BusEcn 1112 - Basic Microeconomics MIDTERMS PDF

BusEcn1112 – Basic Microeconomics MIDTERMS MODULE 5: TIME HORIZON Goods tend to have more elastic demand over longer time ELASTICITY AND horizons...

BusEcn1112 – Basic Microeconomics MIDTERMS MODULE 5: TIME HORIZON Goods tend to have more elastic demand over longer time ELASTICITY AND horizons. THE VARIETY OF DEMAND CURVES ITS APPLICATION Economists classify demand curves according to their elasticity. ELASTICITY Demand is considered ELASTIC when the a measure of the responsiveness of quantity demanded or elasticity is greater than 1, which means the quantity supplied to a change in one of its determinants quantity moves proportionately more than the price. PRICE ELASTICITY OF DEMAND Demand is considered INELASTIC when the a measure of how much the quantity demanded of a good elasticity is less than 1, which means the responds to a change in the price of that good, computed quantity moves proportionately less than the as the percentage change in quantity demanded divided by price. the percentage change in price If THE ELASTICITY IS EXACTLY 1, the percentage change in quantity equals the THE PRICE ELASTICITY OF DEMAND AND ITS percentage change in price, and demand is said DETERMINANTS to have UNIT ELASTICITY. Because the price elasticity of demand measures how much quantity Demand for a good is said to be ELASTIC if the demanded responds to changes in the price, it is quantity demanded responds substantially to closely related to the slope of the demand curve. changes in the price. Demand is said to be INELASTIC if the quantity TOTAL REVENUE AND THE PRICE ELASTICITY demanded responds only slightly to changes in OF DEMAND the price. TOTAL REVENUE AVAILABILITY OF CLOSE SUBSTITUTES The total amount paid by buyers, and received as revenue Goods with close substitutes tend to have more by sellers, equals the area of the box under the demand elastic demand because it is easier for consumers to curve, P x Q. switch from that good to others. At points with a low price and high quantity, the NECESSITIES VERSUS LUXURIES demand curve is inelastic. At points with a high price and low quantity, the demand curve is Necessities tend to have inelastic demands, whereas elastic. luxuries have elastic INCOME ELASTICITY OF DEMAND DEFINITION OF THE MARKET a measure of how much the quantity demanded of a good The elasticity of demand in any market depends on how we responds to a change in consumers’ income, computed as draw the boundaries of the market. Narrowly defined the percentage change in quantity demanded divided by markets tend to have more elastic demand than broadly the percentage change in income defined markets because it is easier to find close substitutes for narrowly defined goods P a g e 1 | 11  BusEcn1112 – Basic Microeconomics MIDTERMS A few goods, such as bus rides, are inferior goods Supply is said to be INELASTIC if the quantity Higher income lowers the quantity demanded supplied responds only slightly to changes in the price. CROSS-PRICE ELASTICITY OF DEMAND Supply is usually more elastic in the long run than in the short run. Over short periods of time a measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage SUMMARY: change in price of the second good The price elasticity of demand measures how much the quantity demanded responds to changes in the price. substitutes are goods that are typically used in Demand tends to be more elastic if close substitutes are place of one another, such as hamburgers and hot available, if the good is a luxury rather than a necessity, if dogs Because the price of hot dogs and the the market is narrowly defined, or if buyers have quantity of hamburgers demanded move in the substantial time to react to a price change. same direction, the cross-price elasticity is positive. The price elasticity of demand is calculated as the complements are goods that are typically used percentage change in quantity demanded divided by the together, such as computers and software. In this percentage change in price. If quantity demanded moves case, the cross-price elasticity is negative, proportionately less than the price, then the elasticity is indicating that an increase in the price of less than 1 and demand is said to be inelastic. If quantity computers reduces the quantity of software demanded moves proportionately more than the price, demanded then the elasticity is greater than 1 and demand is said to be elastic. THE ELASTICITY Total revenue, the total amount paid for a good, equals the price of the good times the quantity sold. For inelastic OF SUPPLY demand curves, total revenue moves in the same direction as the price. For elastic demand curves, total revenue moves in the opposite direction as the price. PRICE ELASTICITY OF SUPPLY The income elasticity of demand measures how much a measure of how much the quantity supplied of a good the quantity demanded responds to changes in responds to a change in the price of that good, computed consumers’ income. The cross-price elasticity of demand as the percentage change in quantity supplied divided by measures how much the quantity demanded of one good the percentage change in price responds to changes in the price of another good. THE PRICE ELASTICITY OF SUPPLY AND ITS The price elasticity of supply measures how much the DETERMINANTS quantity supplied responds to changes in the price. This elasticity often depends on the time horizon under The law of supply states that higher prices raise the consideration. In most markets, supply is more elastic in quantity supplied. The price elasticity of supply measures the long run than in the short run. how much the quantity supplied responds to changes in the price. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the Supply of a good is said to be ELASTIC if the percentage change in price. If quantity supplied moves quantity supplied responds substantially to proportionately less than the price, then the elasticity is changes in the price. less than 1 and supply is said to be inelastic. If quantity P a g e 2 | 11  BusEcn1112 – Basic Microeconomics MIDTERMS MODULE 6: supplied moves proportionately more than the price, then the elasticity is greater than 1 and supply is said to be elastic. The tools of supply and demand can be applied in many SUPPLY, DEMAND, different kinds of markets. This chapter uses them to analyze the market for wheat, the market for oil, and the AND GOVERNMENT market for illegal drugs. POLICIES PRICE CEILING a legal maximum on the price at which a good can be sold PRICE FLOOR a legal minimum on the price at which a good can be sold A MARKET WITH A PRICE CEILING A Price Ceiling That Is Not Binding = as is A Price Ceiling That Is Binding = will change and cause shortage ONE COMMON EXAMPLE OF A PRICE CEILING IS RENT CONTROL A MARKET WITH A PRICE FLOOR A Price Floor That Is Not Binding =as is A Price Floor That Is Binding = will change and cause surplus AN IMPORTANT EXAMPLE OF A PRICE FLOOR IS THE MINIMUM WAGE. TAX INCIDENCE the manner in which the burden of a tax is shared among participants in a market P a g e 3 | 11  BusEcn1112 – Basic Microeconomics MIDTERMS SUMMARY taxes. In the new equilibrium, buyers pay more for the good, and sellers receive less. A price ceiling is a legal maximum on the price of a good or service. An example is rent control. If the price ceiling is below the equilibrium price, then the price ceiling is binding, and the quantity demanded exceeds the quantity supplied. Because of the resulting shortage, sellers must in some way ration the good or service among buyers. A price floor is a legal minimum on the price of a good or service. An example is the minimum wage. If the price floor is above the equilibrium price, then the price floor is binding, and the quantity supplied exceeds the quantity demanded. Because of the resulting surplus, buyers’ demands for the good or service must in some way be rationed among sellers. When the government levies a tax on a good, the equilibrium quantity of the good falls. That is, a tax on a market shrinks the size of the market. A tax burden falls more heavily on the side of the A tax on a good places a wedge between the price paid market that is less elastic. by buyers and the price received by sellers. When the market moves to the new equilibrium, buyers pay more for the good and sellers receive less for it. In this sense, buyers and sellers share the tax burden. The incidence of a tax (that is, the division of the tax burden) does not depend on whether the tax is levied on buyers or sellers. The incidence of a tax depends on the price elasticities of supply and demand. Most of the burden falls on the side of the market that is less elastic because that side of the market cannot respond as easily to the tax by changing the quantity bought or sold. Taxes discourage market activity. When a good is taxed, the quantity of the good sold is smaller in the new equilibrium. Buyers and sellers share the burden of P a g e 4 | 11  BusEcn1112 – Basic Microeconomics MIDTERMS MODULE 7: CONSUMERS, PRODUCERS AND THE EFFICIENCY OF MARKETS WELFARE ECONOMICS The area below the demand curve and above the price measures the consumer surplus in a market the study of how the allocation of resources affects economic well-being CONSUMER SURPLUS WILLINGNESS TO PAY the maximum amount that a buyer will pay for a good CONSUMER SURPLUS the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it PRODUCER SURPLUS MARGINAL BUYER COST At any quantity, the price given by the demand curve shows the willingness to pay of the marginal buyer, the the value of everything a seller must give up to produce a buyer who would leave the market first if the price were good any higher. PRODUCER SURPLUS the amount a seller is paid for a good minus the seller’s cost of providing it The area below the price and above the supply curve measures the producer surplus in a market. MARKET EFFICIENCY P a g e 5 | 11  BusEcn1112 – Basic Microeconomics MIDTERMS EFFICIENCY the property of a resource allocation of maximizing the total surplus received by all members of society EQUALITY the property of distributing economic prosperity uniformly among the members of society !! 1. Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. 2. Free markets allocate the demand for goods to the sellers who can produce them at the lowest cost. 3. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus. FORMULA TO REMEMBER!! MARKET EFFICIENCY basic tools of welfare economics—consumer and producer surplus—and used them to evaluate the efficiency of free markets. MARKET FAILURE MARKET POWER In some markets, a single buyer or seller (or a small group of them) may be able to control market prices. This ability to influence prices is called market power. Market power can cause markets to be inefficient because it keeps the price and quantity away from the levels determined by the equilibrium of supply and demand. EXTERNALITIES P a g e 6 | 11  BusEcn1112 – Basic Microeconomics MIDTERMS MODULE 8: Pollution is the classic example. The use of agricultural pesticides, for instance, affects not only the manufacturers who make them and the farmers who use them but also many others who breathe the air or drink the water contaminated by these pesticides. When a market EXTERNALITIES exhibits such side effects, called externalities EXTERNALITY the uncompensated impact of one person’s actions on the inability of some unregulated markets to allocate the well-being of a bystander resources efficiently. When markets fail, public policy can potentially remedy the problem SUMMARY Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay, and it measures the benefit buyers get from participating in a market. Consumer surplus can be computed by finding the area below the demand curve and above the price. Producer surplus equals the amount sellers receive for their goods minus their costs of production, and it measures the benefit sellers get from participating in a market. Producer surplus can be computed by finding the area below the price and above the supply curve. An allocation of resources that maximizes total surplus An externality arises when a person engages in an activity (the sum of consumer and producer surplus) is said to be that influences the well-being of a bystander but neither efficient. Policymakers are often concerned with the pays nor receives compensation for that effect. If the efficiency, as well as the equality, of economic outcomes. impact on the bystander is adverse, it is called a negative externality. If it is beneficial, it is called a positive The equilibrium of supply and demand maximizes total externality. surplus. That is, the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently. Because buyers and sellers neglect the external effects of their actions when deciding how much to demand or Markets do not allocate resources efficiently in the supply, the market equilibrium is not efficient when presence of market failures such as market power or there are externalities externalities. INTERNALIZING THE EXTERNALITY altering incentives so that people take into account the external effects of their actions P a g e 7 | 11  BusEcn1112 – Basic Microeconomics MIDTERMS The use of such a tax is called internalizing the externality The government can remedy an externality by either because it gives buyers and sellers in the market an requiring or forbidding certain behaviors. incentive to take into account the external effects of their actions. MARKET-BASED POLICIES POSITIVE EXTERNALITIES provide incentives so that private decision makers will choose to solve the problem on their own Consider education, for example. To a large extent, the benefit of education is private: The consumer of education Instead of regulating behavior in response to an becomes a more productive worker and thus reaps much externality, the government can use market-based policies of the benefit in the form of higher wages. Beyond these to align private incentives with social efficiency. private benefits, however, education also yields positive 1: Corrective Taxes and Subsidies externalities. Taxes enacted to deal with the effects of negative externalities are called corrective taxes. They are also called Pigovian taxes after economist Arthur Pigou (1877–1959), an early advocate of their use. An ideal corrective tax would equal the external cost from an activity with negative externalities, and an ideal corrective subsidy would equal the external benefit from an activity with positive externalities. Economists usually prefer Negative externalities lead markets to produce a larger corrective taxes to regulations as a way to deal with quantity than is socially desirable. Positive externalities pollution because they can reduce pollution at a lower lead markets to produce a smaller quantity than is socially cost to society. desirable. To remedy the problem, the government can internalize the externality by taxing goods that have CORRECTIVE TAX negative externalities and subsidizing goods that have a tax designed to induce private decision makers to take positive externalities. into account the social costs that arise from a negative externality Education is heavily subsidized through public schools 2: Tradable Pollution Permits and government scholarships. A potentially important type of positive externality is called a technology spillover the impact of one firm’s research and production efforts on other firms’ access to technological advance. Public Policies toward Externalities COMMAND-AND-CONTROL POLICIES regulate behavior directly. P a g e 8 | 11  BusEcn1112 – Basic Microeconomics MIDTERMS TRANSACTION COSTS Private Solutions to Externalities the costs that parties incur during the process of agreeing to and following through on a bargain Most people choose not to litter just because it is the wrong thing to do. The Golden Rule taught to most children Why Private Solutions Do Not Always Work says, “Do unto others as you would have them do unto you.” bargaining does not always work, even when a mutually beneficial agreement is possible. Another private solution to externalities involves charities SUMMARY: COASE THEOREM When a transaction between a buyer and seller directly affects a third party, the effect is called an externality. If an after economist Ronald Coase activity yields negative externalities, such as pollution, the the proposition that if private parties can bargain without socially optimal quantity in a market is less than the cost over the allocation of resources, they can solve the equilibrium quantity. If an activity yields positive problem of externalities on their own externalities, such as technology spillovers, the socially optimal quantity is greater than the equilibrium quantity. Governments pursue various policies to remedy the inefficiencies caused by externalities. Sometimes the government prevents socially inefficient activity by regulating behavior. Other times it internalizes an externality using corrective taxes. Another public policy is to issue permits. For example, the government could protect the environment by issuing a limited number of pollution permits. The result of this policy is similar to imposing corrective taxes on polluters. Those affected by externalities can sometimes solve the problem privately. For instance, when one business imposes an externality on another business, the two businesses can internalize the externality by merging. Alternatively, the interested parties can solve the problem by negotiating a contract. According to the Coase if private parties can bargain over the allocation of theorem, if people can bargain without cost, then they can resources at no cost, then the private market will always always reach an agreement in which resources are solve the problem of externalities and allocate resources allocated efficiently. In many cases, however, reaching a efficiently bargain among the many interested parties is difficult, so the Coase theorem does not apply. To sum up: The Coase theorem says that private economic MODULE 9: actors can potentially solve the problem of externalities among themselves. Whatever the initial distribution of rights, the interested parties can reach a bargain in which everyone is better off and the outcome is efficient. PUBLIC GOODS P a g e 9 | 11  BusEcn1112 – Basic Microeconomics MIDTERMS AND COMMON The defense of a country from foreign aggressors is a classic example of a public good. Once the country is defended, it is impossible to prevent any single person RESOURCES from enjoying the benefit of this defense. And when one person enjoys the benefit of national defense, she does The Different Kinds of Goods not reduce the benefit to anyone else. Thus, national defense is neither excludable nor rival in consumption. Is the good excludable? That is, can people be prevented from using the good? BASIC RESEARCH KNOWLEDGE Is the good rival in consumption? That is, does one is created through research. In evaluating the appropriate person’s use of the good reduce another person’s ability to public policy toward knowledge creation, it is important to use it? distinguish general knowledge from specific technological knowledge EXCLUDABILITY FIGHTING POVERTY the property of a good whereby a person can be prevented from using it RIVALRY IN CONSUMPTION COST–BENEFIT ANALYSIS The property of a good whereby one person’s use a study that compares the costs and benefits to society of diminishes other people’s use providing a public good PRIVATE GOODS goods that are both excludable and rival in consumption COMMON RESOURCES Common resources, like public goods, are not excludable: PUBLIC GOODS They are available free of charge to anyone who wants to goods that are neither excludable nor rival in consumption use them. Common resources are, however, rival in consumption: One person’s use of the common resource COMMON RESOURCES reduces other people’s ability to use it. Thus, common resources give rise to a new problem: Once the good is goods that are rival in consumption but not excludable provided, policymakers need to be concerned about how much it is used. This problem is best understood from the CLUB GOODS classic parable called the Tragedy of the Commons. goods that are excludable but not rival in consumption TRAGEDY OF THE COMMONS Public Goods a parable that illustrates why common resources are used FREE RIDER more than is desirable from the standpoint of society as a whole a person who receives the benefit of a good but avoids paying for it Some Important Common Resources Some Important Public Goods Clean Air and Water Congested Roads NATIONAL DEFENSE P a g e 10 | 11  BusEcn1112 – Basic Microeconomics MIDTERMS Fish, Whales and other wildlife SUMMARY: Goods differ in whether they are excludable and whether they are rival in consumption. A good is excludable if it is possible to prevent someone from using it. A good is rival in consumption if one person’s use of the good reduces others’ ability to use the same unit of the good. Markets work best for private goods, which are both excludable and rival in consumption. Markets do not work as well for other types of goods. Public goods are neither rival in consumption nor excludable. Examples of public goods include fireworks displays, national defense, and the discovery of fundamental knowledge. Because people are not charged for their use of the public good, they have an incentive to free ride, making private provision of the good untenable. Therefore, governments provide public goods, basing their decision about the quantity of each good on cost–benefit analysis. Common resources are rival in consumption but not excludable. Examples include common grazing land, clean air, and congested roads. Because people are not charged for their use of common resources, they tend to use them excessively. Therefore, governments use various methods, such as regulations and corrective taxes, to limit the use of common resources. P a g e 11 | 11