18112010 Impt Econs Diagrams

1

Diagrams• Diagrams are

an excellent

way to show

analytical skills

• To secure L2

marks,

diagrams are

expected, what

more for L3

marks

• Please explain your

diagrams

• Caution: Do not just

draw conclusions

from your diagrams

but explain how you

arrive at those

conclusions

• Caution: Diagrams

not explained will

not be given credit at

the A levels

• Diagrams must be

completely labelled

and contextualised

• If more than one

market is involved,

like market for

apples and market

for oranges, please

label on the

diagram which

market you are

analysing explicitly

and clearly

• Accuracy in

illustration expected

Microeconomic diagrams

Industry’s level of analysis

Price mechanismAn Example: Corn Industry under perfect competition

Price

Quantity

SS

DD

P

Q4 12

Figure 1: Market for Corn

A

E

B

20

10

5

0

Qd = Qs

• Price adjustment process

– Explain how shortages and surpluses

are eliminated via the price

mechanism

– Explain what shifts the demand

curve (TIPSEY) and what shifts the

supply curve (ecoping)

– Explain how shifts in demand curve

and supply curve will lead to

changes in equilibrium price and

equilibrium quantity

– Note: For simplicity, increase in

demand is reflected by a rightward

shift of the demand curve while

increase in quantity demanded is

reflected by a movement along the

demand curve

• Inflationary gap

• MLC

• J-curve

Demand-supply analysis

• Analyse shifts in

demand curve or

supply curve first

• After analysing the

change in the position

of demand or supply

curve, then provide

refinement if needed

� elasticity of

demand or supply

concepts

2

• Price Elasticity of demand measures the extent of MOVEMENT along the demand curve!!

Important Note:

Price

Qty0

P1

Q1

DP0

Q0

Price

Qty0D

Q1Q0

Price-elastic demand and TR Fig 2(a)

price

0 quantity

DP1

Q1

P0

Q0

When P falls to

P1, Qd increases more than

proportionately, and in turn TR rises.

S0S1

Price-inelastic demand & TR Fig 2(b)

price

0 quantity

D

P1

Q1

When P falls to P1,

Qd increases less than proportionately and in turn, TR falls.

P0

Q0

S0S1

When demand curve shifts to the right

from D1 to D2, the extent of increase

in price depends on the price elasticity

of supply. The more inelastic the

supply curve (S1 is more inelastic in

supply compared to S2), the greater

the extent of increase in price (from

R0 to R1 for S1 as compared to R0 to

R2 for S2.)

When demand curve shifts to

the right, the extent of

increase in quantity supplied

depends on the price elasticity

of supply. The more inelastic

the supply curve (S1 is more

inelastic in supply compared

to S2), the smaller the extent

of increase in quantity

supplied (from Q0 to Q1 for

S1 as compared to Q0 to Q2

for S2.)

PES is relevant when the

demand curve shifts

PED is relevant when the supply curve shifts Income elasticity of demand

• The sign of income

elasticity of demand will

affect the direction of shift

in demand curve – e.g. For

normal goods, the YED is

positive, then when

income increases, the

demand for the good shifts

to the right. For inferior

goods, YED is negative

(elaborate)

• The value of income

elasticity of demand will

affect the extent of shift in

demand curve – e.g. For

necessities or non-luxury,

the YED is positive and

less than one, this means

that when income

increases, the shift to the

right in demand curve is

less than proportionate to

the increase in income.

Elaborate on the value for

non-necessities and

luxuries (YED>1)

3

Cross elasticity of demand

• The sign of cross elasticity

of demand will affect the

direction of shift in

demand curve – e.g. For

substitutes, the CED for

coke with respect to the

price of pepsi is positive,

then when the price of

pepsi increases, the

demand curve for coke

shifts to the right. For

complements, CED is

negative (elaborate)

• The value of cross elasticity

of demand reflects for

instance, the degree of

substitutability between the

two goods and hence the

extent of shift in demand

curve. The higher the value of

positive CED, the more

substitutable the two goods

are, hence the greater the shift

in the demand curve for coke

when the price of pepsi

increases. Elaborate on the

value for goods with negative

CED

Tax incidence

•Do you know

that the incidence

of taxes depend

on the relative

price elasticity of

demand and price

elasticity of

supply?

Subsidy to producers•Before subsidy:

Original equilibrium

price without subsidy

is OP2 and


is OQ2

•After subisdy: New

price paid by

consumers after

subsidy is OP1 and


is OQ1. Price

received by producers

is OP1. Total subsidy

given by government

is P1P3 times OQ1

•What is the

incidence of subsidy?

Consumers’ and Producers’ Surplus with Price Controls

Equity vs Efficiency

Qe Quantity

of X

Price ($)

Pe

Ss

Dd

Pmin

Q1

A

BC

DE

O

Minimum Price •Original consumers’ surplus = •area (A + B + C).

•New consumers’ surplus = •area A.

⇒ Consumers experience a loss of area (B + C).

•Original producers’ surplus •= area (D+ E).

•New producers’ surplus •= area (B + D).

⇒ Producers experience a gain of area B but a loss of area E.

The total change in surplus = change in consumers’ surplus +

change in producers’ surplus= − (B + C) + (B − E)

= − (C + E).

Refer to pg 13

Consumers’ and Producers’ Surplus with Price Controls

Equity vs Efficiency

Maximum Price

Qe Quantity

of drugs

Price ($)

Pe

Ss

Dd

Pmax

Q1O

•Original consumers’ surplus •= area (A + B).

•New consumers’ surplus •= area (A + D).

⇒Change in consumers’ surplus = area (D − B).

* Consumers can experience a net loss or gain depending on the relative size

of area B and D.

•Original producers’ surplus •= area (C + D + E).

•New producers’ surplus •= area E.

⇒ Producers experience a loss of area (C + D).

The total change in surplus= change in consumers’ surplus

+ change in producers’ surplus= (D − B) + (− )( C+ D)

= − (B + C).

Pb

Refer to pg 13

Application to Labour Market : Wage Determination

Price of labour = Wage

Rate

Quantity of

Labour

0

SupplySupply

DemandDemand

We

Qe

4

• Why does the wage gap between high skilled and low skilled workers exist?

– Basics first:

• Explain the POSITION of the demand curve RELATIVE to the supply curve for each market

– Refinements:

• PED & PES for each market

WR

QLSL

WR

QHSL

0

Low skilled

labour e.g.

rubbish

collectors

High skilled labour

e.g. surgeons

0

W0

Q0

D

S

W1

Q1

D

S

0

PL

QL

PL

QL0

Market for high

skilled labourMarket for low

skilled labour

d1 d3

s1 s3

W1

• Why has the wage gap been widening in developed countries like Singapore?

– Basics:• Shifts in demand and supply curves for labour in each

market

– Refinements• Extent of shifts in demand/supply curves

s2

s4

d2

d4

W2

W3

W4

Application to interest rate determination:

Loanable Funds Theory

The equilibrium

interest rate is

determined by

the supply and

demand for

loanable funds

Application to interest rate determination:

Liquidity Preference Theory

The equilibrium

interest rate is

determined by

the supply and

demand for

money

M/Preal money

balances

rinterest

rate

Md

r1

M/P

How the Central Bank raises the interest rate

To increase r, the

central bank

reduces money

supply (money

supply is

assumed to be

determined by the

central bank)M/P

real money

balances

rinterest

rate

Md

r1

r2

M1/PM2/P

5

Cost curves Short-Run Cost

–Total fixed cost is the

same at each output

level.

–Total variable cost

increases as output

increases.

–Total cost, which is the

sum of TFC and TVC also

increases as output

increases.

Cost Curves and Their Shapes

Quantity of Output(bagels per hour)

Costs

$3.002.752.502.252.001.751.501.251.000.750.500.25

0 1 432 765 98 1413121110

ATC

AVC

AFC

Typical Cost Curves for a Firm

Quantity of Output

Costs

$3.002.752.502.252.001.751.501.251.000.750.500.25

0 1 432 765 98 1413121110

MC

ATC

AVC

U-Shaped Long-Run Average

Total Cost

Quantity of

Cars per Day

0

Average

Total

Cost

Internal Economiesof scale

Long run ATC

Internal Diseconomiesof scale

Constantreturns to

scale

Does the AC always rise as output increases?

• Yes in the short run (SRAC comprises of AFC and

AVC. AFC falls throughout as output increases but

AVC falls then rises due to law of diminishing returns

(LDMR explains why MC and AVC curve are U-

shaped). Elaborate

• However, in the long run, LRAC is subjected to internal

EOS and internal diseconomies of scale

– In some industries, where IEOS are extremely significant,

LRAC falls throughout the entire market demand but in

others, LRAC rises quickly as diseconomies of scale sets in

early relative to market demand. There are some industries

where the LRAC curve is saucer-shaped. Are you able to

provide examples of industries that exhibit the following

shapes of LRAC?

6

Minimum Efficient Scale (MES)

Minimum efficient scale (MES) is the smallest

level of output at which a firm can minimise

long run average costs.

MES can be important in determining the

structure of an industry, e.g. where the MES

is:

large relative to the size of the market, the industry

will tend to be more concentrated;

small relative to the size of the market, the industry

will tend to be more competitive.

External Economies of Scale

Quantity of

Cars per Day

0

Average

Total

Cost

LRAC2External

Economies of Scale

LRAC1

External Diseconomies of Scale

Quantity of

Cars per Day

0

Average

Total

Cost

LRAC1

External Diseconomies of

Scale

LRAC2

Firm’s level of analysis /

Market structures

fig

O

Pe

S

D

The PC Industry The PC Firm

$

OutputO

Perfect competition Total Revenue of a Firm in Perfect Competition

$ TR

O Q

D = AR = MR

$

OutputO

7

PC firm• Conditions for profit-maximisation

MR > MC MR > MC MC > MR

Profit-max

condition is

MC=MR and MC

curve cuts MR

from below

(rising MC)

fig

O

$

PC Firm

OutputO

PC Industry

P

Output

S

D

Pe

MC

AR

Qe

AC

AC

Short-run equilibrium of industry and firm in perfect

competition

Short-run equilibrium of industry and firm in perfect

competition

D = AR = MR

fig

O O

P P

Q

S1

D

LRAC

PL

P1

QL

Se

AR1 D1

ARL DL

Q

Long-run equilibrium in perfect competitionLong-run equilibrium in perfect competition

New firms enter dueto lack of entry barriers

Supernormal profitsIn the short run

Normal profits in the LR

Industry Firm

MC

Q1

LR Equilibrium• In the LR, the equilibrium for the PC firm

is at the output level where

• In the LR, the firm is operating at its minimum efficient scale at q*

pLRAC

LRMC

MR = AR

p*

q*

LRAC = LRMC = MR = AR

Firm in imperfect market structure

• Conditions for profit-maximisation: MC=MR

MR

> M

C MC

> M

R

Supernormal profit

$

Q O

MC

AC

Qm

AR

AC

AR

Monopoly making supernormal profits

MR

8

$

Q O

MC ( = supply in

perfect competition)

QM

MR

PM

PC

QC

Comparison of monopoly with perfect competition

D = AR

Deadweight Loss

$

Q O

MR

QM

PM

PC

QC

MC (S)perfect competition

MCmonopoly

AR = D

Comparison of PC and Monopoly with significant IEOSComparison of PC and Monopoly with significant IEOS

The less price elastic the demand ��

the greater the difference between

price and MC and hence, the

greater the allocative inefficiency

$ $

Quantity Quantity

AR

MR

MR

AR

MC MC

Q* Q*

P*

P*

P*-MC

The more elastic isdemand, the less the

markup.

Quantity

MR

q

B

D = AR � MRPPD

Quantity

MR

q**

BB

0

First degree or perfect price discrimination (PPD)

Price

P**

E

MC

qPPD

•Profit-max output

under PPD is qPPD

where MC=MRPPD;

•No single price as

price varies along the

demand curve;

•TR under PPD is

OECqPPD

•Under a single-

priced

monopolist,

profit-max

output is q**

and price is P**.

•TR is

OP**Bq**

Quantity

MR

q

ATC

A

B

D=MRPPD

Quantity

MR

**

ATC

AA

BB

0

Benefits of first degree or perfect price discrimination –

makes it possible to cover costs when the average cost of

production is higher than the average revenue from selling the

good at all units of output

C

Price

P**

E

MC

qPPD

F

G

Second Degree P.D.

7

AR = Dd

Price

Qty100 200 300

8

6

Additional revenue by the

monopoly = loss of

consumer surplus

MR

MC

9

fig

O O OMRX

MRY MRT

MC

D=ARY

5

7

1000 2000 3000

(a) Market X (b) Market Y (c) Total

(markets X + Y)

9

D=ARX

Profit-maximising output under

third degree price discrimination

$

Q O

AC

MR

AR ≡ D

Ps

Qs

MC

Short Run Equilibrium in Monopolistic Competition

$

Q O

LRAC

MRL

ARL ≡ DL

PL

QL

LRMC

Long Run Equilibrium in Monopolistic Competition

Normal Profits in the LR for MPC firm due to lack of barriers to entry

MPC LR Equilibrium

P

q

A

Price

Output

0.

AR2

MR2

MCATC

AR1

MR1

MC = MR

MC = MR

Normal Profits in the LR for MPC

firm due to lack of barriers to entry –Assume existing firm is making supernormal

profits initially. New firms will enter in the long run and existing firm’s demand will fall � AR and MR curves shift left from AR1 to AR2 and MR1 to MR2 � normal profits only in the LR

$

Q O

LRAC

MRL

ARL ≡ DL

PL

QL

LRMC

Long Run Equilibrium in Monopolistic Competition

QO

Excess

Capacity

$

QO

P1

Q1

MC2

MC1

MR

D = AR

E.g. As long as MC varies between MC1and MC2

but the profit maximising output

and price remain unaltered

Oligopoly- Kinked demand curve – firms have a

tendency to avoid price competition

10

Relationship between

PED and MR and total

revenue

Quantity

MR

q

B

D=AR

Quantity

MR

q**

BB

0

Profit-max output level vs revenue max output level

Price

P**

E

MC

Q1

•Total revenue

maximising

output level is

MR=0

•Total revenue

maximising

output level is at

Q1 and price at

P1

•Profit-max

output condition

is MC=MR and

MC is rising.

•Profit-max

output level is

q** and price is

P**.

P1

Basic Conditions

Consumer Demand Production

Elasticity, substitutes Technology,

Location, seasonality etc. Scale

economies etc.

Structure

Numbers of buyers and sellers, barriers to entry, product

differentiation, vertical integration, diversification

Conduct

Advertising, R&D, pricing behaviour, plant investment, legal

tactics, product choice, collusion, merger and contracts

Performance

Price, production efficiency, allocative efficiency, equity, quality,

technical progress, profits

Government Policy

Regulation, antitrust,

barriers to entry, taxes

and subsidies,

investment incentives,

employment incentives,

macroeconomic policies

Source: Carlton & Perloff (2004)

STRUCTURE, CONDUCT AND PERFORMANCE

Market failure

Market Failure & Efficiency

Efficiency Concepts: Allocative Efficiency

An Example: Corn Industry under perfect competition

• Society’s total benefits =

Area OAEQ

• Society’s total costs =

Area OBEQ

• Society’s Net benefit is

maximised = Area AEB

• Sum of CS and PS is

maximised.

• Socially Optimal Outcome

Price

Quantity

SS = MSC

DD = MSB

P

Q4 12

Figure 1: Market for Corn

A

E

B

20

10

5

P=MC, MSB = MSC

0

Page 8

Qd = Qs

A

E

E1

Quantity0

MPB = MSB

MPC

••••

Q

••••

R

MSC = MPC + MECCosts/Benefits

Welfare Loss

to Society

Market Failure

Sources of Market Failure: Negative

externalities ignored due to self-interest

motive

11

Methods by which governments

intervene…

Usage of cars

Price of using cars

MPC

MSC = MPC + MEC

P1

P2

Figure 2: External Cost and the use of Taxation

Qs Q1

P3

A

EC

BMPB = MSB

MPC curve will reflect

the marginal private cost

derived from using the

car. MPC includes cost of

petrol, maintenance cost

etc.

MSC curve will reflect

both MPC & MEC of

using the car.

MEC includes costs of

pollution, congestion etc.

imposed on third parties

arising from usage of cars

MPC1 (MPC+specific tax)D

Page 4

•After implementing quota

•The producer surplus is

area EDO

•This is because the

government receives

P2CDE in the form of

COE revenue from the

producer

2.3 Government Regulation & Legislation

Output Controls – Licensing & Quotas


intervene… Refer to pg 12

P

0

DD

COE/quota

P1

P2

Q1Q2

E

A

BC

D

Quantity of new cars

SS


intervene…Government Subsidies

to Consumers

Taxes and Subsidies

Government Subsidies to

Producers

Figure 5

S1 =

MPC

D1 =

MPBQ

P

Q

1

Q2

D2 = MSB

S2 = MPC

+ subsidy

H

G

FP2

P1

P3

Figure 4

MPC= MSC

MSB=MPB + MEB

= MPB + Direct Subsidy

MPB

Quantity

P

Q2Q10

C

BP2

P1

AP3

Page 7

65

B

A

Quantity of big macs

Price

0

Dd1/perfect

info

Ss

•

Z

Welfare Loss

to Society

Dd0/imperfect info

Y

•

Positive Externalities: Page 12 of lecture notes

C

Overconsumption of demerit goods due to lack of information and hence

resulting in underestimation of

personal costs and overestimation of

personal benefits (personal well-being

argument)

66

B

A

Quantity of health

screenings

Price

0

Dd0/imperfect

info

Ss

•

Y

Welfare Loss

to Society

Dd1/perfect info

Z

•

Positive Externalities: Page 12 of lecture notes

C

Underconsumption of merit goods due to lack of

information and hence

resulting in underestimation

of personal benefits (personal

well-being argument)

12

Market Failure

Sources of Market Failure:Imperfect

Competition

Page 18

2. Productive efficiency

pLRAC

LRMC

MR = AR

P1

Q1

Price taking firm achieves

Productive Efficiency in the long

run

This is because

P=AR=MR (price taker) &

MR=MC (profit-max at q1) &

Normal profits in LR only

� Output produced at MES

since perfectly elastic demand

curve tangent to lowest point on

LRAC curve

Market Failure

Sources of Market Failure: Imperfect

Competition

Page 18

2. Productive Inefficiency

MR

AR

Price

OutputMES Q2

LRAC

MC

This is because

P=AR>MR (price setter)

&

MR=MC (profit-max at

q2) &

Normal profits in LR

� Output produced is

less than that at MES

since downward sloping

demand curve tangent to

falling portion of LRAC

curve

Market Failure


Competition

Page 18

2. Productive Inefficiency

P

Q3

A

Price

Output

0

AR

MR

MCLRAC

MES

This is because

P=AR>MR (price setter) &

MR=MC (profit-max at Q3)

Supernormal profits in LR

� Output produced is less

than that at MES

Monopoly/Oligopoly

making supernormal profit

in the long run is

productively inefficient

Market Failure


Competition

Page 18

2. Productive efficiency

P

q

A

Price

Output

0

AR

MR

MCLRAC

MES

This is because

P=AR>MR (price setter) &

MR=MC (profit-max at q)

Supernormal profits in LR

� Output produced

coincides with output at

MES

2

1

Q1 Q

$

AC

AC + lump-sum tax

MC = MSC

O

a

b


intervene…

This will cause profits

to fall from Area 1+2

to Area 1 alone.

P1

AC

Area 2 represents the

amount of tax paid to

the government.

2.1.3 Taxes & Subsidies to correct for Monopoly Power :

Objective - To reduce excessive monopoly profit

Page 8


intervene…

Q

$MC =

MPC

AR = MSBMR

MC - subsidy

Q

2

P2

Q1

P1

Figure 7

To produce at society’s

optimal level of output,

the government can

impose a per-unit

subsidy which shifts

both MC and AC

downwards.

2.1.3 Taxes & Subsidies to correct for Monopoly Power : Objective - To regulate monopoly output

Page 9

13

2.3. Government Regulation & Legislation Monopoly


intervene…

2.3.2 Pricing Regulation (MC or AC Pricing)

Refer to pg 11

•Profit-maximising output

level is at Oqm and price

is at OPm where MC=MR

•Average cost pricing (AC

pricing) output level is at

Oqf and price is at Opf

(AR=AC)

•Marginal cost pricing

(MC pricing) output level

is at Oqs and price is at

Ops (AR=MC)

PPC

• Opportunity cost

• Attainable vs

unattainable production

• Productive efficiency

• Unemployment vs full

employment

•Do you know what are

the assumptions of the

PPC?

•Do you know how to use

the following concepts to

explain the PPC

•Opportunity cost

•Attainable vs

unattainable

production

•Productive efficiency

•Unemployment vs full

employment

Macroeconomic diagrams

Macroeconomic diagrams

14

Circular flow in a 4 sector economy

Use AD/AS model if the question

focuses on effects of the economy in

general and/or if the question focuses

on inflation

Use Y=AE model if the

question focuses on multiplier

and impact changes in

autonomous spending on NY

only

AD0

Y

0

P0

AS Increase in aggregate

demand leads to rightward

shifts of AD curve …

elaborate

General

AS3

Increase in cost of production leads to upward shift of AS curve …

elaborate

Potential growth as reflected by outward shift of vertical portion of AS

curve � increase in full employment level of national income

accompanied by fall in general price level from PL1 to PL’ � increase

in potential growth and dampening of inflation

• General price

level

Marginal efficiency of investment

•Effectiveness

of a fall in

interest rates on

increasing the

level of

investment

depends on the

interest

elasticity of

MEI

15

•Do you know

how to explain

the tariff

diagram?

•Do you know

the assumptions

behind the tariff

diagram?

Tariff diagram

•In the very short run,

when the Marshall-

Lerner’s condition is not

met (that is, when the sum

of PEDx and PEDm is less

than one), a depreciation of

the exchange rate will

worsen balance of trade

and hence current account

and in turn, BOP.

•In the longer run, when

the Marshall-Lerner’s

condition is met, that is,

when the sum of PEDx and

PEDm is greater than one,

the depreciation of the ER

will eventually improve

BOT and hence current

account and in turn,

Balance of payments.

Trade-off between higher

growth and higher inflation

General price level

Real National Income

AS

Yf

AD0

P0

Y0

AD 1

Y1

P1

Assuming that the economy

is operating at less than full employment, a shift in the

AD curve to AD1 as a result

of a change in any or all of the factors affecting AD

would increase RNY from

Y0 to Y1 accompanied by an increase in GPL from P0

to P1. Hence, actual growth

will be achieved and unemployment reduced but

at a cost of higher inflation

(a trade-off between macro objectives).

Using AD/AS model to

explain why RNY increases

when AD increases

General

price level

Real National Income

AS

Yf

AD0

P0

Y0

The increase in AD from AD0 to AD1 will cause a shortage at the initial GPL P0. The shortage will cause an upward

pressure on the GPL. Since each AS curve is drawn for a given cost of production (COP) and assuming no

change in COP, the increase in GPL will increase the profit margin for producers. Producers will then have the

incentive to step up on production. The increase in production will increase RNY from Y0 to Y1. This means that when

GPL increases, there be a movement along AS curve. There will also be a movement along AD1 curve when GPL

increases and this is in part due to income effect. When GPL increases �

real purchasing power of households

falls and ability to consume falls, hence the movement along AD1 curve as GPL increases. (Note the movement along AD is also due to international trade and interest rate effect but this is not required at H2.)

AD 1

Y1

P1

Be prepared

• Please be prepared for

cross-topical questions

• Please also be

prepared for questions

that combine both

microeconomic and

macroeconomic issues

All the best! ☺

18112010 Impt Econs Diagrams

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Transcript of 18112010 Impt Econs Diagrams