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Price elasticity of demand
Measures how responsive buyers are to price changes
Can drop the negative sign when reporting elasticity since the law of demand ensures price elasticities are always negative
% change in QD / % change in price
Inelastic vs elastic demand
Inelastic is when a decrease in price causes a small increase in QD <1
Elastic is when a decrease in price causes a big increase in QD >1
Elasticity along the demand curve
The curve is linear, therefore it has a constant slope, but that doesn’t mean the elasticity of demand is constant
Perfectly inelastic demand
If QD remains the same after the price changes, the price elasticity of demand is zero
Perfecty elastic demand
QD changes by an infinitely large % from a small price change
The price elasticity of demand is infinity
Unit elastic demand
If the % change in the QD = the % change in price, the price elasticity of demand is 1
Determinants of demand price elasticity
1 more competing products means greater price elasticity
2 specific brands are more price elastic than categories of goods
3 the demand for necessities is less price elastic
4 consumer search makes demand more price elastic
5 demand gets more price elastic over time
Total revenue of firm
= price x quantity
When the price of a good increases, the QD decreases
Total revenue increases/decreases depending on the relative % change in P & Q
Cross-price elasticity of demand
Measures how responsive the QD of a good is to changes in the price of another good
Positive = goods are substitutes
Negative = compliments
Close to zero = independent
% change in QD / % change in price of another good
Income elasticity of demand
Measures how responsive the QD of a good is to a change in consumers income
Positive or zero = normal good
Negative = inferior good
% change in QD / % change in income
Engel curves
Relates to a households total expenditure to the share spent on a particular good
Necessities = downward
Luxury = upward
Price elasticity of supply
Measures how responsive buyers are to price changes
Is always positive
% change in Q supplied / % change in price
Determinants of supply price elasticity
Critically depends on how flexible production is
1 output can be easily stored as inventory
2 variable inputs can be easily adjusted
3 fixed inputs are not being fully utilized, so there is excess capacity
4 low barriers to entry and exit of producers in the market
5 more time is allowed to pass since then all inputs can be adjusted
When is supply elastic?
If it is possible to increase inputs to stabilize output without increasing MC by a lot
Tax on buyers
Reduces consumers marginal benefit by the amount of tax, which reduces sales
Tax on buyers - economic burden
Distinguish between statutory burden and its economic burden
Tax on sellers
Statutory burden falls on sellers now
Increases MC to sellers by the amount of tax which shifts the supply curve up
Tax on sellers - economic burden
The economic burden of a tax is independent of its statutory burden
Tax incidence and price elasticity - supply
Economic burden of tax mostly falls on buyers
Buyers are unable or unwilling to avoid tax by substituting for an alternative good
Tax incidence and price elasticity - demand
Economic burden of tax mostly falls on sellers
Inflexible: unable to avoid tax
Effect of a subsidy
A payment made by the gov’t to a buyer OR seller to incentivize increased consumption = negative tax
Market demand curve shifts up
Effect of a price ceiling
Gov’t regulates a max price that sellers can charge
When the price ceiling falls below the free-market eq. price it is binding
SHORTAGES
Effect of a price floor
Gov’t regulates a min price that sellers can charge
When the price floor is above the free-market eq. price it is binding
SURPLUSES
Effect of a quota
Gov’t sets a max or min quantity that can be sold = quantity regulation
Quota = max quantity regulation
Policy analysis - positive
What can be expected to happen if the policy is adopted
Policy analysis - normative
Whether a policy should be adopted
Always requires making value judgements
Value judgements
Deciding whether the gains to some people in the economy that result from a gov’t intervention outweigh the losses to other people
Efficiency vs equity criterion
Need to measure how peoples welfare changes as a result of gov’t policy intervention when adopting a policy
An outcome is more economically efficient if it yields more total economic surplus over all people in the economy
Increasing economic efficiency doesn’t make everyone happy
Consumer surplus
The economic surplus you get from BUYING something
= MB - P
The area under the D curve and above the price, out to Q sold
Earn consumer surplus except the last item bought = marginal principle
Producer surplus
The economic surplus you get from selling somethinig
= P - MC
The area above the supply curve and bellow the price out to Q sold
Also marginal principle
Voluntary exchange and gains from trade
Makes buyer and seller better off = gain from trade
Economic surplus
= consumer surplus + producer surplus
(MB - P) + (P - MC)
The area between D&S curves to the left of the Q bought and sold
Efficient production
When the Q of output produced is produced at the lowest possible cost
Production is allocated across producers, and each unit of output is produced at the lowest possible MC
Efficient allocation
When the output produced is allocated to consumers in a way that maximizes total consumer surplus
Requires that the product produced goes to the consumer who gets the biggest MB from it
Efficient quantity
The Q of output that produced the largest possible economic surplus
Rational rule for markets
Continue to produce more if the MB exceeds the MC
Competitive markers are efficient bc of self-interest
Market failures
1 market power = barriers to entry, higher prices
2 externalities = choices affect economic surplus of others
3 imperfect information = private information
4 irrationality = rational rule not followed
5 gov’t regulation
Deadweight loss - underproduction
Economic surplus lost bc of market failure
Economic surplus obtained at efficient Q - actual Q
Deadweight loss - overproduction
Production exceeds the efficient Q
Size of dead-weight loss doesn’t depend on P, only Q
Absolute advantage
The ability of a country to produce a good or service at a lower cost or with higher efficiency than other countries
Comparative advantage
When a country can produce a good or service at a lower opportunity cost compared to another country. It allows for specialization and trade, leading to mutual benefits for both countries involved
Internal markets
The use of markets to allocate resources within organizations
The knowledge problem
When the knowledge needed to make an efficient decision isn’t available
Externality
A side effect that falls on bystanders
Uninvolved third party that arises as an effect of another party’s activity
Negative = harms bystanders
Positive = benefits bystanders
Is a price change an externality?
No, it reflects consequences of participants, not bystanders
That would be a direct effect not a side effect
External costs
When sellers make their production decisions, they consider the marginal private cost
Marginal private cost
Cost of producing 1 more
Decisions may impose external costs on bystanders
Marginal external cost
Extra cost
Imposed on bystanders from producing 1 more unit of output
Marginal social cost
= marginal private cost + marginal external cost
Favoured by society
Increases when output expands
External benefits
When buyers make their consumption decisions, they consider the marginal private benefit
Marginal private benefit
Benefit of 1 more unit of production
Decisions may impose external benefits on bystanders
Marginal external benefit
Extra benefit that accrues to bystanders from 1 more unit of ouput
Marginal social benefit
= marginal private benefit + marginal external benefit
Favoured by society
Socially optimal outcome
Most efficient for the WHOLE society
Occurs when marginal social benefit = marginal social cost
Rational rule for society
Says to produce more as long as the marginal social benefit is at least as large as the marginal social cost
Equilibrium outcome is socially inefficient
Competition in the free-market will result in an eq. price that equates S&D
Bystanders who may be affected by eq. play no role in its determination
Negative externalities lead to overproduction
Socially optimal quantity is lower than eq.Q
Eq.Q
Marginal social cost is greater than its marginal social benefit
Positive externalities lead to underproduction
The socially optimal Q is greater than eq.Q
Solutions to the externality problem
Consequence of decision-makers ignoring the well-being of bystanders
Solution #1 - private bargaining
Bystanders and decision-makers negotiate
A side payment will eliminate the externality
Coase theorem
Externality problem can be solved by private bargaining if it is costless and there are clear established property rights
Solution #2 - corrective taxes & subsidies
A corrective tax can induce people to take account of the negative externalities they create
Solution #3 - cap & trade
Gov’t can impose Q limit through a quota
Fixed # of permits: right to produce a certain Q
Allow producers to private trade permits
Solution #4 - LRR
Laws, rules, and regulations
Nonexcludable goods
When other people cannot be kept from enjoying the benefits of a good that I purchase
Nonrival goods
When my use or consumption of a good does not subtract from the benefit other people get from the good, the good is a nonrival good
Free-rider problem
Enjoy the benefits of a good without bearing the costs
Bystanders experiencing a positive externality, happens when a good is nonexcludable
Public goods
Nonrival and nonexcludable its BOTH
Prone to underproduction because benefits of free-riders are not taken into account
Solution #5 - gov’t provision
Solution to underprovision of public goods
Club goods
If businesses make public goods excludable, there is more incentive to provide them
MC = 0
MB = postive
Common resources
Goods that are rival but nonexludable
Private gain, but shared costs = negative externalities
Tragedy of commons
Consequence of common resources
Grazing but paying no cost is the tragedy, as the grass was overgrazed and didn’t grow back
Can be solved through private bargaining if there are ownership rights