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Flashcards in Week 3 Deck (25):

What is a normal good?

A good whose demand increases with an increase in consumers income


What do we assume at market equilibrium

At market equilibrium, we assume ceteris paribus, i.e. prices in related markets (substitutes, complements and FOPs) are constant.



: a situation where demand and supply have been brought into balance.


When does the equilibrium occur

In the competitive market, the equilibrium occurs at the price where Qd = Qs. This price clears the market such that no shortage nor surplus exists.


Equilibrium price and quantity

The equilibrium price balances the quantity supplied and the quantity demanded.
The equilibrium quantity is the quantity supplied and the quantity demanded at the equilibrium price.


Comparative statics

The equilibrium price and quantity depend on the position of the supply and demand curves. When some event shifts one of these curves, the equilibrium in the market changes, resulting in a new price and a new quantity exchanged between buyers and sellers. The analysis of such a change is called comparative statics because it involves comparing an old equilibrium and a new equilibrium.


Comparative static analysis

This analysis is done in three steps:

1.Decide whether the event shifts the supply or demand curve (or perhaps both);

2. Decide in which direction the curve shifts;

3. Use the supply and demand diagram to see how the shift changes the equilibrium price and quantity.


Changes in demand

A change (rise/fall) in demand means that at every price, there is now a different (greater/smaller) quantity demanded. If demand rises the demand curve shifts to the right.


Factors that change demand

Price of substitutes in consumption

Price of compliments in consumption

Consumer income

Consumer tastes

Consumer expectations

Changes in population


Changes in supply

A change (rise/fall) in supply means that at every price, there is now a different (greater/smaller) quantity supplied. If supply rises the curve shifts to the right


Factors that change supply

Price of substitutes in production

Price of compliments in production


FOP Prices


Firm entry/exit


Comparative statics short summary

We examine the effect of a change in the prevailing conditions on the (initial) equilibrium in the market. We find the new equilibrium and compare it to the previous one.


Pareto efficiency

A situation where resources cannot be re-allocated so as to make one person better off without making another worse off


Welfare economics

Welfare economic is the study of how the allocation of resources affects the economic wellbeing of society. Suppose a social planner (e.g. the Government) wants to maximise the economic wellbeing of everyone in society. To do this effectively, the planner must first decide how to measure the economic wellbeing of a society.


How we measure economic wellbeing?

Using the concepts of consumer surplus and producer surplus.


Consumer surplus

The difference between consumers willingness to pay and the amount they actually pay. It is the consumers gains from trade i.e. the benefit of consumers from participating in the market.

Consumer surplus is the area between the demand curve and the price line

Consumer value - amount paid = consumer surplus


Willingness to sell

the minimum price they are wiling to accept at every quantity supplied.


Producer surplus

The difference between producers willingness to sell and the amount they actually receive. It is the producers gains from trade, i.e. the benefit of producers from participating in the market.

Producer surplus is the area between the supply curve and the price line

Amount received - producer cost = producer surplus


Total surplus from trade

Measures the benefit of buyers and sellers from participating in the market, the total gains from trade. It is the sum of consumer and producer surplus.

Consumer surplus + producer surplus = total surplus

Conversely it is the value to buyers minus the cost to sellers

Consumer value - producer cost = total surplus


The total benefit to society

The total benefit to society is the value of consuming the product minus the cost of producing it


Total surplus from trade: how much should society produce?

Society should continue to produce more as long as the marginal consumer value is greater than the marginal cost of production

This will maximise total surplus and the gains from trade in the market


Maximised total surplus

At equilibrium (p*q*), the value to the marginal consumer = the cost of the marginal producer. Total surplus is maximised.

Hence, the free market at equilibrium allocates resources efficiently:


Hence, the free market at equilibrium allocates resources efficiently:

the supply of goods is allocated to the buyers who value them most highly;

the demand for goods is allocated to the sellers who can produce them at lowest cost;

the quantity of goods that is produced maximises the sum of consumer and producer surplus.


When does/should Government intervene in the market?

At equilibrium, the market outcome is efficient; total surplus is maximised. Policy makers/Government cannot improve on it.

However, as we will see:

Intervention by Government may be desirable if the efficient outcome is considered inequitable;

Or if Government wishes to disregard consumer preferences;

Sometimes, a market failure happens – where the market does not achieve efficient an outcome – in such cases,
intervention is warranted.


Analyse the following events diagrammatically and assess their economic impact on the markets likely to be affected.

Which curve will move?

Right or left?

What will the new equilibrium price be?

What will the new equilibrium quantity be?