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Economic Principles Review

Elasticities and Demand

  • Elasticities let us know how much demand (or supply) of a good changes in response to a price change.

    • Price Elasticity of Demand: Measures how quantity demanded reacts to a change in price, ignoring the minus sign.

    • Elastic Demand: If price elasticity > 1

    • Inelastic Demand: If price elasticity < 1

Income Elasticity

  • Income Elasticity of Demand: Measures how quantity demanded changes with income.

    • Greater than 1: income elastic, classified as a normal good.

    • Between 0 and 1: income inelastic, also a normal good.

    • Less than 0: classified as an inferior good.

Cross Price Elasticity

  • Cross (Price) Elasticity of Demand: Measures how the quantity demanded of one good reacts to price changes of another good.

    • Positive Cross Elasticity: Indicates substitute goods.

    • Negative Cross Elasticity: Indicates complementary goods.

Example Problem 1: Price Elasticity Calculation

  • Scenario: The price of Diet Coke rises from $0.75 to $1.25, and the quantity demanded falls from 180 to 140 units.

    • Price Elasticity Calculation: Explanatory Formula:



    • ext{Price Elasticity of Demand} = rac{ ext{Percentage Change in Quantity Demanded}}{ ext{Percentage Change in Price}}

Example Problem 2: Income Elasticity Calculation

  • Scenario: Following a price increase, income increases from $100 to $200 and the consumption of Diet Coke rises to 340 units.

    • Calculate the income elasticity using:



    • ext{Income Elasticity} = rac{ ext{Percentage Change in Quantity Demanded}}{ ext{Percentage Change in Income}}

Example Problem 3: Cross-Price Elasticity Calculation

  • Scenario: The quantity demanded of coffee increases from 50 to 70 units after a price change.

    • Calculate using:



    • ext{Cross-Price Elasticity} = rac{ ext{Percentage Change in Quantity Demanded of Coffee}}{ ext{Percentage Change in Price of Another Good}}

Resource Allocation Methods

Different Methods of Allocating Scarce Resources

  • Allocation methods include:

    • Market price

    • Command

    • Majority rule

    • Contest

    • First-come, first-served

    • Lottery

    • Personal characteristics

    • Force

Market Price

  • Allocates scarce resources to those willing to pay.

    • People generally buy goods and services in markets.

    • The market effectively and efficiently allocates resources for most goods and services.

Command

  • Allocates resources according to orders from an authority.

    • Effective in organizations with clear lines of authority.

    • Ineffective for entire economies due to lack of flexibility.

Majority Rule

  • Allocates resources based on majority preferences.

    • Useful for societal decisions, e.g., tax rates.

    • Works better when self-interest is suppressed for overall efficiency.

Contest

  • Allocates resources among winners of competitions.

    • Examples: sporting events, awards.

    • Suitable when efforts are hard to monitor.

First-Come, First-Served

  • Allocates resources to those who arrive first.

    • Commonly used in casual dining and supermarket checkouts.

    • Best for resources that can serve one person at a time.

Lottery

  • Allocates resources through chance.

    • Used in state lotteries, casino games, and airport landing slots.

    • Effective when distinguishing between potential users is not feasible.

Personal Characteristics

  • Allocates resources based on attributes perceived as beneficial.

    • Examples: choosing marriage partners.

    • Can lead to unacceptable discrimination (e.g., racial or gender biases).

Force

  • Allocates resources through coercion or compulsion.

    • Historically significant in war and theft.

    • Can facilitate transfers of wealth to promote certain economic actions.

Demand, Value, and Willingness to Pay

Key Concepts

  • Value: Benefits received from a good.

  • Price: The monetary amount spent for goods or services.

  • The value of one more unit is defined as its Marginal Benefit.

  • Willingness to Pay: The maximum price a consumer is willing to pay for a good, which determines demand.

  • A demand curve acts as a marginal benefit curve.

Individual Demand and Market Demand

  • Individual Demand: Relationship between price and quantity demanded by an individual.

  • Market Demand: Relationship between price and quantity demanded by all buyers collectively.

Demand Examples

  • Consider Lisa and Nick:

    • Lisa buys 30 slices of pizza at $1 a slice.

    • Nick buys 10 slices at the same price.

    • Together, their market demand is for 40 slices.

Market Demand Curve

  • The market demand curve is represented as the horizontal sum of individual demand curves.

    • Graph illustrates the total quantity demanded at varying prices.

Consumer Surplus

Definition

  • Consumer Surplus: The difference between the benefit received from a good and the payment made for it.

    • Calculated as the marginal benefit minus the price across the quantity purchased.

    • Visual representation is the area under the demand curve and above the price, up to the quantity bought.

Example of Consumer Surplus Calculation

  • Scenario: Lisa at $1 per slice and a value on the 10th slice of $2.

    • Consumer surplus: 2 - 1 = 1 (from the 10th slice).

  • For Lisa buying 30 slices and Nick buying 10, their consumer surplus accumulates under the market demand curve.

Producer Surplus

Definition

  • Producer Surplus: The excess amount received from the sale over the cost of production.

    • Calculated as price received minus minimum supply price (marginal cost) for sold units.

    • Area representation is below market price and above the supply curve up to the quantity sold.

Example of Producer Surplus Calculation

  • Scenario: At $15 per pizza, if Maria is willing to produce the 50th pizza for $10, the surplus is 15 - 10 = 5 for that unit.

Market Efficiency and Failures

Competitive Equilibrium

  • Efficiency achieved when quantity demanded equals quantity supplied.

    • Marginal social benefit (MSB) aligns with marginal social cost (MSC) at equilibrium.

    • Produces maximum total surplus (sum of consumer and producer surplus).

Market Failures

  • Occurs when markets do not achieve efficient outcomes.

  • Reasons include:

    • Underproduction: Producing less than efficiency.

    • Overproduction: Producing more than efficiency.

    • Externalities: Costs or benefits affecting others outside the direct transaction.

    • Public Goods: Items that are non-excludable and non-rivalrous leading to free-riding issues.

    • Monopolies: Sole providers producing less than socially optimal amounts.

    • High Transaction Costs: Costs of market operation prevent efficient exchanges.

Alternatives to Market Outcomes

  • Non-market methods may sometimes allocate resources better.

    • Majority rule, command, and first-come-first-served can supplement market mechanisms, though with their own drawbacks.

Fairness and Economic Outcomes

Utilitarianism & Fairness

  • Utilitarianism: Philosophical idea that efficiency often hinges on equitable distribution of income.

  • Equal income distribution leads to maximized collective benefit.

Symmetry Principle

  • States that individuals in similar circumstances should be treated similarly in economic systems.

    • Encourages equality of opportunity over equality of outcome.

Water Pricing Example

  • Residential vs. agricultural pricing for water raised fairness questions and efficiency analysis of proposed adjustments.