IB BIBLE
IB study guides
MICROECONOMICS
This is the first section of the IB Economics Syllabus. It is quite long, and it's important to know it properly - there's no succeeding on the exams if you don't know Micro and Macro. It focuses on basic economics, day to day interactions and business economics.
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Microeconomics is split into two pages, due to its length. The first part deals with sections 1.1-1.3. Jump to the second part here, to read about 1.4 and 1.5.
SECTIONS
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The Foundations of Economics
Scarcity is one of the asolute most fundamental aspects of economics - one could argue that it is the very reason economics came into being. Scarcity refers to a situation where wants are infinite whilst the availble resources are limited. Effectively, there aren't enough resources to produce all tha thumanity wants. It's from this that the very economics itself stems from, as economics comes from the word for management: the management of scarce resources.
Choices must therefore be made. Humans have many needs and wants. Those needs and wants are generally assumed to be infinite. Resources are, however, not infinite - there has never been and never will be enough "stuff" to completely fulfill all of humanity's wants. As a consequence, a choice must be made - what wants and needs should the limited resources fulfill? Thus, the study of economics is the result of the conflcit between unlimited wants and scarce resources.
Scarcity, choice and opportunity cost
Scarcity and Choice
The three economic questions
As a consequence of the existance of scarcity, any economic system must answer three basic economic questions. These questions refer to resource allocation and the distribution of goods and services.
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What to produce? All economies in the world have to make a distinction about what goods and services should be produced. Should focus be on weapons, healthcare, green energy or coal?
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How to produce? This questions refers to the use of resources in order to produce. More technology, or more manpower? Should it be produced in small co-operatives or by huge companies?
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For whom to produce? This is a big question for all economies in the world and their politicians. How should the produced goods and services be distributed? To the poor? To the rich? To all? To those that can afford it?
Four factors of production
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Land. This is one of the most important one. Land encompasses not only the actual territory, but also natural resources. Minerals, water, timber, oil, gas and so forth.
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Labour. This factor of prodution is perhaps the most straightforward - it's the effort put in by the workers. It is considered labour regardless of whether it is a physical or mental input, producing goods or services. A doctor, taxi driver, plumber and an economist all fall under this category.
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Capital. Capital constitutes the human-made version of land; all tools needed for production falls into this category, be it a banking service, a hammer, tools, airports, harbours, buildings, technology and so forth.
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Entrepreneurship is the final factor of production. It refers to innovation and management; the unique risk of some people to take on the risk of success and failure of a business by attempting to manage the other three factors of production into a specific good or service.
Resources: 4 Factors
1.1 Competitive Markets: Demand and Supply
Demand
What is it? Demand is one of the fundamental concepts of microeconomics, and indeed economics as a whole. Demand refers to the combined wants of something - let's say apples. When discussing the demand of apples, we are discussing the combind want of apples - that is the whole market demand. If we are talking about just one individual, that will be specified as invididual demand.
Demand has a negative causal relationship between quantity demanded and price. That means that the higher the price goes, the less of the product is demanded. The opposite is true; the lower the price, the more is demanded. This is called a negative relationship because as one factor increases, the other decreases. This is true if everything else remains the same, a situation economists like to call ceteris paribus. Ceteris Paribus just means "everything else equal", and is used when describing changes in the demand curve. So, saying that demand shifted from 100 apples demanded to 120 apples demanded because of a price increase, ceteris paribus, means that you are only calculating that price change regardless of what else might have happened.
The demand curve represents this negative relationship, and thus the demand curve is downward sloping. The graph on the right represents the demand curve of apples. As you can see, at the price of 5 dollars per apple, only 100 apples are demanded. As the price decreases, the quantity demanded by the market increases. At a price of 2 dollars per apple, 500 apples are demanded by the market.
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What is Demand?
The Demand Curve
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Price in US Dollars
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Quantity of Apples Demanded
Plotting Demand
The demand curve is one of the most basic things in economics; important to know. It has an inverse relationship with price; the higher price is, the lower the quantity is demanded.
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At 5 dollars per apple, 100 apples are demanded by the market; at that high a price, there are few that are willing to pay it to get an apple. However, at 2 dollars an apple, 500 apples are demanded by the market.
Determinants of Demand
Determinants of Demand
Determinants of Demand
Price
Price is obviously a really big component of how the income of a product will change. A decrease in price will generally lead to an increase in demand, and vice versa. However, in the case with luxury goods, the opposite might sometimes take place. If a Ferrari increases in price, so does its "exclusivity", meaning that more people might want it - just because its more expensive.
Other Factors
Other Factors includes a variety of things, but most importantly the following two:
Government policy changes. For example, if the government passes a law stating that everyone has to wear a helmet when driving a motorcycle demand for it will increase, or if smoking in public places is banned then demand for cigarettes will decrease.
Seasonal changes. In summer, the demand for footballs, sunglasses, and swimsuits etc might go up. In the fall, the demand for umbrellas and coats may increase etc. Surfboards are sold in summer, skis in the winter.
Price of Related Goods
The price of related goods influence the price of the primary good, in two different ways. Related goods can be either complementary goods or substitutes.
Complementary goods: Goods that go together. If you buy one, you will most likely buy the other. Cars and petrol, for example, are complimentary goods. If the price of petrol soars, then the demand for cars will go down. If you buy a racket, you need a ball. Pencil and eraser, bread and butter, a strawberries and cream etc.
Substitutes are goods that can substituted for the primary good. You buy one or the other. Pepsi or Coke, Adidas or Nike, Samsung or Apple. If the price of Coke goes up, people might switch to Pepsi, so the demand for Pepsi also increases.
Unrelated goods: When the price of one goes up, the demand of the other one stays the same. Pencils and toilet paper, for example, or books and motorsaws.
Tastes and Preferences
Taste and Preferences vary between different individuals. Brands and producers try to win you over. Advertisement, coupons and different marketing strategies all try to influence peoples tastes and preferences - to create brand loyalty! When something is "in" demand increases, and when something is "out" demand decreases. If a scientific study shows that eating something might cause senility later in life, preference will change, and demand goes down.
Income
Income is vital because if people make more money, they are more willing to buy. Their disposable income rises. The demand curve shifts to the right, without the price changing. However, with the case of inferior goods, the demand might actually decrease as people's incomes rise. For example, instant noodles - the only nutrition some poor students get. As their income increases, the demand for instant noodles will decrease as they buy "better" products.
Demographic
Demographic Factors are important, and there are three of them.
The size of the population. More people = more demand. It's as simple as that!
Age distribution. For example, alcohol can only be sold to people of a certain age, so if more people are born one year than another, the year the larger generation becomes legal demand for alchohol will increase.
Changes in income distribution. For example, if the poor are better off (through taxing and social benefit) and the rich are worse off, there will be a change in demand for goods especially necessities. The other way around, will be an increase in luxury goods.
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Shifts and Movements along the Demand Curve
Shifts
Movements
Supply
The Law of Supply
Supply is the opposite of demand, and together they make up the fundamental aspects of a market. The supply represents the total output of a good or service in the entire market, and thus helps determine the price of a product.
Supply has a positive casual relationship with price: as the price increases, so does the quantity supplied. If the price decreases, then the supply will also decrease. This is based on the same principle as before with demand: ceterus paribus. This is illustrated in the diagram to the right. A supply curve is upward-sloping, since it has a positive casual relationship with price. At a price of 1 dollars per apple, the market supply was at 100 apples. However, if the price is raised to 4 dollars per apply, the apple farmers will be willing to increase their production and thus supply 400 apples.
What is Supply?
Plotting Supply
The Supply Curve
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The supply curve is one of the most basic things in economics; important to know. It has an positive relationship with price; the higher the price is, the more quantity is supplies.
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At 1 dollar per apple, only 100 apples are supplied by the market; at that low a price, there are few farmers willing to enter the market. However, at 4 dollars a piece, 600 apples are supplied by the market; at that high a price, there are many farmers who are willing to join the apple business and supply it to the market.
The Determinants of Supply
Technology
Technological changes definitely affect the supply of a good. It can do this in many ways: if technology is improved upon, that might mean that more can be produced in less time and/or at a lower cost, which will shift the supply curve to the right since supply increases.
Cost of factors of production
This one might be self-explanatory. If one of the four factors of production, land, labour, entreprenurship or capital, increases in price then supply will decrease. This is because when something gets more expensive, chances are the company will produce less of it, shifting the supply curve to the left.
Land: Increase or decrease in rent affects supply. If the price of raw materials goes up, the profit margin will decrease and this affects supply.
Labour: Wages and salaries can change. Pay rise or decrease, strikes etc. This will decrease supply.
Capital: Price is interest

Number of firms
If more firms decide to produce a good, then the supply will shift to the right and increase. However, if some firms go bankrupt or decide to stop producing something, for whatever reason, the supply will decrease and shift to the left.
Expectations
Expectations refers to what the producer of the good or service predicts about the future. If the company CEO and board are really positive about their product and its market value, they might produce more in anticipation of this - the supply curve shifts to the right because of the expectations. Of course, this also works the other way around: negative expectations decrease demand.
Indirect taxes and subsidies
Taxes: For companies, a tax is just like an added cost to a factor of production. It raises the price of producing a good or a service, which means that they now produce less products for the same price. This shifts the supply curve to the left and decreases production.
Subsidies: For a company, a subsidy works like a reduction in its expenses. THe government pays a subsidy to a company directly, which means that it has the completely opposite effect of a tax. The company will increase its supply, shifting the supply curve to the right.
Price of Related Goods
Related goods in terms of supply are quite different from what they were when we were discussing demand. There are two types of related goods.
Joint Supply: Many products come through joint supply: producing one will also produce the other. A good example would be a barrel of crude oil, from which petrol as well as diesel are extracted. From a cow, you can get beef, milk as well as leather from the hide once it is slaughtered. This means that an increasing demand for milk, leading to more cow production, will also increase the supply of leather since that is also produced jointly. The supply curve shifts to the right.
Competitive Supply: This refers to goods or services that use the same base resources to produce, and so both cannot be produced. For example, a carpenter can either make chairs or tables - but both require wood. So, if the demand for chairs increases, he will have to make more chairs and less tables, which decreases the supply of tables. The supply curve shifts to the left.
Shocks
Sometimes, something happens in the world that firms can't predict or cause. This is the case with many natural disasters, droughts, floods and so forth. This affects the supply of a multitude of products. A drought will for example affect the agricultural production.
Shifts and Movements along the Supply Curve
Shifts
A shift in the supply curve is when it literally moves, producing a new equillibrium. It may shift outward, when supply increases, or it may shift inwards, when supply decreases.
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In the diagram below, the supply curve (S1) has shifted outwards to (S2). This means that at all points along the new supply curve (S2), it can now produce at a higher quantity than before.
Movements
A movement in the supply curve occurs when there is a change in price. When the price has changed the quantity supplied changes with it. In the diagram below, when the price was lowered from 5 to 3 there was a movmeent along the Supply curve from point A to point B.
Market Equilibrium
Equilibrium and changes to equilibrium
What is it?
The market equilibrium is where demand and supply interact. It is the point produced by the free market, where what the producers and consumers want overlap. To the right is a simply demand and supply diagram, where the market equilibrium point is clearly marked as A.
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When does it change?
When the determinants of demand and or supply changes, as discussed above, the curves will shift. When the shift, the market will move to a new equilibrium. The diagram to the right uses a theoretical expansion in supply due to new technology. The market therefore moves from equilibrium point A to B.
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Price Mechanism
Scarcity and opportunity cost
Signalling and Incentive functions
Scarcity necessitates an answer to “What to produce?”
Scarcity is one of hte fundamentals of economics: man has scarce resources but in infinite wants. This gives rise to the question 'What to produce?'- What should be produced with those limited resources, which of the inifinite wants should be satisfied?
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This choice results in an opportunity cost
Choosing what to produce will inevitably result in the forefeiting of all other choices. There is an opportunity cost. If I have limited resources, let's say a limited amount of milk, I can only choose to produce either butter or cheese. If I choose to produce butter, my opportunity cost is what I could've produced, in this case a block of cheese. Thus, all decisions of what to produce have a cost - and it's not monetary, but rather what you are forfeiting.
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The price mechanism is important, and governs most of the decision-making in the answering of the "What to produce" question in capitalist economies. This is due to the fact that price has both a signalling function and an incentive function. When price changes, these two kick into effect, which will result in a reallocation of resources.
Signalling function: The price of agood sends signals to both consumers and producers. When prices are rising, they signal to other producers that this is a business worth investing in, and that supply need ts to increase. So more producers enter the production. For consumers, rising prices signal that it's time to reduce demand or maybe stop using that producrt all together. The opposite is also true. Decreasing prices signal to producers that it's time to leave the market, because the product is loosing in value. To consumers, it's a signal to increase demand, which will in turn drive up the price again.
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Incentive function: This is tied into the one above. Higher prices signal to producers to get into the game, because they also produce an incentive to do so.
Market Efficiency
Consumer Surplus
What is it?
Consumer surplus is a term used when calculating demand and supply diagrams. It refers to the difference between the total that consumers are willing to pay and what they actually end up paying (market price). This is also called a welfare gain, as it is money they save.
Show it on a diagram
The consumer surplus is calcualted by drawing a box under the demand curve, between the price and the quantity set by the market price point.
Producer Surplus
What is it?
Producer surplus is the total difference between what price producers are willing to supply at, and the price they actually receive (market price).
Show it on a diagram
The producer surplus is calculated by drawing a box under the supply curve, between the price and the quantity set by the market price point. The illustration is below.
Allocative efficiency
This is achieved at the competitive market equillibrium, when the free market decides what to produce. That's because this is the best allocation of resources from society's point of view. At market equilibrim, consumer and producer surplus is maximized. Marginal benefit = marginal cost.
1.2 Elasticity
Price Elasticity of Demand
Price Elasticity of Demand (PED) is an important concept within economics. It might at first seem complicated, but don't worry - it's quite easy. PED is basically the measure of how much the quantity demanded is affected when price increases.
To give an example: a toy company decides to increase the price, because the resources they need to produce the doll are getting more expensive. They raise the price of the doll, and the quantity demanded immedietly decreases a lot, because there are many doll companies and other toys on the market. This means that the demand for this company's dolls is price elastic; it is very affected by how price changes.
PED
Price inelastic: when the demand for product X is not very responsive to changes in its price.
Price elastic: when the demand for product X is very responsive to changes in its price.
So how does one calculate price elasticity of demand? The formula to the right is used. PED is completely measured using percentages, because otherwise the different values wouldn't be comparable. It is really quite simple, so don't despair if you don't like math.
The percentage change in quantity of good demanded
The percentage change in price of the same good
PED =
Calculation Example
Calculation Example
A burger joint usually sells hamburgers for 5 dollars each. At that price they manage to sell 150. However, the price increases to 6 dollars each, at which point they now only sell 120.
Using the PED formula, simplified here to the right, the equation would be as follows:
5 - 6 / 6
150 - 120 / 120
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30 / 120
-1 / 6
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1/4 = 0.25
-1/6 = -0.167
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- 1.5
The demand for burgers thus had a PED value of -1.5. In economics, however, when discussing PED the minus is always dropped - it is only the absolute value that is used in the end.
Demand for burgers had a PED of 1.5. What does that mean? Is the demand inelastic or elastic? Well, anything with a PED greater than 1 is elastic whilst anything less than 1 is inelastic. That will also affect the curves the get. Below are two example diagrams for price inelastic demand and price elastic demand. When PED is price inelastic, as in the diagram below to the left, the demand curve is quite steep. When the company thus increases the price from P1 to P2, the quantity demanded decreases proportionately less; from Q1 to Q2. The opposite is true in the diagram below to the right, where the demand curve is price elastic. When price increases from P1 and P2, the quantity demanded falls proportionately more; from Q1 to Q2.
PED =
Change in quantity demanded divided by the new quantity
Change in price divided by the new price
PED Explained
> 1
Inelastic
< 1
Elastic
PED 1 Perfectly Inelastic
PED ∞
Perfectly Elastic
The diagrams above describe two very unrealistic scenarios: what happens when PED is perfectly inelastic or perfectly elastic. In the left diagram, the demand curve is completely vertical. This means that regardless of the price, the demand for the good will remain perfectly the same. In real life, extremely few, if any, goods have a completely inelastic demand. Some examples might be medicine that is necessary for somebody's survival, or perhaps water only for drinking. However, treat it as a theoretical thing. Perfectly elastic demand, however, shows the opposite: when demand is infinite at one price. Anything above or below that price, and demand is 0. This is more or less impossible to find in the real world.
To the right is a diagram showing something special: when PED is 1. This means that every change in price reflects exactly the same proprtionately in demand, and vice versa. So really, all changes in price will result in the same change in demand.
PED Explained
The PED value is important for both firms and for countries. For firms, knowing the PED of their products means they can easier make the correct decisions in terms of pricing. For a firm to maximize their total revenue, they want to be on the slope of the curve where PED is at 1, where it is unit elastic.
PED matters greatly in terms of countries and what they produce. Primary commodities, such as sugar, cotton and coffee, tend to have a very inelastic PED. Even if people in the developed world get richer, and the price of commodities thus get proportionatly smaller, they will not begin consuming more and more cups of coffee each day. This puts the countries that often produce the worlds primary commodities in a difficult position, as they don't increase in wealth when the rest of the world does. More on that in developmental and international economics!
Determinants of PED
Number and closeness of substitutes
This is a major determinant of PED. The more substitutes a product has, that are really similar, the more elastic its demand is. So, for example, chewing gum. There are countless different brands and flavours availbale on the market, so if the price of one increases, customers are very likely to simply choose one of the substitutes on the market. The closer two substitues are, the greater they respond to one another On the contrary, water has no substitutes and so its demand is extremely inelastic.
Luxuries and Necessities
This distinction is perhaps a bit self-explanatory. Luxury goods are goods that people buy when they have a bit of extra cash, things we don't need but that's nice to have. This means that the demand for it is more elastic; it's not something people need to have, thus when price increases people buy it a lot less. However, necessities are just that - necessary - and so people have little choice when the price increases, they need to keep buying it.
Proportion of income spent on good X
This one is very important. If a large portion of one's income is spent on a good, then demand is more elastic for it because when price increases so does the proportion of income spent on it. It is simply felt more by the wallet. For example, an apple takes up very little of most people's monthly salary, so if it increases by, say, 20%, it continues to occupy a very small porportion of someones salary. However, if a big family holiday increases in price, it increases the proportion a lot.
Length of Time
The length of time it takes to make a decision can also affect how elastic or inelastic demand is in regard to price changes. For example, in the short run, a person with a diesel-driven car and no access to public transport has a very inelastic demand for diesel. However, in the long run, the car-owner might switch to another form of transportation to avoid the increases in price. Thus in the long run, the demand for diesel is more elastic.
Cross Price Elasticity of Demand
What is it? Cross price elasticity of demand is quite similar to PED, but it looks at a different relationship than that between quantity demanded and price. Instead, cross elasticity of demand looks at how the change in price of one good, will affect the quantity demanded of another good.
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Why might that be useful? Well, a company which produces several goods might want to know a change in one will affect the other. For example, a company that produces both training shoes and training socks decides to increase the price of its shoes. How will that affect demand of its socks?
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Complementary or subsitute
Cross price elasticity also looks at whether the goods investigated are complementary goods or substitutes.
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Complimentary goods are, as discussed above by demand, goods that are often bought together. Thus an increase in the price of one will lead to a decreases in quantity demanded of the other. That's why, if the XED value turns out to be negative, the goods tested are complimentary.
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However, if the XED is positive then the goods are substititues: two goods that are similar, so that the increase of price in one will lead consumers to switch to the other one, increasing its demnad.
XED =
Percentage change in quantity demanded of good X
Percentage change in price of good Y
Calculation Example
A company sells both toothpaste and toothbrushes. After a decrease in price in toothbrushes, they decide to measure teh XED between these two products. Toothpaste are GOod X and toothbrushes are good Y.
Percentage change in quantity demanded of toothpaste: 20
Percentage change in price of good Y: -30
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XED Calculation: 20 / -30 = -0.66
XED = - 0.66
The two goods are thus complementary.
Income Elasticity of Demand
What is it? Income Elasticity of Demand (YED) is a measure of how much the quantity demanded will change as income changes.
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Why might this be useful? It calculates just how willing people are to buy more of a good when they receive more income. This is important, because it helps determine how dependent people are on products, which ones they can easily cut back spending on when they gain or lose money, which in turn impacts businesses, industries and whole economies. It helps determine what products the world craves when the global economy is doing well, and what products it will immedietly stop buying when the global economy goes to shit.
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Normal and Inferior Goods
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Normal goods YED > 0 < 1
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These are goods that have a positive YED value, such as the apples in the above example. That means that as income rises, people will buy more of them. It's that simple.
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Inferior goods YED < 0
These are goods that have a negative YED value. As people become richer they simply buy less of them. Examples include quick ramen noodles (which tend to be student staples), cheap bread, or charity clothes (although that is becoming hipper). -
Luxury goods YED > 1
These are goods
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Implications for an economy
Primary goods have a relatively low YED, while manufactured goods have a higher YED and services have the highest yet. This has major implications on economies in the world. Primarily, it means that as the globe prospers with a strong world economy (thus giving people more income) this will mainly benefit the econojmies that produce services and manufactured goods. In erverse, when the global eocnomy is going badly and people find themselves with less income, it will negatively impact those same economies more than those who produce primary goods with a low YED. This also means that the countries producing primary goods, which tends to be developing countries, are stuck in a sort of poverty cycle. They cannot gain much when the rest of hte world are benefiting from a boom, and thus odon't increase their own income much, and are stuck relying on primary goods.
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Percentage change in quantity demanded
YED =
Percentage change in income
Calculation Example
Calculation:
It is calculated using the formula to the left. Let's make an example:
People in a town all gain a payraise: their incomes increase by 10%
In response, the quantity demanded of apples in the town increases by 20%. Let's plug that into the formula:
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20 / 10 = 2.
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In summation, when the income increases in the town, the quantity demanded of apples doubles. As income increased, the demand for apples increased, and so the demand curve will have shifted to the right. Apples are a normal good. Firms will make use of this, by producing more income elastic goods during economically good times (such as an upturn in the economy).
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Price Elasticity of Supply
Percentage change in quantity supplied
What is it? Price Elasticity of Supply (PES) is very similiar to what we've previously discussed, but in regards to supply. PES is basically the measure of how much the quantity of supply will react to changes in price along a given supplyn curve.
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Why is it useful? PES measures how quickly suppliers and producers can respond to changes in demand. This is incredibly important, because the quicker a business is to respond, the more it can either earn or cut its losses. PES therefore has a large effect on world economies as well as on businesses.
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The Values of Price Elasticity of Supply
PES = 0 Supply is perfectly inelastic. It does not change at all, no matter the price change.
PES < 1 Supply is price inelastic. It does not react quickly to changes in price. The quantity supplied is not very responsive to changes in price.
PES = 1 Supply is unit elastic. The same percentage change in price occurs in the quantity supplied.
PES > 1 Supply is price elastic. When price changes, the quantity supplied is very responsive and will change to a greater degree than the price did.
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PES for primary commodities is relatively low
Commodities are products that people need,. They are generally natural in origin and thu s take a long time to produce or grow. These include things like coffee, cotton or iron ore. PES for commoditties is generally very high. This is because increasing or decreasing supply takes a very long time. To produce more cocoa, plants need to be planted and will take up to six years before they can be harvested. PES is thus very inelastic.
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PES for manufactured products is relatively high
Manufactured foods has a quite high PES value, because they can easily change the production quantities. Overnight, virtually, a factory can produce less of a good. They can also, in a bit longer time, produce more, by hiring more workers, or buying some more machines. This helps explain why countries that rely on industries tend to fare better in times of economic growth and recession - they can easier adapt to the demand of the global market.
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Perfectly elastic supply
Unit elastic supply
PES =
Percentage change in price
Calculation Example
Percentage change in quantity supplied: 30%
Percentage change in price: 45%
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30 / 45 = 0.66
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PES = 0.66
Since PES is less than 1, the supply is price inelastic of supply.
Determinants of PES
Time
How much time does it take to produce the good?
Mobility of factors of production.
If the factors of production involved in producing a certian good or service are very mobile and easiy to increase or decrease, the PES will be more elastic.
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Unused capacity
Does the producer have machinery that is currently unused? Does his factory not operate at night? This is unused capcity that can quickly be employed, making PES more elastic.
Ability to store stocks
If the good or service produced is possible to store, to produce it in advance, then supply will be more elasti. If an industry produces too many shirts, too many for the current market, they can store some stocks away. When demand increases, they thus have them there, and can easily respond to demand. On the contrary, for example, it isn't possible to store milk for very long.
Perfectly inelastic supply
Inelastic supply
Elastic supply
1.3 Government Intervention
The government can choose to interfere in the economy for a multitude of reasons. Most often, it intervenes to correct some form of failure it sees, like the over-consumption of cigarettes or the under-provision of housing in big cities. The government can intervene in the economy in primarily three ways:
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Indirect Taxes
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Subsidies
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Price Controls
Indirect Taxes
An indirect tax is imposed by the government directly on the price of the good itself. They are paid by the producer of that good directly to the government, which is why they are called "indirect" rather than "direct taxes" paid by the citizens themselves. Even though it is the producer that is reponsible for paying the taxes, it is the consumer that partly shoulders the responsibility for paying them. It is not always a 50/50 split, however, as this is determined by the goods PED. More about that later.
Two types of indirect taxes:
Excise taxes: These are imposed on a specific good, like tobacco, petrol or maybe alcohol.
Taxes on all goods and services: These exists in most countries, and are added on all that is bought. Called value added tax (VAT) in the EU, Canada etc, while it's called general sales taxes in the US.
Consequences of indirect taxes
Consumers
Consumers are generally worse off, because the tax increases the price of a good but also decreases the quantity they buy from it. Thus they both have to pay more but receive less. However, if the good is a demerit good, one could argue that they are better off because they are consuming less alchohol, for example, but economically they are worse off.
Producers
They are also worse off as a consequence of the tax. They receive less money for each good they sell, because they need to pay tax on it, and the increase in price means less sales so they produce at a lesser quantity. They are worse off.
Government
The government is the only one who comes out of all of this positively: it gains money for the state treasury.
Specific Taxes vs. Ad Valorem
There are many diferent types of indirect taxes, two of which are important for you to learn according to the IB syllabus.
Specific taxes: This is when the tax is a fixed amount, as shown in the diagram below. For example, all cars are taxed with an additional 50 pounds, regardless of how many cars one buys. The supply curve therefore shifts completely upward: it just increases with the amount of the tax. The distance between the two represents the amount of the tax.
Ad Valorem taxes: These are different, as they are calculated using a percentage. It is a fixed percentage, which is calculated on the good or service bought. Therefore, the more you buy, the more tax you'll pay. Most VATs and general sales taxes are like this. That's why, in the diagram to the right, the two supply curves differ in steepness.
Why do goverments impose indirect taxes?
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To make money. Taxes on all that is bought helps provide the government with the money it needs to keep governmental process spinning. That is also one of the reasons why high indirect taxes are often imposed on goods and services that have a very high PED, which means they will make a lot of money because people will by them regardless of the price increase. These goods include cigarettes and alchohol.
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Redistribute income. Some indirect taxes might focus primarily on luxury goods, meaning they work to take from the rich to distribute to the poor. For example, on expensive luxury car brands like Ferrari, on boats, jewellery etc.
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To discourage consumption. While taxing alcohol and tobacco allows the government to make money, they are also a demerit goods that severely damage not only the people who take them but society around them. DIscouraging them is good for society.
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HL
How much of the tax is paid by the producers and how much is put on the consumers differ from good to good, and it all comes down to the PED and PES of the good or service in question. In short, the more inelastic demand is for a good, the more of the tax the producer will put on the consumer, since it won't affect his sales negatively. With supply, it is different. When supply is very inelastic, the tax burden is mostly placed on the producers.
Below, we show two diagrams of what happens when a good has an inelastic PED and an elastic PED. Descriptions follow beneath each.
In the above example, demand for product X is very inelastic. So, when the tax per unit is imposed, the supply curve increases from Supply 1 to Supply 2. In doing so, we can see that the the consumers have to pay for everything above the previous price point, while the producers will cover the tax from below the previous price point. The consumers portion is significantly larger than the consumers.
In the above example, demand for product X is very elastic. So, when the tax per unit is imposed, the supply curve increases from Supply 1 to Supply 2. In doing so, we can see that the the consumers have to pay for everything above the previous price point, while the producers will cover the tax from below the previous price point. The producers portion is significantly larger than the consumers.
Subsidies
What is a subsidy?
A subsidy is help from the government giving in the form of money. It can be given to any group of individuals, charities, firms, industries or sectors of an economy.
Why do governments grant subsidies?
What are the consequences?
What does a subsidy look like?
For the opposite reasons they might levy a tax: to spur consumption. When the government subsidies a product or a sector, that becomes cheaper for the consumers and therefore the quantity demanded increases. There a multitude of reasons why a subsidy is used:
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To spur consumption of merit goods. The government can subsidize healthcare, vegetarian food, vaccines and other merit goods. It also increases the revenues of producers, which is a form of support.
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Subsidies are often granted to agricultural producers in the United States and Europe.
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Subsidies also make necessities available, for example in developing countries, as governments subsidize rice, bread or water.
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Support fledgling industries within the country. For many reasons, a country might wish to have the basic economic infrastructur within themselves, though it might work by importing it. Such industries include the army, a basic agricultral system, water systems, biofuels, chemicals and the like. This is partly for the country to not be so reliant on others in the case of natural disasters in other countries, wars etc.
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To subsidize an industry so that it can be more likely to export (since it's cheaper).
The effect of the subsidy on the different stakeholders involved is quite reversed from the tax. Consumers are better off,as the price of the good falls. Producers are also happy, since they get paid more for each good sold as well as increase the quantity they produce and provide. The government, however, has to pay the subsidy. That makes them worse off. Workers in the economy are happy, since the subsidy makes it likely for the firm/sector receiving the subsidy to higher more worker.
However, society needs to foot the bill, and that comes from the taxes. THe subsidy might thus allocate funds that could have gone to school, healthcare, roads and so forth. Additionally, since the good or service is now being delivered at more than market equillibrium, there's an over-allocation of that good or service.
The image on the left shows how a subsidy looks like in a diagram. It looks complicated, but its not, don't worry! At P1-Q1, the market is at market equillibrium as Supply 1 intersects Demand. However, the government adds the subsidy, which shifts the supply curve from Supply 1 to Supply 2. The difference between those two lines illustrated the subsidy per unit, how much the subsidy actually makes a difference in the good. At the new equillibrium, Psub-Qsub, the price per good is significantly lower and a higher quantity is demanded, increased from Q1.The subsidy is, much like a tax, shared between consumers and producers. The blue box shows how much of the subsidy the producers receive: they take everything above the old equillibium price. The consumers receive the rest of the subsidy, meaning that not the entirety of the subsidy went to lower the price for the consumers. How much depends on the elasticity, just as with taxes.
HL
As higher level students, you also need to know how to plot demand and supply curves and what happens after a subsidy is introduced. Let's work through the following example.
These two functions are given:
Qd = 60 - 3P
Qs = -30 + 3P
To find equillibrium, you simply equal the equations to each other. This is because, at market equillibrium, supply and demand meet - the quantity supplied and quantity demanded is the same.
Qd = Qs
60 - 3P = -30 + 3P
6P = 90
90/6 = 15
So, the two curves intercept when the price is 15 dollars per umbrella. From here, it is easy to work out the quantity demanded. Simply subsitute 15 for P in either equation.
60 - 3(15) = 60 - 45 = 15 umbrellas.
At 15 dollars each, there is demand for 15 umbrellas. Great. Plot the market eqillibrium point on your diagram. Now, it's time to plot the intercepts of each curve so you can easily draw them. It's basically finding a bunch of dots that you can connect! Below is the diagram with the market equillibrium marked out.
Next step is finding the intercepts for the demand curve. Begin by substituting in 0 for price, to find the intercept on the x-axis, for quantity. How many umbrellas are demanded if they are free?
60 - 3(0) = 60
The intercept is thus 60. Make dot there, and continue by finding where it ends - at which price is the quantity demanded zero? That will give us the y-intercept.
60 - 3P = 0
60 = 3P
60/3 = P
P = 20
At a price of twenty pounds per umbrella, people would rather get wet - the demand is virtually at zero. Great, now we have two points on either end of the equillibrium, so drawing the curve between those two points is simple. It has been done below, in step 2.
To the right, we have plotted the demand curve with the intercepts and the market equillibrium. That's great: now it's time to plot the supply curve. We will do the same thing for it: finding the intercept. Since the supply curve only has one intercept, we will instead find one extra point at the top - anyone will do. We begin by finding the intercept: when the quantity supplied is zero, which price is that at?
-30 + 3P = 0
3P = 30
P = 10
At a price of ten, there is no supply. Great. Let's plot how much is supplied at a price of 20, which is the max price shown in this diagram.
-30 + 3(20) = Qs
-30 + 60 = Qs
30 = Qs
At a price of 20 pounds per umbrella, the firm will supply 30 umbrellas. Great! Plot these two points and draw a line between them, as done below.
Great! Now we have the diagram we want to be able to add the subsidy!
The government decided more people should use umbrellas, and the industry is subsidized. Each umbrella is subsidized by 5 pounds.
This means that the supply curve will shift downwards by 5 pounds per umbrella. How would you graph this? Well, in this example, one could use common sense to graph new points. If they were willing to start supplying at ten, they are now willing at 5. That's the new y-intercept. If max was at 20, they now supply max at a price of 15. By plotting these two points, you can now draw a new line between them and find the new market equillibrium. The new function will be like this:
Qs = -30 + 3(P + 5)
Simplified, it's:
Qs = -30 + 3P + 15 = -15 + 3P
After the subsidy, quantity supplied is -15 + 3P. With this new function, it is also easy to find price, quantity and intercepts. While in this example it worked by looking at the curve, it is important you know how to find it mathematically as well.
New equillibrium is found the same way:
-15 + 3P = 60 - 3P
-15+ 60 = 6P
6P = 45
P = 7.5
New price is 12.5 pounds! New quantity?
60 - 3(12.5) = 60 - 37.5 = 22.5
So equillibrium is at a price of 12.5 pounds and a quantity of 22.5. This new supply curve is plotted on the left. There you go, folks! How to plot a supply curve plus it's subsidy. However, now the real mathematics begin.
The IB syllabus also wants you to be able to calculate the actual cost to all of the stakeholders, mathematically. Well, this is the tricky part. You need to be able to calculate consumer expenditure, producer revenue, government expenditure and illustrate the consumer and producer surplus.
Let's begin by calculating the price the producers will receive per umbrella sold. So, the consumer will now buy it for 12.5 pounds. The producer, however, will receive this price plus the subsidy per unit, which was 5 pounds. The producers receive 12.5 + 5, which equals 17.5 pounds per umbrella.
How much did consumer expenditure increase? Well, before the subsidy they bought 15 umbrellas at 15 pounds each - a total of 225 pounds. After the subsidy, they buy 22.5 umbrellas at 12.5 pounds each. In total, that is 281 pounds. Consumer expenditure has therefore increased.
How has producer revenue changed? Well, before they earned 15 pounds per umbrella, so 15 x 15 = 225 pounds. Now, however, they receive 17.5 pounds per umbrella sold, and new quantity is 22.5 umbrellas. 17.5 x 22.5 = 394 pounds. How much is the increase? Previously, the revenue was 281 pounds, so to find the change we do this:
394 - 281 = 113.
Producer revenue has increased by 113 pounds.
Government expenditure is calculated by multiplying the amount spent on each umbrella, 5 pounds, times the amount of umbrellas sold, 22.5. 22.5 x 5 = 112.5 pounds.
Consumer and producer surplus is further an important concept. This means that, at the free market equillibrium, producer and consumer surplus are at their maximum - they are both getting the price they want as well as the quantity. However, with the introduction of a subsidy, this changes as they are no longer operating on allocative efficiency. Both the consumer and the producer gain surplus, because one has to pay a lower price and the other makes more money. There is a change in consumer and producer surplus.
Price Controls
What's a price control? It's when the government interfers in the market by placing any type of restriction on the price of a good or of a service, which disrupts the market. There are two. types of price controls: price ceilings and price floors. We'll begin with price ceilings.
Price Ceiling
A price ceiling is a maximum price allowed to be charged for a product or service. It is often imposed by governments on goods that are considered a necessity, like water or housing. The price ceiling is set below the market equillibrium price. This, however, creates a shortage, which is illustrated in the graph to the right.
The price ceiling means that at that price, the producers are willing to supply at Qs. The consumers, however, want demand at Qd since the good is so cheap. This creates a shortage.
So what are the long-term consequences?
Well, when the price ceiling is introduced, the quantity of goods supplied decreases. This means that the company or sector needs less people employed, which might result in unemployment. It also means that a shortage appears on the market. This means that even though the firm is only willing to supply at Qs, the market demands at Qd, since the price is so good. As such, some will be left wanting, and there might be queues and fierce competition for the ones sold. Or, the government might introduce coupons, or rationing. The seller might also sell to preferred customers, making it difficult to gain access. For example, exclusive country clubs might have a lot of people wanting access, but restrict it to certain people from certain families. A further consequence might be the existence of parallel markets (black or underground markets), which are illegal and pay no taxes.
What are the consequences for the different stakeholders?
Consumers. Consumers both gain some and lose some. The good will be available for at a cheaper price - but only for some people, those who can get their hands on it. This means that there's an uncertainty for consumers about whether they may or may not be able to buy it. If the good concerned is, let's say, Gatorade, that might not be a problem. But if the government introduces a price ceiling for water during a drought, this means that at that price it might disappear very quickly. It's a tricky situation.
Producers. Producers lose, because they know produce and supply less and also make less money.
Government. The government neither gains nor loses in real terms, as it does not spend any money. However, since you are all economists, you could say that because some workers are likely to be fired because of a decrease in output, which would increase the government burden with unemployments benefits etc. It all depends.
Price ceilings and floors
Price Floor
A price floor is quite the opposite. It instead sets a minimum price for a product: below that price, the product may not be sold. This is done to protect the producers of a good, to ensure they receive a proper price. It is commonly done on agricultural products, to guarantee the farmers sufficient pay for their labour.
However, this creates the opposite problem - a surplus of the good in question, rather than a shortage, since the producers are being paid to produce more than there exists demand at that price level. This is quite famous within the European Union - that a large amount of milk and butter usually go un-eaten. A price floor is often something that occurs with minimum wages - they are set above the wage that the market would offer. This creates a surplus of workers - a lot of people want that job, but the market only offers a few positions available at that price. Means that not all get employed, but those who do get a decent wage. A tricky question.
What are the consequences of a price floor?
Producers. They are happy: the receive more money yet have to produce less goods.
Consumers are worse off. There is more of the good, but at that price, not as many of them can afford it.
Government. The government can choose to do a number of things with the surplus, but in some way, it needs to be dealt with. In terms of agricultural support, the farmers may be paid for the milk/wheat etc but they simply don't produce it. The land might be used for other things, like hosting a circus or festivals instead. Unemployment is set to decrease, though, if the good is still produced as the company needs more hands on deck to up the production.
Calculate the effects of price floors and ceilings
HL
Time to do some more math!
What are the effects after a price ceilings is introduced?
A government believes that the local economy needs to be boosted, and especially farmers that are threatened by foreign imports. So the government introduces a minimum price for flour. Before, the equillibrium was that at a price of 3 euros, 30 000 kg of flour was demanded. However, the new price is at 4 euros. Plot this and calculate the effects.
Well, in the diagram below we have plotted the price floor. It is possible to tell, by the intersections, that the new quantity demanded is 20 000 kg yet the new quantity supplied is 45 000. What is the surplus? 45 000 - 20 000 = 25 000. That's the surplus.
Change in consumer expenditure. Before, they paid 3 euros for 30 000 kg. 3 x 30 000 = 90 000. Now, they pay 4 euros for 20 000. That's 4 x 20 000 = 80 000. Consumer expenditure has therefore decreased with 10 000 euros.
Change in producer revenue. Before, they earned 90 000. Now, they earn the new price multiplied with the new quantity supplied. That's 4 x 45 000 = 180 000. The change? 180 000 - 90 000 = 90 000. They have thus doubled their revenue!
The math is the same for a price floor