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7.

Microeconomics

7. Microeconomics
What you should know
Markets
You should be able to: • defi ne markets and explain the importance of price as a signal and as an incentive in terms of resource allocation • defi ne demand, explain the law of demand and its exceptions, identify the determinants of demand, distinguish between a movement along a demand curve and shift of the demand curve, and show all of the above in diagrams • defi ne supply, explain the law of supply, identify the determinants of supply, explain the effects of taxes and subsidies on supply, distinguish between a movement along a supply curve and shift of the supply curve, and show all of the above in diagrams • explain the causes and consequences of maximum and minimum prices, explain price support and/or buffer stock schemes and commodity agreements, and show all of the above in diagrams.

Elasticities
You should be able to: • defi ne price elasticity of demand (PED), give the equation, explain the possible range of values, explain the determinants of PED, explain how PED varies along a straight-line demand curve, and show all of the above in diagrams • defi ne cross elasticity of demand (XED), give the equation, explain the possible range of values in relation to substitutes and complements, and show all of the above in diagrams • defi ne income elasticity of demand (YED), give the equation, explain the possible range of values in relation to luxury goods, normal goods, and inferior goods, and show all of the above in diagrams • defi ne price elasticity of supply (PES), give the equation, explain the possible range of values, explain the determinants of PES, and show all of the above in diagrams • explain how PED, XED, and YED may be of use to fi rms and the government when making economic decisions.

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Continued 18 365_IB Prep Econ SL ch07. above which the market price is not allowed to rise. It is a price set by the government.indd 18 5/2/09 09:27:02 . the quantity supplied increases. It is an assumption made by economists in order to construct economic models. explain different reasons for market failure. including monopoly power. subsidies. It does not need to be an actual place. Supply is the willingness and ability of a producer to produce a quantity of a good or service at a certain price over a given time period. Essential definitions Markets A market is where buyers (consumers) and sellers (producers) come together to establish an equilibrium price and quantity for a good or service. Ceteris paribus is a Latin expression that means “let all other things remain equal”. such as rice or house rentals. ceteris paribus. and show all of the above in diagrams • explain sustainable development • explain possible government responses to market failure. Microeconomics Market failure You should be able to: • define market failure. The demand curve is a graphical representation of the law of demand.7. It occurs where demand is equal to supply. public goods. taxation. extension of property rights. tradeable permits. The supply curve is a graphical representation of the law of supply. A maximum price is also known as a ceiling price. demerit goods. An example would be the market for MP3 players. the quantity demanded decreases. direct provision of public and merit goods. and it may be used in markets for essential goods. The law of demand states that as the price of a good or service rises. positive and negative advertising. including legislation. It may be set to protect consumers from high prices. It is an upward-sloping curve (or line) illustrating the direct relationship between price and quantity supplied. and international cooperation among governments. Demand is the willingness and ability to purchase a quantity of a good or service at a certain price over a given time period. merit goods. ceteris paribus. The law of supply states that as the price of a good rises. It is (usually) a downward-sloping curve (or line) illustrating the inverse relationship between price and quantity demanded. Equilibrium price is the market clearing price. positive and negative externalities.

Negative externalities are the bad effects that are suffered by a third party when a good or service is produced or consumed. It is a price set by the government. demand decreases. for example. such as butter and margarine. Merit goods are goods or services considered as beneficial for people and that would be under-provided by the market and so underconsumed. for example. Complement goods have negative cross elasticity of demand. for example. education and health care. Price elasticity of supply (PES) is a measure of the responsiveness of the quantity supplied of a good or service to a change in its price. An indirect tax is shown on a supply and demand diagram as an upward shift in the supply curve. Public goods are goods or services that would not be provided at all by the market. A specific tax is shown as a parallel shift. 19 365_IB Prep Econ SL ch07. cigarettes and alcohol. demand increases. Inferior goods have a negative income elasticity of demand. such as many agricultural products in the European Union (EU). Positive externalities are beneficial effects that are enjoyed by a third party when a good or service is produced or consumed. such as DVD players and DVD discs.7. Cross elasticity of demand (XED) is a measure of the responsiveness of the demand for a good or service to a change in the price of a related good. A buffer stock scheme sets a maximum and a minimum price in a market to stabilize prices. Elasticities Price elasticity of demand (PED) is a measure of the responsiveness of the quantity demanded of a good or service to a change in its price. As income rises. Demerit goods are goods or services considered to be harmful to people and that would be overprovided by the market and so overconsumed. Market failure Market failure is the failure of markets to produce at the socially efficient level of output. Elastic demand means that a change in the price of a good or service will cause a proportionately larger change in quantity demanded and inelastic demand means that a change in price of a good or service will cause a proportionately smaller change in quantity demanded. Substitute goods are goods that can be used instead of each other. Substitute goods have positive cross elasticity of demand. An indirect tax is an expenditure tax on a good or service. A normal good has a positive income elasticity of demand. They have the characteristics of non-rivalry and non-diminishability. It may be set to protect producers producing essential products from facing prices that are felt to be too low.indd 19 5/2/09 09:27:02 . An ad valorem tax is shown as a divergent shift. Complement goods are goods that are used together. flood barriers. below which the market price is not allowed to fall. Microeconomics Markets (continued) A minimum price is also known as a floor price. where the vertical distance between the two supply curves represents the amount of the tax. As income rises. Income elasticity of demand (YED) is a measure of the responsiveness of demand for a good to a change in income.

In this case. a fall in the cost of factors used to make computers or an improvement in technology. for example. An increase in demand Price of computer games ($) D1 D2 S An increase in the supply of computers (S1 to S2) could be caused by a change in any of the determinants of supply.7. Excess demand Q1 Qe Q2 A maximum rent (a rent control) of PMax is placed upon rented accommodation. The result is an increase in quantity (Q1 to Q2) and a fall in price (P1 to P2).indd 20 5/2/09 09:27:03 . Continued 20 365_IB Prep Econ SL ch07. an increase in consumer incomes or a decrease in the price of computers. A maximum price Rent ($) Circular flow of income diagram P1 Pe 0 PMax 0 Maximum price D Quantity of housing P2 S Q1 Q2 Quantity of computer games (000s) An increase in demand for computer games (D1 to D2) could be caused by a change in any of the determinants of demand. Microeconomics Diagrams to remember Markets Equilibrium Price of tea ($) An increase in supply S Price of computers ($) D S1 S2 Pe P1 D 0 Qe Quantity of tea (kg) 0 Q1 Q2 Quantity of computer games (000s) P2 The equilibrium point is where the quantity demanded of a good or service at a given price is the same as the quantity supplied. but it means that there will be an excess demand for rented accommodation of Q1 to Q2. The result is an increase in quantity (Q1 to Q2) and an increase in price (P1 to P2). a complement. for example. the quantity of tea demanded and supplied is Qe. at a price Pe. This keeps the rents low.

21 365_IB Prep Econ SL ch07. but it means that there will be an excess supply of corn of Q1 to Q2. Microeconomics Markets (continued) A minimum price Price of corn($) PMin Pe S Excess supply Minimum price A specific tax on a product Price of bread ($) ST S1 PT P1 R Indirect tax D 0 Q1 Qe Q2 Quantity of corn (000s tonnes) D1 0 QT Q1 Number of loaves of bread (000s) A minimum price of PMin is placed upon the corn market.indd 21 5/2/09 09:27:04 . The revenue per unit received by the producers falls from P1 to R. The quantity demanded and supplied falls from Q1 to QT.7. So the PED for fish becomes more inelastic as the price of fish falls. This keeps the price of corn high. the value of PED falls as price falls along a demand curve. Elasticities Price elasticity of demand (PED) values for a normal demand curve Price of fish ($) PED>1 PED=1 PED<1 0 D1 Quantity of fish (tonnes) Elasticity of demand does not measure the slope of the demand curve. The imposition of an indirect tax of PTR shifts the supply curve upwards from S1 to ST and raises the price to consumers from P1 to PT. The government will receive tax revenue of PTR per unit for QT units. In fact.

There is a loss of welfare and a negative externality has been produced. A negative externality. the level of output is Q1. and so the market is under-producing. Microeconomics Market failure Negative externalities of production Price of chemicals ($) MSC Welfare loss a MPC Negative externality Negative externalities of consumption Price of air travel ($) Welfare loss P1 P* Negative externality MSB 0 Q* Q1 MPB MSC P* P1 0 MSB Q* Q1 Quantity of chemicals (tonnes) Quantity of air travel (miles) The chemical firm is polluting the atmosphere as it produces. and so third parties are affected by increased noise and air pollution. this is a market failure because the socially efficient level of output is Q*. The shaded area shows the potential welfare gain that could be achieved.7. has been created. The benefit to the individuals who are flying (MPB) is greater than the benefit to society (MSB). Positive externalities of consumption Price of vaccinations ($) Positive externality P* P1 MSC Potential welfare gain Circular flow of income diagram Price of chemicals ($) Potential welfare gain P1 P* a MSB 0 Q1 Q* Quantity of chemicals (tonnes) MPC MSC Positive externality MPB 0 Q1 Q* MSB Quantity of vaccinations The chemical firm is giving training to its workers. The shaded area shows the potential welfare gain that could be achieved. since there are fewer carriers. In a free market. When the workers move on. as the market does not produce at the socially efficient level of output (Q*). the third parties. In a free market. this is a market failure because the socially efficient level of output Q* is not achieved. Positive externalities of production By consuming air travel there are more flights. Thus the private cost (MPC) is greater than the cost to society (MSC). This is a market failure. as vaccinations are under-consumed. By paying for and being vaccinated. Thus the cost to society (MSC) is greater than the private cost (MPC). the level of output is Q1. In addition third parties who have not been vaccinated stand less chance of getting the disease. There is a loss of welfare for society as chemicals are overproduced. individuals gain benefit for themselves (MPB). 22 365_IB Prep Econ SL ch07. In a free market. Thus they also benefit. and the total benefit to society (MSB) is greater than MPB. this is a market failure because the socially efficient level of output Q* is not achieved and air travel is over-consumed. a cost to third parties.indd 22 5/2/09 09:27:05 . there is a positive benefit to the firms that employ them. the level of output is Q1.

and that the PES is relatively elastic because it is relatively simple to increase supply in response to price changes. Draw and label a diagram for rice with steep.7. as can be seen from the diagrams. 10 marks [Taken from SL paper 1(a) November 2007] How do I approach the question? Start by defi ning demand and supply and then draw a demand and supply curve diagram to explain how price is determined. Using supply and demand analysis. such as rice. use the diagram to explain that a change in supply with inelastic demand and supply will lead to relatively large changes in price. The following is a typical question from paper 1 part (a) and you should spend approximately 25 minutes on it. Explain that the supply of agricultural goods tends to be rather volatile. The unpredictable supply caused by the weather is also crucial for price instability. the price of agricultural goods tends to fl uctuate more than the price of manufactured goods and that this is because of different elasticities of demand and supply. Draw and label a diagram for your example with fl at. relatively elastic demand and supply curves and show a shift in the supply or the demand curve. which you can then use for the rest of the answer. Defi ne PED and PES and explain that the PED and the PES for agricultural goods tend to be relatively inelastic. Introduce the topic of agricultural goods and give an example. relatively inelastic demand curves and inelastic supply curves and show a shift in the supply curve. Microeconomics You should be able to evaluate: • the advantages and disadvantages of minimum and maximum prices • the likely success of a buffer stock scheme • the effects of government subsidies given to cotton farmers • the effects of government intervention in the markets for demerit goods • the advantages and disadvantages of government policies to control pollution. Explain that the PED and the PES for manufactured goods tend to be relatively elastic. particularly in the short run. explain why the price of agricultural goods tends to fluctuate more than the price of manufactured goods. due to the inability to increase quantity (PES) and the dependence on agricultural goods (PES). Explain that.indd 23 5/2/09 09:27:06 . which you will then use for the rest of the answer. Remember to make reasoned judgments or conclusions. 23 365_IB Prep Econ SL ch07. Explain that the PED for your example will be relatively elastic. Introduce the topic of manufactured goods and give an example. because they are dependent on the weather. Explain that a change in demand or supply with relatively elastic demand and supply will lead to relatively small changes in price. because the industry is very competitive.

The student introduces the idea of seasonality. Since it is not a stable product the demand and supply side change. In an economy the supply and demand depend on each other. so that the demand and supply side have to regulate and change in order for the markets to exist. Agricultural goods depend on the season. The price of an agricultural good tends to fluctuate more than the price of manufactured goods. However. The change shown requires a shift of the demand curve and the statement “as the price of productivity of the good increases the supply will decrease” makes no sense in the circumstances. price would fall. However. 24 365_IB Prep Econ SL ch07.1 D Q This is only a move along the curve. supply. As the productivity of the good increases which means more supply the price will definatly increase as well. This can be shown or noticed if the market is in an equilibrium.1. Microeconomics What are the key areas from the syllabus? • Interaction of demand and supply • Elasticities • Applications of concepts of elasticity What needs to be defined? • Demand • Supply • Elasticity of demand • Elasticity of supply What diagrams do I use? • Basic demand and supply curve diagram • Shifts in demand and supply curves for agricultural goods • Shifts in demand and supply curves for manufactured goods This answer achieved 2/10 Demand.7. and equilibrium could all have been defined. If supply increased. It is a scarce resource – land. as the price of productivity of the good increases the supply will decrease. It is important to have a stable economy. the price changes continuously for every good. This can be seen on Figure 1. P Supply curve S Supply Price The diagram does not tie in with the previous sentence. P1 Po QO Q1 Fig 1. but the last sentence is a significant error.indd 24 5/2/09 09:27:07 .

higher prices S demand P1 D1 Q1 Q2 Fig 1.4 More demand P The student mentions a shortage. While correct. Shown on Figure 1. However.3 Q1 QO This causes a shift to the left of the demand curve. This is also dependable on the if the good for example corn has been grown well this year. it is hard to see the significance. Microeconomics P This diagram suggests that if production costs increase. However it is quiet normal to storage agricultural goods in case of a shortage.indd 25 5/2/09 09:27:08 . so the diagram is redundant.7. supply will fall. The more the farmer has for supply the higher the prices can be. if there is a shortage of an agricultural good and it is important to everyday life then the prices will increase. Q Fig 1.4 D2 price Q 25 365_IB Prep Econ SL ch07. If the demand for a seasonal good is weak because of a substitute for example the prices will decrease of that particular good. S P The comment includes economic terminology. Production costs S1 S0 price production D supply P1 PO Q1 QO The student makes another significant error in thinking that increased supply will lead to higher prices. which makes no sense. Agricultural goods also depend on the demand of the buyers. and yet shows a shift of the demand curve. but makes little sense and has little to do with the question. PO P1 D1 substitute = demand price DO Q Fig 1.2 On the other side if the production price decreases there will be more supply.

This point sets the price for the product. When demand and supply intersect. the needs of the people and other things such as if the product is addictive for example nicotine in cigarettes. and “production price”. It is the price set by the forces of demand and supply. There were significant errors. This means that when the price changes. This is mainly because of the availability of substitutes of the product. Supply is the amount that the producer is willing and is available to sell of a product. P Surplus The first three sentences are relevant and correct. on taste and preferences and on the joined demand. the more inelastic the product. the quantity demanded will not be affected by much. “production costs”. On the other hand.indd 26 5/2/09 09:27:09 . Microeconomics Manufactured goods are stable. The student also wrote away from the point and did not engage with the question being asked and so level 2 could not be awarded.5 D Ceiling Q Examiner report The student showed little understanding of the specific demands of the question. They are available throughout the whole year long. there is an equilibrium point. if the product is elastic a change in price will bring about a much greater change in the quantity demanded. They are always produced constantly and do not depend on weather or a season. This answer achieved 5/10 The student provides reasonable definitions and makes his or her understanding of the basic concept of elasticity clear. “price of productivity”. That’s why the demand depends on how the product is advertised. Elasticity is the responsiveness of a change of price in the quantity demanded of a product. 26 365_IB Prep Econ SL ch07. Demand is the amount consumers are willing to buy. but then the student once again strays from the question asked. The more the vertical the demand curve is. The student never seemed to understand the terms being used and this could be seen from the lack of definitions and the confusion between “productivity of the good”. There are no shortages of surpluses in manufactured goods such as there are in agricultural goods. S Max + Min Prices Floor min P1 max Shortage Q1 Fig 1. There was little recognition of relevant economic theory and none of the relevant terms were defined.7. This puts the response into level 1 and explains the 2 marks given.

There is no mention of elasticity. you choose to consume or not consume. This would be the diagram for manufactured goods. it does support the point made and. the student does not explain why “this would be the diagram for manufactured goods”. then he or she must show a shift of a curve. the quantity demanded will fall drastically from Qe to Q1. With a change in price.7. This lets prices fluctuate much more than on manufactured products that prices cannot fluctuate very much because people will choose the other substitutes. although it does tend to generalize about agricultural goods. in the same way as was the previous diagram. The main weakness was a lack of planning and insufficient explanation. infers some understanding of the question. D q1 qe q The explanation does not say why the price may have changed. in this case a shift of supply to the left. Examiner report The student showed some understanding of the specific demands of the question and recognized some of the relevant theory. but not all. q1 q ∆q D q In the diagram above one can see how a change in price will bring a much smaller change in the quantity demanded.indd 27 5/2/09 09:27:10 . you cannot choose another option. The diagrams were rather simplistic and there was no direct comparison of the relative elasticity values between manufactured and agricultural goods and so level 3 could not be awarded. we can say that the agricultural goods are inelastic because of the reasons mentioned before. 27 365_IB Prep Econ SL ch07. Microeconomics P$ P1 Pe S The diagram is incomplete. Some relevant terms were defined. On the other hand. The quantity demanded at that price will be Qe. Also. along with the brief explanation. There were errors in the explanation. This puts the response clearly into level 2 and explains the 5 marks given. a much greater change in quantity than in price. This would definitely be the diagram for agricultural products. Agricultural goods don’t have substitutes. However. If the student wants to show a change away from the equilibrium. In the diagram above we can see the price equilibrium (Pe) set by the forces of S and D. P$ S P1 ∆p Pe This is a reasonable explanation. The diagram is once again incomplete.

Demand referring to the amount of a good or service that consumers are willing to buy at a given price over a specific period of time. supply of manufactured products is more constant. Take for example. The previously discussed problems are not as prevelent in the manufacturing industry. Supply here refers to the quantity of a good or service that producers are willing to put on the market at a given price over a specific period of time. given that farm produce is inelastic in supply. Fluctuations in price can also be due to changes in supply. perhaps due to a favourable change in tastes and preferences. perhaps due to the development of synthetic substitutes such as artificial sweeteners to replace real sugar. D S'' S S' D'' D' S The student supplies an accurately drawn diagram and a good explanation of why the demand may have changed. supply shifts to the right causing equilibrium price to fall to P2 while in a bad year (year of drought) supply shifts to the left causing equilibrium price to rise to P3. When demand falls to D′′.7. In a good year. and using the diagram to illustrate the points made. price falls to P3. there is excess supply. price of agricultural produce rises to P2. giving realistic factors. Also. Microeconomics This answer achieved 8/10 A good definition of supply was followed by the introduction of supply elasticity and another good definition.indd 28 5/2/09 09:27:11 . 28 365_IB Prep Econ SL ch07. This can be represented in a diagram as shown on the following page. D Price of farm produce p2 p1 p3 q3 q1 q2 Quantity of farm produce When demand rises to D′. with abundant rainfall. supply will again fall. This may be due to weather or technological advancements. This supply is inelastic in nature due to the process of production of agricultural goods. The student refers to the diagram to follow and adds a definition of demand. again due to the nature of its production process. The student suggests how the market for manufactured goods is different and why there would not be such large fluctuations in price. In a year of drought however. the elasticity of supply referring to measure of responsiveness of changes in the supply of a good due to changes in the goods own price. Price of farm produce P3 P1 P2 S' – good year S'' – year of drought q3 q1 q2 Quantity of farm produce As seen from the diagram. The student now uses another good diagram to explain and develop the answer in relation to how changes in supply will also lead to large fluctuations in prices for agricultural goods. a sugar cane farm here in Swaziland. The fluctuation in the price of agricultural produce may be due to the inelastic nature of its supply. in a good year. Given that supply of manufactured goods is elastic due to the non-complexity of the production process. a minor change in its demand can lead to a huge fall in price as shown in the following diagram. Hence. shifts in demand of manufactured products does not result in much of a change in price.

which may include reducing negative externalities and thus market failure. and the cost of negative advertising. The student concentrated too much upon agricultural goods and their prices and did not really go into enough detail regarding manufactured goods. You may now explain the two main methods of government intervention in tobacco markets: indirect taxes on cigarettes. you need to identify what the question is asking you to evaluate. 15 marks [Taken from SL paper 1 May 2007] How do I approach the question? First. showing that the marginal social benefi t (MSB) of cigarettes is less than the marginal private benefi t (MPB). since the intervention will affect more people positively than negatively and will lead to a more socially effi cient allocation of resources. You may also draw a diagram to show the effect that these would have on the tobacco market. the creation of parallel markets. Now you should offer arguments against government intervention. Now introduce and explain the arguments for government intervention. loss of employment in the tobacco industry. so level 4 could not be awarded. in the form of cigarettes. 29 365_IB Prep Econ SL ch07. Now evaluation can take place. Economic terms were defined in all cases and there were no significant errors. and so the consumption of cigarettes causes a negative externality. Then draw a negative externalities (of consumption) diagram. The following is a typical question from paper 1 part (b) and you should spend approximately 35 minutes on it. Then you should explain the diagram. improved health in the work force. should governments intervene in the tobacco market or not? So now you should explain that tobacco is a demerit good. and increased regulation (such as bans. age restrictions.indd 29 5/2/09 09:27:12 .7. You may also explain that cigarettes are an example of a market failure in that they are over-provided and are over-consumed. and health warnings). more socially effi cient allocation of resources. and a source of government revenue. which in this case is the proposition that government intervention in the market for tobacco is justifi ed. reduction of consumer choice. That is. Some diagrams were introduced and explained. which may include distorting the role of prices in the market. and defi ne demerit goods. You might compare the arguments for and against intervention and then decide that the arguments for are more weighty than the arguments against. Evaluate the proposition that government intervention in the market for tobacco is justified. Microeconomics Examiner report The student understood the specific demands of the question and explained and developed relevant theory. No examples were given and there was no use of a diagram to show the relatively elastic demand. This puts the response clearly into level 3 and explains the mark of 8.