Elasticity, Gov. Policy, Welfare

Elasticity

price elasticity of demand

Elastic

small change in price causes a big change in quantity (e > 1)

Inelastic

small change in price causes a small change in quantity (e < 1)

Price elasticity of demand formula

Ed = (% change Qd) / (% change P)

Midpoint method formula

(X - Xo) / ((X + Xo) / 2) to avoid the base effect

Perfectly elastic

elasticity equals infinity (e = inf)

Unit elastic

elasticity equals 1 (e = 1)

Perfectly inelastic

elasticity equals 0 (e = 0)

Linear demand curve elasticity

elasticity of demand decreases as quantity increases

Determinant - Availability of substitutes

more substitutes make demand more elastic

Determinant - Necessity vs. Luxury

luxury goods have higher elasticity than necessities

Determinant - Narrow vs. Broad definition

narrower market definitions have higher elasticity due to more substitutes

Determinant - Time horizon

longer time horizons make demand more elastic

Determinant - Ease of search

easier price comparison makes demand more elastic

Total revenue formula

Price * Quantity

Elastic price & revenue relationship

inverse relationship between price and total revenue

Inelastic price & revenue relationship

direct relationship between price and total revenue

Price elasticity of supply

measures the responsiveness of quantity supplied to changes in price

Supply elasticity determinants

ease of adjustment and time horizon

Cross price elasticity (Exy)

measures responsiveness of quantity demanded of good X to price changes of good Y

Substitute goods (Exy)

cross price elasticity is greater than 0 (Exy > 0)

Complement goods (Exy)

cross price elasticity is less than 0 (Exy < 0)

Unrelated goods (Exy)

cross price elasticity equals 0 (Exy = 0)

Income elasticity of demand

measures responsiveness of quantity demanded to changes in consumer income

Normal good

income elasticity of demand is greater than 0 (e > 0)

Inferior good

income elasticity of demand is less than 0 (e < 0)

Statutory burden

which party is legally responsible for sending taxes to the government

Economic burden

who actually bears the tax cost through price changes

Tax incidence rule

the more inelastic party bears a larger share of the economic burden

Excise tax on buyers

shifts the demand curve downward by the exact amount of the tax

Excise tax on sellers

shifts the supply curve upward by the exact amount of the tax

Government tax revenue formula

Tax per unit * Quantity taxed

Tax wedge vs. Subsidy wedge

taxes create a wedge on the left of equilibrium while subsidies create a wedge on the right

Subsidies

government payments made per unit exchanged to increase consumption or production

Subsidy benefit distribution

the more inelastic party receives more of the economic benefit

Price ceilings

government-imposed maximum legal prices that create short-run shortages

Price ceiling consequences

non-price rationing

Price floors

government-imposed minimum legal prices that create surpluses and excess inventory

Price floor consequences

non-price competition and black markets

Mandates

government-imposed minimum quantity of a good that must be exchanged

Quotas

government-imposed maximum quantity of a good that can be exchanged

Positive analysis

objective analysis describing what is happening

Normative analysis

analysis predicting what should happen involving value judgments

Economic surplus formula

Total Benefits - Total Costs

Economic efficiency

an outcome that yields the largest possible economic surplus

Equity vs. Efficiency

efficiency measures the size of the economic pie while equity concerns how the pie is divided

Consumer surplus

economic surplus derived by consumers located below the demand curve and above price

Producer surplus

economic surplus derived by producers located above the supply curve and below price

Total surplus

total economic surplus generated across the entire market

Market economy advantage

competitive markets minimize costs and allocate production to lowest marginal cost suppliers

Efficient allocation

allocating goods to consumers who derive the highest marginal benefit (willingness to pay)

Rational rule for markets

produce more of a good as long as marginal benefit exceeds marginal cost

Market failure

when market forces lead to an inefficient outcome

Causes of market failure

market power

Deadweight loss (DWL)

the decrease in total economic surplus below the efficient outcome level

Deadweight loss formula

Efficient Outcome Economic Surplus - Actual Economic Surplus

Subsidies deadweight loss location

deadweight loss appears on the right side of equilibrium