1.1.0 Markets
Demand
The law of demand states that: “as the price of a product falls the quantity demanded of
the product will usually increase, ceteris paribus”
The Demand curve slopes downwards because:
Income Effect: When the price of a product falls, then people will have an increase
in the real income - the amount their income buys. Since they can afford more they
are likely to also spend more.
Substitution Effect: When the price of a product falls it will be more attractive
compared to other products. Hence people will substitute other products with the
now cheaper one.
Law of diminishing Marginal Utility: The marginal utility is the added utility of
consuming one more product. This will fall as more products are consumed, as
consumption of more becomes less important. Due to their being less utility to the
added products consumers will be willing to pay less for it.
The law of diminishing Marginal Utility is what equates the demand curve to the marginal
social benefit curve, where the added social benefit also decreases.
Supply
The law of Supply states that: “as the price of a product rises the quantity demanded of it
will increase, ceteris paribus”
,The Supply curve slopes upwards because:
Profit Effect: At higher prices there will be more potential profit and hence
producers will increase output.
Law of Diminishing Returns: At the same price return for the added product
decreases, hence for quantity supplied to increase further the price must increase.
The Supply curve is equated to the Marginal social cost curve. As the quantity produced
increases so does the cost of production and the cost to society.
Linear demand and supply Function
For both the linear function illustrates the relationship between Price and the Quantity:
Demand Function:
P=Price
a=Quantity demanded if the price is 0
b=slope of demand curve
Supply Function:
P=Price
c=Quantity supplies if the price is 0
d=slope of supply curve
Equilibrium:
,Price Mechanism
Allocate resources
Ration resources
Signal to producers
Incentivise producers and consumers
I. Resources are allocated by the price as the price determines how much is supplied and
how much is purchased.
II. The price rations, if there is a shortage the price goes up, where only those willing to
purchase at the higher price will buy the product.
III. It signals to the producers where products are scarce because the price of these
goods increases.
IV. Changes in price due to demand or supply incentivise producers to produce more or
consumers to buy more.
eg. The supply of turnips decreases because of flooding.
The supply curve for turnips shifts to the left as the cost of production increases.
In the following shortage prices ration by increasing prices.
The increased prices incentivise Consumers to consume less because of the
higher prices and producers to produce more
A new equilibrium is formed.
In the long run the high prices signal to producers that they should improve
production policies
Consumer & Producer Surplus
The Consumer surplus is the extra satisfaction (utility) gained by consumers paying less
then they were willing to pay. Eg. if some one would have payed 20 $ but the market price
is 10 $ he has a marginal utility of 10 $, etc.
,The Producer surplus is the excess of actual earnings a producer makes, over what they
would have been willing to make. Eg. If a producer can sell his 3 goods for 10 $ instead of
5 $.
Allocative Efficiency
Markets in equilibrium are in allocative efficiency. This means that the resources are
allocated in the most efficient way from societies stand point. This occurs if the marginal
social benefit is equal to the marginal social cost. At this point the sum of consumer and
producer surplus, the community surplus is at its largest.
, 1.2.0 Elasticities
Price Elasticity of Demand (PED)
= Measures the responsiveness of the quantity demand to changes in the price of a good
or service.
PED is always -ve due to the slope of the PED ≠ Slope - varies along the curve (more ela
demand curve stic further up
Range of PED values:
Inelastic Demand: A change in price will bring about a relatively smaller change in
the quantity demanded. Hence the total revenue gained by a firm will be greater
because the added revenue is larger then the lost one.
Elastic Demand: A change in price will bring about a relatively larger change in the
quantity demanded. Hence the total revenue earned by producers falls because
the loss in revenue is greater then the gain.
Unit elastic demand: A change in price brings about a proportional and opposite
change in the quantity. A curve with unanimous unit elasticity is a box hyperbola.
Demand
The law of demand states that: “as the price of a product falls the quantity demanded of
the product will usually increase, ceteris paribus”
The Demand curve slopes downwards because:
Income Effect: When the price of a product falls, then people will have an increase
in the real income - the amount their income buys. Since they can afford more they
are likely to also spend more.
Substitution Effect: When the price of a product falls it will be more attractive
compared to other products. Hence people will substitute other products with the
now cheaper one.
Law of diminishing Marginal Utility: The marginal utility is the added utility of
consuming one more product. This will fall as more products are consumed, as
consumption of more becomes less important. Due to their being less utility to the
added products consumers will be willing to pay less for it.
The law of diminishing Marginal Utility is what equates the demand curve to the marginal
social benefit curve, where the added social benefit also decreases.
Supply
The law of Supply states that: “as the price of a product rises the quantity demanded of it
will increase, ceteris paribus”
,The Supply curve slopes upwards because:
Profit Effect: At higher prices there will be more potential profit and hence
producers will increase output.
Law of Diminishing Returns: At the same price return for the added product
decreases, hence for quantity supplied to increase further the price must increase.
The Supply curve is equated to the Marginal social cost curve. As the quantity produced
increases so does the cost of production and the cost to society.
Linear demand and supply Function
For both the linear function illustrates the relationship between Price and the Quantity:
Demand Function:
P=Price
a=Quantity demanded if the price is 0
b=slope of demand curve
Supply Function:
P=Price
c=Quantity supplies if the price is 0
d=slope of supply curve
Equilibrium:
,Price Mechanism
Allocate resources
Ration resources
Signal to producers
Incentivise producers and consumers
I. Resources are allocated by the price as the price determines how much is supplied and
how much is purchased.
II. The price rations, if there is a shortage the price goes up, where only those willing to
purchase at the higher price will buy the product.
III. It signals to the producers where products are scarce because the price of these
goods increases.
IV. Changes in price due to demand or supply incentivise producers to produce more or
consumers to buy more.
eg. The supply of turnips decreases because of flooding.
The supply curve for turnips shifts to the left as the cost of production increases.
In the following shortage prices ration by increasing prices.
The increased prices incentivise Consumers to consume less because of the
higher prices and producers to produce more
A new equilibrium is formed.
In the long run the high prices signal to producers that they should improve
production policies
Consumer & Producer Surplus
The Consumer surplus is the extra satisfaction (utility) gained by consumers paying less
then they were willing to pay. Eg. if some one would have payed 20 $ but the market price
is 10 $ he has a marginal utility of 10 $, etc.
,The Producer surplus is the excess of actual earnings a producer makes, over what they
would have been willing to make. Eg. If a producer can sell his 3 goods for 10 $ instead of
5 $.
Allocative Efficiency
Markets in equilibrium are in allocative efficiency. This means that the resources are
allocated in the most efficient way from societies stand point. This occurs if the marginal
social benefit is equal to the marginal social cost. At this point the sum of consumer and
producer surplus, the community surplus is at its largest.
, 1.2.0 Elasticities
Price Elasticity of Demand (PED)
= Measures the responsiveness of the quantity demand to changes in the price of a good
or service.
PED is always -ve due to the slope of the PED ≠ Slope - varies along the curve (more ela
demand curve stic further up
Range of PED values:
Inelastic Demand: A change in price will bring about a relatively smaller change in
the quantity demanded. Hence the total revenue gained by a firm will be greater
because the added revenue is larger then the lost one.
Elastic Demand: A change in price will bring about a relatively larger change in the
quantity demanded. Hence the total revenue earned by producers falls because
the loss in revenue is greater then the gain.
Unit elastic demand: A change in price brings about a proportional and opposite
change in the quantity. A curve with unanimous unit elasticity is a box hyperbola.
