Microeconomics: Price System & Market Failures

Price Mechanism and Market Characteristics

• Price mechanism adjusts prices of goods and services through the interaction of supply and demand.
• Market failures can occur when the price mechanism fails to allocate resources efficiently.
• Public goods, like street lighting, are non-excludable and non-rivalrous, making them difficult for private sectors to supply.
• Externalities, both positive and negative, affect the social costs or benefits not reflected in prices, e.g., pollution leads to market inefficiencies.
• Monopoly and oligopoly markets can distort prices, limit output, and reduce consumer choice.

Income Inequality and Resource Allocation

• Price mechanisms may increase income inequality, where high-income individuals afford more goods while low-income individuals struggle for basics.
• Merit goods (e.g., education, healthcare) may be under-provided, while demerit goods (e.g., alcohol, tobacco) may be over-consumed due to price insensitivity.

Information Asymmetry in Markets

• Consumers or producers often lack perfect information, causing inefficiencies such as moral hazard, where risks are taken without full consequences.
• When demand is elastic, firms might reduce prices to boost sales volume and total revenue.

Elasticity of Demand: Inelastic Demand

• Inelastic demand (PED < 1) means that price increases lead to a less than proportional decrease in quantity demanded, allowing firms to raise prices without heavily impacting sales.
• Governments impose taxes on inelastic goods (e.g., gasoline) because demand remains stable despite price increases, optimizing tax revenue.

Elasticity of Demand: Factors Influencing PED

• Availability of substitutes significantly affects elasticity; goods with many substitutes are elastic, while those with few are inelastic.
• Necessities have inelastic demand; essential goods see less variability in demand with price changes, whereas luxury goods have elastic demand.
• A larger share of income spent on a good leads to more elastic demand; small expenditure goods typically exhibit inelastic demand.
• Time periods influence elasticity; short-term demands are typically more inelastic as consumers have less time to adjust.

Income Elasticity of Demand (YED)

• YED assesses the response of quantity demanded to changes in consumer income, calculated by the percentage change in quantity demanded over the percentage change in income.
• Normal goods have positive YED; luxury goods (YED > 1) see disproportionate demand increase with rising income, while necessities (0 < YED < 1) see lesser increases.
• Inferior goods (YED < 0) encounter decreased demand as income rises as consumers opt for better products.

Economic Impact of YED

• High-income elasticity for luxury goods indicates sensitivity to income fluctuations, benefitting during economic booms, but risking sharp demand drops in recessions.
• Long-term effects of income changes show potential shifts in consumer preferences from inferior to normal or luxury goods.
• YED analysis helps businesses tailor offerings and strategies based on income trends and disparities, influencing product development and sales strategies.

Cross Elasticity of Demand (XED)

• XED measures how the quantity demanded of one good reacts to price changes of another good, affecting competitive pricing strategies.

Supply Elasticity Factors

• Storage capacity influences elasticity; perishables have inelastic supply due to their inability to be stockpiled.
• Complexity in production processes affects responsiveness; simple processes lead to more elastic supplies.
• Barriers to market entry dictate supply elasticity; low entry barriers allow for a more elastic market response, while high barriers restrict supply adjustments.
• Time lags in production, whether short or long, affect how quickly firms can adjust to price changes based on how quickly they can produce goods.