Study Guide for Econ Exam #2I. Elasticitya. Elasticity= a measure of how much buyers and sellers respond to changes in market conditionsi. Luxuries have an elasticity more than 1 while necessities have an elasticity less than 1 ii. Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price iii. Its inelastic if the quantity demanded responds only slightly to changes in the priceiv. Goods with close substitutes tend to have more elastic demands because it is easier for consumers to switch from thatgood to others v. Goods also have more elasticity over long time horizonsb. Price elasticity of demand= a measure of how much quantity demanded of a good responds to a change in the price of that goodi. Price elasticity of demand = percentage change in quantity demanded/ percentage change in price c. Midpoint method: i. (Q1-Q2)/midpoint X 100= %d. Elasticity of demand is similarly related to slope of the demand curve, flatter the demand curve, the greats the price elasticity of demand ise. Vertical demand curve= perfectly inelastic demand (equals 0) f. Horizontal demand curve= perfectly elasticg. Total revenue= the amount paid by buyers and received by sellers of agood, computed as the price of the good times the quantity soldi. If demand is inelastic than an increase in price causes an increase in total revenue ii. If demand is elastic then an increase in price with cause a decrease in total revenue iii. If demand is unit elastic total revenue remains constant when the price changes h. Income elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in consumers’ income, computed as the percentage change in quantity demanded divided by the percentage change in incomei. Income elasticity of demand= (percentage change in quantity demanded)/(percentage change in income) i. Cross price elasticity of demand: a measure of how much the quantity demanded of one good responds to a change in price of another goodi. Cross price elasticity of demand= (percentage change in quantity demanded of good 1)/(percentage change in the priceof good 2)j. Price elasticity of supply: a measure of how much the quantity supplied of a good responds to a change in price of that good,computed as the percentage change in quantity supplied divided by the percentage change in price i. (Percentage change in quantity supplied)/(percentage change in price) II. Taxes and Welfarea. Tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls b. dead weight loss- reduction in total surplus due to the taxi. the fail in total surplus that results from a market distortion, such as a taxii. price elasticities determine the size of deadweight loss 1. when supply is relatively inelastic the deadweight loss of a tax is small 2. when supply is relatively elastic the deadweight loss of a tax is large 3. when demand is relatively inelastic the deadweight loss is small 4. when demand is relatively elastic the deadweight loss islarge 5. when a deadweight loss is too great the market makes a relatively small amount of revenue (situation sometimes called the Laffer CurveIII. Externalitiesa. Externality= the uncompensated impact of one person’s actions on thewell being of a bystander b. Social cost includes the private cost of the aluminum producers plus the costs to those bystanders affected adversely by the pollutionc. Total surplus derived from the market= the value to consumers of aluminum (or other good) minus the cost of producing the goodd. Internalizing the externality= altering incentives so that people take account of the external effects of their actions i. Ex: taxatione. in the presence of a positive externality, the social value of the good exceeds the private value. The optimal quantity Qoptimum is therefore larger than the equilibrium quantityf. Negative externalities lead markets to produce a larger quantity than is socially desirable. Positive externalities lead markets to produce a smaller quantity than is desirable. Governments and internalize the externality by taxing the goods that cause a negative externality and subsidizing those that cause a positive externalityg. Government policies as a result of externalities (Public Solutions) i. The gov can remedy an externality by making certain behaviors either required or forbidden (command and control policies: regulation)ii. Taxes enacted to deal with the effects of negative externalities are called corrective taxes or pigovian taxes (market based policy #1: corrective taxes andn subsidies) 1. Corrective prices sets the price of good (i.e. pollution) while permits sets the quantity of a good (i.e. amount of pollution emitted into the atmosphere) iii. Market based policy #2= permits for firms who value the good most highly h. Private solutions to externalities i. Charities 1. Gov encourages charities through the tax system which allows an income tax deduction for charitable donationsii. Contractsi. Coase Theorem= the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own j. Transaction costs= the costs that parties incur in the process of agreeing to following through on a bargain.IV. Public Goods and Common Resources a. excludabilityi. The property of a good whereby a person can be prevented from using it b. Rivalry in consumption i. The property of a good whereby one person’s use diminishes other people’s use c. public goods i. goods that are neither excludable nor rival in consumptiond. common resources i. goods that are rival in consumption but not excludable e. club goodsi. goods that are excludable but not rival in consumptionf. free rider- a person who receives the benefit of a good but avoids paying for it g. Tragedy of the commons= a parable that illustrates who common resources are used more than is desirable from the standpoint of society as a whole i. General lesson= when one person uses a common resource, he or she diminishes other people’s enjoyment of it, because of this externality, common resources tend to be used excessivelyh. in all cases, the market fails to allocate resources efficiently because property rights are not well established i. when the absence of property rights causes a market failure, the government can potentially solve the problem V. The costs of productiona. Total
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