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Class Reading

• Part B of the course is the largest section in the book from page 63 to 175 and covers Chapter 3 to 7 inclusive

• We are going to split this into two sections covered in week 2 and week 3

• Knowing the diagrams in this section is very important

• Book: CIMA (certificate 4) Fundamentals of Business Economics-Chapter 3: 63-90-Chapter 4: 91-116-Chapter 5: 117- 131

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Price Determination: The Price Mechanism

The Market (page 63)• Potential buyers and potential sellers come together for the

purpose of exchange• Utility is the pleasure or benefit derived from the

consumption of a good. Marginal utility is the utility gained from the consumption of one additional unit

• Consumers are rational:– They prefer more to less– Attempt to max utility from a limited income– Marginal utility decreases as consumption increases

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Figure 1: The Demand Curve

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Demand• See figure 1• Relates to a quantity demanded to a price payable• Slopes down because marginal utility declines as

consumption increases• Demand is also influenced by: price of other goods called

substitutes (goods that are alternatives; tea and coffee)– A rise in the price of a good is likely to increase the demand of its

substitute– A compliment is a good that is bought and used together (tea & milk), a

rise in the price of a good is likely to cause a fall in demand for its compliment

• Income: if demand of a good rises as household income rises it is a normal good, if it falls then it is an inferior good

• Taste & fashion• Expectation of price changes 5

• A movement along the demand curve shows how demand responds to a change in price and nothing else! Any change in the other factors that affect demand cause a shift in the position of the demand curve

• See Figure 2 BelowLeftward Shift:• Fall in household income• Fall in price of substitutes• Rise in the price of compliments• Change in Taste• Expected fall in price

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Figure 2: Shift in Demand Curve

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Rightward Shift• Rise in household income• Rise in price of substitutes• Fall in price of compliments• Change in taste• Expected rise in price

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Supply• Relates to quantity offered to price available• Again a shift in price will cause movement along the supply

curve, but a change in the other factors will cause a shiftFactors that Influence Supply (shift to the right):• Expectation of a future fall in price, to obtain a better price

now• Fall in the price of a substitute in supply• A rise in the price of a good in joint supply• Technological improvements• Fall in cost of factors of production• Introduction of a subsidy• The opposite effects will shift the curve to the left

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Figure 3: Supply Curve & Shift to Right

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The Price Mechanism• The price mechanism brings supply and demand together

at the equilibrium price “P”, see figure 4• Also market clearing price since quantity “Q” is both

supplied so demanded and their is neither surplus or shortage

• Market prices and their movements act as signals to producers, enabling them to produce what is most needed

• The reward is profit• The actions of firms responding to profit opportunities

allocate resources to their best use

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Figure 4: Price Equilibrium

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“P”

• Consumers Surplus: some would have paid more than the market price “A”

• Producer Surplus: some would have sold at less than the market price “B”

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Figure 5: Surplus

A

B

• Some governments attempt to overcome market forces by regulating prices, see page 83

• A maximum (ceiling) price might be used to combat inflation or to make basic goods affordable

• A minimum (flow) price might be used to secure the incomes of favoured producers, such as farmers

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• A minimum wage is set by law is intended to ensure that the lowest paid workers are not exploited

• If min wage is set above the equilibrium price, it is likely to cause unemployment

• However where this is a single purchaser (monopoly) of labour a min wage may increase employment

• When such employers hold wages down they generally have vacancies: a min wage makes it easier for them to recruit

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• Take Quiz Page 89

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Elasticities of Demand & Supply (PED) (page 91)• A measure in the change in demand for a good in response

to a change in its price.• When demand is elastic a small change in price produces a

large change in demand.• When the demand is inelastic, a large change in price

produces only a small change in demand.

• PED= change in quant demanded as % of demand/ change in price as % of price

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Figure 6: Elastic and Inelastic Demand

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BA

• In Figure 6, there is diagram A and diagram B• A is more elastic in that, elastic a small change in price

produces a large change in demand• B is more inelastic in that, a large change in price produces

only a small change in demand

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Figure 7

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A B

• In figure 7, diagram A demand is perfectly inelastic, PED=0

• In diagram B, demand is perfectly elastic, PED= infinity• When PED=1, demand responds proportionally to any

change in price and total expenditure is constant, whatever the price. This is known as unitary elasticity

PED is affected by:• Availability of substitutes• Time horizon(elasticity is low in the short run)• Luxury vs. Necessity• Percentage of Income

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Income Elasticity of Demand (IED)• Is a measure of the change in demand for a good in

response to a change in household income• Demand for normal goods increases as household income

increases• If demand for a good falls when household income rises,

the good is an inferior good

• IED= % change in quantity demanded/ % change in household income

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Cross elasticity of demand (CED)• Measure of the change in demand for a good in response to

a change in the price of another good• CED= % change in quantity of good “A” demanded/ % change in price of good “B”

• If CED is positive, good is a substitute, fall in price of B will cause fall in demand for A

• If CED is negative, good is complement, fall in price of B will cause a rise in demand for A

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Price Elasticity of Supply:• The elasticity of supply of a good indicated the

responsiveness of supply to the change in price• It is a measure of firms’ ability to adjust the quantity of

goods they supply• Elasticity of Supply= % change in quantity supplied/ % change in price

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Factors Affecting Elasticity of Supply• Existence of inventories of all kinds of goods and their

perishability• Ease of adjusting labour inputs up or down• Barriers to entry make supply inelastic• Time scale:

– Elasticities vary with time, during the market period only existing inventories and levels of output are available, supply is very inelastic

– Over the short run, quantities can be adjusted by working overtime or short time. Supply is quite elastic

– Over the long run plant can be built or shut down. Supply is very elastic

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Primary Markets• Where supply is highly inelastic in the short run and as in

agriculture, volumes can only be increased by holding back some breeding stock from market, out of phase oscillations of price and supply can occur.

• This is illustrated by the “hog cycle”, see page 108• Agricultural output is also particularly subject to the

weather and, since demand for foodstuffs is largely inelastic, good weather and high production can lead to very low prices and distress among producers

• Governments attempt to stabilise the market by means of subsidies and purchase of surpluses, but these measures tend to lead to over production and dumping of surpluses on world markets, to the detriment of producers in less developed countries

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• Take Quiz page 113

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Market Failures, Externalities & Intervention• Imperfect knowledge

– Market efficiency is dependent on all parties having complete information about which goods are available and at which prices. When this knowledge is not widely available, prices and hence resource allocation will tend to remain fixed

• Time– Is needed for the market mechanism to have effect. Slows down

changes in resource allocation

• Monopoly Elements– If a firm controls all or much of the supply of a good it can restrict

output and thus drive up price– Similarly, a monopolistic purchaser can exact concessions on price

from suppliers

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Social costs and benefits may differ from private cost and benefits

Scarce resources Private costs Supplier Profit An Economic Transaction Private benefits Purchaser

Social Costs EXTERNALITIES Social Benefits

Public Goods• Consumption by one individual or group does not

significantly reduce availability• Difficult to control access to the good• No incentive to pay for it, people can be free riders, e.g.

National defence and lighthouses29

Merit Goods (and demerit goods)• Society places a different value on these goods from the

value placed on them by the individual• Merit goods have positive externalities (e.g. Education),

demerit goods have negative externalities (e.g. Smoking)• It is a widely accepted role of government to promote

consumption of merit goods and to reduce consumption of demerit goods, via indirect taxation

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Indirect Taxes & Subsidies• Indirect taxes and subsidies can be used to align private

costs and benefits with social costs and benefits• Indirect taxes can be used to increase private costs to

reflect negative externalities, such as the emission of pollutants, while subsidies can be used to promote the consumption of merit goods

• Subsidies are also used to protect politically favoured industries

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Figure 8: Indirect Tax

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A

B P2

Initial equilibrium point

Initial supply curve before tax

S1

S0

Figure 8:• P1, is price paid by consumer• P0, equilibrium price before tax• P2, Price retained by supplier after paying over tax receipts

to government• S1, indirect tax is collected from the supplier, so it has the

effect of being an extra cost, supply curve shifts upwards• S0, supply curve before tax

• Areas A and B represent the extent of the tax burden on the purchaser and suppliers respectively

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• Note, the elasticities of both demand and supply affect the relative sizes of areas A and B

• See book page 125, 126

Effect of a Subsidy• Subsidy works like an indirect tax in reverse• Figure 9, price to the consumer falls from P0 to P1, which is

less that the total value of the subsidy• The supplier benefits by the amount P1-P2• Output rises from Q1 to Q2• Subsidy is paid to the supplier to cover some cost- supply

curve shifts downwards (outwards)• Relative benefits to supplier and consumer depends on

elasticities of demand and supply34

Figure 9: Effect of a Subsidy

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P0

• Take Quiz page 128

• Reading for these chapters extremely important

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