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URI ECN 201 - Exam 2 Study Guide

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Exam # 2 Study Guide Lectures: 7 - 12Material:Exam 3/24, Chafee 277, 12:30-1:45Material:- Krugman chapters 4,5,6,7,9,10- Lectures 7-13Basic Fundamental Knowledge:1. Consumer Surplus and Producer Surplusa. Understand what are consumer surplus, producer surplus, and total surplus-The net gain that a buyer achieves from the purchase of a good is called that buyer’s individual consumer surplus. It’s the consumer’s willingness to pay minus the set price.-Individual producer surplus is the net gain to an individual seller from selling a good. It is equal to the difference between the price received and the seller’s cost.-The total surplus generated in a market is the total net gain to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus.ECN 201 1st Editionb. Be able to calculate consumer surplus, producer surplus, and total surplus.To do this, you find the area of the triangle. The formula for that is ½(base x height)c. When the total surplus is maximized? What’s the implication on market efficiency?Once this market is in equilibrium, there is no way to increase the gains from trade. Any other outcome reduces total surplus. An efficient market performs four important functions:1. It allocates consumption of the good to the potential buyers who most value it, as indicated by the fact that they have the highest willingness to pay.2. It allocates sales to the potential sellers who most value the right to sell the good, as indicated by the fact that they have the lowest cost.3. It ensures that every consumer who makes a purchase values the good more than every seller who makes a sale, so that all transactions are mutually beneficial.4. It ensures that every potential buyer who doesn’t make a purchase values the good less than every potential seller who doesn’t make a sale, so that no mutually beneficial transactions are missed.d. Relationship between market efficiency and total surplusThe market is most efficient when the total surplus is maximized, which, as stated above, is when the price is set at equilibrium.2. Price Controls and Quotas2.1 Price ceilingsa. Understand pricing ceiling graphicallyA price ceiling is a maximum price sellers are allowed to charge for a good or service.b. What is binding & non-binding price ceiling?If a price ceiling is set above the equilibrium price, it won’t have any effect. Suppose that the equilibrium rental rate on apartments is $1,000 per month and the city government sets a ceiling of $1,200. Who cares? In this case, the price ceiling won’t be binding—it won’t actually constrain market behavior—and it will have no effect.c. Be able to explain how price ceilings can lead to inefficiencyWhen price ceilings are introduced, there is a loss of total surplus, making the market inefficient.d. Deadweight loss --- what it is, how to calculate it, and graphically show it-Deadweight loss is the loss in total surplus that occurs whenever an action or a policy reduces the quantity transacted below the efficient market equilibrium quantity. Calculate it by finding the area of the triangle.e. Effects on the market that may result from price ceilings-inefficient allocation to consumers: people who want the good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a low price do get it.-wasted resources: people expend money, effort, and time to cope with the shortages caused by the price ceiling.-a black market is a market in which goods or services are bought and sold illegally—either because it is illegal to sell them at all or because the prices charged are legally prohibited by a price ceiling.2.2 Price floorsa. Understand pricing floor graphically-price floor - a minimum price buyers are required to pay for a good or service.b. What is binding & non-binding price floor?-Just as in the case of a price ceiling, the floor may not be binding—that is, it may be irrelevant. If the equilibrium price of butter is $1 per pound but the floor is set at only $0.80, the floor has no effect.c. Be able to explain how price floor can lead to inefficiency-The price floor will sometime be set at a price that makes suppliers want to supply a lot more than consumers want to supply so it leads to an unwanted surplus for suppliers.d. Deadweight loss – what it is, how to calculate it, and graphically show it-deadweight loss - equal to the area of the shaded triangle in the figuree. Effects on the market that may result from price floor-inefficient allocation of sales among sellers: those who would be willing to sell the good at the lowest price are not always those who actually manage to sell it.-waste: The surplus production is sometimes destroyed, which is pure waste; in other cases the stored produce goes, as officials euphemistically put it, “out of condition” and must be thrown away.-inefficiently high quality are offered: sellers offer high-quality goods at a high price, even though buyers would prefer a lower quality at a lower price.2.3 Quotasa. Understand what are Quotas, effective quota, quota rent/wedge?-A quantity control, or quota, is an upper limit on the quantity of some good that can be bought or sold. The total amount of the good that can be legally transacted is the quota limit.-The Wedge, or Quota: the difference between the demand price and the supply price at the quota limit. Equal to the market price of the license when the license is traded.b. What’s the effect of quota on the market-inefficiency due to missed opportunities: quantity controls create deadweight loss by preventing mutually beneficial transactions from occurring, transactions that would benefit both buyers and sellers.-quantity controls generate an incentive to evade them or even to break the lawc. Be able to explain how quotas can lead to inefficiencyd. Deadweight loss --- what it is, how to calculate it, and graphically show it3. Elasticitya. Price elasticity of demandi. Understand why we use elasticity-The price elasticity of demand compares the percent change in quantity demanded to the percent change in price as we move along the demand curve.ii. Understand the principle of elasticity-A demand curve is elastic when an increase in price reduces the quantity demanded a lot (and vice versa).-When the same increase in price reduces quantity demanded just a little, then the demand curve is inelastic.b. Be able to calculate


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