Test 2 Study Guide Elasticity s of Demand and Supply o Price Elasticity of Demand Elasticity change in QD change in P Measures the size of the change demanded when the price of a good changes Percent Change in Quantity New Quantity Initial Quantity New Quantity Initial Quantity 2 x 100 Percent Change in Price New price Initial Price New Price Initial Price 2 x 100 Absolute Value Larger the value the more sensitive the good is to a price change Smaller the value the less sensitive the good is to a price change Coefficient Greater than 1 Demand is elastic Coefficient Smaller than 1 Demand is inelastic Coefficient Equal to 1 Demand is unit elastic Coefficient Equal to 0 Demand is perfectly inelastic Perfectly Inelastic Demand Vertical curve When price increase quantity demand does not change Small change in price means large change in quantity Perfectly Elastic Demand Horizontal curve Substitutions Income Time More substitutes higher elasticity Large share of income higher elasticity Longer time higher elasticity o Price Elasticity of Supply Elasticity change in QS change in P Substitution More substitutes Higher elasticity o Cross Price Elasticity and Income Elasticity of Demand Cross Price Elasticity change in the QD of a good change in the price of one of its substitutes or compliments Income elasticity of demand change in quantity demanded change in income Positive income elasticity normal good Negative income elasticity inferior good Efficiency of Markets o Consumer and producer surplus Consumer surplus MB P Producer surplus P MC o Efficiency of competitive markets o Tax incidence Economic Efficiency A situation in which the quantities of goods and services produced are those that people value most highly Market Equilibrium A situation in which neither buyers nor sellers have any incentive to change their behavior MB MC QD QS Equilibrium in a competitive market is efficient Market is inefficient when there is a deadweight loss Sources of market inefficiency Taxes and subsidies Regulated prices and quantities Positive and negative externalities Public gods Monopoly and other limits to completion Asymmetric information The division of the burden of tax between the buyer and the seller If the price rises by the full amount of the tax then the burden of the tax entirely on the buyer If the price doesn t change then the burden of the tax falls entirely on the seller If the price rises by a lesser amount than the tax then the burden of the tax falls partly on the buyer and party on the seller 2 types Legal incidence who is legally liable for the payment of the tax the legal incidence is determined by the law Economic incidence who ultimately bears the real economic burden of the tax The market forces of demand and supply determine the economic incidence It is unrelated to the legal incidence If demand is more elastic or less inelastic the price increase is smaller and the buyers bear the smaller share of the tax If supply is more elastic or less inelastic the price increase is larger and the buyers bear the larger share of the tax Price Ceilings and Price Floors o Price ceilings A maximum legal price for a good service or activity When set below equilibrium price is this causes underproduction and thus creates deadweight loss When set above the equilibrium price it has no effect on the market Example rent control o Price floor A minimum legal price for a good service or activity When set above equilibrium price this causes an inefficiency in the market and creates deadweight loss When set below equilibrium price it has no effect on the market Example minimum wage Externalities o Basic concepts Externalities a cost or benefit arising from production that falls on someone other than the producer or a cost or benefit arising from consumption that falls on someone other than the consumer o Positive externalities A production or consumption activity that creates an external benefit Private benefit and social benefit Marginal private benefit the benefit to the consumer of an additional unit of a good or service Marginal external benefit the benefit of an additional unit of a good or service that people other than the consumer of the good or service enjoy Marginal social benefit o The marginal benefit enjoyed by the entire society o MSB MB MEB Example education o Negative externalities A production or consumption activity creates an external cost Private costs and social costs Marginal private cost the cost of production an additional unit of a good or service that is borne by the producer of that good or service Marginal external cost the cost of producing an additional unit of a good or service that falls on people other than the producer Marginal social cost o The marginal cost incurred by the entire society o MSC MC MEC Example pollution o Property rights Coase theorem If property rights are clearly defined and enforced only a small number of individuals are involved transaction are costs are low private negotiation then corrects the inefficiency Example property rights and pollution Inefficiency without property rights If not well enforced the producer will have no incentive to limit negative externalities causing overproduction and deadweight loss Final observation Not every externality problem is worth solving
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