The following are the new tutorials posted under A Level Cambridge Unit 2 (Price system and the theory of the firm):
Movements along the demand curve
In previous lessons, we have already looked into the factors that influence demand. The quantity demanded of a normal good is inversely related to its price. That means, when the price increases, the quantity demanded decreases and vice versa. When the price changes, the change that comes to the quantity demanded is shown by a movement alone the demand curve. Such an increase in the quantity demanded is known as an extension/expansion in the demand. A decrease in the quantity demanded due to an increase in the price is known as a contraction in the demand.
Shifts of the demand curve
Shifts of the demand curve happens due to the changes in the factors other than the price of the good. In other words, the shifts of the demand curve happens when the conditions of the demand changes. These factors are explained in the previous lesson – factors influencing demand.
The price of a product determines how much people will buy that particular product. When the price of a normal good increases, the quantity demanded for that product decreases. This is when other factors that determine demand remains unchanged. When the other factors do change, the the prevailing conditions of the demand for the product changes. These are known as ‘determinants of demand’. Let us look at the factors other than price which influence demand.
When income rises, it is expected that the demand for goods will also rise. When people have more money, they may decide to spend the money doing things that they were not able to do before. That means the demand for normal goods will rise when the income rises. Most of the goods in the economy are normal goods. However, as the income rises, people may stop or reduce the use of certain goods. These types of goods are known as inferior goods. The most well known example is public transportation – more specifically, buses. As the income rises, people may use cabs rather than travelling on buses.
If you watch your favourite shows on TV or movies on a channel, you will always have to bear with advertisements that annoyingly interrupt the main programme. In many Indian channels, the time given to the advertisements has increased ridiculously too much. Hundreds of billions of Dollars are spend worldwide on advertising each year.
But the question is, why are businesses prepared to spend so much on advertising? The reason is that it does affect demand. If a product is heavily advertised, the demand for that product is likely to increase, especially if the advertisement campaign is effective.
The size and the structure of population
As the population grows, there will be an increase in demand for goods and services. The more people are there, the more needs and wants are required to be satisfied. It’s not only the size of the population that affects demand, but the structure of the population also affects the demand. Examples of this are:
- Age distribution – Many countries are now experiencing a trend of ageing population. The reasons for this are, the rising life expectancy and/or reduced birth rate. As the median age of the population rises, there will be more elderly people and thus increased demand for goods such as retirement homes and specialist holidays for elderly people.
- Gender distribution – Census in many countries has shown that there are more women than men in those countries. And the number of women to men is higher in older age groups. This would affect the demand patterns. For example, there will be more demand for women’s clothing.
- Geographical distribution – As a country starts developing and goes up in development, there is a tendency of the population to move to urban areas. This will increase in demand for goods and services in urban areas.
Tastes and Fashion
There are certain goods of which demand is strongly influenced by taste and fashion. Some goods also experience seasonal demand. Clothing industry is a good example of this. The fashion keeps on changing. One type of dresses high in demand now may not be in anymore after 1 year. Some types of clothes are demanded at winder, and some other types are demanded at summer.
Prices of substitutes and complements
When consumers consider buying a good, they usually consider the prices of other goods which can be used instead of that particular good. These goods are known as substitutes. For example, Pepsi is a direct substitute of Coca-Cola. Different types of energy drinks are close substitutes of one another. If cheap substitutes are available, consumers will opt to buy the cheaper ones. Therefore, the changes in the prices of substitutes affect demand for a particular good.
Complementary goods are those goods which are demanded together with a particular good. For example, consumers of corn flakes will also buy milk. Therefore, changes in the price of one of these products will affect the demand for the other good.
The demand for certain goods is influenced by the interest rate. That is because these goods are purchased with borrowed money (loans). If interest rate increases, it becomes difficult for people to take loans and purchase those goods. Goods often bought with borrowed money include houses, cars, holidays and expensive consumer durable goods.
Increase in taxes such as income tax will reduce demand in the market because people will have less disposable income.
Interest rates and taxes are the instruments that the government uses to manipulate demand in the economy.
The term ‘supply’ means the willingness and ability of suppliers/sellers or people to supply goods and services. The quantity supplied of any good or service is the actual quantity offered for sale in the market by the sellers. Let us look at the example of a carpentry. When the price of chairs is high, it is more profitable to sell chairs and therefore produce more of it, and thus the quantity supplied of chairs is higher. The carpentry may work longer hours and may buy new machinery, and dedicate more time for making chairs rather than other furniture. However, when the price of chairs is low, the carpentry will produce less, since it is less profitable to sell chairs. At a low price the carpentry may even stop making chairs altogether, and their quantity supplied will fall to zero. This direct relationship between price and quantity supplied is called the law of supply: When the price of a good rises, the quantity supplied of the good also rises, and when the price falls, the quantity supplied falls too, ceteris paribus.
Individual supply and the market supply
Market supply is the sum of the supplies of all sellers. Let us look at an example of a market where there are only two ice-cream producers, Farish and Saeed. The table below shows the supply schedules for the two ice-cream producers. At any price, Farish’s supply schedule tells us the quantity of ice cream that Farish supplies, and Saeed’s supply schedule tells us the quantity of ice cream that Saeed supplies. The market supply is the sum of the two individual supplies.
|Price of ice-cream||Farish||Saeed||Market|
The graph below shows the supply curves that correspond to the above supply schedules.
We sum the individual supply curves horizontally to obtain the market supply curve. That is, to find the total quantity supplied at any price, we add the individual quantities, which are found on the horizontal axis of the individual supply curves. The market supply curve shows how the total quantity supplied varies as the price of the good varies, holding constant all the other factors beyond price that influence producers’ decisions about how much to sell.
The term ‘elasticity’ means the change in one variable in comparison to another variable. In Economics, elasticity is used especially to compare the effect of change of one variable on another.
The law of demand states the inverse relationship between the price of a product and its quantity demanded. However, this doesn’t tell us how far the changes in price of a product affect its quantity demanded.
Price elasticity of demand
Price Elasticity of Demand is the responsiveness of quantity demanded to changes in price. In other words it is the percentage change in quantity demanded in comparison to the percentage change in price of a product.
Ed = Percentage quantity demanded / Percentage change in price = %∆Qd/%∆P.
For example, if quantity demanded goes up from 100 to 150 as a result of a change in price from 4 to 3, then we can calculate the price elasticity of demand as follows:
Percentage change in quantity demanded = ((150-100)/100) x 100 = 50%
Percentage change in price = ((4-3)/4) x 100 = 25%
Price elasticity of demand = 50%/25% = 2.
This means, at this point on demand curve, the percentage change in quantity demanded is 2 times any percentage change in price.
If the percentage change in quantity demanded is higher than the percentage change in price, the calculated elasticity demanded is greater than 1. In this case we say the demand is elastic.
If the percentage change in quantity demanded is less than the percentage change in price, the calculated elasticity demanded is less than 1. In this case we say the demand is inelastic.
Unit Elastic Demand
If the percentage change in quantity demanded is equal to the percentage change in price, the demand will be unit elastic. The calculated price elasticity of demand is equal to 1.
Perfectly Elastic Demand
In this case any change in price of a product results in infinite change in quantity demanded. For example, buyers are willing to buy all units, as much as the producers can produce at the price of 10. However, a very small change in price, say to 10.10, results in nobody buying anything. The quantity demanded falls to 0. In this case the demand is perfectly elastic. This is shown by a demand curve that is a horizontal line. This situation exists in perfect competition, where there are so many buyers and sellers in a market and no individual of them is able to influence the market price.
Perfectly Inelastic Demand
When demand is perfectly inelastic, it does not respond at all to the change in price. This situation could exist at some price levels of those goods which are absolute necessities. But this situation does not hold for too long, or it seldom exists for any product.
Elastic Demand and Total Revenue
Total revenue is calculated by multiplying price and quantity demanded of a product. If the demand for a product is price elastic, an increase in price will result in a more than proportionate reduction in the quantity demanded for the product. And thus, an increase in price will lead to a reduction in total revenue, if its demand at that point is price elastic.
Inelastic Demand and Total Revenue
If the demand for a product is price inelastic, an increase in price will result in a less than proportionate reduction in the quantity demanded for the product. And thus, an increase in price will lead to an increase in total revenue, if its demand at that point is price inelastic.
Determinants of Price Elasticity of Demand
- Number of substitutes
If a good has more substitutes, an increase in price of the good will result in people choosing to buy the substitute goods. Therefore, the more substitutes a good has, the more price elastic it becomes.
- Necessities verses luxuries
If a good is considered as a necessity, increase in price of it will lead to a less proportionate reduction in quantity demanded. Whereas, if it is considered as a luxury, then it is usually price elastic
- Percentage of one’s budget spent on the good
The greater the percentage of one’s budget that goes to purchase a good, the higher the price elasticity of demand for that product and vice versa.
As time passes buyers have more opportunities to be responsive to a price change. Even if people may not have many alternative products to shift to, it is more likely that as time passes, more substitutes will be available in the market. Therefore, the more the time passes after a change in price, the higher is the price elasticity of demand.
Cross Elasticity of Demand
Cross Elasticity of Demand measures the responsiveness in the quantity demanded of one good to a change in price of another good. It is calculated by dividing the percentage change in the quantity demanded of one good by the percentage change in the price of another good.
In previous topics we have already learnt about substitutes and compliments. Cross elasticity is used to determine whether two goods are substitutes or complements or whether they fall into any of the two categories at all.
If cross price elasticity of two goods are positive, they are substitutes, where as if the cross price elasticity is negative, they are complements.
Income Elasticity of Demand
This measures responsiveness of quantity demanded to a change in income. It is calculated by dividing the percentage change in quantity demanded by the percentage change in income.
We have to note that, increases in income does not always lead to increase in consumption of all types of goods. People often stop the usage of certain goods when they become richer.
Income elasticity of demand for a normal good is positive. Income elasticity of an inferior good is negative.
This tutorial is posted under ‘Cambridge A Level Economics’.
Individual Demand means the goods and services demanded by an individual. Individual demand for a particular good means the demand for that good by a specific individual. Read More …
Individual Demand means the goods and services demanded by an individual. Individual demand for a particular good means the demand for that good by a specific individual.
Individual demand curve is a graphical representation of corresponding quantities demanded by an individual of a specific good at different price levels. It is the locus of all the points showing various quantities of a commodity that a consumer is willing to buy at various levels of price, during a given period of time, assuming no change in the conditions/determinants of demand.
In a market there will be many individuals who demand for the product. Therefore, the market demand will be the total quantity demanded by all the individuals for that particular product. For example, if the market has only Individual A and Individual B who demand for a particular product, look at the following demand schedules and the demand curves.
As we can see, the market demand curve is flatter than the individual demand curves. This actually means it is more elastic. For the market as a whole, the percentage change in quantity demanded will be bigger than the percentage change in price, as compared to that of individual demand curves.
Tutorials have been uploaded to cover the syllabus contents of the Unit 1 of Cambridge A Level Economics (Basic Economic Ideas)
The tutorials cover the following topics:
- Scarcity, choice and resource allocation
- Different allocative mechanisms
- Production possibility curves
- Problems of transition
- The margin: decision making at the margin
- Positive and normative statements
- Ceteris paribus
- Factors of production: land, labour, capital, enterprise
- Division of labour
- Money: its functions and characteristics
I hope you find this work useful.
We have already learned from the previous lessons that individuals are always trying to maximise their satisfaction of wants. Individual Economics, therefore, is about managing resources available to him/her to satisfy as much wants as possible.
When we look into a higher level, a country also tries to maximise the best use of its resources to deliver the best outcome, that is the satisfaction of wants of its people in general. And that is how the types of economic systems have come into place.
We have also seen the types of economic systems and one of them is market economy. In a market economy, resources are allocated by the forces of demand and supply. When something is demanded by the consumers, suppliers try to produce that good. Therefore, in theory, it should deliver the maximum satisfaction of wants.
However, there are reasons why market forces may not always allocate resources efficiently. In this situation we say there is market failure.
Market failure could result in productive inefficiency which means the firms are not producing the best output from the resources they have.
Market failure could also result in allocative inefficiency. This means that businesses are not producing those goods which are most wanted and needed by the consumers. In this case satisfaction of wants of the people will not be as good as it ought to be.
Reasons for market failure
- Negative externalities – When production is done, there are two categories of costs that are incurred. They are, private costs and social costs. Private costs are those incurred by the business or individual who does the production. When production is done, the society as a whole also bears some costs. For example, air pollution. These are known as social costs or external costs. Negative externalities occur when the social costs exceed private costs.
- Positive externalities – Production gives benefits to the business or individual who does the production. This is known as private benefits. production also gives benefit to the society as a whole.
This is known as social benefits. Social benefits = private benefits + external benefits. Positive externalities occur when the external benefits is greater than the private benefit. In this case the individual or the business may be discouraged to do the production, leading to fall in output.
- Public goods – Market forces may not be able to provide public goods. Goods like street lights, light houses, drainage system on the roads, cannot be provided by the private sector. For example, once a lighthouse is provided, the ships at sea cannot be prevented from benefiting from it, and there is no way to charge a price from the ships that benefit from the lighthouse. Therefore, public goods have to be provided by the government as the private sector has no incentive to produce/provide them.
- Imperfect information – For markets to work, there needs to be perfect and symmetric information ie consumers and producers must have the same level of knowledge about the products, and they must know everything there is to know about them. In many cases, however, information may be asymmetric (producers know more than consumers) or incomplete/imperfect. In these situations, we have market failure. In the private healthcare market, doctors know more than patients about healthcare and treatments (asymmetric information). There is an incentive, therefore, for doctors to prescribe more expensive treatment than that is necessary in order to increase their profits. This is an inefficient use of resources. Many consumers in the healthcare market take out insurance to help pay for treatment; this, however, leads to a problem of moral hazard, where they take more risks and therefore require more treatment because they are insured. Again, this is a consequence of asymmetric information in the market where consumers know more than insurers about their intended future actions.
In many markets, such as the tobacco, alcohol or pensions markets, providers of these goods and services often withhold information deliberately from consumers. For example, many tobacco companies knew of the link between tobacco and lung cancer before consumers were aware of it, and they continued to advertise tobacco as being ‘healthy’ and ‘sociable’, leading to over-consumption of tobacco, and therefore market failure.
- Monopolies – A monopoly is a situation where there is only one seller in the market, and everyone else is a buyer. Free markets sometimes result in monopolies, which can charge high prices from consumers and there is under-production of the particular goods that the monopoly provides.
- Factor immobility – Factors of production, such as labour may not be able to move from one place to another for many reasons. If they cannot move to the place where production is done, then there will be unemployment.
- Unfair income distribution – When the production is done for those who can pay for the goods and services, this could leads to the rich becoming richer and the poor becoming poorer.
- Uncertainty – the price of certain goods are subject to fluctuations in the market, which leads to uncertainty for those who produce those goods.