Notesale: Turn your study into money

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Q2

Q4
We may split the overall effect into the income effect and the substitution effect when examining the
consequences of a price shift on good Y, where Y is viewed as an inferior good
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Substitution Effect:
In the event that good Y's price drops, consumers would likely switch from Y to other goods—especially
substitutes—since Y will now be less appealing overall because of its reduced price, provided Y is inferior
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Regardless of the substitution impact, the customer will desire more of Y as a result of the real income gain
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

For an Inferior Good (Y):

When the price of an inferior good (Y) decreases:
The substitution effect decreases the quantity demanded of Y because consumers substitute away from Y
towards other goods
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The net effect on the quantity demanded of Y depends on the
relative strength of the substitution effect (which reduces demand) and the income effect (which increases
demand)
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Goods X and Y are complements if the substitution effect of a price change in Y leads to a decrease in
the quantity demanded of X
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This occurs as a result of consumers switching from
consuming more Y to more X when Y becomes comparatively less expensive
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In this instance, customers are buying more of Y, which complements X, therefore
the price drop of Y lowers the demand for X
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The replacement effect-based categorization shows how buyers
modify their spending habits in reaction to Y price fluctuations, viewing Y as a subpar commodity
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To put it another way, a company may lower its average cost per
unit by spreading its fixed costs—such as overhead, administrative, and infrastructural costs—
over a higher number of units when it produces more units
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• Managerial economies: Bigger companies can afford to hire specialised teams and use
cost- and efficiency-cutting management strategies
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• Marketing economies: The costs of
marketing and distribution can be divided
over a larger number of units by larger
companies
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Effect on Long Run Average Cost (LRAC) Curve: A long run average cost curve (LRAC)
that slopes downward is usually the consequence of economies of scale:
Initially, because economies of scale are realised, average costs reduce as output rises
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Because a company operating at a bigger scale may produce goods more effectively and lower
average costs, the LRAC curve slopes downward
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In this instance, the advantages of economies of scale decrease
or are surpassed by inefficiencies when the company grows its output over a particular
threshold
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• Costs associated with bureaucracy: Bigger businesses may get more bureaucratic,
which would slow down decision-making and raise administrative expenses
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• Limits on specialisation: As scale grows, there could be a limit to how much
specialisation can still save costs
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This leads to an upward-sloping LRAC curve as output increases further
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Shape of the Long Run Average Cost (LRAC) Curve:
• U-shaped: Because of the combined impacts of economies and diseconomies of scale, the
long run average cost curve is sometimes shown as having a U-shaped form
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• Turning point: The LRAC curve usually reaches a minimum point at which time it indicates
the ideal manufacturing size at which economies of scale are maximised
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economies of scale and diseconomies of scale fundamentally influence how production costs
change with the scale of output
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This typically occurs due to factors such as:




Input scarcity: As more firms enter the industry and
demand for inputs (like labor, raw materials)
increases, their prices tend to rise, thereby increasing
production costs
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Shape of Long Run Industry Supply Curve:



Upward-sloping: In an increasing cost industry, the
long run industry supply curve slopes upward
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Therefore, firms require higher prices to cover
these increased costs and remain profitable
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Decreasing Cost Industry:

Definition: A decreasing cost industry is one where the
average costs of production decrease as the industry expands
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This could be due to efficiencies in
production, distribution, or other cost-saving measures
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Shape of Long Run Industry Supply Curve:



Downward-sloping: In a decreasing cost industry, the long run industry supply curve
slopes downward
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Therefore, firms can supply larger
quantities at lower prices, reflecting the decreasing average costs
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Constant Cost Industry:
Definition: A constant cost industry is one where the average
costs of production remain constant as the industry expands
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No significant economies or diseconomies of scale: The
industry operates at a scale where any changes in cost due
to scale are negligible
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Reason: Firms can increase production in response to
higher demand without experiencing changes in average costs
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These ideas are crucial to comprehending the long-term behaviour of industries and the
dynamics of supply and demand in the market as a result of production costs
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Q8
The effect of a tax
Different governments impose taxes for various purposes and in various methods
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Certain items may
be subject to taxes in order to generate income or to influence consumer choices
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Carbon taxes are a crucial instrument for combating climate
change, with the clear goal of lowering greenhouse gas emissions in this instance
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Using taxes to raise revenue: The case of salt

Diagram shows the potential operation of a salt tax
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Let's say that the suppliers are required to pay a 30%
sales tax on the cost of salt
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The new equilibrium is at point B, where a lower quantity is traded
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The consumer price, P1, is 30%
higher than the price received by suppliers (net of the tax), which is P0
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This example illustrates an important feature of taxes: it is not necessarily
the taxpayer who feels its main effect
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the total surplus at equilibrium B with the tax, with the original surplus at A
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Producer surplus falls: Producers supply less and receive a lower net
price, P0
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Total surplus (including tax revenue) is lower: The tax causes a deadweight
loss equal to the area of the white triangle, which is 1/2 × (Q* − Q1) ×
(P1 − P0)
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Compared to the situation before the tax, some of the
surplus has been transferred from consumers and producers to the government,
but also the total surplus is lower: there is a deadweight loss
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To raise as much revenue as possible, and reduce deadweight loss, the
government would prefer to tax a good with low elasticity of demand, so that the
fall in quantity is quite small
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In many modern economies, institutions for tax collection are well established,
with democratic consent
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In contrast, if the government’s objective is to reduce the consumption of a good
that is considered harmful—like tobacco or carbon—the tax will be more
effective if demand is elastic so that quantity falls substantially

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