What is Economics?
Econ111 – Semester 1 Notes Chapter One: What is Economics? Definition of Economics Scarcity Choice Incentives Our inability to satisfy all our wants is called scarcity. Simply, having limited resources with unlimited wants. E.g. time, resources… Because we face scarcity, we must make choices. The choices that we make depend on incentives. These are rewards that encourage or penalties that discourage an action. Economics is the social science that studies the choices that people and institutions make as they cope with scarcity and the incentives that influence these choices. Microeconomics: the study of choices that individuals and businesses make, the way these choices interact in the market and the influence of governments. That is, individual decision making and how people go about them. Macroeconomics: the study of the performance of the national and global economies. “The science of constrained choice” Economic Questions Goods are physical objects e.g computer Services are tasks performed for people e.g haircut What goods and services will be produced? G&S that satisfy demands and needs of customers How will goods and services be produced? By using factors of production - Land: ‘gifts of nature’. Natural resources. Includes metals, oil, natural gas, and coal. Some are renewable, recyclable or nonrenewable. - Labour: Physical and mental efforts that people devote to producing goods and services. The quality of labour depends on human capital – the knowledge and skill people acquire from education and experience. - Capital: tools, instruments, machines etc that businesses use to produce goods and services. - Entrepreneurship: human resource that organizes the land, labour and capital to produce goods and services. For Whom are the goods and services produced? Dependant on the income that people earn and the prices of the goods and services that they buy. People earn income on the factors of production that they own - Land earns rent - Labour earns wages - Capital earns interest - Entrepreneurship earns profit
The Economic Way of Thinking Choices and Tradeoffs Scarcity requires making choices. Every choice involves an exchange – a tradeoff. What tradeoffs – how to spend incomes, what to produce e.g coke gave up 3L of water for one bottle. How tradeoffs – choosing alternative production techniques For whom tradeoffs – who has stronger buying power, which target market. Opportunity cost The highest valued alternative that we must give up in order to obtain another. Choosing at the Margin Marginal benefit (MB): benefit from an increase in activity. Marginal Cost (MC): cost from an increase in activity. If MB > MC, you have an incentive to increase activity If MB < MC, you have a disincentive to increase activity. Economics as a social science Two statements: Positive statement: can be tested against facts. It tells WHAT IS. Normative statement: cannot be tested. It tells WHAT OUGHT TO BE. To answer positive statements, economists use models eg natural experiments, statistical investigation and economic experiments. Chapter Two: The Economic Problem Production Possibilities and Opportunity Cost Quantity of G&S are limited by both available resources and technology. Production Possibility Frontier (PPF) is the boundary between those combinations of G&S that can be produced and those that cannot, given the availability of resources. Demonstrates scarcity of resources, as the points beyond the curve cannot be attained. Points inside the curve are attainable but inefficient as resources are either unused or misallocated. Points along the curve are efficient. Every choice along the PPF involves a tradeoff OC of pizza is the cola forgone (visa versa) OC of the one product is the inverse of the other. Concave: as all resources are not equally productive. Bow outward: as quantity increases, so does OC.
Production Possibilities Frontier and Marginal Cost Marginal cost of a good or service is the opportunity cost of producing one more unit of it.
PPF and Marginal Benefit Marginal benefit is measured by the amount customers are “willing to pay”. General principle of decreasing marginal benefit: the more of something we have, the less we are willing to pay for an extra unit of it.
Point of allocative efficiency: where MB = MC. That is, where the OC for producers = willingness to pay by customers Generally, MC = supply, MB = demand.
Economic Growth EG is the expansion of production – ultimately increasing standard of living. This does NOT overcome scarcity or avoid OC. Results in expansion out or even shift of PPF. Comes from: - Technological change: development of new goods and of better ways of producing goods - Capital accumulation: growth of capital resources, including human capital. It is NOT free – comes with a cost. To use resources in research and development, we must decrease our current consumption
Gains from Trade Producing one good – specialization. Comparative advantage: performing at a lower OC Absolute advantage: being more productive, using fewer resources. Trade allows for extra consumption outside of the PPF without economic growth Dynamic comparative advantage – “learning-by-doing”– a comparative advantage that a person has acquired by specializing in an activity and eventually gaining dynamic absolute advantage Chapter Three: Demand and Supply Markets and Prices - Market: any arrangement that enables buyers and sellers to trade Competitive market: many buyers and sellers so no single buyer or seller can influence the price Money price – number of dollars needed to purchase the good Relative price - the ratio of its money price to the money price of the next best alternative – opportunity cost Demand Want it, can afford it, definite plan to buy it Unlimited desires or wishes people have for a good or service Demand – relationship between price and quality demanded Quantity demanded – amount consumers plan to buy – measured as an amount per unit of time Law of demand: - Higher the price, smaller the quantity demanded - Lower the price, larger the quantity demanded Law of demand results from: - Substitution effect – when the relative price of a good increases (OC), people seek substitutes for this product and as a result, there is a decrease in the quantity demanded - Income effect – when the relative price of a good rises relative to income, people cannot afford all the things they previously bought, as a result there is a decrease in the quantity demanded Demand curve and demand schedule Assuming ceteris paribus, the demand curve shows the relationship between the quantity demanded of a good (x-axis) and the price (yaxis) As price increases, quantity demanded decreases Willingness and ability to pay = demand curve = measure of MB Change in demand Change in relationship between price and quantity demanded Whenever anything (other than the price of the good) changes, there is a change in the demand When demand increases, the curve shifts rightward When demand decreases, the curve shifts leftward
Due to 6 main factors: - The prices of related goods – i.e the price of substitutes and compliments. o If substitute price rises, demand for product increases. o If complement price rises, demand for product decreases. - Expected future prices – if the price of a good is expected to rise in the future, the demand increases NOW - Income - when income increases, demand increases as people can afford to by more products. o Normal good – one for which demand increases as income increases o Inferior good – demand decreases as income increases e.g. “homebrand” goods - Expected future income – when income is expected to increase in the future, the demand might increase now – as they will have credit to pay off debt in the near future - Population – larger the population, the greater the demand is for all goods and services - Preferences - demand depends on preferences. It determines the value that people put on each good and service. Change in the quantity demanded VS a change in demand Change in demand is a shift of the demand curve Change in quantity demanded is a movement up or down along the demand curve (price of the good changes) Supply Has the resources and technology to produce it, can profit from producing it, has made a definite plan to produce and sell it. Supply – reflects a decision about which technologically feasible items to produce. Relationship between the quantity supplied and the price of a good. Quantity supplied – amount that producers plan to sell during a given time period at a particular price. Not always the same as the amount sold! Law of supply: - The higher the price of the good, the greater is the quantity supplied - The lower the price of a good, the smaller is the quantity supplied Law of supply results from: - General tendency for the MC to increase as quantity produced increases - Producers are willing to supply a good only if they can cover their MC of production. Supply curve and supply schedule Assuming ceteris paribus, the supply curve shows the relationship between the quantity supplied of a good and its price “Minimum supply price”- the lowest price at which someone is willing to sell = MC
As quantity produced increases, MC rises Change in supply Whenever anything (other than price of the good) changes, there is a change in supply When supply increases, curve shifts rightward When supply decreases, curve shifts leftward Due to 6 main factors: - The prices of factors of production – if the price of factors of production increases, the supply of the good decreases - The prices of related goods produced: o if the price of substitutes rise, the supply of product decreases. o If the price of compliments rises, the supply of the good increases. - Expected future prices - if the price of a good is expected to rise in the future, supply NOW decreases - The number of suppliers - the larger the number of firms that produce a good, the greater is the supply of a good - Technology – new methods/advances in technologies increase supply - The state of nature – natural forces that influence production. Drought decreases supply while good weather can increase supply in agriculture. Change in the quantity supplied VS change in supply Change in supply is a shift of the supply curve Change in the quantity supplied is a movement up or down along the supply curve (price of good changes) Market equilibrium A situation in which opposing forces balance each other When the price balances the plans of the buyers and sellers Equilibrium price – price at which the quantity demanded equals the quantity supplied Equilibrium quantity – quantity bought and sold at the equilibrium price Price regulates buying and selling plans Price adjusts when plans don’t match Shortages make the price rise Surplus makes the price fall Price as a regulator Price of a good regulates the quantities demanded and supplied There is one price at which the quantity demanded equals the quantity supplied Price adjustments At prices above the equilibrium price, a surplus (more supply than demand) forces the price down At prices below the equilibrium, a shortage forces the prices up
Price adjustments When demand increases, both the price and the quantity increase When the demand decreases, both the price and the quantity decrease When supply increases, the quantity increases and the price falls When supply decreases, the quantity decreases and the price rises (FOR SUMMARY SEE PAGE 72 IN TEXT BOOK) Chapter Four: Elasticity Price elasticity of Demand Units-free measure of the responsiveness of the quantity demanded of a good to a change in its price (given ceteris paribus) Calculating price elasticity of demand % Change in quantity demanded / % change in price Always take the absolute value Point Formula: o Change in price as percentage of original price and change in quantity demanded as a percentage of the original quantity demanded. o % Change in Qd / % change in P = (P original / Q original) x (change in Qd / change in P) Note: change in Qd / change in P = 1 / slope. o Dependant on direction of price changes o Preferred method as it is based on the original Midpoint Formula: o Change in price as a percentage of the average price and change in quantity demanded as a percentage of the average quantity demanded o % Change in Qd / % change in P = (Average price / average quantity) x (change in Qd / change in P) o Dependant on average price and average quantity o Gives approximate responsiveness Elastic and inelastic Demand If quantity demanded changes by an infinitely large percentage in response to a tiny price change – this is perfect elastic demand If the percentage change in the quantity demanded equals the percentage change in the price – elasticity equals 1 and this is known as unit elastic If the quantity demanded remains constant when the price changes – elasticity equals 0 and this is perfectly inelastic demand If the percentage change in Qd < percentage change in P – inelastic if the percentage change in Qd > percentage change in P – elastic
Elasticity along a straight-line demand curve At the midpoint of the curve, the demand is unit elastic Above the midpoint, demand is elastic Below the midpoint, demand is inelastic Total revenue and elasticity ------ FIX TR = P x Q Total revenue = price of good x quantity sold Increasing price: o If demand is elastic, increase in total revenue o If demand is inelastic, decrease in total revenue o If demand is unit elastic, total revenue stays constant Decreasing price: o If demand is elastic, decrease in total revenue o If demand is inelastic, increase in total revenue o If demand is unit elastic, total revenue stays constant Factors that influence the elasticity of demand The closeness of substitutes o A good with close substitutes has an elastic demand o Necessities – poor substitutes - more inelastic o Luxuries – many substitutes - more elastic The proportion of income spent on the good o The greater the proportion of income spent on the good, the more elastic is the demand for it The time elapsed since a price change o The more time consumers have to adjust to a price change the more elastic is the demand for that good Cross Elasticity of Demand A measure of responsiveness of demand for a good to a change in the price of a substitute or complement (assuming ceteris paribus) Percentage change in quantity demanded / percentage change in price of a substitute or complement Cross elasticity of demand for a substitute is positive Cross elasticity of demand for a complement is negative Cross elasticity = 0, unrelated products Income Elasticity of Demand A measure of how the quantity demanded of a good responds to a change in income (assuming ceteris paribus) Percentage change in quantity demanded / percentage change in income Greater than 1 – normal good, income elastic – percentage of income spent on that good increases as income increases Positive and less than 1 – normal good, income inelastic – percentage of income spent on that good decreases as income increases Negative – inferior good
Elasticity of Supply A measure of responsiveness of the quantity supplied to a price change Percentage change in quantity supplied / percentage change in price Inelastic and Elastic Supply Perfectly inelastic – elasticity = 0, vertical line Unit elastic – elasticity = 1, linear line passing through origin Perfectly elastic – elasticity = infinite, horizontal line Factors that influence elasticity of Supply Elasticity of supply depends on: o Resource substitution possibilities – the easier it is to substitute among the resources used to produce a good or service, the greater is its elasticity of supply. Lots of substitutes = highly elastic. o Time frame for the supply decision – the more time that passes after a price change, the greater is the elasticity of supply. Momentary supply – immediately following the price change. Perfectly inelastic. Short-run supply (1-12 months) – somewhat elastic Long-run supply – most elastic SEE TEXT BOOK PAGE 97 FOR ELASTICITY! Chapter Five: Efficiency Resource Allocation The ability of markets to allocate resources efficiently and fairly Market price: o When a market allocates a scarce resource, the people who get the resource are those willing to pay the market price Demand, Willingness to Pay, and Value Value – what we get Price – what we pay Value of one more unit of a good is its marginal benefit Marginal benefit – maximum price that someone is willing to pay Willingness to pay determines demand Demand curve = marginal benefit curve Individual Demand and Market Demand Individual demand – the relationship between the price of a good and the quantity demanded by one person Market demand – the relationship between the price of a good and the quantity demanded by all buyers in the market Market demand curve = marginal social benefit
Consumer surplus Consumer surplus – the value of a good minus the price paid for it, summed over the quantity bought When you buy something for less than it is worth to you Measured by the area under the demand curve and above the price paid, up to the quantity bought Market demand curve is the horizontal sum of the individual demand curves
Minimum Supply Price To make profit, they must sell their output for a price that exceeds the cost of production Cost is what a producer gives up Price is what a producer receives Marginal cost is the minimum price that a firm is willing to except Minimum supply price determines supply Supply curve = marginal cost curve Individual Supply and Market Supply Individual supply – the relationship between the price of a good and the quantity supplied by one producer Market supply – the relationship between the price of a good and the quantity supplied by all producers in the market Market supply curve is the horizontal sum of the individual supply curves Producer Surplus The price received for a good minus the minimum-supply price (marginal cost), summed over the quantity sold Measured by the area below the market price and above the supply curve, summed over the quantity sold
Consumer surplus and producer surplus can be used to measure the efficiency of a market Competitive Equilibrium and Efficiency Resources are allocated efficiently when they are used in the ways that people value most highly i.e. when marginal social benefit = marginal social cost Competitive equilibrium – the quantity demanded = quantity supplied At the equilibrium quantity, marginal benefit equals marginal cost, so the quantity is the efficient quantity. When the efficient quantity is produced, total surplus (the sum of consumer surplus and producer surplus) is maximized. Market Failure – Underproduction and Overproduction Market failure – when the market does not operate at an efficient competitive equilibrium Inefficient market – produce too little of an item (underproduction) or too much (over production) Deadweight loss – decrease in total surplus that results from an inefficient level of production Deadweight loss is a social loss – its borne by society – represented by the area between equilibrium price and the underproduction ‘line’ or overproduction ‘line’ (triangular area) When deadweight loss is not equal to zero – society experiences a loss Chapter Six: Government Actions in Markets Price Ceiling Price ceiling or price cap is a regulation that makes it illegal to charge a price higher than a specified level If price ceiling > the equilibrium price no effect If price ceiling < the equilibrium price powerful effects: shortages and inefficiencies E.g. rent Increased search activity The time spent looking for someone with whom to do business Search activity increases when the price is regulated and there is a shortage It is costly
OC of housing = rent (regulated) plus the OC of search activity (unregulated) Black market An illegal market that operates alongside a legal market in which a price ceiling or other restriction has been imposed Shortage of housing creates a black market Illegal arrangements are made between renters and landlords at rents above the rent ceiling – and generally above what the rent would have been in an unregulated market Inefficiency of Rent Ceilings A rent ceiling set below the equilibrium rent leads to an inefficient underproduction of housing services The marginal social benefit from housing services exceeds its marginal social cost and a deadweight loss arises Rent ceiling decreases the quantity of housing supplied to less than the efficient quantity Producer surplus shrinks Consumer surplus shrinks Increased search activity
Price Floor Price floor is a regulation that makes it illegal to trade at a price lower than a specified level Price floor < equilibrium price no effect Price floor > equilibrium price powerful effects: surpluses and inefficiencies E.g. minimum wage A LABOUR MARKET WITH A MINIMUM WAGE If the minimum wage is set above the equilibrium wage rate, the quantity of labour supplied by workers exceeds the quantity demanded by employers o There is a surplus of labour
o The quantity of labour hired at the minimum wage is less than the quantity that would be hired in an unregulated labour market o Because the legal wage rate cannot eliminate surplus, the minimum wage creates unemployment Inefficiency of a minimum wage
Minimum wage leads to an inefficient outcome The supply of labour measures the marginal social cost of labour – OC of labour forone The demand for labour measures the marginal social benefit form labour – value of the goods produced TAXES Everything you earn and most things that you buy are taxed Income tax – deducted from your pay GST – added to the price of most things you buy Tax incidence – the division of the burden of tax between buyers and sellers When an item is taxed, it may rise by the full amount of tax, by a lesser amount, or not at all o If the price rises by the full amount of the tax, buyers pay the tax o If the price rises by a lesser amount than the tax, buyers and sellers share the burden of the tax o If the price doesn’t rise at all, sellers pay the tax Tax incidence doesn’t depend on the law, it depends on the supply and demand of the market and elasticity of demand and supply Tax division and elasticity of demand The division of the tax between buyers and sellers depends on the elasticities of demand and supply Perfectly inelastic demand – buyer pays the entire tax Perfectly elastic demand – seller pays the entire tax The more inelastic the demand, the larger is the buyer’s share of the tax
Perfectly inelastic demand Demand curve is vertical When a tax is imposed on this good, buyers pay the entire tax
Perfectly elastic demand Demand curve is horizontal When a tax is imposed on this good, sellers pay the entire tax
Tax division and elasticity of supply Perfectly inelastic supply – sellers pay the entire tax Perfectly elastic supply – buyers pay the entire tax The more elastic the supply, the larger is the buyer’s share of the tax Perfectly inelastic supply Supply curve is vertical When a tax is imposed on the good, sellers pay the entire tax
The Economic Way of Thinking Choices and Tradeoffs Scarcity requires making choices. Every choice involves an exchange – a tradeoff. What tradeoffs – how to spend incomes, what to produce e.g coke gave up 3L of water for one bottle. How tradeoffs – choosing alternative production techniques For whom tradeoffs – who has stronger buying power, which target market. Opportunity cost The highest valued alternative that we must give up in order to obtain another. Choosing at the Margin Marginal benefit (MB): benefit from an increase in activity. Marginal Cost (MC): cost from an increase in activity. If MB > MC, you have an incentive to increase activity If MB < MC, you have a disincentive to increase activity. Economics as a social science Two statements: Positive statement: can be tested against facts. It tells WHAT IS. Normative statement: cannot be tested. It tells WHAT OUGHT TO BE. To answer positive statements, economists use models eg natural experiments, statistical investigation and economic experiments. Chapter Two: The Economic Problem Production Possibilities and Opportunity Cost Quantity of G&S are limited by both available resources and technology. Production Possibility Frontier (PPF) is the boundary between those combinations of G&S that can be produced and those that cannot, given the availability of resources. Demonstrates scarcity of resources, as the points beyond the curve cannot be attained. Points inside the curve are attainable but inefficient as resources are either unused or misallocated. Points along the curve are efficient. Every choice along the PPF involves a tradeoff OC of pizza is the cola forgone (visa versa) OC of the one product is the inverse of the other. Concave: as all resources are not equally productive. Bow outward: as quantity increases, so does OC.
Production Possibilities Frontier and Marginal Cost Marginal cost of a good or service is the opportunity cost of producing one more unit of it.
PPF and Marginal Benefit Marginal benefit is measured by the amount customers are “willing to pay”. General principle of decreasing marginal benefit: the more of something we have, the less we are willing to pay for an extra unit of it.
Point of allocative efficiency: where MB = MC. That is, where the OC for producers = willingness to pay by customers Generally, MC = supply, MB = demand.
Economic Growth EG is the expansion of production – ultimately increasing standard of living. This does NOT overcome scarcity or avoid OC. Results in expansion out or even shift of PPF. Comes from: - Technological change: development of new goods and of better ways of producing goods - Capital accumulation: growth of capital resources, including human capital. It is NOT free – comes with a cost. To use resources in research and development, we must decrease our current consumption
Gains from Trade Producing one good – specialization. Comparative advantage: performing at a lower OC Absolute advantage: being more productive, using fewer resources. Trade allows for extra consumption outside of the PPF without economic growth Dynamic comparative advantage – “learning-by-doing”– a comparative advantage that a person has acquired by specializing in an activity and eventually gaining dynamic absolute advantage Chapter Three: Demand and Supply Markets and Prices - Market: any arrangement that enables buyers and sellers to trade Competitive market: many buyers and sellers so no single buyer or seller can influence the price Money price – number of dollars needed to purchase the good Relative price - the ratio of its money price to the money price of the next best alternative – opportunity cost Demand Want it, can afford it, definite plan to buy it Unlimited desires or wishes people have for a good or service Demand – relationship between price and quality demanded Quantity demanded – amount consumers plan to buy – measured as an amount per unit of time Law of demand: - Higher the price, smaller the quantity demanded - Lower the price, larger the quantity demanded Law of demand results from: - Substitution effect – when the relative price of a good increases (OC), people seek substitutes for this product and as a result, there is a decrease in the quantity demanded - Income effect – when the relative price of a good rises relative to income, people cannot afford all the things they previously bought, as a result there is a decrease in the quantity demanded Demand curve and demand schedule Assuming ceteris paribus, the demand curve shows the relationship between the quantity demanded of a good (x-axis) and the price (yaxis) As price increases, quantity demanded decreases Willingness and ability to pay = demand curve = measure of MB Change in demand Change in relationship between price and quantity demanded Whenever anything (other than the price of the good) changes, there is a change in the demand When demand increases, the curve shifts rightward When demand decreases, the curve shifts leftward
Due to 6 main factors: - The prices of related goods – i.e the price of substitutes and compliments. o If substitute price rises, demand for product increases. o If complement price rises, demand for product decreases. - Expected future prices – if the price of a good is expected to rise in the future, the demand increases NOW - Income - when income increases, demand increases as people can afford to by more products. o Normal good – one for which demand increases as income increases o Inferior good – demand decreases as income increases e.g. “homebrand” goods - Expected future income – when income is expected to increase in the future, the demand might increase now – as they will have credit to pay off debt in the near future - Population – larger the population, the greater the demand is for all goods and services - Preferences - demand depends on preferences. It determines the value that people put on each good and service. Change in the quantity demanded VS a change in demand Change in demand is a shift of the demand curve Change in quantity demanded is a movement up or down along the demand curve (price of the good changes) Supply Has the resources and technology to produce it, can profit from producing it, has made a definite plan to produce and sell it. Supply – reflects a decision about which technologically feasible items to produce. Relationship between the quantity supplied and the price of a good. Quantity supplied – amount that producers plan to sell during a given time period at a particular price. Not always the same as the amount sold! Law of supply: - The higher the price of the good, the greater is the quantity supplied - The lower the price of a good, the smaller is the quantity supplied Law of supply results from: - General tendency for the MC to increase as quantity produced increases - Producers are willing to supply a good only if they can cover their MC of production. Supply curve and supply schedule Assuming ceteris paribus, the supply curve shows the relationship between the quantity supplied of a good and its price “Minimum supply price”- the lowest price at which someone is willing to sell = MC
As quantity produced increases, MC rises Change in supply Whenever anything (other than price of the good) changes, there is a change in supply When supply increases, curve shifts rightward When supply decreases, curve shifts leftward Due to 6 main factors: - The prices of factors of production – if the price of factors of production increases, the supply of the good decreases - The prices of related goods produced: o if the price of substitutes rise, the supply of product decreases. o If the price of compliments rises, the supply of the good increases. - Expected future prices - if the price of a good is expected to rise in the future, supply NOW decreases - The number of suppliers - the larger the number of firms that produce a good, the greater is the supply of a good - Technology – new methods/advances in technologies increase supply - The state of nature – natural forces that influence production. Drought decreases supply while good weather can increase supply in agriculture. Change in the quantity supplied VS change in supply Change in supply is a shift of the supply curve Change in the quantity supplied is a movement up or down along the supply curve (price of good changes) Market equilibrium A situation in which opposing forces balance each other When the price balances the plans of the buyers and sellers Equilibrium price – price at which the quantity demanded equals the quantity supplied Equilibrium quantity – quantity bought and sold at the equilibrium price Price regulates buying and selling plans Price adjusts when plans don’t match Shortages make the price rise Surplus makes the price fall Price as a regulator Price of a good regulates the quantities demanded and supplied There is one price at which the quantity demanded equals the quantity supplied Price adjustments At prices above the equilibrium price, a surplus (more supply than demand) forces the price down At prices below the equilibrium, a shortage forces the prices up
Price adjustments When demand increases, both the price and the quantity increase When the demand decreases, both the price and the quantity decrease When supply increases, the quantity increases and the price falls When supply decreases, the quantity decreases and the price rises (FOR SUMMARY SEE PAGE 72 IN TEXT BOOK) Chapter Four: Elasticity Price elasticity of Demand Units-free measure of the responsiveness of the quantity demanded of a good to a change in its price (given ceteris paribus) Calculating price elasticity of demand % Change in quantity demanded / % change in price Always take the absolute value Point Formula: o Change in price as percentage of original price and change in quantity demanded as a percentage of the original quantity demanded. o % Change in Qd / % change in P = (P original / Q original) x (change in Qd / change in P) Note: change in Qd / change in P = 1 / slope. o Dependant on direction of price changes o Preferred method as it is based on the original Midpoint Formula: o Change in price as a percentage of the average price and change in quantity demanded as a percentage of the average quantity demanded o % Change in Qd / % change in P = (Average price / average quantity) x (change in Qd / change in P) o Dependant on average price and average quantity o Gives approximate responsiveness Elastic and inelastic Demand If quantity demanded changes by an infinitely large percentage in response to a tiny price change – this is perfect elastic demand If the percentage change in the quantity demanded equals the percentage change in the price – elasticity equals 1 and this is known as unit elastic If the quantity demanded remains constant when the price changes – elasticity equals 0 and this is perfectly inelastic demand If the percentage change in Qd < percentage change in P – inelastic if the percentage change in Qd > percentage change in P – elastic
Elasticity along a straight-line demand curve At the midpoint of the curve, the demand is unit elastic Above the midpoint, demand is elastic Below the midpoint, demand is inelastic Total revenue and elasticity ------ FIX TR = P x Q Total revenue = price of good x quantity sold Increasing price: o If demand is elastic, increase in total revenue o If demand is inelastic, decrease in total revenue o If demand is unit elastic, total revenue stays constant Decreasing price: o If demand is elastic, decrease in total revenue o If demand is inelastic, increase in total revenue o If demand is unit elastic, total revenue stays constant Factors that influence the elasticity of demand The closeness of substitutes o A good with close substitutes has an elastic demand o Necessities – poor substitutes - more inelastic o Luxuries – many substitutes - more elastic The proportion of income spent on the good o The greater the proportion of income spent on the good, the more elastic is the demand for it The time elapsed since a price change o The more time consumers have to adjust to a price change the more elastic is the demand for that good Cross Elasticity of Demand A measure of responsiveness of demand for a good to a change in the price of a substitute or complement (assuming ceteris paribus) Percentage change in quantity demanded / percentage change in price of a substitute or complement Cross elasticity of demand for a substitute is positive Cross elasticity of demand for a complement is negative Cross elasticity = 0, unrelated products Income Elasticity of Demand A measure of how the quantity demanded of a good responds to a change in income (assuming ceteris paribus) Percentage change in quantity demanded / percentage change in income Greater than 1 – normal good, income elastic – percentage of income spent on that good increases as income increases Positive and less than 1 – normal good, income inelastic – percentage of income spent on that good decreases as income increases Negative – inferior good
Elasticity of Supply A measure of responsiveness of the quantity supplied to a price change Percentage change in quantity supplied / percentage change in price Inelastic and Elastic Supply Perfectly inelastic – elasticity = 0, vertical line Unit elastic – elasticity = 1, linear line passing through origin Perfectly elastic – elasticity = infinite, horizontal line Factors that influence elasticity of Supply Elasticity of supply depends on: o Resource substitution possibilities – the easier it is to substitute among the resources used to produce a good or service, the greater is its elasticity of supply. Lots of substitutes = highly elastic. o Time frame for the supply decision – the more time that passes after a price change, the greater is the elasticity of supply. Momentary supply – immediately following the price change. Perfectly inelastic. Short-run supply (1-12 months) – somewhat elastic Long-run supply – most elastic SEE TEXT BOOK PAGE 97 FOR ELASTICITY! Chapter Five: Efficiency Resource Allocation The ability of markets to allocate resources efficiently and fairly Market price: o When a market allocates a scarce resource, the people who get the resource are those willing to pay the market price Demand, Willingness to Pay, and Value Value – what we get Price – what we pay Value of one more unit of a good is its marginal benefit Marginal benefit – maximum price that someone is willing to pay Willingness to pay determines demand Demand curve = marginal benefit curve Individual Demand and Market Demand Individual demand – the relationship between the price of a good and the quantity demanded by one person Market demand – the relationship between the price of a good and the quantity demanded by all buyers in the market Market demand curve = marginal social benefit
Consumer surplus Consumer surplus – the value of a good minus the price paid for it, summed over the quantity bought When you buy something for less than it is worth to you Measured by the area under the demand curve and above the price paid, up to the quantity bought Market demand curve is the horizontal sum of the individual demand curves
Minimum Supply Price To make profit, they must sell their output for a price that exceeds the cost of production Cost is what a producer gives up Price is what a producer receives Marginal cost is the minimum price that a firm is willing to except Minimum supply price determines supply Supply curve = marginal cost curve Individual Supply and Market Supply Individual supply – the relationship between the price of a good and the quantity supplied by one producer Market supply – the relationship between the price of a good and the quantity supplied by all producers in the market Market supply curve is the horizontal sum of the individual supply curves Producer Surplus The price received for a good minus the minimum-supply price (marginal cost), summed over the quantity sold Measured by the area below the market price and above the supply curve, summed over the quantity sold
Consumer surplus and producer surplus can be used to measure the efficiency of a market Competitive Equilibrium and Efficiency Resources are allocated efficiently when they are used in the ways that people value most highly i.e. when marginal social benefit = marginal social cost Competitive equilibrium – the quantity demanded = quantity supplied At the equilibrium quantity, marginal benefit equals marginal cost, so the quantity is the efficient quantity. When the efficient quantity is produced, total surplus (the sum of consumer surplus and producer surplus) is maximized. Market Failure – Underproduction and Overproduction Market failure – when the market does not operate at an efficient competitive equilibrium Inefficient market – produce too little of an item (underproduction) or too much (over production) Deadweight loss – decrease in total surplus that results from an inefficient level of production Deadweight loss is a social loss – its borne by society – represented by the area between equilibrium price and the underproduction ‘line’ or overproduction ‘line’ (triangular area) When deadweight loss is not equal to zero – society experiences a loss Chapter Six: Government Actions in Markets Price Ceiling Price ceiling or price cap is a regulation that makes it illegal to charge a price higher than a specified level If price ceiling > the equilibrium price no effect If price ceiling < the equilibrium price powerful effects: shortages and inefficiencies E.g. rent Increased search activity The time spent looking for someone with whom to do business Search activity increases when the price is regulated and there is a shortage It is costly
OC of housing = rent (regulated) plus the OC of search activity (unregulated) Black market An illegal market that operates alongside a legal market in which a price ceiling or other restriction has been imposed Shortage of housing creates a black market Illegal arrangements are made between renters and landlords at rents above the rent ceiling – and generally above what the rent would have been in an unregulated market Inefficiency of Rent Ceilings A rent ceiling set below the equilibrium rent leads to an inefficient underproduction of housing services The marginal social benefit from housing services exceeds its marginal social cost and a deadweight loss arises Rent ceiling decreases the quantity of housing supplied to less than the efficient quantity Producer surplus shrinks Consumer surplus shrinks Increased search activity
Price Floor Price floor is a regulation that makes it illegal to trade at a price lower than a specified level Price floor < equilibrium price no effect Price floor > equilibrium price powerful effects: surpluses and inefficiencies E.g. minimum wage A LABOUR MARKET WITH A MINIMUM WAGE If the minimum wage is set above the equilibrium wage rate, the quantity of labour supplied by workers exceeds the quantity demanded by employers o There is a surplus of labour
o The quantity of labour hired at the minimum wage is less than the quantity that would be hired in an unregulated labour market o Because the legal wage rate cannot eliminate surplus, the minimum wage creates unemployment Inefficiency of a minimum wage
Minimum wage leads to an inefficient outcome The supply of labour measures the marginal social cost of labour – OC of labour forone The demand for labour measures the marginal social benefit form labour – value of the goods produced TAXES Everything you earn and most things that you buy are taxed Income tax – deducted from your pay GST – added to the price of most things you buy Tax incidence – the division of the burden of tax between buyers and sellers When an item is taxed, it may rise by the full amount of tax, by a lesser amount, or not at all o If the price rises by the full amount of the tax, buyers pay the tax o If the price rises by a lesser amount than the tax, buyers and sellers share the burden of the tax o If the price doesn’t rise at all, sellers pay the tax Tax incidence doesn’t depend on the law, it depends on the supply and demand of the market and elasticity of demand and supply Tax division and elasticity of demand The division of the tax between buyers and sellers depends on the elasticities of demand and supply Perfectly inelastic demand – buyer pays the entire tax Perfectly elastic demand – seller pays the entire tax The more inelastic the demand, the larger is the buyer’s share of the tax
Perfectly inelastic demand Demand curve is vertical When a tax is imposed on this good, buyers pay the entire tax
Perfectly elastic demand Demand curve is horizontal When a tax is imposed on this good, sellers pay the entire tax
Tax division and elasticity of supply Perfectly inelastic supply – sellers pay the entire tax Perfectly elastic supply – buyers pay the entire tax The more elastic the supply, the larger is the buyer’s share of the tax Perfectly inelastic supply Supply curve is vertical When a tax is imposed on the good, sellers pay the entire tax
