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Section 1: Microeconomics
Define elasticities
Refers to the the responsiveness of the demand of a good/service
Price Elasticity of Demand (PED)
PED measures the responsiveness of demand if the price of a good in changed
...

Equation:
PED = (percentage change in quantity demanded) / (percentage change in price)
Price and quantity demanded are negatively indirectly related, the PED is negative
...

Value of PED

Classification

Interpretation

0 < PED < 1

Inelastic demand

Quantity demanded is relatively unresponsive to price

1 < PED < ∞

Elastic demand

Quantity demanded is relatively responsive to responsive
to price

PED = 1

Unit elastic
demand

Percentage change in quantity demanded equals
percentage change in price

PED = 0

Perfectly inelastic
demand

Quantity demanded is completely unresponsive to price

PED = ∞

Perfectly elastic
demand

Quantity demanded is infinitely responsive to price

Determinants:
● Number and closeness of substitutes
● Necessities vs
...

Primary commodities (goods from factors of production ‘land’
...
cotton and rubber) have a
lower PED than manufactured goods (food)
...
(no replacement for food)
Graphs of PED:

1

PED and Indirect Taxes:
● The government often imposes indirect taxes (taxes imposed on spending to buy goods
and services) to increase their tax revenues
...

● The more inelastic demand a good has, the higher the tax can be imposed, bringing in a
greater tax revenue
...


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Graphs showing PED and Indirect Tax:

Cross Price Elasticity of Demand (XED)
XED measures the responsiveness of demand for one good, given a change in price of a
substitute or complement
...

(-) Value means that the two goods being considered are
complementary
...


The value is taken as an absolute value
...

● High absolute value of XED means that lowering the price of one
good can result in a large increase in demand for the other
...


Income Elasticity of Demand (YED)
YED shows the relationship between the percentage change in quantity demanded of a good, X,
and the change in income
...

○ Both change in the same direction
(-) Value (YED < 0) means that the good being considered is an
inferior good
...
If a good has a YED that is positive but less
than one, it has income inelastic demand
...

YED > 1 : Luxuries
...

○ Percentage increase in income produces a larger percentage
increase in quantity demanded
...

Equation:
PES = (percentage change in quantity of good X supplied) / (percentage change in price of
good X)
Value of PES

Classification

Interpretation

0 < PES < 1

Inelastic supply

Quantity supplied is relatively unresponsive to price

1 < PES < ∞

Elastic supply

Quantity supplied is relatively responsive to responsive
to price

PES = 1

Unit elastic supply

Percentage change in quantity supplied equals
percentage change in price

PES = 0

Perfectly inelastic
supply

Quantity supplied is completely unresponsive to price

PES = ∞

Perfectly elastic
supply

Quantity supplied is infinitely responsive to price

Graphs of PES:

5

Determinants of Supply:
● Length of time:
○ The amount time firms have to adjust their inputs and the quantity supply in
response to price changes
...

■ More easily and quick = More price Elastic
● Spare/unused capacity of firms
○ Sometimes firms have capacity to produce with what is not being used
...

■ The greater the spare capacity = More price elastic
● Ability to store stocks
○ Some firms store stocks of output instead of selling it right away
...


Government Intervention
Indirect taxes
Taxes imposed on spending to buy goods and services paid partly by consumers, but are paid
to the government by producers
Why do governments impose indirect tax?
● A source of government revenue
● Method to discourage consumption of goods that are harmful for the individual
● Can be used to redistribute income (Make rich people spend more)
● Reduce allocative efficiency by correcting negative externalities
Types of indirect taxation:
Specific Tax: A fixed amount of tax per unit of the good or service sold
● Causes a parallel upward shift in supply because tax is a fixed amount for each unit of
output
Ad Valorem: A fixed percentage of the price of the good or service
● New supply curve is steeper than the original supply curve because tax is calculated as
a percentage of price → the amount of tax per unit increases as price increases

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Impacts of market outcomes of these taxation types:
Specific Tax:

Ad Valorem Tax:

Explanation of the Market Outcomes of Ad Valorem and Specific Tax:
● Equilibrium quantity produced and consumed falls from Q* to Q1
● Equilibrium price increases from P* to Pc for consumers
● Consumer expenditure changes from P* x Q* to Pc x Qt
● Price received by firms fall from P* to Pp
● Firm’s revenue falls from P* x Q* to Pc x Qt
● Government receives tax revenue of (Pc - Pp) x Qt
● Underallocation of resources to the production of the good (Qt < Q*)

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Indirect taxes: market outcomes, social welfare, and tax incidence
Tax incidence and price elasticities of demand and supply:
● Consumers and producers share the tax burden of a good that can be called a tax
incidence
● The incidence depends on the price elasticity of demand and supply for the good being
taxed
Incidence of indirect taxes and price elasticity of demand:
● Demand inelastic → Incidence on consumers because they are willing to buy the
good/service at whatever price since there are no substitute for the good
● Demand elastic → Incidence on producers because the consumers are price sensitive
and will refuse to buy the good if prices are too high

Incidence of indirect tax and price elasticity of supply:
● Supply inelastic → most of incidence is on producers
● Supply elastic → most of incidence on consumers
Subsidies
Assistance by the government to individuals or groups of individuals that make take the form of:
● Direct cash payments
● Low interest or interest-free loans
● Provision of good and services at low prices
● Tax relief

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Subsidies and the allocation of resources:
● Increases the price received by producers → producers produce more → price
decreases → consumers buy more
● Allocation of resources changes → greater production and consumption than in the free
market
● Economy that is already allocatively efficient will experience allocative inefficiency and
welfare loss if subsidy is introduced and vice versa
Why governments grant subsidies?
● Increase revenue of producers that governments want to support
● Make certain goods affordable to low-income consumers
● Encourage production and consumption of particular goods/services that are desirable to
consumers
● Support the growth of a particular industry in the economy (solar power, ethanol
production)
● Encourage exports of particular goods (lower export prices increase quantity of exports)
● Improve allocation of resources and correct positive externalities
Impacts of subsidies on market outcomes:

●
●
●
●
●

Equilibrium quantity produced and consumed increases from Q* to Qsb
Equilibrium price falls from P* to Pc
Price received by producers increase from P* to Pp
Distance between S1 and S2 represents government spending on subsidy
Overallocation of resources to the production of good (Qsb > Q*)

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Price Controls
The setting of minimum or maximum prices by the government so that prices are unable to
adjust to their equilibrium level determined by demand and supply
● Once price controls are imposed, there is no new equilibrium and force a situation where
there is market disequilibrium
● Market disequilibrium is when a market is prevented from reaching a market-clearing
price
...

Types of price controls:
Price ceiling: When a government sets a maximum price for a particular good
...
price → shortage because Qd > Qs
Quantity supplied and sold is lower than equilibrium
Larger quantity demanded than equilibrium

Consequences:
● Shortages (Qd exceeds Qs)
● Non price rationing: Inability of the price mechanism to divide up goods among
consumers
...
They can only purchase a fixed
amount of good
○ Favoritism: Sellers sell goods to favorite customers
● Parallel market
○ Arise when there are dissatisfied people who were not able to buy a good
because of the shortage and are willing to do whatever they can to obtain it
Examples of price ceiling:
Rent controls
● Housing becomes more affordable to poor people
● Shortage of housing; quantity demanded is greater than quantity available
● Long waiting lists of interested tenants
● Run-down and poorly maintained rental housing because landlords renovate less to
maximize profit

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Food price controls
● Make food price more affordable to poor people
● Food shortage as quantity demanded exceeds quantity supplied
● Falling farmer income due to lower revenues
● More unemployment in the agricultural sector
Price floor: When a government sets a minimum price for a particular good
...
The free market will produce either too much of a good
or service
...

Production
When production of a good creates spillover costs for society as a whole that are not born by
the producer of that good
...

Current: Q1&P1
Socially optimal level is achieved at MSC=MSB (Q*&P*)
The external cost is shown between the MSC and MPC curve
...

○ Consumers get more of a good for a lower price however it has negative
externalities, meaning the society must bear the burden
...

○ The tax will decrease the quantity from Q1 to Q* and increase the price to match
its equilibrium of P*
...


●
●
●
●
●

Current: Q1&P1
Socially optimum level is where S=MSB at P* and Q*
...

The external cost is the distance between the MPB and MSB curves
...


To fix:
● Tax the goods (decrease the supply)
● Subsidize other merit goods
● Advertising
● Government regulations/legislations

Positive Externalities
Usually arise from the provision of merit goods and services such as education and hospitals
...


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●
●
●
●

Current: Q1&P1
Social optimal: Q*&P*
There is an under allocation of merit goods/services
...


To fix:
● Direct government provision
● Subsidies
Consumption
Consumption of the good/service provides external benefits to third parties
...

There is an under consumption of merit goods, the amount shown between Q1 and Q*
...


Theory of the Firm and Market Structures
Market structure describes the characteristics of market organization that influence the behavior
of firms within an industry
...
Perfect competition
2
...
Monopolistic competition
4
...

● Eg
...

Long Run: The long run is a time period when all inputs can be changed
...

● Eg
...

*** Short run and long run do NOT correspond to any particular length of time ***
Law of Diminishing Returns:
As more and more units of variable input (such as labor) are added to one or more fixed inputs
(such as land), the marginal product of the variable input at first increases, but then at a certain
point, decreases
...

● Specialization in labor ( improves productivity)
● Specialization of managers: efficiency
● Efficiency of capital equipment (use technology to mass produce)

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Diseconomies of Scale: When a firm operates on a larger scale, the average production costs
decrease from complexity or overly rapid growth
● Coordination and monitoring difficulties (managers can’t tell if employees are Working at
appropriate levels)
● Communication difficulties and unmotivated workers

Costs of production short run:
Fixed costs: Arise from the use of fixed inputs
...

●
These costs vary as output changes
...

● Decreasing returns to scale: Output increases less than in proportion to the increase
in all inputs
...
→ tells us by how much output increases as labor increases by one
worker
...
→ tells us how
much output each unit of labor produces on average
...

●
●
●

Total fixed costs (TFC) corresponds with Average fixed costs (AFC)
○ AFC = TFC / Q
Total variable costs (TVC) correspond to Average variable costs (AVC)
○ AVC = TVC / Q
Total costs (TC) corresponds to average total costs (ATC)
○ ATC = TC / Q

MC is the extra cost of producing one more unit of output
...

MC = (∆ TC)/ (∆ Q) = (∆ TVC) / (∆ Q)

Long run cost curves vs short run cost curves:

Revenues
● Total revenue (TR) = P x Q
● Marginal revenue (MR) [the addition revenue arising from the sale of an additional unit of
output] = ∆ TR / ∆ Q
● Average revenue (AR) [revenue per unit of output sold] = TR / Q

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Profit
● Normal Profits: When revue equals costs (pays off exactly)
● Supernormal/abnormal profit: When revenue exceeds the costs, a profit is made
...

Goals of firms
● Profit Maximization
● Economies of Scale
● Corporate Social Responsibility (CSR): improves image
● Satisfying Customers
Perfect competition
Perfect competition assumptions
● Large number of firms
● All firms produce homogeneous goods
● Free entry and exit
● Firms are price takers
● Their activities will have little effect on the industry
Subnormal → Normal

●
●
●
●
●

Firms are making losses due to prices (there are many firms in the industry that they all
must have low prices to attract more customers)
Other firms leave the industry given the low barrier to entry/exit because of the loss
This decreases the supply → increases the price for industry
The price increases enough to where they make profits to cover for the costs (of
production)
The firm is then making normal profits
...


Advantages and Limitations
Advantages:
● Allocative efficiency
● Productive efficiency
● Low (relatively) prices for consumers
● High competition (inefficient businesses close down)
Limitations
● Lack of product variety
● Hard to take advantage of economies of scale
● Limited ability to engage in market research (they need to use their profits wisely)
● Market failure (numerous real- world situations where resources are allocated
inefficiently because of market failure)
Monopoly
Monopoly assumptions
● There is a single or dominant firm in the market
● There are no close substitutes
● Significant barriers to entry/exit
○ Economies of Scale (hard for small firms to compete)
○ Branding (customer loyalty towards a well known brand)
○ Aggressive tactics (used by monopolies, usually pricing strategies)
○ Legal barriers

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■
■
■
■
■
●
●

Patents
Licences
Copyright
Public franchises
Tariffs and quotas (trade restriction)

Price Makers
Their supply/demand (basically) is that of the industry
...

Monopolies achieve its profit maximizing point at MR=MC,
Equilibrium point ‘a’ of perfect competition has a greater quantity and a lower price than
those of point ‘b’
...

In perfect competition, allocative efficiency is reached when the curve MB=MC, however
this does not occur in monopolies
Monopolies: due to allocative and productive inefficiency, there are consequences to
the consumer and producer surplus
...

Monopolies gain producer surplus at the expense of their consumers
The deadweight loss indicates that monopolies are not producing enough quantity of
output based on the price
...


Monopolistic Competition
Monopolistic competition assumptions
● Large number of firms
● No barriers to entry and exit
● Product differentiation
Product differentiation and the demand curve
● Monopolistic competition: combines characteristics of both perfect competition and
monopolies
...


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Competition: Price and non-price
1
...
Non-price: firms use other methods such as marketing, product development, promotions to
attract customers
Profit Maximization (applies the MR =MC)

The profitable industry (figure a)
● Shows the short run equilibrium of a profit making firm
● In the long run, when firms can adjust their sizes by changing their fixed inputs,
economic profits draws new entrants into the industry
...

● Firms continue to enter → demand for each firms starts to decrease until it is tangent
with the ATC curve
...

Efficiency
● Allocative: P = MC
● Productive: production at lowest ATC curve
...
(they plan
the ‘action x’, in assumption the rival responds through ‘reaction y’)
● It takes great effort to guess that actions and reactions of rivals
Conflicting incentives (may occur during rough economic conditions)
● Incentive to collude
● Incentive to compete
Game Theory
● A mathematical analysis of the decision makers who are dependent on each other, and
who use strategic behavior as they try to anticipate the behavior of their rivals
...
etc)
○

Cartel: formal collusion
...

○ Objectives:
■ Co-ordinate prices
■ Avoid competitive price cutting
■ Limit competition

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■
■

Increase profits
Bypass the obstacles created by illegality of formal collusion (cartel)

One type of informal collusion:
● Price leadership
○ Dominant firm in the industry sets a price and initiates the price changes
...

Non-collusive: sticky prices
The kinked demand shows the reactions of other firms if one firm changes their price
...

(Firm A’s demand is now elastic
...
(Demand become inelastic)

Criticisms of oligopolies
● Productive/allocative efficiency not achieved
● Higher prices as lower output (like monopolies)
● Higher production costs due to lack or price competition (X inefficiency)
Benefits
● Economies of scale
● Product development, technological development (dynamic efficiency)
Price Discrimination
First degree
Each consumer pays exactly the price they are willing to pay
...
(electricity, hourly, internet,
text messages)

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Third degree
Consumers are divided into different market segments
...

- X inefficiency
- Dynamic
efficiency

- Greatly benefits
from this

- Can benefit from
this

Market power

Efficiency

- Productive and
allocative efficiency in
the long run equilibrium

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