ECO539 - INTERMEDIATE MICROECONOMICS

CHAPTER 1
MARKET
MECHANISM
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THE ALGEBRA OF
DEMAND, SUPPLY
AND EQUILIBRIUM

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• Market - Consists of buyers and sellers of a good or service

• Market Mechanism - The tendency in a free market for the price of goods
and services to change until market clears (quantity demanded and
quantity supplied are equal).

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 Willingness and ability to buy
• Demand - The ability and willingness of buyers to purchase different
quantities of a good at different prices during a specific time period.

• Law of Demand - When the price of a good increase, the quantity

demanded will decrease, vice versa, ceteris paribus.

• Demand curve slopes downwards - negative relationship between price

and quantity demanded

Change in demand - price constant, other factor chnage

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Demand Curve

Inverse relationship

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• Change in Quantity Demanded - refers to a movement along the
demand curve, which is caused only by a change in price.

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• Change in Demand - refers to a shift in the entire demand curve, which is
caused by a variety of factors (preferences, income, prices of substitutes
and complements, expectations, population, etc.)

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Factors that shift demand curve

• Consumer's income (normal good & inferior good)

• Preferences/taste
• Prices of related goods (Complementary & substitute goods)
• Number of buyers
• Expectation of future prices

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 Willingness & ability to supply
• Supply - The ability and willingness of sellers to produce and offer to sell
different quantities of a good at different prices during a specific time
period.

• Law of Supply - When the price of a good increase, the quantity supplied
will increase, vice versa, ceteris paribus.

• Supply curve slopes upwards - positive relationship between price and

quantity supplied

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Supply Curve

Positive/direct relationship

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• Change in Quantity Supplied - refers to a movement along the supply
curve, which is caused only by a change in price.

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• Change in Supply - refers to a shift in the entire supply curve, which is
caused by shifters such as taxes, production costs, and technology

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Factors that shift supply curve

• Technology
• Tax
• Subsidy
• Expectation of future prices
• Number of sellers

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Demand Function

Qd = a - bP

where:
a = the horizontal intercept of equation
b = the slope of function
P = price

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Supply Function

Qs = a + bP

where:
a = the horizontal intercept of equation
b = the slope of function
P = price

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Market Equilibrium - When the supply and demand curves intersect,
the market is in equilibrium which the quantity demanded and
quantity supplied are equal

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Changes in equilibrium price & quantity

• increase in demand
• increase in supply
• decrease in demand
• decrease in supply

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 Equilibrium: Qd = Qs

Qd = a - bP
Qs = a + bP

For example:
Qd = 27 - 3P
Qs = 9 + 6P

Equilibrium
Qd = Qs
27 - 3P = 9 + 6P
9P = 18
P = RM 2
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As P = RM 2,
Qd = 27 - 3P = 27 - 3(2) = 21
Qs = 9 + 6P = 9 + 6(2) = 21

Therefore,

Equilibrium price = RM2,

Equilibrium quantity = 21

How to draw???

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Qd = 10 – 4P
Qs = -2 + 8P

Calculate the equilibrium price and quantity

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2

1
10 20 azirahazhar
• Consumer Surplus (CS)- The amount that individuals would
have been willing to pay, minus the amount that they actually
paid.

• Producer Surplus (PS)- The amount that a seller is paid for a

good minus the seller’s actual cost.

• Calculation: 1/2 x base x height

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Tax, ceiling price, floor price

APPLICATION OF
DEMAND, SUPPLY AND
EQUILIBRIUM WITH
RESPECTS TO
GOVERNMENT MARKET
INTERVENTION
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 TAX
Eg: Sales tax

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TAX

Before tax
• CS = A + B + C
• PS = D + E + F
• Total surplus = CS + PS
⚬ =A+B+C+D+E+F

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TAX

After tax
• CS = A
• PS = F
• Tax revenue = B + D
• Total surplus = CS + PS
⚬ =A+B+D+F
• Tax cause total surplus to fall
by = C + E = deadweight loss
(DWL)

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 TAX

Deadweight loss (DWL)

• The fall in total surplus that results from a market distortion, such as
tax
• The costs to the society due to market inefficiency - any deficiency
caused by an inefficient allocation of resources

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CEILING PRICE

• Also known as maximum price

• Is a government mandated
maximum price above which legal
trades cannot be made.

• To enable them to obtain some

essential goods.

• Causes shortage

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 CEILING PRICE

ADVANTAGES DISADVANTAGES

• Benefits consumers to enjoy • Cause shortages

goods and services at lower
prices. • Emergence of black market

• Prevent market price from rising • Quantity produced reduces

after certain levels - help the
poor/ low income. • Need to ration the goods

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CEILING PRICE
• The original equilibrium price is $600
with a quantity of 20,000.

• Consumer surplus is T + U, and producer

surplus is V + W + X.

• A price ceiling is imposed at $400, so firms in

the market now produce only a quantity of
15,000.

• As a result, the new consumer surplus is T +

V, while the new producer surplus is X.

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FLOOR PRICE

• Also known as minimum price

• Is a government mandated minimum

price below which legal trades cannot
be made.

• To protect producers' income.

• Causes surplus.

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 FLOOR PRICE

DISADVANTAGES
ADVANTAGES
• Cause surplus
• Producers' income protected
• Consumers need to pay more to
• Higher wage rate purchase the goods and services

• Waste of resources as producers

will produce more.

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FLOOR PRICE

• The original equilibrium is $8 at a quantity of 1,800.

• Consumer surplus is G + H + J, and producer surplus is I + K.

• A price floor is imposed at $12, which means that quantity

demanded falls to 1,400.

• As a result, the new consumer surplus is G, and the new

producer surplus is H + I.

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Exercises
Qd1 = 3,500 -10P
Qs1 = -500 + 10P

1. Find equilibrium P and Q

2. Calculate the Price when Qd and Qs is equal to zero
3. Sketch the market demand and supply curve
4. What is the amount of consumer surplus
5. What is the amount of produce surplus

New supply function after tax

Qs2 = -1000 +10P
1. What is the new equilibrium P and Q
2. What is the net price received by producers
3. What is the value of tax imposed by government
4. The amount of tax collected by government
5. The amount of tax paid by consumers
6. The amount of tax paid by producers
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 ELASTICITIES OF
DEMAND AND ITS
APPLICATION

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 ELASTICITY
• Refers to the degree of responsiveness of the quantity of a good in
relation to changes in price or income.

• It is a number that tells us the percentage change that will occur in

one variable in response to a 1-percent increase in another
variable.

4 types of elasticity:
• Price elasticity of demand
• Price elasticity of supply
• Income elasticity of demand
• Cross elasticity
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PRICE ELASTICITY OF
SUPPLY

• A measure of the responsiveness of quantity supplied to changes

in price.

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PRICE ELASTICITY OF
SUPPLY
Five degrees of elasticity of supply (Es)

• perfectly inelastic supply where the Es=0

⚬ quantity supplied does not change as price changes.

• inelastic supply where the 0<Es<1

⚬ quantity supplied changes proportionally less than price
changes.

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PRICE ELASTICITY OF
SUPPLY
Five degrees of elasticity of supply (Es)

• perfectly elastic supply where the Es =∞

⚬ quantity supplied extremely responsive to even very small
changes in price.

• elastic supply where the Es> 1

⚬ quantity supplied changes proportionally more than price
changes.

• unitary elastic supply where the Es =1

⚬ quantity supplied changes proportionally to price changes.

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PRICE ELASTICITY OF
SUPPLY

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PRICE ELASTICITY OF
SUPPLY
Determinants of price elasticity of supply

• Ease of substitutability of a resource.

• Time horizons: supply is usually more inelastic in the short run than
in the long run.

• Durability versus perishability of a good.

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PRICE ELASTICITY OF
DEMAND

• A measure of the responsiveness of quantity demanded to

changes in price.

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PRICE ELASTICITY OF
DEMAND
Five degrees of elasticity of demand (Ed)

• perfectly inelastic demand where the Ed=0

⚬ quantity demanded does not change as price changes.

• inelastic demand where the 0<Ed<1

⚬ quantity demanded changes proportionally less than price
changes.

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PRICE ELASTICITY OF
DEMAND
Five degrees of elasticity of demand (Ed)

• perfectly elastic demand where the Ed =∞

⚬ quantity demanded extremely responsive to even very small
changes in price.

• elastic demand where the Ed> 1

⚬ quantity demanded changes proportionally more than price
changes.

• unitary elastic demand where the Ed =1

⚬ quantity demanded changes proportionally to price changes.

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PRICE ELASTICITY OF
DEMAND

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PRICE ELASTICITY OF
DEMAND
Determinants of price elasticity of demand

• Availability of close substitutes: the more substitutes a good has,

the more elastic its demand.

• Necessities vs luxuries: luxury are more elastic

• Time horizons: goods tend to have more elastic demand over

longer time horizons.

• Habit

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MEASURING PRICE
ELASTICITY
Price elasticity can be measured at an interval (arc) along demand,
or at a specific point on the demand curve.

• If the price change is relatively small, a point calculation is

suitable.

• If the price change spans a sizable arc along the demand curve,
the interval calculation provides a better measure.

Arc elasticity of demand - price elasticity calculated over a range of

prices.

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INCOME ELASTICITY
OF DEMAND

• A measure of the responsiveness of quantity demanded to

changes in income.

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INCOME ELASTICITY
OF DEMAND

• Income elasticity of demand (Ey) is positive (Ey > 0 ) for normal

goods - income elastic.

• Income elasticity of demand (Ey) is negative (Ey < 0 ) for inferior

goods - income inelastic.

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CROSS ELASTICITY OF
DEMAND
• A measure of the responsiveness of quantity demanded of one
good to changes in the price of another good.

• Complementary goods will have a negative coefficient - (Ec < 0).

• Substitute goods will have a positive coefficient - (Ec > 0).

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APPLICATION OF
ELASTICITY
Elasticity and Total Revenue

• TR = Price times quantity sold = P X Q

• TR depends on price elasticity

Demand is elastic (Ed > 1):

• If P increase, Q decrease = TR decrease
• If P decrease, Q increase = TR increase

Demand is inelastic (Ed < 1):

• If P increase, Q decrease = TR increase
• If P decrease, Q increase = TR decrease

Unitary elastic = TR does not change azirahazhar

APPLICATION OF
ELASTICITY

Agriculture Production

• During bad crop years, prices rise and quantity falls - TR goes up.

• During good crop years, prices fall and quantity increases - TR

goes down.

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APPLICATION OF
ELASTICITY

Government to impose tax

• Depends on price elasticity of demand and supply.

• When demand is elastic - supply is inelastic, and vice versa.

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THANK YOU

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