Allocative Efficiency

In this unit of work we look at how an economy can be allocatively efficient. We begin the unit with the Production Possibility curve (PPC) which is also known as the production possibility curve (PPC).

What Does Production Possibility Frontier - PPF Mean?
A curve depicting all maximum output combinations for two or more goods at a given level of resources and technology, The PPF assumes that all inputs are used efficiently. (maximum output at minimum cost = productive efficiency)

Production Possibility Frontier (PPF)
Production Possibility Frontier (PPF)

On the chart above, points A, B and C represent the points at which production of Good A and Good B is most efficient (production efficiency). Point X demonstrates the point at which resources are not being used efficiently in the production of both goods (under utilisation); point Y demonstrates an output that is not attainable with the given inputs (scarcity).

The PPC can demonstrate key economic concepts like:
  • scarcity
  • opportunity cost (concave PPC)
  • under utilisation of resources
  • diminishing returns & increasing costs

Let's turn to the chart below. Imagine an economy that can produce only wine and cotton. According to the PPF, points A, B and C - all appearing on the curve - represent the most efficient use of resources by the economy. Point X represents an inefficient use of resources, while point Y represents the goals that the economy cannot attain with its present levels of resources.

external image economics1.gif

As we can see, in order for this economy to produce more wine, it must give up some of the resources it uses to produce cotton (point A). If the economy starts producing more cotton (represented by points B and C), it would have to divert resources from making wine and, consequently, it will produce less wine than it is producing at point A. As the chart shows, by moving production from point A to B, the economy must decrease wine production by a small amount in comparison to the increase in cotton output. However, if the economy moves from point B to C, wine output will be significantly reduced while the increase in cotton will be quite small. Keep in mind that A, B, and C all represent the most efficient allocation of resources for the economy; the nation must decide how to achieve the PPF and which combination to use. If more wine is in demand, the cost of increasing its output is proportional to the cost of decreasing cotton production.

Point X means that the country's resources are not being used efficiently or, more specifically, that the country is not producing enough cotton or wine given the potential of its resources. Point Y, as we mentioned above, represents an output level that is currently unreachable by this economy. However, if there was a change in technology while the level of land, labor and capital remained the same, the time required to pick cotton and grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new curve, on which Y would appear, would represent the new efficient allocation of resources.

external image economics2.gif

When the PPF shifts outwards, we know there is growth in an economy. Alternatively, when the PPF shifts inwards it indicates that the economy is shrinking as a result of a decline in its most efficient allocation of resources and optimal production capability. A shrinking economy could be a result of a decrease in supplies or a deficiency in technology.

An economy can be producing on the PPF curve only in theory. In reality, economies constantly struggle to reach an optimal production capacity. And because scarcity forces an economy to forgo one choice for another, the slope of the PPF will always be negative; if production of product A increases then production of product B will have to decrease accordingly.

B. Opportunity Cost
[[terms/o/opportunitycost.asp|Opportunity cost]] is the value of what is foregone in order to have something else. This value is unique for each individual. You may, for instance, forgo ice cream in order to have an extra helping of mashed potatoes. For you, the mashed potatoes have a greater value than dessert. But you can always change your mind in the future because there may be some instances when the mashed potatoes are just not as attractive as the ice cream. The opportunity cost of an individual's decisions, therefore, is determined by his or her needs, wants, time and resources (income).

This is important to the PPF because a country will decide how to best allocate its resources according to its opportunity cost. Therefore, the previous wine/cotton example shows that if the country chooses to produce more wine than cotton, the opportunity cost is equivalent to the cost of giving up the required cotton production.

Let's look at another example to demonstrate how opportunity cost ensures that an individual will buy the least expensive of two similar goods when given the choice. For example, assume that an individual has a choice between two telephone services. If he or she were to buy the most expensive service, that individual may have to reduce the number of times he or she goes to the movies each month. Giving up these opportunities to go to the movies may be a cost that is too high for this person, leading him or her to choose the less expensive service.

Remember that opportunity cost is different for each individual and nation. Thus, what is valued more than something else will vary among people and countries when decisions are made about how to allocate resources.

C. Trade, Comparative Advantage and Absolute Advantage

Specialization and Comparative Advantage
An economy can focus on producing all of the goods and services it needs to function, but this may lead to an inefficient allocation of resources and hinder future growth. By using specialization, a country can concentrate on the production of one thing that it can do best, rather than dividing up its resources.

For example, let's look at a hypothetical world that has only two countries (Country A and Country B) and two products (cars and cotton). Each country can make cars and/or cotton. Now suppose that Country A has very little fertile land and an abundance of steel for car production. Country B, on the other hand, has an abundance of fertile land but very little steel. If Country A were to try to produce both cars and cotton, it would need to divide up its resources. Because it requires a lot of effort to produce cotton by irrigating the land, Country A would have to sacrifice producing cars. The opportunity cost of producing both cars and cotton is high for Country A, which will have to give up a lot of capital in order to produce both. Similarly, for Country B, the opportunity cost of producing both products is high because the effort required to produce cars is greater than that of producing cotton.

Each country can produce one of the products more efficiently (at a lower cost) than the other. Country A, which has an abundance of steel, would need to give up more cars than Country B would to produce the same amount of cotton. Country B would need to give up more cotton than Country A to produce the same amount of cars. Therefore, County A has a [[terms/c/comparativeadvantage.asp|comparative advantage]] over Country B in the production of cars, and Country B has a comparative advantage over Country A in the production of cotton.

This link has some info on the straight line PPC and PPC shifts:

Here is another good link on PPC's

Role of markets & price signals in determining resource allocation using the PPC model

Market Systems

In different economic systems, the three basic questions are solved differently.

In a laissez faire or free market, they are solved by the interaction of the market forces of demand and supply – known as the price mechanism – setting an equilibrium price and output level. The price mechanism works as consumers and producers are motivated by self-interest and profit- and utility-maximization.
§ What to produce: Determined by consumer sovereignity
§ How to produce: Determined by the relative prices of factor inputs
§ For whom to produce: Determined by purchasing powers of individuals or households

In a command or planned economy, the problems are solved by a central planning body.

The mixed economy strikes the balance between the extremes and uses both free market forces as well as government intervention to answer these questions. (See notes on Market Failure and Government Intervention)

The market economy depends on price signals to correctly allocate its scarce resources. Scarce resources should command higher prices than more abundant resources. Guided by correct price signals, resource users will use scarce resources with higher prices for only higher-valued purposes and abundant resources with lower prices for lower-valued purpose.
If prices are absent or set incorrectly, resource users will waste resources by using scarce resources for lower-valued purposes and leaving abundant resources underutilized. (point within the PPC)

For example if the demand for computers increases in the market (diagram 1), this sends a signals to switch resources from food production to computer production (diagram2) represented by moving from point A production combination to point B production combination on the PPC.

Diagram 1
Diagram 2

external image moz-screenshot.pngppc.png

Demand and Supply

You need to know the definitions of demand and supply, Law of demand and Law of Supply. How market Demand and market Supply are calculated and the difference between a price change (movement along the curve) and a change in demand or supply (curve shifts). Memorise demand factors TISCO and supply factors CTP & PLECT.

Law Of Demand

What Does It Mean?
What Does It Mean?

What Does Law Of Demand Mean?
A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer demand for the good or service will decrease and vice versa. (downward sloping curve, individual demand based on marginal utility)

Law Of Demand
Law Of Demand

Investopedia Says
Investopedia Says
Investopedia explains Law Of Demand
This law summarizes the effect price changes have on consumer behavior. For example, a consumer will purchase more pizzas if the price of pizza falls. The opposite is true if the price of pizza increases.

What is derived demand?

Where the demand for one good is
dependent on the demand for another related good eg Construction industry – demand for new office construction – demand for office space
Demand for construction workers – demand for construction work Factor markets – derived demand

Law Of Supply

What Does It Mean?
What Does It Mean?
What Does Law Of Supply Mean?
A microeconomic law stating that, all other factors being equal, as the price of a good or service increases, the quantity of goods or services offered by suppliers increases and vice versa. (upward sloping curve, individual firms' suplly curve based on the Marginal cost curve above the AVC curve )

Law Of Supply
Law Of Supply
Investopedia Says
Investopedia Says

Investopedia explains Law Of Supply
As the price of a good increases, suppliers will attempt to maximize profits by increasing the quantity of the product sold.

Here is a power point worth looking at:

Here are some links for further reading:

demand & market demand:,articleId-9755.html

supply & market supply:

The Concept of Market Equilibrium

Market equilibrium: This is where the demand and supply curves (market forces) intersect, QD=QS and both producers and consumers satisfaction is maximised.

Equilibrium means a state of equality or a state of balancebetween market demand and supply.
Equilibrium means a state of equality or a state of balancebetween market demand and supply.

Equilibrium means a state of equality or a state of balance between market demand and supply. Without a shift in demand and/or supply there will be no change in market price. In the diagram above, the quantity demanded and supplied at price P1 are equal. At any price above P1, supply exceeds demand and at a price below P1, demand exceeds supply. In other words, prices where demand and supply are out of balance are termed points of disequilibrium.
Changes in the conditions of demand or supply will shift the demand or supply curves. This will cause changes in the equilibrium price and quantity in the market.

Changes in Market Demand and Equilibrium Price

Changes in Market Demand and Equilibrium Price
Changes in Market Demand and Equilibrium Price

The demand curve may shift to the right (increase) for several reasons:
  1. A rise in the price of a substitute or a fall in the price of a complement
  2. An increase in consumers’ income or their wealth
  3. Changing consumer tastes and preferences in favour of the product
  4. A fall in interest rates (i.e. borrowing rates on bank loans or mortgage interest rates)
  5. A general rise in consumer confidence and optimism
The outward shift in the demand curve causes a movement (expansion) along the supply curve and a rise in the equilibrium price and quantity. Firms in the market will sell more at a higher price and therefore receive more in total revenue.
The reverse effects will occur when there is an inward shift of demand. A shift in the demand curve does not cause a shift in the supply curve! Demand and supply factors are assumed to be independent of each other although some economists claim this assumption is no longer valid!
Changes in Market Supply and Equilibrium Price
Changes in Market Supply and Equilibrium Price
Changes in Market Supply and Equilibrium Price

���� The supply curve may shift outwards if there is
  1. A fall in the costs of production (e.g. a fall in labour or raw material costs)
  2. A government subsidy to producers that reduces their costs for each unit supplied
  3. Favourable climatic conditions causing higher than expected yields for agricultural commodities
  4. A fall in the price of a substitute in production
  5. An improvement in production technology leading to higher productivity and efficiency in the production process and lower costs for businesses
  6. The entry of new suppliers (firms) into the market which leads to an increase in total market supply available to consumers
The outward shift of the supply curve increases the supply available in the market at each price and with a given demand curve, there is a fall in the market equilibrium price from P1 to P3 and a rise in the quantity of output bought and sold from Q1 to Q3. The shift in supply causes an expansion along the demand curve.
Important note for the exams:
A shift in the supply curve does not cause a shift in the demand curve. Instead we move along (up or down) the demand curve to the new equilibrium position.
A fall in supply might also be caused by the exit of firms from an industry perhaps because they are not making a sufficiently high rate of return by operating in a particular market.
The equilibrium price and quantity in a market will change when there shifts in both market supply and demand. Two examples of this are shown in the next diagram:

The equilibrium price and quantity in a market will change whenthere shifts in both market supply and demand.
The equilibrium price and quantity in a market will change whenthere shifts in both market supply and demand.

In the left-hand diagram above, we see an inward shift of supply (caused perhaps by rising costs or a decision by producers to cut back on output at each price level) together with a fall (inward shift) in demand (perhaps the result of a decline in consumer confidence and incomes). Both factors lead to a fall in quantity traded, but the rise in costs forces up the market price.
The second example on the right shows a rise in demand from D1 to D3 but a much bigger increase in supply from S1 to S2. The net result is a fall in equilibrium price (from P1 to P3) and an increase in the equilibrium quantity traded in the market.
Moving from one market equilibrium to another
Changes in equilibrium prices and quantities do not happen instantaneously! The shifts in supply and demand outlined in the diagrams in previous pages are reflective of changes in conditions in the market. So an outward shift of demand (depending upon supply conditions) leads to a short term rise in price and a fall in available stocks. The higher price then acts as an incentive for suppliers to raise their output (termed as an expansion of supply) causing a movement up the short term supply curve towards the new equilibrium point.
We tend to use these diagrams to illustrate movements in market prices and quantities – this is known as comparative static analysis. The reality in most markets and industries is much more complex. For a start, many firms have imperfect knowledge about their demand curves – they do not know precisely how demand reacts to changes in price or the true level of demand at each and every price level. Likewise, constructing accurate supply curves requires detailed information on production costs and these may not be available.

helpful links on equilibrium:

Shortages and surpluses

Sometimes the market is not in equilibrium-that is quantity supplied doesn't equal quantity demanded. When this occurs there is either excess supply or excess demand.

A Market Surplus occurs when there is excess supply- that is quantity supplied is greater than quantity demanded. In this situation, some producers won't be able to sell all their goods. This will induce them to lower their price to make their product more appealing. In order to stay competitive many firms will lower their prices thus lowering the market price for the product. In response to the lower price, consumers will increase their quantity demanded, moving the market toward an equilibrium price and quantity. In this situation, excess supply has exerted downward pressure on the price of the product.

A Market Shortage occurs when there is excess demand- that is quantity demanded is greater than quantity supplied. In this situation, consumers won't be able to buy as much of a good as they would like. In response to the demand of the consumers, producers will raise both the price of their product and the quantity they are willing to supply. The increase in price will be too much for some consumers and they will no longer demand the product. Meanwhile the increased quantity of available product will satisfy other consumers. Eventually equilibrium will be reached.


  • Shortages occur when the price faced by consumers and producers is held below the equilibrium market price.
  • Government enforced price controls are the most common cause of shortages.
  • When a price is held too low, thus causing a shortage, we call the price a "ceiling."

Market Shortage

  • Equilibrium is at P = 17 and Q = 23.
  • At the artificially low price of 10, buyers want to buy 30 but sellers only want to sell 16.
  • There is a shortage of 14.
  • The price ceiling is 10.
l4fig19.gif (4277 bytes)
l4fig19.gif (4277 bytes)


  • Surpluses occur when the price faced by consumers and producers is held above the equilibrium market price.
  • Price supports and minimum wages are the most common cause of surpluses.
  • When a price is held too high, thus causing a surplus, we call the price a "floor."

Market Surplus

  • Equilibrium is at P = 17 and Q = 23.
  • At the artificially high price of 25, sellers want to sell 31 but buyers only want to buy 15.
  • There is a surplus of 16.
  • The price floor is 25.
l4fig20.gif (4309 bytes)
l4fig20.gif (4309 bytes)

Consumer and producer surplus

Consumer Surplus

In this note we look at the importance of willingness to pay for different goods and services. When there is a difference between the price that you actually pay in the market and the price or value that you place on the product, then the concept of consumer surplus becomes a useful one to look at.
Defining consumer surplus
Consumer surplus is a measure of the welfare that people gain from the consumption of goods and services, or a measure of the benefits they derive from the exchange of goods.
Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price for the product). The level of consumer surplus is shown by the area under the demand curve and above the ruling market price as illustrated in the diagram below:
Defining consumer surplus
Defining consumer surplus

Consumer surplus and price elasticity of demand
When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that people pay matches precisely the price they are willing to pay. This is most likely to happen in highly competitive markets where each individual firm is assumed to be a ‘price taker’ in their chosen market and must sell as much as it can at the ruling market price.
In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand is totally invariant to a price change. Whatever the price, the quantity demanded remains the same. Are there any examples of products that have such a low price elasticity of demand?
The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product. This is shown in the diagram below:
Consumer surplus and price elasticity of demand
Consumer surplus and price elasticity of demand

Changes in demand and consumer surplus
Consumer surplus and price elasticity of demand
Consumer surplus and price elasticity of demand
When there is a shift in the demand curve leading to a change in the equilibrium market price and quantity, then the level of consumer surplus will alter. This is shown in the diagrams above. In the left hand diagram, following an increase in demand from D1 to D2, the equilibrium market price rises to from P1 to P2 and the quantity traded expands. There is a higher level of consumer surplus because more is being bought at a higher price than before.
In the diagram on the right we see the effects of a cost reducing innovation which causes an outward shift of market supply, a lower price and an increase in the quantity traded in the market. As a result, there is an increase in consumer welfare shown by a rise in consumer surplus.
Consumer surplus can be used frequently when analysing the impact of government intervention in any market – for example the effects of indirect taxation on cigarettes consumers or the introducing of road pricing schemes such as the London congestion charge.

Applications of consumer surplus
Paying for the right to drive into the centre of London
In July 2005, the congestion charge was raised to £8 per day. How has the London congestion charge affected the consumer surplus of drivers?
Transport for London has details on the impact of the congestioncharge
Transport for London has details on the impact of the congestioncharge

Transport for London has details on the impact of the congestion charge

Consider the entry of Internet retailers such as Last Minute and Amazon into the markets for travel and books respectively. What impact has their entry into the market had on consumer surplus? Have you benefited from you perceive to be lower prices and better deals as a result of using e-commerce sites offering large discounts compared to high street retailers?
Price discrimination and consumer surplus
Producers often take advantage of consumer surplus when setting prices. If a business can identify groups of consumers within their market who are willing and able to pay different prices for the same products, then sellers may engage in price discrimination – the aim of which is to extract from the purchaser, the price they are willing to pay, thereby turning consumer surplus into extra revenue.
Airlines are expert at practising this form of yield management, extracting from consumers the price they are willing and able to pay for flying to different destinations are various times of the day, and exploiting variations in elasticity of demand for different types of passenger service. You will always get a better deal / price with airlines such as EasyJet and RyanAir if you are prepared to book weeks or months in advance. The airlines are prepared to sell tickets more cheaply then because they get the benefit of cash-flow together with the guarantee of a seat being filled. The nearer the time to take-off, the higher the price. If a businessman is desperate to fly from Newcastle to Paris in 24 hours time, his or her demand is said to be price inelastic and the corresponding price for the ticket will be much higher.
One of the main arguments against firms with monopoly power is that they exploit their monopoly position by raising prices in markets where demand is inelastic, extracting consumer surplus from buyers and increasing profit margins at the same time. We shall consider the issue of monopoly in more detail when we come on to our study of markets and industries.

  • is the difference between what producers are willing and able to supply a good for and the price they actually receive. The level of producer surplus is shown by the area above the supply curve and below the market price.

Consumer & Producer Surplus
Consumer & Producer Surplus
Economic efficiency
E. There are two main types of efficiency - static and dynamic.

Allocative efficiency in a perfectly competitive market.

Allocative efficiency: A condition achieved when resources are allocated in a way that allows the maximum possible NET BENEFIT from their use. When an efficient allocation of the resources has been attained, it is impossible to increase the well-being of anyone person without harming another person.

Consumer surplus: Is the total net benefit that all consumers purchasing the good enjoy. For consumers in the aggregate, it is the area between the demand curve and the market price.

Producer surplus: is the difference between the market price the producer receives and the marginal cost of producing this unit. It represents the profit on the unit, plus any rents accruing to factors of production. For a market as a whole, producer surplus is the area above the supply curve up to the market price.


Illustration of consumer surplus.

Consumer surplus
Consumer surplus

Consumer A would pay $10 for a good whose market price is $5. And therefore enjoys the benefit of $5 ($10 - $5 = $5)

Consumer B enjoys a benefit of $2 ($7 - $5).

No benefit for consumer C, who values good at a market price.

Therefore Consumer surplus measures the total benefit to all consumers is shaded area between the demand curve & the market price.

Economic efficiency
Economic efficiency

Deadweight Loss (DWL)

Deadweight loss refers to any insufficiency caused by ineffective distribution of resources. This is also known as excess burden or allocative insufficiency. These terms are used in economics.

external image moz-screenshot-1.pngexternal image moz-screenshot-2.pngexternal image moz-screenshot-3.pngexternal image ps6a4.jpg

In the above diagram
a. without the tax: Price paid for beer by consumer is P*, Price recieved by sellers is also P*, Quantity of beer sold is Q*. There is NO difference between the price paid by consumers and the price received by sellers.
b. with the $2 tax: Price paid by consumers is Pb, Price received by sellers is Ps, quantity sold is Qt. The difference between the consumer and seller prices is (Pb-Ps) which is equal to $2 in this case (the size of the tax). The quantity of beer sold has decreased with the tax in place. Ttotal welfare has decreased when the tax is imposed. Both producer and consumer surplus shrink, and the government revenue does not equal this loss in CS and PS. There is a deadweight loss.
Causes of Excess Burden
This situation can happen due to artificial scarcity brought about by monopoly pricing. Other reasons are subsidies, binding prices (floorings or ceilings) and externalities. When the term excess burden is used, it often refers to monopoly or taxation. Other factors can bring it about, but these are the most common.
Excess Burden Example 1
Suppose there is a market for screws each worth 10 cents. In this scenario, the demand reaches a high for free screws and zero for $1.25 screws. To understand deadweight loss, imagine this market is competitive. Manufacturers charge 10 cents. All customers with marginal benefits over 10 cents will have a screw.
But if there is monopoly in the market, they fix the price that yields the biggest profit. In this case, the manufacturer charges 60 cents. All customers without 60 cents are not included. The loss is the economic gain the customers would have if the pricing had been competitive.
Excess Burden Example 2
In this example the situation arises because consumers buy a product that costs a lot but with little benefit for them. Imagine there is a market for screws where they’re sold for 10 cents. The government provides a 3 cent subsidy per screw made.
To see how deadweight loss occurs, imagine the subsidy forces the prices to go down to 6 cents. Consumers purchase the 6 cent screws. The benefit is less than the actual cost of the 10 cents. The loss is generated by inadequate use of resources.

Excess Burden Example 3
Suppose a glass of whiskey and champagne both cost $4. The consumer buys the whiskey. If the government imposes a tax of $2 per whiskey glass, the consumer will choose to drink champagne. In this example, the excess burden of tax is utility loss for the consumer. Also note there is no tax generated from the consumer.

helpful links:

Elasticity of Demand: Elasticity is a measure of responsiveness to change. The slope of a curve is an indicator of the type of elasticity. e.g the steeper the slope the less responsive to changes (inelastic) and vice versa.

Types of elasticities you need to know:

Price elasticity of Demand (PED)
Price elastcity of Income (YED)
Cross price elasticity (CED)

Price elasticity of Supply (PES)


What is Elasticity?

Elasticity refers to the degree of responsiveness in supply or demand in relation to changes in price. If a curve is more elastic, then small changes in price will cause large changes in quantity consumed. If a curve is less elastic, then it will take large changes in price to effect a change in quantity consumed. Graphically, elasticity can be represented by the appearance of the supply or demand curve. A more elastic curve will be horizontal, and a less elastic curve will tilt more vertically. When talking about elasticity, the term "flat" refers to curves that are horizontal; a "flatter" elastic curve is closer to perfectly horizontal.
external image e.gif Figure %: Elastic and Inelastic Curves At the extremes, a perfectly elastic curve will be horizontal, and a perfectly inelastic curve will be vertical. Hint: You can use perfectly inelastic and perfectly elastic curves to help you remember what inelastic and elastic curves look like: an Inelastic curve is more vertical, like the letter I. An Elastic curve is flatter, like the horizontal lines in the letter E. external image e2.gif Figure %: Perfectly Elastic and Perfectly Inelastic Curves external image empty.gif
Price elasticity of demand, also called the elasticity of demand, refers to the degree of responsiveness in demand quantity with respect to price. Consider a case in the figure below where demand is very elastic, that is, when the curve is almost flat. You can see that if the price changes from $.75 to $1, the quantity decreases by a lot. There are many possible reasons for this phenomenon. Buyers might be able to easily substitute away from the good, so that when the price increases, they have little tolerance for the price change. Maybe the buyers don't want the good that much, so a small change in price has a large effect on their demand for the good.
external image elastic.gif Figure %: Elastic Demand
If demand is very inelastic, then large changes in price won't do very much to the quantity demanded. For instance, whereas a change of 25 cents reduced quantity by 6 units in the elastic curve in the figure above, in the inelastic curve below, a price jump of a full dollar reduces the demand by just 2 units. With inelastic curves, it takes a very big jump in price to change how much demand there is in the graph below. Possible explanations for this situation could be that the good is an essential good that is not easily substituted for by other goods. That is, for a good with an inelastic curve, customers really want or really need the good, and they can't get want that good offers from anywhere else. This means that consumers will need to buy the same amount of the good from week to week, regardless of the price.
external image inelas.gif Figure %: Inelastic Demand
Like demand, supply also has varying degrees of responsiveness to price, which we refer to as price elasticity of supply, or the elasticity of supply. An inelastic supplier (one with a steeper supply curve) will always supply the same amount of goods, regardless of the price, and an elastic supplier (one with a flatter supply curve) will change quantity supplied in response to changes in price.

How Is Elasticity Measured?

As we have noted, elasticity can be roughly compared by looking at the relative steepness or flatness of a supply or demand curve. Thus, it makes sense that the formula for calculating elasticity is similar to the formula used for calculating slope. Instead of relating the actual prices and quantities of goods, however, elasticity shows the relationship between changes in price and quantity. To calculate the coefficient for elasticity, divide the percent change in quantity by the percent change in price:

Elasticity = (% Change in Quantity)/(% Change in Price)

Remember that to find percent change itself, you divide the amount of change in a variable by the initial level of the variable:

% Change = (Amount of Change)/(Initial Level)

Another important thing to remember is that percentage changes can be positive or negative, but elasticity is always an absolute value. That is, even when an increase in price is paired with a decrease in quantity (as with most demand curves), the elasticity will be positive; remember to drop any minus signs when finding your final value for elasticity.
Let's apply this and solve for elasticity in the market for ping pong balls. When ping pong balls cost $1 each, Alice is willing to buy 10 balls, and Joe is willing to sell 10 balls. When they cost $1.50 each, Alice is willing to buy 6 balls, and Joe is willing to sell 20. First, let's solve for Alice's price elasticity of demand:

% Change in Quantity = (6-10)/10 = -0.4 = -40%
% Change in Price = (1.50-1)/1 = 0.5 = 50%
(-40%)/(50%) = -0.8
Take the absolute value to find elasticity.
Elasticity of Demand = 0.8

Now, we use the same process to find Joe's price elasticity of supply:

% Change in Quantity = (20-10)/10 = 1 = 100%
% Change in Price = (1.50-1)/1 = 0.5 = 50%
Elasticity of Supply = (100%)/(50%) = 2

Elastic vs. Inelastic?

external image empty.gif
An elasticity of 1 is the established borderline between elastic and inelastic goods. A curve with an elasticity of 1 is called unit elastic; an elasticity of 1 indicates perfect responsiveness of quantity to price; that is, in a unit elastic supply curve, a 10% increase in price yields a 10% increase in quantity; a unit elastic demand curve will have a decrease in quantity of 10% with a price decrease of 10%.
If the elasticity of demand is greater than or equal to 1, meaning that the percent change in quantity is great than the percent change in price, then the curve will be relatively flat and elastic: small price changes will have large effects on demand. If the elasticity of the demand curve is less than 1, meaning the percent change in quantity is less then the percent change in price, then the curve will be steep and inelastic: it will take a big change in price to affect demand.
Similarly, if the elasticity of supply is greater than or equal to 1, the curve will be elastic: relatively flat, with quantity supplied very responsive to changes in price. If the elasticity of the supply curve is less than 1, it will be inelastic: the curve will be flatter and quantity supplied will be less responsive to changes in price.
Remember that elasticity is an absolute value; it doesn't indicate an increase in quantity with an increase in price when you are dealing with downward-sloping curves.
Except for curves with an elasticity of 1, elasticity on straight-line curves is not constant. Why is this? As you move along the curve, the slope stays constant, so that each movement yields the same amount of increase or decrease. But as a curve shifts out, these increases or decreases make up a different percentage of the base amount, and the resulting percentage changes are therefore different at different points on the curve. Thus, unless elasticity is specifically stated to be constant on a curve, it usually changes from point to point, and so we usually only study the elasticity of demand or supply at a specific point (usually at the equilibrium point).
Note: One solution to studying elasticity over a curve, rather than at a specific point, is to calculate elasticity using the following formula:

Elasticity = (Change in quantity/Average quantity) / (Change in price/Average price)
Elasticity = ((Q1 - Q2) / (Q1 + Q2)/2 )) / ((P1 - P2)/( (P1 + P2)/2))
This formula will give you an approximation of the elasticity over a range, instead of a point-specific elasticity, but as the range gets larger, the result becomes less and less accurate, which is why many economists prefer to use the traditional measure of elasticity.
It is a little difficult to visualize why elasticity is not constant on a straight-line graph without looking at a diagram. In , the slope of this hypothetical straight-line supply curve is constant (slope = 2), but the elasticity changes as you move along the graph. Let's assume that the price of this good is initially $3, and then increases to $5. In this case, the elasticity for the good can be calculated as follows:

Elasticity = (% Change in Quantity) / (% Change in Price)
Elasticity = [(2 - 1)/1] / [(5 - 3)/3] = 3/2
If the price increases from $5 to $7 however, the elasticity is calculated as follows:
Elasticity = (% Change in Quantity) / (% Change in Price)
Elasticity = [(3 - 2)/2] / [(7 - 5)/5] = 5/4
external image elasline.gif Figure %: Changes in Elasticity Over a Straight Line Graph The lesson? Be careful when dealing with elasticity. Don't assume that elasticity will be constant, just because you're dealing with a straight line.

The Effects of Elasticity on Equilibrium Price and Quantity

As we already know, equilibrium price and equilibrium quantity in a given market are determined by the intersection of the supply and demand curves. Depending on the elasticities of supply and demand, the equilibrium price and quantity can behave differently with shifts in supply and demand. We can see one example of how this works if we imagine a supply curve shifting in and out along a single demand curve. If demand is very elastic, then shifts in the supply curve will result in large changes in quantity demanded and small changes in price at the equilibrium point.
external image shifte.gif Figure %: Shifts in Supply with Elastic Demand If demand is very inelastic, however, then shifts in the supply curve will result in large changes in price and small changes in quantity at the equilibrium point. external image shifte2.gif Figure %: Shifts in Supply with Inelastic Demand

Price Elasticity of Demand (PED)

1. price elasticity of demand

Measures the responsiveness of quantity demanded of a good or service to a change in its price. Can be measured using the mid point method ( the preferred way) or using the percentage change method. This way is only used when there is limited or imperfect information.

2. The midpoint method equation used to calculate price elasticity of demand coefficient.
The answer you calculate will determine the type of elasticity present (see below)
treat all answers (elasticity coefficient) as positive for PED

PED Equation =

(Q1 + Q2)/2

3. Percentage change method (arc elasticity method)

Ep = % change Qd / % change Price

Measures of elasticity, value of the elasticity coefficient:
(a) perfectly inelastic E=0:
When there is no change in quantity demanded for a good or service when there is a change in its price. Perfectly inelastic demand curves are vertical.
(b) elastic demand E>1:
When the change in quantity demanded for a good or service is proportionately more than the change in its price. Elastic demand curves are relatively flat.
>sensitive to price changes<
(c) inelastic demand E<1 (e.g. 2,3,4,5...):
When the change in quantity demanded for a good or service is proportionately less than the change in its price. Inelastic demand curves are relatively steep.>insensitive to price changes<
(d) unitary elasticity E=1:

When the change in quantity demanded for a good or service is proportionately the same as the change in its price.
(e)Perfectly inelastic E= infinity
When the change in the quantity demanded for a good or service is infinite when there is a change in its price.

links on PED:

this link has a good table

this link has some good examples and shows extremes of elasticity i.e. perfectly elastic (horizontal) and perfectly inelastic (vertical) curves

these links has some in depth explanations:

Factors Affecting the Price Elasticity of Demand

  • Availability of substitutes: the more possible substitutes, the greater the elasticity. Note that the number of substitutes depends on how broadly one defines the product.
  • Degree of necessity or luxury: luxury products tend to have greater elasticity. Some products that initially have a low degree of necessity are habit forming and can become "necessities" to some consumers.
  • Proportion of the purchaser's budget consumed by the item: products that consume a large portion of the purchaser's budget tend to have greater elasticity.
  • Time period considered: elasticity tends to be greater over the long run because consumers have more time to adjust their behavoir.
  • Permanent or temporary price change: a one-day sale will elicit a different response than a permanent price decrease.
  • Price points: decreasing the price from $2.00 to $1.99 may elicit a greater response than decreasing it from $1.99 to $1.98.

1. The availability of substitutes - This is probably the most important factor influencing the elasticity of a good or service. In general, the more substitutes, the more elastic the demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers could replace their morning caffeine with a cup of tea. This means that coffee is an elastic good because a raise in price will cause a large decrease in demand as consumers start buying more tea instead of coffee.

However, if the price of caffeine were to go up as a whole, we would probably see little change in the consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.

2. Amount of income available to spend on the good - This factor affecting demand elasticity refers to the total a person can spend on a particular good or service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income that is available to spend on coke, which is $2, is now enough for only two rather than four cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.

3. Time - The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.

helpful links:

demand and supply elasticity:

first year uni presentation:

index of key concepts in this AStd:

(edits: CED, PES)

Incidence of a subsidy:

Income Price Elasticity of Demand (Y.E.D)

Income elasticity of demand measures the sensitivity of a change in quantity demanded to a change in income. The basic formulae for calculating the coefficient of income elasticity are:
>mid point method

YED Equation =

(Q1 + Q2)/2

>% change method:

Normal Goods
Normal goods have a positive (YED>0) income elasticity of demand so as income rise more is demand at each price level. We make a distinction between normal necessities and normal luxuries (both have a positive coefficient of income elasticity).
Necessities have an income elasticity of demand of between 0 and +1. Demand rises with income, but less than proportionately. Often this is because we have a limited need to consume additional quantities of necessary goods as our real living standards rise. The class examples of this would be the demand for fresh vegetables, toothpaste and newspapers. Demand is not very sensitive at all to fluctuations in income in this sense total market demand is relatively stable following changes in the wider economic (business) cycle.
Luxuries on the other hand are said to have an income elasticity of demand > +1. (Demand rises more than proportionate to a change in income). Luxuries are items we can (and often do) manage to do without during periods of below average income and falling consumer confidence. When incomes are rising strongly and consumers have the confidence to go ahead with “big-ticket” items of spending, so the demand for luxury goods will grow. Conversely in a recession or economic slowdown, these items of discretionary spending might be the first victims of decisions by consumers to rein in their spending and rebuild savings and household financial balance sheets.
Many luxury goods also deserve the sobriquet of “positional goods”. These are products where the consumer derives satisfaction (and utility) not just from consuming the good or service itself, but also from being seen to be a consumer by others.
Inferior Goods
Inferior goods have a negative income elasticity of demand. Demand falls as income rises. In a recession the demand for inferior products might actually grow (depending on the severity of any change in income and also the absolute co-efficient of income elasticity of demand). For example if we find that the income elasticity of demand for cigarettes is -0.3, then a 5% fall in the average real incomes of consumers might lead to a 1.5% fall in the total demand for cigarettes (ceteris paribus).
external image income_elasticity_1.gif
Within a given market, the income elasticity of demand for various products can vary and of course the perception of a product must differ from consumer to consumer. The hugely important market for overseas holidays is a great example to develop further in this respect.
What to some people is a necessity might be a luxury to others. For many products, the final income elasticity of demand might be close to zero, in other words there is a very weak link at best between fluctuations in income and spending decisions. In this case the “real income effect” arising from a fall in prices is likely to be relatively small. Most of the impact on demand following a change in price will be due to changes in the relative prices of substitute goods and services.
external image income_elasticity_2.gif
The income elasticity of demand for a product will also change over time – the vast majority of products have a finite life-cycle. Consumer perceptions of the value and desirability of a good or service will be influenced not just by their own experiences of consuming it (and the feedback from other purchasers) but also the appearance of new products onto the market. Consider the income elasticity of demand for flat-screen colour televisions as the market for plasma screens develops and the income elasticity of demand for TV services provided through satellite dishes set against the growing availability and falling cost (in nominal and real terms) and integrated digital televisions.

Normal Goods
Normal goods have a positive income elasticity of demand so as consumers’ income rises, so more is demanded at each price level i.e. there is an outward shift of the demand curve
  • Normal necessities have an income elasticity of demand of between 0 and +1 for example, if income increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.4. Demand is rising less than proportionately to income.
  • Luxuries have an income elasticity of demand > +1 i.e. the demand rises more than proportionate to a change in income – for example a 8% increase in income might lead to a 16% rise in the demand for restaurant meals. The income elasticity of demand in this example is +2.0. Demand is highly sensitive to (increases or decreases in) income.
Inferior Goods
Inferior goods have a negative income elasticity of demand. Demand falls as income rises. Typically inferior goods or services tend to be products where there are superior goods available if the consumer has the money to be able to buy it. Examples include the demand for cigarettes, low-priced own label foods in supermarkets and the demand for council-owned properties.
The income elasticity of demand is usually strongly positive for
Fine wines and spirits, high quality chocolates (e.g. Lindt) and luxury holidays overseas.
Consumer durables - audio visual equipment, 3G mobile phones and designer kitchens.
Sports and leisure facilities (including gym membership and sports clubs).
In contrast, income elasticity of demand is lower for
Staple food products such as bread, vegetables and frozen foods.
Mass transport (bus and rail).
Beer and takeaway pizza!
Income elasticity of demand is negative (inferior) for cigarettes and urban bus services.
Product ranges: However the income elasticity of demand varies within a product range. For example the Yed for own-label foods in supermarkets is probably less for the high-value “finest” food ranges that most major supermarkets now offer. You would also expect income elasticity of demand to vary across the vast range of vehicles for sale in the car industry and also in the holiday industry.
Long-term changes: There is a general downward trend in the income elasticity of demand for many products, particularly foodstuffs. One reason for this is that as a society becomes richer, there are changes in consumer perceptions about different goods and services together with changes in consumer tastes and preferences. What might have been considered a luxury good several years ago might now be regarded as a necessity (with a lower income elasticity of demand).
Consider the market for foreign travel. A few decades ago, long-distance foreign travel was regarded as a luxury. Now as real price levels have come down and incomes have grown, so millions of consumers are able to fly overseas on short and longer breaks. For many an annual holiday overseas has become a necessity and not a discretionary item of spending!
Estimates for income elasticity of demand
How high is the income elasticity for fine wines?
How high is the income elasticity for fine wines?

How high is the income elasticity for fine wines?

Income elasticity for baked beans? Likely to be low but positiveas beans are a staple food
Income elasticity for baked beans? Likely to be low but positiveas beans are a staple food

Income elasticity for baked beans? Likely to be low but positive as beans are a staple food

Income elasticity for cigarettes? According to some estimates,cigarettes are inferior goods
Income elasticity for cigarettes? According to some estimates,cigarettes are inferior goods

Income elasticity for cigarettes? According to some estimates, cigarettes are inferior goods

What of the income elasticity of demand for private executive airtravel?
What of the income elasticity of demand for private executive airtravel?

What of the income elasticity of demand for private executive air travel?

Share of budget
(% of household income)

Price elasticity of demand (Ped)
Income elasticity of demand (Yed)
All Foods
Fruit juices
Instant coffee

Source: DEFRA

The income elasticity of demand for most types of food is pretty low – occasionally negative (e.g. for margarine) and likewise the own price elasticity of demand for most foodstuffs is also inelastic. In other words, the demand for these products among consumers is not sensitive to changes in the product’s price or changes in consumer income.
How do businesses make use of estimates of income elasticity of demand?
Knowledge of income elasticity of demand for different products helps firms predict the effect of a business cycle on sales. All countries experience a business cycle where actual GDP moves up and down in a regular pattern causing booms and slowdowns or perhaps a recession. The business cycle means incomes rise and fall.
Luxury products with high income elasticity see greater sales volatility over the business cycle than necessities where demand from consumers is less sensitive to changes in the economic cycle
The UK economy has enjoyed a period of economic growth over the last twelve years. So average real incomes have increased, but because of differences in income elasticity of demand, consumer demand for products will have varied greatly over this period.
Income elasticity and the pattern of consumer demand
Over time we expect to see our real incomes rise. And as we become better off, we can afford to increase our spending on different goods and services. Clearly what is happening to the relative prices of these products will play a key role in shaping our consumption decisions. But the income elasticity of demand will also affect the pattern of demand over time. For normal luxury goods, whose income elasticity of demand exceeds +1, as incomes rise, the proportion of a consumer’s income spent on that product will go up. For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where the income elasticity of demand is negative) – then as income rises, the share or proportion of their budget on these products will fall

Cross Price Elasticity of Demand (CED)

Cross Price Elasticity of demand measures the responsiveness of demand for a product to a change in the price of other related products. We normally focus on the links between changes in the prices of substitutes and complements.
The formula for cross price elasticity of demand

CED Equation =

(Qb1 + Qb2)/2

where Qb is Quantity Demanded of good b, Pa is price of good a

>% change method:

When the CED coefficient is:
  • Between zero and one (inelastic) - quantity demanded of good B changes by a smaller percentage than the change in price of good A
  • Between one and infinity (elastic) - quantity demanded of good B changes by a larger percentage than the change in price of good A
  • The sign indicates if the goods and substitutes or complements. For instance, substitutes have a positive sign and complements have a negative sign.
  • When there is no relationship between two products, the cross price elasticity of demand is zero.

cross price elasticity of demand diagrams

external image cross_2.gif

external image 200px-Cross_elasticity_of_demand_complements.svg.pngexternal image magnify-clip.png Two goods that complement each other show a negative cross elasticity of demand: as the price of good Y rises, the demand for good X falls
external image 200px-Cross_elasticity_of_demand_substitutes.svg.pngexternal image magnify-clip.png Two goods that are substitutes have a positive cross elasticity of demand: as the price of good Y rises, the demand for good X rises
external image 200px-Cross_elasticity_of_demand_independent.svg.pngexternal image magnify-clip.png Two goods that are independent have a zero cross elasticity of demand: as the price of good Y rises, the demand for good X stays constant

The main use of cross price elasticity concerns changes in the prices of substitutes and complements.
With substitute goods such as brands of cereal or washing powder, an increase in the price of one good will lead to an increase in demand for the rival product. Cross price elasticity will be positive. In recent years, the prices of new cars have been falling. This should increase the demand for new cars and reduce the demand for second hand cars and mass transport services such as bus travel (ceteris paribus)
With goods that are in complementary demand such as the demand for DVD players and DVD videos, when there is a fall in the price of DVD players we expect to see more DVD players bought, leading to an expansion in market demand for DVD videos

The stronger the relationship between two products, the higher is the co-efficient of cross-price elasticity of demand. For example with two close substitutes, the cross-price elasticity will be strongly positive. Likewise when there is a strong complementary relationship between two products, the cross-price elasticity will be highly negative. Unrelated products have a zero cross elasticity.

The demand for necessities will increase with income, but at a slower rate. This is because consumers, instead of buying more of only the necessity, will want to use their increased income to buy more of a luxury. During a period of increasing income, demand for luxury products tends to increase at a higher rate than the demand for necessities.

Price Elasticity of Supply (PES)

Price elasticity of supply measures the responsiveness of a change in quantity supplied to a change in price.

PES Equation =

(Q1 + Q2)/2

>% change method:

  • When Pes > 1, then supply is price elastic
  • When Pes < 1, then supply is price inelastic
  • When Pes = 0, supply is perfectly inelastic
  • When Pes = infinity, supply is perfectly elastic following a change in demand

external image supplyelasticity1.gif
The elasticity of supply depends on the following factors
The value of price elasticity of supply is positive, because an increase in price is likely to increase the quantity supplied to the market and vice versa. The elasticity of supply depends on the following factors:

How much spare capacity a firm has - if there is plenty of spare capacity, the firm should be able to increase output quite quickly without a rise in costs and therefore supply will be elastic

The level of stocks or inventories - if stocks of raw materials, components and finished products are high then the firm is able to respond to a change in demand quickly by supplying these stocks onto the market - supply will be elastic

Consider the sudden and dramatic increase in demand for petrol canisters during the recent fuel shortage. Could manufacturers of cool-boxes or producers of other types of canister have switched their production processes quickly and easily to meet the high demand for fuel containers?
If capital and labour resources are occupationally mobile then the elasticity of supply for a product is likely to be higher than if capital equipment and labour cannot easily be switched and the production process is fairly inflexible in response to changes in the pattern of demand for goods and services.

Supply is likely to be more elastic, the longer the time period a firm has to adjust its production. In the short run, the firm may not be able to change its factor inputs. In some agricultural industries the supply is fixed and determined by planting decisions made months before, and climatic conditions, which affect the production, yield.
Economists sometimes refer to the momentary time period - a time period that is short enough for supply to be fixed i.e. supply cannot respond at all to a change in demand.

external image supplyelasticity2.gif
When supply is perfectly inelastic, a shift in the demand curve has no effect on the equilibrium quantity supplied onto the market. Examples include the supply of tickets for sports or musical venues, and the short run supply of agricultural products (where the yield is fixed at harvest time) the elasticity of supply = zero when the supply curve is vertical.
When supply is perfectly elastic a firm can supply any amount at the same price. This occurs when the firm can supply at a constant cost per unit and has no capacity limits to its production. A change in demand alters the equilibrium quantity but not the market clearing price.
When supply is relatively inelastic a change in demand affects the price more than the quantity supplied. The reverse is the case when supply is relatively elastic. A change in demand can be met without a change in market price.

good interactive applet on PES:

basic demand and supply applet:

Factor commodities:

in this section topics covered:
  • incidence of a subsidy
  • incidence of a indrect/sales tax (e.g. GST)
  • labour market
  • world price and trade

Incidence of Subsidies & Sales tax

Government Subsidy
A subsidy is a payment by the government to suppliers that reduce their costs of production and encourages them to increase output. The effect of a government subsidy is to increase supply and (ceteris paribus) reduce the market equilibrium price. The subsidy causes the firm's supply curve to shift to the right. The amount spent on the subsidy is equal to the subsidy per unit multiplied by total output. Occasionally the government can offer a direct subsidy to the consumer – which has the effect of boosting demand in a market

external image subsidy_f.gif

external image subsidy_curve.gif

The part shaded in blue represents the incidence or benefit of the subsidy to producers
The area shaded in light pink represents the incidence of benefit of the subsidy to consumers
The pink triangle represents the dead weight loss

p* x Q* is the TR before the subsidy
Ps+subsidy x Qs is TR after the subsidy
cost of the subsidy to Govt is the (difference between Ps+subsidy and P*) x Q*
Ps+ subsidy is the price producers recieve after the subsidy
Ps is the price consumers now pay
value of sales after subsidy is Ps+subsidy x Q*

external image Subsidy_incidence.png
Different Types of Producer Subsidy

  1. A guaranteed payment on the factor cost of a product – e.g. a guaranteed minimum price offered to farmers
  2. An input subsidy which subsidises the cost of certain inputs used in production – e.g. an employment subsidy for taking on more employees
  3. Government grants to cover losses made by a business – e.g. a grant given to cover losses in the railway industry
  4. Financial assistance (loans and grants) for businesses setting up in areas of high unemployment – e.g. as part of a regional policy designed to boost employment
To what extent will a subsidy feed through to lower prices for consumers? This depends on the price elasticity of demand for the product. The more inelastic the demand curve the greater the consumer's gain from a subsidy. Indeed when demand is perfectly inelastic the consumer gains most of the benefit from the subsidy since all the subsidy is passed onto the consumer through a lower price. When demand is relatively elastic, the main effect of the subsidy is to increase the equilibrium quantity traded rather than lead to a much lower market price.

The Economic and Social Justifications for Subsidies
Why might the government be justified in providing financial assistance to producers in certain markets and industries? How valid are the arguments for government subsidies?
  1. To control the rate of inflation and boost the real living standards of some groups of consumers – for example lower income households.
  2. To encourage the provision and consumption of merit goods and services which are said to generate positive externalities (increased social benefits). Under-consumption or provision of merit goods can lead to market failure causing a loss of social welfare
  3. Maintain or increase the revenues (incomes) of producers during times of special difficulties in markets (consider some of the examples mentioned below)
  4. Reduce the cost of capital investment projects – which might help to stimulate economic growth by increasing long-run aggregate supply
  5. Subsidies to smooth or slow-down the process of long term structural change/decline in an industry (for example in farming, coal, fishing and steel)
  6. Boost employment for certain groups of workers e.g. the long term unemployed
Economic Arguments against Subsidies
The economic and social case for a subsidy should be judged carefully on the grounds of economic efficiency and also fairness (or equity). We need to be careful to measure and evaluate who gains from any particular subsidy and who pays. Might the money used up in subsidy payments be better spent elsewhere? Government subsidies inevitably carry an opportunity cost and in the long run there might be better ways of providing financial support to producers and employees in specific industries.
Free market economists argue that government subsidies distort the workings of the free market mechanism and can eventually lead to government failure where government intervention actually leads to a worse distribution of resources.
  1. Distortion of the Market: Subsidies distort market prices - this can lead to a misallocation of resources – many economists believe that the free-market mechanism works best. Export subsidies distort the free trade in goods and services and can severely curtail the ability of ELDCs to compete in the markets of industrialised countries
  2. Arbitrary Assistance: Decisions about which groups or industries receive a subsidy can be arbitrary – if tourism is supported, why not the British steel industry?
  3. Financial Cost: Subsidies can become expensive – note the opportunity cost!
  4. Who pays and who benefits?: The final cost of a subsidy usually falls on consumers (tax-payers) who themselves may have derived no benefit from the subsidy
  5. Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need to restructure – i.e. it delays much needed economic reforms
  6. Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments
  7. There are alternatives: It may be possible to achieve the objectives of subsidies by alternative means which have less distorting effects, for example by direct income support through the tax and benefit system

Subsidy impact

Marginal subsidies on production will shift the supply curve to the right until the vertical distance between the two supply curves is equal to the per unit subsidy; when other things remain equal, this will decrease price paid by the consumers (which is equal to the new market price) and increase the price received by the producers. Alternatively, a marginal subsidy on consumption will shift the demand curve to the right; when other things remain equal, this will decrease the price paid by consumers and increase the price received by producers by the same amount as if the subsidy had been imposed on the producers, although in this case, the new market price will be the price received by producers. The end result, again, is that no matter who is subsidized, the prices producers and consumers face will be the same.

Effect of elasticity

Depending on the price elasticities of demand and supply, who bears more of the tax or who receives more of the subsidy may differ. Where the supply curve is more inelastic than the demand curve, producers bear more of the tax and receive more of the subsidy than consumers as the difference between the price producers receive and the initial market price is greater than the difference borne by consumers. Where the demand curve is more inelastic than the supply curve, the consumers bear more of the tax and receive more of the subsidy as the difference between the price consumers pay and the initial market price is greater than the difference borne by producers.

external image as-marketfailure-producer-subsidies_clip_image002.gif

When one or both curves are elastic the incidence of the subsidy to both consumers and producers are affected,

The incidence of a tax

The economic incidence, or burden, of a tax indicates the extent to which someone is made worse off by the tax. In contrast, the statutory incidence simply indicates who the law says will pay the tax. The economic and statutory incidence are often very different.
The incidence of a tax on cigarettes - an example
If the government puts an extra tax of 30c on each packet of cigarettes, the legal incidence is on the cigarette smoker. However, the local market may be very competitive, with many sellers, so that a retailer may fear they will suffer from lost sales, and decide to put up the price by only 20c, and pay the balance of 10c to the government themselves. In this case, the economic incidence is shared because both are worse off. The smoker is worse off because of the price increase of 20c, and the seller is worse off because 10c must come out of their revenue to pay the government.
The effect of price elasticity of demand
In most cases, the burden is split between producers and consumers and both parties are worse off. The key to whether the consumer or producer carries the burden is the extent to which the tax can be passed on to the consumer in terms of higher prices.
In the diagram below the incidence on the consumer is indicated by the price rise, P to P1, times the new quantity sold, 0 to Q1. However, the vertical distance is the tax per unit, which is greater than the price rise, hence the incidence on the producer is measured as the distance P to A, times 0 to Q1 - the blue shaded area. The precise division depends upon how consumers react to a price rise, that is, their price elasticity of demand.

external image Tax-Burden.png

external image Tax+Incidence.gif

Elasticities of the curves impact on the amount of the tax burden (incidence) on consumers and producers

external image mod6nf1.gif

Inelastic supply, elastic demand
Because the producer is inelastic, he will produce the same quantity no matter what the price. Because the consumer is elastic, the consumer is very sensitive to price. A small increase in price leads to a large drop in the quantity demanded. The imposition of the tax causes the market price to increase from P without tax to P with tax and the quantity demanded to fall from Q without tax to Q with tax. Because the producer is inelastic, the quantity doesn't change much. Because the consumer is elastic and the producer is inelastic, the price doesn't change much. The producer is unable to pass the tax onto the consumer and the tax incidence falls on the producer. In this example, the tax is collected from the producer and the producer bears the tax burden. This is known as back shifting.

Similarly-elastic supply and demand

Most markets fall between these two extremes, and ultimately the incidence of tax is shared between producers and consumers in varying proportions. In this example, the consumers pay more than the producers, but not all of the tax. The area paid by consumers is obvious as the change in equilibrium price (between P without tax to P with tax); the remainder, being the difference between the new price and the cost of production at that quantity, is paid by the producers.

Inelastic demand, elastic supply

Because the consumer is inelastic, he will demand the same quantity no matter what the price. Because the producer is elastic, the producer is very sensitive to price. A small drop in price leads to a large drop in the quantity produced. The imposition of the tax causes the market price to increase from P without tax to P with tax and the quantity demanded to fall from Q without tax to Q with tax. Because the consumer is inelastic, the quantity doesn't change much. Because the consumer is inelastic and the producer is elastic, the price changes dramatically. The change in price is very large. The producer is able to pass (in the short run) almost the entire value of the tax onto the consumer. Even though the tax is being collected from the producer the consumer is bearing the tax burden. The tax incidence is falling on the consumer, known as forward shifting.

external image fwk-rittenecon-fig15_009.jpg

Impact of a tax

A marginal tax on the sellers of a good will shift the supply curve to the left until the vertical distance between the two supply curves is equal to the per unit tax; when other things remain equal, this will increase the Price paid by the consumers (which is equal to the new market price), and decrease the price received by the sellers. Alternatively, a marginal tax on consumption will shift the demand curve to the left; when other things remain equal, this will increase the price paid by consumers and decrease the price received by sellers by the same amount as if the tax had been imposed on the sellers, although in this case, the price received by the sellers would be the new market price. The end result is that no matter who is taxed, the price sellers receive will decrease and the price consumers pay will increase.

very good links explaining the concepts with diagrams
good discussion on the effectiveness of subsidies

Sales tax notes:

labour Market

comprises of the demand and supply curves for labourexternal image moz-screenshot-4.pngexternal image moz-screenshot-5.png
external image moz-screenshot-6.png
Derived demand is a term in economics, where demand for one good or service occurs as a result of demand for another, e.g. demand for labour. This may occur as the former is a part of production of the second. For example, demand for coal leads to derived demand for mining, as coal must be mined for coal to be consumed. As the demand for coal increases, so does its price. The increase in price leads to a higher demand for the resources involved in mining coal. And therefore:


Where MRP is the marginal revenue product, MPP is the marginal physical product, and P is the price of the physical product.
Demand for transport is another good example of derived demand, as users of transport are very often consuming the service not because they benefit from consumption directly (except in cases such as pleasure cruises), but because they wish to partake in other consumption elsewhere.
Derived demand applies to both consumers and producers. Producers have a derived demand for employees. The employees themselves are not demanded; rather, the skills and productivity that they bring are.
Another example would be production and demand for fertilizer. Farmers need fertilizer to grow crops, which is his main source of income. Thus for his own consumption he demands fertilizer. Thus its a derived demand of fertilizer to produce crops.
Tickets are a derived demand for entertainment. Entertainment is the demand being satisfied when a ticket is bought; it is purely a means to an end. The ticket is not an end in itself. The ticket is merely a license to attend a specified event at a specified time and place. The ticket agency is merely that, an agent of the principal (the event owner) authorized to make a transaction with a prospective attendee on the behalf of the principle.
When supply for a particular good or service increases, the derived demand for factors of production needed in producing this good or service also increases. Therefore this drives up the price for the factors of production and a firm's average cost curve increases as it has incurred a variable cost eg: increase in wages. Adversely, when supply for a good or service decreases so does the derived demand for its inputs. This causes the price of factors of production to decrease, decreasing a firms average cost curve.

Supply of Labour to Markets

How many people are willing and able to work in different industries and occupations? This question refers to the supply of labour.
The labour supply curve
The labour supply curve for any industry or occupation will be upward sloping. This is because, as wages rise, other workers enter this industry attracted by the incentive of higher rewards. They may have moved from other industries or they may not have previously held a job, such as housewives or the unemployed. The extent to which a rise in the prevailing wage or salary in an occupation leads to an expansion in the supply of labour depends on the elasticity of labour supply.
labour supply curve
labour supply curve

Key factors affecting labour supply
The supply of labour to a particular occupation is influenced by a range of monetary and non-monetary considerations.
  1. The real wage rate on offer in the industry itself – higher wages raise the prospect of increased factor rewards and should boost the number of people willing and able to work
  2. Overtime: Opportunities to boost earnings come through overtime payments, productivity-related pay schemes, and share option schemes and financial discounts for employees in a certain job.
  3. Substitute occupations: The real wage rate on offer in competing jobs is another factor because this affects the wage and earnings differential that exists between two or more occupations. So for example an increase in the relative earnings available to trained plumbers and electricians may cause some people to switch their jobs. In recent times, the British media has been fond of stories of people leaving jobs in academia (including high level university research) and moving in household services because the basic rates of pay and potential earnings are so much greater.
  4. Barriers to entry: Artificial limits to an industry’s labour supply (e.g. through the introduction of minimum entry requirements or other legal barriers to entry) can restrict labour supply and force average pay and salary levels higher – this is particularly the case in professions such as legal services and medicine where there are strict “entry criteria” to the professions. Indeed these labour market barriers are partly designed to keep pay levels high as well as being methods of maintaining the quality of people entering these professions

The length of time it takes to qualify as an architect restrictsthe labour supply and keeps salaries high
The length of time it takes to qualify as an architect restrictsthe labour supply and keeps salaries high

The length of time it takes to qualify as an architect restricts the labour supply and keeps salaries high

  1. Improvements in the occupational mobility of labour: For example if more people are trained with the necessary skills required to work in a particular occupation
  2. Non-monetary characteristics of specific jobs – these can be important – they include factors such as the level of risk associated with different jobs, the requirement to work anti-social hours or the non-pecuniary benefits that certain jobs provide including job security, opportunities for promotion and the chance to live and work overseas, employer-provided in-work training, employer-provided or subsidised health and leisure facilities and other in-work benefits including occupational pension schemes
  3. Net migration of labour – the UK is a member of the European Union single market that enshrines free movement of labour as one of its guiding principles. A rising flow of people seeking work in the UK is making labour migration an important factor in determining the supply of labour available to many industries – be it to relieve shortages of skilled labour in the NHS or education, or to meet the seasonal demand for workers in agriculture and the construction industry
Compensating wage (pay) differentials
Wage differentials in part act as a compensation for people who have to work unsocial hours or who are exposed to different degrees of risk at work, both in the short term and long run. Some jobs require a wage-rate that encompasses this risk premium – so workers in the North Sea Oil industry expect a higher return to adjust for the inherent dangers of their work.
Elasticity of labour supply
The elasticity of labour supply to an occupation measures the extent to which labour supply responds to a change in the wage rate in a given time period. In low-skilled occupations we expect labour supply to be elastic. This means that a pool of readily available labour is employable at a fairly low market wage rate. Where jobs require specific skills and lengthy periods of training, the labour supply will be more inelastic. It is hard to expand the workforce in a short period of time when demand for workers has increased.
In many professions there are artificial barriers to the entry of workers. Examples include Law, Accountancy and Medicine. The need for high level educational qualifications makes the supply of newly qualified entrants to these occupations quite inelastic in the short run and is one reason why these workers may earn a higher real wage than average salaries.
Elasticity of labour supply
Elasticity of labour supply

The work-leisure trade off
Once somebody has entered the labour force how many hours will they choose to work?
For many people, the hours they work are fixed by their employers and they have little or no flexibility in the total number of hours they supply. But the majority of workers have an opportunity at some point to work additional hours, or perhaps switch from a full-time job to a part-time position, a. And the official data probably understates the true number of people who are “moonlighting” and working in a second or third job because of the rapid expansion of the shadow economy which had encouraged the expansion of a shadow labour force.
Often employers adjust the number of hours of work available to meet their employees’ preferences. Over seven million people are now in part-time employment and much of this growth in part-time jobs has been sustained because it meets the preferences of people looking for greater flexibility in their working arrangements.
Economic theory would suggest that the real wage is a key determinant of the number of hours. The real wage is the money wage rate adjusted for changes in the price level and it measures the quantity of goods and services that can be bought from each hour worked. An increase in the real wage on offer in a job should lead to someone supplying more hours of work over a given period of time, although there is the possibility that further increases in the going wage rate might have little effect on an individual’s labour supply. Indeed, there is the possibility of a backward-bending individual labour supply curve. This is illustrated in the next diagram.

The work-leisure trade off
The work-leisure trade off

Labour Market - Demand for Labour

The labour market
. The working of the labour market affects us all because the vast majority of people at some point during their working lives will be active participants in the labour market.
The demand for labour comes from the employer. We shall start with this side of the market. Then we move onto the issue of labour supply before analysing the determination of wage rates in competitive and imperfectly competitive labour markets.
Product and labour markets
We often make a distinction between product and labour markets.
Product markets are where businesses and consumers meet to buy and sell the output of goods and services produced by an economy.
The labour market provides a means by which employers find the labour they need, whilst millions of individuals offer their labour services in different occupations. A simplified set of relationships is shown in the flow chart below.
Product and labour markets
Product and labour markets

The demand for labour
There is normally an inverse relationship between the demand for labour and the wage rate that a business needs to pay for each additional worker employed. If the wage rate is high, it is more costly to hire extra employees. When wages are lower, labour becomes relatively cheaper than for example using capital equipment and it becomes more profitable for the business to take on more employees.
Standard “neo-classical” labour market theory assumes that businesses seek to maximise profits. They will therefore search in the long run for the mix of factors of production (labour and capital) that produces the required level of output as efficiently as possible for the lowest possible total cost. Of course we can drop the assumption of profit maximisation and this has implications for employment and equilibrium wages in particular industries or occupations. But for the moment we will assume that businesses are profit-maximisers when deciding on their desired demand for labour.
The demand for labour is derived from the demand for the goods andservices that workers are asked to produce
The demand for labour is derived from the demand for the goods andservices that workers are asked to produce

The demand for labour is derived from the demand for the goods and services that workers are asked to produce

Marginal revenue product of labour
Marginal revenue productivity of labour (MRPL) is a theory of the demand for labour and market wage determination where workers are assumed to be paid the value of their marginal revenue product to the business
Marginal Revenue Product (MRPL) measures the change in total revenue for a firm from selling the output produced by additional workers employed.
MRPL = Marginal Physical Product x Price of Output per unit
  • Marginal physical product is the change in output resulting from employing one extra worker
  • The price of output is determined in the product market – in other words, the price that the firm can get in the market for the output that they have produced
A simple numerical example of marginal revenue product is shown in the next table:
Capital (K)
Output (Q)
price (£)
MRP = MPP x P (£)


We are assuming in this example that the firm is operating in a perfectly competitive market such that the demand curve for its output is perfectly elastic at £5 per unit. Marginal revenue product follows directly the behaviour of marginal physical product. Initially as more workers are added to a fixed amount of capital, the marginal product is assumed to rise. However beyond the 5th worker employed, extra units of labour lead to diminishing returns. As marginal physical product falls, so too does marginal revenue product.
The story is different is the firm is operating in an imperfectly competitive market where the demand curve for its product is downward sloping. In the next numerical example we see that as output increases, the firm may have to accept a lower price. This has an impact on the marginal revenue product of employing extra units of labour.
Capital (K)
Output (Q)
price (£)
MRP = MPP x P (£)


MRP theory suggests that wage differentials result from differences in labour productivity and the value of the output that the labour input produces. The MRP theory outlined below is based on the assumption of a perfectly competitive labour market and rests on a number of key assumptions that realistically are unlikely to exist in the real world. Most of our labour markets are imperfect – this is one of the many reasons for the existence and persistence of large earnings differentials between occupations which we explore a little later on.
The main assumptions of the marginal revenue productivity theory of the demand for labour are:
  • Workers are homogeneous in terms of their ability and productivity
  • Firms have no buying power when demanding workers (i.e. they have no monopsony power)
  • Trade unions have no impact on the available labour supply (the possible impact on unions on wage determination is considered later)
  • The physical productivity of each worker can be accurately and objectively measured and the market value of the output produced by the labour force can be calculated
  • The industry supply of labour is assumed to be perfectly elastic. Workers are occupationally and geographically mobile and can be hired at a constant wage rate
The profit maximising level of employment
The profit maximising level of employment occurs when a firm hires workers up to the point where the marginal cost of employing an extra worker equals the marginal revenue product of labour. This is shown in the labour demand diagram shown below.
The profit maximising level of employment
The profit maximising level of employment

Shifts in the labour demand curve
Marginal revenue productivity of labour will increase when there is
  • An increase in labour productivity (MPP) e.g. arising from improvements in the quality of the labour force through training, better capital inputs, or better management.
  • A higher demand for the final product which increases the price of output so firms hire extra workers and thus demand for labour increases, shifting the labour demand curve to the right.
  • The price of a substitute input e.g. capital rises – this makes employing labour more attractive to the employer assuming that there has been no change in the relative productivity of labour over capital
The next diagram shows how this causes an outward shift in the labour demand curve. For a given wage rate W1, a profit maximising firm will employ more workers. Total employment in the market will rise.
Shifts in the labour demand curve
Shifts in the labour demand curve

Limitations of MRPL theory of labour demand
Although marginal revenue product theory is a useful aspect of labour market analysis it is important to be aware of some of its limitations:
  1. Measuring productivity: In many cases it is hard to objectively measure productivity because no physical output is produced or the output produced may not be sold at a market price. This makes it hard to place an exact valuation on the output of each extra worker. How does one go about measuring the final output of people employed in teaching or the health service? It is easier to measure physical output in industries where a tangible product is produced each day. It is also costly to measure people’s productivity.
  2. Pay Award Bodies: In some jobs wages and salaries are set independently of the state of labour demand and supply. Public sector workers for example fire-fighters, council workers, nurses and teachers may have their pay set according to decisions of independent pay review bodies with “market forces” having only an indirect role in setting pay-rates
  3. Self employment and Directors’ Pay: There are over three million people classified as self-employed in the UK. How many of these people set their wages according to the marginal revenue product of what they produce? What too of those people who have the ability to set their own pay rates as directors or owners of companies?
Workers employed on an Asian construction site. In some industriesit is easier than others to measure the physical productivity ofworkers
Workers employed on an Asian construction site. In some industriesit is easier than others to measure the physical productivity ofworkers

Workers employed on a construction site. In some industries it is easier than others to measure the physical productivity of workers

Elasticity of labour demand
Elasticity of labour demand measures the responsiveness of demand for labour when there is a change in the ruling market wage rate. The elasticity of demand for labour depends:
  1. Labour costs as a % of total costs: When labour expenses are a high proportion of total costs, then labour demand is more elastic than a business where fixed costs of capital are the dominant business expense.
  2. The ease and cost of factor substitution: Labour demand will be more elastic when a firm can substitute quickly and easily between labour and capital inputs when the relative prices of each change over time. When the two inputs cannot easily be changed in the production process (e.g. when specialised labour or capital is needed), then the demand for labour will be more inelastic with respect to the wage rate
  3. The price elasticity of demand for the final output produced by a business: If a firm is operating in a highly competitive market where final demand for the product is price elastic, they may have little market power to pass on higher wage costs to consumers through a higher price. The demand for labour may therefore be more elastic as a consequence. In contrast, a firm that sells a product where final demand is inelastic will be better placed to pass on higher costs to consumers.
The diagram below shows two labour demand curves with different elasticity
Elasticity of labour demand
Elasticity of labour demand

Labour as a Derived Demand
The demand for all factors of production (inputs), including labour, is a derived demand ie the demand for factors of production depends on the demand for the products they produce. When the economy is expanding, we expect to see a rise in the aggregate demand for labour providing that the rise in output is greater than the increase in labour productivity. In contrast, during an economic recession or a slowdown, the aggregate demand for labour will decline as businesses look to cut their operations costs and scale back on production. In a recession, business failures, plant shut-downs and short term redundancies lead to a reduction in the derived demand for labour.

Each working person is guaranteed a minimum wage for work in NZ. It is illegal for an employer to pay a figure below this. (currently it is $12.75 ph)

- Fair for workers to be paid a minimum wage.
- Helps low earners gain a higher standard of living
- Extra disposable income should lead to extra spending in the economy
- Helps increase the gap between wages for low earners and unemployment benefit
- May help reduce unemployment
- Increases the cost to businesses
-Businesses may increase their prices (cost push inflation)
- Businesses may be unable to afford to employ as many workers
- Could cause unemployment
- Other workers may now ask for a pay rise
- Doesn’t help the unemployed who don’t receive a wage
external image work_minimum_wage_1.gif
In the diagram above, £3.80 is the free market equilibrium wage, supply is equal to demand. At this point 1000 people are employed.
Imagine that a minimum wage is imposed at £4.20. Some businesses can’t afford their wage bill and reduce their workforce. Now only 750 workers are employed. 250 have become unemployed.
notes on the minimum wage: minimun%20prices.html

labour supply curve notes:

back bending supply curve:

Worked question illustrating involuntary unemployment

QUESTION: European governments tend to make greater use of price controls than does the American government. For example, the French government sets minimum starting yearly wages for new hires who have completed le bac, certification roughly equivalent to a high school diploma. The demand schedule for new hires with le bac and the supply schedule for similarly credentialed new job seekers are given in the accompanying table. The price here—given in euros, the currency used in France—is the same as the yearly wage.
Wage per year (euro)
Quantity demanded
(new job offers
per year)
Quantity supplied
(new job seekers
per year)

a. In the absence of government interference, what is the equilibrium wage and number of graduates hired per year? Illustrate with a diagram. Will there be anyone seeking a job at the equilibrium wage who is unable to find one— that is, will there be anyone who is involuntarily unemployed?

b. Suppose the French government sets a minimum yearly wage of €35,000. Is there any involuntary unemployment at this wage? If so, how much? Illustrate with a diagram. What if the minimum wage is set at €40,000? Also illustrate with a diagram.

c. Given your answer to part b and the information in the table, what do you think is the relationship between the level of involuntary unemployment and the level of the minimum wage? Who benefits from such a policy? Who loses? What is the missed opportunity here?

ANS (a) P*=30000, Q*=290,000, and there is no involuntary unemployment. At the going wage, everyone who wants to work for that wage can find a job.
supply and demand
supply and demand

E is the point of equilibrium on x axis quantity of labor supplied and demand is shown and on the y axis wages are shown.

(b) At a minimum salary of 35000, there is excess supply (involuntary unemployment) = 310000-250000=60000. At a minimum of 40000, there is unemployment of 100000.
supply and demand
supply and demand

(c) Involuntary unemployment is increasing in the minimum wage. Workers who can find a job benefit. Workers who can’t find a job and employers who have to pay higher wages, and cannot hire willing workers for less than the minimum, are hurt by the policy. The missed opportunity is that, when the minimum is 40000 and there’s a worker willing to work for 30000 and a firm willing to pay 38000, the worker and firm cannot negotiate to find a mutually desired contract (between 30000 and 38000) because such contracts are illegal.

Real wage:

The term real wages refers to wages that have been adjusted for inflation. This term is used in contrast to nominal wages or unadjusted wages, i.e. contains an inflation component.
The higher the inflation component the less purchasing power of the real wage.

international trade

The Advantages of International Trade
NZ needs to export goods and services to finance imports of those products we cannot produce in this country.
Exports represent an injection of demand into the circular flow of income
There is an improvement in economic welfare if countries specialize in the products in which they have an comparative advantage and then trade with other nations
Trade allows firms to exploit scale economies by operating in larger markets - the European Union (EU)has over 450 million consumers with a massive purchasing power. Economies of scale lead to lower average costs of production that might be passed onto consumers
International competition stimulates higher efficiency - particularly for domestic monopolies.
Free trade provides greater choice for consumers and competition helps keep prices down
Imports can help to satisfy excess demand from consumers - acting as a safety valve for the economy. A trade deficit during an economic boom helps to reduce demand-pull inflation
Trade in ideas stimulates product and process innovations that generates better products

Gains from trade using supply and demand analysis
external image tradetheory9.gif
external image tradetheory9.gif

The diagram shows Japan can produce camcorders at lower costs - its supply curve is lower than the UK. This means that Japan has a comparative advantage in producing camcorders.
In the absence of international trade between the two countries, British consumers would have to buy at a higher equilibrium price than Japanese consumers. Since Japan is more efficient, it makes sense for Japan to specialise in production of camcorders and export their surplus output to the UK at a lower free trade price. At the intermediate price shown in the diagram, (the free trade price) Japan sells exports to the UK for a higher price but this is still lower than the UK equilibrium price. Japan receives revenue from the sale of these exports.
UK consumers can now buy more camcorders at a lower price and have more choice in the market
We are ignoring transportation costs between the two countries and we are assuming that the resources that were previously allocated to producing camcorders in the UK can be reallocated to other industries (i.e. resources are assumed to be occupationally mobile).

external image 90img47.gif
external image 90img47.gif

The main determinant of whether a country imports or exports a product is price. World price is the price prevailing in world markets and is the price at which we can sell or buy goods. Domestic price is the price in our country without trade. Ignoring transportation costs, if the world price is greater than domestic price before trade, then we will export the good. If the world price is less than domestic price before trade, then we will import the good.
Trade allows us to buy goods more cheaply from international businesses and sell them at a higher price than if we were restricted to the domestic market.

Winners and Losers from Trade

To analyze the welfare effects of trade, we begin by assuming we are dealing with a small country, and that its actions have a very small effect on world markets. In general, the economy benefits from trade because we can import goods more cheaply than we can produce them, and can sell our exports for more than people would pay. However some groups will be hurt.
  1. Consider if we export a good such as wheat
    • domestic price will rise to the world price since less of the product will be available for domestic consumption
    • domestic producers benefit from higher prices
    • domestic consumers are worse off because of higher prices
  2. For goods which we import, domestic prices fall and consumers benefit while producers are hurt.

Importing Goods

Lowering the price reduces producer surplus, which is transferred to consumers while consumer surplus is extended. Thus with imports, domestic consumers are made better off while domestic producers are hurt, but overall surplus is increased. Since the gains of the “winners” are larger than the losses of the “losers”, this would allow the winners to compensate the losers and still be better off. In practice, this compensation may not happen, but can be a justification for government intervention to help those groups hurt, by taxing those groups who benefit.

Tariffs and Quotas

Tariffs are taxes levied on businesses for imported goods. Tariffs raise the domestic price above the world price by the amount of the tariff. The increase in the domestic price will lead to a decrease in domestic quantity demanded, and an increase in domestic quantity supplied. Before the tariff, the domestic price is the same as world price. After the tariff, the domestic price rises.
Quotas are restrictions on the maximum amount that may be imported, and have a similar effect as do tariffs. They restrict the amount available to domestic consumers and push up the price, resulting in a deadweight loss similar to that of a tariff. The main difference is the distribution of the surplus. A tariff raises revenue for the government, whereas import quota creates surplus for licence holders. The government could capture surplus from import quotas by charging a fee for the licences. If licence fee equals difference in prices, then import quota works same as tariffs.
How is the quota distributed?
  1. It can be auctioned off to the highest bidder - In this case, the revenue goes to the government and the result is exactly like that of an equivalent tariff.
  2. It can distribute quota without payments - The extra surplus goes to those who get the quota, and may lead to large expenses for lobbying the government for the quotas. In this case, the deadweight loss is usually larger than a tariff due to cost of lobbying.

Arguments for Restricting Trade

  1. The Jobs Argument
    • jobs are created as well as eliminated
    • not possible that a country can be out-competed in all products owing to comparative advantage
  2. National Security Argument
    • products such as weapons and military equipment should be produced domestically
  3. Infant-Industry Argument
    • temporary protection while firms have a chance to learn to compete
    • economists are skeptical that govt can pick “winners” and argue that industry with real promise does not need protection
  4. Unfair-Competition Argument
    • if firms sell at below cost, they are subsidizing our consumption
  5. Protection as a Bargaining Chip Argument
    • restricting trade can be used for leverage in other foreign affairs
While the economy is becoming more global, some factions in developing countries are against the merging of markets. This has lead to violence in some parts of the world. Ambassadors and other officials traveling to foreign nations are normally supplied with body armor and a convoy for protection against hostile groups.
Today, wherever you live, various kinds of things are made by foreign countries. People wear Italian, drive German, and use American computers. Much of the items we consume are imported.
But, how does international trade effect economic well-being? All countries benefit from trading with one another because trading allows each country to specialize in doing what it does best.
A country tends to trade when they have the comparative advantage. And to find out whether they have it or not, we compare their domestic price and the world price, which is the price of a good that prevails in the world market for that good. The domestic price reflects the opportunity cost of the country. If their domestic price is lower than the world price, they have the comparative advantage, therefore they export the good. On the other hand, when the country’s domestic price is higher than the world price, they import the good.

external image cheese1.GIF
external image cheese1.GIF

Export (Left Graph)

World Price>Domestic Price
A country tends to export a good when they have the comparative advantage, which means that their domestic price is cheaper than the world price. Sellers are better off since the producer surplus rises with the price. On the other hand, consumers are worse off because the price of the good rises. But the sellers’ surplus exceeds the consumers’ loss. Therefore, the trade raises the economic well-being of the country as a whole.(+Surplus=The triangle region between the price, S, and D)

Import (Right Graph)

World Price<Domestic Price
A country tends to import a good when they have the comparative advantage, which means that the world price is cheaper than their domestic price. Consumers are better off since they get to buy more goods in cheaper prices. On the other hand, sellers are worse off because they have to compete with the foreign firms, the price drops, and their position in the market decreases. However, the trade still raises the economic well-being of the country as a whole.(+Surplus=The triangle region between the price, S, and D)

Economic analysis

Libertarian economic theories hold that tariffs are a harmful interference with the individual freedom and the laws of the free market. They believe that it is unfair toward consumers and generally disadvantageous for a country to artificially maintain an industry made inefficient by local demands, and that it is better to allow a collapse to take place. Opposition to all tariffs is part of the free trade principle; the World Trade Organization aims to reduce tariffs and to avoid countries discriminating between differing countries when applying tariffs.
Surplus with tariff-v2.svg
Surplus with tariff-v2.svg

In the following graph we see the effect that an import tariff has on the domestic economy. In a closed economy without trade we would see equilibrium at the intersection of the demand and supply curves (point B), yielding prices of $70 and an output of Y*. In this case the consumer surplus would be equal to the area inside points A, B and K, while producer surplus is given as the area A, B and L. When incorporating free international trade into the model we introduce a new supply curve denoted as SW. This curve makes the assumption that the international supply of the good or service is perfectly elastic and that the world can produce at a near infinite quantity at the given price. Obviously, in real world conditions this is somewhat unrealistic, but making such assumptions is unlikely to have a material impact on the outcome of the model. In this case the international price of the good is $50 ($20 less than the domestic equilibrium price).
The model above is only completely accurate in the extreme case where none of the consumers belong to the producers group and the cost of the product is a fraction of their wages. If instead, we take the opposite extreme, and assume all consumers come from the producers' group, and also assume their only purchasing power comes from the wages earned in production and the product costs their whole wage, then the graph looks radically different. Without tariffs, only those producers/consumers able to produce the product at the world price will have the money to purchase it at that price. The small FGL triangle will be matched by an equally small mirror image triangle of consumers still able to buy. With tariffs, a larger CDL triangle and its mirror will survive.
Note also, that with or without tariffs, there is no incentive to buy the imported goods over the domestic, as the price of each is the same. Only by altering available purchasing power through debt, selling off assets, or new wages from new forms of domestic production, will the imported goods be purchased. Or, of course, if its price were only a fraction of wages.
In the real world, as more imports replace domestic goods, they consume a larger fraction of available domestic wages, moving the graph towards this view of the model. If new forms of production are not found in time, the nation will go bankrupt, and internal political pressures will lead to debt default, extreme tariffs, or worse.
Establishing tariffs slows down this process, allowing more time for new forms of production to be developed, but also buttresses industries which may never regain competitive prices.
external image moz-screenshot-7.pngexternal image moz-screenshot-8.png

Economic models

Two simple ways to understand the potential benefits of free trade are through David Ricardo's theory of comparative advantage
Comparative advantageIn economics, the law of comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal cost and opportunity cost than another party. It is the ability to produce a product most efficiently given all the other products that could be produced...

and by analyzing the impact of a tariff
TariffA tariff is a duty imposed on goods when they are moved across a political boundary.-History:...

or import quota
Import quotaAn import quota is a type of protectionist trade restriction that sets a physical limit on the quantity of a good that can be imported into a country in a given period of time....


external image effectoftariff.svg.png

A simple economic analysis using the law of supply and demand
Supply and demandexternal image supply_and_demand.gifSupply and demand is an economic model based on price, utility and quantity in a market. It concludes that in a competitive market, price will function to equalize the quantity demanded by consumers, and the quantity supplied by producers, resulting in an economic equilibrium of price and...

and the economic effects of a tax
TaxTo tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law.Taxes are also imposed by many subnational entities...

can be used to show the theoretical benefits of free trade.

The chart at the right analyzes the effect of the imposition of an import tariff
TariffA tariff is a duty imposed on goods when they are moved across a political boundary.

Prior to the tariff, the price of the good in the world market (and hence in the domestic market) is Pworld. The tariff increases the domestic price to Ptariff. The higher price causes domestic production to increase from QS1 to QS2 and causes domestic consumption to decline from QC1 to QC2. This has three main effects on societal welfare. Consumers are made worse off because the consumer surplus (green region) becomes smaller. Producers are better off because the producer surplus (yellow region) is made larger. The government also has additional tax revenue (blue region). However, the loss to consumers is greater than the gains by producers and the government. The magnitude of this societal loss is shown by the two pink triangles. Removing the tariff and having free trade would be a net gain for society.

An almost identical analysis of this tariff from the perspective of a net producing country yields parallel results. From that country's perspective, the tariff leaves producers worse off and consumers better off, but the net loss to producers is larger than the benefit to consumers (there is no tax revenue in this case because the country being analyzed is not collecting the tariff). Under similar analysis, export tariffs, import quotas, and export quotas all yield nearly identical results. Sometimes consumers are better off and producers worse off, and sometimes consumers are worse off and producers are better off, but the imposition of trade restrictions causes a net loss to society because the losses from trade restrictions are larger than the gains from trade restrictions. Free trade creates winners and losers, but theory and empirical evidence show that the size of the winnings from free trade are larger than the losses.

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