ECON 101: Elasticity, Government Policy, and Welfare

Test 2

Planned Economy

An economic system where a central planner decides what, how, and who produces.

Market Economy

An economic system where buyers and sellers each decide freely, and prices coordinate their choices.

Elasticity

A metric that measures the responsiveness of 1 variable to changes in another variable.

Price Elasticity of Demand ($\varepsilon^d$)

Measures the responsiveness of quantity demanded ($Q^D$) to changes in price ($P$). Calculated as $\varepsilon^d = \left| \frac{\%\Delta Q^D}{\%\Delta P} \right|$, taking the absolute value because it is always negative, and has no units.

Midpoint Method (Price Elasticity of Demand)

A method used to calculate percentage changes that avoids the base effect: $\varepsilon^d = \frac{\frac{Q_1^D - Q_0^D}{\text{avg } Q^D}}{\frac{P_1 - P_0}{\text{avg } P}}$.

Perfectly Elastic Demand

A classification of demand where $\varepsilon^d = \infty$, represented graphically as a horizontal demand curve.

Elastic Demand

A classification of demand where $\varepsilon^d > 1$, meaning a small change in price leads to a large change in quantity demanded.

Unit Elastic Demand

A classification of demand where $\varepsilon^d = 1$.

Inelastic Demand

A classification of demand where $\varepsilon^d < 1$, meaning a small change in price leads to a small change in quantity demanded.

Perfectly Inelastic Demand

A classification of demand where $\varepsilon^d = 0$, represented graphically as a vertical demand curve.

Total Revenue ($TR$)

The total receipts of a firm, calculated as $\text{Price} \times \text{Quantity}$. When demand is elastic, price and total revenue move in opposite directions; when inelastic, price and total revenue move in the same direction; when unit elastic, total revenue is maximized.

Price Elasticity of Supply ($\varepsilon^s$)

Measures the responsiveness of quantity supplied ($Q^S$) to changes in price, calculated as $\varepsilon^s = \frac{\%\Delta Q^S}{\%\Delta P}$.

Cross-Price Elasticity of Demand ($\varepsilon^{xy}$)

Measures how the quantity demanded of good $x$ responds to changes in the price of good $y$ ($\varepsilon^{xy} = \frac{\%\Delta Q_x^D}{\%\Delta P_y}$). A positive value indicates substitutes, a negative value indicates complements, and zero indicates unrelated goods.

Income Elasticity of Demand ($\varepsilon^y$)

Measures the responsiveness of quantity demanded to changes in income, calculated as $\varepsilon^y = \frac{\%\Delta Q^D}{\%\Delta y}$.

Normal Good

A good for which income elasticity of demand is greater than zero ($\varepsilon^y > 0$).

Inferior Good

A good for which income elasticity of demand is less than zero ($\varepsilon^y < 0$).

Excise Tax

A per-unit tax imposed on a specific good (such as gas taxes or soda taxes) with the goals of raising revenue and decreasing the amount of the good exchanged on the market.

Statutory Burden

Designates which party (buyers or sellers) is legally responsible for sending the tax money to the government.

Economic Burden

Refers to who actually pays for the tax in terms of changes in prices; the party that is relatively less responsive to price changes (more inelastic) bears more of the burden.

Tax Incidence

How the economic burden of a tax is divided between buyers ($\frac{P^B - P^*}{t}$) and sellers ($\frac{P^* - P^S}{t}$).

Tax Wedge

The difference between the price paid by buyers and the price received by sellers created by a tax: $P^B - P^S = t$.

Subsidy

A payment made by the government each time a good or unit is exchanged, with the goal of increasing the consumption and production of that good.

Price Ceiling

The legal maximum price that businesses are allowed to charge for a good.

Binding Price Ceiling

A price ceiling set below the equilibrium price ($P^c < P^*$) that directly influences the market, resulting in a shortage ($Q^D > Q^S$), lineups, empty shelves, non-price rationing, and potential black markets.

Shortage

A market condition where quantity demanded exceeds quantity supplied ($Q^D > Q^S$), calculated as $Q^D - Q^S$.

Price Floor

The legal minimum price that businesses are allowed to charge for a good.

Binding Price Floor

A price floor set above the equilibrium price ($P^f > P^*$) that influences the market, creating a surplus ($Q^D < Q^S$), waste, non-price competition, and potential black markets.

Surplus (Market Condition)

A market imbalance where quantity supplied exceeds quantity demanded ($Q^D < Q^S$), calculated as $Q^S - Q^D$.

Mandate

A government-imposed minimum quantity of a good that must be exchanged in the market.

Quota

A government-imposed maximum quantity of a good that can be exchanged in the market.

Positive Analysis

Objective analysis that describes what is happening, explaining why it occurs, or predicting what will happen under a policy.

Normative Analysis

Subjective analysis involving value judgments that prescribes what should happen or which policy the government ought to adopt.

Economic Efficiency

The principle that an outcome is more efficient if it generates more economic surplus, defined as $\text{total benefits} - \text{total costs}$.

Efficiency Outcome

The market outcome that yields the largest possible economic surplus, maximizing the size of the economic pie.

Consumer Surplus ($CS$)

The economic surplus derived by buyers, calculated as marginal benefit minus price ($MB - P$); represented graphically as the area below the demand curve and above the market price.

Producer Surplus ($PS$)

The economic surplus derived by sellers, calculated as price minus marginal cost ($P - MC$); represented graphically as the area below the market price and above the supply curve.

Total Surplus ($TS$)

The total economic surplus generated in a market, calculated as $CS + PS = MB - MC$.

Market Failure

A situation where market forces of supply and demand lead to an inefficient outcome, caused by market power, externalities, informational issues, irrationality, or government regulation.

Deadweight Loss ($DWL$)

The reduction in economic surplus below the efficient outcome, calculated as $\text{economic surplus at efficient level} - \text{actual economic surplus}$.