Market Equilibrium, PED, YED, PES

How is price for a good in a competitive market determined?

By interaction between consumers and producers (demand and supply)

In terms of Qd and Qs when is the market in equilibrium?

When Qd = Qs

What happens to the market at this point?

The market clears

Explain the price mechanism

Excess demand (shortage), or excess supply (surplus) causing a change in price, acting is a signal, creating incentives, leading to more or less of a good being produced, and so a change in allocation of scarce resources.

If you are willing and able to buy a drink for 1$ but it actually costs 75c, how much is your consumer surplus?

25c

Define consumer surplus

Difference between how much consumers are willing to pay and how much they actually pay

What does vertical distance to a demand curve measure?

Marginal benefit (MB) enjoyed from that unit

What is the area of consumer surplus on a diagram?

Below the demand curve, and above the price

If a firm is willing to offer a good for 2$ and the market price is 3$, how much is their producer surplus?

1$

define producer surplus

Difference between the price the producers are willing to sell their good at and the actual market price

What is the vertical distance to the supply curve?

The minimum price a firm requires to be willing to offer that unit

What does the supply curve represent?

Marginal costs (MC) of the firm

What is the area of producer surplus on a diagram?

Above the supply curve, below price

Define social / community surplus

The sum of producer and consumer surplus.

What is social surplus a measure for?

Welfare

What does it means when social surplus is maximised?

Allocative efficiency is achieved

What does PED stand for?

Price Elasticity of Demand

What does PED measure?

The responsiveness of quantity demanded to change in price.

What is the formula for PED?

%change in Qd / %change in P

(Q2 - Q1 / Q1) / (P2 - P1 / P1)

When is demand price ELASTIC

when PED > 1

When demand is elastic, what does a change in price cause?

A proportionally greater change in Qd

Is an elastic demand curve steep or flat?

Flat

When is demand price INELASTIC?

When 0 < PED < 1

When demand is price inelastic, what does a change in price cause?

A proportionally smaller change in Qd

Is an inelastic demand curve steep or flat?

Steep

When is demand unit elastic?

When PED = 1

What does this mean?

Percentage change in Qd = Percentage change in P

What type of curve is this?

Parabola (rounded L shape) - doesn't touch the x-axis

When is demand perfectly elastic?

When PED = infinity

What does this mean?

That a small change in price leads to an infinitely large change in Qd

What type of curve is this?

Straight, horizontal

When is demand perfectly inelastic?

When PED = 0

What does this mean?

A change in price has no effect on Qd

What type of curve is this?

Straight, vertical

Name the 4 determinants of PED

- Number and closeness of available substitutes

- Type / nature of the good (necessary, addictive, etc.)

- Proportion of income spent on the good

- Time period

If there are lots of close substitutes for a good, what is PED likely to be?

Price elastic

Why?

Because if the price of one good rises people will easily switch to a substitute

If there are not many substitutes for a good, what is PED likely to be?

Price inelastic

Why?

Because people cannot easily find a cheaper replacement

If a good is a necessity, what is its PED likely to be?

Price inelastic

Why?

Because people have no choice but to buy goods necessary to survive

If a good is addictive, what is its PED likely to be?

Price inelastic

Why?

It is hard to reduce the consumption of addictive substances because people become dependent on them

If a small proportion of income is spent on goods, what is PED likely to be?

Price inelastic

If a large proportion of income is spent on goods, what is PED likely to be?

Price elastic

Is demand price elastic or inelastic in the short run?

inelastic

Why?

Because it is hard for people to change spending patterns immediately. Individuals need time to notice the change and find suitable substitutes

Does PED become more elastic or inelastic as time goes on?

Elastic

What is the formula for total revenue (TR)?

P x Q

Define profits

Difference between revenues and costs of production

If PED > 1 (elastic) and P rises, how do Q and TR change?

Q decreases proportionally more, TR falls

If PED > 1 (elastic) and P falls, how do Q and TR change?

Q increases proportionally more, TR rises

If 0 < PED < 1 (inelastic) and P rises, how do Q and TR change?

Q falls proportionally less, TR rises

If 0 < PED < 1 (inelastic) and P falls, how do Q and TR change?

Q rises proportionally less, TR falls

How does PED help firms?

- Helps predict direction of change in its revenues given a price change

- Helps determine the extent to which they can shift an indirect tax (the more price inelastic a product, the more tax can be passed onto the consumer by higher prices)

How does PED help governments?

- Low PED (more inelastic) means more tax revenues are collected - because of higher price on good not reducing Qd, can determine which goods to tax

- Determine how high a tax on addictive goods should be to lower consumption

QUESTION: Assume price falls by 6% to an increase in Qd of 9%. What is PED? Is it elastic or inelastic?

9 / -6 = - 1.5, PED is 1.5, PED is price elastic

QUESTION: Assume that the price increases from 3$ to 9$. Qd falls from 12,000 units to 4,000 units. What is PED? Is it elastic or inelastic?

(4,000 - 12,000) / 12,000 = -0.67

(9 - 3) / 3 = 2

-0.67 / 3 = -0.33, PED is 0.33

QUESTION: Assume that PED is -0.74 and price increases by 12%. Calculate change in Qd.

%changeQd / %changeP = PED

%changeQd / 12 = -0.74

%changeQd = -0.74 x 12

%changeQd = -8.88%

What does YED stand for?

Income elasticity of demand

What does YED measure?

The responsiveness of demand to a change in income

What is the formula for YED?

(%change Qd / %change Y)

or

(Q2 - Q1 / Q1) / (Y2 - Y1 / Y1)

What is the YED of a normal good?

YED > 0

Why?

Because as income increases demand for normal goods increases and vice versa

What is the YED of an inferior good?

YED < 0

Why?

Because as income increases demand for inferior goods decreases

For normal goods, when YED > 1, what are demand and income

%change Qd > %change Y

Hence, demand is - -

income elastic

Why?

Because a faster rise in income leads to a proportionally greater increase in demand

Are luxury goods income elastic or inelastic?

elastic

For normal goods, when 0 < YED < 1, what are demand and income?

%change Qd < %change Y

hence demand is - -

income inelastic

Why?

Because a rise in income leads to a proportionally smaller increase in demand

Are basic (everyday or staple) good elastic or inelastic?

Inelastic

When YED = 0 (inelastic) how is demand for a normal good affected by change in income?

It is not affected

When YED = 1 (elastic) how is demand for a normal good affected by a change in income?

% change in Y = % change in Qd (eg. 5% increase in income leads to a 5% increase in Qd)

What graph represents YED values?

The Engel curve

What is the type of goof when YED < 0

Inferior good

What is the type of good when YED > 0

Normal good

What slope does each one have?

Inferior: negative

Normal: positive

What is YED when income rises but Qd is unchanged?

YED = 0

What type of good when 0 < YED < 1 (inelastic)

Luxury good

QUESTION: Suppose that increase in national income of 2.4% leads to a 4.75% fall in bus journeys. Calculate the YED for bus journeys.

-4.75 / 2.4 = -1.98, YED = -1.98, bus journeys are income elastic inferior goods

QUESTION: Assume that annual per capita income levels in Shanghai increase from Rmb 55,000 to Rmg 61,600 leading to an increase in number of manicure appointments from 350,000 to 413,000. Calculate the YED for manicure treatments.

(413,000 - 350,000 / 350,000) = 0.18

(61,600 - 55,000 / 55,000) = 0.12

0.18 / 0.12 = 1.5, YED = 1.5, manicure treatments are income elastic

What does PES stand for?

Price elasticity of supply

what does PES measure?

the responsiveness of quantity supplied to a change in price

What is the formula for PES?

%change Qs / %change P

or

(Q2 - Q1 / Q1) / (P2 - P1 / P1)

What is the PES of a price elastic good?

PED > 1

When supply is price elastic, what does a change in price lead to?

A proportionally greater change in Qs

What does this say about sensitivity of supply where PED > 1 ?

It is relatively sensitive

What axis must a price elastic supply curve cut?

The vertical axis

What is PES when supply is inelastic?

0 < PES < 1

When supply is price inelastic, what does a change in price lead to?

A proportionally smaller change in Qs

What does this indicate about the sensitivity of price inelastic supply?

It is relatively unresponsive

What axis does price inelastic supply have to cut?

The horizontal axis

What is PES when supply is unit elastic?

PES = 1

What is PES when supply is perfectly elastic?

PES = infinity

What does this mean?

A small change in price leads to an infinitely large change in Qs

What is PES when supply is perfectly inelastic?

PES = 0

What does this mean?

A change in price leads to no change in Qs