Concept 1 (Comparative Advantage / Absolute Advantage)

 Basics
o Absolute advantage is the ability to produce more of a good or service than competitors
using the same amount of resources.
o Comparative advantage is the ability of an individual, firm, or country to produce a good
or service at a lower opportunity cost than other producers.
o Economic Principle: The basis for trade is comparative advantage, not absolute
advantage.
o Individuals, firms, and countries are better off if they specialize in producing goods or
services for which they have a comparative advantage and obtain the other good or
service they need by trading.

Example for Concept

China and India make both wheat and potatoes. China can produce either 100 kilograms of wheat or 200
kilograms of potatoes. By contrast, India can produce either 80 kilograms of wheat or 100 kilograms of
potatoes.
 Identify Absolute & Comparative advantage for both products.

o Step 1 – Absolute advantage

 In this example, China makes 100 Kg Wheat and 200 kg Potatoes, while India
produces 80 Kg Wheat and 100 kg Potatoes. China has an absolute advantage in
producing both cars and trucks.

o Step 2 – Identify Opportunity Cost

 For China, 100kg of wheat = 200kg of potatoes. So for each 1kg of wheat, China
must forego 2kg of potatoes. The opportunity cost is therefore what the nation
foregoes to produce the other product. So its opportunity cost of producing
wheat would be 2 ÷ 1 = 2. By contrast, the opportunity cost of making potatoes is
much smaller: 1 ÷ 2 = 0.5.
 For India, 80kg of wheat = 100kg of potatoes. Therefore, the opportunity cost to
India of producing wheat would be 1.25 ÷ 1 = 1.25. By contrast, the opportunity
cost of making potatoes is 1 ÷ 1.25 = 0.8.
Country Wheat Potatoes
China 1 Wheat = 2 Potatoes 1 Potato = 0.5 Wheat
India 1 Wheat = 1.25 Potatoes 1 Potato = 0.8 Wheat

o Step 3 – Identifying Comparative Advantage

 Wheat – Opportunity cost of making wheat in China is 2 potatoes. By contrast, it
is only 1.25 in India. Therefore, the country that has the lowest opportunity cost
has the comparative advantage. So in this case, India would have the comparative
advantage in Wheat production and should focus on this.
 Potato – China has an opportunity cost of 0.5. In other words, it must sacrifice 0.5
wheat. At the same time, India has an opportunity cost of 0.8. So when we look
 at the nation with the lower opportunity cost, it would be China that has the
comparative advantage. Therefore, China should focus on producing potatoes,
whilst India focuses on wheat.

o Step 4 – Compute Trade Off

 Gains from trade exist even if one side is inferior on all fronts.
 There will be gains from trade as long as each has a comparative advantage in
different goods.

Example (Sample Paper)

Suppose that Indonesia and Cambodia both produce maple syrup and honey. The combinations of the
two goods that each country can produce in one days is given in the table below:

Indonesia Cambodia
Honey (in tons) Maple syrup (in Honey (in tons) Maple syrup (in
tons) tons)
0 60 0 50
10 45 10 40
20 30 20 30
30 15 30 20
40 0 40 10
50 0
(a) Who has a comparative advantage in producing maple syrup? Who has a comparative advantage in
producing honey?
(b) Suppose that Indonesia is currently producing 30 tons of honey and 15 tons of maple syrup and
Cambodia is currently producing 10 tons of honey and 40 tons of maple syrup. Demonstrate that
Indonesia and Cambodia can both be better off if they specialize in producing only one good and then
engage in trade.

Solution

 Step 1 – Identify Opportunity Cost

o For Indonesia, 40 tons of Honey = 60 tons of Maple syrup. So for each 1 ton of Honey,
Indonesia must forego 1.5 ton of Maple syrup. By contrast, the opportunity cost of making
Maple Syrup is much smaller i.e. 0.67.
o For Cambodia, 50 tons of Honey = 50 tons of Maple syrup. So for each 1 ton of Honey,
Indonesia must forego 1 ton of Maple syrup and vice-versa
Country Honey MS
Indonesia 1 Honey = 1.5 MS 1 MS = 0.67 Honey
Cambodia 1 Honey = 1 MS 1 MS = 1 Honey

 Step 2 – Identifying Comparative Advantage

o Honey – Cambodia has comparative advantage in production of Honey
o Maple Syrup – Indonesia has comparative advantage in production of Maple Syrup
  Step 3 – Trade Off
o Specialization makes both Indonesia and Cambodia better off.
Before Trade After Trade
Particulars Honey MS Honey MS
Indonesia 30 15 30 20
Cambodia 10 40 20 40

In Below Diagram, “Indonesia = Canada” and “Cambodia = United States”

 Concept 2 (Substitute, Complement and Unrelated)

 Basics
o When two goods are substitutes the more you buy of one, the less you will buy of the
other. An increase in the price of a substitute causes the demand curve for a good to
shift to the right. A fall in price makes a good less expensive relative to other goods that
are substitutes.
 For e.g. Tea & Coffee
o When two goods are complements the more you buy of one, the more you will buy of
the other. A decrease in the price of a complement causes the demand curve for a good
to shift to the right.
 For e.g. Bread & Butter
o When two goods are unrelated then increase / decrease in price of one will not affect
demand of other.
 For e.g. Tea & Butter

 Example (Sample Paper)

o For each of the following pairs of products, state which are complements, which are
substitutes, and which are unrelated.
(a) Pepsi and Coke – Substitute
 Pepsi and Coke are considered substitutes because they are used to satisfy the
same need, and they are both sodas.
(b) Chicken burgers and burger buns – Complements
 When the price of Chicken burgers decreases the demand for burger buns
increases.
(c) Amul butter and strawberry jam – Complements
 Kindly note, Margarine and butter are substitutes because they perform very
similar functions. In the context of bread, they both add flavor and taste to the
bread. As the flavor they add is very similar, they would not be spread together.
 However, Peanut butter and jam also add flavor to bread but for most people
they are complements to each other as peanut butter and jam add different flavor
to the bread and the flavors of jam and peanut butter are very complementary to
each other. Having peanut butter and jam on bread together is an improvement
over just having one of them.
(d) Hewlett-Packard printers and Texas Instruments hand calculators – Unrelated
 When two goods are unrelated then increase / decrease in price of one will not
affect demand of other.
 Concept 3 (Movement along Demand Curve)

 Variables that shift market demand

o Prices of related goods
o Income
o Tastes
o Population and demographics
o Expected future prices

 Prices of related goods

o When two goods are substitutes the more you buy of one, the less you will buy of the
other. An increase in the price of a substitute causes the demand curve for a good to
shift to the right.
o When two goods are complements the more you buy of one, the more you will buy of
the other. A decrease in the price of a complement causes the demand curve for a good
to shift to the right.

 Income
o If household income rises the demand for goods increases which is a rightward shift of
the demand curve.
o A good is a normal good when demand increases following an increase in income.
o A good is an inferior good when demand decreases following an increase in income.

 Tastes
o Taste is a catchall category that refers to the many subjective elements that can enter
into a consumers’ decision to buy a product. Sometimes trends play a substantial role.
For e.g. the popularity of low carbohydrate diets caused a decline in demand for some
goods such as bread.

 Population and demographics

o As population increases so will the number of consumers and the demand for most
products will increase.
o The demographics of a population refers to its characteristics with respect to age,
gender, etc. For instance the demand for baby food will be greatest when the fraction of
the population under age 2 is the greatest.

 Expected Future Prices

o Consumers choose not only which products to buy but also when to buy them. If they
become convinced that the price of a good will be higher 3 months from now, they will
increase their purchases now as they try to beat the expected price increase.
  Example (Sample Paper)
State whether each of the following events will result in a movement along the demand curve for
McDonald’s burgers or whether it will cause the curve to shift. If the demand curve shifts indicate whether
it will shift to the left or to the right.

(a) The price of Burger King’s burger declines

 Demand for McDonald’s burger to decrease as Burger King’s burger is substitute goods. Hence
demand curve of McDonald’s burger will shift to left.

(b) McDonald’s distributes coupons for Rs. 5 off on purchase of a burger

 Demand for McDonald’s burger will be increased.

(c) Because of a shortage of potatoes, the price of French fries increases

 Demand for McDonald’s burger to decrease as price of complementary good (French Fries) has
increased. Hence demand curve of McDonald’s burger will shift to left.
(d) Kentucky Fried Chicken raises the price of a bucket of fried chicken.
 Demand for McDonald’s burger to increase as price of substitute good (Kentucky Fried Chicken)
has increased. Hence demand curve of McDonald’s burger will shift to right.
 Concept 4 (Price Elasticity of Demand)

 Price elasticity of demand

o The responsiveness of the quantity demanded to a change in price is measured by the
price elasticity of demand.
o Price elasticity of demand = – (% change in quantity demanded) / (% change in price)

 Elastic Demand
o Elastic Demand: % change in quantity > % change in price or, elasticity > 1.
o Inelastic Demand: % change in quantity < % change in price or, elasticity < 1.
o Unit Elastic Demand: % change in quantity = % change in price or, elasticity = 1.
o Perfectly Elastic: If a demand curve is a horizontal line, it is perfectly elastic. The
quantity demanded is infinitely responsive to price and the elasticity of demand equals
infinity.
 An increase in price causes the quantity demanded to fall to zero for a perfectly
elastic demand curve.
o Perfectly Inelastic: If a demand curve is a vertical line, it is perfectly inelastic. Here
quantity demanded is completely unresponsive to price and the elasticity of demand
equals zero.

 Key determinants of elasticity of demand

o Availability of close substitutes
 If a product has more substitutes available, it will have more elastic demand. If a
product has fewer substitutes available, it will have less elastic demand.
o Passage of time
 The more time that passes, the more elastic the demand for a product becomes.
o Necessities versus luxuries.
 The demand curve for a luxury is more elastic than the demand curve for a
necessity.
o Definition of the market
 The more narrowly we define a market, the more elastic demand will be. In a
narrowly defined market consumers will have more substitutes available.
o Share of the good in the consumer’s budget
 The demand for a good will be less elastic the smaller the share of the good in
the average consumer’s budget.

 Cross Price Elasticity of Demand

o Cross price elasticity of demand depends on whether product is substitute, complements
or unrelated.
If Products are… Cross Price Elasticity of Demand Example
Substitutes Positive Two brands of printers
Complements Negative Printers and toner cartridges
Unrelated Zero Printers and peanut butter
 o Cross price elasticity of demand = (% Change in quantity demanded of one good) / (%
Change in price of another good)

 Income Elasticity of Demand

o If the quantity demanded of a good increases as income increases, the good is a normal
good.
 A good is a luxury good if the quantity demanded is very responsive to changes
in income a 1% increase in income results in more than a 1% increase in
quantity demanded. Expensive jewelry and vacation homes are examples.
 A good is a necessity if the quantity demanded is not very responsive to changes
in income. Food and clothing are examples of necessities.
o A good is inferior if the quantity demanded falls as income rises. e.g., ground beef with
high fat content.
o During periods of economic expansion producers can expect the quantity demanded of
normal goods to increase. Sellers of luxuries can expect particularly large increases e.g.,
meals in expensive restaurants, high performance automobiles, & luxury apartments.
During recessions firms can expect to experience increases in demand for inferior goods
e.g., demand for rail trips will rise as consumers cut back on air travel.
If Income elasticity of Demand is… Then the good is… Example
Positive but less than 1 Normal and Necessity Milk
Positive but greater than 1 Normal and Luxury Car
Negative Inferior High Fat Meat

 Example
o Price elasticity of demand for beer = -0.23
o Cross price elasticity of demand between beer and wine = 0.31
o Income elasticity of demand for beer = -0.09
o Income elasticity of demand for beer = 5.03
 (i) demand for beer is inelastic,
 (ii) wine is a substitute for beer,
 (iii) 10% increase in income will result in little less than 1% decline in quantity of
beer demanded. Beer is an inferior good,
 (iv) Wine is a luxury good

 Example (Sample Paper)

A study of price elasticities of products sold in supermarkets reported the following data:
Product Price elasticity of demand
Soft drinks 3.18
Canned soup 1.62
Cheese 0.72
Toothpaste 0.45
Note: Price elasticity of demand is always negative. We have dropped the minus sign and shown their
absolute values.
(a) The demand for which products in inelastic?
(b) Use the information in the table to predict the change in the quantity demanded for each product
following a 10 per cent price increase.

Solution
(a) Cheese and toothpaste are inelastic because they are less than 1 (price elasticity). Vice versa
goes for canned soup and soft drinks as they are above 1 which means they have elastic demand
prices.
(b) Decrease in demand with a 10% increase in price will be as under:-
a. Soft Drinks = 3.18/0.1 = 31.8%
b. Canned Soup = 1.62/0.1 = 16.2%
c. Cheese = 0.72/0.1 = 7.2%
d. Toothpaste = 0.45/0.1 = 4.5%
 Concept 5 (Government Price Setting)

 Price Support by Government

o Government introduces minimum wages above market wages then quantity of workers
demanded by employers falls and quantity supplied increases. In such scenario, surplus
worker won’t be able to find jobs. Whatever the extent of employment losses from the
minimum wage, it will cause a deadweight loss just as a price.
o The government then provide employment to those job seekers.

 Price Ceiling by Government

o Support for price floors typically comes from sellers but support for governments setting
price ceilings typically comes from consumers. For e.g. when there is a sharp increase in
oil prices, there will often be proposals for the government to impose a price ceiling on
the market for petrol and diesel.
o When governments impose price ceilings or price floors three important results occur:
 Some people win
 Some people lose
 There is a loss of economic efficiency

 Example (Sample Paper)

The figure below illustrates the market for rice in which the government has imposed a price floor of Rs.
25 per kg.
(a) How much rice will be sold after the price floor has been imposed?
(b) Will there be a shortage or a surplus? If there is a shortage or a surplus, how large will it be?
(c) Will rice producers benefit from the price floor? Explain how they will benefit or lose.

Solution

(a) In the present case, equilibrium price is Rs 20 while quantity demand / supply is 30 million kg
per year. If government impose price floor of Rs 25 per kg then quantity demand will be reduced
to 28 million kg per year (although supply will be increased to 34 million kg per year). Hence,
rice will be sold 28 million kg per year.
(b) Shortage or Surplus will be calculated as under:-
a. Total fall in consumer surplus = Area of rectangle A + Area of triangle B.
b. Total gain in producer surplus = Area of rectangle A ― Area of triangle C.
c. Deadweight loss = Area of triangle B + Area of triangle C.
(c) The price floor has caused the marginal benefit of the last kg of wheat to be greater than the
marginal cost of producing it. Thus the price floor reduces economic efficiency. However, at the
price floor established farmers want to supply 34 million kg per year. The result is a surplus of 6
million kg rice per year. The government then purchases the surplus or pays farmers a subsidy to
take some land out of cultivation.