Download IB Economics SL Unit 1: Microeconomics

IB Economics SL: City Honors School
IB Economics SL
Unit 1: Microeconomics
Mr. R.S. Pyszczek, Jr.
City Honors School
IB Economics SL: City Honors School
Unit 1: Microeconomics
Scarcity*
The basic economic problem that arises because people have
unlimited wants but resources are limited. Because of scarcity,
various economic decisions must be made to allocate resources
efficiently.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Scarcity

When we talk of scarcity within an economic context, it refers to
limited resources, not a lack of riches. These resources are the inputs
of production: land, labor and capital.

People must make choices between different items because the
resources necessary to fulfill their wants are limited. These decisions
are made by giving up (trading off) one want to satisfy another.
IB Economics SL: City Honors School
Unit 1: Microeconomics
4 Factors of Production*

Land: real estate, property, factories

Labor: workers, hourly and salary

Capital: money and capital goods

Entrepreneur: Who is starting up the company?
IB Economics SL: City Honors School
Unit 1: Microeconomics
3 Basic Economic Questions We All Must Answer. *
1.
What to Produce?
2.
How to Produce?
3.
For Whom to Produce?
IB Economics SL: City Honors School
Unit 1: Microeconomics
3 Basic Economic Questions We All Must Answer.
What to Produce?*

Consumer Goods: i.e. Pickup Trucks

Capital Goods: i.e. Garbage Trucks
IB Economics SL: City Honors School
Unit 1: Microeconomics
3 Basic Economic Questions We All Must Answer.
How to Produce?*

In a factory? Quicker & less expensive

Handcrafted or Handmade? Longer and more expensive
IB Economics SL: City Honors School
Unit 1: Microeconomics
3 Basic Economic Questions We All Must Answer.
For whom to Produce?*

High end or niche clientele i.e Ferrari, Maybach,

Middle Class-Upper Middle class i.e. Cadillac, BMW, Benz

Entry level-Middle class i.e Chevy, Honda, Toyota
IB Economics SL: City Honors School
Unit 1: Microeconomics
3 Basic Economic Questions We All Must Answer.
For whom to Produce?*

Nissan make Infiniti or Toyota make Lexus or Honda makes Acura

GM makes Cadillac and Chevy

Ford also make Lincoln brand autos.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.1
Competitive Markets: Demand and Supply
Markets
The Nature of Markets

Outline the meaning of the term market. What is a market?
Cite Examples.
How have markets changed in the last 10 years?
IB Economics SL: City Honors School
Unit 1: Microeconomics
Demand
The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the
price of a good, the less people will demand that good. In other words, the
higher the price, the lower the quantity demanded. The amount of a good that
buyers purchase at a higher price is less because as the price of a good goes
up, so does the opportunity cost of buying that good. As a result, people will
naturally avoid buying a product that will force them to forgo the consumption
of something else they value more. The chart below shows that the curve is a
downward slope.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Demand
The Law of Demand* (2.2 pgs 27-30)

Explain the negative causal relationship between price and quantity
demanded.
Price goes Up, Demand goes Down
Demand goes Up, Price goes Down

Describe the relationship between an individual consumer’s demand and
market demand.
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Demand Curve

Explain that a demand curve represents the relationship between the price
and the quantity demanded of a product, ceteris paribus.

Draw a demand curve.
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Demand Curve*
What kind of slope does it have?
Why is that so?
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Demand Curve
The Non-Price Determinants of Demand (Factors that Change Demand or Shift
the Demand Curve) 2.3 pgs 30-34

Explain how factors including changes in income (in the cases of normal and
inferior goods), preferences, prices of related goods (in the cases of
substitutes and complements) and demographic changes may change
demand.
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Demand Curve
The Non-Price Determinants of Demand (Factors that Change Demand or Shift the
Demand Curve)*
Substitute: A product or service that satisfies the need of a consumer that another
product or service fulfills. A substitute can be perfect or imperfect depending on
whether the substitute completely or partially satisfies the consumer. A consumer
might consider Pepsi to be a perfect substitute for Coke, or Land O'Lakes butter to
be a perfect substitute for Kerrygold Irish Butter. However, if a consumer sees a
difference in these brands, he may see Pepsi and Land O'Lakes as imperfect
substitutes, even if economists might consider them perfect substitutes.
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Demand Curve
The Non-Price Determinants of Demand (Factors that Change Demand or Shift the
Demand Curve)*
Compliment: A good or service that is used in conjunction with another good or
service. Usually, the complementary good has little to no value when consumed
alone but, when combined with another good or service, it adds to the overall
value of the offering. Also, good tends to have more value when paired with a
complement than it does by itself.

Complimentary Goods: i.e. Milk & Cereal, Hot Dogs & Buns, Soda and Chips
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Demand Curve
Movements Along and Shifts of the Demand Curve

Distinguish between movements along the demand curve and shifts of the
demand curve.

Draw diagrams to show the difference between movements along the
demand curve and shifts of the demand curve.
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Demand Curve
What do these movements show?
Why is that so?
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Demand Curve
What do these shifts show?
Why is that so?
IB Economics SL: City Honors School
Unit 1: Microeconomics
Shifts vs. Movement
For economics, the "movements" and "shifts" in relation to
the supply and demand curves represent very different
market phenomena:
IB Economics SL: City Honors School
Unit 1: Microeconomics
Shifts vs. Movement
Movements
A movement refers to a change along a curve. On the demand curve, a
movement denotes a change in both price and quantity demanded from one
point to another on the curve. The movement implies that the demand
relationship remains consistent. Therefore, a movement along the demand
curve will occur when the price of the good changes and the quantity
demanded changes in accordance to the original demand relationship. In
other words, a movement occurs when a change in the quantity demanded is
caused only by a change in price, and vice versa.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Shifts vs. Movement
Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded
or supplied changes even though price remains the same. For instance, if the
price for a bottle of beer was $2 and the quantity of beer demanded increased
from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in
the demand curve imply that the original demand relationship has changed,
meaning that quantity demand is affected by a factor other than price. A shift
in the demand relationship would occur if, for instance, beer suddenly became
the only type of alcohol available for consumption.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Supply
The Law of Supply (2.5 pgs 40-42)
Like the law of demand, the law of supply demonstrates the quantities that
will be sold at a certain price. But unlike the law of demand, the supply
relationship shows an upward slope. This means that the higher the price, the
higher the quantity supplied. Producers supply more at a higher price because
selling a higher quantity at a higher price increases revenue..
IB Economics SL: City Honors School
Unit 1: Microeconomics
Supply
The Law of Supply*

Explain the positive causal relationship between price and quantity supplied.
Price goes Up, Supply stays Up
Price goes Down, Supply goes Down

Describe the relationship between an individual producer’s supply and market
supply.
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Supply Curve

Explain that a supply curve represents the relationship between the price
and the quantity supplied of a product, ceteris paribus.

Draw a supply curve.
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Supply Curve*
What kind of slope does it have?
Why is that so?
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Non-Price Determinants of Supply (factors that change
supply or shift the supply curve) 2.6 pgs 42-47

Explain how factors including changes in costs of factors of production (land,
labour, capital and entrepreneurship), technology, prices of related goods
(joint/competitive supply), expectations, indirect taxes and subsidies and the
number of firms in the market can change supply.
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Non-Price Determinants of Supply (factors that change
supply or shift the supply curve)*

Will Apple still supply as many iphone 5’s as before?

Will Sony still produce VCRs?

Will new cars come with Cassette Tape decks?
So what is the biggest manipulator of Supply?
IB Economics SL: City Honors School
Unit 1: Microeconomics
Movements Along and Shifts of the Supply Curve

Distinguish between movements along the supply curve and shifts of the
supply curve.

Construct diagrams to show the difference between movements along the
supply curve and shifts of the supply curve.
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Supply Curve
What do these movements show?
Why is that so?
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Supply Curve
What do these shifts show?
Why is that so?
IB Economics SL: City Honors School
Unit 1: Microeconomics
Shifts vs. Movement
For economics, the "movements" and "shifts" in relation to
the supply and demand curves represent very different
market phenomena:
IB Economics SL: City Honors School
Unit 1: Microeconomics
Shifts vs. Movement
Movements
A movement refers to a change along a curve. On the demand curve, a
movement denotes a change in both price and quantity demanded from one
point to another on the curve. The movement implies that the demand
relationship remains consistent. Therefore, a movement along the demand
curve will occur when the price of the good changes and the quantity
demanded changes in accordance to the original demand relationship. In
other words, a movement occurs when a change in the quantity demanded is
caused only by a change in price, and vice versa.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Shifts vs. Movement
Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or
supplied changes even though price remains the same. For instance, if the price for a
bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2,
then there would be a shift in the demand for beer. Shifts in the demand curve imply
that the original demand relationship has changed, meaning that quantity demand is
affected by a factor other than price. A shift in the demand relationship would occur if,
for instance, beer suddenly became the only type of alcohol available for consumption.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Market Equilibrium
Equilibrium and Changes to Equilibrium (3.1 pgs 53-57)

Explain, using diagrams, how demand and supply interact to produce market
equilibrium.

Analyze, using diagrams and with reference to excess demand or excess
supply, how changes in the determinants of demand and/or supply result in a
new market equilibrium.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Equilibrium*
When supply and demand are equal (i.e. when the supply function and
demand function intersect) the economy is said to be at Equilibrium. At this
point, the allocation of goods is at its most efficient because the amount of
goods being supplied is exactly the same as the amount of goods being
demanded. Thus, everyone (individuals, firms, or countries) is satisfied with
the current economic condition. At the given price, suppliers are selling all the
goods that they have produced and consumers are getting all the goods that
they are demanding.
IB Economics SL: City Honors School
Unit 1: Microeconomics

What do you notice about this Graph?*
IB Economics SL: City Honors School
Unit 1: Microeconomics
As you can see on the chart, equilibrium occurs at the intersection of the
demand and supply curve, which indicates no allocative inefficiency. At this
point, the price of the goods will be P* and the quantity will be Q*. These
figures are referred to as equilibrium price and quantity.
In the real market place equilibrium can only ever be reached in theory, so the
prices of goods and services are constantly changing in relation to fluctuations
in demand and supply.
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Role of the Price Mechanism
Resource Allocation (3.3 pgs 64-66)

Explain why scarcity necessitates choices that answer the “What to
produce?” question.

Explain why choice results in an opportunity cost.

Explain, using diagrams, that price has a signaling function and an incentive
function, which result in a reallocation of resources when prices change as a
result of a change in demand or supply conditions.
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Role of the Price Mechanism
Opportunity Cost*

1. The cost of an alternative that must be forgone in order to pursue a certain
action. Put another way, the benefits you could have received by taking an
alternative action.

2. The difference in return between a chosen investment and one that is
necessarily passed up. Say you invest in a stock and it returns a paltry 2% over
the year. In placing your money in the stock, you gave up the opportunity of
another investment - say, a risk-free government bond yielding 6%. In this
situation, your opportunity costs are 4% (6% - 2%).
IB Economics SL: City Honors School
Unit 1: Microeconomics
The Role of the Price Mechanism
Opportunity Cost

The opportunity cost of going to college is the money you would have earned if you worked
instead. On the one hand, you lose four years of salary while getting your degree; on the other
hand, you hope to earn more during your career, thanks to your education, to offset the lost
wages.

Here's another example: if a gardener decides to grow carrots, his or her opportunity cost is the
alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.).

In both cases, a choice between two options must be made. It would be an easy decision if you
knew the end outcome; however, the risk that you could achieve greater "benefits" (be they
monetary or otherwise) with another option is the opportunity cost.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Market Efficiency
Consumer Surplus

Explain the concept of consumer surplus.

Identify consumer surplus on a demand and supply diagram.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Market Efficiency
Consumer Surplus*
An economic measure of consumer satisfaction, which is calculated by
analyzing the difference between what consumers are willing to pay for a good
or service relative to its market price. A consumer surplus occurs when the
consumer is willing to pay more for a given product than the current market
price.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Market Efficiency
Consumer Surplus
Consumers always like to feel like they are getting a good deal on the goods
and services they buy and consumer surplus is simply an economic measure of
this satisfaction. For example, assume a consumer goes out shopping for an
MP3 player and he or she is willing to spend $250. When this individual finds
that the player is on sale for $150, economists would say that this person has a
consumer surplus of $100.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Market Efficiency
Consumer Surplus

Consumer surplus is the difference between
the total amount that consumers are willing
and able to pay for a good or service
(indicated by the demand curve) and the total
amount that they actually do pay (i.e. the
market price).

Consumer surplus is shown by the area under
the demand curve and above the equilibrium
price as in the diagram below..
IB Economics SL: City Honors School
Unit 1: Microeconomics
Market Efficiency
Consumer Surplus
Consumer surplus and price elasticity of demand

When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that
people pay matches what they are willing to pay.

In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand does not respond to a
price change. Whatever the price, the quantity demanded remains the same. Are there any examples of
products that have such zero price elasticity of demand?

The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential
consumer surplus because there are some buyers willing to pay a high price to continue consuming the
product. This is shown in the next diagram.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Market Efficiency
Producer Surplus

Explain the concept of producer surplus.

Identify producer surplus on a demand and supply diagram.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Market Efficiency
Producer Surplus*
An economic measure of the difference between the amount that a producer
of a good receives and the minimum amount that he or she would be willing
to accept for the good. The difference, or surplus amount, is the benefit that
the producer receives for selling the good in the market.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Market Efficiency
Producer Surplus
For example, say a producer is willing to sell 500 widgets at $5 a piece and
consumers are willing to purchase these widgets for $8 per widget. If the
producer sells all of the widgets to consumers for $8, it will receive $4,000. To
calculate the producer surplus, you subtract the amount the producer
received by the amount it was willing to accept, (in this case $2,500), and you
find a producer surplus of $1,500 ($4,000 - $2,500).
IB Economics SL: City Honors School
Unit 1: Microeconomics
Market Efficiency
Producer Surplus*
Shown here graphically is the area
(Producer Surplus) above the
producer's supply curve that it
receives at the price point (P(i)). The
size of this area increases as the price
for the good increases.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Market Efficiency
Producer Surplus

The level of producer surplus is shown by the area above the supply curve and below the market price and is
illustrated in the diagram below

Pm is the minimum price that this producer requires to supply the product to the market

As the price rises, there is a great incentive to supply – production will expand as a business moves up their
supply curve

Assuming the the market has reached an equilibrium at quantity Q1 and price P1, then the level of producer
surplus is shown by the shaded/labeled area.

Total revenue = price per unit x quantity sold = P1 x Q1
IB Economics SL: City Honors School
Unit 1: Microeconomics
Market Efficiency
Allocative Efficiency

Explain that the best allocation of resources from society’s point of view is at
competitive market equilibrium, where social (community) surplus
(consumer surplus and producer surplus) is maximized (marginal benefit =
marginal cost).
IB Economics SL: City Honors School
Unit 1: Microeconomics
Theory of Knowledge: Potential Connections

To what extent is it true to say that a demand curve is a fictional entity?

What assumptions underlie the law of demand? Are these assumptions likely
to be true? Does it matter if these assumptions are actually false?
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.2
Elasticity
Price Elasticity of Demand (PED) (4.1 pgs 72-73)
Price Elasticity of Demand and its Determinants

Explain the concept of price elasticity of demand, understanding that it
involves responsiveness of quantity demanded to a change in price, along a
given demand curve.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
The degree to which a demand or supply curve reacts to a change in price is
the curve's elasticity. Elasticity varies among products because some products
may be more essential to the consumer. Products that are necessities are
more insensitive to price changes because consumers would continue buying
these products despite price increases. Conversely, a price increase of a good
or service that is considered less of a necessity will deter more consumers
because the opportunity cost of buying the product will become too high.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Price Elasticity of Demand and its Determinants* (4.2 pgs 73-75)

Calculate PED using the following equation:
PED =
percentage change in quantity demanded
percentage change in price .
If elasticity is greater than or equal to one, the curve is considered to be elastic.
If it is less than one, the curve is said to be inelastic.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Values for price elasticity of demand

If Ped = 0 demand is perfectly inelastic - demand does not change at all when the price changes – the
demand curve will be vertical.

If Ped is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the percentage change in
price), then demand is inelastic.

If Ped = 1 (i.e. the % change in demand is exactly the same as the % change in price), then demand is unit
elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at
each price level.

If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For
example if a 10% increase in the price of a good leads to a 30% drop in demand. The price elasticity of
demand for this price change is –3
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Price Elasticity of Demand and its Determinants

State that the PED value is treated as if it were positive although its
mathematical value is usually negative.

Explain, using diagrams and PED values, the concepts of price elastic
demand, price inelastic demand, unit elastic demand, perfectly elastic
demand and perfectly inelastic demand.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Price Elasticity of Demand and its Determinants*
A good or service is considered to be highly elastic if a slight change in price
leads to a sharp change in the quantity demanded or supplied. Usually these
kinds of products are readily available in the market and a person may not
necessarily need them in his or her daily life. On the other hand, an inelastic
good or service is one in which changes in price witness only modest changes
in the quantity demanded or supplied, if any at all. These goods tend to be
things that are more of a necessity to the consumer in his or her daily life.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Price Elasticity of Demand and its Determinants

Explain the determinants of PED, including the number and closeness of
substitutes, the degree of necessity, time and the proportion of income spent on
the good.

Calculate PED between two designated points on a demand curve using the PED
equation above.

Explain why PED varies along a straight line demand curve and is not
represented by the slope of the demand curve.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Factors affecting price elasticity of demand

The number of close substitutes – the more close substitutes there are in the market, the
more elastic is demand because consumers find it easy to switch

The cost of switching between products – there may be costs involved in switching. In this
case, demand tends to be inelastic. For example, mobile phone service providers may
insist on a12 month contract.

The degree of necessity or whether the good is a luxury – necessities tend to have an
inelastic demand whereas luxuries tend to have a more elastic demand.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Factors affecting price elasticity of demand

The proportion of a consumer’s income allocated to spending on the good –
products that take up a high % of income will have a more elastic demand

The time period allowed following a price change – demand is more price
elastic, the longer that consumers have to respond to a price change. They
have more time to search for cheaper substitutes and switch their spending.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Factors affecting price elasticity of demand

Whether the good is subject to habitual consumption – consumers become less sensitive
to the price of the good of they buy something out of habit (it has become the default
choice).

Peak and off-peak demand - demand is price inelastic at peak times and more elastic at
off-peak times – this is particularly the case for transport services.

The breadth of definition of a good or service – if a good is broadly defined, i.e. the
demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef
are likely to be more elastic following a price change.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Price Elasticity of Demand and its
Determinants*

As we mentioned previously, the
demand curve is a negative slope, and
if there is a large decrease in the
quantity demanded with a small
increase in price, the demand curve
looks flatter, or more horizontal. This
flatter curve means that the good or
service in question is elastic.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Price Elasticity of Demand and its
Determinants*

Meanwhile, inelastic demand is
represented with a much more
upright curve as quantity changes
little with a large movement in price.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Values for price elasticity of demand

If Ped = 0 demand is perfectly inelastic - demand does not change at all when the price changes – the demand
curve will be vertical.

If Ped is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the percentage change in
price), then demand is inelastic.

If Ped = 1 (i.e. the % change in demand is exactly the same as the % change in price), then demand is unit
elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at each
price level.

If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For
example if a 10% increase in the price of a good leads to a 30% drop in demand. The price elasticity of demand
for this price change is –3
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Factors affecting price elasticity of demand

The number of close substitutes – the more close substitutes there are in the market, the more elastic is
demand because consumers find it easy to switch

The cost of switching between products – there may be costs involved in switching. In this case, demand tends
to be inelastic. For example, mobile phone service providers may insist on a12 month contract.

The degree of necessity or whether the good is a luxury – necessities tend to have an inelastic demand whereas
luxuries tend to have a more elastic demand.

The proportion of a consumer’s income allocated to spending on the good – products that take up a high % of
income will have a more elastic demand
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Demand (PED)
Factors affecting price elasticity of demand

The time period allowed following a price change – demand is more price elastic, the longer that consumers
have to respond to a price change. They have more time to search for cheaper substitutes and switch their
spending.

Whether the good is subject to habitual consumption – consumers become less sensitive to the price of the
good of they buy something out of habit (it has become the default choice).

Peak and off-peak demand - demand is price inelastic at peak times and more elastic at off-peak times – this is
particularly the case for transport services.

The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or meat,
demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price
change.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of
Demand (PED)
Demand curves
with different price
elasticity of
demand
IB Economics SL: City Honors School
Unit 1: Microeconomics
Cross Price Elasticity of Demand (XED)
Cross Price Elasticity of Demand and its Determinants (4.4 pgs 83-87)

Outline the concept of cross price elasticity of demand, understanding that it
involves responsiveness of demand for one good (and hence a shifting demand
curve) to a change in the price of another good.

Calculate XED using the following equation:
XED = percentage change in quantity demanded of good x
percentage change in price of good y
IB Economics SL: City Honors School
Unit 1: Microeconomics
Cross Price Elasticity of Demand (XED)
Cross Price Elasticity of Demand and its Determinants

Show that substitute goods have a positive value of XED and complementary
goods have a negative value of XED.

Explain that the (absolute) value of XED depends on the closeness of the
relationship between two goods.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Cross Price Elasticity of Demand (XED)
Cross Price Elasticity of Demand and its Determinants

Show that substitute goods have a positive value of XED and complementary
goods have a negative value of XED.

Explain that the (absolute) value of XED depends on the closeness of the
relationship between two goods.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Cross price elasticity
of demand – analysis
diagrams
IB Economics SL: City Honors School
Unit 1: Microeconomics
Cross Price Elasticity of Demand (XED)
Cross Price Elasticity of Demand and its Determinants

Cross price elasticity (XED) measures the responsiveness of demand for good X
following a change in the price of a related good Y.

We are looking here at the effect that changes in relative prices within a
market have on the pattern of demand.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Cross Price Elasticity of Demand (XED)
Applications of Cross Price Elasticity of Demand

Examine the implications of XED for businesses if prices of substitutes or complements
change.
Cross price elasticity (XED) measures the responsiveness of demand for good X following a
change in the price of a related good Y.

We are looking here at the effect that changes in relative prices within a market have on the
pattern of demand.

With cross elasticity we make a distinction between substitute and complementary
products.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Cross Price Elasticity of Demand (XED)
Cross Price Elasticity of Demand and its Determinants
Substitutes:*

With substitute goods such as brands of cereal, an increase in the price of one good will lead to an increase in
demand for the rival product. The cross price elasticity for two substitutes will be positive.

For example, the iPhone now provides genuine competition for the PC/Computer in providing users with ‘push
technology’ to send all emails through to a mobile device.

Another good example is the cross price elasticity of demand for music. Sales of digital music downloads have
been soaring with the growth of broadband and falling prices for downloads. As a result, sales of traditional
music CD’s are declining at a steep rate.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Cross Price Elasticity of Demand (XED)
Cross Price Elasticity of Demand and its Determinants
Complements:*

Complements are in joint demand

The XED for two complements is negative.

The stronger the relationship between two products, the higher is the co-efficient of cross-price elasticity of
demand.

When there is a strong complementary relationship between two products, the cross-price elasticity will be
highly negative. An example might be games consoles and software games
IB Economics SL: City Honors School
Unit 1: Microeconomics
Cross Price Elasticity of Demand (XED)
Cross Price Elasticity of Demand and its Determinants
Pricing for complementary goods:*

Popcorn, soft drinks and cinema tickets have a high negative value for cross elasticity– they are strong
complements

Popcorn has a high markup i.e. pop corn costs pennies to make but sells for more than a pound. If firms have a
reliable estimate for XED they can estimate the effect, say, of a two-for-one cinema ticket offer on the demand
for popcorn.

The additional profit from extra popcorn sales may more than compensate for the lower cost of entry into the
cinema. For some movie theatres, the revenue from concessions stalls selling popcorn; drinks and other
refreshments can generate as much as 40 per cent of their annual turnover
IB Economics SL: City Honors School
Unit 1: Microeconomics
Income Elasticity of Demand (YED)
Income Elasticity of Demand and its Determinants (4.5 Pg 87-90)

Outline the concept of income elasticity of demand, understanding that it involves
responsiveness of demand (and hence a shifting demand curve) to a change in
income.

Calculate YED using the following equation:
YED = percentage change in quantity demanded
percentage change in income
IB Economics SL: City Honors School
Unit 1: Microeconomics
Income Elasticity of Demand (YED)
Income Elasticity of Demand and its Determinants

Show that normal goods have a positive value of YED and inferior goods have
a negative value of YED.

Distinguish, with reference to YED, between necessity (income inelastic) goods
and luxury (income elastic) goods.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Income Elasticity of Demand (YED)
Normal Goods*

Normal goods have a positive income elasticity of demand so as consumers’ income rises more is
demanded at each price i.e. there is an outward shift of the demand curve

Normal necessities have an income elasticity of demand of between 0 and +1 for example, if
income increases by 10% and the demand for fresh fruit increases by 4% then the income
elasticity is +0.4. Demand is rising less than proportionately to income.

Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more than
proportionate to a change in income – for example a 8% increase in income might lead to a 10%
rise in the demand for new kitchens. The income elasticity of demand in this example is +1.25.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Income Elasticity of Demand (YED)
Inferior Goods*

Inferior goods have a negative income elasticity of demand meaning that
demand falls as income rises. Typically inferior goods or services exist where
superior goods are available if the consumer has the money to be able to buy
it. Examples include the demand for cigarettes, low-priced own label foods in
supermarkets and the demand for council-owned properties.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Income Elasticity of Demand (YED)
The income elasticity of demand is usually strongly positive for

Fine wines and spirits, high quality chocolates and luxury holidays overseas.

Sports cars

Consumer durables - audio visual equipment, smart-phones

Sports and leisure facilities (including gym membership and exclusive sports
clubs).
IB Economics SL: City Honors School
Unit 1: Microeconomics
Income Elasticity of Demand (YED)
In contrast, income elasticity of demand is lower for

Staple food products such as bread, vegetables and frozen foods.

Mass transport (bus and rail).

Beer and takeaway pizza!

Income elasticity of demand is negative (inferior) for cigarettes and urban bus
services.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Income Elasticity of Demand (YED)
Product ranges and longer term trends

Income elasticity of demand will vary within a product range. For example the PED
for own-label foods in supermarkets is less for the high-value “finest” food ranges.

There is a general downward trend in the income elasticity of demand for many
basic products, particularly foodstuffs. One reason is that as a society becomes
richer, there are changes in tastes and preferences. What might have been
considered a luxury good several years ago might now be regarded as a necessity?
How many of you regard a NFL sports subscription or an iPhone, an iPad or a new
laptop as a necessity?
IB Economics SL: City Honors School
Unit 1: Microeconomics
Income Elasticity of Demand (YED)
Applications of Income Elasticity of Demand

Examine the implications for producers and for the economy of a relatively low
YED for primary products, a relatively higher YED for manufactured products
and an even higher YED for services.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Supply (PES)
Price Elasticity of Supply and its Determinants (4.6 pgs 90-94)

Explain the concept of price elasticity of supply, understanding that it involves
responsiveness of quantity supplied to a change in price along a given supply
curve.

Calculate PES using the following equation:
PES = percentage change in quantity supplied percentage
change in price
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Supply (PES)
Price Elasticity of Supply and its Determinants
Price elasticity of supply (PES) measures the relationship between change in
quantity supplied and a change in price.

If supply is elastic, producers can increase output without a rise in cost or a
time delay

If supply is inelastic, firms find it hard to change production in a given time
period.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Supply (PES)
Price Elasticity of Supply and its Determinants

Explain, using diagrams and PES values, the concepts of elastic supply,
inelastic supply, unit elastic supply, perfectly elastic supply and perfectly
inelastic supply.

Explain the determinants of PES, including time, mobility of factors of
production, unused capacity and ability to store stocks.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Supply (PES)
Price Elasticity of Supply and its Determinants
The formula for price elasticity of supply is:
Percentage change in quantity supplied divided by the percentage change in price

When Pes > 1, then supply is price elastic

When Pes < 1, then supply is price inelastic

When Pes = 0, supply is perfectly inelastic

When Pes = infinity, supply is perfectly elastic following a change in demand
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Supply (PES)
Applications of Price Elasticity of Supply

Explain why the PES for primary commodities is relatively low and the PES for
manufactured products is relatively high.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Supply (PES)
Applications of Price Elasticity of Supply
What factors affect the elasticity of supply?

Spare production capacity: If there is plenty of spare capacity then a business can increase
output without a rise in costs and supply will be elastic in response to a change in demand.
The supply of goods and services is most elastic during a recession, when there is plenty of
spare labour and capital resources.

Stocks of finished products and components: If stocks of raw materials and finished
products are at a high level then a firm is able to respond to a change in demand - supply
will be elastic. Conversely when stocks are low, dwindling supplies force prices higher
because of scarcity in the market..
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Supply (PES)
Applications of Price Elasticity of Supply
What factors affect the elasticity of supply?

The ease and cost of factor substitution: If both capital and labour are occupationally mobile then the elasticity
of supply for a product is higher than if capital and labour cannot easily be switched. A good example might be
a printing press which can switch easily between printing magazines and greetings cards.

Time period and production speed: Supply is more price elastic the longer the time period that a firm is allowed
to adjust its production levels. In some agricultural markets the momentary supply is fixed and is determined
mainly by planting decisions made months before, and also climatic conditions, which affect the production
yield. In contrast the supply of milk is price elastic because of a short time span from cows producing milk and
products reaching the market place.
IB Economics SL: City Honors School
Unit 1: Microeconomics
Price Elasticity of Supply (PES)
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Indirect Taxes (5.1 pgs 98-100)
Specific (fixed amount) Taxes and Ad Valorem (percentage) Taxes and their Impact on Markets

Explain why governments impose indirect (excise) taxes.

Distinguish between specific and ad valorem taxes.

Draw diagrams to show specific and ad valorem taxes, and analyze their impacts on market
outcomes.

Discuss the consequences of imposing an indirect tax on the stakeholders in a market, including
consumers, producers and the government.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Indirect Taxes
Specific (fixed amount) Taxes their Impact on Markets
A tax charged a specific amount to be paid for every unit of a good sold.
Specific state and federal taxes are also known as ”per unit tax".
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Indirect Taxes
Specific (fixed amount) Taxes Examples:

Gas Taxes (roughly $1.00 a gallon in NYS)

Cigarette Taxes (per pack charge)*

Alcohol Taxes (Per Bottle, Case, Barrel charge)*
*AKA Sin Taxes
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Indirect Taxes
Ad Valorem (percentage) Taxes and their Impact on Markets
A tax based on the assessed value of real estate or personal property. Ad
valorem taxes can be property tax or even duty on imported items. Property ad
valorem taxes are the major source of revenue for state and municipal
governments.
Municipal property ad valorem taxes are also known as "property taxes".
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Indirect Taxes
Ad Valorem (percentage) Taxes Examples:

Suburban Property Taxes in WNY (School Levy)

Social Security Taxes/FICA 15% (7.5% Individual & 7.5% Employer)

Sales Taxes 8.75% in Erie County (NYS Tax is capped at 7%)

Property Transfer Taxes (Funding for NFTA)
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Subsidies (5.3 pgs 107-112)
Impact on Markets

Explain why governments provide subsidies, and describe examples of subsidies.

Draw a diagram to show a subsidy, and analyse the impacts of a subsidy on
market outcomes.

Discuss the consequences of providing a subsidy on the stakeholders in a market,
including consumers, producers and the government.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Subsidies*
Impact on Markets
A Subsidy is a payment from the government to an individual or a firm for the
purpose of increasing the purchase or a supply of a good.
See Figure 5.9 Subsidy: Simple Case
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Subsidies*
Impact on Markets

The Supply Curve Shifts Right (Downward) by the amount of the Subsidy.

Consumers spend less (and get more) than before

Increases consumer surplus because it lowers the price paid

Producers benefit by receiving much more revenue.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Subsidies*
Different Types of Producer Subsidy

A guaranteed payment on the factor cost of a product – e.g. a guaranteed
minimum price offered to farmers such as under the old-style Common
Agricultural Policy (CAP).

An input subsidy which subsidises the cost of inputs used in production – e.g.
an employment subsidy for taking on more workers.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Subsidies*
Different Types of Producer Subsidy

Government grants to cover losses made by a business – e.g. a grant given to
cover losses in the railway industry or a loss-making airline.

Bail-outs e.g. for financial organisations in the wake of the credit crunch

Financial assistance (loans and grants) for businesses setting up in areas of high
unemployment – e.g. as part of a regional policy designed to boost employment.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Subsidies*
Economic and Social Justifications for Subsidies
Why might the government be justified in providing financial assistance to producers in certain
markets and industries? How valid are the arguments for government subsidies?

To keep prices down and control inflation – in the last couple of years several countries have been
offering fuel subsidies to consumers and businesses in the wake of the steep increase in world
crude oil prices.

To encourage consumption of merit goods and services which are said to generate positive
externalities (increased social benefits). Examples might include subsidies for investment in
environmental goods and services.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Subsidies*
Economic and Social Justifications for Subsidies

Reduce the cost of capital investment projects – which might help to stimulate
economic growth by increasing long-run aggregate supply.

Subsidies to slow-down the process of long term decline in an industry e.g. fishing
or mining

Subsidies to boost demand for industries during a recession e.g. the car scrappage
scheme
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Subsidies*
Economic Arguments against Subsidies

The economic and social case for a subsidy should be judged carefully on the
grounds of efficiency and fairness

Might the money used up in subsidy payments be better spent elsewhere?

Government subsidies inevitably carry an opportunity cost and in the long run
there might be better ways of providing financial support to producers and
workers in specific industries.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Subsidies*

Free market economists argue that subsidies distort the working of the free market
mechanism and can lead to government failure where intervention leads to a worse
distribution of resources.

Distortion of the Market: Subsidies distort market prices – for example, export subsidies
distort the trade in goods and services and can curtail the ability of ELDCs to compete in the
markets of rich nations.

Arbitrary Assistance: Decisions about who receives a subsidy can be arbitrary

Financial Cost: Subsidies can become expensive – note the opportunity cost!
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Subsidies*
Free market economists argue that subsidies distort the working of the free market
mechanism and can lead to government failure where intervention leads to a worse
distribution of resources.

Who pays and who benefits? The final cost of a subsidy usually falls on consumers
(or tax-payers) who themselves may have derived no benefit from the subsidy.

Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need
to restructure – i.e. it delays much needed reforms.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Subsidies*
Free market economists argue that subsidies distort the working of the free
market mechanism and can lead to government failure where intervention leads
to a worse distribution of resources.

Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments.

There are alternatives: It may be possible to achieve the objectives of
subsidies by alternative means which have less distorting effects.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3 Government Intervention
Subsidies
To what extent will a subsidy
feed through to lower prices for
consumers?
A subsidy has the effect of
causing an outward shift in the
market supply curve for a
product
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3 Government
Intervention
Subsidies
A subsidy might be justified
if it encourages increased
supply and consumption of
products that yield high
external benefits
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Subsidies
Governments view of the economy could be summed up in a few short phrases:
If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize
it.
Ronald Reagan, 40th POTUS
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Price Controls (5.4 pgs. 113-116)
Price Ceilings (maximum prices): Rationale, Consequences and Examples

Explain why governments impose price ceilings, and describe examples of
price ceilings, including food price controls and rent controls.

Draw a diagram to show a price ceiling, and analyse the impacts of a price
ceiling on market outcomes.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Price Controls
Price Ceilings (maximum prices): Rationale, Consequences and Examples

Examine the possible consequences of a price ceiling, including shortages,
inefficient resource allocation, welfare impacts, underground parallel markets and
non-price rationing mechanisms.

Discuss the consequences of imposing a price ceiling on the stakeholders in a
market, including consumers, producers and the government.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Price Controls*
Price Ceilings (maximum prices): Rationale, Consequences and Examples
Government mandated minimum or maximum prices that can be charged for
specified goods. Governments sometimes implement price controls when prices
on essential items, such as food or oil, are rising rapidly.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Price Controls
Price Ceilings (maximum prices): Rationale, Consequences and Examples
History has shown that price controls are, at best, effective only on a very short-term
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Price Controls
Price Ceilings (maximum prices):
Rationale, Consequences and
Examples
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Price Controls
Price Ceilings (maximum prices): Rationale, Consequences and Examples
Rent control provides another example of the ineffectiveness of price controls. Rent controls,
such as those used in New York City, are intended to keep housing prices affordable. Instead,
they decrease the supply of rental housing and thereby raise prices of existing rental housing.
In a vicious cycle, rent controls discourage new landlords from entering the market and cause
existing ones to leave, creating a supply of housing that is less than the free market would
allow and causing further upward pressure on housing rental prices. Rent controls also reduce
the financial incentives for landlords to maintain and improve their properties, leading to
lower quality housing.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Price Controls*
Price Ceilings (maximum prices): Rationale, Consequences and Examples
Effects of Price Ceilings

Shortages

Rationing

Decreased market size

Elimination of allocative efficiency (Society doesn't’t make enough of the desired good)

Informal (Black) markets
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Price Controls (5.5 pgs 116-119)
Price Floors (minimum prices): Rationale, Consequences and Examples

Explain why governments impose price floors, and describe examples of price
floors, including price support for agricultural products and minimum wages.

Draw a diagram of a price floor, and analyse the impacts of a price floor on
market outcomes.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Price Controls
Price Floors (minimum prices): Rationale, Consequences and Examples

Examine the possible consequences of a price floor, including surpluses

and government measures to dispose of the surpluses, inefficient resource
allocation and welfare impacts.

Discuss the consequences of imposing a price floor on the stakeholders in a
market, including consumers, producers and the government.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Price Controls*
Price Floors (minimum prices): Rationale, Consequences and Examples
When a "price floor" is set, a certain minimum amount must be paid for a good
or service. If the price floor is below a market price, no direct effect occurs. If
the market price is lower than the price floor, then a surplus will be generated.
Minimum wage laws are good examples of price floors.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Price Controls
Price Floors (minimum prices): Rationale, Consequences and Examples
In many states, the U.S. minimum wage law has no effect, as market wage rates
for low-skilled workers are above the U.S. minimum wage rate. In states where
the minimum wage is above the market wage rate, the law will increase
unemployment for low-skilled workers. Although some low-skilled workers will
get higher pay, others will lose their jobs.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.3
Government Intervention
Price Controls
Price Floors (minimum prices):
Rationale, Consequences and
Examples
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.1 pgs. 123-126)
The Meaning of Market Failure
Market Failure as a Failure to Allocate Resources Efficiently

Analyze the concept of market failure as a failure of the market to achieve
allocative efficiency, resulting in an over- allocation of resources (overprovision of a good) or an under-allocation of resources (under-provision of a
good)
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.1 pgs. 123-126)
The Meaning of Market Failure*
What is market failure?
Market failure occurs when freely-functioning markets, fail to deliver an efficient
allocation of resources. The result is a loss of economic and social welfare. Market
failure exists when the competitive outcome of markets is not efficient from the point
of view of society as a whole. This is usually because the benefits that the freemarket confers on individuals or businesses carrying out a particular activity diverge
from the benefits to society as a whole.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.1 pgs. 123-126)*
Markets can fail because:

Negative externalities (e.g. the effects of environmental pollution) causing the social cost of
production to exceed the private cost.

Positive (or beneficial) externalities (e.g. the provision of education and health care) causing
the social benefit of consumption to exceed the private benefit

Imperfect information means merit goods are under-produced while demerit goods are
over-produced or over-consumed
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.1 pgs. 123-126)*
Markets can fail because:

Market dominance by monopolies can lead to under-production and higher
prices than would exist under conditions of competition

The private sector in a free-markets cannot profitably supply to consumers
pure public goods and quasi-public goods that are needed to meet people’s
needs and wants
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.1 pgs. 123-126)*
Markets can fail because:

Factor immobility causes unemployment hence productive inefficiency

Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution
of income and consequent social exclusion which the government may
choose to change
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.1 pgs. 123-126)
Types of Market Failure
The Meaning of Externalities

Describe the concepts of marginal private benefits (MPB), marginal social benefits
(MSB), marginal private costs (MPC) and marginal social costs (MSC).

Describe the meaning of externalities as the failure of the market to achieve a
social optimum where MSB = MSC.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.1 pgs. 123-126)
Market failure results in:

Productive inefficiency: Businesses are not maximising output from given factor
inputs. This is a problem because the lost output from inefficient production could
have been used to satisfy more wants and needs

Allocative inefficiency: Resources are misallocated and producing goods and
services not wanted by consumers. This is a problem because resources can be
put to a better use making products that consumers value more highly
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.2 pgs. 126-133)
Negative Externalities of Production and Consumption

Explain, using diagrams and examples, the concepts of negative externalities of production
and consumption, and the welfare loss associated with the production or consumption of a
good or service.

Explain that demerit goods are goods whose consumption creates external costs.

Evaluate, using diagrams, the use of policy responses, including market-based policies
(taxation and tradable permits), and government regulations, to the problem of negative
externalities of production and consumption
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.2 pgs. 126-133)
“Merit goods” are goods or services that have significant external benefits to
society if they are produced and consumed. However, many people in
society will not consume merit goods because the private sector charges too
high a price that they can afford or are willing to pay. As a result, if it was left to
the private sector, merit goods would be under produced and under consumed.
The government will usually intervene and provide merit goods free of charge,
or subsidised, so that everyone can consume them. Consequently society will be
better off as a whole due to the increase in external benefits created by merit
goods.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.2 pgs. 126-133)*
Negative Externalities of Production and Consumption
A Merit Good has two characteristic:

People do not realize the true benefit. For example, people underestimate the
benefit of education or vaccinations.

Usually these goods have positive externalities.
Therefore in a free market there will be under consumption of merit goods.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.2 pgs. 126-133)*
Examples of Merit Goods:

Health Care – people underestimate the benefits of getting a vaccination. If
people do get a vaccination, then there will be external benefits to the rest of
society because it will help reduce disease in the rest of society.

Museums – the educational benefit of museums.

Education – People may undervalue benefits of studying.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.2 pgs. 126-133)
A “Demerit Good” is a good or service whose consumption is considered
unhealthy, degrading, or otherwise socially undesirable due to the perceived
negative effects on the consumers themselves. It is over-consumed if left to
market forces. Examples of demerit goods include tobacco, alcoholic beverages,
recreational drugs, gambling, junk food and prostitution. Because of the nature
of these goods, governments often levy taxes on these goods (specifically, sin
taxes), in some cases regulating or banning consumption or advertisement of
these goods.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.2 pgs. 126-133)*
A Demerit Good has two characteristics:

A good which harms the consumer. For example, people don’t realise or
ignore the costs of doing something e.g. smoking, drugs.

Usually these goods also have negative externalities.
Therefore in a free market there will be over consumption of these goods.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.2 pgs. 126-133)*
Examples of Demerit Goods include:

Smoking

Drinking

Taking drugs (Illegal and /or Illicit)
Note: Merit and Demerit Goods involve making a value judgment that something is
good or bad for you.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.2 pgs. 126-133)*
Private Costs and Social Costs
The existence of externalities creates a divergence between private and social costs of
production and the private and social benefits of consumption.

Social Cost
=

Social Benefit =
Private Cost + External Cost
Private Benefit + External Benefit
When negative production externalities exist, social costs exceed private cost. This leads to
over-production if producers do not take into account the externalities.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.2 pgs. 126-133)
External costs from production
Production externalities are generated and received in supplying goods and services - examples include noise and
atmospheric pollution from factories.
External costs from consumption

Consumption externalities are generated and received in consumption - examples include pollution from
driving cars and motorbikes and externalities created by smoking and alcohol abuse and also the noise
pollution created by loud music being played in built-up areas.

Negative consumption externalities lead to a situation where the social benefit of consumption is less than the
private benefit.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.2 pgs. 126-133)

Figure 6.1 Community Surplus Pg. 124

Figure 6.2 Social Benefits and Social Costs Pg. 125

Figure 6.3 Negative Externality of Production Pg. 127

Figure 6.5 Negative Externality of Consumption. Pg 129

Page 130 “Pink Box Questions

Page 133 Exercises questions #1, 2, 3
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.3 pgs. 133-137)
Positive Externalities of Production and Consumption

Explain, using diagrams and examples, the concepts of positive externalitiesof production
and consumption, and the welfare loss associated with the production or consumption of a
good or service.

Explain that merit goods are goods whose consumption creates external benefits.

Evaluate, using diagrams, the use of government responses, including subsidies, legislation,
advertising to influence behaviour, and direct provision of goods and services.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.3 pgs. 133-137)
Positive Externalities of Production and Consumption

Figure 6.8 Positive Externality of Production Pg. 134

Figure 6.10 Positive Consumption Externality Pg. 135

Figure 6.11 Subsidy of Education Pg. 136
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.3 pgs. 133-137)
Positive Externalities of Production and Consumption
There are many occasions when the production and/or consumption of a good or a service
creates external benefits which boost social welfare.

External benefits from development of renewable energy sources such as wind, solar and
hydro power

Social benefits from the Postal Service.

Social benefits to provide free school lunches.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.3 pgs. 133-137)
Positive Externalities of Production and Consumption

Positive externalities and market failure

Where positive externalities exist, the good or
service may be under-consumed or under-provided
since the free market may fail to value them
correctly or take them into account when pricing the
product. In the diagram above, the normal market
equilibrium is at P1 and Q1 – but if there are
external benefits, the Q1 is an output below the
level that maximises social welfare.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.4 pgs. 137-139)
Lack of Public Goods

Using the concepts of rivalry and excludability, and providing examples, distinguish between
public goods (non-rivalrous and non- excludable) and private goods (rivalrous and
excludable).

Explain, with reference to the free rider problem, how the lack of public goods indicates
market failure.

Discuss the implications of the direct provision of public goods by government.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.4 pgs. 137-139)
Public Goods*
A public good is often (though not always) under-provided in a free market because of its characteristics of nonrivalry and non-excludability.
Examples of Public Goods

Public Defense; Armed Services

Street Lights, Roads, Public Parks, Bridges

Police service, Fire Service, Public Education
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.4 pgs. 137-139)
Public goods have two characteristics:*

Non-rivalry: This means that when a good is consumed, it doesn’t reduce the
amount available for others.
– E.g. benefiting from a street light doesn’t reduce light for others, but eating an
apple would.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.4 pgs. 137-139)
Public goods have two characteristics:*

Non-excludability: This occurs when it is not possible to provide a good
without it being possible for others to enjoy.
E.g erecting a dam to stop flooding, or providing law and order.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.5 pgs. 139-143)
Common Access Resources and the Threat to Sustainability

Describe, using examples, common access resources.

Describe sustainability.

Explain that the lack of a pricing mechanism for common access resources means
that these goods may be overused/depleted/ degraded as a result of activities of
producers and consumers who do not pay for the resources that they use, and
that this poses a threat to sustainability .
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.5 pgs. 139-143)
Common Access Resources and the Threat to Sustainability*
Definition of ’Common Resource'

A resource, such as water or pasture, that provides users with tangible benefits. A major
concern with common resources is overuse, especially when there are poor socialmanagement systems in place to protect the core resource.

Common resources that are not owned by anyone are called open-access resources.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.5 pgs. 139-143)
Common Access Resources and the Threat to Sustainability*
Overuse of common resources often leads to economic problems such as the
tragedy of the commons, where user self-interest leads to the destruction of the
resource in the long term, to the disadvantage of everyone.
Common Access Resources and Market Failure video clip
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.5 pgs. 139-143)*
To define environmental sustainability we must first define sustainability.
*Sustainability is the ability to continue a defined behavior indefinitely.*
To define what environmental sustainability is we turn to the experts
Herman Daly, one of the early pioneers of ecological sustainability, looked at the
problem from a maintenance of natural capital viewpoint. In 1990 he proposed
that:
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.5 pgs. 139-143)

1. For renewable resources, the rate of harvest should not exceed the rate of
regeneration (sustainable yield);

2. [For pollution] The rates of waste generation from projects should not exceed
the assimilative capacity of the environment (sustainable waste disposal); and

3. For nonrenewable resources the depletion of the nonrenewable resources
should require comparable development of renewable substitutes for that
resource.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.5 pgs. 139-143)
Common Access Resources and the Threat to Sustainability

Explain, using negative externalities diagrams, that economic activity
requiring the use of fossil fuels to satisfy demand poses a threat to
sustainability.

Explain that the existence of poverty in economically less developed countries
creates negative externalities through over-exploitation of land for
agriculture, and that this poses a threat to sustainability
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Market Failure (6.5 pgs. 139-143)
Common Access Resources and the Threat to Sustainability

Evaluate, using diagrams, possible government responses to threats to
sustainability, including legislation, carbon taxes, cap and trade schemes, and
funding for clean technologies.

Explain, using examples, that government responses to threats to sustainability
are limited by the global nature of the problems and the lack of ownership of
common access resources, and that effective responses require international
cooperation.
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Theory of Knowledge: Potential Connections:

To what extent is the obligation to seek sustainable modes of consumption a moral
one?

What knowledge issues are involved in assessing the role of technology in meeting
future patterns of consumption and decreasing the negative externalities of
consumption associated with fossil fuels?

What are the knowledge issues involved in determining what is a rational cost to
pay for halting climate change?
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Theory of Knowledge: Potential Connections:

How could we know if economically more developed countries are morally
justified in interfering in the development of economically less developed
countries on the grounds of climate change?

How can we know when climate change is sufficiently serious to warrant
government interfering in the freedom of its citizens to consume?
IB Economics SL: City Honors School
Unit 1: Microeconomics
1.4
Market failure
Theory of Knowledge: Potential Connections:

How can we calculate the external costs of producing and running items such
as light bulbs or motor vehicles? For example, low energy light bulbs consume
less energy but they require more energy to produce, and some brands contain
materials that are harmful to the environment such as mercury. Hybrid cars
consume less energy to run but consume more energy to produce.

What are the problems in knowing whether climate change is produced by
human activity?