BBA Principles of Economics Unit 2nd Notes
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Elasticity and Its Applications
Elasticity
- allows us to analyze supply and demand with greater precision.
- Is a measure of how much buyers and sellers respond to changes in market conditions
THE ELASTICITY OF DEMAND PRINCIPLE OF ECONOMIC NOTES
- Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.
- Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.
The Price Elasticity of Demand and Its Determinants
- Availability of Close Substitutes
- Necessities versus Luxuries
- Definition of the Market
- Time Horizon
- Demand tends to be more elastic :
- the larger the number of close substitutes.
- if the good is a luxury.
- the more narrowly defined the market.
- the longer the time period.
Computing the Price Elasticity of Demand
Computing the Price Elasticity of Demand Example :-
The Variety of Demand Curves
- Inelastic Demand
- Quantity demanded does not respond strongly to price changes.
- Price elasticity of demand is less than one.
- Elastic Demand
- Quantity demanded responds strongly to changes in price.
- Price elasticity of demand is greater than one.
Computing the Price Elasticity of Demand
The Variety of Demand Curves
- Perfectly Inelastic
- Quantity demanded does not respond to price changes.
- Perfectly Elastic
- Quantity demanded changes infinitely with any change in price.
- Unit Elastic
- Quantity demanded changes by the same percentage as the price.
- Perfectly Inelastic
- Quantity demanded does not respond to price changes.
- Perfectly Elastic
- Quantity demanded changes infinitely with any change in price.
- Unit Elastic
- Quantity demanded changes by the same percentage as the price.
Total Revenue and the Price Elasticity of Demand
- Total revenue is the amount paid by buyers and received by sellers of a good.
- Computed as the price of the good times the quantity sold.
Elasticity and Total Revenue along a Linear Demand Curve
- With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.
Income Elasticity of Demand
- Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income.
- It is computed as the percentage change in the quantity demanded divided by the percentage change in income.
- Types of Goods
- Normal Goods
- Inferior Goods
- Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.
- Goods consumers regard as necessities tend to be income inelastic
- Examples include food, fuel, clothing, utilities, and medical services.
- Goods consumers regard as luxuries tend to be income elastic.
- Examples include sports cars, furs, and expensive foods.
THE ELASTICITY OF SUPPLY
- Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good.
- Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price.
Determinants of Elasticity of Supply
- Ability of sellers to change the amount of the good they produce.
- Beach-front land is inelastic.
- Books, cars, or manufactured goods are elastic.
- Time period.
- Supply is more elastic in the long run.The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.
THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY
- Can good news for farming be bad news for farmers?
- What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?
- Examine whether the supply or demand curve shifts.
- Determine the direction of the shift of the curve.
- Use the supply-and-demand diagram to see how the market equilibrium changes.
Summary Principles of Economics Notes
- Price elasticity of demand measures how much the quantity demanded responds to changes in the price.
- Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.
- If a demand curve is elastic, total revenue falls when the price rises.
- If it is inelastic, total revenue rises as the price rises.
- The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income.
- The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good.
- In most markets, supply is more elastic in the long run than in the short run.
- The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price.
- The tools of supply and demand can be applied in many different types of markets.
Supply, Demand, and Government Policies
Supply, Demand, and Government Policies
- In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities.
- While equilibrium conditions may be efficient, it may be true that not everyone is satisfied.
- One of the roles of economists is to use their theories to assist in the development of policies.
CONTROLS ON PRICES
- Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.
- Result in government-created price ceilings and floors.
- Price Ceiling
- A legal maximum on the price at which a good can be sold.
- Price Floor
A legal minimum on the price at which a good can be sold.
How Price Ceilings Affect Market Outcomes
- Two outcomes are possible when the government imposes a price ceiling:
- The price ceiling is not binding if set above the equilibrium price.
- The price ceiling is binding if set below the equilibrium price, leading to a shortage.
How Price Ceilings Affect Market Outcomes
- Effects of Price Ceilings
- A binding price ceiling creates
- shortages because QD > QS.
- Example: Gasoline shortage of the 1970s
- nonprice rationing
- Examples: Long lines, discrimination by sellers
Lines at the Gas Pump Principles of Economic Notes
- In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the major input in gasoline, so the higher oil prices reduced the supply of gasoline.
- What was responsible for the long gas lines?
- Economists blame government regulations that limited the price oil companies could charge for gasoline.
Rent Control in the Short Run and Long Run
- Rent controls are ceilings placed on the rents that landlords may charge their tenants.
- The goal of rent control policy is to help the poor by making housing more affordable.
- One economist called rent control “the best way to destroy a city, other than bombing.”
How Price Floors Affect Market Outcomes
- When the government imposes a price floor, two outcomes are possible.
- The price floor is not binding if set below the equilibrium price.
- The price floor is binding if set above the equilibrium price, leading to a surplus.
- A price floor prevents supply and demand from moving toward the equilibrium price and quantity.
- When the market price hits the floor, it can fall no further, and the market price equals the floor price.
- A binding price floor causes . . .
- a surplus because QS > QD.
- nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria.
The Minimum Wage
- An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.
Taxes Principles of Economics Notes
- Governments levy taxes to raise revenue for public projects.
How Taxes on Buyers (and Sellers) Affect Market Outcomes
- Taxes discourage market activity.
- When a good is taxed, the
quantity sold is smaller. - Buyers and sellers share
the tax burden.
Elasticity and Tax Incidence
- Tax incidence is the manner in which the burden of a tax is shared among participants in a market.
- Tax incidence is the study of who bears the burden of a tax.
- Taxes result in a change in market equilibrium.
- Buyers pay more and sellers receive less, regardless of whom the tax is levied on.
- What was the impact of tax?
- Taxes discourage market activity.
- When a good is taxed, the quantity sold is smaller.
- Buyers and sellers share the tax burden.
- In what proportions is the burden of the tax divided?
- How do the effects of taxes on sellers compare to those levied on buyers?
- The answers to these questions depend on the elasticity of demand and the elasticity of supply.
- The burden of a tax falls more heavily on the side of the market that is less elastic
Summary Principles of Economics Notes
- Price controls include price ceilings and price floors.
- A price ceiling is a legal maximum on the price of a good or service. An example is rent control.
- A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage.
- Taxes are used to raise revenue for public purposes.
- When the government levies a tax on a good, the equilibrium quantity of the good falls.
- A tax on a good places a wedge between the price paid by buyers and the price received by sellers.
- The incidence of a tax refers to who bears the burden of a tax.
- The incidence of a tax does not depend on whether the tax is levied on buyers or sellers.
- The incidence of the tax depends on the price elasticities of supply and demand.
- The burden tends to fall on the side of the market that is less elastic.
SUPPLY AND DEMAND MARKETS AND WELFARE
Consumers, Producers, and the Efficiency of Markets
- Do the equilibrium price and quantity maximize the total welfare of buyers and sellers?
- Market equilibrium reflects the way markets allocate scarce resources.
- Whether the market allocation is desirable can be addressed by welfare economics.
Welfare Economics Principles of Economic Notes
- Welfare economics is the study of how the allocation of resources affects economic well-being.
- Buyers and sellers receive benefits from taking part in the market.
- The equilibrium in a market maximizes the total welfare of buyers and sellers.
- Equilibrium in the market results in maximum benefits, and therefore maximum total welfare for both the consumers and the producers of the product.
- Consumer surplus measures economic welfare from the buyer’s side.
- Producer surplus measures economic welfare from the seller’s side.
Consumer Surplus Notes
- Willingness to pay is the maximum amount that a buyer will pay for a good.
- It measures how much the buyer values the good or service.
- Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it.
- The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices.
Using the Demand Curve to Measure Consumer Surplus
- The area below the demand curve and above the price measures the consumer surplus in the market.
What Does Consumer Surplus Measure?
- Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it.
Product Surplus Notes
- Producer surplus is the amount a seller is paid for a good minus the seller’s cost.
- It measures the benefit to sellers participating in a market.
Using the Supply Curve to Measure Producer Surplus
- Just as consumer surplus is related to the demand curve, producer surplus is closely related to the supply curve.
- The area below the price and above the supply curve measures the producer surplus in a market.
Market Efficiency Notes
- Consumer surplus and producer surplus may be used to address the following question:
- Is the allocation of resources determined by free markets in any way desirable?
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to sellers
Total surplus
= Consumer surplus + Producer surplus
or
Total surplus
= Value to buyers – Cost to sellers
- Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society.
- In addition to market efficiency, a social planner might also care about equity – the fairness of the distribution of well-being among the various buyers and sellers.
- Three Insights Concerning Market Outcomes
- Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay.
- Free markets allocate the demand for goods to the sellers who can produce them at least cost.
- Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.
Evaluating the Market Equilibrium Notes
- Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it.
- This policy of leaving well enough alone goes by the French expression laissez faire.
- Market Power
- If a market system is not perfectly competitive, market power may result.
- Market power is the ability to influence prices.
- Market power can cause markets to be inefficient because it keeps price and quantity from the equilibrium of supply and demand.
- Externalities
- created when a market outcome affects individuals other than buyers and sellers in that market.
- cause welfare in a market to depend on more than just the value to the buyers and cost to the sellers.
- When buyers and sellers do not take externalities into account when deciding how much to consume and produce, the equilibrium in the market can be inefficient.
Principles of Economic Notes
- Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay for it.
- Consumer surplus measures the benefit buyers get from participating in a market.
- Consumer surplus can be computed by finding the area below the demand curve and above the price.
- Producer surplus equals the amount sellers receive for their goods minus their costs of production.
- Producer surplus measures the benefit sellers get from participating in a market.
- Producer surplus can be computed by finding the area below the price and above the supply curve.
- An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient.
- Policymakers are often concerned with the efficiency, as well as the equity, of economic outcomes.
- The equilibrium of demand and supply maximizes the sum of consumer and producer surplus.
- This is as if the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently.
- Markets do not allocate resources efficiently in the presence of market failures.
BBA Principles of Economic Question Paper 2019-2021
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