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Microeconomic Principles and Policy Course Introduction and Overview

Contents
1 2 3 4 5 6 7 Course Objectives The Course Author Course Content The Course Structure Learning Outcomes Study Materials Studying the Course 3 3 4 5 6 7 7

Microeconomic Principles and Policy

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Course Introduction and Overview

Course Objectives
In this course, Microeconomic Principles and Policy, you will study the principles economists use to model the behaviour of individual units (or participants) and the ways in which these units interact in a market economy. The course is designed to provide you with a solid grounding in microeconomic theory. Microeconomic theory is a body of knowledge that focuses on the individual units in a market economy. The term individual unit encompasses a multitude of different market economic participants. It can mean one person or a household that is consuming or producing goods and services. It can also mean a small family firm or a large corporation that is consuming or producing goods and services. It can mean any of these on the basis that each one is making an economic choice in the market. In studying consumer theory, you will learn how consumers make decisions about what to consume, how their preferences and budgets determine their demand for goods and services and how goods and services have different demand characteristics. From there, you will go on to study the theory of production and costs, which underlies theories of market supply. You will be learning how firms combine inputs labour, capital and raw materials to produce goods and services in such a way as to minimise their costs and to maximise their profits, and how these production decisions determine the market supply curve. As well as studying the theoretical principles of consumer and producer behaviour, you will also learn how these principles can be applied to economic problems, and their implications for policy.

The Course Author


Alison Johnson is Programme Manager for the Heavily Indebted Poor Countries (HIPC) Capacity Building Programme, which works with developing country Governments to develop the full independent capacity to design and execute their own national debt and resource mobilisation strategies, and to maintain a high level of overall debt and aid management, during and after the HIPC Initiative. Alison also has experience of working debt restructuring and debt strategy and management issues when at the Commonwealth Secretariat. Prior to this, she was Acting Director of Centre for International Education in Economics (precursor of CEFIMS), with responsibility for policy and operations of the postgraduate programmes in economics, finance and development by distance learning, and Lecturer in Economics at SOAS with responsibility for designing and writing distance learning economics courses. She was the convenor and principal author of the courses on economics principles, and she also has extensive experience of writing practically focused training materials and running workshops.

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Microeconomic Principles and Policy

Course Content
This course covers four main topics that you will need to understand in order to have a good grasp of microeconomic theory: basic concepts of the market demand, supply and equilibrium principles underlying consumer demand principles underpinning the theory of the firm concept of market structures, especially competitive and monopolistic markets.

The course starts by introducing the idea of the market, which is comprised of three concepts: demand, supply and equilibrium. In terms of the economic principles you will study here, markets are at the centre of economic activity. But in order to be able to analyse why consumer demand changes when, for example, the price of a good changes or why a firm decides to produce a certain level of output, you need to investigate the theoretical underpinnings of both demand and supply. Unit 2 considers the economic behaviour of consumers and develops an economic model designed to explain how consumers choose the most preferred bundles of goods and services they can afford. There you will study how consumer preferences are explained using indifference curves; how the budget constraint represents the resources available to the consumers; how and why consumer choice is expressed by the interaction of indifference curves and the budget constraint; and lastly, how these choices are used to derive the demand curve for goods and services. Units 3 and 4 turn to the supply side of the market and examine the theory of the firm and how output and pricing decisions are made on the basis of the notion that firms aim to maximise profits. In those units we investigate both the technical and economic relationships of the firm and how it makes its decisions about pricing and output, and how the firm and market supply curves are derived. In developing this model of firms behaviour, it is initially assumed that all markets are perfectly competitive. But in Unit 5, you will study what happens when the assumption of perfect competition is relaxed and what the implications are for the firms pricing and output decisions when the market structure is non-competitive. In Unit 6, we develop a model of the demand and supply for factor input markets, firstly in a competitive market and then in non-competitive markets. Up to this point, your study will focus on the market behaviour of consumers and firms as if they were each a separate market with no interaction between them. Obviously, that is not true in the real world, and you will be introduced to general equilibrium analysis in Unit 7. This is a model of how equilibrium conditions are achieved when consumers, firms and factor markets all interact, and whether the equilibrium achieved is in any way efficient in terms of resource allocation. Finally, in Unit 8, you will study what happens when the market fails to result in pricing and output decisions that are efficient in terms of resource allocation.

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Course Introduction and Overview

The Course Structure


Unit 1 Concepts of Demand, Supply and Markets 1.1 1.2 1.3 1.4 1.5 1.6 Introduction to Unit 1 The Market The Basics of Demand and Supply Elasticities of Demand and Supply Applications of Supply and Demand Analysis Conclusion

Unit 2 Consumer Theory 2.1 Introduction to Consumer Theory 2.2 Consumer Preferences 2.3 Budget Constraint 2.4 Consumer Choice 2.5 Consumer Demand 2.6 Case Study Annex 2.1 Utility Theory Annex 2.2 Revealed Preference Analysis Unit 3 Theory of Production and Costs 3.1 3.2 3.3 3.4 3.5 3.6 4.1 4.2 4.3 4.4 4.5 4.6 4.7 5.1 5.2 5.3 5.4 5.5 5.6 Introduction to the Theory of Production and Costs Production, Technology and the Firm Theory of Production Economic Costs Cost Functions Case Study Introduction Profit Maximisation Perfect Competition Short-run Supply Curves Long-run Supply Curves Applications in Competitive Markets Conclusion Introduction Monopoly and Monopoly Power Monopolistic Competition Contestable Markets Policy Analysis Conclusion

Unit 4 Profit Maximmisation and Competitive Supply

Unit 5 Non-Competitive Market Structures

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Unit 6 Factor Input Markets 6.1 6.2 6.3 6.4 6.5 6.6 6.7 7.1 7.2 7.3 7.4 7.5 8.1 8.2 8.3 8.4 8.5 8.6 Introduction Competitive Input Markets Non-Competitive Factor Markets Summary of Input Markets Applications Case Study Conclusion Introduction General Equilibrium Analysis Efficiency and the Pareto Optimality Criterion Reviewing Theory Conclusion Introduction Externalities Public Goods Asymmetric Information Case Study Conclusion

Unit 7 General Equilibrium, Efficiency and Pareto Optimality

Unit 8 Externalities, Public Goods and Asymmetric Information

Learning Outcomes
When you have completed your study of this course you will be able to explain the basic concepts of the market demand, supply and equilibrium discuss the principles underlying consumer demand identify and discuss the principles underpinning the theory of the firm outline the concept of market structures, especially competitive and monopolistic markets analyse the effect of taxing monopoly profits explain the implications of introducing a minimum wage or a production quota on the pricing and output decisions of the firm argue whether taxing a firm that is dumping pollutants into a river can result in less pollution discuss the implications of introducing a minimum wage or a production quota on the pricing and output decisions of a firm.

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Course Introduction and Overview

Study Materials
This Study Guide is your central learning resource as it structures your learning unit by unit. Each unit should be studied within a week. It is designed in the expectation that studying the unit and the associated core readings will require 15 to 20 hours during the week, but this will vary according to your background knowledge and experience of studying.

Text Books
Two textbooks are provided for this course: Robert Pindyck and Daniel Rubinfeld (2009) Microeconomics, Seventh edition, Upper Saddle River New Jersey USA: Pearson Education International Saul Estrin, David Laidler and Michael Dietrich (2008) Micro-economics, Fifth edition, Harlow Essex UK: Pearson Education Ltd. The reason for having two textbooks is that the two together will provide you with the best grounding in microeconomic theory and its applications. The Pindyck and Rubinfeld textbook covers all the basic theory and provides you with plenty of examples of its applications. At the end of each chapter of this book, the authors set Questions for Review and Exercises, and I recommend that you jot down at least brief answers to these. Estrin, Laidler and Dietrich also cover the theory, but their textbook does so in more depth and this is especially true of the topics youll be studying in the second half of the course. It also provides an algebraic treatment of the main theory and this should be helpful if you are comfortable using calculus. For each course unit you will see instructions for which chapters of the textbooks to study, and when you should stop and read them.

Course Reader
The Course Reader provides a selection of academic articles and extracts from books and journals, which you are expected to read as part of your study of this course. You will note from reading them that the topics covered in these articles often vary widely from the Study Guide. The Course Reader articles are often more technical or adopt a more in-depth approach. This should not put you off, as many were written with an academic audience in mind. These articles were selected so that the central arguments and concepts could be understood and appreciated at a level appropriate to this course.

Studying the Course


In the units, you will be asked to answer questions and solve exercises related to the course materials. The exercises are an essential part of the course, and it is important

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Microeconomic Principles and Policy

that you take your time to answer them. Solution to the exercises are provided either within the text of the Study Guide or at the end of the unit. There are two assignments, after Unit 4 and Unit 8. These count together for 30% of the course grade. A three-hour unseen written examination counts for the other 70%. To gain good marks it is essential that you make use of the materials in the textbooks and reader and apply ideas and techniques to real world circumstances. You will be asked to show your analytical skills and, of course, you will be judged only on the quality of your knowledge and argument and not on your opinions.

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Microeconomic Principles and Policy Unit 1 Concepts of Demand, Supply and Markets

Contents
1.1 Introduction to Unit 1 1.2 The Market 1.3 The Basics of Demand and Supply 1.4 Elasticities of Demand and Supply 1.5 Applications of Supply and Demand Analysis 1.6 Conclusion References Answers to Review Questions 3 3 6 12 15 18 18 19

Microeconomic Principles and Policy

Unit Content
Unit 1 examines the theories and applications of microeconomics. It introduces the basic concepts, such as the market, equilibrium and supply and demand. The unit explains how the demand-supply framework is used for analysing economic problems and its application for policy purposes.

Learning Outcomes
When you have completed study of this unit and its readings, you will be able to outline the characteristics of the market in economic analysis discuss the concept of equilibrium analyse the nature of a market clearing equilibrium explain what factors influence demand and supply draw demand and supply curves and explain their significance discuss the difference between a movement along the demand/supply curve and a shift of the demand/supply curve explain the economics meaning and significance of elasticity use the demandsupply framework for analysis.

Reading for Unit 1


Textbook
Robert Pindyck and Daniel Rubinfeld (2009) Microeconomics, Seventh edition, New Jersey USA: Pearson PrenticeHall. Part I Introduction: Markets and Prices, Chapters 1 Preliminaries and 2 The Basics of Supply and Demand.

Course Reader
DN Hyman (1993) Import Quotas, Tariffs and Consequences of Protecting Domestic Industries from Foreign Competition, Modern Microeconomics Analysis and Applications, Third edition, Homewood Illinois, USA: Richard D Irwin Inc; pp. 41-45.

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Unit 1 Concepts of Demand, Supply and Markets

1.1 Introduction to Unit 1


The first unit of this course focuses on the basics of demand and supply. These concepts are used throughout this course and most of the other courses you will be studying for your degree. So they are important concepts. In this unit are questions and exercises to enable you to apply the theoretical material you are studying to specific economics problems. We expect you to read the course material critically and to question the ideas you meet in your answers. Therefore, to begin this unit, we set the principal question that the unit tries to answer. You should keep this question in mind as you study this unit and, at the end, consider what answer you would give. The overall question for this unit is Can the concepts of demand and supply be used to explain market behaviour, and what are the assumptions required for this to happen?

1.2 The Market


The conventional view of a market is a place, where people buy and sell fruit, vegetables, clothes, household goods and so on. A shop and a large department store are, of course, other examples of markets, as is the stock exchange or the trade in raw materials such as copper bars or gold bullion, or a container loaded with scrap metal. However, the economic definition of a market, the one that you will use in your study of microeconomics, is the means through which buyers and sellers interact and transactions take place. Clearly, for any market to function there must be both buyers and sellers. But usually it is much more than that. There must also be dealers who are ready to make a market. There must be rules and regulations setting out how the market operates, and there must also be a means of transmitting information so that all the market participants know what is going on. We will turn first to the economic agents who are required to make a market function. Buyers or consumers consist of individuals who purchase goods and services, as well as firms that purchase labour, capital and the raw materials needed for the production of goods and services. Sellers are also individuals and firms that sell the goods and services they produce individuals who sell their labour, and resource owners who sell other natural resources such as oil or timber. In a simple market, there are usually just buyers and sellers who interact directly with each other. But in more complex markets, there are a whole host of roles available for intermediaries, such as brokers, dealers, market-makers, information agents and so on, whose role it is to ensure that the market functions by setting prices, providing information and introducing buyers and sellers.

1.2.1 Markets and prices


In economics a market is a concept that should not be thought of as necessarily having a physical location. Although particular markets are located in a specific building or on a particular street, such as the New York Stock
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Exchange on Wall Street, the concept of a market is not confined to a physical location. Some markets such as foreign exchange markets are international in scope, and access to such markets is usually through a computer terminal. Other markets are much smaller and more localised, like the market for rented housing that may be found in the back pages of your local newspaper. The other key element of the market is the role of prices, which provide the signals by which buyers and sellers react to each other. To the buyer, prices provide information about the availability of goods and services in the market, and decisions about the quantities to purchase are based on this information. On the other side, sellers use the information conveyed by prices to decide what quantities to sell. So prices play a key role in coordinating market decisions. Although prices provide the signals that co-ordinate market decisions, there is no overall co-ordination of how these signals are acted upon by the various market players. In other words, there is no conscious direction to the functioning of the market. So in an atomistic market of the type described above, each buyer and seller acts alone and not as part of some centralised plan. This characteristic of the market, whereby economic decisions are co-ordinated on a decentralised basis, led eighteenth century economists to talk of a policy of laissez-faire (to leave alone). These economists used this French expression to condemn any deliberate or governmental interference in business or industry as being inappropriate and potentially harmful. Today it is usually interpreted to mean that the economy functions best when it is largely free from government intervention and economic decisions are determined mainly by the market.

1.2.2 Markets and competition


We study the market because it is a process or mechanism by which economic decisions are made. While it is not the only mechanism for making economic decisions, it is the one that is often used to characterise those of most industrialised countries. The fact that such economies may be better described as mixed economies is sometimes overlooked, and it is the market element that is focused on instead. One of the key features of a market is the decentralised nature of the decision making where each player, whether buyer or seller, makes a decision based on the signals transmitted by the prices. This contrasts with the centralised nature of economic decision making in command economies. It is because of this decentralisation of the markets decision-making process that we study and develop models of the economic behaviour of the buyers and sellers. In other words, you need to study the economic behaviour of buyers and sellers in order to explain how the market functions. There are, however, other specific market features that are important in economics. For example, a market in which there are both many buyers and many sellers, such that no single buyer or seller can influence prices alone, is a perfectly competitive market. Some stock markets, like those in New York and London, are usually considered to be competitive because there are

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Unit 1 Concepts of Demand, Supply and Markets

both many buyers and many sellers and no one party is able to dictate or exert a significant impact on the market price at which company shares or stocks are exchanged. You will study the characteristics of perfect competition in Unit 4 of this course. But perfect competition is not always the case. In some markets, there may be just one producer or a number of producers who between them do influence the price at which goods are traded. Here the actions of the Organisation of Petroleum Exporting Countries (OPEC) in raising the world price of oil in 1973 and again in 1979 provide good examples of noncompetitive market behaviour. A single buyer or a small number of buyers may also be able to influence market prices, and this too would lead to noncompetitive market behaviour. As an analogy, it might be useful to think of a spectrum, where at one end there is perfect competition with its many buyers and sellers, and at the other is a market with just one buyer or just one seller. In between there are many other combinations of buyers and sellers and the markets resulting from their interaction have varying degrees of competitiveness. Reading Please read Section 1.2 of Pindyck and Rubinfeld, pages 712. As you read this section, you should focus on the following questions. What are the assumptions underlying the concepts of competitive and noncompetitive markets? What do we mean by the term market price? What is meant by the extent of a market? Why do we need to be able to define a market? When you have finished this reading, write down some examples of competitive and noncompetitive markets in your local economy. Then, review your list of markets and consider their extent both in terms of physical boundaries and product ranges. Are any of the markets you have listed international in scope? Now that you have studied markets and market behaviour in general, consider the following question: Are there economic activities that take place outside the market? The answer is yes. Think about the meals you eat at home. If you went to a restaurant to eat all your meals, then this would be classified as a market activity as you are buying both goods the food, and a service someone prepares and serves the food to you. Yet, if your meals are prepared by a family member at home, it is a nonmarket activity as (apart from the raw ingredients) its preparation does not involve any buying or selling. Reading The main thrust of Chapter 1 of Pindyk and Rubinfeld is to introduce you to the study of microeconomics. In Section 1.1, the themes of microeconomics are laid out, and in 1.3, the authors discuss the difference between real and nominal prices. Section 1.4 asks
Robert Pindyck and Daniel Rubinfeld (2009) Microeconomics, Chapter 1 Preliminaries. Robert S Pindyck and Daniel L Rubinfeld (2009) Microeconomics, Chapter 1 Preliminaries, section 1.2 What is a Market?

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the question, why study economics?, using the Ford Motor Company to exemplify decision making. You should read the whole of the chapter now. As you read this chapter, please focus on the following questions: How do planned and market economies differ in the allocation of scarce resources? What different sorts of constraints are faced by consumers, workers and firms? How are theories used and evaluated in economics? What is the difference between positive and normative economics? How do real and nominal prices differ?

1.3 The Basics of Demand and Supply


In this course, we shall develop different types of economic models to explain different types of economic behaviour in particular, the equilibrium value of economic decisions.

1.3.1 The concept of equilibrium


Equilibrium can be thought of as analogous to the balance of opposing forces. It is a state in which there is no tendency to change a point of rest. In a set of scales, an equilibrium condition is achieved when the weights on opposite sides of the scale are in balance or at a point of rest. In a mathematical model, the equilibrium condition is the solution derived from a set of equations, given the values of the other parameters. First consider a simple economic model of demand and supply for a good. In this case, we are seeking to explain how demand and supply interact so that the price at which a good is traded means that consumers may purchase all they want of the good and producers can sell all they want to produce of the good. In other words, we are considering the equilibrium price and quantity of a particular good. Underlying this equilibrium solution are assumptions about how consumers and producers behave their demand and supply, respectively. To return to the analogy of the mathematical model, think of the consumer demand and producer supply as a set of two equations and the equilibrium values of price and quantity as the solutions to these equations given the values of other variables. More formally, we say in the case of an economic model that an equilibrium is a set of the values derived on the basis of behavioural assumptions and the values of the other variables. This is not to say equilibrium is always static. Equilibrium can change if one or more of the other variables influencing it changes, or the assumptions underlying the model are altered. For example, if the price of potatoes rises, then consumers may alter their expenditure so that they buy fewer potatoes and more of other goods. This would result in a new equilibrium based on new circumstances. It is important to note that the concept of economic equilibrium does not incorporate any notion of desirability or fairness or correctness. It is simply the outcome of a model based on a set of assumptions and given values for the other factors. Therefore, it is a positive, rather than a normative, concept.

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Unit 1 Concepts of Demand, Supply and Markets

In developing economic models, equilibrium is an important concept, and you need to know how to achieve an equilibrium point and how to move from one equilibrium position to another. To understand consumer behaviour, we need a model that will enable us to explain what quantities are consumed given a set of assumptions about how consumers behave and the values of other factors, as well as what happens when there is a change in price or income. Although we have used the example of quantities in the discussion of equilibrium, it is a general concept and applies to prices, incomes, interest rates, hours worked, acres of land, computers, office buildings or any set of interacting objects or forces. The departure from an equilibrium position or a state in which equilibrium has not been achieved is called disequilibrium. That is, there is no balance of forces and so there is a tendency for things to change over time. It is not a point of rest a state of disequilibrium is considered to be unstable as it involves a tendency for change of one or more of the variables we are trying to explain.

1.3.2 The demand curve and the supply curve


Because these concepts are practical ones, we begin this discussion with and exercise for you to complete. Exercise As an introduction to the concepts of demand and supply, consider the following questions and note down your answers: What determines how much of a particular good or service a consumer is willing to buy at a particular time? What determines the level of output a producer decides to sell? What determines the equilibrium price and quantity? Consider the factors that determine consumer demand for a particular good. The price of the good is obviously one important consideration. But so is the consumers level of income. It is one thing for a consumer to want to buy a bicycle, but the consumer will not plan to buy one unless the price is acceptable and he or she has sufficient income to afford the purchase. The price of other goods, such as bus fares, shoes or cars, is also a consideration affecting the demand for bicycles. If bus fares are very cheap relative to the price of a bicycle, then this may affect the consumers decision about whether or not to buy a bicycle. The consumers demand is also influenced by his or her preference. Perhaps, regardless of relative prices, the consumer has a preference for travelling by bicycle rather than by bus, or vice versa. Other factors that influence a consumers demand for a bicycle may be the weather, advertising, the population of the surrounding area or the state of the roads. So we can say that the quantity demanded of a good or service is determined by, or is a function of, its price, the consumers income, the price of other goods and services and other factors, such as preferences, weather, advertising and population. One of the usual assumptions of market economics is that the higher the price for a product, the lower the quantity demanded. This is sometimes
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referred to as the law of demand, whereby consumers are assumed to buy more if the price of a product falls and less if the price rises. The reasoning underlying this assumption is that as the price of a particular good rises, consumers switch their demand to another good that might serve them almost as well. This would be consistent with the assumption that individuals pursue their self-interest. If the price of bicycles rises, for example, demand falls as people switch to cheaper options such as using the bus or walking. If the price of bicycles falls, then the quantity demanded increases as walkers and bus users now plan to buy bicycles. To represent theoretical concepts, economists often use graphs. In drawing graphs of the relationship between price and quantity, it is customary to put prices on the vertical or Y-axis and quantity on the horizontal or Xaxis. An example of a graph of a demand curve is shown by line DD in Figure 1.1. It slopes down to the right, as consumers are willing to buy more as the price decreases. Exercise Using the lefthand panel in Figure 1.1, consider the following questions: What is happening in moving from point A to point B on the demand curve DD? What happens in shifting from demand curve DD to demand curve D1D1? Figure 1.1 Demand and Supply Curves
D1 D S
A D

P1

P1
B C

S1

P2

P2 S D1 D

S1

Q1 Q2

Q3 Q4

Q1

Q2

Demand

Supply

Moving from A to B on demand DD is a movement along the demand curve, and it represents an increase in the quantity demanded from Q1 to Q2 as the price falls from P1 to P2 . A movement along the demand curve from B to A would represent a price rise and a decrease in the quantity demanded. A shift of the demand curve from DD to D1 D1 is different from the movement along the demand curve. In this case, the whole curve has shifted to the right and at each and every price the quantity demanded has increased. So at price P1 , the new quantity demanded is Q3 , while at price P2 , the new quantity demanded is Q4 . A shift of the demand curve to the left would signify the reverse.

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Unit 1 Concepts of Demand, Supply and Markets

Now consider the supply of a good. This is the amount that producers plan to sell in a particular period, and it too is dependent on price. Like demand, the supply of an item is affected by a number of different factors, such as the prices of other goods and services in the market, the prices of the inputs required to produce the item and the technology used to produce it. In the case of the supply of bicycles, it is influenced by the price of bus travel, cars or other forms of transport; and it is affected by the cost of the inputs such as the metals, the tyres and the labour required to make a bicycle. The usual assumption with respect to the supply of goods is that the higher the price, the larger the quantity producers are willing to supply; while the lower the price, the less they will supply referred to as the law of supply. In the case of firms producing or supplying goods, it is generally assumed that producers require higher prices in order to gain from selling increased quantities because production costs rise as the quantity produced increases. In graphical terms, this means that the supply curve slopes upwards, as shown by line SS in Figure 1.1. As with demand curves, it is necessary to distinguish between movement along the supply curve from C to D and a shift of the supply curve from SS to S1 S1 . The former, a movement along the supply curve, represents an increase in the quantity supplied from Q1 to Q2 as the price increases; whereas a shift of the supply curve to the right represents a higher level of the amount supplied at each and every price. Reading To examine the interaction of demand and supply, you should now read Sections 2.1 and 2.2 of Pindyck and Rubinfeld, pages 2226. When reading these pages, you should note down the assumptions made concerning the operation of the market. You should also note why the assumptions are important for achieving an equilibrium
Robert Pindyck and Daniel Rubinfeld (2009) Microeconomics, Chapter 2 The Basics of Supply and Demand, sections 2.1 Supply and Demand and 2.2 The Market Mechanism.

1.3.3 Market-clearing equilibrium


The market-clearing equilibrium is where consumer demand is fully satisfied and the producers have sold all they supply, as illustrated by point E in Figure 1.2. The market mechanism works to ensure that there are no surpluses or shortages of goods to be bought or sold. It is in equilibrium because there is no reason why the market should move to any other point, and it is market clearing because the quantity demanded and the quantity supplied are equal. In Figure 1.2, the market would not clear at any point other than the equilibrium point E. If the price is P1 , then it is said to be in disequilibrium as the quantity supplied at point B is greater than the quantity demanded at point A and there is pressure for the price to fall until demand equals supply. Consider the following questions: Does an equilibrium always exist? Is it possible for there to be more than one equilibrium point? Is an equilibrium point stable?
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Figure 1.2 Demand and Supply Equilibrium


P D S P1 A B

P0

To achieve equilibrium, we need to have the demand and supply curves crossing. It is possible to think of situations where this does not happen and so there is no equilibrium, as illustrated in Figure 1.3. Figure 1.3 Examples Where There are No Equilibria Panel A
P D S S P

Panel B

D Q Q

In the first case, Panel A, supply is always greater than demand. This can happen if the price of the good is zero or free, either entirely as is the case with the air we breathe or up to a certain quantity. In the second case, Panel B, the price suppliers want to charge is everywhere greater than the price consumers are willing to pay. An example of this might be solid gold briefcases. It is possible to draw other sets of supply and demand curves that do not intersect. However, not all such examples necessarily make sense in economic terms. Figure 1.4 illustrates some examples of multiple equilibria where there is no unique intersection of demand and supply. However, in each of these cases, either the supply curve is not always upward sloping, as in Panels A, B and C, or the demand curve is not always downward sloping, as in Panel C. In general, we can say that there is a unique equilibrium as long as the demand curve is always downward sloping and the supply curve is always upward sloping.
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Unit 1 Concepts of Demand, Supply and Markets

Figure 1.4 Examples of Multiple Equilibria Panel A


P S P

Panel B
P

Panel C
S

S D Q D Q Q

Source: Henderson and Quandt (1980: 131)

An equilibrium is said to be stable if a disturbance results in a return to equilibrium, and it is unstable if it does not. A disturbance denotes a situation where the actual price is not the equilibrium price and so there is excess demand or excess supply. The equilibrium is said to be stable if in this situation consumers and producers adjust the quantities they demand and supply so as to eliminate the excess demand or excess supply. This will always be the case if the demand curve slopes downward and the supply curve slopes upward throughout. This depends on the assumptions made about how consumers and producers behave that is, that consumers demand more at lower prices and producers supply more at higher prices. If the consumers were to demand more at higher prices and therefore the demand curve was upward sloping, then any disturbance is unlikely to lead to a new equilibrium, and so it is referred to as unstable.

1.3.4 Shifts in demand and supply


So far, the graphical analysis has considered demand and supply as a function of price. But, as noted above, demand can be influenced by other factors such as the price of other goods, the level of income, preferences and population whereas supply can be influenced by the prices of other goods, the prices of factors of production and the technology of production. Changes in any of these factors can affect the equilibrium price and so we need to examine, in graphical terms, how the market mechanism handles such changes. Reading Please read Section 2.3 of Pindyck and Rubinfeld, including their examples, pages 2633. When you have finished reading, make a list of the factors that cause the demand curve (1) to shift to the right and (2) to the left, and similarly for the supply curve. In discussing the shifts of the supply curve, we have been making an assumption about production that producers can continue to increase
Centre for Financial and Management Studies 11 Robert Pindyck and Daniel Rubinfeld (2009) Microeconomics Chapter 2 The Basics of Supply and Demand, section 2.3 Changes in Market Equilibrium.

Microeconomic Principles and Policy

the quantity supplied and do not face any constraints such as factory size or limits on the availability of raw materials. In the real world, producers may be able to increase supply only to a certain extent before they face such limits as factory size or lack of skilled labour or other inputs. So markets may not achieve an equilibrium position as seamlessly as we have been indicating. We have also been ignoring time in the discussion of the market mechanism. Time affects the way in which the producer can alter the use of inputs in production. Not all inputs can be increased or decreased quickly. For example, it takes different amounts of time to build a new factory, to install new machinery and to hire new workers. To differentiate these time periods, we talk about the short run, which is the production period where some inputs cannot be varied. The short run usually refers to the time period in which labour can be hired and fired and raw material inputs altered but in which it is not possible to build new factories, for example. The latter occurs only in the long run, when all production inputs can be varied. The analysis so far has been comparing one equilibrium position with another. This type of exercise is known as comparative statics because it involves comparing two equilibria positions without concern as to the time it takes to move from one equilibrium position to another, or to how the market achieves it. Economic analysis concerned with studying the movement of economic systems through time is referred to as dynamics. The movement from one equilibrium to another in time raises interesting questions, and it is generally referred to as disequilibrium dynamics. Most of the analysis you will be doing in this course is comparative statics, which ignores how the market moves from one equilibrium to another. Exercise To make sure you understand the difference between movements along demand and supply curves and shifts in demand and supply, explain what happens to the equilibrium price and quantity, using demand and supply curves, in each of the following situations: hot weather causes the demand for ice cream to rise the demand for gasoline if the price rises the supply of shoes if shoemakers wages increase tea prices rise on the news that pests have destroyed the Sri Lankan tea crop oil producers are refining and selling larger quantities of oil new technology reduces the price of computers. Sample answers are provided at the end of this unit.

1.4 Elasticities of Demand and Supply


The concepts you have been studying enable you to analyse what is happening if there is a change in one of the factors influencing demand or supply. But is it possible to give any quantitative answers to such questions as by how much can we expect the demand and supply for a good to change if the price of that good is halved? In asking this type of question, we are concerned with a measure of sensitivity of the quantity demanded

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or supplied to a change in another variable. This measure of sensitivity is called the elasticity. We can define the elasticity of the quantity demanded or supplied as the percentage change that occurs in the quantity demanded or supplied in response to an incremental change (or a very tiny change such as 1%) in another variable. For instance, the price elasticity of demand (ED) measures the change in quantity demanded of an incremental change in the price, and it can be expressed as ED = P QD PdQD QD /QD = or P/P QD P QD dP

where P is the incremental price change and Qd is the change in the quantity demanded.2 From the last expression you can see that the price elasticity can be expressed as the ratio of price to quantity (P/QD) times the inverse of the slope of the demand curve,

1 dQD = dP /dQD dP .
The price elasticity of demand is usually a negative number because the quantity demanded falls as the price increases. That is, the expression QD/ P is negative, so the whole expression is negative. Price elasticity can range from zero to minus infinity ( ). To express price elasticity as a positive number, multiply by (1). If the percentage change in quantity equals the percentage change in price that is, the elasticity = 1, then we talk of unit elasticity. If the change in quantity is proportionately greater than the change in price that is, the elasticity is greater than 1 (>1), we talk about an elastic demand. In the case where the change in quantity is proportionately less than the change in price (elasticity <1), we refer to that as inelastic demand. Table 1.1 summarises the price elasticity of demand. Table 1.1 Price Elasticity of Demand Relative responsiveness of quantity demanded to price change % change in Q D < % change in P % change in QD = % change in P % change in QD > % change in P Demand Response Inelastic Unit elastic Elastic
Robert Pindyck and Daniel Rubinfeld (2009) Microeconomics Chapter 2 The Basics of Supply and Demand, sections 2.4 Elasticities of Supply and Demand, and 2.5 Short-Run versus Long-Run Elasticitiies.

Value of elasticity (ED) 1 < ED 0 ED = 1 ED < 1

Source: Hyman (1986: 35)

Reading Now read Pindyck and Rubinfeld, Chapter 2, Sections 2.4 and 2.5 on pages 3448. As you do this reading, write down your answers to the following questions: What is meant by the terns completely inelastic and infinitely elastic? What happens to the price elasticity of demand as you move along the demand curve?

If the changes are very small, this can be expressed in terms of calculus, dQ D/dP.

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What measures of elasticity are there besides the price elasticity of demand? How do the presence of substitute goods and complementary goods affect the cross-price elasticity of demand? Why is it important to distinguish between short-run and long-run elasticities? Infinitely elastic or completely inelastic demand can be thought of as special cases of the price elasticity of demand. If demand is perfectly elastic, then any change in price results in an infinite change in the quantity demanded. If it is completely price inelastic, then a change in price has no effect whatsoever on the quantity demanded. These two cases are illustrated on page 36 of Pindyck and Rubinfeld. On page 35 of this textbook in Figure 2.11, the price elasticity of demand varies as you move along the linear demand curve. When the price is zero, the price elasticity of demand is also zero; whereas when the price is very high the price elasticity of demand approaches minus-infinity. This is because elasticity is being measured at different points along the demand curve with the assumption that the percentage change in prices is incrementally small.3 From this, it is seen that consumers are more responsive to price changes when prices are already high than when prices are low. As well as measuring consumers sensitivity to changes in the price of a good, economists are also interested in assessing the responsiveness of consumer demand to percentage changes in income or in the price of other goods. That is, we want to measure the income elasticity of demand and the cross-price elasticity of demand. The expressions for calculating these elasticities are set out on page 36 of Pindyck and Rubinfeld. When goods are substitutes, then the cross-price elasticity of demand is positive because one good can be used in place of the other. This can be illustrated by considering blue ink and black ink pens as substitute goods. If the price of blue ink pens increases and they are more expensive relative to black ink ones, then the likely result is an increase in the demand for black ink pens. However, if goods are complementary, such as lamps and light bulbs, an increase in the price of lamps reduces the demand for lamps and this tends to reduce the demand for light bulbs. Optional Rereading Pindyck and Rubinfeld explain the significance of short-run and long-run elasticities on pages 4048; you should reread those pages if you are unsure about it. As an exercise please do the following: Prepare a similar to Table 1.1 above for the price elasticity of supply. Answer Review Questions 3 and 6 on page 61 of Pindyck and Rubinfeld. My answers are given at the end of the unit, but be sure to complete the exercise yourself before looking at them.

3 This is referred to as the point of elasticity of demand and it is calculated as (P/QD)(dQD/dP), where the last expression is the inverse of the slope of the demand curve for a given P and QD.

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1.5 Applications of Supply and Demand Analysis


In the previous reading, Pindyck and Rubinfeld give some examples of how to use the concept of elasticity for analytical purposes. The next section introduces another application of the concept with respect to the effect of a change in price on the total revenue earned from selling a good.

1.5.1 Price elasticity and revenue


Revenue can be thought of as the receipts from sales the price of the good times the quantity sold. Although we know that if the price of a good falls, the quantity demanded increases, this does not tell us anything about the effect such a change could have on revenue. If the price falls by only a small percentage and yet there is a large percentage change in the quantity demanded, then total revenue could rise. Or, if a fall in prices only results in a small percentage increase in quantity demanded, total revenue could decline. So the effect on total revenue of a change in price depends on the elasticity of demand. The derivation of the relationship between price elasticity and total revenue is set out in the box below. Price Elasticity and Revenue Total revenue (R) is the price of a good times the quantity and is written as P * Q. Assume the price changes to (P + P) and the quantity demanded changes to (Q + Q), then the revenue this generates is (P + P) * (Q + Q), which can be rewritten

R1 = PQ + P Q + Q P + P Q
Taking the difference in revenue as

R = R R1 = P Q + Q P + P Q.
Assume that the last expression ( PQ) is so small that it can be ignored. Therefore, the change in revenue is approximately equal to the original price times the change in quantity plus the original quantity times the change in price. To measure the effect of a change in price on a change in revenue, we can divide both sides of the above expression by P and rearrange it as follows:

R/ P = Q + P( Q/ P) = Q[1 + (P/Q) * ( Q/ P)]


The last expression is equal to the price elasticity so that the change in revenue with respect to a change in price is equal to the quantity times one plus the price elasticity:

R/ P = Q[1 + price elasticity]


Recall that the price elasticity of demand is usually a negative number, so if the absolute value of the price elasticity (the actual number ignoring any negative signs) is greater than one, the change in revenue resulting from a change in price is negative and vice versa. You can also think of it in the following way: if the demand is very responsive to changes in pricethat is, elasticthen a fall in price will increase demand so much that revenue will rise. However, if demand is not very responsivethat is, inelasticthen a fall in price will not change demand by much and total revenue will fall.
Source: Varian (2007: 26567)

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1.5.2 Calculating supply and demand curves


You can complete this section with a reading from your textbook. Reading In Section 2.6, pages 4958, Pindyck and Rubinfeld use numerical examples to construct supply and demand curves using price elasticities. I would like you to read these pages and follow through their examples. When you have completed this reading, I would like you to do Exercises 2 and 8 on pages 62 and 63. Answers are given at the end of the unit.
Robert Pindyck and Daniel Rubinfeld (2009) Microeconomics Chapter 2 The Basics of Supply and Demand, section 2.6 Understanding and Predicting the Effects of Changing Market Conditions.

1.5.3 Analysing government policies


The concepts of demand and supply can also be used to examine the impact of a governments decision to regulate prices by introducing price controls enabling it to set maximum prices price ceilings, or minimum prices price floors. Reading For a further discussion of how the concepts of demand and supply can be used to examine the implications of government price controls, please read Pindyck and Rubinfeld, Chapter 2, Section 2.7 on pages 5861. In this exercise, you should show what would happen to the demand and supply for labour if a minimum wages law were passed. Suppose the government legislates to ensure that all workers are paid a minimum wage for their work. In doing this exercise, you should consider two possibilities: 1 the minimum wage is set at a level below the existing equilibrium wage level, and 2 the minimum wage rate is higher than the present equilibrium wage rate. Illustrate your answer by using supply and demand curves. My answer is provided at the end of the unit. While on the subject of government policy, what do you think would happen to demand and supply if the government imposed a tax on a specific good? Exercise Examine that question by considering a new tax on petrol sales of 10 cents per litre. In this analysis, you can assume that the market is in equilibrium before the tax is imposed and that the petrol supplier collects the tax on behalf of the government. Please draw the relevant demand and supply curves.
Robert Pindyck and Daniel Rubinfeld (2009) Microeconomics Chapter 2 The Basics of Supply and Demand, section 2.7 Effects of Government InterventionPrice Controls.

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For the petrol supplier, the tax will be the same as an increase in the cost of production because each month the supplier will have to remit to the government an amount equal to the new tax rate times the number of litres of petrol sold. What will this do to the supply curve, and why? The supply curve shifts to the left and there is a new equilibrium price of P1 rather than P0 , as shown in Figure 1.5. The new equilibrium quantity of petrol bought and sold will be lower at Q1 rather than Q0 . This analysis can actually tell us quite a lot. The new market price P1 is the gross price paid by the consumer, while the price P2 is the net price received by the supplier. The difference, P1 P2 , is equivalent to the new 10 cents per litre tax and the shaded area represents the total tax revenue the government will receive. Figure 1.5 Impact of new tax on petrol
Price S1 S P1 P0 P2 D Q1 Q0 Quantity

Figure 1.5 also enables us to determine how the payment of the tax is being shared between the supplier and the consumer this usually referred to as sharing the tax burden. The share of the tax being paid by the petrol supplier is P0 P2 , and by the consumer P1 P0 . Exercise Now that you have drawn your own demand and supply curves and studied the analysis, answer the following questions: Which party would be bearing the tax burden if the demand for petrol is inelastic? Is that a realistic assumption? What is the impact of the tax if the supply curve is very elastic? Sample answers are given at the end of the unit. The policy applications of demand and supply that we have been examining so far all relate to price. It is also important to consider what happens if the government were to introduce restrictions on the quantity of goods sold in the form of quotas. Import quotas are a good example, where the government restricts the quantity of a foreign good that can be sold in the country.

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Reading To see how such quotas work, I would like you to read the extract by David Hyman, which illustrates an application of the basic concepts you have learned by examining the effects of tariffs and import quotas on the US textile and clothing industries. While reading the article, you should focus on the following questions: What are import quotas and tariffs? Why is the supply curve kinked following the imposition of quotas on the import of Japanese cars? Why is the price of a car higher with import quotas than without? What factors affect whether sales revenue increases or decreases when quotas are applied to car imports? What effect did quotas on Japanese cars have on the sales of American made cars? Why can the imposition of a tariff have the same effect as introducing quotas from the point of view of consumers? Which would the Japanese producers prefer quotas or tariffs, and why? The answers to all these questions are found in the reading. So refer back to it if you have any difficulties in replying to them.

David Hyman (1993) Import Quotas, Tariffs and Consequences of Protecting Domestic Industries from Foreign Competition, reprinted in the Course Reader from Modern Microeconomics Analysis and Applications.

1.6 Conclusion
It is important that at the end of this units study, you feel comfortable using the concepts of markets, demand and supply. While the demand supply framework may appear simple, it is extremely useful as the basis of quite sophisticated analyses of economic problems. To check your understanding of the concepts, look again at the learning outcomes listed on the introductory page at the start of the unit. If you are unsure of any of the topics, review the unit section that covers it.

References
Henderson, JM and RE Quandt (1980) Microeconomic Theory: A Mathematical Approach, Third edition, London: McGraw Hill. Hyman, DN (1993) Modern Microeconomics Analysis and Applications, Third edition, Homewood Illinois, USA: Richard D Irwin Inc. Parkin, M (2008) Economics, Eighth edition, London: Pearson AddisonWesley. Pindyck, RS and DL Rubinfeld (2009) Microeconomics, Seventh edition, New Jersey USA: Pearson PrenticeHall. Varian, HR (2007) Intermediate Microeconomics, A Modern Approach, Sixth edition, London: Academic Internet Publishers Incorporated.

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Answers to Review Questions


Section 1.3.4
What happens to the equilibrium price and quantity, using demand and supply curves, when hot weather causes the demand for ice cream to rise? Hot weather increases the demand for ice cream at all prices so the demand curve shifts to the right from D to D1 . At price P0 , there is excess demand for ice cream (Q2 Q0 ). This excess demand is then mitigated in some way i.e. through queuing and suppliers also increase the amount of ice cream they can sell. A new equilibrium is reached when prices have risen to P1 and the quantity demanded and supplied is Q 1. Figure 1.6 Demand and supply of ice cream
Price S

P1 P0

D Q0 Q1 Q2

D1 Quantity

What happens to the equilibrium price and quantity, using demand and supply curves, when the demand for gasoline if the price rises? Figure 1.7 Gasoline demand and supply
Price S

P1 P0

D Q1 Q0 Q2 Quantity

The price of gasoline is increased by producers from P0 to P1 . This leads to excess supply of gasoline of Q2 Q1 because at the higher price the quantity demanded is Q1 and the quantity supplied is Q2 . Because there is excess supply, there is a tendency for suppliers to lower the price and this
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will push up the amount demanded and so there is a tendency for the market to return to its original equilibrium position. What happens to the equilibrium price and quantity, using demand and supply curves, when the supply of shoes if shoemakers wages increase? Figure 1.8 Demand and supply for shoes
Price S1 S

P1 P0

Q1

Q0

Quantity

The increase in shoemakers wages increases the price of shoes for all quantities supplied so the supply curve shifts to the left from S to S1 . The result is that the new equilibrium quantity demanded and supplied declines from Q0 to Q1 , where the equilibrium price is P1 . What happens to the equilibrium price and quantity, using demand and supply curves, when tea prices rise on the news that pests have destroyed the Sri Lankan tea crop? The destruction of much of the tea crop means there is a shift of the supply curve to the left and that prices rise for all quantities supplied. As a result of the price rise, the demand for tea declines and a new equilibrium is achieved at a price of P1 and with the quantity traded of Q1 . Figure 1.9 Demand and supply for tea
Price S1 S P1 P2

D Quantity

Q1

Q0

What happens to the equilibrium price and quantity, using demand and supply curves, when oil producers are refining and selling larger quantities of oil?

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If oil producers increase the amount of oil they are selling from Q0 to Q1 , this gives rise to excess supply at the price P0 . Excess supply will put pressure on producers to lower prices or cut back on the amounts refined. The tendency is for the market to return to its original equilibrium position. Figure 1.10 Demand and supply for oil
Price S S1 P0 P1 D

Q0

Q1

Quantity

What happens to the equilibrium price and quantity, using demand and supply curves, when new technology reduces the price of computers? Figure 1.11 Demand and supply of computers
Price S

P0

D Q1 Quantity

Q0

New technology means that computer manufacturers can produce and sell computers more cheaply and so the supply curve shifts right from S to S1 . This results in a new equilibrium at a lower price P1 and at a higher quantity of Q1 .

Section 1.4
Price Elasticity of Supply Value of Relative Responsiveness of elasticity quantity supplied to price change 0 ES < 1 % change in QS < % change in price ES = 1 % change in QS = % change in price 1 < ES % change in QS > % change in price Supply (ES ) response inelastic unit elastic elastic
Source: Hyman (1986: 36)

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Pindyck & Rubinfelds Review Question 3

The elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. So a 6% fall in quantity ( 6) divided by a 3% increase in price (3) yields an elasticity of 2.
Pindyck & Rubinfelds Review Question 6

In the short run, consumers and producers cannot always react quickly to price changes and so their demand and supply curves may be relatively inelastic compared to the long run when all changes can be taken into account. For example, it takes time to build a new factory and increase the amount of goods supplied. In the case of consumers, the demand for non-durable goods, such as paper towels, probably changes very little in the short run and so its demand would be expected to be relatively inelastic in the short run. In the long run, consumers tastes can be expected to change and so one would expect its price elasticity of demand to be greater in the long run. Television sets are considered to be durable goods and it is expected that the quantity demanded is responsive to price changes in the short run.

Section 1.5.2
Exercise 2
a The price elasticity = (P/Q). ( Q/ P) at p = 80, the price elasticity of demand = 0.4; at price = 100, the price elasticity of demand = 0.56 b At p = 80, the price elasticity of supply = 0.50; at price = 100, the price elasticity of supply = 0.56 c The equilibrium price = $100 and the equilibrium quantity = 18 million d With a price ceiling of $80, consumers plan to buy 20 million whereas producers plan to supply 16 million, so there is a shortage of 4 million.

Exercise 8
a Using the same method as outlined in the text, we want to solve for a and b in the equation QD = a b.P. We are given the following data: ED = b.P*/Q* = 0.4, P* = 0.75 and Q* = 7.5. Therefore, 0.4 = b (0.75/7.5), so b = 4. To solve for a = Q* + b.P*; a = 7.5 + 4 (0.75) = 10.5. The demand curve is QD = 10.5 4.P. b If there is a 20% decline in copper demand, this implies the demand curve (QD = 10.5 4.P) is shifted to the left by 20%; that is, equivalent to its being 80% of its original form Q D1 = 80% (10.5 4.P) = 8.4 3.2.P. Equating this with the supply curve QS = 4.5 + 16.P and solving for P, the new equilibrium price is $0.672 or 67.2 cents/lb.

Section 1.5.3
In the minimum wage imposed by the new law is less than the present equilibrium wage WE, then the quantity of labour supplied by workers willing to work at that wage declines from QE to Q1 , while the amount demanded by firms rises to Q2 . At a minimum wage of W1 , there is excess
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demand for labour. On the other hand, if the minimum wage of W2 is higher than the present equilibrium wage, there will be an increase in the quantity of labour supplied at that wage while demand will fall, and hence there is excess supply. It is assumed that the labour market is competitive. Figure 1.12 Minimum wage
Price (wage rate) excess supply

W2

We W1

excess demand D Q1 Qe Q2

When the demand for petrol is perfectly inelastic, the demand curve is a vertical straight line. The imposition of a tax on petrol shifts the supply curve to the left (SS to S1S1 ) and the price increases from P0 to P1 but the equilibrium quantity does not change. The petrol consumers have to bear the full burden of the tax.
Price D S1 P1 P0 S P1 S1 Price D

P0

S1 D S Quantity Q1 Q0 Quantity

Inelastic petrol demand

Elastic petrol supply

If the supply curve for petrol is perfectly elastic, then we show it as a horizontal straight line. In this case, the imposition of new tax shifts the supply curve to the left and the price increases from P0 to P1 while the equilibrium quantity decreases to Q1 . It is the consumers, again, who bear the full burden of the tax.

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