Market Failures and Elasticity in Microeconomics

Market failure

Market failure is defined as the inability of a market to bring about the allocation of resources that best satisfies the wants of society.

Overallocation

Overallocation refers to the excessive allocation of resources to the production of a particular good or service.

Underallocation

Underallocation refers to the insufficient allocation of resources to the production of a particular good or service.

Externalities

Externalities are costs or benefits that affect third parties who did not choose to incur that cost or benefit.

Asymmetric information

Asymmetric information occurs when one party in a transaction has more or better information than the other party.

Total surplus

Total surplus is the sum of consumer and producer surpluses in the market.

Consumer surplus

Consumer surplus is defined as the difference between the maximum price consumers are willing to pay for a product or service and the lower equilibrium price.

Producer surplus

Producer surplus is the difference between the minimum price producers are willing to accept for a product and the higher equilibrium price.

Equilibrium price

Equilibrium price is the price at which the quantity demanded by consumers equals the quantity supplied by producers.

Equilibrium quantity

Equilibrium quantity is the quantity of goods or services that is supplied and demanded at the equilibrium price.

Allocative efficiency

Allocative efficiency occurs at the market equilibrium, where marginal benefit equals marginal cost.

Productive efficiency

Productive efficiency occurs when goods are produced at the lowest possible cost.

Marginal benefit

Marginal benefit is the additional benefit received from consuming one more unit of a good or service.

Marginal cost

Marginal cost is the additional cost incurred from producing one more unit of a good or service.

Maximum willingness to pay

Maximum willingness to pay is the highest price a consumer is willing to pay for a good or service.

Minimum acceptable price

Minimum acceptable price is the lowest price a producer is willing to accept for a good or service.

Efficiency losses

Efficiency losses, or deadweight losses, occur when the allocation of resources is not optimal, leading to a decrease in total surplus.

Demand curve

The demand curve is a graphical representation of the relationship between the price of a good and the quantity demanded.

Supply curve

The supply curve is a graphical representation of the relationship between the price of a good and the quantity supplied.

Market clearing price

The market clearing price is the price at which the quantity supplied equals the quantity demanded.

Competitive markets

Competitive markets are markets where there are many buyers and sellers, and no single buyer or seller can influence the market price.

Deadweight loss

A reduction in the total net benefit that society can obtain from its limited supply of resources.

Externality

Occurs when some of the costs or benefits of a good or service are passed onto or 'spilled over to' someone other than the immediate buyer or seller.

Positive externalities

Occur when people who are not directly involved in a market transaction receive benefits from the market transaction without having to pay for them.

Market demand curves and positive externalities

Fail to include the willingness to pay of the people who receive the positive externality, leading to underproduction.

Negative externalities

Occur when producers or suppliers impose costs on third parties who are not directly involved in a market transaction.

Market supply curves and negative externalities

Fail to include all costs, leading to overproduction.

Government options for externalities

Include passing legislation limiting negative externalities and levying taxes or charges on related goods.

Direct controls

Legislation that limits activities causing negative externalities, forcing firms to incur actual costs.

Examples of direct controls

Maximum emissions limits for factory smokestacks and laws mandating the proper disposal of toxic wastes.

Pigovian taxes

Targeted tax assessments levied by the government on goods related to negative externalities.

Effect of Pigovian taxes

If set correctly, the tax will precisely offset the overallocation (overproduction) generated by the negative externality.

Beekeeper and positive externality

A beekeeper benefits when a neighboring farmer plants clover, illustrating a positive externality.

Manufacturer and negative externality

A manufacturer that dumps toxic chemicals into a river imposes costs on third parties, illustrating a negative externality.

Equilibrium output with positive externalities

Will be smaller than the efficient output when positive externalities are present.

Equilibrium output with negative externalities

Will be greater than the efficient output when negative externalities are present.

spillover benefits

Positive externalities that occur when the benefits of a transaction spill over to third parties.

subsidies to buyers

Financial assistance provided to consumers to increase demand and eliminate underallocation of resources.

subsidies to producers

Financial assistance provided to producers to increase supply and correct the underallocation of resources.

government provision

The act of providing a product for free to everyone to correct underallocation of resources.

Coase Theorem

The theory that private individuals can negotiate mutually agreeable solutions to externality problems without government intervention.

optimal reduction of an externality

The point at which society's marginal cost and marginal benefit of reducing an externality are equal.

moral hazard problem

The tendency for a person to take on more risk after securing a contract that shifts the cost of negative outcomes to another party.

adverse selection problem

A situation in insurance markets where those most likely to need insurance are also the most likely to purchase it.

pollution abatement

The process of reducing or eliminating pollution from the environment.

information asymmetry

A condition where one party has more or better information than the other in a transaction.

trustworthy sellers

Sellers who can be relied upon to provide accurate information about their products.

untrustworthy sellers

Sellers who may provide misleading or false information about their products.

mandatory disclosures

Laws requiring parties to provide specific information to ensure transparency in transactions.

riskier loans

Loans that have a higher probability of default or loss due to the borrower's financial situation.

crop insurance

Insurance that protects farmers against loss of crops due to natural disasters or market fluctuations.

disaster relief

Assistance provided by the government to help individuals recover from natural disasters.

health insurance

Insurance that covers medical expenses for individuals.

airbags

Safety devices in vehicles designed to inflate upon impact to protect occupants.

Price Elasticity of Demand

The price elasticity of demand measures the consumers' responsiveness (or sensitivity) to a change in the price of a product.

Price Elasticity of Demand Coefficient

The formula for price elasticity of demand coefficient = Ed = percentage change in quantity demanded of product X / percentage change in price of product X.

Negative Coefficient

The coefficient would be negative b/c of the law of demand, i.e., price increase (decrease), quantity demanded decrease (increase).

Absolute Value of Coefficient

We ignore the minus sign and use absolute value to make it less confusing to interpret the elasticity coefficient.

Traditional Calculations

Using traditional calculations, the measured elasticity over a given range of prices is sensitive to whether one starts at the higher price and goes down or starts at the lower price and goes up.

Midpoint Formula

The midpoint formula calculates the average elasticity over a range of prices to avoid the problem of differing percentage changes.

Elasticity Coefficient Greater than 1

When the elasticity coefficient is greater than 1, it means that the percentage change in quantity demanded is greater than the percentage change in price, indicating that consumers are sensitive to the change in price, so demand is elastic.

Elasticity Coefficient Less than 1

When the elasticity coefficient is less than 1, the percentage change in quantity demanded is less than the percentage change in price, indicating that consumers are not very sensitive to price changes.

Unit Elasticity

When the elasticity coefficient equals 1, this is a special case called unit elasticity, meaning that the percentage change in price and the percentage change in quantity are exactly equal.

Perfectly Inelastic Demand

Perfectly inelastic demand means that consumers will buy exactly the same amount no matter how high or low the price is.

Perfectly Elastic Demand

Perfectly elastic demand means that nothing will be purchased if there is any deviation from the current price.

Total Revenue Test

The total-revenue test is the easiest way to judge whether demand is elastic or inelastic.

Total Revenue Definition

Total revenue is defined as price of the output produced times the quantity of the output sold.

Inelastic Demand

Demand is inelastic if a decrease (increase) in price results in a decrease (increase) in total revenue.

Elastic Demand

Demand is elastic if a decrease (increase) in price results in an increase (decrease) in total revenue.

Unit Elastic Demand

Demand is unit elastic if total revenue does not change when the price changes.

Linear Demand Curve

On a linear demand curve, the slope is constant throughout, but the price elasticity of demand varies.

Slope vs Elasticity

Slope is computed from absolute changes in price and quantity, while elasticity involves relative or percentage changes in price and quantity.

Determinants of Price Elasticity of Demand

Factors that influence how sensitive the quantity demanded is to price changes.

Substitutability

The larger the number of substitute goods available, the greater the price elasticity of demand will be.

Inelastic Demand Example

Eggs and bread are considered to have relatively inelastic demand since there is no perfect substitute for both.

Elastic Demand Example

The demand for Sprite is more elastic since there are available substitutes.

Narrow Definition Elasticity

The elasticity of demand for a product depends on how narrowly the product is defined.

Proportion of Income

The higher the price of a good relative to consumers' income, the greater the price elasticity of demand will be.

Low-Priced Items Elasticity

Price elasticity for low-priced items tends to be low.

High-Priced Items Elasticity

Price elasticity for high-priced items tends to be high.

Luxuries vs Necessities

The more a good is considered a luxury rather than a necessity, the greater the price elasticity of demand will be.

Time Elasticity

Product demand is more elastic the longer the time period under consideration is.

Price Elasticity of Supply

Price elasticity of supply measures how sensitive firms are to price changes.

Price Elasticity of Supply Formula

The formula for price elasticity of supply coefficient = Es = percentage change in quantity supplied of product X / percentage change in price of product X.

Reference Points in Elasticity

The averages, or midpoints, of the before and after quantities supplied and the before and after prices are used as reference points for the percentage changes.

Coefficient of Price Elasticity of Supply < 1

Supply is relatively inelastic.

Coefficient of Price Elasticity of Supply > 1

Supply is relatively elastic.

Coefficient of Price Elasticity of Supply = 1

Supply is unit-elastic.

Determinant of Price Elasticity of Supply

The amount of time the producer has to adjust inputs in response to a price change.

Immediate Market Period

No time to adjust output in response to a price change; supply curve is perfectly inelastic.

Short Run

Enough time to adjust output by changing variable inputs but not fixed inputs; supply curve is a bit elastic.

Long Run

Enough time to adjust output by changing all inputs; supply curve is more elastic.

Supply Curve for One-of-a-Kind Antique

Perfectly inelastic.

Supply Curve for Reproductions

Relatively elastic.

Cross-Price Elasticity of Demand

Measures how sensitive consumer purchases of one product are to a change in the price of another product.

Positive Coefficient of Cross-Price Elasticity

Indicates that the two goods are substitutes.

Negative Coefficient of Cross-Price Elasticity

Indicates that the two goods are complementary.

Zero or Near-Zero Cross Elasticity

Suggests that the two products are unrelated.

Income Elasticity of Demand

Measures the degree to which consumers respond to a change in their incomes by buying more or less of a particular good.

Positive Income Elasticity Coefficient

Indicates a normal or superior good; demand increases as income rises.