The price elasticity of supply (PES) indicates how responsive producers are to a change in price. The law of supply states that there is a positively relationship between quantity supplied and price.
PES = The percentage change in quantity supplied
The percentage change in price
Price Price
S2
S1
ES1 > 1 0 < ES2 < 1
Quantity Quantity
Elastic supply Inelastic supply
The primary determinant of PES is time period considered. Supply is usually more elastic (responsive) in the long run than in the short run. In the short run, an iron factory cannot directly respond to the change. In the long run, the iron factory can apply more labour and machine to organize a new market output.
Stocks of finished products and components are other determinant of PES. If stocks of coconuts and santan are at high level, a firm can respond to a change in demand quickly by supplying these stocks into the market, supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher and unless stocks can be replenished, supply will be inelastic in response to a change in demand.
PART B
By concept price elasticity of demand (PED), a business can measure the sensitivity of changes in quantity demanded to changes in price, ceteris paribus. Normally, PED is a negative value due to its negative relationship between price and quantity demanded, where it is measure as,
PED = The percentage change in quantity demanded
The percentage change in price
Elastic demand is a situation that the percentage change in quantity demanded is greater than the percentage change in its price. High elasticity in PED will lead in high responsive of consumers towards the good, a business cannot sell high elastic PED product at high price. This is due to consumers’ high sensitivity to the price change; fewer consumers will continue purchase the product. The business should increase the quality of the product and come up strategy, such as promotion to attract consumers back to buy their product.
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Inelastic demand is a situation that percentage change in quantity demanded is less than percentage change in its price. High inelasticity in PED will lead in less responsive of consumers towards the good, so a business can price their product at higher price. The business can use the strategy of wrap up their product in a nice and attractive look.
Perfectly inelastic demand is a situation that quantity demanded does not change as the price change. Consumers do not response to the change in price of the product, e.g. cigarette. Seller can sell it at a reasonable high price.
Price Price
D2
D1
ED1 > 1 0 < ED2 < 1
Quantity Quantity
Elastic demand Inelastic demand
Price Price
D4
D3
ED3 = 1 ED4 = ∞
Quantity Quantity
Unitary elastic demand Perfectly elastic demand
Price D5
ED5 = 0
Quantity
Perfectly inelastic demand
Question 3
PART A
Supply indicates how much of the good producers are both willing and able to offer for sale per period at each possible price. The law of supply states that the quantity supplied is positively related to its price, ceteris paribus. The higher the price, the greater the quantity supplied, vice versa. Diagram below shows increase in quantity supplied,
Price
S0
S1
Quantity supplied
Firstly, a higher price of goods makes producers more willing and able to increase the quantity of goods offered for sale, ceteris paribus. An increase in the price of butter provides producers with a profit incentive to shift some resources out of the production of other goods, such as milk into butter, for which the price of butter is relatively higher than milk.
Secondly, the new invention of technology increases the supply of a product. Assume that a new butter-making machine increases productivity, producers can supply more butter at each possible price or can supply the same quantity at lower price.
Thirdly, increase in the number of producers shift supply curve rightward. For example, during the 1980s the number of video rental shops mushroomed, the supply of rental video increased sharply, shifting the curve to the right.
PART B
Price in most markets is free to rise and fall to their equilibrium levels, no matter how high or low those levels might be. However, sometimes government concludes that supply and demand will produce prices that are unfairly high for buyers or low for sellers. Thus government set price floor and price ceiling to prevent this kind of unfairly situation occurs.
Price ceiling sets the maximum legal price a seller might charge for a product or service. A price at or below the ceiling is legal. When economics say that “price ceiling stifle the rationing function of prices and distort resource allocation”, they means the actual price equilibrium of a product has been affected and changed. A simple rule of market states that when quantity supplied and quantity demanded are unequal, the lesser of the two determinants the quantity actually exchange. The price ceilings result in shortages when they are effective. Even though it may be illegal to charge more than pmax, there are usually enough individuals willing to break the law to create a thriving black market in which the good are sold illegally in violation of the price ceiling law. People who buy at low prices and then resell them at higher prices are arbitrageurs. Diagram below shows when the price ceiling is set at pmax, quantity demanded is q2 and quantity supplied is q1, so there is an excess demand for q2 – q1. Ordinarily, the excess demand would drive the price up to pe, but if the price ceiling is successfully enforced, the price will remain at pmax.
Price Price
S S
Pe P1
Pmax Pe
Excess demand D Pmax D
Quantity Quantity
q1 qe q2 q1 qe
A Price Ceiling The consequences of a Price Ceiling with
a Black Market (P1 is black market price)
Price floor sets a minimum price below which the government will not allow the price to drop. The forces of supply and demand tend to move the price towards the equilibrium price, but when the market price hit the floor, it can fall no further. The market price equals to the price floor. At this floor, the quantity supplied exceeds the quantity demanded. There is an excess of supply or surplus. Diagram below shows when the price ceiling is set at pmin, quantity demanded is q2 and quantity supplied is q1, so there is an excess supply for q2 – q1. Ordinarily, the excess supply would fall the price up to pe, but if the price floor is successfully enforced, the price will remain at pmin .
Price A price floor
Excess Supply S
Pmin
Pe
D
Quantity
q1 qe q2
Question 5
PART A
Demand indicates the quantity of a product that consumers are both willing and able to buy at each possible price, ceteris paribus. However, quantity demanded refers the amount of a product that consumers are willing and able to purchase at a particular price.
Change in demand is a shift (leftward or rightward) of the entire demand curve. Except for price of the product, change in any one of the determinants can lead to shift of the demand curve. For instance, when people become more health conscious, they will tend to buy more fruits instead of candy. Decrease in demand of candy will lead to a leftward shift of the entire demand curve.
Price of candy
D0
D1
Quantity of candy demanded
Change in quantity demanded is a movement (upward or downward) along the demand curve. Only price of the product can lead to change of movement. For instance, an increase in price of candy will decrease the quantity of candy demanded from 5000 to 4500 units, the demand curve move upward.
Price of candy
D
Quantity of candy demanded
PART B
Income elasticity of demand (YED) is the percentage change in demand divided by the percentage change in income. YED implies how the quantity demanded changes as consumer income changes.
YED = The percentage change in quantity supplied
The percentage change in income
A positive sign (0 A zero sign (YED=0) denotes a necessity good, such as cooking oil and salt. The quantity demanded does not change as income change. For example, YED = 0. The good is necessity good. A rise in income of 3% would lead to no change (0%) in quantity demanded.
Question 6
PART A
Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. It measures how much better of individuals in the aggregate are by being able to buy a good in the market. For instance, a student would have been willing to pay RM10 for a tiramisu, even though she had to pay only RM7. The RM3 that she saved is her consumer surplus. When we add the consumer surplus of all consumers who buy a good, we obtain a measure of the aggregate consumer surplus.
Initial consumer surplus
Price
Consumer surplus to new consumers
P0
Additional consumer surplus to initial consumers P1 DA
0 Quantity
Q0 Q1
Consumer surplus
Producer surplus is the amount a seller is paid minus the cost of production. It measures the benefit to sellers of participating in a market. For instance, the cost of production of each tiramisu is RM5, whereas the tiramisu is sold for RM7. The seller gains RM2 for each tiramisu.
Additional producer surplus to initial producers
Price SA
P1
Producer surplus to new producers
Initial producer surplus P0
0 Quantity
Q0 Q1
Producer surplus
Therefore, we can get market equilibrium by combine both diagrams of consumer surplus and producer surplus.
Consumer surplus
Price
S
Producer surplus
D
Quantity
Consumer surplus and Producer surplus
PART B
Production possibility frontier (PPF) is a curve or a boundary that shows the various combinations of output that the economy can possibly produce given the available factors and production technology efficiently. A PPF is normally drawn as concave to the origin because the extra output resulting from allocating more resources to one particular good may fall. This is known as the law of diminishing returns and can occur because factor resources are not perfectly mobile between different uses, for example, re-allocating capital and labour resources from one industry to another may require re-training, added to a cost in terms of time and also the financial cost of moving resources to their new use. Shift in PPF refer to increasing capacity of the economy. Assume spaghetti and cake is two outputs in this case.
Quantity of Spaghetti produced
Unattainable point
Efficient point
Inefficient point
Quantity of cake produced
Production possibility frontier
Quantity of Spaghetti produced
B
A
Quantity of cake produced
A B
Shift in production possibility frontier
There are three economic concepts: opportunity cost, scarcity and trade-off.
Opportunity cost. The PPF shows the opportunity cost of one good as measured in terms of the other good. Choosing more output of good A usually means giving up output of good B. The opportunity cost of a higher output has to be given up. When society reallocates some of the factor of production from the cake industry to the spaghetti industry, the cake has to given up X amount to get additional Y amount of spaghetti at certain economy point. In other words, when the economy is at the certain economy point, the opportunity cost of Y spaghetti is X cake.
Scarcity is a condition when limited resources, goods and services need to satisfy people unlimited wants. A good need to be scarified to produce another good. Flour is the basic ingredient to produce spaghetti and cake. Due to limited flour, producers need to produce either less spaghetti or less cake to produce the other product.
The PPF shows the trade-off between the production of different goods at given time, but the trade-off can change over time. For example, if a technological advance in the cake industry raises the number of cake that a worker can produce per week, the economy can make more cake for any given number of spaghetti. As a result, the PPF shift outwards. Due to this economy growth, the society might move production from point A to point B in shift PPF graph, enjoying more cake and more spaghetti.
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