LAST MINUTE REVISION
GUIDE
Balakumar.R.J
UNIT -2- ALLOCATION OF RESOURCES; HOW MARKETS WORKS AND MARKET FAILURE
CONTENTS
Market and mixed economic system
Demand and supply
PED and PES
Market failure
Private and social costs and benefits
Private and public expenditures
Exploitation and conservation of resources
MARKET ECONOMIC SYSTEM
An economic system where all the economic activities are owned and controlled by private individual
and there is no government intervention
FEATURES OF MARKET ECONOMY
Private property
Freedom of choice
Self-interest ( profit motive)
Price mechanism
Limited role of government
ADVANTAGES OF MARKET ECONOMY
More competition
Lower prices and better quality
Wide variety of choices
Efficient allocation of resources
Better methods of production
consumer sovereignty
DISADVANTAGES OF MARKET ECONOMY
No provision of public goods
Under provision of merit goods
Over provision of demerit goods
Monopoly power
Imperfect information
Inequality
Ignores social cost
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MIXED ECONOMIC SYSTEM
An economic system where public and private sector exists side by side and operate for the welfare of
the people.
FEATURES OF MIXED ECONOMY
Both private and public sector exists
Profit and welfare motive
Price mechanism and price fixation
Freedom of choice
Major role of the government
ADVANTAGES OF MIXED ECONOMY
Provision of public goods and merit goods by government
Demerit goods controlled
Monopoly power controlled
Equality of incomes
Private sector encouraged by profit motive
Tax revenue for government
Price mechanism and fixation helps both producers and consumers
DISADVANTAGES OF MIXED ECONOMY
Heavy taxes reduce incentives to work hard or make profits
Less efficient private sector can limit the choice
Excessive control over business activity can add costs and discourage enterprise
More government power can lead corruption
DIFFERENCE BETWEEN MARKET AND MIXED ECONOMY
MARKET ECONOMY MIXED ECONOMY
Resource allocation Private sector allocates Private and public sector
resources allocates resources
Motive Profit motive only Profit motive and welfare
motive
Price Price mechanism Price mechanism with
government control
Role of government No or limited role Major role of government
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DEMAND
Demand is the desire, willingness and ability to buy a product. The law of demand is more will be
demanded at lower price than higher price, other things remains constant.
FACTORS AFFECTING DEMAND FOR GOODS AND SERVICES
Price of the product
Income of the people
Price of related goods ( substitute goods and complementary goods)
Subsitute goods are goods which can be used instead of others ( Tea and Coffee)
Complementary goods are those goods which have joint demand( DVD and DVD
player)
Expected future price
Taste and fashions
Advertising
Population
CHANGES IN DEMAND
Extension of demand:-
Increasing quantity
demanded due to
decreasing price
Contraction of demand: -
Decreasing quantity of
demand due to
increasing price.
CHANGES IN DEMAND
Increasing demand:- Shift
of demand curve to the
right due to changes in
non-price factor
Decreasing
demand:- Shift of demand
curve to the left due to
changes in non-price factor
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SUPPLY
Supply is the total quantity of goods and services that a supplier is willing and able to sell at a given
price. The law of supply is, more will be supplied at higher price than lower price, other things remains
constant.
FACTORS AFFECTING SUPPLY OF GOODS AND SERVICES
Price of the product Costs of production Improvement in technology Taxation( a compulsory
payment imposed by government from the people and businesses) Subsidy ( a financial
assistance given by the government usually to domestic producer) Natural disasters and
weather conditions Number of suppliers
CHANGES IN SUPPLY
Extension of supply:-
Increasing quantity
supplied due to
increasing price
Contraction of supply: -
Decreasing quantity
supplied due to
decreasing price.
. CHANGES IN SUPPLY
Increasing supply:- Shift of
supply curve to the right due
to changes in non-price
factor Decreasing supply:-
Shift of supply curve to the
left due to changes in non-
price factor
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EQUILIBRIUM PRICE AND DISEQUILBRIUM PRICE
EQUILIBRIUM PRICE DISEQUILIBRIUM PRICE
A price determined by market forces Prices fixed by government (minimum and
A price where demand and supply are equal maximum price)
No shortages or surplus Prices where demand and supply are not equal
Shortages exists when government fix maximum
price and surplus exists when government fix
minimum price
Minimum price:- A price fixed by government above the equilibrium price in order to help producers
Maximum price: - A price fixed by government below the equilibrium price in order to help consumers.
EFFECTS OF CHANGES IN DEMAND AND SUPPLY ON EQUILIBRIUM PRICE AND QUANTITY
EFFECTS OF INCREASING DEMAND
Increase price
Increase quantity
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P
D1
EFFECTS OF DECREASING DEMAND
P
Decreasing price
Decreasing quantity P1
Q1 Q Q
P D
EFFECTS OF INCREASING SUPPLY D
Reduce price S1
Increase quantity
P
P1
Q Q1 Q
EFFECTS OF DECREASING SUPPLY
Increase price
Decrease quantity
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PRICE ELASTICITY OF DEMAND
The responsiveness of quantity of demand due to change in price. It can be calculated using a
formula.
OR
Example 1:- A price of rice increases from MVR 5 per kg to MVR 7 per kg. As a result, quantity
demand decreases from 250 kg to 230 kg. Calculate the price elasticity of demand.
OR
Note that the value of price elasticity of demand is always negative. Because the law of demand
states that increasing the value of price decreases the value of quantity and vice versa. But when
describing the elasticity, the negative sign is ignored.
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Example 2:- Calculate the price elasticity of demand when the price increases from 15 to 30.
PRICE QUANTITY DEMANDED QUANTITY SUPPLIED
10 250 35
15 230 60
30 170 95
45 50 120
Example 3:- Calculate the price elasticity of demand
P 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝
𝑷𝑬𝑫
D 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐩𝐫𝐢𝐜𝐞
𝟐𝟎
𝑷𝑬𝑫
𝟓𝟎
10 𝑷𝑬𝑫 𝟎 𝟒
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝑶𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒑𝒓𝒊𝒄𝒆
5 𝐏𝐄𝐃 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑷𝒓𝒊𝒄𝒆 𝒙
𝑶𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚
𝟏𝟎
𝟏𝟎
𝐏𝐄𝐃 𝒙
𝟓 𝟓𝟎
Q 𝐏𝐄𝐃 𝟎 𝟒
50 60
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TYPES OF PRICE ELASTICITY OF DEMAND
Elastic demand [P E D > 1]
Percentage change in quantity demanded is more than the percentage in price. Elasticity is more
than one. Example: Demand for Air conditioner is elastic. In this case firm’s revenue will increase if
there is a fall in its price.
When demand is price elastic a decrease in price would increase the revenue and rise in price would
decrease the total revenue. So producers fix lower price if the demand is elastic.
Inelastic demand [P E D < 1 ]
Percentage change in quantity demanded is less than the percentage change in price. Elasticity is
less than one. Example: - The demand for petrol is inelastic. In this case firm’s revenue will increase
if there is a rise in price.
Demand curve takes a steep slope. Elasticity < 1
When demand is price inelastic an increase in price would increase the revenue and a decrease in
price reduces total revenue. So producers fix higher price for the goods which have inelastic demand
in order to earn maximum revenue.
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Perfectly (Infinitively) elastic [P E D = ∞]
At the price Op, people are prepared to buy all that they can obtain. They would buy an infinite
amount if it were obtainable. Demand is said to be perfectly elastic. In this case, the more the
individual firm produces the more revenue will be earned.
If producer set a price above the existing price the demand becomes zero.
Demand curve will be parallel to the X axis. Elasticity = ∞
Perfectly inelastic demand [P E D = 0]
Demand is said to be perfectly inelastic when the quantity demanded does not respond to any change
in price. The more the price rises, the bigger will be the level of consumer expenditure.
Demand curve will be parallel to the Y axis. Elasticity = 0
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Unitary Elastic Demand [P E D =1]
Unitary elastic demand means percentage change in quantity demanded is equal to the percentage
change in price. Elasticity is equal to one. In this case total consumer expenditure remains constant.
Demand curve will be rectangular hyperbola in shape. Elasticity = 1
When demand is unitary elastic, a rise in price or fall in price has no effect on total revenue
FACTORS AFFECTING PRICE ELASTICITY OF DEMAND
Availability of substitutes
Income spent on the goods
Time period
Habit forming goods
Luxury or necessary good
PRACTICAL IMPORTANCE OF PRICE ELASTICITY OF DEMAND
Helpful to Producers
Important to Monopolists
Helpful to the government
Important in international trade
Consumer expenditure
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PRICE ELASTICITY OF SUPPLY
The term price elasticity of supply refers to the way in which the quantity supplied responds to a
change in price. In other words it is the rate of change or responsiveness in supply due to change in
price
-OR-
OR
TYPES OF PRICE ELASTICITY OF SUPPLY
Elastic Supply [P E S > 1 ] Inelastic
supply[P E S < 1 ] Perfectly elastic
supply [P E S =∞ ] Perfectly inelastic
supply [P E S = 0 ] Unitary elastic
supply [P E S =1 ]
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FACTORS AFFECTING PRICE ELASTICITY OF SUPPLY
Supply is elastic when firms can easily and quickly change the amounts supplied in response to a
change in price. Supply is inelastic when the quantity supplied cannot be easily and quickly changed
when price changes. Following factors determine the elasticity of supply.
Whether or not there is any excess capacity
Storage facilities
Availability of resources
The level of stocks
Manufactured goods and agricultural products
USEFULNESS OF PRICE ELASTICITY OF SUPPLY
A supplier will be willing to supply more into the market when prices are higher. This is
because they can generate more revenue.
A good’s supply tends to be elastic if it can be supplied easily into the market and inelastic if it
cannot be easily supplied into the market.
So, a producer has to try to find some ways to make those goods which have inelastic supply
to elastic.
This can be done through storage facilities, excess capacities and easy supply of raw
materials. As a result, the firm can sell more and generate more revenue.
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MARKET FAILURE
This occurs when the market economy fails to allocate the resources efficiently
REASONS FOR MARKET FAILURE
No provision of public goods
Under provision of merit goods
Over provision of demerit goods
Monopoly power
Imperfect information
Inequality
Ignores social costs
GOVERNMENT INTERVENTION TO CORRECT MARKET FAILURE
Taxation
Subsidies
Regulation
PRIVATE AND SOCIAL COSTS AND BENEFITS
PRIVATE COST: - This is the cost to an individual or to a firm regarding an economic activity.
Eg. Cost of buying cigarettes, illness caused by cigarettes.
PRIVATE BENEFIT: - This is the benefit to an individual or to a firm regarding an economic
activity. Eg, salary gained by teaching
EXTERNAL COST:- This is the cost or negative effects to third parties other than producers
and consumers regarding an activity Eg illness and smell to non-smokers due to smoking
EXTERNAL BENEFIT: - This is the benefit or positive effects to third parties other than
producers and consumers regarding an activity. Eg. Jobs available
EXTERNALITIES: - It can also be defined as the effects to third parties.
SOCIAL BENEFIT: - Social benefits include the sum of private benefits and external benefits.
Eg benefits to the country of having high qualified and educated citizens.
SOCIAL COST: - Social costs are the sum of private cost and external costs. Eg pollution
and global warming due to factories and cancer and other dangerous diseases caused due to
smoking
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PRIVATE EXPENDITURES AND PUBLIC EXPENDITURES
PRIVATE EXPENDITURES PUBLIC EXPENDITURES
ADVANTAGES High quality Cheap
Efficiency Everyone can benefit
Fast and accurate Inequality reduces
services
Lower quality
DISADVANTAGES Expensive
Everyone cannot afford Opportunity costs
Inequality rises
EXPLOITATION AND CONSERVATION OF RESOURCES
EXPLOITATION CONSERVATION
ADVANTAGES Employment and Positive
income environmental
Economic growth impact
Living standard Future
Better allocation of employment,
resources income and
economic growth
Environmental impact
DISADVANTAGES Slow down current
Fall in future growth, rate of growth
employment and Fall in employment
income due to lack of and income
resources Fall in current
living standard.
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