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I.

Ten Principles of Economics


Business Cycle f l uctuat ions i n economic activi ty, e.g. employment & production
Economics the study of how society manages i ts scarce resources
Eff iciency the property of society getting the most i t can from i ts scarce resources
Equi ty the property of distribut i ng economic prosperi ty fai rly among the members of
society
External i ty the i mpact of one persons actions on the wel l-being of a bystander
I ncentive something that i nduces a person to act
I nf lat ion an i ncrease i n the overal l level of prices i n the economy
Marginal Changes smal l i ncremental adjustments to a plan of action
Market Economy an economy that al locates resources through the decentral ized decisions
of many f i rms & households as they i nteract i n markets for goods & services
Market Fai lure a situat ion i n which a market left on i ts own fai ls to al locate resources
efficiently
Market Power the abi l i ty of a single economic actor (or smal l group of actors) to have a
substant ial i nf l uence on market prices
Opportuni ty Cost whatever must be given up to obtain some i tem
Productivi ty the quanti ty of goods & services produced from each hour of a workers t i me
Property Rightsthe abi l i ty of an i ndivi dual to own & exercise control over scarce resources
Rational People people who systematically and purposefully do the best they can to achieve
thei r objectives
Scarci ty the l i mi ted nature of societys resources
Ten Pri nciples of Economics
1) People face t rade-offs
o Maki ng decisions requi res t rading off one goal against another
o Classic t rade-off is between guns & but ter (national defence vs. consumer
goods)
o Society faces t rade off of efficiency vs. equi ty (size of economic pie vs.
dist ribut ion)
2) The Cost of Somethi ng is What You Give Up to Get I t
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o Comparison of costs & benefi ts of al ternat ive courses of action
o Must consider the opportuni ty cost
3) Rational People Thi nk at t he Margin
o Marginal changes (smal l i ncremental adjustments) to existi ng plan of action
o Decisions made by compari ng marginal benefi ts & marginal costs
o A persons wi l l i ngness to pay for any good is based on marginal benefi t t hat
an extra uni t wi l l yield
o Marginal benefi t depends on how many uni ts a person al ready has
o A rat ional decision maker acts i f & only i f marginal benefi t exceeds marginal
cost
4) People Respond to I ncent ives
o Because rat ional ppl make decisions by compari ng costs & benefi ts
o Di rect & unintended effects of al tering i ncentives
o Al terat ion of the cost-benefi t calculat ion
5) Trade Can Make Everyone Better Off
o Trade al lows each person to special ize i n the 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 l l ions of f i rms
&households
o Fi rms & households i nteract i n marketplace; prices & self-i nterest guide
decisions
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o Free markets comprised of buyers & sellers primari ly i nterested i n own well-
being
o Adam Smi th: Households & f i rms i nteract i n markets as i f guided by an
invisible hand
o Market prices ref lect both value of a good to society & the cost of maki ng t hat
good
o Smi ths i nsight: Prices adjust to guide these i ndividuals to reach outcomes
maximize the welfare of society as a whole
o Taxes distort prices, price control causes harm
7) Governments Can Sometimes Improve Market Outcomes
o Invisible Hand can work magic only i f govt enforces rules & maintains
i nsti tut ions
o Rely on govt-provided services & courts to enforce property r ights
o I. H. not omnipotent 2 reasons for govt to i ntervene i n economy & change
al location of resources
To promote efficiency
To promote equi ty
o Most pol icies aim to either enlarge economic pie or change division of
o I. H. may also fai l to ensure equi table dist ribut ion of economic prosperi ty
o Al though govt can improve market outcomes at t i mes doesnt mean wi l l
8) A Count rys Standard of Li ving Depends on I ts Abi l i ty to Produce Goods & Services
o Large variat ion i n avg. I ncome ref lected i n various measures of qual i ty of l i fe
o Big changes i n l i vi ng standards over t i me
o Al most al l variat ion i n l ivi ng standards is due to differences i n count ries
productivi ty
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o Growth rate of a nat ions productivi ty determi nes growth rate of average
i ncome
9) Prices Rise When t he Government Pri nts Too Much Money
o Keeping i nf lat ion at a low level is a goal of al l economic policy-makers
o Growth i n quanti ty of money causes i nf lat ion bec value of money fal ls
10) Society Faces a Short-Run Trade-off Between I nf lat ion & Unemployment
o Short-run effects of monetary i njections:
Stimulates overal l level of spending, thus demand for goods & services
Cause f i rms to raise prices over t i me, i n meant i me encourages
i ncrease of quant i ty of goods & services produced & to hi re more
workers
More hi ri ng = lower unemployment
o One f inal economy-wide short-run t rade-off between i nf lat ion &
unemployment
o Over short t i me periods, many economic pol icies push i nf lat ion &
unemployment i n opposi te di rections (issue faced regardless of level start i ng
points)
Summary
I ndividual Decision-Maki ng Fundamental Concepts:
People face t rade-offs among al ternat ive goals, cost of any action measured i n terms
of forgone opportuni t ies, rat ional ppl make decisions by compari ng marginal costs &
benefi ts, ppl change behaviour i n response to i ncentives
I nteractions Among People Fundamental Concepts:
Trade can be mutual ly beneficial, markets are usually good way of coordinat i ng
t rade among ppl, govt can potent ial ly improve market outcomes i f t here is some
market fai l ure or i f market outcome is unequi table
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Economy As A Whole Fundamental Concepts:
Productivi ty is t he ul t i mate source of l i vi ng standards, money growth is ul t i mate
source of i nf lat ion, society faces a short-run t rade-off between i nf lat ion &
unemployment
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I I. Thinki ng Li ke An Economist
Ci rcular-Flow Diagram a visual model of the economy that shows how dol lars f low
through markets among households & f i rms
Macroeconomics the study of economy-wi de phenomena, i ncludi ng i nf lat ion,
unemployment, & economic growth
Microeconomics the study of how households & f i rms make decisions & how they i nteract
i n markets
Normative Statements claims that attempt to prescribe how the worl d should be
Posit ive Statements claims that attempt to describe the worl d as i t is
Production Possibi l i t ies Frontier a graph that shows the combinations of output that the
economy can possibly produce given the avai lable factors of production & the avai lable
production technology
Ci rcular Flow Diagram
Ci rcular-Flow Diagram Model
- Economy is simpl i f ied to two types of decision makers households & f i rms
- Fi rms produce goods & services using inputs (e.g. land, labour, capi tal) known as
factors of production whi le households own factors of production & consume g&s
produced
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The Production Possibi l i t ies Frontier Model
- Shows t he various combinat ions of output t hat t he economy can possibly produce
given t he avai lable factors of production & t he available production tech t hat f i rms
can use to turn t hese factors i nto output
- Two end points represent t he extreme possibi l i t ies; mostly l i kely division of t i me
between the two
- Resources are scarce, therefore not every conceivable outcome is feasible
- An outcome = efficient i f economy is getti ng al l i t can from avai lable scarce resources
(represented by points on [rather than i nside] production possibi l i t ies f rontier)
- I f source of i neff iciency is eliminated, economy can i ncrease i ts production of both
goods
- Shows one t rade-off t hat society faces once efficiency is reached, must produce less
of one good to get more of another
- Shows opportuni ty cost of one good as measured i n terms of other good
- PPF often has this bowed shape; shows t rade-off between outputs of different goods
at a given t i me, but can change over t i me
Ex. Posi t ive versus Normative Analysis
Polly: Mi ni mum-wage laws cause unemployment.
Norma: The government should raise the mi ni mum wage.
Why Economists Disagree
~ may disagree about val idi ty of al ternat ive posi t ive t heories about how the world
works
~ may have di fferent values & therefore different normat ive views about what pol icy
should t ry
to accompl ish
Summary
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Economists t ry to address subject wi th scient ists objectivi ty: make appropriate
assumptions & bui ld simpl i f ied models (e.g. circular-f low diagram & production
possibi l i t ies f ront ier)
Field divided i nto 2 subfields: microeconomics (study decision-making by households
+ f i rms & i nteraction among t he two i n marketplace) & macroeconomics (study
forces & t rends that affect t he economy as a whole)
Posi t ive statement = an assert ion about how t he world is; normative = how the world
ought to be. Normative statements are acti ng more as pol icy advisors than scientists
Economists who advise policy-makers offer confl icti ng advice ei ther bec of
di fferences i n sci j udgement or i n values. At t i mes economists may be uni ted i n
advice, but pol icy-makers may ignore
I I I. I nterdependence and the Gains From Trade
Absolute advantage the comparison among producers of a good according to thei r
productivi ty
Comparat ive advantage the comparison among producers of a good accordi ng to thei r opp.
cost
Exports goods and services produced domestically & sold abroad
Imports goods and services produced abroad & sold domestically
Opportuni ty cost whatever must be given up to obtain some i tem
o I f (e.g. farmer & rancher) choose to be self-sufficient, each consumes exactly what is
produced
- PPF = consumption possibi l i t ies f rontier
o Special ization & Trade = mutual ly beneficial
o Comparative advantage: the driving force of special izat ion
absolute advantage: producer that requi res a smal ler quant i ty of inputs to produce a
good
opportuni ty cost & comparat ive advantage: as real locate t i me between producing
goods, move along PPF; opp. cost measures t rade-off
comparative advantage: used when describing opp. cost of two producers; t he one who
gives up less of other goods to produce good X has c.a.
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o Al though possible for one person to have absolute advantage i n producing both goods,
impossible to have comparative advantage i n both
opp. cost of one good is inverse of opp. cost of t he other good
o Comparat ive advantage & t rade: gains f rom special ization & t rade are based on
comparative adv.
when each special izes, total production r ises i ncrease i n size of economic pie
amel iorates al l
benefi ts from t rade by obtaining a good @a price lower than t hei r opp. cost
o For both part ies to gain f rom t rade, price at which t hey t rade must l ie between the two
opportuni ty costs
o Moral: Trade can benefit everyone i n society because i t al lows ppl to special ize i n
activi t ies i n which they have a comparat ive advantage.
Summary
Each person consumes goods & services produced by many others (both domestically
& abroad). I nterdependence & t rade = desi rable bec al low al l to enjoy greater
quant i ty & variety of goods & services
2 ways to compare abil i ty of 2 ppl i n producing a good:
a) person who produce wi th smal ler quanti ty of inputs = absolute advantage
b) person wi th smal ler opp. cost = comparat ive advantage.
Gains from t rade based on comparative, not absolute, advantage
Trade makes everyone better off bec al lows ppl to special ize i n activi t ies of c.a.
Principle of c.a. appl ies to count r ies as wel l; economists use this pri nciple to
advocate f ree t rade
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IV. The Market Forces of Supply & Demand
Competi t ive market a market i n which there are many buyers and many sel lers so that
each has a negl igible i mpact on market price
Complements 2 goods for which i ncrease i n price of one decrease i n demand for other
Demand curve a graph of the relat ionship between the price of a good & the quanti ty
demanded
Demand schedule a table that shows the relationship between the price of a good & the
quanti ty demanded
Equi l ibri um a situation i n which price has reached level where quant i ty suppl ied =
demanded
Equi l ibri um price price that balances quant i ty suppl ied & quant i ty demanded
Equi l ibri um quant i ty quant i ty suppl ied & quant i ty demanded @equi l ibri um price
I nferior good a good for which, other thi ngs equal, an i ncrease i n i ncome a decrease i n
demand
Law of demand the claim that, other thi ngs equal, the quant i ty demanded of a good fal ls
when the price of the good r ises
Law of supply the claim that, other thi ngs equal, quanti ty suppl ied of a good r ises when
price of the good r ises
Law of supply & demand claim that the price of any good adjusts to bri ng the quant i ty
suppl ied & quant i ty demanded for that good i nto balance
Market a group of buyers & sel lers of a part icular good or service
Normal good a good for which, other thi ngs equal, an i ncrease i n i ncome an i ncrease i n
demand
Quanti ty demanded the amount of a good that buyers are wi l l i ng and able to purchase
Quanti ty suppl ied amount of a good that sellers are wi l l i ng & able to sel l
Shortage a situat ion i n which quant i ty demanded > quant i ty suppl ied
Substi tutes two goods for which an i ncrease i n the price of one i ncrease i n demand for
other
Supply curve a graph of the relat ionship between price of a good & quant i ty suppl ied
Supply schedule table that shows relat ionship between price of a good & quant i ty suppl ied
Surplus a situat ion i n which quant i ty suppl ied > quanti ty demanded
Markets many forms: can be highly organized (e.g. many agricul tural commodi t ies,
buyers & sellers meet @specific t i me/place & auctioneer helps set prices & arrange sales)
usually less organized (e.g. buyers/sellers of ice cream i n a town)
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Competi tion each buyer aware there are several sellers to choose f rom; each seller aware
his product is simi lar to that offered by other sellers
thus price & quant i ty are determined by al l sellers & buyers as they i nteract i n t he
marketplace
to reach highest form of competi t ion (perfectly competi t ive) must have 2 characteristics:
(1) the goods offered for sale are al l exactly t he same
(2) the buyers & sellers are so numerous that no i ndividual has any i nf l uence over
market price
in these markets, buyers & sellers must accept price market determi nes = price takers
@ market price, buyers can buy al l t hey want, sellers can sell al l t hey want
monopoly: markets wi th only one seller who is then able to set the price
Demand
o Price of t he good = central determinant of quanti ty demanded
o Quanti ty demanded is negatively related to price
o Market demand vs. i ndividual demand
> sum of al l i ndividual demands for a part icular good or service
sum i ndividual demand curves horizontally to obtain market demand curve
o Shif ts i n t he demand curve:
any change that i ncreases quanti ty demanded @every price shif ts curve to t he r ight,
called an i ncrease i n demand
any change that reduces quant i ty demanded @every price shif ts the demand curve to
left, called a decrease i n demand
Variables that can shif t demand curve:
I ncome
if demand for a good fal ls when i ncome fal ls = normal good
if demand for a good r ises when i ncome fal ls = i nferior good
Prices of Related Goods
when a fal l i n price of one good reduces demand for another, the 2 = substi tutes
when fal l i n price of one good raises demand for other = complements
Tastes
historical and psychological forces beyond realm of economics
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Expectations
about future may affect demand for a good or service today
Number of Buyers
Summary
demand curve shows what happens to quant i ty demanded of a good when i ts price
varies, holding constant al l other variables that i nf l uence buyers
when one variable changes, demand curve shif ts
price on vert ical axis, t hus change represents movement along demand curve
(others not on either axis, thus shif ts demand curve (see pg. 75 for chart)
Supply
o Quanti ty suppl ied = amount that sellers are wi l l i ng/able to sell
o Many determi nants, but price is key
o Quanti ty suppl ied is positively related to the price of the good
o Supply curve slopes upward because, other t hi ngs equal, higher price = greater quant i ty
suppl ied
o Market supply vs. i ndividual supply
> sum of t he suppl ies of all sellers
sum i ndividual supply curves horizontally to obtain market supply curve
o Shif ts i n supply curve:
any change that raises quant i ty suppl ied @every price shif ts the supply curve to t he
r ight, called an i ncrease i n supply
any change that reduces t he quant i ty suppl ied @every price shif ts curve to left, cal led
a decrease i n supply
Variables that can shif t supply curve:
I nput prices
when price of one or more inputs r ise, producing good is less profi table, f i rms
supply less
if input prices r ise substantial ly, f i rm might shut down & stop supplying
supply of a good = negatively related to price of inputs used to make good
Technology
by reducing f i rms costs, advance i n tech raises supply
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Expectations
amount suppl ied by a f i rm today may depend on expectations of future
e.g. i f expect price to r ise i n future, may store some of current production
Number of sellers
Summary
price on vert ical axis, so change reps a movement along supply curve
a change i n one above variables shif ts t he supply curve (see pg. 81 chart)
Supply & Demand Together
Equi l ibri um point at which supply & demand curves i ntersect
> equi l ibri um price & quant i ty
@equi l ibri um price, quant i ty of the good that buyers are wi l l i ng to buy exactly
balances the quant i ty that sellers are wi l l i ng to sell
aka market-cleari ng price (bec everyone has been satisfied)
actions of buyers & sellers natural ly move markets toward equi l ibri um of supply &
demand
in most free markets, surpluses & shortages = temporary bec prices move toward
equi l ibri um
such a pervasive phenomenon, cal led Law of Supply & Demand: price of any good
adjusts to bri ng quant i ty suppl ied & quanti ty demanded for t hat good i nto balance
3 Steps to Analyzing Changes i n Equi l ibri um
comparat ive statics involves compari ng 2 unchanging si tuat ions: i ni t ial & new
equi l ibri um
1) decide whether event shif ts supply curve, demand curve, or i n some cases, both
curves
2) decide whether curve shif ts to left or r ight
3) use supply & demand diagram to compare i ni t ial & new equi l ibri um, which shows
how shif t affects equi l ibri um price & quanti ty
Shif ts i n Curves vs. Movements along Curves
e.g. economists say i ncrease i n quant i ty suppl ied but no change i n supply
Supply refers to posi t ion of supply curve, whereas quanti ty suppl ied refers to
amount suppl iers wish to sell
shi f t i n supply = change i n supply and shif t i n demand curve = change i n demand
movement along a f ixed supply curve = change i n t he quant i ty suppl ied and
movement along f ixed demand curve = change i n t he quant i ty demanded
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Summary
Economists use model of supply & demand to analyze competi t ive markets many
buyers & sellers, each wi th l i t t le/no i nf l uence on market price
Demand curve shows how quant i ty of a good demanded depends on price. Law of
demand: as price of a good fal ls, quant i ty demanded r ises, therefore demand curve
shopes downward
I n addi t ion to price, other determinants of how much consumers buy: i ncome, price
of substi tutes + complements, tastes, expectations, & # of buyers > i f one of t hese
factors change, demand curve shif ts
Supply curve shows how quanti ty of good suppl ied depends on price; Law of supply:
as price of a good r ises, quant i ty suppl ied r ises; curve slopes upward
I n addi t ion to price, other determinants of how much producers want to sell: input
prices, technology, expectat ions, # of sellers. Change causes shif t.
I ntersection of supply & demand curves determines market equi l ibri um. @
equi l ibri um price, quant i ty demanded = quant i ty suppl ied
Behaviour of buyers & sellers natural ly drives market toward equi l ibri um. When
market price is above, there is surpl us of good, which causes market price to fal l.
When market price is below, shortage, causes price to r ise
Use supply-and-demand diagram to analyze how any event i nf l uences market, fol low
3 steps
I n market economies, prices = signals t hat guide economic decisions & t hereby
al locate scarce resources, ensures supply & demand are i n balance
Equi l ibri um price t hen determi nes how much of t he good buyers choose to purchase
& how much sellers choose to produce
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V. Elastici ty & I ts Appl ication
Cross-price elastici ty of demand a measure of how much quanti ty demanded of one good
responds to change i n price of another good, computed as % change i n quant i ty demanded of
1
st
good divi ded by % change i n price of 2
nd
good
Elastici ty a measure of the responsiveness of quanti ty demanded or suppl ied to one of i ts
determi nants
I ncome elastici ty of demand a measure of how much quanti ty demanded of a good
responds to change i n consumers i ncome, computed as % change i n quant i ty demanded
divi ded by % change i n i ncome
Price elastici ty of demand a measure of how much the quant i ty demanded of a good
responds to a change i n price of that good, computed as % change i n quanti ty demanded
divi ded by % change i n price
Price elastici ty of supply measure of how much quant i ty suppl ied of a good responds to
change i n price of that good, computed as % change i n quanti ty suppl ied divi ded by %
change i n price
Total revenue the amount paid by buyers & received by sellers of a good, computed as price
of good t i mes quant i ty sold
The Price Elasticity of Demand & i ts Determi nants
Elastic i f quanti ty demanded responds substant ial ly to changes i n price
I nelastic i f quant i ty demanded responds only slightly to price changes
Price elastici ty of demand measures how wi l l i ng consumers are to move away f rom
good as i ts price r ises
Determinants
Availabili ty of Close Substi tutes
goods wi th these tend to have more elastic demand; easier for consumers to
swi tch
Necessities vs. Luxuries
necessi t ies tend be i nelastic whi le l uxuries are elastic
Defini tion of the Market
depends on boundaries of market
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narrowly defined markets tend be more elastic than broadly defined markets
bec easier to f i nd close subs for narrowly defined goods
Ti me Horizon
tend to have more elastic demand over longer t i me horizons
Computi ng t he Price Elastici ty of Demand
= Prce eastcty of demand Percentage change n quantty demandedPercentage
change n prce
Because quant i ty demanded is negatively related to price, % change i n quanti ty wi l l
always have opposi te sign as % change i n price
Common practice of dropping minus sign, report i ng al l prices as posi tive numbers
(absolute value)
The Midpoint Method: a Bet ter way to Calculate % Changes & Elastici t ies
= ( - )/| + / ( - )/| + / Prce eastcty of demand O2 O1 O2 O1 2 P2 P1 P2 P1 2
The Variety of Demand Curves
Elasticity
0 Perfectly i nelastic
< 1 I nelastic
1 Uni t elastici ty
> 1 Elastic
Perfectly elastic
Total Revenue & Price Elast ici ty of Demand (see pg. 100)
When demand is i nelastic, price & total revenue move i n same di rection
When demand is elastic, price & total revenue move i n opposi te di rections
I f demand is uni t elastic, total revenue remains constant when price changes
Elastici ty & Total Revenue Along a Li near Demand Curve
- Al though slope is constant, elastici ty isnt bec slope = rat io of changes i n the 2
variables, where as elastici ty is rat io of % changes i n the 2 variables
- Whether cross-price elastici ty is posi t ive or negative depends on whether 2 goods are
substi tutes (+ve) or complements (ve )
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The Price Elasticity of Supply & i ts Determinants
Elastic i f quanti ty suppl ied responds substant ially to changes i n prices
I nelastic i f quant i ty suppl ied responds only slightly to changes i n price
in most markets, a key determi nant = t i me period being considered:
more elastic i n long run than i n short run
Computi ng t he Price Elastici ty of Supply
= Prce eastcty of suppy Percentage change n quantty suppedPercentage
change n prce
The Variety of Supply Curves
Elasticity
0 Perfectly i nelastic
< 1 I nelastic
1 Uni t elastici ty
> 1 Elastic
Perfectly elastic
Summary
Price elastici ty of demand measures how much quant i ty demanded responds to
changes i n price. Demand tends to be more elastic i f close subs are avai lable, i f good
is a l uxury (rather t han necessi ty), i f market is narrowly defined, or i f buyers have
substantial t i me to react
Total revenue = price of good x quant i ty sold
For i nelastic demand curves, total revenue r ises as price r ises. For elastic demand
curves, total revenue fal ls as price r ises.
I ncome elastici ty of demand measures how much quant i ty demanded responds to
changes i n consumers i ncome. Cross-price elastici ty of demand measures how much
quant i ty demanded of one good responds to changes i n price of another.
Price elastici ty of supply measures how much quant i ty suppl ied responds to change
sin price often depends on t i me horizon under consideration (usually more elastic
i n long run)
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Tools of supply & demand can be appl ied i n many di ff. markets
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VI. Supply, Demand, & Government Policies
Price ceil ing a legal maximum on the price at which a good can be sold
Price f loor a legal mi ni mum on the price at which a good can be sold
Tax I ncidence the manner i n which burden of a tax is shared among part icipants i n a
market
How Price Ceil ings Affect Market Outcomes
I f price t hat balances supply & demand is below ceil i ng, not bindi ng (no effect)
I f equi l ibri um price above ceil ing, bindi ng constrai nt
Thus market price = price ceil ing
quant i ty demanded exceeds quant i ty suppl ied (shortage)
mechanism for rat ioning wi l l natural ly develop
when the govt i mposes a bindi ng price ceil i ng on a competit ive market, shortage of
the good arises; sellers must rat ion scarce goods among large # of potential buyers
Free markets rat ion goods wi th prices (better)
How Price Floors Affect Market Outcomes
An at tempt by govt to maintain prices at other than equi l ibri um levels (legal
mini mum)
Thus a bindi ng f loor price causes a surpl us
Taxes used to raise revenue for publ ic projects
How Tax on Buyers Affect Market Outcomes (pg. 132)
How does t his law affect t he buyers & sellers? Fol low t he 3 steps i n Chapter I V for
analyzing supply & demand. (1) Whether law affects the supply or demand curve. (2) Decide
which way the curve shif ts. (3) Examine how shif t affects equi l ibri um.
1. I ni t ial impact on which curve? Which curve does t he tax shif t? (demand)
2. Di rection of shif t.
3. See effect of t he tax by comparing i ni t ial & new equi l ibri um.
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Taxes discourage market activi ty. When a good is taxed, quant i ty sold is smal ler i n new
equi l ibri um
Buyers & sellers share burden of taxes. I n new equi l. buyers pay more & sellers receive
less
How Tax on Sellers Affect Market Outcomes (pg. 133)
1. I mmediate impact on which curve? (supply)
2. Di rection of curve shif t. Magni tude of shift?
3. Compare i ni t ial & new equi l ibri um.
Taxes on buyers & sellers are equivalent. Tax places a wedge between price buyers pay &
price that sellers receive, regardless of who tax is levied on.
Elastici ty & Tax I ncidence
Only rarely wi l l tax burden be shared equally
A tax burden fal ls more heavily on the side of the market that is less elastic.
elastici ty measures wi l l i ngness of buyers or sellers to leave market when
condi t ions become unfavourable
smal l elastici ty of demand means buyers do not have good al ternat ives; smal l
elastici ty 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 ki nds of laws: Laws of Supply & Demand and he laws
enacted by govt
Summary
Price ceil i ng is legal max on price of a good/service (e.g. rent cont rol)
if price ceil ing below equi l. quanti ty demanded exceeds supply shortage
sellers must i n some way rat ion good/service among buyers
Price f loor is legal mi n (e.g. mi ni mum wage)
if above equi l. quant i ty suppl ied exceeds demand surplus
buyers demands must be rat ioned among sellers
When the govt levies a tax on a good, equi l. quant i ty fal ls [shri nks size of market]
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Tax on a good places a wedge between price paid by buyers & price received by
sellers
when market moves to new equi l. buyers pay more & sellers receive less
buyers & sellers share tax burden {incidence doesnt depend on who tax is levied
on}
I ncidence of tax depends on price elastici t ies of supply & demand. Burden fal l on
side of market less elastic (bec can respond less easily to tax by changing quant i ty
bought/sold)
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VI I. Consumers, Producers, & the Eff iciency of Markets
Consumer surplus a buyers wi l l i ngness to pay minus the amount the buyer actually pays
Cost the value of everything a seller must give up to produce a good
Eff iciency the property of a resource al location of maximizing the total surplus received by
al l members of society
Equi ty the fai rness of the distribut ion of wel l-being among the members of society
Producer surpl us the amount a sellers is pai d for a good mi nus the sellers cost
Welfare economics the study of how the al location of resources affects economic wel l-being
Wi l l i ngness to pay the max amount that a buyer wi l l pay for a good
Consumer Surplus
Wi l l i ngness to Pay
Li mi t to amount potential buyers are wi l l i ng to buy (wi l l i ngness to pay = each
buyers max)
Each would be eager to buy @a price < wi l l i ngness to pay; i ndi fferent to buy @price
= to
Consumer surpl us = amount a buyer is wi l l i ng to pay amount buyer actually pays
measures the benefi t to buyers of part icipati ng i n a market
Using t he Demand Curve to Measure Consumer Surplus (pg. 147)
Use wi l l i ngness to pay of possible buyers to f i nd demand schedule
@any quanti ty, price given by demand curve shows wi l l i ngness to pay of the
marginal buyer (buyer who would leave market f i rst i f price were any higher)
The area below the demand curve & above the price measures the consumer surpl us
i n a market
How a Lower Price Raises Consumer Surplus (pg. 149)
What Does Consumer Surplus Mean?
Goal i n developing concept of consumer surplus = to make normat ive j udgements
about desi rabi l i ty of market outcomes
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Consumer surpl us: measures benefi t received from a good as buyers themselves
perceive i t
I n some cases, pol icymakers might not care about consumer surplus (e.g. drugs)
I n most markets, consumer surplus does reflect economic well-being
Producer Surplus
Cost & Wi l l i ngness to Sell
o Each is wi l l i ng to take job i f price receives exceeds cost of doing work: [Cost
opportuni ty cost of the sel ler (e.g. painter pg. 151 example)]; cost = measure of
wi l l i ngness to sell
o Each eager to sell @price higher t han cost; @price = to, i ndi fferent
o Producer surpl us = amount seller is paid cost of production; measures benefi t to
sellers of part icipat ing i n a market
Using t he Supply Curve to Measure Producer Surplus (pg. 153)
o @any quanti ty, price given by supply curve shows cost of marginal seller (seller who
would leave market 1
st
i f price were any lower)
o Can use curve to measure producer surplus
o Area below price & above supply curve = producer surpl us i n a market
o How a Higher Price Raises Producer Surplus (pg. 164)
Market Efficiency
The Benevolent Social Planner
- How to measure economic wel l-being of a society
one possibi l i ty is total surpl us (sum of consumer & producer surplus)
- Consumer Surplus = Value to buyers Amount paid by buyers
- Producer Surpl us = Amount received by sellers Cost to sellers
- Total Surplus = Value to buyers Cost to sellers
- I f al location of resources max total surplus, al location exhibi ts efficiency
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- Equi ty involves normat ive judgements about fai rness of division
Evaluat i ng Market Equi l ibri um
1) Free markets al locate t he supply of goods to the buyers who value them most highly,
as measured by thei r wi l l i ngness to pay.
2) Free markets al locate t he demand for goods to t he sellers who can produce t hem at
least cost.
3) Free markets produce quanti ty of goods that max the sum of consumer & producer
surplus.
= Market power abi l i ty to i nf l uence prices (by single or small group buyers/sellers )
can cause i nefficiency bec keeps away f rom equi l. of supply & demand
= External i t ies decisions of buyers & sellers sometimes affect ppl who are not
part icipants i n the market @al l
= Market fai l ure i nabi l i ty of some unregulated markets to al locate resources efficiently
Summary
Consumer & producer surplus(how to compute); al location of resources that
maximizes sum of surplus = efficient (policy-makers often concerned w/ efficiency &
equi ty of economic outcomes); equi l. of supply & demand maximizes sum of surplus
(invisible hand leads to efficient al location); markets dont al locate efficiently i n
presence of market fai l ures (e.g. market power or external i t ies)
VI I I. Appl ication: The Costs of Taxation
Deadweight loss the fal l i n total surpl us that resul ts f rom a market distort ion (e.g. a tax)
[pg. 165]
Tax places wedge between price buyers pay & sellers receive quanti ty sold fal ls below
level that would be sold wi thout a tax (iow causes size of market to shri nk)
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Govts total tax revenue = T (size of tax) X Q (quant i ty of good sold)
(pg. 169) Thus the losses to buyers & sellers from a tax exceed the revenue raised by the
government
fal l i n total surplus that resul ts when a tax (or other pol icy) distorts a market outcome
= deadweight loss
when tax raises price to buyers & lowers price to sellers, gives i ncentive to buyers to
consume less & sellers i ncentive to produce less
as buyers & sellers respond to i ncent ives, size of market shri nks below opti mum
Taxes distort i ncentives & cause markets to al locate resources i neff iciently
Taxes cause deadweight losses because they prevent buyers & sellers from real izing some
of the gains from t rade
The greater t he elastici t ies 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. Reduction i n
consumer & producer surplus usually exceeds revenue raised by govt. Fal l i n total
surplus (sum of producer & consumer surplus + tax revenue) = deadweight loss of
t he tax
Taxes have deadweight losses bec cause buyers to consume less & sellers to produce
less; this change i n behaviour shri nks size of market below level that maximizes
total surplus.
Because elastici t ies of supply & demand measure how much market part icipants
respond to market condi t ions, larger elastici t ies imply larger deadweight losses
As a tax grows larger, distorts i ncentives more & deadweight loss grows larger.
Tax revenue f i rst r ises wi th size of a tax. Eventual ly, however, a larger tax reduces
tax revenue because i t reduces the size of t he market.
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