Unit II: The Nature and Function of Product Markets

Resource Allocation How does society allocate scarce resources among their many possible uses?

Market Interrelation Name some markets for goods/services Are any of these markets related? Which are product markets? Factor markets?

Resource Allocation Which type of economy allocates resources better: pure market or command? What role do prices play in the allocation of resources in each? What information do consumers and sellers get from the price of a good in a competitive market that they would not receive in a command economy? Prices in a competitive market indicate the value consumers place on the items and the costs to sellers of producing the item.

Do Activity 2-1

Marginal Utility and the Law of Demand

Utility: Marginal vs. Total Utility is a subjective notion in economics Utility: amount of satisfaction a person gets from consumption of a certain item Marginal Utility: extra utility a consumer gets from consuming one additional unit of a specific product Total Utility: total satisfaction a person receives from consumption of a specific product OR, the sum of the marginal utilities of the individual units of a good consumed A person’s evaluation of her or his total satisfaction (total utility) from some amount of a good is subjective. Different people will receive different levels of total utility from a given number of units of a good.

Diminishing Marginal Utility As a person consumes additional units of an item, a positive marginal utility means total utility increased, a negative marginal utility means total utility decreased, and a marginal utility of zero means total utility did not change.

Diminishing Marginal Utility As a person consumes more of a good or service, eventually the consumer reaches a point where the marginal utility of an extra unit diminishes. Because of diminishing marginal utility, a consumer will only buy more of a good if its price is reduced. This illustrates the law of demand.

Diminishing Marginal Utility

Substitution and Income Effects When the price of a good changes, the consumer experiences a substitution effect and an income effect. These two effects usually support each other and explain the law of demand. Substitution Effect – When the price of a good falls, consumers will substitute toward that good and away from other goods. Income Effect – When the price of a good falls, consumers experience an increase in purchasing power from a given income level. When the price of a good increases, consumers experience a decrease in purchasing power.

Do Activity 2-2

Elasticities Price Elasticity of Demand, Income Elasticity of Demand, Cross-Price Elasticity of Demand, Price Elasticity of Supply, and Excise Taxes

Elasticity Elasticity – a measure of how strongly one variable responds to a change in another variable Price elasticity of demand Income elasticity of demand Cross-price elasticity of demand Price elasticity of supply

Price Elasticity of Demand Price elasticity of demand – measures the strength of the consumer response to a change in the price of a product. Both the price change and the resulting change in quantity demanded are measured as percentage changes.

Price Elasticity of Demand We measure price change and the resultant change in quantity demanded as percentage changes because a comparison of the actual change in dollars and quantities does not indicate the relative size of the changes. A $5 price increase is a large change if the product is a pizza but it is a small change if the product is a house. The law of demand tells us that the value of the price elasticity of demand will be a negative number. When we interpret that value, we consider its absolute value.

Elastic, inelastic, and unit elastic demand

Calculating Price Elasticity of Demand

Midpoint Formula Why would economists use the midpoint formula? Because the value of the price elasticity of demand is used for that specific part of the demand curve, they use the midpoint as their base value rather than one of the end point values.

Extreme Cases of Price Elasticity of Demand

Other Demand Elasticities

Determinants of Price Elasticity of Demand 1. Substitutes for the product The more substitutes, the more elastic the demand. 2. The proportion of price relative to income The larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more. 3. Whether the product is a luxury or necessity The less necessary the item, the more elastic the demand. 4. The amount of time involved The longer the period of time involved, the more elastic the demand becomes.

Price Elasticity of Supply

Do Activities 2-3 and 2-4

Elasticities (cont.) Price Elasticity of Demand, Income Elasticity of Demand, Cross-Price Elasticity of Demand, Price Elasticity of Supply, and Excise Taxes

Total Revenue Test: If TR falls when P increases, or vice versa, then demand is elastic If TR and P move in the same direction, then demand is inelastic

TAXES Gov’ts levy taxes to raise revenue for public projects How do taxes on buyers (and sellers) affect market outcomes? They discourage market activity When a good is taxed, the quantity sold is smaller The burden of the tax is shared between buyers and sellers.

Elasticity and Excise Taxes Excise Tax – a tax levied on a particular good or service Typically a per-unit tax, which means the seller must give the government a set amount of money for each unit sold. Ex: A tax of $0.50 placed on each gallon of gasoline sold. Sellers view an excise tax as an additional cost, so they try to pass it on to consumers in the form of a higher price

Elasticity and Excise Taxes Because the seller will try to pass the tax on to the consumer, the supply curve will shift up vertically by the amount of the tax at all output levels

Tax Incidence Tax incidence is the manner in which the burden of a tax is shared among participants in a market. The economic burden of a tax is independent of the legal burden. Taxes result in a change in market equilibrium. Buyers pay more and sellers receive less, regardless of whom the tax is levied on.

Tax Incidence So, how is the burden of tax divided? The burden of tax falls on the side of the market that is less elastic.

Tax Incidence If demand is highly elastic, then consumers will buy a lot less of the good if the price is increased so the incidence of the tax rests mainly on the seller.

Tax Incidence If demand is highly inelastic, the seller is able to raise the price by most of the tax and not lose many customers; the burden of the tax will be mainly on the consumer.

Do Activities 2-5 and 2-6

Price Ceilings and Floors Price controls and their effects on markets

Price Controls Price Control – gov’t effort to restrict price of good or service in a particular market Price ceilings Price floors Whom is the government trying to assist with a price control?

Price Ceilings Price Ceiling – a price control used to prevent the price of the item from rising above a predetermined price To be effective (i.e., to have an impact) in the market, the price ceiling must be set below the equilibrium price, and it will result in a shortage of the item. The lower price increases the quantity demanded by consumers and decreases the quantity supplied by sellers. Who is the gov’t try to help? Ex: rent controls

Price Ceilings What are the equilibrium price and quantity in this market? If the government sets a price ceiling of $2.00 in this market, will there be shortage or a surplus? How many units will be exchanged at the price ceiling of $2.00? If the government sets a price ceiling of $4.00 in this market, will there be a shortage or a surplus?

Price Floors Price Floor – a price control used to prevent the price of the item from falling below a predetermined price To be effective, the price floor must be set above the equilibrium price, and it will result in a surplus of the item. The higher price increases the quantity supplied by sellers and decreases the quantity demanded by consumers. A price floor set below the equilibrium or market price has no effect. Who is the gov’t try to help? Ex: Agricultural subsidies, minimum wage laws

Price Floors What are the equilibrium price and quantity in this market? If the government sets a price floor of $5.00 in this market, will there be a shortage or a surplus? How many units will be exchanged at the price floor of $5.00? If the government sets a price floor of $2.00 in this market, will there be a shortage or a surplus?

Affects of Price Controls How is the market output changed as a result of the price floor without a shift in either the demand or supply curve? The government policy stopped the market forces of demand and supply from moving the market to its equilibrium. Who gains and who loses under a price ceiling? What about a price floor? Are there any changes in consumer surplus and producer surplus that result from price controls?

Do Activity 2-7

Property Rights, Market Failure, and Deadweight Loss

Property Rights and Markets A key requirement of a well-functioning market economy is the establishment and enforcement of well-defined property rights. When individuals, rather than central governments, own the land and physical capital, many important economic incentives are created. When a person owns property, he or she has the right to use, sell, or trade with another person for mutual gain. If the property rights to resources are not clearly defined, the market can produce a quantity that is different from the socially desired quantity.

Marginal Benefits vs. Marginal Costs Society’s optimal output in a particular market is where marginal social benefit (MSB) equals marginal social cost (MSC). The market output is determined by marginal private benefit (MPB) being equal to marginal private cost (MPC).

Marginal Benefits vs. Marginal Costs The presence of an externality (external costs or benefits) will result in the MSB being different from the MPB, or the MSC being different from the MPC. This means the quantity produced in the market will be different from the quantity society would like to have the market produce. This outcome is referred to as a market failure.

The Effect of Pollution Assume the firms that make paper clean up all their waste products so there is no pollution. The MSC curve represents the MSC of paper production; it includes the paper companies’ costs of materials, workers, energy, and pollution cleanup. If there is no pollution, the MSC curve is the same as the firms’ MPC and is the market supply curve for paper.

The Effect of Pollution Now assume the paper companies begin to release their untreated wastes into a nearby river. This reduces the production costs for these paper companies. The new supply curve S represents the firms’ MPC of production, but excludes the cost of cleaning up the pollution these firms are creating. Now the MPC is different from the MSC. The demand curve for paper represents both the MSB and the MPB from the consumption of paper. Only the consumers of paper receive benefits from the product.

The Effect of Pollution How much paper is produced when there is no pollution? What is the price of a unit of paper in the absence of pollution? Why does the MPC curve lie below the MSC curve when the paper companies pollute the river? How much paper is produced when the paper companies dump their waste products into the river? What is the price of a unit of paper when there is pollution? How does society feel about the quantity produced by the polluting firms?

Do Activity 2-8

Consumer and Producer Surplus A perfectly competitive market, in the absence of outside interference, will maximize total welfare, which is the sum of consumer surplus and producer surplus. Deadweight Loss – decline in due to something in the market preventing it from reaching its equilibrium outcome Ex: taxes, externalities, price controls

Do Activity 2-9

Deadweight Loss of a Price Ceiling What is the market price of a gallon of gasoline? What is the equilibrium quantity? What is the value of consumer surplus? What is the value of producer surplus? What is the value of total welfare? Assume the government sets a price ceiling of $4.50 in the market. What will be the quantity demanded and the quantity supplied? What area of the graph shows the deadweight loss of the price ceiling?