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Syl l abus Gui de Det ai l ed Out c omes
Having studied this chapter you will be able to:
- Understand the concept of supply and demand.
- Understand the factors that affect supply and demand such as price, substitutes and
complements.
- Have an awareness of the different types of markets a company can operate in.
Ex am Cont ex t
Micro-economics is new to the FAB syllabus and whilst there was just the 1 question based on this area in the pilot
paper it should be expected to feature prominently in the CBE.
Busi ness Cont ex t
It is important for businesses to understand the demand for a product in the market which will provide a guide as to the
acceptable price of their products and the reaction of the demand based on changes in the environment, including
competitors, trends and demand for similar products. This helps dictate how much the business is willing to supply and
at what price
Mi c r o-ec onomi c f ac t or s
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Micro-economics
Markets Supply Demand
Influences
Equilibrium
Price Elasticity of
Demand
Cross Elasticity of
Demand
Income Elasticity
of Demand
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1 Mar k et
1.1 A Market can be defined as a situation in which potential buyers and potential suppliers of a
good or service come together for the purpose of exchange
1.2 There are three types of market that we need to be aware of for this syllabus and these are
- Perfect competitive
- Imperfect
- Monopolistic
1.3 Perfect Competition
Perfect competition is characterised by:
- Many small (in value) buyers and sellers which, individually, cannot influence the
market price
- No barriers to entry or exit, so businesses are free to enter or leave the market as
they wish
- Perfect informationsuch that production methods and cost structures are identical
- Homogeneous (identical) products
- No collusionbetween buyers or sellers
The consequences of perfect competition include:
Suppliers are 'price takers'not 'price makers', that is they can sell as much as they
want but only at the market-determined price
All suppliers only earn 'normal' profits
There is a single selling price (see Figure 14.7)
1.5 Imperfect competition
Is defined as any market structure that does not meet the conditions of perfect competition.
An example of this is Monopolistic competition
1.6 Monopolistic competition
Monopolistic competition is characterised by:
- Many buyers and sellers (as in perfect competition)
- Some differentiation between products (not homogeneous as in perfect competition)
- Brandingof products to achieve this differentiation
- Some (but not total) customer loyalty
- Fewbarriers to entry
- Significant advertisingin many cases

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Consequences of monopolistic competition include:
Increases in prices cause loss of some customers
Only normal profit earned in the long run (as in perfect competition)
1.7 The market mechanism
1.8 The interaction of demand and supply for a particular item.
2 Demand
2.1 What is meant by 'demand'?
2.2 Demand: The quantity of a good that potential purchasers would buy, or attempt to buy, if
the price of the good were at a certain level.
2.3 The demand schedule and the demand curve
2.4 Suppose that the following demand schedule shows demand for biscuits by one household
over a period of one month.
Quantity demanded
Price per kg at this price
kg
1 9
2
/3
2 8
3 6
1
/4
4 4
1
/2
5 2
2
/3
6 1
2.5 We can show this schedule graphically on a demand curve (Figure 4.1), with:
(a) Price on the y axis, and
(b) Quantity demanded on the x axis
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0
1
2
3
4
5
6
0 1 2 3 4 5 6 7 8 9 10
Price
()
A
G
Quantity (kg)
D
B
E
D
Demand curve

Figure 4.1: Demand for biscuits
2.6 What factors determine demand?
- Price
- Inter-related goods: substitutes and complements
- Income levels: normal and inferior goods
- Fashion and expectations
- Income distribution

Lecture example 1
Groupdiscussion

Required
Consider the effects on demand from the following events
Olympic games effect on supermarket products
Computer game making Rabbits fashionable and its effect on various pet related goods

Solution









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2.7 Shifts of the demand curve
0
0
Price of
the goods
()
Quantity demanded
P1
D1
D0
Q Q
0

Figure 4.2: Outward shift of the demand curve
- Movements along a demand curveare caused by changes in the good's price
- Shifts of thedemand curve are caused by changes in any of the other factors
which affect demand for a good, other than its price
3 Suppl y
3.1 What is meant by 'supply'?
3.2 Supply: The quantity of a good that existing suppliers or would-be suppliers would want to
produce for the market at a given price.
3.3 The supply schedule and the supply curve
3.4 The supply schedule for product Y is as follows.
Quantity that suppliers would
Price per unit supply at this price
Units
100 10,000
150 20,000
300 30,000
500 40,000
3.5 The relationship between supply quantity and price is shown as a supply curve in Figure 4.3.

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0
100
200
300
400
500
600
0 10,000 20,000 30,000 40,000
Price
()
Quantity supplied (units)

Figure 4.3: Supply curve
3.6 What factors influence supply?
- Price obtainable for the good
- Prices of other goods
- Price of related goods in 'joint supply'
- Costs of making the good
- Changes in technology
4 The equi l i br i um pr i c e
4.1 Equilibriumprice: The price of a good at which the volume demanded by consumers and
the volume businesses are willing to supply are the same.
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0
0
Price
()
Quantity supplied (units) Q
P
1
P
1
P
0
A B
C D
Supply
Demand

Figure 4.4: Equilibriumprice
4.2 Adjustments to equilibrium
Equilibrium price, supply and demand must adjust following a shift of the demand or supply
curve. There are four possibilities, therefore, which are illustrated by Figure 4.5.
(i) Increase in consumer incomes (ii) Product becomes unfashionable
Price

P2
P1
0
S
= expansion in
supply
Q1 Q2 Quantity
D1 D2
Price

P1
P2
0
S
= contraction
in supply
Q2 Q1 Quantity
D2 D1


Prediction
- Rise in market price
- Rise in quantity supplied
Prediction
- Fall in market price
- Fall in quantity supplied

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(iii) Improvement in production technology (iv) Rise in factor costs
Price

P2
P1
0
S1
= expansion in
demand
Q1 Q2 Quantity
D S2
Price

P1
P2
0
S2
= contraction
in demand
Q2 Q1 Quantity
D S1

Prediction
- Fall in market price
- Rise in quantity supplied
Prediction
- Rise in market price
- Fall in quantity supplied
Figure 4.5: Adjustments in equilibrium

4.3 Price regulation
Government might introduce regulations either:
- To set a maximumprice for a good, perhaps as part of an anti-inflationary economic
policy
- To set a minimumprice for a good below which a supplier is not allowed to fall
However, if we consider the setting of a maximum price:
- If this price is higher than the equilibriumprice, its existence will have no effect at
all on the operation of market forces,
- But if the maximum price is lower than what the equilibriumprice would be, there
will be an excess of demand over supply. The low price attracts customers, but deters
suppliers so supply will fall unless there is scope for the market to exist outside
government-sanctioned channels a so-called 'black market'.
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5 El ast i c i t y
5.1 Elasticity: The extent of a change in demand and/or supply given a change in price.
5.2 Price elasticity of demand
PED =
Change in quantity demanded, as a percentage of original demand
Change in price, as a percentage of original price

=
Proportional change in quantity
Proportional change in price

=
-
( (
( (
( (

2 1 2 1
1 1
Q Q P P

Q P
-

(Where P
1
, Q
1
are the initial price and quantity; P
2
, Q
2
are the subsequent price and
quantity.)
PED less than 1 = inelastic demand
PED more than 1 = elastic demand
PED = 1 = unit elasticity
5.3 Illustrated example
The price of a good is 1.20 per unit and annual demand is 800,000 units. Market research
indicates that an increase in price of 10 pence per unit will result in a fall in annual demand
of 70,000 units.
Requirement
Calculate the elasticity of demand when the price is 1.20.
Solution
At a price of 1.20, annual demand is 800,000 units. For a price rise:
% change in quantity
70,000
800,000
100% = 8.75% (fall)
% change in price
10p
120p
100% = 8.33% (rise)
Price elasticity of demand at price 1.20 =
-8.75
8.33
= 1.05
Using the same details and assuming that the demand curve is a straight line, calculate the
elasticity of demand when the price is 1.30 and falls 0.10 to 1.20
We are now looking at a different point on the curve.
At a price of 1.30, annual demand is 730,000 units.
For a price fall from 1.30 of 0.10:
% change in demand
70,000
730,000
100% = 9.59% (rise)
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% change in price
10p
130p
100% = 7.69% (fall)
Price elasticity of demand =
9.59
-7.69
= 1.25,
or 1.25 ignoring the minus sign.
Demand is even more elastic at this point than it was at 1.20.
5.4 Special values of price elasticity of demand
There are three special values of price elasticity of demand: 0, 1 and infinity.
- Demand is perfectly inelastic: PED = 0
This is the case where the demand curve is a vertical straight line.
- Demand is perfectly elastic: PED = (infinitely elastic).
This is the case where the demand curve is a horizontal straight line.
- Unit elasticity of demand: PED = 1. The
Demand changes proportionately to a price change.
5.5 Positive price elasticities of demand:
- Giffen goods
- Veblen goods
5.6 Factors influencing price elasticity of demand for a good
- Availability of substitutes
- The time horizon
- Competitors' pricing
- Luxuries and necessities
- Percentage of income spent on a good
- Habit-forming goods
5.7 Income elasticity of demand
5.8 Income elasticity of demand: An indication of the responsiveness of demand to changes
in household incomes.
Income elasticity of demand =
%change in quantity demanded
%change in household incomes

- Demand for a good is income elastic if income elasticity is greater than 1. These are
luxury goods.
- Demand for a good is income inelastic if income elasticity is between 0 and 1. These
are normal goods or necessities.
- Demand for a good is negatively income elastic where, in response to an increase in
income, demand actually falls. These are inferior goods.
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5.9 Cross elasticity of demand
5.10 Cross elasticity of demand: A measure of the responsiveness of demand for one good to
changes in the price of another good.
Cross elasticity of demand =
%change in quantity of good A demanded*
%change in the price of good B

*(given no change in the price of A)
Cross elasticity depends upon the degree to which goods are substitutes or complements.
- If the two goods are substitutes cross elasticity will be positive
- If the goods are complements cross elasticity will be negative
- For unrelated goods, such as tea and oil, cross elasticity will be 0.
6 Long r un and shor t r un c ost c ur ves
6.1 We usually assume that suppliers aim to maximise their profits, and the upward slope of the
supply curve reflects this desire to make profit (ie they are prepared to supply more of
something the higher the price that is being paid for it).
6.2 Following the assumption that suppliers are profit maximisers, they will produce at the point
where marginal costs (the cost of producing one extra good) equals marginal revenue (the
extra revenue earned from one extra unit). Therefore the amount a firm will supply will be
affected by the costs of production
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9 Chapt er summar y
Section Topic Summary
1 What is Supply and
Demand
Understanding what supply and demand is and how the
two are interlinked
2 Price elasticity of
demand
Be able to calculate price elasticity of demand on given
numbers. Essentially this is represented by change in
quantity / change in price
3 Long and short form
costs
Looking at economical theories on the behaviour of
short form and long form costs in a business
4 Types of Markets Understand the different features of perfect competition
as well as monopolistic competition, an example of
imperfect competition

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Micro-economics
Markets Supply Demand
Influences
Equilibrium
Price Elasticity of
Demand
Cross Elasticity of
Demand
Income Elasticity
of Demand
- Perefct
- Monopolistic

- Price
- Factor conditions
- Price of other goods
- Price of related goods
- Change in technology

- Price
- Factor conditions
- Price of other goods
- Price of related goods
- Change in technology

PED =
-
( (
( (
( (

2 1 2 1
1 1
Q Q P P

Q P
-