chap3

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MARKET MARKET EFFICIENCY EFFICIENCY

& & ELASTICITYELASTICITY

CHAPTER 3: CHAPTER 3:

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CHAPTER OUTLINE:CHAPTER OUTLINE:

3.1 The Market System

3.2 Market Failure

3.3 Constraint on the Market: Government Intervention

3.4 Market Efficiency & Surpluses Maximization

3.5 Elasticity

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• Stability or equilibrium is a situation when quantity demanded and quantity supplied are equal and there is no tendency for price or quantity to change.Supply = Demand

• Disequilibrium:– The condition that exists in a market when the plans

of buyers do not match those sellers;– A temporary mismatch between quantity supplied

and quantity demanded as the market seeks equilibrium. Supply ≠ Demand

3.1 THE MARKET SYSTEM3.1 THE MARKET SYSTEM

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3.2 MARKET FAILURE3.2 MARKET FAILURE

• Imperfect competition

• Public goods

• Externality/ neighborhood effects

• Imperfect information

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Imperfect CompetitionImperfect Competition

• An industry in which single firm have some control over price & competition. Imperfectly competitive industries give rise to an inefficient allocation of resources.

• Market controlled by monopoly, cartel, illegal co-operation

• Government ownership (Lembaga Air Perak), law & regulation (price control)

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Public GoodsPublic Goods

• Goods or services that are non-rival in consumption and/or their benefits are non-excludable.

• Free-rider problem: because people can enjoy the benefits of public goods whether they pay for them or not, they are usually unwilling to pay them.

• Example: road (transport), hospital (public health), national defense, education.

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Externality/ Neighborhood EffectsExternality/ Neighborhood Effects

• Cost or benefit resulting from some activity or transaction that is imposed or bestowed on parties outside the activity or transaction.

• Example: pollution (cost), chemical usage (cost); a farm located near a city provides resident in the area with nice views and fresher air (benefit).

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• The absence of full knowledge concerning product characteristic, available prices and so fort.

• Adverse selection and moral hazard will occur in the market.

Imperfect InformationImperfect Information

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Imperfect InformationImperfect Information

Adverse Selection

– Occur when a buyer or seller enters into an exchange with another party who has more information

– Example: used car market/ ‘lemon market’• The sellers of used cars have full information about

the real quality of their cars.

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Moral Hazard

– Arises when one party to a contract changes behavior in response to that contract and thus passes on the cost of that behavior change to the other party.

– Example: if my car is fully insured against theft, why should I lock it?

Imperfect InformationImperfect Information

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3.3 CONSTRAINT ON THE MARKET:3.3 CONSTRAINT ON THE MARKET:CASE FOR GOVERNMENT CASE FOR GOVERNMENT

INTERVENTIONINTERVENTION

• Price ceiling• Price floor• Ration coupons• Favored customers• Queuing (waiting in line)• Other restrictions

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Price Ceiling• Government imposed regulations that Government imposed regulations that

prevent prices form rising above a prevent prices form rising above a maximum level set by government. maximum level set by government.

• To control unjust high price (high mark-up price)- E.g: rent control

• Price is set below the equilibrium price, thus will create excess demand (shortage).

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6

5

4

3

2

1

0 2 4 6 8 10 12 14 16 18

Sugar (Kg per week)

Pri

ce (

per

pac

k)

P Qd

RM5

4

3

2

1

2,000

4,000

7,000

11,000

16,000

MarketDemand

200 Buyers

P Qs

RM5

4

3

2

1

12,000

10,000

7,000

4,000

1,000

MarketSupply

200 Sellers

Price Ceiling

7

3

D

S

Price Ceiling

??????????

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Price Floor• Government imposed a regulations that Government imposed a regulations that

prevent prices from falling below a prevent prices from falling below a minimum level set by government.minimum level set by government.

• To adjust unfair low price (price too low). E.g: minimum wage.

• Price is set above the equilibrium price, thus will create excess supply (surplus).

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6

5

4

3

2

1

0 2 4 6 8 10 12 14 16 18

Brown Rice (Kg per week)

Pri

ce (

per

Kg

)

P Qd

RM5

4

3

2

1

2,000

4,000

7,000

11,000

16,000

MarketDemand

200 Buyers

P Qs

$5

4

3

2

1

12,000

10,000

7,000

4,000

1,000

MarketSupply

200 Sellers

Price Floor

7

3

D

S

Price Floor

?????

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• Tickets or coupon that entitle individual to purchase a certain amount for a given per month.

• Everyone would get the same amount

• Example: Introduced rationing of subsidized petrol for target groups.

Ration CouponRation Coupon

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• Those who receive special treatment from dealers during situations of excess demand.

• Example: many gas station owners decided not to sell gasoline to the general public but to reserve their supplies for friends & favored customer.

• Results in hidden costs– Owners changed high prices in service, thus

increased the real price.

Favored Customers

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• Distributing goods & services/ non price rationing mechanism.

• Product cost = cost of waiting

• Example: FBF distributed free ticket for Jay’s concert & student who wait in line can get one ticket for free.– Waiting time imposes a cost on the buyers

(students) of the product (ticket) and provident no benefits to suppliers (FBF).

Queuing (waiting in line)

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• Price control– Production that can only be sell at particular

price by government.– Example: sugar, petrol.

• Licensing/ Permit– Awarding an individual firm exclusive right to

supply the goods and services.– Example: TV signals

Other Restrictions

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Other Restrictions

• Taxes– May be imposed on transactions, institutions,

property, meal & other things but in the final analysis they are paid by individuals/ households.

• Quota– A limit on the quantity of imports from a

country.

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3.4 MARKET EFFICIENCY & SURPLUSUS MAXIMIZATION

• Efficient Market– Pareto Optimality:

• Condition in which no change is possible that will make some members of society better off without hurting some other members of society.

– Simple voluntary change

• Example: I have ‘Principles of Economics’(Mankiw); you have ‘Principle of Economics’ (Case & Fair). My lecturer use Case & Fair while your lecturer use Mankiw. We trade. We both gain and no one losses.

Consumer and Producer SurplusConsumer and Producer Surplus

• Consumer surplus– The difference between the maximum

amount a person is willing to pay for a good & its current market price (actually pay).

• Producer surplus– The difference between the current market

price and the full cost of production for the firm.

• Extra value producer received.• What producer pay for the right to sell at current

price.2222

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Qo

Quantity (hamburger)

Pri

ce (

per

ham

bu

rger

)

P

Q1

Maximum Combined Surpluses

P1

S

D

ProducerSurplus

ConsumerSurplus

Total Surplus (TS) = Consumer Surplus + Producer Surplus

Consumer and Producer SurplusConsumer and Producer Surplus

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Pri

ce

S

D

Quantity

0

$10987654321

10987654321

Producer Surplus

Consumer Surplus

CS = ½(5x5) = 12.5 =Area of blue triangle

PS = ½(5x5) = 12.5 =Area of red triangle

The combination of producer and consumersurplus is maximized atmarket equilibrium.

Consumer and Producer SurplusConsumer and Producer Surplus

2525

Pri

ce

S

D

Quantity

0

RM10987654321

10987654321

Producer Surplus:PS = ½ (RM4 x4) + (RM2 x 4) =RM16

If price is RM6,Consumer Surplus: CS = 1/2 (RM4x4) = RM8

Combined consumer and producer surplus decreaseswhen price is above equilibrium.

Deadweight loss = ½(RM2x1) = RM1

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Deadweight Loss

– Losses of consumer and producer surplus that are not transferred to other parties

– Deadweight Loss is the fall in total surplus.

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Cost of Price Ceiling

Price CeilingPrice Ceiling

SS

DD

PricePrice

QuantityQuantityQQ

PP

AA BB

CC DD

EE

QsQs QdQdBefore After Changes

CS ? ? ?

PS ? ? ?

Total Surplus

? ? ?

Deadweight Deadweight Loss: ?? Loss: ??

P*P*

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Cost of Price Floor

Price FloorPrice Floor

SS

DD

PricePrice

QuantityQuantityQ*Q*

P1P1AA

BB CC

DDEE

QdQd QsQsBefore After Changes

CS ? ? ?

PS ? ? ?

Total Surplus

? ? ?

Deadweight Loss: Deadweight Loss: ????

P*P*

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3.5 3.5 ELASTICITYELASTICITY• Definition:

A general concept used to quantify the response in one variable when another variable changes.

• 4 types of elasticity:

(i) Price elasticity of demand (PED)

(ii) Income elasticity of demand (IED)

(iii) Cross price elasticity of demand (CED)

(iv) Price elasticity of supply (PES)

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Price Elasticity of Demand (PED)

• Definition:

PED is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

• Calculating elasticity using two methods:

(i) Formula method

(ii) Midpoint method

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(i) Formula Method:

(ii) Midpoint Method:

100

2/)(

2/)(

12

12

12

12

x

PPPP

QQQQ

PED

1001/)12(

1/)12(x

PPP

QQQPED

Calculating Price Elasticity of Demand (PED)

Computing the PED Using Formula Method

• Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

0.220/201002/)0.22.2(

10/)108(

xPED

Computing the PED Using Midpoint Method

• Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

32.25.9/22100

2/)22.2(0.22.22/)108(

108

xEd

100

2/)(

2/)(

12

12

12

12

x

PPPP

QQQQ

Ed

• Elimination of minus sign Economist normally ignore the minus sin and present

the absolute value of the elasticity coefficient to avoid an ambiguity.

• Interpretations of PED Economist classify demand curves according to their

elasticity. There are five cases:– Elastic (PED >1)– Inelastic (0< PED <1)– Unitary elasticity (PED =1)– Perfectly elastic (PED = ∞)– Perfectly inelastic (PED = 0)

The Price Elasticity of Demand: ELASTIC

• PED > 1 (Elastic Demand)

• ∆ in Price < ∆ in quantity

• P↓ (5%) < Qd ↑ (10%)5%5%

10%10%

∆∆QQ

∆∆PP

DDDD

QuantityQuantity

PricePrice

The Price Elasticity of Demand: INELASTIC

• PED < 1 (Inelastic Demand)

• ∆ in Price > ∆ in quantity

• P↓ (10%) > Qd ↑ (5%)

5%5%

10%10%

∆∆QQ

∆∆PP

DDDD

QuantityQuantity

PricePrice

The Price Elasticity of Demand: UNITARY ELASTIC

• PED = 1 (Unitary Elastic)

• ∆ in Price = ∆ in quantity

• P↓ (10%) = Qd ↑ (10%)

10%10%

10%10%

∆∆QQ

∆∆PP

DDDD

QuantityQuantity

PricePrice

The Price Elasticity of Demand: PERFECTLY ELASTIC & PERFECTLY INELASTIC

• PED = ∞ (Perfectly Elastic)

• A situation in which a small percentage change in the price leads to an infinite percentage change in the quantity demanded.

DDDD

QuantityQuantity

PricePrice

5 105 10

1010

DDDD

1010

PricePrice

QuantityQuantity

1010

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• PED = 0 (Perfectly Inelastic)

• A condition in which the quantity demanded does not change even though the price changes.

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Income Elasticity of Demand (IED)Income Elasticity of Demand (IED)

• Definition:– Measures the responsiveness of demand

to changes in income.• Formula:

• Uses:– Positive sign (IED ≥0)

• Normal / luxury goods)– Negative sign (IED < 0)

• Inferior goods

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Cross-Price Elasticity of Demand (CED)Cross-Price Elasticity of Demand (CED)• Definition:

– Measure of the response of the quantity of one good demanded to a change in the price of another good.

• Formula:

• Uses:– Positive sign (CED > 0)• Substitute Product (E.g: butter and margarine)– Negative sign (CED < 0)• Complementary product (E.g: Pen and Ink)

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Price Elasticity of Supply (PES)Price Elasticity of Supply (PES)

• Definition:

– measure of the response of quantity of a good supplied to a change in price of that good. Its value is likely to be positive in output markets due to the law of supply.

• FormulaFormula::

pricein change %

suppliedquantity in change % PES

Price Elasticity of Supply

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Refresh Your Mind

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QUESTION 1:

Use the diagram below to:(i) Calculate total consumer surplus and producer surplus at

the equilibrium price.

(ii) If government imposed price floor at RM11, calculate new producer surplus, consumer surplus and deadweight loss.

Refer to the figure. Using the midpoint formula, calculate the values of elasticity between points A and B, and then

between points C and D.

QUESTION 2

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