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BOOK 2: ECONOMICS

13. Elasticity

14. Efficiency and Equity

15. Markets in Action

16. Organizing Production

17. Output and Costs

18. Perfect Competition19. Monopoly

20. Monopolistic Competition and Oligopoly

21. Markets for Factors of Production

22. Monitoring Jobs and the Price Level

23. Aggregate Supply and Aggregate Demand

24. Money, the Price Level, and Inflation

25. U.S. Inflation, Unemployment, and Business Cycles

26. Fiscal Policy

27. Monetary Policy

28. An Overview of Central Banks

3

13

23

37

45

5365

75

87

101

107

115

125

137

149

157

Saif Al Hidabi

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LAN STUDY NOTESLEVEL I BOOK 2ECONOMICS

2009 lan Guides LLC. All rights reserved.

Published in December 2009 by lan Guides LLC.

Required CFA Institute disclaimer:

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Copyright, 2009, CFA Institute. Reproduced and republished from 2010 CFA

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Disclaimer: lan Guides study materials should be used in conjunction with theoriginal readings as set forth by CFA Institute in the 2010 CFA Level 1 Curriculum.The information contained in this book covers topics contained in the readingsreferenced by CFA Institute and is believed to be accurate. However, their accuracycannot be guaranteed.

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3Elasticity

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LOS 13a: Calculate and interpret the elasticities of demand (price elasticity,cross elasticity and income elasticity) and the elasticity of supply, and discussthe factors that influence each measure. Vol 2, pg 8-28

Typically demand curves are downward sloping. An increase in price leads to a decrease inquantity demanded, while a reduction in price results in an increase in quantity demanded.Total revenue equals price times quantity sold, so firms must determine whether their totalrevenues will rise if they were to reduce prices to stimulate sales.

This depends on how responsive quantity demanded is to changes in price, which is measuredby the price elasticity of demand (EP )

Changes in quantity demanded and price are calculated using average amounts in thedenominator. This method results in the same value for elasticity whether prices move upor move down to a particular level.

Because the demandcurve is downwardsloping, quantity

demanded and pricewill move in oppositedirections, and thecalculated value forprice elasticity willbe negative. Thenegative sign isusually ignoredbecause it is theabsolute value ofprice elasticity thattells us howresponsive quantitydemanded is to aprice change.

Example 2: Using Price Elasticity to Calculate the Change in Quantity Demanded

If the price elasticity of demand for a product is 1.2, and the price of the product changesfrom $10 to $11, what is the change in quantity demanded in percentage terms?

Solution

1.2 = Qd / ($1/$10.5)Qd = - 0.1143 = - 11.43%

If the price elasticity of demand for a product equals 1.2, and the price increases from$10 to $11, the quantity demanded will decrease by 11.43%.

Example 1: Price Elasticity of Demand

If the price of a product decreases from $7 to $6, its quantity demanded increases from18 to 20 units. What is the price elasticity of demand for this product?

Solution

ELASTICITY

If we use the absolutevalue of priceelasticity to calculatethe change inquantity, we need tomake sure that thesign in our answer isopposite to directionof the price change.Alternatively, we canput a minus sign infront of the elasticityvalue and simply

solve for the changein quantity.

EP = % change in quantity demanded% change in price

= % Qd

% P

(Q0 - Q1)

(Q0 + Q1)/2

100

(P0 - P1)

(P0 + P1)/2100

=

EP =

(20 - 18)

(20 + 18)/2100

(6 - 7)

(6 + 7)/2100

(-1/6.5) 100

(2/19) 100= = 0.684


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Price elasticity of demand can range from zero to infinity.

If the percentage change in quantity demanded is the same as the percentage changein price, demand is unit elastic (Figure 1a).

If quantity demanded does notchange at all in response to a change in price, thenumerator of the elasticity formula will be zero, and the calculated value of priceelasticity will also be zero. This is known as perfectly inelastic demand (Figure 1b).

If quantity demanded changes by an infinitely large percentage in response toeven the slightest change in price, the denominator in the elasticity formula will beclose to zero (effectively zero), and the calculated value of price elasticity will beinfinity. This is known as perfectly elastic demand (Figure 1c).

If the absolute value of price elasticity of demand lies between zero and 1, demandis said to be relatively inelastic.

If the absolute value of price elasticity of demand is greater than 1, demand is saidto be relatively elastic.

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Factors That Effect Price Elasticity of Demand

Availability of Close SubstitutesIf a consumer can easily switch away from a good, her ability to respond to a price increase(by reducing consumption of the good) is high, and demand for that product is relativelyelastic. For example, if the price of Coke increases, consumers can easily switch to Pepsi.Therefore, one would expect the price elasticity of demand for Coke to be relatively high.

Figure 1: Price Elasticity Of Demand

D

Quantity

D

Quantity

1b. Perfectly Inelastic

D

Quantity

1c. Perfectly Elastic1a. Unit Elastic

Whenever we talkabout changes inquantity or price, weare referring topercentage changes.

Elasticity = 1

Elasticity = 0

Elasticity =

|Ep| = 0

0


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Proportion of income spent on the good

If a relatively small proportion of a consumers income is spent on a good (e.g. soap), shewill not significantly cut down on consumption if prices increase. However, if consumptionof the good takes up a larger proportion of her income, (e.g. automobiles) she might be forced

to reduce quantity demanded significantly when the price of the good increases.Time elapsed since price change

The longerthe time that has elapsed since the price change, the more elastic demand willbe. For example, if the price of labor goes up, firms may not be able to make radical changesto their production methods in the short term and therefore, demand for labor will be relativelyinelastic. However, in the long term, if the price of labor remains high, firms may automatetheir production process and substitute machinery for labor. In the long run, demand for laborwill be relatively elastic.

Other Elasticities of Demand

Cross Elasticity of Demand

Cross elasticity of demand measures the responsiveness of demand for a particular good toa change in price ofanothergood.

Substitutes

If the price of Burger Kings burgers were to go up, what would be the effect on demandfor McDonalds burgers?

For most people, these are close substitutes for each other. An increase in price of BurgerKings burgers will result in a significant increase in demand for McDonalds burgers asconsumers switch to the relatively lower priced substitute.

The magnitude of the cross elasticity figure tells us how closely the two products serve as

substitutes for each other. A high value indicates that the products are very close substitutesi.e., if the price of one rises by only a small amount, demand for the other will rise significantly.

For substitutes, the numerator and denominator of the cross elasticity formula head in thesame direction. Therefore cross elasticity of demand for substitutes ispositive.

Complements

If the price of playing a round of golf on a golf course were to rise, what would be the effecton demand for golf balls?

Since playing a game of golf is impossible without golf balls, these products are complementsfor each other. An increase in price of using a golf course will reduce the number of roundsof golf played, and bring about a decrease in demand for golf balls.

EC =% change in quantity demanded

% change in price of substitute or complement

EC > 0 substitutes

EC < 0 complements


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The absolute value of the cross elasticity figure tells us how closely consumption of the twoproducts is tied together and how closely they serve as complements for each other. A highabsolute number indicates very close complements. If the price of one rises, consumers willsignificantlyreduce their demand for the other.

For complements, the numerator and denominator of the cross elasticity formula head inopposite directions. Therefore, the cross elasticity of demand for complements is negative.

Income Elasticity of Demand

Income elasticity measures the responsiveness of demand for a particular good to a changein income.

Income elasticity of demand can be positive or negative. Products are classified along thefollowing lines:

If income elasticity is greaterthan 1, demand is income elastic and the product is classifiedas anormal good.

As income rises, the percentage increase in demand exceeds the percentage changein income.

As income increases, a consumer spends a higher proportion of her income on theproduct.

If income elasticity lies between zero and1, demand is income inelastic, but the product isstill classified as a normal good.

As income rises, the percentage increase in demand is less than the percentageincrease in income.

As income increases, a consumer spends a lower proportion of her income on theproduct.

If income elasticity is less than zero(negative), the product is classified as aninferior good.

As income rises, there is a negative change in demand. The amountspent on the good decreases as income rises.

Elasticity of Supply

The price elasticity of supply measures the sensitivity of quantity supplied to changes inprice. Typically, supply curves are upward sloping i.e., an increase in price brings about anincrease in quantity supplied.

EI =% change in quantity demanded

% change in income

EI > 1 Normalgood (incomeelastic)

0 < EI< 1

Normal good(income inelastic)

EI < 0 Inferiorgood


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Factors That Effect Elasticity of Supply

Availability of Substitute Resources

If the raw materials required to produce a good are easily available, or if raw materials caneasily be substituted in the production process, elasticity of supply for the product will be

Figure 2: Inelastic And Elastic Supply

Quantity

S

2c. Perfectly Elastic Supply

Quantity

S

2b. Perfectly Inelastic Supply

Quantity

S

S

2a. Unit Elastic Supply

Elasticity ofsupply = 1

Elasticity ofsupply =

Elasticity ofsupply = 0

Es = 0

0


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high. It will be easy for producers to respond to an increase in prices by increasing quantitysupplied. However, if the raw material is not readily available and if no substitute rawmaterials are available, producers will find it difficult to increase production. Hence, supplywill be relatively inelastic.

Time Frame for Supply Decision

There are three time frames for the supply decision:

1. The momentary supply curve shows the response of quantity supplied immediatelyfollowing a price change.

2. The short run supply curve illustrates the response of quantity supplied to a pricechange when only some of the technologically possible production advances havebeen made (e.g. hiring or laying off labor).

3. The long run supply curve shows the response of quantity supplied to a change inprice after all technological advances in production have been embraced.

With a longertime frame, price elasticity of supply will be higher(more elastic).

LOS 13b: Calculate elasticities on a straight-line demand curve, differentiateamong elastic, inelastic, and unit elastic demand, and describe the relationbetween price elasticity of demand and total revenue. Vol 2. pg 13-15

Elasticity Along a Straight Line Demand Curve

A straight line has a constant gradient or slope. However, elasticity differs from a simpleslope calculation becausepercentage changes are used in calculating elasticity, while slope

calculations use absolute changes in the numerator and denominator. Therefore, even thougha straight line has a constant slope, it does NOT have the same value for elasticity at eachpoint.

Elasticity of demand changes along a downward sloping straight line demand curve. Priceelasticity equals 1 at the midpoint of the line. At prices higher than the mid-point, demandis relatively elastic (price elasticity of demand is greater than one) and at prices lower thanthe midpoint, demand is relatively inelastic (price elasticity of demand is less than one).

Question

Does elasticity of demand rise or fall as we move down a straight line demand curve?

Answer

Price elasticity decreases as we move down a straight-line demand curve. Do not confusethe math with the concept of elasticity. Even though calculated price elasticities aretypically negative, the sign is usually ignored. The purpose of calculating price elasticityis to measure the responsiveness of quantity demanded to changes in price. A highprice elasticity means that quantity demanded is very responsive to changes in price,and a low elasticity means that quantity demanded is not very responsive to changes in

price. The responsiveness of quantity demanded to changes in price decreases as wemove down a straight line demand curve.


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When price elasticityis greater than one(relatively elastic),the numeratorMUST be greaterthan thedenominator. If thedenominator changesby 5%, the numeratorHAS to change bymore than 5%. Theeffect of a decreasein prices will beoutweighed by the

effect of the increasein quantitydemanded and totalrevenue will rise.

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Total revenues relationship with price depends on price elasticity of demand:

The values in Table 1 are used to construct the demand and total revenue curves in Figure3.

Table 1: Price, Demand, Total Revenue and Elasticity

If the price cut increases total revenue, demand is relatively elastic.

If the price cut decreases total revenue, demand is relatively inelastic. If the price cut does not change total revenue, demand is unit elastic.

The total revenue test method gauges price elasticity by looking at the direction of the changein total revenue in response to a change in price:

If demand is relatively elastic (elasticity greater than 1), a 5 percent decrease in pricewill result in an increase in quantity demanded ofmore than 5 percent. Therefore,total revenue will increase.

If demand is relatively inelastic (elasticity less than 1), a 5 percent decrease in price

will result in an increase in quantity demanded ofless than 5 percent. Therefore,total revenue will decrease.

If demand is unit elastic, a 5 percent decrease in price will result in an increasein quantity demanded of exactly 5 percent. Therefore, total revenue will notchange.

Total Revenue and Price Elasticity

Now that we have established that price elasticity changes along the demand curve lets lookinto how total revenue changes as prices fluctuate.

Total revenue equals price times quantity sold. If prices are reducedto stimulate sales, totalrevenue will only increase if the percentage increase in demand (sales) is greaterthan thepercentage decrease in prices.

Price

$

1

2

3

4

5

6

7

89

10

Quantity

units

50

45

40

35

30

25

20

1510

5

Total Revenue

$

50

90

120

140

150

150

140

12090

50

Elasticity

-0.16

-0.29

-0.47

-0.69

-1

-1.44

-2.14

-3.4

-6.33

|Ep|=1

|Ep|1

TR remainsthe sameregardless ofthe directionof change inprice

If P, TRIf P, TR

If P, TRIf P, TR

TR is maximizedwhen |Ep|=1


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Figure 3: Elasticity and Total Revenue

175

150

125

100

75

50

25

0

0 10 20 30 40 50

10

9

8

7

6

5

4

3

2

1

0

Quantity

Quantity

0 10 20 30 40 50

Price elasticity ofdemand > 1

Price elasticity ofdemand < 1

Elasticity in the $7 to $8 range

= [(20-15)/17.5]/[(7-8)/7.5] = -2.14


= [(40-35)/37.5]/[(3-4)/3.5] = -0.47


= [(30-25)/27.5]/[(5-6)/5.5] = -1

A decrease in priceresults in a decrease in

total revenue.

A decrease in priceresults in an increase in

total revenue.

Price and total

revenue arenegatively

related.

Price and totalrevenue arepositivelyrelated.

At the point wheretotal revenue is

maximized, priceelasticity of

demand equals 1(demand is unit

elastic).

Unit elastic

Saif Al Hidabi

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Total Expenditure and Price Elasticity

Looking at things from a consumers perspective, the change in the total amount of moneyspent on a good depends on her price elasticity of demand (her ability to respond to a pricechange).

If her demand for a good is relatively elastic, an increase in price will decrease hertotal expenditure on the good.

If her demand for a good is relatively inelastic, an increase in price will increase hertotal expenditure on the good.

If her demand for a good is unit elastic, an increase in price will not change her totalexpenditure on the good.


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Exhibit 1: A Summary of Elasticities

When its magnitude is

Infinity

Less than infinitybut greater than 1

1

Greater than 0but less than 1

0

A relationship is described as

Perfectly elastic

Elastic

Unit elastic

Inelastic

Perfectly inelastic

Which means that

The smallest possible increase is price causes an infinitely

large decrease in quantity demanded.

The percentage decrease in quantity demanded exceedsthe percentage increase in price.

The percentage decrease in the quantity demanded equalsthe percentage increase in price.

The percentage decrease in quantity demanded is lessthan the percentage increase in price.

The quantity demanded is the same at all prices.

Price Elasticities of Demand

Cross Elasticities of Demand


Close substitutes

Substitutes

Unrelated goods

Complements

When its value is

Infinity

Positive, less than infinity

0

Less than 0

Which means that

The smallest possible increase in price of one goodcauses a very large increase in quantity demanded ofthe other good.

If the price of one good increases, the quantity demandedof the other good also increases.

If the price of one good increases, the quantity demandedof the other good remains the same.

If the price of one good increases, the quantity demandedof the other good decreases.

Income Elasticities of Demand


Income elastic(normal good)

Income inelastic(normal good)

Negative income elastic(inferior good)

When its value is

Greater than 1

Less than 1but greater than 0

Less than 0

Which means that

The percentage increase in the quantity demanded isgreaterthan the percentage increase in income.

The percentage increase in the quantity demanded isless than the percentage increase in income.

When income increases, quantity demanded decreases.

Elasticities of Supply


Perfectly elastic

Inelastic

Perfectly inelastic

When its magnitude is

Infinity

Greater than 0but less than 1

0

Which means that

The smallest possible increase is price causes an infinitelylarge increase in quantity supplied.

The percentage increase in quantity supplied is less thanthe percentage increase in price

The quantity supplied is the same at all prices

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13Efficiency and Equity

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EFFICIENCYAND EQUITY

The central question in this reading is whether the market attains an efficient and fair useof resources.

Allocative efficiency is reached when the limited resources of an economy are allocated in

accordance with the wishes of all stakeholders in the economy, including consumers. Anallocatively efficient economy produces an optimal mix of products. It produces the rightgoods for the right people at the right price. An allocatively efficient market is therefore onethat has no imperfections.

LOS 14a: Explain the various means of markets to allocate resources, describemarginal benefit and marginal cost, and demonstrate why the efficient quantityoccurs when marginal benefit equals marginal cost. Vol 2. pg 38-40

Resource Allocation Methods

The basic economic problem is scarcity i.e., there are unlimited wants and only limitedresources to satisfy them. This means that resources have to be allocated to competing usesthrough some allocation method. We describe different allocation methods below:

Market price allocates scarce resources to individuals who have the willingness and theability to pay for the resource. This method works in most situations except when prohibitivemarket prices preclude less-privileged individuals from consuming items that are considerednecessities (e.g. education and healthcare). In these cases, resources are usually allocatedusing one of the other allocation methods.

Command: Scarce resources are allocated by an authority through commands and orders.For example, employees are allocated to various tasks within a firm based on the bosssorders. Such a system works well when: A clear hierarchy is in place. The performance of workers can be monitored easily.

Majority rule: Resources are allocated by the decisions of the majority. For example,democratically elected representative governments determine how tax revenue as a resourceshould be allocated between defense, education and other expenditures. Such a system workswell when: The choices made will affect a large number of people.

The benefit that accrues to the society through effective allocation takes precedenceover self-interest.

Contest: Resources are allocated to the winner. For example, when a manager offers hissubordinates a promotion incentive, employees allocate resources (their hours of labor) ina manner that maximizes their output. Such a system works well when: Performance of individual workers is not easy to monitor. It is hard to reward workers directly.

First come, first-served: Resources are allocated sequentially, with the first individual in linegetting the resource first. Restaurants seat customers on this basis. This system works well

when the scarce resource can be used over and over again, but only by one user at a time.Saif Al Hidabi

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Figure 1: Individual and Market Demand Curves

Quantity

15

10

5

00 10 20 30 40 50

1b. Lauras Demand

Laura is willingto pay $5 for the5th bottle.

D = MB

Quantity

15

10

5

00 10 20 30 40 50

1a. Alans Demand

Alan is willingto pay $5 for

the 15th bottle.

D = MB

Quantity

15

10

5

00 10 20 30 40 50

1c. Market Demand

The society iswilling to pay $5for the 20thbottle.

D = MSB

Laura and Alan are the only two consumers in the market for soda bottles. The horizontal summation of their individualdemand (MB) curves is the market demand curve, which is also called the marginal social benefit (MSB) curve.

The demand curveillustrates yourability andwillingness to buy agood or service atvarious prices.

LOS 14a:Explain

marginal benefit

Lottery: A scarce resource is allocated to the individual who holds the winning number.Rooms in a college dorm are allocated in this manner. Such a system works well when it isnot possible to differentiate between users of the scarce resource.

Personal characteristics: Resources are allocated after taking into account personal

characteristics. The best example is of choosing a marriage partner, where the choice is basedon personal preferences.

Force: Force can be used in a constructive or an unconstructive manner. An example of theformer is the legal authority given to the justice system of a country to protect private propertyrights and enforce contracts. An example of the latter is war, when one country forces theother to allocate resources in a certain manner.

LOS 14b: Distinguish between the price and the value of a product andexplain the demand curve and consumer surplus. Vol 2, pg 41-43

The utility derived from consumption of the last unit of a good or service is known as itsmarginal benefit (MB). Consumers express how much utility they derive from consumingan extra unit of a good or service through the price they are willing to pay for it. If a bottleof soda gets Akshay $5 worth of utility, he will only be willing to pay $5 for it. In otherwords, the marginal benefit curve is the demand curve where the benefit or utility that wederive from the good is quantified by the maximum price we are willing and able to pay forit. Marginal benefit is downward sloping because the utility derived from consumption ofthe next unit will be lowerthan the utility derived from consumption of the last unit (lawof diminishing marginal utility), and therefore consumers will be willing to pay a lower pricefor each additional unit of a given product.

The market demand curve (which represents the marginal benefit curve for all buyers) is thehorizontal summation of individual demand curves (which illustrate the marginal benefit ofconsuming different quantities for each individual). See Figure 1.


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We are measuring utility here in terms of the price consumers are willing and able to payfor each soda bottle (in dollars). Alternatively, prices reflect the value of other goods andservices that consumers are willing to forgo consumption of in order to consume one morebottle of soda.

Consumer Surplus

Consumer surplus occurs when a consumer is able to purchase a good or service for less thanthe maximum she is willing and able to pay for it. It equals the difference between the pricethat consumers are willing and able to pay for a good (indicated by the demand curve) andwhat they actually pay for the good (the market price).

Figure 2a shows Alans consumer surplus from consuming bottles of soda at a price of $5/bottle. At the market price of $5, he purchases 15 bottles and his marginal benefit fromconsuming the 15th unit is the same as the market price. Notice that Alan is willing and ableto pay $7.50 for the 10th bottle, but only pays $5 (the market price) for it. This implies that

his marginal benefit from consuming the tenth unit exceeds its price by $2.50. This is Alansconsumer surplus on the 10th unit. His total consumer surplus is the sum of all the surplusesthat he incurs from the consumption of each bottle of soda. Therefore, his total consumersurplus, is the area of the triangle between his demand curve, the vertical axis and the marketprice. The sum of Alan (Fig. 2a) and Lauras (Fig. 2b) consumer surplus equals total consumersurplus (Fig. 2c).

Figure 2: Demand and Consumer Surplus

Quantity

15

10

5

00 10 20 30 40 50

2a. Alans Consumer Surplus

Alans consumer surplus= 0.5 ($12.5 - $5) 15= $56.25

D = MB

Market price

Quantity

15

10

5

00 10 20 30 40 50

2b. Lauras Consumer Surplus

D = MB

Market price

Lauras consumer surplus= 0.5 ($7.5 - $5) 5= $6.25

Quantity

15

10

5

00 10 20 30 40 50

2c. Total Consumer Surplus

D = MSB

Market price

Total consumer surplus= $56.25 + $6.25= $62.50


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LOS 14c: Distinguish between the cost and the price of a product and explainthe supply curve and producer surplus. Vol 2, pg 43-45

Before making a purchasing decision, consumers compare the price of a product to the benefitor utility that they derive from it. Producers compare the price they will receive for a good

to the cost of producing it in determining whether to produce it. The cost of producing onemore unit of output is known as the marginal cost (MC). Suppliers will only be willing toproduce another unit of a product when the price that they receive for the unit exceeds themarginal cost of producing it. An individual firms supply curve illustrates its willingnessand ability to produce a good at various prices. Therefore, an individual firms supply curveis its marginal cost curve. The market supply curve is the horizontal summation of eachindividual firms marginal cost curve.

LOS 14a:Explainmarginal cost.Vol 2, pg 41

Figure 3: Individual Supply, Market Supply, And Marginal Social Cost

Ryans MC of producing the 20th bottle of soda is $7.50. Therefore, he will only be willing to produce the 20th bottle ifthe market price is at least $7.50. Assuming that Ryan and Michelle are the only producers in this industry, the market supply(MSC) curve is the horizontal summation of their individual MC curves.

Quantity

15

10

5

0

0 10 20 30 40 50

3a. Ryans Supply

S = MC

20 bottles

Ryan is willing tosupply the 20thbottle for $7.50

Quantity

15

10

5

0

3b. Michelles Supply

S = MC

0 10 20 30 40 50

10 bottles

Michelle iswilling tosupply the 10thbottle for $7.50

Quantity

15

10

5

0

0 20 40 60 80 100

3c. Market Supply

S = MSC

20 + 10 =30 bottles

Society is willing tosupply the 30thbottle for $7.50

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Now we are measuring costs in terms of the value of other goods and services (in dollars)that society is willing to forgo the production of in order to produce one more bottle of soda.As more and more of the same unit is produced, the (opportunity) cost of not producingother items increases.

Producer Surplus

Producer surplus occurs when a supplier is able to sell a good or service for more than theprice that she is willing and able to sell it for. It equals the difference between the marketprice and the price at which producers are willing and able to sell their product (indicatedby the supply curve). At a market price of $7.50, Ryan produces 20 bottles because themarginal cost of producing the 20th bottle equals market price (Figure 3a). Notice that Ryanis willing to sell the 10th bottle for only $5, but due to the existence of a standard marketprice, he will actually get $7.50 for it. This excess of price over MC of the 10th unit is Ryansproducer surplus from producing the 10th bottle. Ryans total producer surplus is the sumof the individual surpluses that he earns from selling each bottle. Therefore, his total producer

surplus is the area of the triangle between his supply curve, the vertical axis and marketprice. The sum of Ryans (Fig. 4a) and Michelles (Fig. 4b) producer surplus equals totalproducer surplus (Fig. 4c).

Figure 4: Supply And Producer Surplus

Quantity

15

10

5

00 10 20 30 40 50

4a. Ryans Producer Surplus

S = MC

Market price

Ryans producer surplus= 0.5 ($7.5 - $2.5) 20= $50

Quantity

15

10

5

00 10 20 30 40 50

4b. Michelles Producer Surplus

S = MC

Market price

Michelles producer surplus= 0.5 ($7.5 - $5) 10= $12.50

Quantity

15

10

5

00 20 40 60 80 100

4c. Total Producer Surplus

S = MSC

Market price

Total producer surplus= $50 + $12.50= $62.50


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LOS 14d: Discuss the relationship between consumer surplus, producersurplus, and equilibrium. Vol 2, pg 45-46

We have seen that individual demand and supply curves are also the marginal benefit (MB)and marginal cost (MC) curves respectively. Further, a societys demand and supply curves

for a good are the marginal social benefit (MSB) and marginal social cost (MSC) curvesrespectively. The point at which the demand and supply curves (the MSB and MSC curves)intersect determines the competitive market equilibrium position at which resources arebeing used efficiently by society. Notice that this is also the point at which the sum ofconsumer surplus and producer surplus is maximized. Figure 5 shows a societys demandand supply curves for bottles of soda. The equilibrium price is $2/bottle and the allocativelyefficient quantity is 100 bottles.

Figure 5: Allocative Efficiency

Quantity0 50 100 150 200

4

3

2

1

0

D > S = Shortage S > D = Surplus

S = MSC

D = MSB

Market pricee

MSBexceeds

MSC

MSCexceeds

MSB

At Point e the market supply and demandcurves intersect. This is the allocativelyefficient outcome for society because:

1. Marginal social cost equals marginalsocial benefit.

2. The sum ofconsumer surplus andproducer surplus is maximized ($200).

a. CS = 0.5 ($4 - $2) 100 = $100b. PS = 0.5 ($2 - $0) 100 = $100


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Figure 6 also illustrates a situation where 150 bottles of soda are being supplied. The 150th

bottle of soda costs $3 to produce, but consumers are only willing to pay $1 for it. Themarginal bottle of soda costs more than the value consumers place on it. There is inefficiencyas too many soda bottles are being produced i.e., the opportunity cost of producing sodabottles is too high. The resulting deadweight loss from overproduction is the area shaded ingrey in Figure 6.

Quantity supplied exceeds quantity demanded when 150 units are produced. This surpluswould push down prices. Quantity supplied would fall while quantity demanded would rise.The competitive market will move towards equilibrium where resources would be allocatedefficiently to produce 100 units at a price of $2/unit.

LOS 14e: Explain 1) how efficient markets ensure optimal resource utilizationand 2) the obstacles to efficiency and the resulting underproduction oroverproduction, including the concept of deadweight loss. Vol 2, pg 45-50

If actual production of sodas is at any level other than equilibrium (100 units), resources are

being used inefficiently. Figure 6 shows the efficient quantity as 100 bottles. Lets examinea situation where only 50 bottles of soda are being supplied. At this point consumers arewilling to pay $3 for the 50th bottle of soda, which is produced at a cost of $1. The marginalbenefit of consuming the 50th unit is greater than the opportunity cost of producing it.Limiting total output to 50 units results in a reduction in the sum of consumer and producersurplus. This combined reduction in consumer and producer surplus is known as a deadweightloss, which is borne by society as a whole. The deadweight loss from underproduction isthe region shaded in green in Figure 6.

However, markets usually tend to readjust to restore allocative efficiency. If the societyproduces less than 100 bottles, quantity demanded will exceed quantity supplied. The shortage

of soda bottles would push up prices. Quantity demanded would fall while quantity suppliedwould rise. This process will continue until equilibrium price and quantity are establishedat $2/unit and 100 units respectively.

Deadweight loss from

overproduction.

Figure 6: Deadweight Losses

Quantity

0 50 100 150 200

4

3

2

1

0

S = MSC

D = MB

Market price

Deadweight loss fromunderproduction.

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The market dynamics that we have just illustrated are an example of what Adam Smith calledthe invisible hand. Smith believed that each participant in a competitive market is led byan invisible hand to promote an end (the efficient utilization of scarce resources) which wasnot part of his intention.

Obstacles to Efficiency

Although competitive markets usually allocate resources efficiently, there are situationswhere deviations from the efficient quantity occur, and markets underproduce or overproducea good or a service.

Price ceilings and price floors: A price ceiling is a government regulation that prohibitsproducers from charging a price above a specified level. Rent control is an example of aprice ceiling. A price floor is a government regulation that prohibits individuals from payinga price below a specified level. Minimum wage is an example of a price floor. Such pricecontrols distort the free market mechanism and may result in outcomes that deviate from

those expected from an efficient competitive market. The impact of these regulations isdiscussed in greater detail in the next reading.

Taxes, subsidies, and quotas: Taxes increase the price paid by buyers and reduce the pricereceived by sellers. Subsidies increase the price received by sellers and decrease the pricepaid by buyers. Quotas are government-imposed physical limits on maximum productionof a good. They usually result in production below efficient levels. The impact of theseregulations is also discussed in greater detail in the next reading.

Monopoly: A monopoly is a market structure where one firm controls all, or nearly all of themarket of a good, for which no close substitute exists. Monopolies aim to maximize profits

and achieve this goal by increasing prices and producing less than the efficient quantity ofoutput. Monopolies are discussed in greater detail in Reading 19.

External costs and external benefits:An external cost is the cost that is borne by a third-partyin the production process. A factory that dumps industrial waste in a nearby river providesan example of an external cost because all citizens in the region suffer from greater pollution.A producers supply curve (MC curve) only takes into account its explicit production costs;not external costs. Therefore, she produces more than the socially efficient quantity of thegood. In contrast, an external benefit is the benefit that accrues to a third-party in theconsumption process. An individual who develops a garden outside her house provides anexample of external benefits. Her demand curve (MB curve) only takes into account thebenefit that accrues to her directly, not the benefit that accrues to other residents of the area.As a result, the quantity produced is less than the socially efficient quantity.


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Public goods and common resources:Public goods and services are goods that are non-rivalrous and non-excludable. Non-rivalrous means that consumption of the good by oneperson does not reduce the amount that is available for consumption by others. Non-excludableimplies that once the good has been provided, it is not possible to exclude anyone fromconsuming it. The non-excludable characteristic of public goods gives rise to thefree-riderproblem i.e., a person can benefit from consuming a public good without paying for it.Because of these characteristics, competitive markets will produce less than the efficientquantity of public goods. National defense and street-lighting are examples of public goods.


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LOS 14f: Explain the two groups of ideas about the fairness principle(utilitarianism and the symmetry principle) and discuss the relation betweenfairness and efficiency. Vol 2, pg 51-55

We have determined that in most scenarios, competitive markets ensure efficient allocationof resources. However, is this allocation also fair? Two different schools of thought havedifferent criteria for fairness:

It is not fair if the results are not fair. It is not fair if the rules are not fair.

According to the first criterion, resource allocation is not fair if the outcome is unfair. Ifindividual incomes are too polarized then the allocation of money is not fair. From thisgeneral idea stems the concept ofutilitarianism, which says that the maximum benefit

accrues to the maximum number of people when wealth is transferred from the rich to thepoor, until absolute equality is achieved. For example, if participants in an economy earn atotal of $100 in income and there are 10 people, utilitarianism asserts that each person shouldget $10.

The reasons behind this philosophy are that:

Everybody has the same basic wants and has the same capacity to enjoy life. The increase in marginal benefit from a dollar that is given to a poor person from

the transfer of wealth is greater than the reduction in marginal benefit to a rich person.Because the gain in marginal benefit (to the poor person) is greater than the loss in

marginal benefit (to the rich person), society is better off after the transfer.

The utilitarianism argument has inherent weaknesses. Wealth is transferred from the rich tothe poor through progressive taxes, where the rich pay a higher proportion of their incomesin taxes. High income taxes result in a disincentive to work so less labor is supplied in theeconomy. Further, taxes on capital income reduce savings, which results in a lower thanefficient quantity of capital being produced. The reduction in the quantity of labor and capitalreduces the total size of the economy.

Common resources are resources that are not owned by anyone and therefore, can be usedfreely by everyone. Fish in the ocean are an example of such a resource. If unrestrictedfishing were allowed, pursuit of self-interest in competitive markets would result in overfishingor overproduction (also known as tragedy of the commons). This is not the socially optimaloutcome because ideally, fishing should be limited in order to ensure long term supply.

High transaction costs:Transaction costs represent the opportunity costs of making tradesin a market. To use market price as the allocator of scarce resources, it must be worth bearingthe opportunity cost of establishing a market. Some markets are just too costly to operate.When transaction costs are high, the market will usually underproduce.


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The second source of inefficiency associated with wealth transfers are the administrativecosts involved. Administrative costs include the costs of collecting taxes and the costsincurred by taxpayers to get their returns audited. These activities require significant timeand effort and the resources devoted to these functions could have been employed to producegoods and services that people value.

According to the second criterion of fairness, resource allocation is not fair if the rules areunfair. This is called the symmetry principle, which says that people in similar situationsshould be treated similarly. In economic terms, it implies equality of opportunity. This ideais also backed by Robert Nozick in his bookAnarchy, State, and Utopia (1974). He arguesthat fair resource allocation requires fair rules, not results. According to him, fairness requiresthat:

The government must establish and protect private property rights. Private property can be transferred between individuals only through voluntary

exchange.

If these rules are followed, the results would be fair. An unequal distribution of income inthe economy will be tolerable as long as everyone has an equal opportunity to earn a higherincome through hard work and perseverance. Basically, every individual should have anequal opportunity to succeed.

The symmetry principal advocates that everything that holds value in society should beowned by individuals and it is the governments responsibility to protect private propertyby enforcing relevant laws. The only way an individual can acquire property from someoneelse is by exchanging it for something he owns that is desirable to the seller. At the end ofthe day, individuals can get goods and services from the economy that are equal in value to

their contribution to the economy.

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LOS 15a: Explain market equilibrium, distinguish between long-term andshort-term effects of outside shocks, and describe the effects of rent ceilingson the existence of black markets in the housing sector and on the markets

efficiency. Vol 2, pg 66-72

Equilibrium occurs at the point where market demand equals market supply. Outside shocksmay shift demand or supply, forcing the market towards a new equilibrium. In this readingour purpose is to analyze the effects of outside shocks on markets, and study whether thegovernments response to these shocks results in more desirable outcomes.

The Housing Market

The short run supply curve (SRS) for housing shows the change in quantity of housing unitsavailable for rent as rental rates (prices) change, given that the total number of housing units

remains constant.

The long run supply curve (LRS) on the other hand, shows the change in quantity of housingunits available for rent as rental rates change, given there is enough time for new units tobe built or for existing ones to be brought down. The long run supply curve isperfectlyelastic because the marginal cost of building new homes is relatively constant and does notvary with the number of homes already in existence. Housing developers will build moreunits as long as rental rates exceed the marginal cost of building houses. Therefore, long runsupply is perfectly elastic at the rental rate that equals marginal cost.

Outside shocks can temporarily interrupt the supply of goods and services, resulting in a

decrease in supply. An example of an outside shock to the housing market is the occurrenceof a devastating flood that destroys several thousands of homes in a city. People becomehomeless overnight and the short run supply of housing falls (shifts to the left from SRS0to SRS1 in Figure 1a). The shift in supply breaks initial equilibrium of e0 and brings themarket to a new equilibrium ofe1 where prices are higher,p1, and quantity lower,q1.

At these higher prices there is an incentive for developers to erect more housing units becausemarket price p1 exceeds the marginal cost (MC) of building housing units. Therefore,developers construct more housing units, and over the long run, supply increases (shifts tothe right) gradually back to SRS0 (Figure 1b), restoring initial equilibrium (e0).

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The key to the LR adjustment was the rise in prices (rents), which made it profitable forbuilders to construct more housing units, and brought about the increase in supply.

If the government were to enforce a maximum price, or a rent ceiling on housing, it wouldprevent the markets self-adjusting mechanism from functioning. Suppose the governmentwere to cap rental rates at $20 per unit per month (Figure 2). In this situation, quantitysupplied (60) will be lower than quantity demanded (70). Society will suffer a shortage of10 units and the following undesirable developments might occur:

Figure 1: SR and LR Effects of Outside Shocks on the Housing Market.

Housing Units

e1

e0

q0q1

20, p0

25, p1

D0

SRS1

SRS0

LRS = MC

1a. Immediately After Flood

1b. Long Run Adjustment

e0

q0q1

20, p0

25, p1

D0

SRS1

SRS0

LRS = MC

Housing Units

Step 2: Prices rise in SRdue to housing shortage.

Step 1: Supply shock- Short runreduction in supply due to flood

LR supply is perfectly elastic atthe MC of building new housingunits.

Step 3: As rents rise to p1,quantity demanded falls to q1.

Step 4: At e1, market priceis greater than the MC ofbuilding new homes(LRS). Therefore, housingdevelopers will buildmore units and supply will

move back up to initiallevels (SRS0). Initialequilibrium will berestored where priceequals MC of buildingnew homes.


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Search activity: People would spend a lot of time, energy, and fuel trying to be the first onesat the scene of any housing availability. These resources could have been put to some better,more productive use. Rent ceilings control the explicit rental portion of costs, but do notcontrol the opportunity costs, which might be higher than the difference in rental rates werethe market unregulated.

Black markets: Housing providers know that there are people willing to pay more than theceiling price for a housing unit, but they cannot legally charge them a higher rent. Therefore,they look for other ways of indirectly increasing rents (e.g. by charging higher rates for otherservices, key money, etc.).

Were the rent ceiling of $20 not imposed, market prices would simply rise to $25 (as illustratedin Figure 1) and allocative efficiency would be reached because:

The sum of consumer surplus (CS) and producer surplus (PS) would be maximizedat e0.

Marginal cost (MC) to society would equal marginal benefit (MB) to society at e0.(Demand = Supply)

With the rent ceiling in place however, there is no activity in the market beyond 60 units.Consumers are better off in the sense that they have to pay $20 instead of $25, but also loseout because they only get 60 housing units instead of 65. Producers are worse off becauseof lower realized prices and lower quantities sold. The loss to consumers and producers isthe dead weight loss (DWL) borne by the society. Allocative efficiency is not reached because:

The sum of CS and PS is not maximized MC does not equal MB. At the ceiling price of $20, MB (demand) exceeds MC

(supply).Okay, so ceilings are allocatively inefficient. But, are they fair?

According to the fair rules view (symmetry principle) anything that hinders voluntaryexchange in unfair, so rent ceilings are unfair. According to the fair results view (utilitarianprinciple) fairness would be achieved were housing units allocated to the poorest membersof society. In practice, we cannot be sure that this will be the case. Most probably, the availableunits will be allocated on either first-come, first-served basis, through a lottery, or on thebasis of ones contacts.

The bottom line is that although it sounds like capping rents on housing is a noble idea, itfails to achieve fairness and efficiency, and prevents the housing market from operating insocial interest.

The rent ceiling onlydisrupts marketequilibrium if setbelow equilibriummarket prices. If theceiling were setabove equilibriumprice it would haveabsolutely no effecton economic activity.

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LOS 15b: Describe labor market equilibrium and explain the effects andinefficiencies of a minimum wage above the equilibrium wage.Vol 2, pg 72-77

The Labor Market

The short run supply (SRS) curve for unskilled labor shows the change in labor quantitysupplied as the wage rate changes. In order to increase the supply of unskilled labor, a higherwage must be offered.

In the long run, people can leave the unskilled labor market, go back to school or acquire

new skills that will enable them to enter a higher wage bracket. If unskilled labor wages arehigh enough, others will join the unskilled labor force. The long run supply of labor is the

Figure 2: Effects of a Rent Ceiling

Quantity

S

D

20

25

30

e

b

c

d

a

qd

70qs

60

Rent ceiling = $20

qd > qsHousing shortage

If the market were left on its own to self-adjust, anallocatively efficient outcome would be reached:1. MB=MC at Point e.2. Sum of CS and PS is maximized.

If Rents were Allowed to Rise to $25

ConsumerSurplus

25

a

e

ProducerSurplus

d

e25

With Rents Capped at $20

20

a

b

c

ConsumerSurplus

20

d

c

ProducerSurplus

e

c

DWLb With a rent ceiling in place

below equilibrium price,society suffers a dead weightloss from underproduction.

For a housing supplyof 60 units somepeople are willing topay a black market

price as high as $30

There is no activity in the marketbeyond 60 units once the c eilingis imposed.

Price that wouldexist were marketsallowed to self-adjust.

Area between y-axis,demand curve and price

Area between y-axis,supply curve and price

Consumers now pay alower price of $20, butsuffer because of alower equilibriumquantity. Consumersurplus does notextend beyond 60units.


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relationship between the quantity of labor supplied and the wage rate after enough time haselapsed to allow people to enter or leave the labor market. If there are no barriers to entryor exit in the unskilled labor market, the long run supply of labor will beperfectly elastic.

An example of an outside shock to the labor market is a sudden influx of immigrants who

enter the unskilled labor market and increase (shift to the right from S0 to S1) the supply ofunskilled labor. This development will disrupt initial equilibrium, e0, reduce prices to P1 andset up a new equilibrium ate1with a higher quantity of labor employed, Q1. (Figure 3a)

The reduction in wages is an undesirable outcome for most people, so over the long runpeople would spend time and resources retraining themselves for better (high-paying)employment opportunities. This would decrease the supply of unskilled labor in the economy(supply would shift back towards S0) and gradually prop wages back up to the initial levelof P0, which lies on the long run supply (LRS) curve. (Figure 3b)

The key to the long run adjustment towards equilibrium was the decrease in wages, which

spurred some labor force participants to leave the unskilled labor market and acquire newskills in search of a better wage.

Figure 3: SR and LR Effects on Increase in Supply of Labor

Quantity of Labor

e1

e0

Q0 Q1

10, P0

8, P1

D0

S1

S0

LRS

3a. Immediately After Influx of Immigrants

3b. Long-Run Adjustment

Quantity of Labor

e1

e0

Q0 Q1

10 P0

8 P1

D0

S1

S0

LRS

Step 2: The increase insupply brings down wages.

Step 1: Outside shock- A suddeninflux of immigrants increasesshort run supply of unskilledlabor.

Step 3: Equilibriumquantity of labor increases.

Step 4: Low wage rates (P1)force some workers to leavethe unskilled labor marketand acquire new skills to geta higher-paying job. The exitof these individuals reducessupply and increases wagesback up to original levels (P0).


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If the government were to set a minimum wage at $10 when equilibrium wage rates standat $8, it would prevent the markets self-adjusting mechanism from playing out (see Figure4). At a wage rate of $10, the quantity of labor supplied (40) would exceed quantity demanded(20). People would spend valuable time and resources looking for work, especially as everyhour of labor would fetch $10 (enforced minimum wage) when they are willing to supply

that hour of labor for only $6 (supply curve).

Were the minimum wage of $10 not imposed, wages would simply fall to $8 due to excesssupply and allocative efficiency would be reached because:

The sum of consumer and producer surplus would then be maximized (e0). Marginal cost to society would equal marginal benefit to society (demand would

equal supply).

With the minimum wage in place however, there is no activity in the market beyond 20 units.Workers are better off in a sense because they receive $10 in wages instead of $8, but also

lose out because only 20 units of labor are employed instead of 30. Firms are worse offbecause they have to pay higher wages ($10 instead of $8) and employ less units of laborthan they would ideally like to (At a wage rate of $8, firms would hire 30 units of labor).Society suffers a dead weight loss and allocative efficiency is not reached because:

The sum of CS and PS is not maximized. MC does not equal MB. At 20 units, MC (supply) exceeds MB (demand).

The minimum wageonly disrupts marketactivity if set abovethe equilibrium wagerate. If the minimumwage is set below the

equilibrium wagerate it would haveabsolutely no effecton economic activity.

Figure 4: The Inefficiency Of A Minimum Wage

Quantity of Labor

S

D

6

8

10

e

b

c

d

qd20

qs40

Minimum Wage = $10

qe30

a

Wage rate that the20 units that findemployment earn.

Wage rate that the20 employed unitsof labor werewilling to work for.

At a wage rate of $10:

qs > qd => Surplus / Excess Supply

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LOS 15c: Explain the impact of taxes on supply, demand, and marketequilibrium, and describe tax incidence and its relation to demand and supplyelasticity. Vol 2, pg 77-85

The statutory incidence of a tax refers to whom the law levies the tax upon. As we shall learnsoon, just because the government imposes or levies a tax on a particular group does notnecessarily mean that the actual incidence of the tax falls entirely on that group. Actual taxincidence refers to how the burden of the tax is shared by consumers and producers in termsof a reduction in consumer and producer surplus respectively.

Lets start with an example in which a tax per-unit of $3 is levied on suppliers (Figure 5).The tax increases cost of production and as a result, supply falls (shifts to the left to S1).Consequently, prices rise to $6 and equilibrium quantity falls to 425 units.

The area of the rectangle shaded in green represents government revenue from tax collection.The government earns $3/unit on 425 units that are sold. Consumers purchase 425 units andpay $6/unit. Effectively prices paid by consumers have gone up by $2 ($6 - $4). Producerssell 425 units at $6/unit but only pocket $3/unit after paying the tax. Effectively, their realizedprices have fallen by $1 ($4 - $3).

If the market were left to self-adjust, an allocativelyefficient outcome would be reached:

1. MB = MC at Point e.2. Sum of CS and PS is maximized.

If Wages were Allowed to Fall to $8

8 e

aConsumerSurplus

8 e

d

ProducerSurplus

With Minimum Wage Fixed at $10

10 b

c

d

ProducerSurplus

DWL

e

b

c

10 b

a ConsumerSurplus

With a minimum wage in placeabove equilibrium levels, society

suffers a dead weight loss fromunderproduction.

Area between they-axis, demand

curve andequilibrium wagerate ($8)

Area between they-axis, supplycurve andequilibrium wagerate ($8)

Area between the y-axis,demand curve and minimumwage rate ($10)

Area between the y-axis,supply curve and minimumwage rate. Suppliers benefitfrom higher prices, but sufferfrom being unable to sellmore than 20 units. Theproducer surplus does notextend beyond 20 units.

Despite the fact that price floors in the labor market cause unemployment and give rise todeadweight losses, a popular movement is seeking to create a higher floor at a living wage.A living wage is the hourly wage rate that enables a person to rent adequate housing for notmore than 30 percent of the amount earned.


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Even though this tax was levied on suppliers only, consumers end up bearing the brunt ofthe tax in the form of an effective increase in prices of $2, versus an effective decrease inproducer realized prices of only $1. The government earns $3/unit in tax revenue, but noticethat the increase in government tax revenue from the imposition of the tax does not entirelyoffset the reduction in consumer and producer surplus. The triangle shaded in grey represents

the dead weight loss to society from underproduction caused by the imposition of the tax.

Figure 5 : Tax on Sellers

Allocative efficiency is reached because:

a. MB=MC and demand = supply.b. Sum of consumer and producer surplus is

maximized.

a

4 e

6 b

3 c

d

4 e

6 b

a

3

d

c

4 f

6 b

There is a dead weight loss because thereis no activity in the market beyond 425units. The dead weight loss to societyfrom underproduction equals thereduction in consumer and producersurplus that is not offset by governmenttax revenue.

e

c

b

3 c

4 f

After the Tax is ImposedBefore the Tax is Imposed

S0

S1

D0

$3/unit tax

3

6

4 e

b

c

f

a

Quantity425 450

d

Price paidby consumers.

Price receivedby producers netof tax.

A tax of $3/unit on producers reduces supply.

Consumers surplus isthe area of the trianglebetween the demandcurve, y-axis and marketprice ($4).

Producer surplus is thearea of the trianglebetween the supply

curve, y-axis and marketprice ($4).

Consumers pay $6/unitfor 425 units.

Producers receive $6-$3= $3/unit for 425 units.

Total government taxrevenue.

Reduction in consumersurplus that is offset by taxrevenue for the government.

Reduction in producer surplus

that is offset by tax revenue forthe government.


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Now assume that instead of being levied upon producers, the same $3/unit tax is imposedon consumers (Figure 6). The demand curve would shift to the left to D1. Once again theincrease in government revenue from tax collections will not entirely offset the reductionin consumer and producer surplus, and society will suffer a dead weight loss fromunderproduction (the region shaded in grey in Figure 6).

The factor that determines how the actual tax burden is shared between producers andconsumers is the relative elasticity of the demand and supply curves. The more inelastic thedemand curve, the greater the actual burden borne by consumers regardless of whom the taxwas imposed upon by law. The more inelastic the supply curve, the greater the actual burdenborne by producers regardless of whom the tax was levied upon.

If demand is relatively more elastic than supply, it implies that consumers are moreflexible and hold leverage in the market to substitute away from the good if the pricerises. In this case, more of the actual burden of the tax will fall on suppliers.

If demand is less elastic than supply, it implies that consumers cannot respond toprice increases as easily, and hold less leverage in the market to substitute away fromthe good when faced with an adverse price change. In this case, more of the actualburden of the tax will be borne by consumers.

Finally, lets study a situation where demand is perfectly inelastic (Figure 7).

Figure 6 : Tax on Consumers

S0

D0

$3/unit tax

3

6

4

a

Quantity425 450

d

D1

Price paidby consumersinclusive of tax

Price receivedby producers.

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Figure 7 shows the effects of a $3/unit tax imposed on suppliers when the demand curve isperfectly inelastic. What we find is that the entire tax burden is borne by consumers in theform of reduction in consumer surplus. Another interesting fact is that there is no dead weightloss to society. The reduction in consumer surplus in entirely offset by an increase in taxrevenue. When supply and demand are relatively inelastic, society suffers less of a deadweight loss and the government collects greatertax revenue than when supply and demandare relatively elastic.

Summary:

An imposition of a tax on buyers reduces demand, while an imposition on producersreduces supply.

Actual tax burden does not depend on whom the tax is imposed upon. If the demand curve is more inelastic, consumers will actually bear a greater burden

of the tax in the form of a reduction in consumer surplus. If the supply curve is more inelastic, producers will actually bear a greater burden

of the tax in the form of a reduction in producer surplus. The more inelastic the demand and supply curves, the lower the total dead weight

loss to society from tax imposition, and greater the tax revenue for the government.

LOS 15d: Discuss the impact of subsidies, quotas, and markets for illegalgoods on demand, supply, and market equilibrium. Vol 2, pg 85-92

Subsidies

Think of subsidies as negative taxes. Governments offer subsidies in order to encourage theproduction of a good by subsidizing or reducing the cost of producing it. Subsidies bringabout an increase in supply.


2009 Elan Guides

Figure 7: Actual Tax Burden when Demand is Perfectly Inelastic

Quantity

S0

200

D0S1

7

4

Consumers bear the entireburden of the tax in theform of a reduction inconsumer surplus. Thereduction in consumersurplus equals the increasein government tax revenueso there is no dead weightloss to society.


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The provision of the subsidy results in an output level (70 units) that is greater than theallocatively efficient quantity of output (50 units). At this higher level of output, marginalcost exceeds marginal benefit. Consumers are better off in the form of lower prices paid ($4versus $5 earlier) and producers are better off in the form of higher take-home prices ($4from consumers + $2 subsidy = $6, versus $5 earlier). However, the amount that thegovernment spends on the subsidy outweighs the increase in consumer and producer surplus.Society suffers a dead weight loss from overproduction.

Summary:

Subsidies result in:

An increase in realized prices for producers. An increase in output. A decrease in prices paid by consumers. Dead weight losses from overproduction.

Figure 8 analyzes the impact of a $2/unit subsidy that is offered to producers. Suppliers, whowere previously willing and able to supply 50 units at $5/unit, are now willing and able tosupply 50 units at a price of $3/unit because the subsidy compensates them for the difference.

Markets in Action

Figure 8: Subsidies

Quantity

e1

e0

q050

q170

5

4

D0

S1

S0

a

3

6

e1

e0

aDWL

6 a

4 e1

Society suffers from a dead weight loss from overproduction. The marginalcost to society from producing 70 units is greater than the marginal benefitfrom consuming 70 units. The subsidy results in too many resources beingdedicated to the production of the good.

The price actually realized byproducers ($6) equals $4/unitfrom consumers plus $2/unitfrom the government in theform of subsidy.

Market prices fall to $4/unit The provision of asubsidy results inan increase insupply.

Total government expenditureon subsidy.


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Illegal Goods

If an illegal good were legal, its market would function like any other market, with demandand supply determining the equilibrium price, pe, and equilibrium quantity, qe (Figure 10).When a good is declared illegal, penalties are levied on buyers and sellers who are inpossession of the good (Figure 10). Because there is a risk of having to pay the penalty,buyers reduce their demand to D1. This is because the amount of the penalty would besubtracted from the value of the good by buyers to determine the maximum price they would

be willing to pay for the good. Similarly, supply will fall to S1. Suppliers will add the amountof the penalty to the minimum price at which they would be willing and able to supply theproduct.


2009 Elan Guides

Production Quotas

A quota limits the total amount of a good that can be produced in the economy. In Figure9, we assume that a quota of 100 units is set on the production of a particular good, whoseallocatively efficient quantity is 120 units.

The imposition of the quota prevents any activity in the market beyond a quantity of 100units. The total amount of welfare attributable to consumer and producer surplus is reducedand there is a dead weight loss due to underproduction. Quotas are usually imposed toappease lobbyists who are interested in earning higher profits. Quotas reduce costs forproducers and increase prices paid by consumers, and are therefore very effective in increasingprofits.

Summary

Production quotas limit the production of a good in an economy in order to raiserealized prices for producers.

They result in inefficiency because at the quantity corresponding to the quota (qQ),

MB exceeds MC, resulting in a dead weight loss due to underproduction.

Quotas only distortthe market when theyare imposed at anoutput level that islower than theequilibrium quantity.If they are imposedat a quantity higherthan equilibrium

output they will haveno impact oneconomic activity.

Figure 9: Quotas

Quantity

e0

D0

S0

25 PQ

20 P0

qQ100

q0120

MC falls

DWL

Limiting productionresults in higher prices.

Quantity is forced down to 100 units.

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35Markets in Action

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If the penalty on suppliers and consumers is the same, supply and demand would both shiftto the left by the same magnitude, resulting in the same price level pe, but a lower equilibriumquantity q1. Notice that the buyer pays pe to the seller, but effectively pays a price ofpb (peplus the penalty). Similarly, suppliers receive pe, but effectively pocket only ps(pe minus thepenalty).

If the penalty on suppliers is greater than the penalty on buyers, supply will shift by a greatermagnitude, and prices would actually rise. Were a heavier penalty imposed on consumers,the shift in demand would be more significant, and prices would actually fall.

You might wonder whether it would just be wiser to legalize illegal goods and tax themheavily. A hefty tax would decrease supply, increase prices and achieve the same decreasein equilibrium quantity that a penalty does. Further, the tax revenue could be used by thegovernment for societal welfare programs. However, opponents of legalizing these goodsassert that laws send out a message to society, and decrease the demand for illegal products,which taxes do not.

Figure 10: Illegal Goods

Quantity

S1

S0

D1

e1 e0

qeq1

pe

ps

pb

D0

Producers add the penaltyamount to the price they wereearlier willing and able to supplythe good.

The benefit from the good to theconsumer is reduced by the amount

of the penalty.


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Accounting profit is calculated by subtracting only explicit costs from total revenues. InSteyns case, accounting profit would equal $300,000 ($500,000 - $200,000). Economicprofits are always lowerthan accounting profits because their calculation subtracts explicitandimplicit costs from total revenue.

LOS 16b: Discuss a companys constraints and their impact on the achievabilityof maximum profit. Vol 2, pg 103-104

There are three constraints that limit a companys ability to maximize profits:

Technology constraints: Technology is broadly defined as a method of producing a good orservice. A firm can increase its production by using additional technological resources, whichare costly to procure. The firms ability to generate more profits through increased outputis therefore limited by the cost of acquiring new and more efficient technology.

Information constraints: If firms had perfect information about their employees, customersand competitors, they could make perfectly informed decisions that would increase theirprofits. However, firms do not have access to all desired information and invest considerablesums of money on research. Spending money on acquiring information is only viable to theextent that the increase in firm profits from utilizing the information exceeds the cost ofobtaining it.

Market constraints: Profits are also constrained by how much consumers are willing to payfor the firms goods, how much of the firms output they are willing to buy, and by themarketing strategies and positioning of competitors. Further, profits may also be constrainedby capital market constraints i.e., the willingness and ability of investors to finance the firms

operations and growth.


2009 Elan Guides

Total Revenues

Explicit CostsPlastic

ElectricityWagesInterest expenseTotal Explicit Costs

Implicit CostsRyans wages forgoneInterest forgoneEconomic depreciationNormal profitTotal Implicit Costs

Total Costs

Economic Profit

$

100,000

30,00060,00010,000200,000

30,00020,00015,00055,000120,000

$500,000

(320,000)

180,000


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2009 Elan Guides

LOS 16d: Explain command systems and incentive systems to organizeproduction, the principal agent problem, and measures a firm uses to reducethe principal-agent problem. Vol 2, pg 107-109

In a command system, resources employed in the production process are allocated bysomeone in authority, such as supervising managers. Information passes up and commandstrickle down the hierarchy with the goal of using resources efficiently. Managers spend mostof their time collecting and processing information about the performance of their subordinates,and making decisions regarding what instructions to issue and how to implement them. Themilitary provides the purest example of a command system, where the commander-in-chiefmakes all the big decisions.

In an incentive system, managers offer their workers performance-based incentives. Theseincentives induce workers to perform in a manner that increases personal benefit, and at thesame time, maximizes profits for the firm. For example, sales persons have very low basicsalaries but get large commissions on sales.

Most firms use a combination of command and incentive systems. Command systems areoften used when employee performance can be monitored easily. Incentive systems are usedwhen it is difficult and costly to monitor employee performance.

The principal-agent problem arises when the interests of agents and principals are notaligned. Agents (managers and workers) try to find ways to enjoy on-the-job leisure and aredriven to maximize personal income and benefit. Principals, who are the owners of the firm,want to maximize the firms profits and value. The principal-agent problem would not existif principals were able to monitor their agents effectively. Unfortunately, this is not onlydifficult, but costly as well. To counter the principal-agent problem, interests of workers andowners must be aligned. This is usually accomplished by offering agents:

Ownership interests: If an agent is given an ownership interest in the firm, she willhave an incentive to perform in a manner that will increase the firms value. Thismethod is primarily used to incentivize senior management.

Incentive pay: These compensation schemes pay workers based on their performance.Agents can be compensated in the form of bonuses and promotions.

Long-term contracts: These induce agents to make decisions and lay down strategiesthat will improve the long-term prospects of the firm. CEOs are often awardedmulti-year contracts so that they develop strategies that will achieve maximum profitsover a sustained period.

Method 2 is the economically efficient method. It results in the lowest cost percomputer.

Method 3, which is technologically inefficient, is also economically inefficient. Atechnologically inefficient method can neverbe economically efficient.

Although Method 2 is economically efficient in this example, Method 1 and Method

4 could have been economically efficient if input prices were different.

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41Organizing Production

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LOS 16e: Describe the different types of business organizations and theadvantages and disadvantages of each. Vol 2, pg 109-112

Type of

Organization

Proprietorship

Partnership

Corporation

Description

One owner who hasunlimited liabilityfor the firms debtsand legal obligations.

Profits are taxed atthe personal incometax rate of the owner.

Two or more ownerswith unlimitedliability for the firmsdebt and legalobligations.Profit-sharing based

on proportionalownership.

Profits are taxed atpersonal income taxrate of the owners.

Firm is owned byshareholders, whoenjoy limitedliability.

Profits are taxed at

the corporate incometax rate.

Advantages

Easy to set upDecision making

process is simple andquick.Profits are taxed only once.

Easy to set up.Decision making is

diversified.Profits are only taxed

once. Can survive

withdrawal of apartner.

Owners have limitedliability, whichmeans that their legalobligations arelimited to the money

that they haveinvested.

Capital is usuallyavailable at a lowcost.

Managementexpertise is notlimited to theowners.

Perpetual life.LT labor contracts

reduce costs.

Disadvantages

Decision-making isnot diversified.

Unlimited liabilityputs the ownersentire wealth at risk.

Raising capital andobtaining bank loansis difficult.

If the owner dies, thefirm ceases to exist.

Diversified decision-making could resultin disagreements.

Unlimited liabilityputs the ownerswealth at risk.

Reduction in capitalwhen a partner

chooses to leave.Difficult to raise

capital.

Decision-makingprocess is slow andbureaucratic.

Profits are taxedtwice- once as

company profits andthen as dividends.


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LOS 16f: Calculate and interpret the four-firm concentration ratio and theHerfindahl-Hirschman Index, and discuss the limitations of the concentrationratios. Vol 2, pg 113-117

Concentration ratios are used to evaluate the level of competitiveness of the market that a

firm operates in.

Four-firm concentration ratio: This ratio measures the proportion of total industry salesthat are accounted for by the four largest firms in the industry. The ratio lies between almostzero and 100%, with 0 indicating perfect competition (high competition with lots of firmssharing the market) and 100% indicating a monopoly (low competition with just one firmserving the entire market). A ratio below 40% suggests that a relatively competitive marketexists, while a ratio above 60% indicates that a few firms dominate the industry (oligopoly).

Herfindahl-Hirschman Index (HHI): This ratio is calculated by summing the squaredpercentage market shares of the 50 largest firms in an industry. The HHI is very low for

highly competitive markets and it equals 10,000 (1002) for a monopoly. An HHI of less than1,000 indicates a competitive market (with lots of firms), while an index that lies between1,000 and 1,800 is indicative of a moderately competitive market. An HHI above 1,800suggests that the market is relatively uncompetitive.

Limitations of Concentration Measures

Geographical scope of the market: This refers to the reach of product, which could be local,national or international. For example, concentration ratios for newspapers in the internationalmarket would be low and indicate a high level of competition. However, within cities theseratios are high, indicating a lack of competition.

Barriers to entry and firm turnover: Concentration ratios fail to consider barriers to entry andfirm turnover in industries. Markets may be highly concentrated, as indicated by high ratios,but there may be very low barriers to entry. Even though ratios indicate low levels ofcompetition in the industry, they ignore the ease of entry for potential competitors. Forexample, there might be very few hairdressers in a small town, but it is relatively easy toenter this market, which makes the threat of potential entrants high, and the market relativelycompetitive.

The relationship between the market and industry: When calculating concentration ratios,we assume that every firm fits into one specific industry. However, this is not always the

case. First, markets are more narrowly defined than industries. For example, the shoemanufacturing industry may be highly competitive and have a low concentration ratio.However, some firms might specialize in different markets within the industry, such as sportsshoes, men's shoes, children's shoes, and so on; not necessarily competing with each other.Therefore, competition within the different markets may be relatively low. Second, manylarge firms offer a wide range of products and operate in different markets, while concentrationmeasures assume that any company operates in only one market. Finally, firms may easilymove between markets in search of higher profits. Low barriers to entry make such movementspossible and reduce the usefulness of concentration ratios in evaluating competition levelsin various markets.


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LOS 16g: Explain why firms are often more efficient than markets incoordinating economic activity. Vol 2, pg 118-121

Market coordination: Economic activity refers to the organization of factors of productionto produce goods and services. An example of markets coordinating economic activity is the

organization of a tennis match- the organizers rent a stadium, invite popular tennis players,hire publicity agents to advertise the match, employ ticketing agents to sell tickets and sellthe broadcasting rights to a TV channel. These are all examples of market transactions asopposed to firm level coordination where the organizers would own all the capital (stadium,video equipment, etc.) and employ all the labor needed (players, referees, salespeople, etc.).In essence, the match is produced by coordinating different markets. Outsourcing is anotherexample of markets coordinating economic activity.

Companies decide whether to purchase goods or services from other firms (market coordination)or to produce the good or service themselves (firm coordination) based on relative costs.

Firm coordination occurs when firms can organize economic activity more efficiently thanmarkets. Usually firms are more efficient than markets at coordinating economic activitybecause of:

Lower transaction costs: Transaction costs are incurred as numerous buyers andsellers negotiate and organize economic activity (market coordination). These costsare lower when one single firm coordinates economic activities as the number ofindividual transactions is reduced. Consider the following example of getting yourcar fixed:o Firm coordination: You take the car to a garage where the owner organizes

everything from the purchasing, replacing and repairing of parts to the hiring

of the mechanic. He charges you for the entire job.o Market coordination: You hire a mechanic to recognize the problem, then

go to a store yourself to purchase parts, and to rent tools. Then you hire themechanic again to fix the problem, and you return the tools. You pay themechanic separately, the tool rental store separately, and for the parts separately.

Firm coordination will probably result in a more cost and time effective solution.

Economies of scale: Economies of scale refer to falling average costs as more andmore units of a good are produced. Economies of scale arise from specialization anddivision of labor. These benefits can be realized more effectively by firms thanmarkets.

Saif Al Hidabi

3 Economy Book Saif

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