HL Economics Notes

Opportunity cost: The cost of missing out on the next best alternative to a purchase
(expressed as the product itself - never a monetary amt)

4 Factors of Production (CELL):

- Land:
- Labor:
- Capital:
- Entrepreneurship:

3 Questions of Fundamental Economic Problem:

1. What to produce? And in what quantity?
2. For whom to produce?
3. How should things be produced?

Production-Possibility Curve

* Note: PPC can shift outward or inward with time, due to the values of assumptions
changing (ie. technological enhancement, total resource enlargement, etc.)

PPC - Attainability & Efficiency:

- Points within curve are inefficient, yet attainable (nearly every real-world contrast
is in this zone)
- Points on the curve are efficient & attainable: take advantage of all resources so
no resource is being wasted or unemployed
- Points beyond the curve are efficient, yet unattainable (atleast at the time being)
PPC - Assumptions:
1. The amount of resources are fixed in an economy, although they can be
transferred from one use to another.
2. The level of technology used is constant.
3. The resources are fully and efficiently utilized (if on curve).
4. With the amount of resources in hand, only two goods can be produced.
5. Resources are not equally efficient in the production of all products, so when the
resources are transferred from one use to another, the productivity decreases.

Market: where buyers & sellers come together to carry out economic transactions

Types of Markets Include:

- Product Markets
- Factor Markets
- Stock Markets
- International Financial Markets

Law of Demand
Demand: Quantity of goods / services that consumers are willing and able to purchase
at different prices in a given time period.

Effective Demand: Having the financial means (realistically) to buy the product; thus
the ability to buy
- Ex. If a man makes $10,000 a year, he may want a LV bag worth $8000.
However, it’s not financially realistic for him to do that with his other essential
expenses.

Law of Demand: “As the price of a product falls, the quantity demanded of the
product will usually increase, ceteris paribus”

Ceteris Paribus: Assumption that all other things being equal (non-price determinants
remain constant)
- In terms of this example, price may change but the other determinants of
demand stay the same.
An example of this would be:
Price of Candy ($) Quantitative Demand (QD) of Candy Per Day

$35 150

$30 180

$25 220

$20 270

$15 350

$10 460

$5 610

* Note: drawn straight for simplicity, although it’s curved in reality

Δ Price WILL lead to a Δ Quantity Demanded

Non-Price Determinants
- They cause a change / a shift (either left or right) in demand. Analysis of any one
of these factors assumes ceteris paribus for the rest to simplify the complexity.
- Income: Change in consumers income
- Normal goods:
- When income rises, the demand for the product will also
rise. Consumers are able to buy more goods.
- When demand increases, the demand curve will shift to the
right.
- Inferior goods:
- When income rises, the demand for inferior goods will fall,
whereas consumers will start to buy higher priced
substitutes.
- Demand for an inferior good will then decrease.

- Price of Related Goods: Change in the price of a substitute and

complementary goods. 3 Main Relationships:
- Substitutes (Pepsi & Coke)
- Complements (Milk & Cereal)
- Unrelated (Cars & Fruits)

- Taste & Preferences: Change in consumers tastes and preferences

- Consumer tastes have a big impact on the demanded product.
Taste can change due to:
- Marketing
- Advertising
- Peer pressure
- Media influence

- Future Price Expectations: Expectations among consumers of future

prices of a good or their income
- Consumer Confidence: If the price of a product is expected to
increase, there will be an increase in demand in the present.
- Example – UK Petrol panic buy due to shortage of HGV
drivers.
- Likewise, if they expect product prices to fall, they may wait and
demand less of that product in the present.
 - Number of Consumers: Change in number of consumers in the market
- If there is an increase in the number of consumers of a product, the
demand curve will shift right.
- Special Circumstances: Changes in factors such as weather, natural
disasters, pandemics, terrorism, etc. - unexpected events

Veblen Curve:
- Economist Thorsten Veblen claimed:
- There are products where as the price rose, the demand rose.
- Due to conspicuous consumption
- (conspicuous = attention-seeking / visible)
- People gained satisfaction from being seen to consume expensive
products by other people - “Failure to consume in due quantity and
quality becomes a mark of inferiority and demerit”

Giffen Good:
- A Giffen good is a low-income, non-luxury product for which demand increases
as the price increases and vice versa.
 - A Giffen good has an upward-sloping demand curve which is contrary to the
fundamental laws of demand which are based on a downward sloping demand
curve.
- Demand for Giffen goods is heavily influenced by a lack of close substitutes and
income pressures.

* Note: Veblen goods are similar to

Giffen goods but with a focus on luxury
items.

Note: As price rises, Giffen

good price rises. However,
at a threshold, Giffen goods
take up all the consumer’s
income. If prices rise
beyond this threshold,
people can no longer even
afford the Giffen good.

HL Content - Two reasons for the increase in QD of a product.

1) Income effect – when the price of a product falls, their “real income” will have
increased; reflecting the amount that their incomes buy.
- Eg. If you budgeted to buy a pack of eggs for 10AED per month. The eggs have
now reduced in price to 5AED. You have saved 5AED. Therefore, you now have
an increase of your “real income” by 5AED, thus leading to the income effect
taking place, and you buying more.

2) Substitution effect – Utility (satisfaction) as consumers. When price falls, people

still gain the same amount of utility as before, but they are paying less for it. Satisfaction
ratio to price will be better. Thus, leading to substituting products with a lower ratio of
satisfaction to price with more of ones with a higher satisfaction to price.
- Eg. If you budgeted to buy a dozen eggs for 10AED per month. The eggs have
now reduced in price to 5AED. The dozen eggs provides x satisfaction, and
therefore the satisfaction to price has doubled. Therefore, you’re now
incentivised to buy more eggs substituting similar goods (such as perhaps lentils,
beans, etc)

Demand Summary:
- Changes in price or quantity are movement ALONG; everything else is a SHIFT
in the demand curve
- (A) – There is a change in the price which has led to change in QD – Movement
along.
- (B) – Caused by a non-price shift. Entire demand curve shifts out (increases) and
in (decreases)

Left: Movement Along; Right: Shift in Curve

Exam Practice Q
Using diagrams, explain how a change in one of the determinants of demand might
increase the price of rice (5)

Demand is defined as the quantity of goods or services that consumers are WILLING
and ABLE to purchase at different prices in a given time period. (AO1)

A change in one of the determinants of demand such as income, may increase the
price. An increase in income will indicate that consumers will have more money to
spend (A02) This leads to an increase in demand as they spend more. (A02) Therefore,
the demand curve will shift to the right. (A02) As shown in the diagram below:

A shift in D to D1, will cause Q to increase to

Q1. This then leads to P, increasing from P to
P1. Thus showcasing that an increase in
income as a determinant of demand, will
increase the price of the product, in this case,
rice.

Response Format
- Definition: provide the definitions of relevant term(s)
- Point: what’s your point / main idea
- Example: provide an example if you can
- Explain: the analysis portion (because, therefore, leads to)
- Diagram: draw diagram with correct labels

Behavioral Economics
Theory Behind Demand
Economic Agents: consumers, businesses, & government
Neoclassical theories make assumptions about economic agents, make their choice.
- All agents are rational
- They will pick options that provide the best utility (satisfaction)
- They are selfish – only care for their interests and no one else
- Access to all information – Perfect information

Rational consumer: Homo economicus.

- Will always make logical, intelligent and well considered decisions that give the
most utility.
- Not realistic or applicable in real-life
 - Information Asymmetries: all economic agents, having different levels of
information.
- Human limits: EVEN if all information is available, humans can’t process
everything.
- Therefore, humans make decisions based on imperfect information.

1. Bounded rationality: Rationality limited by the information they have access to.
Therefore they do not have enough time or cognitive availability to process it.

2. Bound selfishness: Argument that humans are not selfish, we actually do care for
each other. Seen through charity work, movements etc.

3. Bounded self control: Humans have temptations and we will give in.

Cognitive Biases:
Cognitive Biases Explanation
Availability bias Processed based on recent information

Anchoring Bias Using previous information to make

decisions; often poor decisions.
 - ie. comparing price of products.

Framing Bias The way information is presented affects

our judgment. If positive, we think
positively about the product; if negative,
we think negatively about the product

Social conformity/Herd Behaviour Following the majority’s choices.

Status Quo/Inertia bias Too many choices = nothing being done.

Leaving things in their current state rather
than choosing the most efficient yet
complex option.
- Ex. Mobile phone contracts could
end, but they choose to stay.

Loss aversion bias Losses are more significant than gains (ie.
stocks down so avoiding them by not selling
→ caring more about the losses, but not
enough about the wins)

Hyperbolic discounting Short term rewards are valued more than

long term rewards (instant gratification)

How can behavioral economics be used to help consumers make better

choices?

- Behavioral Economics: helps consumers make better choices by addressing

their system 1 cognitive biases
- Choice Architecture: decisions we make are heavily influenced by the ways in
which the choices are presented to us
- Choice Architect: presents the choices to us in a specific manner, affecting
our decision making
- Default Choice: the standard, pre-set option (a deliberate choice by the
architect) → the outcome of doing nothing & constant until deliberately
changed
- Ex. web browser being default to chrome
- Ex. organ donation being defaultly set to “yes upon death”
- Mandated Choice: despite wanting to, many people put-off making
choices → requiring & increasing the availability as a choice architect
improves the acceptance drastically
- Forcing decisions increases positive outcome
 - Nudge Theory: consumers maintain their sovereignty to choose, but are
encouraged to make better decisions by addressing and overriding certain
cognitive biases
- Ex. Auto-increasing savings with salary rise via default choice

Dual System Model:

- Humans take time in making decisions.
- When it comes to big decisions, system two takes over.
- When it comes to small decisions, system one takes over.
- Humans make mistakes - We can make decisions based on impulses or on short
term decisions.
- Around 35,000 decisions made a day – humans develop a rule of thumb.
Simply a mental shortcut to solve problems quickly by choosing to do
some quickly with system 1, and some more deliberately with system 2

System 1 System 2

What is it: What is it:

It’s the brain’s fast, automatic, and The slow, effortful, and logical mode in
intuitive approach. which our brains operate when solving
more complex problems.

Features: Features:

- Innate tasks (built since birth) - Slower, requiring more effort

- Repetitive, common, and simplistic - Conscious and logical
tasks
- Primal behaviors

Examples: Examples:

- Recognizing Objects - Buying your first house

- Walking - Finding the closest gas station
- Tying Shoe Laces - Working on a new type of math
problem

Supply
 - Supply: Quantity of good or service that producers are willing and able to supply
at different prices in a given time period
- Effective Supply: Suppliers must have the financial means to produce and
supply the product
- Law of Supply: “As the price of a product rises, the quantity supplied of the
product will usually increase, ceteris paribus.”

Price Per Gallon of Oil ($) Quantity Supplied (Gallons of Oil)

2.50 10000

3.00 15000

3.50 20000

4.00 25000

4.50 30000

5.00 35000

Example Graph of Supply

* Note: In reality supply

is curved (outwards, not
typically exponential), but
for simplicity, it’s drawn
linear

Non-Price Determinants of Supply

- Cost of Factors of Production – Increase in cost of factors of production, will
cause an increase in firm costs incentivizing supplying less. The opposite is also
true if there’s a decrease in cost of factors of production.

For example, if
there’s a rise in
wages, firms will
make less profit → in
turn, they’ll supply
less, reducing supply
from S to S1.

- Price of Related Goods (Competitive Supply) – Suppliers can choose what to

supply due to factors of production, able to make more than one product.
- Ex. a supplier of computers can also make laptops. If there is an increase
in demand for laptops and prices rise, producers will aim to supply more
laptops and less computers.

-
- Price of Related Goods (Joint Supply) – When one good is produced, another
good is produced at the same time - “By product”
- Ex. when you grow wheat, a by-product will be straw. Therefore if demand
for wheat increases, since straw is in joint supply, there will be an increase
in supply of straw. If the demand for straw remained constant across this
period, then prices will fall due to excess straw
 -
- Ex. When the price for petrol rises, suppliers will produce more barrels of
petrol. However, a natural by-product of petroleum, is petroleum jelly (ie.
vaseline) - therefore, there will be excess vaseline to demand, and the
prices will fall.
- Government Intervention – Intervene to alter supply (taxes and subsidies).

Indirect tax – Taxes on

goods and services that
are added to the price
of the product.
Producers pay the tax
to the government, thus
increasing the cost of
production.
Direct tax –
Taxes on individuals, firms, or entities

Subsidies – payments
made by the
government to firms to
reduce their costs of
production.

- Expectations About Future Prices –

 - If future prices are expected to rise, then suppliers will went to produce
extra for the period.
- Furthermore, if future prices are expected to rise, the demand curve will
increase now to take advantage. Therefore, prices will rise now, and
suppliers are incentivized to increase production now.
- Changes in Technology (automation of functions) – An advancement in
technology will increase supply (lower baseline costs, lower cost per unit, faster
production & efficiency). Regressing technology will decrease supply
- Weather or Natural Disasters – Will disrupt and reduce supply if negative, as
producers will face issues (to a certain extent) to maintain supply.

Supply HL
Explaining the Law of Supply
- There are two different time periods when looking at production:
- Short run: Defined as the period of time in which at least one factor of
production is fixed.
- All production takes place in the short run
- Long run: Defined as the period of time in which all factors of production
are variable but the state of technology is fixed.
- All planning takes place in the long run.

1. Short Run:
- Some factors of production are fixed in the short term, even if price goes up
(Capital = fixed, Enterprise, Land = fixed, Labor = fixed)
- Fixed because takes time to make changes to quantity
- Firms wishing to increase output can only do so by adding more units of its
variable factors to fixed factors that it possesses in the short run. While plans
ahead to change the number of fixed factors in long run
- Ex. Mr. Luu has a fixed factor of the number of lawn mowers. It takes 2
weeks to order and receive delivery of a lawn more - therefore, short run is
1 month

2. Law of Diminishing Returns:

- If a firm increases output by adding more and more units of a variable factor to its
fixed factors, eventually each output from the added unit will eventually fall
 - Total Product (TP): total output that a firm produces using fixed and variable
factors in a given time period. In short run, only additional variable factors to fixed
factors can increase output
- Average Product (AP): Output that’s produced on average by each unit of the
variable factor.
- AP = TP / V → V is the number of units of the variable factor employed
- Marginal Product: Extra output that’s produced by using an extra unit of the variable
factor. MP = ΔTP / ΔV → ΔTP = change in total output & ΔV is the change in number of
units of the variable factor employed

Quantity of Labor Total Product (TP) Average Product (AP) Marginal Product (MP)
(V)

0 0

10

1 10 10

15

2 25 12.5

20

3 45 15

25

4 70 17.5

20

5 90 18

25

6 105 17.5

10

7 115 Approx. 16.43

8 120 15
 - The hypothesis of eventually diminishing marginal returns: As extra
units are added to a fixed factor, the output of each additional unit of
variable factor will eventually diminish
- The hypothesis of eventually diminishing average returns: As extra
units are added to a fixed factor, the output per unit will eventually
diminish

3. Increasing Marginal Costs

- Marginal costs (MC): the increase in total cost of producing an extra
unit of output
- MC = ΔTP / ΔQ

Total Product (TP) / Output Total Cost ($) Marginal Cost ($)
(Q)

0 400

20

10 600

13.33

25 800
 10

45 1000

70 1200

10

90 1400

13.3

105 1600

20

115 1800

40

120 2000
- Increasing marginal cost is related to diminishing marginal returns
- Output produced by each additional worker (MP) begins to fall, but all workers
cost the same, the cost of producing an extra unit MC beings to increase
- Law of Diminishing Returns - as output increases, marginal costs will being to
increase also
- Therefore, firms will only be prepared to supply more and increase output if the
prices that they receive for their products are also going up. Firms need to cover
their marginal costs with the price.

Example of Exam Response

 - Definition (AO1) - define a key term you see in the question
- Analysis (AO2) - Chains of reasoning (2x)
- What’s your point?
- What’s your explanation?
- What’s the consequence?
- Diagram (AO4) - Refer to your diagram (2x if applicable)
-
- No evaluation or judgment (No AO3)

Question 1 - Distinguish between a shift of the supply curve for a product

and a movement along the product’s supply curve (10 Marks)

Supply is defined as the quantity of goods suppliers are willing and able to provide at
different prices in a given time period.

A shift in the supply curve, due to non-price determinants such as an increase in the
cost for the factors of production, an increase in rent for example, will shift the entire
supply curve to the left. This is regardless of a change in price, as an increase in the
underlying costs will reduce the supplier’s margins and motivate them to produce less.
A current example of this would be in Morocco, where a non-price determinant of
supply, in this case a natural disaster, is increasing costs for suppliers, henceforth
shifting supply curves across the economy to the left.

On the other hand, a movement along the product’s supply curve would be caused by a
change in price, with increases incentivizing suppliers to produce more of the good
(higher profits), and decreases motivating suppliers to produce less of the good (lower
profits - alternative goods may become more attractive due to higher margins in their
production). This assumes ceteris paribus of all non-price determinants. An example of
this would be during the winter, as more people are looking to purchase Christmas
trees. Therefore, prices rise for the product, and suppliers are incentivized to produce
and sell more trees. All of this occurs due to a shift in ONLY the price of the christmas
tree, not in any of the non-price determinants of supply. This would increase P to P1;
therefore, suppliers would increase Q1 to Q2 to take advantage of the profits.

1. Positive movement along supply curve due to rising prices for christmas trees
2. Shift in supply curve to the left, due to a non-price determinant of supply, a
natural disaster.

Question 2 - Explain 2 factors which could shift a firm’s supply curve to the
left
Supply is defined as the quantity of goods a producer is willing and able to supply at
different prices in a given time period.(AO1) A shift in the supply curve is caused by
non-price determinants of supply, which move the entire curve left (or to the right, but
not in this case).

Two possible factors that may shift a firm’s supply curve to the left could be an increase
in the cost of the factors of production such as a rise in rent, and a decrease in future
price expectations by the firm due to external reasons. For example sake, we are
considering a company producing wheat.
An increase in cost of the factors of production will reduce the companies overall
margins; henceforth, it’ll reduce the amount a firm could supply. In our scenario, if the
cost of rent for the agricultural land rises, then the firm will make lower profits, and
supply will reduce regardless of price (assuming ceteris paribus). In a practical scenario,
this may be because companies would have higher expenses to pay for the rent,
meaning they may have less funds to purchase seeds / equipment resulting in a lower
supply.

A decrease in future price expectations will reduce consumer demand at the moment
(as they would look to wait until prices reduce further to purchase), henceforth reducing
the price of the goods they’re looking to purchase. Furthermore, the expectation of
lower future prices will mean suppliers would look to produce less of the goods at the
moment, in preparation of the decline of the goods profit. In the scenario of our wheat
business, for example, hypothetically, at the moment the wheat market may predict that
future prices of wheat will decline as operational costs are expected to reduce via
Turkey’s trade agreement with Russia. Therefore, consumers expecting lower prices in
the future may reduce purchases now, and producers expecting lower sales prices may
want to supply less, assuming ceteris paribus.

(AO4)
1. The supply curve shifts from S to S1, so the rent for wheat producing land rises
(an increase in cost of a factor of production). Therefore, assuming P to remain
constant, Q would shift left to Q1, as the quantity suppliers can afford to produce
is lowered.
2. The supply curve shifts from S to S1, as the future price expectations of wheat
declines, as consumers may look to purchase slightly less now in order to take
advantage of lower prices in the future and producers may look to lower supply
now in expectation of these changes. Peer Assessed (8/10)

Market Equilibrium
Starter:
 - Short Run: Defined as the period of time in which at least one factor
of production is fixed.
- Law of Diminishing Returns: as output increases, marginal costs
will being to increase also

- Equilibrium: The state of rest, self-perpetuating in the absence of any outside

disturbances
- Excess Supply: More of a good that is being supplied at a given price than is
being demanded
- Excess Demand: More of a good that is being demanded at a given price
than is being supplied

- Equilibrium is at point P,Q

- Price increases from P to P1
- At that price, QD reduces from Q to Q1

Functions of Definition Example

Price
Mechanisms
Resource Allocation Resource allocation refers to how limited When the price of oil rises
due to increased global
resources, such as labor, capital, and land, are demand, it signals to oil
distributed among various competing uses or producers that more
industries in an economy. resources should be
allocated to oil production.
This helps meet the
growing demand.

Signaling Prices convey information about the relative A sudden drop in

smartphone prices can
Information scarcity or abundance of goods and services in signal technological
the market. advancements or surplus
supply, prompting
consumers to consider
upgrading their devices.

Maintaining Market Market equilibrium occurs when the quantity In the housing
market,when demand for
Equilibrium demanded equals the quantity supplied, homes surges, prices
resulting in a stable market price. increase. This encourages
builders to construct more
houses, eventually
stabilizing prices at an
equilibrium point where
supply matches demand.
Price Elasticities of Demand
Elasticity
- Prefix: -e (out, away, out of, or outside)
- Suffix: -ity (the state of being something)
- Meaning: In business and economics, elasticity refers to the degree to
which individuals, consumers or producers change their demand or the
amount supplied in response to price or income changes. It is
predominantly used to assess the change in consumer demand as a result
of a change in a good or service's price. (Source: Investopedia)
- According to the law of demand, when the price of a good increases,
quantity demanded declines, ceteris paribus.
- The extent to which the quantity demanded changes depends on
how 'elastic' its demand is with respect to its price.
- PED= % change in the quantity demanded of good X /
% change in the price of good X
- **It is not correct to refer to goods as price elastic or inelastic.
Demand for goods has elasticity, not the goods themselves.

- Necessity Good: A good or service whose quantity demanded does not

change much in response to a price change because consumers consider it
essential.

Key Words Definition

1. PES (Price Elasticity of Supply)

2. Total Revenue

3. Profit

4. Tax Incidence

5. Commodities (Primary
Commodities, Primary Goods)

6. Manufactured Goods

Elasticity: The responsiveness of one variable to a change in another variable.

Change: Change occurs when something transforms from its initial state or condition to a new
state or condition
- Uncertainty among stakeholders and technological innovation are two driving forces of
change.
- Though we often identify equilibrium in our market analyses, most markets are often
experiencing dynamic change and are thus in disequilibrium.

Elasticity of Demand: measure of the responsiveness of the quantity demanded of a good or

service to changes in one of the factors that determines it.
Price Elasticity of Demand (PED): measure of how much the quantity demanded of a
good changes when there is a change in its own price.
- PED=(% Δ QD of good X) ÷ (% Δ price of good X) = (%△QD) ÷ (%△P)
- ALWAYS PED < 0 because if demand increases, supply decreases or vice versa →
always one of either numerator or denominator is negative.
Written as absolute value.
- When price of good increases, demand decreases. The extent to which QD changes
depends on elasticity with respect to price
- Ex. if the price of train tickets decline by 10 % and, the quantity demanded of
train tickets increases by 15 %, then the price elasticity of demand for train
tickets is -1.5.
Example Question:

Question: Calculate PED Answer: Working Shown Above

Values of PED Classification Explanation

PED > 1 Price elastic demand A change in price leads

 to a proportionately
greater change in the
quantity demanded.

0 < PED < 1 Price inelastic demand A change in price leads

to a proportionately
smaller change in the
quantity demanded.

PED = 1 Unitary elastic demand A change in price leads

to a proportionately
equal change in the
quantity demanded.
PED = 0 Perfectly inelastic A change in price leads
demand to no change in the
quantity demanded.

PED = ∞ Perfectly elastic demand Any change in price

would lead to an infinite
change in the quantity
demanded.

Inelastic = essential
Elastic = non-essential
High elastic = luxuries

Inelastic Products Are (or A Combination Of):

- Most essential
- Lack many substitutes
- Low proportion of your income
- Tend to be one-time purchases

Inelastic Products Are (or A Combination Of):

- Quite a few substitutes are available
- Cost consumes a noticeable portion of the income of consumers
 - Not essential to sustaining their life - can choose to avoid purchasing
- Tend to be frequently purchased in everyday life

Although both the SR and LR gasoline are both inelastic, why is SR gasoline more
inelastic than LR gasoline?
- In the short-run, avoiding gasoline is quite infeasible if the price rises -
furthermore, what if the price declines in the future? Therefore, consumers can’t
avoid purchasing gasoline for the time being, as they would still need to conduct
their day-to-day lives.
- However, in the long-run, consumers can take far more measures to avoid
gasoline making it slightly less inelastic
- Such as purchasing a electric vehicle or using a bicycle
- Reducing electricity consumption in their household

Determinants of PED:

- The number and closeness of substitutes:

- More Substitutes = More Elastic
- ex. Choosing which luxury car to buy is quite elastic because you
have a variety of options
- More Similar or Closer Substitutes = More Elastic
- ex. Choosing between similar brands of yogurt is quite elastic
- The degree of necessity and how widely a product is defined:
- The greater the level of necessity for the consumer, the more inelastic the
demand of the good will be.
- Basic Necessities (ex. water and food)
 - Addictive Goods (ex. drugs and cigarettes)
- Medical Services / Goods (ex. insulin, epi-pen, etc)
- The more widely a good is defined, the more inelastic is its demand.
- ex. You can’t live without the entire category of food. However, if I
define it to be more specific to simply beef, it’d be more elastic as
you’d have chicken, lamb, pork, etc. as alternatives.
- The time period considered:
- The demand for a good will be more inelastic in a short period of time than
in a longer period of time.
- ex. If the price of an epi-pen prescribed for a severe allergy rises,
you’d still purchase for some time perhaps. However, in long-term,
you and your doctor may have more time to look for alternatives
- The proportion of income spent on the good:
- The higher the proportion of income spent on a good, the more elastic the
demand.
- Disposable Income: The income remaining after deduction of
taxes and social security charges, available to be spent or saved as
one wishes.
- ex. If I buy 100 pencils and their price rises, I may still purchase
them without hesitation because relatively they’d make up quite a
small portion of my disposable income. However, if I have to buy a
car, my demand may be more elastic and dependent on the price,
because it would, in contrast, severely affect my disposable
income.

PED & Total Revenue

Key Words
- Total Revenue: The money earned by a firm from selling a good or service;
the selling price multiplied by the total quantity sold.
- Commodity: primary good; an important input to production. Oil, iron ore and
timber are all examples of commodities.

- When there is a change in the price of a good or service, the

impact on the firm's total revenue will depend on the price
elasticity of demand of the good.
- **A firm's total revenue is not the same as profit. Profit is total revenue
minus total costs. If the firm's aim is to maximise profits, this might not
 correlate with maximising total revenue. As revenue increases, total costs
might rise even faster, which would cause a decline in the firm's profits.

3 Cases:
- Inelastic product:
- If a firm increases price of their product by x%, demand will decline by a
lower x% (ie. if price rise by 10%, demand will decline by 5%)
- Therefore, by selling more, the firm will have a higher total revenue, as
their income per product sold rises more than the decline in quantity sold
- Benefit by raising prices
- Unitary elastic product:
- If a firm increases price of their product by x%, demand will decline
equivalently by x% (ie. if price rise by 10%, demand will decline by 10%)
- Therefore, by selling more, the firm will have the same total revenue
regardless, as their income per product sold rises by the same amount as
the decline in the quantity sold.
- No change by raising prices
- Elastic product:
- If a firm increases price of their product by x%, demand will decline
equivalently by a higher x% (ie. if price rise by 10%, demand will decline
by 15%)
- Therefore, by selling more, the firm will have a lower total revenue, as
their income per product sold rises by a lower amount compared to the
percentage decline in the quantity sold.
- Hurts to raise prices / Better to lower prices

Changing PED Along Straight Line, Downward-Sloping

Demand Curve
- **PED should not be confused with the slope of the demand curve. While
the slope of a linear demand curve is constant, PED varies along its price
range
- Slope = △Qd / △P
- PED = (△Qd / Qd1) / (△P / P1) = Slope * (P1 / Qd1)
- For any linear downward-sloping demand curve, demand is price elastic for high
prices and low quantities, and price inelastic for low prices and high quantities
 Demand is:
- Price elastic for high prices
and low quantities
- Price inelastic for low prices
and high quantities

Total revenue is a parabola:

- When elastic at beginning, total
revenue rises when price increased
- When inelastic at ending, total
revenue decline when price rises

Implications of PED on Government Policies

- Government makes decisions to incentivize and de-incentivize the quantity
demanded and supplied of a good for a certain price.
- Tax Incidence: The burden of tax paid by consumers or producers

Impact of an Indirect Tax

 - Vertical distance between S1 and S2 is the cost of the tax
- Quantity supplied will reduce because suppliers will have lower margins
by selling that product. Therefore Q* declines to Qt
- By supply declining to Qt, equilibrium rises from P* to Pc.
- This extra profit (Pc - P*) is given to the government

The incidence of tax depends on the PED of the product.

- When the demand is relatively inelastic, the tax incidence falls more on
consumers than producers
- When the demand is relatively elastic, the tax incidence falls more on producers
than consumers.

PED of Primary Commodities

- Commodity: Primary good; an important input to production
- Oil, iron ore and timber are all examples of commodities.
- Manufactured Goods: Human-made goods that have been produced from
raw materials transformed through a production process.
 - Primary commodities tend to have relatively lower PED than manufactured
goods, because commodities are necessities for those who consume them and
have very few or no substitutes
- Price tends to change more drastically for primary commodities, as they’re quite
inelastic (so change in price leads to lower change in quantity) → can be
explained also by their production often being more unstable
- ie. a farmer’s wheat is more unstable because certain factors are
out of his control
- There are some exceptions to the relationships outlined here. For
example, the demand for some medications, which are manufactured
goods, is inelastic because they are necessities and do not have
substitutes.
Price Effect on Total Revenue
- Price fluctuations combined with a low PED, result in an increase in total
revenue for producers when supply falls, because the percentage increase
in price is greater than the percentage decrease in quantity demanded.

- Example
- A decrease in supply of an agricultural crop and higher prices may result in
higher revenues for farmers in the aggregate. However, if you are a farmer who
has lost her entire crop due to a locust infestation, you will not see these
increases in revenue. So the higher prices and higher revenues that come with
decreased supply in a market assumes that producers have something to sell.

Additionally, it is worth noting that sometimes a good harvest can actually result
in lower revenues, if that good harvest is experienced by a large number of
producers. Increased supplies of a crop in an entire market, for example due to
favourable weather conditions, can lead to a fall in prices in markets and lower
revenues for producers, because of the low PED of primary commodities.
However, if one producer has a successful crop, but others do not, prices may
not fall in the market and the successful producer could see increased revenues.

Income Elasticity of Demand (YED)

- Measure of how much the quantity demanded of a good will change in response
to a change in consumers' incomes
- If incomes rise by 5 per cent in a country, we will likely see an increase in the demand for
many goods → however, some may see demand rise by 10%, whereas others only by 2%
 - YED=%△Qd (percent change in quantity demanded of a product) / % △Y
(percent change in consumer’s income)
Positive value = Normal Good (Income rises, demand rises; vice versa)
Negative value = Inferior Good (Income rises, demand fall; vice versa)
- Engel Curve: A function that describes how household expenditure on a
particular good or service changes with household income (Income = y-axis;
Qd = x-axis)

Normal good = positive

slope

Inferior good = negative slope

Basic necessities have low positive YED ≠ Inferior goods have negative
YED.

Value of YED and classification Explanation/

of demand Interpretation
YED < –1 A change in income leads to a
YED > 1 proportionately greater change in the
quantity demanded.
Income elastic demand
–1 < YED < 1 A change in income leads to a
proportionately smaller change in the
Income inelastic demand quantity demanded.

YED = 0 A change in income leads to no change in

the quantity demanded.
Perfectly income inelastic demand
(Goods with a positive YED value close to
zero are considered necessity goods.)

YED = +/- 1 A change in income leads to a

proportionately equal change in the
No classification quantity demanded.

Income YED for Firms and Sectoral Change in the Economy

- Economic Growth: When a country produces more goods and services in one
period than in a previous one. It is usually measured by changes in the real GDP →
average income per household tends to rise
- Recession: refers to negative economic growth occurring over two or more quarters
→ average income per household tends to low
- As a firm, if you know the income elasticity of demand for your products, you can
make predictions about what may happen to sales and revenues in these
different economic periods
- During recession, income falls, so demand for inferior goods rises / normal
goods falls
- During economic growth, income rises, so demand for inferior goods falls /
normal goods rises

- In periods of economic recession, goods and services with the highest YED
(YED > 1) will be the ones whose demand and quantity demanded will suffer the
largest fall.
- However, products with low YED (YED < 1) may avoid a large reduction in sales,
and inferior goods (YED < 0) are likely to experience an increase.
- Primary Sector: sector of an economy that involves extraction of natural
resources; agriculture and mining are examples.
- Secondary Sector: sector of an economy where raw materials are combined
or changed through manufacturing to make physical products.
- Tertiary Sector: sector of the economy where services are provided to
consumers.
- Sectoral Change: The change in the structure of the economy to
increase or decrease production in one sector or another
 - Consumers on low incomes will spend a large share of their income on necessity goods to
satisfy their basic needs → low income countries typically focus output on primary
products
- As the economy grows and national income rises, demand for manufactured
goods will increase faster (with higher YED) than demand for primary sector (with
lower YED), as consumers are likely to have met their basic needs.
- Additional income will be spent disproportionately in the secondary sector
- When an economy achieves a high level of national income, consumers will
spend disproportionately in tertiary sector (even higher YED) than in the primary
and secondary sectors

- Low income countries usually have a large primary sector, while the secondary
and tertiary sectors are smaller. When a country’s economy grows, the primary
sector shrinks relative to the secondary and tertiary sectors. As the economy
grows even further, this process continues and the tertiary sector becomes the
largest sector in the economy.
- If total output increases over time, the fact that the proportion of spending
on the primary sector is falling does not mean that primary sector's output
is reducing.
- Output of the primary sector may still be rising, just slower compared to
the other two → causes pie to shift towards 2nd and 3rd, but overall pie
could be getting bigger for even 1st.
- Not every country follows this pattern of sectoral growth
- ie. Some low income countries have a large tertiary sector because
they specialize in tourism. Generalizations so they’re often true, but
there are exceptions.

Why is the PED for primary commodities generally lower

than the PED for manufactured products?