Week 3 - Elasticity, Efficiency

Question 1

What are the determinants of elasticity

Answer 1

1. Availability of close substitutes
2. Share on the budget (proportion of you budget do you spend on the good)
3. Time to adjust (SR consumers may have a difficult time altering their behaviour, LR behavioural changes are easier)
4. Addiction/ habitual (addictive goods tend to be more inelastic)

Question 2

What does the perfectly elastic demand curve suggest?

Answer 2

Even the slightest increase in price leads consumers to switch to substitutes
(elasticity = infinite)
horizontal line

Question 3

What does a perfectly inelastic demand suggest?

Answer 3

Consumers cannot switch to substitutes or stop buying when the prices increases
(elasticity = 0)
vertical line

Question 4

What is the arc elasticity?

Answer 4

the price elasticity of demand between two points on the demand curve

Question 5

What is point price elasticity?

Answer 5

provides a measure of the elasticity of demand at a particular point on the demand curve

Question 6

What is the point price elasticity equation

Answer 6

Point elasticity = (Change in Q/ Q) / (Change in P/ P)

Question 7

What does it mean if we take the Change in P to be very small?

Answer 7

then the slope of the demand curve at some point is (Change P) / (Change Q)

so point price elasticity of demand at the point A is
= (Change Q) / (Change P) x (P/ Q) = (1/ Slope) x (P/Q)

Question 8

What does 1/ Slope mean?

Answer 8

Where the demand curve hits the P and Q axis

Question 9

What does point price elasticity value mean? eg 2/3

Answer 9

That when a price of the good is eg 8, a 1% increase in price would lead to a 2/3 % decrease in Qd

A 3% increase in Price leads to a 2% decrease in Qd

Question 10

What is the elasticity across a straight line demand curve

Answer 10

Top half - Elastic
Middle - Unit elastic
Bottom half - inelastic

Elasticity increases as we move down a straight-line demand curve, because P/Q declines while the slope remains constant

Question 11

How is total revenue affected if demand is elastic?

Answer 11

A small increase in price will decrease Qd by a relatively large amount
An increase in price decreases total revenue

Question 12

How is total revenue affected if demand is inelastic

Answer 12

A large increase in price will decrease Qd by a relatively small amount
An increase in price increases total revenue

Question 13

What is cross-price elasticity of demand?

Answer 13

is the percent change in Qd of that good, in response to a 1% change in price of another good

eg if the price of coffee increases by 1% and demand for tea increases by 2% then the cross price elasticity of demand for tea with respect to coffee prices is 2

Question 14

What does the positive value of cross price elasticity of demand mean?

Answer 14

substitutes

Question 15

What does the negative value of cross price elasticity of demand mean?

Answer 15

complements

Question 16

What is income elasticity of demand?

Answer 16

percentage change in Qd associated with a 1% change in consumer income
describes how responsive demand is to income changes

Question 17

What does the negative value of income elasticity of demand mean?

Answer 17

inferior good

Question 18

What does the positive value of income elasticity of demand mean?

Answer 18

normal good
if elasticity greater than 1, sometimes good is luxury good

Question 19

What is the price elasticity of supply?

Answer 19

measures seller’s sensitivity to changes in price

Question 20

What is the price elasticity of supply equation

Answer 20

Percentage change in Qs / Percentage change in Price

Question 21

What are the 4 determinants of Supply Elasticity?

Answer 21

1. Flexibility of inputs
2. Mobility of inputs
3. Ability to produce with substitute inputs
4. Time

Question 22

What is positive economics

Answer 22

Is independent of the ethical value system of the economist

Question 23

What is normative economics

Answer 23

consists of statements in economics that reflect or are based on the ethical value system of the economist, implicitly, explicitly or by omission
‘should be’

Question 24

How do we measure efficiency?

Answer 24

consumer and producer surplus

Question 25

What is consumer surplus?

Answer 25

the difference between a buyer’s reservation price and the price actually paid
(top triangle)

Question 26

What happens to the consumer surplus when demand is more elastic?

Answer 26

consumer surplus reduces

Question 27

What happens to the consumer surplus when demand is more inelastic?

Answer 27

dont have close substitutes, larger consumer surplus

Question 28

What is the producer surplus?

Answer 28

the difference between a seller’s reservation price and the price received
(bottom triangle)

Question 29

What is economic surplus

Answer 29

Total Economic surplus (Total Welfare) = Consumer surplus + Producer Surplus

Question 30

When are consumer and producer surplus at their maximum?

Answer 30

at market equilibrium

Question 31

What is the welfare maximising outcome/ Pareto efficient point?

Answer 31

a concept of efficiency, already achieving the maximum total economic welfare
Point at market equilibrium

Question 32

What is Pareto efficiency?

Answer 32

no one can be made better off without making someone worse off

Question 33

What is another word for the market equilibrium at maximum economic welfare?

Answer 33

competitive equilibrium, which is the benchmark of efficiency

Question 34

What are the 5 assumptions of market equilibrium and efficiency?

Answer 34

1. All benefits from consumption are captured by the demand curve
2. All costs from production are captured by the supply curve
3. Information
4. Low transaction cost
5. Perfectly competitive market

Question 35

What will the market equilibrium be when all the assumptions of market equilibrium and efficiency are true?

Answer 35

Pareto efficient, no one can be made better off without making someone worse off

Question 36

What happens to consumer surplus when there is a price ceiling below equilibrium price?

Answer 36

Below the demand curve, above the new price they pay, but restricted by how many units they can buy

Question 37

What happens to producer surplus when there is a price ceiling below equilibrium price?

Answer 37

reduces down to the new price point out output

Question 38

What does the part of the economic surplus being lost to the price ceiling mean?

Answer 38

eg the government think the price of milk is too high, wanting a more fair and equitable situation in the market, so they restrict the price

called deadweight loss -> the reduction in total economic surplus

Question 39

Is the loss of efficiency worth it (deadweight loss)?

Answer 39

this is the trade off between equity and efficiency, sacrificing efficiency to get to the equitable situation that the government want

but efficiency should be the first goal

Question 40

What happens to consumer and producer surplus when there is a tax imposed on the seller?

Answer 40

shift the supply curve upwards, a tax increases the price to consumers but decreases the price received by sellers

consumer surplus decreases, producer surplus decreases leaving a rectangle in the middle which represents tax revenue received by the government

then the mini triangle next to the tax revenue is the deadweight loss

Question 41

What happens to the tax burden if the demand is inelastic?

Answer 41

consumers are going to bear more of the tax burden

Question 42

What happens to the tax burden if the demand is elastic?

Answer 42

sellers are going to bear more of the tax burden