Midterm #2

Modern Principles of Economics

Elasticity of Demand

A measure of how responsive the quantity demanded is to a change in price

Perfectly Elastic and Perfectly Inelastic Demand Curve

What are some factors that determine if demand becomes more inelastic?

• Fewer Substitutes

• Short Run (Less Time)

• Categories of Product i.e., orange soda

• Necessities

• Small Part of budget

What are some factors that determine if demand becomes more elastic?

• More Substitutes

• Long Run (More Time)

• Specific Brand i.e., Fanta

• Luxuries

• Large Part of Budget

How do you calculate elasticity of demand?

* Elasticity of demand is always negative.

Is Demand Curve I or Demand Curve E more elastic and explain why.

Demand Curve E is more elastic than Demand Curve I because it is flatter and closer to being a horizontal line than Demand Curve I. Demand Curve E is also more responsive to a change in price than Demand Curve I, which is the exact definition of elasticity.

Calculate the E_D of Demand Curve I.

Calculate the E_D of Demand Curve E.

If the absolute value of the elasticity of a demand curve is less than 1, then what does this tell us about the demand curve?

The demand curve is inelastic.

If the absolute value of the elasticity of a demand curve is greater than 1, then what does this tell us about the demand curve?

The demand curve is elastic.

Unit Elastic

When the absolute value of the elasticity is exactly equal to 1

How do you calculate E_D using the midpoint method?

Calculate E_D using the midpoint method.

How do you calculate revenue?

Revenue = Price x Quantity

When the demand curve is inelastic (E_D < 1), price and revenue _________.

Move together

When the demand curve is elastic (E_D > 1), price and revenue _________.

Move in opposite directions

When the demand curve is elastic (E_D = 1), when price changes, revenue _________.

Stays the same

Elasticity of Supply

A measure of how responsive the quantity supplied is to a change in price

When is the supply curve inelastic?

• Difficult to increase production at constant unit cost

• Large share of market for inputs

• Global supply

• Short run

When is the supply curve elastic?

• Easy to increase the supply (production at constant unit cost)

• Small share of market for inputs

• Local supply

• Long run

How to calculate elasticity of supply?

How to calculate elasticity of supply using the midpoint method?

What are the three most important things to remember about commodity tax?

1. Who ultimately pays the tax does not depend on who writes the check to the government

2. Who ultimately pays the tax does depend on the relative elasticities of demand and supply

3. Commodity taxation raises revenue and creates deadweight loss (i.e., reduces the gains from trade)

How do you calculate tax?

Tax = Price paid by buyers - Price received by sellers

When the demand curve is more elastic, the ________ pay more of the taxes.

Sellers/Producers

When the demand curve is more ________, the buyers/demanders pay more of the taxes.

Inelastic

How do you calculate how much the consumers pay of the tax?

(Price demanders pay - Equilibrium price without tax)/Tax

How do you calculate how much the producers pay of the tax?

(Price suppliers receive - Price without tax)/Tax

Calculate how much tax both the consumers and producers pay.

Deadweight Loss

Reduction in the total surplus caused by a market distortion or inefficiency

Label all the parts of the graph.

Light Green - Consumer Surplus

Purple - Tax Revenue

Blue - Producer Surplus

Pink - Deadweight Loss

How do you calculate dead weight loss?

½ (Q* - Q_t)T

When the demand curve is more elastic, deadweight loss …

Increases

Subsidy

Reverse tax, where the government gives money to producers or consumers to purchase a product

What are the three most important things to remember about subsidies?

1. Who gets the subsidy does not depend on who gets the check from the government

2. Who benefits from a subsidy does depend on the relative elasticities of demand and supply

3. Subsidies must be paid for by taxpayers and they create inefficient increases in trade (deadweight loss)

How do you calculate a subsidy?

Subsidy = Price received by sellers - Price paid by buyers

Which part of the graph represents a subsidy?

Pink

Price Ceiling

Maximum price allowed by law

What are the effects of price ceilings?

• Shortages

• Reductions in product quality

• Wasteful lines and other search costs

• A loss of gains from trade (Deadweight Loss)

• A misallocation of resources

Shortage

When prices are held below the market price, the quantity demanded exceeds the quantity supplied

Rent Control

Price Ceiling on rental housing

Arguments for Price Ceiling

• Discipline monopolies

• The public

• Creates affordable housing (but there are better ways to do this like housing vouchers)

Price Floors

A minimum price allowed by law

What are the effects of price floors?

• Surpluses

• Lost gains from trade (Deadweight Loss)

• Wasteful increases in quality

• A misallocation of resources

Minimum wages creates ________.

Unemployment

If minimum wage rises, will that increase or decrease the demand for the average union workers’ labor? Why?

If the minimum wage rises, that will increase the demand for the average union worker’s labor because the competition (unskilled labor) is getting priced out of the market.

Identify what the colors represent.

Pink - Total Value of Wasted Time

Purple - Lost Consumer Surplus

Blue - Lost Producer Surplus

Lost Consumer Surplus + Lost Producer Surplus = ?

Total Deadweight Lost

Identify what the colors represent. Where would the surplus be represented?

Teal - Total Value of Wasted Time

Light Green - Lost Consumer Surplus

Dark Green - Lost Producer Surplus

Identify what the colors represent.

Pink - Loss due to random allocation

Green - Total Consumer Surplus under Random Allocation

How do you calculate the average value?

Average Value = ½ (30 + 6) = $18

Blat

Using one’s connections to get favors

Give an example of blat.

A manager of a radio factory trades the manager of a beed factory a radio in exchange for beef.

_______ are not only incentives, but also signals to producers to make more or less of a certain good and if consumers should buy more of a certain good.

Prices

Great Economic Problem

How to arrange our scare resources to satisfy as many of our wants as possible

Central Planning

An economic system where a government or single authority makes all key decisions about the production and distribution of goods and services

Why does centralized planning fail?

Lack of information and incentives

Decentralized Planning

Strategy that transfers authority, decision-making, and resources from a central body to lower-level or local entities, such as local governments or individual departments (Capitalism)

An example of central planning is ___________; an example of decentralized planning is ______________. 

USSR; United States

Speculation

The attempt to profit future from price price change