Principles of Microeconomics Ch 3-6

Markets

Institutions that bring buyers and sellers together

The Price System

-sends signals in free market economies

-market economies use prices to allocate resources, goods, and services

Demand

the max amount of a product that buyers are willing to purchase over some period at various prices (cerebus paribus)

What happens to quantity demanded as price increases?

decreases (moves along supply curve)

Law of Demand

consumers can afford more goods when prices are lower

Substitution effect

-price falls --> consumers buy more in place of alternative goods (less demand)

-price rises --> consumers buy more alternative goods (more demand)

Income effect

-increase in consumer income --> increase in demand

-decrease in consumer income --> decrease in demand

Demand schedule

table indicating quantities consumers are willing and able to purchase at each price

Market demand

a horizontal summation of all individual demand curves

Horizontal summation

adding the number of units of the product that will be purchased at each price by all consumers

Determinants of demand

nonprice factors that affect demand, held constant for demand curve

1. Tastes and preferences

2. Income

3. Price of related goods

4. Number of buyers

5. Expectations about future prices, income, and product availability

Tastes and preferences

trendy products --> increased demand

Normal goods

demand increases as incomes rise

Inferior goods

demand decreases as incomes rise

Substitute goods

price increase of good A --> increase demand of good B

Complementary goods

generally consumed together; if price of complement decreases, demand for original good increases

Number of buyers

more consumers in market --> demand increases

What happens when one or more of the determinants of demand change?

entire demand curve shifts

What is the one thing that causes change in quantity demanded?

change in product price (movement along demand curve)

Supply

the maximum amount of a product that sellers are willing and able to provide over some period at various prices

Law of supply

price and quantity supplied are positively related

Market supply curve

horizontal summation of individual supply curves

Determinants of supply

1. Production technology

2. Cost of resources

3. Prices of related commodities

4. Expectations about future

5. Number of sellers

6. Taxes and subsidies

Production technology

better tech lowers cost of production --> supply increases

Cost of resources

cost of resources (labor wages or raw materials) decreases --> supply increases

Prices of related commodities

increase in supply of electric cars --> decrease in supply of gas cars

Expectations

future rise in prices decreases supply now

Number of sellers

more producers --> supply increases

Taxes and subsidies

-increase in taxes --> supply decrease

-increase in subsidies --> supply increase

What happens when one or more of the determinants of supply change?

entire supply curve shifts

What is the one thing that can cause change in quantity supplied?

change in price of product (movement along supply curve)

Market Equilibrium

quantity supplied = quantity demanded

Surplus

-occurs when price is above market equilibrium

-consumer surplus shrinks

Shortage

-occurs when price is below market equilibrium

-producer surplus shrinks

What happens to equilibrium point if demand increases?

shifts up

What happens to equilibrium point if supply increases

shifts down

Alfred Marshall (1842-1924)

-Father of modern supply/demand analysis

-John Maynard Keynes' teacher

-noted that supply and demand go together like scissor blades that cross at equilibrium

Consumer surplus

-a measure of the net benefits consumers receive in the market

-price no greater than willingness to pay

How to calculate consumer surplus?

#willingness to pay - cost

-area under demand curve above market equilibrium

Producer surplus

-a measure of the net benefits producers receive in the market

-price no less than willingness to sell

How to calculate producer surplus?

#cost - willingness to sell

-area above supply curve under market equilibrium

Total surplus

-a measure of the overall net benefit gained from a market transaction

#consumer surplus + producer surplus

Deadweight loss

-the reduction in total surplus that results from the inefficiency of a market not in equilibrium

-total surplus falls

Paul Samuelson (1915-2009)

-won Nobel Prize in Economics in 1970 (first American)

-broad research interests; prolific writer

-developed MIT's economics department

-advised President Kennedy

Laissez-faire

-a market that is allowed to function without any government intervention

Governments sometimes intervene in markets

true

Price ceiling

-a maximum price established by the government for a product or service

-price ceiling below equilibrium --> shortage (binding)

#consumer want-quantity supplied = shortage of

-causes misallocation of resources

Misallocation of resources

-when a good or service is not consumed by the person who values it the most

-effect of price ceilings

Price floor

-a minimum price established by the government for a product or service

-price floor above equilibrium --> surplus (binding)

Market failure

-occurs when a free market does not lead to a socially desirable level of output

-caused by free market and societal discrepancies

Reasons for market failure

1. Lack of competition

2. Mismatch of information

3. Existence of externalities

4. Existence of public goods

Lack of competition

-leads to no one seller having the ability to raise price above competitors

-inefficient production

-leads to higher prices to consumers

Mismatch of information

-efficient markets have buyers and sellers that possess adequate information about products

-asymmetric information leads to prices being set too low or too high

Asymmetric information

when one party knows more about a product than the other (mismatch of information)

Existence of externalities

-external benefits or external costs generated by the actions of others

-leads to production and consumption of what people believe to be too much or too little of a good or service

Example of externalities

driving a car creates external costs in terms of traffic congestion and pollution, while obtaining a flu shot creates external benefits by reducing the probability of infecting others

Existence of public goods

-Goods that one person can consume without diminishing what is left for others

-nonrival and nonexclusive

nonrivalry

one person's consumption does not diminish others' benefit

nonexclusively

once a public good is provided, no one can be excluded from consuming

3 Key societal issues in market failure

1. Climate Change

2. Health Care

3. Education

Climate change

-illustrates a market failure because the actions that protect against climate change are costly, but the benefits are enjoyed by everyone

-Exhibits externalities: amount of carbon emissions emitted by countries vary significantly

Health care

-a service that is difficult to provide to everyone, especially when some people prefer not to buy health insurance

-External benefit with reducing sickness and therefore boosting worker productivity and overall happiness

-Rising costs as people live longer, experience more illnesses due to modern lifestyle factors, or have access to expensive treatments --> Creates an external cost as a large portion of budget is needed for healthcare

Education

-offers external benefits by making society more productive

* -Increasing educational opportunities requires subsidies that are paid for by government

Elasticity

measures the responsiveness of one variable to changes in another

Price elasticity of demand

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

- always a negative number so use absolute value

- larger number indicates greater elasticity

Formula for price elasticity of demand

# % change in quantity demanded / % change in price

Elastic demand

#Price elasticity of demand > 1

- responsive to price changes

-demand curves relatively flat

Inelastic demand

-Price Elasticity of Demand < 1

-Less responsive to price changes

-drugs that treat life threatening illnesses

Unitary Elastic

% change in quantity demanded = % change in price

Price elasticity of demand = 1

Determinants of elasticity

1. Availability of substitutes

2. The proportion of income spent on the product

3. Luxuries versus necessities

4. Time period

Availability of substitutes

-more substitutes for product --> easier to switch to competitors --> more elastic the demand

-Beef and Chicken, Coke and Pepsi

-Brand of gasoline is elastic, but gasoline as a product is inelastic

Proportion of income spent on product

smaller the % of household income spent on product, the lower the elasticity of demand

Luxuries vs necessities

luxuries tend to have more elastic demand than necessities

Time period

When consumers have time to adjust their consumption patterns, demand becomes more elastic and vice versa

Midpoint method for computing price elasticities

- allows percentage changes to be the same regardless of the change

# Ed =

((Q1-Q0)/

((Q0+Q1)/2)

/

((P1-P0)/

((P0+P1)/2)

Total revenue

#Price x Quantity demanded

-elastic demand: quantity changes are larger than price changes

--price rises-->quantity demanded falls and total revenue declines

-inelastic demand: price changes are larger than quantity changes

--price rises-->quantity demanded does not decline much and total revenue rises

-Unitary Elastic demand: quantity changes = price changes (price changes do not affect total revenue)

Total revenue is maximized when

demand is unitary elastic

Cross elasticity of demand

-measures how changes in the price of one good affect the demand for other related goods

# E_ab = %change in quantity demanded of product a / %change in price of product b

#Products a and b are substitutes if E_ab > 0

#Products a and b are complements if E_ab < 0

#Products a and b are not related if E_ab ~ 0

Income elasticity of demand

-measures how responsive quantity demanded is to changes in income

#E_y = %change in quantity demanded / % change in income

#Normal goods have (0 < E_y < 1)

#Luxury goods have (E_y > 1)

#Inferior goods have (E_y < 0)

Price elasticity of supply

-measures the responsiveness of quantity supplied to changes in the price of the product

-always positive

# E_s = %change in quantity supplied / % change in price

# elastic when E_s > 1 (curves always cross the price axis)

# inelastic when E_s < 1 (curves always cross the quantity axis)

# unitary elastic when E_s = 1 (curves always cross through origin)

Time and Price Elasticity of Supply

-Time is main determinant

-Supply becomes more elastic (flatter) over time from the short run to the long run

Market Period

-so short that the output and the number of firms in an industry are fixed

-firms have no time to change their production levels in response to changes in product price

Short Run

-period of time during which plant capacity and the number of firms cannot change

-firms can change amounts of labor, raw materials, and other variable inputs they employ in the short run to adjust their output levels

-supply curve more elastic than market period

Long Run

-period long enough for new firms to alter their plant capacity and for the number of firms in the industry to change

-supply curve more elastic than short run

Incidence of tax

-describes who bears the economic burden of a tax

-influenced by elasticity

Progressive tax

as income rises, income is taxed at a higher percentage

Flat tax

-tax is a fixed percentage regardless of income

-Medicare tax = 2.9%

Regressive tax

- tax becomes a smaller percentage as income rises

- social security tax capped at $136,000

- lump-sum tax takes a fixed amount of tax regardless of income

Excise taxes

-taxes placed on specific types of goods

-shifts supply curve left/upward, resulting in higher price

--vertical distance between curves = tax amount

- prices rise by less than full amount of tax as part of burden is shifted to consumers

Effect of Elasticity on tax burden

- For a given supply of some products, the lower the price elasticity of demand, the greater the share of the total tax burden shifted to consumers

- For a given demand of some products, the higher the price elasticity of supply, the greater the share of the total tax burden shifted to consumers

Greater burden on consumers

When demand for a good is inelastic while the supply of a good is elastic, consumers will end up bearing most of the burden of a tax

Greater burden on producers

When demand is elastic and supply is inelastic, producers will end up bearing most of the burden of a tax

Budget Line

combination of two goods that can be purchased with a given income, given the prices of each good

parallel shift of budget line to the right

Increase in income will result in

parallel shift of budget line to the left

increased expenses will result in

Marginal utility analysis

-studies consumer decision making in the face of budget constraints

-asserts that rational consumers will allocate their incomes to maximize their own well-being

Jeremy Bentham (1748-1832)

- social philosopher, legal reformer, and writer who founded utilitarianism philosophy

- idea of utility which explained consumer choices in terms of maximizing pleasure and minimizing pain

Utility

a hypothetical measure of the satisfaction one receives from consuming a good or service

Total Utility

the total satisfaction from consuming a given quantity of a good or service

Marginal Utility

- the additional satisfaction from consuming one more unit of a good or service

#T_u2 - T_u1

- declines as more of a particular product or activity is consumed