Microeconomics
Qn: Apply the concepts of scarcity, opportunity cost and the PPC curve to welfare
economics issues.
The welfare of a society is maximised when it consumes the largest amount of goods and
services its available resources can possibly produce. But because human resources are
unlimited while resources are limited, scarcity arises and it becomes necessary to have
more of one good only by having less of another. The best combination of goods and
services must be achieved for a society to maximise its well-being. Choosing the best
combination involves listing of goods according to their importance. Hence basic necessities
such as food, clothing and shelter come first, followed by public and then merit goods.
Due to scarcity of resources, opportunity costs, which measure the cost of making a choice
in terms of the next best alternative foregone, are incurred. In the short run, a society’s
well-being is maximised at full employment level. That means all available resources are
fully employed given the level of technology. But over a longer period of time, welfare is
further increased by expanding one’s productivity, that is, the given level of resources
produces more output than before. If an economy uses its resources to produce capital
and consumer goods, then by increasing production of capital goods, the country expands
its capacity to produce all goods in the future. However, more capital goods involves an
opportunity cost; consumer goods. Thus, in order to increase future standards of living, it is
necessary to accept a lower one in the present.
Capital goods
A
B
The Production Possibility Curve
(PPC) shows the different maximum
attainable combinations of two goods
or services. Shifting the curve from B
to A means producing more capital
goods at the expense of consumer
goods.
Consumer goods
Qn: ‘Prices tell us what goods and services to produce and consume.’ (Southern Africa
Economist, January 1991) Describe and explain the economic principles on which this
statement is based.
The combination of the analysis of demand and supply will give the equilibrium price and
quantity. For each good, there is a supply schedule and a demand schedule. If the two are
brought together, we find that the quantity demanded and quantity supplied will be equal
at one and only one market price. This is the equilibrium price, P, and the quantity
demanded will be at the equilibrium level, Q. Refer to Fig. 1. (sorry, too lazy to draw 2
graphs to show change/comparison etc.)
Microeconomics
Price
If demand increases, meaning consumers are
more willing and able to consume a product
or service, quantity demanded exceeds
quantity supplied, hence the good often
goes to the highest bidder. Ceteris Paribus,
this pushes the price of the good up, and
suppliers are more willing to increase
quantity supplied at the higher prices.
Ss
P
Dd
Q
Quantity
With the higher price however, quantity demanded decreases along the demand curve and a new
equilibrium is reached where quantity demanded equals quantity supplied
Therefore, the price P tells us what goods and services to produce (using the supply curve) and
consume (using the demand curve), ie. the level Q.
Qn: a) Compare price elasticity of demand, income elasticity of demand and cross
elasticity of demand
PED
Definition PED measures the degree of
responsiveness of quantity
demanded of a good to a
change in its own price,
ceteris paribus
% change in qty demanded
Formula
% change in price
Sign
Always negative
Price
1 <|PED|< ∞ Normal goods
Elastic
Price
Inelastic
Perfectly
Price
Inelastic
Unit Price
Elastic
Perfectly
Price
Elastic
0 <|PED|< 1 Necessities
YED
YED measures the degree of
responsiveness of quantity
demanded to a change in
the income of consumers,
ceteris paribus
% change in qty demanded
% change in income
Can be positive or negative
YED > 1 Normal
goods/Luxury goods
YED < 0 Inferior goods
0 < YED < 1 Necessities
PED = 0 eg. Antiques
YED = 0 Inferior Goods
|PED|= 1
YED = 1
|PED|= ∞
CED
CED measures the degree of
responsiveness of quantity demanded
of a good to a change in the price of
another good, ceteris paribus
% change in qty demanded of good X
% change in price of good Y
Can be positive or negative
CED > 0 Substitutes
CED <0 Complements
CED = 0 Unrelated goods, sales
independent of each other
Microeconomics
b) What are the limitations of these concepts?
Firstly, Ceteris paribus assumption is a fundamental drawback in terms of real world
application as it assumes no factors except the price (PED); income (YED); price of a related
good (CED) respectively changes. However, in the real world, at any particular point in time,
many factors such as the price of a related good, or the income level of consumers may be
changing simultaneously. (give an example) In other words, demand may not behave as
predicted by elasticity concepts.
Secondly, the cost-side of the profits equation is ignored as the concepts are only useful to
help firms increase revenue. PED concept helps businesses decide on appropriate pricing
strategies. YED helps businesses decide on output strategies and CED helps businesses to
decide on joint and reactionary-marketing strategies. However, none of these elasticity
concepts deal with the cost-side of the equation, and do not help with cost-cutting
strategies or productivity enhancing strategies. In short, the concepts are unable to help
firms maximise profits as costs are not taken into consideration since profits = total revenue
minus total costs
Thirdly, the validity of applying elasticity concepts in formulating business marketing
strategies rest on the crucial assumption that all information pertaining to elasticity
concepts are available to firms. It is assumed that firms have perfect information to make
rational business decisions. However, in reality, it is not possible to attain such perfect
information. With imperfect or incomplete information, strategies adopted by firms may
not be as successful.
Lastly, the supply side of the market is ignored. When strategising, firms should also take
price elasticity of supply into consideration – whether they can respond fast to the change in
demand. It is simply assumed that supply can easily cope with changes in demand, though in
reality cutting prices to stimulate demand may not be successful in raising sales and revenue
if supply cannot cope with the increased demand.
c) With reference to PED, discuss the likely effects of increasing the general level of
indirect taxes on goods and services.
Indirect taxes are imposed on items of expenditure, that is, goods and services, for example
sales tax, tariffs etc. When there is an increase in the general level of indirect taxation on
goods and services, the likely effects will depend on the price elasticity of the demand curve
in question.
Microeconomics
Price Relatively Price inelastic Demand
Relatively Price elastic Demand
S1
P1
P0
P2
E1
C
S1
S0
E0
D
S0
P1
Po
P2
E1
C
D
O
Q1
E0
D0
D0
O
Q1
Q0
Quantity
Q0
Quantity
From the figures, the initial equilibrium is at E0, with demand D0, and supply S0. The revenue
is OP0E0Q0. With an increase in indirect tax, price increases from OP0 to OP1. The new
revenue is OP1E1Q1. The burden borne by consumers is represented by the area P 0P1E1C,
and the burden borne by suppliers is P2P0CD. It can be seen that when price elasticity of
demand is more than zero, consumers’ share of the increase in indirect tax is smaller than
that by producers. However, when price elasticity is between 0 and 1, consumers bear a
bigger burden of the tax.
(perfectly inelastic/elastic can be mentioned too, though not much point)
(too lazy to mention deadweight loss)
In conclusion, the more inelastic the demand curve, the higher the incidence of tax on
consumers. Similarly, the more elastic the demand curve, the lower the incidence of tax on
consumers. The overall effect of tax is that price is pushed up and quantity exchanged is
reduced.