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Chap3

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  • 1. MARKET EFFICIENCY & ELASTICITY CHAPTER 3:
  • 2. 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
  • 3. <ul><li>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. </li></ul><ul><li>Supply = Demand </li></ul><ul><li>Disequilibrium: </li></ul><ul><ul><li>The condition that exists in a market when the plans of buyers do not match those sellers; </li></ul></ul><ul><ul><li>A temporary mismatch between quantity supplied and quantity demanded as the market seeks equilibrium. </li></ul></ul><ul><ul><li> Supply ≠ Demand </li></ul></ul>3.1 THE MARKET SYSTEM
  • 4. 3.2 MARKET FAILURE <ul><li>Imperfect competition </li></ul><ul><li>Public goods </li></ul><ul><li>Externality/ neighborhood effects </li></ul><ul><li>Imperfect information </li></ul>
  • 5. Imperfect Competition <ul><li>An industry in which single firm have some control over price & competition. Imperfectly competitive industries give rise to an inefficient allocation of resources. </li></ul><ul><li>Market controlled by monopoly, cartel, illegal co-operation </li></ul><ul><li>Government ownership (Lembaga Air Perak), law & regulation (price control) </li></ul>
  • 6. Public Goods <ul><li>G oods or services that are non-rival in consumption and/or their benefits are non-excludable. </li></ul><ul><ul><li>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. </li></ul></ul><ul><li>Example : road (transport), hospital (public health), national defense, education. </li></ul>
  • 7. Externality/ Neighborhood Effects <ul><li>Cost or benefit resulting from some activity or transaction that is imposed or bestowed on parties outside the activity or transaction. </li></ul><ul><li>Example: pollution (cost), chemical usage (cost); a farm located near a city provides resident in the area with nice views and fresher air (benefit). </li></ul>
  • 8. <ul><li>The absence of full knowledge concerning product characteristic, available prices and so fort. </li></ul><ul><li>Adverse selection and moral hazard will occur in the market. </li></ul>Imperfect Information
  • 9. Imperfect Information <ul><li>Adverse Selection </li></ul><ul><ul><li>Occur when a buyer or seller enters into an exchange with another party who has more information </li></ul></ul><ul><ul><li>Example: used car market/ ‘lemon market’ </li></ul></ul><ul><ul><ul><li>The sellers of used cars have full information about the real quality of their cars. </li></ul></ul></ul>
  • 10. <ul><li>Moral Hazard </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>Example: if my car is fully insured against theft, why should I lock it? </li></ul></ul>Imperfect Information
  • 11. 3.3 CONSTRAINT ON THE MARKET: CASE FOR GOVERNMENT INTERVENTION <ul><li>Price ceiling </li></ul><ul><li>Price floor </li></ul><ul><li>Ration coupons </li></ul><ul><li>Favored customers </li></ul><ul><li>Queuing (waiting in line) </li></ul><ul><li>Other restrictions </li></ul>
  • 12. Price Ceiling <ul><li>Government imposed regulations that prevent prices form rising above a maximum level set by government. </li></ul><ul><li>To control unjust high price (high mark-up price)- E.g: rent control </li></ul><ul><li>Price is set below the equilibrium price , thus will create excess demand (shortage). </li></ul>
  • 13. 6 5 4 3 2 1 0 2 4 6 8 10 12 14 16 18 Sugar (Kg per week) Price (per pack) P Q d RM5 4 3 2 1 2,000 4,000 7,000 11,000 16,000 Market Demand 200 Buyers P Q s RM5 4 3 2 1 12,000 10,000 7,000 4,000 1,000 Market Supply 200 Sellers Price Ceiling 7 3 D S Price Ceiling ?????
  • 14. Price Floor <ul><li>Government imposed a regulations that prevent prices from falling below a minimum level set by government. </li></ul><ul><li>To adjust unfair low price (price too low). E.g: minimum wage. </li></ul><ul><li>Price is set above the equilibrium price, thus will create excess supply (surplus). </li></ul>
  • 15. 6 5 4 3 2 1 0 2 4 6 8 10 12 14 16 18 Brown Rice (Kg per week) Price (per Kg) P Q d RM5 4 3 2 1 2,000 4,000 7,000 11,000 16,000 Market Demand 200 Buyers P Q s $5 4 3 2 1 12,000 10,000 7,000 4,000 1,000 Market Supply 200 Sellers Price Floor 7 3 D S Price Floor ?????
  • 16. <ul><li>Tickets or coupon that entitle individual to purchase a certain amount for a given per month. </li></ul><ul><li>Everyone would get the same amount </li></ul><ul><li>Example: I ntroduced rationing of subsidized petrol for target groups. </li></ul>Ration Coupon
  • 17. <ul><li>Those who receive special treatment from dealers during situations of excess demand. </li></ul><ul><li>Example: many gas station owners decided not to sell gasoline to the general public but to reserve their supplies for friends & favored customer. </li></ul><ul><li>Results in hidden costs </li></ul><ul><ul><li>Owners changed high prices in service, thus increased the real price. </li></ul></ul>Favored Customers
  • 18. <ul><li>Distributing goods & services/ non price rationing mechanism. </li></ul><ul><li>Product cost = cost of waiting </li></ul><ul><li>Example: FBF distributed free ticket for Jay’s concert & student who wait in line can get one ticket for free. </li></ul><ul><ul><li>Waiting time imposes a cost on the buyers (students) of the product (ticket) and provident no benefits to suppliers (FBF). </li></ul></ul>Queuing (waiting in line)
  • 19. <ul><li>Price control </li></ul><ul><ul><li>Production that can only be sell at particular price by government. </li></ul></ul><ul><ul><li>Example: sugar, petrol. </li></ul></ul><ul><li>Licensing/ Permit </li></ul><ul><ul><li>Awarding an individual firm exclusive right to supply the goods and services. </li></ul></ul><ul><ul><li>Example: TV signals </li></ul></ul>Other Restrictions
  • 20. Other Restrictions <ul><li>Taxes </li></ul><ul><ul><li>May be imposed on transactions, institutions, property, meal & other things but in the final analysis they are paid by individuals/ households. </li></ul></ul><ul><li>Quota </li></ul><ul><ul><li>A limit on the quantity of imports from a country. </li></ul></ul>
  • 21. 3.4 MARKET EFFICIENCY & SURPLUSUS MAXIMIZATION <ul><li>Efficient Market </li></ul><ul><ul><li>Pareto Optimality : </li></ul></ul><ul><ul><ul><li>Condition in which no change is possible that will make some members of society better off without hurting some other members of society. </li></ul></ul></ul><ul><ul><ul><ul><li>Simple voluntary change </li></ul></ul></ul></ul><ul><ul><ul><li>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. </li></ul></ul></ul>
  • 22. Consumer and Producer Surplus <ul><li>Consumer surplus </li></ul><ul><ul><li>The difference between the maximum amount a person is willing to pay for a good & its current market price (actually pay). </li></ul></ul><ul><li>Producer surplus </li></ul><ul><ul><li>The difference between the current market price and the full cost of production for the firm. </li></ul></ul><ul><ul><ul><li>Extra value producer received. </li></ul></ul></ul><ul><ul><ul><li>What producer pay for the right to sell at current price. </li></ul></ul></ul>
  • 23. Q o Quantity (hamburger) Price (per hamburger) P Q 1 Maximum Combined Surpluses P 1 S D Producer Surplus Consumer Surplus Total Surplus (TS) = Consumer Surplus + Producer Surplus
  • 24. Consumer and Producer Surplus Price S D Quantity 0 $10 9 8 7 6 5 4 3 2 1 10 9 8 7 6 5 4 3 2 1 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 consumer surplus is maximized at market equilibrium.
  • 25. Consumer and Producer Surplus Price S D Quantity 0 RM10 9 8 7 6 5 4 3 2 1 10 9 8 7 6 5 4 3 2 1 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 decreases when price is above equilibrium. Dead weight loss = ½(RM2x1) = RM1
  • 26. <ul><li>Deadweight Loss </li></ul><ul><ul><li>Losses of consumer and producer surplus that are not transferred to other parties </li></ul></ul><ul><ul><li>Deadweight Loss is the fall in total surplus . </li></ul></ul>
  • 27. Cost of Price Ceiling Price Ceiling S D Price Quantity Q P A B C D E Qs Qd Deadweight Loss: ?? P* Before After Changes CS ? ? ? PS ? ? ? Total Surplus ? ? ?
  • 28. Cost of Price Floor Price Floor S D Price Quantity Q* P1 A B C D E Qd Qs Deadweight Loss: ?? P* Before After Changes CS ? ? ? PS ? ? ? Total Surplus ? ? ?
  • 29. 3.5 ELASTICITY <ul><li>Definition : </li></ul><ul><li>A general concept used to quantify the response in one variable when another variable changes. </li></ul><ul><li>4 types of elasticity: </li></ul><ul><ul><li>(i) Price elasticity of demand (PED) </li></ul></ul><ul><ul><li>(ii) Income elasticity of demand (IED) </li></ul></ul><ul><ul><li>( iii) Cross price elasticity of demand (CED) </li></ul></ul><ul><ul><li>(iv) Price elasticity of supply (PES) </li></ul></ul>
  • 30. Price Elasticity of Demand (PED) <ul><li>Definition : </li></ul><ul><li>PED is a measure of how much the quantity demanded of a good responds to a change in the price of that good . </li></ul><ul><li>Calculating elasticity using two methods : </li></ul><ul><li>(i) Formula method </li></ul><ul><li>(ii) Midpoint method </li></ul>
  • 31. <ul><li>(i) Formula Method : </li></ul><ul><li> </li></ul><ul><li>(ii) Midpoint Method: </li></ul>Calculating Price Elasticity of Demand (PED)
  • 32. Computing the PED Using Formula Method <ul><li>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: </li></ul>
  • 33. Computing the PED Using Midpoint Method <ul><li>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: </li></ul>
  • 34. <ul><li>Elimination of minus sign </li></ul><ul><ul><li>Economist normally ignore the minus sin and present the absolute value of the elasticity coefficient to avoid an ambiguity. </li></ul></ul><ul><li>Interpretations of PED </li></ul><ul><ul><li>Economist classify demand curves according to their elasticity. </li></ul></ul><ul><ul><li>There are five cases: </li></ul></ul><ul><ul><li>Elastic (PED >1) </li></ul></ul><ul><ul><li>Inelastic (0< PED <1) </li></ul></ul><ul><ul><li>Unitary elasticity (PED =1) </li></ul></ul><ul><ul><li>Perfectly elastic (PED = ∞) </li></ul></ul><ul><ul><li>Perfectly inelastic (PED = 0) </li></ul></ul>
  • 35. The Price Elasticity of Demand: ELASTIC <ul><li>PED > 1 (Elastic Demand) </li></ul><ul><li>∆ in Price < ∆ in quantity </li></ul><ul><li>P ↓ (5%) < Qd ↑ (10%) </li></ul>5% 10% ∆ Q ∆ P DD Quantity Price
  • 36. The Price Elasticity of Demand: INELASTIC <ul><li>PED < 1 (Inelastic Demand) </li></ul><ul><li>∆ in Price > ∆ in quantity </li></ul><ul><li>P ↓ (10%) > Qd ↑ (5%) </li></ul>5% 10% ∆ Q ∆ P DD Quantity Price
  • 37. The Price Elasticity of Demand: UNITARY ELASTIC <ul><li>PED = 1 (Unitary Elastic) </li></ul><ul><li>∆ in Price = ∆ in quantity </li></ul><ul><li>P ↓ (10%) = Qd ↑ (10%) </li></ul>10% 10% ∆ Q ∆ P DD Quantity Price
  • 38. The Price Elasticity of Demand: PERFECTLY ELASTIC & PERFECTLY INELASTIC <ul><li>PED = ∞ (Perfectly Elastic) </li></ul><ul><li>A situation in which a small percentage change in the price leads to an infinite percentage change in the quantity demanded. </li></ul>DD Quantity Price 5 10 10 DD 10 Price Quantity 10 5 <ul><li>PED = 0 (Perfectly Inelastic) </li></ul><ul><li>A condition in which the quantity demanded does not change even though the price changes. </li></ul>
  • 39. Income Elasticity of Demand (IED) <ul><li>Definition : </li></ul><ul><ul><li>Measures the responsiveness of demand to changes in income. </li></ul></ul><ul><li>Formula : </li></ul><ul><li>Uses : </li></ul><ul><ul><li>Positive sign (IED ≥ 0) </li></ul></ul><ul><ul><ul><li>Normal / luxury goods) </li></ul></ul></ul><ul><ul><li>Negative sign (IED < 0) </li></ul></ul><ul><ul><ul><li>Inferior goods </li></ul></ul></ul>
  • 40. Cross-Price Elasticity of Demand (CED) <ul><li>Definition: </li></ul><ul><ul><li>Measure of the response of the quantity of one good demanded to a change in the price of another good. </li></ul></ul><ul><li>Formula : </li></ul><ul><li>Uses : </li></ul><ul><ul><li>Positive sign (CED > 0) </li></ul></ul><ul><ul><li>Substitute Product (E.g: butter and margarine) </li></ul></ul><ul><ul><li>Negative sign (CED < 0) </li></ul></ul><ul><ul><li>Complementary product (E.g: Pen and Ink) </li></ul></ul>
  • 41. Price Elasticity of Supply (PES) <ul><li>Definition : </li></ul><ul><ul><li>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. </li></ul></ul><ul><li>Formula : </li></ul>
  • 42. Price Elasticity of Supply
  • 43. <ul><li>Refresh </li></ul><ul><li>Your </li></ul><ul><li>Mind </li></ul>
  • 44. 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 .
  • 45. 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
  • 46. THANK YOU

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