ECO 201 EXAM 2

University of Kentucky

Price elasticity of demand

How much buyers change what they buy when price changes

Price elasticity of supply

How much sellers change what they sell when price changes

Cross-price elasticity

How demand for one good changes when another good’s price changes

Income elasticity

How demand changes when income changes

Determinants of elasticity

1. Availability of Substitutes: more substitutes = more elastic

2. Luxuries / Necessities: more luxurious = more elastic

3. Time Horizon: the more time buyers have to adjust to a price change, the more elastic

4. Definition of Market: the more specific a good is = more elastic.

5. Slopes: flatter the slope = more elastic, steeper the slope = inelastic.

Elasticity Classifications

If |Ed| > 1 | = Elastic (anything bigger than 1)
If |Ed| < 1 | = inelastic (anything between 0 and 1)
If |Ed| = 1 | = unitary elastic (anything that equals to 1)

Total Revenue Formula

TR = (price) x (quantity) 

Elastic demand

Price decrease → Revenue increase.

Inelastic demand

Price decrease → Revenue decrease.

Multi-tiered pricing system

producers charge different groups of consumers different prices

• example: adults $12, children $5

Price Discrimination

Charging different customers different prices for the same product based on how sensitive they are to price.

Price Ceiling

a legal maximum on the price at which a good can be sold. intended to help consumers

Price ceiling binding

if price ceiling is LESS THAN Price equilibrium (below equilibrium)

• result: shortage

Price Floor

A legal minimum at the price of which a good can be sold. Intended to help producers.

Price floor binding

If price floor is GREATER THAN PE (above equilibrium)

• result: surplus

Tax base

How much is being taxed

Tax Rate

The percentage or per-unit amount of the tax (8% in Kentucky)

A tax creates a wedge between

Price buyers pay - Buyers pay more

Price sellers receive - Sellers receive less

Tax Graphically

If tax is on sellers → supply curve shifts upward

If tax is on buyers → demand curve shifts downward

Tax Revenue Formula

Tax per unit × Quantity sold after tax

Tax Burden

The amount of the price increase (tax burden = tax - price increase)

Average Tax rate formula

Total taxes paid / total income

Marginal Tax Rate Formula

Additional taxes / additional income

Consumer Surplus

The amount a buyer is willing to pay for a good minus the amount the buyer pays for it.

Willingness to Pay

The maximum amount a buyer is willing and able to pay

Consumer Surplus Formula and graphically

Consumer Surplus = Willingness to Pay − Price Paid)

• area under demand curve and above price
  (½ x base x (max price – price))

Producer Surplus

The difference between the price suppliers receives (market price) and the minimum price they would be willing to accept

Producer Surplus Formula and graphically

Producer Surplus = Price Received − Cost of Production

• area above supply curve and below price

A market is efficient when…

1. All goods with benefits greater than costs are produced

2. No goods with costs greater than benefits are produced

Total Surplus = Consumer Surplus + Producer Surplus

Deadweight loss

Loss of consumer and producer surplus (total surplus)

Determinants of Deadweight Loss

1. Small tax → small deadweight loss → less elastic

2. Large tax → large deadweight loss → more elastic

Laffer Curve

shows the relationship between the size of the tax and tax revenue.

Protective Function of the Government

• A government maintains a framework of security and order

• An infrastructure of rules within which people can interact peacefully with one another.

Productive Function of the Government

Government sometimes produces products that private markets do not produce at efficient levels.

Negative Externalities

A spillover effect of a market activity that affects a third party who is not directly involved

(ex: secondhand smoking, oil spills on animals, air pollution, not vaccinating your kids and then spreading diseases)

Positive Externalities

When a third-party benefits from a market transaction in which they take no part.

(ex: Wi-Fi, vaccinations, bees' pollen, education/innovation)

Market Failure

Negative: Markets fail because they do not account for external costs or benefits

Positive: fails to consider all benefits because it only considers benefits to buyers and sellers.

Command-and-control policies

policies that rely on regulation (permission, prohibition, standard setting, enforcement, and property right protection)

Market-based policies

Policies that change costs (like taxes or subsidies) to influence how much people buy or produce.

Internalizing the Externality

Altering incentives so that people take account of the external effects of their actions

Pigouvian Tax

A tax on activities that create negative externalities (like pollution).

• It makes firms pay for the harm they cause

Tradable pollution permits

Government gives firms permits to pollute, and firms can buy and sell them.

Cap and trade

Government sets a limit (cap) on pollution and lets firms trade permits.

Moral Code

People reduce harmful behavior because they believe it is the right thing to do

Charities

Private groups try to fix externalities by funding solutions or helping affected people.

Business Integration

Companies combine or work together to handle externalities internally instead of affecting others.

Coase's Theorem (private contracts)

People can fix external problems on their own by negotiating, as long as they can agree. Leading to an efficient outcome where everyone benefits.