Economics Notes

Resource Allocation in Competitive Markets

The Price Theory

The Price theory is an economic model based on the basic supply-demand model which operates in
markets to determine prices, to result in the right mix of goods and services for society.

Demand
- Amount that consumers are willing and able to purchase at each given price over a given
period of time
- Follows the law of consumer demand
o The quantity demanded of a good is inversely related to its price
o Price

Quan
o titybelow
Follows the assumptions
 It is over a specific time period
 It follows ceterus paribus condition, everything except price is constant
 Consumers behave rationally to maximise satisfaction
o Based on observations of the demand schedule which indicates the various quantities
of a commodity that will be demanded at various prices
o Demand curve (above) represents the MAXIMUM PRICE that consumers are willing
and able to pay for the good, and thus the marginal willingness to pay
o The demand curve slopes downwards because the price of a good has the following
effects on consumers
 Income Effect
 Change in price will change the real income of a consumer
 i.e. the same amount of money can now buy more or less of that
commodity , thus the purchasing power of the income changes
 Thus, at lower prices ,the quantity demanded is higher
 Substitution Effect
 When the price of one good changes, the relative price of the good to
other commodities changes too
 This will cause him to substitute the good for cheaper alternatives of
that commodity, in order to maximise satisfaction with the given
income
o Change in demand causes whole curve to shift left or right, while change in quantity
demanded causes a movement of the point along the demand curve.
- Demand is affected by the following factors (Go Take Some P 2I2E2)
o Government Policies
 Direct Tax Policy
 Tax on people’s income, affecting disposable income
 Affects level of demand, as increase in tax reduces disposable income
 Subsidy Policy
 Payments by government to reduce the price consumers pay and
costs incurred by producers (esp. poor)
 Aims to redistribute income from rich to poor, by increasing real
income of poor, increasing demand on food, education etc.
o Tastes and Preferences
 Advertisements, age, education and culture affect tastes and preferences.
 Change in taste in favour of a commodity is likely to increase the demand for
that commodity i.e. shift to the right
o Seasonal Changes
 Demand for certain goods increase with climate (e.g. air-con/fans) and with
festive seasons (clothes/ flowers)
o Population
 Affects level of demand – size of market
 Increase/Decrease proportionally with number of people
 Increase/Decrease with composition of population e.g. ageing
population/ baby boom
o Price of Inter-related goods
 Substitute – Commodity that can be used in place of another – if price
increase, substitutes demand increases.
 Complement – Commodity that is used in conjunction with another – if price
increase, complement demand decrease
o Income
 An increase in money income alone will lead to an income in real income
 Lead to re-adjustments of consumer’s expenditures to goods
 Normal good – Demand increases proportionally
 Inferior good – Demand follows income inversely
o Consumers switch to more expensive substitutes
o Interest Rates
 Price of borrowing/using money
 Increase in rate will reduce the demand of commodities which rely on people
to take loans or hire purchase as the cost of purchase increase, even though
the commodity’s price does not.
o Exchange Rates
 Refers to the rate at which a country’s currency exchanges for another
currency
 Will affect foreign demand for a country’s goods and services
o Expectations of the future
  E.G. If people expect the price of a good to increase , they will increase the
demand before prince increase, ceterus paribus and vice versa
Supply
- Amount of a good or service that produces are willing and able to offer for sale at each given
price over a given period of time
- Follows the law of supply
o Quantity supplied is directly related to the price of a product
o Price

Quan
o Based on observationstity of supply schedule, which shows the different quantities of a
good that all producers are willing and able to supply at various prices over a given
period of time.
o Supply curve represents MINIMUM PRICE at which producers are willing and able to
supply each quantity of good
o The supply curve slopes upwards
 Higher price will induce firms to supply more of the good because the higher
marginal cost of supplying the additional unit can be covered by the marginal
benefit
o Change in demand causes whole curve to shift left or right, while change in quantity
demanded causes a movement of the point along the demand curve.
- Supply affected by the following factors (CREIGN)
o Costs of Factors of Production
 Changes in price of factors will change cost of production, and thus the level
of profit, thereby affecting supply.
o Prices of inter-Related goods
 Joint Supply – Increase in quantity supplied of one good will result in quantity
supplied of another good and vice versa
 Competitive supply – Increase in quantity supplied of one good decreases
quantity supplied of another good (e.g. chickens vs. eggs)
o Innovation
 Represents the economy’s stock of knowledge about how resources can be
combined the most efficiently
 Supply of a good changes with technological change, as cost per unit of output
is lower due to increase in productivity of factors of production
o Natural Factors
 Favourable climatic conditions increase supply of agricultural products and
vice versa
o Government policies
 Indirect taxes (GST) increase minimum supply price of goods
 CPF contributions increase cost of production through increase of wage prices
  Subsidies decrease minimum supply price
o Expectations of Future Price Changes
 Producers stock up if price expected to rise, thus supply fall and vice versa
Consumer and Producer Surplus
- Consumer Surplus
o Difference between maximum amount that consumers are willing to pay for a given
quantity of a good and what they actually pay
o Measure of consumer welfare/satisfaction
o Price
B
E
A

C
Quantit
o Consumer Surplus is OBEC y - OAEC = BAE
- Producer Surplus
o Difference between amount received by producers and minimum amount that they
are willing and able to accept for the supply of the commodity
o Price

B
E

C
Quantity

o Producer Surplus is OBEC – OAEC = BAE

Market Equilibrium
- Situation in which buyers and sellers are on aggregate satisfied with the current combination
of price/ quantity of a good, and under no incentive to change their present economic actions
- Equilibrium price i.e. market clearing price, is the price at which the quantity demanded is
equal to the quantity supplied
- Price

Quantity
- Movement of Prices
o At prices above the equilibrium price (EP), the quantity supplied exceeds the
quantity demanded. There is a surplus in the market and a downward pressure on
the price is expected.
 This is because producers will find that they are unable to sell all their
output at that price. Competition will occur to sell excess supplies, thus
bringing the price lower to EP
o At prices below EP, quantity demanded exceeds quantity supplied, the resulting
shortage exerts and upward pressure on the price.
 Competition among consumers will drive up the price, causing higher prices
to be offered and thus increasing the price to EP.
Role of Price Mechanism in Resource Allocation
- Factor resources are allocated according to the forces of demand and supply
- Increases in demand in a final product market(sunrise industries) will attract resources away
from markets with declining demands (sunset industries)
- Price mechanism causes resources to move into expanding industries and lesser resources to
stay in declining industries, causing effects on interrelated industries
o Interrelated demands
 Joint demands / complements
 Use of one commodity requires use of the other in order to
generate satisfaction
 E.G. Increase in supply of one good , will cause an increase in the
demand of the related good
 Competitive Demands
 Fall in supply of one good, will cause price to rise, thus decreasing
quantity demanded and thus increasing demand of the competitive
good
 Derived Demands
 Increase/Decrease Proportionally
o Interrelated supplies
 Joint Supplies
 Increase/Decrease Proportionally
 Competitive Supplies
 Two goods compete for same FOP, change inversely between goods
Elasticity
- Price-Elasticity of Demand (PED)
o Measures degree of responsiveness of the quantity demanded of a good to a change
in its price
∆ Q P0
o × (Absolute value considered only)
∆ P Q0
 The larger the coefficient, the greater the sensitivity of quantity demanded
to a price change
 If PED =0, the good has perfectly price-inelastic demand
 If PED<1, the good has price-inelastic demand
 If PED = 1, the good has unitary price-elastic demand
 If PED>1, the good has price-elastic demand
 If PED =∞, the good has perfectly price-elastic demand
o Affected by the following factors: (PHAT)
 Availability of Substitutes
 If there are both MANY and CLOSE substitutes of the good, the
greater the PED
 Consumers are likely to switch to alternatives when price increases
 Habit
 If good is bought habitually,, demand is price-inelastic
 However , what may be one society’s habit may not be another’s
 Proportion of Income spent on Good
 The higher the proportion of income spent on the good, the more
price-elastic its demand is, as it will take up more of the consumer’s
available income when price increases, and vice versa
 Time
 The longer the time period, the more price-elastic the demand of a
good will be
o Consumers take time to respond to price change and adjust
consumption pattern
o Substitutes may take time to develop
o The good may be durable, so the consumer need not buy a
new good at the new price
o PED can be applied in various situations
 By Firms (Please Don’t Murder The Dog’s Eldest)
 Pricing Policies
o Refers to decision on the amount of mark up for a particular
good and the necessary adjustment to price in order to
achieve the objective of the firm , CETERUS PARIBUS
o Overall aim is to increase Total Revenue (TR= P×Q)
 Price-elastic demand situation (Diagram needed)
 An increase in price, will lead to a decrease
in TR and vice versa, as there is a more than
proportionate change in quantity demanded
in response to price
 Therefore, if the demand of a good is price-
elastic , firms should lower its price to
increase TR
 Price-inelastic demand situation (Diagram needed)
 An increase in price leads to an increase in
TR and vice versa, as there is a less than
proportionate change in quantity demanded
in response to price
 Therefore, firms should increase its price to
increase TR
 Price Discrimination
o Situation in which a firm will charge different prices for
different units of the same good for reasons not associated
with differences in cost
o In a price-inelastic demand market, the monopolist firm will
charge higher prices, and opposite in a price-elastic one
 Use of Marketing Strategies
o Firms will seek to reduce substitutability by other products,
in order to increase TR by price increases
o Done by product differentiation and advertising
 Timing of Pricing
o In price-inelastic short term, the firm will adopt price
adjustment strategy to increase TR, but in the price-elastic
long term, it will focus on innovation and marketing
strategies to reduce elasticity.
 Deciding type of goods to sell
o Large firms which have economies of scale should sell price-
elastic goods as they can afford to lower costs
o Small firms should focus on goods with inelastic demand
 Effect on price and income stability
o When events occur that reduce quantity, prices/wages can
decrease rapidly if price-inelastic, causing income volatility
 For Government
 Helps to achieve following objectives
o Raise revenue through taxation
 Taxes should be levied on goods with price-inelastic
demand, as it will lead to an increase in price with a
less than proportionate fall in quantity demanded
o Discouraging consumption of goods
 To restrict consumption of demerit goods, a tax can
be imposed to raise price, forcing to find substitutes
 Removes negative externalities
 Knowing the price-elasticity will allow government
to asses effectiveness, more favourable for high PED
 For Trade Unions
 More likely to be successful in asking for wage increases if the
demand for the final product is price-inelastic, as fall in quantity
demanded when supply curve shifts left, is less than proportional
- Income Elasticity of Demand (YED)
o Degree of responsiveness of demand of a good to a change in consumer’s income
∆Q Y 0
o ×
∆ Y Q0
 If YED is negative, the good is an inferior good
 If YED is +, but <1, the good is a normal income-inelastic good (necessities)
 If YED is +, but >1, the good is a normal income-elastic good (luxury goods)
o Determined by
 Degree of necessity of good
 If the good is a basic household item, its YED is lower
 Stage of economic development
 YED of a single item can vary from country to country e.g. bus rides,
due to different perception of a good according to its economy
 Level of income
 Low income levels see certain good as luxuty, however middle
income can see them as necessities, and inferior at high income
o Can be used by
 Firms
 Production Plans
o Responding to changes in come
 If incomes are expected to rise, firms should
produce income-elastic goods
 They should stock uo more normal and luxury goods
to anticipate demand
o Targeting different income groups in different locations
 Will help in segmenting the market to produce good
at appropriate price and quantity to suit consumers
of different income levels
 E.g. more income-elastic goods for higher
end outlets and vice versa
 Government
 Can help predict demand patterns , to project changes in tax
revenues of other government policies
- Cross Elasticity of Demand (CED)
o Degree of responsiveness of demand of a good to change in price of another good
∆ Q A PB
o ×
∆ PB Q A
 If CED< 0, the two goods are complements
 If CED = 0, the goods are unrelated
 Id CED >0 , the goods are substitutes (the higher, the more substitutable)
o Determinants
 Closeness of substitutes or complements
o Can be used (by firms) for
 Pricing Policies
 If it has high CED to a rival’s product, it will need to respond to
changes in price of rival’s product
 Must strive to be as cost efficient as possible to lower prices, to win
over rival’s business and win huge gains
 Marketing and Sales Strategies
 Aim to make good less substitutable from rivals to make its CED
lower
o Through advertising and product differentiation e.g.
customer service and membership for patrons
 If the good is a complement with another good (high negative CED),
it can link marketing plans to pricing policy of other firm
 A firm can package two goods that are complementary together to
sell both of them at the same time
- Price Elasticity of Supply (PES)
o Degree of responsiveness of quantity supplied to a change in the commodity’s price
∆ Q P0
o ×
∆ P Q0
 The larger the coefficient, the greater the sensitivity of quantity SUPPLIED to
a price change
 If PED =0, the good has perfectly price-inelastic supply
 If PED<1, the good has price-inelastic supply
 If PED = 1, the good has unitary price-elastic supply
 If PED>1, the good has price-elastic supply
 If PED =∞, the good has perfectly price-elastic supply
o Determined by
 Time
 Price-inelastic in short terms as the firm can only change few factors
 Price-elastic in long term as all FOP can vary, and supply can change
 Factor Mobility
 The more mobile a good is, the less the increase in marginal cost is,
and PES is higher as the firm is able to expand output by a larger
extent
 Number of Firms
 PES increases with the no. of firms
 Stocks and Spare Capacity
 If a good can be stored easily, the higher the PES, as it can store
more goods
 Length of Production Period
 The shorter the time period for the production process, the more
price-elastic the supply is
o Can be used (by the government) for
 Tax Burden
 In extreme cases, PES is important, as if PES tends towards 0, the
whole burden of tax falls on producer, and vice versa. Thus
governments must take note of this
 Price and Income Stability
 If supply Is price elastic, fluctuations will result in slight fluctuations
in prices and vice versa
 Helps government judge when to implement policies to stabilize
prices of primary products to stabilise incomes
- Problems with Elasticity Concepts
o Computation
 Values of consumer groups may differ due to issues such as income gaps and
social differences, causing it to be difficult to calculate elasticity
 Data may get out-dated easily
o Ceterus Paribus assumption
 Strict assumption that cannot hold in reality
  Causes results to be inaccurate as they are taken in vacuum without
considering that they interact with each other
APPLICATION OF ABOVE CONCEPTS
ECONOMICS OF PRICE CONTROLS
- Price Floors
o Legally established minimum price (above market equilibrium price) to prevent
prices from falling below a certain level
 To protect income of producers from falling in periods of low prices e.g.
agricultural support prices, where their PES is low, and demand is price-
inelastic
 To create a surplus to store in preparation for future
 To create a minimum wage policy to prevent worker’s incomes from falling
below subsistence levels
o There will be a persistent surplus (diagram needed), and accumulation of stocks as
quantity supplied exceeds quantity demanded
 Government needs to buy up surplus or store it, or even destroy/ sell abroad
 Represents misallocation of SCARCE resources
 Financing surpluses will impose heavy tax burden on taxpayers
 Firms will try to evade controls and cut prices
 Can cushion inefficiency as producers are less motivated to look for more
cost-efficient methods of production as they have a minimum price
o In the case of wages
 Higher skilled workers will be hired for the wage rather than low-skilled
workers causing unemployment of workers
 Employers spend less money on on-the job training and non-wage
components to cut costs
 Encourages students to drop out of school early as they have a certain
income, affecting skilled labour in the long tem
- Price Ceilings
o Legally established maximum price (below market equilibrium price) to prevent
prices from rising above a certain level
 To achieve some form of equity
 To protect consumers in times of crisis
o Will cause a shortage as the quantity demanded exceeds the quantity supplied
 Represent misallocation as insufficient resources are allocated to production
of good
 Will increase congestion and waiting times, and hurt the people that the
policy intends to help
 Emergence of black market to sell goods at prices above price ceiling
 Government can encourage supply through drawing out surpluses,
direct production or subsidies
 Or it can control demand by controlling income or producing
alternatives to the good
 - Consumer and Producer’s Surplus with Price Controls
o Allocative efficiency Is achieved when consumer and producer surplus is maximised
o With Price controls, allocative efficiency cannot be achieved , and deadweight
welfare loss arises
o Diagrams Needed

Welfare Loss in Price Floor

Welfare Loss in Price Ceiling

GOVERNMENT POLICIES
- Indirect Taxes
o Compulsory taxes levied by the government on expenditure
o Paid to tax authorities by producers of good
 However, producers may pass on burden to consumers
o Indirect taxes will lead to a leftward shift of the supply curve, as price needed to
induce firms to sell a given unit is increased
 Specific Tax is a constant sum levied, causing a parallel shift , upwards
 Ad valorem tax is a percentage tax, causing the supply curve to move
upward ant-clockwise from the pivot of the supply curve as tax increases
with price
o Incidence of tax refers to distribution of burden of taxation between consumers and
producers (Diagrams Needed)
 When the good has price-inelastic demand, the consumer absorbs most of
the incidence of the tax
 When the good has price-elastic demand, the producer absorbs most of the
incidence of the tax
 When the good has price-elastic supply, the consumer absorbs most of the
incidence of the tax and vice versa
- Subsidies
o Negative tax by the government to the producers
o To lower the cost of production, thus shifting the supply curve downwards
o Incidence of subsidy is shared between consumers and producers
 When demand is price-inelastic, consumers absorb most of the subsidy and
vice versa
 When supply is price-inelastic, producers absorb most of the subsidy and
vice versa
 Based on the concept if demand>supply or supply>demand, as subsidy is
intended to provide better incentive to consumer or produce to the less
responsive party
THE LABOUR MARKET
- Demand of labour
o Derived Demand, and thus linked to monetary value of the additional goods and
services that an additional unit of labour can produce (marginal benefit)
o Non- Wage Determinants
 Changes in price of final product produced
 Any changes in demand and supply of final product will affect price
of final product and thus demand for labour
 Changes in physical output of each unit of labour
 If the worker has higher output, the firms are encouraged to emply
more workers, causing demand for labour to increase (due to
technology/education)
 Changes in price of other FOP
 Capital can be seen as a substitute for labour an this can cause
demand to decrease
 Resources that are complementary labour will cause a proportional
change to the demand for labour
- Supply of labour
o Made up of individuals who are able and willing to work at a given rate
o Non-Wage Determinants
 Changes in size of population
 With factors such as foreign talent , birth/death rates , there will be
a change in the level of supply of labour
 Labour Force Participation Rate
 No. of economically active people out of the working age
population, affects supply of labour
 Can be altered by making changes to retirement age
 Changes in tax and benefit levels
 High tax rate stifles incentive to work, discouraging workers, and
reducing supply
- Movement of Wage Rates
o When wage rates are above EP , competition for jobs forces wages down, causing
less labour to be willing to work and more firms willing to hire, until EP (downward
pressure)
o When wage rates are below EP, competition amongst firms force wages and
opposite to above, until EP (upward pressure)
- Theory of Wage Equalisation
o As demand in a sunrise industry increases, wage rate increase there, causing jobs to
leave sunset industries to join sunrise industries, causing supply to increase and
wage rates to drop , causing wage rates to be equalised across markets
o However wage differentials continue to exist due to
 Non Competing Groups (not all sub-groups interact)
 Compensating Differentials (non-attractiveness should be compensated)
 Market imperfection (stronger trade unions, monopoly restrictions, govt)
 Non-economic reasons (discrimination)