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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.
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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.
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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.
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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
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Price increases
Quantity demanded decreases
The curve is moving to the left
Movement to the right/down the curve/extension of demand
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Price decreases
Quantity demanded increases
The curve is moving to the right
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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
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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
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Demand is increasing
Incomes increasing
Direct tax decreasing
In fashion
Increased advertising
Price of complement decreased
Price of substitute increased
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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.
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Microeconomics
3.2 Resource allocation via the market system

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Perfectly elastic
Demand is infinite, no matter what the price.
This is impossible.
Ep = ∞
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Relatively elastic
Ep > 1
%ΔQD>%ΔP
Many substitutes
Luxury
High Proportion of Income
Durable
Sales tax falls more on the producer
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Unitary Elasticity
Ep = 1
%ΔQD=%ΔP
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Relatively inelastic
Ep < 1
%ΔQD<%ΔP
Few substitutes
Necessities
Low proportion of Income
Single Use Product
Addictive
Sales tax falls more on the consumer
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Perfectly Inelastic
Zero elasticity
No matter what the price is, demand is the same
Highly unlikely
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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.
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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.
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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
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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
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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
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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
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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
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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.
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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.
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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 ($)
1
2
3
4
5
A
10
9
8
7
6
B
15
12
11
9
5
C
30
25
24
15
8
Market Demand
55
46
43
31
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This can also be given as three separate graphs.
To plot the Market Demand curve, the Price column is the y axis and the Market
Demand column is the x axis.
Market Supply
Market supply for a product is the horizontal sum of all individual supply curves and/or
schedules at each price.
Price ($)
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.
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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
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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.
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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).
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