CHAPTER-2 Competitive Market: Demand and Supply

2.1) Market

A market is a place where buyers and sellers exchange goods and services.
Eg- Stock markets, local markets like vegetable market, oil and labour market.

Types Of Markets

Competitive markets are those markets which comprise a large number of

buyers and no individual has the control over the price. Price is determined by
forces of Demand and Supply.

2.2) Demand
Law Of Demand And Demand Curve

Demand is a quantity of a commodity which a consumer wishes to purchase

at a given level of price and during a specified period of time.

Concept Of Effective Demand

It refers to consumers’ willingness and capacity to purchase goods at various

prices supported by their ability to pay.

Law of Demand

1. As price increases, Demand decreases

2. As prices decrease, Demand Increases

As we can see from the table as the price of the apple is reducing the quantity
demanded for the apples increases. This is clearly verifying the Law of
Demand. Price and quantity demanded are inversely correlated.

Demand Curve

As we can see in fig 2.3 as the price drops from PA to PB, the quantity
demanded increases from QA to QB.
 Fig 2.3

2.3) Why The Demand Curve Slopes Downwards

Marginal Benefit Theory

It is a maximum amount a consumer is willing to pay for an additional goods

or services. It is the additional satisfaction or utility that the consumer receives
when the additional goods are purchased.

Note: The marginal benefit for a consumer tends to decrease as consumption

increases. That is why the Demand Curve slopes downwards.

Eg- Imagine you buy an ice cream which provides you with certain benefits.
You want to buy one more, so you buy a second ice cream but the benefit
derived from the 1st ice cream is more than the 2nd one. You enjoyed the 1st
ice cream more in comparison to the 2nd one.

2.4) Individual Demand To Market Demand

Market Demand is the sum of the individual demand for a product from buyers
in the market

2.5) Shift Of Demand Curve Due To Non Price

Determinants

Other than price, the other factors which affect the demand of a commodity
are known as non-price determinants. These were the variables in Law of
Demand which were assumed to be unchanged by use of the Ceteris Paribus
assumption.
2.6) Shift Of Demand Curve

Shift in Demand curve is due to non price determinants, price being constant.
Rightward shift in Demand Curve = Increase in Demand
Leftward shift in Demand Curve = Decrease in Demand

2.7) Income Of Consumer

Impact On Demand Curve

In fig 2.9 (a), with the change in the income of the consumer, the demand
curve shifts from DA to DB. DB<DA. Similarly in fig 2.9 (b), with the change in
income, the demand curve shifts from DA to DB. DB>DA.
Price Of Related Goods

To Sum-Up:

SUBSTITUTE GOODS

If Price of a good INCREASES, Demand for its substitute INCREASES.

COMPLEMENTARY GOODS

If Price of a good DECREASES, Demand for its substitute INCREASES.

Demand Curve of Substitute Good
Demand Curve of Complimentary Goods

in the above fig, when the price of bread is increasing from P1 to P2, the
demand for its complementary good decreases from D1 to D2.

Tastes And Preferences

Favorable tastes and preferences results in increase in demand and

vice-versa.

Demographic Conditions
If the number of buyers are more the demand curve shifts right i.e. increases
and vice versa.

2.8) Movement Along A Demand Curve

In the above figure, when the price increases from Pe to P1, the quantity
demanded decreases from Qe to Q1. This is called contraction of demand.
Similarly, when price reduced from Pe to P2, the quantity demanded increases
from Qe to Q2. This is called extension of demand.

What Is Supply ?

The Supply of an Individual firm indicates the various quantities of a good (or
service) a firm is willing and able to produce and supply to the market for sale
at different possible prices during a particular time period, ceteris paribus.

Law Of Supply
According to the law of supply, the higher the price, the larger the quantity
produced.

Supply Schedule And Curve

As we can see from the above figure, as the price of rice increases the supply
is also increasing.

Market Supply

It is the total quantity of a good or service that all manufacturers are willing to
sell for a certain price over a certain time frame.

Why Does The Supply Curve Slopes Upwards?

A company has an incentive to produce more goods and vice versa because
higher prices mean higher profits. As a result, there is a positive relationship
between supply and price.

The Vertical Supply Curve

vertical Supply Curve = when the quantity of a good that is available cannot
change, regardless of price.
Shift of Supply curve due to non-price determinants

2.10) The Non-Price Determinants Include The

Following:

Cost Of Factor Of Production:

Higher resource cost means lower quantity supplied.

Price Of Related Goods/ Joint Supply:

The production of goods derived from a single product is referred to as joint

supply. Butter and skimmed milk, for instance, are made from sole milk. This
indicates that an increase in the quantity supplied of one product will result
from an increase in the price of another product.

Taxes:

Higher taxes imposed imply lower quantity supplied and vice-versa.

Subsidies:

It is a payment made by the government to the company to boost production.

The supply will be greater the higher the subsidy.

Technology:

Improved technology means higher quantity supplied.

Number Of Firms:

Higher the no. of firms, higher is the quantity supplied.

Expectations:

If a firm expects the price of a product to rise, it implies lesser quantity

supplied at present.

Sudden Unpredictable Events:

Natural catastrophes like earthquakes, war, floods, etc. affects supply.

Decrease in supply will move the supply curve upwards and Increase in
supply will move the supply curve downwards.

2.11) Movement Along The Supply Curve

It happens because of the change in prices of the commodity, keeping other

factors constant.

Market Equilibrium: Demand and Supply

Market Equilibrium is a state in which market demand is equal to market
supply. There is no excess demand and supply in the market.

Market Equilibrium: Demand and Supply

Market Equilibrium is a state in which market demand is equal to market

supply. There is no excess demand and supply in the market.

Equilibrium Price And Quantity:

The equilibrium price is the price at which the quantity demanded and quantity
supplied are equal.

The quantity demanded and supplied at an equilibrium price is known as

equilibrium quantity.
Note:

Excess Demand-

It is the condition in which at any price demand> Supply

Excess Supply-

It is the condition in which at any price supply is less than demand

In the above fig. market equilibrium is at 8000 bars where supply= demand. At
a higher price say at 4$ Qty supplied(10,000 bars)> Qty demanded(6000
bars). There is an excess supply of 4000 bars. With unsold output of 4000
bars, the firm will reduce the price, thus resulting in decreased supply which
will further start increasing the demand and reach the point where qty
demanded=qty [Link] case of excess demand, say for eg at price 1$, Qty
demanded=12000 bars and qty supplied= 4000 bars. There is excess demand
of (12000-4000) 8000 bars, as a result, price increase which inturn increases
increases supply and the quantity demanded begins to fall and this happens
till the point where qty supplied= qty demanded.

2.12) Changes In Market Equilibrium

Due to non price determinants, the demand and supply curve may shift
leftwards or rightwards as the case may be, causing a state of
[Link] is the equilibrium achieved in the following cases, it is
discussed below:

Case 1: Demand Increases

As demand increases, price also increases due to excess demand in the

market from P1 to [Link] prices increases, supply will also increase from Q1
to Q2.

This will result in decreasing the demand, this happens till the new equilibrium
point is reached.

Case 2: Demand Decreases

As demand decreases, the price also decreases due to excess supply in the
market from P1 to P2.
As price falls, the supply will also start falling from Q1 to Q2.
And in return the demand will start increasing. This continues till the new
equilibrium point is reached.

Case 3: Supply Increases

As supply increases, the prices will fall due to excess supply in the market
from OP to OP1.
When a price falls, quantity demanded increases from OQ to OQ1.
Qty supplied starts decreasing till the new equilibrium point is reached.

Case 4: Supply Decreases

As supply decreases, a price increases due to excess demand in the market

from OP to OP2.
As price increases, qty demand falls from OQ to OQ2.
This happens till the new equilibrium point is reached.

Linear Demand Function

Let us understand this with the help of an example. From the above equation
we can draw a schedule and a demand [Link]: let us say demand function,
Qd= 14-2P
Simply by putting different values of P we can obtain different quantities.
If we plot the above table on the graph, we can derive a demand curve.

Change In Parameter ‘A’ Shifts The Demand Curve

In the above fig. a new demand function is obtained i.e. Qd=10a-2P, due to
change in the value of ‘a’ which may be due to a non price determinant which
has shifted demand curve to the left. Similarly, in demand function Qd=19-2P,
again due to change in non-price determinant, the demand curve has shifted
to the right.
Changes In Parameter ‘B’ And The Steepness Of The Demand Curve

Slope is defined as the change in the dependent variable divided by the

change in independent variable between two points. Eg- In the above
equation, Qd = 14-2P, the slope is -[Link]: The greater the absolute value of
the slope, the flatter the demand curve.

Linear Supply Function

From the above equation, we can draw a table and a supply curve; by
substituting different values of ‘P’ we can get the quantity supplied.
Change In Parameter ‘C’ Shifts The Supply Curve

Parameter ‘c’ is a non price determinant of supply. A change in the value of ‘c’
causes a left handed or right handed shift of the supply curve, as seen in the
figure above.

Changes In Parameter ‘D’ And Steepness Of The Supply Curve

Note: The greater the value of the slope, the flatter the curve.

2.21 Price mechanism

Price mechanism is the mechanism in which prices play a key role in directing
the activities of producers, consumers and resources suppliers.

There are two important elements of price mechanism

(1) Prices
(2) Markets
The role of price mechanism in resource allocation:

Resource Allocation: Scarcity, Choice And Opportunity Cost.

The above figure relates to the problem of resource allocation due to the
scarcity of resources.

2.13) Resource Allocation: Prices As Signals And

Incentives.
Market mechanism working through prices is known as the invisible hand of
the market.

How are Prices set in a Free Market?

Adam Smith- wrote the book Wealth of Nations

— Invisible hand
1. Producers will make what is most profitable

2. Consumers have incentive to buy goods at the lowest cost

3. These must be allowed to work itself out. There is an invisible hand

controlling thing.

It works through 2 markets:

1) Resource Market (factor market)

● Land
● Labor
● Capital
● Entrepreneur

2) Product Market (goods & service market)

● Milk
● Yogurt
● Cheese
● Ice cream

Market Efficiency

Allocative Efficiency:
It indicates that resources are distributed in such a way that consumption
benefits the entire society, answering the question, “What to produce?”

Productive Efficiency:

It means producing with the fewest possible resources, it answers the

question, “How to produce?”

NOTE
Allocative and productive efficiency go hand in hand. Allocative efficiency is
reached when a society produces and consumes at its preferred point on its
PPC. These two conditions together are known as economic efficiency or
Pareto Optimality.

2.14.) How Market Efficiency Is Reached Through

Consumer And Producer Surplus?

CONSUMER SURPLUS

Consumer surplus is a measure of the economic welfare that people gain from
purchasing and then consuming goods and services

Consumer surplus is the Price difference between the total amount that
consumers are willing and able to pay for a good or service (shown by the
demand curve) and the total amount that they actually do
pay (i.e. the market price).
A Consumer surplus is indicated by the area under the demand curve and
above the market price.

PRODUCER SURPLUS

Producer surplus is a measure of producer welfare

Producer surplus is the difference between what producers are willing and
able to supply a good for and the price they actually receive.

Producer surplus shown by area above the supply curve and below the
market price.
Higher prices provide an incentive to supply more to the market (profit motive)

COMPETITIVE MARKET EQUILIBRIUM (SOCIAL SURPLUS)

The definition of it is the sum of consumer surplus and producer surplus at its
highest point.

MARKET EQUILIBRIUM & ALLOCATIVE EFFICIENCY

In competitive market equilibrium, as shown in the above figure, production of

goods occurs where MB=MC, also the point of Social Surplus.

This means that markets are achieving Allocative as well as productive

efficiency, producing the quantity of goods wanted by the society at the lowest
possible cost. Optimum utilization of resources is being done.
 Chapter-3 Elasticities

ELASTICITIES OF DEMAND AND SUPPLY

1.1 Meaning Of Elasticity Of Demand

Elasticity of demand is a measure of the degree of responsiveness of

quantity demanded of a good to a change in its price or income or price of
related goods.

THREE CONCEPTS IN ELASTICITY OF DEMAND

1.2 Price Elasticity Of Demand, PED

PED is a measure of responsiveness of the quantity demand of a product to
the change in its price.

Let the initial quantity demand of an item be represented by QD and its

change be represented by ∆ QD. Let the initial price be represented by P
and change in its price be represented by ∆ P. Hence, PED is measured by
using the following formula, Let us try to understand this by following
example- Suppose the price of a commodity falls from Rs.10 to Rs.6 and its
quantity demand increases from 20 units to 30 units,

QD = Initial quantity demand = 20 units P = Initial price of commodity =

Rs.10

∆ QD = Change in quantity demanded of the commodity = 30 – 20 = 10 units

∆ P = Change in price of the commodity = 6 – 10 = Rs.4
PED = ∆QD/∆P x P/QD
= (10/4) * (10/20)
= 1.25

Note: The sign of PED is considered positive ignoring the negative sign.
This is done to avoid confusion. he use of percentages

Elasticity is measured in terms of percentages for two reasons:

To measure in common units.

To measure in absolute terms.

Degrees Of Price Elasticity Of Demand

PERFECTLY ELASTIC DEMAND (𝑃𝐸𝐷 = ∞):

When at a given price, the quantity demanded rises to any level, demand is
said to be perfectly elastic. Items include Pizza, books, etc. (Refer Fig. E
below)

PERFECTLY INELASTIC DEMAND (𝑃𝐸𝐷 = 0):

If change in price causes no change in quantity demanded, demand is said

to be perfectly inelastic. Items include basic necessities such as salt.
(Refer Fig. D below))

UNIT ELASTIC DEMAND (𝑃𝐸𝐷 = 1):

Demand is considered to be unit elastic if the percentage change in

quantity demanded is the same as the percentage change in price. (Refer
Fig. A below)

MORE ELASTIC DEMAND (𝑃𝐸𝐷 > 1):

If percent change in price is less than the percent change in quantity

demanded, demand is said to be more elastic. (Refer Fig. B below)

LESS ELASTIC DEMAND (𝑃𝐸𝐷 < 1):

If percent change in price is more than the percent change in quantity
demanded, demand is said to be less elastic. (Refer Fig. C below)

Variability Of PED Along A Straight Line Demand Curve

Relationship Between PED And Slope Of Demand Curve

Note: PED varies through the range of curve whereas slope is constant for a
linear demand curve.
 ● Factors Affecting Price Elasticity of Demand

FACTOR ELASTIC DEMAND INELASTIC DEMAND

Nature of Luxury Necessities

Commodity

Substitutes More Less

Proportion of Spent is large Spent is small

Income
 Addiction If addicted If not addicted

Time period Long Run Short Run

Examples for the above

● Luxury- a/c and cars.

● Necessity- medicines, etc
● Time- If there’s an increase in the prices of cooking oil in short
period, it’s difficult to switch to cooking gas, but in the long term it
is possible.
● Income- If income is more, expenditures such as family vacations,
luxury travel, etc can be availed.

The Demand Curve’s Steepness And PED:

Steeper demand curves are relatively less elastic or inelastic whereas

flatter demand curves are more elastic.
So to compare 2 demand curves which one is more elastic just draw both
curves on a single diagram and find the intersecting point. To the left of the
intersecting point steeper curve is less elastic.

Applications Of Price Elasticity Of Demand

PED And The Effects Of Price-Changes And Total Revenue:

Total revenue is in the amount of money received by firms when they sell
goods or services.
TR = P x R
TR and PED can be explained with the help of following 3 possibilities

Demand Is Elastic (PED>1)

An increase in price means reduction in TR and vice-versa.

In the preceding graph, TR1 equals A+C in the event of a rise in price from
P1 to P2, whereas TR2 equals A+B in the event of a decrease in price.

Demand Is Inelastic (PED<1)

An increase in price means an increase in total revenue(TR) A decrease in

price results in decrease in TR.
In the above figure, due to increase in price TR1=A+C, and due to decrease
in price TR2=A+B. TR1>TR2.

Demand Is Unit Elastic(PED=1)

Change in price causes no change in total revenue. In the above fig,

TR1(A+C) = TR2(A+B).

Total Revenue Test of Price Elasticity of Demand

IF Fall in LEADS Increase in THEN ELASTIC
price TO Total DEMAND
Revenue
IS

Fall in Decrease in INELASTIC

price

Total
Revenue

Gain in Decrease in ELASTIC

price Total
Revenue
 Gain in Increase in INELASTIC
price

Total
Revenue

A change No Change UNIT

in price in Total ELASTIC
Revenue

PED And Firm Pricing Decisions

The pricing decisions are taken by the firm keeping the type of demand a
product has(elastic, inelastic or unit elastic).

PED In Relation To Primary And Manufactured Products

Many primary commodities have a low PED(Price inelastic demand)
because they are necessities and have no substitutes. Eg- medicines,
agricultural products, etc.
Whereas, manufactured products have high price elastic demand because
they have substitutes.

PED And Indirect Taxes

The lower the price elasticity of demand for the taxed goods, the greater
the government. tax revenues and vice-versa.
1.3 Cross Elasticity Of Demand, XED

XED is a measure of responsiveness of the quantity demand of a product to

the change in price of related products or substitute products.

Let the initial quantity demanded of an item be represented by QD and its

change be represented by ∆ QD. Let the initial price of a related/substitute
good be represented by P and change in its price be represented by ∆ P.
Hence, XED is measured by using the formula,
Note: The sign of XED can be positive or negative. Sign is not ignored.

Positive XED: Substitute Goods

Incase of substitute goods, demand for one good and price of another
good change in the same direction.
Eg- Coke and pepsi.

Note: In substitute goods Larger XED= Greater substitutability between 2

goods= Larger shift in demand curve due to price change.
Eg- A good having XED=+0.7 is a stronger substitute than a good having
XED=+0.3 .
Negative XED: Complementary Goods

Incase of complementary goods, the demand for one good and the price of
the other good change in opposite directions.

In the above figure, when the price of a tennis racket decreases, the
demand for tennis balls increases (Demand shifts from D1 to D2) and vice
versa.

Note: In complementary goods, Larger the –ve value of XED, Greater the
complementarity between 2 goods, larger the shift in demand curve.

Eg- Goods having XED -0.8 are stronger complements than goods having
XED – 0.5.

Zero XED: Unrelated Goods

If XED is zero, then the two goods are unrelated, XED is zero. Eg- Umbrella
and onions.

Application Of Cross Price Elasticity Of Demand

Incase Of Substitute Goods:

Goods of a single business:

Let’s take an example of coke and [Link]’s important for the business to
consider XED while making pricing decisions. Eg- Coke Price Sprite Demand.
Whether the coke price should be cut or not is based on 2 main points
PED of coke to know whether in coke prices will or Total revenue.
Degree of XED for coke and sprite: If XED is positive but low substitutability, then
percentage reduction of coke prices will lead to small percentage change in
sprite demand and vice-versa.

Goods of rival businesses

Eg- Coke and pepsi. A large XED between coke and pepsi means a fall in the
price of coke will lead to a large fall in demand for pepsi.

Incase of Complementary Goods

XED for complementary goods is also helpful in pricing decisions. Eg- A product
with high negative XED means reducing the price of one good will lead to large
increase in demand of the other good.

1.4 Income Elasticity Of Demand, YED

Eg- sports clothings and sports equipment.

YED is a measure of the responsiveness of demand to changes in income,
and involves demand curve shifts. It provides information on the direction
of change due to change in income and on the size of the change.

Note: When YED>0 (positive), it is a normal good. Eg- new car, new clothes.
When YED<0

Let the initial quantity demanded by the consumer be represented by QD

and its change be represented by ∆ QD. Let the initial income of that
consumer be represented by Y and change in its price be represented by ∆
Y.

Hence, YED is measured by using the formula,

𝑌𝐸𝐷 =% Change in Quantity demanded
=% Change in Income
QD Y
=𝑥
∆Y QD

Hence, it can be said that YED will be positive for normal products like
branded items where an increased income leads to higher demand for that
product in the market. However, for inferior/cheap products like local
brands, the same is exactly opposite and YED shall be negative, where an
increased income leads to lesser demand of that product in the market.

Interpretation Of YED Coefficient:

● Elastic: If a product’s quantity demand changes significantly with a

percent change in income. Eg: a need for hybrid vehicles
 ● Inelastic: if a small percentage change in a product’s quantity demand
will result from a change in income. Eg: popularity of fast food
● Unit Elastic: If percent change in income is same as percent change in
quantity demand of a product. Eg: demand for normal goods

Application Of YED

● YED and rate of expansion of industries.

Higher the YED for a good, the greater the marked expansion in
future.
● On the contrary when recession is there YED>1 will experience fall
in sales, YED<0 will experience increase in sales.
● YED and the economy.
Elasticity of supply is the degree of responsiveness of supply of a
commodity due to change in its price.

It is measured by using the formula, Es = % Change in Quantity supplied of

a product/% Change in Its Price

2.1) Type Of Price Elasticity Of Supply

Elasticity Type Of Elasticity Relationship Between Price &
Coefficient Supply

Es = 0 Perfectly Inelastic No change in Supply

Es < 1 Less than Unitary Change in Supply < Change

Elastic in Price

Es = 1 Unitary Elastic Change in Supply = Change

in Price
Es > 1 More than Unitary Change in Supply > Change
Elastic in Price

Es = ∞ Perfectly Elastic Extremely large change in

Supply with no change in
Price
Determinants Of PES

Length of Time Short Short period Long period

Period Highly Inelastic Elastic supply

Quantity of stock Firms with high stock Firms with low stock
High PES Low PES
 Mobility of factors of Immobile resource High mobility resources
production low PES High PES

CAPACITY OF FIRMS Greater spares capacity Lesser spares capacity

SPARE(UNUSED) High PES Low PES

2.2) Factors Affecting Elasticity Of Supply

● Nature of Commodity
● Time Period
● Nature of Inputs used
● Technique of Production

2.3) Importance Of Elasticity Of Supply

Determination Of Rent:
When perfectly inelastic, entire earnings of the factor would be rent.

Determination Of Price:

It helps in determining the price of a commodity.

 Chapter-4 GOVERNMENT INTERVENTION

GOVERNMENT INTERVENTION

Indirect Tax

It is a tax that is levied on the producer—his goods and services—and is then

passed on to the consumer in the form of higher prices—partly paid by the
producer and partly by the consumers. Examples of Indirect Taxes: Excise
Tax, VAT, GST, Service Tax, etc.

NOTE: Excise Taxes are imposed because they are a source of Government’s
revenue and can discourage consumption of harmful goods like cigarettes,
alcohol, etc. They are also imposed on goods produced or manufactured in
India.

Indirect Taxes And Allocation Of Resources

Taxes can change allocation of resources because they raise the price paid by
consumers and lower the price received by producers and it causes the
consumers to buy less and producers to produce less.

Reasons For Indirect Taxes

● Source of government revenue.

● Used to discourage use of harmful goods, such as cigarettes and alcohol.
 ● Redistribution of income: Taxing goods that can be affected by high income
individuals.
● Improves allocation of resources.

Types Of Excise Tax

● Specific Tax: Fixed amount of tax per unit. Eg- 5$ per packet of cigarettes.
● Ad Valorem Tax: Fixed percentage of price of goods.
Note: A firm pays the government when a tax is imposed on a good. For every
level of output, the firm needs to make more revenue than the original price.
This causes an upward shift of the supply curve.
Note: Given a supply function of the general form Qs= c+dP, whenever there
is an upward shift of the function by ‘t’ units, where ‘t’= tax per unit, we replace
P by P-t. The new supply function therefore becomes Qs= c+d(P-t).

Effects Of Excise Taxes On Market, Customer And

Social Welfare

Consumer expenditure:
Before Tax, Consumer paid P* X Q*
After Tax, Consumer paid Pc x Qt T
here was a fall in expenditure.

Producer Revenue:
Before Tax, producer revenues is P* X Q*= Consumer expenditure After Tax,
Producer revenue is Pp X Qt < Consumer expenditure There is a fall in
producer revenue.

Government Revenue:
Government revenue= tax= Pc-Pp (Consumer expenditure- Producer
revenue).

Impact On Stakeholders:

Consumers Are Worse-Off.

● There is a price increase but less quantity. Consumers pay more for less of
the goods.

Producers Are Worse-Off.

● Producers receive less and sell less. There is a revenue decrease.

The Government Gains.

 ● They earn revenue.

Workers Are Worse-Off.

● Fewer workers are needed to produce less output. This may lead to
unemployment.

Society As A Whole Is Worse-Off.

● Mainly because of under allocation of resources.

NOTE: When resources are inefficiently managed, it leads to under or over

allocation of resources. Under allocation means resources are under-utilized.
Over allocation means resources are over-utilized.
Consumer Surplus And Producer Surplus:
The imposition of an indirect tax results in reduced consumer and producer
surplus, part of which is transformed into government revenue and part of
which is a welfare (deadweight) loss. The welfare loss in this case is the result
of under allocation of resources to the production of goods. This is also
indicated by MB>MC, too little of the good is produced and consumed relative
to the social optimum.
Note: Welfare benefits that are lost to society as a result of inefficient resource
allocation are referred to as welfare losses.

Tax Incidence And Price Elasticities Of Demand

And Supply

Note: Tax incidence means the burden of a tax.

Incidence Of Indirect Tax And PED

Incidence Of Indirect Tax And PES

When supply is inelastic, tax incidence is on producers. When supply is

elastic, tax incidence of consumers.

Putting PED And PES Together:

The more elastic a schedule, the more of the tax burden will fall on the other
side.

Subsidy
It is the provision of goods and services at a price lower than the market price
by the government to individuals or businesses, such as low-interest or
interest-free loans for students.
Examples: Subsidized LPG Gas cylinders provided by the Government,
leading to a reduction in price of cylinders, causes an increased demand of
quantity required.
Specific subsidy is a cash payment subsidy of a fixed amount per unit.
Note: Subsidies change the allocation of resources by decreasing the price
paid by consumers and increasing the price earned by producers.

Reasons For Subsidies:

● Increase revenue and income of producers.

● Makes certain goods affordable to low income groups such as bread or rice.
● Produce and make use of desirable products and services. e.g., vaccinations
and education.
● Support growth of specific industries. Eg- solar power manufacturing
industries, chemicals, textiles, etc
● Encourages exports.
● Improves allocation of resources.

Impact Of Subsidies On Market Outcomes:

 ● Equilibrium Q increases from Q* to Qsb.
● Equilibrium P (paid by consumer) falls from P* to Pc.
● Price received by producers rises from P* to Pp.
● Government pays for (shaded) subsidy (Pp – Pc) X Qsb.
● Overallocation Qsb>Q*.

Consequences On Stakeholders:

● Consumers are better off – Pay less and receive more.

● The producers benefit because they can produce more and receive a higher
price.
● The government is worse off –
 ● The subsidy is paid for out of the budget of the government.
● Workers are better off – Firms hire more workers to produce more.
● Society is worse off – Overallocation of resources to subsidized products.
● It depends on foreign producers: If exports receive subsidies, export prices fall
and quantity rises. This is beneficial for domestic producers but detrimental for
international ones.

Subsidies: Market Outcome And Social Welfare:

Price Received By Producer And Price Paid By Consumer After

Subsidy:
Illustrating Consumer And Producer Surplus:

The granting of a subsidy results in greater consumer and producer surplus,

however, society loses due to government spending on the subsidy.
Since the loss from government spending is greater than the gain in consumer
and producer surplus, welfare loss results, reflecting allocative inefficiency,
which in this case is due to overallocation of resources. This is also illustrated
by MB<MC. Too much of the good is being produced and consumed, relative
to the social optimum.

Price Control

It is the setting of maximum/minimum prices by the government so prices

can’t adjust to equilibrium. Disequilibrium results in either excess supply or
excess demand.

Price Ceilings:
 ● A Price ceiling is a maximum legal price for a good. It needs to be set below
the
equilibrium price for it to work.
● The businesses supply Qs at the Pc, but there is a demand for Qd.
● The market cannot clear. There is a shortage (excess demand) of Qd-Qs.

Consequences For The Economy

Rationing

It is a method for distributing something among users. In a free market, the

price system helps by letting people who are willing and able to pay get what
they want.
The price mechanism cannot assist with rationing because there is a
shortage.

Non- Price Rationing: –

The methods used to distribute the quantity among all the buyers.

● “First come first serve”

● distribution of coupons
● Favoritism
Underground (Parallel) Markets: –

They involve buying and selling that are unrecorded and usually illegal. They
involve buying a good at the legal price and selling it at the equilibrium price.

Underallocation Of Resources: –

Qs is lower when the price is lower than the equilibrium. The quantity of
resources used to produce this product is insufficient. Society is in worse
shape.

Negative Welfare Impacts

● Consumer surplus is the

● region of (a+b)
● Producer surplus is the region of (c+d+e)
● When there is allocative
● efficiency MB=MC, CS and Ps is maximum (a+b+c+d+e).
● If the price ceiling Pc is imposed, we move from Qe to Qs, CS is now (a+c)
and PS is (e).
● The social surplus now is the region of (a+c+e).
● The shaded section, (b + d) is welfare (deadweight) loss. These benefits are
lost due to misallocation.
● We can see that MB>MC at Qs. The benefit of an extra good purchase is
greater than the cost of producing it.

Consequences On Stakeholders
Consumers Gain And Lose.

● Consumers gain area c, but lose region b. Consumers that can buy it are
better off.

Producers Are Worse- Off

● Makers can sell a more modest amount and have a misfortune in income.

The Government Is Not Affected

● The economy is unaffected, but the government may gain popularity.

Workers Are Worse-Off

● To produce less output, fewer workers are required. This could result in
unemployment.

Rent Controls

It limits the maximum rent on housing so low income earners can get housing.

● Housing is now more affordable.

● There is a shortage of housing.
● There is a smaller quantity of housing.
 ● There are long waiting lists for people to get a house/apartment.
● Underground markets may appear.
● Poor house maintenance because of unprofitability.

Food Price Controls

● It can be used to make food more affordable when the price of goods rises.
● Lower food prices.
● Food shortages.
● Non-price rationing.
● Underground markets.
● Falling farmer incomes and unemployment.
Price Floors

● A price floor is a legally set minimum price set by the government. It needs to
be above the equilibrium price for it to be effective.
● At the price floor Pf, firms supply Qs, but the demand is at Qd. The market
cannot clear. There is a surplus of Qs-Qd.
● The Government imposes price floors to:
● Provide income support for farmers.
● Protect low-wage workers.
Price Floors (Agricultural)

● Farmer’s incomes are usually unstable because of low elasticities.

● In order to push agricultural products above the equilibrium price,
governments employ price supports known as floor prices.
● Because markets are unable to clear, this results in surplus. Typically, the
government purchases excess supply to maintain the floor.

Agricultural Price Floor Consequences

● There is an excess supply (surplus) of Qs-Qd.

● Government needs to decide what to do with the surplus.
○ Store it – additional costs are .
○ Export it – a subsidy is required as the price floor increases.
○ Send as aid; create additional difficulties for the nations that are
supposed to benefit from it..
● Inefficient production because they are protected by the price floor and have
no incentive to use effective production methods.
● Overallocation of resources to produce goods. Society is getting too much!
● Negative welfare impacts.
○ At equilibrium, CS is (a+b+c); PS is (d+e).
○ After a price floor is imposed, CS falls to (a), and PS becomes
(d+e+b+c+f).
○ The government needs to pay Pf X (Qs-Qd) to buy the excess.

Consequences On The Stakeholders

Consumers lose.
 ● Consumers must pay more and receive less.

Producers gain.

● Producers increase revenue from Pe X Qe to Pf X Qs.

Producers are also protected and don’t have to be as efficient.

The Government loses.

● The Government has the burden of buying the entire surplus.

Workers Gain

Employment increases

Stakeholders in other countries.

● Farmers are supported by price floors in developed nations. After that, the
surplus is exported, lowering the overall cost. In order to compete, these
countries without price floors will need to lower their prices, prompting the
farmers there to reduce production.

Minimum Wages

● Determines minimum price of labour an employer must pay. Similar to the

effect of a price floor, the market does not clear if one is imposed.
● There is a surplus of labour (or unemployment).
 ● Illegal workers – Workers may be paid less than the minimum wage. Generally
includes unlawful foreigners.
Misallocation – Production costs will rise for businesses that employ unskilled
workers, resulting in lower output.

Consequences On Stakeholders

Firms lose.

● Firms now have a higher cost of production.

It depends on workers.

● some get a higher wage . Others lose their jobs.

Consumers lose.

● Supply will decrease if there is an increase in labor costs.

 CHAPTER-5 and 6 Market Failure Negative and
Positive Externalities

Market Failure

It occurs when the price mechanisms (forces of supply and demand) fail
to allocate resources efficiently. Scarce resources are allocated
inefficiently leading to either overprovision (many resources allocated)
or under provision (few resources allocated).

Externalities: Private And Social Benefits And Costs:

An externality occurs when producer’s/consumer’s actions have

positive/negative effects on other people not involved in the actions.

● If the effect benefits the third party, there is a positive externality(or

spillover) benefit. Eg- national defense, police and emergency services,
public parks/libraries.

● If it harms the third party, there is a negative externality (or spill over)
costs.
For e.g.- Public Smoking

Note:
 ● Marginal Private Costs (MPC) It refers to costs to producers of producing one
more unit of a good.
● Marginal Social Costs (MSC) It refers to the costs to society of producing one
more unit of a good.
● Marginal Social Benefits (MSB) It’s about the benefits to society that come
from buying more of something.

Demand, Supply and allocative efficiency with no Externalities

Demand curve = Marginal benefits curve

Supply = Marginal costs curve

Allocative efficiency is reached when MSC=MSB. When there is no

externality, the competitive free market leads to an outcome where
MPC=MSC=MPB=MSB, as in the above figure, indicates allocative efficiency.
An externality creates a divergence between MPC and MSC or between MPB
and MSB. When there is an externality, MPB=MPC, but where MSB≠MSC,
indicating Allocative inefficiency.

Negative Externalities Of Production And

Consumption

Negative Production Externalities

Negative production externalities are external costs created by
producers. It means too much is being allocated to the production of the
goods. Over and above the firm’s private costs of production there are
additional costs like pollution, etc.
 ● In a free market economy, with no government intervention, output will
be at Qm = Pm , where MPC=MPB.
● However, the socially optimum output is at Qopt =Popt , where
consumption levels are low and prices are high and where MSB=MSC.
● There is welfare loss, loss in social benefits, a yellow shaded area which
is equal to the difference between MSC and MSB and overproduced
products. This means that social costs are greater than firm’s private
costs of production.

Corrections
Government Regulations

● Government uses its authority to make regulations to reduce/ prevent

externalities.
● Lowers the quantity produced so that the MPC curve shifts up towards
MSC.

Market Based Policies (Tax)

● Government can impose tax per unit of output produced or per unit of
pollutants emitted.
● Shifts supply curve from S=MPC to MSC (or MPC+tax).
● Best to shift it so that it overlaps with the MSC curve.

Tax On Output/ Tax On Pollutants

● A tax on output works by correcting overallocation of resources and

reducing overall output.
● By providing firms with incentives to use resources that are less
polluting, a pollutant tax works.
● A carbon tax is a tax per unit of carbon emission: The more carbon
emitted, the higher the tax.

Market Based Policies (Tradable Permits)

● Governments can also issue tradable permits (cap and trade schemes)
to firms that permit them to produce a certain amount of pollutants.
● If they need more, they can trade with other firms.
 ● The supply curve of these permits is perfectly inelastic because there is
a fixed number of permits.
● Encourage firms to use less polluting resources so they don’t need to
use permits.

Negative Consumption Externalities

When a consumer smokes in public places there are external costs that
spill over onto society in the form of costs to non smokers due to
passive smoking.
 ● Buyers of cigarettes have an MPB demand curve but when smoking due
to external costs, the MSB curve lies below MPB.
MPB – MSB = External cost
● In a free market economy, output will be at Qm and Pm where MPC =
MPB.
● However, Socially optimum output is at Qopt and Popt , determined by
the intersection of MSB and MSC curves.
● There is overconsumption of demerit goods like cigarettes in the
absence of government intervention.
● The yellow shaded area is the welfare loss.

Note: Products that consumers don’t want are known as demerit goods.
E.g.- cigarettes, alcohol and gambling, etc.

Corrections

● Government regulations – Regulations to limit activities will shift the D = MPB

curve.
● Advertising – It might convince customers to use less of a product, which
would lower demand.
● Market Based Policies – Imposition of excise tax will decrease the supply and
shift supply curve upwards.

Evaluations

Positive Externalities Of Production And

Consumption
Positive externalities occur when production and consumption create
benefit to third parties.

Positive Production Externality

It refers to external benefits created by producers. Eg- Research and

development, new technology, invention/discovery of new medicine,
trained/skilled workers, etc.
The production of goods is underserved by the market: It is produced
with insufficient resources, and insufficient quantities of the product are
produced. This is shown by Qm <Qopt and MSB>MSC at Qm.
In the above figure the shaded area is the welfare loss, the benefits lost
because not enough of a good is being produced.

Corrections

● Government Provision – The government can finance research and

development and training. The cost of this is covered by the government. The
MPC curve is shifted toward the MSC curve as a result.
 ● Subsidies – The government can provide a subsidy and shift the S = MPC
curve towards the MSC curve.

Positive Consumption Externality

In this case, external benefits are created by consumers which benefits

the entire society. E.g.- education, low crime rates, etc.
The market underallocated resources. Qm<Qopt and MSB>MPB at Qm.
The shaded area is the welfare lost and represents lost benefits because
of externality.

Merit Goods

They are goods that are desirable for consumers but are underprovided.

Reasons for underprovision

● Positive externality.
● Low levels of income and poverty.
● Consumer ignorance.

Corrections

● Legislation – It promotes greater consumption, which shifts the MPB curve

closer to MSB. Many countries have made education mandatory.
● Advertising – Promotes consumption.
● Direct government provision – Like education and healthcare resulting in
increasing supply.
● Subsidies

Evaluations

Lack Of Public Goods

Private And Public Goods

● A private good is rivalrous and excludable.

○ Rivalrous – One person’s consumption reduces availability for
others.
○ Excludable – The good might prevent people from using it,
usually because it costs too much.
● A public good is non-rivalrous and non-excludable (AKA pure public
good)
○ Non-rivalrous – Consumption by one doesn’t reduce
consumption for someone else.
○ Non-excludable – It is impossible to prevent individuals from
using the product.

public goods include: national defense, police force, etc.

● A Quasi-public good is non-rivalrous but excludable.

○ Examples are museums and toll roads because they exclude
those that can’t pay.

Example Of Private Goods

Examples of private goods include food, cars, movie tickets, clothing,

private gyms, and Exclusive clubs.

Examples Of Public Goods

Examples of public goods include fresh air, law enforcement, and

national defense.
Free Rider Problem

It comes from non-excludability because people can’t be excluded from

the use of a good. Private businesses are unable to produce these
goods as a result of the Free Rider Problem, resulting in resource
misallocation.

Corrections

● Public goods are directly provided by the government, so are made free
of charge.
● Which ones to provide and in what quantity? Government has
opportunity costs.
● Government needs to perform a cost-benefit analysis to see the benefits
of a certain public good. If benefits are less than costs, good shouldn’t
be provided.
● Costs are easy to estimate, but the benefits are hard. Some people
exaggerate values.

The Danger Of Common Access Resources To

Sustainability:

Common Access Resource And Market Failure

● Resources with no price and no ownership are known as common

access resources. For example – Clean air, fish, rivers, ozone layer, etc.
They are rivalrous but non-excludable.
 ○ Overused by consumers and producers because of
non-excludability.
● Common access resources used without payment can cause serious
environmental problems.

Sustainability

● It is the ability of something to be maintained or preserved overtime.

● Conflicts between environmental and economic goals:
○ Focusing on economic goals could cause destruction of the
environment.
○ Focusing on environmental goals could result in unsatisfiable
needs/wants.
● Sustainable development – It is progress that meets the needs of the
present without compromising the ability of future generations to satisfy
their own requirements.
● Sustainable resource use – It is using resources at a rate so that they
don’t get depleted.

Pollution

● Pollution of affluence – Pollution caused because of high consumption that

relies on the use of fossil fuels and open access resources.
○ Negative externality of production.
● Pollution of sustainability – Environmental destruction caused by
overexploitation by poor people because of the lack of modern technology.
○ For example- they drain the nutrients of the soil by over watering,
making it less productive.
● Sustainability is threatened by the increased economic activities.

Government Response
 ● Legislation
○ The government limits threats to sustainability by having licenses,
permits, restrictions, etc.
○ They are easy to put in effect and oversee, and are effective.
However, they don’t offer incentives.
● Carbon taxes vs Cap and Trade schemes
○ Carbon Tax- It is a tax on carbon usage : fuels that have a higher
carbon emission are taxed more.
○ Gives incentive for producers to switch to cleaner fuels.
○ Makes energy prices more predictable.
○ Easier to implement and can be applied to all users of fossil fuels.
○ No manipulation and little monitoring.
○ Less likely used to restrict competition.
○ May be set to low.
○ Can’t target a particular level of reduction.
○ Regressive.
○ Must be adjusted for inflation.
○ Tradable permits – A cap of total CO2 enforced and permits are
distributed. Useless if the caps are set too high.

Clean Technologies

● They aim towards a more responsible and productive use of resources.

○ Currently available, but their potential has not yet been
discovered due to a lack of policies.
○ Funding for them has opportunity costs – governments should
allocate resources to this area.

International Cooperation

● Co-operation amongst governments can be effective to reduce

environmental damages. Examples include the Montreal Protocol to
phase out ozone – depleting substances and the Kyoto Protocol to
reduce carbon emissions.