AS Micro Economics – Notes Nabeel Ismail Economics - 03008578998

Micro-Economics
CHAPTER 1
The Basic Economic Problem
The fact that resources are scarce compared to the unlimited wants → Choices having to be made

Goods Definition – Tangible products, i.e. products that can be seen and touched, such as cars, food and
washing machines

Services Definition – Intangible Products, i.e. products that cannot be seen or touched, such as banking,
beauty therapy and insurance

The fundamental economic problem: of scarcity arises due to unlimited human wants of consumption
exceeding finite economic resources for production.

 Consumption: is process by which consumers satisfy their wants.

 Production: is process of creating goods and services in an economy

Therefore because of scarcity, economics is concerned with:

 What to produce?
 How to produce?
 For whom?

Needs are necessary, wants are not - Thus, choices have to be made at all levels

1. Consumers – maximum satisfaction.

2. Producers – maximum profit.
3. Governments – maximum benefits.

Choice: is the need to make decision about the possible alternative uses of scarce resources due to scarcity. It
gives rise to the concept of opportunity cost and the 3 basic economic problems.
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Opportunity cost: is the cost of choosing something in terms of the benefit derived from the best alternative
forgone.

Economic resources/factors of production: are inputs available for production of finished goods and services
for consumption.

Factors of Production
Factors of Production Definition – The resource inputs that are available in an economy for the production of
goods and services

The Four Factors:

Land – This is a natural resource. Things such as oil, coal, river and the land itself.

Labor – This is the human resource that is available in any economy / the quantity and quality of human
resources

Some economies (generally poor countries) have large populations but lack a skilled workforce and for other
countries like Germany with declining populations, they depend on immigrant workers to do both skilled and
unskilled jobs. Quality of labour is essential for economic progress.

Capital - Man-made aids for production / Goods used to make other goods it is combined with Land and Labor
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Entrepreneurship - The willingness of an entrepreneur to take risks and organize production. Entrepreneur -
Someone who bears the risks of businesses and who organizes production.

Specialization / Division of Labour

Division of Labor Definition – The specialization of labor where the production process is broken down into
separate tasks

The Advantages of Specialization / Division of Labor to Firm:

 Increased output: With improvement in efficiency and use of machinery output is increased
 More innovation
 Improved quality
 Increased productivity: Specialized machinery can be used which further increases the productivity.
 Economies of scale

The Disadvantages of Specialization / Division of Labor to Firm:

 Reliance on a narrow range of products

 Specialist factor inputs are more expensive per unit
 Limited market size
 Reliance on one specialist resources / suppliers or factor immobility
 Reduced flexibility

Opportunity Cost: Opportunity cost is the cost of missing out on the next best alternative. In other words,
opportunity cost represents the benefits that could have been gained by taking a different decision.

Production Possibility Curve

Production Possibility Curve (Firm) – This shows the maximum quantities of different combinations of output of
two products, given current resources and the state of technology.

Developing Economy - An economy with a relatively low level of income per head

PPC Graph Information:

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Unobtainable – Any point outside the curve, you do not have enough resources to produce that much. E.g.
Point I

Economic Growth – Change in the productive potential of an economy.

Productive Potential – The maximum output that an economy is capable of producing.

Shape 1: Concave

The slope of the production possibility curve indicates the rate at which one good is being transformed into
another, not physically, but by transferring resources from one good to another good. As we move along the
production possibility curve through points P and Q downwards, slope or steepness of each tangent through
these points increases. Thus, the production possibility curve takes a concave shape, indicating increasing
opportunity cost, that is, the economy is willing to give up more Y for an additional unit of X. There is increasing
opportunity cost because of diminishing returns.

Note: slope of PPC = change in Y = opportunity cost of producing an additional unit of X in change in X terms of
Y.

Shape 2: Convex
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As we move downwards from P to Q, the steepness of each gradient falls, i.e., the gradient becomes flatter. In
other words, the slope of the production possibility curve diminishes as we move downwards. This means the
opportunity cost is decreasing (increasing returns). The economy is now willing to give up less units of Y for the
same additional unit of X.

Shape 3: Linear

Here the slope of the production possibility curve remains constant. The Opportunity cost is constant or
unchanged as we moved downwards the curve from left to right. Thus, the production possibility curve
becomes linear or straight line. This means that the economy is willing to give up the same amount of Y for the
same additional unit of X.

Fundamental Reasons of PPC Shift:

1. Changes in the quantity of resources

2. Changes in the quality of resources

3. Changes in technology

Different Types of Shifts

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Cause of Shifts

Employs new technology: Investment in new technology increases potential output for all goods and services
because new technology is inevitably more efficient than old technology.

An economy will not be able to grow if an insufficient amount of resources are allocated to capital goods. In
fact, because capital depreciates some resources must be allocated to capital goods for an economy to remain
at its current size, let alone for it to grow.

Employs a division of labour, allowing specialization: A division of labour refers to how production can be
broken down into separate tasks, enabling machines to be developed to help production, and allowing labour
to specialize on a small range of activities. A division of labour, and specialization, can considerably improve
productive capacity, and shift the PPC outwards.

Employs new production methods: New methods of production can increase potential output. For example, the
introduction of team working to the production of motor vehicles in the 1980s reduced wastage and led to
considerable efficiency improvements. The widespread use of computer controlled production methods, such
as robotics, has dramatically improved the productive potential of many manufacturing firms.

Increases its labour force: Growth in the size of the working population enables an economy to increase its
potential output. This can be achieved through natural growth, when the birth rate exceeds the death rate, or
through net immigration, when immigration is greater than emigration.

Discovers new raw materials: Discoveries of key resources, such as oil, increase an economy’s capacity to
produce.

An inward shift of a PPC

A PPC will shift inwards when an economy has suffered a loss or exhaustion of some of its scarce resources.
This reduces an economy’s productive potential.

A PPC will shift inwards if:

Resources run out: If key non-renewable resources, like oil, are exhausted the productive capacity of an
economy may be reduced. This happens more quickly as a result of the application of ultra-efficient production
methods, and when countries over-specialize in producing goods from non-renewable resources.
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Failure to invest: A failure to invest in human and real capital to compensate for depreciation will reduce an
economy’s capacity. Real capital, such as machinery and equipment, wears out with use and its productivity
falls over time. As the output from real capital falls, the productivity of labour will also fall. The quality and
productivity of labour also depends on the acquisition of new skills. Therefore, if an economy does not invest
in people and technology its PPF will slowly move inwards.

Erosion of infrastructure: A military conflict is likely to destroy factories, people, communications, and
infrastructure.

Natural disaster: If there is a natural disaster, such as the 2005 boxing-day tsunami, or the Haiti earthquake of
2010, an economy’s PPF will shift inwards.

Investment and economic growth

Allocating scarce funds to capital goods, such as machinery, is referred to as real investment. If an economy
chooses to produce more capital goods than consumer goods, at point A in the diagram, then it will grow by
more than if it allocated more resources to consumer goods, at point B, below.

To achieve long run growth the economy must use more of its capital resources to produce capital rather than
consumer goods. As a result, standards of living are reduced in the short run, as resources are diverted away
from private consumption. However, the increased investment in capital goods enables more output of
consumer goods to be produced in the long run. This means that standards of living can increase in the future
by more than they would have if the economy had not made such as short-term sacrifice. Hence economies
face a choice between high levels of consumption in the short run and the long run.

Investment: If an economy chooses to produce more capital goods than consumer goods, at point A in the
diagram, then it will grow by more than if it allocated more resources to consumer goods, at point B.

Factor mobility

If workers, or other resources, are moved from one sector to another, then the position of the PPF will change,
with an increase in the maximum output in the industry receiving the resources, and a fall in the maximum
output of the industry losing resources.

The PPF, for all of its utility, does come with limitations, however:

 It assumes that technology is a constant, meaning that it does not consider how different technologies
can make the production of certain products more efficient than others.
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 This is not always the case, and this leads to confusion occasionally when two products compete for
the same resource but one of them can be produced at a lesser cost due to technological
applications.
 It also does not apply when a country is producing thousands of products that compete for the same
resources. A binary system, the PPF is limited to a side-by-side illustration and cannot break into more
complicated models.

Economics Systems and the Role of the Markets

Economic System – The way in which production is organized in a country or group of countries

Market Economy – An economic system whereby resources are allocated through the market forces of demand
and supply

Price System – A method of allocating resources by the free movement of prices

Command Economy – An economic system in which most resources are state owned and also allocated
centrally

Mixed Economy – An economic system in which resources are allocated through a mixture of the market and
direct public sector involvement
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MARKET ECONOMY:

In a market economy resource allocation is carried out by private individuals only. All factors of production are
privately owned and managed. There is no government intervention and everyone is free to operate according
to his will and desire. The main characteristics of such a system are:

 Price/ market mechanism which manipulates the allocation of resources or tries to resolve the three
fundamental questions of what, how and for whom to produce. In other words, resources are allocated
through changes in relative prices. Adam Smith referred to it as the “invisible hands” of the market.
 Consumer’s sovereignty exists, that is, consumer is a king because it directs the allocation of
resources to a large extent while satisfying its own needs. His basic aim is to maximize satisfaction.
The consumer’s decision can dictate economic actions as what and how to produce.
 Producers aim at profit maximization and rely on higher prices as a “green signal” to higher
production. The foundation is the profit motive. Evidently, the production of those commodities will be
more profitable which are demanded more by consumers.
 Fierce competition among firms exists and basically it is this competition which encourages
technological change, innovation and higher investment.

MARKET FAILURES / IMPERFECTIONS:

Market failure is the economic situation defined by an inefficient distribution of goods and services in the free
market. In theory the price mechanism can go a long way in efficiently and automatically solving the basic
economic problems. However, in practice it fails in many respects. There are many market failures such that
the price system cannot ensure the best use of scarce resources:

1. No provision for public goods or public utilities:

Public goods are goods produced on a non-profit maximization basis because they (street- lighting, defense,
roads) aim at maximizing socio-economic welfare. Thus, they cannot be produced through the market. There is
no possibility of fixing a price for the product in question and hence no possibility of making a profit.

2. Divergence between social cost and private cost:

Private cost refers to the cost which is incurred in the production of a certain commodity, for example, labor
cost or cost of raw materials. However, when production process takes place, there are smokes which come
from factory chimneys, and garbage or wastes thrown in rivers, thereby, creating pollution. Economists
evaluate these costs and name them as external costs or negative externalities. These external costs are never
considered by a private producer in a market economy. This means that nothing much is done to reduce
pollution and any other destruction caused to nature.

3. Harmful products may be produced and consumed:

The absence of a government sector implies the absence of taxes and the free operation of the market
mechanism. Left to the price system, there will be overproduction of certain harmful products such as drugs,
alcoholic drinks and cigarettes. Their high prices initiate higher production and greater infiltration of these
harmful goods which greatly affect the peaceful life.

4. Luxuries in place of necessities:

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Since allocation of resources depends greatly on those goods whose prices are high or are rising, obviously, the
private producers will produce more of these goods and less of other goods may be essential products. Thus, a
rise in the demand of cars may encourage producers to produce more cars and less food which is but an
irrational allocation of resources. The system broadly indicates that only the rich people have the greater say
through their expenditure patterns and the poor, on the hand, remain poor.

5. Unequal wealth distribution / inequalities of income:

Indeed, the laissez-faire capitalism makes the rich richer and the poor poorer. Systematic exploitation by the
capitalists of the poor working class is obvious because they have to maximize returns and minimize costs,
essentially labour costs. The labour cost has to operate at low rates and be very productive in the production
process. In this case, the wealth distribution under this system can never be reduced.

PLANNED ECONOMY:

A planned economy is the direct opposite of the market economy. Here all the resources are owned by the
government or the public sector which is the central body deciding upon the allocation of resources. This
allocation is however exerted on the following grounds:

1. Maximizing socio-economic welfare through creation of public utilities.

2. Non-profit maximizing strategy
3. Parliamentary decisions.

The advantages of a market economy / the disadvantages of command economies:

• Choice – Firms will produce whatever consumers are prepared to buy and there is no restriction on what they
produce in the Free Market (FM). Planners are more concerned that there are enough essentials goods to go
around rather than allocating resources efficiently between all goods.

• Innovation – Firms will look to produce something new in order to be competitive. Because of property rights
(intellectual property rights through patents) there are incentives for innovation and producing better quality
products. Planners do not have this incentive; they are happy just producing essentials.

• Higher Economic Growth Rates – Countries with economic systems closer to the free market tend to have
higher economic growth.

• Efficiency – Free markets are very competitive. Most of their industries are assumed tobe perfectly
competitive and so allocate and productive efficiency occur. This is because decisions about what to produce
are made by the consumers rather than by planners

The advantages of command economy / the disadvantages of market economies:

• Public, Merit and Demerit Goods - Public goods cannot be provided in the private sector. Merit goods are
likely to be under consumed in the free market and demerit goods over consumed. In a command economy
demerit goods are likely to be banned or heavily taxed and public goods and merit goods will be provided at
high levels.

• Unequal Distribution of Income – Benefits will be low and health service and school unaffordable for a lot.
Those who are poor are likely to fall to destitution. A command economy may not allow the successful to make
millions but it will at least try to make sure the poor are not left to destitution so the economy is fairer
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• Environment – Free market economies are likely to produce more pollution. Command economies will
attempt to make sure that the level of output is the socially optimal level of output through things such as
taxes and pollution permits although pollution does tend to still be high

MIXED ECONOMY:

In a mixed economic system, resource allocation is influenced both by the private and public sectors. In other
words, in such an economic system, some economic decisions are taken by the market mechanism and some
by the government planning. It has been found that all modern economies are now, to varying extent, mixed in
nature. Many nations have fluttered from socialism in the course of suggested the superiority of market over
planned economies. Thus, in a mixed economy the price system allocates resources, but on account of market
failures, there is the need for government intervention. In fact, the government has to intervene in order to
attain some important micro and macro-economic objectives.

Classification of Goods

1. Economic goods

An economic good is a good or service that has a benefit (utility) to society. Also, economic goods have a
degree of scarcity and therefore an opportunity cost.

2. Free Good

A free good is a good needed by society but available with no opportunity cost. It is a good without scarcity.
For example, air is a free good, because we can breathe it as much as we want. By breathing, we do not
diminish the available resource for other people.

Note: a good may be given away for no charge (e.g. healthcare is free at the point of use) However, it is not a
free good because there is an opportunity cost – in this case, healthcare is paid for out of taxes.

The Two Different Types of Goods

In economics, goods can be categorized in many different ways. One of the most common distinctions is based
on two characteristics: excludability and rivalrousness. That means we categorize goods depending on whether
people can be prevented from consuming them (excludability) and whether individuals can consume them
without affecting their availability to other individuals (rivalrousness).

Based on those two criteria, we can classify all physical products into two different types of goods: private
goods and public goods

1. Private Goods

Private Goods are products that are excludable and rival. They have to be purchased before they can
be consumed. Thus, anyone who cannot afford private goods is excluded from their consumption.
Likewise, the consumption of private goods by an individual prevents other individuals from
consuming the same goods. Therefore, private goods are also considered rival goods. Examples of
private goods include ice cream, cheese, houses, cars, etc.
2. Public Goods

Public goods describe products that are non-excludable and non-rival. That means no one can be prevented
from consuming them, and individuals can use them without reducing their availability to other individuals.
Examples of public goods include fresh air, knowledge, national defense, street lighting, etc.
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Excludability: refers to extent to which free-riders can be prohibited from consumption.

Free-rider: is someone who has no incentive to pay for the consumption of a product. For example, a fisherman
may take a high catch and free ride on other fishermen who are more concerned to preserve sustainable fish
stocks.

Merit Good A merit good has two characteristics:

1. People do not realize the true personal benefit. For example, people underestimate the benefit of education
or getting a vaccination.

2. Usually, these goods also have a positive externality.

Therefore in a free market, there will be under consumption of merit goods; for example healthcare, education
etc.

Demerit Good A demerit good has two characteristics:

1. A good which harms the consumer. For example, people don’t realize or ignore the costs of doing something
e.g. smoking, drugs.

2. Usually, these goods also have negative externalities. If you smoke you harm yourself, but also the smoke
negatively affects other people.

Therefore in a free market, there will be overconsumption of these goods; for example smoking, drinking
sugary drinks etc.

Value judgment on merit goods: Merit and demerit goods involve making a value judgment that
something is good or bad for you. Classification is not always straightforward. For example:

Ceteris paribus: Ceteris paribus is a Latin phrase meaning ‘all other things remaining equal?’

Positive Statements: Positive statements are objective. As such, they can be tested. These fall into two
categories. One is a hypothesis, like “unemployment is caused by a decrease in GDP.” This claim can be tested
empirically by analyzing the data on unemployment and GDP. The other category is a statement of fact, such
as “It’s raining,” or “Microsoft is the largest producer of computer operating systems in the world.” Like
hypotheses, such assertions can be shown to be correct or incorrect. A statement of fact or a hypothesis is a
positive statement. Note also that positive statements can be false, but as long as they are testable, they are
positive.

Normative Statements: Although people often disagree about positive statements, such disagreements can
ultimately be resolved through investigation. There is another category of assertions, however, for which
investigation can never resolve differences. A normative statement is one that makes a value judgment. Such
a judgment is the opinion of the speaker; no one can “prove” that the statement is or is not correct. Here are
some examples of normative statements in economics:

 We ought to do more to help the poor.

 People in Pakistan should save more for retirement.
 corporate profits are too high.

These statements are based on the values of the person who makes them and can’t be proven false. Because
people have different values, normative statements often provoke disagreement
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Importance of time periods

∙ Very short run – where all factors of production are fixed. (E.g. on one particular day, a firm cannot employ
more workers or buy more products to sell)

∙ Short run – where one factor of production (e.g. capital) is fixed. This is a time period of fewer than four-six
months.

∙ Long run – where all factors of production of a firm are variable (e.g. a firm can build a bigger factory) A time
period of greater than four-six months/one year

∙ Very long run – Where all factors of production are variable, and additional factors outside the control of the
firm can change, e.g. technology, government policy. A period of several years.

Chapter 2: Demand and Supply

Demand – The quantity of a good or service that consumers are willing and able to purchase at any possible
price in a given time period

Law of Demand – “A law that states that, ceteris paribus, there is an inverse relationship between the quantity
demanded and price of a product.”

Effective Demand – The willingness and ability to buy a product. Effective demand = willingness + affordability

Demand Curve – A graph that shows how much of a product will be demanded at any given price.

If the price of said product increases from P0 to P1, the diagram shows that the quantity demanded of the
product should decrease from Q0 to Q1, shown by moving from point A to point B. This makes intuitive sense
as you are likely to buy less of a product when it becomes more expensive. This movement along the demand
curve is known as a contraction of demand. Conversely, if the price of said product decreases from P0 to P2,
the diagram shows that the quantity demanded of the product should increase from Q0 to Q2, shown by
moving from point A to point C. This makes intuitive sense as you are likely to buy more of a product when it
becomes cheaper. This movement along the demand curve is known as an extension of demand.

Why the Demand Curve is Downwards Sloping:

There are 3 reasons as to why the demand curve is thought to be downwards sloping:
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 The law of diminishing marginal utility (satisfaction)

 The income effect
 The substitution effect

The income effect: If we assume that the amount of income (money) you have is fixed, the income effect
suggests that as the price of a good falls, the amount of ‘leftover’ income you have risen.

As a result, at a lower price you can buy more of the same good from the same amount of money, by simply
using the ‘leftover’ income to buy more of the good

NOTE – You could also argue that when a product drops in price, it makes you feel richer because your ability
to buy the product has now increased (e.g. ‘I can afford to buy 2 cans of coke rather than 1’)

The substitution effect: As the price of one good falls, it becomes relatively less expensive than others,
therefore, assuming other alternative products (substitutes) stay at the same price, at lower prices, the good
appears to be cheaper and so consumers will switch from one expensive alternative (substitute) to the
relatively cheaper one.

Market demand curve

Market demand curve is the total demand of all individuals in a market. The following example assumes only
three buyers of a product: A, B & C. The market demand curve can be derived by adding the individual demand
curves of A, B & C.

The demand curves below show the different quantities A, B & C demand at different prices, respectively:

The market demand curve shown below is the horizontal summation of the individual demand curves. In the
figures above, letter‘d’ represented the individual demand curves whereas here, market demand is
represented by ‘D’.
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Movement along the (same) demand curve

Changes in price are graphically represented by movements along the same demand curve e.g. if the price of
the product rises from $20 to $30, the quantity demanded falls from 160 units to 80. This is shown in Fig. by a
movement along the same demand curve from point a to point b.

When Demand increase due price reduction it’s called Demand Expansion and when it reduces due to a higher
price it’s called Demand Contraction.

Shifts in the demand curve

Whilst we have looked at price changes and what they do to the quantity demanded of a product, it is also
important to look at non- price factors and how they can have an effect on the quantity demanded of a product.
If there is say, a decrease in average incomes, possibly due to a recession (resulting in a lot of people being
out of jobs), then it is possible that without any change in price, the total amount of people willing and able to
purchase a given product (e.g. a can of coke) may decrease, resulting in demand decreasing (shifting to the
left) from D to D1.
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Conversely, if, for example, Coca Cola increased advertising of its products, then it is possible that the total
amount of people willing and able to purchase the product (a Coca Cola can, in this case) would increase,
simply due to the increased awareness.

This is because some people who may have been happy to buy a Coca Cola may not have (simply due to not
knowing about its existence), and those who already knew about it may have been reminded of how much they
like it.

As a consequence, the increase in demand (shift to the right) from D to D2, can result in the same price of the
product (P0) leading to a higher quantity demanded of the product (Q2 rather than Q0), simply due to the
increase in overall demand.

Evaluation-

1. For some luxury goods, income will be an important determinant of demand. e.g. if your income increased
you would buy more restaurant meals, but probably not more salt.

2. Advertising is important for goods in which branding is important, e.g. soft drinks but not for bananas

Factors affecting demand:

Demand Shifters / Determinants / Conditions

P – Population – If there is a change in the size of the population, this will change the total amount of people
willing and able to buy any given product, thus changing demand e.g. increase in population size (e.g. due to
increased immigration)

R – Related Goods – If there is a change in the price of a substitute for a product, or a change in the price of a
complement for a product, this will lead to a change in demand for said product e.g. increase in the price of a
substitute product (e.g. Pepsi cans) increase in demand for Coca Cola cans.

I – Interest Rates – If there is a change in interest rates, this will change the cost of borrowing and the amount
of money received in return for those who save. This will change the total amount of people willing and able to
buy any given product, and so change demand as well e.g. decrease in interest rates, cheaper to borrow, less
return from savings, increase in total spending.
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E – Expectations of Future Prices – If there is a change in the expectation of the future price of a product, this
will lead to a change in the current level of demand for said specific product e.g. price of oil is expected to
increase in the future increases in demand for oil now..

T – Tastes – If there is a change in the tastes of consumers, such as a new fashion trend or a rising social
trend towards higher living standards this will lead to a change in demand.

A – Advertising – If there is a change in the level of advertising for a product (e.g. Coca Cola cans) this will likely
lead to a change in demand for said specific product (due to increased awareness)

I – Average Disposable Income – If there is a change in the level of average disposable income, this will
change the total amount of people willing and able to buy any given product, thus changing demand e.g.
average disposable income rises, rise in demand for luxury product

Evaluation-Time period

In the real world, a higher price could cause a movement along the demand curve, but in the long-term, it could
cause a shift as consumers respond to the persistently higher prices.

For example, if there is an increase in the price of petrol, there would be a movement along the demand curve,
and a smaller quantity would be bought. However, there is likely to be only a small fall in demand because the
demand for petrol tends to be quite price inelastic.

However, in the long term, the demand curve may shift to left as well because people respond to the higher
price by looking for alternatives, for example, they buy an electric car and so no longer need petrol.

How important is price?

Some goods are more affected by price than others.

 If petrol increases in price, because it is a necessity, there is only a small fall in demand
 If Aquafina water increases in price, there will be a significant fall in demand because people buy
cheaper substitutes

Supply: It is the willingness and ability to supply a quantity at a certain price, during a given period of time.

Law of Supply: “Assuming other factors constant (ceteris paribus), an increase in price is followed by an
expansion in quantity supplied and a decrease in price leads to a fall in quantity supplied”.
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Put another way, producers are willing to sell more of relatively expensive goods and less of those which are
cheaper, assuming all other factors such as the cost of production, indirect taxes and future expectations etc.
constant.

SUPPLY CURVE

A supply curve always slopes upwards, showing a positive relationship between price and quantity supplied.

Fig. shows a supply curve derived using the supply schedule above. Price is shown along y- axis and quantity
supplied is along x-axis.

The height of the supply curve shows the minimum price a producer is willing to charge. This producer sells the
first unit only if price is $10 or higher.

Why is supply curve generally upward sloping?

Generally, a higher price encourages firms to produce more. This is for two reasons.

 A higher price makes the good more profitable to produce.

 In the short term, increasing output with capital fixed leads to a point where costs rise rapidly, so the
firm needs a higher price to compensate for the higher cost of production.

Market supply curve

Market supply curve shows the total supply of all individuals in a market. As in the case of market demand,
market supply curve is the horizontal summation of individual (supply) curves.

Movement along the supply curve

 As price increases firms have an incentive to supply more because they get extra revenue (income)
from selling the goods.
 If price changes, there is a movement along the supply curve, e.g. a higher price causes a higher
amount to be supplied.
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An increase in the price from 80 to 116 causes an increase in quantity supplied from 60 to 70.

Shifts in the Supply curve

This occurs when firms supply more goods – even at the same price. For example, a new machine which
enables more of the good to be produced for the same cost.

Factors affecting the shift in supply curve

1. A decrease in costs of production. This means business can supply more at each price. Lower costs could be
due to lower wages, lower raw material costs

2. More firm: An increase in the number of producers will cause an increase in supply.

3. The profitability of alternative products: If a farmer sees the price of biofuels increase, he may switch to
growing crops for biofuels on all his fields and this will lead to a fall in the supply of food, such as wheat.

4. Related supply: If there is an increase in the supply of beef (from cows) then there will also be an increase in
the supply of leather.

5. Productivity of workers: If workers become more motivated and work hard, then there will be significant
increase in output and supply.

6. Technological improvements: Improvements in technology, e.g. computers or automation, reducing firm’s

costs.
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7. Lower taxes: Lower direct taxes (e.g. tobacco tax, VAT) reduce the cost of goods.

8. Government subsidies: Increase in government subsidies will also reduce the cost of goods, e.g. train
subsidies reduce the price of train tickets.

Shift in supply to the left

In this case, there is a fall in supply. The supply curve shifts to the left. This causes a higher price. The supply
can shift to the left because

 Fewer firms in the market

 Bad weather (agriculture)
 Higher taxes
 Decline in productivity (workers work less hard.)

Factors that cause a shift in supply to the right

 More firms
 Improved technology
 Lower tax
 Higher government subsidies
 More firms enter the market
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Market equilibrium

 Definition of market equilibrium – A situation where for a particular good supply = demand. When the
market is in equilibrium, there is no tendency for prices to change. We say the market-clearing price
has been achieved.
 A market occurs where buyers and sellers meet to exchange money for goods.
 At most prices, planned demand does not equal planned supply. This is a state of disequilibrium
because there is either a shortage or surplus and firms have an incentive to change the price.

Market equilibrium

Market equilibrium can be shown using supply and demand diagrams. In the diagram below, the equilibrium
price is P1. The equilibrium quantity is Q1.

If price is below the equilibrium

 In the above diagram, price (P2) is below the equilibrium. At this price, demand would be greater than
the supply. Therefore there is a shortage of (Q2 – Q1)
 If there is a shortage, firms will put up prices and supply more. As price rises, there will be a movement
along the demand curve and less will be demanded.
 Therefore the price will rise to P1 until there is no shortage and supply = demand.

If price is above the equilibrium

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 If price was at P2, this is above the equilibrium of P1. At the price of P2, then supply (Q2) would be
greater than demand (Q1) and therefore there is too much supply. There is a surplus. (Q2-Q1)
 Therefore firms would reduce price and supply less. This would encourage more demand and
therefore the surplus will be eliminated. The new market equilibrium will be at Q3 and P1.

Movements to a new equilibrium

1. Increase in demand

If there was an increase in income the demand curve would shift to the right (D1 to D2). Initially, there would
be a shortage of the good. Therefore the price and quantity supplied will increase leading to a new equilibrium
at Q2, P2.

2. Increase in supply
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An increase in supply would lead to the supply curve to shift from S1 to S2. This would further cause a lower
price and more quantity sold.

Complements – are in joint demand, i.e., when demanding one good, a consumer will also be likely to demand
another good. For example, tea and milk. Economic theory suggests that a fall in the price of one good results
in an increase in quantity demanded of that good and therefore a rise in the demand for its complement. A fall
in the price of tea results in more tea to be consumed and a rise in the demand for its complement, milk as
well.

Substitutes – A substitute is a good, which can be replaced by another good. If two goods are substitutes to
each other, they are said to be in competitive demand. For example, tea and coffee are substitutes to each
other. Economic theory predicts that a fall in the price of one good will lead to a decrease in demand for its
substitute. For example, when the price of tea falls, the quantity demanded of tea rises as people substitute
tea for coffee, resulting in the demand for coffee to fall.

Joint Supply: A change in the price of a good that is jointly supplied will have an effect on supply. This is best
understood through an example. If a firm produces mutton, it is jointly producing wool. If the price of mutton
increases in the market this firm will have a greater incentive to increase the supply of mutton, but at the same
time the supply of wool and its supply curve will shift to the right.

Derived Demand: It is the demand for a good or service that arises as a result of demand for another related
good or service. One example of derived demand may be demand for a certain size and configuration of
smartphone case for a new smartphone that just came on the market.

What are the main functions of the price mechanism?

1. Signaling function

Prices perform a signaling function – i.e. they adjust to demonstrate where resources are required. Prices rise
and fall to reflect scarcities and surpluses.

If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production
to meet the higher demand.

If there is excess supply in a market, the price mechanism will help to eliminate a surplus of a good by allowing
the market price to fall.
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2. Incentive function

Through choices consumers send information to producers about their changing nature of needs and wants.

3. Rationing function

Prices ration scarce resources when demand outstrips supply. When there is a shortage, price is bid up –
leaving only those with willingness and ability to pay to buy.

Consumer surplus and producer surplus

Definition of Consumer Surplus

Consumer Surplus is the difference between the price that consumers pay and the price that they are willing to
pay. On a supply and demand curve, it is the area between the equilibrium price and the demand curve

∙ For example: If you would be willing to pay Rs 500 for a ticket to see Atif Aslam perform, but you can buy a
ticket for Rs 400. In this case, your consumer surplus is Rs 100.

Definition of producer surplus

Producer surplus is the difference between the price a firm receives and the price it would be willing to sell it
at.

 Therefore it is the difference between the supply curve and the market price ∙ which also indicates the
profit made as the area below the supply curve will show the cost.
 If a firm would sell a good at Rs 40, but the market price is Rs 70, the producer surplus is Rs 30.

Relation between Elasticity of Demand and Consumer’s Surplus

There is a close connection between elasticity of demand and consumer’s surplus. We know that the demand
for necessaries of life is relatively inelastic. Whatever their price, we must buy’ them. For necessaries,
therefore, we are prepared to pay much more than we actually have to pay, as they are generally cheap.
Hence, in such passes there is a large consumer’s surplus, for consumer’s surplus is equal to the difference
between what the consumers are willing to pay and what they actually have to pay.
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For luxuries, we are not prepared to pay much more than we are paying actually. For them our demand is
elastic. The consumer’s surplus in such cases is small. We may, thus, conclude that the consumer’s surplus is
large when demand is inelastic and small when it is elastic.

Evaluation:

 Monopolies are able to reduce consumer surplus by setting higher prices

 Price Discrimination is an attempt to extract consumer surplus by setting
Relation between Elasticity of Supply and Producer’s Surplus:

If elasticity of supply decreases, producer surplus decreases and vice versa. Price elasticity of supply is
inversely related to producer surplus. If supply is completely elastic, it is drawn as a horizontal line, and
producer surplus is zero. If supply is completely inelastic, it is shown as a vertical line, and producer surplus is
infinite.
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Elasticity is a concept which involves examining how responsive demand (or supply) is to a change in another
variable such as price or income.

 Price Elasticity of demand (PED) – measures the responsiveness of demand to a change in price
 Price elasticity of supply (PES) – measures the responsiveness of supply to a change in price
 Income elasticity of demand (YED) – measures the responsiveness of demand to a change in income
 Cross elasticity of demand (XED) – measures the responsiveness of demand of good A to a change in
the price of good B

Price Elasticity of Demand

The most common elasticity is Price Elasticity of Demand. This measures how responsive demand is to a
change in price.

• If price of tomatoes increase 20%, and quantity falls by 4%, then the PED = -0.2

Inelastic Demand

Characteristics of Inelastic Demand

With goods which have inelastic demand, there will be a few characteristics:
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 Few if any substitutes, gold, diamonds, petrol, sugar

 Goods which are necessities. E.g. if you drive a car to work, it is a necessity to buy petrol. Therefore, if
the price of petrol goes up you are likely to keep buying it.
 Addictive. If you are addicted to cigarettes/drugs, you will keep buying even if the price goes up.
 Bought infrequently and small percentage of income. If salt increases in price, most people wouldn’t
mind.

Elastic demand

Demand is said to be price elastic – if a change in price causes a bigger % change in demand. In the above
example, the price rises 20%. Demand falls 50%. Therefore PED = -50/20 = -2.5

Elastic demand means that you are sensitive to changes in price. For example, if the price of Nestle’s mineral
water increases, you would probably switch to other varieties of mineral water. Therefore a change in price
causes a bigger % change in demand and your demand is quite elastic.

Goods which are elastic, tend to have some or all of the following characteristics:

1. They are luxury goods, e.g. sports cars

2. They are expensive and a big % of income e.g. sports cars and holidays

3. Goods with many substitutes and a very competitive market. E.g. if Sainsbury’s put up the price of its bread
there are many alternatives, so people would be price sensitive.

4. Bought frequently

Using Knowledge of Elasticity

1. If demand is inelastic then increasing the price can lead to an increase in revenue. This is why OPEC try to
increase the price of oil.

Graph showing increase in Revenue following increase in price

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2. If demand is elastic, firms would be unlikely to increase revenue as this could lead to a fall in revenue.
Instead, they could try advertising to increase brand loyalty and make demand more inelastic

3. Tax incidence: If demand is price inelastic, then a higher tax will lead to higher prices for consumers (e.g.
tobacco tax). The tax incidence will mainly be borne by consumers. If demand is price elastic, firms will face a
bigger burden, and consumers will have a lower tax burden.

Factors That Affect the Price Elasticity of Demand

1. Availability of close substitutes: If consumers can substitute the good for other readily available goods that
consumers regard as similar, then the price elasticity of demand would be considered to be elastic. If
consumers are unable to substitute a good, the good would experience inelastic demand.

2. If the good is a necessity or a luxury: The price elasticity of demand is lower if the good is something the
consumer needs, such as Insulin. The price elasticity of demand tends to be higher if it is a luxury good.

3. The proportion of income spent on the good: The price elasticity of demand tends to be low when spending
on a good is a small proportion of their available income. Therefore, a change in the price of a good exerts a
very little impact on the consumer’s propensity to consume the good. Whereas, when a good represents a large
chunk of the consumer’s income, the consumer is said to possess a more elastic demand.

4. Time elapsed since a change in price: In the long term, consumers are more elastic over longer periods, as
over the long term after a price increase of a good, they will find acceptable and less costly substitutes.

Evaluation:

1. PED only works at a given period of time because the demand of consumers change over time.

2. The producers do not have ability to change prices as and when they like to.
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3. Demand tends to be more price inelastic in the short-run as consumers don’t have time to find alternatives.
In the long-run, consumers become more aware of alternatives

Cross elasticity of demand

Cross elasticity of demand (XED) measures the percentage change in quantity demand for a good after a
change in the price of another.

For example: if there is an increase in the price of tea by 10% and the quantity demanded for coffee increases
by 2%, then the cross elasticity of demand = 2/10 = +0.2

 Substitute goods will have a positive cross-elasticity of demand.

 Complements will have a negative cross elasticity of demand
 Unrelated goods will have a cross-elasticity of demand of zero. The price of apples has no effect on
demand for Apple computers.

Substitute Goods and XED

• Weak substitutes like tea and coffee will have a low cross elasticity of demand. If the price of tea increases,
it will encourage some people to switch to coffee. But for most people, their preference for a particular drink is
more important than a small difference in price

• For two alternative brands, for example, Starbucks Coffee and Costa Coffee, these goods are closer
substitutes as the difference is much smaller. If the price of Costa Coffee increases, more consumers will
switch to an alternative brand such as Starbucks. With close substitutes, the XED will be higher

Complementary Goods and XED

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These are goods which are used together, therefore the cross elasticity of demand is negative. If the price of
one goes up, you will buy less of both goods.

 If the price of tea increases, there will only be a very small fall in demand for milk. It will have a
negative cross elasticity of demand, but it will be a low figure.
 However, for two goods like Android Phones and Android Apps, there is a stronger relationship. If the
price of Android Phones increases, this will reduce the demand for Android Phones and therefore,
there will be less demand for Android Apps.

Using knowledge of cross elasticity of demand

Substitutes? When setting prices firms will have to look at what alternatives the consumer has, if there are no
close substitutes they will be able to increase the price. For this reason, firms spend a lot of money on
advertising to differentiate their products and reduce cross-elasticity of demand.

Loss leaders: Firms can use knowledge of complementary products to increase overall revenue. For example,
many companies sell printers as cheaply as possible because if they sell a printer, they know the demand for
their replacement ink cartridges will increase.

If a firm makes a small increase in price and finds people are very willing to switch to alternatives (high XED)
they may make greater efforts to pursue product differentiation and brand loyalty to reduce XED.

Evaluation: Through advertising brand loyalty increases which makes consumers less willing to switch to
another brand – even if price rises.

Income elasticity of demand

Income elasticity of demand (YED) measures the responsiveness of demand to a change in income.

If income rises 10%

 Demand for Tesco bread falls 5%. YED = -0.5 (inferior good)
 Demand for butter increases 8%. YED = 0.8
 Demand for organic bread increases 17%. YED = 1.7
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Definition of Inferior Good

This occurs when an increase in income leads to a fall in demand therefore YED<0. When your income
increase you buy better quality goods and so buy less of the low-quality goods

 Vital value tea as compared to lipton is – an inferior good

 Examples of inferior goods are clothes from charity shops, cheap bread.
 For example, if your income increased 10% and demand for Vital tea sales fell 15%. The YED =
 -15/10 = -1.5

Definition of Normal good

 This occurs when an increase in income leads to an increase in demand for the good, Therefore YED
>0
 For example, if demand for apples rose 4% after a 10% rise in income. The YED = 4/10 = 0.4

Definition of Luxury good

This occurs when an increase in demand causes a bigger percentage increase in demand, therefore YED>1.

For example, if your spending on Game Apps increases 25% after a 10% increase in income – this is luxury
good; the YED = 2.5

 Luxury goods will also be normal goods and we can say they will be income elastic.
 Income inelastic. This means an increase in income leads to a smaller % increase in demand.
Therefore 0> YED <1

Uses of Elasticity of Demand

The concept and theory of elasticity of demand play a vital role in the solution of economic problems
and the determination of various economic policies. Mainly there are four types of elasticity of
demand (price, income, cross, and advertisement). Here we will talk about the importance or uses of
price elasticity of demand. The concept of all the types of elasticity of demand plays a vital role in the
understanding of different economic activities, the relationship between different economic
activities, and they provide guidelines for the analysis and formulation of different economic policies.
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Importance of Price Elasticity

Price Elasticity is a tool to analyze various economic problems, issues, policies, and programs of
different sectors of an economy. Most of the applications of the concept of the price elasticity of
demand have to do with pricing decisions of business firms, government agencies that directly or
indirectly regulate price. The businessman must know the effect of the price change on quantity
demand of the product and factor in the market with the help of the concept of price elasticity of
demand. The following table shows the major importance or use of price elasticity of demand.

Importance Description
1. Product Pricing By using the concept of price elasticity of
demand, the business firms can determine
whether a decline in price is better or a rise in
price is better to increase sales, total revenue,
and the profitability of the business. Generally,
the lower price is xed for the elastic product and
the higher price is for the inelastic product.

2. Price Discrimination It is the act of charging different prices to

different buyers in different markets for identical
products. It is one of the major attributes of a
monopolist seller. Low price is charged in the
market where there is elastic demand and the
higher price is charged in the market in which
price elasticity is relatively low.
3. Pricing and nationalization of Public
Utilities Public utilities are very important for the daily life
of all the people living in the country and
generally, their demand is inelastic. If they are
left at the hand of the private sector, they might
be charged a very high price and there will
reduction in the people’s welfare. Therefore, the
elasticity of demand is used while deciding
which economic undertaking should be
controlled by public authority and which is left on
the hand of the private sector. Similarly, the
pricing problem of public utility is also solved by
4. Pricing of Joint Product price elasticity.

In the case of a joint product like wool and

mutton, paddy and straw, chicken and eggs, etc.
their pricing issue is solved with the help of price
elasticity. The separate pricing is very di cult in
such cases or the separate cost of predication is
not known in such type of joint product. Thus,
5. Demand Forecasting the concept of price elasticity of demand is used
to determine their separate price.
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The value or coefficient of price elasticity of

demand is useful to forecast the future demand
of a commodity. The determination of elasticity
will let know a business firm about the
percentage change in demand with one
6. Shifting Tax Burden percentage change in price. So given the value
of elasticity of demand, future demand
forecasting would become easy.

The shift of the burden of tax is also based on

the degree of price elasticity of the product. If
7. International Trade the value of price elasticity of demand is
relatively lower, then the businessman will shift
more burden of tax on the hand of buyers and
vice versa.

The pricing of goods to be import or export is

also based on these goods’ elasticity of demand.
If the elasticity is higher in the foreign market
8. Formulation of Tax Policies then the lower price is xed for exporting products
and if the value of elasticity is lower than a
higher price is charged for exporting goods by
the domestic firms or government.

The taxation policy of the government is also

based on the elasticity of the products.
Generally, higher taxes are charged on the
products having less elasticity and vice-versa.
Similarly, the government may decide their
9. Factor Pricing protection or subsidy policy for those goods or
products whose elasticity is comparatively high.
It is because they may not be able to face
competition until the prices of these products
are supported by subsidies.

The elasticity of demand concept is also useful

to determine the price of factor inputs. If the
demand for input is elastic, the entrepreneurs
are prepared to pay a low price and vice versa.

Use of Income Elasticity

Income elasticity of demand helps a firm to know the income elasticity for its products and to select
target markets and make forecasts. It is the fact that the income of the consumer is not a
controllable factor for the business firm, but a firm can get selective control by selecting a target
market and target group of the consumers. From the business viewpoint, the concept of income
elasticity of demand has the following important uses.
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Importance Description
1. Demand Forecasting
If the income elasticity of the particular product,
the rate of increase in the income of the target
market is known then the firm can easily
forecast the demand for its products. Thus the
knowledge of income elasticity of demand gives
an idea of how much to produce at a different
level of income. In the long-run, the demand for
luxurious products may become income elastic.
Thus the business firms may formulate their
business strategies accordingly.
2. Classification of Goods
The income elasticity of demand helps to
classify the commodities. Whether the product is
a normal good, luxurious normal good, essential
good, inferior good, or neutral good, we can
easily classify with the help of the coefficient of
income elasticity of demand. If the coefficient of
income elasticity of demand is positive, the
commodity is normal, if greater than one, the
commodity is luxurious, the coefficient is
positive but less than one then the commodity is
essential, if it is negative then the good is
3. Helpful in Strategic Decisions inferior and when it is zero then the commodity
is neutral good.

The business can classify all the people into

different classes based on the measurement of
income elasticity of demand. They can then
produce their product accordingly. The firm
produces high-quality expensive products if its
strategy is to target the richer class of society. In
contrast, they focus to produce normal and low
priced goods if they have the strategy to cover
the comfort and common type of market and
class of people. Thus, the business firm can
4. Helpful to Government for Policy classify the entire market into different classes
Formulation based on income elasticity of demand and
accordingly formulate business policies and
strategies.

The governmental organs also use the concept

of income elasticity of demand in the
formulation of different types of policies. For
example, for the imposition of taxation, the
government can use the concept of income
5. Helpful in Designing Marketing Activities elasticity of demand. The income elasticity of
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demand is highly elastic for luxurious goods and

it is less elastic for normal goods. Thus which
good is to be taxed can be seen from the point
of income elasticity also

Marketing activities deal with promotional

activities of the business for firms.
Generally, businesses apply different types of
promotional tools and activities to increase their
sales volume and profitability. If there is high-
income elasticity of a product then extensive
marketing strategies can be applied to attract
more consumers and increasing the possibility
of business expansion in the future while an
increase in income of the consumers.

Importance of Cross Elasticity of Demand

Business firms want to know the cross elasticity for their product to see their main competitors, their
strategies, and the formulation of their own firm’s business policy according to their observation.
Thus, cross elasticity is a useful tool to formulate business and pricing decisions. The following are
the major uses of cross elasticity of demand.

Importance Description
1. Categorization of Goods The concept of cross elasticity of demand is
useful for the categorization of goods. If the
cross elasticity is positive then two goods are
substitutes and in the case of negative two
goods are complementary. Similarly, if cross
elasticity is zero then goods are independent.
After knowing the commodities the firms can
formulate their policies accordingly.
2. Pricing Policy Related to Other’s Product
The products produced by anyone company are
in many ways related to the output of other
company’s products. Thus their demand is
directly affected by the pricing policies of other
producing firms. By knowing the cross elasticity
the business firm can get information regarding
the pricing policies of other competitors and they
3. Establishment of Interrelation between can formulate the best price for their products.
Industries Based on the measurement of cross elasticity of
demand different industries got to know their
relation as to whether they are related to each
other complementarily or they are substitutable.
In case they are substitutable they cannot raise
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their prices without making consideration and

coordinating with other industries. Similarly, if
they are related complementarily, they also
cannot directly alter their strategies without
negotiating their complement industries. So it
establishes a king of interdependence between
industries of the economy.
4. Classification of Market

The market can be classified based on cross

elasticity of demand. The higher the value of
cross elasticity of demand between goods, the
higher will be the competition in the market and
vice-versa. If the cross elasticity is infinite, the
market structure is perfectly competitive. If it is
5. Pricing Policy Related to Own Goods zero, the market is a monopoly.

Different firms produce a different line of

products. They may be substitutes (a cream
company produces varieties of creams) and
complementary (a company may produce
toothpaste and toothbrush). Thus the pricing of
such products can be done with the help of the
concept of cross elasticity of demand.

Evaluation:

1. A luxury good today may become an inferior good tomorrow as changing technology changes consumer
expectations about goods.

2. In order for making sales in either a recession or boom it makes sense for producers to diversify and offer a
range of products. Hence, typically, a car producer will offer budget cars as well as mid-range and expensive
cars, and in this way it can have some confidence that, whatever the state of the macro-economy, it can still
sell its products.

Importance to firms of elasticity

Firms will wish to try and make supply more elastic so they can respond to increased demand. Firms will
consider

 Invest in spare capacity which can be used if demand rises.

 Paying workers overtime to increase production
 Using agencies to hire more workers at busy times.
 To outsource production to other firms who can meet supply
 Improve efficiency and just in time management techniques to increase supply.

However, all these measures will have a cost. Therefore, a firm has to weigh the benefits of more flexible
supply against the costs.
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Price Elasticity of Supply

Price elasticity of supply measures the responsiveness of quantity supplied to a change in price.

The price elasticity of supply (PES) is measured by % change in Q.S divided by % change in price.

 If the price of a cappuccino increases by 10%, and the supply increases by 20%. We say the PES is
2.0.
 If the price of bananas falls 12% and the quantity supplied falls 2%. We say the PES = 2/12 = 0.16

 Inelastic supply – a change in price causes a smaller proportional change in quantity supply
 Elastic supply – a change in price causes a bigger proportional change in supply

Inelastic supply

This means that an increase in price leads to a smaller % change in supply. Therefore PES <1

In this case the PES =

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 % change in Q.S. = (64-60)/60 = 0.06666

 % change in price = (106-80)/80 = 0.325
 PES = 0.2

Factors that make supply inelastic/elastic

Usually if the price increases, the firm would like to supply more. The good becomes more profitable. However,
there may be several factors which make it difficult for the firm to supply more. Therefore supply is price
inelastic.

• Firm operating close to full capacity: If a firm is operating close to full capacity, then it has limited ability to
increase the supply. It may be able to get workers to do some overtime, but at some point, it will meet capital
limits, and it cannot increase supply without long-term capital investment.

• Running out of raw materials: There will come a time when we run out of raw materials – oil, natural gas.
When this occurs, the supply will be inelastic because it is physically impossible to increase supply.

• Short term: Supply will be more inelastic in the short-term. In the short-term capital is fixed. It takes time to
invest and increase the size of a factory. However, in the long-term, farmers can cultivate more land or firms
can increase the size of their factory and supply will become more responsive.

• Limited factors of production: Some firms may come across labour constraints, especially if the work
requires highly skilled labour. For example, the supply of extra maths lessons may be limited by the ability to
employ sufficiently skilled maths teachers.

• Low levels of stock: If firms can stockpile goods, then they can respond to increases in demand and price.
However, some goods cannot be stored, e.g. intangible services or food with short shelf-life like tomatoes and
bananas.

• Planning restrictions: Homes are often supply inelastic because in certain areas it is hard to find suitable
land or get planning permission to build more houses.

Elastic supply

This occurs when an increase in price leads to a bigger % increase in supply, therefore PES >1
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PES

 % change in Q.S. = 110-60/60 = 0.8333

 % change in Price = 106-80/80 = 0.325
 PES = 2.56

Supply could be elastic for the following reasons

 If there is spare capacity in the factory.

 If there are stocks available.
 In the long run, supply will be more elastic because capital can be varied.
 If it is easy to employ more factors of production.
 If a product can be sold from the internet which increases the scope of international competition and
increases options for supply.

Importance of price elasticity of supply

 If supply is elastic, an increase in demand will cause only a small rise in price, but a significant
increase in demand.

 If supply is inelastic, an increase in demand will cause a large rise in price but only a small increase in
demand

In price mechanism, if there is any change occur in demand and supply, there are certain changes in price and
equilibrium output. If demand for normal goods increases due to any reasons (non-price determinants of
demand), there will be a change in prices. If supply is inelastic, there will be a bigger rise in price as compare to
elastic supply. So if supply is elastic firms’ income will be stable as demand changes but if supply is inelastic,
firms’ income is vulnerable.

Firm which have high price elasticity of supply are more risk bearing because they are highly responsive to
change in prices. It makes them more competitive as compare to their rival firms so they are able to make
more revenue and profits.

Similarly if government levies indirect taxes, producer will bear more burdens if supply is inelastic but gain
more if state subsidizes the product and vice versa. So this concept is also important for the state.
Government prefers to tax such goods which have low price elasticity of supply, because it may not disturb
output and employment considerably.
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Chapter 4: Government Microeconomic intervention

Public Goods: Most economic arguments for government intervention are based on the idea that the market
cannot provide public goods or handle externalities. Public health and welfare programs, education, roads,
research and development, national and domestic security, and a clean environment all have been labeled
public goods.

Public goods have two distinct aspects—"non-excludability" and "non-rivalrous consumption." Non-excludability
means that non-payers cannot be excluded from the benefits of the good or service. If an entrepreneur stages
a fireworks show, for example, people can watch the show from their windows or backyards. Because the
entrepreneur cannot charge a fee for consumption, the fireworks show may go unproduced, even if demand for
the show is strong.

The fireworks example illustrates the "free-rider" problem. Even if the fireworks show is worth a thousand
rupees to each person, no one will pay thousand rupees to the entrepreneur. Each person will seek to "free-
ride" by allowing others to pay for the show, and then watch for free from his or her backyard. If the free-rider
problem cannot be solved, valuable goods and services, ones that people want and otherwise would be willing
to pay for, will remain unproduced.

The second aspect of public goods is what economists call non-rivalrous consumption. Assume the
entrepreneur manages to exclude non-contributors from watching the show (perhaps one can see the show
only from a private field). A price will be charged for entrance to the field, and people who are unwilling to pay
this price will be excluded. If the field is large enough, however, exclusion is inefficient because even non-
payers could watch the show without increasing the show's cost or diminishing anyone else's enjoyment. That
is non-rivalrous competition to watch the show.

Solutions to the Free Rider Problem

 Tax and government provision: One solution is to treat the many beneficiaries as one consumer and
then divide the cost equally. For example, national defense costs $13bn. This results in higher taxes
for taxpayers. Therefore the cost of national defense is paid indirectly by taxpayers. This ensures
everyone who benefits from the service pays towards the cost.
 Appealing to people’s altruism: For some goods like visiting a garden, the garden may be able to raise
funds by asking for donations if you enjoy your visit. There will probably be many ‘free riders’ who don’t
make a donation. But, enough people may be willing to make a donation to fund the cost of the
garden/museum. This solution is only effective for services which have a relatively low cost.
 Make a public good private: A beautiful garden could be seen as a public good. However, if you erect a
high barrier and limit entrance to those willing to pay, it loses its feature as a public good and
becomes a private good.

Externalities

 Externalities: Externalities occur when one person's actions affect another person's well-being and the
relevant costs and benefits are not reflected in market prices.
 Positive Externality: This occurs when the consumption or production of a good causes a benefit to a
third party. For instance, when you consume education you get a private benefit. But there are also
benefits to the rest of society. E.g you are able to educate other people and therefore they benefit as a
result of your education.
 Negative Externality: A negative externality arises when one person's actions harm another. When
polluting, factory owners may not consider the costs that pollution imposes on others.
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Merit and Demerit goods

Definition of Merit Good

A merit good has two characteristics:

1. People do not realize the true personal benefit. For example, people underestimate the benefit of education
or getting a vaccination.

2. Usually, these goods also have a positive externality.

Therefore in a free market, there will be under consumption of merit goods.

Examples of Merit Goods

• Health Care – people underestimate the benefits of getting a vaccination. If people do get a vaccination,
then there will be a personal benefit in protecting against diseases. Also, there will be external benefits to the
rest of society because it will help reduce the prevalence of disease in the rest of society.

• Museums – the educational benefit of museums may be unappreciated.

Definition of Demerit Good

A demerit good has two characteristics:

1. A good which harms the consumer. For example, people don’t realise or ignore the costs of doing something
e.g. smoking, drugs.

2. Usually, these goods also have negative externalities. If you smoke you harm yourself, but also the smoke
negatively affects other people.

Therefore in a free market, there will be overconsumption of these goods.

Examples of Demerit Goods include:

 Smoking – People underestimate health costs or risks of getting addicted.

 Drinking sugary soft drinks – which damage teeth and cause obesity.

Evaluation-However, Merit and demerit goods involve making a value judgment that something is good or bad
for you. Classification is not always straightforward.

Remedies for Externalities

1. Refined Property Rights

When there are refined property rights, all parties are able to negotiate the cost of the externalities produced
from using merit/demerit goods. For example, an owner of a fishery may be affected by downstream pollution
from an industrial firm. The owner of the fishery is able to sue the industrial firm in order to be compensated
for the effect it has had on them. In turn, a settlement can be reached to be reimbursed for that negative
externality.

2. Taxes
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When there are externalities from demerit goods such as pollution, one remedy is to tax them based on units
of consumption. For example, a firm that produces 10 thousand tonnes of carbon-dioxide will be taxed at a
rate of Rs1 lack per tonne. These taxes could then be used to pay for positive externalities such as education
and other public goods.

3. Subsidies

Positive externalities (merit goods) are under produced when the whole social benefit is greater than the
private benefit. In such situations, the merit good is under produced because private individuals value the good
at a lower rate than the overall value it provides to society. One way to resolve this is by offering subsidies and
other financial incentives. For instance, many governments offer a ‘green scheme’ to make it more affordable
to purchase electric cars.

4. Regulation

Another remedy to address externalities is regulation. By making negative externalities illegal, they may
address some of the side effects that occur and reduce its consumption and production. For instance, many
countries have now made it illegal to smoke in a public place, which has helped reduce the effects of second-
hand smoke.

Types of tax

A tax is a charge levied by a government to raise revenue.

Direct and indirect taxes

A direct tax is a tax that a person or company pays directly. For example, income tax is taken out of your salary.

An indirect tax is paid by a third party. For example, when you buy a TV, there is a VAT charge which is included
in the price, the consumer does not pay, but the firm who sells the good is responsible for paying the tax to the
government on your behalf.

Progressive, proportional and regressive taxes

 A progressive tax takes a higher percentage of tax from people with higher incomes.
 A proportional tax means different income levels pay the same % of income in tax.
 A regressive tax takes a higher percentage of tax from people with low income.

Ad valorem vs. specific tax

An ad valorem tax is a certain percentage of the price of the good. VAT is levied at 20% so the more expensive
the good is the more VAT that is paid.
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A specific tax is a fixed levy whatever the price of the good. For example, a £20 passenger levy on long-haul
flights.

The burden of indirect taxes

The application of an indirect tax causes the supply curve to shift to the left. If the government imposes an
indirect tax on a good, the effect on the final price depends on the elasticity of demand. If demand is price
inelastic, then the firm will be able to pass on the majority of the tax to the consumer (consumer burden). If the
demand is price elastic, then the producer will absorb most of the tax in reduced profit margin (known as
producer burden)

ADVANTAGES OF INDIRECT TAXES DISADVANTAGES OF INDIRECT TAXES

Everyone can contribute in indirect taxes: Unlike Indirect Tax can be regressive: Since indirect tax is
Income Tax, which has to be paid by individuals in the same for both the rich and the poor, it can be
certain income brackets and not others, Indirect deemed unfair to the poor. Indirect tax is applicable to
Taxes have to be paid by each and every one who anyone who makes a purchase, and while the rich can
purchases the commodity. Persons not working in afford to pay the tax, the poor will be burdened by the
India like tourists and persons of lower economic same amount of tax. Thus, indirect taxes may be seen
strata also have to pay it because they will in some as regressive.
form purchase commodities. Indirect taxes raise price of commodities: Sellers
Indirect taxes are convenient: Indirect taxes are very cannot always calculate and collect the exact fraction
convenient as far as charging them is concerned. of tax applicable on all commodities that they sell.
Firstly, the taxes can be very nominal and consumers And hence they consciously charge more than the tax
do not feel burdened when paying such small amount so they can be sure that every buyer paid the
amounts. Secondly, these indirect taxes are said to be indirect tax. But this has a cumulative effect and
‘hidden in the price’, which means that the consumer increases the price of commodities.
only effectively sees the price of the commodity itself. Indirect taxes do not raise civic consciousness:
AS Micro Economics – Notes Nabeel Ismail Economics - 03008578998

Indirect taxes cannot be evaded: Indirect taxes cannot Indirect taxes do not raise civic awareness because
be evaded, because they are part of the price of the millions are not even aware that they’re paying a tax
commodity. So anyone who buys the commodity will because it is hidden in the price.
pay the tax.
Indirect taxes are spread over a wide range: Heavy
taxation in any one aspect of a service or commodity
will be highly noticeable as well as a burden on the
consumer. In this regard, indirect taxes can be
beneficial since they are spread out over a wide range
of products in smaller amounts.
Indirect taxes reduce consumption of demerit goods:
As demerit goods are over consumed in an economy
due to failure of provision of information so, through
indirect taxes the government reduces the
consumption of demerit goods.

The burden of direct taxes

A direct tax is paid for by the individual the government is aiming to tax. For example, with income tax, workers
pay the tax directly to the government. Direct taxes can have a higher political cost because the impact is more
pressing to the individual.

Advantages of Direct Tax Disadvantages of Direct Taxes

(i) Equitable: The burden of direct taxes cannot be (i) Inconvenient: The great disadvantage of a direct
shifted. Hence equality of sacrifice can be attained tax is that it pinches the payer. He ‘squeaks’ when a
through progression. Of course, the very low incomes lump sum is taken out of his pocket. The direct- taxes
can be exempted. This cannot be achieved- by taxes are thus very inconvenient to pay. Nobody can help
on commodities which fall with equal force on the rich feeling the pinch.
and the poor. The tax raises the price of the (ii) Evadable: The assesse can submit a false return of
commodity, and the price of a commodity is the same income and thus evade the tax. That is why a direct-
for every person, rich or poor. tax is “a tax on honesty.” There is a lot of evasion.
(ii) Economical: The cost of collection of direct taxes is Many of those who should be paying taxes go scot-
low. They are mostly collected “at the source”. For free by concealing their incomes.
instance,-the income tax is deducted from an officer’s (iii) Arbitrary: If taxes are progressive, the late of
pay every month. This saves expense. The employer progression has to be fixed arbitrarily; and if
acts as an honorary tax collector. This means great proportional, they fall more heavily on the poor. Thus,
economy. both are bad. The rate of taxes depends upon the
(iii) Certain: In the case of a direct tax, the payers whim of the Finance Minister. This is arbitrary.
know how much is due from them and when. The (iv) Disincentive: If the taxes are too heavy, they
authorities also know the amount of revenue they can discourage saving-sand investment. In that case the
expect. There is certainty on both sides. This country will suffer economically. A high level of
minimises corruption on the part of collecting officials. taxation discourages investment and enterprise in the
(iv) Elastic: If the State suddenly stands in need of country. It inflicts a lot of damage, on business and
more funds in an emergency, direct taxes can well industry.
serve the purpose. The yield from income tax or death (v) Less discretionary income: Those paying income
duties can be easily increased by raising their rate. tax will be left with less discretionary income to spend
People cannot stop dying for fear of paying death after income tax has been deducted. This is likely to
duties lead to lower levels of household spending and lower
levels of household saving. However, if the
government spend the tax revenue – overall
aggregate demand (AD) will not be affected.
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Deadweight Welfare Loss of Tax

Taxes can distort economic behavior.

For example, suppose when petrol costs Rs50. You make 1 journey a day.

If the government puts a tax on Rs40 on petrol, it will now cost Rs90. This may cause some people to stop
travelling. This will lead to a loss of consumer surplus. You no longer buy a good you would have consumed
without the tax

Also, producers (petrol retailers) will lose out because they are selling less.

Also, the government doesn’t get tax revenue from the people who don’t travel. Therefore there is a net welfare
loss to society.

The above diagram shows deadweight welfare loss that arises from a simple tax. It is the area showing loss of
consumer and producer surplus and no government tax revenue.

Subsidies
A subsidy is an amount of money given directly to firms by the government to encourage production and
consumption. A unit subsidy is a specific sum per unit produced which is given to the producer.

The effect of a specific per unit subsidy is to shift the supply curve vertically downwards by the amount of the
subsidy. In this case the new supply curve will be parallel to the original. Depending on elasticity of demand,
the effect is to reduce price and increase output.
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Subsidies are negative taxes and their imposition shifts supply curve downwards by the subsidy per unit.

Subsidies are mainly provided to merit goods because the consumption of merit goods is low in the economy
due to failure of provision of information.

Subsidies are of two types:

Specific subsidy

A specific subsidy is one, the amount of which does not change with the price/value of the product e.g. a
subsidy of $0.50/unit.

Such a subsidy causes a parallel, downward shift in the supply curve, as shown Fig. 11.12. S0 is the original
supply curve and S1, the supply curve after subsidy.

In case of specific subsidy, the vertical distance between two supply curves i.e. the subsidy per unit is constant
throughout.

Ad valorem subsidy (percentage subsidy)

Ad valorem subsidy is one, the amount/unit of which varies directly with the price/value of the product e.g. a
subsidy of 5% of the value of the product.

Ad valorem subsidy shifts the supply curve downwards too, but the vertical distance between the two supply
curves rises continuously with the value of the product, as shown in Fig. 11.13.
AS Micro Economics – Notes Nabeel Ismail Economics - 03008578998

Advantages of Subsidies Disadvantages of Subsidies

1. Lowering prices and controlling inflation: They 1. Shortage of supply: Though one of the
are especially applicable in the area of advantages of subsidies is the greater supply
production cost inputs such as fuel prices, of goods, a shortage of supply can also occur.
particularly when global crude oil prices are This is because lowered prices can lead to a
rising. Many countries subsidize fuel costs in sudden rise in demand that many producers
order to keep prices from ballooning. may find very hard to meet. Ultimately, it can
2. Preventing the long-term decline of lead to very high demand that causes an
industries: There are many industries that increase in prices.
should be kept alive and functional, such as 2. Difficulty in measuring success: Subsidies
fishing and farming because they are are usually effective and helpful. However, if
essential to support a population. Many new the government were to make a report of its
and fast-growing industries may also benefit success in using subsidies, it would be a
from being subsidized. different story. This is because it is hard to
3. A greater supply of goods: Governments want quantify the success of subsidies. It is
to increase the access of their population to difficult to estimate the extent of the positive
Goods & Services such as Water, Food, and externality, therefore the government may
Education. They, therefore, provide an have poor information about the service and
incentive that could be in the form of a tax how much to subsidize.
credit or even straight up cash. Markets that 3. Higher taxes: How will the government raise
have positive externalities are usually the funds to use for subsidizing industries? Of
ones that receive such benefits. course, by imposing higher taxes. So, it is the
4. Social Efficiency: Enables greater social general population and corporations who
efficiency. Consumers end up paying the provide the means to enable the government
socially efficient price which includes the to subsidize industries. e.g. income tax, may
external benefit. reduce incentives to work. Though the most
5. Negative Externalities: If you subsidize public efficient way to raise revenue for subsidizing
transport, it will encourage people to drive positive externalities would be to tax goods
less, and reduce their negative externalities. with negative externalities, e.g. tax cars
In the long term, subsidies for a good will driving in city centers (congestion charge)
help change preferences. It will encourage and use the money to pay for public
firms to develop more products with positive transport.
externalities. 4. Inefficient suppliers: There is a danger that
government subsidies may encourage firms
to be inefficient and they come to rely on
subsidy rather than improve efficiency.

Effects of Subsidy to Consumer and Producer

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Subsidies reduce the cost to produce for suppliers. This will cause producers to increase their output as they
can earn higher profits per unit. Hence, the supply curve will shift to the right.

The gain to the producer is C – P per unit and the total gain to the producer is CAFP. The overall cost of the
subsidy to the government is the area, CABP1.

Incidence of Subsidies
Similar to taxes, the amount of subsidy received by the consumer vs. the producer depends on the price
elasticity of demand and supply.

For price elasticity of demand, the amount of subsidy passed on to the consumers depends on how much the
consumer is willing to buy up the increase in quantity produced, given a fall in price. This determines the
amount of subsidy the firm passes on to the consumer.

What about elasticity of supply?

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The more inelastic the supply curve, the higher the subsidy received by the producer. This is because a large
increase in price received by the producer is required to increase output (quantity produced) in the market.

 If demand is price elastic, a subsidy leads to large increase in demand

 If demand is price inelastic, a subsidy is relatively ineffective in increasing demand.

Direct provision of goods and services by the government

The existence of externalities provides an important argument for the common ownership, or nationalization of
a number of key industries.

The argument is that privately owned firms, in order to survive in a competitive world, necessarily have to put
their own interests before those of society at large, for to do otherwise might be inconsistent with the goal of
long run profit maximization, or even survival. This harsh reality of the market is likely to manifest itself in the
generation of negative externalities such as pollution, as the control of these externalities would involve higher
costs and an adverse impact on profits; conversely, production activity which conferred net positive
externalities on society might not be undertaken in sufficient quantities if the criterion of private profitability
could not be met.

Nationalized industries, on the other hand, which, on account of being commonly owned, could be operated
according to broad social criteria, rather than the narrow commercial one of private profitability, and this allows
for the possibility of externalities to be fully incorporated into production decisions. Thus, for example,
questions of workers' safety standards and atmospheric pollution could be accorded priority status, rather than
being ignored on the grounds that to do otherwise would adversely affect profits and competitiveness; and
activities such as the keeping open of 'uneconomic' pits and the provision of postal and transport services to
remote outlying areas, could all be maintained on the grounds that they provide substantial positive
externalities to society at large, although not necessarily being profitable in the sense that the private revenues
from such activities exceed the private costs.

PRICE CONTROL

Consumers can be vulnerable, especially when buying necessities that have an inelastic price elasticity of
demand (PED). This is because firms tend to raise prices to maximize their revenues.
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In this situation, the government may implement Price Controls on goods/services to protect consumer welfare
and ensure we are not exploited.

A Price Control is when the government sets a minimum or maximum price for a good or service.

Governments intervene in order to reduce market failure to:

 Ensure price fairness in the market

 Reduce or eliminate negative externalities
 Increase or maximize positive externalities
 Increase the supply of merit goods
 Reduce the supply of demerit goods
 Supply public goods that would be undersupplied by the market

Maximum Prices (or price ceilings) are generally imposed to protect consumers or encourage consumption of
merit goods. However, this tends to create excess demand in the market due to the lower price.

This means there will be a greater quantity demanded of the good compared to what is supplied, and not all
consumers can benefit from buying the good at a reduced price, as some will not be able to purchase it!

We can analyze this using a Demand & Supply diagram. Assume the price of rental in Lahore

Price is normally PE. Given the unreasonable housing prices, the government now imposes a maximum rent of
PMax in the market. Note that the maximum price will need to be below the original market equilibrium for it to
have an effect on the market. Otherwise producers will just sell at the original price of P E.

As the price is now lowered, the amount that suppliers are willing to produce will be lower than the original
equilibrium. The maximum price will intersect the supply curve and show a lower quantity supplied by
producers (Qs), which is lower than the previous market quantity (QE). On the other hand, the amount that
consumers are willing to buy will increase due to the fall in price. The maximum price will intersect the demand
curve and show us the quantity demanded by consumers (Qd), which is higher compared to the previous
market quantity (QE).

As a result, there will actually be lower quantities of the good available in the market. This is because even
though there is high quantity demanded (Qd), there is not enough quantity supplied to meet the demand (Qd >
Qs). We call this situation in the market excess demand (or shortage), where the market lacks a quantity of Qs -
Qd of the good. This means some consumers are unable to the buy the good. The actual market quantity
transacted will be Qs, which is lower than the original equilibrium QE.
AS Micro Economics – Notes Nabeel Ismail Economics - 03008578998

What are the benefits of maximum pricing?

 Consumers demand more - if maximum prices are set below the current equilibrium price, the market
price will have to fall to a new level. Consumers will likely increase their demand for the good/service.
 The rules are simple for firms to follow - the policy is law and therefore has to be followed. The
maximum price is very clear to the seller.

What are the disadvantages of maximum pricing?

 Leads to imbalance in the market - maximum pricing will cause demand to outweigh supply. Even
though consumers want to buy more at the lower market price, firms do not want to supply more
because the price is lower than it used to be.
 Emergence of black markets - if the maximum pricing laws are extreme enough, it can lead to an
increase in black market activity which is costly for society due to the increase in criminal activity. It
can cost the government (therefore, the taxpayer) to police.

Evaluation of Maximum prices

The most effective way to implement maximum prices would be to also try and deal with the supply. If housing
is too expensive, a long-term solution is to build more affordable housing – and not just rely on maximum
prices.

Maximum prices may be most useful in the case of a monopoly who is both restricting supply and inflating
prices. An alternative may be to reduce the power of monopolies; though, in some industries, this is not
possible – so maximum prices will be the most effective.

Minimum Price
A minimum price is a form of government intervention that prevents the price of a good or service from falling
to low thus being unfair. The most common minimum price is the minimum wage–the minimum price that can
be paid for labor. Minimum price or Price floors are also used often in agriculture to try to protect farmers.

For a price floor to be effective, it must be set above the equilibrium price. If it’s not above equilibrium, then
the market won’t sell below equilibrium and the price floor will be irrelevant.
AS Micro Economics – Notes Nabeel Ismail Economics - 03008578998

 They can strictly enforce the price floor and let the surplus go to waste. This means that the suppliers
that are able to sell their goods are better off while those who can’t sell theirs (because of lack of
demand) will be worse off.
 The government can control how much is produced. To prevent too many suppliers from producing,
the government can give out production rights or pay people not to produce which can lead to bribery
on the long run.
 They can also subsidize consumption.

What are the benefits of minimum pricing?

1. Consumers demand less- if minimum prices are set above the current equilibrium price, the market price
will have to increase to a new level. Consumers will likely decrease their demand for the good/service.

2. The rules are simple for firms to follow - the policy is law and therefore has to be followed. The minimum
price is very clear to the seller.

What are the disadvantages of minimum pricing?

1. Leads to imbalance in the market - minimum pricing will cause supply to outweigh demand. Even though
consumers want to buy less at the lower market price, firms are encouraged to want to sell more due to the
price being higher.

2. Emergence of black markets - if the minimum pricing laws are extreme enough, it can lead to an increase in
black market activity which is costly for society due to the increase in criminal activity. It can cost the
government (therefore, the taxpayer) to police. For example, there could be a rise in illegal smuggling into the
country and sales of cigarettes that are kept off the books.

3. It won't affect the rich so much - a minimum price and inflated prices is unlikely to deter the richer in society
from consuming the product. This might not decrease the consumption of the good/service by as much as
desired.

Evaluation of Minimum Wages

 The effect of a min wage on unemployment is uncertain, the structure of the labour market is very
important. E.g. if the labor market is a monopsony, a minimum wage may not cause unemployment.
 Empirical evidence from the US and the UK suggests that a moderate increase in the minimum wage
doesn’t cause a fall in employment. Therefore the key question is how high the minimum wage can
rise before causing unemployment.
 The impact of the minimum wage on wage differential is important. For example, skilled workers just
above the minimum wage may feel they deserve more. Therefore, an increase in the minimum wage
may lead to wage increases for all pay grades. However, increasing the minimum wage tends to have
limited impacts on wage differentials.
 There may be a good case for a regional minimum wage because actual wages tend to be different in
different parts of the country as it would depend on the cost of living in the city/ rural area.

Buffer stocks
A buffer stock is a price control where the government seeks to keep the price within a certain band. It is
effectively combining elements of maximum and minimum prices. The aim is to both stabilise prices (and
incomes) for farmers and prevent shortages and high prices. If successful, the government buy surplus in a
good harvest and then sell surplus if there is a shortage.
AS Micro Economics – Notes Nabeel Ismail Economics - 03008578998

Transfer Payments

Transfer payments are payments from tax revenue that are received by certain members of the community
without any production activity. They are not made through the market, as no production takes place. Like a
progressive taxation system, their function is to provide a more equitable distribution of income. The main
recipients are vulnerable groups such as the elderly, the disabled, the unemployed and the very poor.
Payments tend to transfer income from those able to work and pay taxes to those unable to work or in need of
assistance.

Advantages of transfer payments: Disadvantages of Transfer payments:

• Less poverty • Acts as an disincentive to accepting to work, so

• More equitable distribution of income increasing the unemployment rate
• Necessary to protect the most vulnerable groups in • Inefficiency
the community • Output in the economy is less than it might be

Causes of changes in absolute poverty

 There is a strong correlation between economic growth & a decrease in absolute poverty
o Economic growth increases household incomes

 Government tax & benefit policies can support the most vulnerable groups in society e.g. children, pensioners,
people stuck in long-term unemployment
o In developed economies, benefit policies can ensure that no household is living in absolute poverty

Causes of changes in relative poverty

 Rising asset prices can decrease relative poverty in households which own their own properties
o Asset prices often increase faster than wages or income

 Trade liberalisation increases potential market size & output in an economy

o This leads to an increase in the demand for labour & a wage rise
o This creates additional income which has a multiplier effect & pulls households out of relative poverty

 Decreased levels of government benefits can lower household income & increase relative poverty

Policies to reduce poverty

In summary, to reduce poverty, government policies could include:

 Means-tested welfare benefits to the poorest in society; for example, unemployment benefit, food stamps, income
support and housing benefit.
 Minimum wages. Regulation of labour markets, for example, statutory minimum wages
 Free market policies to promote economic growth – hoping that rising living standards will filter down to the
poorest in society.
 Direct provision of goods/services – subsidised housing, free education and healthcare.

Inequality
Inequality
AS Micro Economics – Notes Nabeel Ismail Economics - 03008578998

 Income & wealth inequality are two different concepts

o Income inequality refers to the unequal distribution (flow) of income to households i.e. rent, wages,
interest & profit
o Wealth inequality refers to differences in the amount of assets that households own

The two main measures of income inequality are the Lorenz Curve & the Gini coefficient

The Lorenz Curve

 The Lorenz Curve is a visual representation of the inequality that exists between households in an economy
 Data is commonly presented in quintiles (population divided into 5 groups i.e. 20%) or deciles (population divided
into 10 groups i.e. 10%)
o E.g. in 2021 42% of the income flow in the UK went to the top 20% of households (Rich) while only 7%
went to the bottom 20% (poor)

 Perfect income distribution is not the goal (20 % of the population get 20% of the income; 40% get 40% percent
of the income etc.)
o That would equate to socialism & completely remove incentives for work as everyone would be paid
equally

 More equal income distribution is desired as it reduces poverty & social unrest
o What constitutes acceptable income equality is a normative economic issue