Section 2

Diagrams and Definitions

A market is any situation or place that enables the buying and selling of goods and services and factors of production. A market may be a physical location (a street market), it may also be a virtual one (internet buying and selling) or a national one (the market for teachers or doctors). Triple A

Markets exist when buyers and sellers interact. This interaction determines market prices and thereby allocates scarce good and services.

What is a market?

Demand

A schedule (curve) that shows the quantity of a good that consumers are able and willing to buy at a certain price during a specified period of time.

Change in Quantity Demanded

Law of Demand

Determinants of Demand: Price

Determinants of Demand: Non-price

Determinants of Demand

Change in Demand

Movements versus Shifts

Change in Quantity DemandedChange in Demand

Veblen Goods

Giffen Goods

Expectations

Supply

A schedule (curve) showing how much of a product producers will supply at each of a series of prices over a specific period of time.

Law of Supply

Why Does Supply Rise when Price Rises?

I can make more profit!

Determinants of Supply: Price

Change in Quantity Supplied

Determinants of Supply: Non-price

Determinants of Supply

Change in Supply

Movements Versus Shift

Change in Quantity Supplied Change in Supply

Equilibrium

Consumer and Producer Surplus

Consumer Surplus

Price

Quantity

D

Po

Qo

A + B = Maximum Willingness to Pay for Qo

What is paid

Consumer Surplus

A

B

Minimum Amount Needed to Supply Qo

Producer Surplus

Price

Quantity

Po

Qo

What is paid

Producer Surplus

S

Consumer and Producer Surplus

Price

Quantity

Po

Qo

S

Producer Surplus

Consumer Surplus

D

Original Consumer Surplus

Change in Consumer Surplus: Price Increase

Quantity

New Consumer Surplus

Loss in Surplus: Consumers paying more

Loss in Surplus: Consumers buying less

Price

D

Po

Qo

P1

Q1

Price Ceilings

Price Floor

Price Ceiling & Price Floor

Price Support/Buffer Stock Schemes

Governments intervene when there are extreme price fluctuations brought about by seasons factors (agricultural products) and/or economic factors (commodities).

Loss in Efficiency Too High a Price (Price Floor)

Price

Quantity

Po

Qo

S

D

QL

New Consumer Surplus

PH

New Producer Surplus

Lost Consumer Surplus

Lost Producer Surplus

Price Floor

New Producer Surplus

New Consumer Surplus

Loss in Efficiency Too Low a Price (Price Ceiling)

Price

Quantity

Po

Qo

S

D

QL

PL

Lost Consumer Surplus

Lost Producer Surplus

Price Ceiling

ElasticitiesPrice

elasticity of

demand PED

Cross elasticity

of demand

XED

Income elasticity

of demand

YED

Price elasticity of supply

PES

Price Elasticity of Demand (PED)

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

Range of PED values

Price Inelastic Demand

Price Elastic Demand

Range of PED

Extreme Cases

Perfectly Elastic Demand

Perfectly Inelastic Demand

Unit Elastic Demand

Determinants of PED

Determinants of PEDIncome

Determinants of PESTime

Determinants of PESSpare Capacity

Impact on Total Revenue of Firms

• Total revenue is the amount paid by buyers and received by sellers of a good. TR = P x Q

• With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.

• With an elastic demand curve, an increase in price leads to a increase in quantity that is proportionately smaller. Thus, total revenue decreases.

• Governments levy taxes to raise revenue for public projects

• Critics of taxation argue that:– Taxes discourage market activity.– When a good or service is taxed, the

quantity sold is smaller.

Taxation

Indirect Tax Specific Tax

Indirect Tax Ad Valorem Tax

• Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

• How this burden is shared depends on elasticity.

Tax Incidence

Tax and Relatively Inelastic Demand

Tax and Relatively Inelastic Demand

Price for Buyers = .35

Price for Sellers= .2 (150m X .2)

(150m X .15)

(150m X .35)

Tax and Relatively Inelastic Demand

Price for Buyers = .35

Price for Sellers = .25

Before Tax Buyers paid .25After Tax Buyers pay .35 Buyers contribute 15 m to Revenue (150 X .1)

Tax and Relatively Elastic Demand

Summary

• The incidence of a tax refers to who bears the burden of a tax.

• The incidence of a tax does not depend on whether the tax is levied on buyers or sellers.

• The incidence of the tax depends on the price elasticities of supply and demand.

• The burden tends to fall on the side of the market that is less elastic.

Total Revenue and Price Elastic Demand

Total Revenue and Price Inelastic Demand

Some Practical Applications of PED

• With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

Theory of the Firm The Goal

• Provide advice • about the following:• The best price• The best output• The most profit• To breakeven price• The shutdown price

Variable Costs (VC)are the focus as Fixed Costs (FC)cannot change in the short term.

Ways to Measure Output

The Total Product Curve

Average and Marginal Product Curves

Diminishing Average Returns

Diminishing Marginal Returns

Total Costs (TC) = total cost to produce a certain output. TC = TFC + TVC

Total Variable Costs (TVC) = total

cost of the variable assets

that a firm uses in a given period of

time.

Total Fixed Costs (TFC) = total cost

of fixed assets used in a given time period.

Total Fixed Costs (TFC)

Total Variable Costs (TVC)

Total Costs

TC

Average Fixed Costs

(AFC)

Average Variable

Costs (AVC)

Average Total Costs

(ATC)Marginal

Cost (MC) = increase in

TC of producing an extra unit of output

TFC, TVC and TC

Cost Curves

LRAC A firm altering all its factors to meet increasing

demand

Economies and Diseconomies of Scale

Economies and Diseconomies of Scale

Economies of Scale

Specialization

Bulk Buying of Inputs

Financial Savings

Transport Savings

Technology

Advertising and

promotion

Diseconomies of Scale

Control and Communication

Alienation/work satisfaction

Total Revenue

Marginal Revenue

Revenue Curves: Perfectly Elastic Demand

5

Price

Output

D=AR=MR

Accounting Profit

Economic Profit

Determining the Shut Down Price and the Break Even

Price

Shut Down Price

Profit Maximizing Level of Output

Profit Maximizing Level of Output with Perfectly Elastic

Demand

Profit Maximizing Level of Output with Normal Demand

Profit Maximizing Level of Output with Normal Demand

Normal Profit Normal Demand

Abnormal Profit Normal Demand

Loss Normal Demand

Is it alw

ays a

bout p

rofit?

Profit, Sales and Revenue Maximization?