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CONTEMPORARY ECONOMIC POLICY

AND SOCIAL WELFARE

Topic-1

Introduction

Lecturer and Tutor: Dr Hongbo Liu


Room:
DA27-220 Townsville, Australia
Tel:
+61 7 4781 4299

Introduction
Two questions:

Under what conditions should governments intervene


in markets?

And if they decide to intervene, how should they


intervene?

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History of thought on the role of


governments

Mercantilists (18th century)

Laissez-faire (19th century)

Keynesian thinking (1930s)

Deregulation (recent decades)

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Adam Smiths Role of Government


Adam Smith - Wealth of Nations in 1776
The sovereign has only three duties to attend to ...

the duty of protecting the society from the violence and invasion
of other independent societies;

the duty of protecting, so far as possible, every member of the


society from the injustice or oppression of every other member of
it, or the duty of establishing an exact administration of justice,
and

the duty of erecting and maintaining certain public works and


certain public institutions, which it can never be for the interest of
any individual, or small number of individuals, to erect and
maintain....

Role of governments
Hence, these questions have been answered differently
through time.
They constitute the central theme of the subject!

If markets would be efficient and equitable there


would be no role for the government to intervene.
So before analysing market failures, we first return to
BU1003 (or an equivalent first year subject) to define
market efficiency.

However, there is anther important issue-- inequality


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A review

Demand for goods

Supply of goods

The equilibrium market price

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Demand and Supply

Demand curve

Intuition Law of Demand => common sense (lower


price more demand!), or in other words: the
demand curve is downward sloping in (P, Q) space.
That is because:

1.

Substitution effect;

2.

Income effect.

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Demand curve

P
(price)

Actual demand (Q = 5) if
price = 10

P=1
0

Actual demand (Q = 10) if


price = 7.5

P=7.
5

Demand curve =WTP


curve
Q=
5
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Q=1
0

Q
(quantity)
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Determinants of Demand

Prices of related goods

Income of consumers

Population

Preferences of consumers

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Demand curve (and prices related


goods)

Substitutes: If good 2 is a substitute of good 1, an


increase in the price of good 2 will lead to an
increase of demand for good 1.

Complements: If good 2 is a complement to good 1,


an increase in the price of good 2 will lead to a
decrease of demand for good 1.

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Demand curve (and substitutes)

P
good1
P=1
0

Price increase of the


substitute, good 2
befor
e
after

P=7.
5
Dgood

Dgood 1

Q=
5
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Q=1 Q=1
0
2

Q=1
7

Q good1
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Demand curve (and complements)

P
good1
P=1
0

Price increase of the


complement, good 2
befor
e
after

P=7.
5
Dgood

Dgood 1

Q=
5
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Q=1 Q=1
0
2

Q=1
7

Q good1
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Demand curve (and income)

Normal: If good 1 is a normal good, an increase in


income will lead to an increase of demand for good 1.

Inferior: If good 1 is an inferior good, an increase in


income will lead to a decrease of demand for good 1.

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Demand and Supply


Demand curve (for a normal good)

Consumer has more


income
befo
re
after

P=1
0
P=7.
5

D
Q=
5
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Q=1 Q=1
0
2

D
Q=1
7

Q
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Demand curve (for an inferior good)

P
good1
P=1
0

Consumer has more income


befor
e
after

P=7.
5
Dgood

Dgood 1

Q=
1
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Q=3 Q=5

Q=1
0

Q good1
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Demand curve (and preferences)

Consumer appreciates
good more
befo
re
after

P=1
0
P=7.
5

D
Q=
5
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Q=1 Q=1
0
2

D
Q=1
7

Q
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Do not mix up two different


concepts

A change in demand (i.e. a shift of the original


demand curve)

A change in quantity demanded (i.e. a shift along


the original demand curve)

Only a change in the price of the product represented in


the graph will lead to a shift along the demand curve.
Any other changes, are changes of the demand curve
itself.

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Demand curve (and price change


good1)

P
good1
P=1
0

Price increase of good1


befor
e
after

P=7.
5
Dgood 1 =
Dgood 1
Q=
5
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Q=1
0

Q good1
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Demand and Supply

Supply curve

Law of Supply, or in other words: the supply curve is


upward sloping in (P, Q) space.

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Supply curve (individual)

P
good1

Sgood 1

P=1
0
P=7.
5

Q=1
0
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Q=1
5

Q good1
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Determinants of Supply

Prices of factors of production (i.e. cost related


factors)

Prices of other goods

Number of suppliers in the market

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Supply curve (and production costs)

P
good1

Lower production costs (e.g. improved


technology)
Sgood 1
Sgood 1

P=7.
5

befo
re
after

Q=1 Q=1
0
5
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Qgoo
d1
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Supply curve (and prices other


goods)

P
good1

Price substitute good2


increases

Sgood 1
Sgood 1

P=7.
5

befo
re
after

Q=1 Q=1
0
5
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Qgoo
d1
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Do not mix up two different


concepts

A change in supply (i.e. a shift of the original supply


curve)

A change in quantity supplied (i.e. a shift along the


original supply curve)

Only a change in the price of the product represented in


the graph will lead to a shift along the supply curve. Any
other changes, are changes of the supply curve itself.

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Supply curve (and price change


good1)

P
good1

Increase in price
good1

Sgood 1=
Sgood1

P=8
P=7.
5

befo
re
after

Q=1 Q=1
0
5
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Qgoo
d1
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Demand and Supply-- market


Equilibrium
Where demand and supply meet, we have the
equilibrium price, which:

Regulates buying and selling plans;


Adjusts when such plans do not match.

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Market Equilibrium

P
good1

Equilibrium price
= 7.5

Sgood
1

P=7.
5
Dgood
1

Q=1
0
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Qgoo
d1
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Market (Dis)equilibrium (excess


demand)

P
good1

Sgood
1

P=7
P=6
Dgood
1

Q=5

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Q=2
0
Excess
demand

Qgoo
d1
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Market (Dis)equilibrium (excess


supply)

P
good1

Sgood
1

P=8
P=7
Dgood
1

Q=5

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Excess
supply

Q=2
0

Qgoo
d1
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Changes in Demand and Supply

P
good1

Increase in supply;
decrease in demand

Sgood
1

Sgood
P=7.
5

before

P=5

Dgood

after

Dgood
Q=1
0 Q=1
2
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Qgoo
d1
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