ECN1101 – Micro

Economics
Ms. Farida’s class
Law of Demand (dd)
• The demand of an individual consumer indicates the various quantities of a good (or service) the consumer
is willing and able to buy at different possible prices during a particular time period, ceteris paribus.
• According to the law of demand, there is a negative causal relationship between the price of a good and its
quantity demanded over a particular time period, ceteris paribus: as the price of the good increases, quantity
demanded falls; as the price falls, quantity demanded increases, ceteris paribus.
 Non-price determinants of demand and shifts of the
demand curve
• The non-price determinants of demand are the variables other than price that can influence demand.
• Changes in the determinants of demand cause shifts in the demand curve: the entire demand curve moves to the
right or to the left
Non price determinants of demand
• Income in the case of normal goods. A good is a normal good when demand for it increases in response to an
increase in consumer income (demand for the good varies directly with income). Most goods are normal goods.
Therefore, an increase in income leads to a rightward shift in the demand curve, and a decrease in income leads
to a leftward shift.
• Income in the case of inferior goods. While most goods are normal, there are some goods where the demand
falls as consumer income increases; the good is then an inferior good (the demand for the good varies inversely
with income). Examples of inferior goods are second-hand clothes, used cars and bus tickets. As income
increases, consumers switch to more expensive alternatives (new clothes, new cars and cars or aeroplanes rather
than travelling by bus), and so the demand for the inferior goods falls. Thus an increase in income leads to a
leftward shift in the demand curve and a decrease in income produces a rightward shift.
• Preferences and tastes. If preferences and tastes change in favour of a product (the good becomes more
popular), demand increases and the demand curve shifts to the right; if tastes change against the product (it
becomes less popular), demand decreases and the demand curve shifts to the left.
• Prices of substitute goods. Two goods are substitutes (substitute goods) if they satisfy a similar need. An
example of substitute goods is Coca-Cola® and Pepsi ®. A fall in the price of one (say, Coca-Cola) results in a
fall in the demand for the other (Pepsi). The reason is that as the price of Coca-Cola falls, some consumers
switch from Pepsi to Coca-Cola, and the demand for Pepsi falls. On the other hand, if there is an increase in the
price of Coca-Cola, this will result in an increase in the demand for Pepsi as some consumers switch from Coca-
Cola to Pepsi.
• Prices of complementary goods. Two goods are complements (complementary goods) if they tend to be
used together. An example of complementary goods is DVDs and DVD players. In this case, a fall in the price
of one (say, DVD players) leads to an increase in the demand for the other (DVDs). This is because the fall in
the price of DVD players results in a bigger quantity of DVD players being purchased, and the demand for
DVDs increases.
• Demographic (population) changes, i.e. changes in the number of buyers. If there is an increase in the
number of buyers (demanders), demand increases and therefore the market demand curve shifts to the right; if
the number of buyers decreases, demand decreases and the curve shifts to the left.
A change in price produces a change in quantity demanded, shown as a movement on the demand
curve. Any change in a non-price determinant of demand leads to a change in demand, represented by
a shift of the entire demand curve.
Law of supply
• The supply of an individual fi rm indicates the various quantities of a good (or service) a firm is willing and
able to produce and supply to the market for sale at different possible prices, during a particular time period,
ceteris paribus
• According to the law of supply, there is a positive causal relationship between the quantity of a good
supplied over a particular time period and its price, ceteris paribus: as the price of the good increases, the
quantity of the good supplied also increases; as the price falls, the quantity supplied also falls, ceteris paribus.
Non-price determinants of supply and shifts of the supply curve

• Non-price determinants of supply, or the factors other than price that can influence supply. Changes in the
determinants of supply cause shifts in the supply curve.
• A rightward shift of the supply curve indicates that more is supplied for a given price; a leftward shift of the
supply curve indicates that less is supplied for a given price. A rightward shift of the curve is called an
increase in supply; a leftward shift is called a decrease in supply.
 Non price determinants of supply
• Costs of factors of production (factor or resource prices). The firm buys various factors of production (land,
labour, capital entrepreneurship) that it uses to produce its product. Prices of factors of production (such as wages,
which are the price of labour) are important in determining the firm’s costs of production. If a factor price rises,
production costs increase, production becomes less profitable and the firm produces less; the supply curve shifts to
the left. If a factor price falls, costs of production fall, production becomes more profitable and the firm produces
more; the supply curve shifts to the right.
• Technology. A new improved technology lowers costs of production, thus making production more profitable.
Supply increases and the supply curve shifts to the right. In the (less likely) event that a firm uses a less productive
technology, costs of production increase and the supply curve shifts leftward.
• Prices of related goods: competitive supply. Competitive supply of two or more products refers to production of
one or the other by a firm; the goods compete for the use of the same resources, and producing more of one means
producing less of the other. For example, a farmer, who can grow wheat or corn, chooses to grow wheat. If the price
of corn increases, the farmer may switch to corn production as this is now more profitable, resulting in a fall in
wheat supply and a leftward shift of the supply curve. A fall in the price of corn results in an increase in wheat
supply and a rightward shift of the supply curve.
• Prices of related goods: joint supply. Joint supply of two or more products refers to production of goods that are
derived from a single product, so that it is not possible to produce more of one without producing more of the other.
For example, butter and skimmed milk are both produced from whole milk; petrol (gasoline), diesel oil and heating
oil are all produced from crude oil. This means that an increase in the price of one leads to an increase in its
quantity supplied and also to an increase in supply of the other joint product(s).
• Producer (firm) expectations. If firms expect the price of their product to rise, they may withhold some of their current
supply from the market (not offer it for sale), with the expectation that they will be able to sell it at the higher price in
the future; in this case, a fall in supply in the present results, and hence a leftward shift in the supply curve. If the
expectation is that the price of their product will fall, they increase their supply in the present to take advantage of the
current higher price, and hence there is a rightward shift in the supply curve.
• Taxes (indirect taxes or taxes on profits). Firms treat taxes as if they were costs of production. Therefore, the
imposition of a new tax or the increase of an existing tax represents an increase in production costs, so supply will fall
and the supply curve shifts to the left. The elimination of a tax or a decrease in an existing tax represents a fall in
production costs; supply increases and the supply curve shifts to the right
• Subsidies. A subsidy is a payment made to the firm by the government, and so has the opposite effect of a tax.
(Subsidies may be given in order to increase the incomes of producers or to encourage an increase in the production of
the good produced.) The introduction of a subsidy or an increase in an existing subsidy is equivalent to a fall in
production costs, and gives rise to a rightward shift in the supply curve, while the elimination of a subsidy or a decrease
in a subsidy leads to a leftward shift in the supply curve.
• The number of firms. An increase in the number of firms producing the good increases supply and gives rise to a
rightward shift in the supply curve; a decrease in the number of firms decreases supply and produces a leftward shift.
This follows from the fact that market supply is the sum of all individual supplies.
• ‘Shocks’, or sudden unpredictable events. Sudden, unpredictable events, called ‘shocks’, can affect supply, such as
weather conditions in the case of agricultural products, war, or natural/man-made catastrophes. For example, the
Louisiana oil spill in 2010 resulted in a decrease in the supply of locally produced seafood.
A change in price produces a change in quantity supplied, shown as a movement on the supply curve. Any change in a
determinant of supply (other than price) produces a change in supply, represented by a shift of the whole supply curve.

Movements along and shifts of the supply curve

Market Equilibrium • When a market is in equilibrium, quantity demanded equals
quantity supplied, and there is no tendency for the price to change.
In a market disequilibrium, there is excess demand (shortage) or
excess supply (surplus), and the forces of demand and supply cause
the price to change until the market reaches equilibrium.

• The price in market equilibrium is the equilibrium price, and the

quantity is the equilibrium quantity. At the equilibrium price, the
quantity consumers are willing and able to buy is exactly equal to
the quantity fi rms are willing and able to sell. This price is also
known as the market clearing price, or simply market price.

• In a free market, a market disequilibrium cannot last, as demand

and supply force the price to change until it reaches its equilibrium
level.

• the equilibrium price is $3 per chocolate bar, and the equilibrium

quantity is 8000 bars. At any price other than the equilibrium price,
there is market disequilibrium.
Changes in market equilibrium
• Once a price reaches its equilibrium level, consumers and
firms are satisfied and will not engage in any action to make
it change. However, if there is a change in any of the non-
price determinants of demand or supply, a shift in the
curves results, and the market will adjust to a new
equilibrium.
Changes in demand and the new equilibrium price and quantity

• a change in a determinant of demand that causes the demand curve to

shift to the right from D1 to D2 (for example, an increase in consumer
income in the case of a normal good).
• Given D2, at the initial price, P1, there is a movement to point b, which
results in excess demand equal to the horizontal distance between points
a and b. Point b represents a disequilibrium, where quantity demanded is
larger than quantity supplied, thus exerting an upward pressure on price.
• The price therefore begins to increase, causing a movement up D2 to
point c, where excess demand is eliminated and a new equilibrium is
reached.
• At c, there is a higher equilibrium price, P2, and greater equilibrium
quantity, Q2, given by the intersection of D2 with S.
• A decrease in demand, leads to a leftward shift in the demand curve from
D1 to D3 (for example, due to a decrease in the number of consumers).

• Given D3, at price P1, there is a move from the initial equilibrium (point a)
to point b, where quantity demanded is less than quantity supplied, and
therefore a disequilibrium where there is excess supply equal to the
horizontal difference between a and b.

• This exerts a downward pressure on price, which falls, causing a movement

down D3 to point c, where excess supply is eliminated, and a new
equilibrium is reached.

• At c, there is a lower equilibrium price, P3, and a lower equilibrium

quantity, Q3, given by the intersection of D3 with S.
Changes in supply and new equilibrium
price and quantity
• the initial equilibrium is at point a where D intersects S1, and
where equilibrium price and quantity are P1 and Q1.
• An increase in supply (say, due to an improvement in technology)
shifts the supply curve to S2.
• With S2 and initial price P1, there is a move from point a to b,
where there is disequilibrium due to excess supply (by the amount
equal to the horizontal distance between a and b).
• price begins to fall and there results a movement down S2 to point
c where a new equilibrium is reached.
• At c, excess supply has been eliminated, and there is a lower
equilibrium price, P2, but a higher equilibrium quantity, Q2.
• A decrease in supply is shown (say, due to a fall in the number of firms).
• With the new supply curve S3, at the initial price P1, there has been a
move from initial equilibrium a to disequilibrium point b, where there is
excess demand (equal to the distance between a and b).
• This causes an upward pressure on price, which begins to increase, causing
a move up S3 until a final equilibrium is reached at point c, where the
excess demand has been eliminated, and there is a higher equilibrium price
P3 and lower quantity Q3.
 Market Interventions
• An important justification for government intervention is to
compensate for the inability of markets to carry out socially desirable
economic activities effectively.
• Few reasons for government interventions at micro level are:
Earn revenue for the government
Support the firms
Support to low income households
Influence level of production
Influence level of consumption etc….
 Main forms of intervention

• Price control ( Price ceiling, Price flooring)

• Subsidies
• Indirect taxes.
 Price controls
• Price controls refer to the setting of minimum or maximum prices
by the government (or private organisations) so that prices are unable
to adjust to their equilibrium level determined by demand and supply.

• Price controls result in market disequilibrium, and therefore in

shortages (excess demand) or surpluses (excess supply).
Price ceiling
Price floors: setting a legal minimum price
• A legally set minimum price is called a price floor.

• The price that can be legally charged by sellers of the good

must not be lower than the price floor, or minimum price.

• a price floor, Pf, is set above the equilibrium price, Pe. At

Pe, consumers are willing and able to buy Qd of the good,
but firms are willing and able to supply Qs of the good.
Therefore, a surplus, or excess supply, equal to the
difference between Qs and Qd, arises. If the market were
free, the forces of demand and supply would force the price
down to Pe. However, now this cannot happen.
 Why governments impose price floors

• Price floors are commonly used for two reasons:

• (a) to provide income support for farmers by offering them
prices for their products that are above market determined
prices; and
• (b) to protect low-skilled, low wage workers by offering
them a wage (the minimum wage) that is above the level
determined in the market.
INDIRECT TAXES
 SUBSIDY
• A subsidy, in a general sense, refers to assistance by the government to
individuals or groups of individuals, such as firms, consumers, industries
or sectors of an economy