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Week 4: Elasticities & economic efficiency

This week we finish off our discussion of the elasticity idea by looking at cross price and income elasticities as well as elasticities of supply. This is straightforward work though there is a fair bit of economics language to learn.

By the way if you can start to use the supply and demand model to analyse problems and know something about elasticities you can already do quite a bit of economics. One problem, posed by a student in class was, what will happen to competitive market in cars if cost-savings technologies result in a cheaper although better-equipped vehicle*? If you can answer this accurately using the elasticity idea you have come a long way in 3 weeks!

Having completed our discussion of how market equilibrium is determined we begin to look at normative characteristics of markets – roughly how ‘socially good’ are free markets? To answer this we proceed in several stages:

We ask what the dollar value of benefits consumers get from participating in markets and measure this as their consumers’ surplus.

Similarly we measure the dollar value of benefits vendors get from participating in markets as their sellers’ or producers’ surplus.

Then social surplus measures the dollar value of benefits consumers and producers get together – the sum of their consumer and producer surpluses.

We then characterise our idea of ‘socially good’ in terms of the efficiency idea.

Definition: A market is efficient if the price prevailing in the market maximises the dollar value of social surplus delivered by the market.

This definition is a particular instance of the earlier definition of Pareto efficiency given – that resources cannot be redistributed toward making one person better off without making anyone else worse off.

We then have a big result:

First Theorem of Welfare Economics (for a single market). Charging the free market price for which supply=demand maximises social surplus.

Then charging any other price than this (by price support or maximum price schemes) or leving a sales tax on a good (and accounting for revenue benefits to government) always reduces the social surplus generated. The reduction in social surplus here from the maximum level is called a deadweight loss.

We will prove that the first theorem is true and we will examine some applications of it by calculating deadweight losses in markets where it does hold.

NOW YOU ARE REALLY DOING SOME INTERESTING ECONOMICS! You can now analyse how markets do work (a positive question) and also make judgements about how well they work (a normative issue).

* The cost reduction shifts the supply curve right and the improvement in quality shifts the demand curve right. Thus the quantity of cars will certainly increase. What will happen to price? That depends on which curve shifts furthest. If the supply curve shifts furthest so the cost reduction effects dominate then price will fall – this is what seems to have happened over the past 20 years in Australia. You can come up with more specific insights here by discussing the elasticities of the respective supply and demand curves.

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