F101ECO H01 Revision Teaching

Your Tutor for the
Session
BSc Programme
Economics
Revision Session
2012
Building Futures
Topics
3 Hour Exam : 4 questions from 8 :
1) How markets work
5) NI measurement
2) Indifference theory
6) Multipliers
3) Monopoly
7) Inflation
4) Demand for Labour
8) International trade
1. How markets work

Market Equilibrium
Price of
tomatoes
(dollars per kg.)
40
Supply
35
30
25
Demand
0
200
100
300
400
Quantity demanded & supplied per month ( 000s kgs. )
1. How markets work

The Market clearing process
Price of
tomatoes
(dollars per kg.)
40
Supply
Excess supply
Case 1 35
30
Case 2 25
Excess demand
Demand
0
100
200
300
400
1. How markets work

Price of
tomatoes
(dollars per kg.)
40
Supply
1) Sellers reduce price to clear

accumulating unsold stock.
Excess supply
(Buyers may offer lower prices for
Case 1 35
otherwise unsold stock)
1
30
25
Demand
0
200
100
300
400
1. How markets work

Price of
tomatoes
(dollars per kg.)
40
Supply
price falls due to the substitution
Excess supply
(value-for-money) effect and the
Case 1 35
2) Quantity demanded extends as
real income (affordability) effect.
30
25
Demand
0
100
200
300
400
1. How markets work

Price of
tomatoes
(dollars per kg.)
40
Supply
the lower price squeezes
Excess supply
profitability and the higher
Case 1 35
3) Quantity supplied contracts as
marginal costs of intensive
30
production are no longer

worthwhile.
25
Demand
0
100
200
300
400
1. How markets work

Price of
tomatoes
(dollars per kg.)
40
Supply
4) Sellers raise price to cash in on

the shortages (Buyers may offer
higher prices to secure the good)
35
30
4
Case 2 25
Excess demand
Demand
0
100
200
300
400
1. How markets work

Price of
tomatoes
(dollars per kg.)
40
Supply
5) Quantity supplied extends as

the higher price boosts profitability
and the higher marginal costs of
35
more intensive production become

worthwhile.
30
4 5
Case 2 25
Excess demand
Demand
0
100
200
300
400
1. How markets work

Price of
tomatoes
(dollars per kg.)
40
Supply
6) Quantity demanded contracts

as price rises due to the
substitution (value-for-money)
35
effect and the real income

(affordability) effect.
30
Case 2 25
Excess demand
Demand
0
100
200
300
400
1. How markets work

Price of
tomatoes
(dollars per kg.)
40
Supply
Excess supply
Such changes will persist until
Market equilibrium
4 5
off changes in price, demand

and supply.
Case 1 35
30
Either type of excess triggers
the excesses disappear. The
variables cease to change
Case 2 25
when:
Excess demand
DEMAND = SUPPLY
Demand
0
200
100
300
400
1. How markets work

Price of
tomatoes
(dollars per kg.)
40
Supply
But how do these disequilibrium

cases come about ?
Excess supply
Case 1 35
30
Answer Either some external

force has caused it (eg Govt.
price control), or MORE LIKELY
the equilibrium has moved
because of a shift in demand or
supply.
Market equilibrium
4 5
Case 2 25
Excess demand
Demand
0
100
200
Each of the six numbered arrows

should be EXPLAINED in
behavioural terms !
300
400
1. How markets work

This topic title can be extended to take in How WELL markets work in
which case EFFICIENCY (and maybe equity) would be brought into the
analysis.
Listen to the Introductory AUDIO POWERPOINT on this subject.
Price,
welfare
S (reflecting
opportunity
costs)
CS
PS
Maximum
welfare gains
from trade
D (reflecting
consumption
benefits)
Qe
Quantity per
unit of time
1. How markets work in MIXED Economies

Forms of Government intervention in Markets
Price
a) An indirect
tax
Price
S + tax
P2
b) An indirect
subsidy
c) A maximum price
Price
S
S+
subsidy
MC
P1
P1
P1
P2
MC
P2
D
S
MB
Q2
Q1
Quantity per unit of time
D
0
Q1
Q2
D
0
Q2
Q1
The WELFARE LOSS

in each case
Building Futures

1) Government price control
Can be:
price ceilings BELOW equilibrium
(eg. rent control)
Price floors ABOVE equilibrium
(eg. Minimum wages)
Fixed prices either side of equilibrium
(eg. Fixed exchange rates)
Building Futures

Government indirect tax decisions
Indirect taxes are so called because they affect consumers
indirectly through pushing up prices. How demand responds
to such price rises will be relevant to the purposes of the tax.
Two main purposes exist:
To raise revenue (revenue duties)
To discourage consumption (demerit taxes)
Low PED is preferable for the first objective WHY?
High PED is preferable for the second objective WHY?
Building Futures

Incidence (who pays the tax?)
Indirect taxes are handed over to the Govt. by suppliers but
they pass on some of the tax to consumers by charging
higher prices. Thus consumers pay some of the tax and
suppliers pay some. The PROPORTION is called the incidence
or burden of the tax.
An incidence rule states that the ratio of the respective
burdens equals the inverse ratio of the respective price
elasticities!!
Building Futures

Incidence Rule
Amount consumer pays
(through higher prices)
Amount supplier pays
(net of higher price receipts)
PES value
(over relevant range)
PED value
(over relevant range)
Thus, in the special case where PED and PES values were
equal. The tax per unit on the good would be exactly twice the
size of the resulting price rise and the two groups would finish
up paying equal shares!!
Building Futures

Incidence and price elasticities
Supply + Tax
Supply (Inelastic)
Price
Price
Supply + Tax
P2
P2
P1
Supply (Elastic)
Demand
(Elastic)
Ps
P1
Ps
Demand
(Inelastic)
Q2 Q1
Demander
pays
Supplier
pays
(the price rise)
(the rest)
Q2
Q1
Building Futures
2. Indifference Theory
The Indifference Model provides us with information on FOUR
important variables that affect the consumer decision:
1.
2.
3.
4.
Consumer income (the budget available)

The price of good X (discos)
The price of good Y (meals)
Consumer tastes
Changes in any of these would affect the optimal decision.

1
Building Futures
10
The combinations
An Indifference Curve
Quantity
Consumed
of Good Y
Utility U
Higher Utility U1
12Y
12Y+5X and 6Y+8X

both give the SAME
utility (U)
Consumers are
INDIFFERENT
between them.
6Y
5X
8X
Quantity Consumed of Good X

Building Futures
The combinations
A budget line
Quantity
Consumed
of Good Y
10Y+4X and 5Y+8X
If B = 60 pw
Price of Good X must be . ?
Price of Good Y must be .. ?
10Y
both give the SAME

level of SPENDING
(B for Budget) Both
combinations are
equally affordable.
5Y
4X
8X
Quantity Consumed of Good X

Building Futures
11
Consumer Equilibrium
Meals
8
7
6
U1
U0
U
5
4
3
2
1
F
0
Discos
Point E is on the highest attainable indifference curve

Building Futures
Point E is a POINT of TANGENCY
Therefore at E:
The gradient of the
Budget Line
The gradient of the

Indifference Curve
Price of X
Price of Y
Marginal Utility of X
Marginal Utility of Y
MU of Y
Price of Y
Therefore at E:
Therefore at E:
MU of X
Price of X
Building Futures
12
3. Monopoly
Definition:
A pure monopolist is the only firm in a particular industry
and will (almost certainly) be protected by barriers to entry.
A monopolist may:
differentiate its own product
price discriminate
(But these are not definitional characteristics)
NB: The difference between PURE monopoly and firms that have
monopolistic power.
3. Monopoly
The two key definitional characteristics are therefore:
a) The FIRM IS the industry and therefore faces the market
demand curve.
b) The barriers to entry will mean that there are likely to be
long run supernormal profits.
We can add to these the general (commercial) assumption
that monopolists will profit-maximise and will therefore
follow the decision rule, MC = MR.
This gives the equilibrium output shown on the next slide.
13
3. Monopoly
Monopoly Equilibrium
MARGINAL
COST
Price
Pe
AVERAGE
COST
Supernormal
profit
DEMAND
(Average
revenue)
AC
MARGINAL
REVENUE
0
Qe
Quantity per time period
3. Monopoly
Inefficiency in Monopoly (welfare loss)
MARGINAL
COST
Price
Pe
Welfare
Loss
AVERAGE
COST
DEMAND
(Average
revenue)
AC
MARGINAL
REVENUE
0
Qe
14
3. Monopoly
Inequity in Monopoly (Exploitation)
MARGINAL
COST
Price
HIGH
PRICE
AVERAGE
COST
HIGH
profit
DEMAND
(Average
revenue)
AC
MARGINAL
REVENUE
0
Qe
3. Monopoly
But all is not negative with monopolies.
They will tend to be BIG firms therefore they may enjoy
INTERNAL ECONOMIES of SCALE
Increasing returns to scale
Factor price advantages
Research & Development advantages
All of these will tend to SHIFT the COST curves downwards.
15
3. Monopoly
Possible COST advantages to Monopoly
Price
MC1
MC2
P1
P2
AC1
AC2
DEMAND
(Average
revenue)
MARGINAL
REVENUE
AC2
Q2
3. Monopoly
Lower costs will reduce price (P2 < P1) and therefore will
offset the exploitative nature of monopoly
It could be a WIN-WIN outcome (lower price and higher
profits)
There will still be welfare loss inefficiency BUT the lower
costs make the maximum attainable welfare greater
(An inefficient high welfare world may be preferable to an
efficient low welfare world.)
A REGULATED monopoly attempts to achieve the best of
both worlds!
16
4. Demand for Labour

Demand for labour is an example of derived demand
Input demand is derived from output demand
Thus the demand for car-workers is derived from the
demand for cars
And the demand for property space is derived from the
demand for whatever is produced in that space!
But the exact nature of the link between input and
output demand is a little more complicated than that!
Building Futures

The THEORY of derived demand is based on the
concept of MARGINAL REVENUE PRODUCT (MRP)
THREE definitions of MRP ..
MRP is the extra revenue from the extra product

generated by the last unit of input
MRP = Change in REVENUE

Change in INPUT
MRP = MPP x MR
MPP = Change in Product

Change in Input
MR =
Change in Revenue
Change in Product (sold)

Building Futures
17

An arithmetic example ..
Labour demand
rises by
2 workers pw
Production
rises by 600
units per week
Sales revenue
rises by
1800 per week
MPP = +600 / +2 = 300 units pw per worker

MR = +1800 / +600 = 3 per week per unit
MRP = +1800 / +2
or
300 x 3 = 900 pw per worker.
Building Futures

BUT MRP is not a constant value. It will be
variable in response to:
Changes in Quantity of Labour used
(ie movements along the MRP curve)
Changes in Productivity (MPP) and Output
Market (MR) conditions
(ie shifts in the MRP curve)
Building Futures
18

The Firms MRP curve for labour
This may rise at first as more workers are used
(due to some specialisation)
But will eventually fall due to the Law of Diminishing
Returns (MPP )
and (possibly) the firms need to lower price to sell
extra production (MR )
Building Futures

The Firms MRP curve
MRP
()
900
MRP
0
10
12
14
16
Quantity of
labour
(workers pw)
Building Futures
19

The Firms Optimum level of demand
for this we need to

introduce info. on Input
price (ie wage rate)!
MRP
Wage ()
MC of labour
Wage pw
= 800
MRP = MCL
0
10
MRP
12
14
16
Quantity of
labour
(workers pw)
Building Futures

The Firms Demand Curve
MRP
Wage ()
for this we need to

introduce different
possible wage rates!
MC1
MC2
MC3
MRP
w1
w2
w3
The firms Dcurve for
labour!
0
D1 D2 D3
Quantity of
labour
(workers pw)
Building Futures
20

The Firms Demand Curve for Labour
MRP
Wage ()
MC1
Wage rate
The firms Dcurve for

labour!
D1
Quantity of
labour
(workers pw)
Building Futures

Shifts in the Demand Curve
MRP
Wage ()
Wage rate
MC
D1 (MRP1)
D1
Quantity of
labour
(workers pw)
Building Futures
21

Shifts in the Demand Curve
MRP
Wage ()
Wage rate
MC
D0 (MRP0)
0
D0
Quantity of
labour
(workers pw)
Building Futures

As previously stated (rightward) SHIFTS are caused by
Changes in Productivity (MPP)
Better quality workers
More other factors (more space, more machinery)
Better quality other factors (better machinery, better

space planning, better management)
Output Market (MR) conditions
Greater demand in the output market
Reduced competition/supply in the output market

Building Futures
22
5. National Income Measurement

NATIONAL INCOME is the extra product
wealth generated by an economy
during the course of a year.
There are THREE ways in which this PRODUCTION
concept can be measured
PRODUCT method (direct)

INCOME method (indirect)
EXPENDITURE (indirect)
Building Futures

The circular flow of income
Goods &
Services
Expenditure on
goods & services
HOUSEHOLDS
HOUSEHOLDS
FIRMS
Factor payments
(wages, rents,
profit)
NATIONAL
PRODUCT
NATIONAL
INCOME
NATIONAL
EXPENDITURE
NP = NI = NE
Factor services
(labour, land, etc)
Building Futures
23

The NATIONAL PRODUCT Approach
All firms
Output
&
ALL
VALUEADDED
Doublecounted
output
value
Output
of non-firm
institutions
Imputed
value of
owner-occupied
accommodation
&
Imputed
Rent
Transfer
interest
as output
of
financial
institutions
Transfer
interest

The NATIONAL INCOME Approach
All
Household
income
Wages and
salaries
Imputed
value of
owner-occupied
Accommodation
&
Retained profit
&
Any income
diverted to the
government in
tax
Stock
appreciation
&
Transfer
Income
Income from self

employment
Rent & Imputed

Rent
+
All profit less
stock
appreciation
24

The NATIONAL EXPENDITURE Approach
All
Household
Expenditure
Imputed
rental expenditure
&
Firms expenditure on
capital equipment
&
Inventory investment
&
Government spending
on the provision of
services
&
Foreign expenditure on
exports
&
Subsidies on goods &
services
Consumer
spending
Transfer
spending
&
Imports
&
Taxes on
goods &
services
Investment
Govt spending
Exports less
imports
Indirect taxes
net of subsidies
6. Multipliers
Theoretical Background
The SAY view (Supply creates its own Demand)
The KEYNES view (Demand determines Supply)
To be more exact it is AGGREGATE DEMAND that
determines NATIONAL PRODUCT, where:
AD = C + I + G + X M
Building Futures
25
6. Multipliers
The economy will react to changes (shifts) in these
components through a process involving:
Multiplier repetitions
Spending brings forth new production hence creating
new income. Partial respending of that income
finances new spending which brings forth etc
Inventory adjustments at each stage

Each round of spending lowers stocks (inventory) and
that is the signal for producers to increase output. In
service sectors it is pressure on capacity that
constitutes the equivalent signal.
Building Futures
6. Multipliers
NI
The Multiplier Process
The shift upward in

the Agg. Demand line
of 60 billion triggers
off an upward
multiplier process
which eventually
raises National
Income by 120
billion!
Aggregate
Demand,
(National
Income)
( billion)
New AD
Upward
Multiplier
Process
15
30
Original
AD
60
Initial rise in
Govt
Spending of
60 billion
160
Overall
increase in
National
Income
of 120 billion
100
The multiplier is TWO

45o
200
320
National Income
( billion)
Building Futures
26
6. Multipliers
Multipliers are Measures of Sensitivity (like
marginals and elasticities). They usually involve
an initial CAUSE that brings about a larger
(multiplied) EFFECT.
In Economics 1 you may encounter SIX multipliers
The BASIC INJECTIONS multiplier (kj)
FIVE Fiscal multipliers (kj, kt, kb, kg, kr)
The CREDIT (or Deposit) multiplier (kc)
6. Multipliers
INJECTIONS MULTIPLIER calculations are based on the effects
of the multiplier process.
Suppose there is an autonomous increase in Govt. spending of
60 billion.
This is an autonomous increase in aggregate demand of 60
billion.
Suppose also that there are enough resources in the economy
to meet the rising demand.
Let us further suppose that people, on average, tend to spend
exactly half (0.5) of any extra income they receive on UK
(domestic) goods. The rest is saved, taxed, or spent on imports.
Building Futures
27
6. Multipliers
( AD of 60b)
( Cd of 30b)
( NP of 60b)
( NP of 30b)
( Cd of 15b) ( NP of 15b)
( Cd of 7.5b) etc
Hence the resulting overall change in National product (NP) will be:
60b ( 1 + 0.5 + 0.25 + 0.125 + etc )
which equals:
60b ( 1 + 0.5 + 0.52 + 0.53 + 0.54 + )

Building Futures
6. Multipliers
The expression in brackets is the sum of a geometric
progression that can be calculated as:
1
`
( 1 MPCd)
where MPCd ( the Marginal Propensity to

Consume domestic goods) is that 0.5
fraction we assumed described peoples
spending behaviour.
So the overall change in National product (NP) is:

60b ( 1 )
( 1 0.5)
60b x 2
120 billion
Building Futures
28
6. Multipliers
There are two basic multiplier equations to learn :
1 The Multiplier value (kJ)
kJ =
1
` =
(1 MPCd)
1 ` =
MPW
1
`
MPS + MRT + MPM
2 The Multiplier prediction

Overall NP (or NI) =
kJ x Original AD
Building Futures
6. Multipliers
The basic multiplier process can be triggered by any
INJECTION I (Investment), G (Govt Spending) or X
(foreign spending).
Exercise: Suppose firms spend an extra 500m
on new machinery and MPCd = 0.8
CALCULATE: a) The Multiplier value
b) The final effect on National Income
What would be the overall effect if the 500m was
c) Only this year ?
d) Financed from extra tax?
29
7. Inflation
1) What is inflation
3) Effects of inflation
Definitions
Efficiency effects
Measuring Price indices & inflation
Equity effects
Macro effects
2) Causes of inflation
Demand-pull
4) Policies for inflation
Cost-push
Fiscal deflation
Monetarist view
Monetary deflation
Principal references; Paper

0498 and the DVD!)
Monetarist prescription
7. Inflation
Measuring Retail Price Inflation
A basket of goods is defined which includes all major
items of expenditure. Contents of this basket can
change over time.
Price rises (and falls) are monitored for each of these
items, usually over the course of a year. They are
expressed in percentage form.
These price changes are then weighted according to
the proportion of spending that they account for.
30
7. Inflation
The weighted price changes for all the basket items
are added up.
This addition is then divided by the sum of the weights
to give retail price inflation in percentage form.
This percentage of the previous years index value is
added to that previous years index to give the new RPI.
The original index value is conventionally set
at 100 for a chosen base year.
7. Inflation
Item
%Price Expenditure Weight
P x w
Food
+ 20
40m
+ 40
Accom.
+ 50
60m
+ 150
Others
10
100m
50
INFLATION = (40 + 150 50) / (2 + 3 + 5) = 14%

New Index = (Previous Index) x (1 + 0.14)
31
7. Inflation
Keynesian Demand-Pull View
Building Futures
7. Inflation
The COST-PUSH view
Wagepush; autonomous increases in wage costs cause
inflation.
Imported costpush; increases in the prices of imported
raw materials.
Taxpush; increases in business taxes or indirect taxes
which raise business costs.
Profitpush; increases in profit margins or mark-ups
associated with an increase in monopolistic power.
Building Futures
32
7. Inflation
The MONETARIST view
Monetarists argue that the amount of money in circulation is the
crucial determinant of INFLATION. This view of inflation is known
as The Quantity Theory of Money!
M . V =
then
Y . P
Building Futures
7. Inflation
(A)
(B)
If the MONEY SUPPLY were to expand (more than

real output (Y)),
And VELOCITY of CIRCULATION is stable,
(C)
Real output will temporarily surge due to asset

disequilibrium, then back to its original level,
(D)
Therefore PRICES will tend to rise in line with the

monetary expansion !!
Building Futures
33
8. International Trade
Key points
Absolute advantage
Definition
Numerical example
Diagrammatic model
Comparative advantage
Definition
Numerical example
Diagrammatic model
Building Futures
Other arguments for trade
Economies of scale
Choice
Co-operation
Arguments against protectionism

The arguments FOR trade!
Infant industries may not grow up
Employment protection encourages inefficiency
Prices (& maybe inflation) are higher
Building Futures
34
The Principle of Comparative Advantage.
(David Ricardo)
Trade creates economic welfare.
Providing there is no compulsion, there are no losers
only winners with trade.
In spite of this basic truism, many people still cant
appreciate why it can be beneficial to trade
internationally with countries whose productivity
capabilities are inferior.
Building Futures
Maximum Production Possibilities
Country
P
Country
Q
Zips
100
120
Buttons
50
200
Building Futures
35
Maximum Consumption Possibilities
(no trade, 50% resource split)
Country
P
Country
Q
Zips
50
60
Buttons
25
100
Building Futures
Production Specialisation (Q devotes 75% of
resources to buttons ie PARTIAL Specialisation)
Country
P
Country
Q
Zips
100
30
Buttons
150
Building Futures
36
Consumption
(after trading 40 units of each good @ 1Z =1B)
Country
P
Country
Q
Zips
60
70
Buttons
40
110
Building Futures
Consumption Gains !!
Country
P
Country
Q
Zips
+10
+10
Buttons
+15
+10
Building Futures
37
The Absolute Advantage (Adam Smith) model !!
Units of
Wine
(000s)
300
PV
CPCC
Country
C
Country
V
Maize
100
60
Wine
200
300
200
PPCC
CPC V
100
PPCV
0
20
PC
40
60
80
100
Units of Maize (000s)

Building Futures
The Comparative Advantage (David Ricardo) model !!
Units of Coal
(x tonnes)
Country Country
G
UK
400
PG
300
CG
200
CPC UK
160
100
80
Coal
400
160
Steel
120
100
NTG
CUK
PPCUK
PPCG
NTUK
0
20
30
40
50
60
CPCG Terms of trade

2C = 1S
PUK
80
100
120
Units of Steel (x tonnes)
Building Futures
38
KEY to previous slide
With no trade G produces and consumes at NTG
With no trade UK produces and consumes at NTUK
With PARTIAL specialisation G produces at PG
With complete specialisation UG produces at PUK
With TRADE G consumes at CG
With TRADE UK consumes at CUK
Building Futures
39

F101ECO H01 Revision Teaching

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4) Demand for Labour

1. How markets work

Quantity demanded & supplied per month ( 000s kgs. )

1. How markets work

Quantity demanded & supplied per month ( 000s kgs. )

1. How markets work

1) Sellers reduce price to clear

(Buyers may offer lower prices for

otherwise unsold stock)

Quantity demanded & supplied per month ( 000s kgs. )

1. How markets work

price falls due to the substitution

(value-for-money) effect and the

2) Quantity demanded extends as

real income (affordability) effect.

Quantity demanded & supplied per month ( 000s kgs. )

1. How markets work

the lower price squeezes

profitability and the higher

3) Quantity supplied contracts as

marginal costs of intensive

production are no longer

Quantity demanded & supplied per month ( 000s kgs. )

1. How markets work

4) Sellers raise price to cash in on

Quantity demanded & supplied per month ( 000s kgs. )

1. How markets work

5) Quantity supplied extends as

more intensive production become

Quantity demanded & supplied per month ( 000s kgs. )

1. How markets work

6) Quantity demanded contracts

effect and the real income

Quantity demanded & supplied per month ( 000s kgs. )

1. How markets work

Such changes will persist until

off changes in price, demand

Either type of excess triggers

the excesses disappear. The

variables cease to change

Quantity demanded & supplied per month ( 000s kgs. )

1. How markets work

But how do these disequilibrium

Answer Either some external

Each of the six numbered arrows

Quantity demanded & supplied per month ( 000s kgs. )

1. How markets work

1. How markets work in MIXED Economies

Quantity per unit of time

Quantity per unit of time

The WELFARE LOSS

1. How markets work in MIXED Economies

1. How markets work in MIXED Economies

1. How markets work in MIXED Economies

1. How markets work in MIXED Economies

1. How markets work in MIXED Economies

(the price rise)

Consumer income (the budget available)

Changes in any of these would affect the optimal decision.

12Y+5X and 6Y+8X

Quantity Consumed of Good X

10Y+4X and 5Y+8X

both give the SAME