Unit II: The Nature and
Function of Product
Markets
Resource Allocation
How does society allocate scarce resources among their
many possible uses?
Market Interrelation
• Name some markets for goods/services
• Are any of these markets related?
• Which are product markets? Factor markets?
Resource Allocation
• Which type of economy allocates resources better: pure market or
command?
• What role do prices play in the allocation of resources in each?
• What information do consumers and sellers get from the price of a good in
a competitive market that they would not receive in a command economy?
Prices in a competitive market indicate the value consumers place on the items and the costs to
sellers of producing the item.
Do Activity 2-1
Marginal Utility and the Law of
Demand
Utility: Marginal vs. Total
• Utility is a subjective notion in economics
• Utility: amount of satisfaction a person gets from consumption of a certain item
• Marginal Utility: extra utility a consumer gets from consuming one additional unit of a
specific product
• Total Utility: total satisfaction a person receives from consumption of a specific product
• OR, the sum of the marginal utilities of the individual units of a good consumed
• A person’s evaluation of her or his total satisfaction (total utility) from some
amount of a good is subjective. Different people will receive different levels of total
utility from a given number of units of a good.
Diminishing Marginal Utility
• As a person consumes additional units of an item, a positive marginal
utility means total utility increased, a negative marginal utility means total
utility decreased, and a marginal utility of zero means total utility did not
change.
Diminishing Marginal Utility
• As a person consumes more of a good or service, eventually the consumer
reaches a point where the marginal utility of an extra unit diminishes.
• Because of diminishing marginal utility, a consumer will only buy more
of a good if its price is reduced. This illustrates the law of demand.
Diminishing Marginal Utility
• To receive the greatest total utility from a given income, a consumer should
allocate that income between two products in such a way that the marginal
utility per dollar is the same for each product.
• (MU Price)A = (MU Price)B
• This condition is called the consumer equilibrium because the consumer
has no incentive to change the allocation of income unless the price of a
product changes.
Substitution and Income Effects
• When the price of a good changes, the consumer experiences a substitution
effect and an income effect. These two effects usually support each other
and explain the law of demand.
• Substitution Effect – When the price of a good falls, consumers will substitute toward
that good and away from other goods.
• Income Effect – When the price of a good falls, consumers experience an increase in
purchasing power from a given income level. When the price of a good increases,
consumers experience a decrease in purchasing power.
Do Activity 2-2
Elasticities
Price Elasticity of Demand, Income Elasticity of Demand, Cross-Price
Elasticity of Demand, Price Elasticity of Supply, and Excise Taxes
Elasticity
• Elasticity – a measure of how strongly one variable responds to a change in
another variable
• Price elasticity of demand
• Income elasticity of demand
• Cross-price elasticity of demand
• Price elasticity of supply
Price Elasticity of Demand
• Price elasticity of demand – measures the strength of the consumer
response to a change in the price of a product.
• Both the price change and the resulting change in quantity demanded are
measured as percentage changes.
Price Elasticity of Demand
• We measure price change and the resultant change in quantity demanded as
percentage changes because a comparison of the actual change in dollars and
quantities does not indicate the relative size of the changes.
• A $5 price increase is a large change if the product is a pizza but it is a small change if
the product is a house.
• The law of demand tells us that the value of the price elasticity of demand
will be a negative number.
• When we interpret that value, we consider its absolute value.
Elastic, inelastic, and unit elastic demand
• If the percentage change in quantity demanded is greater than the percentage
change in price, then demand is elastic over that price range.
• If εd > 1, then demand is elastic over this price range
• If the consumer response is weak compared to the price change, demand is
inelastic.
• If εd < 1, then demand is inelastic over this price range
• If the two percentage changes happen to be equal, then demand is unit
elastic (also called unitary elastic).
• If εd = 1, then demand is unit elastic over this price range
Calculating Price Elasticity of Demand
1. εd =
percentage change in quantity demand of Good X
percentage change in price of Good X
2. Midpoint Formula: εd =
(Q2 −Q1 )
Q2 +Q1
2
(P2 −P1 )
P2 +P1
2
=
%∆Qd
%∆P
Midpoint Formula
• Why would economists use the midpoint formula?
• Because the value of the price elasticity of demand is used for that specific
part of the demand curve, they use the midpoint as their base value rather
than one of the end point values.
Extreme Cases of Price Elasticity of Demand
• A horizontal demand curve is perfectly
elastic because consumers will completely
stop buying the good if the price is
increased even by a small amount.
• This extreme case is shown by the demand
curve facing a perfectly competitive firm.
• Such a firm can sell all it wants at the current
market price (P1), but if it raises its price it
will lose all of its customers to other firms
selling the same product at price P1.
Extreme Cases of Price Elasticity of Demand
• A vertical demand curve is
perfectly inelastic because
consumers want to buy the same
amount (Q1 ) of the good, no
matter what the price.
• If the price increases, there is no
response by consumers.
Other Demand Elasticities
• Income elasticity of demand – measures how strongly consumers of a
particular product respond to some percentage change in income
• εI =
percentage change in quantity demand of Good X
percentage change in income
• If εI > 0, then Good X is a normal good
• If εI < 0, then Good X is an inferior good
Other Demand Elasticities
• Cross-price elasticity of demand – measures how strongly consumers of
one good respond to some percentage change in the price of a related good
(a substitute or a complement)
• εCP =
percentage change in quantity demand of Good X
percentage change price in Good W
• If εCP > 0, then X and W are substitute goods
• If εCP = 0, then X and W are unrelated goods
• If εCP < 0, then X and W are complementary good
Determinants of Price Elasticity of Demand
1. Substitutes for the product
• The more substitutes, the more elastic the demand.
2. The proportion of price relative to income
• The larger the expenditure relative to one’s budget, the more elastic the demand, because
buyers notice the change in price more.
3. Whether the product is a luxury or necessity
• The less necessary the item, the more elastic the demand.
4. The amount of time involved
• The longer the period of time involved, the more elastic the demand becomes.
Price Elasticity of Supply
• The price elasticity of supply shows how responsive producers of Good
X are to a change in the price of Good X.
• The law of supply tells us that the sign of εs will be positive because price
and quantity supplied move in the same direction.
• εs =
percentage change in quantity suppliedof Good X
percentage change in price of Good X
Price Elasticity of Supply
• If εs > 1, then supply is elastic over this price range
• If εs = 1, then supply is unit elastic over this price range
• If εs < 1, then supply is inelastic over this price range
Do Activities 2-3 and 2-4
Elasticities (cont.)
Price Elasticity of Demand, Income Elasticity of Demand, Cross-Price
Elasticity of Demand, Price Elasticity of Supply, and Excise Taxes
Total Revenue and εd
• Total Revenue is the amount paid by buyers and the amount received by
sellers of a good
TR = P x Q
• Since P and Q are the two variables involved in the calculation of εd , we can
safely say that a definite relationship exists between the two.
Total Revenue and εd
• Total Revenue Test:
• If TR falls when P increases, or vice versa, then demand is elastic
• If TR and P move in the same direction, then demand is inelastic
TAXES
• Gov’ts levy taxes to raise revenue for public projects
• How do taxes on buyers (and sellers) affect market outcomes?
• They discourage market activity
• When a good is taxed, the quantity sold is smaller
• The burden of the tax is shared between buyers and sellers.
Elasticity and Excise Taxes
• Excise Tax – a tax levied on a particular good or service
• Typically a per-unit tax, which means the seller must give the government a set amount
of money for each unit sold.
• Ex: A tax of $0.50 placed on each gallon of gasoline sold.
• Sellers view an excise tax as an additional cost, so they try to pass it on to
consumers in the form of a higher price
Elasticity and Excise Taxes
• Because the seller will try to pass
the tax on to the consumer, the
supply curve will shift up vertically
by the amount of the tax at all
output levels
Tax Incidence
• Tax incidence is the manner in which the burden of a tax is shared among
participants in a market.
• The economic burden of a tax is independent of the legal burden.
• Taxes result in a change in market equilibrium.
• Buyers pay more and sellers receive less, regardless of whom the tax is levied
on.
Tax Incidence
• So, how is the burden of tax divided?
The burden of tax falls on the side of the market that is
less elastic.
Tax Incidence
• If demand is highly elastic, then
consumers will buy a lot less of the
good if the price is increased so the
incidence of the tax rests mainly on
the seller.
Tax Incidence
• If demand is highly inelastic, the
seller is able to raise the price by
most of the tax and not lose many
customers; the burden of the tax
will be mainly on the consumer.
Do Activities 2-5 and 2-6
Price Ceilings and Floors
Price controls and their effects on markets
Price Controls
• Price Control – gov’t effort to restrict price of good or service in a
particular market
• Price ceilings
• Price floors
• Whom is the government trying to assist with a price control?
Price Ceilings
• Price Ceiling – a price control used to prevent the price of the item from
rising above a predetermined price
• To be effective (i.e., to have an impact) in the market, the price ceiling must be set
below the equilibrium price, and it will result in a shortage of the item.
• The lower price increases the quantity demanded by consumers and decreases the
quantity supplied by sellers.
• Who is the gov’t try to help?
• Ex: rent controls
Price Ceilings
• What are the equilibrium price and
quantity in this market?
• If the government sets a price ceiling
of $2.00 in this market, will there be
shortage or a surplus?
• How many units will be exchanged at
the price ceiling of $2.00?
• If the government sets a price ceiling
of $4.00 in this market, will there be a
shortage or a surplus?
Price Floors
• Price Floor – a price control used to prevent the price of the item from falling
below a predetermined price
• To be effective, the price floor must be set above the equilibrium price, and it will result in a
surplus of the item.
• The higher price increases the quantity supplied by sellers and decreases the quantity
demanded by consumers.
• A price floor set below the equilibrium or market price has no effect.
• Who is the gov’t try to help?
• Ex: Agricultural subsidies, minimum wage laws
Price Floors
• What are the equilibrium price and
quantity in this market?
• If the government sets a price floor of
$5.00 in this market, will there be a
shortage or a surplus?
• How many units will be exchanged at
the price floor of $5.00?
• If the government sets a price floor of
$2.00 in this market, will there be a
shortage or a surplus?
Affects of Price Controls
• How is the market output changed as a result of the price floor without a
shift in either the demand or supply curve?
• The government policy stopped the market forces of demand and supply from moving the market to its
equilibrium.
• Who gains and who loses under a price ceiling? What about a price floor?
• Are there any changes in consumer surplus and producer surplus that result
from price controls?
Do Activity 2-7
Property Rights, Market Failure, and
Deadweight Loss
Property Rights and Markets
• A key requirement of a well-functioning market economy is the
establishment and enforcement of well-defined property rights.
• When individuals, rather than central governments, own the land and
physical capital, many important economic incentives are created.
• When a person owns property, he or she has the right to use, sell, or trade
with another person for mutual gain.
• If the property rights to resources are not clearly defined, the market can
produce a quantity that is different from the socially desired quantity.
Marginal Benefits vs. Marginal Costs
• Society’s optimal output in a particular market is where marginal social
benefit (MSB) equals marginal social cost (MSC).
• The market output is determined by marginal private benefit (MPB) being
equal to marginal private cost (MPC).
Marginal Benefits vs. Marginal Costs
• The presence of an externality (external costs or benefits) will result in the
MSB being different from the MPB, or the MSC being different from the
MPC.
• This means the quantity produced in the market will be different from the
quantity society would like to have the market produce.
• This outcome is referred to as a market failure.
The Effect of Pollution
• Assume the firms that make paper clean
up all their waste products so there is no
pollution.
• The MSC curve represents the MSC of
paper production; it includes the paper
companies’ costs of materials, workers,
energy, and pollution cleanup.
• If there is no pollution, the MSC curve is
the same as the firms’ MPC and is the
market supply curve for paper.
The Effect of Pollution
• Now assume the paper companies begin to release
their untreated wastes into a nearby river.
• This reduces the production costs for these paper
companies.
• The new supply curve S represents the firms’ MPC of
production, but excludes the cost of cleaning up the
pollution these firms are creating.
• Now the MPC is different from the MSC.
• The demand curve for paper represents both the MSB
and the MPB from the consumption of paper.
• Only the consumers of paper receive benefits from
the product.
The Effect of Pollution
• How much paper is produced when there is no
pollution?
• What is the price of a unit of paper in the absence of
pollution?
• Why does the MPC curve lie below the MSC curve
when the paper companies pollute the river?
• How much paper is produced when the paper
companies dump their waste products into the river?
• What is the price of a unit of paper when there is
pollution?
• How does society feel about the quantity produced by
the polluting firms?
Do Activity 2-8
Consumer and Producer Surplus
• A perfectly competitive market, in the absence of outside interference, will
maximize total welfare, which is the sum of consumer surplus and producer
surplus.
• Deadweight Loss – decline in due to something in the market preventing it
from reaching its equilibrium outcome
• Ex: taxes, externalities, price controls
Do Activity 2-9
Deadweight Loss of a Price Ceiling
•
•
•
•
•
•
What is the market price of a gallon of gasoline?
What is the equilibrium quantity?
What is the value of consumer surplus?
What is the value of producer surplus?
What is the value of total welfare?
Assume the government sets a price ceiling of
$4.50 in the market. What will be the quantity
demanded and the quantity supplied?
• What area of the graph shows the deadweight loss
of the price ceiling?