ECON 251 Exam 1

Allocative efficiency

at the market clearing price, MC(Q)=MB(Q)

Tax

an additional charge imposed by a government on a good or service; add to supply, subtract from demand

Excise tax or per-unit tax

a tax on each unit sold, example being gas

Ad valorem tax

a tax on the value of a good, example being sales tax

Binding

a constraint that is relevant; binding restrictions have an impact, non-binding restrictions have no impact

Why do governments tax?

to raise revenues and deterrence (pigouvian taxes or sin taxes)

How do taxes impact sellers?

they sell less and their “take home price” is lower

How do taxes impact buyers?

they buy less and pay a higher price

The result of being elastic when it comes to taxes

being inelastic results in paying a greater amount of the tax, being elastic results in paying less of the tax

Common misconception

if you tax sellers, the buyers don’t have to pay the tax; elasticity matters, not who you tax

Statutory burden

describes the burden of being assigned by the government the responsibility of sending a tax payment

Economic burden

describes the burden created by the change in after-tax prices faced by buyers and sellers

Tax incidence

the division of the economic burden of a tax between buyers and sellers, depends on price elasticity (more elastic, less burden)

Tax revenue

tax*quantity sold

Effects of tax on supply and demand

add to supply curve y-intercept, subtract from demand curve y-intercept

Algorithm for finding a graphical equilibrium with a tax

add appropriate curve by the amount of the tax (add to supply or subtract from demand), find intersection of new curve to find quantity in market when tax is imposed, go up (or down) to other curve to find wedge, Pd=Ps+tax

What happens in a market when you inpose a tax?

quantity exchanged decreases, price sellers get goes down, price buyers pay goes up, different between what buyers pay and what sellers get is tax per unit, tax revenue is tax per unit multiplied by quantity sold, market no longer efficient

Subsidy

a payment made by the government to those who make a specific choice, doesn’t matter who receives it, essentially negative tax; subtract from seller, add to demand

Algorithm for subsidies

add appropriate curve by the amount of the subsidy (add to demand or subtract from supply), find intersection of new curve to find quantity in market when subsidy is imposed, go up (or down) to other curve to find wedge, Pd=Ps-subsidy, how much subsidy costs government is amount sold multipled by subsidy

Price ceiling

maximum price sellers can charge

Price floor

minimum price sellers can charge

Binding price ceiling

maximum price that sellers can charge that is below the equilibrium price (shortages), prevents market from reaching equilibrium price

Binding price floor

minimum price that sellers can charge that is above equilibrium price (surpluses), prevents market from reaching equilibrium price

Quantity regulation

minimum or maximum quantity that can be sold

Mandate quantity regulation

minimum quantity that can be sold

Quota quantity regulation

maximum quantity that can be sold, causes prices to raise

Elasticity importance to sellers

do you raise prices or lower them to increase revenue?

Elasticity importance to policymakers

if you do something like impose a tax, will it hurt buyers or sellers more?

Point elasticity equation

(New-Old)/Old * 100%

Midpoint method equation

(New-Old)/Average * 100%

Elasticity

percentage change in something in response to a percentage change in something else

Price elasticity of demand

a measure of how responsive buyers are to price changes, measure by what percent the quantity demanded will change following a 1% change in price

Price elasticity of demand equation

(Percent change in quantity demanded)/(Percent change in price)

When PED>1

demand is elastic and the demand curve is not very steep (demand is highly impacted by price changes)

When PED<1

demand is inelastic and the demand curve is very steep (demand is barely impacted by price changes)

When PED=1

demand is unit elastic

When PED=0

demand is perfectly inelastic and the demand curve is a vertical line

When PED=∞

demand is perfectly elastic and the demand curve is a horizontal line

Slope does not equal elasticity

along a linear demand curve, as price decreases, demand gets less elastic

Determinants of the price elasticity of demand

elasticity is larger when there are more competing products, when it is a specific brand rather than a category of goods, when it is not a necessity, when consumers have more time to search, when there’s more time to adjust

Total Revenue Rule (TR Rule)

Total Revenue=Price*Quantity; if PED is elastic, a seller should decrease prices; if PED is inelastic, a seller should increase prices

Perfectly inelastic

there is no change in quantity in response to a change in the denominator

Perfectly elastic

there is an infinite change in quantity in response to a change in the denominator

Price Elasticity of Supply (PES)

PES=(percent change in quantity supplied)/(percent change in price); measures how responsive sellers are to price changes

Cross-price elasticity of demand (XED)

XED=(percent change in quantity demanded of good A)/(percent change in price of good B); measures how responsive the demand of one good is to price changes of another, positive for substitutes, negative for complements

Income elasticity of demand (YED)

YED=(percent change of quantity demanded)/(percent change in income); measure of how responsive the demand for a good is to changes in income, positive for normal goods, negative for inferior goods

Perfectly elastic supply

when percent change in quantity supplied is infinite for any change in price

Perfectly inelastic supply

when percent change in quantity supplied is zero for any change in price

Cross-price elasticity of demand number line

XED< -1; elastic strong complements

XED> -1; inelastic weak complements

XED= 0; goods are independent

XED< 1; inelastic weak substitute

XED> 1; elastic strong substitute

Income elasticity of demand number line

YED< -1; elastic luxury inferior good

YED> -1; inelastic necessity inferior good

YED< 1; inelastic necessity normal good

YED> 1; elastic luxury normal good

Implications of price elasticity of demand

Can: luxury or necessity (based on elasticity)

Can’t: inferior/normal, complement/substitute

Implications of price elasticity of supply

can make no implications about the type of good

Implications of income elasticity of demand

Can: luxury/necessity (based on elasticity), inferior/normal (based on sign)

Can’t: complement/substitute

Implications of cross-price elasticity of demand

Can: complement/substitute (based on sign), how complementary/substitutable (based on elasticity)

Can’t: inferior/normal

Just in time (JIT) inventory

management technique that has raw materials on hand “just in time” to produce to meet demand, inelastic supply

Using the market model as a tool

helps us model what happens to price and the amount exchanged (“sold”) when market conditions change, save us from memorization, helps us drop our assumptions and make our markets more complicated and realistic

Market

any setting that brings together potential buyers (demanders) and sellers (suppliers)

Economic system questions

1. What will be produced?

2. How much will be produced?

3. How will that production be allocated?

Types of economic systems

market economies (market is the answer to economic questions), command economies (central planner answers economic questions), and mixed economies (mix of both)

Factor market

market for different factors of production

Market equilibrium

quantity supplied is equal to quantity demanded, no incentive for buyers or sellers to alter their behavior, saying “market equilibrium” refers to equilibrium price and equilibrium quantity

Equilibrium price

price at which the quantity supplied equals the quantity demanded

Shortages

firms have an incentive to raise prices (and can do so), and higher prices mean fewer buyers are interested

Surpluses

firms have an incentive to lower prices which attracts more customers

Predicting market changes

intersection of market supply and demand curves determines the equilibrium price and quantity, can use to predict how prices (and quantities) will change when economic conditions change

Three-step recipe to predict market outcomes

1. Is the supply curve or demand curve (or both) shifting?

2. Is it an increase, shifting the curve to the right? Is it a decrease, shifting the curve to the left?

3. How will prices and quantities change in the new equilibrium?

Normal goods

income increases, demand increases

Inferior goods

income increases, demand decreases

When demand increases

the price and quantity increase

When demand decreases

the price and quantity decrease

When supply increases

the price decreases and the quantity increases

When supply decreases

the price increases and the quantity decreases

When supply AND demand shift

the conclusion for price/quantity will often be “it depends” and “stays the same” is almost never correct

Market economies

each individual makes their own production and consumption decisions, buying and selling in markets

Planned economies

centralized decisions are made about what is produced, how, by whom, and who gets what

Agents of markets

buyers (represented by demand) and sellers (represented by supply)

Perfectly competitive market aspects

many buyers, many sellers, sellers selling completely identical products, perfect information shared between buyers and sellers, free entry and exit; lead to believe buyers and sellers have no control over price

Demand

describes various quantites demanded at different prices, acts as “what if”, lists all of the different quantities a buyer wanted to purchase at a particular price, the whole demand curve, entire demand equation

Price

what is paid for an item in $

Quantity demanded

how much a buyer wants to purchase at all possible prices, point on demand curve, solving the equation for Q at a given price

Individual demand curve

a graph summarizing a set of plans, involves quantity demanded and price

Demand schedule

a table of prices and quantities demanded at each price

Demand equation

P=A-B*Q, where p is price and q is quantity

Anatomy of demand graph

label axes, label schedules (curves), put particular values on appropriate axes (not floating above curve)

Law of demand

The tendency for quantity demanded to be higher when price is lower (price and quantity demanded have an inverse relationship)

Market demand

describes demand for all buyers in a market, add all buyers demand for each price to solve for

Movement along the demand curve

movement from one point on a fixed demand curve to another point on same curve that is caused by a price change, change in quantity demanded by price

Shift in demand curve

movement of entire demand curve, caused by determinants, increase in demand curve is to the right, decrease in demand curve is to the left

Determinants of demand

changes in income, changes in preferences, changes in price of related goods, changes in expectations, congestion and network effect, type and number of buyers

Number of buyers (demand determinant)

more buyers, demand increases; fewer buyers, demand increases (positive relationship), only shifts market supply

Changes in preferences (demand determinant)

increases in preference, demand increases; decrease in preference, demand decreases (positive relationship)

Changes in expectations (demand determinant)

when buyers expect the price of something to increase in the future, they will buy more of it today

Changes in income (demand determinant)

when income increases, the demand for normal goods increase; when income increases, the demand for inferior goods decrease

Changes in prices of other goods (demand determinant)

price of good increases, demand for substitutes increase; price of good increases, demand for complements decrease

Network effect (demand determinant)

effect occurs when a good becomes more useful because others use it; if more people buy such a good, your demand for it will also increase

Congestion effect (demand determinant)

effect occurs when a good becomes less valuable because others use it; if more people buy such a product, your demand for it will decrease

Inferior good

a good for which higher income causes a decrease in demand

Normal good

a good for which higher income causes an increase in demand

Supply equation

P=A+BQ, where p is price and q is quantity

Quantity supplied

quantity that sellers are wiling to sell at a specific price