Week 3

Question 1

What is a normal good?

Answer 1

A good whose demand increases with an increase in consumers income

Question 2

What do we assume at market equilibrium

Answer 2

At market equilibrium, we assume ceteris paribus, i.e. prices in related markets (substitutes, complements and FOPs) are constant.

Question 3

Equilibrium

Answer 3

: a situation where demand and supply have been brought into balance.

Question 4

When does the equilibrium occur

Answer 4

In the competitive market, the equilibrium occurs at the price where Qd = Qs. This price clears the market such that no shortage nor surplus exists.

Question 5

Equilibrium price and quantity

Answer 5

The equilibrium price balances the quantity supplied and the quantity demanded.
The equilibrium quantity is the quantity supplied and the quantity demanded at the equilibrium price.

Question 6

Comparative statics

Answer 6

The equilibrium price and quantity depend on the position of the supply and demand curves. When some event shifts one of these curves, the equilibrium in the market changes, resulting in a new price and a new quantity exchanged between buyers and sellers. The analysis of such a change is called comparative statics because it involves comparing an old equilibrium and a new equilibrium.

Question 7

Comparative static analysis

Answer 7

This analysis is done in three steps:

1. Decide whether the event shifts the supply or demand curve (or perhaps both);
2. Decide in which direction the curve shifts;
3. Use the supply and demand diagram to see how the shift changes the equilibrium price and quantity.

Question 8

Changes in demand

Answer 8

A change (rise/fall) in demand means that at every price, there is now a different (greater/smaller) quantity demanded. If demand rises the demand curve shifts to the right.

Question 9

Factors that change demand

Answer 9

Price of substitutes in consumption

Price of compliments in consumption

Consumer income

Consumer tastes

Consumer expectations

Changes in population

Question 10

Changes in supply

Answer 10

A change (rise/fall) in supply means that at every price, there is now a different (greater/smaller) quantity supplied. If supply rises the curve shifts to the right

Question 11

Factors that change supply

Answer 11

Price of substitutes in production

Price of compliments in production

Taxes

FOP Prices

Technology

Firm entry/exit

Question 12

Comparative statics short summary

Answer 12

We examine the effect of a change in the prevailing conditions on the (initial) equilibrium in the market. We find the new equilibrium and compare it to the previous one.

Question 13

Pareto efficiency

Answer 13

A situation where resources cannot be re-allocated so as to make one person better off without making another worse off

Question 14

Welfare economics

Answer 14

Welfare economic is the study of how the allocation of resources affects the economic wellbeing of society. Suppose a social planner (e.g. the Government) wants to maximise the economic wellbeing of everyone in society. To do this effectively, the planner must first decide how to measure the economic wellbeing of a society.

Question 15

How we measure economic wellbeing?

Answer 15

Using the concepts of consumer surplus and producer surplus.

Question 16

Consumer surplus

Answer 16

The difference between consumers willingness to pay and the amount they actually pay. It is the consumers gains from trade i.e. the benefit of consumers from participating in the market.

Consumer surplus is the area between the demand curve and the price line

Consumer value - amount paid = consumer surplus

Question 17

Willingness to sell

Answer 17

the minimum price they are wiling to accept at every quantity supplied.

Question 18

Producer surplus

Answer 18

The difference between producers willingness to sell and the amount they actually receive. It is the producers gains from trade, i.e. the benefit of producers from participating in the market.

Producer surplus is the area between the supply curve and the price line

Amount received - producer cost = producer surplus

Question 19

Total surplus from trade

Answer 19

Measures the benefit of buyers and sellers from participating in the market, the total gains from trade. It is the sum of consumer and producer surplus.

Consumer surplus + producer surplus = total surplus

Conversely it is the value to buyers minus the cost to sellers

Consumer value - producer cost = total surplus

Question 20

The total benefit to society

Answer 20

The total benefit to society is the value of consuming the product minus the cost of producing it

Question 21

Total surplus from trade: how much should society produce?

Answer 21

Society should continue to produce more as long as the marginal consumer value is greater than the marginal cost of production

This will maximise total surplus and the gains from trade in the market

Question 22

Maximised total surplus

Answer 22

At equilibrium (pq), the value to the marginal consumer = the cost of the marginal producer. Total surplus is maximised.

Hence, the free market at equilibrium allocates resources efficiently:

Question 23

Hence, the free market at equilibrium allocates resources efficiently:

Answer 23

the supply of goods is allocated to the buyers who value them most highly;

the demand for goods is allocated to the sellers who can produce them at lowest cost;

the quantity of goods that is produced maximises the sum of consumer and producer surplus.

Question 24

When does/should Government intervene in the market?

Answer 24

At equilibrium, the market outcome is efficient; total surplus is maximised. Policy makers/Government cannot improve on it.

However, as we will see:

Intervention by Government may be desirable if the efficient outcome is considered inequitable;

Or if Government wishes to disregard consumer preferences;

Sometimes, a market failure happens – where the market does not achieve efficient an outcome – in such cases,
intervention is warranted.

Question 25

Analyse the following events diagrammatically and assess their economic impact on the markets likely to be affected.

Answer 25

Which curve will move?

Right or left?

What will the new equilibrium price be?

What will the new equilibrium quantity be?