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# Theories Applied

Theories Applied:

Theory of Demand

Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period.

If you demand something, then you:

Want it.

Can afford it.

The quantity demanded of any good or service is the amount that consumers plan to buy during a given time period at a particular price, all other things remain constant.

When the demand is HIGH and the supply is LOW, the price will be HIGH.

The Law of Demand states that the quantity of goods and services demanded are negatively or inversely related to its price, Holding everything else constant.

In other words, holding everything else constant, when the price of a good or service falls, the quantity demanded increases and vice versa.

A) Substitution Effect

– When the price of a good rises, other things remaining the same, its relative price – its opportunity cost – rises. Hence, people buy less of a good as its opportunity cost rises and more of its substitutes.

Eg. As price of beef rises, consumers may buy more chicken and less beef.

B) Income Effect

– Consumers buy less because of the fall in real income (or purchasing power).

Eg. As price of cars increase, we find ourselves poorer than before so we would curb our consumption of cars and other goods.

Individual Demand Curve

Because of the negative relationship between P and Qd, the demand curve is downward sloping.

Change in Quantity Demanded

A change in quantity demanded is caused by a change in the price, ceteris paribus.

Change in Demand

A change in non-price determinants (other factors) leads to a change in demand.

Illustrated as a shift of the demand curve.

Non-Price Determinants of Demand

a) The prices of related goods

A change in the price of a related good can bring about a change in the demand for a particular good.

Related goods are either substitutes or complements.

A substitute is a good that can be used in place of another. i.e. it meets the same needs or wants

Examples:-

– Coke and Pepsi – Tea and coffee

When Price of Coke increases, quantity demanded for Coke falls while demand for Pepsi increases.

A complement is a good that is used in conjunction with another good.

Examples

– Bread and butter – Car and petrol

For example, when price of car increases, quantity demanded for car falls, thus causing demand for petrol to fall.

b) Expected future income

Any increase in income will increase demand for goods and services, vice versa.

c) Population

When population size increases, demand for goods and services will increase.

d) Taste and Preferences

Changes in taste and preferences may be affected by advertising and promotion, news events or behavior of a popular public figure.

e) Expected Future Price

Expected Future Price (current) Demand Expected Future Price (current) Demand

Eg. If you expect the price of apartments to fall in the future, you are likely to hold back your purchase.

Theory of Supply

Supply is the quantity of a product that a producer is willing and able to supply onto the market at a given price in a given time period.

The quantity supplied of a good or service is the amount that producers plan to sell during a given time period at a particular price.

The term supply refers to the entire relationship between quantity supplied and the price of a good.

Law of supply states that there is direct or positive relationship between price and quantity supplied, all other things remain constant.

That is, the higher the price of a good; the greater is the quantity supplied, vice versa.

Supply Curve

The supply curve shows the relationship between P and Qs in a graphical form

Since P and Qs are positively related, the supply curve is upward sloping

Market Supply Curve The market supply curve is the horizontal summation of individual supply curves

It is found by adding together the quantities supplied by all firms or sellers at each price.

Change in Quantity Supplied

A change in quantity supplied is caused by a change in price.

Change in Supply

A change in supply is caused by a change in non-price determinants.

A change in supply is shown as a shift of the supply curve.

Non-Price Determinants of Supply

a) Prices of factors of production

The changes in the price of factors of production (i.e. wages, rent and price of raw materials, utilities) would affects the cost of production and hence supply. For example, the rise in wages, would increase the cost of production and hence reduce supply.

b) Prices of Related Goods

Produced Goods in Competitive Supply

Goods in competitive supply are goods that compete for or makes use of the same resources.

Example of goods in competitive supply – Butter and cheese

When price of butter increase, ceteris paribus, suppliers will devote more resources to producing butter as it is now more lucrative to produce butter.

However,to produce more butter, the production of some amount of cheese has got to be given up. Hence, the supply of cheese falls.

Produced Goods in Joint Supply

Goods in joint supply are goods that are produced together.

Examples:

– By-products such as beef and cow hide (leather) – Wood and wood shaving

c) Expected future price

If the price of a good is expected to rise, the return from selling the good in the future is higher than it is today.

Hence, supply decreases today and increases in the future.

d) The number of Suppliers

The larger the number of firms that produce a good, the greater is the supply of the good.

e) Technology

An positive change in technology would increase supply

f) Change of weather

Natural disasters like flood, drought, earthquake will reduce supply

Price Elasticity of Demand

Price Elasticity of Demand (Ed) measures the responsiveness of quantity demanded of a good to a change in its price, ceteris paribus.

Price elasticity of demand will always be negative.

When comparing elasticity, we ignore the negative sign.

Look only at the magnitude (or sometimes known as the mode value/absolute value).

Ranges of Elasticity of Demand

Factors that influence the Ed

a) Availability and closeness of Substitutes

• Goods with close substitutes or many substitutes tend to be more elastic.

Eg. Price of Coke increases, consumers may choose to buy its close substitute Pepsi.

b) Proportion of Income Spent

The smaller the proportion of income spent on the good, the more price inelastic is the demand for the good. Eg. Salt

The larger the proportion of income spent on a good, the more elastic is the demand. Eg. Car

c) Time elapsed since a price change

The more time (long run) people have to adapt to a new price change, the greater the elasticity of demand.

More time to develop similar substitutes and to change their patterns of consumption.

The short-run demand curve is generally less elastic (slope is steeper) than the long-run demand curve (slope is gentle).

d) Luxuries or Necessities

Necessities have an inelastic demand (eg. medicines)

Luxuries have more elastic demand (eg. Diamonds)

Habit forming goods tend to have an inelastic demand.

Consumer (brand) loyalty reduces price elasticity of demand.

Relationship between price elasticity and Total Revenue

Income Elasticity of Demand

Income Elasticity of demand indicates to us if a good is normal or inferior. And if it is a normal good, whether it is a necessity or a luxury good.

Income Elasticity of Demand is a measure of the responsiveness of demand for a good or service to a change in income, ceteris paribus.

Cross Elasticity of Demand

Indicates to us the relationship between two goods

Whether they are substitutes or complements

Cross Elasticity of Demand is a measure of the responsiveness of the demand of a good to a change in price of a substitute or complement, ceteris paribus.

Price Controls

Price mechanism in the free market may not always happen.

Governments may implement non-price equilibrium prices like:

1) Price ceiling

Price ceiling is a legal maximum price

Is a regulation that makes it illegal to charge a price higher than the equilibrium price. Hence, set the price ceiling below the equilibrium price Impose to keep prices low. Government is concern that consumers are paying too high a price.

Example: Rent ceiling

2) Price floors

Price floor is legal minimum price

Is a regulation that makes it illegal to trade at a price lower than the equilibrium price. Hence, set above the equilibrium price. Imposed to keep prices high Government is concerned that producers are receiving too low a price. Example: Minimum wage.

Effects on Tax

Incidence of Taxes:

– Burden of the Tax

• Tax incidence is the division of the burden of a tax between the buyer and the seller.

• The division of the tax burden between buyer and seller depends in part on the elasticity of demand.

• The more inelastic the demand, the more the buyer pays.

Welfare Loss Due to Imposition of Tax

• Welfare effects – The gains and losses associated with government intervention in markets.

• To understand the welfare effects of tax, we need to look at consumer surplus and producer surplus

Externalities

An externality is a cost or benefit that arises from production and falls on someone other than the producer, or a cost or benefit that arises from consumption and falls on someone other than the consumer.

A negative externality imposes an external cost and a positive externality creates an external benefit.

The four possible types of externality are:

– Negative production externalities

– Positive production externalities

– Negative consumption externalities

– Positive consumption externalities

Negative & Positive Production Externalities

• Negative production externalities are common.

• The production of specified goods will result in spillover costs to third parties.

• Examples are noise from aircraft, logging and clearing of forests, and pollution

• Positive production externalities are less common than negative externalities. The production of specified goods will result spillover benefits to third parties.

• Examples: technology improvement – i.e. computers & robots

Negative consumption externalities are a common part of everyday life. The consumption of certain goods result in spillover cost to third parties.

• Examples: Smoking in a confined space poses a health risk to others; noisy parties or loud car stereos disturb others.

• Positive consumption externalities are also common. The consumption of certain goods result in spillover benefits to third parties.

• Examples: when you get a flu vaccination, everyone you come into contact with benefits.

• When the owner of an historic building restores it, everyone who sees the building benefits.

Negative Production Externalities: Pollution

• Pollution is an old problem and is faced by both rich industrial countries and poor developing countries.

• It is an economic problem that is coped with by balancing benefits and costs.

Sources of pollution:

• Air pollution – Emissions causing greenhouse gases are a tough problem to tackle

• Water pollution – Output of sewage treatment plants, the use of pesticides and fertilisers

• Land pollution – Toxic waste and ordinary household garbage

• Private Costs and Social Costs

– A private cost of production is a cost that is borne by the producer.

– Marginal private cost (MPC) is the private cost of producing one more unit of a good or service.

– An external cost of production is a cost that is not borne by the producer but is borne by others.

– Marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer.

– Social cost refers to the total cost of production borne by the society for the production of goods and services.

Social Cost = Private Cost + External Cost

– Marginal social cost (MSC) is the marginal cost incurred by the entire society and is the sum of marginal private cost and marginal external cost.

MSC = MPC + Marginal external cost

• Negative production externality: the production of certain goods or services brings about spillover cost on a third party.

– In an unregulated market (with no government intervention) with an externality, the pollution created depends on the market equilibrium price and quantity of the good produced.

– In this case, MSC is NOT EQUAL to MSB.

– There tends to be overproduction of goods.

– The market equilibrium price does not include the external cost (i.e. cost of pollution).

• Government Actions in the Face of Negative Production Externality:

– There are three main methods that the government uses to cope with external costs (i.e. pollution):

• Taxes

• Emission charges

• Licences and marketable permits

Pigovian Tax (tax on pollution)

– The government can set a tax equal to the marginal external cost.

– The effect of such a tax is to make marginal private cost plus the tax equal to marginal social cost:

MPC + Tax = MSC

– This tax is called Pigovian Tax, in honour of the British economist Arthur Cecil Pigou, who first proposed dealing with externalities in this fashion.

Emissions Charges

– The government sets a price per unit of pollution, so that the more a firm pollutes, the higher are its emissions charges.

– For the emissions charge to induce the firm to generate the efficient level of pollution, the government would need a lot of information that is usually unavailable.

Marketable Permits

– Each firm is assigned a permitted amount of pollution per time period, and firms trade permits.

– The market price of a permit confronts polluters with the social marginal cost of their actions and leads to an efficient outcome.

Negative consumption externality: the consumption of certain goods or services will bring about spillover cost to a third party.

• Example: Smoking, illegal drugs or gambling

• Government should discourage the consumption of such goods or services.

• Efficient equilibrium: MSC = MSB

• Government Action in the Face of Negative Consumption Externality (Smoking): • Tax

• Education

• Ban the consumption

• Private Benefits and Social Benefits

– A private benefit is a benefit that the consumer of a good or service receives.

– Marginal private benefit (MPB) is the private benefit from consuming one more unit of a good or service.

– An external benefit is a benefit that someone other than the consumer receives. – Marginal external benefit is the benefit from consuming one more unit of a good or service that people other than the consumer enjoy.

– Social Benefit refers to the total benefit to the society from the consumption of certain goods or services.

– Marginal social benefit (MSB) is the marginal benefit enjoyed by the entire society and is the sum of marginal private benefit and marginal external benefit. That is:

MSB = MPB + Marginal external benefit

Positive Consumption Externality: Education

• Positive consumption externality: the consumption of certain goods or services will bring about spillover benefits to a third party.

Example: Education, Vaccination or Vitamins

• Government should encourage the consumption of such goods or services.

• Efficient equilibrium: MSC = MSB

Government Action in the Face of Positive Consumption Externality:

• Public provision

• Private subsidies

Positive Production Externality: Robots and Computers

• Positive production externality: the production of certain goods or services will bring about spillover benefits to a third party.

Example: Production of computers and robots

• Government should encourage the production of such goods or services.

• Efficient equilibrium: MSC = MSB

Government Action in the Face of Positive production Externality:

• Tax rebates

• Private subsidies