Chapters 3 (Part 2), 4 and 5
Economics Department Xavier University- Ateneo de Cagayan

B. Markets at Work
 The market system tries to respond the 3 basic economic questions and another essential (and the most important among

these) question in economics:
 4th question: How can the system accommodate

 Internally (within the firm)  Externally (the environment)

Answers to the Questions
 1st Question: What to produce?
 Only the profitable goods
 What the consumer likes

PROFIT is taken from revenues minus costs 1. Recall that there are costs of production:
    Wages and salaries (labor) Lease or Rent (land) Interest payments, rent (financial and physical capital. Salaries to entrepreneurs (this is equivalent to normal profit if the owner is also the manager.

What to produce?
 Thus,
 ∏ = TR-TC = = (TR) – (salaries + rents + Interest payments + normal profit)

The excess profit is now called the economic profit. It is therefore necessary for the firm to acquire high profit in order to finance the next production.

What to produce?
 Produce only what the consumer likes.
 Consumer power- we can dictate what products we want

the firm to produce regardless of their preferences or selfinterest.

 Peso votes- a reflection of my preferences.  I spend more for the good that I like so much.  The Peso invested symbolizes my desire and preferences.
 Derived demand- firms see a potential demand for a

product and decides to focus on it. But in order to do this, he must demand the factors of production needed.
 Example: high demand for automobiles and mechanics.

How to produce?
 Again, we need to produce efficiently and at minimum cost.
 Maximize inputs available to get the output target

For whom to produce?
 Again, the specific market (recall market segmentation)
 Thus, firms must produce for the consumers

who LIKE and CAN AFFORD their products.
 Remember that one of the characteristics of the

market is the use of money.

How to cope up with ∆s?
 Example 1: Internal changes
 Ppizza = f (Qd, Qs, Price, taste)
 If there are changes in the non-price

determinants, the firm needs to adjust prices.

 Example 2: External changes
 Inflation = high cost of production, lower inputs

and lower output.  Financial crisis, civic unrest, oil crisis, etc.

After knowing the answers…
 The firm must then decide if:
 If it should EXPAND.  If it should change its focused good.

 Relocate?
 Well-being of both workers and consumer are


 More to the point:

 Creative destruction- innovation

C. Market Models
1. 2.

Pure competition – N firms, the same product Pure monopoly – 1 firm, the same or differentiated product


Monopolistic competition –N firms, differentiated products
Oligopoly – Few firms, the same or differentiated products

MARKET POWER –power to set the price.

 

One can set the price if it is the supplier with no competition Thus, only MONOPOLISTS AND OLIGOPOLISTS can do this. In oligopoly, firms collude, so that all members should set a common price. (Ex. Organization of Petroleum Exporting Countries or OPEC)

CHAPTER 4: Demand
 People desire a good that they can afford and

are Willing to Pay (WTP) for it.
 Demand schedule- a tabular presentation of

the prices of a certain good and the corresponding Qd of a consumer or the whole market.
 Demand curve- graph of the Demand

Schedule. Usually downward- sloping.

 Law of Demand- There is an inverse

relationship between the price and Qd of a good, ceteris paribus.
 By ceteris paribus, we mean all other nonprice

determinants held constant.
 The reason behind the law of demand is that, as

the price increases, consumers may be unable to afford the product anymore and so, Qd drops.

 Non-Price determinants:
 Taste – if increasing (i.e. I like the product more)  Population and # of consumers – i.e. bigger market size  Income- people are wealthier; spending may

 According to income, we categorize goods as:
1. Inferior good – as I rises, Qd drops 2. Normal good – as I rises, Qd rises too. (necessity) 3. Luxury good – as I rises, Qd rises unreasonably

 Non-Price determinants
 Prices of related goods  According to relationships, we categorize:
1. Substitute goods – as Pa rises, Qda drops, Qdb rises 2. Complementary goods - as Pa rises, Qda drops, Qdb drops 3. Unrelated goods -∆ Pa does not imply ∆ Qdb

 Future expectations  Inflation announced for tomorrow – then buy more today.  Bad news means more demand today and lower or none for the next period.

 A strict rule:
 If there are only ∆P of the product, then there is

only ∆Qd (i.e. no shift in the demand curve only a change along the line)  If there are changes in Non-Price determinants, then there is a change in D (i.e. the Demand curve shifts either to the right or to the left)

 Firms are Willing to Supply (WTS) a given amount of goods for a certain price.
 The law of supply entails that at high prices, Qs

should be high in order to achieve greater profit.  As we all know, the Supply curve is upwardsloping.


 Non-Price determinants
 Input prices- if high, then costs are high too,      

then Inputs, outputs and Qs decrease Tech progress- high tech means efficiency, Output and Qs increase Taxes – if high, then costs increase, decrease production Subsidies- the opposite for taxes. Prices of substitutes- if high, then Qs increases. Expectations (ex. Prices)- if high, then sell more tomorrow. # of sellers – more competition, increase in market supply.

Equilibrium (market clearing)
 When supply and demand curve intersect,

then there is an equilibrium price and equilibrium Qs and Qd.
 Case 1: shortage, Qs < Qd, then increase P.
 Case 2: surplus, Qs > Qd, then decrease P.

 If the demand curves and supply curves shift, then

a new equilibrium is exemplified.

 Price ceiling- when the eq price and Q are too high, the government sets a ceiling of price for firms to help the consumers afford this product.
 Ex. High demand for cars means high demand for

gasoline. This leads to high price for gasoline. A price ceiling is set to make it affordable. But still there might be shortage. The government allocates (equitably) by tickets, the fixed gasoline amount to be consumed by everyone.
 Consequences – firms may restrict supply, or black markets may occur.

 Price floor – a min. price fixed by the government, to protect

suppliers and consumers.  Ex. Minimum wages  Ex. Price of Rice: By competition, there is a low price per kilo of rice, which affects the farmers negatively. Thus, the government sets a price floor above the market price to help them.
 Consequences: surplus
 To solve, the government restricts supply (in case of agri lands publicly owned) or  Increase the demand (market the product elsewhere)  If ineffective, it buys the surplus and stocks it for the future.  Caution: at a low market price, farmers may shift to another crop  Caution: at high price floor, consumers are worse-off (taxes rise to purchase the surplus

CHAPTER 5: Elasticities
 Elasticity – the responsiveness of Q to changes in one of its determinants.

Just like the slope, only that we use the percentage change (i.e. we do not care about the unit of measurement)

Demand Elasticity
 Price elasticity – how responsive consumers are to ∆P.

Εp = (%∆Q)/ (%∆P) = (P/Q) x (∆Q/ ∆P)

Ignore the negative sign and focus on the value:
If Εp > 1 (elastic) ∆Q > ∆P = 1 (unit elastic) ∆Q and ∆P are proportionate < 1 (inelastic) ∆Q < ∆P ∞ (perfectly elastic) flat DC = 0 (perfectly inelastic) vertical DC

Demand Elasticity
 Other elasticities:
 Arc elasticity – given an arc and a set of points,

you can get the elasticity for this specific range
Εp = (Pave/Qave) x (∆Q/ ∆P)
 Point elasticity - at one point only

Εp = (Q/ P)

Demand elasticity
 Price and Expenditure (E): the relationship
 If prices decrease, people buy more. But looking at

elasticities, we can have different answers:
 If prices drop, E rise (if Εp > 1 ,elastic)  If prices drop, E no change (if If Εp = 1 ,unit elastic)  If prices drop, E drops (if If Εp <1 ,inelastic)

Demand elasticity
 Income elasticity Qd may change due to income

Εy = (Y/Q) x (∆Q/ ∆Y) Ignore the negative sign and focus on the value: If Εp > 1 (luxury) ∆Q > ∆Y = 1 (normal) ∆Q and ∆P are proportionate < 1 (inferior) ∆Q < ∆Y ∞ (perfectly elastic) flat income-demand curve = 0 (perfectly inelastic) vertical

Demand elasticity
 Cross price elasticity- ∆Qdx with respect to ∆Py

Εxy= (Py/Qx) x (∆Qx/ ∆Py) If Εxy is (+), then the goods are substitutes is (-), then the goods are complements is 0 , then the goods are unrelated

Demand factors
Demand factors:  Closeness of substitutes  % income spent on goods  Necessities and luxuries (priorities)  Duration of price changes

Supply elasticity
 The same derivation.
 For price elasticity , arc and point elasticities, just

change Qd to Qs and the same analogy follows.

 Supply factors
 Available resources (if abundant, it affects Qs)

 Duration of production

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