EC1A5 - Topic 2: elasticity, speculation

Purpose of economic models

To simplify complex real-world interactions so economists can understand and predict economic behaviour.

Why economists use models

They help maintain logical consistency and focus on essential relationships within an economy.

Limitation of economic models

Models rely on assumptions that may not always hold true in reality, limiting their accuracy.

Einstein's quote on models

'Make things as simple as possible but no simpler' means models should simplify reality to capture its essence but not omit crucial elements that affect outcomes.

Models like maps

They are useful representations that simplify reality for a purpose but can be misleading if used beyond their intended scope.

Model of a market assumption

It assumes many buyers and sellers, identical goods, and that both sides make decisions based on price.

Law of demand

As price increases, quantity demanded decreases, all else being equal.

Demand curve

A graphical representation showing the relationship between price and quantity demanded.

Law of supply

As price increases, the quantity supplied increases, all else being equal.

Supply curve

A graphical representation showing the relationship between price and quantity supplied.

Market-clearing price

The price at which quantity demanded equals quantity supplied.

Price above market-clearing level

There is excess supply, leading sellers to reduce prices.

Price below market-clearing level

There is excess demand, leading buyers to bid prices up.

Market equilibrium

The state in which quantity demanded equals quantity supplied and prices have no tendency to change.

Do prices always clear markets?

Not always; real-world factors like regulation, contracts, or rigidities can prevent price adjustment.

Excess supply

A situation where sellers want to sell more than buyers want to purchase at a given price.

Excess demand

A situation where buyers want to purchase more than sellers are willing to supply at a given price.

Markets not clearing instantly

When prices are sticky, such as due to contracts, social norms, or regulation.

Comparative statics

The analysis of how equilibrium changes when an external condition changes, such as demand or supply shifting.

Demand curve shifts rightward

Equilibrium price and quantity both increase.

Supply curve shifts rightward

Equilibrium price decreases and equilibrium quantity increases.

Shift 'along' a curve

A change caused by a movement in price, not by external factors affecting the whole curve.

Shift 'of' a curve

A change caused by external factors, such as income or production costs, that move the entire curve.

Elasticity

A measure of how responsive quantity demanded or supplied is to a change in price.

Price elasticity of demand

The percentage change in quantity demanded in response to a 1% change in price.

Price elasticity of supply

The percentage change in quantity supplied in response to a 1% change in price.

Elastic demand

A small change in price causes a large change in quantity demanded.

Inelastic demand

A change in price causes a relatively small change in quantity demanded.

Factors affecting elasticity of demand

Availability of substitutes, proportion of income spent, and time horizon.

Factors affecting elasticity of supply

Production flexibility, resource availability, and time for firms to adjust output.

Unit-free measure

Elasticity measures independent of the units of measurement.

Durable good

A good that lasts over time and can be used repeatedly, such as housing or financial assets.

Non-durable good

A good consumed quickly and with no lasting value, such as food or fuel.

Expected future price effect on durable goods

If future prices are expected to rise, current demand increases.

The more durable a good, the more price elastic its demand, because consumers can postpone purchases

Non-durable goods (food, fuel) are consumed quickly and bought regularly, so consumers are less able to delay, making demand more inelastic.

Speculative bubble

A sustained rise in the price of an asset driven by expectations of future price increases rather than fundamentals.

Causes of bubbles bursting

When expectations of rising prices collapse, leading to falling demand and sharp price declines.

Problems caused by bubbles

They cause misallocation of resources and can lead to economic instability when they burst.

Positive analysis

Explains how markets work.

Normative analysis

Evaluates whether outcomes are good or bad.

Deviations from equilibrium

Studied to understand causes of inefficiency such as price controls, rigidities, or shocks.

Elasticity in comparative statics

Determines the magnitude of price and quantity changes when demand or supply shifts.

Flat supply curve interpretation

As highly elastic — quantity responds strongly to price changes.

Steep supply curve interpretation

As inelastic — quantity responds weakly to price changes.

Prices when supply is inelastic and demand rises

Prices increase sharply, while quantity rises only slightly.

Prices when supply is elastic and demand rises

Prices rise slightly, but quantity rises substantially.

Markets tending toward equilibrium

Competitive pressures usually drive prices toward the market-clearing level over time.

Key takeaway from the simple model of a market

Prices coordinate the behaviour of buyers and sellers to allocate resources efficiently under competition.