Econ 2.pdf

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I. Ten Pr inciples of Economics

Business Cycle f luctuat ions in economic activ ity, e.g. employment & production

Economics the study of how society manages its scarce resources

Efficiency the property of society getting the most it can from its scarce resources

Equity the property of distributing economic prosperity fairly among the members of

society

Externality the impact of one persons actions on the well-being of a bystander

Incentive something that i nduces a person to act

In flation an increase in the overall level of prices in the economy

Marginal Changes small incremental adjustments to a plan of action

Market Economy an economy that allocates resources through the decentralized decisions

of many fi rms & households as they interact in markets for goods & services

Market Failure a situation i n which a market left on its own fai ls to allocate resources

efficiently

Market Power the abi l i ty of a single economic actor (or smal l group of actors) to have a

substant ia l in f luence on market pr ices

Opportun ity Cost whatever must be given up to obtain some item

Productivi ty the quant ity of goods & services produced from each hour of a workers time

Proper ty Rightsthe abil i ty of an ind iv idual to own & exercise contro l over scarce resources

Rational People people who systematically and purposefully do the best they can to achieve

their objectives

Scarcity the limited nature of societys resources

Ten Pri nciples of Economics

1) People face trade-offs

o Making decisions requires trading off one goal against another

o Classic t rade-off is between guns & but ter (nat ional defence vs. consumer

goods)

o Society faces trade off of eff iciency vs. equity (size of economic pie vs.

distribution)

2) The Cost of Something is What You Give Up to Get I t

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o Comparison of costs & benefi ts of alte rna tive courses of act ion

o Must consider the opportunity cost

3) Rational People Think at the Margin

o Marginal changes (small incremental adjustments) to existing plan of action

o Decisions made by compar ing marginal benefits & marginal costs

o A persons wil li ngness to pay for any good is based on margina l benefit tha t

an extra unit wil l yield

o Marginal benefi t depends on how many un i ts a person already has

o A rational decision maker acts if & only if marginal benefit exceeds marginal

cost

4) People Respond to Incentives

o Because ra tional ppl make decisions by compari ng costs & benefits

o Di rect & unintended effects of alter ing incentives

o Alteration of the cost-benefit calculation

5) Trade Can Make Everyone Better Off

o Trade al lows each person to specialize in t he activi t ies he/she does best &

enjoy a greater variety of goods & services

o Simul taneously competi tors & partners

6) Markets Are Usually a Good Way to Organize Economic Activi ty

o Market economy > central planning

o Decisions of a central planner = replaced by decisions of mi ll ions of fi rms

&households

o Fi rms & households in teract in marketplace; pr ices & self-in terest guide

decisions

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o Free markets comprised of buyers & sellers primarily interested in own well-

being

o Adam Smith: Households & f i rms in teract in markets as if guided by an

inv isible hand

o Market pr ices ref lect both value of a good to society & the cost of making that

good

o Smiths insight : Pr ices adjust to guide these individuals to reach outcomes

maximize the welfare of society as a whole

o Taxes distort pr ices, pr ice control causes harm

7) Governments Can Sometimes Improve Market Outcomes

o Invisible Hand can work magic only if govt enforces rules & maintains

institutions

o Rely on govt-provided serv ices & cour ts to enforce property r igh ts

o I.H. not omnipotent 2 reasons for govt to intervene in economy & change

allocation of resources

To promote efficiency

To promote equity

o Most policies aim to either enlarge economic pie or change division of

o I.H. may also fail to ensure equitable distribution of economic prosperity

o Although govt canimprove market outcomes at times doesnt mean wil l

8) A Countrys Standard of Liv ing Depends on Its Abi li ty to Produce Goods & Services

o

Large variation in avg. Income reflected in various measures of quality of life

o Big changes in li ving standards over t ime

o Almost al l var iat ion in li ving standards is due to dif ferences in count ries

productivity

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o Growth rate of a nations productivity determines growth rate of average

income

9) Pr ices Rise When the Government Prints Too Much Money

o Keeping in f lation at a low level is a goal of all economic policy-makers

o Growth in quant i ty of money causes in flat ion bec value of money falls

10) Society Faces a Short-Run T rade-off Between In f la tion & Unemployment

o Short-r un effects of monetary injections:

Stimulates overal l level of spending, thus demand for goods & services

Cause fi rms to ra ise pr ices over t ime, in meantime encourages

increase of quant i ty of goods & serv ices produced & to hire more

workers

More hi ri ng = lower unemployment

o One final economy-wide short-run trade-off between inflation &

unemployment

o Over shor t t ime per iods, many economic policies push in flat ion &

unemployment in opposite directions (issue faced regardless of level star ti ngpoints)

Summary

Ind ividual Decision-Making Fundamental Concepts:

People face trade-offs among alternative goals, cost of any action measured in terms

of forgone oppor tun i ties, rat ional ppl make decisions by comparing marginal costs &

benefits, ppl change behaviour in response to incentives

In teractions Among People Fundamenta l Concepts:

Trade can be mutually beneficial, markets are usually good way of coordinat ing

t rade among ppl, govt can potent ial ly improve market outcomes if there is some

market fai lure or if market outcome is unequitable

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Economy As A Whole Fundamental Concepts:

Productiv ity is the ult imate source of liv ing standards, money growth is ul timate

source of in f lation, society faces a shor t-run t rade-off between in f lation &

unemployment

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I I. Thinking L ike An Economist

Circular-Flow Diagram a visual model of the economy that shows how dol la rs f lowthrough markets among households & fi rms

Macroeconomics the study of economy-wide phenomena, includ ing in flat ion,

unemployment, & economic growth

Microeconomics the study of how households & f irms make decisions & how they in teract

in markets

Normative Statements claims that attempt to prescribe how the world should be

Posit ive Statements claims that attempt to describe the world as it is

Production Possibili ties Front ier a graph that shows the combinat ions of output that the

economy can possibly produce given the avai lab le factors of product ion & the available

production technology

Circular F low Diagram

Circular-Flow Diagram Model

Economy is simpl if ied to two types of decision makers households & fi rms

Fi rms p roduce goods & serv ices using inputs (e.g. land, labour, capita l) known as

factors of productionwhile households own factors of production & consume g&sproduced

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The Production Possibilities Frontier Model

Shows the various combinations of output that the economy can possibly produce

given the available factors of production & the available production tech that firms

can use to tu rn these factors in to output

Two end points represent t he extreme possibi li ties; mostly l ikely div ision of time

between the two

Resources are scarce, therefore not every conceivable outcome is feasible

An outcome = eff icient if economy is getting al l i t can from availab le scarce resources(represented by points on [rather than inside] production possibilities frontier)

If source of ineff iciency is el imina ted, economy can increase i ts p roduction of both

goods

Shows one trade-off that society faces once eff iciency is reached, must p roduce less

of one good to get more of another

Shows oppor tuni ty cost of one good as measured in terms of other good

PPF often has this bowed shape; shows trade-off between outputs of different goodsat a given time, but can change over t ime

Ex. Posit ive versus Normat ive Analysis

Polly: Minimum-wage laws cause unemployment.

Norma: The government should raise the minimum wage.

Why Economists Disagree

~ may disagree about val idi ty of al ternat ive positive theor ies about how the world

works

~ may have different values & therefore different normative views about what policyshould try

to accomplish

Summary

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Economists t ry to address subject wi th scientists objectiv ity: make appropr iate

assumptions & build simplified models (e.g. circular-flow diagram & production

possibil it ies front ier)

Field d ivided in to 2 subfields: microeconomics (study decision-mak ing by households

+ fi rms & in teraction among the two in marketplace) & macroeconomics (study

forces & t rends tha t affect the economy as a whole)

Posit ive statement = an assertion about how the world is; normative = how the world

ought to be. Normative statements are acting more as policy advisors than scientists

Economists who advise policy-makers offer conflicting advice either bec of

di fferences in sci judgement or i n values. At ti mes economists may be uni ted in

advice, but policy-makers may ignore

I I I . In terdependence and the Gains From Trade

Absolute advantage the comparison among producers of a good accord ing to thei r

productivity

Comparative advantage the comparison among producers of a good according to their opp.

cost

Exports goods and services produced domestically & sold abroad

Imports goods and services produced abroad & sold domestical ly

Opportun ity cost whatever must be given up to obtain some item

o I f (e.g. farmer & rancher) choose to be self-suff icient, each consumes exactly what is

produced

- PPF = consumption possibi li ties frontier

o Specialization & Trade = mutually beneficial

o Comparative advantage:the driving force of specialization

absolute advan tage: producer tha t requires a smal ler quan ti ty of inpu ts to produce a

good

opportuni ty cost & comparat ive advantage: as reallocate t ime between producing

goods, move along PPF; opp. cost measures trade-off

comparati ve advantage: used when describing opp. cost of two p roducers; the one who

gives up less of other goods to produce good X has c.a.

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o Although possible for one person to have absolute advantage in producing both goods,

impossible to have comparative advantage in both

opp. cost of one good is inverse of opp. cost of the other good

o Comparat ive advantage & t rade: gains from specialization & t rade are based on

comparative adv.

when each special izes, tota l p roduction r ises increase in size of economic pie

ameliorates all

benefi ts f rom trade by obtain ing a good @a pr ice lower than thei r opp. cost

o For both parties to gain from trade, price at which they trade must lie between the two

opportunity costs

o Moral: Trade can benefit everyone in society because it allows ppl to specialize in

activities in which they have a comparative advantage.

Summary

Each person consumes goods & services produced by many others (both domestically

& abroad). In terdependence & t rade = desirab le bec allow al l to enjoy greater

quantity & variety of goods & services

2 ways to compare abili ty of 2 ppl in producing a good:

a) person who produce with smaller quanti ty of inputs = absolute advantage

b) person wi th smaller opp. cost = comparative advantage.

Gains from trade based on comparative, not absolute, advantage

Trade makes everyone better off bec allows ppl to specialize in activities of c.a.

Pr incip le of c.a. applies to count r ies as well; economists use this pr incip le to

advocate free trade

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IV. The Market Forces of Supply & Demand

Competitive market a market in which there are many buyers and many sellers so that

each has a negligible impact on market price

Complements 2 goods for which increase in pr ice of one decrease in demand for other

Demand curve a graph of the relat ionship between the pr ice of a good & the quantity

demanded

Demand schedule a tab le that shows the relat ionship between the pr ice of a good & the

quantity demanded

Equilibrium a situa tion in which pr ice has reached level where quant ity supplied =

demanded

Equilib rium price pr ice that balances quant ity suppl ied & quant ity demanded

Equilibrium quantity quantity supplied & quantity demanded @equil ibr ium pr ice

In fer ior good a good for which, other things equal, an increase in income a decrease in

demand

Law of demand the claim that, other things equal, the quanti ty demanded of a good fal ls

when the pr ice of the good r ises

Law of supply the claim that, other things equal, quant ity suppl ied of a good r ises when

price of the good rises

Law of supply & demand claim tha t the price of any good adjusts to br ing the quant ity

supplied & quant ity demanded for that good into balance

Market a group of buyers & sellers of a part icula r good or service

Normal good a good for which, other things equal, an increase in income an increase in

demand

Quanti ty demanded the amount of a good that buyers are wi l l ing and able to purchase

Quantity supplied amount of a good that sellers are wi l l ing & able to sell

Shortage a situat ion in which quanti ty demanded > quant ity supplied

Substi tu tes two goods for wh ich an inc rease in the pr ice of one increase in demand for

other

Supply curve a graph of the relat ionship between pr ice of a good & quant ity supplied

Supply schedule table that shows relat ionship between pr ice of a good & quant ity supplied

Surplus a situat ion in which quanti ty suppl ied > quanti ty demanded

Markets many forms: can be high ly organized (e.g. many agricu ltural commodit ies,

buyers & sellers meet @specif ic t ime/place & auctioneer helps set p rices & ar range sales)

usually less organized (e.g. buyers/sellers of ice cream in a town)

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Competit ion each buyer aware there are several sellers to choose from; each seller aware

his product is similar to that offered by other sellers

thus p rice & quant i ty are dete rm ined by al l sel lers & buyers as they interact in t he

marketplace

to reach highest form of competi t ion (perfectly competitive) must have 2 character ist ics:

(1) the goods offered for sale are al l exactly the same

(2) the buyers & sellers are so numerous tha t no individual has any in fl uence over

market pr ice

in these markets, buyers & sellers must accept price market determines = price takers

@ market price, buyers can buy all t hey want, sel lers can sell al l they want

monopoly: markets wi th only one seller who is then able to set the pr ice

Demand

o Pr ice of the good = central determ inan t of quant i ty demanded

o Quanti ty demanded is negatively relatedto pr ice

o Market demand vs. individual demand

> sum of al l ind iv idual demands for a part icu lar good or serv ice

sum indiv idual demand curves horizontallyto obtain market demand curve

o Shifts in the demand curve:

any change tha t i ncreases quantity demanded @every price shif ts curve to t he r ight,

called an increase in demand

any change tha t reduces quanti ty demanded @every price shifts the demand curve toleft, called a decrease in demand

Variables that can shift demand curve:

Income

if demand for a good falls when i ncome fal ls = normal good

if demand for a good r ises when i ncome fal ls = inferior good

Prices of Rela ted Goods

when a fall in p rice of one good reduces demand for another, the 2 = subst ituteswhen fal l i n p rice of one good raises demand for other = complements

Tastes

histor ical and psychological forces beyond realm of economics

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Expectations

about fu tu re may affect demand for a good or service today

Number of Buyers

Summarydemand curve shows what happens to quan ti ty demanded of a good when i ts p rice

varies, holding constant all other variables that influence buyers

when one var iab le changes, demand curve shif ts

price on vertical axis, thus change represents movement along demand curve

(others not on either axis, thus shifts demand curve (see pg. 75 for chart)

Supply

o Quanti ty supplied = amount tha t sellers are wil li ng/able to sell

o Many determinan ts, but pr ice is key

o Quantity supplied is positively relatedto the price of the good

o Supply curve slopes upward because, other th ings equal, higher p rice = greater quant i ty

supplied

o Market supply vs. indiv idual supply

> sum of the supplies of all sellers

sum i nd iv idual supply curves horizontallyto obtain market supply curve

o Shifts in supply curve:

any change tha t raises quantity supplied @every price shifts the supply curve to the

right, called an increase in supply

any change tha t reduces the quanti ty supplied @every p rice shif ts curve to lef t, cal led

a decrease in supply

Variables that can shift supply curve:

Inpu t prices

when price of one or more inputs r ise, producing good is less profi tab le, f i rms

supply less

if input pr ices r ise substantia lly, f i rm migh t shut down & stop supply ing

supply of a good = negat ively re lated to price of inputs used to make good

Technology

by reducing f i rms costs, advance in tech raises supply

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Expectations

amount supplied by a f i rm today may depend on expectations of fu tu re

e.g. if expect price to r ise in fu tu re, may store some of cur ren t p roduction

Number of sellers

Summary

price on vertical axis, so change reps a movement a long supply curve

a change in one above variab les shif ts the supply cu rve (see pg. 81 chart)

Supply & Demand Together

Equi lib rium point at wh ich supply & demand curves intersect

> equi l ib r ium pr ice & quan tity

@equil ibri um pr ice, quant ity of the good that buyers are wi ll ing to buy exactly

balances the quanti ty that sellers are wi l l ing to sellaka market-clearing pr ice(bec everyone has been satisfied)

actions of buyers & sellers na tu ra lly move markets toward equi l ib rium of supply &

demand

in most free markets, surp luses & shor tages = temporary bec pr ices move toward

equilibrium

such a pervasive phenomenon, called Law of Supply & Demand: price of any good

adjusts to br ing quanti ty supplied & quanti ty demanded for that good in to balance

3 Steps to Analyzing Changes in Equil ibr ium

comparat ive stat ics involves comparing 2 unchanging situat ions: ini tial & new

equilibrium

1) decide whether event shi fts supply curve, demand curve, or in some cases, both

curves

2) decide whether curve shifts to left or right

3) use supply & demand diagram to compare ini tia l & new equil ibr ium, which shows

how shift affects equil ibr ium p rice & quanti ty

Shif ts in Curves vs. Movements along Curves

e.g. economists say increase in quanti ty supplied but no change in supply

Supply refers to posit ion of supply curve, whereas quanti ty supplied refers to

amount suppliers wish to sell

shi ft insupply = change in supply and shif t indemand curve = change in demand

movement alonga fixed supply curve = change in the quantity supplied and

movement alongf ixed demand curve = change in the quanti ty demanded

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Summary

Economists use model of supply & demand to analyze competit ive markets many

buyers & sellers, each with li tt le/no in fl uence on market p rice

Demand curve shows how quanti ty of a good demanded depends on pr ice. Law of

demand: as price of a good falls, quantity demanded rises, therefore demand curve

shopes downward

In addi tion to pr ice, other determ inants of how much consumers buy: income, pr ice

of substitu tes + complements, tastes, expectat ions, & # of buyers > if one of these

factors change, demand curve shifts

Supply curve shows how quantity of good supplied depends on price; Law of supply:

as price of a good rises, quantity supplied rises; curve slopes upward

In addition to price, other determinants of how much producers want to sell: input

pr ices, technology, expectat ions, # of sellers. Change causes shif t.

In tersection of supply & demand curves determines market equilib rium. @

equil ibr ium pr ice, quanti ty demanded = quanti ty supplied

Behaviour of buyers & sellers natura lly d rives market toward equilib rium. When

market p rice is above, there is surplus of good, which causes market p rice to fal l.

When market price is below, shortage, causes price to rise

Use supply-and-demand diagram to analyze how any event in f luences market, fol low

3 steps

In market economies, pr ices = signals tha t guide economic decisions & thereby

al locate scarce resources, ensures supply & demand are in balance

Equi libri um pr ice then determines how much of the good buyers choose to purchase

& how much sellers choose to produce

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V. Elasticity & I ts Application

Cross-price elasticity of demand a measure of how much quanti ty demanded of one goodresponds to change in pr ice of another good, computed as % change in quanti ty demanded of

1stgood div ided by % change in pr ice of 2nd good

Elasticity a measure of the responsiveness of quantity demanded or supplied to one of its

determinants

Income elasticity of demand a measure of how much quanti ty demanded of a good

responds to change in consumers income, computed as % change in quantity demanded

divided by % change in income

Pr ice elastici ty of demand a measure of how much the quant ity demanded of a good

responds to a change in pr ice of that good, computed as % change in quanti ty demanded

divided by % change in pr ice

Pr ice elastici ty of supply measure of how much quant ity suppl ied of a good responds to

change in price of that good, computed as % change in quantity supplied divided by %

change in price

Total revenue the amount paid by buyers & received by sellers of a good, computed as pr ice

of good times quantity sold

The Price Elasticity of Demand & its Determinants

Elastic if quant i ty demanded responds substantia lly to changes in pr ice

Inelastic if quant it y demanded responds only sligh tly to p rice changes

Pr ice elasticity of demand measures how willing consumers are to move away from

good as its price rises

Determinants

Availabi li ty of Close Substi tutes

goods with these tend to have more elast ic demand; easier for consumers to

switch

Necessities vs. Luxuries

necessit ies tend be inelast ic wh ile luxur ies are elastic

Definit ion of the Ma rket

depends on boundaries of market

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narrowly defined markets tend be more elast ic than broadly def ined markets

bec easier to f ind close subs for narrowly def ined goods

Time Hor izon

tend to have more elastic demand over longer t ime horizons

Computing the Price Elasticity of Demand

Because quanti ty demanded is negat ively re la ted to price, % change in quantity wi l l

always have opposite sign as % change in pr ice

Common pract ice of dropping minus sign, repor t ing al l p rices as posi tive numbers

(absolute value)

The Midpoint Method: a Better way to Calculate % Changes & Elasticities

The Variety of Demand Curves

Elasticity

0 Perfectly inelastic

< 1 Inelastic

1 Unit elasticity

> 1 Elastic

Perfectly elastic

Total Revenue & Pr ice Elast ici ty of Demand (see pg. 100)

When demand is inelastic, pr ice & total revenue move in same di rection

When demand is elastic, pr ice & total revenue move in opposite di rections

If demand is un it elastic, total revenue remains constant when pr ice changes

Elasticity & Total Revenue Along a Linear Demand Curve

Al though slope is constant, elastici ty isnt bec slope = ra tio of changesin the 2

var iables, where as elasticity is ra tio of % changesin the 2 var iables

Whether cross-price elasticity is positive or negative depends on whether 2 goods are

substi tu tes (+ve) or complements (ve )

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The Pr ice Elasticity of Supply & its Determinants

Elastic if quantity supplied responds substantially to changes in prices

Inelastic if quantity supplied responds only slightly to changes in price

in most markets, a key determ inant = t ime per iod being considered:

more elastic in long run than in shor t run

Comput ing t he Price Elasticity of Supply

The Variety of Supply Curves

Elasticity

0 Perfectly inelastic

< 1 Inelastic1 Unit elasticity

> 1 Elastic

Perfectly elastic

Summary

Pr ice elasticity of demand measures how much quant i ty demanded responds to

changes in pr ice. Demand tends to be more elastic if close subs are avai lable, if good

is a luxury (ra ther t han necessity), if market is narrowly defined, or if buyers have

substantial time to react

Total revenue = pr ice of good x quanti ty sold

For inelastic demand curves, total revenue rises as price rises. For elastic demand

curves, tota l revenue falls as pr ice r ises.

Income elastici ty of demand measures how much quanti ty demanded responds to

changes in consumers income. Cross-pr ice elast ici ty of demand measures how muchquanti ty demanded of one good responds to changes in pr ice of another.

Pr ice elasticity of supply measures how much quanti ty supplied responds to change

sin p rice often depends on t ime hor izon under considerat ion (usually more elastic

in long run)

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Tools of supply & demand can be appl ied in many di ff. markets

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VI. Supply, Demand, & Government Policies

Pr ice ceili ng a legal maximum on the price at which a good can be soldPr ice floor a legal minimum on the pr ice at wh ich a good can be sold

Tax Incidence the manner in which burden of a tax is shared among participants in a

market

How Pr ice Ceilings Affect Mar ket Outcomes

If pr ice that balances supply & demand is below ceil ing, not bind ing(no effect)

If equil ibr ium p rice above ceiling, bind ing constrain t

Thus market price = price ceiling

quant i ty demanded exceeds quant it y supplied (shortage)

mechanism for rat ioning wi ll natural ly develop

when the govt imposes a binding price ceil ing on a competi t ive market, shortage of

the good arises; sellers must ration scarce goods among large # of potential buyers

Free markets ra tion goods with p rices (better)

How Pr ice Floors Affect Ma rket Outcomes

An attempt by govt to mainta in pr ices at other than equilib rium levels (legalminimum)

Thus a bind ing f loor pr ice causes a surplus

Taxes used to raise revenue for public projects

How Tax on Buyers Affect Market Outcomes (pg. 132)

How does th is law affect the buyers & sellers? Follow the 3 steps in Chapter I V for

analyzing supply & demand. (1) Whether law affects the supply or demand curve. (2) Decide

which way the curve shifts. (3) Examine how shift affects equilibrium.

1. In i tia l impact on which curve? Which curve does the tax shift? (demand)

2. Direction of shift.

3. See effect of the tax by comparing ini tial & new equilibr ium.

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Taxes discourage market activi ty. When a good is taxed, quant it y sold is smaller in new

equilibrium

Buyers & sellers share burden of taxes. In new equil . buyers pay more & sellers receive

less

How Tax on Sellers Affect Market Outcomes (pg. 133)

1. Immediate impact on which curve? (supply)

2. Direction of curve shift. Magnitude of shift?

3. Compare ini tial & new equilibrium.

Taxes on buyers & sellers are equivalen t. Tax places a wedge between price buyers pay &

price that sellers receive, regardless of who tax is levied on.

Elasticity & Tax Incidence

Only ra rely wi ll tax burden be shared equally

A tax burden falls more heavily on the side of the market that is less elastic.

elasticity measures wi l li ngness of buyers or sellers to leave market when

condi tions become unfavourable

small elasticity of demand means buyers do not have good al ternat ives; small

elasticity of supply means sellers do not

when a good is taxed, market wi th fewer good al ternatives cannot easily leave,

bear burden

Economy is governed by 2 kinds of laws: Laws of Supply & Demand and he laws

enacted by govt

Summary

Price ceiling is legal max on price of a good/service (e.g. rent control)

if price ceil ing below equi l. quant i ty demanded exceeds supply shortage

sellers must in some way ra tion good/service among buyers

Price floor is legal min (e.g. minimum wage)

if above equi l. quan tity supplied exceeds demand surplus

buyers demands must be rat ioned among sellers

When the govt levies a tax on a good, equi l. quant it y falls [shri nks size of market]

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Tax on a good places a wedge between pr ice paid by buyers & pr ice received by

sellers

when market moves to new equi l. buyers pay more & sellers receive less

buyers & sellers share tax burden {inc idence doesnt depend on who tax is levied

on}

Inc idence of tax depends on pr ice elasticit ies of supply & demand. Burden fal l on

side of market less elastic (bec can respond less easily to tax by changing quantity

bought/sold)

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VII. Consumers, Producers, & the Efficiency of Markets

Consumer surplus a buyers willingness to pay minus the amount the buyer actually paysCost the value of everyth ing a seller must give up to produce a good

Efficiency the property of a resource allocation of maximizing the total surplus received by

all members of society

Equity the fai rness of the dist r ibut ion of well-being among the members of society

Producer surp lus the amount a sellers is paid for a good minus the sellers cost

Welfare economics the study of how the allocation of resources affects economic well-being

Will ingness to pay the max amount that a buyer wi l l pay for a good

Consumer Surplus

Will ingness to Pay

Limit to amount potentia l buyers are wil li ng to buy (wil li ngness to pay = each

buyers max)

Each would be eager to buy @a price < wil l ingness to pay; indi fferent to buy @pr ice

= to

Consumer surplus = amount a buyer is willing to pay amount buyer actually pays

measures the benefit to buyers of part icipating in a market

Using the Demand Cu rve to Measure Consumer Surplus (pg. 147)

Use willingness to pay of possible buyers to find demand schedule

@any quant i ty, pr ice given by demand curve shows wi ll ingness to pay of the

marginal buyer(buyer who would leave market f i rst if pr ice were any higher)

The area below the demand curve & above the pr ice measures the consumer surp lus

in a market

How a Lower P rice Raises Consumer Surplus (pg. 149)

What Does Consumer Surplus Mean?

Goal in developing concept of consumer surplus = to make normative judgements

about desirabi li ty of market outcomes

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Consumer surplus: measures benefit received from a good as buyers themselves

perceive it

In some cases, policymakers might not care about consumer surplus (e.g. drugs)

In most markets, consumer surplus does reflect economic well-being

Producer Surplus

Cost & Wi ll ingness to Sell

o Each is willing to take job if price receives exceeds cost of doing work: [Cost

opportunity cost of the seller (e.g. painter pg. 151 example)]; cost = measure of

willingness to sell

o Each eager to sell @pr ice higher than cost; @price = to, indi fferent

o Producer surplus= amount seller is paid cost of production; measures benefi t to

sellers of part icipating in a market

Using the Supply Curve to Measure Producer Surplus (pg. 153)

o @any quantity, price given by supply curve shows cost of marginal seller(seller who

would leave market 1st if pr ice were any lower)

o Can use curve to measure producer surplus

o

Area below pr ice & above supply curve = producer surplus in a market

o How a Higher Price Raises Producer Surplus (pg. 164)

Ma rket Efficiency

The Benevolent Social Planner

How to measure economic well-being of a society

one possibi l i ty is total surplus(sum of consumer & producer surplus)

Consumer Surplus = Value to buyers Amount paid by buyers

Producer Surplus = Amount received by sellers Cost to sellers

Total Surplus = Value to buyers Cost to sellers

If allocation of resources max tota l surplus, allocation exhibits efficiency

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Equi ty involves normative judgements about fai rness of divis ion

Evaluating Market Equilibrium

1) Free markets allocate the supply of goods to the buyers who value them most highly,

as measured by thei r wi ll ingness to pay.

2) Free markets allocate the demand for goods to the sellers who can produce them at

least cost.

3) Free markets produce quant ity of goods that max the sum of consumer & producer

surplus.

Market power abil i ty to in f luence pr ices (by single or small group buyers/sellers )

can cause inef ficiency bec keeps away f rom equil. of supply & demand

External it ies decisions of buyers & sellers sometimes affect ppl who are not

participants in the market @all

Market failu re inabil i ty of some unregula ted markets to al locate resources efficiently

Summary

Consumer & producer surp lus(how to compute); allocat ion of resources that

maximizes sum of surp lus = efficient (policy-makers often concerned w/ eff iciency &

equity of economic outcomes); equi l. of supply & demand maxim izes sum of surp lus

(invisible hand leads to efficient allocation); markets dont allocate efficiently in

presence of market fai lu res (e.g. market power or externa li ties)

VIII . Application: The Costs of Taxation

Deadweight loss the fall in total surplus that results from a market distortion (e.g. a tax)

[pg. 165]

Tax p laces wedge between pr ice buyers pay & sellers receive quantity sold falls below

level that would be sold wi thout a tax (iow causes size of market to shrink)

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Govts total tax revenue = T (size of tax) X Q (quantity of good sold)

(pg. 169) Thus the losses to buyers & sellers from a tax exceed the revenue ra ised by the

government

fall i n total su rp lus tha t results when a tax (or other policy) disto rts a market outcome

= deadweight loss

when tax ra ises price to buyers & lowers p rice to sellers, gives incentive to buyers to

consume less & sellers incentive to produce less

as buyers & sellers respond to incent ives, size of market shrin ks below opt imum

Taxes distor t incentives & cause markets to al locate resources ineff icient ly

Taxes cause deadweight losses because they prevent buyers & sellers from real izing some

of the gains from t rade

The greater t he elastici ties of supply & demand, the greater the deadweight loss of a tax

Summary

A tax on a good reduces the welfare of buyers & sellers of the good. Reduct ion in

consumer & producer surplus usually exceeds revenue raised by govt. Fall in tota l

surp lus (sum of producer & consumer surplus + tax revenue) = deadweight loss of

the tax

Taxes have deadweight losses bec cause buyers to consume less & sellers to p roduce

less; th is change in behaviour shr inks size of market below level that maximizes

total surplus.

Because elastici ties of supply & demand measure how much market par tic ipants

respond to market condit ions, larger elastici ties imply la rger deadweight losses

As a tax grows larger, distorts incent ives more & deadweight loss grows larger.

Tax revenue fi rst r ises with size of a tax. Eventual ly, however, a larger tax reduces

tax revenue because it reduces the size of the market.

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