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DRAFT MICROECONOMICS for INTRECO

DEMAND AND SUPPLY ANALYSIS Demand Demand represents the willingness and ability of consumers to purchase goods and services at a specific point in time, given the available price. There is a negative relationship between quantity demanded and price. The Law of Demand states that as the price of a good or service rises (falls), the quantity of that good that people are willing and able to purchase during a particular period of time falls (rises), everything else held constant. A demand schedule is a table of the prices and the corresponding quantities demanded of a particular good or service. Plotting the points from the schedule, with price in the y-axis and quantity in the x-axis, will produce a demand curve. Given the negative relationship between price and quantity demanded, we predict a downward-sloping demand curve.

Source: http://www.investopedia.com/university/economics/economics3.asp Aside from price, there are other factors which influence consumer demand. These are termed as determinants of demand and the list includes, income, size of the market, price of related goods, tastes, and special influences. Income spells whether a good is to be considered a normal or an inferior good. The demand for a normal good increases as the income increases. The opposite is true for an inferior good such as sardines, for some. In this case, as income rises, demand for sardines fall since consumers will opt for a more satisfying good. Related goods can either be substitutes or complements of each other. If the goods are substitutes, a rise in the price of another will increase the demand for the other good, as in the case of say, Coke and Pepsi. On the other hand, a rise in the price of say, coffee, will decrease demand for cream, as they are complements. Special influences like weather and expectations are relative. A change in price will cause a movement along the demand curve, and change in quantity demanded; whilst changes in any of the determinants will cause a shift of the demand curve, and a change in demand. Below is a demand function. The signs indicate the relationship of the factor to demand.

Qd = f ( P, Y, Pr, T, S, Popn) (-) (+) (+) (+) comp subs (-) (+)

Supply

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Supply represents the willingness and ability of producers to produce and sell goods and services

at a specific point in time, given the market price. There is a positive relationship between quantity supplied and price. The Law of Supply states that as the price of a good or service rises (falls), the quantity of that good that producers are willing and able to offer for sale at each possible price, during a particular period of time rises (falls), everything else held constant. A supply schedule is a table of the prices and the corresponding quantities supplied of a particular good or service. Plotting the points from the schedule, with price in the y-axis and quantity in the x-axis, will produce a supply curve. Given the positive relationship between price and quantity supplied, we predict an upward-sloping supply curve.

Source: http://www.investopedia.com/university/economics/economics3.asp Aside from price, there are other factors, which influence supply. These are termed as

determinants of supply and the list includes cost of production, technological advancements, prices of inputs, prices of related goods, and special influences. For instance, two goods, say, apples and oranges, are being sold by a store, the other an easy substitute for the other. Then, a rise in the price of apples will induce the firm to sell more of it than oranges. Special influences include weather, and government policies. A government policy might prohibit or regulate the production and sale of a good. A change in price will cause a movement along the supply curve, and a change in quantity supplied; whilst changes in any of the determinants will cause a shift of the supply curve, and a change in supply. Below is a supply function. The signs indicate the relationship of the factor to supply.

Qs = f ( Px, Pi, Tech, Prel, S) (+) (-) (+) (-)

The interaction of demand and supply will allow us to determine the equilibrium point. The market is in equilibrium where the price and quantity at which quantity demanded and supplied are equal. On occasions that the market veers away from this position, it is believed that eventually, though not immediate, the market will clear once more. Certain policies may cause distortions to this equilibrium situation. A price floor policy disallows price to fall below a certain level. This often causes a surplus of goods. A price ceiling policy disallows price to rise beyond a certain level. This often results to a shortage of goods.

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Source: http://www.investopedia.com/university/economics/economics3.asp Key Concepts demand shift of the demand curve law of demand supply demand schedule law of supply demand curve supply schedule determinants of demand supply curve substitutes determinants of supply complements equilibrium normal good price floor inferior good price ceiling movement along the demand curve Key Formulas Two-point formula: given: P1,P2,Q1,Q2 (P – P1) = (P2 – P1) = (Q – Q1) (Q2 – Q1) then, Qd = mx + P and Qs = mx + P then, Qd = Qs; solve for Pe and Qe Slope-intercept form m = (P2 – P1) (Q2 –Q1) then, solve for b: given P and x, where x = Q; P = mx + b the, substitute solved m and b into function Exercises Problem Solving

1. Cigarettes per carton P Qd Qs

60 800 1100 50 900 1000 40 1000 900 30 1100 800

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20 1200 700 a. Derive the demand and supply equations in P & Q form. b. Graph the demand and supply curves. Label.

2. Hamburgers per piece P Qd Qs

15 300 180 20 270 270 25 240 360 30 210 450 35 180 540

a. Derive the demand and supply equations in P & Q form. b. Graph the demand and supply curves. Label.

3. When priced at P11000, a certain mobile phone model had a demand of 3750 units, while

producers were willing to supply 5000 units. As price dropped by P3000, demand for the good rose by 12%, while supply declined to 4100 units. Derive the demand and supply equations in P & Q form.

4. A local band is to hold a mini-concert. At P400 per ticket, there is demand for 1350 tickets.

At this same price, the concert organizers are willing to sell 1100. Meanwhile, demand drops to 810 tickets as price is raised by P200. At the new price, supply rises to P1450 per ticket. Derive the demand and supply equations in P & Q form.

5. Consider the market for juice drinks. Suppose the market demand for juice drinks is given by

Qd = 300 – 20P and the market supply is given by the equation Qs = 20P – 100. Determine the equilibrium price (Pe) and quantity (Qe) for juice drinks.

6. Demand: Qd = 3550 – 266P

Supply: Qs = 1800 + 240P Determine the equilibrium price (Pe) and quantity (Qe) for juice drinks. Graph the demand and supply curves; label appropriately the intercepts and the Pe and Qe.

7. Magazines per copy

P Qd Qs 130 1300 1750 120 1445 1600 110 1500 1545 90 1650 1400

a. Derive the demand and supply equations. b. Determine the Pe and Qe. c. Graph the demand and supply curves. Label.

Identification

1. A fundamental concept that refers to having less of something available than is wanted at zero price.

2. Any item for which we would pay to have less of. 3. The factor of production which refers to the physical and intellectual services of people,

including the training, education, and abilities of the individuals in a society. 4. The analysis of “what is”. 5. The analysis of “what ought to be”. 6. A simplification or abstraction of the real world that enables scientists to organize their thoughts.

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7. The study of economics at the level of the individual. 8. The study of the economy as a whole. 9. The cost of giving up one good or activity in order to obtain some other good or activity. 10. A graphical representation showing the maximum quantity of goods and services that can be

produced using limited resources to the fullest extent possible. 11. The amount of a product that people are willing and able to purchase at every possible price. 12. Goods that can be used in place of each other; as the price of one rises, the demand for the other

rises. 13. Goods that are used together; as the price of one rises, the demand for the other falls. 14. A graph of a supply schedule that measures price on the vertical axis and quantity supplied on the

horizontal axis. 15. Refers to the movement of the demand curve brought about by a change in demand. 16. Brings about a movement along a demand curve, and not a shift. 17. A situation where the price is not allowed to decrease below a certain level. 18. A vertical demand curve. 19. The price elasticity of demand measured over a price range using the midpoint, or average, as the

base. 20. Charging different customers different prices for the same product.

Modified True or False

1. Positive analysis imposes the value judgements of one individual on the decisions of others. 2. Ceteris Paribus is Latin for “let the buyer beware”. 3. Rational self-interest is the same thing as selfishness. 4. An economic good is scarce if it has a positive price. 5. An economic bad is an item that has positive price. 6. A resource is the ingredient used to make factors of production. 7. An increase in demand is represented by a movement up the demand curve. 8. An increase in supply is represented by a movement up the supply curve. 9. An increase in demand without any changes in supply will cause the price to rise. 10. An increase in supply without any changes in demand will cause the price to rise.

Essay

1. Which of the following are economic goods? Explain why each is or is not an economic good. a. Steaks b. Houses c. Sardines d. Garbage e. Cars

2. Use economics to explain why diamonds are more expensive than water, when water is necessary

for survival and diamonds are not. 3. A doctor earns $200 per hour, a plumber $40 per hour, and a teacher $20 per hour. Everything

else the same, which one will negotiate more hours to negotiating the price of a new car?

4. Perhaps you’ve heard of the old saying “There is no such thing as a free lunch”. What does it mean? If someone invites you to a lunch and offers to pay for it, is it free to you?

5. The prices of Ralph Lauren line of clothing are considerably higher than comparable quality lines.

Yet, it sells more than Bench brand line of clothing. Does this violate the law of demand? Illustrate each of the following using demand and supply diagram for bananas.

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1. Reports surface that imported bananas are infected with a deadly virus. 2. Consumers’ incomes drop. 3. The price of banana rises. 4. The price of oranges falls. 5. Consumers expect the price of bananas to decrease in the future.

Answers Problem Solving

1. a. Qd = 1400 – 10P Qs = 500 – 10P

2. a. Qd = 388.23 – 5.88P Qs = -120 + 20P

3. Qd = 5399.18 – 0.15P Qs = 1696.70 + 0.30P

4. Qd = 2431.08 – 270P Qs = 398.25 + 1.75P

5. Pe = 10 Qe = 100 6. Pe = 3.46 Qe = 2630.64 7. Qd = 2342.31 – 7.70P

Qs = 743.07 + 7.30P Pe = 106.67 Qe = 1521.37

Identification 1. scarcity 11. demand 2. economic bad 12. substitutes 3. labor 13. complements 4. positive 14. supply curve 5. normative 15. shift 6. model 16. change in quantity demanded 7. microeconomics 17. price floor 8. macroeconomics 18. perfectly elastic 9. opportunity cost 19. arc elasticity

10.production possibilities frontier 20. price discrimination Modified True or False

1. F – Positive – Normative 2. F – “let the buyers beware” – “everything else held constant” 3. F – is the same – is not the same 4. F – positive – zero 5. F – positive – negative 6. F – factors of production – goods 7. F – movement up – shift of 8. F – movement up – shift of 9. T 10. F – rise - fall

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Taxes and Subsidies

Tax is an amount paid by consumers and producers to the government, which has the essential effect of raising the price of the good. Taxes are the primary source of government revenue. Moreover, if the consumption and sale of a good is to be regulated, taxing that good discourages its sale and consumption. Taxing cigarettes can curb its consumption. This move may be oriented towards health and environment policies of the government. Taxes can be indirect or direct. The income of individuals and companies can be taxed directly. Indirect taxes are taxes on goods and services. Examples are sales tax, excise tax, specific tax, and ad-valorem tax. A greater percentage of direct taxes in the scheme makes for a progressive tax policy, since once is taxed based on ones income. Indirect taxes are thought to be regressive since, upon buying the same good, irregardless of income, people are taxed the same amount essentially. A specific tax is an exact amount added to the price of the taxed good. An ad-valorem tax is tax as a percentage of the taxed item. Taxes cause distortions such as loss in consumer surplus and producer surplus. Consumer surplus is the amount a consumer is willing to pay minus what he actually pays. Producer surplus is the amount producers receive minus cost (actual+opportunity) of producing. The resulting net loss of total surplus is called deadweight loss. Revenues are used by the government for various growth and development purposes. One way by which government provides support to consumers and producers alike is through subsidies. A subsidy is a payment of the government for which it receives no goods or services in return, to either firms or households for making goods more affordable. It has the essential effect of lowering prices. Specific tax Ad-Valorem tax Subsidy Key Concepts tax progressive taxation tax incidence regressive taxation specific tax consumer surplus ad-valorem tax producer surplus direct tax deadweight loss indirect tax subsidy Key Formulas For specific tax: Given Qd = 20 – 0.33P and Qs = -5 + 0.50P, and t = P1.00 Qs = -5 + 0.50P take the supply equation P = 10 + 2Qs + t change into P form, add tax P = 10 + 2Qs + 1 Qs’ = 5.5 + 0.5P change back into Q form Qs’ = Qd equate with old demand equation

20 – 0.33P = 5.5 + 0.5P For ad-valorem tax: Given Qd = 20 – 0.33P and Qs = -5 + 0.50P, and t = 0.10 Qs = -5 + 0.50P take the supply equation P = (10 + 2Qs)(1+t) change into P form, multiply (1+tax) P = (10 + 2Qs)(1.10)

St S

St S

St

S

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Qs’ = 12.1 + 2.2P change back into Q form Qs’ = Qd equate with old demand equation

20 – 0.33P = 12.1 + 2.2P For subsidy: Given a demand and supply equation, apply the same process as of the specific tax case,

but, this time subtracting the tax instead of adding.

Exercises Problem Solving

1. Demand: Qd = 7500 – 250P Supply: Qs = -4000 + 333.33P Given that a specific tax of P1.00 is imposed, solve for: a. Old equilibrium price and quantity b. New supply equation and new equilibrium price and quantity. c. Tax burden of the consumers and producers. d. Tax revenue collected by the government. e. Old and new consumer and producer surplus. f. The deadweight loss. g. Graph the old and new curves.

2. Demand: Qd = 20 – 0.33P

Supply: Qs = -5 + 0.50P Given that an ad-valorem tax of 10% is imposed, solve for: a. New equilibrium price and quantity. b. Tax burden of the consumers and producers. c. Tax revenue collected by the government. d. Old and new consumer and producer surplus. e. The deadweight loss. f. Graph the old and new curves.

3. A particular brand of junkfood generated sales of 32 million packs when it was priced at

P7.50 per pack. When price was reduced to P5.20, sales increased to 50 million packs. Production on the other hand increased from 34 million to 48 million packs when prices rose from P5.85 to P7.00 per pack. Solve for: a. The demand and supply equations. Pe and Qe. b. Given specific tax of P0.85/pack is imposed, new supply equation. c. New Pe and Qe. d. Tax incidence. e. Old and new consumer and producer surplus. f. The deadweight loss. g. Graph the old and new curves.

4. Demand: Qd = 2580 - 194P

Supply: Qs = 1800 + 240P Determine the old and new Pe and Qe when a subsidy of P2/unit is given by the government.

5. Demand: Qd = 3385 - 279P

Supply: Qs = 1728 + 288P Subsidy = P1.00/unit a. Solve for the old and new Pe and Qe. b. Graph the old and new curves.

Answers

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1. a. Pe = 19.71 Qe = 2572.50

b. Qs’ = -4333.33 +333.33P; Pe = 20.29; Qe = 2427.50 c. consumer = 1407.95 producer = 1043.83 d tax revenue = 2541.78 e. old CS = 13235.51; new CS = 11785.50; old PS = 9916.99; new PS = 8848.24

f. DWL = 73.23 2. a. Pe = 30.12 Qe = 10.06

b. Qs’ = -5 + 0.45P; Pe = 32.05; Qe = 9.42 c. consumer = 18.18 producer = 12.06 d tax revenue = 30.24 e. old CS = 153.36; new CS = 134.52; old PS = 100.6; new PS = 99.15

f. DWL = 1.03

3. a. Qd = 89.70 – 7.69P; Qs = -39.13 + 12.5P; Pe = 6.38; Qe = 40.64 b. Qs’ = -49.75 + 12.5P; Pe = 6.90; Qe = 36.56 c. consumer = 19.01 producer = 12.06 d. old CS = 107.29; new CS = 37.66; old PS = 66.04; new PS = 53.38

e. DWL = 0.73 4. Pe = 1.80; Qe = 2231.33; Pe’ = 0.70; Qe’ = 2444.20 5. Pe = 2.92; Qe = 2570.32; Pe’ = 2.41; Qe’ = 2711.36

CONCEPT OF ELASTICITY Elasticity is a measure of responsiveness or sensitivity of one variable to another. It is the percentage change that will occur in one variable in response to a one percent change in another variable. The different types of elasticities are to be discussed below. 1. Price elasticity of demand

Price elasticity of demand measures how much the quantity demanded responds to a change in price. It is the ratio of the percentage change in quantity demanded to the percentage change in price. We may know that if we decrease the price, quantity demanded of that good will rise, but elasticity allows us to know just how great the response will be. Hence, we can get an idea whether, say, a price increase, would be such a good idea, because, though revenue may increase due to the price increase, there might be a trade-off in terms of reduced sales. Elasticity values may range from perfectly inelastic to perfectly elastic. The greater the elasticity, the more responsive is demand to price. Demand for basic necessities such as rice and oil are often price inelastic as they are bought despite of price increases. A point to note is that the degree by which people value the same goods may vary. Hence, a demand for a good may be highly elastic for some and inelastic for others. Key Concepts Price elasticity of demand

Perfectly inelastic: Ep = 0 Inelastic: Ep < 0 Unit elastic: Ep = 1 Elastic: Ep > 1 Perfectly elastic: Ep ∞ 0

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Key Formulas

* Due to the negative relationship between price and quantity demanded, price elasticity of

demand values are negative. To avoid confusion, the absolute vale is used. Exercises Problem Solving

1. Rice per kilo P Qd

22 2000 25 1800

Compute for price elasticity of demand as price increases from P22 to P25. Is demand for rice elastic or inelastic to price changes? 2. Per tablet

P Qd 5 500 10 480

Per pair of shoes

P Qd 400 50 420 25

Compute for the elasticities given an increase from P5 to P10 in the first table and from P400 to P420 in the second table. Which good has an elastic demand?

3. Per cd

P Qd 200 4000 300 3500 400 3200 500 3000

Compute for price elasticity of demand as price falls from P400 to P300. 4.

P Qd TR ep 8 1000 7 2000 6 3000 5 4000 4 5000 3 6000 2 7000

( )

( )Ep

PPPP

QQQQ

PQ DD

DD

D =×

+−

×+

−

=∆

∆

1002

1

1002

%%

21

2

21

12

11

1 8000 a. Complete the total revenue and price elasticity of demand columns. b. What is the price range wherein demand is elastic? wherein demand is inelastic? c. At which point should the company stop decreasing the price, because revenue, anyway, is

decreasing? Relate this to the elasticity values computed for. What can you conclude regarding the relationship of elasticity and total revenue and pricing policies?

5. When an item was priced at P3.00, demand for it was 11500 units. Upon raising prices by

P0.30, demand fell by 1500. Given only the elasticity, will total revenue increase or decrease due to the price increase. No need to solve for the revenue.

6.

Given the graphs, solve for the elasticity of each and determine the relationship between the slope of a demand curve and elasticity. 7. Given the demand function Px = 500 – 20Qd, with Qd = 10, determine whether demand is

price elastic or not. Answers

1. Ep = 0.82 inelastic 2. Ep = 0.06 inelastic; Ep = 13.67 elastic 3. Ep = 0.31 inelastic; Ep = 1.00 unit elastic 4.

P Qd TR ep 8 1000 8000 7 2000 14000 5.00 6 3000 18000 2.60 5 4000 20000 1.57 4 5000 20000 1.00 3 6000 18000 0.63 2 7000 14000 0.38 1 8000 80000 0.20

5. Ep = 1.4 elastic; lose total revenue 6. a. Ep = 0.00 perfectly inelastic

b. Ep = 0.43 inelastic c. Ep = 1.00 unit elastic d. Ep = 3.00 elastic e. Ep = ∞ perfectly elastic

7. Ep = 1.5 elastic 2. Price elasticity of supply

Price elasticity of supply measures how much the quantity supplied responds to a change in price. It is the ratio of the percentage change in quantity supplied to the percentage change in price. We may know that a decrease in the price results to quantity supplied of that good to fall, and vice versa, but elasticity allows us to know just how great the response will be. Most often, the degree and rate of response of supply is determined by how easy it is to produce the good. Manufactured goods can have

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greater elasticity since more can be made and sold when prices increase. House and lots are not as easily and quickly made available, hence, supply of them is more likely to be less elastic. Elasticity values may range from perfectly inelastic to perfectly elastic. The greater the elasticity, the more responsive is supply to price. Key Concepts Price elasticity of supply

Perfectly inelastic: Ep = 0 Inelastic: Ep < 0 Unit elastic: Ep = 1 Elastic: Ep > 1 Perfectly elastic: Ep ∞ 0 Key Formulas

Exercises Problem Solving

1.Per cd P Qs

200 1200 300 1500 400 2000 500 3000

Compute for the price elasticity of supply as price falls from P400 to P300.

2. Suppose that the price of salt rises from $0.17 per pound causing supply to increase from 525 pounds to 600 pounds per month. Compute for the price elasticity of supply. Is it price elastic or otherwise?

3. Tea per ounce

P Qd ep 5 200 10 400 15 650 20 950 20 1300

Compute for the elasticity for each price change in the supply schedule for tea.

4. A producer will sell 22 units of a product at P6.00 a piece and only 18 units when price falls to P4.00 a piece. Is the supply of the good price elastic or inelastic?

5. Coffee per cup

P Qd 70 350 90 490

( )

( )Ep

PPPP

QQQQ

PQ SS

SS

S =×

+−

×+

−

=∆

∆

1002

1

1002

%%

21

2

21

12

13

Solve for the price elasticity of supply as price rises from P70 to P90. Answers

1. Ep = 0.9 inelastic 2. Ep = 1.07 elastic 3.

P Qd ep 5 200 10 400 1.00 15 650 1.19 20 950 1.31 20 1300 1.40

4. Ep = 0.5 inelastic 5. Ep = 1.33 elastic

3. Cross-price elasticity Goods, especially substitutes and complements, are related to each other. A change in the price of one affects the demand for the other, depending on what kind of goods they are. If we want to measure the sensitivity of quantity demanded for a certain good in response to a change in the price of another good, we simply compute for the cross-price elasticity.

When two goods complement each other, such as cars and gasoline, the cross-price elasticity of demand between each good is negative. As the price of one increases, quantity demanded for the other decreases since both of them go together. For instance, the price of gasoline increased, quantity demanded for cars will decrease because the cost of fuel in expensive. Buyers of cars will think twice if they are willing to meet the increase in the price of gasoline.

Goods that are substitutes, on the other hand, have positive cross-price elasticity of demand.

There are a number of goods that have substitutes here in the Philippines. For instance, Nestea Iced Tea and Lipton iced tea. Both have the same taste and could be substitutes. In other words, homogeneous products with different kinds of brands are usually substitutes. Demand for one good is positively affected when the price of its substitute increases or decreases. Key Concepts

cross-price elasticity complements substitutes Ec > 0 goods are substitutes Ec < 0 goods are complements Ec = 0 goods are independent of each other

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Key Formula

where: Q = quantity P = price Exercises: Problem Solving 1. A certain market sells only two goods, shampoo and soap. Compute for the cross-price elasticity

demand given the data below:

POINT PSoap Qd Shampoo (per 250 ml) 1 2

P 15.00 16.50

20 18

2. Potatoes are relatively expensive than cassava. That is why cassava is sometimes substituted for

potatoes. If the price of potatoes decreased from P 45/kilo to P 43/kilo and demand for cassava decreased from 60 kilos to 57 kilos, what is the cross-price elasticity of demand for cassava?

3. How responsive is the demand for McDonald’s cheeseburgers if Jollibee has a promo of buy 1 take 1

cheeseburgers? Below is the table to help you answer the question.

PJollibee CB QdMcdonalds CB P 15.00 P 7.50

760 CB/day 350 CB/day

4. A consultant was hired to do an industry analysis, particularly on the goods sold by Popular Grocery Store and BILBO’s Supermarket. Both stores offer a variety of products and both dominate the market. The consultant found out that the price of Surefresh Milk in Bilbo’s Supermarket increased from P 50 to P 56.50/250 g while demand for the same good at Popular Grocery increased from 150 units to 225 units. He now wants to determine the sensitivity of demand for Surefresh Milk at Popular Grocery with the increase in price of the same good at BILBO’s Supermarket.

5. As a mom of 3 children, Mrs. Dela Rosa is tasked of making sure that her family stays healthy. Most

of the time, she makes the snacks of her children when they go to school instead of giving them money to be assured that they are eating the right food. Given the data below, compute for the cross-price elasticity of cheese.

PBread Qd Cheese (month)

P 19.50 22.75

12 10

( )

( )C

AA

AA

DD

DD

A

D E

PPPP

QQQQ

PQ

BB

BB

B =×

+−

×+

−

=∆

∆

1002

1002

%

%

21

12

21

22

15

6. Tell which combination of goods are complementary and which are substitutes. Explain why.

Ec of coffee and sugar -0.92 pork and beef 1.34 pencil and eraser -0.89 camera and film -1.96 Colgate and Close-up 2.55 Surf and Tide 1.57 thread and cloth -0.56 shoes and socks -1.55 gravy and ketchup 2.34 SIM card and cellphone -1.02

True or False 1. Puto and dinuguan will most likely have negative cross-price elasticity because they are substitutes. 2. Complementary goods are goods that go together. 3. If the price of one good increases, the demand for its substitute will increase also. 4. Shampoo and conditioner go together that is why as the price of one increases, demand for the other

also increases. 5. People will shift to AXION dishwashing liquid when the price of JOY dishwashing liquid is

discounted. 6. When two goods have a positive cross-price elasticity, they are substitutes. 7. Margarine could be substituted for butter. 8. The price of gasoline increased, it follows that demand for cars decreases. 9. Anton will stop using AXE deodorant when the price of Rexona decreases by 50 %. 10. Farmers will still buy the same amount of fertilizers when the price of seedlings increase. ANSWERS: Problem Solving 1. –1.11 goods are complements 2. 1.13 substitutes 3. 1.11 substitutes 4. 3.28 substitues 5. –1.18 complements True or False 1. False 6. True 2. True 7. True 3. True 8. True 4. False 9. True 5. false 10. False 4. Income Elasticity of Demand Nominal income, that is actual income or income at current market prices, affects the demand for goods and services. If people have lesser income, the goods that they purchase are lower in prices. However, once their income increases, they are now capable of purchasing goods that have higher quality and are relatively expensive. Goods for which income elasticity is positive are normal goods and luxury goods. They are goods that as income increases, demand for them also increases. Normal goods can be classified as luxury goods or necessity goods. A good is a luxury good if the computed income elasticity is a value grater than 1. But if it is less than 1, it is a necessity. On the contrary, inferior goods are goods that have negative income elasticity since the increase in income leads to a decrease in the purchase of this good.

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A family of six earns a gross annual income of P 100,000.00. After five years, the father gets a promotion and his income increases by 75%. The usual things that they buy such as fish and other locally produced goods are now replaced by imported goods since they could already afford this. The goods that they bought before when the family was earning a small amount of income are called inferior goods. The normal goods and luxury goods, on the other hand, are those goods that the family purchased after the increase in the income. The income elasticity of demand measures the responsiveness of a demand for a certain good that is brought about by a change in income and is represented by the formula below. Key Concepts Income elasticity EI > 0 normal good EI < 0 inferior good

EI > 1 luxury good

EI < 1 necessity good

EI = 1 normal good Key Formula

where: Q = quantity Y = income

Exercises:

1. Below is a table showing Bernardo’s allowance and the number of goods he consumes. Compute for the income elasticity of the demand for the following goods and identify each of the goods.

Monthly Allowance Burger CDs Movies Turon

P 2,000 3,000

2 4

4 6

6 6

8 6

2. Jonan’s monthly allowance when he was in high school was P 1,500. Now that he is in college, his

allowance increased by P 500.

a. He used to buy an average of 10 banana q’s monthly but because of his new allowance, his demand for the good decreased by 4. What is the income elasticity for the good and what kind of good is it?

b. With his allowance now, Jonan is able to buy things that he wanted but could not buy before because of his limited allowance. Before he used to eat at Kenny Rogers once a week, now he could afford to eat there three times a week. Compute for the income elasticity of demand for Kenny Rogers. Describe the kind of good he is consuming.

3. Mr. Pascual was promoted and his salary increased by 25 %. Before he was promoted, he was earning

a gross monthly income of P 45,000. Below is a table showing the demand behavior of his family

( )

( )I

D E

YYYY

QQQQ

YQ

=×

+−

×+

−

=∆

∆

1002

1002

%%

21

12

21

12

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based on his income before and after his promotion (on a monthly basis). Compute for the income elasticity of both chicken and tilapia.

Month Chicken (kilos) Tilapia (kilos)

1 2

18 20

10 5

4. Does Sheila have an inferior good among the goods below? Given that her monthly income increased

from P 10,000 to 12,000.

Monthly Income Fishball Kikiam Squidballs P 10,000 12,000

20 18

18 18

15 20

5. Based on question #4, what kind of goods are kikiam and squidball for Sheila? True or False 1. Your demand for goods will decrease as your income decreases. 2. Norman’s allowance increased this school year. His demand for McDonald’s decreases thus McDo for

him is a normal good. 3. People will demand less of tuyo when their income increases. 4. A good with a negative income elasticity is an inferior good. 5. Imported chocolates, which are usually expensive compared to local chocolates, are a luxury for those

whose income is not that high. 6. Cheaper goods are demanded more as income increases. 7. Good such as jewelry, sports car, and designer clothes are examples of normal goods. 8. Pedro will demand more fishballs when his allowance increases. 9. A positive income elasticity tells us that a certain good is a normal good. 10. High quality and expensive goods are goods which have a negative income elasticity most of the time. Identification 1. Measures the responsiveness of one good to another. 2. Substitutes such as Papa ketchup and UCF ketchup have a __________ cross-price elasticity. 3. Goods that go together are 4. The sensitivity of a variable to changes in income. 5. Items that as income increases, demand for it decreases. 6. A kind of good that can be an alternative for another good. 7. Responsiveness of people to quantity demanded when there are changes in prices. 8. What kind of good has an increase in its demand when income increases? 9. As income increases, plans of buying a second hand car_______________. 10. Inferior goods that have _____________ income elasticity will be demanded less as salary increases. ANSWERS: Problem Solving 1. Burger = 1.67; CDs = 1; Movies = 0 ; Turon = -.71 2. a. –1.75 inferior good

c. 3.5 luxury good 3. chicken = .47 necessity good

fish = -3 inferior good 4. fishball = -.58 inferior good

kikiam = 5.5 luxury good squidballs = 1.57 luxury good

5. kikiam and squidballs are normal goods specifically luxury goods

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True or False 1. True 6. False 2. False 7. False 3. True 8. False 4. True 9. True 5. True 10. False Identification 1. Elasticity 6. Substitute goods 2. Positive 7. Cross-price elasticity 3. Complements 8. Normal or luxury good 4. Income elasticity 9. decreases 5. Inferior goods 10. Negative

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MARKET STRUCTURES PERFECT COMPETITION

Characteristics

A perfectly competitive market is characterized by many firms that produce or sell homogeneous products or goods that are perfect substitutes. Since there are many firms in the market, no one can dictate the price. One firm is too small to affect the price. If it increases its price, the consumers will react by shifting to another good or product since there are many substitutes in the market. The demand curve, thus, for a perfectly competitive market is perfectly elastic or is horizontal. The price is the same regardless of how many firms enter or exit the market or how much quantity is supplied. If you are wondering who sets the price, it is the dynamics of supply and demand.

Another characteristic of this kind of market is that there is free entry and exit of firms at least in

the long run where all inputs are variable. Information is shared between the consumer and supplier. The producers know how much is the demand of the consumers for a certain good and the consumers also are informed of the amount of supply in the market. However, this does not happen in the real world. Consumers will never have perfect information as to what is the exact supply of let us say rice because the suppliers themselves will not give away information that will be to their disadvantage. Profit maximization

The profit maximizing condition under a perfect competition market is MR=MC. Where MR is the marginal revenue, the change in total revenue brought about by a change in output; and MC is the marginal cost, the change in total cost brought about by a change in output. Since the price (P) is also the MR, we could say that the profit maximizing condition is P = MC.

Break-even & Shut-down Points A firm is breaking-even or is earning enough profits to cover all its expenses when the average

total cost (total cost in producing 1 unit of good), marginal cost and marginal revenue are equal. The break-even price is simply the marginal revenue. This break-even point is usually encountered during the first few months or years of operation. Once the firm has overcome the stage of break-even, that is the time when it earns positive profits. However, when the average total cost exceeds the profit maximization point (MR=MC), it is better for the firm to shut-down than to operate at a loss.

Here is an example to understand more the concepts of break-even and shut-down: Aling Nena

spends PhP 4.00 for every banana-Q (average total cost) she sells. For each day, she is able to sell 30 pieces. An additional banana-Q costs PhP 4.00 in production and at the same time this is also the additional revenue that she receives if she is able to sell 31 banana-Qs. Aling Nena is breaking-even in her business because the amount she spent in making each banana-Q is PhP 4.00. Her profit is just enough to cover her expenses. However, if she spends more than PhP 4.00 and still earns the same revenue, she will have to stop selling banana-Q and maybe think of another business. Exercises 1. A firm is supposed to shut-down if

a. ATC is below the profit maximization point (MR=MC) b. ATC is above MR = MC c. ATC = MR = MC d. None of the above

2. A restaurant is breaking-even if the following condition is satisfied:

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a. ATC = MR = MC b. ATC > MR = MC c. ATC < MR = MC d. None of the above

3. Profit maximizing level in a perfectly competitive market is achieved when

a. marginal revenue = marginal cost b. MR > MC c. MR < MC d. ATC = MR

4. Given the graph below, determine the area of profit for the firm P

MC P* MR=AR=P C ATC F AVC Q* Q

a. FCBE c. P*ABC b. FP*AE d. none of the above

5. Based on the graph in #4, at what point will the firm produce to maximize its profits?

a. Q1 c. P* b. P1 d. Q*

6. Suppose you are the manager of a sign pen-making firm operating in the competitive market. Your

cost of production is : TC = 100 + Q2. If the price of each sign pen is P60.00, how many sign pens should you produce to maximize profits? Given: MC = 2Q

7. How many quantities of rubber slippers should a factory produce per hour given the following: MC =

5Q; MR = 100 Answers 1. b 2. a 3. a 4. c 5. d MONOPOLY A market with a sole producer/supplier of a good or service is called a Monopoly. Since it is the only supplier in the market, it dictates the price. The price is set above the marginal cost (MC) and marginal revenue (MR). This reduces the consumer’s welfare because there is a decrease in the consumer surplus. The demand curve faced by a monopolist is downward sloping and this is also its supply curve since it is the only firm/industry to meet the demand in the market. Entry and exit of other firms are difficult because of the barriers to entry. One hindrance is high sunk cost. Sunk cost is defined as cost that cannot be recovered if ever the firm decides to shut-down and

A

B

E

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exit the market. For instance, a firm that usually advertises their products spends a lot of money for it. Not only in advertising but in the research and development of its products as well.

Second, once a firm gets control over a scare resource, it will be difficult, even impossible, for other firms to penetrate the market. A good example is National Power Corporation (NAPOCOR), the Philippines’ power industry. NAPOCOR generates it own electricity, transmits it and distributes it to Meralco. Moreover, high amount of capital is an obstacle for other firms to enter the market. Usually, firms that provide basic necessities such as water and electricity are those that require a huge amount of money to start and finance it. It is also hard for other firms to penetrate the market especially if the existing one has the license or patent to produce a certain good. Like the perfect competition market, profits are maximized when MR = MC. Since it is the sole producer or supplier of a good or service, it can control the price. However, it does not necessarily earn profits if the price is below average cost. The reason behind this is that the monopolist is still limited by the demand curve in the amount that can be sold at each price. Once MR is equal to MC, the monopolist now knows how much it will sell & at what price in order for it to maximize profits. Once it knows the profit maximizing output, it will charge a price higher than MR=MC until the point where demand in the market is met (not sure).

A monopolist, on the other hand, could add to its profits by charging various buyers different

prices or what is called price discrimination. There are three points to remember about price discrimination: (1) a monopolist can use price discrimination only when there is some way of identifying and separating segments of its market; (2) if price differentials arise because of differences in cost, there is no discrimination; and (3) in some situations price discrimination may have more desirable results for the public interest than would a single monopoly price (Lipsey and Steiner, 1981). Communication and electric utilities frequently separate their market by end users. The industrial or commercial users are charged higher rates compared to ordinary home users. This is evident in industries such as MERALCO and PLDT. Exercises 1. Answer the succeeding questions using the graph of a monopolist below. P MC P* C AC P1 D MR Q

Q* a. Area which shows the profit of this market

1. CBYP1 3. P*AYP1 2. P*ABC 4. P*AEC

b. Price that the firm charges in order for profits to be maximized. c. Area which indicates loss in consumer surplus.

2. Jollibee hypothetically faces the following total revenue curve:

TR = 100Q – 0.01Q2

A E B Y

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where Q is weekly production and P is price, measured in pesos per unit. The firm’s total cost function is given by: TC = 5Q + 30,000. Another factor to be taken into consideration is that it maximizes profits. Compute for the following: a. level of output that will maximize profits b. price that it should charge to maximize profits c. total profit per week

3. A monopolist has the following characteristics except:

a. the seller is a price-maker b. profit is maximized where MR = MC c. the seller’s MR is lower than P d. freedom of entry into the market

4. The reason why the National Power Corporation (NAPOCOR) can manipulate the price is because

a. it is the country’s sole power firm b. it generates, transmits and distributes electricity c. other firms could not penetrate the market due to barriers to entry d. all of the above

5. With the ratification of the Power Reform Bill which aims to privatize NAPOCOR by selling most of

its generating plants to various privatized generating companies, which of the following is not true? a. competition will be encouraged b. there will be more than one electric company in the Philippines c. there will still be one distributor of electricity, MERALCO d. foreign investors will be enticed to invest in the country

Answers 1. a. 2

b. P* c. 3

3. d 4. d 5. c

MONOPOLISTIC COMPETITION Products or goods and services under a monopolistic competition market are homogeneous but are differentiated. What makes these products different or unique from each other? One is through physical appearance and this includes taste, color, shape, size, etc. Some goods are actually the same, they only differ in color and even packaging. Advertising could also help a lot in giving the product an identity of its own. All products advertised have their own slogan that speak for itself. Most of the time, people are enticed to buy a certain good because of the eye-catching ad. In addition, the service offered to consumers varies among firms. Let us take for instance the business of food. There are food chains that have their own kind of gimmick to draw consumers. Examples are Jollibee, McDonalds, Burger King. Another example is toothpast. Close-up, Colgate, Aquafresh, and the others have a common ingredient sodium monofluorophosphate. They are all actually the same, the only difference is in the packaging, slogan, color. Because of product differentiation, firms gain control over the price (Pindyck & Rubinfeld, 1995). Most firms win the trust of the consumers thus brand loyalty exists in this kind of market. Leading brands in the monopolistic competition market share the following characteristics:

��easy to remember ��reasonably priced ��of high quality ��of good appearance

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��durable ��comfortable and convenient to use ��fashionable ��healthy ��backed by guarantees and return privileges ��accompanied by regular sales promotions gimmicks

The demand curve of a monopolistic competition market is less elastic than that of a perfectly competitive market but is more elastic than that of a monopolist. The reason behind this is because the products are close substitutes. Unlike in a monopolistic kind of market where there is only one product being supplied in the market since there is only one sole producer. Goods in a perfectly competitive market, on the other hand, are perfect substitutes. Exercises: 1. Goods under a monopolistic competition market enjoy brand loyalty because of:

a. product differentiation b. barriers to entry c. economies of scale d. price control

2. The following are characteristics of a monopolistic competitive market excluding:

a. branding, labelling, packaging, shaping, etc. in physically characteristics are practised b. sellers enjoy a certain degree of market control c. goods are perfect substitutes d. consumers enjoy a variety of goods

3. Jollibee and McDonalds’ have gained popularity over the years. The following are some of the

gimmicks that they did to attract consumers aside from: a. advertise their products with TV personalities b. promotions such as buy one take one c. direct d. varied flavors of ice cream

4. The difference between a monopolistic competitive market & a perfectly competitive market is

a. demand curve of MC is less elastic b. demand curve of MC is more elastic c. demand curve of PC is less elastic d. none of the above

5. Which of the following products found in the Philippine market belong to a monopolistic competition

market? a. Meralco b. Zest soap c. SHELL Philippines d. Tomatoes

6. The main difference between the characteristics of a monopolistic competitive market & a perfectly

competitive market is that the former a. does not try to maximize profits b. charge a higher price c. faces an inelastic demand d. sell similar but not identical products

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Answers 1. a 2. c 3. c 4. a 5. b 6. a OLIGOPOLY If there are only a few large but dominant firms whose products are homogeneous or differentiated, this market is called an oligopoly. The behavior of each firm is interdependent on others. A firm will base its decisions on the actions of other firms in the market. The rationale behind this is so that they would not lose in the market. For instance, if a firm decreases its price, naturally the demand for that product will increase (law of demand). Consumers will choose the product that has the lowest price, thus the profit for that firm increases. In order for other firms not to lose in the market, when a firm decreases its price, others will follow to avoid losing consumers and profits. There are some firms that get together and collude to form a cartel in order for the profits to be shared among them. They charge almost the same price and restrict output. One good example is the OPEC or Organization of Petroleum Exporting Countries. Instead of competing with each other, merging is more advantageous because it assure member firms that they earn profit. Aside from the Collusion model, there is also the Cournot model wherein there are only two firms in an industry (Case & Fair, 1999). An industry with only two firms producing the same good is called a duopoly. A firm assumes the output of the other firm and bases its own output decision on it. They actually take the output of the other as given (Case & Fair, 1999). Like any other firm, they maximize profits as much as possible (expound more on this). Exercises: 1. Identify which of the following are characteristics of an oligopoly.

a. several firms but they are dominant b. decisions are not based on other firm’s actions c. consumers are most likely to benefit from this kind of market d. easy entry into the market e. some firms collude to restrict output and charge high prices f. profit maximization is MR = MC g. firms are usually large h. goods in this kind of market are substitutes

2. In an oligopolistic market, joint profit maximization by setting prices through implicit agreement is

a. more likely the less similar the products b. more likely the fewer the number of firms c. more likely when prices are falling than when they are increasing d. always illegal under the antitrust laws

3. It is possible in an oligopolistic industry to earn profits in the long run primarily because

a. firms can always set the profit-maximization price and output b. oligopolistic firms use the most efficient production methods c. prices are quite rigid d. entry of new firms is difficult

4. A firm faces a kinked demand curve under what condition?

a. a rise but not a decrease in price

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b. a fall but not an increase in price c. both a rise and a fall in price d. neither a rise nor a fall in price

5. What is most likely to happen when the output of oil is restricted by the Organization of Petroleum

Exporting Countries (OPEC)? a. supply decreases and price increases b. supply increases and price decreases c. demand decreases and price decreases d. demand increases and price increases

6. An oligopoly model wherein an industry has only two firms producing the same good. The firm

assumes the output of the other and bases its own output decision on it. a. collusion model c. cournot model b. cartel model d. kinked model

Answers 1. a, e,f, g,h 2. b 3. d 4. b 5. a 6. c Market Structures Identification 1. Identify what market structure each good belongs to.

a. Honda Civic car b. Velocity Shell c. Nescafe d. SMART e. Comfort fabric conditioner f. PLDT during the 1980’s g. Onions h. PAGCOR i. Cigarettes j. Touch of Beauty salon

Match column A with column B

A B 1. profit maximizing condition 2. an imperfect market structure characterized by

product differentiation 3. products are homogeneous and are perfect

substitutes 4. one and only producer of a certain

good/commodity 5. Shell, Caltex, and Petron 6. A firm is earning just enough to cover all costs 7. Incremental change in revenue when the

number of goods produced increase 8. Goal of all firms 9. Charging various customers with different

a. monopoly b. break-even point c. marginal revenue d. monopolistic competition e. total revenue f. profit maximization g. MR = MC h. Price discrimination i. Oligopoly j. Perfect competition k. Sunk cost l. Fixed cost m. Shut-down point

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prices 10. This cannot be recovered anymore once it has

been spent

n. Marginal cost

True or False 1. A firm in a perfectly competitive market will shut-down when it is only earning enough to cover all

expenses. 2. A monopoly industry has only one buyer but many sellers. 3. The demand curve of a firm in a perfectly competitive market is horizontal. 4. Product differentiation occurs when a certain firm has a unique product that cannot be found in any

other company. 5. Interdependence among firms is usually prevalent in an oligopolistic market. 6. Filipino consumers will have more choices if the market is perfectly competitive. 7. Goods in the monopolistic competition market are not perfect substitutes. 8. Prices are likely to decrease when firms merge and decide to control output. 9. Most of the goods in the country could be classified under an oligopolistic market. 10. Information is always symmetric especially in the market. Answers: Identification 1. Oligopoly 6. monopoly 2. Oligopoly 7. Perfect competition 3. monopolistic competition 8. monopoly 4. monopolistic competition 9. monopolistic competition 5. monopolistic competition 10. Perfect competition Matching type 1. g 2. d 3. j 4. a 5. i 6. b 7. c 8. f 9. h 10. k True of False 1. F 2. F 3. T 4. F 5. T 6. T 7. T 8. F 9. F 10. F