanded. Because quantity demanded and income move in opposite directions, inferior goods have negative income elasticities.

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Cross-price elasticity of demand


The cross-price elasticity of demand is a measure of the responsiveness of a change in the price of a good to a change in the price of some other good. The cross-price elasticity of demand between the goods j and k can be expressed as:

EQ j Pk

Q j / Q j Pk / Pk

Pk Q j Q j Pk

Notice that this cross-price elasticity measure does not have an absolute value sign around it. In fact, the sign of the cross-price elasticity of demand tells us about the nature of the relationship between the goods j and k. A positive cross-price elasticity occurs if an increase in the price of good k is associated with an increase in the demand for good j. This occurs if and only if these two goods are substitutes. A negative cross-price elasticity of demand occurs when an increase in the price of good k is associated with a decline in the demand for good j. This occurs if and only if goods j and k are complements.

Price elasticity of supply


We can also apply the concept of elasticity to supply. The price elasticity of supply is defined as:

Note that the absolute value sign is not used when measuring the price elasticity of supply since we do not expect to observe a downward sloping supply curve. A perfectly inelastic supply curve is vertical as in the figure below. The price elasticity of supply is zero when supply is perfectly inelastic.

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A perfectly elastic supply curve is horizontal as illustrated in the figure below. The supply curve facing a single buyer in a market in which there are a very large number of buyers and sellers is likely to appear to be perfectly elastic (or close to this, anyway). This will occur when each buyer is a "price-taker" who has no effect on the market price.

Short-run and Long-run Elasticities


When analyzing demand and supply, we must distinguish between the short run and the long run. In other words, if we ask how much demand or supply changes in response to a change in price, we must be clear about how much time is allowed to pass before we measure the changes in the quantity demanded or supplied. If we allow only a short time to pass-say, one year or less-then we are dealing with the short run. When we refer to the long run we mean that enough time is allowed for consumers or producers to adjust fully to the price change. For example, demand is much more price elastic in the long-run than in the short-run (i.e. if price of coffee rises sharply, the quantity demanded will fall only gradually as it takes time for people to change their consumption pattern).

Tax incidence
As your text notes, the distribution of the burden of a tax depends on the elasticities of demand and supply. When demand is inelastic, consumers bear a larger share of the tax burden (i.e. tobacco, alcohol and petroleum oil)

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Mathematical Illustrations

Example 1: The Market for Wheat: The supply curve for wheat is approximately as follows: Supply: Qs = 1800 +240P where price is measured in nominal dollars per bushel and quantities in millions of bushels per year. These-studies also indicate that in 1981, the demand curve for wheat is Demand: QD = 3550-266P Lets set the quantity supplied equal to the quantity demanded. The market-clearing price of wheat can be determined as follows: Qs = QD 1800 + 240P = 3550 - 266P 506P = 1750 P = $3.46 per bushel To find the market-clearing quantity, substitute this price of $3.46 into either the supply curve equation or the demand curve equation. Substituting into the supply curve equation, we get: Q = 1800 + (240)(3.46) = 2630 million bushels. What are the price elasticities of demand and supply at this price and quantity? We use the demand curve to find the price elasticity of demand: PQ 3.46 D EP (266) 0.35 QP 2630 Thus demand is inelastic. We can likewise calculate the price elasticity of supply: PQ s 3.46 S EP (240) 0.32 QP 2630 Since these supply and demand curves are linear, the price elasticities will vary as we move along the curves. Now, suppose that a drought caused the supply curve to shift far enough to the left to push the price up to $4.00 per bushel. In this case, the quantity demanded would fall to: 3550 - (266)(4.00) = 2486 million bushels. At this price and quantity, the elasticity of demand would be 4.00 D EP (266) 0.43 2486 Example 2: Fitting linear demand and supply curves to market data. We can write these curves algebraically as follows: Demand: Q = a bP. Eq. 1 Supply: Q = c + dP... Eq. 2 Lets find numbers for the constants a, b, c, and d. This is done, for supply and for demand, in a two-step procedure: Step 1: Recall that each price elasticity, whether of supply or demand, can be written as:
E = (P/Q)(Q/P)

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Where Q/P is the small change in quantity demanded or supplied resulting from a small change in price. For linear curves Q/P is constant. From the equations above, Q/P = d for supply and Q/P = -b for demand. Lets substitute the values for Q/P into the elasticity formula: Demand: ED = -b(P*/Q*). Eq. 3 Supply: Es = d(P*/Q*)... Eq. 4 where P* and Q* are the equilibrium price and quantity for which we have data and to which we want to fit the curves. Since we have numbers for Es' ED' P*, and Q*, we can substitute these numbers in equations 3 and 4 and solve for band d. Step 2: Since we now know b and d, we can substitute these numbers, as well as P* and Q*, into equations 1 and 2 and solve for the remaining constants a and c. We can rewrite equation 1 as a = Q* + bP* and then use our data for Q* and P*, together with the number we calculated in Step 1 for b, to obtain a.
a/b Supply: Q = c + dP

Ep = -b(P*/Q*) P* Ep = d(P*/Q*)

-c/d
Q*

Demand: Q = a - bP

Let's apply this procedure to a specific example: long-run supply and demand for the world copper market. The relevant numbers for this market are as follows: Quantity Q*= 12 million metric tons per year (mmt/yr) Price P*= $2.00 per pound Elasticity of supply Es= 1.5 Elasticity of demand ED = -0.5. Lets start with supply curve equation and use the two-step procedure to calculate numbers for c and d. The long-run price elasticity of supply is 1.5, P* = $2.00, and Q* = 12. Step 1: Substitute these numbers in equation to determine d: 1.5 = d (2/12) = d/6 So that d = (1.5)(6) = 9
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Step 2: Substitute this number for d, together with the numbers for P* and Q*, into equation 4 to determine c: 12 = c + (9)(2.00)= c + 18 So that c = 12- 18= -6. Now, we know c and d, so we can write our supply curve: Supply: Q = -6 + 9P Following same steps for the demand curve equation: The long-run elasticity of demand is -0.5. First, substitute this number, as well as the values for P* and Q*, into equation 3 to determine b: -0.5 = -b(2/12) = -b/6 So that b = (0.5)(6)= 3. Second, substitute this value for b and the values for p* and Q* in equation 3 to determine a: 12 = a - (3)(2)= a - 6 So that a = 12 + 6 = 18. Thus, our demand curve is: Demand: Q = 18 -3P Example 3: Demand might also depend on income as well as price. We would then write demand as: Demand: Q = a-bP + fI... Eq. 5 where I is an index of aggregate income or GDP? For Example, I might equal 1.0 in a base year and then rise or fall to reflect percentage increases or decreases in aggregate income. For our copper market example, a reasonable estimate for the long-run income elasticity of demand is 1.3.For the linear demand curve in equation 5,we can then calculate f by using the formula for the income elasticity of demand: E = (I/Q)(Q/I) Taking the base value of I as 1.0, we have: 1.3 = (1.0/12)(f) Thus f= (1.3)(12)/(1.0) = 15.6. Finally, substituting the values b = 3, f=15.6, P* = 2.00, and Q* = 12 in equation 5, we can calculate that a must equal 2.4. Now, we have seen how to fit linear supply and demand curves to data.

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