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Final

ECO1104 Final: Micro eco1104: Complete Course Notes - chapters 1-8, 10 & 11, 13-15
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Department
Economics
Course
ECO1104
Professor
Gordon Lenjosek
Semester
Winter

Description
ECO1104: Microeconomics – Complete Notes for Final Exam Chapter 1: Ten Principles of Economics  Opportunity Cost: The loss of potential gain from other alternatives when one alternative is chosen.  Ten Principles of Economics o To keep in mind:  The word economy comes from the Greek work for “one who manages a household.”  The management of society’s resources (e.g., people, land, buildings, machinery) is important because resources are scares.  Scarcity: The limited nature of society’s resources  Economics: The study of how society manages its scares resources.  Economist: Person who o How people make decisions:  1. People Face Trade-offs  “There ain’t no such thing as a free lunch.”  Making decisions requires trading-off one goal against another one  E.g.: how to allocate your time, your income, efficiency vs. equality  Efficiency: The property of society getting the maximum benefits from its scares resources.  Equity: The property of distributing economic prosperity fairly among the members of society.  2. The cost of Something is What You Give up to Get it  The Opportunity Cost: Whatever must be given up to obtain some item. o When calculating the cost of something you need to take into account (Ex. Cost of university)  The explicit cost (direct and obvious): Fees, books, etc.  The implicit cost (indirect): Your time and energy o Example: You have a free ticket for a concert and cannot resell it. You also have the opportunity to go see Bob Dylan in concert the same night. A Bob Dylan ticket costs 40$. On any other day you would be willing to spend 50$ on Bob Dylan’s concert. What is the opportunity cost of attending Bob Dylan’s concert?  3. Rational people think at the margin  Assumption: Economic agents are rational (arguable)  Rational people: People who systematically and purposefully do the best they can to achieve their objectives.  Assumption:  Marginal changes: Small incremental adjustments to a plan of action.  Rational agents: Make decisions by comparing marginal benefits with marginal costs, because they maximize the value of their opinions.  4. People respond to incentives  incentives: Something that induces a person to act. For instance, a punishment or a reward  Since people compare marginal costs and benefits to make decisions they respond to incentives, because they modify the benefits or/and the costs o For example, are you going to study if there is no exam?  Examples on power point o How people interact:  5. Trade can make everyone better off  property rights: The ability of an individual to own and exercise control over scares resources. o Gains pf trade:  Differences in preferences. Buyer and seller place difference values on the traded items.  Comparative advantage: One seller may be able to produce the item more efficiently.  6. Markets are usually a good way to organize economic activity  Market economy: An economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services.  In in 1776 book, Adam Smith observed that households and firms interacting in markets act as if they are guided by an “invisible hand” that leads them to desirable market outcomes.  Individuals are motivated by self-interest o Invisible hand guides this self-interest into promoting general economic well-being.  7. Governments can sometimes improve market outcomes  we need governments for (at least) two reasons: o 1) To enforce property rights: the ability to own and exercise control over scares resources. o 2) Because the invisible hand is powerful, but it is not omnipotent  two broad reasons for a government to intervene in the economy:  the goal of efficiency o market failure: A situation in which a market left on its own fails to allocate resources efficiently o Externality: The impact of one ersn’s actions on the well- being of a bystander  The goal of equity o How the economy as a whole works:  8. A country’s standard of living depends on its ability to produce goods and services  productivity: the quantity of goods and services produced from each hour of a worker’s time.  In countries in which productivity is high, most people enjoy a high standard of living  9. If the government prints too much money – price will rise (inflation)  inflation: An increase in the overall level of prices in the economy  what causes inflation? o Growth in the quantity of money lowers the value of money  10. Society faces a short run trade-off between inflation and unemployment  This short run trade-off plays a key role in the analysis of the business cycle  Business cycle: The irregular and largely unpredictable fluctuations in economic activity, as measured by the production of goods and services or the number of people employed. Chapter 2: Thinking like an economist  The economist as scientist o Economist try to address their subject with a scientist’s objectivity. o The scientific method involves observation, theory, and more observation. o Economists use theory and observation like other scientists, but they do face an obstacle that makes task especially challenging:  Experiments are often difficult in economics. o The role of assumptions  Assumptions can simplify the complex world and make it easier to understand  The art in scientific thinking is deciding which assumptions to make. o Economic models:  Economists also use models to learn about the world that are most often composed of diagrms and equations  Economic models omit many details to allow us to see what is truly important  All the models are built with assumptions 1. The circular-flow diagram a. A visual model of the economy that shows how dollars flow through markets among households and firms 2. The production possibilities frontier a. A graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology  Microeconomics and macroeconomics o Microeconomics: The study of how households and firms make decisions and how they interact in markets o Macroeconmics: The study of economy-wide phenomena, including inflation, unemployment, and economic growth  The economist as policy advisor o When economists are trying to explain the world, they are scientists o When they are trying to help improve it, they are advisers o Positive statements: Claims that attempt to describe world as it is o Normative statements: Claims that attempt to prescribe how the world should be o Economists in Ottawa:  Economists at finance Canada help design tax policy  Economists at industry Canada help design and enforce Canada’s competition laws.  Economists at global affairs Canada help negotiate trade agreements with other countries  Economists at employment and social development Canada analyze data on workers and on those looking for work to help formulate labour-market policies  economists at environment Canada help design environmental regulations. Statistics Canada employs economists to collect the data analyzed by other economists and then give policy advice. o Why economists’ advice is not always followed  Any economist who advises government knows that his or her recommendations are not always heeded  In the real world, figuring out the right policy is only part of the job for the government.  There are two basic reasons:  They can disagree about the validity of alternative positive theories about how the world works  They can have different values and, therefore, different normative views about what policy should try to accomplish  Why economists disagree o Differences in scientific judgments  Economists often disagree about the direction in which truth lies  For example, economists disagree about whether the government should levy taxes based on a household’s income or its consumption o Differences in value  Suppose that Peter and Paula both take the same amount of water from the town well. To pay for maintaining the well, the town taxes its residents. Peter has income of $50 000 and is taxed $5000, or 10% of his income. Paula has income of $10 000 and is taxed $2000, or 20% of her income.  Is this policy fair?  If not, who pays too much and who pays too little? o Perception versus reality  Because of differences in scientific judgments and differences in values, some disagreement among economists is inevitable.  But they do often share a common view. o Proposition about which most economists agree 1. A ceiling on rents reduces the quantity and quality of housing available (93%) 2. Tariffs and import quotas usually reduce general economic welfare (93%) 3. Flexible and floating exchange rates offer an effective international monetary arrangement (90%) 4. Fiscal policy has a significant simulative impact on ales than fully employed economy (90%) 5. The government should not restrict employers from outsourcing work to foreign countries (90%) 6. Economy growth in developed countries like Canada leads to greater levels of well-being (88%) 7. Agricultural subsidies should be eliminated (85%) 8. An appropriately designed fiscal policy can increase the long-run rate of capital formation (85%) 9. Local and state governments should eliminate subsidies to professional sports franchises (85%) 10. If the federal budget is to be balanced, it should be done over the business cycle rather than yearly (85%) 11. Cash payments increase the welfare of recipients to a greater degree than do transfers-in-kind of equal cash value (84%) 12. A large federal budget deficit has an adverse effect on the economy (83%) 13. The redistribution of income is a legitimate role for the government (83%) 14. Inflation is caused primarily by too much growth in the money supply (83%) 15. A minimum wage increases unemployment among young and unskilled workers (79%) 16. The government should restructure the welfare system along the lines of a “negative income tax.” (79%) 17. Effluent taxes and marketable pollution permits represent a better approach to pollution control than imposition of pollution ceilings. (78%) Chapter 3: Interdependence and the Gains from Trade  Interdependence o Everyday we rely on many people from around the world, most of whom we’ve never met, to provide us with goods and services we enjoy o Principle#5: Trade can make everyone better off  We’ll now explore this principle to learn why people and nations choose to be interdependent, and how they can gain from trade o We’ll do this by using a two-country, two-goods example:  Two countries: Canada and Japan  Two goods: Computers and wheat  One resource: Labour (measured in hours) o We will consider how much of each good each country produces and consumes in two different scenarios  If each country chooses to be self-sufficient  If each trades with the other country  Production Possibilities Frontier o Panel A shows the production opportunities available to Frank the Farmer and Rose the rancher. o Panel B shows the combinations of meat and potatoes that Frank can produce.  If Frank devotes all 8 hours of his time to potatoes, he produces 32 kg of potatoes and no meat. If he devotes all his time to meat, he produces 8 kg of meat and no potatoes. If Frank divides his time equally between the two activities, spending 4 hours on each, he produces 16 kg of potatoes and 4 kg of meat. The figure shows these three possible outcomes and all others in between. o Panel C shows the combinations of meat and potatoes that Rose can produce. o Both production possibilities frontiers are derived if Frank and Rose each work 8 hours a day. If there is no trade, each person’s production possibilities frontier is also his or her consumption possibilities frontier. o If Frank and Rose choose to be self-sufficient rather than trade with each other, then each consumes exactly what he or she produces. In this case, the production possibilities frontier is also the consumption possibilities frontier. That is, without trade, Figure 3.1 shows the possible combinations of meat and potatoes that the farmer and rancher can each consume.  Specialization and Trade o The proposed trade between Frank the farmer and Rose the rancher offers each of them a combination of meat and potatoes that would be impossible in the absence of trade. o In panel (a), Frank gets to consume at point A* rather than point A. o In panel (b), Rose gets to consume at point B* rather than point B. Trade allows each to consume more meat and more potatoes.  Comparative advantage: The driving force of Specialization o As a first step in developing this principle, consider the following question: In our example, who can produce potatoes at lower cost—Frank or Rose? There are two possible answers, and in these two answers lie the solution to our puzzle and the key to understanding the gains from trade. o Absolute Advantage: Comparing the productivity of one person, firm, or nation to that of another.  The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.  Example, time is the only input, so we can determine absolute advantage by looking at how much time each type of production takes.  Rose has an absolute advantage both in producing meat and in producing potatoes because she requires less time than Frank to produce a unit of either good.  Rose needs to input only 20 minutes to produce a kilogram of meat; Frank needs 60 minutes.  Similarly, the rancher needs only 10 minutes to produce a kilogram of potatoes, whereas the farmer needs 15 minutes.  Based on this information, we can conclude that Rose has the lower cost of producing potatoes, if we measure cost in terms of the quantity of inputs. o Opportunity Cost & Comparative Advantage  Rather than comparing inputs required, we can compare the opportunity costs. Recall from Chapter 1 that the opportunity cost of some item is what we give up to get that item.  In our example, we assumed that Frank and Rose each spend 8 hours a day working. Time spent producing potatoes, therefore, takes away from time available for producing meat. When reallocating time between the two goods, Rose and Frank give up units of one good to produce units of the other, thereby moving along the production possibilities frontier. The opportunity cost measures the tradeoff between the two goods that each producer faces.  Rose’s opportunity cost.  According to the table in panel (a), producing 1 kg of potatoes takes her 10 minutes of work.  When Rose spends those 10 minutes producing potatoes, she spends 10 minutes less producing meat.  Because Rose needs 20 minutes to produce 1 kg of meat, 10 minutes of work would yield 0.5 kg of meat.  Hence, Rose’s opportunity cost of producing 1 kg of potatoes is 0.5 kg of meat.  Frank’s opportunity cost.  Producing 1 kg of potatoes takes him 15 minutes.  Because he needs 60 minutes to produce 1 kg of meat, 15 minutes of work would yield 0.25 kg of meat.  Hence, Frank’s opportunity cost of 1 kg of potatoes is 0.25 kg of meat.  The table shows the opportunity costs of meat and potatoes for the two producers. Notice that the opportunity cost of meat is the inverse of the opportunity cost of potatoes.  Because 1 kg of potatoes costs Rose 0.5 kg of meat, 1 kg of meat costs Rose 2 kg of potatoes.  Similarly, because 1 kg of potatoes costs Frank 0.25 kg of meat, 1 kg of meat costs Frank 4 kg of potatoes.  The producer who gives up less of other goods to produce Good X has the smaller opportunity cost of producing Good X and is said to have a comparative advantage in producing it.  Example: Frank has a lower opportunity cost of producing potatoes than Rose: A kilogram of potatoes costs Frank only 0.25 kg of meat, while it costs Rose 0.50 kg of meat. Conversely, Rose has a lower opportunity cost of producing meat than Frank: A kilogram of meat costs Rose 2 kg of potatoes, while it costs Frank 4 kg of potatoes. Thus, Frank has a comparative advantage in growing potatoes, and Rose has a comparative advantage in producing meat.  It is possible for one person to have an absolute advantage in both goods, But it is impossible for one person to have a comparative advantage in both goods.  The Price of Trade o For both parties to gain from trade, the price at which they trade must lie between the two opportunity costs. o Example, Rose and Frank agreed to trade at a rate of 3 kg of potatoes for each 1 kg of meat.  This price is between Rose’s opportunity cost (2 kg of potatoes per 1 kg of meat) and Frank’s opportunity cost (4 kg of potatoes per 1 kg of meat).  The price need not be exactly in the middle for both parties to gain, but it must be somewhere between 2 and 4.  Should Canada Trade with Other Countries? o Canada has a clear comparative advantage in the provision of natural resources. We are a leading provider of oil, forest products, and agriculture goods to the world market because of our natural geographic, geological, and topological advantages. o The Canadian workforce is highly educated, healthy, and productive relative to many countries. This gives Canada a comparative advantage in the production of high-value-added goods that require a skilled labour force.  Other Examples: o Production Possibilities in Canada  Assumptions:  50,000 hours of labour available for production each month  Producing one computer requires 100 hours of labour  Producing one ton of wheat requires 10 hours of labour  The opportunity cost of computers is constant o Production Possibilities in Japan  Assumptions:  30,000 hours of labour available for production each month  Producing one computer requires 125 hours of labour  Producing one ton of wheat requires 25 hours of labour  The opportunity cost of computers is constant o Can they gain from trade?  Without trade  Canadian consumers get 250 computers and 2500 tons of wheat  Japanese consumers get 120 computers and 600 tons of wheat  To see if Canadian and Japanese consumers could be better off (consume more of both goods) if they trade with each other, let’s suppose  Canada instead produces 3,400 tons of wheat  Japan instead produces 240 computers  How would this assumption be reflected on their PPFs?  Canada: 3,400 tons of wheat requires 34,000 labour hours o 16,000 labour hours are left to produce computers o 160 computers are produced  Japan: 240 computers require 30,000 labour hours o 0 labour hours are left to produce wheat o no wheat is produced  Production Possibilities With Trade  Canadian Consumption & Production with Trade  Japanese Consumption & Production with Trade  Trades makes both countries better off  Why Do Both Countries Gain?  Absolute advantage is the ability to produce a good using fewer inputs than another producer  Canada has an absolute advantage in producing wheat o It uses only 10 labour hours to produce a ton of wheat while Japan uses 25  If each country has an absolute advantage in one good and specializes in that good, then both countries can gain from trade  But does Japan have an absolute advantage in computer production? o It uses 125 labour hours to produce one computer while Canada uses 100  No, it does not !! o Japan does not have an absolute advantage in computers  The fact is that Canada has an absolute advantage in both goods !!  So why does Japan specialize in computers? And why do both countries gain from trade?  Where do the Gains come from?  Two countries can gain from trade when each specializes in the good it produces at lowest cost  Absolute advantage measures the cost of a good in terms of the inputs required to produce it o But from principle #3, we know opportunity cost is another measure of cost  In our example: The opportunity cost of a computer is the amount of wheat production that would have to be given up to produce one computer  This idea leads us to the concept of comparative advantage o The ability to produce a good at a lower opportunity cost that another producer  Opportunity cost of Computers  To answer this we must determine the opportunity cost of a computer in each country  The opportunity cost of a computer in Canada is 10 tons of wheat because: o One computer requires 100 hours of labour to produce, which could have instead produced 10 tons of wheat o The slope of the PPF for Canada is 10 (5000 tons of wheat/500 computers)  The opportunity cost of a computer in Japan is 5 tons of wheat because: o One computer requires 125 hours of labour to produce, which could have instead produced 5 tons of wheat o The slope of the PPF for Japan is 5 (1200 tons of wheat/240 computers)  So Japan has a comparative advantage in computers  Lessons: o Absolute advantage is not comparative advantage o Absolute advantage is not necessary for gains from trade Chapter 4: The Market Forces of Supply and Demand  Demand o The Demand Curve: The relationship between Price and Quantity Demanded  The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase.  One determinant plays a central role—the price of the good.  If the price of ice cream rose to $20 per scoop, you would buy less ice cream. You might buy frozen yogurt instead.  If the price of ice cream fell to $0.20 per scoop, you would buy more.  This relationship between price and quantity demanded is true for most goods in the economy. When the price of a good rises, the quantity demanded of the good falls, and when the price falls, the quantity demanded rises.  The demand schedule shows the quantity demanded at each price. The demand curve, which graphs the demand schedule, shows how the quantity demanded of the good changes as its price varies. Because a lower price increases the quantity demanded, the demand curve slopes downward. o Shifts in the Demand Curve  Any change that raises the quantity that buyers wish to purchase at a given price shifts the demand curve to the right. Any change that lowers the quantity that buyers wish to purchase at a given price shifts the demand curve to the left.  Many variables can shift the demand curve:  Income  Prices of related goods  Tastes  Expectations  Number of buyers  Shifts in the demand curve versus movements along the demand curve  If warnings on cigarette packages convince smokers to smoke less, the demand curve for cigarettes shifts to the left. o In panel (a), the demand curve shifts from D1 to D2. o At a price of $10.00 per pack, the quantity demanded falls from 20 to 10 cigarettes per day, as reflected by the shift from point A to point B.  By contrast, if a tax raises the price of cigarettes, the demand curve does not shift. o Instead, we observe a movement to a different point on the demand curve. o In panel (b), when the price rises from $10.00 to $20.00, the quantity demanded falls from 20 to 12 cigarettes per day, as reflected by the movement from point A to point C.  Alternatively, policymakers can try to raise the price of cigarettes. If the government taxes the manufacture of cigarettes, for example, cigarette companies pass much of this tax on to consumers in the form of higher prices. A higher price encourages smokers to reduce the number of cigarettes they smoke. In this case, the reduced amount of smoking does not represent a shift in the demand curve. Instead, it represents a movement along the same demand curve to a point with a higher price and lower quantity, as in panel (b) of Figure 4.4.  Supply o The Supply Curve: The Relationship between Price and Quantity Supplied  The quantity supplied of any good or service is the amount that sellers are willing and able to sell.  There are many determinants of quantity supplied, but once again price plays a special role in our analysis.  When the price of ice cream is high, selling ice cream is profitable, so the quantity supplied is large.  By contrast, when the price of ice cream is low, the business is less profitable, so sellers produce less ice cream.  At a low price, some sellers may even choose to shut down, and their quantity supplied falls to zero.  This relationship between price and quantity supplied is called the law of supply: Other things equal, when the price of a good rises, the quantity supplied of the good also rises, and when the price falls, the quantity supplied falls as well.  The table in Figure 4.5 shows the quantity of ice-cream cones supplied each month by Ben, an ice-cream seller, at various prices of ice cream. At a price below $1.00, Ben does not supply any ice cream at all. As the price rises, he supplies a greater and greater quantity.  This is the supply schedule, a table that shows the relationship between the price of a good and the quantity supplied, holding constant everything else that influences how much producers of the good want to sell.  The supply schedule shows the quantity supplied at each price. This supply curve, which graphs the supply schedule, shows how the quantity supplied of the good changes as its price varies. Because a higher price increases the quantity supplied, the supply curve slopes upward. o Shifts in the Supply Curve  Because the market supply curve is drawn holding other things constant, when one of these factors changes, the supply curve shifts.  For example, suppose the price of sugar falls. Sugar is an input into the production of ice cream, so the fall in the price of sugar makes selling ice cream more profitable.  This raises the supply of ice cream: At any given price, sellers are now willing to produce a larger quantity. The supply curve for ice cream shifts to the right.  The figure to the right illustrates shifts in supply.  Any change that raises quantity supplied at every price, such as a fall in the price of sugar, shifts the supply curve to the right and is called an increase in supply.  Similarly, any change that reduces the quantity supplied at every price shifts the supply curve to the left and is called a decrease in supply.  Any change that raises the quantity that sellers wish to produce at a given price shifts the supply curve to the right. Any change that lowers the quantity that sellers wish to produce at a given price shifts the supply curve to the left.  Many variables can shift the supply curve:  Input prices  Technology  Number of sellers  Supply and Demand Together o Equilibrium  The figure to the right illustrates the market supply curve and market demand curve together.  Notice that there is one point at which the supply and demand curves intersect. This point is called the market’s equilibrium.  The price at this intersection is called the equilibrium price, and the quantity is called the equilibrium quantity.  Here the equilibrium price is $2.00 per cone, and the equilibrium quantity is 7 ice-cream cones.  The equilibrium is found where the supply and demand curves intersect. At the equilibrium price, the quantity supplied equals the quantity demanded. Here the equilibrium price is $2: At this price, 7 ice-cream cones are supplied, and 7 ice-cream cones are demanded. o Three Steps to Analyzing Changes in Equilibrium  The equilibrium price and quantity depend on the position of the supply and demand curves. When some event shifts one of these curves, the equilibrium in the market changes, resulting in a new price and a new quantity exchanged between buyers and sellers.  When analyzing how some event affects the equilibrium in a market, we proceed in three steps. 1. First, we decide whether the event shifts the supply curve, the demand curve, or in some cases, both curves. 2. Second, we decide whether the curve shifts to the right or to the left. 3. Third, we use the supply-and-demand diagram to compare the initial and the new equilibrium, which shows how the shift affects the equilibrium price and quantity.  Equilibrium price and quantity depend on the position of the supply and demand curves. When some event shifts one of these curves, the equilibrium in the market changes, resulting in a new price and a new quantity exchanged between buyers and sellers.  When analyzing how some event affects the equilibrium in a market, we proceed in three steps. 1. First, we decide whether the event shifts the supply curve, the demand curve, or in some cases, both curves. 2. Second, we decide whether the curve shifts to the right or to the left. 3. Third, we use the supply-and-demand diagram to compare the initial and the new equilibrium, which shows how the shift affects the equilibrium price and quantity.  How an Increase in Demand Affects the Equilibrium  An event that raises quantity demanded at any given price shifts the demand curve to the right.  The equilibrium price and the equilibrium quantity both rise.  Here, an abnormally hot summer causes buyers to demand more ice cream.  The demand curve shifts from to D2, which causes the equilibrium price to rise from $2.00 to $2.50 and the equilibrium quantity to rise from 7 to 10 cones.  Shifts in Curves versus Movements along Curves  “Supply” refers to the position of the supply curve, whereas the “quantity supplied” refers to the amount suppliers wish to sell. o In this example, supply does not change because the weather does not alter firms’ desire to sell at any given price. o Instead, the hot weather alters consumers’ desire to buy at any given price and thereby shifts the demand curve to the right. o The increase in demand causes the equilibrium price to rise. o When the price rises, the quantity supplied rises. o This increase in quantity supplied is represented by the movement along the supply curve. Chapter 5: Elasticity and Its Application  The Elasticity of Demand o The Price Elasticity of Demand and Its Determinants  The price elasticity of demand measures how much the quantity demanded responds to a change in price.  Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price.  Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price.  The price elasticity of demand for any good measures how willing consumers are to buy less of the good as its price rises.  Availability of Close Substitutes  Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others.  Necessities versus Luxuries  Necessities tend to have inelastic demands, whereas luxuries have elastic demands. When the price of a visit to the dentist rises, people will not dramatically alter the number of times they go to the dentist, although they might go somewhat less often.  o Computing the Price Elasticity of Demand  (Always positive) Original New Average Change Percentage change Quantity +/- +/- Price +/- +/-   o The Midpoint Method  o The Variety of Demand Curves  Perfect Inelastic Demand: =0  Inelastic Demand: >1  Unit Elastic Demand: =1  Elastic Demand: <1  Perfectly Elastic Demand: = o Total Revenue and the Price Elasticity of Demand  P x Q = Total Revenue o Elasticity and Total Revenue along a Linear Demand Curve  The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic. o Other Demand Elasticities  Income elasticity of Demand   Cross-price elasticity of Demand   The Elasticity of Supply o The Price Elasticity of Supply and Its Determinants  The price elasticity of supply measures how much the quantity supplied responds to changes in the price.  Supply of a good is said to be elastic if the quantity supplied responds substantially to changes in the price. Supply is said to be inelastic if the quantity supplied responds only slightly to changes in the price.  In most markets, a key determinant of the price elasticity of supply is the time period being considered.  Supply is usually more elastic in the long run than in the short run. Over short periods of time, firms cannot easily change the size of their factories to make more or less of a good.  Thus, in the short run, the quantity supplied is not very responsive to the price.  By contrast, over longer periods, firms can build new factories or close old ones.  In addition, new firms can enter a market, and old firms can exit.  Thus, in the long run, the quantity supplied can respond substantially to price changes. o Computing the Price Elasticity of Supply  (Always positive) Original New Average Change Percentage change Quantity +/- +/- Price +/- +/-   o The Variety of Supply Curves  Perfectly Inelastic Supply: =0  Inelastic Supply: >1  Unit Elastic Supply: =1  Elastic Supply: <1  Perfectly Elastic Supply: = Chapter 6: Supply, Demand, & Government Policies  Price Ceilings: Legal maximum on price at which a good can be sold o Regulated price designed to protect interests of consumers o Government dictates a maximum price for a commodity  Ex. Rent Control Laws  Gov’t decided that rents aren’t fair  It intervenes in housing market to provide affordable housing o A price ceiling is ineffective unless it is below equilibrium price o If price ceiling is below equilibrium rent, a situation of excess Qd for housing emerges  Price decrease, quantity supplied decreases o Developers stop building o Landlords cease to maintain units  Price decreases, quantity demanded increases o Shortage causes upward pressure on rents, & other perverse effects o Outrageous parking & key charges o Binding versus not binding price ceiling o In panel (a), the government imposes a price ceiling of $4.  Because the price ceiling is above the equilibrium price of $3, the price ceiling has no effect, and the market can reach the equilibrium of supply and demand.  In this equilibrium, quantity supplied and quantity demanded both equal 100 cones. o In panel (b), the government imposes a price ceiling of $2.  Because the price ceiling is below the equilibrium price of $3, the market price equals $2.  At this price, 125 cones are demanded and only 75 are supplied, so there is a shortage of 50 cones. o Binding price ceiling creates a shortage  Price floors: Legal minimum on price at which a good can be sold o Again, market generates a price which offends our sense of “social justice” o This time, price is so low that producers can’t make a decent living o It is consumers – on demand side who are exploiting producers on supply side o Government comes to rescues by imposing a price floor o It is a minimum bound on prices  Ex. Minimum wage, agricultural products  Ex. Government legislates a “fair price” these goods which is above equilibrium level o A price floor in ineffective unless It is above equilibrium price o If price floor is above equilibrium, it creates a situation of excess Qs.  Price increases, quantity supplied increases  Price increases, quantity demanded decreases o Big surpluses emerge, placing downward pressure on prices o Situation is unstable unless surplus is removed from market o Example of Price Floor: Minimum Wage o In labour market, by convention, employers demand labour & employees supply it o Equilibrium wage for unskilled labour is unbefitting of a civilized society  Government intervenes to improve their well-being by raising their wages  A wage increases, Qd decreases & Qs increases o A situation of surplus, or excess quantity supplied of labour, emerges o Workers who queue for jobs remain unemployed o Workers who remain on job benefit o Labour unions love minimum wage, claiming that it promotes justice o Binding versus not binding price floor o In panel (a), the government imposes a price floor of $2.  Because this is below the equilibrium price of $3, the price floor has no effect.  The market price adjusts to balance supply and demand.  At the equilibrium, quantity supplied and quantity demanded both equal 100 cones. o In panel (b), the government imposes a price floor of $4, which is above the equilibrium price of $3.  Therefore, the market price equals $4.  Because 120 cones are supplied at this price and only 80 are demanded, there is a surplus of 40 cones. o Binding price floor creates a surplus  Incidence of an Excise Tax o When a good is taxed, buyers and sellers of the good share the burden of the tax o The firm has legal responsibility for remitting tax to government o Consumers are explicitly charged the tax o Given a normal upward sloping S curve & a normal downward sloping D curve, both parties share the burden of a tax once we take into account the change in equilibrium price o Suppose that a tax is imposed on seller  Since the firm has legal responsibility to pay it, its costs of production rise by amount of the tax Further explanation: o At each possible Qs, firms require a higher price (by amount of tax), or at each possible price, they are willing & able to sell less tan before imposition of tax o S curve shifts up by full amount of tax o A new equilibrium price and quantity is established where the new S curve intersects D curve o Amount of revnue collected is based on a lower Q  Lower revenue of (P1 –?) x Q1 o When a tax of $0.50 is levied on buyers, the demand curve shifts down by $0.50 from D1 to D2. o The equilibrium quantity falls from 100 to 90 cones. o The price that sellers receive falls from $3.00 to $2.80. o The price that buyers pay (including the tax) rises from $3.00 to $3.30. o Even though the tax is levied on buyers, buyers and sellers share the burden of the tax. o When a tax of $0.50 is levied on sellers, the supply curve shifts up by $0.50 from S1 to S2. o The equilibrium quantity falls from 100 to 90 cones. o The price that buyers pay rises from $3.00 to $3.30. o The price that sellers receive (after paying the tax) falls from $3.00 to $2.80. o Even though the tax is levied on sellers, buyers and sellers share the burden of the tax. Government Tax Revenue & Tax Burden o Consumers pay a higher price – their share is then  New price minus old price o Producers receive higher price from consumer, but they also have to divide the tax  New price amount of tax = Net price  Their share is old price minus net price  Elasticity and Tax Incidence o If supply is more price-elastic than demand  Then suppliers respond more to ‘tax squeeze’ than demanders & demanders will pay most of the tax, as sellers succeed in passing on most of the cost of the tax in form of higher prices o If demand is more price-elastic than supply  Then demanders respond more to ‘tax squeeze’ than suppliers & suppliers will pay most of the tax, as they are unable to pass on the cost of the tax in form of higher prices o How the burden of the tax is divided  In panel (a), the supply curve is elastic, and the demand curve is inelastic.  In this case, the price received by sellers falls only slightly, while the price paid by buyers rises substantially.  Thus, buyers bear most of the burden of the tax.  In panel (b), the supply curve is inelastic, and the demand curve is elastic.  In this case, the price received by sellers falls substantially, while the price paid by buyers rises only slightly.  Thus, sellers bear most of the burden of the tax.  Summary o Both producers and consumers respond to imposition of the tax, which changes their supply & demand choices  Generates a new equilibrium P&Q Chapter 7: Consumers, Producers, and the Efficiency of Markets  Consumer Surplus: o Willingness to pay: The maximum amount that a buyer will pay for a good. Buyer Willingness to pay Ellen $100 Anjali $80 Pete $70 Cami $50
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