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ib economics hl notes
IB ECONOMICS HL

Understanding The Basic Concepts OF Microeconomics. Economics Notes For Students Of IB Program

UPDATED ON - 03 APR 2020
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Learning Points:

  1. Demand

  2. Supply

  3. Interaction of Demand and Supply

  4. Price Controls

  5. Commodity Agreements

  6. Price Elasticity of Demand

  7. Price Elasticity of Supply

  8. Applications of Concept of Elasticity

  9. Flat Rate and Ad Valorem Taxes

  10. Cost Theory

  11. Economies of Scale

  12. Diseconomies of Scale

 

Market: Any situation where buyers/demanders and sellers/suppliers can interact (maybe local, national or international).

 

Importance of price as a signal and as an incentive in terms of resource allocation

Price signals and resource allocation: Goods that are in high demand and are therefore scarce demand a high selling price – this attracts producers to the market as a high price means higher profit

  •  Goods in high demand are produced in preference to those, not in demand
  • Resource allocation is efficient

Demand

Demand: The quantity buyers are willing and able to buy at a given price.

Effective Demand: A want backed by money and the willingness to pay.

 

Law of demand with diagrammatic analysis

Law of demand: The quantity demanded decreases as the price increases and vice versa.

  • The income effect. As prices fall, so real income increases. Consumers can, therefore, afford to consume a greater quantity.
  • The substitution effect. As a good fall in price, it becomes cheaper in relation to other goods (substitutes).

 

 

 

Exceptions to the law of demand (the upward-sloping demand curve)

  • Goods of conspicuous consumption (Veblen goods): Some people buy luxury goods for ‘snob value’, for example, expensive trainers.
  • Speculative goods: As share prices rise, the quantity demanded of these shares increases, as individuals predict further price increases.
  • Giffen goods: If a good is very inferior and represents a large part of a consumer’s expenditure then the income effect of an increase in price may outweigh the substitution effect so leading to an increase in the quantity demanded. E.g. Potatoes in Ireland during the potato famine.

 

Determinants of demand

Factor

Causing an increase in demand

Causing a decrease in demand

 

   Household real income

Increase in real income

The decrease in real income

  Tastes, preferences,
  fashions

Move-in favour of the product

Move-in opposition to the product

  Advertising

Successful advertising

Unsuccessful / less advertising

  Health aspects

Improves health

Detrimental to health

  Weather

Favours product

Goes against product

  Change in price of
  substitute

Price of substitute increases
(this product is now relatively
cheaper)

Price of substitute decreases
(this product is now relatively more

expensive)

  Change in price of
  complement

Price of complement decreases

Price of complement increases

  Population

Higher population

Lower population

  Expectations about prices

Expect higher future prices
(buy more now)

Expect lower future prices
(buy later)

 

 

Note: A move along the curve is caused by a change in the price of the good or a change in the quantity demanded of the good and is termed an expansion or contraction in demand. A shift of the whole curve is caused by a change in an autonomous factor and is termed an increase or the decrease in demand.

Examples:
Weather: Ice-cream, umbrellas.
Change in price of substitute: Domestic or foreign holidays.

Supply
Supply: The quantity of a good or service suppliers are willing and able to supply at each price.

Law of Supply with Diagrammatic Analysis

Law of supply: As price increases the quantity supplied increases.

 

 

Determinants of supply

Factor

Causing an increase in supply

Causing a decrease in supply

 

    Costs of production

Lower production costs
(make the product more profitable)

Higher production costs
(make the product less profitable)

    Level of technology

Improved technology

Decreased level of technology

    Number of firms

New firms enter the market

Firms leave the market

    Seasonal influences

Favourable conditions

Unfavourable conditions

    Price of producer substitute

Price of producer substitute falls

Price of producer substitute rises

    Producer preferences

In favour of the product

Against product

    Exports

Decrease in exports

Increase in exports

    Imports

Increase in imports

Decrease in imports

 

Interaction of Demand and Supply

Interaction of demand and supply: equilibrium market clearing price and quantity are established where demand and supply curves meet – when established the market is said to be “at equilibrium”.

In free-market prices act as a signal, incentive and rationing device.

             

  At P1: QD1 > QS1 > shortage, therefore, price is bid up by keen buyers

 At P2: QS2 > QD2 > surplus, therefore, price decreases to clear surplus

 At PE: QS = QD >  no shortage or surplus, therefore, no tendency for price to change; the market is at equilibrium

 

 

 

Price Controls

Governments intervene in markets because they believe that the equilibrium reached by the free market is not desirable. In other words, they believe that price and/or quantity are in the wrong place. For example, most governments believe that the free market equilibrium price of cigarettes would be too low and therefore they tax them. Of course, there are issues of market failure involved here (i.e. negative externality – health costs).

Maximum Price/Price Ceiling

Set below equilibrium price so that the product is affordable for all

  •   Results in a shortage, which produces:
  •  Queuing
  •  Waiting lists
  •  Ration vouchers to equally distribute good
  •  A black market with illegal higher prices may develop where D meets QS.
  •  Solutions to shortage (by increasing supply at the maximum price):
  •  Subsidize private producers to increase supply (clears shortage)
  •  The government could supply the shortage
  •  Allow imports to increase supply

Minimum Price/Price Floor

Set above equilibrium price to protect suppliers’ income (e.g. agricultural producers). The minimum price can be temporary (e.g. to protect farmers’ incomes against fluctuating prices) or permanent (e.g. minimum wages).

 Results in surplus:

  •  Those able to sells at minimum price receive good income, but those who hold surplus potentially receive no income (e.g. minimum wage helps those in jobs but results in more unemployment).
  •  A black market may develop at a lower price where QD meets S (e.g. people are willing to work below the minimum wage).

 Solutions to surplus:

  •  The government buys surplus (increases demand), stores surplus in warehouses or dumps it abroad.
  •  Suppliers paid to leave the industry (decreases supply), e.g. small inefficient farmers.

      

Buffer Stock Scheme

Buffer stock schemes aim to reduce price fluctuations by buying stocks when prices are low to reduce supply and selling from stocks when prices are high to increase supply. Buffer stocks used in primary product markets such as wheat, gold, tin, etc, as these prices tend to fluctuate more than the price of the manufactured goods or services.

 

  • The supply curves S1 and S2 represent the supply of wheat at the end of two different seasons. Supply is perfectly inelastic since farmers cannot change the quantity supplied onto the market post-harvest. The organization wishes to keep price fluctuations within a certain band: it will not allow the price of the product to rise above P max or to fall below P min.

 

  • Assume that in one particular year there is a bumper harvest so that S1 is supplied onto the market. In absence of any intervention the market price would drop below P min, so the organization buys up A-B of the product to increase the market price up to P min (by buying stocks, the organization increase demand so that the demand curve shifts to the right). In the next year, bad weather may result in a poor harvest so that only S2 is supplied. The market price would rise above the maximum permitted by the organization, so the organization sells C-D of its stocks onto the market to reduce the price to P max (by selling stocks the organization increase supply and therefore the supply curve shifts to the right).

Problems:

  • The expense of storage. Setting up a buffer stock scheme also requires a significant amount of start-up capital, since money is needed to buy up the product when prices are low. There are also high administrative and storage costs to be considered.
  • Many perishable goods cannot be stored. 
  • Years of shortage and surplus do not balance each other out and it is possible there would be many years of shortage or surplus.

Commodity Agreements

A commodity agreement is where the supply of a product is limited through producer quotas (e.g. OPEC)

  • A quota is a physical limit to a production set by the government. Examples are quotas for imports and for the production of milk and catching of fish in the EU.

 

The advantage of quotas is that the total quantity allowed to be produced by the market (0 to Qquota) can be divided into individual tradable permits to produce.

The object of quotas is usually to raise the price above the equilibrium level to ensure more income/profit for producers. However, there may be other reasons for quotas, e.g. fish quotas for environmental reasons.

Price Elasticity of Demand (PED)

Price elasticity of demand (PED) measures the responsiveness of the quantity demanded to a change in price.

                                                                   % Change  in quantity  demanded

                                                  PED =      __________________________________

                                                                               % Change in price

 

The calculation of PED results in a coefficient or real number. This number tells us two major things about the responsiveness of the quantity demanded to a change in price.

If:         PED > 1, demand for the product is price elastic
            PED = 1, demand for the product has a unitary price elasticity
            PED < 1, demand for the product is price inelastic
            PED = 0, demand for the product is perfectly price inelasticity
            PED = ∞, demand for the product perfectly prices elastic

 

           

 D1: Perfectly Inelastic Demand
 D2: Relatively Inelastic Demand
 D3: Relatively Elastic Demand
 D4: Perfectly Elastic Demand
 D5: D curve with unitary elasticity   along the whole length (rectangular   hyperbola)  

 

 

         

 

Determinants of Price Elasticity of Demand

Goods with price elastic demand

Goods with price inelastic demand

Many close substitutes

Few/no substitutes

Non-essential/luxury good

Essential / necessity

Big budget item

Small budget item

Non-addictive

Addictive

Durable

Non-durable

 

Maybe a cheap complement to an expensive good
eg. petrol (complement to the car)

Cross Elasticity of Demand

Cross elasticity of demand (XED) measures the responsiveness of the quantity demanded of one good to a change in the price of another.     

                                                                           % change in  quantity demanded good A

                                                            XED =   ___________________________________

                                                                                            % change in price good B         

If:             XED = 0, goods are unrelated
                XED = +, goods are substitutes (the more positive, the closer the substitutes)
                XED = -, goods are complements (the more negative, the stronger the complements)       

Income Elasticity of Demand

Income elasticity of demand (YED) measures the responsiveness of the quantity demanded to a change in the real income of consumers.

                                                                                % change  in quantity demanded

                                                                YED =    _________________________________

                                                                                            %  change in real income

If:             YED > 1, good is income elastic
                YED < 1, good is income inelastic

  •  A normal good: A good where an increase in income results in an increase in the quantity demanded of it, therefore, its YEDis positive.

  • An inferior good: a good where the quantity demanded decreases as income increases, therefore, its YED is negative.

Price Elasticity of Supply

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

                                                                                 % change in quantity supplied 

                                                                PED =   ____________________________

                                                                                           % change in price

If:             PES > 1, the supply of a good is price elastic
                PES = 1, supply of good has unitary price elasticity
                PES < 1, supply of good is price inelastic

 

S1: perfectly inelastic supply 
S2: relatively inelastic supply
S3: relatively elastic supply
S4: perfectly elastic supply
SU: curves with unitary PES

 

 

 

 

 

 

Determinants of Price Elasticity of Supply

Goods with price elastic supply

Goods with price inelastic supply

Short production period

Long production period

Production not at full capacity

Production at full capacity

Able to hold stocks / non-perishable

Not able to hold stocks / perishable

Long time frame (of measurement)

Short time frame (of measurement)

Many producer substitutes

Few producer substitutes

Applications of Concepts of Elasticity

PED and business decisions: the effect of price changes on total revenue

      To increase TR:
       If D is price elastic --> decrease prices
       If D is price inelastic --> increase prices
        If D has unitary price elasticity --> keep prices the same (TR is at maximum)

 

 

 

 

PED and Taxation

Indirect taxes decrease the supply / raise the S curve by the amount of the tax

 

An indirect tax on goods with price inelastic demand collects more tax than one on goods with price elastic demand, therefore taxes on tobacco, petrol, and alcohol are common (they do respond to price but PED is less than one). Indirect taxes are taxes on expenditure. Subsidies are payments by a government to producers. Quotas are physical limits to the production set by governments.

Significance of income elasticity for sectoral change (primary > secondary > tertiary) as economic growth occurs

  • Production in developing countries consists mainly of primary sector industries (eg basic food crops, minerals) producing goods that have mostly income inelastic demand.
  • As global incomes increase, this means demand for the countries’ produce does not increase many àcountries’ exports do not increase.
  • But as incomes within these countries increase, domestic consumers’ demand for secondary/tertiary sector income elastic goods increases (through conspicuous consumption) imports into countries increase.
  • The trade balance is unfavourable/worsens. 
  • Solution: Some developing countries diversify to producing income elastic goods (but must be sustainable) e.g. timber, seafood, tourism export and improve the trade balance. Also, successful countries have built up the domestic manufacturing industry, sometimes behind high tariff walls.

Flat rate and Ad Valorem taxes

Taxation will move the supply curve upwards to the left. If the tax is a specific tax (a fixed monetary amount on each unit of output), the supply curve shift will be a parallel shift. If the tax is an ad valorem tax (a percentage tax), the new supply curve will gradually diverge from the original.

 

Note: The incidence of the tax (who bears the burden) will depend on the PED and the PES, which determine the slopes of the supply and demand curves. Thus here, the consumer bears most of the burden.

Cost Theory

There is a wide range of possible aims and objectives for firms to target, including:

  • Sales revenue maximization
  • Consumers value companies with increasing sales and are more likely to buy from them; consumers rarely know about the profits of companies.
  • Financial institutions may be more willing to lend to a company with increasing sales
  • Salaries may be linked to sales.
  • Output maximization and growth
  • Large firms are less vulnerable to takeover
  • Salary may be linked to the size of the firm
  • Managerial goals
  • Increasing the salary
  • The increasing number of employees
  • Investing
  • Behavioural goals
  • Market share
  • Satisficing

But underpinning much of the theory in this section is the aim of profit maximization.

Profits = Total revenue - Total cost                                                                                                                           
Total Revenue = Price × Quantity
Total Cost = Average Cost × Quantity (or
Fixed Costs + Variable Costs)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Costs in the Short Run

A firm is a combination of the four factors of production. These four factors are transformed into output. As these factors much are paid for, production incurs costs.

In the short run, at least one factor is variable, and at least one factor is fixed. Even though the firm’s size is fixed, increasing amounts of a variable factor (e.g. labor) can be added to the firm.

The law of diminishing returns applies. The law states that as successive units of the variable factor are added, the extra (marginal) output produced will at first increase and then decrease.

Assumptions of the law of diminishing returns:

  • At least one factor is fixed.
  • Each unit of the variable factor is the same (e.g. each worker is equally trained).
  • The level of technology is held constant.

This results in the marginal product (MP) and average product (AP) curve below:

 


 

 

Each time a unit of the variable factor is added a new cost I incurred. If this new cost allows output fist to increase and then decrease, the marginal costs and average variable costs much fist decrease and then increase.

This results in the marginal cost (MC) and average variable cost (AVC) curves below. Marginal cost is the cost of producing one extra unit of output.

               

 Fixed costs are the cost of producing nothing, and so

  average fixed costs (AFC) fall as output increases.

 Total costs are the sum of fixed and variable costs, and so
 average total costs are the sum of average fixed costs and
 average variable costs.

 

 

 

Costs in the Long Run

In the long run, all factors are variable, and therefore a firm can change its size (scale).

If a firm increases its size, then one of three things can happen to output:

  • Output can increase more than proportionately (increasing returns to scale)
  • This will cause average costs to fall.
  • Out can increase proportionately (constant returns to scale)
  • This will cause average costs to remain constant.
  • Output can increase less than proportionately (decreasing returns to scale)
  • This will cause average costs to rise, resulting in the long-run average cost curve below.

 

 

It is economies of scale that cause average costs to fall in the long run and diseconomies of scale that cause average costs to rise in the long run.

Economies of Scale

Internal economies of scale can be divided into the following categories:

  • Bulk-buying economies

As businesses grow they need to order larger quantities of production inputs. For example, they will order more raw materials. As the order value increases, a business obtains more bargaining power with suppliers. It may be able to obtain discounts and lower prices for the raw materials.

  • Technical economies

Businesses with large-scale production can use more advanced machinery (or use existing machinery more efficiently). This may include using mass-production techniques, which are a more efficient form of production. A larger firm can also afford to invest more in research and development.

  • Financial (purchasing) economies

Many small businesses find it hard to obtain finance and when they do obtain it, the cost of finance is often quite high. This is because small businesses are perceived as being riskier than larger businesses that have developed a good track record. Larger firms, therefore, find it easier to find potential lenders and to raise money at lower interest rates.

  • Marketing economies

Every part of marketing has a cost – particularly promotional methods such as advertising and running a sales force. Many of these marketing costs are fixed costs and so as a business gets larger, it is able to spread the cost of marketing over a wider range of products and sales – cutting the average marketing cost per unit.

  • Managerial economics

As a firm grows, there is greater potential for managers to specialize in particular tasks (e.g. marketing, human resource management, finance). Specialist managers are likely to be more efficient as they possess a high level of expertise, experience, and qualifications compared to one person in a smaller firm trying to perform all of these roles.

External economies of scale can be divided into the following categories:

  • Transport and communication links improve

As an industry establishes itself and grows in a particular region, it is likely that the government will provide better transport and communication links to improve accessibility to the region. This will lower transport costs for firms in the area as journey times are reduced and also attract more potential customers. For example, an area of Scotland known as Silicon Glen has attracted many high-tech firms and as a result, improved air and road links have been built in the region.

  • Training and education becomes more focused on the industry

Universities and colleges will offer more courses suitable for a career in the industry which has become dominant in a region or nationally. For example, there are many more IT courses at being offered at colleges as the whole IT industry in the UK has developed recently. This means firms can benefit from having a larger pool of appropriately skilled workers to recruit from.

  • Other industries grow to support this industry

A network of suppliers or support industries may grow in size and/or location close to the main industry. This means a firm has a greater chance of finding a high quality yet affordable suppliers close to their site.

Diseconomies of Scale

  • Coordination and communication

Large firms have long chains of command. Information from the top management may not be communicated to the production line properly and vice-versa.

  • Industrial relations

Because of the lack of contact between senior management and the workforce, the workers may feel insignificant or uncared for. Industrial disputes may arise and production may suffer.

  • Interdependency

In large firms with many different departments, each part of the company becomes interdependent. A machine failure in the packaging department may result in stopping the whole production line for example.

  • Lack of control

Also as output increases in an industry, each of the factors of production, land, labour, capital, and enterprise, become scarcer. As they become scarcer their prices increase.

 

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