Chapter 1: An introduction to microeconomics
Chapter 1
An introduction to microeconomics
1.1 What is economics all about?
Each day we read and hear reports about the economy because it affects our lives in many ways. Economics studies the decisions
made by individuals, businesses, governments and other groups. While not all of these decisions are economic in nature, many will
tend to have economic consequences. Economics is, therefore, a social (and sometimes imprecise) science that tries to answer a
number of big questions, such as those listed below.
•How do people choose what they consume?
•How do producers decide what and how they will produce?
•How are these choices influenced by new discoveries and
technological change?
•What determines what a person earns?
•Why do some people become unemployed?
•Why do prices change for goods and services?
•Why do governments intervene and how are living standards affected?
•What factors influence world trade and how does interaction with
the rest of the world influence Australia’s living standards?
•Why does poverty occur and why are some countries richer than
others?
Study tip: In economics, we often use the expression ‘economic agents’ to refer to any entity (such as a
person, household, government or business) that makes economic decisions.
Ultimately, economics studies human behaviour; why we make the decisions we do and what motivates us to make these
decisions. Economists want to know how the world works and the implications of all the decisions that are made.
An economy is a place where scarce resources are allocated among competing uses. Economists distinguish between
three main types of resources that can be used to produce goods and services to meet the needs and wants of the
people on the planet. For this reason, they are also referred to as factors of production, where the quantity and quality of
these factors of production has a big impact on national living standards or welfare. The three factors are as follows.
•
•
•
L and or natural resources refers to all those resources that occur in nature. These can be utilised in the production process
to generate more elaborate products or consumed in their raw form. Examples of such resources include, water, forests,
minerals, land, animals, fruit and vegetables. It may seem obvious but all production depends on natural resources.
Labour refers to the mental and physical effort by humans in the production process. In Chapter 6 a detailed analysis of the
Australian labour force will be undertaken. The Australian labour force only includes those who are employed plus those
who are actively seeking employment. This means that some labour resources may not be available for firms to use in the
production process.
Capital refers to those resources that have been made by combining labour and natural resources to create a more
sophisticated input in the production process. Capital goods are made with the intention of making more goods and services
in the future and generally these will increase the efficiency with which natural resources can be converted into end-use
products for consumption. A common example of a capital resource is machinery, such as computers and robotics.
In some texts you will see reference to a fourth scarce resource (or factor of production) referred to as entrepreneurship or
enterprise. This refers to the skills of those individuals who combine our resources to produce goods and services. They take
financial risks to establish enterprises and are extremely important to wealth creation for every nation. They not only include
high profile entrepreneurs like Rupert Murdock, Bill Gates or James Packer, but include the owners of every small or medium sized
business in existence. This type of scarce resource typically forms part of ‘labour resources’ given that entrepreneurs are providing
their expertise or skills to the business sector of the economy.
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Economic Fundamentals in Australia
Each economy around the world attempts to answer the three basic economic questions:
1.What goods and services will be produced and in what quantities?
2.
How will the goods and services be produced?
3.For whom will these goods and services be produced?
In any economy these economic questions could be answered in a number of ways. In Australia we rely predominantly on the market
to answer these questions. The types of goods and services that are produced is primarily determined by the decisions of consumers.
When a person buys a product at a given price they send a signal to the market. This behaviour gives producers the incentive to
produce the product if doing so brings with it an economic profit. The producers will look to produce the good or service to the
highest quality level and at the lowest cost. Primarily, they will be driven by the profit motive, as well as a desire to gain repeat
business and develop a good reputation. The goods and services will be allocated to those who are willing and able to exchange their
income, gained from a variety of sources, for the products. The system described above is a market system where the interaction of
demand and supply arrives at a market price and quantity traded.
Study tip: In the VCE 3/4 Economics course, we focus on the role of the Federal Government and how
it influences resource allocation. In reality, all levels of government (which includes State and Local
governments) play an active role in re-allocating resources to areas considered to be in the national
interest.
In the Australian economy, the allocation of resources is also influenced by the government. The government may choose to intervene
in the free market to ensure that certain goods and services are produced and others are not. The government may also regulate
the production activities of private producers so that they do not cause unnecessary pollution or excessive depletion of natural
resources. The government also redistributes income and provides services so that those who may not be able to afford necessities
in a free market are able to access them. This combination of market capitalism and planned socialism makes Australia a mixed
economy. Refer to Box 1.1 to gain a better understanding of the different ways economies can allocate scarce resources.
Box 1.1 Different systems used to allocate resources
Market capitalism
A market is seen as any place that allows buyers and sellers to interact and exchange goods and services. This interaction and
exchange may or may not take place in a physical space. A market system is therefore one that allocates resources based on the
buying and selling decisions of consumers and producers. Prices give signals which influence the behaviour of these buyers and
sellers. Capitalism refers to an economic system where the majority of productive resources are owned by private individuals
and firms. Capitalists will therefore use their assets to generate revenue which motivates them to provide the goods and services
that are demanded.
Planned Socialism
A completely different type of economic system is one in which the government is primarily responsible for resource allocation.
Governments may make long-term and short-term plans about what to produce, how to produce it and who gains the produce
after it is produced. This is referred to as a planned economy. Socialism indicates that the majority of productive assets are state
owned (owned by the people of the country collectively) and therefore no one can benefit excessively from producing goods
and services.
Planned Capitalism
An unusual economic system may evolve whereby the government directs the private owners of productive assets to produce
certain goods and services. This has been utilised by countries during war time when the owners of factors of production are
directed to the production of goods and services that are needed for defence.
Market Socialism
Under this system the government owns most of the resources but markets determine what goods and services are ultimately
produced. For example, the businesses may be owned by the government but their operations would be left to independently
appointed management who would try to maximise profits.
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Chapter 1: An introduction to microeconomics
As an introduction to economics, it is often useful to look at a number of principles that were developed by Gregory Mankiw, a
Harvard Professor. These principles are related to how people make decisions (1 -4), how people interact (5 -7) and how the economy
as a whole works (7 -10). These principles are summarised in Table 1.1 and become a useful starting point for any discussion about
the economy.
One needs to be aware that in order for economists to arrive at some of their conclusions, they must make simplifying assumptions.
For example, for much of our analysis of the market mechanism, it will be assumed that markets are completely flexible so that
there is perfect information and prices are very responsive to changes in demand and supply. This may be somewhat unrealistic, as
producers do not always have all the information they require to make perfect pricing decisions and prices change very infrequently
for many goods and services. To illustrate, when was the last time a ticket to the movies increased in price (or decreased)?. While the
demand and supply for a movie ticket may change on a daily basis, the price of the tickets changes only rarely. The operation of the
market, and limitations on its free operation, will be considered in more detail in Chapter 2.
As you proceed through this book, keep Mankiw’s principles in mind. As you gain a greater understanding of economics, you will be
in a better position to question whether Mankiw’s principles are accurate or overly simplistic. For example, one notable ecological
economist, Herman Daly, would argue that there is inadequate reference to the environment in Mankiw’s principles, arguing that
instead, these should be a key starting point for a discussion on Economics. The issue of the economy and the environment will be
discussed in more depth in Chapters 4 and 16.
Table 1.1 Mankiw’s “Ten Principles of Economics”
1
People face tradeoffs
In order to get something you like, you usually have to give up something
else.
2
The cost of something is what
you give up to get it
Whenever a decision is made the decision maker looks at the explicit costs
but also include the value of what they have given up.
3
Rational people think at the
margin
This is another way of saying that a rational person will do something if the
extra benefit of doing so exceeds the extra cost associated with the action.
4
People respond to incentives
The behaviour of people will change when the costs and benefits associated
with any action change.
5
Trade can make everyone better
off
Trade allows people and countries to specialise in what they do best. By
trading, a country’s citizens are generally able to buy more goods and
services and therefore increase living standards.
6
Markets are usually a good way
to organise economic activity
In his 1776 book An Inquiry into the Nature and Causes of the Wealth of
Nations, Adam Smith observed that households and firms interacting in
a market act as if they are guided by an “invisible hand” that leads them
to desirable market outcomes. Prices are generally seen as the way the
invisible hand works its magic.
7
Governments can sometimes
improve market outcomes
In some cases markets are unable to efficiently allocate resources (referred
to as market failure). In these cases governments develop public policy to reallocate resources to those areas that will maximise society’s wellbeing.
8
A country’s standard of living
Income is derived from the production of goods and services, so producing
depends on its ability to produce a greater volume of goods and services will increase living standards.
goods and services
Increases in productivity will mean that more goods and services can be
produced from a nation’s resources thereby increasing income and living
standards.
9
Prices rise when the government When the government creates large volumes of its money, its value will fall.
prints too much money
If this is the case, and there are the same number of goods and services
available, then it makes sense that more money will be needed to purchase
a given good or service.
10 Society faces a short-term
trade off between inflation and
unemployment
Reducing inflation often results in a temporary increase in the
unemployment rate because it may require policies that reduce the ability of
consumers to spend.
Study tip: While knowledge of Mankiw’s principles of economics will enhance and provide a frame of
reference for your understanding of economics, they are not required knowledge according to the VCE
Economics Study Design.
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Economic Fundamentals in Australia
Microeconomics and Macroeconomics
Microeconomics is the study of the economic behaviour of individuals as consumers and producers. The first three chapters of this
book have a microeconomics focus and, in particular, the factors that influence the choices made by individuals and businesses.
Microeconomics studies the role of markets in allocating resources and how the government intervenes in individual markets to
improve efficiency.
Macroeconomics is the study of the economy as a whole. Macroeconomics therefore builds on the knowledge gained from studying
the individual components of the economy. The aggregates that will be considered in this book will be Australia’s national income,
production and expenditure (real GDP), inflation, unemployment, the current account deficit and net foreign debt and how Australia’s
income is distributed. Macroeconomics is therefore concerned with the ‘big picture’ of how the economy works and how the
government may influence the level of economic activity through the use of aggregate demand and aggregate supply side policies.
1.2 Relative scarcity, opportunity cost and the basic economic questions
“Praise, like gold and diamonds, owes its value only to its scarcity. ” – Samuel Johnson
Scarcity is an important concept in economics. It can be simplified by comparing the needs and wants of society with the resources
available to meet those needs and wants. Relative scarcity occurs because (most) resources are generally seen as finite whereas
needs and wants are assumed to be relatively infinite. Both rich and poor individuals and countries face scarcity. Economies set about
solving the problem of scarcity (and are unlikely to ever succeed).
Faced with scarcity, individuals, businesses, governments and other groups must make
choices. We cannot have everything we want and there aren’t enough hours in the day to
do everything we want to do. We must therefore allocate our scarce resources to those
areas that will maximise our wellbeing. Accordingly, economics attempts to understand the
choices made by different economic agents, the consequences of these choices and how
changing circumstances can affect choice.
To illustrate, the Federal Government would like to spend more on defence, health,
education and other services, but a lack of resources means that there will always be
competing interests. Economists use the term opportunity cost to describe the value of the
next best alternative that is foregone whenever a choice is made. The best thing that you
choose not to do is sometimes referred to as the economic cost.
Opportunity cost could be measured in a number of ways. Let’s consider the decision to
buy a new Hi Fi system. A person with no background in economics may think that the
cost of the purchase is the price paid. A person who has studied economics, however,
will soon learn that the opportunity cost has not been considered in this analysis. The
person who foregoes $2000 to purchase the new stereo can no longer afford to take an
overseas holiday. This is the real cost of the purchase if it was the next best alternative
for the person in question. If the person has a mortgage then the opportunity cost might
be that they now have to pay more interest on their home loan and they may have to
work for more years to pay it off. It is important to remember that there can only be
one opportunity cost, and that is the value of the next best alternative which has been
foregone.
The existence of scarcity means that resources have competing uses. It also means that sometimes people need to compete against
each other to obtain the goods and services they desire. Competition has evolved and many aspects of competition have been
facilitated by a legal framework. The Australian economy assumes that people own what they have acquired through the voluntary
exchange of goods and services. People contribute to the production process in exchange for financial or non-financial reward.
This income can then be used to purchase their needs and wants. If there is competition for particular goods and services then the
purchaser who is able to offer the most favourable exchange will be rewarded. This may mean a seller offering a lower price or a
buyer offering a higher price.
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Chapter 1: An introduction to microeconomics
Relative scarcity?
Wants/Needs
>
Resources
Case Study/Analysis task 1.1 Dealing with relative scarcity in Australia and
overseas
Scarcity can be described in a microeconomic sense (in terms of households or businesses) or in a macroeconomic
sense (the whole economy).
Each country around the world deals with relative scarcity in a
different manner. For Australian households, there may be a scarcity
of resources to meet their wants rather than their needs. In some
countries, such as heavily indebted poor countries, the inability of
the population to meet their daily needs truly highlights the power
of relative scarcity.
In Australia, relative scarcity certainly exists because needs and wants
are greater than the resources available. The problem of relative
scarcity is therefore addressed in a country like Australia through a
combination of market forces and government intervention. Relative
scarcity essentially means that choices must be made so that scarce
resources are allocated. In Australia, this “directing” of resources is
done by price signals. The prices are determined by the interaction of demand and supply. Increased demand
will send signals to producers that certain goods and services should be produced. Unfortunately, this might
mean that the “wants” of some people will result in fewer resources being available to satisfy the “needs” of
other people - there is an opportunity cost. For example, some people may be able to purchase a Ferrari, while
other people cannot afford a roof over their head. The market does not concern itself with judging whether this
is right or wrong. It is impartial in the way it allocates scarce resources.
In terms of the world economy, decisions made by people in Australia may actually affect the degree of relative
scarcity experienced in other countries. For example, the decision by an Australian family to take a holiday
overseas might actually increase the ability of foreign workers to purchase their needs and wants as their incomes
rise. Alternatively, the popularity of a tourist location might impact negatively on the ability of others to satisfy
their needs and wants as the prices of basic goods like real estate and food are increased in the tourist location,
perhaps forcing some local residents to relocate. Similarly, a decision by a large multinational firm to “exploit”
foreign labour and resources might mean that it is harder for them to develop their economy effectively and
reduce the causes of poverty (where there is generally more scarcity experienced – especially in terms of needs).
The Australian government interferes in the free market to reallocate resources and help some people to
meet their needs. If there was no government intervention then some people might actually starve to death,
have nowhere to live and never become educated. These needs are therefore provided by taxing incomes and
spending or reallocating these funds, either directly or indirectly, to those in need.
As you proceed through this book, keep this important concept in the back of your mind, as all economic
discussion can eventually be brought back to relative scarcity, choice and opportunity cost.
Application questions
1. Explain what is meant by the term relative scarcity.
2. Discuss how markets in Australia deal with the problem of relative scarcity. Is this a fair way to allocate
resources?
3. Outline why the Australian Government intervenes in the market with respect to the problem of relative
scarcity.
4. Identify and discuss one example where the decisions made in Australia might increase relative scarcity
in another country. (Students should try to use a different example to those mentioned in the case study.)
5. Identify and discuss one example where the decisions made by Australian households could help foreigners
to meet more needs and wants. (Students should try to use a different example to those mentioned in the
case study.)
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Economic Fundamentals in Australia
1.3 The production possibility frontier
One way of illustrating the concept of opportunity cost is to use a production possibility diagram, also called a production
possibility frontier (PPF). An economy has a number of choices that can be made in terms of how to allocate its scarce
resources. Any allocation of resources to the production of certain goods and services will mean that an alternative
combination cannot be achieved, hence the concept of opportunity cost arises.
For simplicity it is useful to assume that the economy can produce two types of products – Goods or Services. A combination
of goods and services may be produced using the available resources (factors of production) and the available technology
for a small economy. The combination of goods and services for a theoretical economy is show in Table 1.2
Table 1.2 Production possibilities
Production combinations
Production of services
(units per year - million)
Production of goods
(units per year - million)
A
600
0
B
570
50
C
450
175
D
300
275
E
100
335
F
0
350
If the data above is transferred to a Production Possibilities Frontier (PPF) then it would appear like Figure 1.1, with the
production of goods on one axis (in this case the y-axis) and production of services on the other axis (x-axis). The economy
has a number of choices when it comes to allocating resources. The economy can choose, for example, to allocate all of its
scarce resources to the production of services (at which point they would produce 600 million services and no goods). If
they were able to achieve this point along the PPF then it is said that they have efficiently allocated their resources because
they have been utilised to get the maximum that can be made with the resources.
Figure 1.1 Production Possibility Frontier
400
350
Production of goods
300
250
200
150
100
50
0
0
100
200
300
400
500
600
700
Production of services
The hypothetical economy could choose any of the points along the PPF and in doing so there would always be trade-offs.
Once a point on the PPF has been reached the only way to move to another point is to give something up. For example if
the economy moves from point A to C it will gain 175 goods, but in doing so it will no longer be able to produce 150 services
(which is the opportunity cost of producing the first 175 goods).
All points along the PPF represent efficient outcomes in the sense that the maximum volume of goods and services is being
produced from the resources available. But which one is the most efficient? There is only one point along the PPF that
achieves the maximum satisfaction for society. This is referred to as allocative efficiency (see section 1.4) and its location
will depend on the preferences of the citizens of the country. Consumers may reveal their preferences through their buying
decisions and governments may decide to intervene in the market to ensure that resources are allocated more efficiently.
Prices will give signals to producers and consumers which will generally promote the production of those goods and services
that are most valued by a society. The mechanics of the market as a way to allocate resources will be discussed in Chapter 2.
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Chapter 1: An introduction to microeconomics
Things to note about the PPF:
•A movement along the PPF to the left means a country is allocating more to the production of goods and less to the
production of services. To increase production of goods the economy must sacrifice the production of some services (the
opportunity cost of producing extra goods).
•Points outside the PPF are not achievable today, but the economy may be able to consume a combination of goods and
services that is outside the PPF through specialisation and trade.
•Over time, a country may expand its productive capacity and therefore the PPF will shift to the right. Points outside the
current PPF will therefore be obtainable as a result of improvements in the quality or quantity of resources or more
productive use of resources.
•Points inside the current PPF indicate that the economy is not allocating its resources efficiently. It may also mean that
some resources are either underemployed or unemployed (see Chapter 6) as the maximum production levels are not being
attained.
1.4 An efficient allocation of resources
Allocative efficiency
There are an infinite number of ways that resources could be allocated in an economy. A small change in consumer preferences
or technology or the availability of resources will have implications for the way resources are allocated. The most efficient
allocation of resources will be one that is able to maximise the needs and wants of society. If resources are allocated efficiently
the goods and services that people want will be produced in the best possible way; i.e the right goods and services will be
produced. Goods and services will be made in the right quantities and will generally go to those people who value them the most.
When allocative efficiency occurs no resources will be wasted and it will be impossible to make someone better off without making
someone else worse off. From a production point of view, the cost of producing a given output is minimised (or maximising the
output from a given quantity of inputs) and from a consumption point of view, the goods and services produced by society will
provide the highest level of ‘collective’ satisfaction. While this ideal may never be achieved in reality, it is certainly possible to make
assessments about whether resources are being allocated more efficiently over time. A reduction in waste or higher living standards
for a society may be some of the indicators used to assess whether a society is allocating its resources more efficiently.
Economists have identified a number of alternative ways of explaining efficiency.
Technical (or productive) efficiency will occur when it is not possible to increase output without increasing inputs (resources).
Therefore the most technically efficient point of production occurs where productivity is at a maximum and where average costs
are at a minimum. Technical efficiency, could therefore be improved if workers are able to produce more goods or services per hour
worked (an increase in labour productivity).
Dynamic efficiency refers to how quickly an economy can reallocate resources to achieve allocative efficiency. Because prices are
often seen as ‘sticky’ it takes some time before resources are reallocated to where they are best able to meet the needs and wants
of society. Successive Federal Governments from both sides of politics have encouraged flexibility in a range of markets to promote
dynamic efficiency (for, by example, deregulating markets or removing subsidies that distort the allocation of resources). This will be
covered in more detail in Chapter 15.
Study tip: When discussing the impact of a change in economic conditions or government policy on
efficiency try to focus on one or two of the types of efficiency discussed above.
In recent times economists have been concerned about how resources are allocated over different time periods. If resources
are consumed in excessive proportions by current generations then future generations may suffer a relative decrease in living
standards. Alteration of the earth’s delicate ecosystem could also decrease the earth’s ability to facilitate future growth in the
economy. If inadequate savings are available then investment opportunities may be missed. Current investment translates into
future consumption so it is important for a country’s long term economic prosperity to maintain adequate levels of investment. The
need for balancing current and future consumption is often referred to as inter-temporal efficiency.
There is often a complementary relationship between each of the types of efficiency. For example, if the economy is able to generate
more goods and services at a lower cost then it is likely that technical efficiency will be achieved. By producing more at the lowest
possible cost, more goods and services can be attained which is likely to maximise society’s needs and wants (i.e. improve allocative
efficiency). A society that is dynamically efficient is also more likely to achieve allocative efficiency. When market conditions change,
businesses need to respond quickly and if they are able to do so then they are more likely to maximise the needs and wants of society.
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Economic Fundamentals in Australia
Achieving one type of efficiency, however, does not guarantee that another type will also be achieved. For example, an economy
could be technically efficient by reducing costs and boosting productivity. But if this involves producing goods and services that
nobody wants, then it will not be seen as allocatively efficient. Similarly a decision by the Federal Government to subsidise solar
panels will help to promote inter-temporal efficiency because it will reduce greenhouse gases. Experts have agreed, however, that it
is probably one of the most inefficient ways for an economy to reduce carbon emissions. In this respect, the improvement in intertemporal efficiency is not matched by an improvement in allocative efficiency.
Case Study/Analysis task 1.2 Fuel subsidies for the mining industry – an inefficient
allocation of resources?
In some cases, decisions made by government may actually lead to a more
inefficient allocation of resources. Decisions may have been made in the past that
seemed like a good economic decision but, when viewed from a modern economic
perspective, may seem to distort markets and alter incentives.
Consider the case of fuel subsidies for the mining industry. The government initially
introduced the Fuel Tax Credit Scheme to benefit all of those farmers who used
diesel-based machinery that was never driven on public roads. This meant that
farmers were effectively exempt from paying the fuel excise (which was orginally
introduced to help fund the construction and maintenance of Australia’s road
network).
Given that the structure of the economy has changed over time, the biggest
beneficiaries of the scheme are now the large mining companies. Huge mining trucks
are not driven on public roads and therefore the companies gain a huge windfall.
Their exemption from the fuel excise effectively amounts to a public subsidy. While
subsidies to the automotive sector have been gradually cut and the government has
suggested that firms need to stand on their own two feet the mining sector is still
the recipient of generous government subsidies. How do these subsidies affect the
efficiency of resource allocation?
Allocative efficiency
It could be argued that the ‘subsidy’ (or the exemption from the fuel excise) amounts to a distortion of price signals. The
mining companies already make very high economic profits and by reducing their cost of production, the government is
effectively encouraging more resources to be allocated to this area of production. Viewed purely in terms of prices, this will
not maximize society’s needs and wants because other businesses will have to pay the taxes and this may disadvantage them
in attracting needed resources compared to the mining companies.
Technical efficiency
The fuel excise exemption reduces the incentive for the mining companies to reduce their fuel consumption and seek the most
cost effective way to transport their materials. Economic agents alter their behaviour based upon the incentives that they
face. With lower fuel prices they have less incentive to reduce their waste and seek more productive production methods.
Dynamic efficiency
The fuel subsidy effectively protects the mining industry from fully transparent and accurate price signals. While fuel excise is
expected to increase in line with inflation (see 2014/15 Budget analysis), the mining companies will not face this rising cost of
production in the same way that other businesses will. Therefore they are less likely to alter their allocation of resources as
quickly.
Inter-temporal efficiency
The subsidies send the wrong signals to the mining companies in terms of environmental sustainability. The lower fuel prices
discourage conservation and the pollution caused by using excessive diesel use is unlikely to be curtailed in the industry. As
a result, for example, global warming may be worsened as the companies have an incentive to mine more coal. This is an
industry that does not need price advantages as it is already profitable and is associated with carbon pollution, making future
generations face potential environmental costs.
Application questions
1. How does allocative efficiency differ from technical efficiency?
2. Identify and justify a reason why the government may provide the mining companies with a fuel excise exemption.
3. Explain how the fuel excise exemption might affect the incentives of economic agents.
4. What might be the opportunity cost for the government in providing excise exemptions to the mining sector?
5. Explain how the fuel excise exemption is likely to result in a decrease in both technical and inter-temporal efficiency.
6. Why might an increase in one type of efficiency lead to a reduction in another? Give an example.
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Chapter 1: An introduction to microeconomics
Review questions 1.1
1. Discuss why economics is referred to as a social science.
2. Explain why economics is concerned with relative scarcity. Why does the existence of scarcity imply that there is a need
for choice?
3. Discuss why there are always trade-offs associated with any decision.
4. What is the opportunity cost of buying a new computer?
5. Describe four trade-offs associated with buying a new car.
6. What is meant by the term allocative efficiency?
7. Distinguish ‘allocative efficiency’ from ‘technical efficiency.’
8. Discuss how an improvement in technical efficiency can improve allocative efficiency.
9. Discuss how an improvement in dynamic efficiency can improve allocative efficiency.
10. Explain why it is important for an economy to focus on inter-temporal efficiency.
1.5 Factors influencing the decision making of economic agents
The study of economics is generally about understanding how economic agents respond to incentives. It is assumed that rational
people make decisions by analysing the costs and benefits of a decision and in doing so they respond to the incentives before them
(based on their available information).
Decision making by consumers
When economists discuss the behaviour of consumers they often make a number of simplifying assumptions. These assumptions
allow them to make predictions about the way markets may react to new economic information.
Rational
The average consumer is assumed to be fairly rational. This means that he or she will use their income to gain the greatest amount of
satisfaction. This satisfaction is often referred to as utility and consumers aim to maximise this for the lowest possible cost. To do so
they will compare the costs or benefits associated with any possible purchase and make a fully informed decision.
Preferences
It is generally assumed that consumers have clear preferences between the choices that are available. It is also assumed that
consumers are aware of how much extra utility they are likely to gain from consuming an extra unit of the product that they will
choose. The satisfaction that a person derives from a good is naturally subjective and economists do not generally attempt to explain
differences between individual’s tastes. To analyse the impact of changes on markets it is generally assumed that preferences and
tastes are reasonably stable.
Budget constraints
Each consumer is assumed to have a limited income to devote to the consumption of goods and services. Some people will obviously
be less constrained than others, but the lack of income means that most consumers are forced to make choices based on their
preferences and their budget constraints.
The implications of these assumptions are the basis of demand
analysis that will be covered in Chapter 2. It may seem obvious,
but all goods and services that are purchased involve the sacrifice
of income. The consumer cannot buy everything and the consumer
must therefore make compromises, and choose among alternative
products to obtain his or her maximum level of satisfaction.
The consumer is assumed to benefit from greater consumption of
a good or service rather than less and this is why products may be
described as ‘goods’ (rather than ‘bads’). It is generally assumed,
however, that each additional unit of a good does not necessarily
generate the same degree of satisfaction. In fact, economists argue
that the more of a good or service that is consumed per period, the
smaller the increase in total utility that is generated from the last
unit. This is referred to as diminishing marginal utility.
9
Economic Fundamentals in Australia
Every person faces trade-offs in the economy. If they choose to consume more of one product then this means that their budget may
not extend to another choice. The price and their income may therefore influence their choice, but what else might influence the
tastes, preferences and buying behaviour of consumers?
Influences on consumer choice
Marketing experts spend an enormous amount of time trying to understand what motivates a consumer to purchase one product
over another. They want to understand these motivations in order to influence the decision making process and encourage the
consumer to shift their buying behaviour.
There is obviously a vast array of factors that can influence the buying decisions of consumers. Two broad influences will be considered,
but a full explanation of buying behaviour is beyond the scope of this book.
Internal influences
There are a range of factors that are unique to each person that may affect their decision to
buy. The individual will have a certain level of knowledge of what is available and how they
perceive each product. If a person has never had exposure to an iPod, and is unaware of its
functionality, then it is unlikely they would sacrifice their income in exchange for the product.
Consumers may also develop an attitude towards a product. If they have a bad meal at a
restaurant then they may form the impression that all meals from the restaurant are bad, even
if the restaurant is highly regarded in the wider community.
Each person will have a perception of how they see themselves and their role in the world.
This can have a big influence on their buying behaviour. For example, older citizens may make
purchases that make them feel younger, or younger people may purchase products that make
them feel more powerful or influential. Similarly, people cannot take in and retain all of the
information that they are exposed to; they tend to filter out certain information and develop
attitudes about themselves and the products that are available. As a result, each of us will have an existing set of knowledge we
have gathered over our lifetime that might influence our buying decisions. We have different personalities and will therefore react
differently to the information that is presented to us. Some people may be less concerned with what others think of them, while
others may seek recognition and status from the goods and services they purchase. The role that a person plays in society, or in their
household, can also affect buying decisions. For example, a person’s buying behaviour is likely to change once they become a parent
or once they achieve a certain status or position in the community.
People may also be motivated by the time available to make the decision and may in some cases worry about making the wrong
decision when there is a range of options available. Clearly people have internal differences relating to patience, risk preferences,
self restraint, etc. While one person may rush to purchase the latest high tech item on the shelves, others may be more patient,
preferring to wait some time in order to develop a better picture of the product’s capabilities and/or limitations.
External influences
A consumer’s buying decisions are often influenced by their culture. This might include the way they learned certain behaviour
from their family and friends, educational environment or workplace. Marketers also like to focus on sub-cultures, which refers to
a smaller group that may share an ethnicity, religious belief, special interest or any other factor that may bring people together. If a
person identifies with a certain sub-culture, such as Punks or Emos, this may influence their clothing and music choices.
Sometimes consumers like to increase their knowledge of a product by accessing research conducted by independent organisations.
A consumer who wanted to purchase a new television may want to read a recent report by a magazine or website that reviews them,
such as ‘Choice’. Consumers often choose the movies they see based on the reviews they read in the paper or see on ‘At the Movies’
for example. Current affairs programs have gradually devoted more on-air time to consumer reports as the demand for information
from consumers has increased.
The purchase situation often has an influence on buying behaviour, even if the consumer is not aware at the time of purchase. The
physical environment and the reason for the purchase may heavily influence buying decisions. The layout of a supermarket is not
accidental, as much research has gone into ways to extract as much income from consumers as possible. Impulse buying, where
rational evaluation of the purchase is minimal, is a good example of how the purchasing situation may influence consumer behaviour.
Consumers may also buy a product in haste. For example, time constraints may cause a person to search for a gift at the last minute,
resulting in the purchase of a product that is ‘sub-optimal’ compared to the one they might have purchased if more time had been
allocated to the search.
10
Chapter 1: An introduction to microeconomics
Advertising is used extensively to influence consumer behaviour. Successful
advertising campaigns will shift consumer preferences and may encourage
the purchase of a product that may not have been considered. Successful
advertising may develop brand loyalty, where the purchaser may not
reasonably consider a viable substitute, thereby making consumers
less responsive to price changes. In addition, a lack of time may make it
convenient to stick with the brand you know. The advertising industry is
often accused of manipulating people to purchase goods and services that
they later regret. They have employed a vast number of psychologists to
understand the motivations of people. The need for approval is an aspect of
the human condition that advertisers have exploited extensively and it is for
this reason that the industry is often criticised. Advertising is considered in
more detail in Chapter 2.
Consumers may also be influenced by the behaviour and buying decisions of others. People often make inter-personal comparisons
and may purchase products that are deemed to be status symbols by society. If a neighbour purchases a new car then this may
motivate someone else to purchase one that is slightly better. Watching the lifestyles of others on TV can also influence buying
decisions and may account for the high level of debt that many households carry in the modern era.
Consumer buying behaviour may also be influenced by governments. The government can influence prices, encourage and discourage
consumption of certain products and ban or mandate products. For example, the government actively makes the purchase of
cigarettes unattractive. They impose high excise taxes on them, ban the consumption of the product in most public indoor areas, force
producers to use only plain, unbranded packaging and run advertising campaigns designed to show that the smoking of cigarettes is
very unappealing.
Decision making by businesses
It is generally assumed that businesses are created to make a profit. They are therefore motivated by increasing sales While minimising
costs. The factors that influence their behaviour may ultimately be determined by the impact that these factors have on their bottom
line. In other words, the impact they have on their level of profit.
The profitability of a firm will be influenced in general by:
a. The price of the product that they want to supply to the market
b. Their costs of operating
These factors will be covered in more detail in Chapter 2.
Generally speaking, firms will respond to consumer demand by producing those goods and services desired by consumers. However,
as previously discussed, businesses spend enormous amounts of money trying to influence the buying behaviour of consumers in
order to create new or additional demand for their products.
Chapter 3 will consider the role of competition in influencing the behaviour of firms. A lack of competition can, for example, result
in a restriction in supply and higher prices for consumers. In doing so, the business knows that this strategy will generate the highest
profits. Generally speaking the prevalence of competition forces a discipline on the way firms operate. They must pay attention to
the behaviour of other firms who offer substitute products and find a way to make their product more appealing to consumers. A
successful advertising campaign by Coca Cola, for example, may prompt Pepsi to conduct an extensive
campaign to maintain their market share.
Businesses may also be influenced by community attitudes. An increased awareness of environmental
damage and sustainability issues may force them to analyse and alter their production practices.
Ultimately the firm may be doing this to generate positive publicity that will increase their profitability.
The behaviour of businesses can be significantly affected by the policy decisions made by government.
The Gillard Government, for example, introduced a ‘carbon tax’ package in 2012, that placed a price
on the emission of carbon pollution by many of Australia’s largest emitters. It made the production
of energy using fossil fuels relatively more expensive. (see Chapter 16)This was designed to influence
a number of businesses to shift resources away from these industries and into those that are more
energy efficient.
11
Economic Fundamentals in Australia
Decision making by government
Much of the discussion in this book will examine the role of the government in the economy. Governments are elected by the
population and are therefore motivated by a willingness to stay in power and do what is best for the economy at large. The
government will intervene in individual markets to influence the allocation of resources, to smooth the impact of the business cycle
and to redistribute income more equitably. Each of these will be considered throughout the book.
Other organisations
There are also a range of organisations such as not-for-profit organisations that are motivated by the desire to help others or their
members. Aid agencies such as Oxfam are motivated by altruism, which is a desire to help others who may be less fortunate than
themselves. Schools, clubs and associations are run to benefit their students and members respectively. Their behaviour will therefore
be motivated by the impact that it will have on their members.
Review questions 1.2
1.
2.
3.
4.
5.
6.
7.
8.
Outline the three key assumptions made about the way consumers behave.
Discuss why consumers experience diminishing marginal utility.
Explain the difference between external and internal influences on consumer buying behaviour.
Describe four external factors that may influence the type of mobile phone you would choose to consume.
Explain why profit is the guiding principle behind most business decisions.
Explain one example of where government policy has influenced the behaviour of consumers.
Explain one example of where government policy has influenced the behaviour of businesses.
Explain why brand loyalty can make consumers less responsive to price changes.
Multiple choice review questions
1.
a)
b)
c)
d)
Economies around the world experience relative scarcity because:
Natural resources are inadequate
Needs and wants of consumers are manipulated by marketing experts
Shortages develop in markets leading to higher prices
Needs and wants are generally greater than the resources available to meet them
2.
a)
b)
c)
d)
The Australian economy allocates scarce resources through:
The market mechanism only
Government planning
A combination of the market mechanism and government planning
Assessing the needs of each person
3.
Which of the following statements would be inconsistent with Mankiw’s 10 principles of economics?
a)
China specialises in the production of clothing and trades this with Australia
b)In choosing to attend university a young man gives up the opportunity to earn wages working in a local supermarket
c)
The government is better able to allocate resources because there wouldn’t need to be any advertising
d)Australia is a rich country because we are able to utilise our resources and increase production levels each year
4.
a)
b)
c)
d)
A study of microeconomics is unlikely to include:
An analysis of the market for blue shirts in Australia
A prediction about the future of house prices in 2015-16
The role of governments in encouraging safe levels of alcohol consumption
Why the general level of prices in Australia has increased in the last 12 months
5.
a)
b)
c)
d)
The opportunity cost of building a new sports pavilion at your school is:
The loss of interest that the money could have earned if it were left in the bank
About $2 million based on current market prices
The loss of students if the pavilion had not been constructed
A decrease in the number of students visiting the library
12
Chapter 1: An introduction to microeconomics
6.
a)
b)
c)
d)
A country’s production possibility frontier may temporarily shift to the left if:
There is an increase in the number of skilled immigrants entering.
There is a decrease in demand caused by a recession
The country experiences a drought for two years
There is an increase in the participation rate
For question 7, 8 and 9 refer to the following production possibilities for a hypothetical economy producing only services and
goods (million units per year)
Production combinations
7.
a)
b)
c)
d)
Production of services
Production of goods
A
1 000
0
B
800
2 000
C
600
2 200
D
300
2 700
E
50
2 900
F
0
3 000
If the people of this country value services twice as much as goods, then the optimal allocation of resources is:
Combination A
Combination B
Combination C
Combination D
8.In 2015, the country consumed 600 services and 2400 goods. If their PPF had not expanded how could they have reached
this new consumption point?
a)
They specialised in one area and traded with another country
b)
Made their workers work longer hours
c)
Discovered new resources
d)
Had an increase in rainfall that year.
9.
a)
b)
c)
d)
If the country produces 600 services and 1800 goods then this may create the economic problem of:
A lack of economic efficiency
Unemployment
Incorrect prices
A lack of resource availability
10.
a)
b)
c)
d)
Allocative efficiency in the Australian economy may be improved if:
The taxes on alcohol are decreased
The Government increases flexibility in a range of markets
Taxes are placed on goods that the government deem to be luxuries
Government workers are granted a pay increase
11.
a)
b)
c)
d)
Inter-temporal efficiency may be improved if:
Drugs and alcohol are banned from outdoor music festivals
Firms are forced to pay for a permit to pollute the atmosphere
Taxes are increased on the interest earned from savings
Governments spend money on street lights
12.
a)
b)
c)
d)
Diminishing marginal utility generally means that:
Greater consumption of a product always yields more satisfaction
Products that are rare will have a higher price
Each additional unit consumed is a little less satisfying
The opportunity cost of extra consumption is always lower
13
Economic Fundamentals in Australia
13.
a)
b)
c)
d)
Supermarkets often place essential products like milk and bread at the back of the supermarket to encourage:
Impulse buying
Rational consideration of all the products available
Increased fitness for their customers
Convenience because these shelves are stacked more often
14.
a)
b)
c)
d)
Which of these external factors may influence a consumer to purchase a new digital music device?
A change in their music tastes
An increase in the price of toasters
An article in The Age reviewing the benefit of new applications
A need to appear younger
15.
a)
b)
c)
d)
A company is interested in developing brand loyalty amongst its customers because:
It cares about its customers’ self-perception
It would like its customers to be less concerned about price increases
It cares about the environment
It keeps its advertising department busy
16.
Which of the following statements about a planned socialist country is correct?
a)Assets are generally owned by the government but the buying behaviour of consumers determines what is produced
b)Assets are generally owned by private firms and households and resources are generally allocated according to consumer
demand.
c)
The government owns the assets and determines what goods and services should be produced.
d)Assets are generally privately owned but the government determines what goods and services should be produced
17.Assume that you win $ 1 million in a lottery. If you choose to put the money into a high interest bearing account the
opportunity cost would be:
a)
A loss of income from working
b)
An increase in income tax payable to the Federal Government
c)
The house that you may wish to purchase with the money
d)
An increased fear of a banking collapse
18.
a)
b)
c)
d)
A business is unlikely to enter a new market if:
there are low set up costs establishing the business
there are a large number of employees who are available to work for the business
there are a small number of large established businesses with strong brand loyalty
the government removes restrictions on businesses in the industry
19.Which of the following changes made by business was not in response to changing community values and attitudes?
a)
An increase in the availability of fuel efficient vehicles
b)
An increase in the use of palm oil to reduce the cost of producing food
c)
The labelling of food with nutritional information
d)
Safer working conditions at building sites
20.
a)
b)
c)
d)
14
An increase in the flexibility of labour market agreements will:
Increase inter-temporal efficiency
Decrease allocative efficiency
Increase dynamic efficiency
Have no impact on technical efficiency
Chapter 1: An introduction to microeconomics
Chapter 1 Applied economic exercise 1
1. Draw a production possibility frontier for a small country that can produce the combinations of goods and services outlined
in table 1.3 below.
Table 1.3 Production possibilities
Production combinations
Production of services
(units per year - million)
Production of goods
(units per year - million)
A
1000
0
B
700
2000
C
600
2200
D
320
2700
E
100
2900
F
0
3000
2. Highlight a point on the PPF you have drawn which would be most efficient (in terms of allocative efficiency) if the country
valued goods and services equally.
3. If the country’s preferences changed so that goods were valued twice as much as services, what would the new allocatively
efficient point be on the PPF?
4. What is the opportunity cost of increasing production of services from 100 to 320 million units per year?
5. If the economy produced 320m services and 2500m goods describe the economic problem that this may cause.
6. Explain how the economy could consume 600m services and 2400m goods.
7. Explain how a movement from one point on the PPF to another can be used to illustrate the concept of ‘dynamic efficiency.’
8. Construct a hypothetical PPF with Savings on one axis and Consumption on the other. Highlight how a movement along
this PPF can demonstrate a change in ‘inter-temporal efficiency.’
Chapter 1 Applied economic exercise 2
Climatic conditions, relative scarcity and efficiency.
Australia is considered to be the driest inhabited continent and drought is a regular feature of its weather patterns.
A drought is seen as a prolonged period without adequate rainfall. This means that there is a lack of an essential
resource to cater for users’ normal needs. It could be argued that Australians, whose livelihood is dependent upon
agriculture, are the most affected during periods of drought. During periods of drought there tends to be a decrease in
the productivity of the land and in some cases long term damage to the quality of the soil through loss of topsoil and
erosion. Bushfires and dust storms may also become more prevalent. During 2002 and 2003 Australia was said to
experience its worst drought since records began (1910). The drought shared characteristics with similar droughts in
the past, but the difference was that the temperature was above average, resulting in more rapid evaporation, drying
of soils and water needs for agriculture. It was estimated to have caused a 23% reduction in Australia’s agricultural
production and a reduction of the rate of economic growth by 0.7 percentage points. Similarly, economic prosperity
in Australia can also be worsened when a drought is broken. In early 2011, many eastern regions in Australia were
negatively affected by floods, as the drought of the preceding years broke. Floods reduce the number of goods and
services that are available and therefore increase the degree of relative scarcity. In addition, cyclones destroyed
banana crops in 2006 and 2011. The poor weather conditions were reversed in 2012 and this helped producers to
increase production, which led to a decrease in the price of much of Australia’s food.
1. Explain how unfavourable climatic conditions would affect the relative scarcity of each of the factors of production; land,
labour and capital.
2. On a production possibility curve illustrate how unfavourable climatic conditions might affect Australia’s productive
capacity.
3. Explain how drought may lead to an improvement in efficiency. In your answer discuss the type of efficiency that may be
affected.
4. Explain how the on-going threat of climate change might affect the purchasing decisions of consumers and businesses.
5. Identify and describe one government response to the following climatic disasters in Australia:
a) drought
b) floods
c) bush fires
15
Economic Fundamentals in Australia
Chapter 1 Applied economic exercise 3
Australia could end up with a scarcity of natural gas!
Australian families could face gas prices that are three times their current amount by 2021. This, on first glance, would appear to
be a case of relative scarcity. Economists would predict that an increase in price is likely to be driven by the relative change in the
level of demand and supply. That is, the product has become scarcer.
But Australia has plenty of liquefied natural gas (LNG), so why is the price expected to increase significantly? The price prediction
is linked to an expected export boom in the industry. When exporters can sell their gas to the world market at a much higher
price, they will expect local buyers to pay the same price. Australians have faced much lower gas prices compared to their global
counterparts so the higher prices will come as a shock to many households and businesses.
This case highlights the problem of scarcity from a local and international perspective. From Australia’s perspective (and viewed
in isolation), LNG is not necessarily scarce and prices have reflected this. Once Australia was able to export its LNG reserves, it
entered the world market where LNG was relatively scarce. Australian buyers will now face the same scarcity problems as the rest
of the world and therefore they will need to assess their current use and whether there are cheaper alternatives available.
1. If Australia were unable to trade its LNG reserves (i.e. export them to other countries), comment on the degree of
relative scarcity in the industry.
2. Explain why entering the world market for LNG results in higher prices for Australian consumers.
3. “Australia could end up with a scarcity of natural gas”. Comment on the accuracy of this statement from an economic
perspective.
4. Explain how changing gas prices might affect behaviour in Australia.
5. Should the government intervene in this market? Explain
Chapter summary
1. Economics is the study of choices and how these choices affect the wellbeing of the individual and society.
2. All economies attempt to answer the three basic economic questions of what to produce, how to produce and for whom to
produce.
3. Economists distinguish between three main types of resources that can be used to produce goods and services to meet the
needs and wants of the people on the planet – land or natural resources, labour and capital.
4. Microeconomics studies the behaviour of individual economic agents whereas macroeconomics studies how the whole
economy operates.
5. The primary way that resources are allocated in the Australian economy is via the market mechanism.
6. Relative scarcity occurs because the demand on resources is assumed to be infinite but the earth can only provide limited
resources to meet our needs and wants.
7. Whenever a choice is made there is always a cost. The existence of trade-offs means that there will be an opportunity cost –
the sacrifice of the next best alternative foregone.
8. Opportunity cost can be effectively illustrated using a production possibility frontier. This shows the combinations of goods
and services that an economy can produce using all of its available resources and technology.
9. It is impossible for a country to produce at a point outside their PPF in the short term. Over time they may add to their
resource pool through discoveries and immigration or find ways to use their resources more productively.
10. Any point inside the PPF represents an inefficient allocation of resources as some resources will be idle.
11. Allocative efficiency is achieved when resources are directed to those goods and services that provide society with the highest
end-use.
12. Technical efficiency occurs when the society is able to produce the largest volume of goods and services from their given
factors of production.
13. Dynamic efficiency can be improved when factors of production can be reallocated quickly following changing economic
circumstances.
14. Inter-temporal efficiency focuses on the balance between consumption today and consumption tomorrow.
15. Consumers are assumed to be rational when making decisions based on available information about the costs and benefits
of their actions.
16. All consumers are assumed to be making decisions subject to a budget constraint.
17. There are a range of internal and external factors that will influence consumer behaviour such as self esteem, perception,
culture, marketing, past experiences, independent evaluations and governments.
18. The overriding factor influencing business decisions is the desire to generate profit.
16
Chapter 2: The market mechanism
Chapter 2: The market mechanism:
demand and supply
2.1 What is microeconomics?
Microeconomics is the branch of economics that looks at the behaviour of the small economic agents that make up the whole
economy. In this area of study, the behaviour of consumers and businesses is explored in detail: what motivates each of them and
how they respond to changing incentives in individual markets. It is important to study microeconomics as it allows economists to
make predictions about the impact of changing circumstances on prices and volumes sold. It also forms the basis of macroeconomic
analysis which follows later in the course.
2.2 What is a market?
The market is the main instrument for allocating scarce resources in Australia. It is therefore the primary way to answer the three key
economic questions discussed in Chapter 1:
• What to produce
• How to produce
• For whom to produce
A market is seen as any place (which may or may not be a physical
space) that allows buyers and sellers to interact and exchange
goods and services. The purchasers of goods and services may be
households, businesses, governments or a range of other economic
groups such as not-for-profit organisations. The suppliers of goods
and services are generally businesses, but in the labour market,
households supply businesses with their labour and government
bodies frequently supply goods and services.
To understand how the market works, simplifying assumptions are generally made. The first is that the buyers and sellers are operating
in a competitive market. A competitive market is one where there are a large number of buyers and sellers and each of them has
little influence on the prices. This is often referred to as price-taking. Resources can be moved quickly in a competitive market which
allows price signals to do their job. It is therefore assumed that there are low barriers to enter and exit a market so that profitable
opportunities can be taken advantage of. The concept of a competitive market is discussed in more detail in Chapter 3.
‘The price that is determined in the free market is a compromise between the
desires of the buyers and the sellers.’
Consumers and businesses are assumed to be acting in their own self interest. Consumers will want to obtain the good or service they
wish to purchase for the lowest possible price. If they are willing to purchase the good or service at a certain price then they are giving
the suppliers a clear signal that they value the good or service at least that much. If they obtain the good or service for less than the
maximum they are willing to pay, then they have obtained what is referred to as consumer surplus. Consumer surplus is therefore
the difference between the price the consumer is willing to pay and the market price. The seller in a competitive market, on the other
hand, will try to sell their product at the highest price possible to maximise their profits (revenue less expenses). If they are able to
sell the product at a price above their economic costs (which includes the opportunity cost), then they generate a producer surplus.
The price that is determined in any market therefore is a compromise between how much the consumers are willing to pay and how
much suppliers are willing to accept for their product.
The market mechanism (or price mechanism) describes how the forces of demand and supply determine the relative prices of
goods and services, which then ultimately determine the way our productive resources (e.g. labour and capital) are allocated in the
economy. The role of relative prices in the allocation of resources will be discussed more fully in section 2.9.
17
Economic Fundamentals in Australia
2.3 The law of demand and the demand curve
As mentioned in the previous section, buyers in any market will generally want to obtain the product at the lowest price possible
and will exchange the amount of money for what they see as equal to, or less than, the value they place on the product. It is logical
therefore that at higher price levels, less of most goods and services will be demanded. As the price rises, the opportunity costs
associated with purchasing the product will increase, resulting in some buyers dropping out of the market. In simple terms, the
willingness and ability to purchase the good or service diminishes as prices rise.
The law of demand
→→ As the price decreases, the quantity demanded increases.
→→ As the price increases, the quantity demanded decreases.
The law of demand makes sense for the following reasons:
•
•
•
Some people may no longer be able to afford the product as the price rises. At a lower price we can afford more of a good
or service. As the price increases, however, some household budgets will no longer cater for the purchase of the product.
Economists commonly refer to this as the ‘income effect’.
Price is generally seen as an obstacle that may deter people from buying a product and an increase in price may mean that
the supplier is now asking for an amount that exceeds what people think the product is worth. Given that each person is
assumed to have an amount they are willing to pay for a good or service (based on its perceived value to them), it makes
sense that at higher prices less will be demanded. More people will drop out of the market as the price exceeds its perceived
value. Higher prices may also encourage consumers to look at the alternatives that are available in the market. When
the price of one good increases, consumers will look towards cheaper substitutes so quantity demanded is likely to fall.
Economists commonly refer to this as the ‘substitution effect’.
Many products are subject to diminishing marginal utility. Each
successive item of the product purchased yields less satisfaction.
Therefore a lower price is needed to induce greater purchases of
the product by individuals.
Attending a house auction is a clear way to see how the law of demand
works. There is generally one product for sale (the house) and there are
generally a number of possible buyers who are interested in the property.
In this environment, the potential buyers must compete against one
another. As the price is bid up, the number of potential buyers decreases.
The person who places the highest bid obviously wins the auction. Those
who have dropped out of the race have either accepted that the price is
above their budget or have decided that the house is not worth the price that has been achieved. There may also be similar houses
nearby which they believe may sell for less. If there is only one person who is interested in the property then they may obtain it for
less than what they were willing to pay. Thankfully the real estate agent is unable to read the mind of the buyer.
An alternative way to think about the law of demand is to think about the sales conducted by retail outlets. When stock is released
to the market, it may sit on the shelf for longer than what the retailer would like. The retailer is then keen to free up shelf space
and reduces the price to attract customers. As the price is reduced, some
Table 2.1 - Demand for compact discs
consumers will decide that the product is now worth the lower purchase
price and sales should increase as more consumers will also be able to
Price (AUD)
Quantity demanded per week
afford the product.
There are a range of factors that affect the quantity demanded in any
market but people cannot generally visualise more than two dimensions.
Economists have therefore decided that it makes more sense to choose
the most important factor that influences the demand for most goods and
services, namely price. The demand curve therefore shows the relationship
between various possible prices for a product and the quantity that
consumers would be willing and able to buy at each of these prices.
5.00
120,000
10.00
100,000
15.00
80,000
20.00
60,000
25.00
40,000
30.00
20,000
Consider the following hypothetical information about the market for prerecorded compact discs . Table 2.1 shows the number of CDs that would
be purchased at any given price. It is clear that the demand for CDs follows the law of demand. Lower prices result in an increase
18
Chapter 2: The market mechanism
in the quantity demanded and higher prices result in a lower quantity
demanded. For example, if the price of CDs increases from $5.00 to
$10.00, demand contracts from 120,000 per week to 100,000 per
week.
The law of demand is represented in a two dimensional diagram with
the price on the vertical (y) axis and the quantity demanded on the
horizontal (x) axis. This is represented in Figure 2.1
.
It is important to note that when the price of the product changes,
there will be a movement along the demand curve. When prices
increase, demand generally contracts (moves left along the demand
curve). When prices fall, demand usually expands (moves right along
the demand curve).
Figure 2.1
Demand for compact discs per week
Price($)
35
30
25
20
15
10
5
10
20
30
40
50
60
70
80
90
100 110 120
Demand
Quantity (000)
It is also necessary to be able to distinguish a movement along the
demand curve versus a shift of the demand curve. In both cases the
demand for a good or service will change, but the reasons for the change are distinct. A movement along the curve occurs when a
price change has caused the quantity demanded to be different. A shift of the entire demand curve will occur when one of the factors
of demand have changed and, therefore, at any given price there is either an increase or decrease in the quantity demanded. These
demand factors will now be discussed in section 2.4.
2.4 M
icroeconomic demand side factors that influence price and
quantity
Price is a significant factor that influences the demand for any good or service purchased in the market. There are a range of other
factors, however, that will affect the quantity demanded for a given product and each will cause the demand curve to shift. When the
demand curve is constructed, it is assumed that each of these other demand factors is held constant (ceteris paribus). Whenever one
or more of them changes, the position of the demand curve will also change.
If the demand curve shifts to the right this means that for each given price, there is a greater quantity demanded. A change in a
factor of demand will cause a shift in the demand curve. Accordingly, if a demand factor causes demand to increase, the demand
curve will shift to the right, and if a demand factor causes demand to decrease, the demand curve will shift to the left. Some of the
more significant factors that affect the demand for goods and services include: disposable income, changes in interest rates, the
price of substitutes, the price of complements, preferences and tastes, population growth and demographic change and consumer
sentiment. Each of these is discussed below.
Disposable income
Disposable income is defined as the total income that households have received in exchange for their participation in the production
process plus government transfers less direct (income) taxes. This represents the total amount that consumers (or businesses) have
to spend on goods and services.
Study tip: It is important to distinguish between disposable income and discretionary income. Income
tax increases will decrease disposable income but interest rate increases won’t (unless the individual has
savings) because the individual will still receive the same rewards from their contribution to the production
process. Discretionary income is a measure of how much households have to spend on non-essential items.
An increase in disposable income will generally lead to an increase in demand for normal goods. This will shift the demand curve to
the right as consumers (and businesses) may be willing and able to purchase a greater quantity at any given price.
Some goods, however, are considered to be inferior. These are goods where demand actually decreases when disposable income
increases. For example, a home brand product in a supermarket would be considered an inferior good because people are likely to
substitute towards higher quality branded products as their income increases.
Referring to the previous example regarding pre-recorded compact discs, if the government granted a tax cut to all workers then
the disposable income of all those who receive a taxable income would increase. Some of these workers may choose to spend their
increased income on purchasing music, even if the price remained the same.
19
Economic Fundamentals in Australia
This would be represented by a shift of the demand curve to the right and the demand information could change as follows in table
2.2:
Figure 2.2
Table 2.2 - Higher Demand for compact discs
Price (AUD)
Demand for compact discs per week
(after a tax cut)
Quantity demanded per week
5.00
130,000
10.00
110,000
15.00
90,000
20.00
70,000
25.00
50,000
30.00
30,000
Price($)
35
30
25
20
15
10
5
D1
10
20
30
40
50
60
70
80
90
D2
100 110 120 130
Quantity (000)
Figure 2.2 shows how a personal income tax cut affects the demand for compact discs. For example, at a price of $20.00, the demand
has increased by 10,000 CDs per week, from 60,000 to 70,000. This occurs at every other price, which is why the demand curve has
shifted to the right in a parallel fashion. The tax cut in this case is likely to result in an extra 10,000 CDs being demanded per week
(we can’t yet predict how many will be sold) across Australia as people have chosen to allocate some of their extra disposable income
to this product.
Change in interest rates
Increases in interest rates will generally have the greatest impact on those who are indebted. Home loans in Australia are usually based
on variable interest rates, which means that the banks can adjust the amount payable in line with changing economic circumstances.
An increase in interest rates will mean that indebted households (and businesses) will have less discretionary income after paying
interest. This will result in a decrease in demand and a shift of the demand curve to the left. In this case, less will be purchased at
each price.
There are a number of other ways (called transmission mechanisms) that changes in interest rates can affect the demand for goods
and services. These will be discussed in more detail under the monetary policy section (Chapters 12 and 13).
The price of substitutes
A substitute is a viable good or service that may be used instead of the product in question. Remember that one of the reasons for
the downward sloping demand curve is that when the price increases, it is assumed that some customers will switch to cheaper
alternatives. If a substitute becomes cheaper, and the price of the good we are analysing doesn’t change, then it is assumed that
demand will fall for the original good, resulting in a shift of the demand curve to the left as consumers substitute into the relatively
cheaper good. For example, in the market for televisions the two main substitutes are LCD/LED and Plasma. They are both capable of
receiving digital broadcast signals and facilitate the use of DVD players, the internet and game consoles. If the price of LCD televisions
increased, it would be reasonable to expect that some consumers would look for the cheapest alternative that meets their needs.
This should result in a shift of the demand curve for Plasma televisions to the right. Similarly, in the market for compact discs (CDs),
there are now a wide range of substitutes available that would account for the decrease in demand for CDs. Assuming that all
consumers are honest and happy to pay for music, they could download the music legally from a site such as iTunes or subscribe to a
music service such as Spotify or JB HiFi Now. Given that these services allow music consumers to access music at significantly reduced
prices, it makes sense that fewer CDs will be demanded.
The price of complements
Complementary products are generally consumed together. Continuing with the LCD/LED/Plasma TV example, it would be reasonable
to argue that a Blu-ray player is a complementary product to a big screen television. If the price of either type of TV increased, then it
would be reasonable to expect a decrease in the demand for Blu-ray players, shifting the demand curve to the left as some consumers
will be unable (or less willing) to purchase both. With respect to CDs, the price of CD players has probably had a minimal effect on the
sales of CDs. As alternative listening devices such as mp3 players have become cheaper and are more convenient, it has meant that
CD players are no longer sold in vast quantities. As a result, the producers of the CD players need to charge more for what is seen as
a niche market because they cannot achieve economies of scale. The higher price for CD players would therefore be another reason
why fewer CDs are demanded.
20
Chapter 2: The market mechanism
Preferences and tastes
Demand may be affected by an individual’s tastes, attitudes and preferences towards each good or service. A person who is fanatical
about music may have a greater demand for CDs than someone who is tone deaf. A music connoisseur may prefer to buy physical
copies of the music for collection purposes which may also affect the demand for compact discs, vinyl LPs and downloadable music.
The recent (and somewhat surprising) resurgence of vinyl as a musical source has been driven by people who prefer analog recordings
to the perceived coldness of digital audio. If a particular band tours Australia then music sales tend to increase. Consumers are
exposed to the music of the performer and they may become more fashionable. Going to see a music concert can influence the way
the consumer considers and appreciates the music. Advertising plays a big role in influencing consumer tastes. This is discussed at
length in the section on price elasticity of demand (section 2.11).
Population growth and demographic change
A growing population will generally need more goods and services, so it
is not surprising that the production of goods and services will usually
increase every year. The structure of the population may also affect
the range of goods and services that are sold in the market. An ageing
population, for example, may mean that demand for certain products
increase, such as healthcare and nursing homes. Some younger
generations have grown up with the belief that music is free so they are
less likely to sacrifice their income for this type of product. As a result,
CD demand for this demographic (10- 25 year olds) may be significantly
less than for older generations.
Consumer sentiment (confidence)
Consumer sentiment or consumer confidence is a measure of the
general expectations about the future state of the economy. Consumers’
expectations may affect their marginal propensity to consume (which
in turn affects their willingness to save) and their willingness to take on new debt. The marginal propensity to consume measures
the change in consumption that would result from a one dollar increase in income. If consumers feel secure about their future
employment opportunities, for example, they may be more willing to bring forward purchases and go into debt to purchase items.
Therefore when consumer confidence is high the marginal propensity to consume might increase. This means that for every extra
dollar consumers receive, they might wish to spend a greater amount of it. During periods of high confidence, households are
more likely to take on debt as they feel secure with their ability to service the debt. This would particularly affect the purchase of
discretionary items such as a new car or a holiday.
Review questions 2.1
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Define a market and describe its role in allocating resources.
Define what is meant by the law of demand.
Distinguish a consumer surplus from a producer surplus.
Explain, using sound economic reasoning, why the demand for chocolate bars is likely to contract as their price increases.
Describe how an auction process highlights the law of demand. In your answer, distinguish the income effect from the
substitution effect.
Distinguish a movement along the demand curve from a shift of the demand curve.
Explain the difference between a normal and an inferior good and give examples of each to illustrate your response.
Explain what is meant by the term ‘disposable income’ and outline how an increase in disposable income will affect the
position of the demand curve.
Explain why indebted households are likely to be sensitive to changes in Australian interest rates and discuss how this will
affect the position of the demand curve for a range of goods and services.
Identify two goods that would be considered viable substitutes for one another. Explain how an increase in the price of one
would affect the demand curve of the other.
Identify two goods that would be considered complementary and discuss how an increase in the price of one would affect
the demand curve of the other.
Explain how a significant increase in the rate of population growth might affect the demand curve for a range of goods and
services.
Explain how a change in consumer sentiment can affect the marginal propensity to consume and the demand curve for a
range of goods and services. Give specific examples.
21
Economic Fundamentals in Australia
2.5 The law of supply and the supply curve
While a higher price may act as a deterrent to the consumer, it tends to act as an incentive for the supplier of a particular good or
service. To the supplier, each unit sold represents an increase in their revenue. A higher price received for each product will also result
in an increase in revenue received. Assume, for example, a farmer can use his or her land to grow a range of crops, but he or she has
decided to focus on the production of strawberries. An increase in the price of strawberries in the market (which could be driven by
a change in tastes and fashion in the market) would tend to encourage this farmer, and indeed all strawberry farmers, to increase
the supply of strawberries in the market. They might be able to achieve this by using up more of their available land or by increasing
productivity. They recognise more profits are likely to be made from strawberries than any alternative use of the land, therefore the
opportunity cost of producing anything other than strawberries is higher.
In addition, for some suppliers, a higher output level might be associated with higher per unit costs of production. When the scale
of production increases beyond a certain point, the firm’s capital resources may become crowded at relatively high production levels,
the production facility becomes stretched, bottlenecks start to appear and efficiency declines. As a consequence, production costs
rise and higher prices are needed to justify higher production volumes.
Law of Supply
→→ As price rises, the quantity supplied increases
→→ As prices falls, the quantity supplied decreases
The law of supply makes sense because:
• a higher price received for the product represents an increase in revenue for the supplier;
• a higher price increases the opportunity cost of using resources to supply an alternative product; and
• to increase production, the cost per unit might increase (i.e. the marginal cost might rise).
It is therefore useful to think about supply in terms of what prices will be required to encourage producers to supply the market
a given quantity. There are a range of factors that affect the quantity supplied in any market but it is assumed that these are held
constant (ceteris paribus) for each different price level when the supply curve is constructed. Consider the following information
about the market for CDs.
Table 2.3 shows the number of CDs that would be supplied at any given price. It is clear that the supply for CDs follows the law of
supply. Lower prices decrease the quantity supplied. When price increases from $5 to $10, supply expands from zero per week to
20,000 per week. Like the demand curve the supply curve can be represented in a two-dimensional diagram with price on the vertical
axis and quantity supplied on the horizontal axis. This is represented on the supply curve in figure 2.3.
Figure 2.3
Table 2.3 - Supply of compact discs
Price (AUD)
Quantity supplied per week
5.00
0
10.00
20,000
15.00
40,000
20.00
60,000
25.00
80,000
30.00
100,000
Supply of compact discs per week
Price($)
35
Supply
30
25
20
15
10
5
0
10
20
30
40
50
60
70
80
90
100
110
120
Quantity (000)
When the price of a product changes, there will be a movement along the supply curve. When prices increase, supply generally
expands (moves along the supply curve to the right). This can be seen when the price increases from $10 to $15. The supply will
expand from 20,000 to 40,000. When prices fall, supply usually contracts (moves along the supply curve to the left).
22
Chapter 2: The market mechanism
2.6 Microeconomic supply side factors that influence prices and quantity
There are a range of factors that will cause the supply curve to shift. When the supply curve is constructed, it is assumed that each
of these supply factors (other than price) is held constant. Whenever one or more of them change, the position of the supply curve
will change.
Study tip: Remember that when demand or supply increases, the respective curves shift right, and when
they decrease, the curves shift left. Avoid talking about moving the curves up or down .
If the supply curve shifts right this means that for each given price, there is a greater quantity supplied. A change in a factor of supply
will cause a shift in the supply curve. If a supply factor causes supply to increase, the supply curve will shift to the right. If a supply
factor causes supply to decrease the supply curve will shift to the left. Some of the more significant factors that affect the supply
for goods and services include the prices of factors of production, profit margins, prices of other products, technological change,
productivity and climatic conditions. Each of these will be examined below.
Study tip: When trying to conceptualise the impact of a shift to the left of the supply curve, it can be useful
to assume that quantities remain unchanged and then ask the following question. What price does the
supplier now need to charge to justify supplying that particular quantity? The price needs to be higher at
every quantity level or else the supplier will no longer be willing to supply. Consequently, this causes the
whole supply line to shift left.
The prices of the factors of production
Each good and service that is produced in the economy requires resources, which are often referred to as the factors of production
(land, labour and capital). The position of a firm’s supply curve will depend on the costs involved in making a good or service as this
will influence the price they are willing to accept in return for the good.
Referring back to the market for compact discs, there are a number of resources that are needed to put together an album which can
be released for purchase. The artist may need to record the music in a studio which runs on electricity. The cost of hiring the studio
would therefore increase if the price of electricity increased. Similarly, if the price of oil increased then each CD would cost more to
make and transport. The record company may then need to increase the price they charge the retailer, which would represent an
increase in their cost of production (stock). As a result, the supply will decrease at each given price, which is represented by a shift
to the left of the supply curve. In other words, the higher costs of production reduce the willingness and/or ability of the retailer to
supply at a given price. Refer to Box 2.1 for further information about the common costs that can affect the supply curve of most
businesses.
Box 2.1 Common costs of production
The common costs of production faced by businesses include the following:
• Wages/Salaries and other on-costs such as superannuation and Workcover premiums
• Rent and property expenses
• Interest on loans and overdraft facilities
• Utility bills such as electricity, water and gas
• Delivery costs
• The cost of technology
• The rate of depreciation of assets
• The cost of raw materials used in the production process
• Financial and insurance services
• The level of government assistance or taxes and charges
23
Economic Fundamentals in Australia
Profit margins
This is really a subset of ‘the price of factors of production’ outlined above. Every good or service that is produced must charge a price
that is high enough to cover all of the costs of production, as well as provide a return to cover the risk associated with operating a
business. In other words, the owner(s) will require a portion of the price of the product to return to them in the form of profit, where
this must be at least enough to justify the owner(s)’ continued investment in the business. In economics, this is sometimes referred
to as a ‘normal profit.’ The profit margin is loosely defined as the difference between total sales revenue and total expenses. Most
businesses will seek to maximise this difference but are constrained by many factors, most significantly, the degree of competition
in the market for their particular product. When a supplier seeks to lift the profit margin, this effectively results in the supply curve
moving to the left, causing price to rise and the quantity sold to fall. Whether this strategy works to lift total revenue, and/or profits,
ultimately depends on the price elasticity of demand for their product (see section 2.10).
Prices of other products
The price of other products can be an important factor determining the willingness to supply and the position of the supply curve.
This stems from the fact that our factors of production (or resources) have many alternative uses and the use of these resources in
any productive activity involves opportunity costs. When there is an increase in the price of other products, it effectively results in
an increase in the opportunity costs, and pushes the supply curve to the left. To illustrate, assume that the CD producer uses a small
studio to manufacture the product and the owner devotes 40 hours of his labour to the business per week. Then he notices that the
prices for artwork are soaring to high levels. Assume further that he has an interest in art and his studio could easily be converted
into an art gallery. As the price of art continues to rise, the opportunity costs of staying in his current CD producing activity also climb.
Accordingly, he may exit the CD market to concentrate on artwork, thereby resulting in a decrease in supply of CDs. This therefore
represents a change in the allocation of resources, which will be discussed in section 2.9.
In some cases, goods are complements in production and the increase in price of one of those goods might result in an increase in
the supply of another. For example, when the demand for beef products increased due to an increase in tastes and fashion, farmers
naturally responded to the higher prices available in the market by increasing supply. This also resulted in an increase in the supply
of leather to the market which is made from the skins of the cows. Notice how the increase in supply of leather was not the result of
an increase in the price of leather itself, but the price of beef products.
Technological change and productivity growth
New technology will generally increase the productivity of existing resources. This means that a greater volume of goods and services
may be produced from any given quantity of land, labour and capital. If the price of these resources remains constant, this should
result in a decrease in the cost per unit. Higher levels of productivity would allow the supplier to supply more at a given price.
Computer technology has significantly reduced the costs associated with recording music. Many artists no longer need to hire a
professional studio as there are programs that can improve the sound quality of a
recording for little monetary investment. This has meant that the cost of making
music has significantly decreased and may have helped to increase the supply of CDs
in the market. The supply of music may have been further enhanced by the ability
to buy and sell digital files which are a much cheaper way of providing music to the
public.
Climatic conditions and other disruptions
Most goods and services rely upon nature for the provision of the raw materials
either directly or indirectly. Some agricultural products are heavily dependent
upon favourable climatic conditions. Until relatively recently, droughts experienced
across Australia decreased the productive capabilities of many farmers as they
were lacking an essential resource - water. This, for example, decreased the supply
of wheat available in the market. If wheat is used to produce bread and cereal
then the manufacturers of these products faced higher production costs which also
shifted their supply curves to the left. Furthermore, the Australian economy has
been subjected to erratic weather patterns that might be linked to climate change.
In 2011, many regions of eastern Australia were flooded. If a CD manufacturing
plant was in Brisbane, for example, then its ability to supply CDs to the market
would have been severely hampered. The facility may have been destroyed by
floods and the business might not have been physically able to supply the market.
Disruptions to supply could also be caused by human action. For example, wars
and acts of terrorism could result in the destruction of infrastructure or labour
and other resources may be lost in these situations.
24
Chapter 2: The market mechanism
Review questions 2.2
1.
2.
3.
4.
5.
Define what is meant by the law of supply.
Explain, using sound economic reasoning why supply is likely to expand as the price of chocolate bars increase.
Distinguish a movement along the supply curve from a shift of the supply curve.
Explain how an increase in the cost of production for firms will affect the position of the supply curve.
Explain how an increase in the price of strawberries will affect the supply curve for raspberries, assuming that they can be grown
on the same type of land.
6. Explain how an increase in annual rainfall may affect the supply curve for wheat.
7. Discuss how the introduction of the National Broadband Network may affect the willingness and ability of firms to supply a range
of new services.
8. Discuss why a shift of the demand curve will not necessarily result in a shift of the supply curve.
2.7 Market equilibrium
Up until this stage, demand and supply have been considered in isolation. In reality, buyers and sellers interact in the market to
determine the selling price and quantity traded of a certain good or service. There will be one price at a moment in time, that satisfies
the buyers and sellers, and the price at which the quantity demanded is equal to the quantity supplied is called the equilibrium price.
At this price, an efficient outcome has been achieved, because all that has been supplied to the market has been purchased.
Study tip: The market is generally seen as the best way to achieve the market clearing price. If prices are
determined by a central body, which is unresponsive to the desires of consumers, then shortages and
surpluses can develop. If the government, for example, set a price floor (a minimum price) for a certain
product and consumers no longer desired the product, a surplus would be created and equilibrium would
not be achieved.
In Table 2.4, the demand and supply for compact discs is reproduced in one table. The table also shows disequilibrium, where the
price is either above or below the market clearing level, resulting in either a surplus or a shortage of CDs in the market.
Table 2.4 – Compact discs – demand and supply
Price (AUD)
Quantity demanded
(CDs per week)
Quantity supplied (CDs
per week)
Surplus (+) or shortage
(-)
Quantity traded
5.00
120,000
0
-120,000
0
10.00
100,00
20,000
-80,000
20,000
15.00
80,000
40,000
-40,000
40,000
20.00
60,000
60,000
0
60,000
25.00
40,000
80,000
+40,000
40,000
30.00
20,000
100,000
+80,000
20,000
The market will have a natural tendency to move towards equilibrium. When the market price is set below the equilibrium price, such
as $10.00 there will be a shortage of 80,000 CDs per week. The price may be set at this level because the suppliers have entered a
new market and are trying to ascertain buyer response. It will soon become evident to the supplier that the price they are charging
is too low because they will run out of stock relatively quickly (resulting in a shortage). The supplier is then likely to take advantage
of this by raising the price in order to maximise profits. In some markets the buyers may actually try to outbid each other to obtain
the scarce products. With a higher price, some buyers will decide to leave the market because they are no longer willing or able to
purchase the CDs. The higher price will also act as an incentive for the suppliers to make more CDs available to the market. This will be
represented by movements along the demand and supply curves (demand contracts while supply expands). This price will therefore
continue to increase until the shortage is eliminated and the quantity demanded is equal to quantity supplied.
If the price is initially set above the equilibrium, the market will also move naturally towards its equilibrium. If, for example, the price
was initially set at $30.00 then the suppliers would notice that they are not generating enough sales. Compact Discs may have been
recorded by a number of artists, but due to the high prices, many of them are not being purchased. This represents a surplus of
80,000 CDs, which should encourage suppliers to lower their selling price and entice new customers into the market. (This is often the
motivation for stores who conduct regular sales to offload stock where prices were initially set too high.) When the price is lowered,
however, it gives a clear signal to potential suppliers in the market that this product may not be profitable (or less profitable than it
may have been). As a result, supply should contract and some manufacturers or retailers will decide to allocate their scarce resources
25
Economic Fundamentals in Australia
to relatively more profitable areas. The price will continue to decrease until there is no reason for suppliers to alter it, which means
that the market has reached a state of equilibrium. This analysis is highlighted in Figure 2.4.
Figure 2.4
Demand and supply for compact discs per week
Excess supply (surplus) of
80,000 CDs and price falls until
the surplus is eliminated
Price($)
35
Supply
30
25
20
Equilibrium price
15
10
Demand
5
10
Excess demand (shortage) of
80,000 CDs and price rises until
the shortage is eliminated
30
40
50
60
70
80
90
20
100 110 120
Quantity (000)
Equilibrium quantity
2.8 The effects of changes in supply and demand on equilibrium prices
and quantities traded
As noted in sections 2.4 and 2.6, the factors of demand and/or supply can change at any point in time. For example, an increase in the
price of a substitute will generally result in an increase in demand for the cheaper product. This would be represented by a shift of
the demand curve to the right for these products which may result in a new set of equilibrium prices and quantities traded. Consider
the following simple cases outlined below:
Changes in demand while supply remains constant
Suppose demand increases for CDs because the government manages to close down all illegal file sharing websites, such as
Limewire. The demand curve would shift to the right due to decreased availability of a viable and cheaper substitute. This indicates
that there is an increase in demand for CDs at all possible prices. This is shown in the diagram to the left in Figure 2.5 below. The
market price will tend to increase as the new equilibrium is at a point which is higher on both axes. The supply will expand because
the higher demand initially causes a shortage. When there is a shortage, the price will increase, thereby encouraging an expansion
in supply. The end result is a higher equilibrium price and quantity traded.
Figure 2.5
Higher demand: a shift of the demand curve to the right
Price
Lower demand: a shift of the demand curve to the left
Price
S
S
P2
Shortage
P1
Shortage
Q1
Q2
I
I
I
I
I
I
I
I
I
I
I
P1
D2
D1
Quantity
A shortage is created at the old price (P1)
and price will continue to increase until the
shortage is eliminated at P2
26
P3
I
I
I
I
I
I
I
I
I
I
I
Surplus
D1
Surplus
Q2
Q1
D2
A surplus is created at the old price (P1)
and price will continue to decrease until
the surplus is eliminated at P3
Quantity
Chapter 2: The market mechanism
Similarly, a decrease in demand for compact discs, which may be caused by a decrease in consumer sentiment, (consumers may
delay the purchase of discretionary items) will result in a shift in the demand curve. This is shown in the diagram to the right in
Figure 2.5 on the previous page. At each given price fewer compact discs will be demanded which is represented by a shift of
the demand curve to the left. This will initially create a surplus in the market and sellers will most likely conduct a sale and lower
their prices. In doing so the surplus may be removed and some suppliers will realise that the profitability of this market has fallen
so will contract their supply (and some may leave the market altogether). The new equilibrium price is therefore lower and the
quantity traded also falls.
Changes in supply while demand remains constant
If supply increases, due to technological advancements for example, this will result in an increase in the quantity supplied at each
price level. This will be represented by a shift of the supply curve to the right. This is shown in the diagram to the left in Figure 2.6
below. The shift to the right will generally result in a surplus of stock available in the market. Prices will fall and this will encourage
new consumers to enter the market. Therefore demand expands and a new lower equilibrium price is achieved with a greater
quantity traded.
Figure 2.6
Higher supply: a shift of the supply curve to the right
Price
Lower supply: a shift of the supply curve to the left
Price
S2
S1
S1
S2
P2
Surplus
P1
P1
Shortage
P3
D
D
Shortage
Surplus
Q1
Q2
Quantity
A surplus is created at the old price (P1)
and price will continue to decrease until
the surplus is eliminated at P3
Q2
Q1
Quantity
A shortage is created at the old price (P1)
and price will continue to increase until the
shortage is eliminated at P2
Conversely a decrease in supply will result in a decrease in the quantity traded and a higher equilibrium price. This is shown in
the diagram to the right in Figure 2.6. An increase in the cost of oil, for example, will have an impact on most goods and services
consumed. The oil is used as an input in the production of compact discs as well as the transportation of the final product to the
retail outlet. Therefore less will be supplied at each price and the supply curve will shift to the left. The shortage that is created
results in prices being bid up and some consumers will therefore leave the market as they are no longer willing and/or able to
purchase the product. These dynamics are summarised in Table 2.5.
Table 2.5
Change in demand
Change in supply
Impact on market
Increase
Unchanged
P increase, Q increase
Decrease
Unchanged
P decrease, Q decrease
Unchanged
Increase
P decrease, Q increase
Unchanged
Decrease
P increase, Q decrease
There are four more complicated scenarios. Sometimes the factors of demand and supply can both change (or a factor can affect
both curves such as interest rates). If, for example, interest rates are lowered across the economy then both curves are likely to shift.
The lower interest rates will mean that indebted households will have more discretionary income to spend on a range of goods and
services (such as CDs). This would shift the demand curve to the right. At the same time the lower interest rates will tend to reduce
the cost of production for firms who operate with some level of debt. Their supply curve will therefore shift to the right. When the
demand curve and the supply curve both shift to the right this is more than likely to lead to an increase in the quantity traded. It may
at first glance seem impossible to determine what impact this will have on the prices of CDs. Further knowledge of the consumers
27
Economic Fundamentals in Australia
and suppliers is needed to make a meaningful prediction. The price change will depend upon whether changes in interest rates will
have a bigger effect on consumers or producers. Given that many producers may not be operating with debt and producers are
unlikely to pass on any savings in a climate of higher demand, it is more than likely that the prices for CDs will increase. This may
also depend on other factors such as the level of confidence in the economy, the degree of spare capacity and the price and income
elasticity of demand. The four more complicated scenarios summarised in Table 2.6 below indicate that there will always be one of
the two parameters which is difficult to determine (either price or quantity) and further knowledge of the individual market will be
required to reach a conclusion.
A summary of the more complicated scenarios appears in Table 2.6
Table 2.6
Change in demand
Change in supply
Impact on market
Increases
Decreases
P increase, Q ?
Decrease
Decreases
P ?, Q decrease
Increase
Increase
P ?, Q increase
Decrease
Increases
P decrease, Q ?
Case Study/Analysis task 2.1: The changing value of the dollar and the impact
on demand and supply curves.
When the Australian dollar changes in value it can potentially affect the demand and the supply curves for some
products. Consider the market for Australian-made motor vehicles. Each of the car manufacturers who have operated
factories in Australia have chosen to cease their operations in Australia after making on-going losses. One factor that
has affected both the demand and supply for Australian made cars is the value of the Australian dollar. This is a factor
that is very much out of the control of the manufacturers themselves. So how does it affect the demand and supply
curves for Australian-made motor vehicles?
The demand curve is affected via the price of substitutes. For
the three years between 2010 and 2013 the Australian dollar
appreciated rapidly and hit historically very high levels (in
terms of a number of currencies). It had not been this high
for more than 30 years. This meant that the relative price
of imported cars fell as dealerships in Australia were able to
lower their costs of production. [Their costs of production
fell because, for Australian car dealers selling imported
cars, one of their ‘input costs’ is the wholesale cost of the
imported cars themselves.] The price-conscious consumer
would therefore have a greater incentive to substitute away
from the Australian-made car and purchase an imported
one instead. This is represented by a shift to the left of the
demand curve for Australian-made cars.
The high dollar also affected the supply curve for Australian-made cars. Whilst the cars were assembled in Australia,
many of the parts were made in foreign countries. The cost of imported inputs would therefore be lower because less
Australian dollars would be needed for each unit of foreign currency. As the cost of production fell (holding all else
constant), this factor would shift the supply curve to the right.
When the demand curve shifts to the left and the supply curve shifts to the right, the equilibrium price should fall.
But what happens to the quantity traded? In the case of Australian-made cars the demand side effect outweighed the
supply-side effect and fewer cars were sold.
Application questions
1. Using a fully-labelled demand and supply diagram, illustrate how the appreciation of the AUD in recent years
affected the market for Australian-made vehicles.
2. Explain, with the aid of an appropriate diagram, how the high value of the dollar may have affected the market
for imported cars in Australia.
3. Identify and explain one other demand factor that may have led to the decrease in demand for Australian-made
cars.
4. Explain how the high Australian dollar may have affected Australian car-parts manufacturers.
5. Identify and explain one other supply factor that may have reduced the competitiveness of Australian car
manufacturers.
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Chapter 2: The market mechanism
Case Study/Analysis task 2.2: Movie Theatres
Have you ever sat in a half empty movie theatre? This could be an indication that the market has the price wrong.
With the increasing incidence of illegal downloading and cheap DVDs and Blu-rays on sale, paying $15 to $20 to sit
in the dark might be a little too much for some customers. This creates a
surplus in the market for movie tickets at cinemas (which may or may not
be temporary). Even though there are peak times for cinema-goers (such
as Friday and Saturday nights), there doesn’t seem to be much change in
the prices that the cinema charges. They also charge the same price for a
popular film as one that has been given one star by reviewers.
If the cinema was looking like it was going to be empty, it would be very
difficult for the cinema manager to lower ticket prices on a particular
day. If management did choose to lower the price, then consumers might
delay their purchases of movie tickets in future to wait for a possible price
decrease. Over time, if cinemas continued to be empty the operators would
have to reflect upon their pricing decisions and the price may be decreased.
Application questions
1. Illustrate, using a demand and supply diagram, how a price of $20
per ticket may lead to an empty movie theatre.
2. Explain why the cinema operators are unable to offer movie tickets at a lower price when there is an
unexpected decrease in demand.
3. Identify and explain two demand side factors that could lead to an increase in the demand for movie tickets.
4. Identify and explain two supply side factors that could lead to an increase in the supply of movies.
5. Explain one strategy that the cinema operators could implement that might help to curb the decline in
demand caused by online piracy.
29
Economic Fundamentals in Australia
2.9 Resource allocation and the role of relative prices
Resource allocation is the study of how resources such as land, labour and capital are used to produce goods and services to meet the
needs of households, businesses, governments and other economic agents. Economists are interested in ‘What’ goods are produced.
Therefore they want to know where the resources are being directed in terms of production. Is the country using its labour resources
to produce mineral exports or to manufacture shoes? Economists may also be interested in ‘How’ resources are being used in the
production process. Generally speaking, firms with a profit incentive will try to minimise their costs of production. This may mean that
they seek the most efficient way to convert their land, labour and capital into the end product. Finally, economists will look at how
the products that are made are ultimately distributed in the economy - in other words, ‘Who’ gets to enjoy the goods and services
that are produced. In a market capitalist economy, markets will typically allocate resources to those who are willing and able to pay.
Study tip: It is possible to make links between seemingly unrelated markets if one is prepared to investigate
far enough. For example , any change in one market will affect labour and other factor markets for
substitutes and complements as well as financial markets.
Markets are able to reveal information about consumer preferences which helps to direct the allocation of resources. The ability
to make free choices shows producers what consumers value, their priorities and preferences. Ultimately, the value of any good or
service is determined by the buyer’s willingness to pay relative to its availability. The price is therefore used to ration the scarce goods
and services to the point where the market will allocate resources to the highest end-use. The market will typically lead to the most
efficient allocation of resources in the sense that resources are allocated
to the production of those goods and services most satisfying the needs
and wants of society. However, markets do sometimes fail, and this will
be explored in Chapter 3.
Across the economy there will be a set of prices for every good or service
that is offered for sale. Economists are not only interested in the price of
individual goods and services but also relative prices. The relative price
is seen as the price of any one good or service measured in terms of the
price of another good or service. This usually involves dividing the price of
one good by the price of another. It is therefore a measure of opportunity
cost (which was discussed in Chapter 1) as the relative price of one good
can be expressed in terms of what is given up to obtain the other. For
example, if the price of a CD is $20 and the price of a download album is
$10, then the relative price is $20/$10 = 2:1. This means that for every
CD you purchase you forego the opportunity to purchase two download
albums. If the price of a CD increased to $25 then the relative price would
be 2.5:1 meaning the consumer would now be giving up the opportunity
to purchase 2.5 download albums for each CD purchased. Changes in
these relative prices will therefore alter the incentives of producers and
consumers and will result in an alteration to the goods and services that
are produced and consumed in the country.
With respect to the question of what to produce, an economy that relies on the market mechanism will allocate resources to
those goods that are in high demand. When the relative price of a good or service increases due to an increase in demand (and/
or a decrease in supply) this sends a clear signal to economic agents. A supplier may see the price movements and decide that it is
now more profitable to use their resources to produce that good or service. Consumers are therefore said to be the main driver of
resource allocation in the market based economy. For example, if there was an increase in the price of petrol then people may look
for cheaper forms of transport such as scooters (because they use less fuel). This will result in an increase in the demand for scooters
(the demand curve shifts right) and this would create a shortage of scooters at the existing price. The shortage will encourage some
potential buyers to bid up the price and existing suppliers will take the opportunity to raise the price. The price of scooters has now
risen relative to other forms of transport (such as cars), which indicates that this is an area of production providing greater profit
opportunities. Producers will therefore decide to allocate more land, labour and capital to the production of scooters.
The introduction of the carbon tax from July 2012 (albeit for a brief period) also influenced the structure of relative prices. The carbon
tax was imposed on country’s largest carbon emitters (approximately 260 companies) and it resulted in an increase in the price of
carbon intensive products, such as electricity produced at coal-fired power stations. The price of coal-fired electricity increased
relative to the price of installing solar panels, which then raised the demand for solar panels (shifting the demand curve to the right)
and resulted in a higher equilibrium price for solar panels. As a result, producers noticed the higher ‘relative price’ of solar panels
(compared to other goods that they might wish to produce), and allocated more resources to the production of solar panels. The
30
Chapter 2: The market mechanism
higher price of electricity generated from coal led to a contraction along the demand curve for coal generated electricity and less coal
resources were ultimately utilised within Australia to make electricity.
Interestingly, a carbon tax (or carbon pricing more generally) both increases and decreases the relative price of solar panels, providing
important signals to economic agents and helping to explain why and how resources are allocated in response to price signals. First,
the relative price of solar panels will fall when compared to coal-fired electricity, encouraging demand to move away from this form of
energy production and toward less carbon intensive forms of energy production. Resources will therefore shift out of the production
of coal-fired electricity. Second, the relative price of solar panels will rise when compared to other products, resulting in more
resources flowing to the production of solar panels.
The price mechanism describes how the forces of demand and supply determine relative
prices of goods and services, which then ultimately determine the way our productive
resources (e.g. labour and capital) are allocated in the economy.
The price mechanism will also influence the second fundamental economic question of how to produce the good or service. Generally
speaking, a business will seek to maximise its profits by minimising its costs and selling the good or service at the highest price
possible. The competitive market will ensure that resources are used as efficiently as possible so that producers can offer their
product at the most attractive price to the consumer. Therefore when the price of one resource increases relative to the price of
another, this may influence firms to change the way they produce their goods and services (and in the process alter the allocation
of resources). For example, if unions are successful in raising wages of unskilled labour, this increases the price of labour, relative
to capital, and may cause some substitution out of labour and into capital. The relatively high price of labour (when compared to
capital) offered to unskilled labour in Australia, may have encouraged the supermarket industry to implement self-serve checkouts
which decreases the need to hire as many workers.
Similarly, the price mechanism will effectively allocate resources within
factor markets themselves, with changes in the relative prices for factor
inputs sending clear signals to the owners of these resources about how
best to use their resources in production. For example, in labour markets,
the shortage of engineers over recent years has resulted in a higher price
(i.e. the wage or remuneration) for engineers relative to the price for other
professions, which has sent a signal to people, such as university entrants,
that a career as an engineer is relatively more lucrative. This is likely to lead to
greater allocation of labour resources to this particular section of the labour
market. In other words, there will be greater supply of engineers to this
market as the price (or wage) of engineers has increased relative to the price
offered in other professions. Again, the price mechanism has facilitated this
movement of (labour) resources from one activity to another.
a
The third fundamental question of for whom to produce is determined by the potential consumers’ willingness and ability to pay.
Resources will end up being allocated to the production of goods and services that are demanded by the consumers but some
consumers will be able to demand a lot more goods and services than others. More land, labour and capital may therefore be
devoted towards the material needs of the high income earners in our society because they can afford to purchase more goods and
services. Therefore, the relative wages of different professions will ultimately influence who gets to consume the resources available
in a country (or the world at large).
Generally speaking, those goods and services that are profitable to produce in a competitive market will be produced and those that
involve making a loss will not. However, governments will intervene to ensure that efficient outcomes are achieved when the market
is unable to do so and to reallocate resources when equity is not achieved. Some of these instances are investigated in Chapter 3.
Review questions 2.3
1.
2.
3.
4.
Define what is meant by the term equilibrium.
Explain how the market for haircuts would return to equilibrium if the price was initially set above the equilibrium.
Explain how the market for haircuts would return to equilibrium if the price was initially set below the equilibrium.
Explain how the market will answer the fundamental economic question of “what to produce”. Make reference to the role of
relative prices in your response.
5. Explain how goods and services are likely to be produced in a competitive market. Make reference to the role of relative
prices in your response.
6. Explain how the price mechanism will cause a reallocation of labour resources in the event that there is a shortage of
engineers.
7. Explain why reliance on the price mechanism will often result in an unequal distribution of the products that are made in a
country.
31
Economic Fundamentals in Australia
Case Study/Analysis Task 2.3: The price mechanism at work
Quinoa – the superfood
Not so long ago, quinoa was an ancient grain that no one knew
how to pronounce (it is kin wa) but the increasing interest in
healthy eating and preventative medicine has meant that it has
become in high demand around the world. The grain is unique
in that it has a high protein content (with essential amino acids)
which can be used to replace meat in the diet.
The rapid increase in demand has, not surprisingly, led to a
significant increase in prices as world supply has been unable
to keep with demand. In some cases, the original consumers of
the quinoa, Bolivians, have been unable to afford the grain. But
the change in demand has had some interesting impacts on the
allocation of resources.
Quinoa consumption in the countries where it was originally
produced (in the Andes Mountains of South America) has fallen as
its relative price has increased. Families have chosen to consume
more pasta and rice as a result and in some countries, quinoa
is more expensive than chicken. Consumers have responded to
price incentives and altered their consumption levels accordingly.
The higher prices for Quinoa have had some positive effects in
Bolivia. Farmers can now afford to send their teenagers to school
and they are able to earn the income sufficient to buy a wider range of fruit and vegetables at the market. The
increased revenue for the country has enabled the building of better roads, and houses that were once free of
electricity now have access to this vital form of energy. The income earned by the farmers has encouraged many
young people to consider staying on the land because they can now earn a decent living (they are choosing to
reallocate their labour resource).
The popularity and higher prices received for quinoa has encouraged agricultural entrepreneurs in Australia to
reallocate their scarce land resources to its production. The crops, planted in Tasmania, have been successful and
this may encourage other farmers to produce the grain in the future.
Application questions
1. Explain, with the aid of a demand and supply diagram, how the market for quinoa has changed in the
last 10 years.
2. Explain why the increase in demand led to a shortage in the world market for quinoa.
3. Analyse how the higher relative price of quinoa may have affected the decision making of Australian
farmers.
4. Identify and explain one potential cost associated with the increased popularity of quinoa in developed
nations.
5. Explain why the increase in the price of quinoa might lead to an increase in the use of electricity in Bolivia.
6. Identify and explain one reason from the case study why the allocation of resources to rice might increase
in some countries but decrease in others.
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Chapter 2: The market mechanism
Case Study/Analysis task 2.4: The structure of relative prices – the story of alcohol,
drugs and (seemingly free) rock ‘n’ roll
This case study highlights how changes in relative prices influences the choices
made by consumers and businesses.
A recent report entitled Australian Trends in Ecstasy and Related Drug Markets
2010 highlighted the growing number of young people using illicit drugs such
as ecstasy. Could this increase in drug use be the result of illegal downloading
and well-meaning governments? An analysis of markets may help uncover the
truth by looking at the structure of relative prices and resource allocation.
In recent years both Federal and State Governments have sought to reduce
the damage caused by alcohol consumption. Some of the damage included
the negative health effects of binge drinking and alcohol-related violence.
One of the most publicised policy initiatives to tackle the problems was
the introduction of the so-called “Alco-pops tax” which targeted pre-mixed
alcoholic drinks. In addition there was a tightening of liquor licensing rules
which effectively increased the cost of operating a nightclub or music venue.
This is one contributing factor to the increasing cost of alcohol at entertainment
venues.
Over the last 10 years there has been an increase in the incidence of “file sharing” which has resulted in a significant
decrease in the revenues received by recording artists. One way that the recorded music industry has sought to recoup
some of these losses is to increase the fees that are payable by the venues that play their music. This also increases the
cost of production and is one factor that has contributed to an approximate increase in the price of alcohol at bars of
between 20 to 25%. This is far in excess of the rate of inflation over the same period. Some nightclubs, not surprisingly,
reported a decrease in alcohol sales by up to 30%. The price of concert tickets also increased because artists may have
been seeking ways to recuperate the lost revenue from illegal downloading and file sharing.
In response to the growth in demand for ecstacy, the Government, through its relevant drug education authorities,
undertook an extensive education program. The program influenced tastes and fashion and the demand for the drug
decreased. Unfortunately, the National Drug Strategy Household Survey Report found that consumption of cocaine,
especially by women, had increased. The report suggested that it had become more widely available and that the high
value of the Australian dollar had made it cheaper to acquire. Given the highly addictive nature of cocaine, the price
elasticity of demand for the product might be quite low, and this can encourage some users to resort to crime to support
their habit.
The change in the structure of relative prices may be having consequences that the Government did not foresee. The
relative prices of alcohol and illicit drugs have moved in an opposite direction. It may have also resulted in an increase
in the instance of “preloading” where people drink a large amount of (cheaper) liquor before they go out. Unfortunately,
the government’s efforts to curb one problem may therefore have contributed to the increase in the consumption of an
illegal drug whose effects are yet to be fully realised and where the product’s ingredients cannot be guaranteed.
The consumption of alcohol and drugs is associated with market failures and negative exernalities, which will be discussed
in Chapter 3. As a consequence, governments are likely to continue investigating ways to reduce consumption of these
substances.
Application questions
1. Identify and explain two microeconomic demand factors that have increased in the cost of supplying alcohol at
nightclubs and entertainment complexes broadcasting pre-recorded music.
2. Explain why the increased incidence of illegal downloading has resulted in a change to the structure of relative
prices in the pre-recorded music industry. Explain how these price changes have influenced the price of alcohol sold
in entertainment venues.
3. Explain how an increase in the price of alcohol sold at entertainment venues has influenced the allocation of
resources in the alcohol industry.
4. Explain how government interference in the alcohol market has affected:
• relative prices
• the consumption of ecstacy
• the allocation of resources
5. Discuss how the legalisation of ecstacy consumption is likely to impact on the markets for both alcohol and ecstacy.
33
Economic Fundamentals in Australia
2.10 The meaning and significance of price elasticity of demand
The demand curve shows the relationship between various possible prices of a particular product and the quantities that buyers are
willing and able to purchase at each of these prices. The law of demand suggests that consumers will respond to a lowering of price
by purchasing more of the good or service in question.
Economists are also interested in how much demand will change when a factor affecting demand changes. In particular, the price
elasticity of demand measures the responsiveness of changes in the quantity demanded to changes in price. A small percentage
decrease in the price of a product could result in a large percentage increase in the quantity demanded, meaning that the good or
service has a high price elasticity of demand.
Price Elasticity of Demand (PED) is measured by the following formula:
PED = percentage change in quantity demanded
percentage change in price
The value for PED can be broken into three distinct categories:
High PED (elastic)
The product will have a high PED if the absolute value is greater than 1. In this situation the percentage change in quantity demanded
will be greater than the percentage change in price. This will mean that if a supplier lowers their price they are likely to attract a bigger
percentage increase in demand. If they increase the price however they will lose a much bigger percentage in quantity demanded. A
demand curve where the PED is high would be one that is relatively flat (See Figure 2.7).
Study tip: When the PED is calculated it will result in a negative value. This negative is generally ignored
when examining data related to the PED.
Low PED (inelastic)
The product will have a low PED if the value is less than 1. In this situation the percentage change in quantity demand will be less than
the percentage change in price. This will mean that if the supplier lowers their price they are likely to attract a smaller percentage
increase in the quantity demanded. An increase in price however will result in a smaller percentage loss in quantity demanded. A
demand curve where the PED is low would be one that is relatively steep. (See Figure 2.7)
Box 2.2 Elasticity and Pricing
One way of telling whether a product has a high or low price elasticity of demand (PED) is to look at what
happens to the total revenue that results from a price change. If a price increase results in an increase in total
revenue then the product will have a low PED (that is less than 1). This is because the percentage increase in
price will outweigh the percentage that is lost in quantity demanded. A good with a high PED will be one where
a decrease in price will result in an increase in revenue. The response of demand will outweigh the decreased
price resulting in greater revenue. Generally speaking, the greater the degree of competition in markets, the
higher the PED, whereas in less competitive markets, such as an oligopolistic market (for example, banking in
Australia) the PED is lower. Market structures and competition will be explored more fully in Chapter 3.
Medium PED (unit elastic)
In some cases the percentage change in quantity demanded and price may be equal. This is called unit elasticity because the elasticity
value will be exactly 1.
If a product has a low PED it does not generally mean that consumer demand is completely unresponsive to changes in price. A
perfectly inelastic demand curve, however, would be vertical as demand in this situation would be completely unresponsive to
changes in price. A perfectly elastic demand curve would be horizontal as the smallest percentage increase in prices would result in
a complete loss of sales.
34
Chapter 2: The market mechanism
Figure 2.7
High price elasticity of demand
Unit price elasticity of demand
Price
Low price elasticity of demand
Price
Price
Price
D
D
Quantity
Quantity
D
Quantity
2.11 Factors affecting price elasticity of demand
The degree of necessity
Goods and services that are deemed to be necessities will usually have a low PED,
whereas luxury products will have a relatively higher PED. If the price of bread increased,
for example, the quantity demanded would decrease, but by a smaller percentage, as
bread is a staple item for most households. Similarly, if a person is a diabetic, they are
unlikely to decrease their consumption of insulin if the price increases. Therefore, both
products would have a low PED.
Addiction can also turn a seemingly discretionary item into a good with a low price
elasticity of demand. When a person is addicted to a product they may continue to buy
it in large quantities (remember there will be some decrease) even if the price increases.
This is one reason why the Federal Government is able to continually increase the excise
tax on alcohol and cigarettes. The price for the product increases (due to a decrease in
supply) but the decrease in sales is relatively small. The impact of rising alcohol prices is
discussed in Case study/Analysis Task 2.4.
Luxury goods on the other hand can be foregone more easily because, by definition, they are not necessities. If the price increases
there is likely to be a greater percentage reduction in the quantity demanded.
Availability of substitutes
The greater the number of substitutes that are available for a product, the greater the PED. Consumers are likely to switch to a
close substitute if the price rises. At a highly competitive fruit market, like the Victoria Market, the price elasticity of demand for
each orange would be very high. If one stall holder increased their prices by a small percentage they may find that they lose a
big percentage of sales. Consumers would be able to easily compare prices and there would be a multitude of suppliers who the
consumer could turn to quickly and easily. This is also a key reason that insulin has a low PED, as there are no viable substitutes. Case
Study/Analysis Task 2.5 analyses the role of advertising in influencing the viability of substitutes. Effective advertising will decrease
the viability of competitors’ products and is designed to reduce the price elasticity of demand.
Proportion of income
The greater the percentage of income that is needed to purchase a good or service, the greater the PED. If the price of a box of
matches increased by 50% for example, it would be surprising to see a decrease in sales by 50%. A 10% increase in the price of a new
house, however, could amount to thousands of dollars which, for the average person, could be the deciding factor excluding them
from the market, resulting in a larger than 10% drop in the quantity demanded.
Time
Many consumers have habitual buying behaviour. This sometimes means that they are less likely to notice price changes in the short
term. Over time however, consumers may notice the price increase and experiment with alternative products. Consider the example
of petrol. If the price of petrol rises then people may continue to purchase similar quantities. In time they may be able to make
alternative travel arrangements, such as public transport or car pooling. In the long run they may actually choose a more fuel-efficient
car or hybrid car so that their petrol consumption can decrease in line with higher prices. This means that, for many products, price
elasticity of demand is more elastic in the longer term.
35
Economic Fundamentals in Australia
Case Study/Analysis task 2.5: The role of advertising
Firms often spend thousands to millions of dollars per year on advertising and other
forms of marketing. In terms of demand analysis the aim is twofold. Advertising
is designed to inform the consumer of the product and influence their tastes and
preferences. A successful advertising campaign should result in an increase in the
demand for the product at each given price level, thereby shifting the demand curve
to the right.
Advertising is also designed to increase brand loyalty. Successful advertising and
marketing will enable consumers to associate a certain lifestyle or image with the
product. If firms are able to successfully create a sense of brand loyalty, then this
makes their competitors’ products less viable as alternatives. Therefore a successful
advertising campaign can decrease the PED for their product.
A lower PED for a product may allow the company to charge higher prices and gain an increase in revenue. This may help to
explain why some designer or luxury brands are able to charge far more than what it costs to produce their product.
Application questions
1. Outline two reasons why businesses spend millions of dollars on advertising, using a D/S diagram to illustrate.
2. Explain what is meant by brand loyalty and outline how advertising can generate brand loyalty.
3. Identify one other product (apart from Apple) where brand loyalty is likely to be high.
4. Discuss the possible relationship between an increase in advertising expenditure, brand loyalty and the PED.
5. Explain why it is considered to be profit maximising behaviour if a business raises the price on those products with a
low PED.
Case Study/Analysis task 2.6: Apple – using marketing to create a low PED
Why is it that people will queue up when a new iPhone is released? The first iPhone was
released in 2007. Since then, there have been 7 new iterations of essentially the same phone
which have encouraged people to upgrade their phone (even when their previous phone was
was still fully functional). How do the factors influencing PED influence the market for iPhones?
Percentage of income: iPhones are certainly not cheap (often costing in excess of $700)
but many purchasers are shielded from the large initial outlay by purchasing the phone on
a plan (they effectively pay for it over 12 to 24 months and it has been partially subsidised
by the telecommunications companies). Therefore in reality the relatively low percentage
of income that is allocated to paying a phone plan may make some people less responsive
to any potential price increase in the phone.
Number of substitutes: Many people have developed brand loyalty towards the Apple
iPhone. They do not view the competitors as viable substitutes, which allows Apple to
charge a higher relative price for their products without losing a large percentage of their
sales.
Degree of necessity: In many cases a new phone may not be a necessity but this is where Apple’s marketing and
development team have been very clever. They have been able to develop a sense of urgency (and sometimes hysteria)
amongst potential buyers, creating the feeling that they just have to have the latest phone. Apple has also been accused
of planned obsolescence because the phone may mysteriously become less functional at the end of the two year plan
(which might necessitate its replacement). This often occurs when software upgrades don’t function properly on earlier
models and battery life diminishes.
Application questions
1. Define what is meant by the price elasticity of demand.
2. With reference to at least two of the three factors discussed, explain whether the price elasticity of demand for
iPhones is likely to be high or low.
3. Research what is meant by planned obsolescence. Explain how planned obsolescence might affect the allocation of
resources.
4. Identify one of Apple’s competitors in the mobile phone market. Explain why it might struggle to attract demand even
if it were to lower the price of its product.
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Chapter 2: The market mechanism
2.12 The meaning and significance of price elasticity of supply
Price elasticity of supply (PES) looks at the responsiveness of changes in supply when prices change. The PES is the percentage change
in the quantity supplied of a good divided by the percentage change in its price.
PES = percentage change in quantity supplied/percentage change in price
Supply curves with a high price elasticity and a low price elasticity are depicted in Figure 2.8. A product with a PES that is greater
than one will have a relatively flat supply curve. This means that suppliers are willing and able to increase the supply by a bigger
percentage than the price increase. If the PES is less than one, the supply curve will be relatively steep. This means that when prices
increase by a certain percentage, suppliers are either unwilling and/or unable to increase supply by the same percentage.
High price elasticity of supply
Figure 2.8
Price
Low price elasticity of supply
Price
S
S
Quantity
Quantity
2.13 Factors affecting price elasticity of supply
Production period
If prices increase for a particular product this will give signals to suppliers that allocating resources into the area may now be more
profitable. Firms may wish to increase their supply, but it will take time to shift resources from the production of other goods and
services. If there is an increase in the demand for apricots, the demand curve will shift to the right, resulting in a higher price. The
higher price will therefore act as an incentive for more apricots to be grown. Unfortunately they cannot be instantly produced and
require growing and harvesting. As a result, the PES will be low in the short term but will increase over time as more resources can
be shifted into their production. If, however, the apricots could be stored for long periods, then suppliers may be more responsive to
price changes.
Spare capacity
If a firm has spare capacity then it is more likely to be able to respond to changing prices. There may be idle labour which can
work more hours and machinery can be utilised to increase supply quickly. If the industry is running at capacity and there are skills
shortages, making it hard to attract labour to expand operations, the PES will tend to be relatively low. Over a period of time the firm
may be able to increase their productive capacity and attract new labour (the Government may assist in this manner by expanding
immigrant numbers and training those who are structurally unemployed).
Durability of goods
If the goods can be stored, then it will be much easier to respond to changing prices. The supplier can simply access the inventory
that has been stored. Many firms face higher costs from storage however, which may limit their ability to respond to more profitable
price levels. Food products tend to have a low price elasticity of supply in the short run as they have a limited storage life. Canned
products, such as softdrinks, however, may be stored for extended periods. Therefore, if there was a sudden increase in demand
(which resulted in higher prices), the supplier could simply access any inventory that is available and reap the rewards.
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Economic Fundamentals in Australia
Review questions 2.4
1. Define what is meant by price elasticity of demand.
2. Explain whether the market for following products have a high or low price elasticity of demand.
a) mobile phones
b) mobile phones made by Samsung
c) BMW motor vehicles
d) apples
3. Explain three factors that might make the price elasticity of demand increase for a particular brand of chocolate bar.
4. Explain how an increase in advertising expenditure may impact on the price elasticity of demand.
5. Explain what is likely to happen to the total revenue for a business if the product it sells has a very low price elasticity of
demand and it voluntarily restricts supply (or raises price).
6. Define what is meant by price elasticity of supply.
7. Outline three factors that would lead to an increase in the price elasticity of supply for newspapers.
8. Explain whether the following products would have a high or low price elasticity of supply:
a) apples
b) cinema tickets
c) leather jackets
d) Heineken Beer
9. Discuss how the price elasticity of supply of fruit and vegetables is likely to be affected by new technology that prolongs the
shelf life of all fresh produce.
Multiple choice review questions
1. Which of the following statements about the demand curve is incorrect?
(a)The demand curve is generally downward sloping because many products lose their value when they are consumed
excessively
(b) The demand curve is generally downward sloping because at higher prices fewer people can afford the good or service
(c)The demand curve is generally downward sloping because at higher prices substitutes become a more viable option
(d)The demand curve is generally downward sloping because at lower prices the opportunity cost of buying the product has
increased
2. The demand curve for Kleenex tissues is likely to shift to the right when:
(a)
There is an increase in supply of tissues
(b)
The cost of paper production decreases
(c)
There is an increase in the price of Sorbent Tissues
(d)
There is a shortage of tissues in the market
3. The demand for wind-generated electricity is likely to increase if:
(a)
The Government introduces a carbon pollution reduction scheme
(b)
More energy efficient appliances are developed
(c)
The cost of producing coal-generated electricity decreases
(d)
There is an increase in interest rates across the economy
4. The supply curve for haircuts is likely to shift to the right if:
(a)
There is an increase in the price of scissors
(b)
The Government provides subsidies for the hiring of apprentices
(c)
The rent increases for buildings across Australia
(d)
There is a new fashion where people choose to grow their hair long
5. Which of the following is a factor that is likely to shift the supply curve for prescription spectacles to the left?
(a)
An increase in competition from new suppliers
(b)
An increase in the price of oil
(c)
The ageing of the Australian population
(d)
The introduction of new technology which enables optometrists to make more spectacles per hour
6. There would be a movement along the demand curve to the right for lettuces grown in Australia if:
(a)
Drought conditions persist
(b)
Interest rates across Australia increase
(c)
Lettuces are shown to have anti-cancer properties
(d)
New production techniques are developed which increase the volume that can be produced each year
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Chapter 2: The market mechanism
7. A ban on cigarette smoking indoors would affect the demand and supply curves for cigarettes in the following way:
(a)
The demand curve would shift left and the supply curve would shift right
(b)
The demand curve would shift left and the supply curve would not shift
(c)
The demand curve would shift right and the supply curve would shift left
(d)
The demand curve would shift right and the supply curve would not shift
8. An increase in the oil price is unlikely to lead to:
(a)
More resources being allocated to the production of bicycles
(b)
Less resources being devoted to the production of 4 Wheel Drive vehicles
(c)
Less resources being devoted to the production of airline travel
(d)
More resources being allocated to the production of plastic bottles
9. An increase in the wages paid to electricians may be the result of:
(a)
A decrease in demand for electricians due to a decrease in the number of new houses being built
(b)
A decrease in the number of electricians being trained at TAFE colleges
(c)
A decrease in the number of electrical faults reported by households
(d)
An increase in the supply of electricians as the government has subsidised apprenticeships
10. If a farmer can grow quinoa or chickpeas on her land, an increase in the market price for quinoa will result in
(a)
An increase in the demand for quinoa and chickpeas
(b)
A movement along the supply curve to the right for quinoa
(c)
A shift of demand curve for chickpeas to the left
(d)
A shift of the demand curve for quinoa to the left
11. Sales of Australian-made cars have fallen in recent years. This may have been caused by:
(a)
An appreciation of the Australian dollar against the US dollar
(b)
A decrease in the value of subsidies paid to car manufacturers by the Federal Government
(c)
An increase in fuel prices
(d)
All of the above
12. A factor that will cause a movement along the supply curve to the right for lemon cheesecake is:
a)
a cut in income taxes in July
b)
an increase in interest rates in November 2006
c)
a decrease in the price of lemons
d)
the drought
13. The Government currently restricts the importation of bananas into Australia. A removal of this restriction would result in
(a)
an increase in the price for bananas as the demand would increase
(b)
an increase in the price for bananas as the supply would increase
(c)
a decrease in the price of bananas as the demand would decrease
(d)
a decrease in the price of bananas as the supply would increase
14. Which of the following goods is likely to be an inferior good?
(a)
A small car such as the Mini Cooper
(b)
A block of Lindt chocolate
(c)
A can of home brand baked beans
(d)
A newspaper
15. An increase in the wages paid to teachers would result in
(a)
An increase in the number of students attending private schools
(b)
An increase in the demand for whiteboard markers
(c)
A decrease in the number of students studying Mathematics
(d)
An increase in the cost of providing education across all sectors
16. The price elasticity of demand for chocolate is likely to increase if:
(a)
More addictive ingredients are added
(b)
A new competitor enters the chocolate market
(c)
There is an imposition of a new tax on chocolate
(d)
A news report indicates that chocolate has health giving properties
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Economic Fundamentals in Australia
17. Consider a market with only two competing suppliers. If one supplier exits the market, allowing the remaining supplier to
enjoy a low price elasticity of demand, then to maximise profit it makes sense to:
(a)
Increase the price
(b)
Decrease the price
(c)
Maintain the equilibrium price set in the market
(d)
Offer a new range of products
18. Which of the following products would have the lowest price elasticity of supply?
(a)
An apricot
(b)
A painting by Vincent Van Gogh
(c)
A truck
(d)
A compact disc
19. If the value of the Australian dollar appreciates then:
(a)
The demand for televisions will increase, leading to an increase in their equilibrium price
(b)
The equilibrium price for televisions will decrease, resulting in an expansion in demand
(c)
The supply of televisions will decrease, resulting in an increase in demand for books
(d)
The demand and supply curves for televisions will both shift to the right.
20. An increase in the number of people watching Digital Pay Television is likely to lead to:
(a)
An increase in the demand for rental DVD movies
(b)
A decrease in the advertising revenue received by Free-To-Air television stations
(c)
An increase in the supply of television sets
(d)
A decrease in the price charged for Digital Pay Television
Chapter 2 Applied economic exercise
The falling price of pay TV
On November 3, 2014, Australia’s biggest TV provider, Foxtel, felt the need to significantly lower its selling price. The price for a
monthly subscription to the basic package was reduced from $50 to $25 per month. Foxtel, who lacked any meaningful competition
in the pay TV market, had been able to charge what many saw as a relatively high fee for their service. As a result, there had not been
any significant increase in the demand for connections over a 10 year period. But what drove Foxtek to change its pricing structure?
Despite Foxtel being the only Pay TV provider in the metropolitan region, the substitute entertainment services available to consumers
has expanded rapidly in recent years. Many consumers, objecting to the high prices charged by Foxtel, decided to use peer to peer
sites such as Pirate Bay to download popular programs, including ‘Game of Thrones’, ‘Breaking Bad’ and ‘The Walking Dead’. Those
consumers unwilling to break the law were able to access a wider range of programs using subscriptions services such as Quickflix.
Foxtel also realized that with new competitors entering the market, such as the US based Netflix, it was likely to lose even more
market share. Accordingly, the fall in Foxtel prices was clearly as a result of changing conditions of demand and supply.
Foxtel has essentially taken a big risk. Will the dramatic drop in price have a positive or negative impact on its total revenue? Given
that the price decrease was effectively 50% for the basic package, it is hard to imagine Foxtel’s demand increasing by such a large
percentage. After all, people will still be required to pay $45 to watch Game of Thrones or $50 to $60 to view the AFL games in high
definition.
It would be very difficult to ascertain the price elasticity of demand given that Foxtel is essentially changing the structure of its
packages. There is also the perceived increased availability of substitutes that Foxtel is trying to gain business from before they exist.
The new price requires customers to sign up for a 12 months.
Brian Walsh, executive director of television, echoed comments by HBO chairman and CEO Richard Plepler, saying Foxtel wants to
“build addicts” to its products - people who “can’t live without” their “must-watch shows” such as Game of Thrones. They hope to
boost its demand, not just by reducing prices, but by adding more content. There will be an increasing number of programs that will
be exclusive to Foxtel so the company is focusing on a number of demand factors to not only shift their demand curve to the right
but also make it steeper.
Another factor that might help Foxtel in its quest to grow its market base (which it has little direct control over) is the proposed
changes to data collection by the Federal Government. If the government decides to force telecommunications companies to collect
“meta-data” then they may be able to more easily identify and prosecute those who breach copyright legislation. The Government is
also considering proposals that would block file sharing sites such as Pirate Bay.
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Chapter 2: The market mechanism
Application questions
1.
2.
3.
4.
Explain using a demand and supply diagram, how the decrease in price by Foxtel may affect the market for their services.
Explain, with reference to substitute products how the demand curve for Foxtel may have changed over the last 3 years.
Identify and explain one other demand factor that may help to boost the number of pay TV subscriptions sold.
Analyse the degree of price elasticity of demand for pay TV services such as Foxtel. In your answer refer to the factors
affecting the PED
Chapter summary
1. Microeconomics is the study of the individual parts of the economy that interact to make up the whole economy.
2. A market is anywhere that facilitates the exchange of goods and services.
3. A competitive market is one where all economic agents are price takers. No individual buyer or seller has the market power
to influence prices.
4. Consumers will try to obtain the product at the lowest price possible while the seller will try to extract the highest price
possible. Analysis of demand and supply predicts the likely compromise between the two parties.
5. The law of demand states that as the price of a product increases the quantity demanded will tend to decrease. Conversely
if the price of the product decreases, the quantity demanded will tend to increase.
6. The law of demand is logical because at higher prices a consumer’s ability and willingness to purchase tends to decrease and
because the consumption of most goods is subject to the law of diminishing marginal utility.
7. An increase in price is represented by a movement along the demand curve to the left. A decrease in price is represented by
a movement along the demand curve to the right.
8. When the demand curve is drawn with price on the vertical axis and quantity on the horizontal axis, all other factors that
affect the demand for the product are assumed to be held constant. A change in any of these factors will result in a shift of
the demand curve to the left or right.
9. A shift of the demand curve to the right means that more is being demanded at each given price. A shift to the left of the
demand curve means that less is being demanded at each given price.
10. An increase in disposable income will generally lead to a shift of the demand curve to the right for normal goods.
11. A decrease in interest rates will increase discretionary income for indebted households and businesses and usually result in
an increase in demand for most goods and services.
12. If the price of a substitute good or service increases there will be an increase in demand for the alternative product (resulting
in a shift to the right of the demand curve).
13. A complementary good or service is one that is consumed together with another. An increase in the price of a complementary
good or service will mean that the cost of consuming both has increased resulting in a decrease in demand for the
complementary good (even if its price has not increased).
14. An increase in population will generally result in an increase in the demand for most goods and services.
15. An increase in consumer sentiment, which measures consumers’ general expectations about future economic prosperity,
will generally lead to an increase in discretionary spending and result in an increase in the demand for a broad range of
goods and services.
16. If a product becomes fashionable it is likely to result in an increase in demand.
17. The law of supply states that as the price increases for a good or service there will generally be an increase in the quantity
supplied.
18. The law of supply is logical because at higher prices suppliers have more incentive to shift resources into those areas which
will generate greater profits.
19. An increase in the price of a product will result in a shift along the supply curve to the right. A decrease in the price of a
product will result in a shift along the supply curve to the left.
20. When the supply curve is drawn with price on the vertical axis and quantity on the horizontal axis, all other factors affecting
supply are assumed to be held constant. A change in any of these factors will result in a shift of the supply curve to the left
or right.
21. If the supply curve shifts to the right, there will be a greater volume supplied to the market at each given price. A shift of the
supply curve to the left means that less will be supplied at each given price.
22. An increase in the cost of any inputs associated with making a product will result in a shift of the supply curve to the left.
23. New technology may reduce the cost per unit and will tend to shift the supply curve to the right.
24. The profit margin is loosely defined as the difference between total sales revenue and total costs (or the difference between
price and costs of producing the product). When a supplier seeks to lift the profit margin, this effectively results in the
supply curve moving to the left.
25. The price of other products can be an important factor determining the willingness to supply and the position of the supply
curve. When there is an increase in the price of other products, this effectively results in an increase in the opportunity
costs, and pushes the supply curve to the left.
26. Supply for any good or service that depends upon favourable climatic conditions will shift left if changes in the climate
restrict the production of the raw ingredients used to make these goods and services.
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Economic Fundamentals in Australia
27.
28.
29.
30.
31.
32.
33.
34.
35.
36.
37.
38.
39.
40.
41.
42.
43.
44.
42
The market equilibrium is a situation where the demand for a good or service is equal to the supply of a good or service.
A shortage develops when the price is below the equilibrium price and the demand is greater than the supply for the product.
A surplus develops when the price is above the equilibrium price and the demand is less than the supply for the product.
A movement of the demand and/or supply curve will result in a new equilibrium price and quantity traded.
The relative price is seen as the price of any one good or service measured in terms of the price of another good or service.
Relative prices send clear signals to producers and consumers and therefore direct resources to their highest end use.
Prices help to answer the three economic questions; what to produce, how to produce and for whom to produce. They
therefore determine how resources are allocated in the economy.
The price mechanism describes how the forces of demand and supply determine relative prices of goods and services, which
then ultimately determines the way our productive resources (e.g. labour and capital) are allocated in the economy.
Price elasticity of demand refers to the responsiveness of demand to changes in prices.
A low price elasticity of demand means that the percentage change in quantity demanded is less than the percentage change
in price. A high price elasticity of demand means that the percentage change in quantity demanded is higher than the
percentage change in prices.
Price elasticity of demand will tend to increase if there are a number of viable options available for the consumer as small
price increases result in a substitution towards these alternative products.
Price elasticity of demand will tend to decrease if the good or service is deemed to be a necessity or is highly addictive.
Price elasticity of demand will tend to increase if the purchase of the product consumes a large portion of a purchaser’s
income.
Price elasticity of supply measures the responsiveness of quantity supplied to changes in price.
A low price elasticity of supply means that the percentage change in quantity supplied is less than the percentage change in
price. A high price elasticity of supply means that the percentage change in supply is less than the percentage change in price.
Price elasticity of supply will tend to increase if the product can be easily stored.
Price elasticity of supply will tend to increase if firms are operating with some spare capacity and can ramp up production
quickly.
Price elasticity of supply will tend to be lower in the short term but as resources are re-allocated across the economy to more
profitable areas, price elasticity will tend to increase.