• Created by: Izzy
  • Created on: 11-05-14 13:19

Demand - Adjustment Process

Increase in Demand 

  • Outward shift in demand (D to D1) following a change in one of the demand conditions, in which case the ceteris paribus assumption no longer holds.
  • Demand curve shifts to a new position
  • Due to the excess demand, the price rises untill a new equilibrium point
  • The price of the good changes, increases due to a shortage off supply (excess demand)
  • Causing an extension of the supply curve (Q to Q1)
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Supply - Adjustment Process

Supply: The amount offered for sale at each given price level.

Joint Supply: Occurs when production of one good, results in the production of another. 

Extension/Contraction of Supply

  • When there is an increase/decrease in supply, because the market price has risen/fallen

Shift in Supply (affected by anything other than price)

  • If costs rose, but price level remained the same. Firm's would have less incentive to stay in the market as there are lower profits and the least efficient firms would posisbly leave the market. So there would be a lower supply. 
  • Improvements in labour productivity (more output per worker) then costs of production fall, so profits can potentially rise, increasing the likely level of supply.
  • Wage rates - Production costs will rise, driving down profit margins.
  • Subsidies - Payments by the government to encourage production. In effect reduces the costs borne by the firm, they can achieve profits - likely to encourage greater supply.
  • Objectives of firms - Usually profit maximization, possible at higher output levels. But they might want increased market share etc. 
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Speculative Demand

  • Shift in demand may be driven by speculators entering the market to seek to buy the product at a low price and sell it at a higher price - aim of making a considerable profit.
  • Increases the price of the product, because there may be a limited supply
  • If inelastic - this is especially devastating with respect to price increases


  • Higher prices for consumers - meaning that they will purchase less
  • Add to general inflation figure for the economy
  • Affecting hosueholds negatively aswell - they will have to pay more for these goods
  • Less disposable income for other purchases - negative effects on other industries
  • Long term effect - Sends a signal to markets that the good is even more valuable
  • Create greater incentives for producers to increase supply in the long ryn
  • Firms might seek different ways of sourcing the good - more efficient allocaiton of resources
  • High price creates incentives for consumers to use the good more sparingly and search for alternative goods.
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Price Elasticity of Demand

PED measures the responsiveness of demand to a change in the price level of a good. 

% change in quantity demanded / % change in price

(To find a % change = change / original value x 100) 

Perfectly Inelastic = 0

Inelastic (fairly unresponsive = 0 to -1

Unit Elastic (exact change) = -1 or 1

Elastic = Larger than -1 or 1 

What affects PED?

Habitual consumption / addictions / brand loyalty / cost of switching products / proportion of income spent / availability of substitues / off peak and peak conditions

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Price Elasticity of Demand

Inelastic Demand (0 to -1)

Potentially larger consumer surplus. 

 Buyers are willing to pay a higher price to continue to use the product (e.g. an addict)

Elastic Demand (-1 +) 

Less consumer surplus 

Effect of a Tax:

Inelastic (Price rises, with only a small contraciton in demand.)

  • Producers pass on the majority of the cost to the producer in the form of higher prices, without losing too many sales.

Elastic (Price rise would mean a large contraction in demand)

  • Producer must absorb makority of tax i.e. accept lower profit margins 
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Price Mechanism

Adam Smith: Theorised the "invisible hand of the price mechanism" in which the hidden hand of the market operating in a competitive economy, pursues self interest.  (self regulating behaviour)

Signalling Function: Price performs a signalling funciton. They adjust to demonstrate where resources are required. 

  • If there is a surplus in supply, the price mechanism will eliminate it allowing a fall in the price. Signal to consumers that their real income has increase and they can now buy the good. 
  • If prices rise because of high demand by consumers. Signal to producers to expand production to meet the higher demand. 

Incentive Function: For compeitive markets to work, all economic agents must resond appropriately to price signals. 

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Types of Demand

Demand: Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period.

Effective Demand: How much consumers will be prepared to buy at a given price level. They must have sufficient 'purchasing power'.

Joint Demand: Goods that are consumed together, such as complementary goods e.g. fish and chips. 

Derived Demand: Demand for one good comes from the demand for another e.g demand for car, stimulate the demnd for steel. (demands are coming from different sources)

Composite Demand: A good that is demanded for more than one purpose e.g. milk is demanded for cheese, yogurt and ice cream. 

Latent Demand: Willingness to purchase a good, but they can't afford it. 

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What affects demand?

  • Changes in tastes/ fashion
  • Advertising influences consumer choice
  • Changes in legislation
  • Time of year - seasonal factors
  • Population change 
  • Price of other goods - e.g. of substitutes (XED is positive) or complements (XED is negative)
  • Income spent on good - e.g. For a normal good (positive) for an inferior good (negative)
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Price Elasticity of Supply

Relationship between the responsivness of the quantity supplied and the change in price.

  • Co-efficient is positive (increase in price, increase in quantity supllied in the market)

Elastic: Producers can increase production without a rise in cost or time delay. 

Inelastic: Firms find it hard to change their production levels in a given time period. 

What determines it?

  • FOP substitution possibilities - Can labour/capital inputs be switched easily when there is a change in demand?
  • If factors are highly specialised - this may mae it harder to switch FOP?
  • Spare production / capacity available - Can firms expand output easily to meet the rising demand, wihtout upward pressure on costs?
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Cross Price Elasticity of Demand

Extent to which changes in the price of one good affect the demand for another good. 

% change in qty demanded of Good A / % change in price of Good B

Low XED = Weak relationship

High XED = Close Relationship

Complements - XED is negative (fish and chips)

Substitutes - XED is positive (coke and pepsi)

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Income Elasticity of Demand

Proportion to which demand changes when there is a change in income

Inferior Good -

  • Negative (inelastic) 
  • Income rises, demand falls 
  • Less than O 

Normal Good

  • Positice (Elastic)
  • Between 0 and 1 
  • Income rises, demand rises

Luxury Good

  • Income rises, demand rises more
  • Positive (Elastic)
  • Above 1
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Types of Goods

Public Good:  A good that possess the characterisitcs of non-exludability and non-rivalry in consumption. e.g. light-houses . Left to the free market, it would not be produced at all. 

Rivalry: When one person buys and consumed the good, it is not available for another person to consume

Exludable: The property of a good, wherby it is not available for another person to buy and consume it.

Private Good: A good that isboth rival and excludable in consumption.

Merit Good: A good that would be underconsumed in the free market, as individuals do not fully perceive the benefits of its consumption. e.g. Education 

Demerit Good

Free Good: Goods that have no oppurtunity cost e.g. air 

Excludability: The seller can exclude those consumers who are unable to pay for the product. Benefits are restricted to those who pay for them. 

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Negative Externalities

Negative Externalities

  • Social costs exceed private costs
  • Leads to the private optimum level of output, being greater than the socially optimum level
  • Individual does not take the effects of externalities into their calculations
  • No appropriate consumption is paid
  • Price will be lower than the full cost to soceity
  • Thus the level demanded will be higher than if the social costs had been considered
  • Becomes a market failure issue - when it leads to too much of the good being produced or consumed
  • External costs not considered - misallocation of resources - loss in allocative efficiency
  • Free market fails to provide an efficient allocation of resources

(Social cost = Private cost + external cost)

  • Private costs of any action - those suffered by the individual decision maker
  • Social costs of any action - all the perceivable costs assosciated with it 
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Negative Externalities in Over-production

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Negative Externalities in Over-consumption

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Negative Externality Solutions : Indirect Tax

Tax on suppliers in a market, which affects their costs of production and affect the market supply at each price level. 

Aim: (1) To change the level of demand for the good and deter it's consumption (as it is considered to be harmful). (2) Also to encourage the long-term conservation of scarce economic resources.

  • Allows the internal costs to be 'internalised' (i.e. accounted for by the price mechanism)
  • Free market equilibrium price and quantity is at Q and P, where MPC = MSB
  • Including the external cost, the supply curve shifts leftwads to S2 or MSC
  • The vertical distance between the two is the MEC 
  • Government impose a tax equa to the marginal external cost
  • Effect of which would shift the supply curve left from S to S1
  • This would correct the market failure
  • Leading to a socially optimal level of output at Q2
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Tax Diagram


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Benefits of a Tax Solution (Diagram)

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Argument against Taxes

  • The tax would have to be very high in order to completely cover the welfare loss
  • PED for certain goods (e.g. smoking - habitual and addictive) is inelastic
  • Producer passes on most of the cost to the consumer, via a higher price. 
  • But it will stilll be demanded without losing too many sales as so the price will rise with only a small contraction in demand - ineffective policy. 
  • Producer burden is less
  • Regressive effects on low income consumers - where the tax burden is heaviest - can make the distribution of income in the economy more unequal
  • Loss of economic welfare - Higher prices and reduced output, shown by a loss in consumer and producer surplus.
  • If it is set too high - can create an incentive to avoid taxes through "boot legging"
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Represents payments from the government to suppliers. They aim to reduce firm's costs and encourage them to increase output. 

  • Form of financial intervention, to address market failure cause by Positive Externalities
  • The free market equilibrium occurs where demand = supply (labelled A) Here MPC = MPB with a price of OP1 and a quantity demanded at OQ2.
  • There are external benefits, so soceity requires consumption to increase to Q2.
  • This will only occur as a result of a lower price
  • A subsidy will shift supply out to S2, as business costs have been decreased so the good is cheaper to produce.
  • Through this shift in supply and lower price of P2, there is an expansion in demand to Q2
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Subsidy Diagram


The cost to the government is the "Total subsidy per unit (A to B) x Quantity of good consumed at Q1" 

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Benefits of a Subsidy

  • Encourage consumption of the merit goods - good which would be underconsuemed in the free market. 
  • Enables greater  social efficiency - Positive rate of social return as consumers pay the socially efficient price, which includes the social benefit. 
  • Keep market prices down, to raise the real income of buyers 
  • Consumers now pay less for the producer and their is higher output so their consumer surplus has increased.
  • Firms producer surplus has increased - their net revenue should be higher, as they are producing more and gaining more demand. 
  • May even encourage more firms to develop products with positive externalities.
  • Maintain the revenues and incomes of producers
  • Protect employment in industries which produce these goods
  • Smooth the process of long-term structural change/decline in an industry
  • Reduce the cost of capial investment projects, which might help to stimulate long-term economic growth
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Costs of a subsidy

  • Costs will have to be met through government funds i.e. tax payers money. The costs may lead to increased tax rates (such as income tax, which would reduce incentives to work). In an ideal world they should tax goods with negative externalities, to make the schemes revenue neuteral. 
  • Oppurtunity cost in government spending - the money could be spent in alternative ways.
  • Difficult to estimate the extent of the positive externality, due to imperfect information. There is a risk of government failure as they may have poor information about the good and how much to subsidize it. 
  • Distorts market prices - Can lead to a misallocation of resources. They artificially raise the supply, and this may be classed as 'inefficient'. 
  • Some may arugue that the free-market mechanism works the best. 
  • There is an ever present risk of fraud when allocating subsidy payments
  • Subsidies artificially protect inefficient firms who need to restruture - leading to higher costs and prices in the long-run. It may delay much needed economic reforms. 

Only really effective if the PED for a good is more inelastic - Because a higher proportion of the subsidy goes to the consumer. As it leads to a small rise in output, but an even larger fall in market price. 

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Minimum Price

Legally imposed price floor, below which the normal market price cannot fall. 

  • Protects sellers from too low prices, which would not cover their costs. 
  • To be effective it has to be artifically set above the normal equilibrium price.


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Minimum Price Diagram

  • Market equilibrium is set at Qe for output and Pe for price
  • If the minimum price is set at Pmin, there will be a reduction in demand because the price is higher - this is shown at Q1
  • This will mean an excess supply (a surplus) becuase more firms will be willing and able to supply at the higher price 

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Disadvantages of a Minimum Price

  • More expensive for the consumer, reducing demand for the product.
  • Unfair on those in lower-income households, who now can't afford the product. Sense of income inequality being widened. 
  • The supplier's profits are reduced by the price restriction therefore may drive out some suppliers from the market. 
  • Distortion of the market i.e. the excess supply. - Encourage inefficienct allocation of resources. 
  • Less quantity demanded than quantity supplied, resulting in a surplus. This would in the free market, cause the price to drop below the equilibrium. So the government would have to either buy up the surplus, allow it to go to waste, control how much is produced (ie. giving out production rights - could lead to bribery) or subsidize consumption. 
  • Cause a deadweight loss - Divergance between the price the marginal demander is willing to pay and the equilibrium price. It's the loss of consumer and producer surplus. The regulation moves the market away from equilibrium.
  • Just a short term strategy - It is good if the good is PED elastic - so consumers will adjust to the new price
  • May not be effective - People may go abroad to find cheaper prices or black markets might be created. 
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Minimum Wage

  • A price floor i.e. employers cannot legally undercut the minimum wage rate per hour
  • Applies to both full-time and part-time workers
  • Market equilibrium wage for this particular labour market is P1(demand = supply)
  • If a minimum wgae is set at Pmin there will be an excess supply of labour (Q3 - Q2)
  • Because the supply of labour will expand
  • More people will be willing and able to offer themselves for work at the higher wage rate
  • Risk that firm's demand for workers will contract if a minimum wage is introduced


  • If demand for labour is inelastic - Then a contraction in employment, is likely to be less severe
  • If demand for labour is elastic - More severe as the excess supply will be much higher 
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Minimum Wage Evaluation

  • (+) Equity Justification: Every job should offer a fair rate of pay consummerate with the skills and experience of an employee.
  • (+) Labour Market Incentives: Designed to improve incentives for people to start looking for work, therby boosting the economy's supply of labour.
  • (+) Labour Market Descrimination - Designed to offset some of the effects of persistent descrimination of many low-paid, gender biased and younger employees.
  • (-) Creates an excess supply of labour - may cause higher unemployment
  • (-) May also make employers break the law by paying vulnerable workers below minimum wage. 
  • (-) Risk that the demand for workers from employers will contract, as it will mean a rise in labour costs making it more expensive to employ people. 
  • (-) Distort the way the labour market works, it reduces the flexibility.
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Maximum Price

Government can set a legally imposed maximum price in a market, that suppliers cannot exceed. 

Aim: Attempt to prevent the market price from rising above a certain level. 

  • Price is artificially held below the equilibrium price and is not allowed to rise
  • To be effective it should be set below the free market price
  • Seeks to control the price, involves a normative judgement on behalf of the government on what the price should be
  • Normal free market equilibrium is shown at P1
  • Government introduces a maximum price (Pmax)
  • Price ceiling creates excess demand for the product, equal to the qty (Q3-Q2)
  • Creates a shortage (efficiency problem due to a distortion of the market) 
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Maximum Price Diagram

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Maximum Price Advantages

  • Consumers gain due to the price being set artifically lower
  • BUT there is a loss in consumer surplus - due to the reduction in quantity traded
  • May stop price gouging - Firms attempting to increase prices to unreasonable levels. 
  • Protects consumers from exploitation - goods become more afforable.
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Disadvantages of a Maximum Price

  • Producer surplus is reduced to a lower level.
  • A deadweight lossThere has been a net reduction in economic welfare shown by the triangle DBE.
  • Black markets develop when there is excess demand. Some consumers are prepared to pay the higher price in order to get the goods they want. With a shortage, higher prices act as a rationing device
  • InequitableThis may result in supplier allocating the scarce resource unfairly  - such as to preferred consumers, discrimination, via bribery etc. 
  • In the long-run, consumers might respond to a maximum price by reducing their supply (the supply curve will become more elastic in the long run. 
  • If suppliers believe they can't make a satsifactory rate of return by producing this good, they might withdraw their goods or withdraw from the market all together. A smaller quantity available in the long-run, would make the shortage even worse. 
  • The quality might deteriorate - less incentive to make improvements, maintain and innovate. This would result in a loss of allocative efficiency, because there are fewer properties avaialble and they are of a lesser quality. 
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Buffer Stock Scheme

Internvention system that aims to limit fluctuations of the price of a good - usually a commodity. 

  • Stabilises prices - first step is to select a target price to keep stable (P1)

Good Year

  • When harvests are plentiful supply shifts to S2
  • The government should buy up supplies of the product (the excess supply of Q2-Q1) and add this to it's buffer stock, to prevent a lower price from occuring

Bad Year

  • If there was a decrease in supply, with it shifting from S1 to S2
  • To stop a rise in the equilibrium price above P1, the government would need to sell some of it's stock back onto the market
  • To match the excess demand (Q1-Q3)
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Problems with a Buffer Stock System

  • High Finacial Cost - Setting up a buffer stock scheme requires a significant amount of start-up capital - since money is needed to buy up the product when prices are low, run administration and also pay the huge storage costs.
  • Long-term - Certain items are persishable and cannot be stored for very ong and so may decay before they can be sold back onto the market. They represent a loss.
  • Surplus -  A guarenteed minimum price might cause over production and rising surpluses, which have economic and environmental costs. 
  • Results in a misallocation of resources - through artificially raising the supply - inefficient.
  • If there are a lot of bumper harvests, then the government will overspend trying to buy the excess supply.
  • If there are a lot of bad harvests, the government will run out of supply to sell, excess demand
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Buffer Stock Scheme Benefits

  • The benefits of a more price stable market are that it will lead to more predictable revenues and incomes for farmers and their families.
  • In turn, this might also increase the incentive to grow legal crops
  • Enables capital investment in agriculture, needed to lift productivity
  • Farming has positive externalities as it helps sustain rural communities
  • Stable prices prevent excessive prices for the consumer - increasing the consumer surplus 
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Buffer Stock Evaluation

  • One country introducing a buffer stock scheme would do little to stabilise world prices, therefore may have little impact
  • The success of a buffer stock scheme however ultimately depends on the ability of those managing a scheme to correctly estimate the average price of the product over a period of time.
  • Consideration of alternative forms of intervention, such as minimum price law.
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Government Failure

Occurs when policy intervention leads to a deepening of the Market Failure or even worse a new failure may arise. 


  • Damaging long-term consequneces
  • Creating more losers than winners
  • Being wholly ineffective


  • Political self-interest - Innapropriate decisions to politically please
  • Imperfect Information - How does government know the extent of problems and what is best?
  • Regulatory Capture - Regulator becomes it's champion vs. it's watch dog (identifies with its interests)
  • Law of Unintended Consequences - Economic law which distorts consumer / producer behaviour in a way that is not expected.
  • Policy Myopia - May only provide short-term relief
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A market structure dominated by a single seller of a good or service.

  • Example of market failure as there is a lack of competition


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