WECO1 DD-SS-EL, DL Notes Notes 2

1.3.
2 Demand and consumer behaviour
1 The demand curve.. The distinction between movements along a demand curve and shifts of a
demand curve.
What is Demand? The amount of a good or service that consumers are willing and able to buy at a
given price
It is important to remember that in economics we are concerned with effective demand. This is the
quantity of a good or service that consumers would be willing and able to purchase at any given price.
We are not interested in how much consumers would buy if they had unlimited resources (desire); of
course we know that consumers do have limited resources, and so in economics, when we refer to
‘demand’ we are always talking about ‘effective demand’, ie, wants/desires backed up by purchasing
power.
It is also worth noting that individual demand is the demand of one person whereas market demand
is the demand that comes from everyone in a particular market.
Demand and Utility

Utility is the satisfaction people get from consuming (using) a good or a service. Utility varies from
person to person. Some people get more satisfaction from eating chips than others. Even the same
person can gain greater satisfaction by eating chips when hungry than when he has lost his appetite.
‘Utility’ means ‘benefit’. Rational consumers demand goods and services in order to maximise their
personal utility. They will be guided by price signals from the market in making decisions about how to
allocate their scarce resources between different goods and services in order to maximise their utility.
What product or service gives you the most utility? How much more than the retail for this product or
service?
Demand for DVDs: an example of a demand curve
A demand schedule below tells us how many DVDs would be demanded by consumers in the UK at
each given price over the course of the year, 2012.
The demand schedule for DVDs for 2012

Price of DVDs (£) Quantity demanded in 2008 (millions)
2 200
4 180
6 160
8 140
10 120
12 100
14 80
16 60
18 40
20 20
Ahmadhiyya International School / Gr-11 Economics unit-1 (WEC01) Notes-Topics-2 / Semester-1 / 2015
1
Points to note:
 Price (p) is always on the vertical axis and Quantity demanded (Qd) is always on the horizontal
axis
 The demand curve always slopes downwards from left to right. This is because of the inverse
(negative) relationship between quantity demanded and price, embodied in the law of demand:
“There is normally an inverse (negative) relationship between price and quantity demanded,
all other things being equal.”
 When isolating the relationship between 2 variables, here Qd and P, we use the phrase ‘all other
things being equal’ to indicate that all other variables that may affect Qd are assumed to remain
constant. Economists use the Latin phrase ‘ceteribus paribus’ to say ‘all other things being equal.’
 The slope of the demand curve tells us how Qd for a product changes in response to a change in P,
and nothing else. Only a change in P can cause a movement along the demand curve. Such
movements along the demand curve are called a contraction or expansion in demand.
Movements along the demand curve
From the demand curve we drew you can see what happens to the demand for DVD as price changes.
Assume the current (average) price of DVDs in 2012 is £14. What happens if price changes to £10 and
£16
Demand before Demand now

Falls to £10 80 million 120 million This is called an expansion in
(movement from A demand
to B)
Rises to £16 80 million 60 million This is called a contraction in
(movement from A demand
to c)
Illustrate these changes on the demand curve below:
Price
D1
Qantity
2
Shifts in demand
All other factors (other than price of DVDs) will cause the demand curve to shift its position i.e. these
can lead to an increase or decrease in demand.
In general factors that affect demand are:
 The (real) income of consumers & income tax changes: higher income allows consumers to buy
more goods and services. This could occur if income tax fell or if wages & salaries rose.
 The demand for substitutes (e.g. Pepsi & Coke): consumers may demand less goods & services
if they decide to buy a substitute good instead, possibly due to a cheaper price or increased quality.
 The demand for complements (e.g. dishwasher tablets and dishwashers): if consumers demand
more dishwashers there will be more demand for complements like tablets.
 Fashion and changes in consumer tastes: consumers may start to prefer products if they become
more fashionable or if consumer tastes move towards a certain product.
 Changes in legislation e.g. less demand for smoking after the smoking ban?
 Advertising: should increase the demand for products if it is effective
 Changes in population: should also increase demand as there are more people to buy goods and
services e.g. rising populations in China and India.
Price
An increase in Demand shift D1
to D2.
A decrease in Demand shift D1 to

D0.
D2
D0 D1
Q
Joint Demand, Competitive Demand and Derived Demand
Joint Demand When an increase in demand for good X, causes consumers to demand
more of good Y.
E.g. complements such as dishwasher tablets and dishwashers
Competitive Demand When a rise in demand for one good, reduces the demand for another
E.g. substitutes such as Channel 4 and BBC
Derived Demand When goods are demanded only because they are needed for the
production of other goods
E.g. Vaseline and crude oil, if there is consumer demand for Vaseline,
then producers will demand crude oil
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The theory of consumer choice
Utility
Economists use the term utility to describe the satisfaction or enjoyment derived from the consumption
of a good or service. If we assume that consumers act rationally, this means they will choose between
different goods and services so as to maximize total satisfaction or total utility.
Qualifications to assumption of rationality

Other people affect the individual’s behaviour
Habit and consumer inertia;
Poor at computation
Need to feel valued.
Marginal utility
Marginal Utility is the change in total utility or satisfaction resulting from the consumption of one
more unit of a good.
The hypothesis of diminishing marginal utility states that as the quantity of a good consumed
increases, the marginal utility derived from that good decreases.
Example - A consumer enjoys successive pints of his favourite soft drink. The total and marginal utility
gained from each extra glass in shown in the table below. Total utility is maximised when marginal
utility = zero. Consuming the seventh pint would create dis-utility as total utility falls (marginal utility
becomes negative)
Glass of soft Total Utility Marginal Utility

drink
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 29 -1
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Law of equi marginal returns
A rational consumer will spend his/her income in a way that maximises the total utility derived from
all goods and services consumed.
Consider an example where a consumer has a choice between two goods A and B which have prices Pa
and Pb respectively.
Total Utility will be maximised when the utility derived from the last pound's worth of A is equal to the
utility derived from the last pound's worth of B.
Total utility Marginal = Marginal = Marginal

maximised utility of good utility of utility of
when A good B good C
Price of good Price of good Price of
A B good C
Diminishing marginal utility- if we consume a commodity continuously the marginal utility derived
from it diminishes.
Rationality- consumers aim to maximise utility by making rational choices.
Irrationality- that consumers do not always aim to maximise utility
Habitual behaviour: Consumers are not acting rationally because they are keeping to their habits
rather than switching to achieve better returns
The supply curve . The distinction between movements along a supply curve and shifts of a
supply curve.
. The factors that may cause a shift in the supply curve, e.g. changes in the costs
of production, the introduction of new technology, indirect taxes (specific and ad valorem),
government subsidies.
What is Supply?
Supply How many goods firms are willing and able to put on the market (ie, supply) at any given
price.
Just as previously we constructed a demand curve which told us how much of a good consumers were
willing and able to buy (ie, demand) at any given price, we can also construct a supply schedule. As
with demand, there is a distinction between individual supply and market supply.
The Supply Curve for Wheat
SUPPLY SCHEDULE FOR WHEAT

Price of wheat/tonne Qs of wheat
(£) (tonne - millions)
10 2
20 4
30 6
40 8
50 10
60 12
70 14
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Points to Note:
 Again, price always goes on the vertical (Y) axis, quantity supplied on the horizontal (X) axis
 The slope of the supply curve tells us how Qs for a product changes in response to a change in P,
and nothing else.
 Whilst the demand curve sloped downwards from left to right (negatively sloped) the supply curve
slopes upwards from left to right (positively sloped).
Why is supply upward sloping?
Supply curves for most products slope upwards from left to right giving a positive relationship between
the market price and quantity supplied. Two main reasons for this are as follows:
1. When the market price rises (for example following an increase in consumer demand), it becomes
more profitable for businesses to increase their output.
2. Higher prices send signals to firms that they can increase their profits by satisfying demand in the
market. When output rises, a firm's costs may rise, therefore a higher price is needed to justify the extra
output and cover these extra costs of production
Movements along the supply curve
The only factor that causes a movement along the supply curve is price. Suppose the market price for
wheat was £40 per tonne. What happens when price changes to £30 and then to £60
Supply before Supply now

Falls to £30 8 million 6 million This is called a contraction in
(point C in the Diagram) supply
Rises to £60 8 million 12 million This is called an expansion in
(point B in the Diagram) supply
movements along the supply curve :
Price
S
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Shifts in the supply curve
In general the supply curve will shift due to the following factors:
 Costs of production: higher costs of production will decrease supply as there is less incentive
to supply in that market due to lower profitability
 Indirect Taxes and Subsidies on a good: taxes will increase costs of production as they need
to be paid to the Government but subsidies reduce costs of production. Therefore taxes will
reduce supply and subsidies will increase supply.
 Technology & Productivity: better technology could improve productivity and reduce costs of
production and therefore increase supply.
 Supply of alternative goods the producer could make with the same resources
i.e. competitive supply. If producers can switch to producing a more profitable product they
may reduce the supply of their current product.
 Supply of goods actually produced at the same time (i.e. joint supply): some goods will see
a rise in supply if other goods are produced e.g. beef and leather
 The weather e.g. in agriculture the weather can determine the crop yield / the size of the
harvest. Therefore good weather may increase supply.
 Entry/exit of new firms into/out of the market: if more firms enter a market then the market
supply will increase and will decrease when firms leave the market.
 Producer cartels: this is when many firms/countries operate together and decide how much to
supply onto the market and hence determine price. The main example is OPEC for oil. They
can restrict world supply of oil and therefore lower supply & raise the oil price.
Illustrating Shifts in Supply An increase in supply shows

a shift to S2.
A decrease in supply shows a

shift to S0.
Price S0
S1
S2
Q
Joint Supply and Competitive Supply
Joint Supply When an increase of supply of good X, means more is automatically

supplied of good Ya E.g. beef and leather
Competitive Supply When an increase in price of good X, leads to a contraction in supply

of good Y (producers reallocate their production to good X)a
E.g. maize and barley
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ELASTICITY
- In economics, elasticity is the responsiveness of percentage change in one variable to a percentage
change in another variable.
- The quantity demanded or supplied is affected by any change in price or income or price of other
goods, and so on.
- Elasticity is a measure of how much the quantity demanded or supplied will be affected by a
change in price or income.
- There are different types of elasticities.
1- PRICE ELASTICITY OF DEMAND:-
- The responsiveness of change in quantity demanded to a change in price.
- Elasticity will be always negative.
Formula
OR OR OR
(i) Elastic demand

- If the value of elasticity is greater than one.
- Percentage change in price will bring about an even larger percentage
change in quantity demanded.
- Luxury goods normally have an elastic demand.
- Eg:- if a 20% rise in price of shoes leads to 40% fall in
demand of shoes, the elasticity will be,
PED = 2 (PED >1)

(ii) Perfectly elastic demand
- If the value of elasticity is infinity(∞)
- Which means a fall in price will lead to infinite increase in quantity
demanded, while a rise in price leads to Zero demand.
(iii)Inelastic demand
- If the value of elasticity is less than one (PED<1).
- A percentage change in price leads to a smaller percentage
change in demand
-
(iv) Perfectly inelastic demand
- If the value of elasticity is Zero.
- Price change will not have any effect on quantity demanded.
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(v) Unitary elasticity of demand
- If the value of elasticity is equal to one.
- Percentage change in price leads to an exact and opposite
change in quantity demanded.
- The shape of the curve is rectangular hyperbola.
Price elasticity along a straight demand curve
 At point A → PED=(-)∞.
 Point A to B→PED>(-)1 → elastic demand, at point
B →PED>(-)1 → elastic demand.
 At point B(half way along the line)→PED=1.
 At point C→ PED =0.
The determinants of price elasticity of demand.

1- Availability of substitutes:-
- The more substitutes for the product, the higher the price elasticity of demand will be.
- Eg:- Salt (no substitutes)., spaghetti (rice or flour)
2- Width of market definition.
- The more widely the market is defined or considered the fewer will be its substitutes.
- Eg:- spaghetti → many substitutes (elastic) / but food has no substitutes (inelastic).
3- Time:-
- The longer the product is in the market the higher will be the elasticity.
- Eg:- new model car will be more inelastic.
- In the long run, there can be more substitutes, demand would become more elastic.
- In the long run, behavior can be adjusted, so even for habit forming goods, demand would become
more elastic in the long run.
4- Proportion of income spent on commodity

- If less percentage of income is spent on a commodity the demand for that product will be inelastic
(1kg sugar, which costs RF5).
- If more percentage of income is spent on a commodity then demand will be more elastic (Air
conditioner, costs Rf5000).
5- Nature of the good:-

- For necessities, demand will be inelastic (food).
- For luxuries, demand will more elastic (dinner in a restaurant).
6- Influence of habits
- For habit forming goods demand will be inelastic (cigarette).
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The relationship between price elasticity of demand and total revenue.
If the commodity is price elastic (PED>1) a reduction in price will lead to a rise in total revenue and
vice versa.
If the commodity is price inelastic (PED<1) a reduction in price will lead to a fall in total revenue and
vice versa.
If the commodity is Unitary price elastic (PED= 1) a change in price will not have any effect in total
revenue, total revenue remain the same.
Price elasticity of demand and its relationship to revenue concepts.

Here we are going to assume that the market we are studying is imperfectly competitive. You must be
able to explain the relationship between the total revenue curve, the average revenue curve (i.e.
demand) and the marginal revenue curve. Price elasticity of demand (PED) plays a crucial role here as
we saw in Unit 1.
Key Points:
PED varies along the demand curve (AR curve) as
we learnt in Unit 1 and we can label the elastic and
inelastic sections of this curve.
 TR is maximised when MR = 0 (and PED is
unitary)
 AR is the same as price (i.e. AR = P x Q / Q)
and also the demand curve (as it shows the
quantity demanded at different price levels). For
a monopoly to sell more they must lower their
price.
 Also, MR falls twice as fast as AR.
Explanations
a) Why does TR rise up to point B? Refer to
marginal revenue and PED in your answer
• Total revenue will rise up to point B as marginal revenue is positive. This means that each unit
sold will contribute positively to total revenue.
• Furthermore, dropping price (moving down the demand curve from point A to B) will increase
TR as demand is elastic on this part of the demand curve. This means as price falls, quantity demanded
will rise more than proportionately and therefore revenue will rise (remember this from Unit 1).
b) Why does TR fall after point B? Refer to marginal revenue and PED in your answer
• Total revenue will fall after point B as marginal revenue is negative. This means that each unit
sold will subtract from total revenue.
• Furthermore, dropping price (moving down the demand curve from point B towards C) will
decrease TR as demand is inelastic on this part of the demand curve. This means as price falls, quantity
demanded will rise less than proportionately and therefore revenue will fall.
NB. It may seem strange that MR can be negative. It does not mean that you sell the good at a negative
price but that in order to sell that good you have had to lower price on all other goods as well and this
can make total revenue fall as PED is inelastic at this point.
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2- INCOME ELASTICTIY OF DEAMND
- Demand for a good will change if there is a change in consumer’s income.
- The responsiveness of change in quantity demanded to a change in income.
- Formula
-
- OR OR OR
(i) Positive YED

- An increase in income will bring about an increase in quantity
demanded.
- Or a decrease in quantity demanded due to a
decrease in income.
- Normal goods have a positive YED
 Luxury goods (YED >1), the % change
in quantity demanded is greater than % change in
income. Eg:- international air travel tickets.
 Normal necessities (YED<1 (between o
and 1)), the % change in quantity demanded is less than
% change in income.. Eg:- food, power, water, etc.
(ii) Negative YED

- An increase in income will bring about a fall in quantity demanded.
- Or a decrease in quantity demanded due to an increase in income.
- Inferior goods have negative YED.
- Inferior goods are those goods which have superior substitutes.
- EG:- bread – expensive meat, margarine – butter, public transport – own car.
- A Good can be both a normal and an inferior good depending on the level of income.
- Which means a good may be considered as a normal good at low income level but
- as income increases it becomes an inferior good.
- Eg:-bread, desktop, Nokia torch, etc.
(iii) Zero YED

- Change in income will bring about no change in quantity
demanded.
- Eg:- medicine ( if the income increases by 5% there will be
no increase in quantity demand),
Eg.water.
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3- CROSS ELASTICITY OF DEMAND(XED)
- Quantity demanded of a particular good may change according to a change in price of other goods.
- If the price of car increases – leads to a decrease in demand for petrol.
- Cross elasticity of demand measures the responsiveness of change in quantity demanded of one
good to a change in price of another good or
responsiveness of quantity demand to a change in
price of other goods.
-
(i) Positive XED

- An increase in price of one good will lead to an
increase in quantity demanded of another good.
- Substitutes have positive cross elasticity of
demand.
- Eg:- An increase in price of coffee will lead to an increase in demand for tea.
 Elastic:- if XED is greater than one.
 Inelastic:- if XED is less than one.
(ii) Negative XED

- An increase in price of one good will lead to a
decrease in quantity demanded of another good.
- Complements have negative cross elasticity of
demand.
- Eg:- an increase in price of printer will lead to a
decrease in demand for cartridge.
 Inelastic: - if XED is greater than minus
one(between -1 to 0).
 Elastic:- if XED is less than minus one.
(iii) Zero XED

- An increase in or decrease in price of one good will have no change in quantity demanded of
another good.
- The XED of two good which have no relation to each other would be zero.
- Eg:- increase in price of wall paint will have no effect on demand for fertilizers.
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ELASTICITY OF SUPPLY
- Price elasticity of supply measures the responsiveness of quantity supplied to a change in price.
- This means when there is an increase in price to what extent the quantity supplied changes.
Formula
OR OR OR
- Price elasticity of supply will be always positive. Because as supply curve is an upward sloping
curve, when price increases quantity supplied will increase.
- Eg:- price of coal increased from £60 to £80 and quantity supplied of coal increased from 500
to 1000. Calculate the price elasticity of supply.
Step1 Step 2 Step 3 step 4
Different Ranges or Degrees of elasticity
1- ELASTIC SUPPLY(PES>1)
- Value of elasticity is greater than one.
- % change in price will bring about a greater change in quantity
supplied.
2- PERFECTLY ELASTIC SUPPLY:-

- If the value of elasticity is infinity (∞)
- This means if there is rise in price the supply will be infinite.
- If there is a fall in price there will be zero supply.
- Percentage change in price = zero
3- UNITARY ELASTICITY OF SUPPLY (PES= 1):-

- If the value of elasticity is equal to one.
- The percentage change in price equals the percentage change in
quantity supplied.
4- INELASTIC SUPPLY (PES<1):-

- If the value of Price elasticity of supply is less than one.
- A percentage change in price leads to a smaller percentage change
in quantity supplied.
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5- PERFECTLY INELASTIC SUPPLY
- If the elasticity is zero
- Here there is no change in quantity supplied due to a change in
price.
- Percentage change in quantity supplied = zero.
Factors effecting Price Elasticity of Supply

1) Time Scale:
- Short term after a price rise – price elasticity of supply is low –
can’t quickly increase supply.
- Long term – more price elastic – increasing supply more easily.
True at any point where a supplier is unable to respond to a higher price.
2) Spare Capacity:
- If there are spare resources – supply can be raised to meet an unexpected increase in demand
e.g. paying workers to work overtime, therefore PES is higher.
- Firm/industry operating at full capacity – supply is inelastic.
- Recession – lots of spare/unemployed resources – S can be increased more easily.
3) Stocks of raw materials/components/finished products:

- High levels of stocks – firms can increase supply quickly – PES is higher.
- If a good is perishable, e.g. flowers, it can’t be stocked for long therefore supply is more
inelastic.
4) Factor Substitutability:
- Firm can increase supply by converting factors of production towards the output where P is
rising.
- May take time – some factors are more flexible than others, making PES for them higher.
5) Ease of entry into an industry:

- High entry barriers – difficult for new firms to enter even with prices rising – PES is lower.
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1.3.4 Price determination 1 Determination of market equilibrium. Equilibrium price and
quantity and how they are determined. The use of a supply and demand diagram to show how
shifts in demand and supply curves cause the equilibrium price and quantity to change. The
operation of market forces to eliminate excess demand and excess supply.
Market Equilibrium a price where the quantity demand equals the quantity supply
The equilibrium price is called the market clearing price: the price at which there is neither excess
demand nor excess supply. This is simply where demand = supply, as illustrated below:
If the price is above the
Price equilibrium there will be
excel supply but the free
S market forces will eliminate it
and equilibrium will be
E0 settled at E0.
P0
If the price is below the
equilibrium there will be
excess demand but market
forces will eliminate it and
D
brings it back to market
equilibrium E0.
Quantity
Q0
NB. We are assuming we are in a free market
As this is a free market it is producers and consumers who will determine the price and quantity.
Market forces will ensure that the price tends towards the equilibrium, there is no need for
Government intervention. Only if the market fails to do this would a Government intervene (e.g. for
goods which no one would be willing to purchase like street lighting).
How shifts in demand and supply curves cause the equilibrium price and quantity to change
Key Points
 Initial equilibrium will be where D = S

 Increase in supply caused by increased productivity. This causes a shift in the supply curve to
the right and a movement along the demand curve (i.e. an expansion in demand)
 Increase in demand caused by advertising (not the price fall) will shift demand to the right and
a movement along the supply curve (i.e. an expansion in supply).
 New equilibrium is where D1 = S1
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Evaluation: what will happen to price and quantity?
The impact on equilibrium price and quantity depends on the strength of each factor (i.e. how much
each curve shifts), as well as the shape / elasticity of each curve.
3 Functions of the price mechanism

. The rationing, incentive and signalling functions of the price mechanism for allocating scarce
resources.
. The price mechanism in the context of different types of markets, including local, national and global
market.
The Price Mechanism Where the free markets allocate resources through the interaction of
demand and supply
Functions of the price mechanism
Signalling, Incentive and Rationing Functions
1) Signals. Prices reflect market conditions and send signals to agents. An increase in demand causes
prices to rise and signals to firms to increase quantity supplied. An increase in supply causes prices to
fall and signals to consumers to increase quantity demanded.
2) Incentives. Incentives affect choices. Higher prices incentivize producers to increase quantity
supplied because they can earn higher profits. Lower prices incentivize consumers to increase quantity
demanded because they can buy more goods per £ spent.
3) Rationing. At the market price for a good, only those consumers with sufficient effective demand
can buy the good, those with a lower effective demand cannot buy the good. So goods are rationed by
prices. As resources (and therefore goods) become less scarce, supply becomes more plentiful, price
falls and more consumers can buy the good.
Example of the Price Mechanism: UK Broadband
In a free market goods and services are allocated by demand (consumers) and supply (producers). In
this example we see how resources are reallocated when consumers increase their demand for
broadband.
1. If there is an increase in consumer demand for Broadband Internet, then this will signal to
producers that Broadband is a profitable market.
2. There is therefore an expansion in supply to take advantage of this incentive
3. The new higher price rations who buys Broadband.
Example of the Price Mechanism: World Oil Supply
This time we are going to see the functions of the price mechanism responding to a change in supply
i.e. world oil supplies depleting.
1. If there is a decrease in the world oil supply then the oil price will rise. This higher price will signal
to consumers that consuming oil is less desirable due to the high cost.
2. There is therefore a contraction in demand as there is an incentive for consumers to switch to

renewable energy sources or reduce oil consumption (e.g. switching to public transport).
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3. The amount of oil used has been rationed and will help to stop the decline in oil supplies. Only
those with higher incomes will be able to continue purchasing oil on a large scale.
These can be illustrated on the diagram below:
2 Consumer and producer surplus

. The distinction between consumer and producer surplus.
. The use of a supply and demand diagram to illustrate consumer and producer surplus.
. How changes in demand or supply might affect consumer and producer surplus.
Consumer surplus and producer surplus.
What’s Consumer Surplus?
Consumer Surplus The difference between what consumers are willing and able to pay for a
good and what they actually pay.
In the diagram, the demand curve shows the price consumers

are willing and able to pay for each unit and the equilibrium
price is P*. Consumer surplus is therefore represented by the
shaded area under the demand curve but above the equilibrium
price.
What’s Producer Surplus?
Producer Surplus The difference between the market price which firms receive and
the price at which they are willing and able to supply.
In the diagram above, the supply curve shows

how much of a good will be supplied at any
given price and P* is the equilibrium. Producer
surplus is therefore represented by the shaded
area above the supply curve but below the
equilibrium price.
Consumer & Producer Surplus: measures of

welfare
Consumer surplus shows the extra satisfaction that consumers get if the price is at P*. Some consumers
valued the product at more than P* and have therefore ‘got a bargain’ – their welfare has increased.
The total level of consumer welfare equals consumer surplus.
Similarly, producer surplus shows the welfare of producers. According to the supply curve they would
be willing to accept a lower price than P*. The producers therefore get extra profit and their welfare
increases.
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Changes in demand and supply
When demand and supply changes there are also changes in consumer and producer surplus.
Activity: Changes in Consumer and Producer Surplus
Analyse how producer and surplus change when:

a) Demand increases and decreases
b) Supply increases and decreases Use diagrams to illustrate your answer.
EXTENSION: how does the steepness of the curves affect your answer?
a
INDIRECT TAXES AND SUBSIDIES

INDIRECT TAX
- An indirect tax is a tax on expenditure (goods and services).
- There are 2 types of indirect taxes.
- There are mainly 2 types of indirect tax levied in UK; excise (a unit tax) duty and VAT (an
advalorum tax).
i. Unit or specific tax
ii. Advalorum tax
1- Unit or specific tax (excise duty):-
an indirect tax or specific tax or expenditure tax / set as a fixed amount per unit of good .
Diagrammatic analysis or written explanation: parallel shift of supply curve inwards / tax area
or incidence identified / original price and new price identified on the diagram .
2-
- Specific amount per each unit (amount fixed).
- The amount of tax levied does not change with the value of the good, but with the amount or
volume of goods purchased.
- Eg:- Excise duty on fishcan will be the same whether a can costs 2 or 20
- Main excise duties in UK are levied on Alcohol, tobacco and petrol
3- Advalorum tax (value added tax/ goods &services tax):-
- It is a percentage tax.
- The tax levied increases in proportion to the value of the tax base. The tax base is the price of
the good.
- In simple words as price increases tax will increase.
- Amount of tax per unit is not fixed.
- Amount of tax per unit is based on the value (price), of the good.
Tax Revenue:- is the revenue that the govt earn from tax.
- Tax revenue = Per unit tax × Quantity
THE INCIDENCE OF TAX

Incidence of tax: upon who the burden of taxation falls onto.
- Incidence of tax means the tax burden on the tax payer.
- Here we will be checking who bears the burden of tax, whether it’s the consumer or supplier.
1- Unit or specific tax:-
- Suppose the government imposed a specific tax of AB or CD per can of fish.
- This will reduce the supply. Hence the supply curve will shift to left (parallel shift). Price
increases form F to C and quantity decreases from Q1 to Q2.
18
Form the diagram, when tax is imposed there is increase in price
by FC.
This is because the tax burden does not fall completely on the
consumer.
 Consumer’s tax burden is FCAG.
 Producer’s tax burden is DFGB.
 Total govt tax revenue is DCAB.
 Producers revenue before tax is O,F,e1,Q1
 Producers revenue after tax – ODBQ2
2- Advalorum tax:-
tax that is levied as a percentage of the value of the good
- Tax is levied on the price of good.
- Imposition of an advalorum tax will lead to an upward shift in the supply curve.
- There won’t be a parallel shift; it will be a pivotal shift, as price increase the tax per unit will
increase.
 Incidence of per unit tax on consumer – AC

 Incidence of per unit tax on producer – AB
 Total govt tax revenue is CBFD
 Producers revenue before tax – O,A,e1,K
 Producers revenue after tax – OBFJ
Subsidies
subsidy government grant to increase production / reduce price of a good ,subsidy acts to reduce
production costs.
- Direct or indirect payment, economic concession, or privilege granted by a government to
private firms, households or govt units, inorder to promote a public objective.
- A grant given by govt to encourage production or
consumption.
- When a subsidy is given it will lead to a shift in Supply
curve to right from S1 to S2. (WhenSubsidy is given cost of
production will fall).
- Even though a subsidy of AC is given the price will not fall
by AC.
- The price fall enjoyed by consumer will be only BA.
- The rest BC,will be used by producer to cover the cost of
production of increase in output or as profit.
- Producer’s benefit from subsidy is BCDF.
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- Consumer’s benefit from subsidy is ABFG.
- ACDG is the total govt spending on subsidy
TAXES, SUBSIDIES AND ELASTICITY

The extent to which the tax incidence fall on consumers or producers depends on the elasticity of
demanded and supply.
Elasticity:-
The responsiveness of change in quantity demanded or supplied to a change in price or the
responsiveness of quantity demanded or supplied to a change in price.
Supply being perfectly elastic
 Producer is sensitive to price. A small drop in price will lead to a

fall in Supply to zero.
 The more elastic the SS the higher will be tax burden on
consumer.
 The government tax revenue will be less as supply is perfectly
elastic.
 If a subsidy is given, the subsidy will be enjoyed by the consumer.
Demand being perfectly inelastic
 Consumer will demand the same quantity no matter what price.

 The more inelastic the demand is the higher will be consumer’s tax
burden.
 Government tax revenue will be high as demand is perfectly
inelastic.
 If a subsidy is given, the subsidy will be enjoyed by the consumer.
Supply being perfectly inelastic
 When supply is perfectly inelastic, the producer will produce the

same quantity no matter what price.
 The more inelastic Supply the higher will be producer’s burden.
 Government tax revenue will be high as supply is perfectly
inelastic.
 If a subsidy is given, the benefit will be on producer.
Demand being perfectly elastic

 Consumer is sensitive to price, a rise in price will lead to zero
demand.
 The more elastic demand is the higher will be producer’s burden.
 Government tax revenue will be less as demand is perfectly elastic.
 If a subsidy is given, the benefit will be on producer.
20
THE LABOUR MARKET
- The labour market is a factor market (land, labour& capital).
- Price of labour is wage. Wage is price per unit of time to hire a single worker (per
hour/day/month/year).
- In free market, the price of labour is determined by the forces of demand and supply.
Demand for labour:-

The demand for labour is known as derived demand — this means that demand for labour is
determined by demand for the goods and services that they produce. Businesses will demand more
labour if there is a high demand for the goods and services they produce, for example at times of
economic boom.
Demand for labour also increases if workers are more productive, or if capital becomes more
expensive (labour and capital are substitutes).
- Supply of labour:-
- Labour is supplied to market by individuals
- And they supply only for an incentive they give up their leisure and other time.
- Main incentive is pay or wage. (Others also work for charitable cause, or for the experience of
working with others).
DEMAND AND SUPPLY CURVE OF LABOUR

Demand curve of labour:-
- Wage is a factor influencing demand of labour.
- As wage increase demand for laobur decrease. There are two reasons for this:-
 If wage rate increase and price of capital
remain same then producer will replace
labour with capital. Hence demand for
labour will fall.
 When wage rate increase the cost of production

will increase. Hence producer will pass on the
cost to consumer, supply will shift to left, as a
result price increases. When price of good is high
demand for commodity will fall which leads to a fall in demand for labour that produce this good.
Supply curve of labour:-
- Supply is also influenced by price of labour wage rate.
- Higher the wage rate higher will be the supply of labour because
workers will be attracted to work in such a market.
- Eg:- wage of carpenters increase in UK – people start to train as
carpenters, carpenters form other areas will come to UK.
o Equilibrium wage is OB and
Employment level is OA.
- If the wage rate is not in equilibrium

then market forces act to return it to
equilibrium.
- Suppose if the wage rate is at OW2 (above equilibrium).
 There will be excess Supply of labour of BC.
21
 OB has jobs – BC unemployed.
 With this excess BC workers – producers will be able to offer lower wage of OW1 and attract
BA of labour.
 If wage is below OW1 – there will be excess dd- increase in wage. In such a cause there will be
shortage of BC.
FACTORS AFFECTING THE DD FOR LABOUR( Shift)

- Number of other factors other than wage which effect demand
1- The price of other factors of production:-

- If the price of other factors of production such as machinery or raw material change, then demand
for labour will change.
- Eg:-as machines and labour are substitutes. When price of machines fall, machines become
relatively cheaper than labour and demand for labour falls.
- Raw materials and labour are complements. When price of raw materials increase, cost of
production increase hence production falls and demand for labour will also fall.
2- The price of other workers:-
- The demand for labour in one market will be affected by wage rate in another market.
- Due to globalization more goods are produced abroad in places where labour is cheap such as
china, India, etc. – demand for labour in china and India will increase – demand for labour in UK
will fall.
3- New technology:-
- Means introduction of new machinery which replaces labour and demand for labour will falls.
- But demand for labour servicing new machine will increase.
4- Increased efficiency:-
- Means fall in per unit labour cost.
- Firms find new ways of increasing output with same input, which will reduce per unit labour. As a
result demand for good will increase due to fall in price, hence demand for labour increases.
5- Demand for the product:
- If demand for the product that labour makes increases – it will increase demand for labour.
i- Substitutes:- if the price of substitute (tea) falls – demand for the product (coffee) will fall –
demand for labour (coffee maker) will fall.
ii- Complementary goods:- if the price of complementary (printer) good increase – demand for
product (cartridge) will increase – labour’s (worker who makes cartridge) demand will
increase.
FACTORS AFFECTING SUPPLY OF LAOBUR(shift)

1- Natural population changes:-
- Developing countries birth rates are high, - there are large number of young people entering the
work force each year →Supply increases → wage will fall.
- In developed countries like japan & EU the problem is completely opposite (few young worker).
2- Migration:-
- Often migration takes place from developing countries to developed countries.
- Eg:- Africa, west Asia, low waged countries to Eastern Europe
i- Immigration:- to developed countries – supply of labour will increase – wage rate will fall.
ii- Emigration:- from developing countries – supply of labour will fall – wage rate will increase.
22
3- Welfare benefits: the greater the welfare benefits, the less will be the supply of labour.
a. Higher unemployment benefits-incentive for unemployed to take longer to find right job
b. Higher pension benefits-discourage old from staying in work
c. Higher sickness benefits –more days off for sickness benefit
4- Income tax, and National Insurance Contributions: when individuals work, they earn more
---But when the Income tax and National Insurance Contributions increase,
The disposable income decreases, discouraging people to work.
The tax reduces wage rate. Therefore the higher the tax, the lower will be the supply of
labour.
Effect of Marginal tax rate: how much tax will a worker pay
How much will the wage rate after tax be
If an extra hour or day or week is worked. Eg: Rf 100 (no tax)
No incentive to work Rf 120 (25% tax)
More incentive to work If marginal tax rate is 5%, or even 10%
5- Government regulations: protect Labour, increase cost of employing
a. Rights to holiday entitlement
b. Minimum wage: Introduction of minimum wage, will all increase the supply of labour
c. Minimum standard of living
d. Welfare benefits, etc.
6- Trade Unions: organizations that represent workers, aimed at increasing the welfare of the
workers. Represent in pay negotiations, pushing up the wage rates from what they would
otherwise have been.
Elasticity of demand for labour
Degree of responsiveness of demand for labour to a change in wage rate.
• Formula: %Δ Quantity demand for labour ÷ %Δ wage rate
• Be prepared to undertake simple calculations
Determinants of elasticity of demand for labour:
titution of labour with other factor inputs such as capital
Elasticity of supply of labour

Degree of responsiveness of supply for labour to a change in wage rate.
• Formula: %Δ Quantity supply of labour ÷ %Δ wage rate
• Be prepared to undertake simple calculations
Determinants of elasticity of supply of labour:
mobility of labour
experience, qualifications) Training period.
Minimum wage
- the legal amount which labour cannot be paid below.
- Minimum wage is imposed by govts in order to raise very low income to a minimum level.
equilibrium level of employment is OA, wage OW1
A minimum wage rate of OW2 is imposed by govt.
Employers will reduce demand for labour from OA to OB because wage
rate is high.
At the high wage, more workers want to work, supply of workers increase
from OA to OC.
Actual level of employment is OB – the amount employers wish to hire.
23
BC workers who want a job but unable to get one.
Conclusion: Minimum wage at national level would:

- Raise wage rate
- Create unemployment (raise wage at the cost of increasing unemployment)
Elasticity and Unemployment:

a- The more elastic D&S: the more will be unemployed due to minimum wage
- The more inelastic D&S: the less will be unemployed due to minimum wage
Factors effecting price elasticity of demand of labour:-

- Substitutes (machines).
- Demand for the good:- if demand of good is elastic then demand for labour will also be elastic as
labour has a derived demand.
- Time (training period).
Maximum wages
Maximum wages is a legally set cap on wages in a particular occupation.
Maximum prices is a legally set cap on price of a good or service.
• Apply to different contexts e.g. football, private rental sector, bank bonuses, gas and electricity
prices.•
Consider the effects of a maximum wage or price set above the free market equilibrium position (no
effect). Maximum wages and maximum pricing. Diagram to show effects of a maximum wage / price
set below the free market equilibrium – excess
demand
24
Labour Mobility
Occupational mobility
Occupational mobility refers to the ability of workers to transfer from one occupation to another at an
individual level. eg:a teacher becoming an accountant.
Some jobs require only general work skills. Eg: cleaners; while other jobs require particular
knowledge and aptitude skills. Eg: doctor.
25
Immobility of labour
Though in theory labour maybe mobile in several ways, in practice there are varieties of barriers to
mobility of labour. Labour can be highly immobile, difficult to move from job to job.
Geographical immobility of labour:
This is when workers find it difficult to move from one area to another in search of a job due to
individual reasons as follows:
1. Search costs: people in one city maybe not be aware of what jobs are available in the other
city, it will be too costly to go to another city and struggle to find a job.
2. Personal immobility: even if people may find a job in another city or area, they may not be
willing to leave the family and friends and move so far. Many workers are unwilling to leave
their geographical area because they feel they have strong roots there.
3. Cost of housing:
a. Workers who rent their accommodation from social landlords like the local council or a
housing association may not be able to get a new house if they move elsewhere. Alternative
b. Alternative private rented accommodation may be much more expensive or unsuitable.
c. If the workers own their own home, house prices in the area they wish to move to may be
much more expensive.
d. Selling a house is also a major cost in itself.
Therefore, the lower the income of an individual, the greater is housing a barrier to
mobility.
occupational labour immobility /

Immobility labour unable to change occupations to take available work. A decrease in training
programmes for the unemployed means they may lack appropriate skills / qualifications /work
experience for a particular job)
In short term, it is very difficult for workers to transfer from one occupation to another and in many
cases it is impossible. In the long term it becomes more possible, although the cost to the individual
may be very high.
Government policy
Governments use a variety of policies to tackle the immobility of labour.
1. Education and training:
In the long term, education provides young people with the skills to compete in the labour market.
a. Government spending on education is increasing in the western world and large proportions of
young people are being educated to a higher level.
b. Importance is also given to adult learning with universities offering adult students a chance to gain
qualifications.
c. Directly, or indirectly, government also subsidisesshort term training by firms.
2. Relocation subsidies and housing:
Governments may provide a variety of financial incentives for workers to move to where there are
jobs. Eg: provide cheap accommodation, or grants for first few months of work.
3. Relocating industry:
a. Government could have Regional policy to take work to the workers rather than taking workers to
work. This can be achieved by offering grants to firms locating in high unemployment areas.
Advantage:
i. This policy would be very helpful as workers are too immobile to expect workers to
move to regions where there were job vacancies.
ii. This will also prevent over crowding and over-population in the low unemployment
regions such as major cities.
26

WECO1 DD-SS-EL, DL Notes Notes 2

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1.3.

2 Demand and consumer behaviour

Demand and Utility

Demand for DVDs: an example of a demand curve

The demand schedule for DVDs for 2012

Demand before Demand now

Illustrate these changes on the demand curve below:

In general factors that affect demand are:

A decrease in Demand shift D1 to

Qualifications to assumption of rationality

Glass of soft Total Utility Marginal Utility

Total utility Marginal = Marginal = Marginal

Rationality- consumers aim to maximise utility by making rational choices.

Irrationality- that consumers do not always aim to maximise utility

The Supply Curve for Wheat

SUPPLY SCHEDULE FOR WHEAT

Why is supply upward sloping?

Movements along the supply curve

Supply before Supply now

Illustrating Shifts in Supply An increase in supply shows

A decrease in supply shows a

Joint Supply When an increase of supply of good X, means more is automatically

Competitive Supply When an increase in price of good X, leads to a contraction in supply

(i) Elastic demand

PED = 2 (PED >1)

Price elasticity along a straight demand curve

The determinants of price elasticity of demand.

4- Proportion of income spent on commodity

5- Nature of the good:-

Price elasticity of demand and its relationship to revenue concepts.

(i) Positive YED

(ii) Negative YED

- as income increases it becomes an inferior good.

- Eg:-bread, desktop, Nokia torch, etc.

(iii) Zero YED

(i) Positive XED

(ii) Negative XED

(iii) Zero XED

Step1 Step 2 Step 3 step 4

Different Ranges or Degrees of elasticity

2- PERFECTLY ELASTIC SUPPLY:-

3- UNITARY ELASTICITY OF SUPPLY (PES= 1):-

4- INELASTIC SUPPLY (PES<1):-

Factors effecting Price Elasticity of Supply

3) Stocks of raw materials/components/finished products:

5) Ease of entry into an industry:

 Initial equilibrium will be where D = S

3 Functions of the price mechanism

Functions of the price mechanism

Signalling, Incentive and Rationing Functions

Example of the Price Mechanism: UK Broadband

Example of the Price Mechanism: World Oil Supply

2. There is therefore a contraction in demand as there is an incentive for consumers to switch to

These can be illustrated on the diagram below:

2 Consumer and producer surplus

Consumer surplus and producer surplus.

What’s Consumer Surplus?

In the diagram, the demand curve shows the price consumers

What’s Producer Surplus?

In the diagram above, the supply curve shows

Consumer & Producer Surplus: measures of

Activity: Changes in Consumer and Producer Surplus

Analyse how producer and surplus change when: