CONTENTS OF ENTIRE BOOK

Unit 1 Markets: How They Work.......................................................................................... 1

Positive and normative thinking ................................................................................................1
Opportunity cost ........................................................................................................................1
The production frontier or production possibility curve ............................................................3
Specialisation and foreign trade..................................................................................................6
Demand and supply: an introduction..........................................................................................8
The elasticity of demand...........................................................................................................20
The elasticity of supply.............................................................................................................30
Demand and supply: applications to any market are possible..................................................32
The market mechanism working...............................................................................................34
Consumer and producer surplus...............................................................................................39

Unit 2 Markets : Why Markets Can Fail.............................................................................43

What does market failure mean?..............................................................................................44
Reason 1 - Monopoly elements or market dominance.............................................................47
Oligopoly..................................................................................................................................51
Imperfect competition or monopolistic competition................................................................54
Reason 2 - externalities, social cost and private costs..............................................................58
Reason 3 - public goods............................................................................................................64
Reason 4 - merit goods.............................................................................................................65
Reason 5 - demerit goods.........................................................................................................66
Reason 6 - information failures................................................................................................67
Reason 8 - factor immobility....................................................................................................70
Other issues and market problems exist:
The distribution of income and wealth....................................................................................75
Economies of scale...................................................................................................................79
Price fixing by government or one of its bodies.......................................................................84

Unit 3: Managing the Economy.............................................................................................90

Why is the government involved in the economy....................................................................90
How can government try to manage the economy?..................................................................92
Inflation.....................................................................................................................................95
Unemployment.......................................................................................................................100
The balance of payments........................................................................................................106
Gross domestic product (GDP)...............................................................................................110
Economic growth....................................................................................................................113
Aggregate demand..................................................................................................................120
Aggregate supply....................................................................................................................122
Altering the level of national income.....................................................................................123
Macroeconomic policy – what the government does or tries to do........................................128
The multiplier.........................................................................................................................136
The interest rate and the level of investment..........................................................................136
Money and monetary policy...................................................................................................138
Fiscal policy............................................................................................................................146
Supply side economics...........................................................................................................152
The Phillips curve...................................................................................................................158

Unit 4: “The Theory of Production & Costs”....................................................................164

The growth of firms................................................................................................................164
The external growth of firms:.................................................................................................167
Multination corporations.........................................................................................................169
An introduction to production theory and costs......................................................................170
Cost curves..............................................................................................................................175
The different possible market conditions................................................................................178
Perfect competition.................................................................................................................179
Monopoly................................................................................................................................184
Imperfect competition or monopolistic competition..............................................................188
An introduction to efficiency..................................................................................................192
An introduction to price discrimination..................................................................................196
Pricing strategies.....................................................................................................................199
Game theory............................................................................................................................201
Oligopoly - the kinked demand curve.....................................................................................203

Unit 5A: Labour Markets....................................................................................................207

The supply of labour...............................................................................................................207
The demand for labour............................................................................................................210
Determining the equilibrium wage.........................................................................................214
The effects of trade unions......................................................................................................217
Differences in earnings...........................................................................................................222
Labour participation, unemployment and ageing...................................................................229
An introduction to the distribution of income and wealth......................................................233

Unit 6, The UK in the Global Economy: “Globalisation and Protection”.......................236

An introduction to globalisation and protection.....................................................................236
Trade protection and trade liberalisation................................................................................238
Trading blocs and the world trade organisation (WTO).........................................................242
The balance of payments........................................................................................................247
The European monetary union (EMU)...................................................................................255
Public expenditure in the UK..................................................................................................258
Inward foreign investment by multinational corporations......................................................264
External shocks and the global economy................................................................................266
 Module 2881 The Market System, Unit 1:
“Markets: How They Work”

The course is the GCE Advanced Level in Economics, following the Edexcel syllabus but if you are
following a different syllabus then you can simply select the parts of this book that you can use. Economics
is economics! The GCE A level is normally taken in the UK in the Sixth Form (grades 11 and 12) and it is
most commonly used for selecting students for university entrance.

This is a series of teaching notes I used until I stopped teaching recently. If you spot any errors, please email
me and let me know. I maintain a few email addresses for different purposes; currently they
are:[email protected] and [email protected]. If you receive no reply it may mean
that somewhere along the line a spam trap has nabbed your message. You can try sending it again, but try
taking out any words that you thing a spam trap might not like. An alternative explanation is that Hotmail
thought it was spam and deleted it after a few days when I was on holiday or something and was not
checking my junk mail box regularly. Converting my files to PDF format resulted in the occasional strange
error appearing. I corrected all that I noticed but if I missed any and you spot them, please email me!

Now down to business. If you want good marks, these notes should be read and reread until you really know
them. Practise drawing the diagrams until you can do them from memory without making mistakes. It is a
good idea to revise something and practise drawing diagrams for a short period every day.

1-1. INTRODUCTION

POSITIVE AND NORMATIVE THINKING

Positive economics deals with what is; normative thinking deals with what ought to be and is value-laden.
All sciences and fields of learning try to be positive and deal with facts and models based on facts. You
should try to be positive i.e. scientific in your statements, especially when writing essays and in the exam
room.

Words like "ought", or "should" or “as a nation we must” are all normative statements and you should do
your best to avoid them. Try not to say things like “It would be better if…”,or “the government should….”
“it would be a good thing for X to do Y”. Many policy prescriptions you might wish to make are normative,
e.g., “The economy would be better off if we….” and it can raise an examiner’s hackles. You might get
away with a general statement such as “Some advocate…”, “It has been suggested that…” or “Many believe
that….” as these are positive statements and sound less normative. Note that the words used in an otherwise
scientific study can themselves carry a normative feeling, e.g. "freedom", "democracy", "efficiency", or
"welfare" may all seem to be “good words to many people; whereas words such as “inequitable”,
“exploitation”, "unsound", "interference", "fascist", or "police state" seem "bad" to many people.

OPPORTUNITY COST

We live in a world of scarcity, in the sense that we can never have everything that we might like. As a result
we must make choices, for instance whether to buy this or that, whether to eat this or that, whether to walk
in the park or go to a movie, or whether to produce this or that. Every time we make a choice to do some-
thing we automatically exclude something else that we did not do we have given it up. We call this the
“opportunity cost”.

Definition “Opportunity cost is the best forgone alternative”

i.e. it is what we gave up to get what we did. The opportunity cost of buying new pair of shoes might be a
lunch forgone.
1
 · The opportunity cost of buying a new shirt might be not going to the cinema.
· The opportunity cost of taking a part-time job might be not being able to hang out in the mall with
your friends.

For a producer
The opportunity cost of buying plastic packaging material might be the cardboard he did not buy.

NB there can be many alternatives foregone, but only one will be the opportunity cost you cannot add them
up and say they are all the opportunity cost, because it must be a choice between them.

Opportunity cost can be thought of as:

1. The cost in pounds (represents a real thing given up); or

2. The cost in time.

Opportunity cost is important

1. We use it whenever we are deciding what to do, for example shall we hire a couple of videos or buy a piz-
za instead.

2. It always arises with budget allocations. At some point in your life you may have to draw up a budget and
allocate money for different purposes. You will be forced to weigh up what is really needed in your tennis
club, computer society, your country or whatever.

3. It lies behind the cost curves that we draw. How does this work?

Consider two producers, A and B. Producer A might have to pay £20 a ton to get the iron ore to make into
motor cars. Producer A sees the cost as £20, but we see it as the way of making sure he gets the resources,
rather than letting B get them! So the opportunity cost really does stand behind the cost curves we draw.

Similarly in consumption: if something costs £10, you have to pay £10 to buy it. That £10 is not only the
price of the object, it is also the amount you have to pay to get the resources, raw materials, labour etc. that
went into making it. This prevented these resources from going into making something else.

After you buy the item it will be reordered by the shopkeeper and replaced on the shelf. S/he orders from a
wholesaler who in turn orders more from the producer. The producer then buys the raw materials etc. to
make another of whatever you bought! In this way, resources keep on going into making whatever people
demand.

4. This is how the price mechanism really works – that is, how it allocates resources to wherever the de-
mand is the greatest.

2
THE PRODUCTION FRONTIER OR PRODUCTION POSSIBILITY CURVE

What is it?
It shows us the maximum that a country can produce. There is clearly a limit to this at any one time just
like there is a limit to the weight that you can lift over your head or eat at any time. We assume two goods
(I will use apples and bananas as these easily can be represented by A and B) for ease of explanation –
but it is true of any number of goods.

Drawing the diagram – we start with the maximum amount of good A we can produce if all our resources
are devoted to producing A which gives us a point on the vertical axis; then we do the same for the case if
we only produce B to give us a point on the horizontal axis. Then we join the two positions with a straight
line. Once we have drawn the line, we do not have to have all apples or all bananas but we can chose some-
where along it. Any point on it represents a mix of the two goods that people wish to buy. At the point se-
lected above, people consume 0A1 apples and 0B1 Bananas.

Apples

A1

PPC1

Bananas
0 B1

[DIGRESSION: DRAWING THE CURVES

You should practise drawing all the diagrams regularly – several times each day is a good idea. In the end,
they need to be second nature to you so that you can recall and correctly draw the appropriate diagram
whenever you want. It is most important to be able to this so that you can quickly gain good marks.
The wrong diagram, a mislabelled one, or one lacking labels, more or less dooms you to fail. It shows
that you do not really understand what you are saying and examiners hate that. Labels, by the way, are the
words on the diagram, like “apples”, “bananas” or “ppc 1” in this diagram.

When tutoring, I would draw each diagram again in front of the student, and explain the importance of get-
ting it right (and remind them of this now and then later). It is important to see how a diagram is built up as
they are really easy to do, but to be suddenly presented with a complicated finished product can be a bit
daunting. For this reason, I have put in a sensible order of drawing the diagram for the first few times I
present them. It is just about impossible to get a good mark in economics without drawing diagrams, so
start practicing without delay!

Warning! It may seem easy, but it helps you much less if you download diagrams from the Internet and paste
them into essays. It is more valuable for you to draw them, and learn them, for yourself. END OF DIGRES-
SION]
3
The way the diagram of the production possibility curve is drawn.

Apples Apples Apples

A1
PPC1 PPC1

0 0 0 B1
Bananas Bananas Bananas

We usually draw the production function curved , to reflect the law of diminishing returns. Some factors of
production are better at producing A and not as good at B, as you might imagine. Some land is simply bet-
ter at growing bananas than apples, just as some of your friends are better at doing maths, swimming or
playing the guitar than others. So as we move down the production possibility curve and get more bananas,
we can expect to get a few less bananas than we might expect; perhaps we used to give up 5 apples to get 5
more bananas, but as we slide down the curve we will get, say, only 4 more bananas, then only 3 more, or 2
more, as we keep sliding down.

The line curves in at each end to show this as in the diagram below.

Apples

A
Equilibrium point
where ppc is just
A2 tangent to the
PPC price line AB
A1

0 B1 B2 B
Bananas

[Digression. It is unlikely in my view that you will be asked why the production frontier is curved as op-
posed to a straight line, but if you do, the reasoning above and the diagram explains it. In the diagram you
can easily see that if we had a straight line production possibility curve (like AB) we could produce the max-
imum amount of apples at the end of it, that is, at A, and have no bananas at all. But as diminishing returns
do exist, we are actually on the curved A2B2. The maximum apples possible are at A2 (not A which we
could reach if we were on the straight line ppc ). As diminishing returns put us on the curve not the straight,
the difference between A2 and A is the quantity of apples lost because of diminishing returns, End of digres-
sion]

It is common to use straight line production frontiers in text books because they are easier to draw and ma-
nipulate, so they often look like the diagram below.
4
 Apples

A1

PPC1

Bananas
0 B1

What happens if we swivel the curve? If society learns to get better at producing Apples alone, it would
swivel the curve out along the vertical axis of apples. This reflects the fact that we can get more output
from the resources and factors of production that we have. The swivel that gives us more apples reflects
a productivity increase in apples, but not in bananas.

Apples
A2

A1

0 B
Bananas
After the productivity increase in the apple growing industry, withe same quantity and quality of factors of
production, society can increase the output of apples from 0A1 to 0A2, that is, by the distance A1 to A2.

If we swivel it the other way, and push out B , we would get a productivity increase in bananas, but not in
apples.

What if we move the whole curve out? If a country has learned to get better at producing every-
thing, this would physically move the production frontier upwards and outward, which is economic growth.

5
 Apples

ppc1 =
now
A2
A1 ppc2 =
4 years time

0 B1B2 B
Bananas

We return to the subject of economic growth in the unit “Managing the economy”.

SPECIALISATION AND FOREIGN TRADE

If people specialise they are more productive – if you are like me, you probably could not make a good pair
of shoes, do brain surgery or advise on investing for pensions! We tend to do what we are best at. Imagine
the result if we did what we are worst at!

Countries are the same – if they concentrate on what they are best at, they produce more and better goods or
services. As a rule of thumb, countries that follow a protectionist policy (protecting their industries from
foreign competition) are trying to do what they are worst at, or at least not trying to do what they could be
best at. Most economists would probably think that protectionism is not exactly a good idea.

Two concepts of “advantage”

Absolute advantage – this means a country can produce more of almost everything than another, i.e., it is a
wealthy country. The USA can produce more than Egypt for instance – clearly, the USA has an absolute
advantage over Egypt. It is of no particular interest as an idea: the rich are just rich!

Comparative advantage – this means that a country is better at producing something, but not necessarily
everything, than another. For instance, Sweden is better at making marine engines than the UK, but we are
better at organising financial markets and insurance. All countries are better at doing a few things more than
others.

Comparative advantage is the one that matters in economics and it is the main reason why countries trade
with each other. We do not simply buy pineapples from tropical countries because it is too cold to grow
them here. We could in fact grow them under glass and with heating, but we clearly lack a comparative ad-
vantage in the pineapple producing business. Hawaii on the other hand has a strong comparative advantage
in that area.

The gains from trade

If a country tries to produce everything for itself, it will stay poor. Examples: China under Mao Zedong and
Russia under Stalin both followed such a policy and the people suffered a very low standard of living as a
result. The message is that trade helps the people in a country to gain wealth!

6
The gains from trade consist of:

· Comparative advantage – we do what we are best at and thus produce more. We then exchange our
surplus with other countries for something we are less good at. Both the other countries and our
country do better and enjoy higher living standards as a result.

· Economies of scale – if we specialise we can follow a system of mass production, and lower our
costs. We can then exchange the surplus with other countries. Economies of scale are examined in
Unit 2.

· We can gain wider consumer choice e.g., we can drive Volvos, Renaults or BMW’s, as well as lo-
cally-made Fords!

7
1-2. DEMAND AND SUPPLY: INTRODUCTION

(Abbreviations: S = “supply”; D = “demand”; Y = “income”; r = “rate of interest”)

At the equilibrium price, the quantity demanded just equals the quantity supplied. There are unsatisfied con-
sumers who could not buy at that price even though they were willing. What do we mean by equilibrium?
Equilibrium is the state of affairs in which there is no tendency to change. How do we show this equilibrium
price? We use demand and supply curves.

Demand
What is the demand curve? It is a curve showing the quantity that will be bought on the market at different
prices.

The lower the price, the more will be demanded; the higher the price the less will be demanded. Think! If
all Nike trainers were £2 a pair, would you buy more than if they were £200 a pair? It seems probable!

Price

D So the demand curve is drawn sloping down-

ward, left to right. Examine the one here - at a
high price, high up on the price axis, little is de-
manded as we trace a line down to the quantity
axis. But at a lower price, a greater quantity is
demanded.

Quantity
0
In economics, “demand” means demand is backed by money – it is not just a need or a desire, but people do
have the money to buy and are prepared to buy.

Supply

What is the supply curve? The supply curve is a curve showing the quantity that will be offered on the mar-
ket at different prices. We believe that higher prices cause more people to sell. Imagine: in your classroom,
if I offer to buy each T shirt for £500, almost everyone will sell to me; but if I offer £1 each, probably few if
any would be willing If however I were to offer £7, more would sell but probably not everyone. That is why
the supply curve slopes upward.

8
 Price
S

Quantity
0

Let’s put both the demand and supply curves on the same diagram .

Price
D S

Quantity
0 Q

Guess where the equilibrium price will be? Right! Where the two curves cross! As said earlier, at the equi-
librium price, the quantity demanded just equals the quantity supplied. There are no unsatisfied consumers
who could not buy at that price even though they were willing and everyone who wanted to sell at that price
could do so. This happy situation happens at the intersection of D and S with price P and quantity Q.

When I started in economics, I had to chant along with the rest of the class: "price is determined by supply
and demand!” It certainly made it stick in my mind and might help you too!

Let us return and look at demand in more detail (We’ll look at supply later too)
9
What determines the D curve? i.e., why is it where it is and not somewhere else?

Price

D here? Or why not here?

D D
Quantity
0

1. There are four main personal determinants of demand

· Income
· Taste
· Prices of other goods or service
· Expectations about future prices of this good or service

2. AND several other market determinants

· Income distribution - if you think of all the other people in your house and you as you are now, then
if you suddenly got all the total income and savings and the others had none, there would be a dif-
ferent pattern of demand from what it is now. They probably do not eat lunch every day if they have
no money. It is the same in society in general: change the income distribution and a new pattern of
demand curves follows.

· Wealth distribution (as opposed to income distribution). If 10% of the population have 90% of
the wealth, probably more Porsche motor cars will be demanded than if we all have the same rather
lowish amount!

· Population size - the larger the population, the bigger the demand, ceteris paribus. That is a Lat-
in tag meaning “all other things remaining the same” and you might come across it in a lot of eco-
nomics books.

· Population age distribution - if there are many old people, important demands in society will be for
medicines, hip replacement operations and Zimmer frames but fewer Beastie Boys CDs, or prams.

· The interest rate. This is especially important for house purchases, motor cars, long-life consumer
goods often on a credit card, or hire purchase generally. A higher rate of interest means more to re-
pay, so people tend to borrow less.

What can cause a shift in the demand curve? (= a 10

new curve)
A change in any of the above determinants of demand will do it!

If demand increases, overall, more of the good/service is bought at any unchanged (the same) price. You can
see this in the diagram below, where at P1 an amount OQ1 is demanded, but after demand increases to D2,
at the same price an large amount is demanded, i.e., OQ2. It is easy to remember what “an increase in de-
mand” means; there must be a new curve and it will move upwards and to the right.

Price
D1 D2

Quantity
0 Q1 Q2

The effects of an increase in demand are usually analysed using the equilibrium positions determined by the
intersection of demand and supply.

Price

D1 D2 S

P2
P1

Quantity
0 Q1 Q2

You can see that the increase in demand means we move from the equilibrium position P1Q1 to the new
equilibrium position P2Q2. More is demanded - we shift from the position Q1 to the position Q2, so the dif-
ference (OQ2 minus OQ1) is Q1Q2.

11
The way the diagram of a shift in demand is drawn,(shown not moving to the new equilibrium, so
you can see that more is demanded at the same price)

Price Price Price Price

S1 S1 S1

P1 P1

D1 D1 D1 D1 D2
Quantity Quantity Q1 Quantity Q1 Q2 Quantity

The way the diagrams are built up should be reasonably clear by now. If you have any worries, check
back and examine those supplied earlier. The general principles are:

1. Draw the axes and label them immediately (“one axis, two axes”).
2. Put in the first curve and label it.
3. Add the second curve and label it.
4. Draw the equilibrium position – preferably using dotted lines.
5. Make the necessary changes, such as shift a curve inwards or outwards by drawing a new curve and la-
belling it.
6. Draw the new equilibrium position – preferably using dotted lines.
7. And finally you compare the new equilibrium position with the first one, using your own words but trying
to get in the necessary jargon phrases such as “increase in demand”, or “economic growth”, whatever is
relevant to the question you are tackling.

Henceforth I shall not be supplying the series of pictures showing how the diagrams are built up, as you
should be able to follow the above principles for yourself. Before long, it will become second nature to ex-
amine a finished diagram and work out how it was built up.

If demand decreases, the demand curve shifts the other way, downward and to the left. Again we have a
new curve, as in the diagram below.

Price
D2 D1

Quantity
0 Q2 Q1
You will notice that less is bought at any given price, such as P.
12
Again, a decrease in demand is usually analysed by determining the new equilibrium position and the com-
paring it with the original one. For this we need to put the supply curve in.

Price

D2 D1 S

P1
P2

Quantity
0 Q2 Q1

As you can see, if demand decreases, then less is bought (as you might imagine!) and the quantity demanded
falls from Q2 to Q1; price also falls, in this case from P1 to P2

Let us look at supply in more detail

What determines the supply curve, i.e. why is it where it is and not somewhere else?

Price

S?? S??

Quantity
0

The answer is, the price, quantity, and quality of inputs used. These consist of things like machinery,
equipment, staff and workers, raw materials, and fuel. These are collectively known as “the factors of
production”, and are often summarised as land, (L) labour (N) and capital (K) plus a remainder term, R.
13
 · Land - is what it says but can include things like diamonds or oil that are found there.

· Labour mostly means workers, but also includes managers.

· Capital means machinery and equipment. A subset of this is“social overhead capital” - like roads,
bridges and docks.

[Digression: The whole production of the nation can be summed up as: O = f(L, N, K) + R
or put into words, “output is a function of (= is in some as yet undefined way caused by) land, labour, capi-
tal, and a few other things”. You will need this later; I am just sowing a few seeds.]

· The remainder term “R”, which covers things in both labour and capital is the really interesting one

The labour component of “R”. This consists of things like entrepreneurial ability, the managerial methods in
use, labour motivation and how good it is, labour skills, the strength of the trade union and its attitudes, the
bonus and other incentive systems in force, the quality of the education system, and the retraining facilities
available in society.

The capital component of “R”. This consists of things like:

The level of technology, knowledge about what technology is available, the adequacy of factory organi-
sation, and economies of scale. They can obviously affect the supply curve, or the output possible, if they
are good or bad.

· Maybe the weather, e.g. floods can destroy crops, effect transport, reduce supply, and raise
price.

· Joint supply - if we increase the number of sheep to supply an increased demand for mutton, it auto-
matically increases the wool supply. So the price of related good can be a determinant of supply.
Examiners like questions on joint supply, but it is not often encountered in the world in which we
live.

· The productivity of the factors of production – this is closely related to technology; but it can also be
how hard workers are prepared to work, motivation, and incentives systems etc. (it too can appear
separately, or be included in the remainder term, R, as above).

· The size and number of firms in the industry, including the marketing conditions.

· War and social unrest.

What can cause an increase or decrease in supply?(a shift in the curve)

Like demand, it needs a change in one or more of the determinants. For supply these include things like:
· A change in the price of a factor of production.
· A change in the productivity of a factor.
· New technology invented.
· The discovery of a new raw material or fuel.
· More worker enthusiasm. This occurs often in war time, because of patriotism.

An increase in supply = the curve shifts downward and to the right (more is supplied at the unchanged
price) - e.g., if labour productivity increases or someone finds a new cheap source of materials.

14
 Price

S1 S2

P1

Quantity
0 Q1 Q2

You will notice that the quantity supplied at the unchanged price P1 increases - well, that’s what an increase
in supply does!

And if we put in a demand curve we can see both the equilibrium positions and work out that an increase in
supply means a fall in price and an increase in the quantity purchased.

Price

S1 S2

P1
P2

Quantity
0 Q1 Q2

15
A decrease in supply is the opposite; the supply curve shifts up and to the left:

Price

S2 S1

P1

Quantity
0 Q2 Q1

Again, less is supplied at any chosen price; we move from a supply of OQ1 to the smaller quantity OQ2.

The new and old equilibrium positions need both a supply curve and a demand curve.

Price

S2 S1

P2
P1

Quantity
0 Q2 Q1

More analysis! A decrease in supply means a fall in the quantity supplied and an increase in price. Work out
for yourself the old and new quantities and prices - good practice!

16
Time Periods And Supply

Three time periods matter:

· the very short run (VSR) (or “momentary supply”),

· the short run (SR) , and
· the long run (LR).

They have different slopes to their curves and different elasticities (more later!).

The very short run. This is defined as the time when no change can be made in any of the factors of produc-
tion – the supply curve is vertical. Examples are the fruit and vegetables that appear in the wholesale market
each day.

The short run.

This is defined as the period in which the variable factors can be altered but not the fixed factors, i.e. we can
make some changes.

· Fixed factors = those that do not vary with output such as factory building, transport fleet, office
staff, and the bill for heating and lighting the premises.

· Variable factors = those that vary directly with output such as raw materials, the energy used, the
petrol in the trucks, and the wages of some unskilled workers who might be taken on when
needed, perhaps part-time.

The supply curve we usually draw is the short run one.

The long run

Is defined as the period when all factors can be varied i.e., the producer can do any changes s/he wants. This
means a flatter curve, possibly even downward sloping sometimes.

How the supply curve can vary with the time period we are considering:
The flatter the curve, the more elastic it is (“quantity stretches more”). Producers will only make changes
that help them produce more or reduce costs.

Price
S very short run S short run
totally inelastic fairly inelastic

S short run close

to unit inelastic

S long run
high elasticity

Falling long run S curve

(modern hi tech goods for example
get cheaper over time)
Quantity
0

17
NOTE that all the curves are drawn on the one diagram; this means the scale is the same for all; if you draw
each in a separate diagram, the flatter one (S long run) is not necessarily the most elastic, as the horizontal
axis might be on a much wider scale. If this seems incomprehensible to you, Do Not Worry! Just remember
to put them all on the same diagram.

Remember that you should practise drawing the diagrams regularly!

Increases and Extensions of Supply And Demand

We know that the word "increase" means a shift of the curve – but what about extensions?

"Extensions" are movements along an existing curve.

Questions are often set to see if you know the difference between an ”increase” and an “extension”.

[A digression: if a line crosses two others, an increase in one curve always means an extension of the other!
The diagram here shows that.

We see two upward

sloping lines that cross a
single line. The upward
sloping lines reflect an
increase (or decrease)
and we slide down (or
up) the single line.

For supply and demand:

With an increase in demand we slide up an unchanged supply curve.

Price

S1

The shift of D1 to D2 is
P2 an increase in demand
It’s clear that an increase in de-
P1 The sliding up the unchanged mand goes with an extension of
S curve is an extension of supply supply.

D1 D2

Q1 Q2 Quantity
18
NOTE that we start on demand curve D1 and supply curve S1 to ascertain the equilibrium price and
quantity; then we look at D2 to get the second equilibrium position.

Reminder: In economics, at this level we always start in equilibrium, then we alter something, and move to
the new equilibrium position. We then compare the two equilibrium positions for the analysis.

And we can see an increase in supply goes with an extension of demand, as we slide down an unchanged
demand curve:

With an increase in supply we slide down an unchanged demand curve

Price
The shift of S1 to S2 is
S1 S2 an increase in supply

P1 Sliding down the unchanged

P2 D curve is an extension of demand

Quantity
0 S1 S2

Decreases and contractions of supply and demand

A decrease means a new curve, which shifts backwards; a contraction means sliding back along an un-
changed curve.

A contraction of demand following a decrease in supply :

Price
The shift of S1 to S2 is
S2 S1 a decrease in supply

P2 Sliding up the unchanged D curve

P1 is a contraction of demand

Quantity
0 S2 S1

19
A contraction of supply following a decrease in demand

Price

S
The shift of D1 to D2 is |
a decrease in demand

P1
P2 Sliding down the unchanged
S cuve is a contraction of supply

D1
D2
Quantity
0 S1 S2

Here is one of the hoary old trick questions. "Demand increases, so price rises. The rise in price means
fewer can afford the good, so demand decreases and prices fall again." Do you agree with this statement?

Question: what do you think?

At first glance it might seem to make sense. But it is in fact false!

Why is it false? You draw the diagram now on a piece of paper. First increase the demand curve and
you will see the price rise as we extend up the supply curve.

Then think about the new equilibrium. Why on earth should it change? It is an equilibrium position!
That was why you learned the definition of equilibrium a little while ago - to be able to detect fallacies
in argument.

This is a proposition in logic, designed to test if you really understand supply and demand. You should
try to get the words “extension” and “increase” in to show you can use them properly and you definitely
need a diagram.

1-4. THE CONCEPT OF ELASTICITY: MEASURING THE

RESPONSIVENESS OF DEMAND AND SUPPLY (very popular with examiners)

ELASTICITIES

Elasticities are a sort of measure of supply and demand.

If demand increases, and we ask how much does supply extend, we need more than an answer like
"quite a lot"!! Government may be trying to raise tax to get a certain amount of revenue for instance.
The question is “How much will quantity change, a lot or a little?”

20
WE START WITH THE ELASTICITY OF DEMAND

Three broad types of elasticity of demand

1. Price elasticity = the usual one, it deals with 1 good.

2. Cross elasticity = a special one, it deals with 2 goods.
3. Income elasticity = a special one and it deals with changes in incomes.

1. Price Elasticity of Demand

Definition: "Price elasticity of demand is a measure of the responsiveness of the quantity demanded
to a small change in price". Learn this by heart!

[In simpler terms, “is the proportional change in quantity greater or lesser than the change in price?”
As an example, if the price was 20 and it falls by 2, the fall is 10% (2 times 100, all divided by 20); and
if quantity then increases from 100 to 200, the increase is 100%.
We can see that the increase in Q is greater (100% compared with 10%) - i.e., it stretches out a lot - it
is elastic!]

How do we actually measure price elasticity?

Price elasticity of demand is measured by the percentage change in Qd, divided by the percentage change
in price:
%∆Qd
%∆P

So the price elasticity of demand is:

∆Q
Q
------------
∆P
P

= ∆Q x ∆P (to divide by fraction invert and multiply)

Q P

(gathering the change terms all on side for neatness. If

= ∆Q x Q this shuffling makes you unhappy, just remember that
∆P P 3 x 4 is the same as 4 x 3)

21
In the example above, the percentage change in Q was 100 and the percentage change
in price was 10 so the elasticity is 100 divided by 10 = 10.0 In the world in which we
live this is actually very high! (Anything over 2 in the real world is pretty high.)

Logically the answer can have only 1 of 3 results: <1, = 1, or >1

(< stands for “less than”; > stands for “more than”; if we are looking at “<” left to right, the way we read,
we see it goes little to big so it is easy to remember!)
When we look at the fraction, we find that the answer is less than 1 if the top is smaller than the bottom,
equal to 1 if the top and bottom are the same, or more than 1 if the top is greater than the bottom.

What does each possible answer mean?

a] If the answer is greater than 1 (e.g., 1.62) the demand curve is elastic.
It means that a small change in price led to big change in quantity (Q stretched a lot which means that
it is elastic); graphically the curve tends to look flat when compared with an inelastic curve. But
remember all curves must have the same scale and axis or else be on the same diagram.

Examples of demand curves which are price elastic:

Dell computers (one brand of many substitutes); foreign travel by cheap airlines.

b] If the answer is less than 1, e.g., 0.75, the demand curve is inelastic People do not respond so
much to price cuts and although they buy more, they do not buy a lot more.

Examples:
Salt, bread, sets of cutlery (essentials; no substitutes).

c] If the answer just happens to equal 1 it is “unit elastic” (unity = 1), a special case and rarely seen,
except perhaps for a small part of a large demand curve! The answer would work out at exactly 1.0 and
the curve is asymptotic; this means that it approaches more and more closely but never quite reaches the
axes.

Reminder: if you draw one rather flat demand curve in one diagram, demand is actually only
relatively elastic etc because we do not know the scale - don’t worry about it, it’s technical!
Just remember to say “relatively inelastic” or “relatively elastic” in the exam room! If you
draw them on one diagram then you are on safer ground if you just say “elastic”.

What do the different elasticity demand curves look like?

Price

Elastic D

[The unit elastic de-

mand is not drawn well Inelastic D
- I am a rotten artist I
fear.]
Unit elastic D
(not well drawn!)
Quantity
0
22
The importance of the elasticity concept

It allows us to get precise answers, not be vague.

We need it for certain questions e.g., if a hairdresser is considering increasing her price for a basic cut from
£20 to £25, will profits rise or fall?

What determines price elasticity?

· The number of substitutes - the greater the substitutes, the more elastic the good - a small price
rise means consumers switch to another brand. THIS IS THE MAIN DETERMINANT!

· The proportion of income - the greater the proportion of income going on good, the more elastic
it tends to be. Salt is relatively inelastic and very cheap - would you consume a £2’s worth a year?

· Luxuries and necessities - luxuries tend to be more elastic (airfares, foreign travel); necessities
more inelastic (electricity). Some economists do not like this “luxuries” point because what
constitutes a luxury alters too much and in addition they can be personal to different individuals.

· Time - the longer the time, the more elastic demand tends to be, probably because
· More substitutes become available , the good or service is copied by others, new manufac-
turers can enter, imports be made etc.
· Habits change only slowly, so we adjust to new prices slowly.
· Capital may need to wear out to make change, e.g., if the price of petrol rises, drivers have
to wait until it is time to buy a new and smaller car in order to reduce petrol consumption.

Q. For the hairdresser earlier who is considering a price rise, I asked earlier what would happen to her profit if she
charged more. Assume she is very good and her clients feel that there is no real substitute?

A. The demand curve for her services is inelastic so profit would rise!

Q. But consider what would happen if she were just another high street hair dresser?

Draw the diagram for me now!

Another example of the importance of elasticity: if the government raises the tax on cigarettes, will
government revenue rise or fall? And by how much?
The government normally wishes to raise more revenue - although there are health benefits if people
reduce cigarette consumption, which saves on National Health Service expenditure too.
If the government raises tax by 5% and demand is inelastic, the quantity will fall as price rises, but it
will fall by less than 5%, so revenue will increase.

If the government imposes an indirect tax, it pushes up the supply curve by the exact amount of tax.

If the tax is absolute e.g., £1 each item, it pushes the curve up parallel. The original producer faces no
change in supply conditions, but £1 is added to each quantity.

23
When we draw the diagram for the imposition of indirect tax: we start at the original equilibrium, and
add the tax.
Price

S2 S1

P2

P1

Quantity
0 Q1

When we look at the market equilibrium, we start with a supply and demand curve and see the original
equilibrium. We then add the tax, which pushes up the supply curve and look at the new equilibrium
position, to see what changes the tax has made.
Price

S2 S1

Note that the supplier works

on the original S1 curve - the
P2
S2 curve merely includes the
P1
government tax.

Quantity
0 Q2 Q1

We can see that the original equilibrium position P1Q1 becomes P2Q2 once the tax is imposed. There
is a rise in price - but by less than the whole tax - and there is a fall in quantity.

Price

S2 S1

P2 C
P1
B
A
D

Quantity
0 Q2 Q1

The increase in tax per unit is AC, but the price only goes from P1 to P2 = BC; and BC is less than AC
(price rises but by less than the whole amount of tax per unit)
24
What about the change in government revenue? This is the quantity now sold (OQ2 at the new
equilibrium position = the number of units) times the tax per unit (AC). This is the area bounded by
P2CAP3 in the diagram below.
Price

S2 S1

P2 C
P1
B
P3 A
D

Quantity
0 Q2 Q1

If the indirect tax is ad valorem (proportional not absolute, e.g., 10%) it pushes up the supply curve
at an increasing rate

Q. Why?

A. Because 10% of £1 is only 10P, but 10% of £10 is £1!

Price
S2

[Not very well drawn = S1

my inadequacy as an artist] C
P2
P1 B
A

Quantity
0 Q2 Q1

25
 Price

S2 S1

P2 C
P1
B
A
D

Quantity
0 Q2 Q1

The government revenue is the quantity now sold (OQ2 at the new equilibrium position = the number of
units) times the tax per unit (AC). This is the area bounded by P2CAP3.

If the indirect tax is ad valorem (proportional not absolute, e.g., 10%) it pushes up the supply curve
at an increasing rate

Q. Why?

A. Because 10% of £1 is only 10P, but 10% of £10 is £1!

Price
S2

S1

P2 C
P1 B
A

Quantity
0 Q2 Q1

26
A subsidy is just a negative tax e.g., government gives producer some money (subsidy) rather
than a producer or consumer giving money to the government (tax).

Subsidy questions are not usually as interesting as tax ones!

Let’s draw the diagram for putting on a subsidy.

Price

S1 S2

P1

P2
D

Quantity
0 Q1

We start, as ever, in the initial equilibrium position, P1Q1 on the curves S1 and D1. The subsidy goes
on, the size of it is P1 to P2, and the new supply curve is S2. You can see that the unchanged quantity,
Q1, is now cheaper at price P2- but we have not yet examined the new equilibrium position to see the
results of the change.

What is the total amount of the subsidy, i.e., the cost to the government? We need to look at the new
equilibrium position, which will be at P2Q2, below.
Price

S1 S2

A
P1
P2

B
D

Quantity
0 Q1 Q2
27
The subsidy is AB for each unit in the diagram above.
The quantity sold after the subsidy is imposed is OQ2.

So how much does the subsidy cost the government, and ultimately the tax payer?
Price

S1 S2

P3 D
A
P1
P2 C

B
D

Quantity
0 Q1 Q2
The subsidy the government pays is the new quantity sold, (0Q2) times the subsidy amount per unit of
BA.
We know that BA is the same as CD because the curve shifts parallel.
We know that the suppliers continue with curve S1, so they require price 0P3 for quantity 0Q2 (Note
that the supplier works off the original supply curve - there has been no change in the determinants of
his or her supply.)
We see that consumers pay the rectangle 0Q2CP2.
We see that the government pays the rectangle P2CDP3 - this is the subsidy cost to the tax payer.
And together these add up to the total expenditure of 0Q2DP3.
Notice also that consumption rises from 0Q1 to 0Q2 - which is the point of the subsidy: more is pro-
duced and consumed.

The limits of price elasticity of demand

Perfectly elastic = a horizontal line; this means that consumers will demand an infinite amount at that
price! It is merely a limit and obviously it cannot be reached.

Perfectly inelastic = vertical line; this means that consumers will pay any amount at all, such as £1, or £1
million, or £1 trillion…. to buy the good or service. Again this is unreasonable, it’s merely a limit. They
look like this:
Price
Perfectly inelastic demand

Perfectly elastic demand

Quantity
0
28
2. Cross Elasticity of Demand

Definition: "Cross elasticity of demand is a measure of the responsiveness of the quantity demanded of
one good or service to a small change in price of another". Learn this! It is virtually the same as the
definition of price elasticity earlier - go on, compare them now!

Cross elasticity measures substitutes and complements (note the spelling; it is not “compliments”)

If the supply of beef increases so the equilibrium price falls, it may induce some people to switch from
eating chicken or pork to eating the now cheaper beef. The fall in price of beef causes a decrease in
quantity demanded of chicken or pork.
%∆Qd of good A
%∆P of good B

Note the “A” and “B” difference: we are dividing the percentage change in the quantity of A by the
change in the price of B.
If the price of beef fell and the quantity of chicken fell the answer will be positive, because two negatives
make a positive, so any items with a positive cross elasticity are substitutes.
If the price of heating oil falls it may induce some to install oil generated central heating in houses. We
see that a fall in the price of A means an increase in the quantity of generators, so the answer is nega-
tive (one plus and one minus) so these two goods are complements.

Cross elasticity does not seem to be used much in economics, except in exams.

3. Income Elasticity of Demand

Now this is most important! Incomes keep increasing over time, so the demand pattern for various goods
and services keeps changing. This matters for new firms looking to move into the market and produce
something: the market for what goods or services is likely to grow the fastest? That’s the area to be in! It
matters for existing firms looking to diversify, or be concerned about the prospects for the future in the
area they produce and sell in.

Definition: "Income elasticity of demand is a measure of the responsiveness of the quantity demanded
of a good or service to a small change in income". Learn!

Income elastic: a given change in income leads to a greater than proportionate increase in demand for
the good or service. Examples of income elastic goods: foreign travel, good wines, smart motor cars,
eating in restaurants, and currently well-regarded brands, e.g., Adidas sportswear or Rolex watches.
Income inelastic: a given change in income leads to a less than proportionate increase in demand for
the good or service. Examples: bread, staple foods generally, cheap stores, and all lowly-regarded
brands. If our income happens to double (lucky us!) we do not spend twice as much on such items.

Income neutral elastic: should it just happen that, say, a 5% increase in income leads to a 5% increase in
demand for a good or service, then it is income neutral elastic. This is not really an interesting case,
merely a bit strange. Oddly enough, Pizza Hut in Australia claimed in the 1990s that they were like this:
in a recession some people stopped eating out so stopped going to Pizza Hut, but other people switched
from “proper” restaurants to Pizza Hut which cancelled things out, so the company did not suffer!

Income negative elastic: this is most interesting! This happens when an increase in income causes a fall
in demand. Really it indicates that we dislike this product but for some reason we must consume it at
the time. When we can afford not to consume it, then we stop buying it. Examiners like this concept!
29
Examples are scarce, but it is suggested that probably potatoes were like this in Ireland during the Nine-
teenth century. Currently, the demand for mealies (sweet corn) in some African countries may be in-
come negative elastic. It is a rare event anyway. Negative income elasticity means that it is an “inferior
good”.

THE ELASTICITY OF SUPPLY

Definition: the responsiveness of the quantity supplied to a small change in price. It is measured by:

%∆Qs
%∆P

The measure roughly indicates the slope of the supply curve; the steeper the more inelastic. Why is
this only “roughly”? Because it depends on the scale of the diagram - for instance both the diagrams
below have the same elasticity, but because the horizontal scale is not the same the slopes look differ-
ent. That is why we have to draw two different elasticities on the same diagram where the scale is the
same.
Price Price
S S
x x

x x
l l l l l Quantity l l l l l l l l l l Quantity
5 0
1 2 3 4 1 2 34 5 l l

BUT unit elastic supply is any straight line that cuts through the origin! (Just remember this, and do
not worry! If you are a mathematician, you may already see why.)
Price

Quantity
0

30
Supply periods and time: (covered briefly earlier)

Price
S very short run S short run
totally inelastic fairly inelastic

S short run close

to unit inelastic

S long run
high elasticity

Falling long run S curve

(modern hi tech goods for example
get cheaper over time)
Quantity
0

Very short run = totally inelastic supply = fixed supply (e.g., the amount in a wholesale vegetable
market delivered each morning; all the works of dead painters or sculptors).

Short run = perhaps moderately inelastic.

Long run = more elastic; or even negative elasticity (it slopes downward).

Why is supply more elastic in the long run?

Because the company can alter both the fixed and variable factors (i.e., all the factors of production). It
can also find new or cheaper sources of raw materials; improve the training of labour; and introduce
new technology or better machines. This allows the company to obtain more output without needing
much increase in price.
The downward sloping supply curve in the long run is already familiar to you: computers, scanners,
TV sets, digital cameras, DVD players and discs, CD players and discs….. Most if not all of the prod-
ucts of modern hi-tech industry fall into this category. As the years go by, they get better and a lot
cheaper.

Elasticity of supply is probably a bit less interesting to economists than the elasticities of demand - and
it is easier to learn as there is less of it!

31
1-5. DEMAND AND SUPPLY: APPLICATIONS TO ANY MARKET ARE POSSIBLE

Popular ones that examiners often like to set a question about include:
· Housing
· Foreign exchange
· Agricultural products or raw material production, like tin or coal (often inelastic S and D so fluc-
tuations are common)

But the analysis is virtually identical in each case! You need to mention supply and demand very early in
your answer and then use supply and demand analysis, drawing the curves you need.

Be prepared to handle:

· The concept of equilibrium

· The determinants of supply and of demand
· An increase in demand and a decrease in demand
· An increase in supply and a decrease in supply
· An extension of both demand and supply
· The elasticity of demand and supply
· Minimum price fixing (examined in Unit 2)
· Maximum price fixing (examined in Unit 2)
· Applying an indirect tax (which shifts S curve up and to right).

An example of foreign exchange

You must use a diagram or two!

The value of a currency is determined by the supply and demand for it - just like any other good or
service, it is the normal equilibrium diagram you need.

The supply of £’s comes from the UK importing goods and services from abroad. We pay in pounds to
a bank, which uses them to buy the US $ etc. that we need to pay the foreign supplier. If we import more,
we increase the supply of pounds on the market, thus putting pressure on the pound to fall in value.
Similarly, if we export, we buy the pounds back, thereby increasing the demand for pounds.

You could usefully practice drawing diagrams to fit these scenarios. They are the standard increase in
supply and decrease in supply diagrams, but with “Quantity of £” on the horizontal axis and “Price of £
in $” on the vertical one. We have to value the pound in some other currency, such as US$.
Value of the
pound in $
S1

($)P1

D1
0 Q1
Quantity of pounds in
international markets
32
If the UK increases its imports, this puts more pounds on the international markets as we pay for the
extra imports. This means an increase in the balance of trade deficit. This increase in supply then puts
pressure on the value of the pound, which falls.

Value of the
pound in $
S1
S2

($)P1
($)P2

D1
0 Q1 Q2
Quantity of pounds in
international markets

If foreign holders of pounds, largely banks but also others such as large international companies as
well as international speculators, decide the pound is overvalued and about to fall, they might sell. The
results are the same: the increase in supply reduces the value of the pound. This may be termed “self
justifying expectations”.

An example of the labour market.

If the UK allows more migrants in, this increases the supply of labour. Because many migrants are
relatively young males, they add to the supply of labour, normally producing more than they take out
in social security benefits.

The increase in the supply of labour puts pressure on to lower wages, especially for the unskilled or
semi-skilled. It is difficult for many migrants to find more professional work unless their English is
good; they tend to end up in the unskilled sector, even if they have skills and abilities, until their lan-
guage skill improves sufficiently and this can take many months or years.

The result is the normal diagram for an increase in supply, in this case of labour. You need the quantity
of labour on the horizontal axis and wages on the vertical. Go on, draw it now!

Remember! You must use diagrams to answer questions about price or wages. Many markers glance at
the diagrams first and if they are correct, he or she is immediately disposed to give you a good mark and
a decent pass! If your diagrams are clear and correct, they might also give you the benefit of the doubt
if they have trouble with your handwriting or standard of grammatical English. In the exam room in
economics it is virtually impossible to get a good mark without diagrams.

33
1-6 LET’S RECAP AND SHOW THE MARKET MECHANISM WORKING IN ALL ITS
GLORY IN A PERFECT WORLD

In a perfect world, a market system will give a perfect result - resources will be allocated exactly to
where people need them to produce what the people demand.

Think supply and demand curves for two goods, both in equilibrium; assume people spend all their
money (as this is easier to imagine how it works). Then increase the demand for one good (which means
you must reduce demand for the other, because they are spending all their money by assumption).

First we look at the goods market - let’s assume they are bread and milk; we start in equilibrium, then
we will increase the demand for one good and see what happens.

Secondly, we examine the factor market which lies below the goods market. That consists of those
resources that are used to produce the bread and milk. We use the labour market as the factor of production.

We have simplified the model by using two goods and one factor to show the perfect workings of the
market. With any number of goods and services and more factors we can still get this perfect resource
allocation.

(The whole of Unit One in this course is devoted to this market solution. Unit Two will explain why we
may not in fact attain this theoretical perfection.)

Abbreviations used:

MC = marginal cost
AC = average cost
P = price
Q = quantity
MR = marginal revenue
Lab = labour
AR = average revenue
PPC = production possibility curve (production frontier)

34
We start with the market for goods or services (bread and milk) in equilibrium

Bread Milk
Price Price
D S D S

P P

Quantity Quantity
0 Q 0 Q

And we can also examine the factor market for these goods; in this case we will use the people who make
the bread and produce the milk (Unit 4 covers labour markets in detail). Again we start in equilibrium.
(The two diagrams below do not have to look exactly the same as the two above; they just have to be
normal supply and demand curves.)

Bread workers Milk workers

Wage Wage
D S D S

W W

0 Qlab 0
Quantity Qlab Quantity
of labour of labour

35
THEN, WE CHANGE SOMETHING AND ALTER THE EQUILIBRIUM POSITIONS
let’s increase the demand for bread and reduce the demand for milk. (On the assumption that all in-
come is spent, if people spend more on bread they must spend less on milk.) We start as usual in equi-
librium, on the demand curve for bread, “D1” and increase it to “D2”. People switch to consuming
more bread and away from milk, so the demand for milk falls, from D1 to D2.
Bread Milk

Price Price
D2
D1 S D1 S
D2

P2
P1 P1

P2

Quantity Quantity
0 Q1 Q2
0 Q2 Q1

You can see on the left that the price of bread rises (people demand it more) and on the right the price of
milk falls (less demand).
Because of this change in the demand pattern, we get an increase in the demand for workers to produce
more bread and a fall in the demand for milk workers - and we will reach a new equilibrium in the factor
market.

Again, demand increases from “D” to “D1” for the bread workers, and falls from “D” to “D1” for the
milk workers.
Bread workers Milk workers

Wage Wage
D2
D1 S D1 S
D2

W2
W1
W1
W2

0 Qlab1Qlab2 0 Qlab2 Qlab1

Quantity Quantity
of labour of labour

You can see on the right that wages rise where demand for the product has increased (bread), and on
the left they fall where the product is less in demand than previously (milk).

36
We can put changes in goods/services market and factor markets together into one diagram, one directly
above the other and read it vertically to see what happens to the factors of production in both industries
as demand changes.

Bread Milk

Price Price
D2
D1 S D1 S
D2

P2
P1 P1

P2

Quantity Quantity
0 Q1 Q2 0 Q2 Q1

Trace the lines down

from the equilibrium
Bread workers Milk workers positions in the goods
market to the corre-
Wage Wage sponding equilibrium
D2
S
in the labour market
D1 S D1
D2 for the workers need-
ed to produce the
W2
quantity in the top di-
W1 agrams
W1
W2

0 Qlab1Qlab2 0 Qlab2 Qlab1

Quantity Quantity
of labour of labour

We see, as the demand for a good or service increases (top left hand side), this sucks factors into that
industry - but where do they come from?

They come from the contracting industry, where the demand for a good or service has decreased (top
right hand side) - the factors of production (land, capital and workers) have to leave that industry (in
the real world, if unemployment already existed, some of the unemployed might be drawn into work).

Where demand for a good or service falls, the workers might simply be dismissed - which really
annoys
people, upsets the trade unions, and might have a political fallout with loss of support for the government.

Or the firms may take advantage of “natural wastage”; that is to say that is to say, as people voluntarily leave,
they are not replaced.

37
Who leaves? Several groups may be involved:

· old workers who are retiring because of age

· those who get ill and retire
· those resigning and moving to a better job as part of a career move
· those who move to a new area of the country, following their spouse, to get to a better climate
or school area for instance
· those who migrate to a different country
· those who die

Unemployed people are naturally very upset and social problems can emerge which the government
may have to deal with. But with capital, e.g., trucks, or warehousing facilities, shifting the use of these
causes little upset - things have no feelings! They may be sold or leased to other companies to use.

Land is similar to capital, it can often be transferred to several other uses fairly easily.

The above diagrams of resources moving from declining sectors to expanding ones and stopping
in equilibrium demonstrate the way the market mechanism (price mechanism) operates.
This was first spotted by Adam Smith in the Wealth of Nations as early as 1776 although the diagrams
did not come until later. Understanding how an economic system works in this fashion led to the phrase
“the consumer is king” as the next sentence explains.

Resources (land, labour and capital) flow from where they are not in demand, or demand is falling, to
where they are in demand, or demand is rising. So the price mechanism is well-regarded as a good (but
by no means perfect) way of allocating resources to society’s demands.

Later, in Unit 2 “Why markets fail” you will learn what can, and actually does, go wrong with this
apparently brilliant market system.

A reminder: are you revising something and practising drawing a few diagrams each day?

38
1-7 CONSUMER AND PRODUCER SURPLUS
We know that there is an equilibrium market price at which both consumers buy and suppliers sell. But
what about the consumers and producers who are not themselves exactly at that equilibrium price? They
receive a benefit.
For consumers, we can see from the demand curve that the first consumer, buying at 1 on the quantity
axis, would be willing to pay P1, which is much more than the market price he or she has to pay (P mkt).
So the column above P mkt is a sort of surplus that the first buyer enjoys!
Price

D
P1
This triangle is the
consumer surplus

P mkt

Quantity
0 123 Q

Similarly, for the second buyer, at 2 on the quantity axis; and the same goes for the third and subsequent
buyers until we get out to Q1 and P Mkt. All these early consumers would pay more but do not have to
do so - and they gain a lot of extra enjoyment as a result. Eventually the whole triangle above P Mkt is
filled in; and the filled in bit of this triangle, indicated by an arrow, is the consumer surplus.

For producers, we have an analogous argument. Some would be willing to supply more cheaply than
the equilibrium price, P Mkt. In the diagram below, we can see from the supply curve that the supplier
of the first unit would be happy to do this at a price well below P Mkt. The column above quantity 1 up
to P Mkt is again a sort of extra or surplus - which in this case belonging to the producers.

Moving to quantity 2, again we can see a column, but a bit smaller than for quantity 1. And as we move
out towards Q1, the triangle above the supply curve but below P Mkt is filled in. The arrow again points
to it. This is “the producers’ surplus”.
Price
This triangle is the S
produce surplus

P mkt

P1

Quantity
0 123 Q1
39
If we put the two diagrams together, we can see that both the triangles thus make up the total con-
sumer surplus and the producer surplus.
Price
S

This triangle is the

consumer surplus
P mkt

This triangle is the

producer surplus
D
P1

Quantity
0 123 Q1

Use of the concept

With indirect taxation, the imposition of a tax (or if there already is such a tax, an increase or decrease
in such a tax) may impinge more on consumers than producers - or vice versa! “Who gains the
most (or who loses the most)?” is the question. This may be called “the incidence of taxation”, “the tax
burden”, or a question may be asked, such as “who bears the brunt of the tax?”

The answer as to who gains or loses the most depends on the elasticities involved.
Let us assume that an indirect tax on a good increases. If demand is highly inelastic (consumers will
pay almost any high price without reducing consumption much) then the increase must largely fall on
these consumers - they are simply willing to pay!
We know they are prepared to do so because the demand curve is relatively inelastic and that is what
inelastic demand means. Cigarettes probably fall into this category, as do all addictive drugs.

Think of a vertical demand curve: if we increase the tax, the supply curve just moves up; there is no
change in the quantity demanded; suppliers still receive the old price (reading off their supply curve S1;
the gap between S1 and S2 is all tax and goes to the government not to the supplier). There is clearly
no loss of producer surplus as their situation has not changed at all - and consumers pay all the difference:
Price
Perfectly inelastic demand

S2

P2 S1

P1

Quantity
0 40
It can be proved, but you can take it on trust, that if the elasticity of demand is lower than the elasticity
of supply, the consumer loses more than the supplier! In other words, it is the relative elasticities that
count.
The usual supply and demand situation divides the incidence of tax (who pays it, or more of it) between
suppliers and consumers - and of course the incidence falls heavier on the side which is relatively
inelastic.
You may get a question about the incidence of tax - or one about imposing (or increasing) an indirect
tax.

A reminder: in introductory economics we nearly always use “static equilibrium analysis” which means
we start in equilibrium, change something, and analyse the result.

Who then bears the burden of tax when an indirect tax increases? See the diagram below.

Price

Demand

S2

B
P2
S1
A
C
P1
D

Quantity
0 Q2 Q1
We start on the curves S1 and Demand, with the equilibrium price P1 and quantity Q1.

Then we add a tax (or increase an existing tax!) which shifts the supply curve up to S2, by the amount
of the tax. Any tax per unit shifts the supply curve up vertically; the tax is the line BD in the diagram
above.

Having made our change, we look at the result: consumers pay BC of the tax, and producers pay CD
of it. The distance CD is smaller than the distance BC, the consumer pays more of the tax, and we
also know that the elasticity of supply must be greater than the elasticity of demand!

We can also look at the areas and see the changes in both surpluses:
The consumer surplus reduces by ABC.
The producer surplus reduces by ACD.
In Unit 4, “Industrial economics”, we again use the concept of surpluses in our monopoly diagram. We
can show the deadweight loss of monopoly, as well as the loss of consumer surplus and the increase in
the producer surplus that results from the monopolist being able to set the quantity that he or she pro-
duces which results in the most profitable price possible. More of this later!

41
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