Section 1 MICROECONOMICS

1. Section 1MICROECONOMICS Supply & Demand Economics Course Companion (Blink & Dorton, 2011)

2. MICROECONOMICS Overview of Topics • Demand and Supply • The Interaction of and applications of, Demand and Supply • Elasticities. • Indirect Taxes, Subsidies and Elasticity. • Costs, revenues and profit.

3. MICROECONOMICS Overview of Topics • Perfect Competition • Monopoly • Monopolistic Competition • Oligopoly • Price Discrimination and Contestable Markets • Market Failure

4. DEMAND AND SUPPLYDemand • Demand is the quantity of goods or services that consumers are willing and able to purchase at a given price in a given time. • The important phrase is “willing” and “able” • It is not enough for consumers to be willing to purchases a good of service, they must be able to purchase it. They must have the financial means to buy the product. • This is known as effective demand and it is this that is shown on a demand curve.

5. Law of Demand • As the price of a product falls, the quantity demanded of that product will usually increase, ceteris paribus. • It is sometimes expressed even more simply as the “the demand curve normally slopes downwards”. • Remember that ceteris paribus is assumption that all other things being equal. • The law of demand will not apply if other non price factors change.

6. Demand Schedule Example

7. Demand Schedule • The quantity of soft drinks demanded increases as the price falls. • The table is known as a demand schedule. • The same information can be shown in graphical form using a demand curve. • The curve shows the relationship between the price of a product, which is placed on the vertical axis and the quantity demanded of the same product over time, which is placed on the horizontal axis.

8. A Demand Curve for Soft Drink As can be seen from this diagram, demand curves should be convex to the origin.... BUT Economists usually draw them as straight lines, although they still call them curves. Source: Blink & Dorton, 2007: 26

9. When the price falls why does an increase in demand occur? According to Economic theory there are two reasons: Income Effect and Substitution Effect • Income Effect • When the price of a products falls, then people will have an increase in their “real income”, which reflects the amount that their incomes will buy. • With this increase income, the people will be likely to buy more of the product.

10. When the price falls why does an increase in demand occur? 2. Substitution Effect • When the price of a product falls then the product will be relatively more attractive to people than other products, whose prices have stayed unchanged, and so it is likely that consumers will purchase more of the product, substituting it for products that were previously purchased.

11. The Determinants of Demand (p26-27) • There are number of factors that determine demand and lead to an actual shift of the demand curve either to the right or the left. • Whenever we examine a change in one of the determinants we always make the ceteris paribus assumption.

12. The Determinants of Demand INCOME There are two types of products to consider when we are attempting to understand how a change in income effects the demand for a Product. There are • Normal Goods • Inferior Goods

13. The Determinants of Demand INCOME Normal Goods • For most goods as income rises, the demand for the product will also rise. These ds are known as normal goods • As income rises, the demand curve for a normal good will shift to the right. • The size of the shift in demand will depend upon the good itself. • For example: An increase in income may cause a very small shift to the right in the demand curve for salt, but a larger increase in the demand curve for cinema tickets.

14. The Determinants of Demand INCOME Inferior Goods • If a product is considered to be inferior, then demand for the product will fall as incomes rises and the consumers starts to buy higher priced substitutes in place of the inferior good. • Examples of inferior goods may be cheap wine or “own brand” supermarket detergents. • As income rises, the demand curve for the inferior good will shift to the left. • When incomes reaches a certain level, the consumer will be buying only the higher priced goods and the demand for the inferior good will become zero. • The demand curve will disappear.

15. The Determinants of Demand THE PRICE OF OTHER PRODUCTS There are three possible relationship between Products. They may be: • Substitutes for each other • Compliments to each other • Unrelated

16. The Determinants of Demand THE PRICE OF OTHER PRODUCTS Substitutes • If products are substitutes for each other, then a change in the price of one of the products will lead to a change in demand for the other product • For example, if there is a fall in the price of chicken in an economy, then there will be an increase in the quantity demanded of chicken and fall in the demand for beef.

17. Graph 1 A fall in the price of chicken from p to p1 leads to an increase in the quantity demanded of chicken from q to q1 Graph 1 A DECREASE IN THE PRICE OF A SUBSTITUTE Graph 2 The change in the price of a substitute means that some consumers will switch from buying beef to buying chicken and there will be a fall in the demand for beef at all prices and the demand curve will shift to the left from D to D1. Even though the price of beef has not changed, there is a fall in demand from q to q1 Graph 2

18. The Determinants of Demand THE PRICE OF OTHER PRODUCTS An Increase in the Price of Substitute • An increase in the price of substitute product will lead to fall in the quantity demanded of that product and an increase in demand (shift of the demand curve to the right) for the substitutes whose prices have not change.

19. The Determinants of Demand THE PRICE OF OTHER PRODUCTS COMPLEMENTS • Complements are products that are often purchased together such as printers and ink cartridges. • If product are compliments to each other, then a change in the price of one of the products will lead to change in demand for the other product.

20. Graph 1 Graph 1 A fall in the price of DVD players from p to p1 leads to an increase in the quantity demanded from q to q1 A DECREASE IN THE PRICE OF COMPLEMENT Graph 2 The change in the price of complement (DVD players) means that some consumers will buy more DVDs to go with the additional DVD players they are buying and there will be an increase in demand for DVDs at all prices. The demand curve will shift to the right from D to D1. Even though the price of DVDs has not changed, there is an increase in demand from q to q1. Graph 2

21. The Determinants of Demand THE PRICE OF OTHER PRODUCTS An Increase in the Price of Complements • An increase in the price of a complementary product will lead to a fall in the quantity demanded of that product and fall in demand (shift of the demand curve to the left) for the complements whose prices have not changed.

22. The Determinants of Demand THE PRICE OF OTHER PRODUCTS Unrelated Goods • If products are unrelated, then obviously a change in the price of one product will have no effect on the demand for the other product.

23. The Determinants of Demand TASTES • To the Economist, tastes are usually considered to be outside the scope of study, BUT marketing and advertising must be considered. Marketing and Advertising • Marketing may shift the demand curve to the right. Special Events • Eg: Major sporting events may lead to shift in the demand curve to the right for specific products.

24. Other Factors Influencing Demand SIZE OF THE POPULATON • If the population begins to grow, then it is logical to assume that the demand for most products will increase and that their demand curves will start to shift to the right.

25. Other Factors Influencing Demand CHANGES IN THE AGE STRUCTURE OF THE POPULATON • If the age structure of the economy starts to alter, then this will affect the demand for certain products. • Eg: If the percentage of older people in an economy starts to increase, then there will be an increase in demand associated products and services, like walking frames, retirement homes, etc.

26. Other Factors Influencing Demand CHANGES IN INCOME DISTRIBUTION • If there is a change in the distribution of income this may lead to shift in the demand curve for specific products. • Eg: If the relatively poor are better off, then there may be increase in demand for basic necessity goods such as meat.

27. Other Factors Influencing Demand GOVERNMENT POLICY CHANGES • Changes in direct taxes (eg, taxes on incomes) may affect the money that people have to spend and thus their demand. • Changes in government policies such as compulsory seat belts, compulsory wearing of bicycle helmets, or a ban on smoking win public places would all affect demand in the relevant markets.

28. Other Factors Influencing Demand SEASONAL CHANGES • Changes in seasons may lead to changes in the pattern of demand in the economy. • Eg: There will be more demand for warm coats in winter and less demand for swimsuits.

29. MOVEMENT ALONG A DEMAND CURVE vs A SHIFT IN A DEMAND CURVE (p29) Movement Along a Demand Curve • A change in the price of good itself, leads to a movement along the existing demand curve, since the price of the good is one of the axes Shift of the Demand Curve • A change in non price factors will always lead to a shift of the demand curve to either the left of the right.

31. EXCEPTIONS TO THE LAW OF DEMANDGiffen Goods (p30) • Giffen goods are unique type of inferior good that was first identified by Sir Robert Giffen in the 19th century. • He suggested that there was a tendency for the very poor to buy more of the basic foodstuffs on which they depended when the price of them rose and less when the price of them fell. • In Giffen’s case the observation took place regarding peasants in Ireland and their reaction to changes in the price of potatoes, a staple good for them.

32. EXCEPTIONS TO THE LAW OF DEMANDGiffen Goods (p30) • The key point here is poverty. • When the price of a staple products falls for the very poor, then the are likely to buy less of the product and use their increased real income to buy higher quality products, which they can now afford. • In the same way when the price of staple good rises, for the very poor, then they will buy more of it, because they now cannot afford the higher quality products and will consume more of the giffen good, since it has no substitutes.

33. At low prices, a typical Giffen Good will experience an increase in quantity demanded as the price rises.

34. Do Giffen goods exist today? • In modern times Economists would agree that there are no real examples of giffen goods in developed economies. • Some economists, such as Jenson and Miller (2002) have shown than Giffen goods may exist in the form of rice or noodles in different parts of China, but they are still a rarity.

35. EXCEPTIONS TO THE LAW OF DEMAND Veblen Goods (p31) • Thorstein Veblen, another economist, identified a similar situation where the quantity demanded rose as price rose, but for very different reasons. • In his book the `Theory of the Leisure Class` Veblen reported that some products become more popular as their prices prises. • Part of the reasons for this he attributed to “conspicuous consumption” – the fact that people get satisfaction from being seen by other people to consumer expensive products.

36. EXCEPTIONS TO THE LAW OF DEMAND Veblen Goods (p31) • Veblen believed that failure to consume in due quantity and quality becomes a mark of inferiority and demerit. • As the price of a Veblen good rises, such as Louis Vuitton handbag, people with high incomes begin to buy more of the product because it has a “snob value”: it is a “good of ostentation.”

37. VEBLEN GOODS A typical Veblen good will have a normal demand curve, with the quantity demanded falling as the price rises. However, as the price continues to rise, the product achieves a “snob value status” and further price rises start to lead to increases in the quantity demanded.

40. EXCEPTIONS TO THE LAW OF DEMAND The Role of Expectations: The Bandwagon Effect (p31) • It is often argued that there are times when the quantity demanded of a product rises, because of expectations of what is going to happen to prices in the future. • In some cases such as house prices, an increase in prices may lead to more people “jumping on the bandwagon” if they think that prices are going to rise even further in the future.

41. The Role of Expectations: The Bandwagon Effect (p31) • The bandwagon effect sometimes occurs with the price of shares on the stock market. • Some may argue that the increase in prices in these cases is caused by a shift of demand to the right, which then brings about the next increase in demand to the right and so on. • However, economists disagree about this issue.

42. SUPPLY (p32) • Supply is the willingness and ability of producers to produce a quantity of a good or service at a given price in a given time frame. • It is not enough for producers to be willing to produce a good or service, they must also be able to produce it. • They must have the financial means to supply the product, the ability to supply • This is known as effective supply

43. Law of Supply (p32) • The Law of Supply states that as the price of the product rises, the quantity supplied of the product will usually increase, ceteris paribus. • It sometimes expressed more simply as the “supply curve normally slopes upwards”

44. Supply Schedule Example

45. Supply Curve • A supply schedule can be shown in graphical form, using a supply curve. • Supply curves are normally curved get steep as the price rises. • HOWEVER... for the ease of analysis, economists usually draw them as straight lines.

46. Graph Interpretation A change in the price of frozen pizzas from $2.50 to $3.00 leads to an increase in the quantity supplied of frozen pizzas from 3500 to 4000 pizzas per week.

47. Why do suppliers produce more at a higher price? • At a higher prices there will be more potential profits to be made and so the producer will increase output. • At higher price levels, other producers may be attracted to enter the market

48. DETERMINANTS OF SUPPLY • There are a number of factors that determine supply and lead to an actual shift of the supply curve to either the right or left. • Whenever we look at a change in on of the determinants, we always make the ceteris paribus assumption (other things remain unchanged)

49. DETERMINANTS OF SUPPLYThe Cost of Factors of Production • If there is an increase in the cost of a factor of production such as a wage increase, this will increase the firms costs, meaning they can supply less, shifting the supply curve to the left. • In contrast, a fall in the cost of the factors of production will enable firms to increase their supply shifting the supply curve to the right.

50. Shift of Supply Curve to the Left A rise in the level of wages in the textile firm means that the firm must now supply fewer textiles at all prices and supply curve will shift to the left from S to S1.