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Microeconomics 3.2 Resource allocation via the market system 3.2 MICROECONOMICS 2 - Resource allocation via the market system The Economic Problem and Production Possibility Curves The Economic Problem Trying to satisfy unlimited wants using scarce resources. Therefore a choice has to be made. Scarcity - Limited resources relative to unlimited wants, therefore a choice has to be made. Opportunity Cost - The next best alternative foregone (not all the alternatives). Free goods - These are goods that have no cost to them, for example the wind and sun. Consumer goods - These are goods that are sold to consumers for private use. Producing more consumer goods now means a better standard of living now, but not in the future as there are no capital goods to sustain it. Capital goods - These are man-made goods that are used to make other goods and services. Producing more capital goods now means a lower standard of living now, but a higher standard of living in the future as it increases a country’s productive capacity. Assumptions on PPC: Two goods only Fixed level of resources Given level of technology The curve shows the maximum level of output that a company can produce. The slope shows the opportunity cost of one good in relation to another. Point A: Production inefficiency: There are resources that are not fully employed. This represents an under-utilisation of resources. Point B or C: Allocative Efficiency: A single point on PPC. This is what society wants. Point B & C: Production Efficiency: The country is producing at its maximum level. This is any point on PPC. Point D: This point is unachievable unless a country goes into international trade, new/improved technology is created or new resources are discovered. If you move from A to B or from A to C, there is no opportunity cost. This is because a good does not have to be sacrificed to produce another good. If you move from B to C, there is opportunity cost as you are sacrificing some Capital Goods to produce more Consumer Goods. The blue shaded area is the opportunity cost. The red shaded area is what is gained from the movement. 1 Microeconomics 3.2 Resource allocation via the market system Bowed PPC: This reflects the law of diminishing returns. There is increasing opportunity cost as you move from one end of the curve to the other. This is concave to the origin. Straight line PPC: Resources and technology are equally suited to the production of either good. Resources are completely interchangeable. Opportunity Cost is constant. In this situation, the production capacity of Good Y has increased. This means new resources have been discovered and new technology has been developed that increases the production of Good Y. In this situation, the production capacity of Good X has increased. This means new resources have been discovered and new technology has been developed that increases the production of Good X. New resources have been discovered and new technology has been developed that increases the productive capacity for both Good X and Good Y. 2 Microeconomics 3.2 Resource allocation via the market system Demand The law of demand is from the consumer’s point of view. A fall in the price of a good or service will lead to an increase in quantity demanded ceteris paribus (other things remaining the same). ↑P ↓QD A rise in the price of a good or service will lead to a decrease in quantity demanded ceteris paribus (other things remaining the same). ↓P ↑QD Demand Schedule Price ($) 1 2 3 4 5 Quantity Demanded for lollies Quantity Demanded (000) 10 8 5 1 0 Demand Curve When drawing a demand curve, remember to: Label the y axis Label the x axis Label the curve on both sides Have an even scale Have a title Derived Demand The demand for something is dependent on the demand for the goods or services they produce. 3 Microeconomics 3.2 Resource allocation via the market system Movements in the demand curve Movement is caused by a change in the price only. There is an inverse relationship. Movement to the left/up the curve/contraction of demand Price increases Quantity demanded decreases The curve is moving to the left Movement to the right/down the curve/extension of demand Price decreases Quantity demanded increases The curve is moving to the right 4 Microeconomics 3.2 Resource allocation via the market system Shifts in the demand curve Shifts are caused by a change in Ceteris Paribus (conditions of demand). This includes: Income Direct tax Taste Fashion Advertising Prices of complements (a good or service that has to be used in conjunction with the good or service that we are looking at, for example pen and paper) Prices of substitutes (a good or service that can be used instead of the good or service that we are looking at, for example Coke and Pepsi) A change in Ceteris Paribus causes a change in demand (not quantity demanded). Price remains the same. Shift to the left Demand is decreasing Incomes decreasing Direct tax increasing Not in fashion Decreased advertising Price of complement increased Price of substitute decreased Shift to the right Demand is increasing Incomes increasing Direct tax decreasing In fashion Increased advertising Price of complement decreased Price of substitute increased 5 Microeconomics 3.2 Resource allocation via the market system Price Elasticity of demand Price elasticity of demand measures the responsiveness of quantity demanded of a good or service to changes in its price. Percentage change method: Midpoint Method: It will always be negative, so ignore it. Ep > 1 or %ΔQD>%ΔP Ep = 1 or %ΔQD=%ΔP Ep < 1 or %ΔQD<%ΔP Elastic demand Unitary elasticity Inelastic demand Total Revenue Method: ↓P ↑TR or ↑P ↓TR P and TR stays the same ↓P ↓TR or ↑P ↑TR Elastic demand Unitary elasticity Inelastic demand If a good is 0.1 and another good is 0.5, the 0.1 good is more of a necessity compared to the 0.5 good. 6 Microeconomics 3.2 Resource allocation via the market system Perfectly elastic Demand is infinite, no matter what the price. This is impossible. Ep = ∞ Relatively elastic Ep > 1 %ΔQD>%ΔP Many substitutes Luxury High Proportion of Income Durable Sales tax falls more on the producer Unitary Elasticity Ep = 1 %ΔQD=%ΔP Relatively inelastic Ep < 1 %ΔQD<%ΔP Few substitutes Necessities Low proportion of Income Single Use Product Addictive Sales tax falls more on the consumer Perfectly Inelastic Zero elasticity No matter what the price is, demand is the same Highly unlikely 7 Microeconomics 3.2 Resource allocation via the market system Cross Elasticity of demand Cross Elasticity of demand is the responsiveness of quantity demanded of one good to changes in the price of another good. This compares two goods. We are trying to find out whether or not they are complements or substitutes. Percentage change method: Midpoint method: Substitutes ↑P Tea ↑D Coffee When the price of one good and demand of another good move in the same direction, it’s a substitute. When calculating cross elasticity, the answer will be positive. The higher the positive number, the closer the substitutes are. Complements ↑P Cars ↓D Petrol When the price of one good and demand of another good move in opposite directions, it’s a complement. When calculating cross elasticity, the answer will be negative. The lower the negative number, the closer the complements are. 8 Microeconomics 3.2 Resource allocation via the market system Income elasticity of demand Income elasticity of demand is the responsiveness of quantity demanded of a good or service to changes in income. We are trying to determine if a good is inferior, a necessity or a luxury. Percentage change method: Midpoint method: Inferior goods The answer will be negative. The lower the negative number, the more inferior it will be. Income and quantity demanded will move in the opposite direction. It is inferior as you will buy more of the good when your income is lower. For example, second hand clothes and budget brands. Necessities (Normal goods) The answer will be between 0 and 1. Income and quantity demanded will move in the same direction. For example, food and water. Luxuries (Normal goods) The answer will be more than 1. The higher the number, the more of luxurious it is. Income and quantity demanded will move in the same direction. For example, caviar and Hubbards cereal. 9 Microeconomics 3.2 Resource allocation via the market system Supply The law of supply is from the producer’s point of view. A fall in the price of a good or service will lead to a decrease in quantity supplied ceteris paribus (other things remaining the same). ↑P ↑QS A rise in the price of a good or service will lead to an increase in quantity supplied ceteris paribus (other things remaining the same). ↓P ↓QS Supply Schedule Quantity Supplied for organic chicken Price ($) Quantity Supplied (000 kg) 5 5 10 10 15 15 20 20 25 25 Supply Curve When drawing a supply curve, remember to: Label the y axis Label the x axis Label the curve on both sides Have an even scale Have a title 10 Microeconomics 3.2 Resource allocation via the market system Movements in the supply curve Movement is caused by a change in the price only. The relationship is in the same direction. Movement to the left/down the curve/contraction of supply Price decreases Quantity supplied decreases The curve is moving to the left Movement to the right/up the curve/extension of supply Price increases Quantity supplied increases The curve is moving to the right 11 Microeconomics 3.2 Resource allocation via the market system Shifts in the supply curve Shifts are caused by a change in Ceteris Paribus (conditions of demand). This includes: Costs of production Wages Indirect tax (GST) Technology Workers productivity Price of a related good Subsidies Tariffs A change in Ceteris Paribus causes a change in supply (not quantity supplied). Price remains the same. Shift to the left Supply decreases Costs of production increases Wages increase Indirect tax increased (Labour is in government) Technology malfunctions Workers productivity decreases Price of a related good increases Subsidy decreases Tariff increased Shift to the right Supply increases Costs of production decreases Wages decrease Indirect tax decreased (National is in government) Technology improves Workers productivity increases Price of a related good decreases Subsidy increases Tariff decreased 12 Microeconomics 3.2 Resource allocation via the market system Other influences on supply Environmental - If producers are concerned about the environment, costs of production may increase because packaging is recyclable. Also they may do things in a way that decrease wastage. This will decrease supply. Other non-environmental firms may not care and packaging may be cheaper, increasing supply. Legal Factors - Companies must operate legally. Adhering to the law may cost more money. For example, packaging standards including nutritional information, staff health and safety and holiday pay. Supply likely is to decrease. Political Factors - The government may discourage goods, for example, alcohol, by taxing them, increasing costs of production which decreases supply. It may also provide subsidies increasing supply. Trade agreements may also influence supply, for example CER. Trade Factors - Tariffs may change affecting supply. Changes in the world price affects supply, for example, if world price increases, local firms may increase quantity supplied to get more money from exporting. Cultural Factors - Respect for cultural people may increase costs of production, for example permission to build on Maori land. 13 Microeconomics 3.2 Resource allocation via the market system Price Elasticity of supply Price Elasticity of supply is the responsiveness of quantity supplied of a good or service to changes in its price. Percentage change method: Midpoint method: It will always be positive as they move in the same direction. Ep > 1 or %ΔQS>%ΔP Ep = 1 or %ΔQS=%ΔP Ep < 1 or %ΔQS<%ΔP Elastic supply Unitary elasticity Inelastic supply Extreme situations Perfectly Elastic Es = ∞ This is impossible. Perfectly Inelastic Es = 0 Momentary supply: Supply at a moment in time. This is usually the situation for one particular day. There is only a fixed amount of stock for that day in storage out the back or on the shelf. Supply over time Short run supply The firm is restricted in their supply in the short term. Quantity supplied is limited to the quantity of finished goods on hand or easily available. Therefore it is inelastic. Quantity supplied changes very little compared to the change in price. This cuts the x axis. Long run supply The firm has some time to expand their use of all factors and so increase their output capacity. If there are shortages and high profits, more firms are attracted to the industry. Over time, quantity supplied is more responsive to price because new producers can enter the market and technology can be improved to increase supply. Therefore it’s elastic. Price changes very little compared to change in Quantity Supplied. This cuts the y axis. 14 Microeconomics 3.2 Resource allocation via the market system Market demand Market demand for a product is the horizontal sum of all individual demand curves and/or schedules at each price. Price ($) 1 2 3 4 5 A 10 9 8 7 6 B 15 12 11 9 5 C 30 25 24 15 8 Market Demand 55 46 43 31 19 This can also be given as three separate graphs. To plot the Market Demand curve, the Price column is the y axis and the Market Demand column is the x axis. Market Supply Market supply for a product is the horizontal sum of all individual supply curves and/or schedules at each price. Price ($) 1 2 3 4 5 A 2 3 4 5 6 B 12 14 17 22 25 C 20 23 25 28 30 Market Supply 34 40 46 55 61 This can also be given as three separate graphs. To plot the Market Supply curve, the Price column is the y axis and the Market Supply column is the x axis. 15 Microeconomics 3.2 Resource allocation via the market system Market equilibrium The Price equilibrium is the price that prevails in the market. The market clears. Therefore all stock is sold and no stock is unsold. No shortage or no surplus. It is allocatively efficient. Surplus When price is above the equilibrium there is a surplus. Therefore suppliers will have excess stock. They will bring down prices so that all stock is sold. Shortage When price is below the equilibrium there is a shortage. Therefore suppliers won’t have enough stock. Consumers will push up prices as they are willing to buy the good at a higher price. 16 Microeconomics 3.2 Resource allocation via the market system A new equilibrium in the market Demand shifting to the right. Price increases. Quantity increases. Demand shifting to the left. Price decreases. Quantity decreases. Supply shifting to the right. Price decreases. Quantity increases. Supply shifting to the left. Price increases. Quantity increases. 17 Microeconomics 3.2 Resource allocation via the market system Consumer surplus and Producer surplus Consumer surplus is the difference between what consumers would be willing to pay and what they actually pay. Consumer surplus (before tax) is shown in the graph by the blue shaded area. Producer surplus is the difference between the total earnings of suppliers for a certain quantity sold and the total costs required to put that quantity on the market. Producer surplus (before tax) is shown in the graph by the red shaded area. At equilibrium, consumer surplus and producer surplus are maximised. They do not necessarily equal each other. This is allocative efficiency. The effect of the government imposing a sales tax (GST) If the government imposes a sales tax, supply will shift to the left as supply decreases (because indirect tax reduces supply). This causes a reduction in consumer surplus. The new price that the consumers have to pay is Pe’. The new consumer surplus is shown in the area shaded in light blue. The amount of consumer surplus that is lost is shown in the area shaded in yellow. This causes a reduction in producer surplus. The price producers actually receive is Pp. The new producer surplus is shown in the area shaded in pink. The amount of producer surplus that is lost is shown in the area shaded in light green. The amount of tax collected by the government is shown by the total area shaded in brown. The consumer surplus share of the tax is shaded in dark brown and the producer share of the tax is shaded in light brown. The sales tax causes a deadweight loss. This is a loss of welfare by an individual or group which is not offset by welfare gain to some other individual or group. The deadweight loss is shown in the total area shaded in grey. The consumer surplus share of the deadweight loss is shaded in dark grey and the producer surplus share of the deadweight loss is shaded in light grey. 18 Microeconomics 3.2 Resource allocation via the market system Government setting the price in the market Minimum price control (Price floor) A minimum price control is when the market price is not allowed to fall below a certain minimum level. It is only effective if it is set above equilibrium because if it was set below equilibrium, consumers would bid up prices up to equilibrium. This causes a surplus/excess supply. This also causes a deadweight loss (shaded in red). Therefore the government must decide what they do with the excess stock. In the past this has been stockpiled. The minimum price is imposed so that producers do not receive an unreasonably low price. Maximum price control (Price ceiling) A maximum price control is when the market price is not allowed to rise above a certain maximum level. It is only effective if it is set below equilibrium because if it was set above equilibrium, producers would bid down prices down to equilibrium. This causes a shortage/excess demand. This also causes a deadweight loss (shaded in red). Therefore a black market may arise as well off consumers are prepared to pay more than the government will allow. A solution to this is to provide a subsidy to producers (see next page). The maximum price is imposed because some things are deemed as necessities (eg medicines) and poorer people need to be able to purchase these. The government may impose a maximum or minimum quantity as well. This may because it causes environmental damage. This creates a deadweight loss as well from the quantity pointing to the equilibrium from the left or from the right. 19 Microeconomics 3.2 Resource allocation via the market system Subsidy A subsidy is paid by the government to firms to keep their costs down and as a result firms will increase supply (supply curve shifts to the right). The advantage of this is that prices remain low without a shortage. However it can be costly to the government. The price that consumers have to pay is Pmax. The price that producers receive is Pp. The subsidy per unit is the vertical distance between the supply curves. The total cost to the government of the subsidy is the vertical distance between the supply curves times the quantity sold (Qd). This is shown by the area shaded in red. The value of the subsidy is never the same as the decrease in price. This is because of the slopes of the supply and demand curves. The deadweight loss caused by the subsidy is shown by the area shaded in yellow. The amount of producers’ revenue after the subsidy has increased from the light grey shaded area to the total area shaded in grey. The amount of consumers’ expenditure after the subsidy has changed from the pink, purple and dark brown shaded area to the area shaded in pink, dark brown and 20 light brown. Microeconomics 3.2 Resource allocation via the market system The consumer surplus before the subsidy is shaded in light blue. This extends to the area shaded in light blue and dark blue. This is because the price consumers have to pay has now lowered; therefore the difference between what they are willing to pay and what they actually pay has increased (i.e. consumer surplus has now increased). The producer surplus before the subsidy is shaded in light green. This extends to the area shaded in light green and dark green. This is because the price producers receive has now increased; therefore the difference between what they are willing to receive and what they actually receive has increased (i.e. producer surplus has now increased). If the demand curve is inelastic, consumers If the demand curve is elastic, producers will benefit more than producers. will benefit more than consumers. The gain in consumer surplus is shaded in blue and the gain in producer surplus is shaded in green. 21 Microeconomics 3.2 Resource allocation via the market system Trade and the market When goods are exported from a country, price will increase. Therefore quantity demanded locally decreases and quantity supplied locally increases. This surplus stock is then traded overseas in the form of exports. This may happen to a country that is very efficient at producing a particular good. When goods are imported into a country, price will decrease. Therefore quantity demanded locally increases and quantity supplied locally decreases. The shortage created is eliminated by importing goods from overseas. This may happen to a country that is inefficient at producing a particular good. The resulting price is negotiated between the two countries that are trading. In practice, the world price is drawn halfway between the exporters and importers local prices. However in reality it varies because of negotiation. It is also important to note that when comparing graphs that the currencies are the same. New Zealand faces a perfectly elastic supply curve for exports and imports. This is because New Zealand is a very small country compared to the output from the world. Therefore we must accept the world price as we are insignificant to influence the world price. There is no deadweight loss when two countries trade. However there is a deadweight loss if the government imposes a tariff. 22 Microeconomics 3.2 Resource allocation via the market system Exports In an exporting situation, important areas to note are: Producer surplus before trade: green Producer surplus after trade: green, red & yellow Consumer surplus before trade: blue & red Consumer surplus after trade: blue Net welfare gain: yellow The exporting country benefits in terms of a net welfare gain. This is because even though consumer surplus decreases, producer surplus increases by a larger amount, so overall the country has benefited from trade. Imports In an importing situation, important areas to note are: Producer surplus before trade: green & red Producer surplus after trade: green Consumer surplus before trade: blue Consumer surplus after trade: blue, red & yellow Net welfare gain: yellow The importing country benefits in terms of a net welfare gain. This is because even though producer surplus decreases, consumer surplus increases by a larger amount, so overall the country has benefited from trade. Imports with a tariff A tariff is a tax imposed on imported goods. The tariff effectively lifts the world price. Therefore quantity supplied domestically will increase from Qs to Qs’ and quantity demanded domestically will decrease from Qd to Qd’. In an importing situation with a tariff, important areas to note are: Producer surplus before trade: green, pink & purple Producer surplus before the tariff: green Producer surplus after the tariff: green & pink Consumer surplus before trade: blue Consumer surplus before the tariff: blue, purple, pink, yellow, red & grey Consumer surplus after the tariff: blue, purple & yellow Net welfare gain before the tariff: yellow, red & grey Net welfare gain after the tariff: yellow Tax collected by the government: red Deadweight loss: grey 23 Microeconomics 3.2 Resource allocation via the market system Nominal and Real Wages Normal wage - the return to labour measured in current dollars Real wage - wages that take the effect of inflation out To work out real wages: If nominal wages have increased by 2% and the rate of inflation is 3%, real wages have actually decreased by 1%. The Labour market The demand for labour curve is sloped downwards because employers would be willing to pay a higher wage for more skilled workers and can not afford to pay a high rate to a greater number of workers. The demand for labour is a derived demand. This means the demand for labour is dependent on the demand for the final product. A shift would be caused by changes in demand for the final product. The supply is sloped upwards because it is logical to assume that more people are willing to work more hours as the wage rate increases (provided that they do not take time for leisure because they have enough money already). The straight line shows that there is a limited working age population. A shift would be caused by changes in the size of the working age population because of school leaving age, retirement age, general population growth and migration. 24 Microeconomics 3.2 Resource allocation via the market system At the wage equilibrium, there will only be actual employment and voluntary unemployment (people who will not work until the wage rate rises). The labour market will clear. However, because of the fact that this wage would not sustain a reasonable standard of living, the government sets a minimum wage (unions may also negotiate a higher wage rate). This is the minimum wages employers can legally pay to workers. If they pay wages lower than the minimum wage, they will be breaking the law. A minimum wage is only effective if it is set above equilibrium. The minimum wage rates (as of 18/6/07) are $11.25 for adults and $9 for 16 and 17 year olds. This creates involuntary unemployment. These people are willing and able to work but are still out of a job. These people will fall into three categories: structural (people who need to up-skill before entering the work force again), frictional (people who are in between jobs looking for work) and cyclical (unemployment caused by a downturn in the economy). 25