Unit 2: Microeconomics

Rishabh Agrawal
 Markets

Housing prices in Spain over the last 25 years

Demand
 Demand definition

“Demand is the quantity of a good or service that consumers are willing and able to
purchase at various prices during a specific time period, ceteris paribus”

Ceteris paribus - All else being equal

Demand schedule
Demand curve
 Disclaimer

Quantity
Demand
demanded

Demand presentation
 Movements along the curve

Changes in price leads to changes in quantity demanded

Exercise: Movement along the curve
Draw a demand curve for Nike Air shoes with the
following demand schedule
Price Quantity of shoes demanded per month

10 1000

20 700

30 500

40 400

50 300

60 250
 Movement of the curve

Changes in factors that aren’t price lead to change in demand

Non-price determinants of demand

● Changes in income
● prices of substitutes and complements
● tastes and preferences
● future expectations
● seasonal changes etc
 Exercise: Movement of demand
curves
1. Using a diagram, show the effect of an increase of consumers’ income on the demand for
Ford cars.
2. Using a diagram, show the effect of an decrease in the price of Dominoes pizza on the
demand for Papa John’s pizza.
3. It’s been a particularly warm summer this year. Using a diagram, show the effect on the
demand for surf boards.
4. The price of Gasoline has risen. Using a diagram, show the effect it has on the demand for
gas-powered cars.
5. Sony has added a new feature to its Play Station 5s to include Virtual Reality Technologies,
making the playing experience better. Using a diagram, show the effect that this added feature
has on the demand for Play Station 5.
6. Zara decides to increase the price of its white tshirts. Show this on a graph.
Supply
 Supply definition

“Supply is the quantity of a good or service that producers are willing and able to
produce at various prices during a specific time period”
Supply schedule
Supply curve
 Movements along the curve

Changes in price leads to changes in quantity supplied

 Movement of the curve

Changes in non-price related factors lead to change in supply

 Non price
determinants of
supply
● Changes in costs of production
● technological changes
● future expectations
● number of firms in the market
● subsidies, taxes, regulations
 Exercise: Movement of supply
curves
1. Show the effect of an increase in the wages of Danone employees on the supply of
Danone yoghurts.
2. The price of white t-shirts increases. Show the effect this has using a supply diagram.
3. Show the effect of the decrease in the price of milk on the supply of cheese.
4. The government decides to implement an indirect tax (VAT) on tobacco. How will this
affect the supply of tobacco? Show on a graph.
5. Apple discovers a new technology that makes their production process more efficient.
How does this affect their supply?
6. Explain the effect of a subsidy on the supply of solar panels.
7. As a result of the popularity of vapes, many new vape companies have emerged. How
will this affect the supply of vapes?
Market
equilibrium
Markets in equilibrium
Markets in equilibrium
 Markets in disequilibrium
Shortages
Markets in disequilibrium
Surplus
Price mechanism
 Key terms
Market equilibrium occurs where supply = demand, in other words the resources employed by firms to
produce a good or service is exactly equal to the number of units that consumers are willing and able to
purchase. The output level at the equilibrium is said to be allocatively efficient.

Market disequilibrium - when the market is not allocatively efficient because the market has either too
few or too many of the goods and services being produced, from society's point of view.
 Exercise: Market equilibrium

1. The government has imposed a subsidy on the production of electric vehicles

(EVs). How will this affect the market for EVs.
2. Olive producing areas in Spain faced a drought last year. How did this affect the
market for olive oil in Spain this year?
3. The price of tobacco has increased. How will this affect the market for vapes?
4. Rota is a beach town in Spain that receives a lot of tourists every year. What
happens to the market for beach-side restaurants after the summer ends.
 Productive and allocative efficiency

Productive efficiency: Producing the maximum output with the fewest resources.

Allocative efficiency: Producing the optimal combination of goods from society's point
of view. Achieving allocative efficiency involves maximising social/community surplus.
Consumer surplus
Producer surplus
Activity community surplus
Activity community surplus cont
Elasticity
 Determinants of price elasticity of
demand

● Number and closeness of substitutes

● The degree of necessity
● The time period considered
● Proportion of income spent on good
 Price elasticity of demand

Price elasticity of demand (PED) is the responsiveness of the quantity demanded of a

good to a change in price of the same good.

Price elasticity of demand (PED) is a measure of how much the quantity demanded of a
good changes when there is a change in its own price.

PED = % change quantity demanded/% change in price

Elastic demand

Using information in the

figure, calculate the price
elasticity of demand for
bagels using points A and B.
Inelastic demand

Using information in the figure,

calculate the price elasticity of
demand for Elote when the price
increases from $15 to $17
 Unitary elastic demand

PED = 1
 Perfectly inelastic demand

PED = 0
 Perfectly elastic demand

PED = ∞
 PED implications for businesses
revenue
Revenue = Price x Quantity

When a good is elastic, an increase in price decreases firm’s revenue

When a good is inelastic, an increase in price increases firm’s revenue

 Activity: Elasticity and firm’s
revenue
Calculate the change in the firm’s revenue when the price increases from $2.0
to $2.10
 Activity: Elasticity and firm’s
revenue
Calculate the change in the firm’s revenue when the price increases from 10 to
20.
 PED implications for government
policies

● Incidences on taxes and subsidies

● PED and influencing production/consumption
● PED and government revenue
PED implications on government
policies
 Activity PED and government

1. Draw the demand and supply curve for gasoline

2. Show the effect an indirect tax has on the market for gasoline.
3. Is the tax likely to have a big effect on the quantity consumed?
4. Using a graph, explain who pays a higher proportion of the tax, the consumer or
the producer?
 Income elasticity of demand (YED)

Income elasticity of demand (YED) is the responsiveness of the quantity demanded of a

good to a change in the consumers’ income.

YED = % change quantity demanded/% change in income of consumer

 Categories of YED

YED > 0 Normal good

YED < 0 Inferior good

Normal goods and inferior goods
 Activity YED
1. If incomes in China increase by 6 per cent, and as a
result demand for beef increases by 10 per cent, what is
the income elasticity of demand for beef? Is it a normal
good or a inferior good?
 Price elasticity of supply (PES)
Price elasticity of supply (PES) is the responsiveness of the quantity supplied of a good
to a change in the price of the same good.

Price elasticity of supply (PES) is a measure of how much the quantity supply of a good
changes when there is a change in its own price.

PES = % change in quantity supplied/% change in price

 Categories of PES

PES > 1 Elastic supply

0 < PES < 1 Inelastic supply

PES = 0 Perfectly inelastic supply

PES = 1 Unitary elastic supply

PES = ∞ Perfectly elastic supply

 Determinants of PES

● Time period considered

● Mobility or flexibility of factors of production
● Unused capacity
● Ability to store stock
 Activity PES
1. Suppose the price for a session of yoga in a Mumbai hotel increases
from INR 1000 to INR 1250 (Indian rupees). Calculate PES if the
number of yoga sessions that the hotel offers increases from 60 to 90
a month.

2. Imagine that a soft drink manufacturer wanted to make its supply

more elastic. What could it do to become more responsive to price
changes in the market?
 Common mistakes
01 Label your diagrams!

Demand and quantity demanded are NOT

02
the same!
03 Supply and quantity supplied are NOT the
same
04 Elasticities are not analysed through the
perspective of a business unless specifically
asked
Role of
government in
microeconomics
 Why do governments intervene?
● To earn government revenue
● To support firms
● To support households on low incomes
● To influence the level of production
● To influence the level of consumption
● To correct market failure
● To promote equity
 How governments intervene in
microeconomics
● Price controls
● Indirect taxes
● Subsidies
● Direct provision of services
● Command and control regulation and legislation
● Consumer nudges
 Price controls
Price ceilings (maximum price)
are implemented in order to:
● reduce the price of certain goods or
services for low-income
consumers.
● prevent exploitation by monopolies
Housing and pharmaceutical drugs are
examples of goods that might have price
ceilings placed on them
Example of exploitation by
monopoly
Graph showing price ceiling
 Consequences of setting a price
ceiling
● It can produce shortages.
● It generates a rationing problem.
● It promotes the creation of parallel (black) markets.
● It eliminates allocative efficiency and generates welfare loss.
● Consequences for stakeholders:
Consumers - better off
Producers - worse off
Workers - potentially worse off
Government - economically no change, but may gain popularity
 Effect on stakeholders of price
ceiling

Consumers: Producers:
Workers:
Better off Worse off Government:
worse off
(lower (lower No change
(less
prices) prices)
employed)
 Price ceiling causes welfare loss

A welfare loss is a decrease in

community (social) surplus caused
by government intervention.
 Policies to solve welfare loss caused
by a price ceiling - Increase supply

● Grant subsidies to the producers

● The government produces the shortage quantity itself
● Store product then increase supply when needed by releasing some of its
stocks on to the market.
Graph showing a government policy to increase the supply
of housing to deal with a shortage due to a maximum
price policy
 Price controls
Price floors (minimum price) are
implemented in order to:
● to increase the income of producers of
goods and services that the government
considers important, such as agricultural
products
● to protect workers, by setting a minimum
wage that ensures they earn enough to
have a reasonable standard of living.
Graph showing a price floor
Consequences of setting a price floor

● It can produce surpluses.

● The government needs to dispose of the surplus.
● It might create firm inefficiency.
● It eliminates allocative efficiency and generates welfare loss.
 Effect on stakeholders of price floor

Consumers: Government: Workers:

Worse off Producers:Better Worse off, Better off,
(Higher prices, off (Higher prices, purchases more workers
consume less) produce more) surplus employed
Policies to solve welfare loss caused
by price floors

● store the good, which will generate additional costs.

● sell the surplus abroad (export).
● send the surplus as aid to developing countries
● burn the excess good
 Exercises on Price Controls
1) Which diagram is a
price ceiling and which
is a price floor?

2) Show the effect of a 3) What are two 4) Give 2 examples of

price ceiling on the policies to solve goods that might have
housing market. welfare loss caused by a price floor set on
a price ceiling? them? Why?
 Indirect taxes
Definition: Indirect taxes are a Indirect taxes are imposed to:
tax on the consumption of ● collect government revenue.
goods and services (in Spain
● discourage consumption of
this is called IVA)
undesirable and/or dangerous
goods.
● correct negative externalities and
socially inefficient allocation of
resources.
Indirect tax affecting supply
Welfare loss due to indirect tax
 Effect on stakeholders indirect tax

Consumers: Producers: Governmen

Workers:
Worse off Worse off t: Better off
Worse off
(Higher P, less (less Q sold, (gains tax
(less
Q consumed) less revenue) revenue)
employed)
 Subsidies

● to increase revenues of producers.

● to make basic necessities and merit goods more affordable
● to encourage the consumption of a good or service
● to support growth of a particular industry.
● to encourage exports and protect national industry from foreign competition.
● to correct positive externalities, improving the allocation of resources.
Effect of subsidy on market
 Effect on stakeholders of subsidies

Consumers: Producers:
Government:
Better off Better off Workers:
Worse off
(lower P, (higher P, Better off
(cost of
higher Q higher Q (more
subsidy)
consumed) produced) employed)
 Direct provision of services

● Public transport
● Rail networks
● Healthcare
● Education
● Energy
● Telecommunications
● Airlines
 Direct provision - healthcare

Total healthcare expenditure as a share of GDP, 2019

 Regulation and legislation

Quotas, bans, age restrictions,

advertising bans, strict standards
for goods etc
Exercises on Indirect Taxes & Subsidies

1) Define indirect tax. Show the effect of an indirect tax on the market for a good.
Give 2 reasons why the government might impose an indirect tax on a good.

2) Show the effect of a subsidy on the market for a good. What is the effect on the
different stakeholders?
 Paper 1 type questions
1. (a) Explain with a diagram how the government imposition of a specific tax could
reduce pollution levels in a city. [10 marks]
(b) Using real-world examples, evaluate the effectiveness of indirect taxes in
reducing the consumption levels of demerit goods such as tobacco, petrol and
alcohol products? [15 marks]
2. (a) Explain how firms can use the concept of price elasticity of demand to increase
sales revenue. [10 marks]
(b)Using real world examples discuss the importance of price elasticity of demand
for governments when intervening in different markets. [15 marks]
 How to answer essay questions

1. Define any economic terms that you will use in the essay
2. Draw and label the graphs you will use to explain your answer
3. Explain what the graph shows
4. Evaluate the policy shown in the graph (consequences, how does it affect different
stakeholders etc)
5. Real world examples
 Answer key

1. https://teacher-sites-storage.inthinking.net/ib/economics/files/p1-mark-schemes
/unit-2-q7.pdf
2. https://teacher-sites-storage.inthinking.net/ib/economics/files/new-p1-marksche
mes/mark-scheme-q11-microeconomics-mark-scheme.pdf
Market failure
 Definition Market Failure
Market failure occurs when
markets fail to allocate resources in
the most efficient way possible
from society’s point of view.
 Examples of market failure

● When a production process causes pollution, such as in the air or water

● When people consume goods that are harmful for them and the rest of society,
such as cigarettes and illegal drugs
● When the current generation exploits or depletes resources so that they won't be
available to future generations
Marginal social
benefit (MSB) =
Marginal private
benefit (MPB) +
External benefit

Marginal social
cost (MSC) =
Marginal private
cost (MPC) +
External cost
 Negative externality of consumption
These occur when the
consumption of a good
creates negative side
effects on third parties.
(MSB < MPB)

Example: Passive smokers are harmed by being

around smokers
 Possible government response to
negative externalities of
consumption
1. Banning or regulating the good
Effect of
2. Imposing an indirect tax on the indirect tax
good
3. Negative advertising (influence
demand)
 Positive externality of consumption
These occur when the
consumption of a good
creates positive side
effects on third parties.
(MSB > MPB)

Example: Consumption of healthcare (going

to the doctor) helps keep others healthy too
 Possible government response to
positive externalities of consumption
Effect of
subsidy
1. Subsidising firms
2. Direct government provision
3. Legislation to make
consumption compulsory
4. Positive advertisement
 Negative externality of production
These occur when the
production of a good or service
creates negative side effects
on third parties, that are not
paid for by the producer (MSC >
MPC).

Example: Carbon
emissions when producing
 Possible government response to
negative externalities of production

1. Imposing a carbon tax on polluting

firms
2. Legislation
3. Tradable emission permits
 Positive externality of production
These occur when the production of
a good or service creates positive
side effects on third parties, that are
not paid for by them (MSC < MPC).

Example: Society benefits from bee keeping as bees

pollinate agricultural plants and grow the harvest
 Possible government response to
positive externalities of production
1. Subsidising firms
2. Direct government provision

https://app.kognity.com/study/app/202
5-economics-sl-group-d/sid-187-cid-236
736/book/positive-externalities-of-produ
ction-id-31182/review
 Merit goods

Merit goods are those goods that will

be under-produced by the market as
consumers do not appreciate the
benefits to themselves and society of
their consumption. As a result, they are
under-provided by the market.
 Demerit goods

Demerit goods are those goods that

will be over-consumed as
consumers do not appreciate the
costs to themselves and society of
their consumption. As a result, they
are over-provided by the market.
 Public goods, common pool
resources, private goods
Rivalrous - once it has been consumed, it cannot be consumed again by another person

Excludable - it is possible to exclude people from its use

 Exercise types of goods
1. For the following goods, write whether they are excludable and rivalrous, and determine which type of
good they are.:
Chocolate bars
Lighthouses
A museum
A beach
 Exercise: Externalities

1. Draw and explain a market failure diagram of the market for tobacco. What are two
measures the government can implement to correct the market failure?
2. Draw and explain a market failure diagram of the market for education.
3. Evaluate the view that merit goods should be provided by the government.
 Sustainability

https://www.theguardian.com/environment/2023/nov/30/the-climate-crisis-explained-i
n-10-charts-co2-green-energy-cop28
 Sustainability - Carbon taxes
Benefits:
● easier to apply than other measures,
such as tradable emission permits.
● Tax revenues from carbon tax will be
collected, and can be invested in
new technologies such as renewable
energy sources

Problems:
● Difficult to measure the pollution created and put a
value on it
● Difficult to identify which firms are polluting and to
what extent
 Sustainability - Tradable emission
Benefits of this solution:
permits
● It encourages firms to seek lower-cost methods of
Permission
reducing emissions, such as better energy efficiency to emit x
● The price of permits is determined by the free amount of
market, which allows greater flexibility to firms,. carbon

Problems with this solution:

● To start with, it is difficult to set an acceptable level
of pollution. It is also difficult to measure a firm's
pollution production in order to establish the
amount of permits per firm.
● Firms pay for the pollution they create but it does
not lead to a reduction in pollution once the allowed
limit has been set.
 Sustainability - Legislation
Problems with this solution:
● The ban or restriction may lead to unemployment in the corresponding industry, as
jobs would be lost if firms are closed or the market reduced.
● Banning a firm would create non-consumption of the good that was being
produced, which might be a good necessary or desirable to consumers.
● The cost of setting and then enforcing the policy standards may be very difficult to
implement, and/or have a greater cost than the pollution itself.
 Activity: drawing diagrams
1. Using a market failure diagram, explain the effect of an indirect tax on the market of
gasoline-powered cars.
2. Using a market failure diagram, explain the effect of a subsidy on the consumption of
electric cars has on it’s market.
3. Using a market failure diagram, explain how energy from non-renewable sources is over
produced in a free market.
4. Using a market failure diagram, explain how energy from renewable sources is
underproduced in a free market.
5. Using a diagram, explain some positive consumption externalities that arise from the
rise in the education level.
 Practice questions
1. (7. (a) Explain with a diagram how the government imposition of a specific tax could reduce pollution levels in a city. [10
marks]

(b) Using real-world examples, evaluate the effectiveness of indirect taxes in reducing the consumption levels of demerit
goods such as tobacco, petrol and alcohol products? [15 marks]

2. (a) Explain how the incidence of an indirect tax depends on the price elasticity of demand. [10 marks]

(b) Using real world examples, discuss the consequences of imposing an indirect tax on unhealthy food.

3. a) Describe the internal and external benefits of going to university. [10 marks]
(b) Using real-world examples, evaluate possible measures that a government might take to increase university
participation rates? [15 marks]