ECO 162 LEVEL PROGRAM CREDIT CONTACT HOUR COURSE STATUS LECTURER

: MICRO ECONOMICS : DIPLOMA : BM112 / AM110 :3 :4 : CORE

: NICHOLAS AMIN
FACULTY OF BUSINESS MANAGEMENT

SYLLABUS / SCHEME OF WORK

1. 1.1 1.2 1.3 1.4 1.5 INTRODUCTION TO ECONOMICS Definition of Economics Economic concepts Production Possibilities Curve (PPC) Basic Economic Problems Different Economic Systems including Islamic Economic System DEMAND AND SUPPLY 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 Definition of demand, law of demand, individual and market demand Determinants of demand Exceptional demand Change in quantity demanded and change in demand Definition of supply, law of supply, individual and market supply Determinants of supply Exceptional supply Change in quantity supplied and change in supply Demand and supply from Islamic perspective

2.

3. 3.1

ELASTICITY Elasticity of Demand 3.1.1 Price elasticity of demand - Definition - Measurement and interpretation - Determinants of price elasticity of demand - Relationship between price elasticity of demand and Total Revenue 3.1.2 Income elasticity of demand - Definition - Measurement and interpretation 3.1.3 Cross elasticity of demand - Definition - Measurement and interpretation Elasticity of Supply - Definition - Measurement and interpretation - Determinants of elasticity of supply MARKET EQUILIBRIUM AND GOVERNMENT INTERVENTION 4.1 4.2 4.3 Determination of equilibrium price and quantity Changes in equilibrium price and quantity Government Intervention in the market 4.3.1 Maximum price 4.3.2 Minimum price 4.3.3 Subsidy and Indirect taxes Price control from Islamic perspective

3.2

4.

4.4

5. 5.1

THEORY OF CONSUMER BEHAVIOUR Ordinal approach 5.1.1 Budget line 5.1.2 Indifference Curve (IC) 5.1.3 Consumer equilibrium PRODUCTION AND COST THEORY 6.1 6.2 6.3 6.4 6.5 Short-run production Law of diminishing marginal returns Stages of production Short-run costs Long-run average cost 6.5.1 Economies of scale 6.5.2 Diseconomies of scale

6.

7. 7.1 7.2

THEORY OF FIRM AND MARKET STRUCTURE Profit Maximization: Total and Marginal approach Perfect Competition 7.2.1 Characteristics 7.2.2 Short-run equilibrium 7.2.3 Shut-down point 7.2.4 Long-run equilibrium Monopoly 7.3.1 Characteristics 7.3.2 Short-run equilibrium 7.3.3 Long-run equilibrium 7.3.4 Third degree price discrimination 7.3.5 Comparison between long-run equilibrium of perfect competition and monopoly Monopolistic Competition 7.4.1 Characteristics 7.4.2 Short-run equilibrium 7.4.3 Long-run equilibrium Oligopoly 7.5.1 Characteristics 7.5.2 Kinked demand curve 7.5.3 Short-run equilibrium THEORY OF DISTRIBUTION 8.1 8.2 Wage determination (Perfect Competition) Other reward to factors of production (brief introduction) 8.2.1 Rent 8.2.2 Profit 8.2.3 Interest

7.3

7.4

7.5

8.

TEACHING METHODOLOGY Lectures Active Learning ASSESSMENT Test 1 Test 2 Assignment (1 2) Quizzes (2 4) Final Examination 10% 10% 10% 10% 60% 100%

Recommended Text Deviga Vengedasalam and Karunagaran Madhavan, (2007), Principles of Economics, Oxford Fajar. Parkin, M. (2010), Economics, 9th ed. Pearson: New York.

References Begg. D, Fischer, S. and Dornbusch, R. 92004), Economics. McGraw Hill. John Sloman, (2006), Economics. 6th ed. Prentice Hall: New York. Hasan, Zubir, (2009), Introduction to Microeconomics: An Islamic Perspective. 2nd ed. King Abdul Aziz University: Islamic Economic Research Centre and INCEIF. Hasan, Zubir, (2009), Theory of Profit from Islamic Perspective. Encyclopedia of Islamic Economics, Vol. 3, Islamic Foundation, UK. Hasan, Zubir, (2009), Markets and role of government in an economy from Islamic Perspective. Encyclopedia of Islamic Economics, Vol. 3, Islamic Foundation, UK. Slavin Stephen l., (2007), Economics. International Ed., McGraw Hill. Nur Huda Abdul Wahab et. Al., (2010), Economic Theory in the Malaysian Context. Cengage Learning: Singapore.

1. INTRODUCTION TO MICROECONOMICS
What is ECONOMICS?
1. Definition of Economics
1.1 Conventional Economics
A social science which studies the behaviour of mankind as a relationship between ends and scarce resources which have alternative uses (L. Robbins) Resources are scarce relative to human wants. Economics is the study of how man makes use of the limited resources to fulfill his worldly needs (ends) as efficiently as possible. Resources are fully and efficiently utilized when consumers maximize their satisfaction (utility) and producers maximize their profits. Utility maximization, profit maximization and rewards maximization therefore becomes the focus of conventional economics.

1.2

Islamic Economics
Economics in Islam is defined as a study of mans activities in line with Syariah to obtain, use and manage the economic resources for the betterment of oneself and others both materially and spiritually in order to achieve the blessings of Allah S.W.T. In Islamic Economics, the ultimate objective of all economic activities and decisions is the achievement of Al-Falah (blessings of Allah S.W.T.) who will guarantee ones happiness both in this world and in the hereafter.

2.

Philosophical Foundations
2.1 Conventional Economics
The philosophical foundations of conventional Economics are: - Utility maximization. This refers to the desire (objective) of man to maximize his satisfaction from the consumption of goods and services. - Profit maximization. This refers to the desire (objective) of producers to obtain the maximum profit when producing goods and services for consumers. Rewards maximization. This refers to the desire (objective) of owners of scarce resources to obtain the maximum reward from the making available of their scarce resources to producers to enable the latter to produce goods and services.

In conventional Economics, resources are fully and efficiently utilized and material welfare is maximized when: - consumers maximize their satisfaction from the consumption of goods and services - producers maximize profits from the production and sale of goods and services - owners of economic resources maximize rewards/returns from their resources.

2.2

Islamic Economics
Islamic Economics is based on the following philosophical foundations: the relationship between man and his Creator, Allah S.W.T. (Hablumminaan Allah) the relationship between (Hablumminnanas) man and his fellow men

the relationship between man, nature and his surroundings the meaning of his living in this world

Relationship between Man and his Creator is termed Tawhid or Unity of Thought or Unity and Sovereignty of Allah S.W.T.. Tawhid is the belief and understanding that Allah S.W.T. is the Creator, the Lord, the Sovereign, the Sustainer and the Giver. To uphold the concept of Tawhid, a Muslim should perform all duties and responsibilities required of him. These include: acting as a vicegerent of Allah S.W.T.(Khilafah) taking care, making good use of and enriching the resources endowed by Allah S.W.T.(Tazkiyyah) totally submitting himself to Allah S.W.T. by diligently obeying his rules and regulations (Rububiyyah) and maintaining good relationship with other Muslims to uphold the concept of brotherhood and justice in Islam.(Ukhwah)

3.

Economic Concepts
3.1 Scarcity, Choice and Opportunity Cost
Scarcity arises because the available economic resources are insufficient to produce all the goods and services required to satisfy all human wants. A want refers to mans desire to possess/consume goods and services. Mans wants are unlimited, that is, his desire to possess/consume goods and services are unlimited. The resources available in the world is insufficient to produce all the goods and services to satisfy all of mans wants.

Due to the insufficient resources available to satisfy all of mans wants, man need to make choices. In choosing to consume or produce a certain good, society have to forego (give up) the consumption or production of other goods. For example, if society wants to build more hospitals, it will have to build less schools because there is insufficient resources to build more of both hospitals and schools. Each time society makes a choice, the consumption of certain goods which will provide satisfaction is foregone. Opportunity cost refers to the next best alternative foregone when making a choice. It is defined as the amount of goods or services that need to be given up in order to produce something else For example, if more hospitals are built, less schools can be built. The opportunity cost of building hospitals is schools.

4. Production Possibility Frontier (PPF)/Production Possibility Curve (PPC)

Definition The production possibility frontier/curve is a model that can be used to illustrate the concept of scarcity, choice and opportunity cost. It shows the different efficient combinations of 2 goods which can be produced using a particular level of technology and a certain amount of resources. Assumptions The production possibility frontier is based on the following assumptions: 2 goods are produced There is a given amount of resources There is a given level of technology and Resources are used efficiently and the latest technology is employed Interpretation of combinations on, to the left and to the right of the PPF All combinations of goods which lie on the PPF are efficient, i.e. they represent the maximum amount of the 2 goods that can be produced using the available technology and resources. Combinations of goods lying on the PPF represent choices. Combinations which are within (to the left of) the PPF are achievable but not efficient. They are due to some resources not being fully employed or the technology used being not the most efficient or both reasons. Combinations to the left of the PPF represent opportunity cost. Combinations to the right of the PPF are not achievable. They will become achievable only when resources are increased or when technology improves or both. Combinations to the right of the PPF represent scarcity.

Slope of the PPF The slope of the PPF indicates the nature of trade off between the 2 goods. A concave PPF indicate increasing opportunity cost; a convex PPF indicate decreasing opportunity cost. A linear PPF indicate constant opportunity cost. Increasing opportunity cost means that more and more of a good have to be given up to get additional units of another good. Decreasing opportunity means that less and less of a good have to be given up to get additional units of another good. Constant opportunity means that the same amount of a good have to be given up to get additional units of another good.

Shift of the PPF An outward shift of the PPF (that is, a shift to the right) indicates an increase in societys capability to produce goods. The PPF shifts to the right when there is an increase in resources or an improvement in the technology or both.

3.2

Basic Economic Problems

Due to the scarcity of resources which arise because of mans unlimited wants, 4 basic economic problems arise. These are: - What to produce - How to produce - How much to produce and - For whom to produce What to produce: Economic resources have alternative uses, that is, they can be used to produce different types of goods and services. However, because there are insufficient resources to produce all the goods and services that man wants, there is a need to decide what goods and services to produce. The goods and services to be produced must be those that are most desired by society, i.e. those goods and services which will provide the maximum utility/satisfaction. For example, land can be used either to grow vegetables, fruits, paddy, oil palm, rubber etc. Society need to decide which crops are to be produced. If society thinks that paddy will provide the maximum satisfaction, then it will decide to produce paddy with the land available. The problem of what to produce is solved in different ways in different economic systems. In a capitalist economy, this problem is solved through price mechanism which reflects consumers preferences. Consumers express their preference through the amount of money they are willing to spend on different products. If they spend more on a product, demand would go up which in turn would cause price to rise. The rising price acts as a signal to the producer to produce more of the product. Price mechanism works through the forces of supply and demand and decides how resources are allocated in an economy. How to produce: The method of production must be the one that is most efficient, i.e. it will result in the lowest cost. This means that the method of production selected must take into account the available technology, the availability of resources and the cost of the resources. In the above example, society will choose the method of producing paddy which involve the lowest cost. How much to produce: How much of a good or service to produce will be dependent on the amount desired to be consumed by society. When more of a good or service is produced, less of other goods or services can be produced since less resources will be available for their production. Continuing the above example, society will produce the quantity of paddy which it desires to consume.

For whom to produce: Once a good have been produced, there is the need to decide who shall get to consume the good. This will be determined largely by the distribution of income in society. Goods and services will be produced for and consumed by those who have the ability and willingness to pay for them. The paddy that is produced will be consumed by those consumers who have the money and are willing to pay for it.

5. Economic Systems
An economic system refers to the way in which society organizes the production and consumption of goods and services in order to solve the 4 basic economic problems. Under conventional economics, there are 3 main economic systems, namely capitalism (market economy/free market economy/laissez-faire), socialist economy (centrally planned economy/command economy/central command economy) and mixed economy.

5.1 Capitalism
Characteristics: Private ownership of resources: Resources are owned by private individuals and companies, not the government (public sector). Freedom of enterprise and choice: Individuals and Private companies have the freedom to decide the type of businesses they wish to engage in while private individuals have the freedom to decide the goods and services they wish to consume. Maximizing income, profits and satisfaction are the driving force of economic performance: Private individuals, by attempting to maximize their income and utility and private companies by attempting to maximize their profit, contribute to the efficient allocation of resources and the functioning of the economy. Strong competition in markets and industries: There is strong competition among private companies for resources for production of goods and services and for customers to purchase the goods and services they produced. Limited role for government: The governments role is confined mainly to stabilize the economic condition. Consumer sovereignty: Consumers determine the types and quantity of goods and services that are to be produced. Producers will produce only the quantity types of goods that consumers wish to purchase.

Advantages No centralized planning required: There is no need for a central planning authority to make decisions on the quantity and types of goods and services to be produced. This saves resources associated with central planning. Higher efficiency and incentive to work hard. Capitalism promotes efficiency among producers and incentives for individuals to work hard.

More optimum utilization of resources: Since producers produce only the quantity and types of goods and services that consumers wish to purchase, there is less wastage of resources. Better quality of goods and services: Due to competition among producers, the quality of goods and services are higher. This is because consumers will not want to purchase goods and services that are of low quality Promote technological progress and productivity: To attract customers, producers have to continuously improve the quality of their goods and services and lower the price. This will lead to continuous technological progress and higher productivity.

Disadvantages Misallocation of resources: This occur when companies due to certain reasons were able to exercise control over the market. By virtue of this power, they may find it more profitable to produce at a non-optimal level, thereby resulting in a misallocation of resources. Wasteful competition: The need to attract customers may cause companies to engage in wasteful competition such as engaging in advertising and producing many versions of a good or service. Individual interest takes precedence over societys interest: In trying to maximize profit, companies may engage in undesirable practices which is harmful to society such as polluting the environment, not willing to produce socially desirable goods due to absence of profit or producing goods which are harmful such as cigarettes and drugs. Inequitable distribution of income: Certain segments of society such as the handicapped, poorly educated, aged and people living in the remote areas may not be able to compete effectively, thereby earning lower incomes. This leads to income being not equally distributed. Unemployment and inflation: These became common occurrences due to the fluctuations in the level of economic activity. Unemployment and inflation are undesirable because they create problems for society.

Solving the Fundamental Economic Problems Capitalism relies on the price mechanism to solve the basic economic problems. The price mechanism refers to a system whereby price is used to help make economic decisions. Consumers, by indicating the prices they are willing to pay for goods and services, send signals to producers which helped them to decide what to produce and how much to produce. Likewise, prices of resources serve as signals to producers regarding the production methods to use to minimize costs (how to produce). Lastly, the problem of for whom to produce is solved by producing for those people who are able and willing to pay the prices charged by producers of the goods.

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5.2 Socialist System

Characteristics All economic decisions are made by the central authority/government Public ownership of resources Limited use of the price mechanism

Advantages Promotes social justice. reduced to a minimum.

Under socialism, income differences are Everybody is

No serious recession or unemployment problems. provided with a job.

No inflation. This is because prices are controlled by the government. Can also promote technological and scientific advancement comparable to the capitalist countries. When the Soviet Union adopted a socialist economic system, it was able to match the United States in terms of space and defence technology

Disadvantages Socialist countries normally do not enjoy high standard of living due to the absence of motivation for individuals to work hard. The lack of incentives results in economic inefficiency Consumers do not have freedom of choice in terms of the quantity and types of goods and service they wish to consume. This is decided by the central planning authority. Economic resources are wasted when goods produced are not sold because they are not wanted by consumers.

Solving the Fundamental Economic Problems The fundamental economic problems in a socialist system are solved by the central authority. The central authority decides what to produce and how much to produce. Regarding the issue of for whom to produce, the central authority may distribute goods in accordance to peoples needs or give more to selected groups of individuals. Goods and services may be distributed directly or people may be provided with an income and given the choice to decide on what they want to purchase. With regard to how to produce, again it is the central authority which makes the decision.

5.3 Mixed Economy

Characteristics A mixture of both the capitalist and the centrally-planned economy. The government may influence relative prices of goods and services through taxation, subsidies or direct controls The government influence income through a system of income tax, welfare payments or direct controls

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The government influence the pattern of production and consumption through legislation, taxes and subsidies or through directly providing certain goods and services. There is significant extent of cooperation between the government and the private sector.

5.4 Islamic Economic System

Characteristics A moderate economic system which has the objective of achieving success (Al-Falah) materially and spiritually and of achieving true peace of mind and body through the complete submission to Allah in all economic activities. Both the government and individuals economy. Islamic individuals will fulfill Syariah in order to achieve Al-Falah. goods and services for society with the Al-Falah. play important roles in the their needs according to the The private sector produces main objective of maximizing

The government seek to achieve the macroeconomic objective of maintaining economic growth and stability. It set regulations according to the Syariah and ensure that the basic needs of society are fulfilled by producing/supplying the basic (Dharuriyat) goods.

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QUIZ
(i) State the 3 philosophical foundations of convention economics. .. .. ..

(ii)

Explain briefly the concepts of scarcity, choice and opportunity cost

(iii)

State the 4 basic economic problems .

(iv)

State the 4 philosophical foundations of Islamic Economics .. ... ... ...

(v)

Explain the production possibility curve

(vi)

What is another name for the production possibility curve? .

(vii)

State the assumptions of the production possibility curve.

(viii)

What factors can cause the production possibility curve to shift to the right?

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(ix)

.. .. What are the 3 economic systems under conventional economics? . . State 1 advantage and 1 disadvantage of capitalism.

(x)

(xi)

It is possible for the production possibility curve model to incorporate 3 goods. Right or wrong? ..

(xii)

Points to the right of the production possibility curve are achievable and efficient. Right or wrong?

EXERCISES
1. Base on the figure below, answer the following questions:

Butter (kg) A

B D E G F C Guns (Units) (a) Identify the points A, D, and G by their appropriate terminology. (b) If you are the prime minister of the country represented by the production possibility frontier above, what would you do to move away from points F and G towards the production possibility frontier? (c) Further, suppose you as the prime minister managed to convince the prime minister of Country X, your enemy that it is better for both your countries 14

to live in peace. Which of the point(s) A to G would be the most likely point selected by you? (d) What is the likely reason for your answer in Part c above? (e) What is the shape of the production possibility curve shown in the diagram? (f) What type of opportunity cost is represented by the shape of the production possibility curve?

2. The following table shows the combinations of palm oil and rubber that Country Fortune is capable of producing in a year. Palm oil (thousand tonnes) 200 160 120 80 40 0 Rubber (thousand tonnes) 0 20 40 60 80 100 Opportunity cost per tonne of palm oil

a. Using graph paper, plot the production possibility curve showing palm oil on the Y-axis and rubber on the X-axis. b. c. Complete the above table for the column on opportunity cost. State 3 assumptions in the construction of the production possibility curve and explain each of them. When the production of rubber is increased from 40,000 tonnes to 80,000 tonnes, how much is the production of palm oil reduced?

d.

3. The following table shows the production possibility combinations in Country X. Combination A B C D E F (a) (b) Shoes (units) 0 50 100 150 200 250 Cakes (kg) 500 360 240 140 60 0 Opportunity cost per unit of shoe

Plot the production possibility curve Complete the above table.

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(c) If Country X wishes to produce 350 units of shoes and 350 kg of cakes, what is the implication? Suggest 2 ways in which this combination can be achieved. 4. The diagram shows the production possibility curve for rice and clothes. Rice (Tonnes)

Cloth-making machine (Units) (a) (b) Identify the points which represent scarcity, choices, and inefficiency. Copy the above diagram and indicate the effects when the following situations occur: (i) The discovery of a new kind of seedling that can increase the yield of rice. (ii) The invention of a more efficient cloth-making machine. (iii) An improvement in the technology of producing both cloth and rice. (c) The production possibility curve represent a situation of .. (increasing/decreasing/constant) opportunity cost.

5. The diagram below depicts the production possibility curve for a nation producing carrots and tomatoes. Carrots (Kg) 1500

1000

500

Tomatoes (Kg) (a) What is the opportunity cost of producing 2,500 kg of tomatoes?

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(b) Calculate the opportunity cost of increasing the production of carrots from 500 kg to 1,000 kg. (c) What type of opportunity cost is represented by the production possibility curve? Justify your answer. (d) Illustrate in separate diagrams the effect of the following situations on the production possibility curve: (i) A massive flood hit the country. (ii) The introduction of a new fertilizer that increases the yield of crops. (iii) The election of a new president in the general election.

6. The Prime Minister (PM) of Malaysia, an island in the Pacific Ocean, is keen to increase his countrys production of coconuts. He summons his minister of agriculture (MOA) to discuss the idea. The following is an excerpt of their discussion: PM: Our production of coconut has achieved an all-time high of 1 million fruits a year this year. Congratulations. However, I think we should target for a production level of 3 million fruits a year by the year 2010. What do you think?

MOA: That will be quite difficult. We will need more land and better technology to do so. At the present, we are already using all the land available as well as the latest technology. The only way we can have more land for coconut cultivation is to reduce our production of vegetables. To improve our technology, we will need to intensify our research and development. PM: What is our current production of vegetables. How much reduction in the production of vegetables would be required to achieve a doubling of coconut production using present technology? MOA: We are currently producing 500,000 kilogrammes of vegetables a year. To double the production of coconuts, we will have to reduce vegetable production by 200,000 kilogrammes if our levels of technology remain unchanged. PM: How about if our level of technology improved? MOA: In that case, we can maintain the current level of vegetable production. PM: Suppose we stop the production of vegetables. How many coconuts do you think we can produce using the additional land previously used for vegetable production? How about vegetables? How much vegetable can we produce if we do not produce any coconuts? MOA: I would say 2.5 million coconuts. The answer to your second question is 800,000 kilogrammes. PM: I remember 5 years ago when we were producing only 700,000 coconuts and 400,000 kilogrammes of vegetables. What do you think were the reasons for that level of performance? MOA: .

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PM: Well, those were the mistakes of the previous government. Let us not make the same mistakes. MOA: I totally agree with you. PM: By the way, what do you think of my plan to increase the production of coconuts to 3 million fruits by the year 2010? I am also keen to see the production of vegetables increase to 1 million kilogrammes by the same year. I think eating more vegetables is good for our people, many of whom are suffering from diabetes. MOA: If you can provide a bigger budget for opening up new lands and for research and development, I think we have a good chance to realize your dream. PM: I will consider your request. Thanks for your time.

On the basis of the above discussion, answer the following questions.

(a) What theoretical Microeconomic framework would be relevant to depict the discussion between the prime minister and the minister of agriculture? (b) Depict the theoretical framework using a diagram to show the situation 5 years ago, the present and the possible situation in the year 2010. Ensure that your diagram is clearly labelled and that all the relevant information in the discussion is captured. (c) What do you think is the answer given by the minister of agriculture in the dotted line? (d) Why do you think the minister of agriculture need more funds to open up new land and conduct more research and development?

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2. Demand and supply

1.

Definition of Goods
Goods are a general term to include all products and services that yield satisfaction to consumers.

Classification of Goods According to the Conventional Perspective

In conventional Economics, goods are classified into free goods, public goods and economic goods. Free goods: Goods that do not cost anything to produce (zero production cost) e.g. fresh air, rain water, sunshine. Public goods: Goods which are available for use by everybody, whether or not they pay for the goods. The production of public goods involves costs but once produced; their use cannot be restricted to those who paid for it. Public goods are normally produced by governments. Examples of public goods are radio stations, schools, hospitals, public parks, bridges, roads Economic goods: Goods which are limited in supply and require costs to be incurred in their production. Most goods are economic goods.

Classification of Goods According to the Islamic Perspective

From the Islamic perspective, goods are classified according to the consumption hierarchy as follows: Dharuriyat (Essentials): These goods serve the basic needs of human beings e.g. food, clothing, house, education, health service, transportation, defence. Hajiyat (Complementary): Goods which improve the quality of human life, e.g. radio, TV, furniture, cars, computers. Kamaliat (Perfection): Goods which contribute to the perfection of life e.g. bungalows, luxury cars, air conditioners. Tarafiat (Extravagant): Goods which are considered extravagant and wasteful e.g. golden bed, antiques, works of art.

2.

Demand

Demand refers to the quantity of a good that consumers are willing and able to demand at various prices. Individual demand refers to the quantity of a good demanded by an individual at different levels of prices. For example, if Ahmad buys 10 kg of rice when the

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price of rice is RM 3/kg, we say that the individual demand of Ahmad for rice is 10 kg at RM 3/kg

Market demand refers to the sum of the individual demand of all consumers for a good at different levels of prices. For example, if there are 3 consumers in the market for rice and each has an individual demand of 10 kg, 15 kg and 20 kg respectively when the price is RM 3/kg, the market demand for rice at a price of RM 3/kg will be 10+15+20 kg or 45 kg.

The Law of Demand

Both individual and market demand are governed by the Law of Demand. The law states that as price rises, quantity demanded decreases and as price falls, quantity demanded increases. The Law of Demand implies that there is a negative relationship between price and the quantity demanded.

Demand Schedule and Demand Curve

The relationship between quantity demanded and price is represented by the demand curve. The demand curve slopes downwards from left to right, that is, it has a negative slope. The negative slope indicates the negative relationship between price and quantity demanded by consumers.

Price (RM)

DD Quantity Demanded (Units)

Change in Quantity Demanded and Change in Demand Change in Quantity Demanded

A change in the price will result in a change in the quantity demanded. An increase in the price leads to a decrease in the quantity demanded. A decreases in the price leads to an increase in the quantity demanded. The demand curve do not shift when there is a change in the quantity demanded.

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Price

P1

B A

P0 C P2 Qty demanded Q1 Q0 Q2

P0 is the original price. If the price increases from P0 to P1, total quantity demanded decreases from Q0 to Q1. This involves an upward movement along the demand curve from point A to point B. This movement is known as contraction of demand On the other hand, if the price decreases from P0 to P2, total quantity demanded increases from Q0 to Q2. This involves a downward movement along the demand curve from point A to point C. This movement is known as expansion of demand Change in demand
A change in the other determinants of demand leads to a change in demand. A change in demand will cause the demand curve to shift. An increase in demand will cause the demand curve to shift to the right while a decrease in demand will cause the demand curve to shift to the left. Price

D1 D0

Qty demanded

Q0

Q1

Fig 3.1 Increase in demand

Price

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Demand curve shifts to the right from D0 D0 to D1D1. There is an increase in demand

Price

Decrease in demand

D0

Qty demanded

Q2

Q0

D2

Fig 3.2 Decrease in demand Demand curve shifts to the left from D0 D0 to D2D2. There is a decrease in demand

Determinants of Demand
Determinants of demand refer to those factors which have the ability to cause the demand for goods to change . Some of the determinants of demand include: consumers income consumers taste and preferences number of buyers expectation of future prices weather availability of credit facilities

Income: An increase in consumers income normally causes an increase in demand while a decrease in income cause a decrease in demand. Taste: Change in consumers taste may cause either an increase or decrease in demand. For example, the change in consumer preference for local fruits will cause the demand for local fruits to increase and the demand for imported fruits to decrease. Number of Buyers: An increase in the number of buyers will cause an increase in demand. For example, if more students eat their lunch at the canteen, the demand for canteen meals will increase.

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Expectations of future prices: When consumers expect future prices to decline, demand will decrease; when they expect future price to increase, demand will increase. For example, consumers expect the price of houses in the future to increase. They will increase their demand for houses now in order that they will not have to pay the higher prices in the future. Weather: When the weather is hot, the demand for ice-cream will increase. When it is raining, the demand for ice-cream will decrease. In the case of umbrellas, rainy weather will increase its demand. Credit facilities: The availability of credit facilities will cause demand to increase. For example, the increasing availability of credit for the purchase of household electrical goods lead to an increase in the demand of such goods.

3. Supply
Supply refers to the quantity of a good/service that firms are willing and able to offer for sale at various prices during a given period of time.

The Law of Supply

The Law of Supply states that the quantity of a good/service supplied will increase as price increase, i.e. there is a positive relationship between the quantity supplied and price.

The Supply Schedule and Supply Curve

The supply schedule shows the quantity of a product that firms will supply at different prices. The supply curve is a graphically presentation of the supply schedule. The supply curve slopes upward from left to right. Price (RM) SS

Quantity Supplied (Units)

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Firm (Individual) Supply Curve and Market Supply Curve

The quantity which a firm is willing and able to supply at different prices is represented graphically by its supply curve. The market supply curve is the sum of the individual supply curves of different firms. It shows the quantity of a good/service that firms collectively (together) are willing and able to supply at different prices.

CHANGE IN QUANTITY SUPPLIED AND CHANGE IN SUPPLY

Change in Quantity Supplied A change in quantity supplied refers to a movement along the same supply curve. It occurs when there is a change in price.

Price (RM) SS

C A B

Quantity Supplied

An upward movement along the supply curve from point A to point C is known as expansion of supply A down ward movement along the supply curve from point A to point B is known as contraction of supply
Change in supply A change in supply occurs when the supply curve shifts. It occurs when a determinant of supply other than price changes. An increase in supply means that the supply curve shifts to the right; a decrease in supply means the supply curve shifts to the left.

Price (RM) SS

Quantity Supplied (Units)

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Increase in Supply

Price (RM) SS

Quantity Supplied (Units) Decrease in Supply

Determinants of Supply
Determinants of supply refer to the factors which have the ability to cause the supply of a good to change (increase or decrease). The determinants of supply include: Cost of Production Profitability of alternative goods/services Technological change Firms expectation of future price change Size or scale of production Government policy

Cost of Production : When the cost of production increase, the supply will decrease and vice versa. Profitability of Alternative Goods When the production of alternative

goods/ services become more profitable, more resources will be directed towards their production. Hence, the supply of the less profitable good/service will decrease.
Technological Change: An improvement in the technology for production of a good will increase its supply.

Expectations: When firms expect future price to increase, they will reduce the current supply in order to sell the good at a higher price in the future.

25

Size/Scale of Production: The larger the number of firms producing a particular good/ service, the larger the supply of that good/service will be. Likewise, the larger the scale of production, the larger the supply will be. Government Policy : When the government imposes a tax on a good/service, the supply of the good/service will decrease. When a subsidy is given, the supply of the good/service will increase.

4.

Determination of Output and Price

Equilibrium Price and Output
Equilibrium price refers to the price in which the quantity demanded (market demand) is equal to the quantity supplied (market supply). Equilibrium output refers to the quantity at which the price which consumers are willing to offer is equal to the price which producers are willing to accept. At the equilibrium price, there is neither shortage nor surplus. When the market price is below the equilibrium price, the quantity demanded exceeded (is more than) the quantity supplied. A shortage (excess demand) occurred and resulted in some consumers not able to purchase their requirements. They will therefore be willing to offer higher prices than the prevailing market price. Producers on the other hand were happy to accept higher prices. As a result of this, the price would increase. It would continue to increase until it reached the equilibrium price level. At the equilibrium price level, all consumers were able to purchase their requirements. They would therefore not be motivated to offer any prices which are higher than the equilibrium price. The price would therefore stop increasing once it reached the equilibrium price level.

When the market price is above the equilibrium price, the quantity demanded (market demand) is less than the quantity supplied (market supply). A surplus (excess supply) situation occurs and some producers were not able to sell all their goods. They therefore become willing to accept lower prices than the prevailing market price in order to get more consumers to purchase from them. Consumers on the other hand were happy to pay lower prices. As a result of this, the price would decrease. It would continue to decrease until it reaches the equilibrium price level. At the equilibrium price level, all producers were able to sell all their goods. They would not be motivated to offer prices which are lower than the equilibrium price. The price would therefore stop decreasing once it reaches the equilibrium price level.

Example : Table showing total demand and supply of cabbage in Kuching Price (RM/Kg) Quantity demanded (kg) Quantity supplied (kg) 2 46 20 4 42 30 6 36 36 8 32 40 10 28 48

26

Price (RM) SS

P0

DD Total quantity Q0 demanded/supplied

Changes in Equilibrium Price and Equilibrium Quantity

When the demand curve or supply curve or both the demand and supply curve shifts, it will cause the equilibrium price and equilibrium quantity to change. In other words, when there is a change in demand or change in supply or a change in both demand and supply, there will be a new market equilibrium (ie a new equilibrium price and new equilibrium quantity) Change in Demand When demand changes, the demand curve shifts. An increase in demand shifts the demand curve to the right. A decrease in demand shifts the demand curve to the left. An increase in demand causes the equilibrium price and equilibrium quantity to increase. A decrease in demand causes the equilibrium price and equilibrium quantity to decrease.

Change in Supply When supply changes, the supply curve shifts. An increase in supply shifts the supply curve to the right. A decrease in supply shifts the supply curve to the left. An increase in supply causes the equilibrium price and equilibrium quantity to decrease. A decrease in supply causes the equilibrium price and equilibrium quantity to increase.

27

Simultaneous Change in Demand and Supply When supply and demand changes simultaneously, both the supply curve and demand curve shifts. An increase in supply shifts the supply curve to the right. The equilibrium price and equilibrium quantity may increase, decrease or remain unchanged depending on the relative change in demand and supply.

Supply Changes more than Demand

Supply Changes less than Demand

Change in Supply is equal to Change in Demand

5. Demand for Goods and Services in Islam

Goods are bounties bestowed by Allah SWT on mankind. The Al-Quran defines goods in Islam as consumable goods, which attribute moral and ideological values to them. There are two terms used to describe goods; a. Al-tayyibat (good and pure things) b. Al-rizq (heavenly gifts) 28

5.1

Determinants or factors Affecting demand in the Islamic Perspective (as given by Ibn Taimiyah); i. A consumers desire - a consumer has different kinds of desire and this varies frequently according to abundance or scarcity. More desired when it is scarce than when in abundance. ii. Number of consumers price increases when the number of people increases due to increase in demand and vice versa. iii. Quality of consumers the demand for a good also varies according to the quality of the consumers with whom exchange is taking place. If the consumer is trustworthy in paying his debts, a smaller price for him is acceptable compare to someone who is not. iv. Strength or weakness of the need for the good.

6. Elasticity
5.1

Elasticity of Demand
Elasticity of demand refers to the degree of responsiveness or the sensitivity of demand to a change in the determinants of demand. When the elasticity of demand is high, the responsiveness of demand to a change in the determinant of demand is high and vice versa. 3 types of elasticity of demand can be identified, namely: - price elasticity of demand - income elasticity of demand and - cross elasticity of demand

Price Elasticity of Demand Price elasticity of demand measures the responsiveness of the quantity of demand of a good to a change in the price of the good. Price elasticity is mathematically expressed as: p
=

% Change in Quantity Demanded for Product A % Change in Price of Product A Q1 - Qo Qo X Po P1 - Po

where: Qo = the original quantity demanded Po = P1 = the original price the new price Q1 = the new quantity demanded

Due to the negative relationship between the change in price and the change in the quantity demanded, price elasticity have a negative value. It is common however, to ignore the negative sign.

29

Price elasticity of demand may range from 0 (zero) to infinity ( ) The range of price elasticity is classified as follows: O < p < 1, - inelastic demand; the percentage change in quantity demanded is less than the percentage change in price p = 1, unitary elasticity; the percentage change in quantity demanded is equal to the percentage change in price elastic demand; the percentage change in quantity demanded is more than the percentage change in price perfectly inelastic demand; there is no change in the quantity demanded when price changes - perfectly elastic demand; there is infinite change in the quantity demanded when price changes

> 1,-

p = O, p = ,

Determinants of Price Elasticity of Demand Among the determinants of price elasticity are: - the availability of substitutes the relative importance of the good in the consumers budget the time period the status of good, i.e. whether luxury or necessity consumers income level consumers habits

Substitutes: The larger the number of substitutes available, the more elastic demand will be. For example, the demand for soft drinks, which have many substitutes, will be more elastic than the demand for sugar, which have almost no substitutes. Budget: The larger the proportion of income spent on the good, the more elastic the demand will be. For example, the demand for cars will be more elastic than the demand for pens because consumers spent a larger proportion of their budget on cars compared to pens. Time period: The longer the time period, the more elastic the demand will be. This is because the longer the time period, the better consumers can adjust to an initial price change. For example, when the price of petrol increased, consumers will not be able to decrease their demand of petrol very much initially. Over a longer period, they will be better able to reduce their demand. Nature of good: Luxury goods are more price elastic than necessities. For example, the demand for holidays will be more elastic than the demand for food. Income: The higher the income, the less elastic demand will be. For example, the demand for meat by rich consumers will be less price elastic than the demand for

30

meat by poor consumers. In other words, when the price of meat increase, the poor consumers will reduce their demand for meat more than the rich consumers. Habits: Goods which are consumed as a matter of habit tend to be less price elastic. For example, the demand for cigarettes and beer are relatively price inelastic.

Income Elasticity of Demand Income elasticity is a measure of the degree of responsiveness of the demand for a good to a change in consumers income, i.e. y % Change in Quantity Demanded % Change in Income or y
=

Q1 - Qo Qo X

Yo Y1 - Yo

For normal and luxury goods, the quantity demanded increases when income increases, i.e. income elasticity is positive. For giffen or inferior goods, the quantity demanded decreases when income increases, i.e. income elasticity is negative. For necessities, the income elasticity equals zero, i.e. there is no change in the quantity demanded when income changes. The classification of goods in accordance with their income elasticities are summarized as follows: O < y < 1 inelastic; normal goods y > 1 elastic; luxury goods y < O negative elasticity; giffen or inferior goods y = O zero income elasticity; necessities

Cross Elasticity of Demand Cross elasticity of demand measures the degree of responsiveness of demand for a product to a change in the price of a related product i.e. x x
=

% Change in Quantity Demanded for Good X % Change in Price of Good Y Qx1 - Qxo Qxo Pyo Py1 - Pyo

Where:

Qxo = the original quantity demanded of Good X Qx1 = the new quantity demanded of Good X Pyo = the original price of Good Y

31

Py1

the new price of Good Y 0 (negative) Goods X and Y are complements 0 (positive) Goods X and Y are substitutes 0 (zero) Goods X and Y are not related

When: x < x > x =

REVENUE and ELASTICITY

Total Revenue is the total money received by the producers after selling their goods and services in the markets. Total revenue is calculated by multiplying the price of good (P) sold in the market with its quantity (Q).

Total Revenue (TR) = Price (P) X Quantity (Q)

The amount of TR collected depends on the price elasticity of demand of the goods in the market. Generally, if demand is inelastic, an increase in price will lead to an increase in TR. Conversely, when there is a fall in price, TR will decrease.

SUMMARY OF PRICE ELASTCICITY ON TOTAL REVENUE The relationship between TR and Price Elasticity of Demand when Price Increases Elasticity Coefficient Greater than 1 (Ed > 1) Equal to 1 (Ed = 1) Less than one (Ed < 1) Priec elasticity of Price (P) demand (p) Elastic Increases Qty. demanded Total (Q) revenue (TR) Decrease more Decreases than proportionate Decrease in Remain the exact same proportion Decrease less Increases proportionate

Unitary Elastic

Increases

Inelastic

Increases

32

The relationship between TR and Price Elasticity of Demand when Price Decreases Elasticity Coefficient Greater than 1 (Ed > 1) Equal to 1 (Ed = 1) Less than one (Ed < 1) Priec elasticity of Price (P) demand (p) Elastic Qty. demanded Total (Q) revenue (TR) Decreases Increases more Increases than proportionate Decreases Increases in Remain the exact same proportion Decreases Increase less Decreases proportionate

Unitary Elastic

Inelastic

5.2

Price Elasticity of Supply

Price elasticity of supply is defined as the responsiveness or sensitivity of quantity supplied to a change in price. Mathematically, it can be expressed as: % Change in Quantity Supplied
=

ss

% Change in Price of Goods/Service

=

% Qs %P

Q1 - Qo Qo Q1 - Qo P1 - Po

Po P1 - Po Po Qo

ss =

Price elasticity of supply can vary from 0 (zero) to (infinity). The range of supply elasticity and their interpretation are as follows:
Range 0 < ss < 1 Interpretation Fairly inelastic. The percentage change in quantity supplied is less than the percentage change in price

ss > 1 ss = 0

Elastic. The percentage change in quantity supplied is more than the percentage change in price Perfectly inelastic. There is no change in the quantity supplied when price changes

33

 ss =

Perfectly elastic. The percentage change in quantity supplied is infinitely larger than the percentage change in price.

Factors Influencing Price Elasticity of Supply

Time : In the short-run, supply is relatively inelastic compared to the long-run. In the long-run, firms can fully adjust their supply to changes in price.

Nature of the Goods :

The time taken to produce a good determined its elasticity. Goods which require a long production period (gestation period) such as agricultural products are relatively inelastic. Goods which require a small change in production cost to bring about a change in supply will have higher elasticity of supply. Goods that have lower storage costs have higher elasticity of supply.

Cost and Feasibility : of Storage

Substitutability of : Factor Inputs

Goods which used specialised factors of production tend to have more elastic supply than goods which used non-specialised factors of production.

Perishability :

Goods which are perishable tend to be more supply inelastic e.g. green vegetables.

QUIZ
(i) State the 3 types of goods under conventional economics.

(ii)

State the 4 types of goods under Islamic Economics

34

(iii)

State 4 determinants of demand .. . ..

(iv)

State 4 determinants of price elasticity

(v)

Which types of goods will have positive price elasticity?

(vi)

Name 2 types of goods which have joint demand. .

(vii)

The 3 types of demand elasticities are:. ..

(viii)

Perfectly elastic demand refers to price elasticity which have a value of: .. Luxury goods tend to have (higher/lower/same) elasticity than normal goods. Habitual goods tend to have (higher/lower/same) elasticity than normal goods.

(ix) (x)

(xi)

Which types of goods, that is, normal, luxury, giffen or necessities have the highest income elasticity? ..

(xiii)

When the cross elasticity of 2 goods are negative, the 2 goods are likely to be goods.

(xiii) The slope of the demand curve of luxury goods is steeper than the slope of the demand curve of normal goods. Correct or incorrect?

35

(xiv)

When the price elasticity is equal to 2 (minus 2), a 10% increase in the price will lead to a .% ..(increase/decrease) in the quantity demanded.

(xv)

When my income increase by 10%. my demand for Good X increase by 5%. My income elasticity is equal to .

EXERCISES
1. Given the following information, answer the following questions: Demand for Good X (units) 100 50 25 20 18 Demand for Good Y (units) 1000 500 250 200 180 Demand for Good Z (units) 10 20 40 80 180

Price of Good X (RM/unit) 1 2 3 4 5

(a) Suppose the price of Good X increases from RM 4 per unit to RM 5 per unit, calculate: (i) The price elasticity of demand for Good X (ii) The cross elasticity of demand for Good Y with respect for Good X (iii) The cross elasticity of demand for Good Z with respect for Good X

(b)

What is the relationship between Good X and Good Y and between Good X and Good Z?

(j)

2.

The following table shows the price and quantity demanded for tickets sold in a badminton tournament. Price per ticket (RM) 13 11 9 7 5 3 Quantity demanded (Units) 1,000 2,000 3,000 4,000 5,000 6,000

If the hall in which the tournament is held can seat a maximum of 5,000 persons,

36

(a)

Calculate the price elasticity of demand for the seats when the price of tickets fell from RM 13 to RM 9. What is the effect if the management charges RM 7 per ticket? Comment on the elasticity of supply of seats for the tournament. If the management wants a full house for the tournament, what price should be charged?

(b) (c ) (d)

6.

Given the following table, answer the questions that follows: Quantity of Good X demanded (Units) 2 4 6 8 10 15 Quantity of Good Y demanded (Units) 10 8 6 4 2 1 Consumers income per month (RM) 5000 4000 3000 2000 1000 500

Price of Good X (RM) 10 8 6 4 2 1

(a ) What is the price elasticity of demand of Good X when its price increased from RM 4 per unit to RM 6?

(b) Calculate the cross elasticity of Good Y when the price of Good X decrease from RM 8 per unit to RM4. (c) Calculate the income elasticity of Good X and Good Y when consumers income increases from RM 2,000 to RM 3,000 a month. (d) What is the relationship between Good X and Good Y? (e) What types of goods are Good X and Good Y?

4. A 20 % rise in the price of Good S results in the following:

Good T U V

Percentage Change in Quantity Demanded Increase by 50% Decrease by 30% Unchanged

37

(a) Calculate the cross price elasticity of demand between Good S and Goods T, U and V. (b) What is the relationship between Good S and Goods T, U and V? The table below shows the relationship between the price of Good X and the quantity demanded for Goods X and Y. Price of Good X (RM) 5 10 15 20 Quantity demanded for Good X 160 140 120 100 Quantity demanded for Good Y 100 120 140 160

5.

(a)

Calculate the price elasticity of demand for Good X if the price of Good X falls from RM 10 per unit to RM 5. Is the demand elastic or inelastic? Calculate the cross elasticity of demand for Good Y if the price of Good X increases from RM 10 per unit to RM 15. What is the relationship between Good X and Good Y? Draw a diagram to show what will happen to the demand for Good Y when the price of Good X increases. When the income of consumers increase from RM 1.000 to RM 1,400, the demand for Good X increases from 40 to 80 units. Calculate the income elasticity of demand for Good X. What type of good is Good X?

(b)

(c )

(d)

6.

The Kota Samarahan Pineapple Growers Association found that when they reduced the price from RM1.50 for a fruit to RM1.20, the demand decreased from 10,000 to 8,000 pineapples a week. However, when the price was increased to RM1.80, the demand increased 12,000 pineapples a week. What type of good is pineapples? What is the price elasticity of demand for pineapples when the price increase? What is the elasticity when the price deceased?

38

MARKET EQUILIBRIUM : A REVIEW

Definition of a Market:
Market place is where there is an interaction between buyers and sellers to solve the economic problem of what and how much to produce through the market forces of demand and supply. Demand or supply alone cannot determine the price and quantity that the want.

39

TOPIC 3 GOVERNMENT INTERVENTION IN THE MARKET

1. The Control of Prices
Market equilibrium is determined by the forces of demand and supply in the absence of government intervention. At the equilibrium price, there is no shortage or surplus, i.e. the markets clears. However, the equilibrium price may not be the most desirable price. Therefore, the government does intervene in the market through price control, or price regulation or also known as the fixed or legal price.

Thus, price control refers to the process of fixing the price regardless of the market demand and supply. The government may refer to keep prices below or above the equilibrium price due to the following reasons;

(i)

To protect the income of farmers or workers by setting up minimum prices, and

(ii)

To protect consumers especially the poor so that they can afford to buy basic necessities by setting maximum prices.

1.1 Minimum/Floor Price Scheme

Refers to a minimum/floor price set by the government; i.e. the government will not allow the market price to fall below the minimum/floor price.

Minimum/Floor Price
Price (RM) Pmin = 4 E Po = 2 D S

Minimum Price - leads to surplus of 120 (200 80) units

D Total quantity demanded/supplied

Q0

80

100 40

200

The minimum price (or floor price) is the LOWEST PRICE permitted by law or authority. Reasons for imposition of minimum price schemes may include: to protect producers incomes. By ensuring producers of a minimum price, the incomes of producers (such as farmers or suppliers) are protected and will not fall below certain minimum level. An example of minimum price scheme implemented by the Malaysian government to protect producers income is the guaranteed price for paddy. This is especially so if an industry is subjected to supply fluctuation such as climatic conditions may affect supply and if the industry demand is inelastic, prices are likely to fluctuate. When a surplus threatens to force prices down, the government sets minimum prices to prevent the fall of sellers or producers income during periods of low prices. to create a surplus (in preparation for future shortages). A minimum price scheme will encourage producers to produce larger quantities. This will ensure that there will be stocks to draw upon in future should supply be less than demand. to prevent workers incomes from falling below a certain level. By preventing wages from falling below a certain level, workers are assured of a minimum level of earnings/income. For example, the Australian government specified that workers should be paid a minimum wage of 6 Australian dollars per hour.

Disadvantages of minimum price schemes include: higher prices for consumers. Unfair to consumers. Minimum price schemes normally resulted in the price being higher than the equilibrium price. Consumers need to pay more for goods under minimum price schemes. excess of supply over demand. Unfair to taxpayers. Minimum prices may result in the quantity supplied exceeding the quantity demanded. The excess supply may have to be disposed off through destruction, storage or export or simply bought by government through taxpayers money. cushion inefficiency. Minimum price schemes allowed inefficient producers to continue producing. This results in inefficient production and wastage of resources.

Example
The following diagram shows the market for paddy in Malaysia. To enable more paddy farmers in Malaysia to enjoy an income of at least RM800/month, the Malaysian government decided to impose a minimum price of RM900/tonne for paddy.

(i)

What is the equilibrium price and equilibrium quantity of paddy before the introduction of the minimum price scheme? .

41

(ii)

Is there an excess supply or excess demand after the introduction of the minimum price scheme? How much is the excess supply or excess demand? . By how much did the production of paddy increase arising from the introduction of the minimum price scheme? .. What can the Malaysian government do to overcome the problem identified in (ii) above arising from the introduction of the minimum price scheme?

(iii)

(iv)

...

1.2

Maximum Price Scheme/Ceiling Price Scheme

Refers to a maximum (highest) /ceiling price set by the government i.e. the government will not allow the market price to exceed the maximum price specified.

Maximum/Ceiling Price
Price (RM) D S

E Po = 2 P1 = 1 S D Total quantity demanded/supplied

Maximum Price leads to shortage of 130 (200 70) units

Q0

70

100

200

Reasons for imposition of maximum/ceiling price schemes may include the desire of the government to keep the price level affordable for lower income consumers or to maintain prices at a fair and reasonable level. Examples of maximum price schemes implemented by the Malaysian government include the fixing of the maximum price for sugar at RM 1.60/kg for sugar and dressed chicken at RM 6.50/kg. Disadvantages of maximum/ceiling price schemes include: Unfair to producers and the emergence of black market. A black market refers to the illegal sale and purchase of goods. The market is illegal either because the price or quantity is legally not permitted or the good itself is not legally allowed. When maximum price schemes are implemented, a shortage may occur which will result in the sale of

42

the good at prices which are higher than the maximum/ceiling price specified by the government. smaller level of output. Due to the maximum/ceiling price being lower than the equilibrium price, producers will produce a quantity that is less than the equilibrium quantity. exploitation by producers. Due to the smaller quantity produced, some consumers will not be able to purchase their requirements. Dishonest producers will take the opportunity of the shortage to increase their profits for example through requesting for illegal payments.

Example
The following diagram shows the market for sugar in Malaysia. To enable a larger proportion of the lower income group to afford sugar, the Malaysian government decided to impose a maximum price of RM1.60/kg.

(j)

What is the equilibrium price and equilibrium quantity of sugar before the introduction of the maximum price scheme? Is there an excess supply or excess demand after the introduction of the maximum price scheme? How much is the excess supply or excess demand? . By how much did the production of sugar decline arising from the introduction of the maximum price scheme? What can the Malaysian government do to overcome the problem identified in (ii) above arising from the introduction of the maximum/ceiling price scheme?

(ii)

(iii)

(iv)

The effects of Indirect Taxes on Equilibrium Price and Quantity of Goods. Government levy taxes on a wide variety of goods such as cigarettes and alcohol, on payrolls and profits. Taxes basically aim to restrict consumption by reducing demand or supply or both. There are two (2) types of taxes: 1. 2. Indirect Taxes and Direct Taxes.

Indirect Taxes are imposed by the government on an individual but he or she can pass on or shift the burden of paying taxes to another person, usually the consumer or end user of the goods or services. Examples are sales taxes, import duties and service taxes.

43

Indirect taxes will increase the price of the good sold as the imposition of indirect taxes will increase the cost of production of the goods or services concerned. To avoid making lower profits, the producer would reduce the supply of the good / service in the market. Thus, assuming demand remains unchanged; the price of the good will increase but the quantity will decrease.

The effect of Indirect Taxes on Price and Quantity

Price (RM) D S1

Supply after tax

So
E1 P1 Po S1 Eo D

Supply before tax

So
Q1 Qo

Total quantity

The effect of Indirect Taxes on Price and Quantity

Price (RM) D S1

Supply after tax

So
E1 P1 onsumer Po Producer S1 D Eo

Supply before tax

So
Q1 Qo

Total quantity

Note: How much indirect tax is paid by consumers or producers depend on the price elasticity of demand and supply of the good (or service) in the market

44

The case when demand is inelastic:

The effect of Indirect Taxes on Price and Quantity when demand is inelastic
Price (RM) D

Consumers bears more tax compared to producer

Supply after tax

S1

So
E1 P1 = 6 Consumer Po = 2 Producer P2 = 1 S1 D (steep) Eo

Supply before tax

So
2 4

Total quantity

Example from above diagram: The tax rate is RM5 per unit. Based on the diagram;

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

The equilibrium price (before tax) = RM2 The new equilibrium price (after tax) = RM6 The equilibrium quantity before tax = 4 units The new equilibrium quantity after tax = 2 units Tax per unit paid by consumers = RM6 RM2 = RM4 Total Tax paid by consumers = (RM6-RM2) X 2 = RM4 X 2 = RM8 Tax per unit paid by producers = RM2 RM1 = RM1 Total Tax paid by producers = (RM2-RM1) X 2 = RM1 X 2 = RM2 Tax per unit collected by the government = RM6-RM1 = RM5 Total tax collected by government = (RM6-RM1) X 2 = RM5 X 2 = RM10

The effects of Subsidy on Equilibrium Price and Quantity of Goods. Subsidy works in exactly the opposite way as taxes. The objective is to encourage the consumption and production of certain goods (or services) by the Government.
Subsidy is the assistance or aid given by government to help farmers or suppliers to increase their income and hence standard of living. Subsidies are given in the form of fertilisers, pesticides, diesel and other inputs to the

45

suppliers to help them to reduce the cost of productions, hence increase supply. Assuming demand remain unchanged, the price of the good will decrease but the quantity will increase.

The effect of Indirect Taxes on Price and Quantity

Price (RM) D So

Supply before subsidy

S1
Eo Po Po So Eo D

Supply after subsidy

S1
Qo Q1

Total quantity

Price (RM)

D So

Supply before subsidy

S1
Eo Po Consumers Po Producers So D Eo

Supply after subsidy

S1
Qo Q1

Total quantity

Note: How much subsidies received by consumers or producers depend on the price elasticity of demand and supply of the good (or service) in the market. The analyses follows the example given in the case of indirect taxes above.

46

1.3

Price Control from Islamic Perspective

Under Islamic Economics, prices are determined by supply and demand; however, the market price is deemed to be socially just and fair only if there is no manipulation by sellers or buyers.

Price controls are forbidden from the Islamic perspective because they are unfair to producers and consumers. Price controls are only allowed to counter price manipulations. Islam allows the government to control prices if it is proven that the increase and the decrease in prices are dur to injustice or manipulation of the market.

2.

Indirect Taxes
An indirect tax on a good refers to a tax in which the incidence (burden of paying) can be shifted to the final consumer. Examples of indirect taxes include sales tax, value-added tax, tariffs and import duties. The imposition of an indirect tax will shift the supply curve to the left. Producers and consumers both bear the burden of the indirect tax. Equilibrium price becomes higher and equilibrium quantity becomes lower after the imposition of indirect taxes. The amount of indirect tax burden borne by producers and consumers depend on the relative price elasticities of supply and demand. When demand is more price elastic than supply, producers bear a bigger share of the indirect tax; when supply is more price elastic than demand, consumers bear the bigger burden.

(1) When Supply is more elastic than demand SS1 Price (RM) RM t P1 P0 P2 A B C SS0

DD Total quantity demanded/supplied

Q1

Q0

The original equilibrium price of product X is given by 0P0 and the original equilibrium quantity demanded/supplied is given by 0Q0. Suppose the government imposes a tax of RM t on the good, then the supply curve would shift to the left . The new equilibrium price is 0P1 and the new equilibrium quantity demanded/supplied is given by 0Q1. The total tax burden borne by: the producer= P0 P2BC

47

The total tax burden borne by: the consumer= P0 P1AB Since P0 P1AB > P0 P2BC, the consumer bears a larger burden of the tax. Total tax revenue collected by the government = P0 P2BC + P0 P1AB

(2) When demand is more elastic than supply

SS1
Price (RM) RM t SS0 C P2 P0 P3 E D DD

Q2

Q0

Total quantity demanded/supplied

The original equilibrium price of product X is given by 0P0 and the original equilibrium quantity demanded/supplied is given by 0Q0. Suppose the government imposes a tax of RM t on the good, then the supply curve would shift to the left . The new equilibrium price is 0P2 and the new equilibrium quantity demanded/supplied is given by 0Q2. The total tax burden borne by: the producer= P0 P3DE The total tax burden borne by: the consumer= P0 P2CD Since P0 P2CD > P0 P3DE, the producer bears a larger burden of the tax. Total tax revenue collected by the government = P0 P2CD + P0 P3DE

Example
The following diagram shows the market for Mercedes Benz cars in Malaysia. To discourage Malaysians from importing too many Mercedes Benz cars, the Malaysian government decided to impose a tariff on the import of Mercedes Benz cars.

(i)

What is the equilibrium price and equilibrium quantity of Mercedes Benz cars before the introduction of the indirect tax? . What is the equilibrium price and equilibrium quantity of Mercedes Benz cars after the introduction of the indirect tax? .. How much is the indirect tax imposed by the Malaysian government per unit of Mercedes Benz car? How much indirect tax revenue is collected by the Malaysian government from the imposition of indirect tax on Mercedes Benz cars? ..

(ii)

(iii)

48

(iv)

What is the amount of indirect tax paid by consumers for 1 unit of Mercedes Benz car after the introduction of the indirect tax? What is the total amount of indirect tax paid by consumers? . What is the amount of indirect tax paid by producers for 1 unit of Mercedes Benz car after the introduction of the indirect tax? What is the total amount of indirect tax paid by producers? ... By how much did the sale of Mercedes Benz cars decline arising from the introduction of the indirect tax?

(v)

(vi)

3.

Market Failures
Market failures refer to instances when the market or price mechanism fails to allocate resources for the purpose of production or the distribution of goods in an optimal manner. Market failures occur when too much or too little of a good is produce. This arise when the true or total cost of production is not reflected in the market price of the good. Examples of market failures include the case of public goods, externalities and market imperfections. The government is forced to intervene in the market in cases of market failures.

QUIZ
(i) When the market price is below the equilibrium price, a situation of ..(surplus/shortage) will occur.

(ii)

When the market is in equilibrium, the quantity supplied equaled the quantity demanded. True or false? ..

(iii)

If the market is initially in equilibrium and the demand subsequently increases, the new equilibrium price will be (higher/lower/same) and the new equilibrium quantity will be ..(larger/smaller/unchanged)

(iv)

If the market is initially in equilibrium and both the demand and supply subsequently increases, but the increase in demand is more than the increase in supply, the new equilibrium price will be (higher/lower/same) and the new equilibrium quantity will be .. (larger/smaller/unchanged)

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(v)

State some of the ways in which the government intervenes in the market: .

(vi)

Under a minimum price scheme, the government normally fixed the minimum price ..( above/below/equal to) the equilibrium price. Under a maximum price scheme, (surplus/shortage) situation normally occurs. a ..

(vii)

(viii)

State 3 reasons why the government implements a minimum price scheme.

(ix)

When the government imposed an indirect tax, the new equilibrium price will be ..(higher/lower/same) and the new equilibrium quantity will be .(larger/smaller/unchanged)

(x) Under Islamic Economics, price control is permitted. ...

True or false?

EXERCISES
1. Given the following information, answer the following questions: Price (RM/unit) Quantity Demanded (units) 600 500 400 300 200 100 Quantity Supplied (units) 50 150 200 300 500 700

a.

10 20 30 40 50 60

(b)

Plot the demand and supply curves and determine the equilibrium price and equilibrium quantity. Assume the government fixed the maximum price at RM 20/unit. Explain the disequilibrium problem that would occur. Assume the government imposed a tax of RM 5/unit. Plot the new market equilibrium situation and determine the new equilibrium price and equilibrium quantity.

(c)

(d)

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(e)

Calculate the amount of tax paid by the producers and consumers.

2.

The following diagram shows the market for cigarettes before and after an indirect tax is imposed by the government. Based on the diagram, answer the following questions:

(a) (b)

The price paid by consumers before the indirect tax is RM The price paid by consumers after the indirect tax is RM.. The amount of the .indirect tax per packet of cigarettes is RM The total amount of indirect tax paid by producers and consumers are RM.. and RM respectively. Explain how the price elasticity of demand can influence the portion of indirect tax paid by producers and consumers.

(c ) (d)

(e)

3.

Assume that there are 2 markets, Market A and Market B. An indirect tax of RM 7 will shift the supply curves in both markets as shown in the diagram below: Price (RM) RM 7 SS0 P1 P0 DD P2

Q1

Q0

Total quantity demanded/supplied

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(a ) What is the equilibrium price and equilibrium quantity before the tax was imposed in both markets? (b) In which market do the producers have to bear more tax burden compared to consumers? Why? .

(c) What is the percentage change of the equilibrium quantity in both markets? ............ ... (d) Calculate the total revenue received by the government from the two markets; ..

4.

There are 3 vegetable sellers in a wet market. The quantity of vegetables supplied by each seller at different price levels is presented in the table below. Price per kg (RM) 8.00 7.50 7.00 6.50 6.00 5.50 Quantity supplied by Seller A (Kg) 20 19 18 17 16 15 Quantity supplied by Seller B (Kg) 32 28 24 20 16 12 Quantity supplied by Seller C (Kg) 35 33 31 29 27 25 Market Supply (Kg)

The demand schedule for vegetables in the wet market is given as follows: Price per kg (RM) 8.00 7.50 7.00 6.50 6.00 5.50 (a) (b) Quantity demanded by Buyer 1 (Kg) 10 12 14 16 18 20 Quantity demanded by Buyer 2 (Kg) 6 10 14 20 26 32 Quantity demanded by Buyer 3 (Kg) 15 20 25 30 35 40 Market Demand (Kg)

Complete the above table. Using a graph paper, plot the market demand and supply curves for vegetables in the wet market. Based on the graph in (b), identify the price and quantity of vegetables that will clear the market. Suppose the government removes the subsidy on vegetables by RM 1/kg. Show the effect of this action on the supply of vegetables in the diagram. Label the new equilibrium point as E1 .

(c )

(d)

(e)

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(f)

If the government fixed the price of vegetables at RM 6/kg, what type of price control is this? Is there a shortage or surplus? How much is the shortage or surplus?

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