Straight Line PPF

Good X

This point means all resources are being

xmax used to produce Good X so there is
none of Good Y at all and the maximum
amount possible of Good X

This curve represents all of the possible

combinations of Good X and Good Y
which can currently be produced

x This point means all

resources are being used to
produce Good Y so there is
none of Good X at all and
the maximum amount
possible of Good Y

PPF1
y ymax Good Y
Good X Opportunity Cost on PPF

xmax
This reduction in output of
Good X represents the
A movement along the PPF like this
OPPORTUNITY COST of
means that a choice is being made
increasing output of Good Y
to use scarce resources in a different
way – a REALLOCATION
x1

x2
The REALLOCATION
increases output of Good Y
but means that less of Good
X can be produced

PPF1
y1 y2 ymax
Good Y
 Curved PPF
Good X

This line is curved because

xmax NOT all of the factors of
x1 production will be equally
x2 good at producing both units.

Increasing output of Good Y

here means giving up very
little of Good X – there is not
much OPPORTUNITY COST

Giving up the same amount of

X here yields very little gain in
Y – the OPPORTUNITY COST is
much greater
x3
x4

PPF1
y1 y2 y3y4 ymax
Good Y
 Econ Growth on PPF
Good X

xmax2

xmax1

Economic growth means that more

of all goods can be produced so
the PPF shifts to the right

PPF1 PPF2
ymax1 ymax2
Good Y
 Market Equilibrium
£
At this price, the amount being
demanded is equal to the amount
being supplied – the market clears S

q Q
 Increase in demand
£

p2
p1

D2
D1

q1 q2 Q
 Price Elasticity of Demand
£

p1 Dperfectly elastic
Large fall in quantity
demanded

Delastic
Proportional
No fall in Small fall in fall in
quantity quantity quantity
demanded demanded demanded

Dperfectly inelastic Dinelastic Dunitary

Q
 Increase in supply
£

S1
S2

p1
p2

q1 q2 Q
 Price Mechanism
£
1: The market price is not
the equilibrium price. 2: At this price – more
This may be because S or is supplied than will
D have shifted. be demanded. The S
market does not clear.
There is a SURPLUS

p1 4: As the price is cut,

there is an extension of
demand because of a
p* smaller rationing effect
and a contraction of
supply because of smaller
3: To clear the surplus, incentive effect
producers cut price
towards the
equilibrium price (p*)

qd q* qs Q
 Minimum Price
£
Minimum price needs to
be above the equilibrium
to have any impact.
S

pmin

p
At this price – more is
supplied than will be
demanded. The
market does not clear.
The policy is normally used There is a SURPLUS
to reduce consumption of a
demerit good. The higher
price contracts demand.
D

qd q* qs Q
 Maximum Price
£

S
Maximum price needs to
be below the equilibrium
to have any impact. At this price – more is
demanded than will
be supplied. The
market does not clear.
p There is a SHORTAGE

pmax
The policy is normally used
to enable higher
consumption of a merit
good. The trade-off is the
reduced incentive to supply
D

qs q* qd Q
 Elasticity & Revenue
£
The increase in price of each
unit sold means that this area
is revenue gained.

p2 This line shows an

smaller than
proportional fall in
p1 quantity demanded
following a price
change
The fall in quantity demanded INELASTIC
means that this area is
revenue lost.

D
q2 q1 Q
 Consumer Surplus
£
S2

S1
This shaded area is the consumer
surplus which remains for those
p2 willing and able to pay more

p1 The increase in price of each unit

sold means that this shaded area
is consumer surplus lost.

q2 q1 Q
 Negative Externalities of Production
£
This is the equilibrium MSC
which takes account of
external costs MPC
This distance is the
external cost

psoo

pfm
This is the
equilibrium which
will be reached in the
market
At the market outcome,
this is the welfare loss to
society from
overproduction D=MSB=MPB

qsoo qfm Q
 Positive Externalities of Consumption
£

S=MPC=MSC
This is the equilibrium
which will be reached This is the equilibrium
in the market which takes account of
external benefits
p*

pm This distance between

MSB and MPB is the
external benefit

MSB
At the market outcome,
this is the potential
welfare gain to society
from increasing
consumption D=MPB

qm q* Q
 Flat Rate Indirect Tax
£
S+tax
Incidence of
taxation on
consumer
S1

p2
This distance is the
unit tax amount
p1
Combined shaded
area is the overall tax
revenue
Incidence of
taxation on Fall in level of
producer consumption
D

q2 q1 Q
 Ad Valorem Indirect Tax
£
Incidence of
S+tax
taxation on
consumer
S1

p2
This distance is the
unit tax amount
p1
Combined shaded
area is the overall tax
revenue

Fall in level of
consumption
from q1 to q2 D
Incidence of
taxation on
producer q2 q1 Q
 Subsidy
£
Incidence of
S
subsidy on
producer S+subsidy

This distance is the

unit subsidy amount
p2

p1
Combined shaded
area is the overall
Incidence of cost of the subsidy
subsidy on
consumer

Increase in level
of consumption
D

q1 q2 Q
 Maximised supernormal profit in imperfect
£ market

Supernormal MC
profit
AC

AR

Qpm MR Q
 Long run monopolistically competitive
£ market

MC AC

Normal profit
only being made

AR

Qpm MR Q
 Price stability in oligopolistic market – the
£ Kinked Demand Curve

Firm faces elastic curve if it

were to increase price as
customers would move to
competitor meaning many sales
would be lost

p
Firm would lose revenue in
the face of any price
change, therefore best to
stick to one price and avoid
price comp.
Firm faces inelastic curve if it
were to reduce price as
competitors would do the same
meaning little gain in sales

AR
q Q
 Price stability in oligopolistic market
£ (complex)

AR curve ‘kinks’ at
market price
MC2
MC1
p
Changes in cost will
not alter profit
Discontinuation in maximising output
the MR curve

AR

q* MR Q
 Revenue maximisation
£
When MR=0, TR will be
maximised, selling an additional
unit would mean a lower
amount of revenue overall

TR

MR Q
 Perfectly competitive market in the
£ long run

MC

AC

p AR=MR
Horizontal
revenue curves

Qpm is profit
maximising, allocatively
& productively efficient

Qpm Q
 Shut down price levels
£

MC

ATC

pL ARL
AVC

pS ARS

qShut q* Q
 Derivation of LRAC from
£
SRAC positions

Barriers to entry are

highest at the MES point
as the incumbent faces
its lowest cost, which is
hard to be achieved by
another competitor. LRAC

Increasing output Increasing output here

here generates generates diseconomies
economies of scale as of scale as the firm
the firm benefits from becomes too large and
efficiencies complex

MES Point Q
 Dynamic Efficiency
£
Dynamic efficiency means that firms are
developing new processes which reduce LRAC

LRAC1

LRAC2

Q
 Natural Monopoly
£
Fixed costs are so high, increasing
output always reduces LRAC

Competition in this market would

create smaller firms facing higher LRAC
at q1 who would seek to merge until
there was only one firm again at q2

c1

c2 LRAC

q1 q2 Q
 Efficiency output levels in
£
imperfect market
MC

AC

Allocative efficiency
when firm is at qa
MC=AR

Productive efficiency AR
when firm is at qp
MC=AC

q* qp qa MR Q
Wage
Demand
S for Labour
MRP has this distinctive
shape because of the
diminishing physical product
of labour

If the wage rate is w1 then

only the workers up to qL1
w1 will generate more revenue
for the firm than it costs to
employ them – this will be
the quantity of labour
demanded

The workers beyond qL1 will

only be employed if the
wage falls of if their
marginal revenue product
increases
DL=MRP

qL1
Quantity of Labour
Wage Market SSupply of Labour
An increase in wage from w1 to w2
will encourage workers to enter this
industry to provide labour and the SL
quantity of labour supplied will
increase from qL1 to qL2

w2

w1

qL1 qL2
Quantity of Labour
Wage Trade Union

1. The power of the

trade union means
that no workers will
be will to supply
SL
labour below wtu

wtu
w1

2. This might mean

that there will be a
surplus of labour in
the market (qLD-qLS)
DL=MRP

qLD qL1 qLS

Quantity of Labour
Wage Monopsony
MCL ACL
The monopsonist can employ
at the profit maximising level
(less than competitive
market)

w1
The is the competitive
market equilibrium
wm wage rate

The monopsonist can set a

lower wage than the
competitive market DL=MRP

qLm qL1 Quantity of Labour

Price Level Cyclical Unemployment
(Negative Output Gap)
LRAS

SRAS

A fall in AD means that

p1 the actual level of
output in the economy
(Y2)falls below that of
p2 full employment (Yfe)

Demand-deficient
unemployment
increases
AD1

AD2

y2 yfe
Real Output
 Positive Output Gap
Price Level
A rise in AD means that
economy is temporarily
LRAS above (Y2) long run
potential Yfe)

SRAS
p1

p2

Demand-Pull
inflationary
pressure grows
AD2

AD1

yfe y2
Real Output
 Demand-Pull Inflation
Price Level

SRAS
p1

p2

Demand-Pull
inflationary
pressure grows
AD2

AD1

y1 y2
Real Output
 Cost-Push Inflation
Price Level

SRAS2

SRAS1

p1 An increase in costs
e.g. higher average
p2 wages or a weaker
currency cause a
Cost-Push
reduction in SRAS
inflationary
pressure grows

AD

y2 y1
Real Output
 Economic Cycle
Real GDP

Boom Phase
• Slowdown Phase
High inflation
• Falling confidence and activity
• High tax revenues
• Falling C, I and M
• Rising wages and profits
• Increase in unemployment and
• C, I and M all high
• benefit spending
Automatic fiscal contraction
Actual
growth
Trend
(potential)
growth

Recovery Phase Slump Phase

• Increasing inflation • High unemployment
• Falling unemployment • Low levels of activity
• Confidence grows • Low inflation
• C and I start to rise • Automatic fiscal stimulus

Time
 Keynesian View
Price Level

LRAS

Yfe = Economy at capacity –

further increases in AD
result in inflation only

Y1 = Economy reaching
capacity – economic
growth has inflation trade-
off

AD3

Y = Mass unemployment -
the economy can grow
without inflation AD2
AD1
Y Y1 Yfe Real Output
AD Components & Factors
• Disposable income
• Consumer confidence (future income)
Consumption • Wealth effect
• Interest rates
• Availability of credit

• Interest rates
• Economic growth (accelerator)
Investment • Costs and profits
• Business expectations and confidence (“animal spirits”)
• Government action

• Automatic stabilisers – changes to taxation and benefits

Government • Political objectives
• Reduction in inequality
Expenditure • Levels of debt/deficit

• Relative prices
Net Trade • Domestic (for imports) and foreign (for exports) income growth
• The exchange rate
(X-M) • Protectionism
• Non-price competitiveness
Aggregate Supply Factors

• Average wage rates (e.g. minimum wage)

• Raw material cost (e.g. commodities)
SRAS • Taxation
• Exchange rates (in terms of buying
components from abroad)

• Population size
• Levels of education/skill
• Technological advances
LRAS • Competition policy
• Factor mobility
• Productivity
• Institutions and regulations
 Policies
• Direct taxes – e.g. income tax/corporation tax
• Indirect taxes – e.g. VAT
Fiscal • Current expenditure – e.g. sport, public sector
(Keynesian) salaries
• Capital expenditure – e.g. construction of roads

• Interest rates – altering the base rate

Monetary • Quantitative Easing (QE) – reducing the market
(Monetarist) rate without reducing base rate

• Increasing incentives to work

• Increasing levels of industrial competition
Supply Side • Improving labour market flexibility
(Classical) • Improving factor mobility within the economy
• Encouraging enterprise
Cum. Income
Inequality
Perfect Equality
Each 1% of the population
has 1% of the total income

The further the blue

curve bows away
from the red line the
more unequal the
society.
The Gini Index is
measure of this
difference: A
Gini = A/A+B
B
Actual Distribution
The highest earning 1% of
the population earn much
more that 1% of the total
income

Cum. Pop
 Opening the economy to trade
£

The closed economy Sdomestic

equilibrium – no
trade
Increase in domestic
consumer surplus

pdom The lower price means

that consumption of the
good increases

pglobal Sglobal
Reduced domestic production
- lower price means fewer
domestic firms can compete D

qgl1 qdom qgl2 Q

 Trade Creation
£
Trade creation is when
the elimination of tariffs
against trading bloc Sdomestic
partners means that their
more efficient firms
provide more of the good Sbloc

pdom More efficient

trading bloc firms
pbloc have supply curve
to the right

pglobal Sglobal

qdom qbloc qglobal Q

 Trade Diversion
£
Trade diversion is when joining a
trade bloc means that the
producers within the block Sdomestic
appear more competitive than
those outside because of
external tariffs Sbloc

pdom
Pgl+tarr Sglobal+tariff
pbloc

pglobal The lowest cost Sglobal

producers have tariffs
applied meaning that
the bloc producers Deadweight loss D
appear cheaper

qdom qbloc qglobal Q

Price of
Floating Exchange Rate Determination
£ in $
The £ has appreciated against the
dollar as it now buys more $ with
£1.
S
Increased demand for £ sterling
(for trade, speculation or hot
money) shifts demand right and
strengthens the £ sterling

$1.30
$1.24

D2
D1

q1 q2 Q of £
Trade balance The Impact of Depreciation on trade
balance (J-Curve)

Improvement in balance of
trade once Marshall Lerner
Condition is met

Point of depreciation

Trade balance initially

worsens due to inelastic
demand for imports/exports

Time
 The Impact of an Import
£
Tariff
Sdomestic

Tax revenue for the

government

pdom

ptariff Sglobal+tariff
pglobal Sglobal
Higher price enables
more domestic supply Deadweight loss (with red
D other side)
shaded area on

qgl1 qqu1 qdom qqu2 qgl2 Q

 Guaranteed Minimum
£
Price (Buffer Scheme)
S1 S2
‘Normal’ price
above minimum

p1 Government sets
pmin minimum price for
producers
p2
Government buys
surplus (qs-qd) at the
guaranteed price
In ‘glut’ years the
supply increases
dramatically and
would reduce price D

q1 qd q2 qs Q
 Increasing money supply
Market Interest

(Quantitative Easing)
Rate

SM1 SM2

Increase in supply of money

reduces its ‘price’ (i.e. the Money supply is
rate of interest paid within perfectly inelastic
the economy)

pm1
More money is demanded
pm2 at low interest rates –
stimulating the economy

DM

qm1 qm2 Quantity of

money