EC 201: Quiz 3

Quiz Question: Which of the following is a consequence of free riders? A. The good or service is never produced because not enough people paid to use it. B. The good or service is produced regardless. C. The government always steps in to produce the good or service. D. Consumers are better off by not having the good or service be produced.

*A. The good or service is never produced because not enough people paid to use it.*

Clicker Question: Michael buys a handmade sweater for $60 for which he was willing to pay $85. The minimum acceptable price to the seller, Susan, was $45. Michael experiences a: A. consumer surplus of $25 and Susan experiences a producer surplus of $15 B. producer surplus of $15 and Susan experiences a consumer surplus of $25 C. consumer surplus of $15 and Susan experiences a producer surplus of $15 D. producer surplus of $25 and Susan experiences a consumer surplus of $15

*A. consumer surplus of $25 and Susan experiences a producer surplus of $15*

Clicker Question: The basic formula for the price elasticity of demand is: A) absolute decline in price/absolute increase in quantity demanded B) absolute decline in quantity demand/absolute increase in price C) percentage change in quantity demanded/percentage change in price D) percentage change in price / percentage change in quantity demanded

*C) percentage change in quantity demanded/percentage change in price*

Quiz Question: Which of the following is most likely to be overconsumed due to unclear or unenforceable property rights? A. Cereal in your dorm room B. Sandwiches at the school café shop C. Soda in the vending machines D. Donuts sitting in the common study area in the dorm

*D. Donuts sitting in the common study area in the dorm*

Quiz Question: Which of the following is NOT correct when describing allocative efficiency? A. It occurs where marginal benefit equals marginal cost B. It occurs when the right amount of goods and services are produced C. It occurs when total surplus is maximized D. It occurs when firms produce at the lowest possible average total cost

*D. It occurs when firms produce at the lowest possible average total cost*

Quiz Question: The government may intervene in the market when market failures occur and: A. move the market towards an efficient outcome. B. tax or legislate when negative externalities exist. C. subsidize positive externalities. D. do all of the above

*D. do all of the above*

Quiz Question: Incorporating the external and private benefits and costs: A. impedes the decision-making process. B. is not necessary as long as marginal benefit is greater than marginal cost. C. eliminates the decision-making process. D. results in socially optimal production and consumption.

*D. results in socially optimal production and consumption.*

Clicker Question: The concept of price elasticity of demand measures the: A. Slope of the demand curve B. number of buyers in the market C. extent to which the demand curve shifts as the result of a price decline D. sensitivity of consumer purchases to price changes

*D. sensitivity of consumer purchases to price changes*

Big Questions

1. How do we measure the responsiveness of demand and supply? 2. How do we calculate the elasticity of demand? 3. How do we categorize the elasticity of demand? 4. What does the relationship between demand, elasticity, and total revenue tell us? 5. What are some factors that make demand more elastic?

Big Questions

1. How do we measure the social benefits and costs in a market? - *External MB (negative externality); External MC (positive externality)* 2. What happens to market outcomes when society is affected? - *With negative externality, too much is produced; With positive externality, too little is produced; market outcomes need to change to socially optimal point 3. What is the difference between a private good and a public good?

Big Questions

1. How do we measure what consumers get out of a transaction? - *Through Consumer Surplus (CS)* 2. How do we measure what producers get out of a transaction? - *Through Producer Surplus (PS)* 3. What is economic surplus? What does it measure? - *Economic Surplus (or total surplus); measures welfare in a market* 4. What does deadweight loss measure? - *Lost economic surplus (compared to equilibrium)* 5. How do we know if a market or policy is efficient? 6. What are some tapes of efficiency?

Elasticity

A measure of how responsive one variable is to a change in another variable

Market Failure

A situation in which a market fails to produce the efficient level of output that maximizes total surplus

Perfectly Elastic Demand

An example of a perfectly elastic demand is a firm's demand curve in a purely competitive industry such as the mining industry who is unable to change the price.

Extreme Cases

An example of a perfectly inelastic demand might be a diabetic's demand for insulin.

Public Good

Any good or service that is both nonrival and nonexcludable

What if there are more costs than just the private costs?

Anything in addition to the private costs, or external to the private decision, is called an external marginal cost or an externality

How can a market interaction lead to inefficient results?

Considering again our decision rule, we should realize that is there are no external costs, we will get efficient outcomes

Price Elasticity of Demand Formula

For Consumers: Elasticity = %∆Qd/%∆Price 𝐸𝑑 = 25 / (−10) = -2.5 •We now have the percentage change in quantity demanded and the percentage change in price, so all we need to do is calculate the price elasticity of demand.

Price Elasticity of Demand Formula

For Consumers: Elasticity = %∆Qd/%∆Price 𝐸𝑑=22.2/(−10.5) = •We now have the percentage change in quantity demanded and the percentage change in price, which is all we need to calculate the price elasticity of demand.

Calculating %∆

Here is the formula for calculating the percentage change in price.

Calculating %∆

Here is the formula for percentage change in price.

The Coarse Theorem

If a property right is well-defined and transaction costs are low, resources will naturally gravitate to their highest-valued use, regardless of who owns the property rights

Unit-elastic Demand

If the absolute value of the elasticity of demand is exactly 1, it is considered unit-elastic.

Elastic Demand

If the absolute value of the elasticity of demand is greater than 1, it is considered elastic.

Inelastic Demand

If the absolute value of the elasticity of demand is less than 1, it is considered inelastic.

What does it mean?

If the price decreases by 1% the quantity demanded will increase by 2.1%

Updated Decision Rule

MBprivate + MBexternal ≥ MCprivate + Mcexternal MBsocial ≥ MCsocial •Combine both our updates to the decision rule by taking into consideration both external costs and external benefits. •Each side of the equation can be reduced down to what we call the social marginal benefit and the social marginal cost.

Example

Note that the negative percentage change in price means that the price dropped. Note: Figures have been rounded to the nearest tenth.

Decision Rule

Old Decision Rule MB ≥ MC Decision Rule Updated External Costs MB ≥ MCprivate + MCexternal

Decision Rule

Old Decision Rule MB ≥ MC Decision Rule Updated for External Benefits MBprivate MBexternal ≥ MC

Solution

Subsidize production

Solution

Tax or legislate production

Exteranility

The benefit enjoyed by or cost imposed on a third party not directly involved in the production or consumption of a good or service

Private Marginal Cost

The cost to the producer of an additional unit of a good or service

Property Right

The exclusive right to determine how a resource is used

Free-rider Problem

The idea that when a good is nonexcludable, people will choose to consume the good without paying for it, making it difficult for private companies to profitably provide the good

Negative Externality

The uncompensated cost imposed on a third party not directly involved in the production or consumption of a good or service

Positive Externality

The unpaid benefit enjoyed by a third party not directly involved in the production or consumption of a good or service

Socially Optimal Production & Consumption

When MBsocial = MCsocial we have socially optimal production and consumption.

Productive and Allocative Efficiency

•A few more terms we need to discuss efficiency in economics are productive efficiency and allocative efficiency •Learning Objective: Define and identify productive and allocative efficiency in a competitive market

What is an elasticity?

•A measure of response to a stimulus •Related to law of demand and law of supply

Producer Suplus

•Again, the videos represented the supply curve by a number of specific points as dots at various price and quantity combinations

What if there are more benefits than just the private benefits?

•Anything in addition to the private benefits, or external to the private decision, is called an external marginal benefit or an exteranility

Welfare At Equilibrium

•At the equilibrium price of a market you can see the total consumer surplus and producer surplus

Maximizing Welfare

•At the equilibrium price we are maximizing total surplus •There is no missing surplus because there are no missing trades (all trades up to Qe take place)

How can a market interaction lead to inefficient results? (6)

•But if there are external benefits, we may not. People will likely consider only their own private marginal benefit and cost when deciding whether to act or not. •In this case, if one considers the private costs and benefits, they will choose not to do the activity, but from an overall social perspective it will be efficient (the benefits exceed the costs).

How can a market interaction lead to inefficient results?

•But if there are external costs, we may not get an efficiency outcome. People likely consider only their own private marginal benefit and cost when deciding whether to act or not •In this case, if one considers the private costs and benefits they will choose to do the activity, but from an overall social perspective it will be inefficient (the costs exceed the benefits)

Online entertainment sites like Hulu, Netflix, etc. are nonrivalrous

•Cable television, satellite radio, and other providers of entertainment content like Hulu, Netflix, etc. are examples of activities that are nonrivalrous •Your consumption of them does not diminish my ability to •Yet, these activities are excludable; providers can ensure that you don't receive the content without paying for it

Production Possibilities Frontier

•Connection to Other Material: •Consider efficiency and the production possibilities frontier ○Everything inside the curve is not efficient ○Everything outside the curve is not possible ○Any point on the curve is efficient (more accurately, any point on the curve is productively efficient) ○The point on the curve at the optimal mix consumers desire is the point that is allocatively efficient •You might be using your resources with productive efficiency if you make 300 buckets of water and 0 bananas, but it may not be the optimal production that consumers desire and thus it may not be the point that is allocatively efficient

Consumer Surplus

•Consumer surplus can be thought of as the wealth that trade creates for consumers in a market •Consumer surplus is measured in dollars •Graphically, consumer surplus is the area below the demand curve and above the equilibrium price, from zero to the quantity traded

Nonexcludable

•Definition: A characteristic of some goods or services whereby people *cannot* easily be prevented from consuming the good or service, even if they don't pay for it •For example, a fireworks display is non-excludable, since anyone nearby can see the show once the rockets are launched. Sometimes referred to as nonexcludable in consumption

Private Market

•Definition: A market in which the demand and supply curves represent the benefits and costs to only the consumers and producers in the market •If all costs and benefits are reflected in the private market, then individuals following our rational decision rule will help create efficient results

Productive Efficiency

•Definition: Producing output at the lowest possible average total cost of production •Using the fewest resources possible to produce a good or service

Allocative Efficiency

•Definition: Producing the goods and services that are most wanted by consumers in such a way that their marginal benefit equals their marginal cost

Nonrival

•Definition: The characteristic of some goods or services whereby the consumption of the good or service by one person does *not* diminish the amount available to someone else •For example, the Internet is nonrival, since multiple consumers can use the Internet without diminishing the use of the Internet to someone else

External Marginal Cost

•Definition: The cost of an additional unit of a good or service that is imposed on people other than the producer •One example is pollution. Pollution adds an external cost to the private cost. A polluted river costs other people access to clean drinking water, a place to boat and swim, and harms the natural habitat. •Ex. Pollution

Producer Surplus

•Definition: The difference between the price producers receive for a good or service and the minimum price they are willing and able to accept

Economic Surplus

•Definition: The sum of the consumer and producer surplus

Deadweight Loss

•Definition: The value of the economic surplus that is foregone when a market is not allowed to adjust to its competitive equilibrium •From what we have analyzed so far, we can see deadweight loss any time there is a transaction that does not take place but should have (i.e., the MB for that transaction was greater than the MC, yet the transaction was prevented from taking place)

What to remember about Elasticity

•Elasticity is simply a measure of response to some factor •All elasticities are percent changes •Think about what is changing and what is causing the changing •No units!

Absolute Value

•Elasticity of demand is always negative. •Economists use the absolute value of the negative number for easier comparison.

Producer Surplus: Hint

•Everything above the supply curve and below the price

Consumer Surplus: Hint

•Everything below the demand curve and above the price

Large-scale fireworks show is both nonrival and nonexcludable (Public Good)

•Fireworks are both nonexcludable and nonrival. Anyone near the area can see the fireworks, and many people can enjoy them at the same time •This makes fireworks a public good

Price Elasticity of Demand

•First, we will start with consumers and use the midpoint formula. To calculate the price elasticity of demand we will look at consumers' responsiveness to a change in price. •Learning Objective: Calculate the price elasticity of demand using the midpoint formula

Price Elasticity of Demand

•First, we will start with consumers. To calculate the price elasticity of demand we will look at a consumer's responsiveness to a change in price. •Definition: Calculated as the percentage change in quantity demanded divided by the percentage change in price. •Learning Objective: Define and calculate the price elasticity of demand.

Consumer Surplus

•For example, consider a price drop. If the price drops we see an expansion of consumer surplus in two ways. First, we see additional surplus due to lower prices for previous quantities purchased

Producer Surplus

•For example, consider a price increase •If the price increases we see an expansion of producer surplus in two ways. First, we see additional surplus due to higher prices for previous quantities sold

Calculating Elasticity

•General Formula: Elasticity = %∆Quantity/%∆Price •For elasticity of supply we will look at the percentage change in the quantity supplied. •For elasticity of demand we will look at the percentage change in the quantity demanded.

Formulas

•General: ○Elasticity = %∆Quantity / %∆Price •For Consumers (Demand): ○Elasticity = %∆Qd / %∆Price

Solution to the Free-rider Problem

•Governments can fund the good or service using tax revenue •Sell advertising to firms •Develop technologies to bypass the nonexcludability of the good or service

Property Rights/NO Property Rights

•Homeowners ○Have property rights ○Try to maintain or increase the value of their property •Free public housing ○Have no property rights ○No incentive to maintain or increase the value of their property

Calculating %∆ (Midpoint)

•How do you calculate percentage changes? •Percentage change is the absolute change in the value of a variable divided by the mid value and multiplied by 100. •Here is the formula for percentage change in quantity demanded.

Calculating %∆

•How do you calculate percentage changes? •Percentage change is the absolute change in the value of a variable divided by the original value of the variable, multiplied by 100. •Here is the formula for calculating the percentage change in quantity demanded.

How can a market interaction lead to inefficient results?

•If people follow the basic decision rule here, it seems impossible to reach inefficient results. We will act in such a way that the benefits exceed the costs

What does it mean?

•If the price decreases by 1% the quantity demanded will increase by 2.5%

Consumer Surplus

•If we took all of the possible points and made our curve a continuous set of dots we would see the total consumer surplus (often represented as CS) •Understanding the concept of consumer surplus will provide great benefit to our supply and demand analysis or our analysis of changing market conditions

Producer Surplus

•If we took all of the possible points and made our curve a continuous set of dots we would see the total producer surplus (often represented as PS) •Understanding the concept of producer surplus will provide great benefit to our supply and demand analysis or our analysis of changing market conditions

Property Rights

•Incentivize owners to protect and improve their property •Poor defined or enforced property rights => inefficient outcomes •Essential for competitive markets

Fish in the open sea are non-excludable

•It is very hard to prevent people from fishing and consuming them •However, they are rivalrous, as your consumption of a fish does diminish my ability to consume it (since once you consume it the fish is gone!)

Negative Externalities

•Just as there are positive externalities, there are also negative externalities, which is what we call external marginal costs. We will now consider how to represent negative externalities within our supply and demand graphs. •Learning Objective: Discuss negative externalities in a demand and supply framework.

Market Failures and Property Rights

•Learning Objective: Explain how market failures generally result from poorly defined or poorly enforced property rights

Higher Price

•Let's set a higher price and see what happens •At P1 the quantity supplied is quite large, but the quantity demanded is quite small. The quantity demanded limits the number of trades that occur to the quantity traded or Qt •Trades between Qt and the equilibrium quantity do not occur and thus producers and consumers miss out on the surplus from those exchanges

Lower Price

•Let's set a lower price and see what happens •At P2 the quantity demanded is quite large, but the quantity supplied is quite small. The quantity supplied limits the number of trades that occur to the quantity traded, or Qt. •Trades between Qt and the equilibrium quantity do not occur and thus producers and consumers miss out on the surplus from those exchanges

Price Ceilings: An Efficiency Analysis

•Let's use our efficiency concepts to analyze some of our disruptions or distortions to the market via regulation. First, lets consider price ceilings. •Learning Objective: Illustrate the effect of a price ceiling on economic welfare using consumer and producer surplus

Economic Surplus

•Measuring "wealth" created from trades/market transactions •Looking at how markets influence society, not just buyers or sellers ○Social welfare •Equilibrium = maximizing surplus = best outcome = efficient •Not in equilibrium = DWL = inefficient = reduce social welfare

Economic Surplus

•Measuring how much both sides are gaining, or the total benefits towards the producers and consumers, is called economic surplus •Economic surplus is a measure of the total welfare, or wealth, that trade creates for consumers and producers in a market •It is also known as social welfare or total surplus. It is the combination of CS and PS

Deadweight Loss

•Missing surplus has a technical name in economics and it is called deadweight loss •Learning Objective: Use changes in consumer and producer surplus to identify a deadweight loss

Background of the Free-rider Problem

•Nonexcludability ○Why pay for what you can get for free? •Private firms have little incentive to produce public goods •Ex) National defense, police protection, safe drinking water

Consumer Surplus

•Now that we can see the interaction of supply and demand, we need to be able to talk about the overall efficiency of the market. To start, we will consider the gains for consumers, otherwise known as consumer surplus •Learning Objective: Determine consumer surplus and predict how changes in price impact consumer surplus

How can a market interaction lead to inefficient results?

•Now we could consider our decision rule ad realize that if there are no external benefits, we will get efficient outcomes

Price Floors: Efficiency Analysis

•Now we will consider price floors, another regulation •Learning Objective: Illustrate the effect of a price floor on economic welfare using consumer and producer surplus

Tax on Suppliers: Efficiency Analysis

•Now we will consider taxes on suppliers, another regulation

Producer Surplus

•Producer surplus can also be thought of as the wealth that trade creates for producers in a market •Producer surplus is measured in dollars •Graphically, producer surplus is the are below the equilibrium price and above the supply curve, from zero to the quantity traded

Consumer Surplus

•Second, we see additional surplus due to more goods being consumed •Both changes chow the idea that consumers are made better off when price decreases •The concept of consumer surplus is a part of what is often referred to as welfare economics, a branch of economics that focuses on measuring the welfare of market participants and how changes in the market change their well-being

Producer Surplus

•Second, we see additional surplus due to more goods being surplus •Both changes show the idea that producers are made better off when price increases. This may seem simple now, but having this precise tool of producers surplus within the supply and demand model will allow us to analyze more complex or counter-intuitive phenomenon

Higher Price

•Set a higher price and the surplus shrinks

Lower Price

•Set a lower price and the surplus shrinks

Economic Surplus: Maximizing the Gains from Trade

•So what we've seen with consumer and producer surplus is that when people trade with each other, both parties come away from the exchange better off. In economics we refer to this situation as being mutually beneficial. •Learning Objective: Determine the economic surplus and gains from trade in a market

External Marginal Benefit

•The benefit of an additional unit of a good or service that is enjoyed by people other than the direct consumer of the good or service. •One example is dressing nicely when heading off to a college class. You consider the costs and benefits of how you look (and you privately care to some extent what others think of how you are presented), but you do not fully take in the benefits of looking nice. Wouldn't it be a better world for you if everyone else looked a little nicer also? •Looking good adds an external benefit to the private benefit. •Ex. Vaccines

Private Marginal Benefits

•The benefit to the consumer of an additional unit of a good or service •If all costs and benefits are reflected in the private market, then individuals following our rational decision rule will help create efficient results

Social Marginal Cost

•The cost to society of producing an additional unit of a good or service •It is the sum of private marginal cost and the external marginal cost

Consumer Surplus

•The difference between the maximum price consumers are willing and able to pay for a good or service and the price they actually pay

Social Marginal Benefit

•The full benefit to society of consuming an additional unit of a good or service •It is the sum of private marginal benefit and the external marginal benefit

Marginal Benefits and Costs - Private and Social

•The interaction of markets results in allocative and productive efficiency, but not always. At times, markets experience what economists refer to as market failures. It is important to be able to identify the ways in which markets can at times not reach efficient outcomes •Learning Objective: Describe the relationship between private and social benefits and costs

Price Elasticity of Demand: Hint

•The price elasticity of demand will always be negative •This is because of the inverse relationship for price and quantity demanded, according to the law of demand

Elasticity

•The shape of our supply and demand curves will help us understand the responsiveness of supply and demand to changes in market conditions. This responsiveness is known as elasticity •Learning Objective: Define elasticity and its role in economics

Consumer Surplus

•The videos represented the demand curve by a number of specific points as dots at various price and quantity combinations

Positive Externalities

•We call external marginal benefits positive externalities. We will now consider how to represent positive externalities within our supply and demand graphs. •Learning Objective: Discuss positive externalities in a demand and supply framework.

Public Goods

•We can also experience market failures when considering non-private, or public, goods •Learning Objective: Categorize public and private goods

Consumer Surplus

•We could do this for each and every unit purchased to find the consumer surplus for every transaction •We do not consume past P1 and Q1, as once we go beyond this quantity the MB of the purchase is less than the MC. There would be no consumer surplus and thus consumers would not purchase the item

Producer Surplus

•We could do this for each and every unit sold to find the producer surplus for every transaction •We do not sell past P1 and Q1, as once we go beyond this quantity the MB of the sale is less than the MC. There would be no producer surplus and thus producers would not be willing to sell the item

Consumer Surplus

•We could look at the dot representing that first quantity of the item and see that the willingness to pay (the marginal benefit represented by the demand curve dot) is much greater than what the consumer had to pay (the price, P1, or the marginal cost of the purchase) •The difference between the dot and the dashed line is the consumer surplus for that item •It is the difference between the willingness to pay and what they actually had to pay

Producer Surplus

•We could look at the dot representing that first quantity of the item and see that the willingness to sell (the marginal cost represented by the supply curve dot) is much greater than the price actually received (the price, P1, or the marginal benefit of the sale) •The difference between the dot and the dashed line is the producer surplus for that item. It is the difference between the willingness to sell and what they actually sold the item for

Producer Surplus

•We will also be able to consider the gains for producers, also known as producer surplus •Learning Objective: Determine producer surplus and predict how changes in price affect producer surplus

Elastic, Inelastic, and Unit-Elastic Demand

•When considering what these elasticity numbers mean, economists have three terms that help clarify the potential impact from changes in market settings. When it comes to elasticity, we can consider if demand is elastic, inelastic, or unit-elastic. •Learning Objective: Interpret the numerical value found by calculating the price elasticity of demand for a good or service.

How can a market interaction lead to inefficient results?

•When we look at actions, people will act efficiently if they follow the decision rule AND ALL of the benefits and costs are taken into consideration

Price Ceiling

•When you put a price ceiling in place the price is prevented from going higher than Pc •Thus quantity is stopped at Qt as suppliers will not provide any more than Qt at the price Pc •CS has changes, and PS has shrunk •There is DWL (some transactions that should have taken place but do not - where costs are less than benefits)

A Price Floor

•When you put a price floor in place the price is prevented from going lower than Pf •Thus quantity is stopped at Qt as demanders will not purchase any more than Qt at the price Pf •CS has shrunk, and PS has changed •There is DWL (some transactions that should have taken place but do not - where costs are less than benefits)

Positive Externality

•With a social demand curve we get a new socially optimal equilibrium point •When the private demand is less than the social demand the price does not reflect the true societal value, and too little of the good is produced

New Equilibrium

•With a social demand curve we get a new socially optimal equilibrium point. •When the private demand is less than the social demand the price does not reflect the true societal value, and too little of the good is produced.

Affect on Demand

•With external benefits, we would see an increase in the social demand curve. •Social demand is equal to the private demand curve, plus the demand from the benefits the activity provides to others; reflects both the private and external benefits of its consumption.

Negative Externality

•With external costs we should see an decrease in the social supply curve •Social supply represents the higher social costs from the negative externality, as it considers both the private and the social costs of production

New Equilibrium

•With external costs we would see an decrease in the social supply curve. •Social supply represents the higher social costs from the negative externality, as it considers both the private and the social costs of production.

Affect on Supply

•With external costs we would see an decrease in the social supply curve. •Social supply represents the higher social costs from the negative externality, as it considers both the private and the social costs of production; The supply of a good or service that reflects both the private and external costs of its production.

The Double Thank You

•You see the reality of the mutually beneficial nature of exchange all the time •For example, consider the "double thank you" moments that occur during exchanges. Often at stores the seller of an items says thank you and the purchaser also says thank you. Why? Because the consumer is gaining consumer surplus and the producer is gaining producer surplus