Micro Unit 2 Notes

Demand
Market: an institution or mechanism, which brings together buyers ("demanders") and sellers
("suppliers") of particular goods and services.

EK: A well-defined system of property rights is necessary for the market system to function well.

EK: Individuals often respond to incentives, such as those presented by prices, but also face constraints,
such as income, time, and legal and regulatory frameworks.

Three questions the market can answer. Any economic system should be able to answer these
questions.
1) The market decides what will be produced.
2) The market decides how things will be produced?
3) The market decides for whom the products will be produced.

Demand-
The number of units of a good or service that a buyer is willing and able to buy at various prices.

Quantity Demanded: The number of units of a good or service that a buyer is willing and able to buy at
a specific price.

Price ($) Quantity Demanded

This is what we call a demand schedule. It is a table that shows how much consumers are willing and
able to purchase at various prices.

You can have a demand schedule for an individual or a market. The market demand curve is just the
summation of all the individuals demand curves.

In looking at the table you will notice that as the price decreases quantity demanded (notice not your
demand) increases.

The law of demand: a change in the own-price causes a change in quantity demanded in the opposite
direction and movement along a demand (marginal benefit) curve.

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 This is what is called a DEMAND CURVE: A graph of a demand schedule: a demand curve is drawn on
the assumption that everything except the commodity's own price is held constant (ceteris paribus) a change
in any of the variables previously held constant will shift the demand curve to a new positions.

There are three main reasons for a downwardly sloping demand curve.
1) The income effect
2) Substitution effect
2) The Law of Diminishing Marginal Utility.

Income effect: The lower the price the more one can afford of a good without giving up other goods.
If the price of one good declines, you also have more money to buy more of other goods.

Substitution effect: at a lower price, you have the incentive to substitute the cheaper goods for similar
goods, which are now relatively more expensive

Law of Diminishing Marginal Utility: The utility any household derives from successive units of a
particular commodity diminishes as total consumption of the commodity increases while the consumption
of all other commodities remains constant

A decrease in price leads to an An increase in price leads to a

increase in Quantity Demanded decrease in Quantity Demanded

DETERMINANTS OF DEMAND:
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When a determinant changes the demand curve shifts. The direction of the shift comes from the
determinant that causes the change.

Increase in Demand Decrease in Demand

1) CONSUMERS INCOMES: a rise in average household income shifts the demand curve for most
commodities to the right. This indicates that more will be demanded at each possible price. The direction
of the shift depends on whether the good is inferior or normal (also called superior).

Normal Goods (aka Superior): those goods whose demand varies directly with income.

Increase in income will lead to increase in demand for the normal good
Decrease in income will lead to decrease in demand for the normal good

Inferior Goods: those goods whose demand varies inversely with income.

2) CONSUMERS TASTES AND PREFERENCES: A change in tastes and preferences in favor of a

commodity shifts the demand curve to the right more will be bought at each price.

If people prefer more of a product you will get an increase in demand. If they prefer less of a product you
will get a decrease in demand.

3) THE PRICE OF COMPLEMENTARY GOODS: A fall in the price of a complementary commodity

will shift a commodity’s demand curve to the right.

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 Decrease in price of chips Increase in demand for dips

Given an increase in the price of chips will cause demand curve for dip to decrease.
(Can you graph this?)

4) THE PRICE OF SUBSTITUTES: A rise in the price of a substitute for a commodity shifts the
demand curve for the commodity to the right.

Increase in the price of cereal Increase in the demand for pop tarts

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5) CHANGE IN POPULATION: A rise in population will shift the demand curves for commodities to the
right, indicating that more will be bought at each price. (THIS ALSO INCLUDES NEW MARKETS.)
A decrease in population will shift the demand curve for the commodity to the left.

6) CONSUMER EXPECTATIONS ABOUT PRICE: If consumers expect prices to rise in the near
future the demand for goods will increase. (Increase in Demand)
If consumers expect prices to fall in the near future the demand for goods will decrease. (Decrease in
Demand)

7) CONSUMER EXPECTATIONS ABOUT INCOME: If consumers expect overall incomes to fall the
demand will decrease now.

*** You must know the difference in a change in demand and a change in quantity demanded.

SUPPLY: The number of units of a good or service that a seller is willing and able to sell at various prices.

EK: The market supply curve (schedule) is derived from the summation of individual supply curves
(schedules). The market supply curve is upward-sloping.

SUPPLY SCHEDULE: A table that shows how much sellers are willing and able to supply at various
prices.

LAW OF SUPPLY: A change in own-price causes a change in quantity supplied in the same direction and
a movement along a supply curve.

Supply curve
A decrease in price leads to a decrease in Quantity
Supplied.

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 Increase in Supply Decrease in Supply

DETERMINANTS OF SUPPLY

1) RESOURCE PRICES:
A rise in the price of inputs shifts the supply curve to the left indicating that less will be supplied at any
given price.
A fall in the price of inputs shifts the supply curve to the right.

2) TECHNOLOGICAL CHANGE:
A decrease in production costs will increase the profits that can be earned at any given price of the
commodity. This change shifts the supply curve to the right.

An increase in production costs will decrease the profits that can be earned at any given price of the
commodity. This change shifts the supply curve to the left.
3) TAXES
An increase in the taxes will shift the supply curve to the left.

4) SUBSIDIES:
A subsidy is a payment to a company to produce (or not produce) something. This makes it cheaper
for the company to produce so the supply curve shifts to the right.

5) EXPECTATIONS:
If the supplier expects future profits of their good to rise they will decrease the supply of the good now.
This will shift the curve to the left.

If the supplier expects future profits of their good to fall they will increase the supply of the good now.
This will shift the curve to the right.

6) NUMBER OF SELLERS:
An increase in the number of sellers will shift the supply curve for the product to the right.

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The price at which the quantity demanded equals the quantity supplied is called the equilibrium price.

Equilibrium is defined as a state of balance between opposing forces. What are these forces?

What happens to equilibrium when one of the determinants of demand change?

In this case a determinant of demand causes an increase in demand. This caused the price to increase and
the quantity to increase.

Can you draw a decrease in demand?

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What happens to equilibrium when the one of the determinants of supply change?

In this case a determinant of supply causes an increase in supply. This caused the price to decrease and the
quantity to increase.

Can you draw a decrease in supply?

What happens if both supply and demand shift? In economics we do not deal with absolute terms. That
means we do not really know how far the curves shift. This means that any time you shift both curves,
either Quantity or Price will not be able to be determined. (Indeterminate)

Increase in S and an increase in D.

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 Decrease in S and a decrease in D.

Decrease D and Increase supply

Increase D and Decrease supply

Market Equilibrium and Consumer and Producer Surplus

EK: Equilibrium price provides information to economic decision-makers to guide resource allocation.
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 Consumer Surplus: the difference between the
market price and the maximum price the consumer
would pay to obtain that unit.

Producer Surplus: the difference between the market

price and the minimum price the producer would be
willing to take for the product.

EK: Market equilibrium maximizes total economic surplus in the absence of market failures, meaning that
perfectly competitive markets are efficient.

Shortage:
In this case the producer has set the price too low.
This means quantity demanded is much higher than
quantity supplied.

This market is not in equilibrium. As sellers realize

they can not keep the product on the shelves, they
will raise the price. The market will work its way
to equilibrium.

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 Surplus
In this case the producer has set the price too high.
This means quantity demanded is much lower than
quantity supplied.

This market is not in equilibrium. As sellers realize

they are not selling as much of their product as they
want at this price, they will lower the price. The
market will work its way to equilibrium.

Elasticity
EK: Economists use the concept of elasticity to measure the magnitude of percentage changes in quantity
owing to any given changes in the own-price, income, and prices of related goods.

What happens when price decreases?

The responsiveness, or sensitivity, of consumers to a change in the price of a product is measured by the
concept of Price elasticity of demand.

Simply put, if consumers respond (relatively) to a change in price it is said to be elastic. If they do not
respond (relatively) to a change in price the product is said to be inelastic.

What would you expect elasticity to be if the price decreased by 1% and Qd increased by 4%.

A one percent change in price leads to a smaller change in Qd is inelastic.

EK: Price elasticity of demand is measured by the percent change in quantity demanded divided by the
percent change in price or the responsiveness of the quantity demanded to changes in price.

Percent Change: Change

Original

Ed= % change in quantity demanded of product X

% change in price of product X

Because of the law of demand this number will always be negative. Ignore negatives.

This number tells us that a 1% change in price leads to a x percent change in Qd.

EK: Elasticity varies along a linear demand curve, meaning slope is not elasticity.

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 Less than one is inelastic. More than one is elastic. One is unitary.

Demand is elastic if a given percentage change in price results in a larger percentage change in quantity
demanded. (a 4% increase in price results in a 8% decline in QD.)

Demand is inelastic if a given percentage change in price is accompanied by a relatively smaller change in
quantity demanded. ( a 4% increase in price results in a 2% decline in Q.D.)

When a given percentage change in price is accompanied by an identical change in quantity demanded this
is said to be unitary elastic.

The Total-Revenue Test

If demand is elastic a decrease in price will result in an increase in total revenue. This means that at
the lower price more units are being bought. This offsets the lower price.

TR = P x Q

When you calculate TR you can look at it graphically.

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If demand is elastic a change in price will result in a change in TR in the opposite direction.
If a 3% decrease in price leads to a 5% increase in Q. 5% divided by 3% is elastic. This means TR will be
going up.

If demand is inelastic a change in price will result in a change in TR in the same direction. (Ex: If
price increases total revenue will also increase. People cannot do without the product so they will buy it no
matter how high the price.) If a 5% decrease in price leads to a 3% increase in Q. 3% divided by 5% is
inelastic. This means TR will be going down.
If demand is unitary elastic a change in price will have no change in total revenue.

Elastic demand curve vs. Inelastic demand curve

There are four things that go into determining the elasticity of a demand curve.
1) Luxuries versus necessities. This is what we have been discussing. Your quantity demanded for
heart surgery will not change much with the change in price.

2) Availability of substitutes. The greater the number of substitute the more elastic the product.

3) Proportion of income. The greater the price of a good relative to one's budget, the greater the
elasticity of demand.

4) Time: The longer the time period the more elastic a demand curve becomes.
A good is perfectly inelastic when there will be no change in quantity demanded no matter what the %
change in price. ex. Medicine

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 A good is perfectly elastic when there is a major change in quantity demanded when there is a small %
change in the price. ex:

Price Elasticity of Supply:

If suppliers are responsive to price changes the supply is elastic.

If suppliers are not responsive to price change the supply is inelastic.

This is the exact formula used in Ed except you substitute supply for demand.

Es= % change in quantity supplied of product X

% change in price of product X

Less than one is inelastic. More than one is elastic. One is unitary.

Elasticity of Supply depends on

1. Availability of substitutes: The more availability of resources to produce the product the more elastic the
supply for that product. Sellers respond to changes in price if they are able to easily substitute inputs.

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2. Time: If they have to sell in now, they are not responsive to prices (inelastic) For example, once apples
are ripe, they have to sell them very soon. They do not have time to wait for the price to change.

In dealing with price elasticity you are dealing with movement along the curves. For Cross Elasticity and
Income Elasticity you are dealing with movement of the curves.

CROSS ELASTICITY OF DEMAND: measures how sensitive consumer purchases of one product are to
the change in price of some other product.

Exy= % change in quantity demanded of product X

% change in price of product Y

If cross elasticity is positive: quantity demanded of X varies directly with the price of Y then X and Y
are substitute goods.

If cross elasticity is negative: quantity demanded of X varies inversely with the price of Y then X and Y
are complementary goods.

If the cross elasticity is near zero then the goods are independent goods and are unrelated.

INCOME ELASTICITY OF DEMAND: measures the percent change in quantity of product demanded
which results from the percent change in consumer income.

Ey= % change in quantity demand

% change in income

Remember that income is one of the determinants of demand. When income changes you get a change in
demand rather than a chance in quantity demanded.

For normal or superior goods the higher the income the more of a product a person will purchase.
(The higher the Ei the more likely that people will purchase the good as the income increases.) This will
yield a positive number.

For inferior goods the Ei will be low. The higher the income the less likely they will purchase the
good or service. (used clothes, ...) This will yield a negative number.

Government Intervention
Enduring Understanding: Government policies influence consumer and producer behavior and therefore
affect market outcomes.

EK: Government intervention in a market producing the efficient quantity through taxes, subsidies, price
controls, or quantity controls can only decrease allocative efficiency.

PRICE CEILING: The maximum legal price a seller may charge for a product or service.

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 This allows people to purchase G&S at a lower price
than they would have otherwise been able to get it
for. This allows many a chance to afford these
things.

A price ceiling is below equilibrium point.

A ceiling keeps the price low and does not

allow the market to drive the price up. This keeps
buyers in the market that would have otherwise
gotten out. At that price the quantity supplied and
the quantity demanded cannot reach equilibrium.
Hence a shortage.

PRICE FLOORS: Minimum prices fixed by government which are above equilibrium prices.

The floor keeps the price above the equilibrium.

Suppliers are willing to increase Qs at this artificial
price while some demanders are driven out of the
market. The net result is a surplus.

Combined consumer and producer surplus after the ceiling

EK: Deadweight loss represents the losses to buyers and sellers as a result of government intervention in an
efficient market.

EK: Governments use taxes and subsidies to change incentives in ways that influence consumer and
producer behavior, shifting the supply and demand curves.

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Increase in tax on producer decreases supply. Increase in tax on consumer decreases demand. Increase in
subsidy to producer increases supply, a consumer subsidy (tax incentive) increases consumer demand.
(YOU HAVE TO KNOW HOW TO DRAW ALL OF THESE SITUATIONS)

EK: Taxes and subsidies affect government revenue or costs.

EK: The incidence of taxes and subsidies imposed on goods traded in perfectly competitive markets
depends on the elasticity of supply and demand.

Tax incidence: income lost as a result of the taxes after tax shifting.

At the current market the price is $12 and the quantity is 100.

Now let’s go in and put a government tax of $2 on this product. This will cause the supply curve to shift
back the equivalent of $2. (Notice the distance between the lines at any quantity will be $2. (Why does
this shift occur?)
Businesses do not absorb all of the taxes imposed. They attempt to pass this on to their customers.

Yet, they are only paying part of the tax. The other part is passed on to the consumer in the form of higher
prices.

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 When a tax is imposed since both consumer and
producer are giving part of the money to the
Government, they both lose surplus.

You also have Deadweight Loss.

Elasticity:

EK: Factors that shift the market demand and market supply curves cause price, quantity, consumer surplus,
producer surplus, and total economic surplus (within that market) to change. The impact of the change
depends on the price elasticities of demand and supply.

Given supply, the more inelastic the demand for the product the larger the portion of the tax shift
forwarded to consumer.

Elastic Demand Inelastic Demand

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The area between P and Pe is the increased price charged to the consumer and the area between P and Pa is
the increase price charged to the producer.

Look at the difference in the two. Notice the change in quantity. WHY IS THIS SO?

This is why taxes on gas, alcohol, and cigarettes work so well. They have very inelastic demand.

Given Demand, the more inelastic the supply. The larger the proportion of the tax borne by the
producers.

Elastic supply inelastic supply

When a tax is imposed both consumers and producers are giving part of their surplus to the Government.

Practice on the following graphs:

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 Micro 2.9
International Trade and Public Policy
EK: Tariffs, which governments sometimes use to influence international trade, affect domestic price,
quantity, government revenue, and consumer surplus and total economic surplus.

Now assume a foreign producer brings in a product. They have the absolute advantage in producing
this item and can do it at a lower price

This will drop the price to Pw (World Price). At this price d will be sold.
The difference between d and a is the amount that the foreign producer sells.
Once the US imposes a tariff it will drive the price up. People will want less of the quantity. It will
move up to the point where Demand intersects the new tariff price. (Q is c and Price is Pt)
Quantity demanded decreases and price increases.
Furthermore, the domestic producers are now getting more for their goods. They get Pt instead of
Pw. They will also move up their supply curve (from Oa to Ob.) This means they are getting
more money and increase sales.
The US government will get the amount equal to (Pt - P) times the number of foreign goods (bc).
They only collect tax from the sale of foreign goods. They do not tax domestic producers.

From all of this we get:

1. A decline in consumption in the United States. (Because of higher prices.) This means US
consumers are hurt.
2. An increase in Domestic Production (over the amount prior to the tariff.) They will move up the
supply curve.
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 3. A decline in imports. (It costs more to sell to us now.)
4. An increase in Tariff revenue for the government. This is in effect a transfer of money from the
consumers to the government.
5. US companies now are operating (using resources) in a less efficient manner.

In addition, tariffs affect consumer surplus, producer surplus and total surplus.

Who is made worse off as a result of import barriers?

(1) Foreign producers
(2) domestic consumers who must pay higher prices.
(3) domestic producers who produce goods that complement the imported goods.)

Who gains and who loses from subsidies to our export industries?
Export producers gain
taxpayers who must provide the subsidy lose through paying higher taxes.

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