CHAPTER SUMMARY

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1 CHAPTER Explain how each of the following situations illustrates one of the four principles of individual choice. a. You are on your third trip to a restaurant s all-you-can-eat dessert buffet and are feeling very full. Although it would cost you no additional money, you forgo a slice of coconut cream pie but have a slice of chocolate cake. b. Even if there were more resources in the world, there would still be scarcity. c. Different teaching assistants teach several Economics 101 tutorials. Those taught by the teaching assistants with the best reputations fill up quickly, with spaces left unfilled in the ones taught by assistants with poor reputations. d. To decide how many hours per week to exercise, you compare the health benefits of one more hour of exercise to the effect on your grades of one less hour spent studying. 2. You make $45,000 per year at your current job with Whiz Kids Consultants. You are considering a job offer from Brainiacs, Inc., which will pay you $50,000 per year. Which of the following are elements of the opportunity cost of accepting the new job at Brainiacs, Inc.? a. The increased time spent commuting to your new job b. The $45,000 salary from your old job c. The more spacious office at your new job Explain how each of the following situations illustrates one of the five principles of interaction. a. Using the college website, any student who wants to sell a used textbook for at least $30 is able to sell it to someone who is willing to pay $30. b. At a college-tutoring co-op, students can arrange to provide tutoring in subjects they are good in (like economics) in return for receiving tutoring in subjects they are poor in (like philosophy). c. The local municipality imposes a law that requires bars and nightclubs near residential areas to keep their noise levels below a certain threshold. d. To provide better care for low-income patients, the local municipality has decided to close some underutilized neighborhood clinics and shift funds to the main hospital. e. On the college website, books of a given title with approximately the same level of wear and tear sell for about the same price. 2. Which of the following describes an equilibrium situation? Which does not? Explain your answer. a. The restaurants across the street from the university dining hall serve better-tasting and cheaper meals than those served at the university dining hall. The vast majority of students continue to eat at the dining hall. b. You currently take the subway to work. Although taking the bus is cheaper, the ride takes longer. So you are willing to pay the higher subway fare in order to save time. 1. Explain how each of the following examples illustrates one of the three principles of economy-wide interactions. a. The White House urged Congress to pass major tax cuts in the spring of 2001, when it became clear that the U.S. economy was experiencing a slump. b. Oil companies are investing heavily in projects that will extract oil from the oil sands of Canada. In Edmonton, Alberta, near the projects, restaurants and other consumer businesses are booming. c. In the mid-2000s, Spain, which was experiencing a big housing boom, also had the highest inflation rate in Europe. 1-3 SUMMARY 1. All economic analysis is based on a list of basic principles. These principles apply to three levels of economic understanding. First, we must understand how individuals make choices; second, we must understand how these choices interact; and third, we must understand how the economy functions overall. 2. Everyone has to make choices about what to do and what not to do. Individual choice is the basis of economics if it doesn t involve choice, it isn t economics. 3. The reason choices must be made is that resources anything that can be used to produce something else are scarce. Individuals are limited in their choices by money and time; their supplies of human and natural resources limit economies. 4. Because you must choose among limited alternatives, the true cost of anything is what you must give up to get it all

2 costs are opportunity costs. 5. Many economic decisions involve questions not of whether but of how much how much to spend on some good, how much to produce, and so on. Such decisions must be taken by performing a trade-off at the margin by comparing the costs and benefits of doing a bit more or a bit less. Decisions of this type are called marginal decisions, and the study of them, marginal analysis, plays a central role in economics. 6. The study of how people should make decisions is also a good way to understand actual behavior. Individuals usually exploit opportunities to make themselves better off. If opportunities change, so does behavior: people respond to incentives. 7. Interaction my choices depend on your choices, and vice versa adds another level to economic understanding. When individuals interact, the end result may be different from what anyone intends. 8. The reason for interaction is that there are gains from trade: by engaging in the trade of goods and services with one another, the members of an economy can all be made better off. Underlying gains from trade are the advantages of specialization, of having individuals specialize in the tasks they are good at. 9. Economies normally move toward equilibrium a situation in which no individual can make himself or herself better off by taking a different action. 10. An economy is efficient if all opportunities to make some people better off without making other people worse off are taken. Resources should be used as efficiently as possible to achieve society s goals. But efficiency is not the sole way to evaluate an economy: equity, or fairness, is also desirable, and there is often a trade-off between equity and efficiency. 11. Markets usually lead to efficiency, with some well-defined exceptions. 12. When markets fail and do not achieve efficiency, government intervention can improve society s welfare. 13. One person s spending is another person s income. 14. Overall spending in the economy can get out of line with the economy s productive capacity, leading to recession or inflation. 15. Governments have the ability to strongly affect overall spending, ability they use in an effort to steer the economy between recession and inflation. TERMS Individual choice: the decision by an individual of what to do, which necessarily involves a decision of what not to do. Resource: anything that can be used to produce something else. Scarce: there is not enough the resource available to satisfy the various ways a society wants to use them. Opportunity cost: the real cost of the item. What you must give up in order to get it. Trade-off: when you compare the costs with the benefits of doing something. Marginal decisions: decisions about whether to do a bit more or a bit less of an activity. Marginal analysis: the study of marginal decisions. Incentive: anything that offers rewards to people who change their behavior. Interaction: my choices affect your choices and vise versa. Trade: individuals provide goods and services to others and receive goods and services in return. Gains from trade: people can get more of what they want through trade than they could if they tried to be self-sufficient. Specialization: each person specializes in the task he or she is good at performing. Equilibrium: when no individual would be better off doing something else. Efficient: if the economy takes all opportunity to make some people better off without making other people worse off. Equity: everyone gets his or her fair share. Isn t as well defined as concept of efficiency.

3 CHAPTER True or false? Explain your answer. a. An increase in the amount of resources available to Tom for use in producing coconuts and fish does not change his production possibility frontier. b. A technological change that allows Tom to catch more fish for any amount of coconuts gathered results in a change in his production possibility frontier. c. The production possibility frontier is useful because it illustrates how much of one good an economy must give up to get more of another good regardless of whether resources are being used efficiently. 2. In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the United States, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day. a. Which country has an absolute advantage in the production of automobiles? In washing machines? b. Which country has a comparative advantage in the production of washing machines? In automobiles? c. What pattern of specialization results in the greatest gains from trade between the two countries? 3. Explain why Tom and Hank are willing to engage in a trade of 1 fish for 1.5 coconuts. 4. Use the circular-flow diagram to explain how an increase in the amount of money spent by households results in an increase in the number of jobs in the economy. Describe in words what the circular-flow diagram predicts. 1. Which of the following statements is a positive statement? Which is a normative statement? a. Society should take measures to prevent people from engaging in dangerous personal behavior. b. People who engage in dangerous personal behavior impose higher costs on society through higher medical costs. 2. True or false? Explain your answer. a. Policy choice A and policy choice B attempt to achieve the same social goal. Policy choice A, however, results in a much less efficient use of resources than policy choice B. Therefore, economists are more likely to agree on choosing policy choice B. b. When two economists disagree on the desirability of a policy, it s typically because one of them has made a mistake. c. Policy makers can always use economics to figure out which goals a society should try to achieve. 2-2 SUMMARY 1. Almost all economics is based on models, thought experiments or simplified versions of reality, many of which use mathematical tools such as graphs. An important assumption in economic models is the other things equal assumption, which allows analysis of the effect of a change in one factor by holding all other relevant factors unchanged. 2. One important economic model is the production possibility frontier. It illustrates: opportunity cost (showing how much less of one good can be produced if more of the other good is produced); efficiency (an economy is efficient in production if it produces on the production possibility frontier and efficient in allocation if it produces the mix of goods and services that people want to consume); and economic growth (an outward shift of the production possibility frontier). There are two basic sources of growth: an increase in factors of production, resources such as land, labor, capital, and human capital, inputs that are not used up in production, and improved technology. 3. Another important model is comparative advantage, which explains the source of gains from trade between individuals and countries. Everyone has a comparative advantage in something some good or service in which that person has a lower opportunity cost than everyone else. But it is often confused with absolute advantage, an ability to produce a particular good or service better than anyone else. This confusion leads some to erroneously conclude that there are no gains from trade between people or countries. 4. In the simplest economies people barter trade goods and services for one another rather than trade them for money, as in a modern economy. The circular-flow diagram represents transactions within the economy as flows of goods, services, and money between households and firms. These transactions occur in markets for goods and services and factor markets, markets for factors of production land, labor, capital, and human capital. It is useful in understanding how spending, production, employment, income, and growth are related in the economy. Ultimately, factor markets determine the economy s income distribution, how an economy s total income is allocated to the owners of the factors of production. 5. Economists use economic models for both positive economics, which describes how the economy works, and for normative economics, which prescribes how the economy should work. Positive economics often involves making

4 forecasts. Economists can determine correct answers for positive questions, but typically not for normative questions, which involve value judgments. The exceptions are when policies designed to achieve a certain prescription can be clearly ranked in terms of efficiency. 6. There are two main reasons economists disagree. One, they may disagree about which simplifications to make in a model. Two, economists may disagree like everyone else about values. TERMS Model: simplified representation of a real situation that is used to better understand real-life situations. Other things equal assumption: all other relevant factors remain unchanged. Production possibility frontier: illustrated the trade-offs facing an economy that produces only two goods. It shows the maximum quantity of one good that can be produces for any given quantity produced of the other. Factors of production: resources used to produce goods and services. Technology: technical means for producing goods and services. Comparative advantage: producing a good or service if the opportunity cost of producing the good or service is lower for that individual than for other people. Absolute advantage: in an activity if he or she can do it better than other people. Barter: when people directly exchange goods or services that they have for goods or services that they want. Circular-flow diagram: represents the transactions in an economy by flows around a circle. Household: a person or a group of people that share their income. Firm: an organization that produces goods and services for sale. Markets for goods and services: where firms sell goods and services that they produce to households. Factor markets: where firms buy the resources they need to produce goods and services. Income distribution: the way in which total income is divided among the owner of the various factors of production. Positive economics: the branch of economic analysis that describes the way the economy actually works. Normative economics: makes prescriptions about the way the economy should work. Forecast: simple prediction of the future. CHAPTER 3

5 Explain whether each of the following events represents (i) a shift of the demand curve or (ii) a movement along the demand curve. a. A storeowner finds that customers are willing to pay more for umbrellas on rainy days. b. When XYZ Telecom, a long-distance telephone service provider, offered reduced rates on weekends, its volume of weekend calling increased sharply. c. People buy more long-stem roses the week of Valentine s Day, even though the prices are higher than at other times during the year. d. The sharp rise in the price of gasoline leads many commuters to join carpools in order to reduce their gasoline purchases Explain whether each of the following events represents (i) a shift of the supply curve or (ii) a movement along the supply curve. a. More homeowners put their houses up for sale during a real estate boom that causes house prices to rise. b. Many strawberry farmers open temporary roadside stands during harvest season, even though prices are usually low at that time. c. Immediately after the school year begins, fast-food chains must raise wages, which represent the price of labor, to attract workers. d. Many construction workers temporarily move to areas that have suffered hurricane damage, lured by higher wages. e. Since new technologies have made it possible to build larger cruise ships (which are cheaper to run per passenger), Caribbean cruise lines have offered more cabins, at lower prices, than before In the following three situations, the market is initially in equilibrium. After each event described below, does a surplus or shortage exist at the original equilibrium price? What will happen to the equilibrium price as a result? a was a very good year for California wine-grape growers, who produced a bumper crop. b. After a hurricane, Florida hoteliers often find that many people cancel their upcoming vacations, leaving them with empty hotel rooms. c. After a heavy snowfall, many people want to buy secondhand snowblowers at the local tool shop In each of the following examples, determine (i) the market in question; (ii) whether a shift in demand or supply occurred, the direction of the shift, and what induced the shift; and (iii) the effect of the shift on the equilibrium price and the equilibrium quantity. a. As the price of gasoline fell in the United States during the 1990s, more people bought large cars. b. As technological innovation has lowered the cost of recycling used paper, fresh paper made from recycled stock is used more frequently. c. When a local cable company offers cheaper pay-per-view films, local movie theaters have more unfilled seats. 2. Periodically, a computer chip maker like Intel introduces a new chip that is faster than the previous one. In response, demand for computers using the earlier chip decreases as customers put off purchases in anticipation of machines containing the new chip. Simultaneously, computer makers increase their production of computers containing the earlier chip in order to clear out their stocks of those chips. Draw two diagrams of the market for computers containing the earlier chip: (a) one in which the equilibrium quantity falls in response to these events and (b) one in which the equilibrium quantity rises. What happens to the equilibrium price in each diagram? SUMMARY 1. The supply and demand model illustrates how a competitive market, one with many buyers and sellers, none of whom can influence the market price, works. 2. The demand schedule shows the quantity demanded at each price and is represented graphically by a demand curve. The law of demand says that demand curves slope downward; that is, a higher price for a good or service leads people to demand a smaller quantity, other things equal. 3. A movement along the demand curve occurs when a price change leads to a change in the quantity demanded. When economists talk of increasing or decreasing demand, they mean shifts of the demand curve a change in the quantity demanded at any given price. An increase in demand causes a rightward shift of the demand curve. A decrease in demand causes a leftward shift.

6 4. There are five main factors that shift the demand curve:a change in the prices of related goods or services, such as substitutes or complements, a change in income: when income rises, the demand for normal goods increases and the demand for inferior goods decreases, in tastes, in expectations and in the number of consumers 5. The market demand curve for a good or service is the horizontal sum of the individual demand curves of all consumers in the market. 6. The supply schedule shows the quantity supplied at each price and is represented graphically by a supply curve. Supply curves usually slope upward. 7. A movement along the supply curve occurs when a price change leads to a change in the quantity supplied. When economists talk of increasing or decreasing supply, they mean shifts of the supply curve a change in the quantity supplied at any given price. An increase in supply causes a rightward shift of the supply curve. A decrease in supply causes a leftward shift. 8. There are five main factors that shift the supply curve: A change in input prices, the prices of related goods and services, technology, expectations and a change in the number of producers 9. The market supply curve for a good or service is the horizontal sum of the individual supply curves of all producers in the market. 10. The supply and demand model is based on the principle that the price in a market moves to its equilibrium price, or market-clearing price, the price at which the quantity demanded is equal to the quantity supplied. This quantity is the equilibrium quantity. When the price is above its market-clearing level, there is a surplus that pushes the price down. When the price is below its market-clearing level, there is a shortage that pushes the price up. 11. An increase in demand increases both the equilibrium price and the equilibrium quantity; a decrease in demand has the opposite effect. An increase in supply reduces the equilibrium price and increases the equilibrium quantity; a decrease in supply has the opposite effect. 12. Shifts of the demand curve and the supply curve can happen simultaneously. When they shift in opposite directions, the change in equilibrium price is predictable but the change in equilibrium quantity is not. When they shift in the same direction, the change in equilibrium quantity is predictable but the change in equilibrium price is not. In general, the curve that shifts the greater distance has a greater effect on the changes in equilibrium price and quantity. TERMS Competitive market: market in which there are many buyers and sellers of the same good or services, none of whom can influence the price at which the good or service is sold. Supply and demand model: model of how a competitive market works. Demand schedule: shows how much of a good or service consumers will want to buy at different prices. Quantity demanded: actual amount of good or service consumers are willing to pay at some specific price. Demand curve: demand schedule. It shows the relationship between quantity demanded and price. Law of demand: a higher price for a good or service, other things equal, leads people to demand a smaller quantity of that. Shift of the demand curve: change in the quantity demanded at any given price, represented by the change od the original demand curve to a new position, denoted by a new demand curve. Movement along the demand curve: a change in the Q demanded of a good that is the result of change in goods P. Substitutes: two goods are _ if a rise of the price of one of the goods leads to an increase in the demand for the other good. Complements: two goods are _ if a rise in the price of one good leads to a decrease in the demand for the other good. Normal good: when a rise in income increases the demand for a good - the normal case- Inferior good: when a ride in income decreases the demand for a good. Individual demand curve: illustrates the relationship between quantity demanded and price for an individual consumer. Quantity supplied: is the actual amount of a good or service producers are willing to sell at some specific price. Supply schedule: shows how much of a good or service producers will supply at different prices. Supply curve: shows the relationship between quantity supplied and price. Shift of the supply curve: change in the Q supplied of a good or service at any given P. represented by the change of the original supply curve to a new position, denoted by a new supply curve. Movement along the supply curve: a change in the Q supplied of a good that is the result of a change in that goods P. Input: good or service that is used to produce another good or service. Individual supply curve: illustrates the relationship between Q supplied and P for an individual producer. Equilibrium price: when P has moved to a level at which the Q of a good or service demanded equals the Q of that g/s. Equilibrium quantity: the quantity of a G/S bought and sold at the equilibrium price or market-clearing price. Market-clearing price: The price at which is equilibrium price. Surplus: of a G/S when the Q supplied exceeds the Q demanded. They occur when the P is above its equilibrium level. Shortage: of a G/S when the Q demanded exceeds the Q supplied. They occur when the P is below its equilibrium level.

7 CHAPTER Consider the market for cheese-stuffed jalapeno peppers. There are two consumers, Casey and Josey, and their willingness to pay for each pepper is given in the accompanying table. (Neither is willing to consume more than 4 peppers at any price.) Use the table (i) to construct the demand schedule for peppers for prices of $0.00, $0.10, and so on, up to $0.90, and (ii) to calculate the total consumer surplus when the price of a pepper is $0.40. Quantity of Peppers Casey s willingness to pay 1 st pepper nd pepper rd pepper th pepper Josey s willingness to pay Consider the market for cheese-stuffed jalapeno peppers. There are two producers, Cara and Jamie, and their costs of producing each pepper are given in the accompanying table. (Neither is willing to produce more than 4 peppers at any price.) Use the table (i) to construct the supply schedule for peppers for prices of $0.00, $0.10, and so on, up to $0.90, and (ii) to calculate the total producer surplus when the price of a pepper is $0.70. Quantity of Peppers Cara s cost 1 st pepper nd pepper rd pepper th pepper Jamie s cost Using the tables in Check Your Understanding 4-1 and 4-2, find the equilibrium price and quantity in the market for cheese-stuffed jalapeno peppers. What is total surplus in the equilibrium in this market, and who receives it? 2. Show how each of the following three actions reduces total surplus: a. Having Josey consume one less pepper, and Casey one more pepper, than in the market equilibrium b. Having Cara produce one less pepper, and Jamie one more pepper, than in the market equilibrium c. Having Josey consume one less pepper, and Cara produce one less pepper, than in the market equilibrium 3. Suppose UNOS alters its guidelines for the allocation of donated kidneys, no longer relying solely on the concept of net benefit but also giving preference to patients with small children. If total surplus in this case is defined to be the total life span of kidney recipients, is this new guideline likely to reduce, increase, or leave total surplus unchanged? How might you justify this new guideline? In some states that are rich in natural resources, such as oil, the law separates the right to above-ground use of the land from the right to drill below ground (called mineral rights ). Someone who owns both the above ground rights and the mineral rights can sell the two rights separately. Explain how this division of the property rights enhances efficiency compared to a situation in which the two rights must always be sold together. 2. Suppose that in the market for used textbooks the equilibrium price is $30, but it is mistakenly announced that the equilibrium price is $300. How does this affect the efficiency of the market? Be specific. 3. What is wrong with the following statement? Markets are always the best way to organize economic activity. Any policies that interfere with markets reduce society s welfare. SUMMARY 1. The willingness to pay of each individual consumer determines the demand curve. When price is less than or equal to the willingness to pay, the potential consumer purchases the good. The difference between willingness to pay and price is

8 the net gain to the consumer, the individual consumer surplus. 2. Total consumer surplus in a market, the sum of all individual consumer surpluses in a market, is equal to the area below the market demand curve but above the price. A rise in the price of a good reduces consumer surplus; a fall in the price increases consumer surplus. The term consumer surplus is often used to refer to both individual and total consumer surplus. 3. The cost of each potential producer, the lowest price at which he or she is willing to supply a unit of that good, determines the supply curve. If the price of a good is above a producer s cost, a sale generates a net gain to the producer, known as the individual producer surplus. 4. Total producer surplus in a market, the sum of the individual producer surpluses in a market, is equal to the area above the market supply curve but below the price. A rise in the price of a good increases producer surplus; a fall in the price reduces producer surplus. The term producer surplus is often used to refer to both individual and total producer surplus. 5. Total surplus, the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus. 6. Usually, markets are efficient and achieve the maximum total surplus. Any possible reallocation of consumption or sales, or change in the quantity bought and sold, reduces total surplus. However, society also cares about equity. So government intervention in a market that reduces efficiency but increases equity can be a valid choice by society. 7. An economy composed of efficient markets is also efficient, although this is virtually impossible to achieve in reality. The keys to the efficiency of a market economy are property rights and the operation of prices as economic signals. Under certain conditions, market failure occurs, making a market inefficient. Three principal sources of market failure are: attempts to capture more surpluses that create inefficiencies, side effects of some transactions, and problems in the nature of the good. TERMS Willingness to pay: the maximum price at which the consumer would buy that good. Individual consumer surplus: the net gain to an individual buyer from the purchase of a good. It is equal to the difference between the buyers willingness to pay and the price paid. Total consumer surplus: the sum of the individual consumer surpluses of all the buyers of a good in a market. Consumer surplus: both individual and to total consumer surplus. Cost: lowest price at which the seller is willing to sell a good. Individual producer surplus: the net gain to an individual seller from selling a good. It is equal to the difference between the price received and the seller s cost. Total producer surplus: in a market is the sum of the individual producer surpluses of all the sellers of a good in a market. Producer surplus: both to individual and to total producer surplus. Total surplus: generated in a market is the total net gain to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus. Property rights: the rights of owners of valuable items, whether resources or goods, to dispose of those items as they choose. Economic signal: any piece of information that helps people make better economic decisions. Inefficient: A market or an economy is inefficient if there are missed opportunities: some people could be made better off without making other people worse off. Market failure: occurs when a market fails to be efficient. CHAPTER 5

9 On game days, homeowners near Middletown University s stadium used to rent parking spaces in their driveways to fans at a going rate of $11. A new town ordinance now sets a maximum parking fee of $7. Use the accompanying supply and demand diagram to explain how each of the following corresponds to a price-ceiling concept. a. Some homeowners now think it s not worth the hassle to rent out spaces. b. Some fans who used to carpool to the game now drive alone. c. Some fans can t find parking and leave without seeing the game. Explain how each of the following adverse effects arises from the price ceiling. d. Some fans now arrive several hours early to find parking. e. Friends of homeowners near the stadium regularly attend games, even if they aren t big fans. But some serious fans have given up because of the parking situation. f. Some homeowners rent spaces for more than $7 but pretend that the buyers are nonpaying friends or family. 2. True or false? Explain your answer. A price ceiling below the equilibrium price of an otherwise efficient market does the following: a. Increases quantity supplied b. Makes some people who want to consume the good worse off c. Makes all producers worse off 3. Which of the following create deadweight loss? Which do not and are simply a transfer of surplus from one person to another? Explain your answer The state legislature mandates a price floor for gasoline of PF per gallon. Assess the following statements and illustrate your answer using the figure provided. a. Proponents of the law claim it will increase the income of gas station owners. Opponents claim itwill hurt gas station owners because they will lose customers. b. Proponents claim consumers will be better off because gas stations will provide better service. Opponents claim consumers will be generally worse off because they prefer to buy gas at cheaper prices. c. Proponents claim that they are helping gas station owners without hurting anyone else. Opponents claim that consumers are hurt and will end up doing things like buying gas in a nearby state or on theblack market Suppose that the supply and demand for taxi rides is given by Figure 5-8 but the quota is set at 6 million rides instead of 8 million. Find the following and indicate them on Figure 5-8. a. The price of a ride b. The quota rent c. The deadweight loss

10 d. Suppose the quota limit on taxi rides is increased to 9 million. What happens to the quotarent? To the deadweight loss? 2. Assume that the quota limit is 8 million rides. Suppose demand decreases due to a decline in tourism. What is the smallest parallel leftward shift in demand that would result in the quota no longer having an effect on the market? Illustrate your answer using Figure 5-8. SUMMARY 1. Even when a market is efficient, governments often intervene to pursue greater fairness or to please a powerful interest group. Interventions can take the form of price controls or quantity controls, both of which generate predictable and undesirable side effects consisting of various forms of inefficiency and illegal activity. 2. A price ceiling, a maximum market price below the equilibrium price, benefits successful buyers but creates persistent shortages. Because the price is maintained below the equilibrium price, the quantity demanded is increased and the quantity supplied is decreased compared to the equilibrium quantity. This leads to predictable problems: inefficiencies in the form of deadweight loss from inefficiently low quantity, inefficient allocation to consumers, wasted resources, and inefficiently low quality. It also encourages illegal activity as people turn to black markets to get the good. Because of these problems, price ceilings have generally lost favor as an economic policy tool. But some governments continue to impose them either because they don t understand the effects or because the price ceilings benefit some influential group. 3. A price floor, a minimum market price above the equilibrium price, benefits successful sellers but creates persistent surplus. Because the price is maintained above the equilibrium price, the quantity demanded is decreased and the quantity supplied is increased compared to the equilibrium quantity. This leads to predictable problems: inefficiencies in the form of deadweight loss from inefficiently low quantity, inefficient allocation of sales among sellers, wasted resources, and inefficiently high quality. It also encourages illegal activity and black markets. The most well known kind of price floor is the minimum wage, but price floors are also commonly applied to agricultural products. 4. Quantity controls, or quotas, limit the quantity of a good that can be bought or sold. The quantity allowed for sale is the quota limit. The government issues licenses to individuals, the right to sell a given quantity of the good. The owner of a license earns a quota rent, earnings that accrue from ownership of the right to sell the good. It is equal to the difference between the demand price at the quota limit, what consumers are willing to pay for that quantity, and the supply price at the quota limit, what suppliers are willing to accept for that quantity. Economists say that a quota drives a wedge between the demand price and the supply price; this wedge is equal to the quota rent. Quantity controls lead to deadweight loss in addition to encouraging illegal activity. TERMS Price controls: legal restrictions on how high or low a market price may go. Price ceiling: a maximum price sellers are allowed to charge for a good or service. Price floor: minimum price buyers are required to pay for a good or service. Deadweight loss: the loss in total surplus that occurs whenever an action or a policy reduces the Q transacted below the efficient market equilibrium quantity. Inefficient allocation to consumers: people who want the good badly and are willing to pay a high price don t get it, and those who care relatively little about the good and are only willing to pay a low price do get it. Wasted resources: people expend money, effort, and time to cope with the shortages caused by the price ceiling. Inefficiently low quality: sellers offer low-quality goods at a low price even though buyers would prefer a higher quality at a higher price. Black markets: market in which goods or services are bought and sold illegally either because it is illegal to sell them at all or because the prices charged are legally prohibited by a price ceiling. Minimum wage: a legal floor on the wage rate, which is the market price of labor. Inefficient allocation of sales among sellers: those who would be willing to sell the good at the lowest price are not always those who actually manage to sell it. Inefficiently high quality: sellers offer high-quality G at a high P, even though buyers would prefer a lower quality at a lower price. Quantity control or Quota: an upper limit on the quantity of some good that can be bought or sold Quota limit: The total amount of the good that can be legally transacted License: gives its owner the right to supply a good. Demand price: of a given quantity is the price at which consumers will demand that quantity. Supply price: of a given quantity is the price at which producers will supply that quantity. Wedge: that is, the price paid by buyers ends up being higher than that received by sellers. Quota rent: The difference between the demand and supply price at the quota limit. CHAPTER 6

11 The price of strawberries falls from $1.50 to $1.00 per carton and the quantity demanded goes from 100,000 to 200,000 cartons. Use the midpoint method to find the price elasticity of demand. 2. At the present level of consumption, 4,000 movie tickets, and at the current price, $5 per ticket, the price elasticity of demand for movie tickets is 1. Using the midpoint method, calculate the percentage by which the owners of movie theaters must reduce price in order to sell 5,000 tickets. 3. The price elasticity of demand for ice-cream sandwiches is 1.2 at the current price of $0.50 per sandwich and the current consumption level of 100,000 sandwiches. Calculate the change in the quantity demanded when price rises by $0.05. Use Equations 6-1 and 6-2 to calculate percent changes and Equation 6-3 to relate price elasticity of demand to the percent changes For each case, choose the condition that characterizes demand: elastic demand, inelastic demand, or unit-elastic demand. a. Total revenue decreases when price increases. b. The additional revenue generated by an increase in quantity sold is exactly offset by revenue lost from the fall in price received per unit. c. Total revenue falls when output increases. d. Producers in an industry find they can increase their total revenues by working together to reduce industry output. 2. For the following goods, what is the elasticity of demand? Explain. What is the shape of the demand curve? a. Demand by a snake-bite victim for an antidote b. Demand by students for green erasers After Chelsea s income increased from $12,000 to $18,000 a year, her purchases of CDs increased from 10 to 40 CDs a year. Calculate Chelsea s income elasticity of demand for CDs using the midpoint method. 2. Expensive restaurant meals are income-elastic goods for most people, including Sanjay. Suppose his income falls by 10% this year. What can you predict about the change in Sanjay s consumption of expensive restaurant meals? 3. As the price of margarine rises by 20%, a manufacturer of baked goods increases its quantity of butter demanded by 5%. Calculate the cross-price elasticity of demand between butter and margarine. Are butter and margarine substitutes or complements for this manufacturer? Using the midpoint method, calculate the price elasticity of supply for web-design services when the price per hour rises from $100 to $150 and the number of hours transacted increases from 300,000 hours to 500,000. Is supply elastic, inelastic, or unit-elastic? 2. True or false? If the demand for milk rose, then, in the long run, milk-drinkers would be better off if supply was elastic rather than inelastic. 3. True or false? Long-run price elasticities of supply are generally larger than short-run price elasticities of supply. As a result, the short-run supply curves are generally flatter than the long-run supply curves. 4. True or false? When supply is perfectly elastic, changes in demand have no effect on price. SUMMARY 1. Many economic questions depend on the size of consumer or producer responses to changes in prices or other variables. Elasticity is a general measure of responsiveness that can be used to answer such questions. 2. The price elasticity of demand the percent change in the quantity demanded divided by the percent change in the price (dropping the minus sign) is a measure of the responsiveness of the quantity demanded to changes in the price. In practical calculations, it is usually best to use the midpoint method, which calculates percent changes in prices and quantities based on the average of starting and final values.

12 3. The responsiveness of the quantity demanded to price can range from perfectly inelastic demand, where the quantity demanded is unaffected by the price, to perfectly elastic demand, where there is a unique price at which consumers will buy as much or as little as they are offered. When demand is perfectly inelastic, the demand curve is a vertical line; when it is perfectly elastic, the demand curve is a horizontal line. 4. The price elasticity of demand is classified according to whether it is more or less than 1. If it is greater than 1, demand is elastic; if it is less than 1, demand is inelastic; if it is exactly 1, demand is unit-elastic. This classification determines how total revenue, the total value of sales, changes when the price changes. If demand is elastic, total revenue falls when the price increases and rises when the price decreases. If demand is inelastic, total revenue rises when the price increases and falls when the price decreases. 5. The price elasticity of demand depends on whether there are close substitutes for the good in question, whether the good is a necessity or a luxury, the share of income spent on the good, and the length of time that has elapsed since the price change. 6. The cross-price elasticity of demand measures the effect of a change in one good s price on the quantity of another good demanded. The cross-price elasticity of demand can be positive, in which case the goods are substitutes, or negative, in which case they are complements. 7. The income elasticity of demand is the percent change in the quantity of a good demanded when a consumer s income changes divided by the percent change in income. The income elasticity of demand indicates how intensely the demand for a good responds to changes in income. It can be negative; in that case the good is an inferior good. Goods with positive income elasticities of demand are normal goods. If the income elasticity is greater than 1, a good is incomeelastic; if it is positive and less than 1, the good is income-inelastic. 8. The price elasticity of supply is the percent change in the quantity of a good supplied divided by the percent change in the price. If the quantity supplied does not change at all, we have an instance of perfectly inelastic supply; the supply curve is a vertical line. If the quantity supplied is zero below some price but infinite above that price, we have an instance of perfectly elastic supply; the supply curve is a horizontal line. 9. The price elasticity of supply depends on the availability of resources to expand production and on time. It is higher when inputs are available at relatively low cost and the longer the time elapsed since the price change. TERMS Price elasticity of demand: the ratio of the percent change in the quantity demanded to the percent change in the price as we move along the demand curve (dropping the minus sign). Midpoint method: a technique for calculating the percent change. In this approach, we calculate changes in a variable compared with the average, or midpoint, of the starting and final values. Perfectly inelastic demand: Demand is perfectly inelastic when the quantity demanded does not respond at all to changes in the price. When demand is perfectly inelastic, the demand curve is a vertical line. Perfectly elastic demand: Demand is perfectly elastic when any price increase will cause the quantity demanded to drop to zero. When demand is perfectly elastic, the demand curve is a horizontal line. Elastic demand: Demand is elastic if the price elasticity of demand is greater than 1. Inelastic demand: Demand is inelastic if the price elasticity of demand is less than 1. Unit-elastic demand: if the price elasticity of demand is exactly 1. Total revenue: total value of sales of a good or service. It is equal to the price multiplied by the quantity sold. Cross-price elasticity of demand: between two goods measures the effect of the change in one good s price on the quantity demanded of the other good. It is equal to the percent change in the quantity demanded of one good divided by the percent change in the other good s price. Income elasticity of demand: percent change in the quantity of a good demanded when a consumer s income changes divided by the percent change in the consumer s income. Income-elastic demand: The D for a good is income-elastic if the income elasticity of D for that good is greater than 1. Income-inelastic demand: The demand for a good is income-inelastic if the income elasticity of demand for that good is positive but less than 1 Price elasticity of supply: The P elasticity of supply is a measure of the responsiveness of the Q of a G supplied to the P of that G. It is the ratio of the percent change in the Q supplied to the percent change in the P as we move along the S curve. Perfectly inelastic supply: when the price elasticity of supply is zero, so that changes in the price of the good have no effect on the quantity supplied. A perfectly inelastic supply curve is a vertical line. Perfectly elastic supply: when even a tiny increase or reduction in the price will lead to very large changes in the quantity supplied, so that the price elasticity of supply is infinite. A perfectly elastic supply curve is a horizontal line.