Chapter 3

The micro-economic environment

Microeconomics

Maiximum and minimum prices

1 Defining microeconomics

Microeconomics is a branch of economics that studies the

behavior of individuals, firms and industries in making
decisions regarding the allocation of scarce resources.
Basic concepts of microeconomics
2.1 What is a market?

A market refers to the situation that potential buyers and sellers come
together for the purpose of exchange with goods or services.
2.2 What is utility
• Utility: It describes the pleasure or satisfaction as a result of
consumption of goods or services by a person.

• Marginal utility quantifies the added satisfaction that a consumer

gains from consuming additional units of goods or services

• Total utility is the total satisfaction that people gain from

spending their income.
2.2 What is utility

Marginal util ity

2.3 Assumptions about consumer rationality

Consumer rationality is the assumption that consumers attempt to

obtain the greatest possible satisfaction from the money resources
they have available when making purchases.
2.4 What is the Price theory
A theory that examines how interaction of demand and supply affect the market prices for goods.
3 Demand and supply
3.1 Introduction

• Individual Demand shows the quantity of how much good or

service someone intends to buy at different prices. This demand
needs to be effective, which means the consumer should be willing
and able to buy, rather than just generally desiring them.

• Individual supply shows thye quantity of how much of a good or

service someone intends to produce at different prices. Similar to
demand, supply also need to be effective.
 Price

Demand Supply
3.2 The demand curve
In economics, the demand curve is the graph depicting the relationship
between the price of a certain commodity and the amount of it that
consumers are willing and able to purchase at any given price.

Price Demand
5,000 100
8,000 90
10,000 70
20,000 50
100,000 10
 3.2 The demand curve

P
Price Demand
P1
Price Demand
P2

Q1 Q2 Q

Ceteris paribus: this assumption that “all other things remain equal”.
3.3 Substitutes and complements

OR D
A N
3.3 Substitutes and complements
Substitute is a product or service that can be used in place of another
(A or B)
An increase in the demand for one is likely to cause a decrease in the
demand for another.

Complements refers to a complementary good or service used in

conjunction with another good or service. (A and B)
An increase in the demand for one is likely to cause an increase in the
demand for the other.
3.4 Factors determining demand for a good
a. The price of the good
b. The size of income/The distribution of income

c. The price of substitute goods

d. The price of complement goods

e. Tastes and preferences

f. Expectation of future price changes

g. Population
3.4 Factors determining demand for a good
a. The price of the good Point Movement
(expansion/contraction of demand)
b. The size of income

c. The distribution of income

P
d. The price of substitute goods

e. The price of complement goods A

P1
f. Tastes an preferences

g. Expectation of future price changes B

P2
h. Population

Q1 Q2 Q
3.4 Factors determining demand for a good
a. The price of the good Point Movement
b. The size of income

c. The distribution of income

d. The price of substitute goods

Shift
e. The price of complement goods
(increase/decrease of demand)
f. Tastes and preferences

g. Expectation of future price changes

h. Population
3.4 Factors determining demand for a good

Demand rises Shift to right

Shift
P Demand falls Shift to left

P1

Q3 Q1 Q2 Q
3.4 Factors determining demand for a good
d. The size of income
e. The distribution of income

P1

Q1 Q2 Q
3.4 Factors determining demand for a good
b. The price of complement goods
c. The price of substitute goods
3.3 Substitutes and complements
b. The price of complement goods
c. The price of substitute goods

P1

Q3 Q1 Q2 Q
3.4 Factors determining demand for a good
f. Tastes and preferences
g. Expectation of future price changes

h. Population

P1

Q1 Q2 Q
3.4 Factors determining demand for a good
3.5 Elasticity of demand
Elasticity measures the responsiveness of one variable to a change in another variable.

A B
3.5.1 The price elasticity of demand

PED>1——elastic

PED=1——Unit elastic

PED<1——inelastic
3.5.1 The price elasticity of demand
• Arc elasticity of demand: measure elasticity between two points on the
demand curve.

• Point elasticity of demand: measure elasticity at one particular point.

 Example question 1
The price of a good is $2.50 per unit and annual demand is 900,000 units. Market
research indicates that an increase in price of 10 cents per unit will result in a fall in
annual demand of 90,000 units.
1.What is the arc price elasticity of demand over this range
2. What is the point elasticity of demand at the current price of $2.50
1. 有用数据: 2.5 900K
2.6 810K
percentage change in demand = (900K-810K)/[(900K+810K)/2] = 0.105
Percentage change in price = (2.6-2.5)/[(2.6+2.5)/2] = 0.039

PED= 2.68

2. percentage change in demand =90K /900K=0.1

Percentage change in price = 0.1/2.5 =0.04

PED=2.5
3.5.2 The income elasticity of demand

A B
3.5.2 The income elasticity of demand
percentage change in demand
Income elasticity of demand (IED) = percentage change in income

Elasticity Value Types of good Example

Negative IED<0 Inferior goods Public transport

Inelastic 0<IED<1 Necessities Basic food

Elastic IED>1 Luxury goods Yacht

3.5.3 Cross elasticity of demand
percentage change in demand of good A
Cross elasticity of demand =
percentage change in the price of good B

Cross elasticity Comment

<0 Complements
0 Unrelated

>0 Substitutes

交叉弹性为负数时，两商品为互补关系
交叉弹性为正数时，两商品为替代关系

If = -1, perfect complements;

If = 1, perfect substitutes.
 Price

Demand Supply
3.6 The supply curve
The supply curve depicts the relationship between two variables only, price and quantity supplied.

Price Supply

5,000 10

8,000 50

10,000 70

20,000 90

100,000 100
3.6 The supply curve

P Price Supply

Price Supply
P1 B

A
P2

Q1 Q2 Q
3.7 Factors that affect the supply quantity
a. The price of the goods

b. The costs of making the good

c. The prices of other goods

d. Expectations of price changes

e. Changes in technology
3.7 Factors that affect the supply quantity
a. The price of the goods Point Movement (expansion/contraction of supply)

b. The costs of making the good P

c. The prices of other goods

d. Expectations of price changes P1

e. Changes in technology
P2

Q2 Q1 Q
3.7 Factors that affect the supply quantity

a. The price of the goods Point Movement

b. The costs of making the good

c. The prices of other goods

Shift (increase/decrease of supply)
d. Expectations of price changes

e. Changes in technology
 Shift
3.7 Factors that affect the supply quantity
Supply rises Shift to right

P
Supply falls Shift to left

P1

Q3 Q1 Q2 Q
3.7 Factors that affect the supply quantity
b. The costs of making the good

P1

Q2 Q1 Q
3.7 Factors that affect the supply quantity
c. The prices of other goods

P1

Q1 Q2 Q
3.7 Factors that affect the supply quantity
d. Expectations of price changes
3.7 Factors that affect the supply quantity
e. Changes in technology

P1

Q1 Q2 Q
3.7 Factors that affect the supply quantity
4 The price mechanism and the equilibrium price
4.1 The equilibrium price
The equilibrium price is where the market supply equals the market demand.
ü P is the equilibrium price, and there will only be one equilibrium price.
ü Shifts in the supply curve will change the equilibrium price.
4.2 Price mechanism
• The supply and demand will push prices towards equilibrium price if the market is in disequilibrium.
• The equilibrium price will prevail and remain stable if there is no change.
5 Maximum and minimum prices
5.1 Maximum prices
• protect consumers
• set below the equilibrium price
• maintain affordability/slow inflation.
• This will result in a situation in which the quantity
demanded will exceed the quantity supplied
(excess demand-Q1Q2), and this led to an illegal
market developing (black market).
5.1 Maximum prices

Rent S

E
Maximum price

D
0 Quantity
5.2 Minimum prices
• protect producers.
• Here, the quantity supplied will exceed the quantity
demanded (Excess supply-Q1Q2), provided the minimum
price is struck at a level above the equilibrium price.
5.2 Minimum prices

In order to ensure the low-paid workers can afford an acceptable standard of living, government
will set a minimum wage. Usually the statutory minimum wage enforced is probably above the
current market level.

Wage
S
Minimum price
E

D
0 Quantity of labor
Example question 2
The government has imposed a maximum price on basic foodstuffs in order to protect consumers.
Which TWO of the following are potential consequences of this
measure?
A. Excess SUPPLY B. Black market
C. Excess DEMAND D. Increased tax revenues
6 The economic behavior of costs
 6 The economic behavior of costs

Microeconomics not only study the relationship between prices and supply/demand
of goods and services, but also research how costs will vary over time.
According to the span of time, it can be divided by short run and long run costs.
6.1 Short-term cost behaviour

Total cost = Average fixed cost + variable cost

It is implied that to certain amount of production, average
fixed cost per unit will fall with the increase of production,
while the variable cost per unit remains constant. As a result,
the average cost per unit also falls. However, it should be
noted that total fixed cost will increase if the production is
beyond certain amount. Under such situation, the total cost per
unit will rise due to increase of both fixed and variable cost,
following the law of diminishing returns.
6.2 Long-term cost behaviour

In the long term, all costs are variable in nature no matter

they are variable or fixed before. This is because it is now
possible to change the quantities of any factors that were
fixed in the short term.
It means that organisations will become inefficient due to
some factors like poor management or pressure of
supplies when they pursue expansion of businesses.
Eventually, the average cost of production will increase.
This effect could be referred to diseconomies of scale.
6.3 Short run supply curve
Marginal revenue (MR): additional revenue gained by selling
additional one unit.
Marginal cost (MC): additional cost occurred by producing
additional one unit.
① Profit maximisation: MR = MC
② Price = AR (Average revenue) = MR

When would suppliers be willing and continue to produce products?

MC>AVC
 6.3 Short run supply curve

Marginal cost curve = Supply curve

Price/cost
Average total cost
P3 AR3=MR3

P2 AR2=MR2
Average variable cost
P1 AR1=MR1

Quantity
Q1 Q2 Q3
7 Types of markets
 7 Types of markets

competition

Imperfect
Perfect competition
competition

Monopolistic
Oligopoly Monopoly
competition
7.1 Perfect markets
A perfectly competitive market is one in which:
a) there are many buyers and sellers;
b) The products/service sold are homogeneous (identical);
c) there are no barriers to enter into the market or exit from the market;
d) both producers and consumers have perfect information of the market.
7.1 Perfect markets

Under such conditions, the price and level of output will

always tend towards equilibrium as any producer that sets a
price above equilibrium will not sell anything at all, and any
producer that sets a price below equilibrium will obtain 100%
market share. The demand ‘curve’ of each company is
perfectly elastic, which means that it will be horizontal.

Each participant in perfect market is a price taker

 7.2 Imperfect markets
Perfect market is seen as the “ideal” market position. If any of the factors above do not realise, the market will
be described as the imperfect one.
You need to be aware of three specific forms of imperfect market. Each of these forms depends on how
organisations compete within the market.

7.2.1 Monopolistic competition

Monopolistic competition arises in markets where there are
m a n y p ro d u c e r s , b u t t h e y w i l l t e n d t o u s e p ro d u c t
differentiation to distinguish themselves from other producers.
Therefore, although their products may be very similar, their
ability to differentiate means that they can act as monopolies in
the short run. There tends to be fewer barriers to entry or exit
than in oligopolistic markets.
 7.2.2 Oligopolies
An oligopoly arises when there are few producers who
exert considerable influence in a market. As there are few
producers, they are likely to have a high level of knowledge
about the actions of their competitors and should be able to
predict responses to changes in their strategies. The minimum
number of firms in an oligopoly is two, and this particular
form of oligopoly is called “duopoly”.
It is frequently noted that their characteristics include
complex use of product differentiation, significant barriers to
entry and a high level of influence on prices in the market.
 7.2.3 Monopoly
Monopoly occurs when one company controls all or nearly
all of the market for a particular product or service and has no
major competitors.

The key features include:

a) Only one major supplier in the market
b) No close substitutes
c) The supplier has high power to determine prices.

High barriers to entry and government legislation are main

factors that lead to monopoly.
 7 Types of markets

competition
• Many buyers and sellers (No dominants)
• Homogenous (identical) products
• Complete information
• No barriers to entry and exit Perfect Imperfect • Only one producer
competition competition • No close substitutes
• High power to determine prices

Monopolistic
Oligopoly Monopoly
competition

• Significant influence over the prices • A fewer producers

• Differentiation • have a high degree of control over price
Example question 3
Which of the following is the characteristic of perfect competition?
A. Few producers
B. Horizontal demand curve
C. Difficult for new firms to enter the market
D. Significant influence over the prices of the goods and services that they sell.
Example question 4
Which of the following is the characteristic of oligopoly?
A. Few producers
B. Many customers and producers
C. Products or service is identical
D. Perfect information
E. No barrier to entry