Al 12 - chapter 2

 2. Analyses the
Rational Behavior of
Households and
Firms in the Market.
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 Factor Market : is a
market which use to
exchange the services
for a factor of
production: land,
labour, capital,
entrepreneurship.
factor markets also
termed as resource
markets, exchange the
services of factors not
the factors themselves.
 E.g. – labour services of
workers exchanged
through factor markets.
 Market for Goods &
Services : the place of
any convenient set of
arrangements by which
buyers and sellers
communicate to
exchange good and
services.
 Where the people can
satisfy their needs and
wants – a pen , a
phone which is tangible
things. intangible like
services – teaching,
doctor’s advice..
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The Use of Graphs in Economics
 Economic theory identifies important
economic variables and attempts to
explain their relationships. Economists
frequently rely on graphs to illustrate
these relationships.
 Economics: A Tool for Critically
Understanding Society contains
numerous graphs, so it is important to
be clear about how they are
constructed and what they show. 4444

 Variables: The basic elements of algebra,
usually called X, Y, and so on, that may
be given any numerical value in an
equation
 Functional Notation: A way of denoting
the fact that the value taken on by one
variable (Y) depends on the value taken
on by some other variable (X) or set of
variables
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)(XfY =

 Independent Variable: In an
algebraic equation, a variable that
is unaffected by the action of
another variable and may be
assigned any value.
 Dependent Variable: In algebra, a
variable whose value is determined
by another variable or set of
variables.
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 Y is a linear function of X
› Table 1. shows some value of the
linear function Y = 3 + 2X
 Y is a nonlinear function of X
› This includes X raised to powers other
than 1
› Table 1.A.1 shows some values of a
quadratic function Y = -X2
+ 15X
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bXaY +=

Linear Function
Y = f (X)
x = 3 + 2X
-3 -3
-2 -1
-1 1
0 3
1 5
2 7
3 9
4 11
5 13
6 15
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 Graphs are used to show the relationship
between two variables
 Usually the dependent variable (Y) is
shown on the vertical axis and the
independent variable (X) is shown on the
horizontal axis
› However, on supply and demand curves, this
approach is reversed
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 A linear function is an equation that is
represented by a straight-line graph
 Figure 1A. represents the linear function
Y=3+2X
 As shown in Figure 1A, linear functions
may take on both positive and negative
values
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10
5
3
-5-10
-10
-5
0 1 5 10
Y-axis
Y-intercept
X-intercept
X-axis

 The general form of a linear equation is
Y = a + b X
 The Y-intercept is the value of Y when X
equals 0
› Using the general form, when X = 0,
Y = a, so this is the intercept of the
equation
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 The slope of any straight line is the ratio of
the change in Y (the dependent variable)
to the change in X (the independent
variable)
 The slope can be defined mathematically
as
 where Δ means “change in”
 It is the direction of a line on a graph.
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X
Y
∆
∆
==
XinChange
YinChange
Slope

 For the equation Y = 3 + 2X the
slope equals 2 as can be seen in
Figure 1A. by the dashed lines
representing the changes in X and
Y
 As X increases from 0 to 1, Y
increases from 3 to 5
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2
01
35
Slope =
−
−
=
∆
∆
=
X
Y

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10
5
3
-5-10
-10
-5
0 1 5 10
Y-axis
Y-intercept
X-intercept
Slope
X-axis
2
01
35
=
−
−
=
∆
∆
=
X
Y
Y∆
X∆

 The slope is the same along a straight
line.
 For the general form of the linear
equation the slope equals b
 The slope can be positive (as in Figure
1A), negative (as in Figure 1A.2) or zero
 If the slope is zero, the straight line is
horizontal with Y = intercept
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 Figure 1A.4 shows the graph of the
nonlinear function Y = -X2
+ 15X
 As the graph shows, the slope of
the line is not constant but, in this
case, diminishes as X increases
 This results in a concave graph
which could reflect the principle
of diminishing returns
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Y
60
50
40
A
30
20
10
0 1 2 3 4 5 6
X

 The graph of a nonlinear function is not a
straight line, Upward sloping curve.
 Therefore it does not have the same
slope at every point
 The slope of a nonlinear function at a
particular point is defined as the slope of
the straight line that is tangent to the
function at that point.
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 The points are ones for which the slope is
zero.
 As in the graphs below; point A is the top
of the curve, so it’s the maximum point
and point B is the bottom of the curve,
so it’s the minimum point.
 The value of these slopes of the curve at
each point are zero.
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MAXIMUM POINT
SLOPE = 0

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MINIMUM POINT
SLOPE = 0

 Demand – is a schedule
indicating the quantity of a
well defined good that
consumers are willing and
able to buy at each possible
price during a given period of
time, other things being
constant (Ceteris Paribus).
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 Consumers desire to but
something is backed by
willingness and an ability to
pay for it is called as
effective demand.
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 Consumers – people who make decisions
about buying goods, services. some
consumers are individuals acting for
themselves alone, others are members of
households buying on behalf of their
groups.
 Consumer Motivations – we assume that
consumers seek to allocate their
expenditures among all the goods &
services, that they might buy so as to gain
the greatest possible satisfaction.
 Demand is a flow, it takes place over time
measured as so much per period of time.
thus it means effective demand that in the
sense of being able and wiling to buy.
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 Individual Demand – the quantity of a
commodity that an individual is willing and
able to buy during a given period of time.
 Influencing factors of a consumers demand
for good X over given period of time (d x );
1. Price of good X (P x)
2. Prices of other goods X (P r)
3. Consumers income ( y )
4. Consumers taste ( T )
5. Consumers expectations ( E )
6. Advertising ( A )
7. Other factors, like population ( Z ) 26
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 We can writ the demand function;
d x = f ( P x , P R, y, T, E , A , Z )
 Ceteris Paribus – Economists analyze
the relationship between a consumer’s
demand for good X and the price of X
by assuming all other factors remained
unchanged.
d x = f ( P x ) , Ceteris Paribus
 This states that individuals demand for X
is determined by the price of X,
assuming all others constant.
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 An individual demand curve for a
good – shows the relationship
between the quantity demanded
by the individual and the price of
the good, ceteris paribus.
 Demand Schedule – is a table
showing how much of a given
product a consumer would be
willing to buy at different prices.
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Price of X
Pence per unit
Consumer’s
Demand
Units per week
10 3
20 2
30 1
40 0
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0
10
20
30
40
50
1 2 3 4 5
D
Price of XPrice of X
Pence per unitPence per unit
Consumer’s DemandConsumer’s Demand
Units per weekUnits per week

 Market – The market for a
product is the area in which
buyers and sellers come in to
contact with each other in order
to exchange the product.
 Market Demand – Market
demand for a product is the sum
of all the individual consumers
demands in the relevant market.
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 So we assume that the market demand
( D x ) for good X, the function is ;
D x = f ( P x , P R , Y, T, A , Z )
 As in short form;
D x = f ( P x ) , Ceteris Paribus
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0
P2
P1
Q1 Q2
D
Price
Quantity
Market Demand for good
X ; The market demand
curve for good X shown
herewith a negative
slope, that means if price
falls down, quantity
demanded increases
(Ceteris Paribus).

 The Demand Curve for the good X , has a
positive slope. This means that as price
falls, quantity demanded decreases.
Ceteris Paribus and Vice Versa
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0
Price
Quantity
D
P1
P2
Q1Q2
“A market is a group of
individuals and firms
who interact with each
other in order to buy,
sell goods. Markets vary
in their size,
arrangements,
procedures. Basically
markets consists of
buyers and sellers and
also 3rd
parties such as
brokers , agents as
well.”

 The Law of Demand – that the quantity
demanded is inversely related to its price,
when other things are held constant
(Ceteris Paribus) thus higher the price, the
smaller will be the quantity demanded;
and the ,lower the price ,greater will be the
quantity demanded.
 A Demand Curve is a downward sloping
curve showing the quantity of a well
defined commodity demanded at various
possible prices.
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P0
P1
Q0 Q1
0
A
B
“When the price increases P0, the quantity demanded
decreases to Q0 and when the price falls to P1,the
quantity demanded increases to Q1.this shows a
movement along the demand curve, from A to B.”

 When the price changes, other things being
equal, the change is shown as a movement
along the demand curve. that means when
prices fall, buyers increase their quantity of
goods purchased. therefore ,a movement
along the demand curve is referred to as a
change in quantity demanded.
 The Quantity Demanded – is the amount of a
product that a consumer would buy in given
time period at the current market price. the
important relationship in individual markets is
that between market price and quantity
demanded.
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P0
P1
Q1 Q0
D
A
B
Price
Quantity
“When the price increases P1, the quantity
demanded decreases to Q1 and when the
price falls to P0,the quantity demanded
increases to Q0.this is known as the change
in quantity demanded. this shows a
movement along the demand curve, from A
to B.”

 Substitute Goods – is a good that
can be used in a place of another
good. E.g. tea & coffee, scooters &
bicycles, margarine & butter.
 Complementary Goods – is a good
that should be consumed together
with another product. E.g. pen &
ink, tooth brush & tooth paste, shoe
& socks.
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 If household or individuals receive more
income , they can be expected to
purchase more of the most commodities
even though commodity prices remain
same.
 it is that a commodity whose demand
increases when income increases is called a
normal good.
 A rise in average household income shifts
the demand curve for normal commodities
to the right, indicating that more will be
demanded at each possible price.
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D
D1
0
P
P1
Q Q1
S
So the
demand
curve will
shift to the
right from D
to D1. e.g. –
milk powder,
tea powder,
sugar.

 For a few commodities, called inferior
goods( low quality goods), a rise in their
income leads households to reduce their
purchases (they cannot afford the price
as such expensive).
 A rise in the income will shift the demand
curve for inferior goods to the left,
indicating that less will be demanded at
each price.
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D1
D
0
P1
P
Q1 Q
S So that the
demand
curve for
inferior
goods will
shift the
curve to left,
from D to D1.
e.g.-
firewood,
black and
white TV’s.

 The demand curves have a negative
slope because the lower a commodities
price, the cheaper it becomes relative to
other commodities that can satisfy the
same need. those other relative
commodities are known as substitutes.
 A commodity becomes cheaper relative
to its substitutes if its own price falls.
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 If a fall in the price of one good causes a
fall in the quantity demanded another
good, this two goods are called as
substitutes.
 E.g. if the price of Pepsi rise, the quantity
demanded will falls because there are
many ways to fulfill thrust, then you can buy
a substitute for Pepsi as like Cream Soda or
Coca Cola.
 Because people switched to purchases
from increasingly expensive Pepsi to it
substitutes which is not high in price.( Coca
Cola or Cream Soda).
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P1
P
Q Q1
D
D1
S
If the commodities
(pepsi) substitutes
price rises the
demand curve for
Pepsi will shift to
right. But if the
commodities (pepsi)
substitutes price
falls the curve shifts
to left.

 Geffen goods – named by a Scottish
economist, Robert Giffen who first
described the inverse relationship which
may exist between price and quantity
demanded of staple foodstuffs such as
potatoes, bread, rice in developing
countries. in these countries most of the
peoples money is spent for basic
foodstuffs.
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 If the price of giffen goods rises, definitely
people will not buy such expensive goods
because they need to buy giffen good
which is cheaper to them. this is the point
that the price of giffen goods rises people
tend to buy more for their consumption.
 E.g. – think of rice and bread, if the prices
increased will they buy ? Yes, because
those are the basic foodstuffs of the poor.
they did not buy cakes or meat. this is the
relationship described by Robert Giffen
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Whenever the price rises from OP to OP1
, amount
demanded too increases from OQ to OQ1
and vice-versa.
DD is an exceptional or abnormal demand curve. Below is
the list of few exceptions to the law of demand
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 Conspicuous Consumption:
 This exception to the law of demand is
associated with the doctrine propounded by
Thorsten Veblen. A few goods like diamonds etc
are purchased by the rich and wealthy sections
of the society. The prices of these goods are so
high that they are beyond the reach of the
common man. The higher the price of the
diamond the higher the prestige value of it. So
when price of these goods falls, the consumers
think that the prestige value of these goods
comes down. So quantity demanded of these
goods falls with fall in their price. So the law of
demand does not hold good here.
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 Demand is influenced by a number of factors;
Consumer Income, Prices of Related Goods,
Expectations, No. of Consumers in the Market
and Consumer Tastes.
 A change in any of the influencing factors except
price of the good X, causes a shift in the demand
curve for X.
 Change in Income – if the peoples income
increases, they are able to buy more goods, so if
the real national income increases, so that every
one has more to spend on all goods. so the
market demand for good X will increase at all
prices. So the demand curve shifts to right side.
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 When the real income of the consumers
rises, will increase the ability to purchase
more goods, So that demand curve shifts
to right from D0 to D1.
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0
P0
Q0 Q1
D0
D1
Price
Quantity
The Demand for
inferior (Cheap
Goods) goods
decreases as
income rises, the
demand for a
normal good
increase as
income rises.

 The prices of related goods - There are
many ways to satisfy our wants. if the price
of Coke goes up, the quantity demanded
of Pepsi will go up because there is a
alternative way to satisfy thirst. there are no
perfect substitutes (butter and margarine,
carrots and cabbages, cinema tickets and
theater tickets) for any commodity, goods
that are used in combination to satisfy a
particular want are called complements.
 E.g. – Tea and sugar, if there is a increase in
tea will falls down the demand for sugar,
(Skis and boots, strawberries and cream,
needles and sewing thread)
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Copyright©2003 Southwesern/Thomson Learning
Price of
Ice-Cream
Cone
Quantity of
Ice-Cream Cones
Increase
in demand
Decrease
in demand
Demand curve, D3
Demand
curve, D1
Demand
curve, D2
0

 Change in Taste also shifts the demand
curve to right, due to people always
change their taste over time and changes
in price expectations also shifts the demand
curve due to consumers reaction on future
prices of goods. if the consumer think price
will go up in the future so that the demand
will be increased. e.g. – the demand for
housing and land.
 Change in Number of Consumers – Market
demand is the sum of the individual
demand, if the number of consumers in the
market changes, will shifts the demand
curve to right. e.g. – growing population
leads demand for food will increases.
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 Shift to Right – Price of
complement goods
falls, income rises
(normal goods),
population grows,
future prices
increase, tastes in
favour, price of
substitutes rise,
increase in
advertising.
 Shift to Left – Price of
substitutes falls,
income rises (inferior
goods), income
decrease expected,
rise in price of
complementary
goods, change in
tastes against,
decrease in
advertising, fall in
future price.
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 Elasticity – a measure of the sensitivity of
quantity demanded or supplied to changes
in price.
 Price Elasticity of Demand – the measure of
responsiveness of the quantity demanded for
a good to changes in its own price.
 Symbolized by Greek letter ղ (eeta), defined
by the following formula.
PID (ղd ) = % Change in Quantity
Demanded
56
56565656% Change in Price

(ղd ) = % Change in Quantity Demanded
% Change in Price
= Δ Qd x 100
Qd
= Δ P X 100
P
= Δ Qd X P
Δ P Qd
“This formula tells us that the elasticity of
demand is calculated by dividing the %
change in quantity demanded by the %
change in price which brought it about”
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ΔΔ Qd = Change in Q.D.Qd = Change in Q.D.
Qd = Quantity Before ChangeQd = Quantity Before Change
Δ P = Change in Price
P = Price Level Before Change

 E.g. – if the price of a product rises from %
20 and demand falls to %10, the
coefficient will be
% 20
%10 = 2
 The price elasticity of demand is usually
negative since for most products price and
demand are inversely related.
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 Point Elasticity of Demand takes
the elasticity of demand at a
particular point on a curve (or
between two points).
 on the other words it can be
defined as the proportionate
change in the quantity demanded
resulting from a very small
proportionate change in the price.
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 Formula for Point Elasticity of Demand is:
 PED = % Δ Q / Q
————
% Δ P / P
 % Δ Q = change in quantity demanded.
 Q = quantity demanded.
 % Δ P = change in price.
 P = price demanded.
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6262
Quantity increase from 200
to 300
= 100/200 = 50%
Price falls from 4 to 3 = 1/4
= -25%
Therefore PED = 50/ -25 = –
2.0
Point Elasticity A to B
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 With the most demand curves, the elasticity
coefficient varies along the curve.
 we have,
1. Perfectly Inelastic ( = 0).ղ
2. Perfectly Elastic ( = ).ղ ∝
3. Unitary Elastic ( = 1).ղ
4. Inelastic Demand (PED < 1).
5. Elastic Demand (1 < PED < ∝ ).
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 This is not in reality, in this case the demand
curve would be represented by a vertical
line. but there are such instances that the
relatively inelastic demand situations, like
demand for land in the city area.
 Also known as zero elasticity, perfectly
inelastic and completely inelastic.
 A demand curve of zero elasticity is a
straight vertical line.
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 The PID curve, when a change in price arising it has no
effect on quantity demanded. the same amount is
demanded at all prices, so the change in quantity
brought about by a change in price is zero.
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Price
D0
D1
P2
P1
D ( = 0)ղD ( = 0)ղ
( = 0)ղ( = 0)ղ

 Infinite elasticity arises when a small
decrease in price raises quantity
demanded from zero to an infinite larger
amount.
 Also known as perfectly, completely,
infinitely elastic demand curve.
 A demand curve of infinite elasticity is a
straight horizontal line.
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 When elasticity of demand is infinite, nothing is
bought at price above P1, but at that price
consumers will buy any amount that is offered
for sale.
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Q1 Q2
P1
P2
D0
D1
Price
Quantity
D ( =ղD ( =ղ ∝∝)) “A relatively
elastic
demand
curve is a
demand
curve which
is very
responsive
to changes
in price.”

 Here the coefficient of price elasticity is equal
to 1, that means the change in quantity
demanded responds at the same rate as any
change in price.
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P2
P1
Q1 Q2
D0
The %
change in
quantity
demanded
is equal to
% change in
price
D ( = 1)ղD ( = 1)ղ

 When the % change in quantity is less than
the % change in price the demand is said
to be inelastic and the price elasticity is less
than 1 (PED<1) in the case.
 In other words, the quantity demanded is
less responsive to price change in case of
relatively inelastic demand.
 If quantity demanded responds slowly to a
relatively large price, then the demand is
inelastic. A relatively steeper demand
curve will represent inelastic demand.
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P1, 15
P2 , 20
Q1, 4Q2, 30
D
• When prices increase
the consumer
expenditure will
increase and also
when the price is low
consumer expenditure
will decrease because
consumers tend to
buy at a lower price.

 When the % change in quantity
demanded exceeds the % change
in price, then the elasticity is greater
than 1.
 in this case the response of quantity
demanded is higher than the price.
 A relatively flatter demand curve
represents a situation where the
demand is elastic.
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 The slope of the linear demand curve
= ∆P/ ∆Q
 So the one part of the equation is ∆Q/ ∆P
which is the inverse of the slope of the
linear demand curve.
 Second part of the equation is P/Q which
is the ratio of price to quantity at any
point on the line therefore we know as
Point Elasticity.
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 The slope of the demand curve is different
from its price elasticity. This fact is
evidenced by measuring price elasticity on
two demand curves of the same or
different inclines.
 Two straight line demand curve originating
from the same point.
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 There are two straight line curves PQ and PR in this
representation. PR is flatter than PQ and hence it
appears that its price elasticity is higher than the
other curve. But this is not actuality. If we further
draw another line TS, passing through these curves
and touching the vertical axis at point T, the
elasticity at point U on the PQ curve as per the
point formula is (QU/UP) = (OT/OP). Similarly,
elasticity at point S on the PR curve is (RS/SP) =
(OT/OP) and hence, (QU/UP) = (RS/SP) = (OT/OP) =
1. 75
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 Thus the elasticity is equal on both the
points U and S of the two curves. We may
conclude that if two linear demand curves
originate from the vertical axis at the same
point, such as P, they have exactly equal
elasticity at every single price.
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 Slope is not the same as elasticity, but it does give us
some insight into the concept. To see the nature of the
relationship let's compare the two demand curves that
intersects at one point in the diagram below. Put your
pen at the point where the two demand curves
intersect and then move it up to signify an increase in
price.
 At the higher price there will be less demand - but
how much does demand fall? If you now move your
pen to the left your pen hits the green line (demand B)
first. If you keep moving further to the left your pen
finally comes across the blue line (demand A).
 The change in demand caused by the price increase
was greater when the curve was flatter so we would
say that demand curve A is more elastic.
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 What generalizations can we make? All other things
equal, an increase in price elasticity of demand will show
up as a flattening of the demand curve. In the left-side
diagram below, a small increase in price will produce a
large decrease in demand. For this reason if you thought
demand was responsive to price changes (elastic), then
you would draw a flat demand curve.
 If on the other hand you thought demand was
unresponsive to price (inelastic), if demand was inelastic,
then you would want to draw a steep demand curve.
When demand is inelastic, a large increase in price will
produce only a small decrease in demand (right-side
diagram).
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 The Price of the Commodity – if the price of
the commodity is high, demand is likely to
be more elastic than if the price is low. for
example, the elasticity of demand for beef
is greater than that of salt.
 The Type of Commodity – if the commodity
is a necessity, demand is likely to be less
elastic than if the commodity is luxury. For
example, the elasticity of demand for rice is
less elastic than that of grapes.
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 The % of Income Spent on the Commodity – if
the high % of income is spent on a
commodity, the elasticity of demand is likely
to be high. For example, the expenditure on
cars, expensive jewelry, clothes, furniture and
others are high than commodities such as
newspapers, cheap books, magazines.
 The Number and the Availability of Substitutes
for the Commodity – if there are more and
better substitutes for a commodity, demand
for the commodity is likely to be more elastic.
For example, if the coffee price rises,
consumers will change to good substitutes
such as tea, Milo, coca cola and others. so
the coefficient of price elasticity of demand
for coffee is likely to be high.
80
8080

 The Time Factor – if the time period is
longer, its likely that the elasticity of
demand for a commodity is more elastic.
this is because it takes time for consumers
to be able to react to changes in the
prices of the commodities.
81
8181

 The quantity demanded of a good can be
affected by changes in the price of other
goods. the responsiveness of demand to
changes in the price of another good is known
as, the cross elasticity of demand.
xyղ = % change in quantity of good X
% change in the price of good Y
 Goods which are substitutes for each other
have positive cross elasticity's, goods which are
complements to each other have negative CE.
82
82828282

 The numerical value of cross elasticity
depends on whether the two goods in
question are substitutes, complements or
unrelated.
 Types and Example:
 (i) Substitute Goods. When two goods are
substitute of each other, such as coke and
Pepsi, an increase in the price of one good
will lead to an increase in demand for the
other good. The numerical value of goods
is positive.
83
8383

 For example there are two goods.
Coke and Pepsi which are close
substitutes. If there is increase in the
price of Pepsi called good y by 10%
and it increases the demand for
Coke called good X by 5%, the
cross elasticity of demand would
be:
 Exy = %Δqx / %Δpy = 0.2
 Since Exy is positive (E > 0),
therefore, Coke and Pepsi are close
84
8484

 (ii) Complementary Goods. However, in case
of complementary goods such as car and
petrol, cricket bat and ball, a rise in the price
of one good say cricket bat by 7% will bring
a fall in the demand for the balls (say by 6%).
The cross elasticity of demand which are
complementary to each other is, therefore,
6% / 7% = 0.85 (negative).

 (iii) Unrelated Goods. The two goods which a
re unrelated to each other, say apples and
pens, if the price of apple rises in the market,
it is unlikely to result in a change in quantity
demanded of pens. The elasticity is zero of
unrelated goods 85
8585

 (1) Theoretical Importance:
 The concept of elasticity of demand is very
useful as it has got both theoretical and
practical advantages. As regards its
importance in the academic interest, the
concept, is very helpful in the theory of
value.
86
8686

 (2) Practical Importance:
 (i) Importance in taxation policy. As regards its
practical advantages, the concept has
immense importance in the sphere of
government finance. When a finance minister
levies a tax on a certain commodity, he has to
see whether the demand for that commodity is
elastic or inelastic.
 (ii) Price discrimination by monopolist. If the
monopolist finds that the demand for his
commodities is inelastic, he will at once fix the
price at a higher level in order to maximize his
net profit. In case of elastic demand, he will
lower the price in order to increase, his sale and
derive the maximum net profit. Thus we find that
the monopolists also get practical advantages
from the concept of elasticity. 87
8787

 (iii) Price discrimination in cases of joint supply. The
concept of elasticity is of great practical advantage
where the separate, costs of Joint products cannot be
measured. Here again the prices are fixed on the
principle. "What the traffic will bear" as is being done in
the railway rates and fares.
 (iv) Importance to businessmen. The concept of
elasticity is of great importance to businessmen. When
the demand of a good is elastic, they increases sale by
towering its price. In case the demand' is inelastic, they
are then in a position to charge higher price for a
commodity.
 (v) Help to trade unions. The trade unions can raise the
wages of the labor in an industry where the demand of
the product is relatively inelastic. On the other hand, if
the demand, for product is relatively elastic, the trade88
8888

 (vi) Use in factor pricing. The factors of
production which have inelastic demand
can obtain a higher price in the market
then those which have elastic demand.
This concept explains the reason of
variation in factor pricing
89
8989

90
 An elasticity of demand greater than 1,
means that a given proportionate increase
in national income will cause a bigger
proportionate increase in quantity
demanded.
 It says that the producers of such goods
may need to plan extra capacity in times of
rising income.
y = % change in quantityղ
demanded
% change in income
90909090

 Income elasticity of demand (YED)
measures the responsiveness of quantity
demanded to changes in real income.
 YED = %Δ demand / %Δ in income
 Example:
› A rise in consumer real income of 7%
leads to an 9.5% rise in demand for
pizza deliveries.
› The income elasticity of demand:
= 9.5/ 7 = +1.357…..
91
9191

Effect Income elasticity
coefficient
Classification of
good
A proportionately
larger change in
the quantity
demanded
>1 Luxury good
A proportionately
smaller change in
the quantity
demanded
<1 Normal
A negative change
in the quantity
demanded
<0 Inferior good
92
9292

 Inferior goods - goods which have a
negative relationship with demand and
income, have a negative income elasticity
of demand. Demand falls as income rises
 For example:
› A 12% rise in incomes leads to a 3% decrease in
the demand for bus travel
› The income elasticity of demand = -3/+12
› YED = -0.25
93
9393

 Normal goods have a positive income elasticity
of demand so as income rise more is demand
at each price level. We make a distinction
between normal necessities and normal luxuries
(both have a positive coefficient of income
elasticity).
 Necessities have an income elasticity of
demand of between 0 and +1. Demand rises
with income, but less than proportionately.
Often this is because we have a limited need to
consume additional quantities of necessary
goods as our real living standards rise. The class
examples of this would be the demand for fresh
vegetables, toothpaste and newspapers.
Demand is not very sensitive at all to
fluctuations in income in this sense total market94
9494

 Luxuries on the other hand are said to have an income
elasticity of demand > +1. (Demand rises more than
proportionate to a change in income). Luxuries are
items we can (and often do) manage to do without
during periods of below average income and falling
consumer confidence. When incomes are rising
strongly and consumers have the confidence to go
ahead with “big-ticket” items of spending, so the
demand for luxury goods will grow. Conversely in a
recession or economic slowdown, these items of
discretionary spending might be the first victims of
decisions by consumers to rein in their spending and
rebuild savings and household financial balance
sheets.
 Many luxury goods also deserve the sobriquet of
“positional goods”. These are products where the
consumer derives satisfaction (and utility) not just from95
9595

9696
Different Types of Goods and theirDifferent Types of Goods and their
Income ElasticityIncome Elasticity
96

 High Income Elasticity
› Demand is sensitive to changes in real incomes
› Demand is therefore cyclical – in an economic
expansion, demand will grow strongly. In a
recession demand may fall
› Can be difficult for businesses to accurately
forecast demand and make capital investment
decisions
97
9797

 Low Income Elasticity
› Demand is more stable during fluctuations in
the economic cycle than high YED
› Over time, the share of consumer spending on
inferior goods and normal necessities tends to
decline
› Long run – businesses need to invest in / focus
on products with a higher income elasticity of
demand if they want to increase total profits
98
9898

101
 Supply indicates how much of goods or
services producers are willing and able to
offer for sale at each possible price during a
specific period of time.
 The price and the quantity supplied depicts
a direct relationship. the law of supply states
that as the price of any good rises, the
quantity of the good that suppliers are
willing and able to offer for sale increases,
while other things being constant – ceteris
paribus. supply decisions depends on profit
potentials.
101101101101

102
 Defined as the sum of the
quantities of the good that
firms are willing and able to
offer for sale over a period of
time.
102102102102

1. Price of the Commodity ( P ),
2. Prices of Factors of Production, Inputs
( F ),
3. Prices of Related Goods ( P n ),
4. State of Technology ( T ),
5. Producers Expectations ( Ex ),
6. Government Subsidy/Tax ( G ),
7. Number of Producers in the Market ( N ),
8. Other Factors ( O ).
103
103103

Qs = f (P,F,Pn,T,Ex,G,N,O)
Supply Equation (positive
slope)
Qs = a + ΔQ
ΔP
104
104104

Prices of Related
Goods and Services
Number
Of
Producers
Expectations
Of
Producers
Technology
And
Productivity
Resource
Prices
Supply
105
105105

 Price of Inputs (Resource Prices) - When costs
go up, profits go down, so that the incentive
to supply also goes down.
 Technology - Advances in technology reduce
the number of inputs needed to produce a
given supply of goods.
 Costs go down, profits go up, leading to
increased supply.
 Expectations - If suppliers expect prices to rise
in the future, they may store today's supply to
reap higher profits later.
 Number of Suppliers - As more people decide
to supply a good the market supply increases
(Rightward Shift).
106
106106

 Price of Related Goods or Services - The
opportunity cost of producing and selling any
good is the forgone opportunity to produce
another good.
 If the price of alternate good changes then
the opportunity cost of producing changes
too!
 Example Mc Don selling Hamburgers vs.
Salads.
 Taxes and Subsidies - When taxes go up,
costs go up, and profits go down, leading
suppliers to reduce output.
 When government subsidies go up, costs go
down, and profits go up, leading suppliers to107
107107

 Its an increase in supply means if another
determinant of supply other than price of
the concerned good increases,
 then the consumers now supply more of a
product at each and every prices than
they did before.
 Since the price of the input has been
decreased, the producer can supply more
than before at each and every price.
 So the supply curve shifts to rightward.
108
108108

 A decrease in supply means if another
determinant other than the price of the
concerned good decreases, then the
producers now supply less of a product at
each and every prices than they did
before.
 Since the price of input has been
increased, the producer supplies less than
before at each and every prices.
 Then the supply curve will shifts to the
leftward.
110
110110

112
 A Supply Schedule shows various quantities of
any given product that a supplier is willing and
able to supply at each possible price level
during a specific period of time.
 The supply curve depicts the relationship
between the price per unit of goods and the
quantity of good offered for sale.
 Producers offer more goods for sale when
prices are higher. higher prices for any good
means that the producers are rewarded for
increased production to maximize profit. if the
prices falls, the quantity supplied also falls, this
shows a movement along the supply curve.112112112112

113
 As the price falls the quantity supplied falls to
40 M, tones of rice and also when the price is
120 Rs the supply will rise to 100M, tones.
113113113113
60
80
100
120
Price of
Rice Rs.
Quantity (Millions Tones)40 60 80 100
S
0
The Supply Curve is
a upward sloping
,showing that firms
increase productions
of a good as its price
increases, this is
because at a higher
price enables firms
to make more profits.
this shows a upward
movement along the
curve

114
 The supply curve express the relationship
between the price and quantity supplied
for a particular community, other thing
being constant (C.P).
 The other influencing factors are;
technology, prices of relevant resources,
prices of alternative goods, producer
expectations, number of producers,
changes in physical environment, changes
in the political situation.
114114114114

115
 Changes in Technology – Refers to the stock of
knowledge and skills of an economy to
produce an economic good. the supply curve
is drawn on the assumptions that the
technology available does not change. if new
methods which are efficient and cost effective
can be invented the suppliers will be willing
and able to supply that commodity. this will
cause the supply curve to shifts to the right.
 E.g.- The technological advances in
developing crop yields of rice, and will reach a
huge production of rice in a short period, this
will reduce the cost of production and
producers will supply more to the market. this
shows a new supply curve as S1 in the supply
115115115115

116
 A rightward shift in the supply curve from S0
to S1,indicates an increase in the quantity
supplied at each price.
116116116116Q0 Q1
P
S0
S1
0
Price
Quantity

117
 Change in the prices of relevant resources – if
the price of an input used the production
process increases, the cost of production also
increases. then the supply curve will shift to the
left indicating reduction in supply.
 Change in price of alternative goods – if the
cost of production of a good increases, it may
be leads to produce an alternative good using
the same resources. thus the supply of the
former good will go down in relation to the new
good.
 Changes in producer expectations – a
producer may foresee some positive or
negative situations in sales, he may adjust the
production and then control supply. E.g. –the
oil exporting countries (OPEC) decide to
reduce their supply of oil for several times to
maintain their oil resources and to create a
good demand situation in the market.
117117117117

118
 Changes in the number of producers – the
market is supplied by individual producers,
if the number of producers increases
supply will shifts to the right. e.g.-
automobile industry.
 Other factors – other effecting conditions
like environmental condition such as
drought, floods could reduce the
agricultural production. political and civil
unrest will affect all sectors of the
economy.
118118118118

 Elasticity of Supply – is a measure of extent
to which the quantity supplied of a good
responds to changes in one of the
influencing factors.
 Price Elasticity of Supply – is
a measure of the
responsiveness of quantity
supplied to a change in the
goods owns price, Ceteris
Paribus.
120
120120120120

(E s) = % Change in Quantity Supplied
% Change in Price
(E s) = %Δ Qs
%Δ P
 In other words it is the % change in
the quantity supplied of a product
that results from a 01% change in
the price of that product, ceteris
paribus.
121
121121121121

 Marginal Cost – (which is the increase
in cost by producing one more unit) if
the cost of producing one more unit
keeps rising as output rises or marginal
costs rises rapidly with an increase in
output, then the rate of output
production will be limited.
 So price elasticity of supply will be
inelastic and if the marginal costs rises
slowly then the supply will be elastic.
122
122122

 Effective Time – over time price elasticity of
supply tends to become more elastic, which
means that the producers would increase the
quantity supplied by a larger % than the increase
in price.
 The Ability To Store The Product – the larger the
number of firms, the larger number of stock, the
more likely supply is elastic.
 If factors of production are mobile, then the
price elasticity of supply tends to be more elastic.
 The Level Of Spare Capacity – if firms operating
below the full capacity and so there are
unemployed resources. if firms have spare
capacity, the PES is elastic, they are able to
produce more, quickly with a change in price.
123

 This measures the elasticity at a point on
the supply curve, in other words it can be
defined as proportionate change in the
quantity supplied resulting from a very
small proportionate change in price.
124
124124

 This calculates the average elasticity
(responsiveness) of quantity supplied over
some portion of the supply curve.
 Here we can use a average price and
quantity, which enable us to avoid the
direction problem in point elasticity.
 Now we will consider the other extreme
forms of supply elasticity's.
125
125125

 Perfectly Inelastic Supply - PES = 0
 Perfectly inelastic supply, Es = 0. this shows a vertical line and
indicate that suppliers would supply a limited amount of a
commodity regardless of any changes in its price.
126
1261261261260
q1
S
Price
If there is no
change at all in
quantity supplied
in response to a
price change,
then the price
elasticity would
be 0.

127
 Unitary Elastic Supply - PES = 1.
 Unitary elastic supply, E s = 1,a straight line drawn
through the origin has a unitary price coefficient of
supply along the line.
127127127127
0
P1
P2
Q1 Q2
S
Where the %
change in
quantity
supplied is
equally
response to the
% change in
price.

 Perfectly Elastic Supply - PES = ∝
 Perfectly elastic supply, E s = . Is a horizontal line and indicates a∝
change in price produces an infinite response in the quantity
supplied.
128
128128128128
0
P1
Price
Quantity
S
The
quantity
supplied is
infinitely
responsive
to changes
in own
price of the
commodity.

 When the % change in quantity is less than
the % change in the price. the price
elasticity is less than 1.
129
129129
0
P
P1
Q Q1
S

 When the % change in the quantity
supplied exceeds the % change in
price, then the elasticity is greater
than 1.
 A relatively flatter supply curve
starting from the price axis
represents a situation where the
supply is elastic and intercept is a
positive value.
130
130130

132
 Market – is an any kind of institutional
arrangement whereby buyers and
sellers communicate with each other
to buy and sell a commodity.
 Buyers always concern about
satisfaction and sellers aims to
maximize their profit.
 Equilibrium – a state of rest in which no
economic forces are being generated
to change the market situations. 132132132132

133
 Equilibrium occurs when supply and demand
are balanced, when the quantity suppliers want
to offer for sale balances the quantity
consumers want to purchase. at this price there
are no unsatisfied buyers or sellers. the market is
exactly cleared.
 Thus, graphically, the equilibrium price is the
price at which the demand and supply curve
intersect. when the market price is equal to the
equilibrium price.
 There will be neither unsatisfied demanders nor
unsatisfied suppliers in the market. the market is
said to be exactly cleared.
133133133133

134
 The Equilibrium occurs when the supply and
demand equal in the market. this is shown
at point E, where Supply = Demand.
134134134134
S
D
P0
Q0
E = S = D
Market
Equilibrium
0

135
 Disequilibrium – a situation in which the
expectations of buyers and sellers in a
market are not balanced or realized. the
market is unstable, and economic force are
being generated to change the situation.
 Disequilibrium occur when; where the
government or other bodies impose artificial
restrictions on price or quantity, where
market equilibrium is unstable, production
plans are not realized and lagged responses
of consumers.
135135135135

136
 When the quantity demanded is greater
than the quantity supplied, there is said to
be EXCESS SUPPLY or at price levels above
the equilibrium price the quantity supplied
exceeds the quantity demanded, this is
known as SURPLUS.
 When the quantity supplied is greater than
the quantity demanded, there is said to be
EXCESS DEMAND or at a price level below
the equilibrium, the quantity demanded
exceeds the quantity supplied resulting the
market SHORTAGE.
136136136136

 Demand price less than the
equilibrium price is shown as the
excess demand price.
138

 Supply price greater than the
equilibrium price is known as the
excess supply price.
139

140
 At P0, Q0 is the equilibrium market price and quantity.
Above the P0 is the excess demand or surplus and
below the P0, is the excess supply or shortage.
140140140140
S
D
0
Po
SHORTAGE
SURPLUS
Q0
E

141
 The below figure is giving the situation of
disequilibrium market supply and demand
for automobiles, we assume that ceteris
paribus, the equilibrium price P1 and
quantity sold Q1 are given. thus the price of
petrol / diesel increases. as the petroleum
and automobiles are complement goods
and the increase of petrol price will cause
the demand for automobiles to decrease
from D1 to D2.
 This reduction in demand for automobiles
will cause the price to fall to P2 and quantity
supplied to decrease to Q2.
141141141141

142
 Here a new equilibrium price occur as E2.
142142142142
S
D1
D2
P1
P2
Q2 Q1
E1
E2

 As market prices are
determined in free markets by
the interactions of demand and
supply, changes in market
prices are due to changes in
demand or supply, or both.
143

 In the short run, other things being equal,
an increase in demand will raise the
price and this will cause an extension in
supply, shifts the demand to the right.
 In the short run, other things being equal,
a decrease in demand will lower the
price and cause a contraction in supply,
will shifts the demand to the left.
145

 Look at the below curves, if the
demand increases from DD to
D1D1,the immediate effect to
cause a shortage (shown by the
dotted lines) at the ruling price P.
 this shortage cause the price to be
bid upwards and supply to extend
until new equilibrium price is
established at P1. the quantity
demanded and supplied is now
Q1.
146

D
D
D1
D1
S
P
P1
Q Q1
0
E
E1
Increases in demand shifts the demand
curve to right.
147

 The below curve shows, a
decrease in demand, then
demand curve will shifts to the left
D1D1.
 Here is a surplus at price P (equal to
the horizontal distance between
demand curves).
 Suppliers will be obliged to lower
the prices to P1 in order to clear
their stocks. this fall in price will
cause contraction in supply. 148

149
S
D
D1
D1
D
0
P
P1
Q1 Q
E
E1

 In the short run , other thing being
equal, an increase in supply will
lower the price and it cause a
extension in demand.
 In the short run, other things being
equal, an decrease in supply will
raise the price and cause a
contraction in demand.
150

 The below curve shows, an
increase in supply, then the supply
curve moves from SS to S1S1.the
immediate effect is a surplus
(shown by the dotted lines) at the
ruling price at P.
 This will force the price to move
downwards to P1 and lower the
price will result in an extension in
demand.
 The quantity demanded and 151

152
D
D
S1
S
S
S1
Q Q1
P1
P
E
E1
0

 The below curve shows , a
decrease in supply. When supply
falls from SS to S1S1 there will be
excess demand at price P (equal
to the horizontal distance
between the supply curves).
 This will cause the price to rise to a
new equilibrium price of P1, then
this higher price results a
contraction in demand.
153

154
0
P
P1
Q1 Q
D
D
SS1
S
S1
E1
E

 So far we have seen the situation where the
demand or supply changes in an equilibrium
market situation. suppose if the both demand
and supply curves changes at once what will
be the market situation ?, what the firms
decisions will be ? May be Confused.
 E. g. – if a large rise in the demand for apples
because of successful ads, this will cause a
unexpected bumper for apples. see the
below curves, if there is a huge demand for
apples, this will shifts the curves to right
and at a lower equilibrium price at P1 and
higher quantity supplied at Q1.
155

O Q Q1
D
D1
S
S1
E
E1P
P1
Fall in Price
156

 On the other side, if there is a
price increase in apples, but
there is a huge demand for that
so people tend to buy at a higher
price even suppliers also supply
more to the market.
 This will shifts the curves – D to
D1, S to S1, to the rightward and
creating a new higher
equilibrium price at E1,quantity
at Q1 157

O
P
P1
Q Q1
E
E1
D
D1
S
S1
Rise in Price
158

159
 The Consumer Surplus – Arises
because consumers would be
willing to pay more than the given
price for what they buy.
 The shaded area under the
demand curve and above the
price line. it is the difference
between the total utility and total
outlay can be applicable to a 159159159159

160
 The Triangle A, E, P1, depicts the consumer
surplus, where consumers agree to pay
more than the market price when the price
is lower.
160160160160
0
P1
Q1
E
Market Price
D
Consumer SurplusA
Price
Quantity Demanded

161
 If the Market Price Increases, then
consumer surplus is reduced as some
consumers are unwilling to pay the higher
the price.
1611611611610 Q2 Q1
P1
P2
E1
E2
New Consumer
Surplus
New Market Price
D
A The new
Consumer
Surplus is A,
E2, P2 and the
loss of
Consumer
Surplus is
shown by P1,
P2, E2, E1.

 Consumer surplus occurs when
people pay less for a product than the
willing to pay. ( i. e. less than the
value they place on the product
based on their marginal utilities).
Consumer Surplus =(M.D.P.– E. P) X E.Qty.
2
 M.D.P. = MAXIMUM DEMAND PRICE
 E.P = EQUILIBRIUM PRICE,
 E. QTY = EQUILIBRIUM QUANTITY. 162

164
Initial
consumer
surplus
Quantity
(b) Consumer Surplus at Price P
Price
0
Demand
A
B
C
D E
F
P1
Q1
P2
Q2
Consumer surplus
to new consumers
Additional consumer
surplus to initial
consumers

 Producer surplus occurs when suppliers get
more for a product than they were willing to
earn. the excess of total sales revenue going
to producers over the area under the supply
curve for a good shows the produce surplus.
165

166
Producer
surplus
Consumer
surplus
Price
0 Quantity
Equilibrium
price
Equilibrium
quantity
Supply
Demand
A
C
B
D
E

167
Quantity
Price
0
Supply
Demand
Cost
to
sellers
Cost
to
sellers
Value
to
buyers
Value
to
buyers
Value to buyers is greater
than cost to sellers.
Value to buyers is less
than cost to sellers.
Equilibrium
quantity

 There are 2 main types of taxes; direct and
indirect taxes.
 Direct taxes are those which directly levied
from peoples income. e.g.- income tax,
 Indirect taxes are those which levied from
expenditure.
 The most important indirect taxes are unit tax
(specific tax, excise duty), value added
tax( ad valorem tax).
 VAT is levied as a % of the ceiling price of the
commodity.
 Unit tax (excise duty ,specific tax) is levied
per unit of commodity, irrespective of its
price. 168

169
 There are many types of taxes:
› Personal Income taxes
› Corporate Income taxes
› Excise Taxes
› Value Added Taxes (VAT)
› Property Taxes
› Social Security Taxes
› Sales Taxes

 If we wish to demonstrate the effect
of a tax upon the demand and
supply situation, this is done by
moving the supply curve vertically
upwards by the amount of the tax.
 The tax is regarded as the cost of
production and the producer has to
pay wages, rent and now the tax to
the government.
170

171
 The costs of taxation include:
› The direct cost of the revenue paid to
government
› The loss of consumer and producer surplus
caused by the tax
› The cost of administering the tax codes.

172
 When government institutes taxes, there is a
loss of consumer and producer surplus that
is not gained by government. This is known
as deadweight loss.
 Graphically the deadweight loss is shown
on a supply-demand curve as the welfare
loss triangle.
• The welfare loss triangle – a geometric
representation of the welfare loss in terms of
misallocated resources caused by a
deviation from a supply-demand
equilibrium.

173
 For government to provide goods and
services such as national defense, social
security, national parks, etc. it must have
money.
 The Government raises money several
ways including user fees and taxes.
 User Fees are fees paid by those that use
the good or service: it is a price.
 Taxes may be paid by everyone or only
those that use a good or service: who
pays depends on the type of tax.

 The unit tax
has raised the
supply curve
from S to S1.
 You can see
the S1 curve is
Rs 1 above
the S curve at
every point.
174
0 10 20 30 40 50
01
02
03
04
QUANTITY
PRICE
S
S1
Rs 1

 The effect of
a 50% VAT is
shown and
you can see
that the new
supply curve
diverges from
the old supply
curve as the
tax increases
with price.
175
0 10 20 30 40 50
01
02
03
04
QUANTITY
PRICE
S
S1
50%
50%

A tax on
buyers shifts
the D curve
down by
the amount
of the tax.
176
S1
D1
$10.00
500430
P
Q
D2
$11.00PB =
$9.50PS =
Tax
Effects of a $1.50 per
unit tax on buyers
The price
buyers pay
rises, the
price sellers
receive falls,
eq’m Q falls.

how the burden of a tax is shared among
market participants
177
430
S1
P
Q
D1
10.00
500
D2
11.00PB =
9.50PS =
Tax
Because
of the tax,
buyers pay
$1.00 more,
sellers get
$0.50 less.

A tax on
sellers
shifts the S
curve up
by the
amount of
the tax.
178
S1
P
Q
D1
10.00
500
S2
430
11.00PB =
9.50PS =
Tax
Effects of a $1.50 per
unit tax on sellers
The price buyers pay
rises, the price sellers
receive falls, eq’m Q
falls.

What matters
is this:
A tax drives
a wedge
between the
price buyers
pay and the
price sellers
receive. 179
S1
P
Q
D1
10.00
500430
9.50
11.00PB =
PS =
Tax
The effects on P and Q, and the tax incidence
are the same whether the tax is imposed on
buyers or sellers!

0 100 200 300 400 500
10
20
30
40
QUANTITY
PRICE
S = supply before tax
St = supply after tax
50
60
600
35
25
Unit tax
250
A
B C D
FGH
I
J
K
180

 Consumer price increase from 30 to
35,producer price decrease to 25 Rs and
equilibrium quantity decreases from 300 to
250.
 Consumer expenditure changes from 900
(30*300) to 8750 (35*250),firms gross revenue
changes from 900 (30*300) to 8750 (35*250).
 Consumer surplus reduces from ABCD to A
and producer surplus reduces from HGFIJ to IJ.
 Consumer and producer surplus decreases by
the amount of BCDFGH, government tax
revenue is BCGH. social welfare is reduced by
the amount of DF.
 Consumer tax burden is BC, producer tax
burden is GH.
181 181

 The effect of a unit tax can be shown as,
supply before tax; Qs = a + bp.
 Supply after tax; Qst = a + b (p – t).
 For e.g.- the product X has the following
demand ,supply equations;
Qd = 600 – 10P, Qst = 10P.
 For each unit of good, 10 Rs. Unit tax
charged. find the equilibrium quantity &
price before and after tax?
182

 Before tax;
 Qd = Qs
Qd = 600 – 10 P Qs
= 10 P.
 So, 600 – 10 P = 10 P
600 = 20 P
P = 30.
 Qd = 600 - 10 X 30
Qd = 300.
 Equilibrium price is
30 Rs. And
equilibrium quantity
is 300 units.
 After tax;
Qd = Qst
600 – 10 P = 10 P – 100
700 = 20 P
P = 35.
 Qd = 600 – 10 P
Qd = 600 – 10 * 35
Qd = 600 – 350
Qd = 250.
 Equilibrium price
after tax is 35 Rs. And
equilibrium quantity
after tax is 250 units.
183

184
 Elasticity is a measure of how easy it is for
the supplier and consumer to change their
behavior and substitute other goods.
 Consequently, the more one group
(consumers or suppliers) is able or willing to
change its behavior relative to the other
group the more likely it is to avoid the tax
burden.

185
 The relative burden of the tax dictates that
the more relatively inelastic the behavior of
one’s group (supply or demand), the larger
the tax burden one will bear.
 If demand is more inelastic than supply,
consumers will pay the higher share. If supply
is more inelastic than demand, suppliers will
pay the higher share.

186
 Since the free market system is very efficient,
Governments with free market economies
desire to change the behavior of suppliers
and demander as little as possible.
 Hence, Governments should tax inelastic
goods or services.
 In the language of consumer and producer
surplus, if the government seeks to minimize
welfare loss, it should tax goods with inelastic
supplies and demands.

CASE 1: Supply is more elastic than demand
187
P
Q
D
S
Tax
Buyers’ share
of tax burden
Sellers’ share
of tax burden
Price if no tax
PB
PS
In this
case,
buyers
bear most
of the
burden of
the tax.

CASE 2: Demand is more elastic than supply
188
P
Q
D
S
Tax
Buyers’ share
of tax burden
Sellers’ share
of tax burden
Price if no tax
PB
PS
In this case,
sellers bear
most of the
burden of
the tax.

 If buyers’ price elasticity > sellers’ price
elasticity, buyers can more easily leave the
market when the tax is imposed, so buyers
will bear a smaller share of the burden of
the tax than sellers.
 If sellers’ price elasticity > buyers’ price
elasticity, the reverse is true.
189

190
P
Q
D
S
Tax
Buyers’ share
of tax burden
Sellers’ share
of tax burden
PB
PS
Demand is
price-elastic.
In the short
run, supply is
inelastic.
Hence,
companies
that build
yachts pay
most of
the tax.

191
 The level of taxes is determined by the amount
of government services and goods provided.
 The Government’s roles include:
› Providing a stable set of institutions, laws and
rules.
› Promoting effective and workable competition.
› Correcting for externalities.
› Creating an environment that fosters economic
stability and growth.
› Providing public goods.
› Adjusting for undesirable market results.

192
Intervention in markets for farm products
takes two main forms:
› Subsidies
› Production quotas
A subsidy is a payment made by the
government to a producer.
A production quota is an upper limit to the
quantity of a good that may be produced
during a specified period.

25
30
35
0 300 350
A
B C
F
GH
I
J
K
D
S1
S0
60
QUANTITY
PRICE
SUPPLY CURVE
BEFORE SUBSIDY
SUPPLY CURVE
AFTER SUBSIDY
193

 As a result of the subsidy on a unit, the payable
consumer price reduced by 30 to 25 Rs. the
receivable producer price increased by 30 to 35
Rs.
 Equilibrium quantity increased by 300 to
350.gross revenue changes from 30 X 300 = 9000
to 25 X 350 = 8750.
 Consumer surplus increases from A + B to A + B +
I + H + G.
 Producer surplus increases from I + J to I + J + B +
C.
 Consumer and producer surplus increases by B +
C + I + H + G.
 Cost of subsidy tot eh government is B + C + F + G
+ H +I.
 Consumer benefit from the subsidy is I + H + G.
Producer benefit from the subsidy is B + C.
194

 Supply equation before the
subsidy:
Qs = a + bp
 Supply equation after the
subsidy:
Qst = a + b(P + S)
195

 When the market system determining the
prices of goods and services unfairly then
the government interfere the market and
stabilize the market prices.
 By this government control the price and
determine the maximum price below the
equilibrium and minimum price above
the equilibrium.
196

25
30
0 Q1 Q3
D
S
QUANTITY
PRICE
EXCESS DEMAND
EQUILIBRIUM PRICE
MAXIMUM PRICE
LEVEL
Q2
197

 A black market price may be occur.
 Insufficient availability of the product in
the market.
 Economic inefficiencies may occur.
198

 A type of economic activity that takes
place outside of government-sanctioned
channels. Black-market transactions
typically occur as a way for participants
to avoid government price controls or
taxes, conducting transactions 'under
the table.' The black market is also the
means by which illegal substances or
products - such as illicit drugs, firearms or
stolen goods - are bought and sold.
199

25
30
35
0
Q2 Q3
D
S
QUANTITY
PRICE
Q1
BLACK MARKET
PRICE & QUANTITY
EQUILIBRIUM PRICE AND
QUANTITY
MAXIMUM GOVERNEMNT
STABILIZE PRICE
F
D
B
C
A
E
200

 Before the price(controlled price),
economic surplus is – A+B+C+D+E+F, and
after imposing the controlled price, a
maximum price level A is the consumer
surplus and D is the producer surplus.
 Strategies that are used to promote
maximum price.
1. Rationing – queues to buy goods, issuing
ration cards to buy a limited amount of
goods.
2. Importing – goods imported from countries
to increase the availability of the product in
the market.
201

 The minimum price control is imposing for
the producers.
 This is setting above the equilibrium price.
 Effects of minimum pricing – creating
excess supply, increasing unemployment
, excess investment situation, selling
goods at discounted price while keeping
minimum price as a nominal price.
202

25
30
35
0
Q2 Q3
D
S
QUANTITY
PRICE
Q1
MINIMUM PRICE &
QUANTITY
EQUILIBRIUM PRICE AND
QUANTITY
MAXIMUM GOVERNEMNT
STABILIZE PRICE
F
D
B
C
A
E
203

 Economists use the model of supply and
demand to analyze competitive
markets.
 In a competitive market, there are many
buyers and sellers, each of whom has
little or no influence on the market price.

 The demand curve shows how the
quantity of a good depends upon the
price.
› According to the law of demand, as the price
of a good falls, the quantity demanded rises.
Therefore, the demand curve slopes
downward.
› In addition to price, other determinants of
how much consumers want to buy include
income, the prices of complements and
substitutes, tastes, expectations, and the
number of buyers.
› If one of these factors changes, the demand
curve shifts.

 The supply curve shows how the quantity
of a good supplied depends upon the
price.
› According to the law of supply, as the price of
a good rises, the quantity supplied rises.
Therefore, the supply curve slopes upward.
› In addition to price, other determinants of how
much producers want to sell include input
prices, technology, expectations, and the
number of sellers.
› If one of these factors changes, the supply
curve shifts.

 Market equilibrium is determined by the
intersection of the supply and demand
curves.
 At the equilibrium price, the quantity
demanded equals the quantity supplied.
 The behavior of buyers and sellers naturally
drives markets toward their equilibrium.

 To analyze how any event influences a
market, we use the supply-and-demand
diagram to examine how the even
affects the equilibrium price and quantity.
 In market economies, prices are the
signals that guide economic decisions
and thereby allocate resources.

 Consumer surplus equals buyers’ willingness
to pay for a good minus the amount they
actually pay for it.
 Consumer surplus measures the benefit
buyers get from participating in a market.
 Consumer surplus can be computed by
finding the area below the demand curve
and above the price.
209

 Producer surplus equals the amount sellers
receive for their goods minus their costs of
production.
 Producer surplus measures the benefit
sellers get from participating in a market.
 Producer surplus can be computed by
finding the area below the price and
above the supply curve.
210

 An allocation of resources that maximizes
the sum of consumer and producer surplus
is said to be efficient.
 Policymakers are often concerned with
the efficiency, as well as the equity, of
economic outcomes.
211

 The equilibrium of demand and supply
maximizes the sum of consumer and
producer surplus.
 This is as if the invisible hand of the
marketplace leads buyers and sellers to
allocate resources efficiently.
 Markets do not allocate resources
efficiently in the presence of market
failures.
212

 A tax on a good places a wedge between
the price buyers pay and the price sellers
receive, and causes the equilibrium
quantity to fall, whether the tax is imposed
on buyers or sellers.
 The incidence of a tax is the division of the
burden of the tax between buyers and
sellers, and does not depend on whether
the tax is imposed on buyers or sellers.
 The incidence of the tax depends on the
price elasticity's of supply and demand.
213

 A price ceiling is a legal maximum on the
price of a good. An example is rent
control. If the price ceiling is below the
equilibrium price, it is binding and causes a
shortage.
 A price floor is a legal minimum on the
price of a good. An example is the
minimum wage. If the price floor is above
the equilibrium price, it is binding
and causes a surplus. The labor surplus
caused by the minimum wage is
unemployment.
214

 Price elasticity of demand measures how
much the quantity demanded responds
to changes in the price.
 Price elasticity of demand is calculated
as the percentage change in quantity
demanded divided by the percentage
change in price.
 If a demand curve is elastic, total
revenue falls when the price rises.
 If it is inelastic, total revenue rises as the
price rises.

 The income elasticity of demand measures
how much the quantity demanded
responds to changes in consumers’
income.
 The cross-price elasticity of demand
measures how much the quantity
demanded of one good responds to the
price of another good.
 The price elasticity of supply measures how
much the quantity supplied responds to
changes in the price. .

 In most markets, supply is more elastic in
the long run than in the short run.
 The price elasticity of supply is calculated
as the percentage change in quantity
supplied divided by the percentage
change in price.
 The tools of supply and demand can be
applied in many different types of markets.

1. In economics ,what do you understand by
the term ceteris paribus?
2. What is demand and a demand schedule?
3. What is the difference between ‘an
increase in demand and an increase in
quantity demanded’?
4. What are the influencing factors affect
demand other than the price?
5. state the law of demand and supply.
6. What are the shapes of demand and
supply curves? Explain why?
218

7. Define a change in supply and change in
quantity supplied.
8. What are the influencing factors that
affects supply? Explain.
9. What are the types of elasticity's in demand
and explain.
10.What are the types of elasticizes in supply
and explain.
11. Define what is equilibrium and equilibrium
quantity and price?
12.What is price elasticity of demand and
price elasticity of supply? Explain with
examples. 219

13. Define income effect of demand and
substitution effect of demand.
14. Write the demand function and explain.
15. Write the supply function and explain.
16. What is market equilibrium and
disequilibrium?
17. If there is a change in demand and
supply what is the effect of equilibrium?
18. Differentiate increase and decrease in
demand and supply with examples.
19. Define and explain excess demand and
supply and also producer and consumer
surplus.
220

20. What are the types of taxes that
imposed by a government and say how
it affects the consumers and producers?
221

• Prof. VIDHANAPATHIRANA .UPALI, ANANDA. P D J,
”Principles of Microeconomics,2nd
Edition ,2007,The
Open University of Sri Lanka Press,Sri Lanka. ISBN-
9552305421.
• Prasadini Dharmawardena, GCE A/ L Economics –
New Complete Text Books for grade 12 & 13, ESL
Publishers.
• LIPSY G, RICHARD." An Introduction to Positive
Economics”,7th
Edition,1992,Butlar & Tanner Ltd,
London. Low Price Edition, ISBN- 0297795562.
• ANDERTON,ALAIN.”Economics”,3rd
Edition, 2005,
Pearson Education Publishers Ltd, Singapore, ISBN-
8129711567.
• LIPSY G, RICHARD, HURBURY. COLIN," First Principles of
Economics”,2nd
Edition,1992,Butlar & Tanner
Ltd,London.Low Price Edition, ISBN- 0297821288.222
222222222222

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