Week 3 - Elasticity, Efficiency Flashcards
Elasticity, Efficiency
What are the determinants of elasticity
- Availability of close substitutes
- Share on the budget (proportion of you budget do you spend on the good)
- Time to adjust (SR consumers may have a difficult time altering their behaviour, LR behavioural changes are easier)
- Addiction/ habitual (addictive goods tend to be more inelastic)
What does the perfectly elastic demand curve suggest?
Even the slightest increase in price leads consumers to switch to substitutes
(elasticity = infinite)
horizontal line
What does a perfectly inelastic demand suggest?
Consumers cannot switch to substitutes or stop buying when the prices increases
(elasticity = 0)
vertical line
What is the arc elasticity?
the price elasticity of demand between two points on the demand curve
What is point price elasticity?
provides a measure of the elasticity of demand at a particular point on the demand curve
What is the point price elasticity equation
Point elasticity = (Change in Q/ Q) / (Change in P/ P)
What does it mean if we take the Change in P to be very small?
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)
What does 1/ Slope mean?
Where the demand curve hits the P and Q axis
What does point price elasticity value mean? eg 2/3
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
What is the elasticity across a straight line demand curve
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
How is total revenue affected if demand is elastic?
A small increase in price will decrease Qd by a relatively large amount
An increase in price decreases total revenue
How is total revenue affected if demand is inelastic
A large increase in price will decrease Qd by a relatively small amount
An increase in price increases total revenue
What is cross-price elasticity of demand?
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
What does the positive value of cross price elasticity of demand mean?
substitutes
What does the negative value of cross price elasticity of demand mean?
complements
What is income elasticity of demand?
percentage change in Qd associated with a 1% change in consumer income
describes how responsive demand is to income changes
What does the negative value of income elasticity of demand mean?
inferior good
What does the positive value of income elasticity of demand mean?
normal good
if elasticity greater than 1, sometimes good is luxury good
What is the price elasticity of supply?
measures seller’s sensitivity to changes in price
What is the price elasticity of supply equation
Percentage change in Qs / Percentage change in Price
What are the 4 determinants of Supply Elasticity?
- Flexibility of inputs
- Mobility of inputs
- Ability to produce with substitute inputs
- Time
What is positive economics
Is independent of the ethical value system of the economist
What is normative economics
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’
How do we measure efficiency?
consumer and producer surplus
What is consumer surplus?
the difference between a buyer’s reservation price and the price actually paid
(top triangle)
What happens to the consumer surplus when demand is more elastic?
consumer surplus reduces
What happens to the consumer surplus when demand is more inelastic?
dont have close substitutes, larger consumer surplus
What is the producer surplus?
the difference between a seller’s reservation price and the price received
(bottom triangle)
What is economic surplus
Total Economic surplus (Total Welfare) = Consumer surplus + Producer Surplus
When are consumer and producer surplus at their maximum?
at market equilibrium
What is the welfare maximising outcome/ Pareto efficient point?
a concept of efficiency, already achieving the maximum total economic welfare
Point at market equilibrium
What is Pareto efficiency?
no one can be made better off without making someone worse off
What is another word for the market equilibrium at maximum economic welfare?
competitive equilibrium, which is the benchmark of efficiency
What are the 5 assumptions of market equilibrium and efficiency?
- All benefits from consumption are captured by the demand curve
- All costs from production are captured by the supply curve
- Information
- Low transaction cost
- Perfectly competitive market
What will the market equilibrium be when all the assumptions of market equilibrium and efficiency are true?
Pareto efficient, no one can be made better off without making someone worse off
What happens to consumer surplus when there is a price ceiling below equilibrium price?
Below the demand curve, above the new price they pay, but restricted by how many units they can buy
What happens to producer surplus when there is a price ceiling below equilibrium price?
reduces down to the new price point out output
What does the part of the economic surplus being lost to the price ceiling mean?
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
Is the loss of efficiency worth it (deadweight loss)?
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
What happens to consumer and producer surplus when there is a tax imposed on the seller?
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
What happens to the tax burden if the demand is inelastic?
consumers are going to bear more of the tax burden
What happens to the tax burden if the demand is elastic?
sellers are going to bear more of the tax burden
