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Micro Economics: An Essay-centric Guide Demand and Supply / Market Equilibrium Definitions  Demand – different qtys of a good or service that consumers are willing and able to purchase at each possible price during a given time period  Supply - Different qtys of a good or service that producers are willing and able to offer for sale at each possible price over a given time period  Competitive demand – commodities that satisfy the same want  Complementary demand – use of one commodity requires the other to generate satisfaction  Competitive supply – commodities which requires the same factors of production  Complementary supply – commodities which are produced together from the same source  Law of Opp Cost – as more and more of a particular good is being produced, increased quantities of the alternative good has to be sacrificed due to factor unsuitability  Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price they do pay. Producer surplus is defined as the difference between the amount the producer is willing to supply goods for and the actual amount received by him when he makes the sale.  PED is a measure of responsiveness of a change in quantity demanded of a good to a change in its own price, ceteris paribus. |PED| > 1 = demand is price elastic (a change in price brings about a more than proportionate change in quantity demanded). Affected by substitutes, necessity, proportion of income (less difficulty in affording the percentage increase in price), time period.  PES measures the degree of responsiveness of quantity supplied of a commodity to a change in its own price, ceteris paribus. If supply is price elastic, when demand increases, there is a minor change in price but output increases more than proportionately (vice versa). Affected by spare capacity, nature of production (factor mobility, production period), inventory, time period.  Income elasticity of demand measures the degree of responsiveness of demand to a change in income of consumers, c.p  Cross elasticity of demand measures the degree of responsiveness of demand of one good to the change in price of another good. Positive for subs, negative for complements. The larger the value, the closer the goods. Demand refers to the different quantities of a products consumers are willing and able to buy at each possible price during a given time period, ceteris paribus.  Price of related good - substitutes and complements (cross demand elasticity)  Tastes and Preferences – seasons, government policies, advertisements, fad  Income – inferior and normal goods measured based of amount of satisfaction it brings to consumers  Demographics – number of consumers / gender / age  Expectations – of a price rise/fall, of income Supply refers to the different quantities of a products producers are willing and able to offer for sale at a given set of prices over a time period, ceteris paribus  Cost of production – price of inputs, technology, productivity, taxes and subsidies  Price of related good – competitive and joint supply  No. of producers  Supply shocks  Seller’s price expectations Shared by Cheryl Yau On owlcove.sg XX will cause an increase in demand from DD to DD1. At the same price, quantity demanded exceeds quantity supplied which causes an upward pressure on price. Quantity demanded drops, while quantity supplied increases and a new equilibrium price and output is reached. Scenario-based (for essays) Asking how a scenario affects a certain market / total revenue / expenditure Markets: good itself, substitutes, complements, factors of production, competitive supply a) Introduction (1) Price and output / expenditure / output in a market is affected whenever there is a change in demand and supply (2) Identify demand / supply factors that are changing and its general effects e.g. increasing oil prices will decrease supply of cars. (3) Overall impact on equilibrium price and output is dependent on the relative shifts of the demand and supply curve and the price elasticity of the curves (/CED/YED) *If more than one market, split the markets, then within the market, split into demand and supply factors - more often than not, one market will affect the other! b) Shift in demand and supply and extent of shift: state clearly if overall demand and supply increases / decreases and to what extent Demand: P-TIDE, Joint / Derived / Complement; YED, CED o Derived – As demand for exports/ domestic goods increases, derived demand for packaging, a factor input increases o Joint Demand – items cannot be used separately o Complement – Petrol is a complement to cars as both have to be used together to satisfy the driver’s need; hence when demand for cars increase, demand for petrol increases too (VS price of related goods –evaluate which is more important) o YED – The impact of the increase in income on demand is dependent on YED (insert definition). As [item] is generally regarded as a low/high quality option [insert justification e.g. the better ingredients, service and ambience], in comparison to [insert options], it is an income elastic luxurious good. Hence, when incomes are growing, demand increases more than proportionately to increase in income (as consumers prefer to spend their money on items that are perceived to be of higher quality) o XED – Furthermore, as Good X is generally regarded as a strong/weak complement / substitute to Good Y, with XED > value (with XED measuring…), an increase in price of Good Y will cause demand for Good X to increase more than proportionately to the price increase of Good Y. Supply: CPPSE; proportion and significance o An increase in wages will cause an increase in COP which will cause supply to decrease, while an increase in number of suppliers will cause supply to increase. o Analysis: Since wages form a small proportion of total cost, there is a net increase in supply Market analysis o After establishing whether there is a net increase or decrease in demand / supply. Do once for shortage, once for surplus o At initial price, Qd exceeds Qs and there is a shortage. This puts an upward pressure on prices as consumers bid up the prices of real output. As prices increase, Qd falls and Qs increases until a new Pe and Qe is reached at DD = S2 c) PES / PED Shared by Cheryl Yau On owlcove.sg - Given an increase in supply / demand, the impact on Pe and/or Qe depends on the PED/S Define PED/S As item is _________, it is likely to have a price elastic / inelastic demand / supply Hence, a large / small increase in demand over a price elastic supply will hence bring about an increase in price and output, with output rising more than proportionately to price. **PES only determines whether price / Q drops / increases more. PED determines if TR increases or decreases d) Conclusion (1) Shift in demand / supply: With reference to Figure 1 (this is a must!), a rise in incomes will lead to an overall small rise in demand from DD0 to DD1 and rising costs lead to a large fall in supply from SS0 to SS1. (2) PED / PES: A large / small increase in demand over a price elastic supply will hence bring about an increase in price and output, with output rising more sharply than prices and a large / small decrease in supply over a …. (3) Effect on price and output: state the non-contentious (e.g. the effect of both increase in demand and fall in supply causes prices to rise) then evaluate the contentious. Since (offer evaluation e.g. since cost increases at 10% which is much higher than the economic growth of 3), impact of decrease in supply is probably more / less significant than increase in demand, and Qe falls. (4) Assumptions / Limitations – explain why it is critical, and specific to the context (5) Note: always link back to what the question is asking e.g. price, output, expenditure, surplus, who benefits etc When the increase in price was due to the increase in demand, both consumer and producer surpluses rise  well-being of both improve (vice versa when increase in price is due to fall in supply) Increase in prices may not lead to an increase in TR (dependent on PED) – producer may not benefit Taxes and subsidies Correct externalities if present 1. A tax equivalent to the EMC at Qse shifts the PMC to PMC’ where SMC = PMC’. Hence at PMC’ = PMB, SMC = SMB, and allocative efficiency is achieved. 2. A subsidy equivalent to the EMB at Qse shifts the PMC to PMC’ 3. Qualification: When item has a price elastic demand, an increase in price (due to tax) will only lead to a less than proportionate fall in Qe. Hence a large tax must be imposed to restore Qse which may be unviable BUT could distort efficiency for other goals (e.g. equity) 1. Raises / lowers the MC of production, hence decreasing / increasing market supply by tax per unit. 2. Allocative efficiency is achieved when the allocation of resources cannot be changed to increase society’s welfare. 3. Assuming no market failure, the tax will exaggerate the opp cost to society of using the resources in the next best alternative / the subsidy will understate the opp cost to society… 4. When society consumes at Q2, society values an additional unit of output more than it cost society. Hence, society’s welfare can be increased if resources are diverted Shared by Cheryl Yau On owlcove.sg Incidence  Taxes increases the MC of production, hence decreasing market supply by tax per unit, shifting supply from S1 to S2. At initial price, Qd exceeds Qs and there is a shortage. This puts an upward pressure on prices as consumers bid up the prices of real output. As prices increase, Qd falls and Qs increases until a new equilibrium settles at P2 and Q2  Total tax is represented by tax per unit multiplied by post-tax output (label area).  As prices have risen from P1 to P2, the consumer burden of the tax is _____ while producers bear _____.  Incidence of the tax is dependent on the relative PED and PES. Define PED and PES.  When faced with a price inelastic demand, producers are able to pass on cost to customers without suffering a proportionate fall in Qe and hence a fall in TR. Hence, consumers suffer a heavier tax burden. (Draw graph)  Tax is more detrimental to the side with the relatively more price inelastic curve, as more disincentive as to be given to the side that is less willing or able to cut back on quantity supplied / demanded. Hence we should tax on luxury items with a price inelastic demand, price elastic supply where rich households bear the brunt of the tax But most luxury goods are price elastic  Subsidy is more beneficial to the side with the relatively more price inelastic curve, as more incentive as to be given to the side that is less willing or able to cut back on quantity supplied / demanded. Hence we should subsidise basic necessities with a price inelastic demand, price elastic supply where poor households enjoy the bulk of the subsidy But rich and poor households alike can benefit from the subsidies (budget concerns) Price Controls   Price floor / price ceiling: legally established min / max price above / below market equilibrium price Price floor: protects income and equity BUT results in surplus at the stipulated min price (allocative inefficiency + budget deficit) Price ceiling: keeps basic needs affordable BUT results in shortage at the stipulated max price (allocative inefficiency + exacerbating black market) **for labour it is productive, not allocative inefficient Extent of shortage and surplus dependent on PED and PES (draw graph) Typically preferred as a short run solution, as supply and demand usually get more price elastic over time (change of taste and preferences to a cheaper alternative, , which exacerbates the surplus / shortage Elasticity – Government (1) Identify the government goal (efficiency, equity, 4 macro-economic goals, budget) (2) Explain how the tool(s) will achieve the goal (if equity, focus on changes to price and vice versa) Tax (efficiency, equity - market dominance) Subsidy (efficiency, equity) Price controls (equity) Alternative policy (education, regulation (output), alternatives, nationalization) (3) Explain the effectiveness of the tool, making reference to elasticities Shared by Cheryl Yau On owlcove.sg Effectiveness is dependent on ________. As item is _________, it is likely to have a price elastic / inelastic demand / supply (4) Going by ‘markets’ Externalities: PED & tax, YED & externality size (draw EMC as divergent when PMB i.e. DD increases externality increases), XED & alternative policy  When income is rising, the income effect outweighs the price effect (of output taxes) and equilibrium quantity may still rise, unless we use YED to estimate the impact on an increase in income on demand Equity – price controls: PED and PES to estimate shortage / surplus Equity – curbing monopoly power: PED/PES & specific tax / subsidy Elasticity – Businesses [PED/YED for the good will be ____ because ______. Hence, ___ should do _____ so as to ____. ]     PED: General pricing policy PES: Output decisions – increase production when there’s expected demand increase (especially if demand is price inelastic) XED: mark competitors, joint promotions, product dev or promotion to differentiate YED: adjust output in the face of boom or bust, change nature of produce to luxurious or inferior, segment markets by income levels (right location to situate outlet) Evaluation: Ceteris Paribus, Perfect information, Perfect competition, Government, Time (CPPGT) 1. Ceteris Paribus: for e.g when non 3G phones prices are falling, non 3G phone plans may not face an increase in demand due to changing taste and preference | when incomes are rising, boutique sales may not rise due to outdated designs 2. Perfect information: can’t determine the value of the relevant elasticities always changing, matter of perception 3. Divorced from market structure – oligopoly i.e. price rigidity, PC cannot change prices, does not account for cost (PED), using market demand curves and not firm demand curves 4. Government 5. Time Shared by Cheryl Yau On owlcove.sg Market Structure Market structure is the set of characteristics that determines the nature and extent of competition within a particular industry Defining Characteristics  Monopoly: one firm, unique product, high BTE, high profit levels  Oligopoly: MCR high, high BTE, high profit levels, interdependence with other firms  MC: many firms, low BTE, product promotion over innovation What determines market structure? 1. iEOS / BTE (obstacles that prevent the entry of new firms) In industries with high fixed cost to variable cost ratio, LRAC will decline over a large output as there is great scope for high fixed cost (from large and indivisible machines) to be spread over a large output (MES occurs at a high % of market output) Firms will be motivated to expand their scale of production to reap cost savings In extreme cases, LRAC will decline over the entire range of market demand, hence resulting in a natural monopoly Not only will existing firms be motivated to expand, high iEOS functions as BTE: it is difficult for new firms to enter as they will be unable to compete on cost / not have the clientele base High BTE = less firms and vice versa 2. Size of demand – a) if firm can already satisfy market demand without hitting MES, there is no incentive to expand, in fact expanding when there is no demand, increases average cost of production due to higher average fixed cost b) size of demand may lead to a natural monopoly where market can only support one firm 3. Nature of demand (e.g. if it requires personalization, reaping of iEOS from mass production would become a secondary concern) 4. Government (regulations, anti-monopoly laws etc) Why expand? 1. Cost savings – As firms increase their scale of production they experience increasing returns to scale (till MES) where output increases more than proportionately to input. This means that average cost decreases as seen in the graph. Cost savings can be reaped in the following ways – technical (specialization and factor indivisibility), administrative, marketing, financial, risk-bearing (lower per unit xx cost) 2. Revenue advantages – large firms also tend to have larger market share (and hence price inelastic curve) which confers upon it greater market power – the ability to raise prices profitably. 3. Erect barriers to entry – high iEOS functions as a BTE allowing firms to retain supernormal profits as new firms cannot compete with it on cost. Profits can also be ploughed back into product promotion or innovation to increase brand name as a form of BTE and to further increase demand / make it more price inelastic Shared by Cheryl Yau On owlcove.sg How can small firms survive? 1. COST – different cost structure, MES occurs over large output, band with other small firms, 2. Demand – niche demand, income elasticity 3. May in fact be good if a) demand is small or specialized b) no substantial iEOS What determines price / output and behavior? 1. BTE – determines number of firms and hence market power and price setting ability In an industry with high BTE, there are usually only a few firms or only one firm (as it is difficult to enter the industry). As such, each firm has a significant market share (high demand) and market power (price setting ability) due to the lack of substitutes (price inelastic). Especially so if firms are selling differentiated / unique products. In an industry with low BTE, there are usually many firms (as it is easy to enter the industry). As such, each firm will have an insignificant market share, and hence limited price setting ability due to the presence of many substitutes. In an extreme case of perfect competition, low BTE (many firms) with perfectly homogenous goods means that firms have no price setting ability at all and are price takers. In an MC industry, firms have a limited ability to set prices due to the many firms selling similar products. However, as the products are not perfect substitutes, each firm will still have a certain degree of price setting ability by capturing a “niche market” 2. BTE – determines ability to retain profit in LR and hence ability to compete on production promotion “price setting in the long run” – in the LR, monopolists can continue pricing above MC and earn supernormal profits, while PC firms can only make normal profits as new firms enter MC firms have no financial ability to engage in price competition and engage in cost reduction or product promotion instead 3. Behaviour of other firms In an MC industry, there are many firms selling differentiated products. As such, each firm holds an insignificant share of the market and behavior of firm depend minimally on other firms – gains or losses arising from price competition are spread thinly across the many firms in the entire industry In an oligopoly industry, each firm holds a significant market share, and firms display high interdependence as behaviour of one firm affects the others directly  This interdependence is reflected in its price rigidity, price leadership and tendency to collude 4. Cost Conditions Knowledge of BTE helps firms to determine their revenue curves, however, price and output cannot be determined without knowledge of cost conditions. A profit maximising firm would set output at the point where marginal cost = marginal revenue; producing at any output level below PMO would mean that that an additional output would incur less cost than revenue and hence more profit can be made. At any point beyond, .... 5. Others: Alternative objectives, Government, Demand side factors (increasingly important) How does XX affect equilibrium? 1. Depends on the market structure in which it operates in (COST) Shared by Cheryl Yau On owlcove.sg - Proportion of fixed to variable cost (divergence between AC and AVC) Likelihood of AR falling below AC or AVC is lower in an oligopoly (either compare LR curves or use LRAC SRAC curves) 2. Depends on the market structure in which it operates in (REVENUE) Ability to use accumulated profits (LR) 3. Nature of good – income elastic? 4. Others: Government, consider how other factors may be affected (are factor inputs cheaper? Change in taste and preference etc) Are big firms good? Yes 1. Lower prices / higher output (substantial iEOS) 2. Ability to innovate (variety, DE) 3. Stability 4. Price discriminate / support the market – excess capacity theorem No 1. Higher prices / lower output (no substantial iEOS) 2. Allocative and productive inefficient (Xinefficient) Divergence between P and MC at PMO is larger when demand is more price in elastic 3. No incentive to innovate 4. Inequity Perspective 1. Society: AE, PE, Equity, stability 2. Consumer: Price / output, DE / variety, can the good even be produced, price discrimination 3. Firm: higher profits? Consider cost and revenue (sufficient demand?) Anti-competition behaviour primary seeks to increase one’s market share in the LR 1) Greater market share = higher output = reap internal EOS = cost savings (also no need to spend money on advertisements, bid up prices of factor inputs etc) 2) Greater market share = more market power = raise prices = TR increases 3) However, unit cost may increase due to X-inefficiency Price Discrimination Practice of charging difference prices for the same product, or different units of the same product, where there are no cost differences (1) Price setting ability – consumers who are charged discriminatory prices cannot turn to an alternative supplier (2) Segregation of markets (different PED) – higher price to price inelastic demand, lower to price elastic (3) No seepage between markets – prohibitively costly / impossible for consumers to buy in the lower priced market and sell in the higher priced market (i.e. arbitrage) Shared by Cheryl Yau On owlcove.sg