Economics (Resource allocation in

competitive markets I)
Circular flow of economic activity:
1. Households (consumers) demand consumer goods and services from
the product (output) market, and supply labour into the factor (input)
market.
2. Firms (producers) demand labour, capital (includes producer goods) and
land from the factor (input) market, while supplying the product (output)
market with goods and services

Price mechanism (market mechanism)

In the market economy, resource allocation results from many decentralized,
independent decision made by both consumers (buyers) and producers (sellers)
in the market.

The market is an economic situation (can occur anywhere like online, over the
phone…) in which buyers and sellers negotiate the exchange of any well-defined
commodity, like flour, laptops or T-shirts.

The buyers, as a group, will determine the demand for a product, while the
producers will determine the supply. This result in a market price (Price
consumers pay for a certain good of service) and quantity transacted (number
of goods and services consumed)

Hence, the theory of price determination was developed, which assumes that
the markets are perfectly competitive [Good and services offered for sale are
identical (ie. Does not matter who you buy from), and there is no monopoly (ie.
No individual can influence market solely)]

The product market is where consumer goods and services are bought and
sold.

The theory of demand

Demand is the willingness and ability of a consumer to pay a specific price for a
good or service in a given period of time.

Willingness refers to the desire of a consumer to consume a good or service, to

satisfy a need/want (they do not necessary obtain it)

Ability refers to the fact that the consumer can afford it.

Effective demand is the quantity of a good or service that consumers are

willing and able to purchase in a given period of time, across a range of prices.

Done by Nickolas Teo Jia Ming, CG 12/11

Hence it involves opportunity cost, measured by the price of the good or service
in monetary terms.

It is determined by own-price and non-own price determinants, which affects

the willingness and ability of consumers to buy

The law of demand

The lower the price, ceteris paribus, the greater the quantity demanded.

Thus, there’s an inverse relationship between price and quantity demanded.

This is due to the substitution effect and income effect (Own-price

determinants)

The substitution effect measures the change in quantity demanded, due to a

change in its relative price

When the price of a good falls, it becomes cheaper relative to its substitutes,
causing consumers to increase the quantity demand. Vice-versa

The income effect measures the change in quantity demanded, due to a

change in consumer’s real income (purchasing power)

When the price of a good falls, ceteris paribus, the real income of the consumer
rises, increasing the quantity demanded. Vice-versa (Note: the actual income
of the consumer does not change)

Demand curve
The demand curve is downward slopping, due the marginalist principle in
decision making and the law of demand.

Every additional unit of a good consumed, gives marginal utility (additional

utility).

The marginal utility decreases with every additional unit consumed, hence
consumers are willing to pay less for every additional unit, until marginal utility
= marginal cost.

Market demand curve

The market demand is the demand for a good by all households. (overall
demand)

It is obtained from the horizontal summation of all individual demand curves

Affected by own-price and non-own-price determinants

Non-own-price determinants

Done by Nickolas Teo Jia Ming, CG 12/11

1. Consumer tasters and preferences
 The taste of consumers is influenced by a range of factors. Like
education, fashion, advertisements, culture, age, new innovations
 A favorable change in consumer preferences will shift the
demand curve to the right
2. Prices of related goods
 Substitutes are goods that satisfy similar needs within the same
price range
 A change in the price of a substitute of a good will cause a
similar change in the quantity demanded of the substitute, but an
opposite change will occur to the demand of the original good.
 The effect is increased when both goods are in a closer price
range
 Complementary goods are goods that are consumed together
and are jointly demanded
 A change in the price of the complement of a good will cause a
similar change in the quantity demanded of the complement, and a
similar change will occur to the demand of the original good.
 However, the complementary relationship may not work both
ways. As in when a change in good A affects good B, a change in
good B might not affect good A.
3. Changes in consumer’s income
 A change in real disposable incomes will cause a similar change
to the demand for normal goods.
 But the demand for inferior goods will experience an opposite
change
 Real disposable incomes is the quantity of goods and services
that a given money income, after income tax, can buy.
 It is affected by money income, income tax, government subsidy
and inflation.
 An increase in equity of income will also decrease the demand
for luxury and inferior goods (less rich and poor), but increase
the demand for necessities.
4. Changes in population statistics
 When the overall population size changes, the demand for
goods will experience a similar change, due to the change in
consumers in the market.
 This does not hold true for third-world countries.
 A change in population structure (age, sex, location), will affect
goods according to the needs for the current population (goods for
young, for old, for disabled etc.)
5. Changes in expectations
 When people expect a change in the relative price of a good, a
similar change will occur to the demand for the good
 When people expect a change in their income, a similar change
will occur to the demand for the goods

Done by Nickolas Teo Jia Ming, CG 12/11

  Side note: When the expected increase in income > actual increase,
harm will be caused to the economy, as people cannot repay loans.
E.g. US financial crisis
6. Seasonal factors
 Weather (temperature, rain. Disasters), affects the demand for
goods
 Festive seasons (CNY, Christmas), affects the demand of certain
goods
7. Other factors
 A change in interest rate, will bring about an opposite change
to the demand for more expensive goods
 A change in exchange rate will affect tourism, hence changing
the demand for goods by tourists

Movement and shift of the demand curve

• A movement along the demand curve results from the change in
quantity demanded, due to a change in the own-price determinants
• A shift of the demand curve results from a change in demand, due to a
change in a non-own-price determinants

Consumer surplus
• Consumer surplus is the difference between the maximum amount a
consumer is willing to pay, and the price he actually paid.
• It is the gain by consumers for paying less than what they are prepared
to pay

The theory of supply

• Supply is the amount of a commodity that producers are able and willing
to produce in a given time over a given range of prices
• The effective supply is backed by willingness and ability to produce
• The willingness of producers to produce is in the pursuit of their self-
interest, to maximize profit
• The ability of producers involves an opportunity cost or price
• Effective supply is determined by own-price and non-own-price
determinants, which affects the willingness and ability of producers to
produce

The law of supply

• The direct relationship between price and quantity supplied is the law of
supply
• This is due to the marginalist principle in decision making. There is
increasing marginal costs and incentive for increasing production
(own-price determinants)

Done by Nickolas Teo Jia Ming, CG 12/11

 • When producers produce an additional unit of a good, they have to use
more factors of production (increasing marginal costs)
• Given the ability to produce, as marginal cost continues to rise, the
price to entice a rational producer produce an additional unit will have to
be higher.
• There is increasing relative profitability as price rises.
• Ceteris paribus, a rise in price of a product raises the marginal
revenue and hence the profit margin, making production of the product
more profitable relative to other products and entices firms to move
resources into this industry.
• Hence the supply curve is upward-sloping

Market supply curve

• It is the horizontal summation of all the individual supply curves of all
firms in the market for a good
• It reflects the producers cost for producing the goods

Non-own-price determinants
1. Costs of production
 A change in factor prices will change the cost of production,
causing an opposite change in supply
 Changes in the state of technology will cause an opposite
change in cost of production due to a change in productivity
(output per unit of input). Hence, changing the supply.
2. Government policies
 A change in indirect tax will change the cost of production,
and cause an opposite change in supply
 A government subsidy (direct financial aid given to producers)
will decrease the cost of production, and cause an increase in
supply
 Other government policies will change the supply, like price
floors/celling and trade agreements
3. Prices of related goods
 A change in the price of a competitive good will cause a similar
change in the quantity demanded of the competitive good, but an
opposite change will occur to the supply of the original good.
 This is because producers move resources from the sunset
industry into the sunrise industry
 Jointly supplied goods are goods that are produced together.
 A change in the price of a jointly supplied good will cause a
similar change in the quantity demanded of the jointly supplied
good, and a similar change will occur to the supply of the
original good.
4. Number of suppliers
 A change in the number of producers will change the supply.

Done by Nickolas Teo Jia Ming, CG 12/11

  A change in the scale of production (amount of resources
invested) by producers will change the supply
5. Nature and other unpredictable events
 Abnormal weather (e.g. flooding) will decrease the supply
 Good weather (e.g. enough rain and sun) will increase the supply
 Unpredictable events (e.g. wars, industrial disputes) will also
decrease supply
6. Firms’ objectives
 Some producers might aim for sales maximization instead of
profit maximization, hence increasing supply
7. Seller’s price expectation
 When sellers expect a change in the relative price of a good, an
opposite change will occur to the supply for the good, as they
either withhold or unload their supply.

Movement and shift of the supply curve

• A movement along the supply curve results from the change in
quantity supplied, due to a change in the own-price determinants
• A shift of the supply curve results from a change in supply, due to a
change in a non-own-price determinants

Exceptions to the law of supply

• Some goods (e.g. antiques) have a fixed quantity, which will not change
with regards to price. (Perfectly inelastic supply curve)
• The quantity of other goods (e.g. crops) cannot be changed in the short
run, hence the quantity is independent of price. (Perfectly inelastic supply
curve)
• Not all supply curves are upward-sloping in the long run, as costs do
not always rise when output increases. They could remain constant, giving
a perfectly elastic supply curve.

Producer surplus
• It is the difference between the total amount producers receive for all
units sold of a commodity and the minimum amount they are willing to
accept to supply those units
• It is the gain by producers for being paid more than what they are
prepared to accept

Market equilibrium
• Equilibrium is the state of balance between 2 opposing forces (demand
and supply)
• The equilibrium price (market price) is the price that clears the market
• The equilibrium quantity is the quantity traded at the equilibrium price

Done by Nickolas Teo Jia Ming, CG 12/11

Market disequilibrium
• At all other prices, other than the equilibrium price, there is market
disequilibrium.
• If the price is too high, a glut (surplus) will occur, pushing prices down
• If the price is too low, a shortage will occur, pushing prices up
• The invisible hand (collective actions in self-interest) causes the
shortage and surplus to correct themselves

Effects of changes in demand and supply

1. Increase in demand
 Shortage pushes prices up
 This signals the producers to produce more (for profit
maximization)
 It also signals for more resources to be allocated to produce the
product
 It helps to ration the product to those with ability to pay
 Hence increasing quantity supplied and decreasing quantity
demanded
2. Decrease in demand
 Glut pushes prices down
 This signals the producers to produce less (for profit
maximization)
 It also signals for less resources to be allocated to produce the
product
 It helps to ration the product to those with ability to pay
 Thus decreasing quantity supplied and increasing quantity
demanded
3. Increase in supply

 Glut pushes prices down

 This provides the incentive for the consumers to consume more
(for utility maximization)
 It signals the producers to produce more as quantity demanded
increases (for profit maximization)
 It also signals for more resources be allocated to produce the
product
 It helps to ration the product to those with ability to pay
 Hence increasing quantity demanded and supplied
4. Decrease in supply
 Shortage pushes prices up
 This provides a disincentive for consumers to consume (for utility
maximization)
 It signals the producers to produce less as quantity demanded
falls (for profit maximization)

Done by Nickolas Teo Jia Ming, CG 12/11

  It also signals for less resources be allocated to produce the
product
 It helps to ration the product to those with ability to pay
 Hence decreasing quantity demanded and supplied
5. Change in both demand and supply
 Resultant effect depends on the relative strength (magnitude) of
the shift

Done by Nickolas Teo Jia Ming, CG 12/11