Microeconomics Study Guide: Market Equilibrium, Elasticity, and Government Intervention

Market Equilibrium

Understanding Market Equilibrium

Market equilibrium occurs where the quantity demanded equals the quantity supplied, resulting in a stable market price and quantity. This is a fundamental concept in microeconomics, as it determines how resources are allocated in a market.

• Equilibrium Price (P*): The price at which quantity demanded (Qd) equals quantity supplied (Qs).

• Equilibrium Quantity (Q*): The quantity bought and sold at the equilibrium price.

• Shortage: Occurs when Qd > Qs, causing upward pressure on price.

• Surplus: Occurs when Qs > Qd, causing downward pressure on price.

Example: If P = $6, Qd is less than Qs, resulting in a surplus. If P = $14, Qd is greater than Qs, resulting in a shortage.

Government Intervention in Markets

Taxes and Subsidies

Governments can intervene in markets by imposing taxes or providing subsidies, which affect equilibrium price and quantity, as well as the distribution of benefits and burdens between buyers and sellers.

Tax on Sellers

• Without Tax: Find equilibrium P* and Q*.

• With Tax: A tax shifts the supply curve upward by the amount of the tax. New equilibrium price and quantity are determined where the new supply curve intersects the demand curve.

• Buyers' Price (Pb): The price buyers pay after tax.

• Sellers' Price (Ps): The price sellers receive after tax.

• Tax Burden: The division of the tax between buyers and sellers depends on the relative elasticities of demand and supply.

Formula: $P_b - P_s = ext{Tax}$

Tax on Buyers

• Without Tax: Find equilibrium P* and Q*.

• With Tax: A tax shifts the demand curve downward by the amount of the tax. New equilibrium is found at the intersection of the new demand curve and the supply curve.

• Tax Burden: Similar principles apply as with a tax on sellers.

Subsidy to Sellers

• Without Subsidy: Find equilibrium P* and Q*.

• With Subsidy: A subsidy shifts the supply curve downward by the amount of the subsidy, increasing equilibrium quantity and lowering the price buyers pay.

• Subsidy Benefit: The benefit is shared between buyers and sellers depending on elasticities.

Formula: $P_s - P_b = ext{Subsidy}$

Subsidy to Buyers

• Without Subsidy: Find equilibrium P* and Q*.

• With Subsidy: A subsidy shifts the demand curve upward by the amount of the subsidy, increasing equilibrium quantity and raising the price sellers receive.

Price Ceilings and Price Floors

Price controls are government-imposed limits on how high or low a price can be charged for a product.

Price Ceiling

• Definition: A maximum price set below the equilibrium price.

• Effect: Causes a shortage if set below equilibrium, as Qd > Qs.

• Example: If the regulated price is above equilibrium, it has no effect. If below, it is binding and creates a shortage.

Price Floor

• Definition: A minimum price set above the equilibrium price.

• Effect: Causes a surplus if set above equilibrium, as Qs > Qd.

• Example: If the regulated price is below equilibrium, it has no effect. If above, it is binding and creates a surplus.

Production Quota

• Definition: A limit on the quantity of a good that can be produced.

• Effect: Reduces supply, increases price, and decreases quantity sold.

• Comparison: Quotas restrict quantity directly, while price floors affect quantity indirectly through price.

Elasticity

Price Elasticity of Demand

Price elasticity of demand measures how much the quantity demanded of a good responds to a change in its price.

• Formula: $e_d = \frac{\% \text{ Change in Quantity Demanded}}{\% \text{ Change in Price}}$

• Calculation Steps:

  1. Calculate % change in Qd: $\frac{\text{Change in Qd}}{\text{Average Qd}} \times 100\%$

  2. Calculate % change in P: $\frac{\text{Change in P}}{\text{Average P}} \times 100\%$

  3. Divide % change in Qd by % change in P.

• Interpretation:

  • $e_d > 1$: Demand is elastic (quantity demanded changes more than price).

  • $e_d < 1$: Demand is inelastic (quantity demanded changes less than price).

  • $e_d = 1$: Unit elastic.

Example: If price falls from $16 to $14 and quantity increases, calculate elasticity using the above steps.

Elasticity and Total Revenue

The relationship between price elasticity of demand and total revenue (TR) is crucial for understanding pricing strategies.

• Total Revenue: $TR = P \times Q$

• Elastic Demand ($e_d > 1$): Price decrease increases TR; price increase decreases TR.

• Inelastic Demand ($e_d < 1$): Price decrease decreases TR; price increase increases TR.

• Unit Elastic ($e_d = 1$): TR remains unchanged with price changes.

Value of Price Elasticity	Demand is...	Impact of a change in Price
Larger Than 1	Elastic	P decreases: TR increases P increases: TR decreases
Smaller Than 1	Inelastic	P decreases: TR decreases P increases: TR increases
Equal to 1	Unit Elastic	P changes: TR unchanged

Types of Elasticity

• Income Elasticity of Demand ($e_Y$): Measures responsiveness of demand to changes in income.

  • $e_Y = \frac{\% \text{ Change in Qd}}{\% \text{ Change in Income}}$

  • Normal goods: $e_Y > 0$

  • Inferior goods: $e_Y < 0$

  • Luxury goods: $e_Y > 1$

• Cross Price Elasticity of Demand ($e_{xy}$): Measures responsiveness of demand for one good to changes in the price of another good.

  • $e_{xy} = \frac{\% \text{ Change in Qd of Good X}}{\% \text{ Change in Price of Good Y}}$

  • Substitutes: $e_{xy} > 0$

  • Complements: $e_{xy} < 0$

Elastic vs. Inelastic Demand Examples

Elastic Demand	Inelastic Demand
Fresh tomatoes (4.60) Movies (4.41) Lamb (2.65) Restaurant meals (1.60) China/tableware (1.54) Automobiles (1.14)	Household electricity (0.13) Eggs (0.32) Car repairs (0.36) Food (0.58) Household appliances (0.63) Tobacco (0.86)

Shifts in Supply and Demand

Changes in Market Conditions

Supply and demand curves can shift due to changes in factors such as technology, consumer preferences, and government policies.

• Increase in Supply: Supply curve shifts right; equilibrium price falls, quantity rises.

• Decrease in Supply: Supply curve shifts left; equilibrium price rises, quantity falls.

• Increase in Demand: Demand curve shifts right; equilibrium price and quantity rise.

• Decrease in Demand: Demand curve shifts left; equilibrium price and quantity fall.

Change	Price	Quantity
Increase in Demand	Increase	Increase
Decrease in Demand	Decrease	Decrease
Increase in Supply	Decrease	Increase
Decrease in Supply	Increase	Decrease

Applications and Examples

Market	Changes	Effect on Market
DVDs	New processing method reduces costs; more consumers download music	Supply increases, demand decreases
Organic vegetables	Vegetarianism increases; tighter regulations	Demand increases, supply decreases
Day-care services	More mothers return to work; subsidies introduced	Demand increases, supply increases

Summary Table: Elasticity and Revenue

Elasticity Value	Demand is...	Impact on Revenue
> 1	Elastic	Price decrease: Revenue increases Price increase: Revenue decreases
< 1	Inelastic	Price decrease: Revenue decreases Price increase: Revenue increases
= 1	Unit Elastic	Revenue unchanged

Key Formulas

• Price Elasticity of Demand: $e_d = \frac{\% \text{ Change in Qd}}{\% \text{ Change in P}}$

• Income Elasticity of Demand: $e_Y = \frac{\% \text{ Change in Qd}}{\% \text{ Change in Income}}$

• Cross Price Elasticity of Demand: $e_{xy} = \frac{\% \text{ Change in Qd of X}}{\% \text{ Change in Price of Y}}$

• Total Revenue: $TR = P \times Q$

Additional info: Some context and definitions have been expanded for clarity and completeness, including the effects of government intervention and the interpretation of elasticity values.