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 1 www.notesolution.com 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 2 www.notesolution.com 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 3 www.notesolution.com 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 4 www.notesolution.com 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 5 www.notesolution.com 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 6 www.notesolution.com 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 7 www.notesolution.com 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. 8 www.notesolution.com 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 9 www.notesolution.com 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) 10 www.notesolution.com 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 11 www.notesolution.com 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 12 www.notesolution.com 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 13 www.notesolution.com 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 14 www.notesolution.com 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 15 www.notesolution.com 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 ) 16 www.notesolution.com 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) 17 www.notesolution.com Tools of supply & demand can be appl ied i n many di ff. markets 18 www.notesolution.com 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. 19 www.notesolution.com 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] 20 www.notesolution.com 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) 21 www.notesolution.com 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 22 www.notesolution.com 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 23 www.notesolution.com - 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) 24 www.notesolution.com 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. 25 www.notesolution.com