Sie sind auf Seite 1von 75

INDUSTRIETECHNIK

SRI LANKA INSTITUTE of ADVANCED TECHNOLOGICAL


EDUCATION

Electrical and Electronic


Engineering
Instructor Manual

Training Unit

Economics 1
Theory

No: AS 052

Training Unit
Economics 1
Theoretical Part
No.: AS 052

Edition:

2009
All Rights Reserved

Editor:

MCE Industrietechnik Linz GmbH & Co


Education and Training Systems, DM-1
Lunzerstrasse 64 P.O.Box 36, A 4031 Linz / Austria
Tel. (+ 43 / 732) 6987 3475
Fax (+ 43 / 732) 6980 4271
Website: www.mcelinz.com

List of Content

Learning Objectives .............................................................................................................6


1

The Fundamentals of Economics .................................................................................7


1.1

Scarcity and Efficiency .........................................................................................7

1.2

Microeconomics and Macroeconomics ................................................................8

1.3

The Logic of Economy .........................................................................................8

1.4

Fundamental Economic Problems .......................................................................9

1.5

Positive Economics..............................................................................................9

1.6

Normative Economics ........................................................................................10

1.7

Market, Command and Mixed Economies .........................................................10

1.7.1

Market Economy ............................................................................................10

1.7.2

Command Economy.......................................................................................11

1.7.3

Mixed Economy..............................................................................................11

1.8
1.8.1

Land ...............................................................................................................12

1.8.2

Labor ..............................................................................................................13

1.8.3

Capital ............................................................................................................13

1.8.4

Entrepreneurship............................................................................................14

1.9

The Production Possibility Frontier ....................................................................14

1.9.1

The Trade-off .................................................................................................18

1.9.2

Efficiency........................................................................................................21

How to read and use Graphs......................................................................................23


2.1
2.1.1

Reading Graphs.................................................................................................23
Determining Profits based upon different Levels of Output............................23

2.2

How two Variables are related ...........................................................................25

2.3

Plotting Graphs ..................................................................................................26

2.4

Measuring the Slope ..........................................................................................28

2.4.1

Measuring the Slope of a Straight Line ..........................................................28

2.4.2

Measuring the Slope of a Curved Line...........................................................29

2.4.3

Shifts of Curves and Movement along Curves...............................................31

2.5

Inputs and Outputs.............................................................................................12

Special Graphs ..................................................................................................32

2.5.1

Time Series ....................................................................................................32

2.5.2

Scatter diagrams ............................................................................................33

2.5.3

Diagrams with One or More Curves...............................................................34

Markets and Government in a Modern Economy .......................................................35

3.1

Market ................................................................................................................35

3.1.1

Market Equilibrium .........................................................................................36

3.1.2

How Markets solve the What, the How, and the for Whom............................36

3.1.3

The Market System ........................................................................................37

3.1.4

Market Failures ..............................................................................................39

3.2

Trade, Money, and Capital.................................................................................39

3.2.1

Trade, Specialization, and the Division of Labor............................................40

3.2.2

Money ............................................................................................................40

3.2.3

Capital ............................................................................................................41

3.3

The Economic Role of Government ...................................................................42

3.3.1

Efficiency........................................................................................................43

3.3.2

Imperfect competition.....................................................................................43

3.3.3

Externalities....................................................................................................44

3.3.4

Public Goods..................................................................................................44

3.3.5

Equity .............................................................................................................45

3.3.6

Macroeconomic Growth and Stability.............................................................47

3.3.7

Fiscal Policy ...................................................................................................48

3.3.6.1 The Effect of Spending ...................................................................................49


4

Basic Elements of Supply and Demand .....................................................................51


4.1

The Demand Schedule ......................................................................................52

4.2

The Demand Curve............................................................................................54

4.2.1

Law of downward-sloping demand.................................................................55

4.2.2

The Market Demand ......................................................................................55

4.3

The Difference between Economic Movements and Shifts ...............................56

4.3.1

Movements along the Demand Curve............................................................56

4.3.2

Shifts in the Demand Curve ...........................................................................56

4.4

Forces behind the Demand Curve .....................................................................56

4.4.1

Average Income .............................................................................................57

4.4.2

Size of the Market ..........................................................................................57

4.4.3

Related Goods ...............................................................................................57

4.4.4

Consumer Preferences ..................................................................................57

4.4.5

Special Influences ..........................................................................................58

4.5

Shifts in Demand................................................................................................58

4.6

The Supply Schedule .........................................................................................60

4.7

The Supply Curve ..............................................................................................61

4.8

Forces behind the Supply Curve........................................................................62

4.8.1

Input Prices ....................................................................................................62


4

4.8.2

Technological Advances ................................................................................62

4.8.3

Prices of Related Goods ................................................................................63

4.8.4

Government Policies ......................................................................................63

4.8.5

Special Influences ..........................................................................................63

4.8.6

Table of the Factors affecting the Supply Curve ............................................64

4.9

Shifts in Supply ..................................................................................................64

4.10

Equilibrium of Supply and Demand....................................................................66

4.11

Equilibrium with Supply and Demand Curves ....................................................68

4.11.1

Effects of a Shift in Supply and Demand....................................................69

ECONOMICS 1

Learning Objectives

The student should

be able to analyze how institutions and technology affect prices and the allocation of
resources.
be able to explore the behavior of the financial markets, including interest rates and
stock prices.
know how to examine the distribution of income.
be able to study the patterns of trade among nations.
know about how monetary policy can be used to moderate the fluctuations in
unemployment and inflation.
know about how to propose ways to encourage the efficient use of resources.
know about the pursuit of important goals such as rapid economic growth, efficient use
of resources, price stability, full employment and fair distribution of income.
know about government policies and their influence on the economy.

1.1

The Fundamentals of Economics

Scarcity and Efficiency

Economics is the study of how societies use scarce resources to produce valuable
commodities and distribute them among the people. Goods are scarce and must be used
efficiently. A situation of scarcity is one in which goods are limited relative to desires. It is
important that economy makes the best use of limited resources. Economic models
assume that all people are rational with well-ordered preferences wanting to always
maximize something such as profit or satisfaction and do the best they can, given their
scarce resources. Most economic models have three common elements: scarcity, cost
and marginal analysis.

Scarcity: People wanting more than can be satisfied with available resources. A good is a
scarce if another unit of the good would benefit someone. Fresh water can be a scarce in
countries where fresh water is not freely available. Scarcity is the source of all choice.

Efficiency: It denotes the most effective use of a societys resources in satisfying peoples
wants and needs. The economy is producing efficiently when it is producing more of one
good and therefore less of another.

1.2

Microeconomics and Macroeconomics

Microeconomics is concerned with the behavior of individual entities such as markets,


firms and households. Economists consider how individual prices are set and study the
determination of prices of land, labor and capital. Most importantly, the remarkable
efficiency of properties of markets is identified. Also economic benefits from individual
actions were observed.

Macroeconomics on the other hand, is concerned with the overall performance of the
economy. It studies the economy as a whole. Macroeconomics studies what determines
the price level of all goods. Today Macroeconomics examines a wide variety of areas
such as total investment, consumption, money, interest rates, economic growth etc.

These two branches, Micro- and Macroeconomics form the core of modern economy.

1.3

The Logic of Economy

Economic life is a complicated center of activity, with people buying, selling, bargaining,
investing and persuading.

Economists use the scientific approach to understand economic activities. This involves
observing economic affairs and the drawing of statistics and historical records. Often,
economists must rely on analysis and theories. Theoretical approach allows the
economist to make broad general assumption. Economists also, in addition, have
developed a technique called econometrics, which applies the tools of statistics to
economic problems. Using this technique it is able for the economists to sift through
massive amounts of data to extract simple relationships. The ultimate goal of economic
science is to improve the living conditions of people in their everyday life. Increasing the
gross domestic product (GDP) is not just a numbers game. Freedom from hunger,
disease, and the elements is a universal human aspiration. It is important to determine the
best route to economic progress or an equitable distribution of societys output. One must
objectively weigh the costs and benefits of different approaches.
Society must find the right balance between the discipline of the market and the
compassion of government social programs.

1.4

Fundamental Economic Problems

Whether an advanced industrial nation, or a centrally planned economy must resolve


three fundamental economic problems.
Every society must be able to determine what commodities are produced, how these
goods are made, for whom they are produced.

What commodities and in what quantity must they be produced?

A society must appoint how much of each of the possible goods and services it shall make
and when they will be produced. Using scarce resources to produce many consumption
goods (like food) or to produce fewer consumption goods but more investment goods (like
food-making machines) which boosts production and consumption must be decided upon.

How are goods produced?

A society must determine who will produce, with what resources, and what production
techniques they will use.

For whom are goods produce?

Who gets to consume the product of economic activity and is the distribution of income
and wealth fair, are issues that must be resolved.

1.5

Positive Economics

Positive economics deals with questions such as: Why do doctors earn more than busdrivers? Does free trade raise or lower the wages? These questions can be resolved by
reference to analysis and empirical evidence. That puts them in the realm of positive
economics.

1.6

Normative Economics

Normative economics involves ethical norms of fairness. Is it better to raise


unemployment to ensure that price inflation does not rapidly grow? Questions like this do
not have a definite answer because they involve ethics rather than facts. They can be
resolved by political debate and decisions and not by economic analysis alone.

1.7

Market, Command and Mixed Economies

Alternative economic systems can answer the questions of what, how and for whom a
society produces goods.

We generally distinguish two different kind of organizing an economy.


At one extreme, government makes most economic decisions. At the other extreme
decisions are made in markets where individuals or enterprises agree to exchange goods
and services.

1.7.1

Market Economy

In most countries most of the economic questions are solved in the market. Hence their
economic systems are called market economies. Major decisions about production and
consumption are made by individuals and private firms in a market economy.
Firms produce the goods that bear the highest profit (what) with production techniques
that are least costly (how). Consumption is set by the individuals decision about how and
on what to spend their income generated by their labor/work and property ownership (for
whom).

10

1.7.2

Command Economy

In a command economy the government makes all the important decisions about
production and distribution. Command economy is preferably being used and operated
with in communist societies. The government owns most of the means of production (land
and capital). It decides how the output of the society is to be divided among different
goods and services. It also directs the operations of industries. It is the employer of most
workers. In short, in a command economy the government resolves economic questions
through its ownership of resources and its power to enforce decisions.

1.7.3

Mixed Economy

A mixed economy is what most societies are, with elements of market and command.
Nowadays most decisions are made in the marketplace but the government plays an
important role in overseeing and observing the market activities. By passing laws the
government is able to regulate economic life.

11

1.8

Inputs and Outputs

Inputs or factors of production are commodities or services that are used in order to
produce goods and services.

Outputs are the result, in form of goods or services, of production which can be either
consumed or used for further production.

Example: The production of a car.


The engine, seats, wires and the labor of many skilled workers are the inputs. The car
itself is the output.

The factors of production can be divided in four broad categories: land, labor, capital, and
entrepreneurship. The factor concept and the division into four categories are used to
construct models illustrating general features of the economic process without getting
caught up in inessential details. These include models intending to explain growth, value,
choice of production techniques/methods, income distribution, and social classes.
One intuitive basis for the classification of the inputs (factors of production) is the manner
of payment for their services: rent for land, wages for labor, interest for capital, and profit
for entrepreneurship.

1.8.1

Land

Land or natural resources represents the gift of nature to our productive processes. It
consists of the land used for farming or for being ground to houses, factories, and roads.
Natural resources also stand for natural energy resources. This includes sea resources
and offshore mineral deposits. Water and air are environmental resources. Natural
resources are useful for power generation, transport, and irrigation.

12

1.8.2

Labor

Labor consists of human time as a factor of production. The labor supply stands for those
able and willing to work, including self-employed, unemployed, and employed workers.
Labor economics is concerned with the supply and demand for labor. It is at once the
most familiar and the most crucial input for an advanced industrial economy.

1.8.3

Capital

Capital goods are goods designed to be used for the production of other goods. Capital
goods include machines, roads, computers, steel mills, automobiles, buildings, etc. The
accumulation of specialized capital goods is essential to the task of economic
development.

1.8.3.1 Human capital

Human capital refers to the experience and skills which enhances a workers productivity.
Human capital is different to material capital in that it cannot be bought or sold and
therefore it cannot be used as collateral for loans.

13

1.8.4

Entrepreneurship

In entrepreneurship the role of the entrepreneur is to take responsibility for decision-taking


in a business. He receives any profits and bears losses. The entrepreneur does not
essentially need to contribute to labor, which can be hired, or capital, which can be
borrowed. In a business the entrepreneur can be a sole trader. In incorporated businesses
the role of the entrepreneur is dispersed among directors and shareholders.

1.9

The Production Possibility Frontier

The Production Possibility Frontier (PPF) also known as Production Possibility Curve is a
diagram showing the maximum output of one good with the available resources given that
can be obtained by an economy. In a two-dimensional diagram the PPF usually slopes
downwards. The slope shows the opportunity cost of each good in terms of the other. The
downwards-slope is a result of limited supplies of factors of production and differences in
factor proportions between industries. A PPF can be drawn up for a firm, an industry, or a
country.

14

Example 1:

An economy produces two kinds of goods: chairs and milk. Suppose that the economy
decides to produce only milk. There is a maximum amount of milk that can be produced
per year. The maximal amount of milk depends on the quality and quantity of the
economys resources and the productive efficiency with which they are used.

Suppose 5 million liters of milk is the maximum amount that can be produced.
On the other hand, suppose that all resources are instead devoted to producing chairs
and this also to a certain extent because of the limited resources given. For this example,
we assume that 15,000 chair are being produced and no milk.

These are two extreme possibilities. In between are various others. If we produce less of
one good we are able to produce more of another.

Different possibilities:

Possibilities

Milk (millions of liters)

Chairs

15

14

12

Combination F shows the extreme, where all milk and no chairs are produced, while
combination A shows the opposite extreme. Combination B, C, D, E, and F are in between
and show that the lesser chairs, the more milk is being produced.

15

The graph below displays the alternative combinations of the production possibilities.

Chairs (thousands)

(Figure 1)

Milk (millions of liters)

On the horizontal axis milk is measured and on the vertical axis chairs is measured. On
point F we can see that 5 million liters of milk and 0 chairs is produced. On point E, 4
million liters of milk and 5 thousands chairs are produced. And finally at point A, we can
observe that 0 liters of milk and 15 thousands chairs are produced.

If we represent all different combinations of chairs and milk by points we have a


continuous curve as seen in the graph below. This curve represents the production
possibility frontier or production possibility curve.

16

(Figure 2)

This frontier shows how society can choose to substitute chairs for milk. Any points
outside the frontier (such as point I) are infeasible or impracticable. Any point inside the
curve (such as U) represents a production possibility which has not achieved production
efficiency (a high unemployment rate can be a factor).
The production possibility curve represents the list of goods and services available to
society.

17

1.9.1

The Trade-off

The need to trade goods against one another is a sign of economic efficiency. It is the
process of deciding whether to give up some of one good to obtain more of another good.

1.9.1.1 The trade-off of time

One of the most important decisions people have to make is how to use their time. Time is
limited and therefore we must decide carefully how to make use of it.

Example 2:

The table below shows the trade-offs a worker might face when the worker has only four
hours in total to produce two kinds of goods: tables and benches. In this example, time
(four hours) is the source of scarcity (time is limited). The more time the worker spends
making tables, the less time he has for the production of benches.

Tables

Benches

Time Spent (hours)

Product Made

Time Spent (hours)

Product Made

20

18

14

10

18

The graph below shows the production possibility curve derived from these numbers. If
the worker spends all four hours on making benches, 20 benches and no tables will be
produced (Point A). One hour spent making table means one hour less for making
benches and results in 4 tables and 18 benches being produced (Point B). Two hours on
each result in 7 tables and 14 benches (Point C).

(Figure 3)

19

Opportunity Costs

Because resources are scarce, we must always consider how to spend our limited income
or time. If a good has not been produced, the resources used in making it can be used to
produce other goods and services. When one decides whether to produce good A or good
B, in each case one must consider how much the decision will cost in terms of forgone
opportunities. The cost of the forgone alternative is the opportunity cost of the decision.

The concept of opportunity cost can be illustrated using the PPF.

1.9.2.1 Measuring the Opportunity Cost

For example (referring to Example 2), a third hour is added to making tables. This means
that the gain of table-production is 2 (from 7 to 9 tables) and the loss of benches is 6 (from
14 to 8 benches). So the opportunity cost per table over this range is 3 benches per table
(6/2).

Example:

Problem: The worker is currently spending one hour making tables and three hours
making benches. What is the opportunity cost per table of spending a second
hour in making tables (assuming the worker still is limited to four hours)? What is
the money value of this opportunity cost if benches sell for 12 $ and tables for 25
$? How many hours should be spent making tables?

Answer: By working the second hour on tables, 3 more tables are made but 4 fewer
benches. So the opportunity cost per table during the second hour is four-thirds
(4/3) of a bench. In money terms, this is 16 $ (4/3 x 12 $). That is, in the second
hour, for every table made, the worker gives up making 4/3 of a bench. The
money opportunity cost per table of a third hour added to table-making is 36 $ (3
x 12 $) and for a fourth hour added to table making, 98 $ (8 x 12 $). The worker
should spend two hours making tables; up to and including the second hour,
each table adds more (25 $) than is given up. The opportunity cost per table
during the third and fourth hour (26 $ and 96 $) exceeds the 25 $ gain from
making the table. These are better spent making benches.

20

1.9.2

Efficiency

Economy using production possibilities on the PPF is producing efficiently. Efficiency


means that the economys resources as effectively as possible to satisfy peoples needs.
Getting the maximum possible output with the smallest possible input is efficient. One
important aspect of overall economic efficiency is efficiency in production, efficiency in
consumption, and efficiency in choice.

1.9.3.1 Efficiency in Production

Productive efficiency happens when an economy cannot produce more of one good
without producing less of another good. This implies that the production is on its
production-possibility frontier.

One further point about productive efficiency can be illustrated using the production
possibility curve. Being on that curve means that producing more of one good inevitably
necessitates, sacrificing another good. In Example 1 we can see that when we produce
more chairs, we are substituting chairs for milk. In a full-employment economy,
substitution is the law of life and the production possibility depicts the menu of societys
choices.

1.9.3.2 Efficiency in Consumption

Consumptive efficiency means allocating goods between consumers so that it would not
be possible by any reallocation to make some people better off without making anybody
else worse off.

21

1.9.3.3 Efficiency in Choice

Efficiency in the choice of the goods to be produced means choosing these goods so that
it would not be possible to change it so as to make some consumers better off without
others becoming worse off.

22

How to read and use Graphs

2.1

Reading Graphs

A graph is a diagram showing how two or more variables are related to each other. One of
the variables is measured along the bottom of the graph and the other variable is
measured along the left side of the graph. The bottom line is the horizontal axis or X axis
and the side line is the vertical axis or Y axis. A variable is an item of interest that can be
defined and measured and that takes on different values at different times or places.
Important variables studied in economics are prices, quantities, land, working hours,
income, etc.
Graphs are read like a page, from left to right.

Graphs are essential in economics because they allow us to analyze economic concepts
and examine historical trends. Some graphs show how variables change over time, other
graphs show the relationship between different variables.
2.1.1

Determining Profits based upon different Levels of Output

In Figure 4, at the left of the graph, output is 0 and revenue equals 0 too. As output
increases, revenue increases as well. At output level A, revenue reaches point D. As
output continues to increase, profits (revenue) climb until to output level B. Profits reach
their highest level at point E and at output level at point B.
Increasing output beyond point B causes the profit to fall, until to it reaches 0 at output
level C.

23

(Figure 4)

24

2.2

How two Variables are related

Figure 5 shows four different ways two variables, X and Y, can be related:

1. Panel A shows that X and Y are positively (or direct) related. When X goes up, Y goes
up, and when X goes down, Y goes down.
Example: X could be workers hired and Y could be the output.

2. Panel B shows that X and Y are negatively (or inversely) related. When X goes up, Y
goes down, and when X goes down, Y goes up.
Example: X could be the amount of safety equipment in a firm, and Y the accident rate.

3. Panel C shows that X has no effect on Y. No matter how large or small X is Y does not
change.
Example: X could be the size of a lake, and Y car production.

4. Panel D shows that Y has no effect on X. No matter how large or small Y is, X does not
change.
Example: Y could be the price of a dead writers book, and X could be the world supply of
the writers books.

(Figure 5)

25

2.3

Plotting Graphs

To make a graph, for each value of the variable on the X (horizontal) axis, plot above it the
value of the variable on the Y (vertical) axis that corresponds to it.

One type of graph used in economics is the budget constraint, which shows the different
combinations of goods a person could buy on a fixed budget.

Example:

A person has a weekly budget of 10 $ and can buy bread for 1 $ each or a slice pizza at 2
$ each. The graph (figure 6) shows the budget constraint of that person assuming he
spends all of the 10 $. The slice of pizza is shown on the horizontal axis, and bread is
shown on the vertical axis.

If that person buys no pizza, then he/she can buy ten pieces of bread (point A). If he/she
buys one slice of pizza for 2 $, he/she can buy eight pieces of bread (point B). Buying 5
slices of pizza means that he/she has no budget left for bread (point C). If we connect
these points with a line, we have the budget constraint. The two variables (pizza and
bread) are negatively related. As that person buys more pizza, he/she has less money for
bread.

26

Bread

(Figure 6)

Budget Constraint

Pizza

27

2.4

Measuring the Slope

One important way to describe the relationship between two variables is by the slope of
the graph line. The slope of a line represents the change in one variable that occurs when
another variable changes. It is the change in the variable Y on the vertical axis per unit
change in the variable X on the horizontal axis.

2.4.1

Measuring the Slope of a Straight Line

Slope for straight lines is rise over run. Thus in both graph of figure 7 the numerical
value of the slope is rise/run = CD/BC = s/1 = s. Note that the first graph indicates a
negative slope, and the second graph indicates a positive slope.

(Figure 7)

28

On figure 7 we can measure the slope of the line between points B and D. First comes a
horizontal movement from B to C indicating a 1-unit increase in the X value (with Y
remaining the same). Second comes a compensating vertical movement up or down. The
two-step movement brings us from one point to another on the straight line.
Because the BC movement is a 1-unit increase in X, the length of CD indicates the
change in Y per unit change in X. On the graph this change is called the slope of the line
ABDE. The slope is often defined as the rise over the run. The rise is the vertical
distance (in figure 7, the rise is the distance from C to D. The run is the horizontal distance
(in figure 7, the run is the distance from B to C). The rise over run in this example would
be CD over BC. Thus the slope BD is CD/BC.

2.4.2

Measuring the Slope of a Curved Line

A straight line has the same slope at every point on the line. The slope of a curved or
nonlinear line constantly changes. To find the slope of a curved line at one of those points,
just draw a tangent line through that point. A tangent line is a straight line that matches the
direction of curve at that point and touches the curve just once. Line FJ in figure 8 is such
a tangent line. It measures the slope of the curve at point B.

(Figure 8)

29

To find the slope at point B in figure 8, we simply draw a line connecting the points FBJ as
a tangent to the curved line at point B. Then we calculate the slope of the tangent as
NJ/MN by using the usual right-angle measuring technique shown in the example from
before (measuring the slope of a straight line).

Another example of the slope of a curved line is shown in the figure below. This shows a
curve with a typical shape in microeconomics and has its maximum point at point C.
Up to point C (A to C) the slope is always positive where the curve is rising and negative
in the falling region (C to E). At the maximum of the curve, the slope is exactly zero. A
zero slope indicates that a tiny movement in the X variable around the maximum has no
effect on the value of the Y variable.

(Figure 9)

30

2.4.3

Shifts of Curves and Movement along Curves

In economics there is an important difference between shifts of a curve and movement


along curves. This distinction is illustrated in figure 10.

Example:
At point D on the inner production-possibility curve society chooses to produce 30 units of
food and 90 units of machines. If society decides to consume more food with a given
production-possibility curve, then it can move along the PPF to point E. This movement
represents the choice of society to produce more food and fewer machines.

The inner PPF represents societys production possibilities for 1999. In 2000 we can see
that the PPF has shifted (from the inner PPF to the outer PPF). A factor for this kind of
shift could be more capital or an increase in labor. In 2007 society might choose a
production-possibility such as at point G (more food and more machines than in year
1999). The movement from point D to G (unlike D to E) is an example for a shift of the
curve.

(Figure 10)

31

2.5

Special Graphs

The production-possibility frontier or PPF is one of the most important graphs in


economics, one depicting the relationship between two variables.

2.5.1

Time Series

Some graphs show how a certain variable has changed over time. Time-series graphs
have the variable time on the horizontal axis and variables of interest on the vertical axis.

32

2.5.2

Scatter diagrams

Sometimes individual pairs of points or combinations of variables for different years will be
plotted (figure 11). The consumption function is a very important scatter diagram from
macroeconomics as seen on figure 11.

(Figure 11)

The diagram displays the national total disposable income on the X axis and total
consumption on the Y axis. Consumption and income are very close to each other.
Scatter diagrams show how close the relationship between two variables is.

33

2.5.3

Diagrams with One or More Curves

When putting two curves in the same graph, it is called a multi-curved diagram. These
graphs show two different relationships at the same time such as supply and demand.

34

3.1

Markets and Government in a Modern Economy

Market

A market is a place or institution in which buyers and sellers of goods or assets meet.
Nowadays the market is a network of dealers linked by trading rules and conventions. A
market economy is an elaborate mechanism for coordinating people, businesses, and
activities through a system of markets. It is a communication device for uniting actions of
all the diverse individuals. In a market economy no individual is responsible for production,
distribution, consumption, and prizing.
In general, markets are places where buyers and sellers interact to set prices and trade
goods and services. There are markets for almost everything. A market can be centralized
such as the stock-market. A market can also be decentralized such as the market for
labor. E-commerce is the electronic existence of a market.

A price, in a market system, is the value of a good in terms of money. Prices characterizes
the terms on which individuals voluntarily exchange their commodities. Prices serve as
signals to produces and consumers. If the demand for a good rises, so does the price,
sending a signal to producers that more supply is needed. Prices coordinate the decisions
of producers and consumers in a market. A higher price usually reduces consumers
activity and encourages production. Lower prices, on the other hand, animates
consumptions and discourages production. Prices can be described as balance device for
the market mechanism.

35

3.1.1

Market Equilibrium

Market equilibrium occurs when supply and demand in a market are equal at the
prevailing price. Markets are constantly solving the what, how, and for whom.
Not only do they balance all the forces operating on the economy, but also finding market
equilibrium of supply and demand. It represents a balance between all the different buyers
and sellers. The equilibrium price is determined by supply and demand. A price too high
would mean a full supply of goods with too much output. A price too low would mean a
deficiency and overstock of goods. Those prices for which buyers desire to buy exactly
the quantity that sellers desire to sell cause equilibrium of supply and demand.

3.1.2

How Markets solve the What, the How, and the for Whom

Markets work synchronously to set a general equilibrium of prices and production. By


matching supply and demand in each market of all the existing ones, a market economy
simultaneously solves the three problems of what, how and for whom.

3.1.2.1 How Markets solve the What

What goods and services will be produced is determined by the dollar vote of consumers
in their daily buying decisions. Firms are motivated to maximize profits. Profits are net
revenues or the difference between total sales and total costs. Firms are attracted in
producing goods of high demand for profitable revenues.

36

3.1.2.2 How Markets solve the How

How goods and services are produced is determined by the competition among the
different producers. The best way for producers to meet price competition and maximize
profits is to keep costs as low as possible. Very important in a competitive market is to
adopt production methods to the drastic shifts in technology.

3.1.2.3 How Markets solve the For Whom

For whom things are produced depends on the supply and demand in the markets for
factors of production. Factor markets determine the factor prices (wage rates, interest
rates, land rents, profits, etc.). The markets income can be determined by calculating all
the revenues from factor.

3.1.3

The Market System

The market system relies on supply and demand to solve the three economic problems. In
the figure below the circular flow of economic life is illustrated. It shows an overview of
how consumers and producers interact in order set the right price and quantity for inputs
and outputs. In this flow there are two different kinds of markets. Product market or the
flow of outputs is on the top and at the bottom are the markets for input or factors of
production such as labor. Decisions are made by two sides, consumers and businesses.
Consumers buy goods and sell factors of production and the businesses sell goods and
buy factors of production. Prices are set to balance consumer demand with business
supply. The prices in factor markets are set balance household supply with business
demand.

37

(Figure 12)

The interaction of the dollar votes of consumers with the business supply enables us to
determine the economic problem of what is to be produced. Business competition to have
the lowest costs of production of goods to be sold determines the how goods are to be
produced. Demands for production inputs meet the supply of other inputs in the factor
markets such as labor to help determine wage, rent, etc. Thus, incomes influence for
whom goods are to be produced.

38

3.1.4

Market Failures

Market not always leads to the most efficient outcome. One set of market failures
concerns monopolies and other imperfect competitions. A failure comes when there are
negative effects on positive externalities - positive externality such as scientific discoveries
and negative effects such as pollution. Also a failure of market occurs when income is
distributed politically or ethically unacceptable. When any of these elements happen
governments should interact.

Under perfect competition and with no market failures occurring, markets will effectively
and usefully produce goods and services out of the available resources as is possible. But
when monopolies or pollution or other market failures become more widespread, the
market efficiency may be at risk.

3.2

Trade, Money, and Capital

In capitalist economies are three distinguishing features: trade, money and capital.

An advanced economy is characterized by an elaborate network of trade that


depends on specialization and a complex division of labor.

Modern economies make a broad use of money as a mean of payment. Money is


a tool for measuring the economic value of things.

Modern industrial technologies rest on the use of great amounts of capital. Capital
goods leverage human labor into a more efficient factor of production and allow
more advanced and greater productivity.

39

3.2.1

Trade, Specialization, and the Division of Labor

The economy depends on the specialization of individuals and firms, connected by a


network of trade.

Specialization occurs when societies concentrate their efforts on particular tasks to use
specific skills and resources to an advantage. The enormous efficiency of specialization
allows the complex network of trade among nations and people that we can observe
today.

Division of labor is a system in which different individuals do different types of work. This
allows the individual to specialize on work or tasks at which they have the comparative
advantage.

Advanced economies commit to specialization and the division of labor. This increases
productivity of their resources. Nations and individuals trade their goods in which they
specialize for others products, increasing living standards.

3.2.2

Money

Money is anything that is accepted as a payment for goods and services. It is the currency
and checks that we use when we buy things. It is used as a medium of exchange, a unit of
account, and a store of value. But more than that, money is a lubricant that facilitates
exchange. The dominant form of money is the currency.
Governments control the money supply through their central banks. Money can also grow
out of control and damage the economic engine. It can cause hyper-inflation, in which
prices increase drastically.
The money supply requires proper management and is a major issue for government
macroeconomic policy.

40

3.2.3

Capital

Capital or capital goods in economics are factors of production used to create goods or
services that are not themselves consumed in the process of production. It is a produced
factor of production, a durable input which is itself an output of the economy.
Capital is one of the three major factors of production. The other two, labor and land, are
referred to as primary factors of production. That means that their supply is determined by
non-economic factors. Capital, in the other hand, has to be produced before it can be
used (for example machines for production).

3.2.3.1. Capital and Private Property

In a market economy, capital typically is privately owned, and the income derived from
capital goes to individuals. Capital goods have market values. Property rights bestow on
their owners the ability to use, exchange, or exploit their capital goods. However, property
rights are limited. The most valuable economic resource, labor, cannot be turned into a
commodity that is bought and sold as private property. It is against the law to treat labor
like capital assets.

41

3.3

The Economic Role of Government

In an ideal market economy all goods and services are voluntarily exchanged for money
at market prices. This system extracts the maximum benefits out of the available
resources without government intervention. However, every market economy suffers from
imperfections such as pollution, unemployment, and a big gap between wealth and
poverty. For that reason every government intervenes with the economy. Government
funding is very important for the economy. Governments also apply tax-regulations.

Governments operate by requiring people to pay their taxes, obey the law and regulations,
and consume certain goods and services. Because of its coercive powers, governments
can perform functions, which would not be possible under voluntary exchange.

Governments generally have three functions in a market economy.

1. Increasing Efficiency:

Governments increase efficiency by promoting competition, preventing excessive


pollution, and providing public goods.

2. Promoting Equity:

Governments promote equity by using tax and expenditure programs to redistribute


income toward particular groups.

3. Fostering Macroeconomic Stability and Growth:

Governments foster macroeconomic stability and growth. They reduce unemployment and
inflation while encouraging economic growth through fiscal policy and monetary
regulations.

42

3.3.1

Efficiency

The righteousness of market mechanism are fully realized when checks and balances of
perfect competition are present. Perfect Competition is an ideal market situation in which
buyers and sellers are so numerous and well informed that each can act as a price-taker.
They are able to buy or sell any desired quantity without affecting the market price.
Perfectly competitive markets will produce an efficient allocation of resources, so that the
economy is on the production possibility frontier (PPF). When all firms and industries are
subject to perfect competition, markets will produce consumers most desired output by
using the most efficient ways of production and the minimum amount of input.

There are numerous ways markets do not reach the level of perfect competition. These
market failures lead to inefficient production or consumption, and governments must
intervene. The three most important examples of a not-efficient perfect competition are
imperfect competition, externalities, and public goods.

3.3.2

Imperfect competition

Unlike in a perfect competition, where no consumer can affect the prices, imperfect
competition occurs when a buyer or a seller can affect a goods price. It is a market
situation with limited buyers and sellers. This is also known as a monopolistic competition.
When imperfect competition arises, society may move inside its production possibility
frontier. This would happen, if a single seller (monopolist) raised the price to make more
profits. The output of that good would be reduced below the most efficient level making
the efficiency of the economy suffer.

Imperfect competition leads to prices that rise above cost and to consumer purchases that
are reduced below efficiency. Too high of a price and too low output is a particular pattern
of an imperfect competition.

The monopolist is a single supplier who alone sets the prices of a good or service.
Governments, in the extreme cases of imperfect competition, regulate the price and profits
of monopolies.

43

3.3.3

Externalities

Externalities are another type of inefficiency, which involve an imposition of costs or


benefits. It occurs when firms or people impose costs or benefits on others outside the
marketplace.

Example: When a firm buys a chicken to make frozen chicken nuggets, it buys the chicken
from the seller in the market for chickens, and the seller receives the full value for the
chicken. Or, the personal trainer receives the full value for time, skill, and rent.

In general, governments are more concerned with negative externalities than with the
positive ones. As production methods have increased in the use of chemicals, energy, etc.
negative externalities have majorly grown. Governments then have to regulate
externalities such as pollution.

3.3.4

Public Goods

As an example of positive externalities, public goods are open to use by all members of
society. Public goods cannot be provided for private profit. Public goods are goods that
are non-rivaled. This means that the consumption of a public good by one individual does
not reduce the availability of the good for the others.

The best example of a public good is national defense. It is provided by government


bodies. Governments can raise taxes needed to pay for them.
Governments must encourage the production of public goods. Governments buy public
goods and behave like another large spender. By casting sufficient dollar votes in certain
directions, it causes resources to flow there. This makes the market mechanism take over
and direct resources to firms and industries so they can then produce public goods.

44

3.3.4.1 Taxes

Governments must find revenues to budget their public goods. Such revenues come from
taxes imposed as a financial charge by the government or state. The taxes are levied on
personal and corporate incomes, on sales of private goods, on wages, etc. Taxes are the
price to pay for public gods. Taxes are not voluntary. Everyone is subject to the paying of
taxes.

3.3.5

Equity

In general, equity is the concept of fairness in economy.


If we assume that the economy functioned completely efficient, always on the possibility
frontier, with no imperfections, which can be corrected by judicious intervention, it might
still lead to an imperfect outcome. Markets do not always produce a fair distribution of
income. The reason why market mechanisms produce inequalities in income and
consumption and therefore an unacceptable solution to the question to whom, is that
incomes are determined by many factors such as effort, factor prices, education, etc.. This
results to an unfair outcome. Goods follow the dollar vote and not the greatest need.

Economics can analyze whether different income-redistribution devices such as taxes


lead to a more efficient way of reducing poverty, for example, and help design more
efficient programs to increase the incomes of the poor.

45

Table of the Economic Role of the Government:

Failures of Market
Economy

Government Intervention

Examples of Government
Policy

Inefficiency:
Monopoly

Encourage competition

Antitrust laws

Externalities

Intervene in markets

Antipollution laws

Public Goods

Encourage benefits

Provision of public
education

Inequality:
Unacceptable inequalities of Redistribute income

Taxation of income and

income and wealth

wealth

Macroeconomic
problems:
Inflation and Unemployment

Slow economic growth

Implement macroeconomic

Monetary policies and

policies for stabilization

Fiscal policies

Stimulate economic growth

Invest in education

46

3.3.6

Macroeconomic Growth and Stability

Capitalism has ever since been irritated with rising prices (inflation) and high
unemployment (recession). These fluctuations are known as the business cycle and are
simply referred to as ups and downs in the economy.
By fiscal policies and monetary policies, governments can influence output, employment,
and inflation.

The fiscal policies of government involve the ability to tax and the ability to spend.

Monetary policies involve determining the supply of money and interest rates. This affects
investments in capital goods.

By using these two tools, governments can influence the level of output, the level of
spending, employment and unemployment, inflation, price level, etc. in an economy.

Governments now became more concerned with

designing and implementing

macroeconomic policies to promote long-term objectives such as economic growth and


productivity. Economic growth denotes the growth in a nations total output. Productivity
represents the efficiency with which resources are used.

47

3.3.7

Fiscal Policy

Fiscal policy is the use of government spending to influence the economy. The two main
tools of fiscal policy are government spending and taxation. The figure below shows the
circular flows in an economy with a governmental sector.

(Figure 13)

When beginning at point U, households either consume (C) or save (S) their disposable
income. Savings go into financial institutions such as bank accounts, mutual funds, or
retirements plans, and come back into the spending stream as investment spending at
point V.
Then, at point W, we add government spending (G). Total spending and the GDP equals
C + I + G (Consumption + Investments + Government Spending). Businesses pay out as
total income the GDP at point X. The government collects taxes (T) at point Y, leaving
disposable income (DI) equal to GDP T.

48

3.3.6.1 The Effect of Spending

Government adds spending but it takes away dollars from the economy in the tax
revenues it collects.

Example:

We will examine the effect of spending, holding tax revenues constant. Then we will
examine the effect of changing taxes, holding government spending constant. To
determine the combined effect, we simply add these two effects together.
Government spending is just like investment spending and has identical effects. The table
below shows the spending at various levels of real GDP (Q).

Output
Response

3000

1800

500

1500

3800

Increase

4000

2400

500

1500

4400

Increase

5000

3000

500

1500

5000

No Change

6000

3600

500

1500

5600

Decrease

7000

4200

500

1500

6200

Decrease

Q = Income/Output
C = Consumption
I = Investment Spending
G = Government Spending
D = Total Spending

49

When output equals 5000 $, total spending (D) equals income and the economy is in
equilibrium. Note that Q, real output, is also the real income.
Figure 14 displays the table from before. It is a visual look at the total government
spending and the effect of economic equilibrium. Equilibrium occurs where spending
equals income or where the total spending curve (D) crosses the 45 degrees line (at point
E). Note that D (total spending) is derived by adding C, I, and G at each level of output.

(Figure 14)

50

Basic Elements of Supply and Demand

The analysis of supply and demand enables you to forecast prices and outputs in
individual markets. These careful studies of markets will reveal certain forces underlying
the random movements.
The theory of supply and demand is a very powerful instrument for explaining dramatic
shifts in the economic environment. It shows how consumer preferences determine
consumer demand for commodities. Increases in prices may occur due to the increase of
demand and because supply has decreased. Changes in supply and demand changes
output and prices. Understanding how supply and demand operates, is very important for
understanding how the market economy operates.

(Figure 15)

51

The figure 15 shows the gasoline prices move with demand and supply changes.
Gasoline prices are a very good example for the fluctuation in the market. As seen in
figure 15, the supply for gasoline decreased in the 1970 calling for increased regulation.
Reductions in demand from new energy-saving technologies led to a decline in price after
1980. In 1999 the oil cartel reduced supply, causing the oil price to shoot up sharply.

The tools of supply and demand are crucial for understanding these trends.

4.1

The Demand Schedule

The amount of a commodity people buy depends on the price. The higher the price,
without changing any of the other determinants of demand, the fewer of these goods
consumers want to buy. The lower the price, the more units of it are sold.
There is a definite relationship between market price of a good and the quantity
demanded of that good. This relationship between price and demand is the demand
schedule, or the demand curve.

52

Example:

The table below shows a demand schedule for chocolate. At each price level, we can
determine the quantity of chocolate that consumers buy.
At 5 $ (P) per box, for example, consumers buy 9 million boxes (Q) per year. At 4 $ per
box, 10 million boxes per year are bought. At 3 $ per box, the quantity demanded is still
greater (12 million).

Demand schedule for chocolate:

Price

Quantity demanded

($ per box)

(millions of boxes per year)

10

12

15

20

At each market price, consumers buy a certain amount of chocolate. The lower the price,
the more of chocolate is bought. Note the negative relationship between price and
quantity demanded.

53

4.2

The Demand Curve

The demand curve is a graph relating demand for a good or service to its price. It shows
the quantity demanded of a good at various prices, assuming that other things do not
change (non-price determinants).
The graphical representation of the demand schedule is the demand curve.
In figure 16, the demand curve of the demand schedule from the example of before is
shown, which graphs the quantity of chocolate demanded on the horizontal axis and the
price of chocolate on the vertical axis. The price of the good is usually shown on the
vertical axis and the quantity demanded at each level of its own price on the horizontal
axis. The quantity and price are inversely (negative) related; Q goes up and P goes down.
The demand curve slopes downwards.

(Figure 16)

Each pair of numbers (P and Q) from the example of the demand schedule is plotted as a
point. By connecting the points the demand curve is determined (DD). The negative slope
of the demand curve illustrates the law of downward-sloping demand.

54

4.2.1

Law of downward-sloping demand

When the price of a commodity increases (and other things held constant), the quantity
demanded decreases. When the price decreases (and other things held constant),
quantity demanded increases. The quantity demanded and the price, have an inverse or
negative relationship.

The price increases and makes the quantity demanded fall for two reasons; substitution
effect and the income effect.

4.2.1.1 Substitution Effect:

The substitution effect is the effect observed with changes in relative price of goods.
When the price of a good increases, consumers will substitute other similar goods for it. If
the price for pork increases, consumers will buy more beef.

4.2.1.2 Income Effect:

When a price increases, the consumers have less income to spend. If the price for a good
doubles, the consumer also has to pay double the amount than before for the same good.
This affects his income.

4.2.2

The Market Demand

The market demand represents the total sum of all individual demands and preferences.
The market demand curve is found by adding the quantities demanded by all individuals
at each price.

55

4.3

The Difference between Economic Movements and Shifts

It is one of the most important distinctions in economics. We distinguish between:

4.3.1

Movements along the Demand Curve

This refers to moving along a given demand curve, tracing out the effects that different
prices have on the quantity of goods people want to buy.

4.3.2

Shifts in the Demand Curve

This refers to changing the demand curve by shifting it left or right, because some variable
other than price has changed.

4.4

Forces behind the Demand Curve

The market demand curve is determined by a whole array of factors, which influences
how much will be demanded at a given price. These factors are the average income, the
size of the population, prices and availability of related goods, taste, and special
influences.

56

4.4.1

Average Income

It is an important determinant of demand. If the income rises, people tend to buy more.
The prices do not necessarily have to change. Yet with more income, purchase/spending
power increases.

4.4.2

Size of the Market

The size of the market is measured by the population. The size of the population affects
the market demand curve. The bigger the population is, the higher is the
purchase/spending power.

4.4.3

Related Goods

Another factor and influence of the market demand is the price and availability of related
goods. A good that has the same function or satisfaction for the consumer is also called a
substitute good. If the demand of a good is low, the price of the same or similar good is
low too.

4.4.4

Consumer Preferences

A consumers preference is unlike the other factors a subjective element of the market
demand. Culture, tradition, history, religion are few factors that influences the taste or
preference of a society. Also psychological or physiological needs are factors that form
consumers preferences for a good such as luxurious cars, fashion, cigarettes, etc.

57

4.4.5

Special Influences

There are some special influences that will affect the demand for particular goods.
The weather, for example, plays an important role. The demand for winter fashion is
higher in colder climate countries than in warm areas. The demand for cars is lower in big
metropolis.
Expectations about future economic conditions, especially prices, have an important
impact on demand.

4.5

Shifts in Demand

The demand changes all the time. Influences, other than the goods price (non-price
variables), shift the demand curves. When there are changes in factors other than the
goods own price which affects the quantity purchased, we call these changes shifts in
demand. Demand increases or decreases when the quantity demanded at each price
increases or decreases.

58

Example:

The quantity of automobiles demanded increased at each price due to a sharp rise of the
average income effect. If the average income rises by 10 percent, the quantity demanded,
at a price of 10 000 $, rises from 10 million to 12 million cars. In figure 17 the rightward
shift of the demand curve is shown. This would be a shift in the demand curve because
the increase in quantity demanded reflects factors other than the goods own price.

(Figure 17)

As factors other than the price change, the demand for automobiles is affected. In figure
17 we see the effect of rising average income, increased population, and lower gasoline
prices making the demand for cars change. This shift of the demand curve is called an
increase in demand.

59

4.6

The Supply Schedule

The supply schedule relates the quantity supplied of a good to its market price, when
other things are held constant. Other things held constant in regard to supply include
costs of production, prices of related goods, and government policies.
The relationship between the market price and the amount of a commodity that producers
are willing to sell is the supply schedule, or the supply curve.

Example:

The table below shows a supply schedule for chocolate. At each price level, we can
determine the quantity of chocolate that producers produce and sell.
At 1 $ (P) per box, for example, no (0) chocolate (Q) will be produced. As the price
increases, more chocolate will be produced. A higher market price will increase the output
of chocolate.

Supply schedule for chocolate:

Price

Quantity supplied

($ per box)

(millions of boxes per year)

18

16

12

At each market price, the quantity manufacturers want to supply is shown. Note the
positive relationship between price and the quantity supplied.

60

4.7

The Supply Curve

The supply curve is a graph relating supply for a good or service to its price. It shows the
quantity supplied of a good at various prices, assuming that other things do not change
(non-price determinants).
The graphical representation of the supply schedule is the supply curve.
In figure 17, the supply curve of the supply schedule from the example of before is shown,
which graphs the quantity of chocolate supplied on the horizontal axis and the price of the
chocolate on the vertical axis. Figure 17 shows the typical case of an upward-sloping
supply curve for an individual commodity. The reason for the upward slope is the law of
diminishing returns. The quantity and price have a positive relationship; Q goes up and P
goes up too.

(Figure 18)

Each pair of numbers (P and Q) from the example of the supply schedule is plotted as a
point. By connecting the points the supply curve is determined (SS).

61

4.8

Forces behind the Supply Curve

The cost of production is a very important element determining the supply curve.
Producers supply commodities for profit and revenues. When production costs for a good
are low relative to the market price, it is profitable for the producers to supply that good.
When production costs are high relative to price, producers either produce little, or
produce other products.

The cost of production is determined by the prices of inputs and technological advances.

4.8.1

Input Prices

The input prices are determined by the cost of labor, energy, and machines used for
production. When in 1970, for example, oil prices increased, it raised the prices of energy,
the production costs and therefore lowered the supply.

4.8.2

Technological Advances

Technological advances consist of changes in technology that lower the quantity of inputs
needed to produce the same quantity of output. Technological changes involve scientific
changes or simply a reorganization of the flaw of work. For example, the production with
machines is a very efficient way of producing goods faster.

62

4.8.3

Prices of Related Goods

The supply curve is also influenced by the prices of related goods. If the price of one
substitute good increases, the supply of another substitute good decreases. For example,
when the price for a particular car rises, the car company will focus on producing more of
that model, and the supply of other models will fall.

4.8.4

Government Policies

The government also has a major influence on the supply curve. Environmental and
health policies determine what manufacturing technologies can be used, while taxes and
minimum-wage laws can significantly increases input prices. For example, free-trade
agreements open up the market for international competition and therefore supply
increase.

4.8.5

Special Influences

There are also other, special influences that affect the supply curve. The weather, as
mentioned before for an influence on demand, also affects supply. For example, in
countries with long raining seasons the supply of umbrellas increases for that particular
time. Innovation is a very important criterion for the computer industry. Market structure
and expectations about future price developments also affect the supply curve.

63

4.8.6

Table of the Factors affecting the Supply Curve

Factors affecting the Supply Curve


1. Technology

2. Input Prices

3. Prices of related goods

Examples
Computerized manufacturing lowers
production costs and increases supply
Lower wages/salaries lowers production
costs and increases supply
If prices for a good fall, prices for the
substitute also fall.
Removing quotas and tariffs on an

4. Government policies

imported good increases the total supply of


that good
Internet researches of a goods price helps

5. Special Influences

the buyer to compare prices and drives


high-cost sellers out of business

4.9

Shifts in Supply

Products and services provided change constantly. Shifts in supply are changes in factors
other than the goods own price that affect the quantity supplied. Supply increases or
decreases when the amount supplied increases or decreases at each market price.

64

Example:

We can see the supply shift in the automobile market. Supply would increase if new
computerized production methods reduced the labor required to produce cars. This would
lower the production costs and the supply for cars increases. This increase of supply is
illustrated in figure 19.

(Figure 19)

As production costs fall, the supply of automobile increases. At each price, manufacturers
will supply more cars. Therefore the supply curve shifts to the right.

65

4.10 Equilibrium of Supply and Demand

After considering demand and supply, we will put both sides of the market together.
Supply and demand interact to produce an equilibrium price and quantity (market
equilibrium).

The market equilibrium is the situation when supply and demand in a market are equal at
the prevailing price. It comes at that price and quantity where the forces of supply and
demand are in balance. The quantity demanded equals the quantity supplied. At that
equilibrium, there is no need for the price to rise or fall.

There equilibrium price is also called the market-clearing price. At the equilibrium price,
the amount that buyers want to buy is equal to the amount that sellers want to sell.

66

Example:

The table below will show us how supply and demand determine the market equilibrium.
In order to find the equilibrium price, we must find the price at which the amount of
chocolate demanded matches the amount of chocolate supplied.
At a price of 5 $ per box, for example, producers would like to sell 18 million boxes per
year while consumers only want to buy 9. This will result in an overstock of chocolate.
At a price of 2 $ per box, demand for chocolate exceeds the production of chocolate.
The equilibrium price therefore is at a market price of 3 $ per box. At this price the desired
demand equals exactly the producers desired production.
Too high a price produces a surplus, which will depress the price and too low a price
causes a shortage, which increases the price.

Combining Demand and Supply for Chocolate


Quantity

Quantity

demanded

supplied

Possible

(millions of

(millions of

price ($ per

boxes per

boxes per

State of

Pressure on

box)

year)

year)

market

price

18

Surplus

Downward

10

16

Surplus

Downward

12

12

Equilibrium

Neutral

15

Shortage

Upward

20

Shortage

Upward

67

4.11 Equilibrium with Supply and Demand Curves

Figure 20 is a supply-and-demand diagram, showing the market equilibrium. It contains


the demand curve (figure 16) and the supply curve (figure 18) from the examples of
before. By putting together those two graphs, we can determine the market equilibrium
point graphically. It comes at the intersection of the supply and demand curve (point C).
At point C the price per box of chocolate is 3 $ and the quantity is 12 units. The quantity
demanded and supplied are equal. Only at point C the forces of supply and demand are in
balance.

(Figure 20)

In a competitive market, the equilibrium is found at the intersection of the demand curve
and the supply curve. At this point, there are no shortages or surpluses.

68

4.11.1 Effects of a Shift in Supply and Demand

By analyzing demand and supply curves and methods carefully, predictions about the
impact of changes in economic conditions on prices and quantities can be made.

The table is an overview of the effects on price and quantity of different demand and
supply shifts.

Shift in Demand and Supply


If demand rises

the demand curve shifts to the Price increases


right, and

If demand falls

Quantity increases

the demand curve shifts to the Price decreases


left, and

If supply rises

Quantity decreases

the supply curve shifts to the Price decreases


right, and

If supply falls

Effect on price and quantity

Quantity increases

the supply shifts to the left, Price increases


and

Quantity decreases

The following figures (21 24) show graphical examples of the table above.

69

Example:

A bad harvest caused producers and manufacturers to raise their prices for bread, making
the quantity demanded for bread exceeds the quantity supplied. The increase of price
encourages production and thereby raising quantity supplied. At the same time the
increase of price discourages consumption and lowers the quantity demanded. The price
continues to rise until to the new equilibrium price, where the amount demanded equals
the amount supplied. Figures 21 and 22 show the shift of the supply and the demand
curve.

(Figure 21)

This figure shows a leftward shift of the supply curve. The new equilibrium (E) is found at
the intersection of the new supply curve (SS) and the original demand curve. Increased
prices lowers quantity demanded (law of downward-sloping demand).

70

(Figure 22)

This figure shows a rightward shift of the demand curve. The new equilibrium (E) is found
at the intersection of the new demand curve (DD) and the original supply curve.

For both examples (shift of supply and demand curve) a variable underlying the demand
or supply curve has changed. In the case of supply the variable of change might be a
change of input prices or technology for more efficient production. In the case of demand,
the population rate, consumer preferences, or the prices of related goods, may be the
reason for the change and shift of the demand curve.

71

AS 052

Economics 1
Theoretical Test

72

AS052
ECONOMICS 1
TEST

1. What is Scarcity?

2. What is Efficiency?

3. What are the three fundamental economic problems?

4. What are the four possible relationships two variables can have?

5. If variable X and Y are negatively (or inversely) related and X decreases, what will
happen to Y?

6. What is the relationship between price and demand called?

7. What are the two main tools of fiscal policy?

8. Name the three most important examples of a not-efficient perfect competition.

9. What is the only factor that changes the quantity demanded and supplied but not
the demand?

10. If the cost of production goes up, does the supply curve shift to the left or to the
right?

73

AS052
ECONOMICS 1
TEST
(Solution)

1. Scarcity is the problem of unlimited human needs and wants in a world with limited
resources.

2. Efficiency is the most effective use of a societys resources in satisfying peoples


wants and needs.

3. What, how, and for whom goods are to be produced.

4. Variables X and Y can have a positive effect, a negative effect; X no effect on Y,


and Y no effect on X.

5. Y will decrease.

6. It is called the demand schedule, or the demand curve.

7. They are government spending, and taxation.

8. The three most important examples are imperfect competition, externalities, and
public goods.

9. It is the price.

10. The supply curve shifts to the left. When the costs of production increases, supply
decreases and therefore the curve shifts to the left.

74

KEY TO EVALUATION

PER CENT

MARK

88 100

75 87

62 74

50 61

0 49

75