Economics Resource Guide 2024-2025 PDF

OUR CHANGING CLIMATE Bowie High School - El Paso , TX ECONOMIC...

OUR CHANGING CLIMATE Bowie High School - El Paso , TX ECONOMICS An Introduction to Economics and the Economics of Climate Change Resource Guide 2 0 24 – 2 0 25 The vision of the United States Academic Decathlon® is to provide students the opportunity to excel academically through team competition. Toll Free: 866-511-USAD (8723) Direct: 712-326-9589 Fax: 712-366-3701 Email: [email protected] Website: www.usad.org This material may not be reproduced or transmitted, in whole or in part, by any means, including but not limited to photocopy, print, electronic, or internet display (public or private sites) or downloading, without prior written permission from USAD. Violators may be prosecuted. Copyright ® 2024 by United States Academic Decathlon®. All rights reserved.  Table of Contents INTRODUCTION.................. 6 The Characteristics of Competitive Market Equilibrium.......................... 21 SECTION I: FUNDAMENTAL Applications of the Competitive ECONOMIC CONCEPTS............ 7 Market Model..................... 23 Basic Assumptions of Economics.... 7 Changes in Market Equilibrium........ 23 Scarcity............................. 7 Elasticity........................... 26 Trade-offs........................... 8 Using Elasticity...................... 27 Opportunity Cost..................... 8 Rationality........................... 8 Evaluating Government Policy: The Gains from Trade..................... 8 Bowie High School - El Paso , TX Impact of Price Controls and Taxes... 30 Price Controls....................... 30 Models and Economic Theory....... 8 Taxes...............................34 Positive and Normative Economics... 9 Efficiency as a Goal................ 9 International Trade................ 35 Microeconomics and An Isolated Economy................. 35 Adding the Opportunity to Trade....... 37 Macroeconomics................... 9 Comparative Advantage and the Gains Section I Summary................ 10 from Trade.......................... 37 The Political Economy of Trade........ 37 SECTION II: MICROECONOMICS.... 11 Perfectly Competitive Markets....... 11 The Profit Motive and the Behavior Markets............................. 11 of Firms........................... 41 Demand............................. 13 Economic Profits and Accounting Shifts in the Demand Curve........... 14 Profits.............................. 41 Income...............................14 Finding the Firm’s Supply Curve.......43 The Prices of Related Goods........... 14 Entry, Exit, and the Market Supply Tastes................................ 15 Curve.............................. 43 Expectations......................... 15 Number of Buyers.................... 15 Imperfect Competition............ 44 Monopoly........................... 44 Supply.............................. 15 Monopoly Supply.................... 45 Shifts in the Supply Curve............. 16 Welfare Consequences of Monopoly.... 46 Input Prices...........................16 Dealing with Monopolies..............46 Technology...........................16 Expectations......................... 16 Price Discrimination................. 46 Number of Sellers..................... 16 Oligopoly........................... 48 Monopolistic Competition............. 49 Equilibrium.......................... 16 2024–2025 Economics Resource Guide Revised Page June 17, 2024 2 Creative Destruction: The Profit Motive Yet Another Way to Measure GDP: and the Sources of Economic Income Equals Production Equals Change........................... 49 Expenditures........................ 72 Real GDP........................... 73 Market Failures................... 50 Measuring Inflation.................. 73 Externalities........................ 50 Unemployment...................... 75 The Effect of Externalities on Resource Frictional Unemployment............. 76 Allocation........................... 51 Structural Unemployment............. 77 Private Responses to Externalities..... 51 Cyclical Unemployment............... 77 Government Regulation of Externalities........................ 52 Economic Growth, Productivity, and Property Rights..................... 54 Living Standards.................. 77 The Effects of Private Ownership......54 The Circular Flow Model of the Public and Private Goods............. 56 Economy........................... 78 Private Goods......................... 57 What Determines How Much an Economy Common Resources.................. 57 Produces?.......................... 78 Collective Goods..................... 57 Public Goods......................... 57 Savings, Investment, and the Financial Institutions, Organizations, and System............................81 Financial Markets.................... 82 Government...................... 57 Bowie High School - El Paso , TX The Bond Market..................... 82 Pork Barrel Politics.................. 59 The Stock Market..................... 82 Rent Seeking........................ 59 What Is the Proper Role for Financial Intermediaries.............. 82 Government?........................ 60 Banks................................ 83 Mutual Funds......................... 83 Section II Summary............... 60 Saving and Investment in Aggregate.... 83 International Capital Flows in an Open SECTION III: MACROECONOMICS.. 62 Economy........................... 84 Macroeconomic Issues............. 62 How Financial Markets Coordinate Saving Economic Growth and Living and Investment Decisions............ 85 Standards.......................... 62 Recessions and Expansions.......... 64 Money and Prices in the Long Run... 86 Unemployment...................... 65 What Is Money?......................88 Inflation............................ 66 Measuring Money.................... 88 International Trade................... 66 The Federal Reserve System, Banks, and the Supply of Money.................. 89 Macroeconomic Measurement..... 67 Bank Runs.......................... 92 Measuring Total Output: Gross Domestic Money and Inflation in the Long Run.....92 Product............................. 67 Why Worry about Inflation?........... 94 Market Value......................... 68 Final Goods and Services............. 68 Short-Run Economic Fluctuations... 94 Within a Country..................... 70 Characteristics of Short-Run During a Specified Period.............. 71 Fluctuations........................ 96 Understanding What GDP Measures.... 71 Potential Output, the Output Gap, and the Other Ways to Measure GDP: Expenditures Natural Rate of Unemployment........ 96 Equal Production..................... 71 Explaining Short-Run Fluctuations in Output.............................. 98 2024–2025 Economics Resource Guide Revised Page June 17, 2024 3  The Aggregate Demand Curve........ 101 Whose Child is This?—Obligations to Wealth Effects....................... 101 Future Generations.................. 117 Interest Rate Effects.................. 101 Spending Now or Saving for Later?.... 117 Foreign Exchange Effects............. 101 Choices Over Time and Sustainability.. 117 The Aggregate Supply Curve......... 102 Economic Issues and Climate...... 117 The Keynesian Model of Short-Run Damages Due to Climate Change...... 117 Fluctuations........................ 102 Economic Damages due to Increasing Inflation in the Keynesian Model...... 104 Temperatures....................... 118 Using Fiscal and Monetary Policy to The Social Cost of Carbon: Estimation Stabilize the Economy............... 104 Basics............................... 119 The Uncertainty of Damage Section III Summary.............. 108 Estimates............................ 119 Burdens Facing Poorer Regions....... 119 SECTION IV: CLIMATE CHANGE— The Unequal Impacts of Climate ECONOMICS MEETS ECOLOGY.... 110 Change............................. 119 Introduction and Overview........ 110 Latitude, Location, and Household Economic Concepts and Climate: Income..............................120 Cities, States, and Nations Vulnerable to Theory and Practice............... 111 Climate Change..................... 120 Externalities: Doing unto Others....... 111 Bargaining Across Jurisdictions and the Bowie High School - El Paso , TX Negative Versus Positive Externalities.. 111 Global Commons.................... 120 One-Way Versus Reciprocal Externalities.......................... 111 Rapid Reductions in the Cost of Control and Time..................... 112 Renewable Energy.................. 121 Resolution: Economic and Legal The End of the Hydrocarbon Epoch: Means............................... 112 How Soon?.......................... 121 The Renewables Surprise............. 121 Public Goods and Public Spaces.......112 The Cost Race........................ 121 Definitions: Rivalry and Excludability... 113 Playing Favorites and Betting Which Public Goods and Public Bads: Social Road Is Right........................ 122 Benefits and Costs................... 114 Space, Authority, and Jurisdiction..... 114 Policy Responses to Climate Economic House: Obligations and Free Riding............................... 114 Change............................. 122 Norms, Institutions, and Expectations.. 115 Doing Nothing and Hoping for the Best: The Case for Waiting and Seeing...... 123 Common Property and Collective The Risks of Delay: The Logic of “No Action............................... 115 Regrets”............................ 123 The Tragedy of the Commons........ 115 Unilateral Intervention: Collective Action and Its Critics....... 115 Geoengineering..................... 123 Space and Jurisdiction: From Village Free-Driving: I’m in Charge Here...... 123 Commons to Global Village.......... 115 Volcanic Disruption.................. 124 Managing the Commons: Who Will Guard the Guardians?............... 116 Negotiating Over Climate Targets..... 124 A Brief History....................... 124 Discounting: The Shadow of the Problems of Enforcement and False Future..............................116 Overcommitment................... 125 How Much Is Something Today Worth The Fuzzy Locus of Decision and Tomorrow?.......................... 116 Responsibility........................ 125 Looking Forward and Looking The Absence of Alternatives..........126 Backward........................... 116 2024–2025 Economics Resource Guide Revised Page June 17, 2024 4  Multilateralism From the Bottom Up: Russian Dolls: A Nested Negotiating A Global Environment Organization Strategy............................ 128 (GEO).............................. 126 Economic and Ecological Section IV Summary............. 128 Interdependence.....................126 The Commercial Commons and the Section IV Timeline............... 130 Climate Commons...................127 Voluntary Climate Commitment with GLOSSARY.................... 132 Trade Strings Attached...............127 Managing the Climate Commons.....127 NOTES........................ 137 Summing Up..................... 128 Comparative Choices: What Is “Least BIBLIOGRAPHY................ 139 Worse”?............................ 128 Collective Responsibility and Obligations of Those Better Off.................. 128 Bowie High School - El Paso , TX 2024–2025 Economics Resource Guide Revised Page June 17, 2024 5  Introduction For well over two hundred years, the field of In the second and third sections of the resource economics has studied how human societies organize guide, we describe some of the most important themselves to transform their available resources into themes in economics. The second section provides the goods and services that their members wish to a description of microeconomics. This section starts consume. The outlines of modern economic analysis with the model of perfectly competitive markets. were already apparent in Adam’s Smith’s An Inquiry Although the assumptions of this model apply into the Nature and Causes of the Wealth of Nations, precisely to only a small subset of economic activity, published in 1776, but discussion of topics relevant to it is a crucial starting point. In the remainder of the economics can be found even earlier in the writings of section, we show how relaxing the assumptions of Aristotle. the perfectly competitive model allows us to analyze Bowie High School - El Paso , TX a much broader range of phenomena, and how this At its core, economics is concerned with how analysis in turn leads to important insights about individuals make choices and how these individual public policy and individual actions. decisions and actions interact with one another to determine what happens at the level of the entire The third section of the resource guide turns economy. Modern economics approaches this problem to the subject of macroeconomics. It begins by from several directions. Whereas microeconomics describing important characteristics of aggregate begins with the analysis of individual decisions economic performance and how these characteristics and then explores how these individual decisions are measured. It then lays out a framework for are coordinated through market transactions, understanding differences over time and across macroeconomics begins by considering aspects of the countries in the quantity of output produced behavior of entire economies and develops models by economies and for understanding short-run that help make sense of these observed phenomena. fluctuations in economic activity. Although these two branches of economic analysis start from different points, they are unified by a set of In the fourth and final section of this resource guide, fundamental assumptions about human behavior. we employ some of the conceptual tools developed in the first three sections to examine the economics This resource guide begins by describing the basic of climate change. assumptions on which all economic analysis rests. The list of these assumptions is relatively short, and, NOTE TO STUDENTS: You will notice as you read as you will see, they are not terribly controversial. through the resource guide that some key terms and Yet, these assumptions provide the basis for the phrases are boldfaced. While many of these terms development of an extremely rich and flexible set are defined and/or explained in the text of the guide, of theories that can account for a wide range of you can also find explanations of these terms in the observed phenomena. glossary at the end of the resource guide. 2024–2025 Economics Resource Guide Revised Page June 17, 2024 6  Section I Fundamental Economic Concepts It is not from the benevolence of the butcher, to grow wheat, or the baker to bake bread; they didn’t the brewer, or the baker, that we expect our take these actions so that you could stop to pick up a dinner, but from their regard to their own loaf of bread on the way home; they did what they did interest. We address ourselves, not to their because it was in their own best interest. Yet somehow, humanity but to their self-love, and never almost magically, all of these individual choices were talk to them of our own necessities but of coordinated so that when you arrive at the store there their advantages. is an entire aisle of different types of bread available —Adam Smith, An Inquiry into the Nature and for you to choose from. Causes of the Wealth of Nations Now step back and consider the fact that the store Economics is about everyday life, about the choices you are in is only one of thousands of supermarkets Bowie High School - El Paso , TX each of us makes, and how these choices affect our across the country, and that the supermarket is only neighbors, our community, our nation, and our world. one of the many millions of businesses that make up Looking at these choices from the perspective of our economy. Many people take all of this for granted, economics helps to illuminate hidden wonders in but as the example of less developed countries around the everyday world around us. For example, the next the world makes clear, there is nothing automatic or time you stop at the supermarket to pick up a loaf of inevitable about how well our economy functions. bread on your way home, pause for a minute to reflect Economics can help us to understand both why our on your surroundings. If your supermarket is like economy functions smoothly most of the time, and most, there will be rows of fresh produce, aisles of why it occasionally breaks down. baked goods, shelves full of laundry detergent, cases of frozen foods and dairy products, and many other BASIC ASSUMPTIONS OF items. In fact, the average supermarket carries about 31,530 different items.1 ECONOMICS Economics is the study of how individuals make choices That each of these items is on the shelf is the result about how to allocate scarce resources in order to of a complicated chain of decisions by an almost satisfy virtually unlimited human wants and about how uncountable number of different people. For example, individuals interact with one another. While economists for a loaf of bread to reach the store, a farmer had to study a vast range of different behaviors, their work is decide to grow the wheat, a milling company had to unified by their reliance on a few seemingly simple, yet purchase the wheat and grind it into flour, a bakery remarkably powerful assumptions. had to purchase the flour along with other ingredients and then combine them to produce the loaf, and finally Scarcity this perishable product had to be delivered in a timely Scarcity is an inescapable fact of human existence. fashion to the store. Each product has a similar story. There are only twenty-four hours in the day to devote to work, study, play, sleep, and other essential When you go to the store, you expect to be able to find activities. No matter how wealthy a society is, the the bread and all the other products your supermarket amount of work, energy, knowledge, and capital carries; but what insures that all of them will be there, available to produce the goods and services people as they almost always are? No one ordered the farmer wish to consume is limited. On the other hand, our 2024–2025 Economics Resource Guide Revised Page June 17, 2024 7 desires are insatiable. Just as families must choose opportunity costs of that action and then select the how much income to spend on food, clothing, vacation action that produces the greatest benefit. It is important travel, and savings for retirement, societies face to note that the benefits can be interpreted broadly. choices about how much of their resources to devote to Many people care a great deal about social issues—such healthcare, national defense, and education. as reducing pollution or helping those less fortunate than themselves. Such concerns are entirely consistent with Trade-offs rational decision-making or rationality. Scarcity implies that every choice we make requires us to give up something to get something else. If you Most of the time, people perform this cost-benefit decide to spend an hour watching television, then that calculation intuitively and approximately. In the same is one less hour you have available to study. Similarly, way that a basketball player does not stop to calculate if you choose to spend $10 to go to a movie, then you the physics behind a perfect three-point shot, rational have $10 less to spend on video games or to save for people acquire a feel for what the costs and benefits college expenses. of their actions will be. Just as some of us are better at hitting three-point shots than others, we are not Opportunity Cost born with the ability to infallibly calculate costs and The cost of what you choose is what you have to give benefits. One of the rewards of studying economics is up to get it. Economists call what you give up the that it helps us to become better decision-makers. “opportunity cost” of your choice. It is important to note that the opportunity cost is not necessarily the Gains from Trade same as the monetary price you pay. For example, Individuals differ in their abilities, interests, and Bowie High School - El Paso , TX suppose a friend offers you a free ticket to a baseball resources. As a result, we all are better at and get game. You may not have to pay for the ticket, but the more pleasure from some activities than others. By opportunity cost of attending the game is the value of specializing in the things we like and do the best, and what you would have been doing during that time if then trading with other people who have different you had not gone to the game. For example, if you had abilities, both we and they can then be better off. As been planning to work mowing lawns, the opportunity long as the exchange is voluntary, then the benefits must cost of this choice is the income from mowing that you outweigh the costs for both of the people involved. would forego by attending the game. MODELS AND ECONOMIC THEORY Opportunity cost is a seemingly simple concept but Economic analysis relies on careful observation, applying it can sometimes be rather tricky. Consider description, and measurement of economic activity. the cost of attending college. It might seem obvious But it also relies on theory. To understand how the that the cost of attending college is the sum of the price economic phenomena we observe fit together, it is of tuition, books, room and board. But this answer necessary to build theoretical models that capture the excludes an important cost of attending college. For essential features of these interactions while stripping most people, the biggest cost of attending college is away the unnecessary details. Models come in a the value of their time. By choosing to attend class wide variety of forms and can be expressed in many and do homework, you are giving up time that could different ways. otherwise be spent working for pay. At the same time, the explicit monetary costs of attending college may In economics, models most often consist of diagrams overstate the true expense. Even if you did not attend or mathematical formulas. At first glance, many of college, you would still need to eat and have someplace these models may appear hopelessly simplistic. But to live. Thus, the costs of room and board are not really the test of a model is in how well it captures the part of the cost of college. aspects of reality that we are seeking to understand. The simplicity and lack of realism of many of these Rationality models is what allows us to identify so clearly what Economics assumes that people make choices by assumptions and characteristics are important. comparing the benefits of each action with the 2024–2025 Economics Resource Guide Revised Page June 17, 2024 8 POSITIVE AND NORMATIVE EFFICIENCY AS A GOAL ECONOMICS An important criterion that economists often apply The insights that economics offers about individual in evaluating a society’s use of scarce resources is and social decisions can be used in two ways. Positive the efficiency of the resulting allocation. Given any economics uses the tools of economic analysis to particular outcome, economists would say that it was describe and explain economic phenomena and to efficient if there is no way to improve at least one make predictions about what will happen under person’s well-being without reducing the well-being of particular circumstances. It focuses on identifying someone else. This criterion is called Pareto efficiency, cause-and-effect relationships and measuring their after the Italian economist Vilfredo Pareto (1848–1923), size. For example, positive economics tells us how who was the first to make use of this concept. much we might expect the consumption of gasoline to Notice that Pareto efficiency can characterize a wide decrease when the price of gasoline increases. In this range of different economic outcomes. Consider, for sense, positive economics is essentially value free. It example, an economy with ten people that produces does not require that the economic analyst express any $100 worth of goods and services. If each citizen opinion about the relative merits of different choices. receives $9 of benefits and $10 of production is wasted, Normative economics is the term used to describe the then this outcome is not Pareto efficient. Redistributing use of economic analysis to guide decisions about what the $10 would make at least some of the citizens better should be as opposed to what is the case. Normative off without making any of them worse off. On the other economic statements combine economic analysis with hand, a situation in which each citizen receives $10 is value judgments about the relative merits of different Pareto efficient; there is no way to increase the well- Bowie High School - El Paso , TX possible economic outcomes. The tools of economic being of any citizen without reducing the benefits of analysis, such as cost-benefit comparisons, can help to another. structure a discussion of different possible outcomes. However, an outcome in which one citizen receives $91 But, choices between these outcomes usually require of income and each of the other nine citizens receives $1 us to refer to criteria beyond the scope of economic is also efficient by the Pareto criterion. The only way to theory to justify our particular choices. make anyone better off is through redistribution. Pareto To better illustrate this, let’s consider the debate about efficiency does not provide a basis for choosing between whether to increase the minimum wage. Positive these alternative efficient distributions of benefits. economics can help identify the way in which such an Which distribution is best is, from the perspective of increase would affect different groups as well as provide economic analysis, a normative judgment that rests on estimates of their size. In addition to recognizing that a criteria outside the realm of positive economics. While hike in the minimum wage would increase the incomes economic theory does not provide a basis for such of those workers who hold minimum-wage jobs, it is choices, economists often offer such value judgments important to also note that higher wages may result along with their positive analysis. in some minimum-wage workers losing their jobs. Despite this limitation, efficiency is an important first Moreover, others who are seeking employment in jobs step in maximizing overall well-being. When we make covered by the law may be unable to find employment. decisions about how to allocate resources, it is important Finally, employers who have to pay higher wages may that we do so in a way that does not waste any of them. see their profits diminish, and they may pass some of the costs on to consumers, who will see the prices of MICROECONOMICS AND goods and services that depend on minimum-wage workers increase. As this list suggests, an increase MACROECONOMICS in the minimum wage will benefit some people and The tools of economic analysis can be used to hurt others. To decide whether the benefits outweigh study a wide array of phenomena, ranging from the costs requires a value judgment about the relative how individuals and businesses make decisions, to ranking of these effects on the different groups affected how they interact in markets, on up to the factors by the legislation. that determine the overall level of production, employment, and the price level of national economies. 2024–2025 Economics Resource Guide Revised Page June 17, 2024 9 The field of economics is traditionally divided 6  conomics assumes that people make choices E into two broad subfields: microeconomics and rationally by comparing the benefits and macroeconomics. Microeconomics concentrates on opportunity costs of each action and selecting individual behavior and the operation of particular the action that yields the greatest net benefit. markets. Macroeconomics concentrates on the overall Trade makes everyone involved better off. 6 performance of the national economy. 6  conomic models help us to understand E Clearly microeconomics and macroeconomics are economic phenomena by capturing essential closely linked. They share common assumptions about details and eliminating unnecessary details. the basic features of human behavior. But, because  ositive economics uses the tools of economic P 6 they focus on economic activity on different scales, analysis to describe economic phenomena and different aspects of this behavior are important. And, make predictions about what will happen under their modes of analysis are sufficiently different, so it is particular circumstances. useful to consider them separately. 6  ormative economics uses the tools of N economic analysis to evaluate the relative SECTION I SUMMARY merits of different situations. 6  conomics is the study of how individuals E 6  areto efficiency is an important criterion in P make choices about how to allocate and economics. It describes a situation in which the distribute scarce resources and how they only way that anyone can be made better off interact with one another. is by reducing the well-being of one or more Bowie High School - El Paso , TX  carcity is inescapable because resources are S other people. 6 limited and human desires are insatiable. 6  he two main branches of economics are T  very choice we make involves trade-offs. The E microeconomics and macroeconomics. 6 opportunity cost of what we choose is what we must give up by making that choice. 2024–2025 Economics Resource Guide Revised Page June 17, 2024 10  Section II Microeconomics As the example of the supermarket discussed earlier PERFECTLY COMPETITIVE illustrates, our modern economy achieves a high degree of coordination. The mechanism that produces this MARKETS coordination is the interaction of supply and demand Markets within markets. Within markets, the actions of buyers A market is comprised of all of the buyers and sellers of and sellers determine the price at which each product a particular good or service. Some markets, such as the or service sells and the quantity that changes hands. New York Stock Exchange or the Chicago Mercantile Individual buyers and sellers respond to market prices Exchange, are highly organized. Buyers and sellers in in predictable ways. such markets come together at a single location, and an auctioneer helps to set a price at which exchanges take The interaction of supply and demand in markets is place.2 Bowie High School - El Paso , TX the central topic of microeconomics. Our starting point is to develop an understanding of the behavior More often, markets are less formal. Nevertheless, we of perfectly competitive markets. We will begin by can think of the interaction between buyers and sellers defining what we mean by a market, and then we will as constituting a market. For example, consider the describe in more detail how supply and demand are market for gasoline in your community. The sellers determined by the self-interested choices of individual in this market are all the local gas stations in town, market participants. Although the assumptions of while the buyers consist of all the vehicle owners in the perfect competition may seem unrealistic at first, community or passing through it. Each of the sellers the resulting model is an essential building block for in this market posts the prices at which they will sell a economic analysis. It is approximately true in many gallon of gasoline, and buyers will select where to fill situations and provides an important benchmark their tanks based on price and convenience. The buyers against which to compare many other more of gasoline are likely to be well informed about prices complicated models. because gas prices are continually posted at all of the different stations. After developing the model of perfect competition, we will illustrate its usefulness in analyzing a range The market for gasoline is highly competitive. There of important topics, including the effects of taxation are many buyers and sellers even in a relatively small and other types of government policies, as well as community, and none of these market participants trades the costs and benefits of trade. Having explored these more than a small fraction of the gasoline that changes applications, we will then begin to introduce additional hands. As a result, no one buyer or seller influences features necessary to capture a wider range of the price of gasoline, or the quantity sold. Rather, the economic phenomena. In this segment of the resource price and quantity sold are determined by the combined guide, we will examine a number of different ways in actions of all the buyers and sellers in the market. The which markets may “fail” to be economically efficient. owner of each gas station knows that there are other stations selling a very similar product, so if the owner We will conclude our discussion of microeconomics raises their price above the going price, then customers with a closer look at the role of government and other will go elsewhere. On the other hand, the owner has no forms of collective choice. reason to lower the price significantly below the going price because this will simply reduce their income. 2024–2025 Economics Resource Guide Revised Page June 17, 2024 11  FIGURE 1 STEVE'S DEMAND SCHEDULE PRICE QUANTITY OF GASOLINE DEMANDED $0.50 52.5 $1.00 50 $2.00 45 $3.00 40 $4.00 35 $5.00 30 $6.00 25 $7.00 20 $8.00 15 $9.00 10 Bowie High School - El Paso , TX STEVE'S DEMAND CURVE Steve’s Demand Schedule Steve’s and Demand Schedule Demand and Demand Curve forCurve Gasoline for Gasoline In much the same way, because each buyer purchases buy or sell as much as they wish without influencing the only a small amount of gasoline compared to the total market price. market, no one buyer can influence the price. While only a few markets precisely conform to We say that a market is perfectly competitive if the good the assumptions of perfect competition, many real or service being bought and sold is highly standardized, world markets are characterized by a high degree of the number of buyers and sellers is large, and all of the competition and can usefully be described in terms of participants are well informed about the market price. the perfect competition assumption. The market for In such a market, buyers and sellers know that they can gasoline is a good example of a nearly competitive 2024–2025 Economics Resource Guide Revised Page June 17, 2024 12  FIGURE 2 PRICE STEVE NORA MARKET 0.5 52.5 + 18.5 = 71 1 50 17 67 2 45 14 59 3 40 11 51 4 35 8 43 5 30 5 35 6 25 2 27 7 20 0 20 8 15 0 15 9 10 0 10 Bowie High School - El Paso , TX Derivation of Market Derivation Demand of Market Demand for Gasoline for Gasoline market. Unless you live in a very small town, you Demand have probably noticed that the price of gasoline is The quantity demanded of any good is the amount of not precisely the same at different stations. But, the that good buyers are willing and able to purchase. This differences in prices are never very large. As a result, quantity depends on a wide range of factors. One of the many of the lessons we learn from analyzing perfectly most important is the good’s price. If the price of the competitive markets can be applied to less than perfectly good is higher, buyers will demand less of the good; if competitive markets. Our analysis of perfect competition the price is lower, then they will demand more. This will also provide a useful benchmark against which to negative relationship between a good’s price and the compare the outcomes of other types of markets. quantity demanded is called the law of demand. 2024–2025 Economics Resource Guide Revised Page June 17, 2024 13 The law of demand is a result of the cost-benefit analysis The graph shows that we add the two demand curves that rational decision-makers use when deciding how horizontally to obtain the market demand. to allocate their resources. As the price of a good increases, the opportunity cost of consuming that good Shifts in the Demand Curve also increases since consumers must cut back on their The market demand curve depicts the relationship consumption of other goods to afford the higher price. between the quantity demanded and its price, assuming If, for example, the price of gasoline rises, people that all other factors that might influence the quantity will likely find ways to reduce the amount that they demanded remain unchanged. But many other things drive. They might do this by planning their trips more can influence the quantity demanded. If one of these carefully or choosing to take the bus or ride a bicycle factors changes, it causes the entire demand curve to rather than drive. shift. The table in Figure 1 illustrates how Steve’s purchases For example, if your community creates a new system of gasoline each month depend on the price per gallon. of bicycle lanes that make it easier to bike from place to At $1 per gallon, Steve buys 50 gallons; when the price place, the quantity of gasoline demanded will decline at rises to $2 a gallon, he cuts back to 45 gallons. If the every price. As Figure 3 shows, such a change causes price rises further, to $3 a gallon, he cuts back to 40 the market demand curve to shift to the left, indicating gallons. This table is called a demand schedule. that at each price a lower quantity is demanded. Let’s consider some of the most important factors affecting The graph in Figure 1 shows another way of the quantity demanded. representing Steve’s demand schedule. The downward- sloping line in this graph is called Steve’s demand Income Bowie High School - El Paso , TX curve. Notice that we plot the points of Steve’s Suppose Steve’s employer reduces his weekly hours demand schedule with the quantity demanded on the of work, and thus his income. Because Steve has less horizontal axis and the price on the vertical axis. To money to spend on all the things he wishes to buy, he read this graph, find a price on the vertical axis (say will likely reduce his consumption of gasoline. For most $3 per gallon) and then draw a line horizontally until it goods, demand is positively related to income: when intersects the demand curve. Now draw a line vertically income rises, the quantity demanded rises, but when downward from that point until it intersects the income falls, the quantity demanded falls. Goods for horizontal axis. The point at which this line intersects which this is true are called normal goods. the horizontal axis (40 gallons) is the quantity Steve demands when the price is $3 per gallon. Not all goods are normal goods, however. Goods for which the quantity demanded falls as income rises are When the market price changes, we find Steve’s quantity called inferior goods. Bus rides might be an example of demanded by moving up or down along the demand an inferior good. As their income increases, consumers curve until we reach the height corresponding to the will be more likely to buy a car and drive instead of new market price. For example if the price were to taking the bus. rise from $3 to $5 a gallon, Steve’s quantity demanded would decline from 40 gallons a month to 30 gallons The Prices of Related Goods a month. This movement is illustrated in Figure 1 by Suppose that the price of airline tickets falls. The law the arrow pointing up and to the left along the demand of demand says that consumers will purchase more curve. airline travel. Because airline travel is to some extent a substitute for travel by car, people will likely reduce the Steve is, of course, just one buyer. To find the market number of miles they drive and hence the quantity of demand schedule, we must add up the quantity that gasoline they demand at any price. When a decline in every consumer will purchase at each possible price. the price of one good causes a reduction in the quantity Figure 2 illustrates how this process works with two demanded of another, we say that these goods are individuals. In addition to Steve, the market now substitutes. includes Nora. The table in Figure 2 shows that the market quantity demanded is the sum of the quantities Suppose, on the other hand, that the price of that Steve and Nora wish to consume at that price. automobile insurance falls. Lower insurance costs 2024–2025 Economics Resource Guide Revised Page June 17, 2024 14  FIGURE 3 Bowie High School - El Paso , TX Effects ofEffects a Bike Lane of a Bike Lane onon Demand Demand for Gasoline for Gasoline make it easier for more people to afford to own anticipation of this future change in his income. automobiles; car ownership will increase and so will the number of miles driven. When a lower price for Number of Buyers one good causes demand for another good to increase, Market demand is derived by adding up the demands we call those two goods complements. of individual consumers. If there are more consumers, then demand will increase. If your community is Tastes growing because people and businesses are moving Remember that the quantity demanded reflects a there, then the market demand for gasoline will be comparison of the benefits of consumption with the increasing with this growing population. opportunity costs of purchasing the good. If the perceived benefits of consumption change, then so Supply will the quantity demanded. For example, suppose that The quantity supplied of any good is the amount that concerns about the environmental impacts of driving sellers of that good are willing and able to produce. cause people to be more concerned about pollution. Many factors influence the quantity supplied, but the The likely impact will be a reduction in the demand for most important is the price that suppliers receive. gasoline. The higher the price is, the greater the quantity that suppliers will want to produce. This positive relation Expectations between price and quantity supplied is called the law Changes that you expect to occur in the future may of supply. also affect the quantity demanded. For example, if Steve is afraid that he may lose his job next month, The positive relationship between price and quantity then he might cut back on his driving now in supplied reflects the cost-benefit analysis of rational 2024–2025 Economics Resource Guide Revised Page June 17, 2024 15 suppliers. Gasoline station owners compare the Technology benefits of each gallon sold to the opportunity cost of Changes in technology can affect how businesses their time, effort, and expense to supply that gallon operate and hence the quantity supplied. In the case of gasoline. As the price rises, it will be rational to of gasoline, the shift from full-service to self-service devote more resources to supplying gasoline. So long reduces labor costs and increases the quantity supplied. as the price they receive exceeds their opportunity Similarly, pumps with credit card readers further reduce cost, they will be willing to supply gasoline. At higher labor costs and increase the quantity supplied. prices, they will be willing to work longer hours, hire additional help, and expand the size of their stations to Expectations boost sales. At lower prices, they will cut back on the If suppliers expect prices to rise in the future, then they time they spend supplying gasoline, reduce the number may reduce the quantity they will supply today and store of their employees, or shift their efforts toward selling current inventory in expectation of the higher future other products. prices. Figure 4 illustrates the relationship between price and Number of Sellers quantity supplied for Shelly. Again, we plot the price of As more sellers enter the market, the quantity supplied gasoline on the vertical axis and the quantity supplied will increase. On the other hand, if a seller decides to on the horizontal axis. Shelly’s supply curve is upward leave the market, then the quantity supplied will be sloping, reflecting the positive relationship between reduced. price and quantity supplied. Equilibrium The market supply curve is obtained by adding the Bowie High School - El Paso , TX What will the price of gasoline be? How many gallons quantities supplied at each price by all of the suppliers will be sold? To answer these questions, we need to put in the market. This is illustrated in Figure 5 for the the information about the market demand and market case where there are two suppliers. Again, we obtain supply together. There is, as we will see, only one the market supply curve by adding the individual combination of price and quantity at which the market supply curves horizontally. is at equilibrium, and it is at this point that the market will settle. Shifts in the Supply Curve The market supply curve shows the quantity supplied Equilibrium is a widely used concept in both the at each price, assuming that all other things remain physical and social sciences. It is defined as a point at unchanged. There are, however, many other factors which all the forces at work in a system are balanced that will influence the quantity supplied. A change by other forces, resulting in a stable and unchanging in any of these factors will cause the supply curve to situation. In economics, a market is in equilibrium when shift. Let’s consider some of the most important factors no participant in the market has any reason to alter their that might cause the supply curve to shift. behavior. Input Prices The market equilibrium occurs at the combination of Inputs are any of the things that suppliers have to price and quantity where the market supply and demand purchase to supply a product. For example, the price curves intersect. Because the supply curve is upward that gasoline stations must pay their suppliers for sloping and the demand curve is downward sloping, gasoline is a major cost of doing business. If this price there is only one possible point of intersection. Figure falls, the quantity of gasoline supplied will increase, 6 illustrates the market equilibrium for gasoline. In causing the supply curve to shift to the right. But, this hypothetical example, the equilibrium price is there are other inputs that are important as well. These $2.50, and the equilibrium quantity is 10,000 gallons of include labor costs, the real estate costs for the land gasoline per month. on which the gasoline station is located, and utilities such as electricity. If any of these input costs increases, At this point, we can say that the buyers and sellers in it will decrease the quantity supplied at every price, this market are all satisfied, in the sense that buyers are causing the entire supply curve to shift to the left. able to purchase as much gasoline as they would like at a price of $2.50 a gallon, and suppliers can sell as much 2024–2025 Economics Resource Guide Revised Page June 17, 2024 16 FIGURE 4 PRICE OF A GALLON OF GASOLINE QUANTITY OF GASOLINE SUPPLIED $1.50 65 $2.00 70 $2.50 75 $3.00 80 $3.50 85 $4.00 90 $4.50 95 $5.00 100 $5.50 105 $6.00 110 $6.50 115 $7.00 120 $7.50 125 $8.00 130 Bowie High School - El Paso , TX $8.50 135 $9.00 140 $9.50 145 $10.00 150 Shelly’s Shelly’s Supply Schedule and Supply Curve Supply Schedule and Supply Curve 2024–2025 Economics Resource Guide Revised Page June 17, 2024 17 FIGURE 5 PRICE OF A SHELLY’S LUTHER’S MARKET GALLON OF GASOLINE QUANTITY SUPPLIED QUANTITY SUPPLIED QUANTITY SUPPLIED $0.50 55 + 82 = 137 $1.00 60 89 149 $1.50 65 96 161 $2.00 70 103 173 $2.50 75 110 185 $3.00 80 117 197 $3.50 85 124 209 $4.00 90 131 221 $4.50 95 138 233 $5.00 100 145 245 $5.50 105 152 257 $6.00 110 159 269 $6.50 115 166 281 $7.00 120 173 293 Bowie High School - El Paso , TX $7.50 125 180 305 $8.00 130 187 317 $8.50 135 194 329 $9.00 140 201 341 $9.50 145 208 353 $10.00 150 215 365 Derivation of ofthe Derivation Market the Market Supply Curve Supply Curve 2024–2025 Economics Resource Guide Revised Page June 17, 2024 18  FIGURE 6 Bowie High School - El Paso , TX Market Market Equilibrium Equilibrium gasoline as they would like at this price. There are, no price of $3.90 a gallon, it will attract buyers from other doubt, buyers who complain that the price of gasoline stations, and its surplus will be reduced. But once the is too high and would like the price to be lower, and other stations see that they are losing customers, they similarly suppliers who complain that the price is too will be forced to lower their prices as well. The pressure low and would like it to be higher. to cut prices and attract business will not go away until the price has reached the equilibrium level of $2.50 a An important feature of market equilibrium is that gallon. the market has an automatic tendency to gravitate toward this combination of price and quantity. Figure 7 Now suppose that the price is below the equilibrium illustrates this point. We start (Figure 7a) by supposing price. Figure 7b illustrates this situation. At a price that the price is higher than $2.50. At a price of $4, a of $1.50, there is an excess demand for gasoline. gallon, for example, suppliers would like to sell 10,600 Buyers wish to purchase 11,000 gallons of gasoline, gallons, but buyers only wish to purchase 8,500 gallons but suppliers are willing to sell only 9,600 gallons. a month. In other words, there is an excess supply. Now there are shortages: some drivers cannot find No one can force people to buy more gasoline than any gasoline, and others have to wait in long lines to they want. Suppliers will find that they have too much purchase gasoline. gasoline on hand, their storage tanks are filling up, and they cannot unload their inventory. Buyers might be tempted to offer to pay a little bit extra to be sure to get what they need, and sellers will see they Under these circumstances, suppliers have an incentive can raise prices without sacrificing sales. The pressure to lower their price a little bit. If one station posts a to raise prices will continue until the price has reached 2024–2025 Economics Resource Guide Revised Page June 17, 2024 19 FIGURE 7 (a) EXCESS SUPPLY Bowie High School - El Paso , TX (b) EXCESS DEMAND Markets out of Equilibrium Markets out of Equilibrium 2024–2025 Economics Resource Guide Revised Page June 17, 2024 20 the equilibrium level. Only at this point will buyers and to pay $80, his benefit is $20, and Sharon’s benefit is sellers have no desire to change their behavior. just $10. Adding these amounts together, we see that the three purchasers receive a combined benefit of $70. We The Characteristics of Competitive call this amount the consumer surplus since it is the Market Equilibrium surplus value that consumers receive. Competitive markets tend to gravitate toward The demand curve in Figure 8 slopes downward, the equilibrium quantity and price. This is a very indicating that as the price falls, more of the fans will important feature of markets and has several desirable be willing to purchase tickets. At any point along consequences. First, competitive markets are an this demand curve, its height shows the marginal extremely effective method of allocating resources. purchaser’s willingness to pay. Because the height of the When the market for a good is in equilibrium, the price demand curve measures buyers’ willingness to pay, the conveys important information for potential suppliers difference between the height of the demand curve and about the value consumers place on that good. At the a horizontal line drawn at the market price measures same time, the price informs potential demanders about the consumer surplus for the marginal buyer at each the opportunity cost of supplying the good. This two- quantity demanded. More generally, we can use the way communication is how markets insure that scarce total area below the demand curve and above the market goods and services are produced at the lowest cost and price as a measure of total consumer surplus. This area, allocated to the buyers who value them the most highly. then, provides a monetary measure of how much benefit The competitive market equilibrium insures that the all of the buyers in a particular market receive from available supply goes to those buyers who value the participating in that market. Bowie High School - El Paso , TX good most highly, and that it is provided by those In the same way the height of the demand curve suppliers who have the lowest costs of supplying the represents buyers’ willingness to pay, the height of the good. This fact leads to the second characteristic of supply curve at each quantity supplied measures the the competitive market equilibrium: it maximizes the willingness to supply of the marginal seller—that is, the benefits buyers and sellers receive from exchange. seller who would leave the market if the price were any Let’s begin by considering the benefits buyers receive lower. Put somewhat differently, the height of the supply from participating in the market. The important insight curve measures the opportunity cost to the marginal is the height of the market demand curve at each point seller. If the market price exceeds this opportunity reveals the marginal buyer’s willingness to pay. The cost, the difference is a monetary measure of what is marginal buyer is the buyer who, at that price, is just called the producer surplus. And we can measure indifferent between buying the good in question or not the combined surplus of all suppliers using the area buying it. above the supply curve and below the market price as is illustrated in Figure 9. To illustrate this, let’s consider the highly simplified example presented in Figure 8. The table lists the Combining consumer surplus and producer surplus amount each of four fans would be willing to pay to provides a measure of the total benefits that market purchase a ticket to a Bruce Springsteen concert. The participants receive from their transactions. We call table shows that Barb values attending the concert at this benefit the total surplus. One goal of a benevolent $100, and at any price less than that she will purchase a social planner should be to maximize this combined ticket. The other potential buyers place a lower value on surplus, since this is the outcome that produces the attending the concert. greatest overall good. An outcome that maximizes total surplus satisfies the economist’s criterion of If the concert promoter sets the price of tickets at $60, Pareto efficiency, since at this point there is no way to then Steve will not purchase a ticket, since the most he make anyone better off without reducing the welfare of is willing to pay is $50. The other three consumers will someone else. all purchase tickets, but the benefit they receive from being able to purchase the ticket for $60 varies. Barb To see that the competitive market equilibrium indeed would have paid $100, so attending the concert produces meets the efficiency criterion and maximizes total a benefit valued at $40 for her. Since Bob was willing surplus, let’s consider Figure 10. Suppose first that a 2024–2025 Economics Resource Guide Revised Page June 17, 2024 21 FIGURE 8 BUYER BUYER WILLINGNESS WILLINGNESS TO TO PAY PAY Barb Barb $100 $100 Bob Bob $80 $80 Shar Sharon on $70 $70 Steve Steve $50 $50 DEMAND SCHEDULE PRICE PRICE BUYERS BUYERS QUANTITY QUANTITY DEMANDED DEMANDED more more than than $100 $100 None None 00 $80 $80 to to $100 $100 Barb Barb 11 $70 $70 to to $80 $80 Barb, Barb, Bob Bob 22 $50 $50 to to $70 $70 Barb, Barb, Bob, Bob, Sharon Sharon 33 $50 $50 or or less less Barb, Barb, Bob, Bob, Sharon, Sharon, and and Steve Steve 44 Bowie High School - El Paso , TX DEMAND CURVE The DemandTheCurve Represents Buyers’ Willingness to Pay Demand Curve Represents Buyers’ Willingness to Pay 2024–2025 Economics Resource Guide Revised Page June 17, 2024 22  FIGURE 9 Bowie High School - El Paso , TX Producer Surplus Producer Surplus quantity Q1, which is less than the equilibrium quantity, be produced, by whom, and to whom it should be was exchanged in the market. At this point, the value given. While such a task would be extremely difficult, of the good to buyers exceeds the cost to sellers of a competitive market achieves the same result simply supplying the good. A slight increase in the quantity through the self-interested actions of its participants, in such a market would yield an increased benefit to responding only to the signals provided by the market both parties. So Q1, or any other point to the left of the price. market equilibrium, cannot be efficient. Now, suppose that the quantity traded in the market is Q2, an amount APPLICATIONS OF THE greater than the equilibrium quantity. At Q2, the supply curve is above the demand curve, indicating that the COMPETITIVE MARKET MODEL cost to producers exceeds the value to consumers. Such Changes in Market Equilibrium an exchange cannot be accomplished voluntarily, but if Now that we have seen how to use the concepts of it did take place, then buyers or sellers would suffer a supply and demand to find the equilibrium price and loss in welfare. Moving to the left would raise overall quantity in a competitive market, we can use our market well-being. model to make predictions about how shifts in the economy will affect the market. Let’s consider some To achieve an efficient outcome, a market planner examples illustrating how the competitive market model would need to know the value each consumer places can be used to analyze important issues. on the good in question, and the cost of producing each unit, and would have to determine how much should One of the defining characteristics of our modern 2024–2025 Economics Resource Guide Revised Page June 17, 2024 23  FIGURE 10 Bowie High School - El Paso , TX Competitive Market Equilibrium Competitive Market Maximizes Equilibrium Maximizes Social Welfare Social Welfare economy is technological progress. New inventions the point at which supply and demand intersect moves are continually being developed that allow suppliers down along the demand curve from point A to point to produce more at lower costs. One example is the B. In the new equilibrium, the price is lower, and the development of synthetic Bovine Growth Hormone quantity is higher. (BGH), which allows dairy farmers to increase milk production by between 10 and 20 percent at little It is clear that the total surplus has increased as well, additional cost. The direct effects of this innovation since the shaded area between the supply and demand are illustrated in Figure 11. As is often the case, curves is now larger. Consumers are unambiguously the introduction of a new technology has other, better off as a result of the innovation. Since the market more subtle effects, called externalities, that are not price is now lower, everyone who previously purchased immediately obvious from an analysis of the market milk receives a larger surplus. In addition, at the lower that is immediately affected.3 We will discuss how to price consumers purchase additional quantities of incorporate externalities into our analysis later in this milk. The effect on producers is more ambiguous. The section of the resource guide. increase in sales causes an increase in producer surplus, but the lower price reduces the producer surplus on The first panel shows the market equilibrium before the the quantity that was previously being sold. Whether introduction of BGH. The shaded regions indicate the producers benefit depends on the balance of these two consumer and producer surplus at this equilibrium. The effects. introduction of BGH is illustrated in the second panel of Figure 11. This innovation allows dairy farmers to Let’s consider another example of how shifts in supply increase the quantity of milk they supply at any price, so and demand affect market equilibrium. Public health the supply curve for milk shifts to the right. As a result, officials have long recognized that cigarette smoking is 2024–2025 Economics Resource Guide Revised Page June 17, 2024 24 FIGURE 11 (a) MARKET EQUILIBRIUM BEFORE BGH Bowie High School - El Paso , TX (b) MARKET EQUILIBRIUM AFTER BGH Effects Effects of BGH on the Market for Milk of BGH on the Market for Milk 2024–2025 Economics Resource Guide Revised Page June 17, 2024 25 harmful. As a result, policymakers would like to reduce demanded. And demand is said to be unit elastic if a one smoking. One approach is to reduce the demand for percent change in price results in a one percent change cigarettes through public education campaigns and the in the quantity demanded. inclusion of warning labels on packages of cigarettes. Assuming that these efforts do in fact cause buyers Economists use elasticity because it provides a measure to demand fewer cigarettes, what is the effect on the of the responsiveness of demand to price changes that is market for cigarettes? independent of the units of measurement. For example, if we express the quantity of gasoline demanded in The answer can be found by examining Figure 12. To liters, then we will find that the demand curve has a illustrate the effect of public efforts to reduce smoking, different slope from the one that would result if we Figure 12 shows the demand curve for cigarettes measured demand in gallons. However, the elasticity shifting to the left. As a result, the intersection of the will be the same in both cases. supply and demand curves shifts down and to the left along the market supply curve for cigarettes. After this Measuring the actual elasticity of demand for particular shift, the equilibrium price and quantity both decrease. products is an important activity of applied economics. Nonetheless, we can state some general guidelines about Elasticity the factors that influence the price elasticity of demand. The competitive market model we have developed 6 Substitutes. Goods with close substitutes will allows us to predict the direction in which equilibrium tend to have relatively high price elasticities price and quantity will change in response to changes of demand because it is easy for consumers in market supply or demand. But to fully understand to switch from one product to another. For Bowie High School - El Paso , TX the impact of these changes, it is important to be able to example, the price elasticity of demand for a measure the size of the changes in prices and quantities particular cola drink is likely quite high because as well as their direction. To do this, we need to consumers can easily switch to a different brand introduce the concept of price elasticity. if the price rises. Conversely, when there are no The price elasticity of demand measures how much close substitutes, the price elasticity of demand the quantity demanded responds to a change in price. will tend to be lower. We calculate the price elasticity of demand using the 6 Necessities. Items that are regarded as following formula: necessities will generally have lower price elasticities of demand than luxuries. Many Price elasticity of demand = people must drive to and from work and use (Percentage change in quantity demanded) / their cars to run important errands. As a (Percentage change in price) result, the demand for gasoline has a low price Recall that because of the law of demand, the quantity elasticity of demand. demanded of a good is negatively related to its price, 6 Market Definition. The price elasticity of so this ratio will always be negative. It is conventional demand will depend on how we define the to ignore this sign when discussing the elasticity of market. The broader the market definition, demand. In other words, in practice, we use the absolute the fewer close substitutes there will be and value of the price elasticity of demand. the lower the elasticity of demand. The price elasticity of demand for soft drinks will be The price elasticity of demand reflects how responsive lower than the price elasticity of demand for any consumers are to changes in the price of a good. The particular brand of cola drink. greater the elasticity, the greater the proportionate change in the quantity consumers demand due to any 6 Time Horizon. Fully adjusting to changes given change in the price. Demand is said to be elastic in prices may take time. Take the example if a one percent change in price results in a greater than of gasoline prices considered earlier. At first one percent change in the quantity demanded. Demand there is not much people can do to reduce their is said to be inelastic if a one percent change in price consumption when the price of gasoline rises. results in a less than one percent change in the quantity But, over time people will buy more fuel- efficient cars, move closer to their work, and 2024–2025 Economics Resource Guide Revised Page June 17, 2024 26  make other changes that will allow them to 6 Time horizon. The longer the time horizon is, more significantly reduce their demand. the greater the elasticity of supply will be. Over Elasticity is related to the slope of the demand curve. short time horizons, firms may not be able to If two demand curves pass through the same point, the hire and train additional workers or add the curve that is flatter will have a higher elasticity. It is necessary equipment to increase production. important to note that as we move down along a linear Over a longer horizon, they can do this more demand curve, the elasticity will be falling continuously. easily. To see this, note that a linear demand curve must have As was the case with the price elasticity of demand, a constant slope ∆P/∆Q = e, (where we use the Greek if two supply curves pass through the same point, the letter ∆ to denote the change in price and quantity flatter curve will be the more elastic one. Figure 14 along the demand curve). The ratio ∆Q/∆P = 1/e, is also illustrates the variety of possible supply curves. Again a constant.4 Consequently the elasticity of demand is there are five cases. In the extreme case (a) the supply is equal to (1/e)·(P/Q). As we move down and to the right perfectly inelastic, indicating that the quantity supplied along the demand curve, P is falling and Q is rising, so will not change at all as the price changes. The supply the ratio P/Q must be decreasing. Since 1/e is constant, of Van Gogh sunflower paintings is perfectly inelastic the elasticity must also be falling. since there is no way to produce more of these. The remaining cases illustrate (b) inelastic supply, (c) unit Figure 13 shows five different possible demand curves elastic supply, (d) elastic supply, and the other extreme illustrating the range of possible elasticities. In the case (e) perfectly elastic supply. extreme case (a) demand is perfectly inelastic; the quantity demanded does not depend on price at all. The Using Elasticity