econ 1000 principles of microeconomics dr. y. kong · pdf file1.1 what is economics? ... the...

ECON 1000 Dr. YING KONG

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I. The Economic Problem (Ch.1 &2)

1.1 What is Economics?

1.1.1 A Simple Model: The Circle Flow:

ECON 1000

PRINCIPLES OF MICROECONOMICS Dr. Y. KONG


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(1).The Four Factors (Land, Labour, Capital, and Enterprise)

• Capital: all human-made resources that can be used to produce goods and services.

• Enterprise: the human resource that innovates and takes risks.

(2). Two Sectors in a Free Market Economy

• Business Sector

• Household Sector

(3). Definitions

• Economics is the social science that studies the choices that

individuals, businesses, governments, and societies make as they cope with scarcity and the

incentives that influence and reconcile those choices. The subject is divided into two parts:

Microeconomics

Macroeconomics

Microeconomics

Microeconomics is the study of choices made by individuals and businesses, and the influence of

government on those choices.

Macroeconomics

Macroeconomics is the study of the effects on the national and global economy of the choices that

individuals, businesses, and governments make.

1.1.2 The Two Basic Questions of Economics

What, How, and For Whom?

Goods and services are the objects that people value and produce to satisfy wants.

(1) What?

What we produce changes over time.


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(2) How?

Goods and services are produced by using productive resources that economists call factors of

production.

Factors of production are grouped into four categories:

Land

Labour

Capital

Entrepreneurship

The quality of labour depends on human capital, which is the knowledge and skill that people

obtain from education, on-the-job training, and work experience.


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The tools, instruments, machines, buildings, and other constructions that are used to

produce goods and services are capital.

The human resource that organizes land, labour, and capital is entrepreneurship.

(3) For Whom?

Who gets the goods and services depends on the incomes that people earn.

Land earns rent.

Labour earns wages.

Capital earns interest.

Entrepreneurship earns profit.

1.1.3 Economic Goals

• The task of an economic system is to transfer all inputs such as labour, capital and natural

resources into outputs such as goods and services.


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(1). Economic Efficiency

• In general, economic efficiency means getting the highest benefit from an economy’s

scarce resources. Or, efficiency requires that scarce economic resources be employed in a

way that maximizes utility.

(2). Effectiveness

• The economy produces goods and services that are needed and wanted.

1.2 Choices and Tradeoffs- Opportunity Costs and Production Possibilities

• When wants exceeds the resources available to satisfy them, there is scarcity. Facing with

scarcity, people must make choice. We cannot have everything we want and everything we

produce.

• Economists use the term “opportunity cost” to emphasize that making choices in the face of

scarcity implies a cost. The opportunity cost of any action is the best alternative foregone.

1.2.1 The Production Possibilities Curve and Economic Reasoning

The production possibilities frontier (PPF) is the boundary between those

combinations of goods and services that can be produced and those that cannot.

To illustrate the PPF, we focus on two goods at a time and hold the quantities of all

Production System

Labor

Capital

Resources

Goods Services


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other goods and services constant.

That is, we look at a model economy in which everything remains the same (ceteris

paribus) except the two goods we’re considering.

Figure 2.1 shows the PPF for CDs and pizza, which stand for any pair of goods and services.


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(1) Production Efficiency

We achieve production efficiency if we cannot produce more of one good without producing

less of some other good. Points on the frontier are efficient.

Any point inside the frontier, such as point Z, is inefficient. At such a point, it is possible to

produce more of one good without producing less of the other good.

At Z, resources are either unemployed or misallocated.

(2) Tradeoff Along the PPF

Every choice along the PPF involves a tradeoff. On this PPF, we must give

up some CDs to get more pizza or give up some pizza to get more CDs.

(3) Opportunity Cost

The PPF makes the concept of opportunity cost precise.

If we move along the PPF from C to D the opportunity cost of the increase in pizza is the decrease in

CDs.

Examples:

A move from C to D, increases pizza production by 1 million. CD production decreases from 12 million

to 9 million, a decrease of 3 million. The opportunity cost of 1 million pizza is 3 million CDs.

One pizza costs 3 CDs.

A move from D to C, increases CDs production by 3 million. Pizza production decreases by 1 million.

The opportunity cost of 3 million CDs is 1 million pizza. One CD costs 1/3 of a pizza.

Note: that the opportunity cost of CDs is the inverse of the opportunity cost of pizza. One pizza costs 3

CDs. One CD costs 1/3 of a pizza.

Example


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12 11

AA PPrroodduuccttiioonn PPoossssiibbiilliittyy FFrroonnttiieerr

A

DVDs

Burgers4 7 90 1

5 DVDs

5

9

15

3

2 DVDsB

C

D

E

F

14 12

4

1 DVD

% of resources devoted to production of burgers

Number of burgers

% of resources devoted toproduction of DVDs

Number of DVDs Row

0 20

40 60 80 100

0 4 7 9 1 1 12

100 80 60 40 20 0

15 14 12 9 5 0

A B C D E F


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The PPF and Marginal Cost-Using Resources Efficiently

The marginal cost of a good or service is the opportunity cost of producing one more unit of it.

Figure 2.2 illustrates the marginal cost of pizza.

As we move along the PPF in part (a), the opportunity cost and the marginal cost of pizza increases.


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In part (b) of Figure 2.2, the bars illustrate the increasing opportunity cost of pizza. The black dots and

the line labeled MC show the marginal cost of pizza.

(4) Preferences and Marginal Benefit

Preferences are a description of a person’s likes and dislikes.

The marginal benefit of a good or service is the benefit received from consuming one more unit

of it. We measure marginal benefit by the amount that a person is willing to pay for an additional

unit of a good or service.

The principle of decreasing marginal benefit: the more we have of any good or service, the

smaller is its marginal benefit and the less we are willing to pay for an additional unit of it.

The marginal benefit curve shows the relationship between the marginal benefit of a good and

the quantity of that good consumed

Figure 2.3 shows a marginal benefit curve. The curve slopes downward to reflect the principle of

decreasing marginal benefit.

At point A, with pizza production at 0.5 million, people are willing to pay 5 CDs per pizza.


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At point E, with pizza production at 4.5 million, people are willing to pay 1 CD per pizza.

(5) Efficient Use of Resources

When we cannot produce more of any one good without giving up some other

good, we have achieved production efficiency, and we are producing at a

point on the PPF.

Figure 2.4 illustrates allocative efficiency. The point of allocative efficiency is the point on the PPF at

which marginal benefit equals marginal cost. This point is determined by the quantity at which

the marginal benefit curve intersects the marginal cost curve.


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If we produce less than 2.5 million pizza, marginal benefit exceeds marginal cost. On the PPF at point

A, we are producing too many CDs, and we are better off moving along the PPF to produce

more pizza.

If we produce more than 2.5 million pizza, marginal cost exceeds marginal benefit. On the PPF at point

C, we are producing too much pizza, and we are better off moving along the PPF to produce less

pizza.


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1.2.2 Economic Growth

Two key factors influence economic growth:

Technological change

Capital accumulation

Technological change is the development of new goods and of better ways of producing goods and

services.

Capital accumulation is the growth of capital resources, which includes human capital.

The Cost of Economic Growth: To use resources in research and development and to produce new

capital, we must decrease our production of consumption goods and services.

Figure 2.5 illustrates the tradeoff we face.We can produce pizza or pizza ovens along PPF0.

By using some resources to produce pizza ovens, the PPF shifts outward in the future.


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Economic Growth in Canada and Hong Kong

In 1965, Hong Kong’s production possibilities (per person) were much smaller than those in Canada.

The Production By 2005, Hong Kong’s production possibilities (per person) were similar to those in

Canada. Hong Kong’s PPF shifted out more quickly than did Canada’s because Hong Kong

devoted more of its resources to capital accumulation.


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1.2.3. Gains from Trade

(1) Comparative Advantage

A person has a comparative advantage in an activity if that person can perform the activity at a lower

opportunity cost than anyone else.

Joe and Liz operate smoothie bars and produce smoothies and salads.

Liz's Smoothie Bar

In an hour, Liz can produce 40 smoothies or 40 salads. Liz's opportunity cost of producing 1

smoothie is 1 salad. Liz's opportunity cost of producing 1 salad is 1 smoothie. Liz’s

customers buy salads and smoothies in equal number, so she produces 20 smoothies and 20

salads an hour.

Joe's Smoothie Bar

In an hour, Joe can produce 6 smoothies or 30 salads. Joe's opportunity cost of producing 1 smoothie

is 5 salads. Joe's opportunity cost of producing 1 salad is 1/5 smoothie. Joe’s spend 10

minutes making salads and 50 minutes making smoothies, so he produces 5 smoothies and 5

salads an hour.


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Absolute advantage

When one person is more productive than another person in several or even all activities he/she has

absolute advantage.

Liz’s Absolute Advantage: Liz is four times as productive as Joe—Liz can produce 20 smoothies and

20 salads an hour and Joe can produce only 5 smoothies and 5 salads an hour.

Liz’s Comparative Advantage: Liz’s opportunity cost of a smoothie is 1 salad while Joe’s opportunity

cost of a smoothie is 5 salads. Liz’s opportunity cost of a smoothie is less than Joe’s, so Liz has a

comparative advantage in producing smoothies.

Joe’s Comparative Advantage: Joe’s opportunity cost of a salad is 1/5 smoothie. Liz’s opportunity

cost of a salad is 1 smoothie. Joe’s opportunity cost of a salad is less than Liz’s, so Joe has a

comparative advantage in producing salads.

(2) Achieving Gains from Trade

Liz and Joe produce more of the good in which they have a comparative advantage:

Liz produces 35 smoothies and 5 salads.

Joe produces 30 salads.

Liz and Joe trade:

Liz sells Joe 10 smoothies and buys 20 salads.

Joe sells Liz 20 salads and buys 10 smoothies.

After trade: Liz has 25 smoothies and 10 salads; Joe has 25 smoothies and 10 salads.


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Copyright © 2006 Pearson Education Canada

Figure 2.7 shows the gains from trade.

Joe initially produces at point A on his PPF


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Liz initially produces at point A on her PPF

Joe’s opportunity cost of producing a salad is less than Liz’s.So Joe has a comparative advantage

in producing salad.

Liz’s opportunity cost of producing a smoothie is less than Joe’s.So Liz has a comparative

advantage in producing smoothies.

If Joe specializes in producing salad, he produces 30 salads an hour at point B on his PPF.

If Liz produces 25 smoothies and 5 salads an hour, she produces at point B on her PPF.

They exchange salads for smoothies along the red “Trade line.” The price of a salad is 2 smoothies or

the price of a smoothie is ½ of a salad.

Joe buys smoothies from Liz and moves to point C—a point outside his PPF.

Liz buys salads from Joe and moves to point C—a point outside her PPF.


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III. Demand, Supply and Market Equilibrium (Ch.3)

3.1 Demand

• Demand means a willingness and capacity to pay.

• The quantity demanded of a good or service is the amount that consumers plan to

buy during a particular time period, and at a particular price.

The Law of Demand

The law of demand states: Other things remaining the same, the higher the price of a good, the

smaller is the quantity demanded.

The law of demand results from

Substitution effect

Income effect

3.1.1 Demand Curve and Demand Schedule

The term demand refers to the entire relationship between the price of the good and quantity

demanded of the good.

A demand curve shows the relationship between the quantity demanded of a good and its

price when all other influences on consumers’ planned purchases remain the same.


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Figure 3.1 shows a demand curve for recordable compact discs (CD-Rs).

A rise in the price, other things remaining the same, brings a decrease in the quantity

demanded and a movement along the demand curve.

A demand curve is also a willingness-and-ability-to-pay curve.

The smaller the quantity available, the higher is the price that someone is willing to pay for

another unit. Willingness to pay measures marginal benefit.

From a Demand Table to a Demand Curve:

• You plot each point in the demand table on a graph and connect the points to derive the

demand curve.

Assumption of Other Things Constant

• “Other things constant” in our definition of demand means that all other factors that affect

Price per cassette (in dollars)

A Demand Curve

Quantity of cassettes demanded (per week) 1 2 3 4 5 6 7 8 9 10 11 12 13

$6.00

5.00

4.00

3.00

2.00

1.00 .50

0

3.50 E

D

C

B FA

Price per cassette

A B C D E

A Demand Table

Cassette rentals demanded per week

$0.50 1.00 2.00 3.00 4.00

9 8 6 4 2

Demand for cassettes

G


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the analysis are assumed to remain constant, whether they actually remain constant or not.

• These factors may include changing tastes, prices of other goods, even the weather.

3.1.2 Shifts in Demand versus Movements along a Demand Curve

A Change in Demand

When any factor that influences buying plans other than the price of the good changes, there

is a change in demand for that good.

The quantity of the good that people plan to buy changes at each and every price, so there is

a new demand curve.

When demand increases, the demand curve shifts rightward. When demand decreases, the

demand curve shifts leftward.

Six main factors that change demand are:

(1) Prices of Related Goods

A substitute is a good that can be used in place of another good.

A complement is a good that is used in conjunction with another good.

Figure 3.2 shows the shift in the demand curve for CD-Rs when the price of CD burner falls.

Because a CD burner is a complement of a CD-R, the demand for CD-Rs increases.


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(2) Expected Future Prices

If the price of a good is expected to rise in the future, current demand increases and the demand

curve shifts rightward.

(3) Income

When income increases, consumers buy more of most goods and the demand curve shifts rightward.

A normal good is one for which demand increases as income increases. An inferior good is a good

for which demand decreases as income increases.

(4) Expected Future Income

When expected future income increases, the demand might increase.

(5) Population

The larger the population, the greater is the demand for all goods.

(6) Preferences

People with the same income have different demands if they have different preferences.

A Change in the Quantity Demanded Versus a Change in Demand

Figure 3.3 illustrates the distinction between a change in demand and a change in the quantity

demanded.

When the price of the good changes and everything else remains the same, there is a change

in the quantity demanded and a movement along the demand curve.


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When one of the other factors that influence buying plans changes, there is a change in

demand and a shift of the demand curve.


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3.2 Supply

Resources and technology determine what it is possible to produce. Supply reflects a

decision about which technologically feasible items to produce.

The quantity supplied of a good or service is the amount that producers plan to sell during a

given time period at a particular price.

The Law of Supply

Other things remaining the same, the higher the price of a good, the greater is the quantity supplied.

The law of supply results from the general tendency for the marginal cost of producing a

good or service to increase as the quantity produced increases (Chapter 2, page 37).

Producers are willing to supply a good only if they at least cover their marginal cost of

production.

3.2.1 Supply Curve and Supply Schedule

The term supply refers to the entire relationship between the quantity supplied and the price

of a good.

The supply curve shows the relationship between the quantity supplied of a good and its

price when all other influences on producers’ planned sales remain the same.


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Figure 3.4 shows a supply curve of recordable compact discs (CD-Rs).

A rise in the price, other things remaining the same, brings an increase in the quantity

supplied and a movement along the supply curve.

A supply curve is also a minimum-supply-price curve.

The greater the quantity produced, the higher is the price that a firm must offered to be willing to

produce that quantity.

3.2.2 Shifts in Supply versus Movements along a Supply Curve

A Change in Supply

When supply increases, the supply curve shifts rightward.

When supply decreases, the supply curve shifts leftward.

The five main factors that change supply of a good are

(1) Prices of Productive Resources

If the price of resource used to produce a good raises, the minimum price that a supplier is

willing to accept for producing each quantity of that good rises.

So a rise in the price of productive resources decreases supply and shifts the supply curve

leftward.

(2) Prices of Related Goods Produced

A substitute in production for a good is another good that can be produced using the same

resources. The supply of a good increases if the price of a substitute in production falls.

Goods are complements in production if they must be produced together. The supply of a

good increase if the price of a complement in production rises.

(3) Expected Future Prices

If the price of a good is expected to fall in the future, current supply increases and the supply curve

shifts rightward.

(4) The Number of Suppliers

The larger the number of suppliers of a good, the greater is the supply of the good. An increase in

the number of suppliers shifts the supply curve rightward.

(5) Technology


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Advances in technology create new products and lower the cost of producing existing products, so

they increase supply and shift the supply curve rightward.

A Change in the Quantity Supplied Versus a Change in Supply

When the price of the good changes and other influences on selling plans remain the same,

there is a change in the quantity supplied and a movement along the supply curve.


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When one of the other factors that influence selling plans changes, there is a change in

supply and a shift of the supply curve.

3.2.3 Individual and Market Supply Curves

• The market supply curve is derived by horizontally adding the individual supply curves of

each supplier.


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FFrroomm IInnddiivviidduuaall SSuupppplliieess ttoo aa MMaarrkkeett SSuuppppllyy

Quantities Supplied

A B C D E F G H I

(1)Price

(in dollars)

(2) Ann’s Supply

(5)MarketSupply

(4) Charlie's Supply

$0.000.501.001.502.002.503.003.504.00

012345678

001234555

0 0 0 0 0 0 0 2 2

0 1 3 5 7 9

111415

(3)Barry's Supply


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3.3 Market Equilibrium

Equilibrium is a situation in which opposing forces balance each other. Equilibrium in a market

occurs when the price balances the plans of buyers and sellers.

The equilibrium price is the price at which the quantity demanded equals the quantity supplied.

The equilibrium quantity is the quantity bought and sold at the equilibrium price.

FFrroomm IInnddiivviidduuaall SSuupppplliieess ttoo aa MMaarrkkeett SSuuppppllyy,,

Price per cassette (in dollars)

Charlie Barry Ann

Quantity of cassettes supplied (per week)

0

I H

G

F

E D

C

B A

Market Supply

CA


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3.3.1 Excess Supply and Excess Demand

(1) Price as a Regulator

Figure 3.7 illustrates the equilibrium price and equilibrium quantity in the market for CD-Rs.

If the price of a disc is $2, the quantity supplied exceeds the quantity demanded and there is

a surplus of discs.

If the price of a disc is $1, the quantity demanded exceeds the quantity supplied and there is

a shortage of discs.

If the price of a disc is $1.50, the quantity demanded equals the quantity supplied and there

is neither a shortage nor a surplus of discs.

(2) Price Adjustments

At prices above the equilibrium, a surplus forces the price down.

At prices below the equilibrium, a shortage forces the price up.

At the equilibrium price, buying plans selling plans agree and the price doesn’t change.

Because the price rises if it is below equilibrium, falls if it is above equilibrium, and remains

constant if it is at the equilibrium, the price is pulled toward the equilibrium and remains there until

some event changes the equilibrium.


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3.3.2 Predicting Changes in Price and Quantity

(1) A Change in Demand

An increase in demand shifts the demand curve rightward and creates a shortage at the original price.

(2) A Change in Supply

An increase in supply shifts the supply curve rightward and creates a surplus at the original price.

The price falls and the quantity demanded increases.

(3) A Change in Both Demand and Supply

A change both demand and supply changes the equilibrium price and the equilibrium quantity but

we need to know the relative magnitudes of the changes to predict some of the consequences.


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Supply and demand come together to determine equilibrium quantity and equilibrium price.

Figure 3.10 shows the effects of a change in both demand and supply in the same direction.

An increase in both demand and supply increases the equilibrium quantity but has an

uncertain effect on the equilibrium price.

Figure 3.11 shows the effects of a change in both demand and supply when they change in opposite

directions.

An increase in supply and a decrease in demand lowers the equilibrium price but has an

uncertain effect on the equilibrium quantity.


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EEffffeeccttss ooff SShhiiffttss ooff DDeemmaanndd aanndd SSuuppppllyy oonn PPrriiccee aanndd QQuuaannttiittyy,,

No change in supply

Supply shifts out Supply shifts in

No change in demand No change.

Price falls; Quantity rises.

Price rises; Quantity falls.

Demand shifts out

Price rises; Quantity rises.

Quantity rises; Price could be higher or lower.

Price rises; Quantity could rise or fall.

Demand shifts in

Price falls. Quantity falls.

Price falls; Quantity could rise or fall.

Quantity falls; Price could rise or


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4. Elasticity (Ch 4)

4.1 Price Elasticity of Demand

In Figure 4.1(a), a change in supply brings a small increase in the quantity demanded and a large

fall in price.

In Figure 4.1(b), a change in supply brings a large increase in the quantity demanded and a small

fall in price.

The contrast between the two outcomes in Figure 4.1 highlights the need for a measure of the

responsiveness of the quantity demanded to a price change.

The price elasticity of demand is a units-free measure of the responsiveness of the


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quantity demanded of a good to a change in its price when all other influences on buyers’

plans remain the same.

Calculating Elasticity

The price elasticity of demand is calculated by using the formula:

The Mid-point Formula

-Using the mid-point formula, the average of the two end points is used when calculating

percentage change.

)()(

))(2/1())(2/1(

21

21

12

12

21

21

12

12

QQPP

PPQQ

QQPP

PPQQ

++

−−

=++

−−

=

Example

Figure 4.2 calculates the price elasticity of demand for pizza.

The price initially is $20.50 and the quantity demanded is 9 pizzas an hour.

The price falls to $19.50 and the quantity demanded increases to 11 pizzas an hour.

The price falls by $1 and the quantity demanded increases by 2 pizzas an hour.

The average price is $20 and the average quantity demanded is 10 pizzas an hour.

price in change Percentage demandedquantity in change Percentage=Dε

( )

( )21

12

21

12

P+P½)P-(P

QQ½)Q-(Q

= +ε D


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The percentage change in quantity demanded, % ∆ Q, is calculated as ∆ Q/Qave, which is 2/10 =

1/5.

The percentage change in price, % ∆ P, is calculated as ∆ P/Pave, which is $1/$20 = 1/20.

The price elasticity of demand is (1/5)/ (1/20) = 20/5 = 4.

Note: By using the average price and average quantity, we get the same elasticity value

regardless of whether the price rises or falls.

Changing the units of measurement of price or quantity leave the elasticity value the same.

Calculating Elasticity at a Point

• Let us now turn to a method of calculating the elasticity at a specific point, rather than

over a range.

• To calculate elasticity at a point, determine a range around that point and calculate the

elasticity using the mid-point formula.


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The alternative method:

66.02444

244

40/1011

====QP

slopeDε

Note:

The formula yields a negative value, because price and quantity move in opposite directions. But

it is the magnitude, or absolute value, of the measure that reveals how responsive the quantity

change has been to a price change.

Elastic Demand

-For elastic points on curves, the percentage change in quantity is greater than the

percentage change in price, in absolute value.

εD > 1

CCaallccuullaattiinngg EEllaassttiicciittyy aatt aa PPooiinntt

Quantity

$10 9 8 7 6 5 4 3 2 1

C

BA

24 40 2820

( )

( )0.66

3+5½3)-(5

2028½20)-(28

=D =+εPrice


38

-Common sense tells us that an elastic demand means that quantity changes by a greater

percentage than the percentage change in price, in absolute value.

Inelastic Demand

-For inelastic points on curves, the percentage change in quantity is less than the

percentage change in price, in absolute value.

εD < 1

-Common sense tells us that an inelastic demand means that the percent change in

quantity is less than the percentage change in price, in absolute value.

Three Special Cases

(1) If the quantity demanded doesn’t change when the price changes, the price elasticity

of demand is zero and the good as a perfectly inelastic demand.

Figure 4.3(a) illustrates the case of a good that has a perfectly inelastic demand and that

has a vertical demand curve.

(2) If the percentage change in the quantity demanded is greater than the percentage

change in price, the price elasticity of demand is greater than 1 and the good has elastic

demand.

Figure 4.3(c) illustrates the case of perfectly elastic demand—a horizontal demand curve.


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(3) If the percentage change in the quantity demanded equals the percentage change in

price, the price elasticity of demand equals 1 and the good has unit elastic demand.

Figure 4.3(b) illustrates this case—a demand curve with ever declining slope. (Note that

the demand curve is not linear.)

4.2 Elasticity Along a Straight-Line Demand Curve

At prices above the mid-point of the demand curve, demand is elastic.

At prices below the mid-point of the demand curve, demand is inelastic.

Example


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If the price falls from $25 to $15, the quantity demanded increases from 0 to 20 pizzas an

hour. The average price is $20 and the average quantity is 10. The price elasticity of

demand is (20/10)/(10/20), which equals 4.

If the price falls from $10 to $0, the quantity demanded increases from 30 to 50 pizzas an

hour. The average price is $5 and the average quantity is 40. The price elasticity of

demand is (20/40)/(10/5), which equals 1/4.

If the price falls from $15 to $10, the quantity demanded increases from 20 to 30 pizzas

an hour. The average price is $12.50 and the average quantity is 25. The price elasticity

of demand is (10/25)/(5/12.5), which equals 1.


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Price

Elasticity declines along demand curve as we move toward the

quantity axis

$10 9 8 7 6 5 4 3 2 1

0 1 2 3 4 5 6 7 8 9 10

εD = ∞

ε D = 1

ε D = 0

Quantity

EEllaassttiicciittyy aalloonngg aa SSttrraaiigghhtt LLiinnee DDeemmaanndd CCuurrvvee

ε D < 1

ε D > 1


42

IInntteerrpprreettiinngg PPrriiccee EEllaassttiicciittyy ooff DDeemmaanndd

Consumers are completely unresponsive to price change

Perfectly inelastic εD=0

Consumers are unresponsive to price changes

Inelastic εD<1

Percent change in price and quantity are equal

Unit elastic εD=1

Consumers are responsive to price changes

Elastic εD>1

Quantity responds enormously to changes in price

Perfectly elastic εD=∞

Interpretation Description of demand

εD


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4.5 Price Elasticity of Demand and Total Revenue

The total revenue from the sale of good or service equals the price of the good multiplied by the

quantity sold.When the price changes, total revenue also changes. But a rise in price doesn’t

always increase total revenue.

• If demand is elastic (ε D > 1), a 1 percent price increases decreases the quantity sold by

more than 1 percent, and total revenue decreases-Price and total revenue move in

opposite directions.

• If demand is unit elastic (ε D = 1), a 1 percent price increases decreases the quantity sold

by 1 percent, and total revenue remains unchanged.

A

Price Elastic Demand

ε D > 1

Quantity

$10

8

6

4

2

0 1 2 3 4 5 6 7 8 9

C

B

F E

Lost revenue

Gained revenue


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• If demand is inelastic (ε D < 1), a 1 percent price rises increases the quantity sold by more

than 1 percent, and total revenues increases.

-Price and total revenue move in the same direction.

A

Unit Elastic Demandε D = 1

C

0 6

P

Quantity

$10

8

6

4

2

1 2 3 4 5 7 8 9

J

K

B

Lost revenue

Gained revenue


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Total Revenue along a Demand Curve

• Demand is elastic at prices above the middle point where demand is unit elastic – a rise

in price in that range lowers total revenue.

• Demand is inelastic at prices below the middle point where demand is unit elastic – a rise

in price in that range increases total revenue.

A

Price Inelastic Demand

ε D < 1

Quantity

$10

8

6

4

2

0 1 2 3 4 5 6 7 8 9

CH

B G

Lost revenue

Gained revenue


46

Example

Elastic range ε D > 1

ε D = 1

Inelastic range ε D < 1

Q0 Quantity(a)

0 0Quantity(b)

HHooww TToottaall RReevveennuuee CChhaannggeess AAlloonngg aa DDeemmaanndd CCuurrvvee

Q0

P TR


47

The Factors That Influence the Elasticity of Demand


48

The elasticity of demand for a good depends on:

The closeness of substitutes

Necessities, such as food or housing, generally have inelastic demand.

Luxuries, such as exotic vacations, generally have elastic demand.

The proportion of income spent on the good

The greater the proportion of income consumers spent on a good, the larger is its elasticity of

demand.

The time elapsed since a price change

The more time consumers have to adjust to a price change or the longer that a good can be

stored without losing its value, the more elastic is the demand for that good.

Figure 4.6 shows how the elasticity of demand for food varies with the proportion of income

spent on food in different countries.

4.6 Other Elasticities

• Two other demand elasticities are important in describing consumer behaviour:

-Income elasticity of demand.

-Cross-price elasticity of demand.

Income Elasticity of Demand

• Income elasticity of demand is defined as the percentage change in demand divided by

the percentage change in income.


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• Income elasticity of demand tells us how demand responds to changes in income.

• Normal goods are those goods whose consumption increases with an increase in income.

-They have income elasticities greater than zero (positive).

• Normal goods are usually divided into two categories:

-luxuries and necessities.

• Luxuries are goods that have income elasticity greater than 1.

-Their percentage increase in quantity demanded is greater than the percentage increase

in income.

-They are an “income elastic normal good”.

• Shoes are a necessity—a good that has an income elasticity less than 1, but still positive

(shoes are an “income inelastic normal good”).

-The consumption of a necessity rises by a smaller proportion than the rise in income.

• Inferior goods are those whose consumption decreases when income increases.

-Inferior goods have income elasticities less than zero (negative).

-Generic (store-brand) cereals are one example of inferior goods.

incomein change Percentage demandedquantity in change Percentage= η


50

Example

Figure 4.8 shows estimates of the income elasticity for food in different countries. A higher

average income is associated with a lower income elasticity of demand for food.

↑ I → ↓ Qd

Inferior good

Income elastic normal good (“superior” good)

Income inelastic normal good (“necessity”)

Two cases of normal good:

↑ I → ↑ Qd Normal good

Description

Coefficient

Interpretation

0>η

10 <<η

1>η

IInntteerrpprreettiinngg IInnccoommee EEllaassttiicciittyy ooff DDeemmaanndd

0<η


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P0

D0 D1

P0

18 Quantity25

Shift due to rise in income

CCaallccuullaattiinngg IInnccoommee EEllaassttiicciittyy

Price

η=6.5


52

Cross-Price Elasticity of Demand

• Cross-price elasticity of demand is computed by dividing the percentage change in

quantity demand by the percentage change in the price of another good.

• Depending on how consumers respond to changes in the price of related products, goods

can be classified as

-Substitutes or Complements

Complements and Substitutes

• Substitutes are goods that can be used in place of one another.

-When the price of a good goes up, the demand for the substitute good also goes up.

Cross-price elasticity of substitutes is positive

• Complements are goods that are used in conjunction with other goods.

-A rise in the price of a good will decrease the demand for its complement, and a fall in

the price of a good will increase the demand for its complement. The cross-price

elasticity of complements is negative.

Example

goodanother of pricein change Percentage demandedquantity in change Percentage=

XYε

IInntteerrpprreettaattiioonn ooff CCrroossss--PPrriiccee EEllaassttiicciittyy

↓PY ⇒ ∆QX=0

Unrelated Goods εXY = 0

↓PY ⇒↑QX Complementary Goods

εXY < 0

↓PY⇒↓QX Substitute Goods

εXY > 0

Ratio Interpretation Coefficient


53

Figure 4.7 shows the increase in the quantity of pizza demanded when the price of burger (a

substitute for pizza) rises.

The figure also shows the decrease in the quantity of pizza demanded when the price of a soft

drink (a complement of pizza) rises.


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4.7 Price Elasticity of Supply

• Measures the responsiveness of firms to a change in the price of their product.

• The price elasticity of supply is calculated as the percent change in quantity supplied over

the percent change in price.

• Inelastic Supply

Common sense tells us that an inelastic supply means that the percent change in quantity

is less than the percentage change in price.

In Figure 4.9(a), a change in demand brings a small increase in the quantity supplied and

a large rise in price.

CCaallccuullaattiinngg CCrroossss--PPrriiccee EEllaassttiicciittyy

P0 P0

3 Quantity of ketchup4

Shift due to rise in price of hot dogs

D1

D0

Price of ketchup

εXY= -0.7

pricein change Percentage suppliedquantity in change Percentage=ε S


55

• Elastic Supply

An elastic supply means that quantity supplied changes by a larger percent than the

percent change in price.

In Figure 4.9(b), a change in demand brings a large increase in the quantity supplied and

a small rise in price.


56

Figure 4.10 on the next slide shows three cases of the elasticity of supply.

Supply is perfectly inelastic if the supply curve is vertical and the elasticity of supply is

0.

Supply is unit elastic if the supply curve is linear and passes through the origin. (Note

that slope is irrelevant.)

Supply is perfectly elastic if the supply curve is horizontal and the elasticity of supply is

infinite.

• Substitution and Supply

-The longer the time period considered, the more elastic the supply.

In the long run there are more alternatives so it is easier (less costly) for suppliers to

change and produce other goods.

• Economists distinguish three time periods relevant to supply:

-The instantaneous period.

-The short run.

-The long run.

• In the instantaneous period, quantity supplied is fixed so supply is perfectly inelastic.

This supply is sometimes called the momentary supply.

• In the short run, some substitution is possible, so the short-run supply curve is somewhat

elastic.

• In the long run, significant substitution is possible; the supply curve becomes very

elastic.


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• An additional factor to consider in determining elasticity of supply:

One must take into account how easy or how difficult it is to produce more of the

same good. The easier it is to produce additional units, the more elastic the

supply.

4. Efficiency and Equity

4.1 Demand and Marginal Benefit

4.1.1Individual Demand and Market Demand

The relationship between the price of a good and the quantity demanded by one person is

called individual demand.

The relationship between the price of a good and the quantity demanded by all buyers in the

market is called market demand.

In reality, the sellers do not add up individual demand curves.

They estimate total market demand for their product which becomes smooth and downward

sloping curve.

The demand curve is downward sloping for the following reasons:

-At lower prices, existing consumers buy more.

-At lower prices, new consumers enter the market.

Figure 5.1 on the next slide shows the connection between individual demand and market demand.

Lisa and Nick are the only buyers in the market for pizza. At $1 a slice, the quantity demanded by

Lisa is 30 slices and by Nick is 10 slices. The quantity demanded by all buyers in the market is 40

slices.

The market demand curve is the horizontal sum of the individual demand curves.


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4.1.2 Consumer Surplus

Consumer surplus is the value of a good minus the price paid for it, summed over the

quantity bought.

It is measured by the area under the demand curve and above the price paid, up to the

quantity bought.

Figure 5.2 on the next slide shows the consumer surplus from pizza when the market price is $1 a

slice.

At $1 a slice, the consumer surplus for the economy is the area under the market demand curve

above the market price, summed over the 40 slices bought.


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At $1 a slice, Lisa spends $30, Nick spends $10, and together they spend $40 on pizza.

The consumer surplus is the value from pizza in excess of the expenditure on it.

4.2 Supply and Marginal Cost

4.2.1 Supply, Cost, and Minimum Supply-Price

The cost of one more unit of a good or service is its marginal cost.

Marginal cost is the minimum price that a firm is willing to accept.

But the minimum supply-price determines supply: A supply curve is a marginal cost

curve.

Individual Supply and Market Supply

The relationship between the price of a good and the quantity supplied by one producer is

called individual supply.

The relationship between the price of a good and the quantity supplied by all producers in

the market is called market supply.

Figure 5.3 on the next slide shows the connection between individual supply and market supply.

At $15 a pizza, the quantity supplied by Max is 100 pizzas and by Mario is 50 pizzas. The

quantity supplied by all producers is 150 pizzas.

The market supply curve is the horizontal sum of the individual supply curves.


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4.2.2 Producer Surplus

Producer surplus is the price received for a good minus the minimum-supply price

(marginal cost), summed over the quantity sold.

It is measured by the area below the market price and above the supply curve, summed

over the quantity sold.

Figure 5.4 on the next slide shows the producer surplus from pizza when the market price is $15

a pizza.

Max is willing to produce the 50th pizza for $10. Max’s producer surplus from the 50th pizza is

the price minus the marginal cost, which is $5. At $15 a pizza, Max sells 100 pizzas. So his

producer surplus is the area of the blue triangle.

At $15 a pizza, Mario sells 50 pizzas. So his producer surplus is the area of the blue

triangle.

At $15 a pizza, the producer surplus for the economy is the area under the market price

above the market supply curve, summed over the 150 pizzas sold.


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The red areas show the cost of producing the pizzas sold.

The producer surplus is the value of the pizza sold in excess of the cost of producing it.

4.2.3 Efficiency of Competitive Equilibrium

Figure 5.5 show that a competitive market creates an efficient allocation of resources at

equilibrium. In equilibrium, the quantity demanded equals the quantity supplied.


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At the equilibrium quantity, marginal benefit equals marginal cost, so the quantity is the

efficient quantity.

When the efficient quantity is produced, total surplus (the sum of consumer surplus and

producer surplus) is maximized.

4.2.4 The Invisible Hand

Adam Smith’s “invisible hand” idea in the Wealth of Nations implied that competitive


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markets send resources to their highest valued use in society.

Consumers and producers pursue their own self-interest and interact in markets.

Market transactions generate an efficient—highest valued—use of resources.

Figure 5.6(a) shows the effects of underproduction.

The efficient quantity is 10,000 pizzas a day.

If production is restricted to 5,000 pizzas a day, a deadweight loss arises from underproduction.

This loss is a social loss.

Figure 5.6(b) shows the effects of overproduction.

Again, the efficient quantity is 10,000 pizzas a day.

If production is expanded to 15,000 pizzas a day, a deadweight loss arises from overproduction.

This loss is a social loss.


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Two Questions we are asked very often:

(1) Is the Competitive Market Efficient?

Obstacles to Efficiency

In competitive markets, underproduction or overproduction arise when there are

Price and quantity regulations

Price regulations sometimes put a block of the price adjustments and lead to underproduction.

Quantity regulations that limit the amount that a farm is permitted to produce also lead to

underproduction.

Taxes and subsidies

Taxes increase the prices paid by buyers and lower the prices received by sellers.

So taxes decrease the quantity produced and lead to underproduction.

Subsidies lower the prices paid by buyers and increase the prices received by sellers.

So subsidies increase the quantity produced and lead to overproduction.

Externalities

An externality is a cost or benefit that affects someone other than the seller or the buyer of a good.

An electric utility creates an external cost by burning coal that creates acid rain. The utility

doesn’t consider this cost when it chooses the quantity of power to produce. This result is

overproduction.


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An apartment owner would provide an external benefit if she installed a smoke detector. But she

doesn’t consider her neighbor’s marginal benefit and decides not to install the smoke detector.

The result is underproduction.

Public goods and common resources

A public good benefits everyone and no one can be excluded from its benefits.

It is in everyone’s self-interest to avoid paying for a public good (called the free-rider problem),

which leads to underproduction.

Monopoly

A monopoly is a firm that has sole provider of a good or service.

The self-interest of a monopoly is to maximize its profit. To do so, a monopoly sets a price to

achieve its self-interested goal.

As a result, a monopoly produces too little and underproduction results

High transactions costs

Transactions Costs

The opportunity cost of making trades in a market.

To use market prices as the allocators of scarce resources, it must be worth bearing the

opportunity cost of establishing a market.

Some markets are just too costly to operate.

When transactions costs are high, the market might under produce.

Are Markets Fair?

Ideas about fairness can be divided into two groups:

It’s not fair if the result isn’t fair

The idea that “it’s not fair if the result isn’t fair” began with utilitarianism, which is the

principle that states that we should strive to achieve “the greatest happiness for the greatest

number.”

If everyone gets the same marginal utility from a given amount of income, and if the marginal

benefit of income decreases as income increases, taking a dollar from a richer person and given it

to a poorer person increases the total benefit. Only when income is equally distributed has the

greatest happiness been achieved.


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Figure 5.7 shows how redistribution increases efficiency.

Tom is poor and has a high marginal benefit of income. Jerry is rich and has a low marginal

benefit of income. Taking dollars from Jerry and giving them to Tom until they have equal

incomes increases total benefit.

Utilitarianism ignores the cost of making income transfers.

Recognizing these costs leads to the big tradeoff between efficiency and fairness.

Because of the big tradeoff, John Rawls proposed that income should be redistributed to point at

which the poorest person is as well off as possible.

It’s not fair if the rules aren’t fair

The idea that “it’s not fair if the rules aren’t fair” is based on the symmetry principle, which is

the requirement that people in similar situations be treated similarly.

In economics, this principle means equality of opportunity, not equality of income. Robert

Nozick suggested that fairness is based on two rules:

The state must create and enforce laws that establish and protect private property.

Private property may be transferred from one person to another only by voluntary

exchange.


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This means that if resources are allocated efficiently, they may also be allocated fairly. A case

study on pp. 116-117 examines Nozick’s claim.

4.3 Markets in Action

4.3.1Housing Markets and Rent Ceilings

The 1906 earthquake in San Francisco left 200,000 people—more than half the city—homeless.

By the time the San Francisco Chronicle started publishing again, a month after the earthquake,

there was not a single mention of a housing shortage.

The classified advertisements listed many more houses and flats for rent than the advertisements

for houses and flats wanted.

The earthquake decreased the supply of housing and the supply curve shifted leftward to

SSA.

The rent increased to $20 a month and the quantity decreased to 72,000 units.

Long-Run Adjustment: The long-run supply of housing is perfectly elastic at $16 a month.

With the rent above $16 a month, new houses and apartments are built.

The building program increases supply and the supply curve shifts rightward.

The quantity of housing increases and the rent falls to the pre-earthquake levels (other

things remaining the same).


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A Regulated Housing Market-Price Ceiling

A price ceiling is a regulation that makes it illegal to charge a price higher than a specified level.

When a price ceiling is applied to a housing market it is called a rent ceiling.

If the rent ceiling is set above the equilibrium rent, it has no effect. The market works as if there

were no ceiling.

But if the rent ceiling is set below the equilibrium rent, it has powerful effects.

Figure 6.2 shows the effects of a rent ceiling that is set below the equilibrium rent. The

equilibrium rent is $20 a month. A rent ceiling is set at $16 a month. So the equilibrium rent is in

the illegal region.

At the rent ceiling, the quantity of housing demanded exceeds the quantity supplied and there is

a housing shortage.


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70

With a housing shortage, people are willing to pay $24 a month.

Because the legal price cannot eliminate the shortage, other mechanisms operate:

Search activity

Black markets

Inefficiency of Rent Ceilings

A rent ceiling leads to an inefficient use of resources.

The quantity of rental housing is less than the efficient quantity and there is a deadweight loss,

illustrated in Figure 6.3 (page 125).

A rent ceiling decreases the quantity of rental housing, shrinks the producer and consumer

surplus by using resources is search activity, and creates a deadweight loss.

4.3.2 The Labour Market and Minimum Wage: Price Floor

A price floor is a regulation that makes it illegal to trade at a price lower than a specified

level.

When a price floor is applied to labour markets, it is called a minimum wage.


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If the minimum wage is set below the equilibrium wage rate, it has no effect. The market

works as if there were no minimum wage.

If the minimum wage is set above the equilibrium wage rate, it has powerful effects.

Example:

The equilibrium wage rate is $7 an hour. The minimum wage rate is set at $8 an hour. So the

equilibrium wage rate is in the illegal region. The quantity of labour employed is the quantity

demanded.

The quantity of labour supplied exceeds the quantity demanded.

Unemployment is the gap between the quantity demanded and the quantity supplied.

With only 20 million hours demanded, some workers are willing to supply the last hour

demanded for $6.

Inefficiency of a Minimum Wage

A minimum wage leads to an inefficient use of resources.

The quantity of labour employed is less than the efficient quantity and there is a deadweight loss.

Figure 6.6 illustrates this loss.


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A minimum wage decreases the quantity of labour employed, shrinks the firms’ and workers’

surplus by using resources in job search activity, and creates a deadweight loss.

4.3.3 Taxes

The law might impose a tax on the buyer or the seller, but the outcome will be the same.

To see why, we look at the tax on cigarettes in Ontario.

In January 2005, the government of Ontario upped the tax on the sales of cigarettes for the

third time since taking office in the fall of 2003.

(1) A Tax on Sellers

Figure 6.7 shows the effects of this tax. With no tax, the equilibrium price is $6 a pack. A tax on

sellers of $2 a pack is introduced. The curve S + tax on sellers show the new supply curve.


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The vertical distance between the original supply curve and the supply curve with the tax

is equal to the amount of the tax—$2 a pack.

Buyers would have to pay $8 a pack to induce firms to offer the original quantity for sale.

The tax changes the equilibrium price and quantity.

The price paid by buyers rises to $7.50 a pack and the quantity decreases.

The price received by the sellers falls to $5.50 a pack.

So buyers pay $1.50 of the tax and sellers pay the remaining 50¢.

(2) A Tax on Buyers

Now suppose that buyers, not sellers, are taxed $2 a pack. Again, with no tax, the equilibrium

price is $6 a pack.

A tax on buyers of $2 a pack is introduced.

The curve D − tax on buyers shows the new demand curve.


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The vertical distance between the original demand curve and the demand curve minus the

tax is equal to the amount of the tax—$2 a pack.

Sellers would have to accept $4 a pack to induce people to buy the original quantity.

The tax changes the equilibrium price and quantity.

The price received by sellers falls to $5.50 a pack and the quantity decreases.

The price paid by buyers rises to $7.50 a pack.

So buyers pay $1.50 of the tax and sellers pay the remaining 50¢.

So, exactly as before when the seller was taxed:

The buyer pays $1.50 of the tax.

The seller pays the other 50¢ of the tax.

Tax incidence is the same regardless of whether the law says the seller pays or the buyer

pays.

Note: The division of the tax between the buyer and the seller depends on the elasticities of

demand and supply.

(3) Tax Division and Elasticity of Demand

To see the effect of the elasticity of demand on the division of the tax payment, we look at two


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extreme cases.

Perfectly inelastic demand: the buyer pays the entire tax.

Perfectly elastic demand: the seller pays the entire tax.

The more inelastic the demand, the larger is the buyer’s share of the tax.

In this figure, demand is perfectly inelastic—the demand curve is vertical.

When a tax is imposed on this good, the buyer pays the entire tax.


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In this figure, demand is perfectly elastic—the demand curve is horizontal.

When a tax is imposed on this good, the seller pays the entire tax.

(4) Tax Division and Elasticity of Supply

To see the effect of the elasticity of supply on the division of the tax payment, we again look at

two extreme cases.

Perfectly inelastic supply: the seller pays the entire tax.

Perfectly elastic supply: the buyer pays the entire tax.

The more elastic the supply, the larger is the buyer’s share of the tax.

In this figure, supply is perfectly inelastic—the supply curve is vertical.

When a tax is imposed on this good, the seller pays the entire tax.


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In this figure, supply is perfectly elastic—the supply curve is horizontal.

When a tax is imposed on this good, the buyer pays the entire tax.

(5) Taxes and Efficiency

Except in the extreme cases of perfectly inelastic demand or perfectly inelastic supply when the

quantity remains the same, imposing a tax creates inefficiency.

Figure 6.11 shows the inefficiency created by a $10 tax on CD players.

With no tax, the market is efficient and total surplus (the sum of consumer surplus and

producer surplus) is maximized.

A tax shifts the supply curve, decreases the equilibrium quantity, raises the price to the

buyer, and lowers the price to the seller.

The tax revenue takes part of the consumer surplus and producer surplus.

The decreased quantity creates a deadweight loss.

4.4 Subsidies and Quotas

Example: Harvest Fluctuations

Figure 6.12(a) shows the market for wheat in normal times.

Once the crop is planted, supply is perfectly inelastic along the momentary supply curve MS0.


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The price is $200 a tonne and farm total revenue is $4 billion.

A poor harvest decreases supply.

Farmers lose $1 billion of total revenue on the decreased quantity sold.

But they gain $1.5 billion from the higher price.

Because demand for wheat is inelastic, total revenue increases—to $4.5 billion.

Now a bumper harvest increases supply.

Farmers lose $2.0 billion of total revenue on the original quantity because the price falls.

They gain only $0.5 billion from the increased quantity.

Because demand for wheat is inelastic, total revenue decreases—to $2.5 billion.


79

Intervention in markets for farm products takes two main forms:

Subsidies

Production quotas

A subsidy is a payment made by the government to a producer.

A production quota is an upper limit to the quantity of a good that may be produced during a

specified period.

(1) Subsidies

Figure 6.13 shows how a subsidy works in the market for peanuts.

With no subsidy, the price is $40 a tonne and the quantity is 40 million tonnes a year

A subsidy of $20 a tonne is introduced.

Marginal cost minus subsidy falls by $20 a tonne and the new supply curve is S –

subsidy.

The new equilibrium is at 60 million tonnes and $30 a tonne.

The quantity produced increases.

The market price falls to $30 a tonne, but farmers’ marginal cost increases to $50 a tonne.

With the subsidy, farmers receive more on each tonne sold—the price of $30 a tonne plus

the subsidy of $20 a tonne, which equals $50 a tonne.


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(2) Production Quotas

The markets for milk, eggs, and poultry among others, are regulated with production

quotas.

Figure 6.14 shows how a production quota works.With no quota, the price is $3 a tonne

and the quantity is 16 million tonnes a year.

A production quota limits total production to 14 million tonnes a year.

The equilibrium quantity decreases to this amount.

The price rises to $5 a tonne and marginal cost falls to $2 a tonne.

4.5 Markets for Illegal Goods

The Canadian government prohibits trade of some goods, such as illegal drugs.

Yet, markets exist for illegal goods and services.

To see how the market for an illegal good works, we begin by looking at a free market

and see the changes that occur when the good is made illegal.

(1) A Free Market for Drugs

Figure 6.15 shows the market for a drug such as marijuana. Market equilibrium is at point E.

The price is PC and the quantity is QC.


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Prohibiting transactions in a good or service raises the cost of such trading.

If sellers (drug dealers) are penalized, we must add the cost of breaking the law to the

minimum supply price.

If the penalty on the seller is the amount HK, the quantity supplied at a market price of

PC is QP.

A new supply curve passes through point H.

The new equilibrium is at point F. The price rises and the quantity decreases.

Starting again at the equilibrium point E, suppose that buyers are penalized (and not sellers).

Now, we must subtract the cost of breaking the law from the maximum price that the buyer is

willing to pay.

If the penalty on the buyer is the amount JH, the quantity demanded at a market price of PC is

QP.

A new demand curve passes through point H.

The new equilibrium is at point G. The market price falls and the quantity decreases.


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But the opportunity cost of buying this illegal good rises to PB because the buyer pays the

market price plus the cost of breaking the law.

Now suppose that both buyers and sellers are penalized for trading in the illegal drug.

We add the cost of breaking the law to the minimum supply price and get a new supply curve.


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The new equilibrium is at point H.

The quantity decreases to QP.

The market price is PC.

The buyer pays PB and the seller receives PS.

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