IGCSE MICROECONOMICS
DIAGRAMS
Unit 1
PPC – efficient/inefficient/attainable/unattainable
Production Possibility Curve AB shows
the different combinations of
producing wooden furniture and olive
oil when all resources are fully
employed. The area ABO represents
the potential total GDP of a country.
Production at points C & D (or any other
points on the PPC) is attainable (can be
reached) because all factors of
production are fully employed (no
waste or unemployed resources), so
any point on the PPC will be efficient.
Production at point F or any other point
inside the PPC is attainable. At point F
only part of all the resources available in the economy are used. The economy will have spare capacity.
However, production at point F will be inefficient because the factors of production are not fully
employed. The economy therefore wastes its potential almost like an athlete who runs the 100m in 15
seconds when he could do it in 10 seconds if he runs at maximum speed.
Production at point E is currently unattainable as the economy does not poses the quantity/quality of
resources to produce beyond the PPC. In the long run production at point E might be attainable if the
quantity/quality of resources can be improved.
PPC and economic growth
When the quantity and/or the quality of factors of
production increases, e.g. growth of the labour
force, increase in net immigration, higher level of
skills, greater investment in the economy, the
production potential of an economy will expand.
This growth in production capacity (potential GDP)
is shown by an outward shift of the PPC from PPC₁
to PPC₂
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Should the quantity and/or quality of resources
decrease, e.g. depletion of natural resources, net
emigration, the production potential (potential GDP)
of the economy will decrease, shifting the PPC
inward from PPC₁ to PPC₂
Contraction of production level
In this case the country does not have less or poorer
quality resources. Total production might decrease
because of a recession or fiscal/monetary contractionary
policy. Consequences of the lower level of production
might be an increase in unemployment or dis-investment.
Changes in production levels
This type of situation frequently pops up in
exams. The scenario will explain at which point of
production the economy currently finds itself,
then an event which will influence the level of
production is described. You are then required to
indicate at which point the economy will produce
after the event happened.
If current production is at C, it will move to D if
only factors of production benefitting the
production of consumer goods, e.g. an increase in
cotton production, is experienced. More clothing,
a consumer good, can therefore be produced.
Cotton cannot be used to manufacture capital
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goods, e.g. machinery or robots, therefore the quantity of capital goods that can be produced does not
change.
Production will move from C to E if resources to produce machinery/equipment/robots increases in
quantity and/or quality, e.g. more skillful robotics engineers become available. These engineers will not
contribute to producing more consumer goods, therefore the quantity of consumer goods produced
remain unchanged.
Production will move to point F if e.g. total investment in producing consumer goods and capital goods
increase. More capital goods and consumer goods can then be produced.
Re-allocation of resources
At point X on the PPC, 0C units of producer goods and 0A
of consumer goods are produced. If the economy wants to
produce more consumer goods it will need to re-allocate
resources currently used for producing producer goods to
producing consumer goods. This will be necessary as
resources are scares and on the PPC all resources are fully
allocated. If AB more consumer goods are required, CD
less producer goods can be produced. This will cause a
movement along the PPC from X to Y.
PPC and Opportunity cost
Because of the re-allocation of resources
mentioned above, the economy had to give up CD
producer goods to gain AB consumer goods. The
opportunity cost of increasing the production of
consumer goods from A to be is therefore CD
producer goods
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Increasing opportunity cost
If all resources are allocated to the production
of food, 1000 tonnes of food and zero units of
guns are produced. If the country wants to
produce guns and food, resources will need to
be re-allocated from producing food to
producing guns. If 1 million guns would be
required only 750 tonnes of food can be
produced. To allow the economy to produce 1
million guns, 100 tonnes (1 000 – 900) of food
will need to be given up. The opportunity cost
to produce 1 million guns is therefore 100
tonnes of food. If another million guns are
required only 750 tonnes of food can be
produced. The additional tonnes of food that
will need to be given up to produce an
additional million guns is therefore 900 – 750 =
150 tonnes of food. The opportunity cost to
produce the second million guns is therefore 150 tonnes of food. Likewise, to produce an additional
million guns (3 million), the opportunity cost will be an additional 200 (750 – 550) tonnes of food. The
opportunity cost to produce yet another million guns will be 550 – 300 = 250 tonnes of food.
The opportunity cost increases because resources are not evenly suitable to produce both good.
Constant opportunity cost
The diagram shows constant opportunity costs
because when you move from point A to point B
you give up 10 pizzas and when you move from
point B to point C you give up 10 pizzas. This
happens because all resources are evenly
suitable to produce both the goods.
Note that the curve is linear. Total possible output
for each of the two products need not be equal.
To produce 30 pizzas might require more of the
resources than to produce 30 Calzones. In this
case with the same amount of resources to
produce 30 calzones, you might only be able to
produce 20 or 15 or even 5 pizzas. The ratio of
number of calzones to number of pizzas produced
will, however, be constant
(A calzone is an Italian oven-baked folded pizza)
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Unit 2
Demand curve
The demand curve for a good or service represents the total
demand of all individual consumers’ demand for that particular
good or service.
The demand curve shows the quantity of a good or service which
will be demanded at different unit prices.
The demand curve slopes downwards which indicates that the
higher the price the lower the quantity that will be demanded.
As the price decreases, the quantity demanded increases. This is
known as the Law of Demand. It indicates that there is an inverse
relationship between price and quantity demanded.
Quantity demanded vs demand
Points A; B; C and D represents the quantity demanded at
different prices and Demand is the entire line with all the points
that make up the line.
Students should make sure they use these 2 terms, ‘quantity
demanded’ and ‘demand’ correctly as they have quite different
meanings.
Movement along the demand curve
This will be the result of a change in price
Contraction of demand
Based on the Law of Demand, when price increases, quantity
demanded will decrease. Contraction (decreasing in size) of
quantity demanded, will therefore cause a movement upwards
along the demand curve.
Demand, therefore contracts from Q to Q1 as a result of a rise in
price from P to P1.
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Expansion of demand
Based on the Law of Demand, when price decreases, quantity
demanded will increase. Expansion (increasing in size) of
quantity demanded, will therefore cause a movement
downwards along the demand curve.
Demand, therefore expands from Q to Q1 as a result of a fall
in price from P to P1.
Shifts of the demand curve
Reasons for shifts are also known as determinants or conditions of demand
Determinants are non-price factors that can cause the entire demand curve to increase or decrease (shift to
the right or shift to the left).
The Acronym INSECT can be used to easier remember the factors that would shift the demand curve

I = Income

N = Number of Buyers/Consumers

S = Substitutes – goods which can replace each other, eg Coca Cola and Pepsi

E = Expectations of Future Price

C = Complements – goods which are consumed together, eg cars and petrol

T = Tastes and Preferences
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Shifts to the right
Demand will increase (shift right) if:
I = Income increases ⬆️
N = Number of Buyers/Consumers increases ⬆️
S = Substitutes' prices increase ⬆️
E = Expectation of Future Price increases ⬆️
C = Complements' prices decrease ⬇️
T = Tastes and Preferences for that good increase
(for example, through advertising!)
When there is no adjustment of the price after the shift of
the demand curve to the right, quantity demanded will increase.
Shifts to the left
Demand will decrease (shift left) if:
I = Income decreases ⬇️
N = Number of Buyers/Consumers decreases ⬇️
S = Substitutes' prices decrease ⬇️
E = Expectation of Future Price decreases ⬇️
C = Complements' prices increases ⬆️
T = Tastes and Preferences for that good
decrease ⬇️
When there is no adjustment of the price after the shift of
the demand curve to the left, quantity demanded will decrease
Supply curve
The supply curve for a good or service represents the
cumulative supply of all individual suppliers of that good
or service. Also referred to as the market supply.
The supply curve shows the quantity of a good or
service which will be supplied at different unit prices.
The supply curve slopes upwards which indicates that
the higher the price the higher the quantity that will
be demanded. As the price decreases, the quantity
supplied decreases. This is known as the Law of
Supply. It indicates that there is a direct relationship
between price and quantity supplied.
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At price P₁, quantity Q₁ will be supplied. When the price increases to P₂, the quantity supplied increases
to Q₂.
Movement along the supply curve
Based on the Law of Supply, when the price increases,
the quantity supplied will increase too. If price
increases from P₁ to P₃ the quantity suppliers would
be willing to supply increases from Q₁ to Q₃ as more of
them them can benefit more from economies of
scale. It means they might be in a position to produce
more efficiently. The market therefore experiences
an extension (an upward move along the supply
curve) because the quantity supplied increases.
Similarly, if the price decreases from P₁ to P₂, the
quantity suppliers would be willing to supply would
decrease from Q₁ to Q₂ as some suppliers don’t find it
lucrative enough to supply such small quantities. The
market therefore experiences a contraction
(downward movement along the supply curve)
because the quantity supplied decreases.
Shifts of the supply curve
When there is an increase in supply (not quantity supplied), the supply curve will shift to the right. At every
price level, there is an increase in quantity supplied. When there is a decrease in supply, the supply curve will
shift to the left. At every price level, there is a decrease in quantity supplied.
The acronym R-O-T-T-E-N is a way to remember all of the non-price factors which will shift the supply
curve.

R - Resources

O - Other goods’ prices
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
T - Taxes

T - Technology

E - Expectations of the supplier

N - Number of competitors
Shifts to the right
If supply increases (shift to the right) it could be due to
the following changes:
R - Resources increase/improve ⬆️
O - Other goods’ prices decrease ⬇️
T - Taxes – indirect (and other government
regulations) decrease ⬇️
T - Technology increases ⬆️
E - Expectations of the supplier increase ⬆️
N - Number of competitors decrease ⬇️
When there is no adjustment of the price after the shift
of the supply curve to the right, quantity supplied will increase more than if price is adjusted
downwards
Shifts to the left
If supply decreases (shift to the left) it could be due to
the following changes:
R - Resources decrease ⬇️
O - Other good prices' increase ⬆️
T - Taxes – Indirect (and other government
regulations) increase ⬆️
T - Technology decrease ⬇️
E - Expectations of the supplier decrease ⬇️
N - Number of competitors increase ⬆️
When there is no adjustment of the price after the
shift of the supply curve to the left, quantity supplied
will idecrease more than if price is adjusted upwards
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Price determination
In a market economy, the price for a good or service will be
determined where the price at which suppliers are willing to sell =
the price consumers are willing to pay, i.e. where the demand and
supply curves intersect. This is called the equilibrium price. The
quantity traded at the equilibrium price is called the equilibrium
quantity
Dis-equilibrium
Dis-equilibrium occurs at a price higher or lower than
the equilibrium price.
At a price higher than equilibrium price suppliers wish to
sell a higher quantity than consumers are willing to buy.
There will, therefore be an over-supply or surplus
supply. The surplus is the difference between the
quantity supplied and the quantity demanded.
At a price below equilibrium price consumers would
want to buy a larger quantity than suppliers are willing
to sell. In this case the will be an under-supply or
shortage. The shortage is the difference between
quantity demanded and quantity supplied
Correcting a surplus
In a market economy the price (market) mechanism
– demand and supply – sets the price.
To re-establish equilibrium, the price mechanism will
lead suppliers to lower their price and quantity
supplied (contraction of supply) and consumers to
reduce the quantity demanded (expansion of
demand)
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Correcting a shortage
To re-establish equilibrium, the market mechanism
will be at work to cause a contraction of demand and
an expansion of supply. For this to happen
consumers will decrease the quantity demanded and
suppliers will increase the quantity supplied.
Simultaneous shifts of the demand and supply curves
If, e.g. an improvement in technology and an
increase is consumers’ income happens
simultaneous, both the demand and supply
curves would shift to the right. If the shift of the
demand curve and the shift of the supply curve
is equal (the horizontal distance between the 2
demand curves = horizontal distance between
the 2 supply curves), the price will not change
but the quantity traded will increase.
If both curves shifts equal distances to the left,
the price will also not change, but quantity
traded would decrease
If the demand curve’s shift to the right is less than
the supply curve’s shift to the right, price will
decrease and quantity traded will increase.
If the demand curve’s shift to the right is greater
than the supply curves shift to the right, price and
quantity traded will increase.
If the demand curve’s shift to the left is smaller
than the supply curve’s shift to the left, price will
increase and quantity traded will decrease
If the demand curve’s shift to the left is greater
than the supply curve’s shift to the left, both price
and quantity traded will decrease
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Price elasticity of demand (PED)
The PED measures the sensitivity of quantity demanded to a change in price. It is calculated using the
formula
As the Law of Demand indicates that there is an inverse relationship between quantity demanded and
price, i.e. when price increases (+), quantity demanded will decrease (-), the value of PED will ALWAYS
be negative. For this reason, the negative sign may be disregarded. We are more interested in the
absolute value of PED.
In some questions the percentage changes will be given, but in others you will be required to calculate
the percentages. The formula for doing this is
Levels of PED
Elastic demand [PED > 1]
From the diagram it can be seen that the change in
price is 10% and the change in quantity demanded is
15%.
By applying the formula
we can easily calculate the PED = 1.5 (elastic)
NOTE: Always add elastic or inelastic in brackets after
the value of PED calculated.
When PED is elastic, a drop in price would increase the total revenue. In the diagram the revenue
before the drop in price was PAQ 0. After the drop in price the total revenue is P₁BQ₁ 0. The revenue
decrease is represented by PACP₁ and the revenue gain is represented by CBQ₁Q. The gain in revenue is
larger than the revenue loss and thus the total revenue after the drop in price, increased. As revenue =
Unit price X Quantity demanded, it should be clear that if the quantity demanded increases
proportionately more (at a higher $) than the decrease in price, the revenue must increase. Similarly, if
the quantity demanded decreases proportionately more than the increase in price, the revenue will
decrease. When the PED is elastic both these scenarios will be true.
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Inelastic demand [PED <1]
So, PED = 10% / 50% = 0.2 (inelastic)
In this case, consumers are less sensitive to changes in
price. I.e. consumers will not change the quantity
demanded much when there is a price change.
When PED is inelastic, a rise in price will cause an
increase in revenue. A drop in price, however, will cause
a decrease in revenue.
Unit elastic demand [PED = 1]
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Perfectly elastic demand [PED = ∞]
Perfectly inelastic demand [PED = 0]
As the price increases from P1 to P2, the quantity
demanded remains unchanged at Qe.
Realistically, demand will never be completely
independent of the price level, but the demand for
prescription drugs, anti-venom or water would be
very price inelastic
Although there are many determinants of PED, the key factors can be remembered by THIS acronym:
• Time – in the long run PED will be more elastic
• Habits, addictions and tastes – the stronger these are embedded, to more inelastic PED will be
• Income – for consumers with a low income PED will be more elastic; at a higher income PED will be
more inelastic
• Substitutes (availability and price of) – the stronger the competition between substitutes, the more
elastic PED will be. If there are no substitutes PED will be more inelastic
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Price Elasticity of Supply [PES]
The Law of Supply states that an increase in price will cause an increase in quantity supplied, because
the higher the price the higher the quantity producers will be willing and able to supply. Therefore,
there is a direct relationship between price and quantity supplied. PED will therefore always have a
positive value.
Elastic PES (PES > 1)
In the diagram the price decreased from $30 per
unit to $27 per unit. To calculate the % change in
price divide the difference [30 – 27 = 3] by the
original price [30] and multiply the answer by
100%
3 / 30 X 100% = 10%
Similarly calculated, the % change in quantity
supplied is 38%.
The PES in this case is therefore 38% / 10% = 3.8. This means that the quantity supplied will
increase/decrease 3.8 times faster than an increase/decrease in the price.
Goods which are luxuries, are quick and cheap to produce, can be stored for long periods of time are
examples of goods which will have an elastic PES.
Inelastic PES (PES < 1)
In this case the price increased by 33% and the quantity supplied increased
by 7%. PES = 7% / 33% = 0.21
In this case producers are not price sensitive and will only raise their supply
by a small margin after a price rise. This will only happen in the short run.
In the long run supply will be elastic as producers might be able to increase
their productive capacity.
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Unit elastic supply
The %
QS = %
P, therefore PES = 1
A change in price will cause an equal % change in quantity
supplied
Perfectly inelastic supply [PES = 0]
Here, supply is perfectly price inelastic at Qe. Irrespective of
price changes, the firm can only supply a maximum of Qe, so
changes in price have no impact on the quantity supplied, i.e.
PES = 0. An example is a football stadium or a concert hall that
cannot accommodate more than the seating capacity.
If a producer had reached full production capacity, no matter
how high the price is, in the short run the producer cannot
produce more. When more production capacity is developed
the supply curve will become less inelastic and even elastic in
the long run.
Perfectly elastic supply (PES = ∞)
Here, supply is perfectly price elastic at a price of Pe. For
example, Duracell might have a huge stock of batteries, so any
increase in demand will simply result in more Duracell batteries
being sold, without the price being raised. Hence, as quantity
supplied can increase from Q1 to Q2 irrespective of a price
change, the PES = ∞.
When a government has created buffer stock of e.g. wheat,
after a minimum price was set. an increase in demand can be
met without raising the minimum price.
Determinants of price elasticity of supply
The main factors which determine the PES of a product are:
 the time taken to produce it
 the cost of altering its supply capacity
 the feasibility of storing it
 the level of spare production capacity
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Allocative efficiency
Allocative efficiency occurs when resources are allocated in a way that maximises consumers’
satisfaction. This means that firms produce the products that consumers demand, in the right quantities.
(a)
Allocative efficient
(b)
(c)
Allocative inefficient
under-production
Allocative inefficient
over-production
In diagram (a) the quantity demanded and quantity supplied is equal. Resources are allocated
efficiently. Suppliers supply the quantity consumers demand.
In diagram (b) more is being demanded than is supplied. Allocation of resources is inefficient as
consumers cannot buy the quantity they are demanding because not enough is supplied.
In diagram (c) more is being supplied than is demanded. Again, resource allocation is inefficient as some
resources are allocated to goods that won’t be sold. Resources are therefore wasted.
Productive efficient
Productive efficiency is reached where production cost is at its lowest.
This is achieved at any point on the PPC because on the PPC all
resources are fully allocated without any waste or un-allocated
resources.
At point B only part of all the resources available for allocation is
allocated. That will be the true for any point inside (to the left of) the
PPC. At point B productive inefficiency therefore exists.
Market failure
Market failure occurs when social cost ≠ social benefits.
The diagram shows that if only the private costs to the firm are taken into
account, then the supply would be curve SS, whereas the full cost to society is
higher at curve SxSx. The difference between the two is accounted for by the
external costs. The allocative efficient output is Qx, but the market output is
Q. The market therefore is experiencing over production.
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In this case, the demand for degree courses, based on private
benefits, is curve DD, whilst the total benefit to the economy is
shown by curve DxDx. The number of degree courses that would be
undertaken, if left to market forces, is Q, whereas the number which
would cause the maximum benefit to the society is Qx. Too few
degree courses are therefore provided by the market (under
production)
Merit goods
Merit goods are products which the government considers consumers do not fully appreciate how
beneficial they are and so which will be under-consumed if left to market forces. Such goods generate
positive externalities
The diagram shows the demand that will exist if left to market forces, DD,
and demand based on the full benefits to society, DxDx. To persuade
consumers to purchase more of the merit good, the desired allocative
efficient quantity of Qx, the price of the product needs to fall to P₁. In the
diagram at P₁, however, the market is not in equilibrium. Government should
thus step in to “force” equilibrium onto the market.
This diagram shows the effect of government intervention in the form
of a subsidy paid to producers of the merit good. Because the subsidy
decreases the cost of production producers will increase production,
shifting the supply curve to the right. Now equilibrium is achieved at
P₁Q ₓ
Incidence of a subsidy
The economic incidence of a subsidy indicates who gains from the subsidy.
In this diagram the subsidy per unit is A – B, the price drops from P
to P₁ and the new quantity consumed is Q1. The total subsidy per
unit is equal to the vertical distance between the two supply lines,
AB.
Consumers pay P - P₁ less because of the subsidy. The incidence of
the subsidy to consumers is thus PFBP₁. Producers previously sold
OQ quantity at price P per unit. After the subsidy the receive P₁ per
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unit from consumers and they receive the subsidy from government. They therefore receive PC
more per unit after the subsidy compared to before the subsidy. This gain, CAFP, is therefore the
incidence of producers from the subsidy.
The total revenue of producers before the subsidy was PFQO. After the subsidy the total
revenue is CAQ₁O
The price the consumer pays does not fall by the full
amount of the subsidy – instead it falls from P to P1.
Hence, although the intention of the subsidy may be
to reduce the price to the consumer by the full
amount of the subsidy, the producer gets some of the
benefit in terms of extra revenue that they can
keep. The gain to the consumer is P – P1 per unit, and
the whole gain to the consumer is the area PFBP1.
The gain to the producer is C – P per unit and the total
gain to the producer is CAFP. The overall cost of the
subsidy to the government is the area, CABP1.
The incidence of a subsidy to both the consumer and
producer will depend on the PED
Inelastic PED
Here the total value of the subsidy is GP₁
/ unit of production.
The incidence to consumers is PP₁ (the
difference between the price paid
before the subsidy and the price paid
after the subsidy). GP represents the
incidence to the producer (the
difference between the price before the
subsidy (P) and the subsidy per unit (G).
When PED is inelastic the consumer
gains the greater part of the subsidy.
The total revenue received by the
producer = the price paid by consumers
after the subsidy (P₁BQ₁O) plus the total
subsidy paid by government (GMBP₁)
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Elastic PED
In this diagram PED is elastic. Here the total value of
the subsidy is GP₁ / unit of production.
The same arguments to explain the incidence to
consumers and producers used for the inelastic PED,
are applicable here. However, we see that the
incidence to consumers is a much smaller portion of
the total subsidy (P₂CBP₁) than was the case when PED
was inelastic.
The incidence to consumers is PP₁ (the difference
between the price paid before the subsidy and the
price paid after the subsidy). GP represents the
incidence to the producer (the difference between the
price before the subsidy (P) and the subsidy per unit
(G).
When PED is inelastic the consumer gains the greater part of the subsidy.
The total revenue received by the producer = the price paid by consumers after the subsidy (P₁BQ₁O)
plus the total subsidy paid by government (GMBP₁)
Follow this link for a detailed explanation of the effect of PED on the incidence from a subsidy.
https://www.youtube.com/watch?v=cxaXbsR3l9A
Demerit goods
To discourage consumers to buy demerit goods such as alcoholic beverages and tobacco products,
government can intervene by imposing an indirect tax on these goods. Usually this tax will be an excise
duty which would be a specific tax (fixed amount per unit) rather than an Ad Valorem tax (percentage).
The tax will increase the price per unit, indicated by a
leftward shift of the supply curve. Less will be
supplied as the cost of production is increased. [An
indirect tax is aimed at producers]. The unit price will
increase (P to P₁) while the quantity demanded will
decrease (Q to Q₁)
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Incidence of an indirect tax
PED elastic
The tax per unit is equal to the vertical distance
between the two supply lines (P₁ - Pt). The total
amount of tax at the new quantity traded (Q₁) is
P₁E₁TPt.
Consumers pay P₁ - P more because of the tax. As
the tax is aimed at the producer we can say the
producers passed on this part of the tax burden to
the consumers. The incidence of the tax on
consumers will therefore be (P₁ - P) X Q₁
The incidence on the producer is (P – Pt) X Q₁.
It should be clear that the larger part of the tax
burden will be on the producer when PED is
elastic.
PED Inelastic
The total tax (P₁ - Pt) X Q₁) is the same as in the
previous diagram, but because of the change in
PED from elastic to inelastic, the consumer price
now increases from P to P₁ which is much larger
than when PED was elastic. The producer carries
only (P – Pt) X Q₁ of the tax burden which is much
smaller than when PED was elastic.
An indirect tax on goods with an elastic demand
would therefore be more effective as the
quantity traded will decrease more than
proportionate to the increase in price. As the tax
is aimed at decreasing the consumption of
demerit goods, it won’t be very successful if the
PED for the goods is elastic. If the PED is inelastic
the tax should be raised very high for the
decrease in demand to be significant.
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Maximum price
A maximum price is set by government below the equilibrium price to decrease the price of a range of
goods in order for it to be more affordable for consumers.
The imposition of a maximum price (also
called a price ceiling) of P2 (below the market
equilibrium price of Pe) reduces supply to S1,
while demand expands to D1. This results in
excess demand for the product — in other
words, there is a shortage.
At price P₂ consumers will demand D₁ while
producers will limit the supply to S₁. We
therefore have a position of disequilibrium.
As the maximum price was set by government
market forces cannot change it.
Minimum price
A minimum price is set by government above the current equilibrium price to increase the supply of a
good/service.
A minimum price could be offered to
agricultural farmers, giving them an incentive
to supply more (S1) than the market
equilibrium (Qe). At a price higher than the
equilibrium, demand contracts from Qe to D1,
but supply extends to S1. This results in excess
supply, as shown by the shaded area., The
surplus is bought at a price of P2 by the
government as a buffer stock to support the
agricultural farmers, and released on to the
market during times of bad harvests to
stabilise food prices.
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Effect rules and regulations
Restrictive rules and regulations can be imposed by government to decrease the demand for demerit
goods such as tobacco products/alcoholic beverages/gambling.
In the diagram the equilibrium quantity
for cigarettes is Q₁. If government would
raise the age at which consumers may
buy cigarettes, the demand would
decrease as less consumers are allowed
to purchase the product. This would shift
the demand curve to the left (D₂) and
cause a contraction of supply. The
quantity traded decreases by Q₁ - Q₂. The
price, however decreases from P₁ to P₂
which might make this approach less
effective in the long run.
Providing information on the benefits of merit goods could change eating habits
The demand curve for fresh fruit and vegetables
shifts from D1 to D2 and the equilibrium quantity
increases from Q1 to Q2. Healthier people in the
economy should mean less absence from work
and school, resulting in improved productivity.
Therefore, healthy eating produces an external
benefit for society.
C
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Unit 3
The relationship between disposable income and consumption
At very low levels of income, there is dissaving. At Z level of
income, all income is spent. Then as income rises past Y, saving
occurs. Over the complete range of income, expenditure
continues to rise but it rises at a slower rate.
Equilibrium wage
The equilibrium wage rate is determined when the
wage rate workers are willing to work for equals the
wage rate that fi rms (employers) are prepared to
pay — that is, when the demand for labour is equal
to the supply of labour. In the diagram, the
equilibrium wage rate is We and Ne workers are
employed. Changes in the demand for or supply of
labour in an industry will therefore change the
equilibrium wage rate.
Wage determination
The higher the demand for and the lower the supply of workers in an occupation, the higher the pay is
likely to be.
The supply of doctors is low, relative to
demand for their services. There is only a
limited number of people with the necessary
qualifications, and the willingness and ability
to undertake a long period of challenging
training to become doctors.
The supply of waiters is often high relative to
their demand. This is because although some
people may not be keen to work as a waiter,
they do so because the job does not require
any qualifications, or special skills, and only a
minimum amount of training is sufficient. This
often results in the supply of waiters being
high relative to their demand.
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Unskilled workers are generally paid less than skilled workers. Demand for skilled workers is high, whilst
their supply is low. There are two main influences on the demand for workers. One is the amount of
output they can produce and the other is the price for which that output can be sold. Skilled workers are
usually highly productive, producing both a high quantity and a high quality of output per hour. Also, the
supply of skilled workers is usually lower than that of unskilled workers
Increase in demand for labour
Just like an increase in the demand for any commodity
can be illustrated by a shift to the right of the demand
curve, an increase in demand for labour would cause the
labour demand curve shift to the right. It will also cause
an expansion of supply of labour. This is because
employers will offer a higher wage to attract more
employees. (W to W₁). The quantity of labour supply
would then increase from Q to Q₁.
Decrease in labour supply
A decrease in labour supply could be the
consequence of net emigration, aging population or
a shrinking population.
When less people are supplying their services,
labour would become more scarce and therefore the
wage (price for labour) would increase while the
quantity of labour decreases. This can be illustrated
by the labour supply curve shifting to the left (S₁ to
S₂) with the wage rate increasing from W₁ to W₂ and
the quantity of labour supply decreasing from Q₁ to
Q₂
Minimum wage
A minimum wage set by government will be set above equilibrium
wage. At the higher wage employers will demand less employees
as the higher wage will increase the firm’s cost. Higher cost might
decrease the profit margin. In the diagram equilibrium wage is W
when Q quantity of labour is demanded. The quantity of labour
demanded will fall from Q to QD In the short run employers will
have higher cost of D The cost to make workers redundant might
also be too high. In the long run the number of employees could
be decreased by not replacing those who voluntarily leave, those
who retire and those who might pass away.
At the higher minimum wage more people would be willing to
take up a job. The quantity of labour supply will therefore increase from Q to Qs. Labour supply at wage
W₁ therefore exceeds the demand for labour by Qs – QD. If people who gave up on looking for a job (left
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the labour force) before the minimum wage was imposed, rejoined the search for a job (re-entering the
labour force), unemployment will increase because of the imposition of the minimum wage.
Effect of PED wage rates and quantity of labour supplied.
PED inelastic
PED Elastic
Because a wage is the
price of labour, the effect
of PED on wage rates and
quantity of labour
demanded is similar to
the effect of PED on the
price ò a commodity.
When PED is inelastic, an
increase in the supply of
workers from S to S₁ will
cause a less than
proportionate increase in the quantity of labour demanded. However, if labour demand is price elastic,
an increase in supply will cause a less than proportionate increase in quantity of labour demanded.
Economies/diseconomies of scale
When cost of
production decreases
because of economies ò
scale, the average costs
(AV) will decrease up to
a point where the firm
reaches its most
efficient level of output
with existing resources
and infrastructure. This
will be reached when
the AV is at its lowest
point. Marginal cost (the additional cost to produce the last unit) will now be equal to AV. Should the
firm attempt to produce even more with the same resources and infrastructure e.g. force labour to work
overtime in an attempt to increase output, or working the machines 24/7 AV will increase. Overtime
wages is more than normal time wages and more would need to be spent on maintenance when
machines are worked 24/7. The marginal cost will therefore increase which will increase AV. The firm is
now experiencing dis-economies of scale shown by an upward sloping AV curve.
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Fixed costs
Fixed costs (FC) are those costs which does not
increase as output increases. It remains constant for
at least one year.
The diagram therefore shows a horizontal line á the
costs remains constant irrespective of the level of
output.
Examples: Rent, Insurance depreciation
Variable costs
Variable costs (VC) are costs of production that change when
the level of output changes. Examples are the costs of raw
materials, component parts and the payment of wages to
production workers. The total variable cost line starts at the
origin because when there is no output, no variable costs are
incurred.
Total costs
Total cost (TC) refers to the sum of all fixed and
variable costs of production. The total cost line, starts
at the same value as fixed costs because even when
nothing is produced, fixed costs still have to be paid
by the firm.
Total cost (TC) = fixed costs (FC) + variable cost (VC)
Average fixed costs
Average fixed cost (AFC) is the fixed cost per unit. As a firm
produces more output, its fixed costs are divided by a greater
quantity (of output), so AFC continually declines. It is calculated
using the formula:
Average fixed cost (AFC) = fixed cost (FC) ÷ output level
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Average variable costs
Average variable cost (AVC) is the variable cost of production per unit of
output. As output increases, the firm will benefit more from economies
of scale and therefore the AVC will decrease as output increases for as
long as marginal cost is less than AVC. When marginal cost exceeds
AVC, the AVC will start sloping upwards.
It is calculated by dividing total variable cost by the number of units
produced.
Average variable cost (AVC) = variable cost (VC) ÷ output level
Average total costs
Average total cost (ATC), also known as the cost per unit, refers to
the total cost of making one unit of product — it is the unit cost of
production. The diagrammatic representation of ATC shows an
initial down sloping curve – this is because of moving from undercapacity production to point (b) which represents full capacity.
Output beyond (b) í over-capacity which will lead to dis-economies
of scale as explained earlier.
The formula to calculate ATC is:
Average total cost (ATC) = total cost (TC) ÷ output level
Impact of competition on market price and output
A high degree of competition in a market tends to benefit
consumers. This is because they get higher-quality products
and good customer service. In addition, competition brings
about greater choice, higher output and more competitive
prices.
Increased competition shifts the market supply curve
outwards from S1 to S2. This causes the market price to fall
from P1 to P2, thereby causing the quantity demanded to
increase from Q1 to Q2.
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Total revenue
Total revenue is the total amount of income a firm will earn at
different levels of output. There is a direct relationship between total
revenue and quantity sold.
Total revenue = Total quantity sold X price per unit
Average Revenue
Firms might not sell each unit of a product at the same price.
Discounts allowed and following a policy of discrimination pricing
could be reasons why different units are sold at different prices. A
firm will find it necessary, however, to calculate the average price at
which each unit was sold to determine its profitability.
Average price (AR) = Total revenue (TR) ÷ Total units sold
Average and total revenue in a monopoly market
Average Revenue
Total revenue
The average
revenue decreases
as output rises
because the greater
the supply, the
lower the price.
Total revenue rises
at first but at a
slowing rate
because, output
rises to satisfy an
increasing demand
and the market is not yet saturated, i.e. demand is still higher than supply. However, prices increase at a
slower rate. Output rises because more competitors enter the market forcing prices to increase at a
slower rate firstly because more competitors enter the market and secondly because the market is
nearing saturation at the higher price. Eventually the output increases to a level which saturates the
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market. Producers will at point A start decreasing their prices in an effort to increase sales. Although
output will increase beyond Qm, revenue will fall as a result of prices lower than Rt.
The choice facing a monopolist
A monopoly has control over the supply of the product,
but although it can seek to influence the demand, it does
not have control over it. In fact, a monopoly has to make
a choice. It can set the price, but then it has to accept the
level of sales that consumers are prepared to buy at that
price.
If, on the other hand, it chooses to sell a given quantity,
the price will be determined by what consumers are
prepared to pay for this quantity. The diagram shows that
if a firm sets a price P, the demand curve determines that
it will sell amount Q. If it decides to sell amount Q1, it will
have to accept a price of P1 .
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