ECON 101: CH. 5, 6, 7, 8, 10 - TERMS NO GRAPHS

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