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12 Key Diagrams
for AS Microeconomics
Advice on drawing diagrams in the exam
•
The right size is about 1/3 of a side of A4 – don’t make them too small
•
Avoid wrapping text around the diagram
•
Avoid directional arrows – label each curve clearly so that it is clear which curves are shifting
•
Remember to label both the x and the y axis
•
Always draw dotted lines to the x and y axis to show changing prices, quantities etc.
•
Draw in pencil
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(1) The Production Possibility Frontier (PPF)
A PPF shows the different combinations of goods and services that can be
produced with a given amount of resources in their most efficient way
Any point inside the curve – suggests resources are not being utilised efficiently
Any point outside the curve – not attainable with the current level of resources
An outward shift of the PPF implies that an economy has achieved economic
growth
OUTPUT
OF GOOD
Y
D
C
A
X
B
PPF1
PPF2
OUTPUT OF GOOD X
Point X is an allocative inefficient combination – it lies within the PPF
Points, C, A and B are all allocatively efficient
D is unattainable unless there is an outward shift if the PPF
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(2) The Effects of an Indirect Tax on Producers and Consumers
Ain direct tax increases the costs faced by producers. The amount of the tax is shown
by the vertical distance between the two supply curves. Because of the tax, less can be
supplied at each price level. The result is an increase in the equilibrium market price
and a contraction in market demand to a new equilibrium output of Q2
Price
Supply
post-tax
Supply pre-tax
Tax per unit
P2
P1
P3
Demand
Q2
Q1
Quantity
P2 is the price paid by consumers after the introduction of the tax
P2-P3 is the tax per unit received by the government
(P2-P3) x Q2 is the total tax revenue received by the government
The producer keeps price P3 after the tax has been paid
The consumer pays P2-P1 of the tax
The producer pays P1-P3 of the tax
The effect of the tax depends on the price elasticity of demand & supply for the good
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3) A Government Subsidy to Producers
A government subsidy encourages an increase in supply at each price level because the
subsidy provides a reduction in a firm’s costs of production. The extent of the subsidy
per unit is shown by the vertical distance between the two supply curves.
S1
Price
Supply +
Subsidy
P3
P1
Subsidy per unit
P2
Demand
Q1
Q2
The price before the subsidy is offer is P1 and the equilibrium quantity is Q1
Following the subsidy, the price falls to P2 (this is the price paid by consumers)
Output rises to Q2 i.e. the lower price has encouraged an expansion of demand
The producer then receives the subsidy P2-P3 and received price P3
Total government spending on the subsidy equals Q2 x (P2P3)
Once again, the elasticities of demand and supply affect how a subsidy causes changes
in price and quantity in the market
Most students forget to show the subsidy payment to producers in their diagrams!
Governments may use subsidies for a variety of reasons including reducing the price
and increasing the consumption of merit goods – check your notes on subsidies for the
arguments for and against government subsidies for producers
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Quantity
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4) Drawing shifts in demand and supply – and their effects on market price
An Outward Shift in Demand and a Rise in Supply
An Inward Shift in Demand and a fall in Supply
Price
Price
S2
S1
S1
S2
P2
P1
P1
P3
D3
D1
D1
D2
Q2
Q1
Quantity
Q1
Q2
When drawing price theory diagrams
•
Avoid any use of arrows – clear labelling does that job for you!
•
Always draw to the axis to show prices and quantities
•
It is often a good idea to draw two diagrams in the latter parts of questions –
this allows you to change the elasticities of demand and supply and see how
this changes your analysis
•
Shifts in demand do not normally cause a shift in supply
•
Likewise shifts in supply cause movements along the demand curve and not
shifts in the demand curve
•
Inelastic demand and supply curves mean that equilibrium prices tend to be
volatile when conditions of demand and supply change
•
Think about the implications of such shifts in price and quantity on the
incomes of producers – applying the concept of price elasticity of demand is
often very helpful when discussing the incomes and profits of suppliers
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Quantity
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5) Economies of large scale production
Economies of scale are the advantages of large scale production that result in lower unit
(average) costs (cost per unit)
Costs
Demand
AC1
AC2
Long run average
cost
AC3
Q1
Q2
Q3
Output (Q)
Economies of scale lead to a fall in the long run average cost curve
It is more cost efficient to produce output Q2 at an AC of AC2 than it is to produce Q1
Q3 is the output where the economies of scale have been fully exploited
This is known as the output of productive efficiency in the long run
Depending on the elasticity of the demand curve, output Q3 gives higher total profits at
output Q2 – and the consumer also benefits from lower prices
Economies of scale therefore increase both consumer and producer surplus
Important when discussing the economics of large scale production and also the potential
costs and benefits of monopoly power in a market
Make sure you have examples of the different types of economy of scale that a business can
exploit
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6) Consumer and producer surplus and allocative efficiency in a market
Costs
Revenues
Supply
Consumer
Surplus (CS)
Consumer
Surplus (CS)
P1
Producer
Surplus (PS)
Producer
Surplus
Demand
Allocative efficiency is
achieved here where the
market clears and the price
reflects the costs of supply.
Consumer and producer
surplus is maximised!
Output (Q)
Q1
Supply
CS
P2
Producer
Surplus
P1
Producer
Surplus
Demand
If output is reduced to Q2
and the price is raised to P2,
then there is a loss of
allocative efficiency –
leading to a deadweight loss
of consumer and produce
surplus
Q2
Q1
Allocative efficiency occurs when the market clears at a price when the price charged to
consumers reflects the true cost of factors of production used in supplying the product
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7) Market failure when there are negative externalities
Social Cost
Price
Private Cost
(Supply)
P2
P1
When there are negative
production externalities then
the social cost of supplying
the product is greater than
the private cost
The product is over-supplied
and under-priced by the
market – i.e. market failure
External
Cost
Q2
Demand = Private
Benefit = Social Benefit
Q1
Price
Output (Q)
Private Cost = Social Cost
When there are negative
consumption externalities
then the social benefit of
consuming the product is
less than the private benefit
- The product is overconsumed by the market –
i.e. market failure
P1
P2
Demand = Private
Benefit
Social Benefit
Q2
Q1
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Output (Q)
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8) Price elasticity of demand – two important applications
(i) Price elasticity of demand and the total revenue to a supplier
Relatively Inelastic Demand
Relatively Elastic Demand
Price
Price
P2
P1
P1
P2
Demand
Demand
Q2 Q1
Q1
Q2
(ii) Price elasticity of demand and the profit margins of a business
Relatively Inelastic Demand
Relatively Elastic Demand
Price
Price
Higher profit
margin
P2
Lower profit
margin
P2
AC
P1
AC
Demand
P1
Demand
Q2
Q1
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Q2
Q1
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9) Merit Goods – positive externalities
Merit goods – could be provided by the market but consumers may not be able to
afford or feel the need to purchase – thus the free-market economy would not
provide them in the quantities society needs
Costs
Benefits
Welfare loss because merit goods
tend to be under-consumed by the
A
free market
Supply
C
External Benefit
B
Social
Benefit
Private
Benefit
Qp
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Qs
Output (Q)
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10) Market failure due to information failure
Market failure with demerit goods – the free market may fail to take into account the
negative externalities of consumption (because the social cost > private cost).
Consumers too may experience imperfect information about the long term costs to
themselves of consuming products deemed to be de-merit goods
Costs
Benefits
Social Cost
External costs (negative
externalities)
Private Cost
Demand (Limited Information)
Demand (Full Information)
Q3
Q2
Q1
Quantity
The social optimal level of consumption would be Q3 – an output that takes into account the
information failure of consumers and also the negative externalities.
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11) Maximum and minimum prices – when governments intervene in a market
A maximum price for rented accommodation or for a foodstuff
Supply
Rent
£s
Free Market
Equilibrium
Pe
P max
Price (Rent) Ceiling
Excess
Demand
Demand
Q2
Q1
Quantity of Rented Property
A minimum wage in the labour market
Wage
£s
Supply of
Labour
Minimum Wage
W1
We
Demand for
Labour
E2
Ee
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E2
Employment of Labour
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12) Buffer stock schemes to support prices and incomes in a market
Buffer stock schemes seek to stabilize the market price of agricultural products by buying
up supplies of the product when harvests are plentiful and selling stocks of the product
onto the market when supplies are low
Supply
S2
Price
P min
Price Floor (Guaranteed)
Pe
Demand
Q3
Q1 Q4
Quantity
The government offers a guaranteed minimum price (P min) to farmers of wheat. The price
floor is set above the normal free market equilibrium price.
If the government is to maintain the guaranteed price at P min, then it must buy up the
excess supply (Q3-Q1) and put these purchases into intervention storage. Should there be a
large rise in supply putting downward pressure on the free market equilibrium price. In this
situation, the government will have to intervene once more in the market and buy up the
surplus stock of wheat to prevent the price from falling.
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