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IB Economics SL: City Honors School IB Economics SL Unit 1: Microeconomics Mr. R.S. Pyszczek, Jr. City Honors School IB Economics SL: City Honors School Unit 1: Microeconomics Scarcity* The basic economic problem that arises because people have unlimited wants but resources are limited. Because of scarcity, various economic decisions must be made to allocate resources efficiently. IB Economics SL: City Honors School Unit 1: Microeconomics Scarcity When we talk of scarcity within an economic context, it refers to limited resources, not a lack of riches. These resources are the inputs of production: land, labor and capital. People must make choices between different items because the resources necessary to fulfill their wants are limited. These decisions are made by giving up (trading off) one want to satisfy another. IB Economics SL: City Honors School Unit 1: Microeconomics 4 Factors of Production* Land: real estate, property, factories Labor: workers, hourly and salary Capital: money and capital goods Entrepreneur: Who is starting up the company? IB Economics SL: City Honors School Unit 1: Microeconomics 3 Basic Economic Questions We All Must Answer. * 1. What to Produce? 2. How to Produce? 3. For Whom to Produce? IB Economics SL: City Honors School Unit 1: Microeconomics 3 Basic Economic Questions We All Must Answer. What to Produce?* Consumer Goods: i.e. Pickup Trucks Capital Goods: i.e. Garbage Trucks IB Economics SL: City Honors School Unit 1: Microeconomics 3 Basic Economic Questions We All Must Answer. How to Produce?* In a factory? Quicker & less expensive Handcrafted or Handmade? Longer and more expensive IB Economics SL: City Honors School Unit 1: Microeconomics 3 Basic Economic Questions We All Must Answer. For whom to Produce?* High end or niche clientele i.e Ferrari, Maybach, Middle Class-Upper Middle class i.e. Cadillac, BMW, Benz Entry level-Middle class i.e Chevy, Honda, Toyota IB Economics SL: City Honors School Unit 1: Microeconomics 3 Basic Economic Questions We All Must Answer. For whom to Produce?* Nissan make Infiniti or Toyota make Lexus or Honda makes Acura GM makes Cadillac and Chevy Ford also make Lincoln brand autos. IB Economics SL: City Honors School Unit 1: Microeconomics 1.1 Competitive Markets: Demand and Supply Markets The Nature of Markets Outline the meaning of the term market. What is a market? Cite Examples. How have markets changed in the last 10 years? IB Economics SL: City Honors School Unit 1: Microeconomics Demand The Law of Demand The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope. IB Economics SL: City Honors School Unit 1: Microeconomics Demand The Law of Demand* (2.2 pgs 27-30) Explain the negative causal relationship between price and quantity demanded. Price goes Up, Demand goes Down Demand goes Up, Price goes Down Describe the relationship between an individual consumer’s demand and market demand. IB Economics SL: City Honors School Unit 1: Microeconomics The Demand Curve Explain that a demand curve represents the relationship between the price and the quantity demanded of a product, ceteris paribus. Draw a demand curve. IB Economics SL: City Honors School Unit 1: Microeconomics The Demand Curve* What kind of slope does it have? Why is that so? IB Economics SL: City Honors School Unit 1: Microeconomics The Demand Curve The Non-Price Determinants of Demand (Factors that Change Demand or Shift the Demand Curve) 2.3 pgs 30-34 Explain how factors including changes in income (in the cases of normal and inferior goods), preferences, prices of related goods (in the cases of substitutes and complements) and demographic changes may change demand. IB Economics SL: City Honors School Unit 1: Microeconomics The Demand Curve The Non-Price Determinants of Demand (Factors that Change Demand or Shift the Demand Curve)* Substitute: A product or service that satisfies the need of a consumer that another product or service fulfills. A substitute can be perfect or imperfect depending on whether the substitute completely or partially satisfies the consumer. A consumer might consider Pepsi to be a perfect substitute for Coke, or Land O'Lakes butter to be a perfect substitute for Kerrygold Irish Butter. However, if a consumer sees a difference in these brands, he may see Pepsi and Land O'Lakes as imperfect substitutes, even if economists might consider them perfect substitutes. IB Economics SL: City Honors School Unit 1: Microeconomics The Demand Curve The Non-Price Determinants of Demand (Factors that Change Demand or Shift the Demand Curve)* Compliment: A good or service that is used in conjunction with another good or service. Usually, the complementary good has little to no value when consumed alone but, when combined with another good or service, it adds to the overall value of the offering. Also, good tends to have more value when paired with a complement than it does by itself. Complimentary Goods: i.e. Milk & Cereal, Hot Dogs & Buns, Soda and Chips IB Economics SL: City Honors School Unit 1: Microeconomics The Demand Curve Movements Along and Shifts of the Demand Curve Distinguish between movements along the demand curve and shifts of the demand curve. Draw diagrams to show the difference between movements along the demand curve and shifts of the demand curve. IB Economics SL: City Honors School Unit 1: Microeconomics The Demand Curve What do these movements show? Why is that so? IB Economics SL: City Honors School Unit 1: Microeconomics The Demand Curve What do these shifts show? Why is that so? IB Economics SL: City Honors School Unit 1: Microeconomics Shifts vs. Movement For economics, the "movements" and "shifts" in relation to the supply and demand curves represent very different market phenomena: IB Economics SL: City Honors School Unit 1: Microeconomics Shifts vs. Movement Movements A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa. IB Economics SL: City Honors School Unit 1: Microeconomics Shifts vs. Movement Shifts A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption. IB Economics SL: City Honors School Unit 1: Microeconomics Supply The Law of Supply (2.5 pgs 40-42) Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.. IB Economics SL: City Honors School Unit 1: Microeconomics Supply The Law of Supply* Explain the positive causal relationship between price and quantity supplied. Price goes Up, Supply stays Up Price goes Down, Supply goes Down Describe the relationship between an individual producer’s supply and market supply. IB Economics SL: City Honors School Unit 1: Microeconomics The Supply Curve Explain that a supply curve represents the relationship between the price and the quantity supplied of a product, ceteris paribus. Draw a supply curve. IB Economics SL: City Honors School Unit 1: Microeconomics The Supply Curve* What kind of slope does it have? Why is that so? IB Economics SL: City Honors School Unit 1: Microeconomics The Non-Price Determinants of Supply (factors that change supply or shift the supply curve) 2.6 pgs 42-47 Explain how factors including changes in costs of factors of production (land, labour, capital and entrepreneurship), technology, prices of related goods (joint/competitive supply), expectations, indirect taxes and subsidies and the number of firms in the market can change supply. IB Economics SL: City Honors School Unit 1: Microeconomics The Non-Price Determinants of Supply (factors that change supply or shift the supply curve)* Will Apple still supply as many iphone 5’s as before? Will Sony still produce VCRs? Will new cars come with Cassette Tape decks? So what is the biggest manipulator of Supply? IB Economics SL: City Honors School Unit 1: Microeconomics Movements Along and Shifts of the Supply Curve Distinguish between movements along the supply curve and shifts of the supply curve. Construct diagrams to show the difference between movements along the supply curve and shifts of the supply curve. IB Economics SL: City Honors School Unit 1: Microeconomics The Supply Curve What do these movements show? Why is that so? IB Economics SL: City Honors School Unit 1: Microeconomics The Supply Curve What do these shifts show? Why is that so? IB Economics SL: City Honors School Unit 1: Microeconomics Shifts vs. Movement For economics, the "movements" and "shifts" in relation to the supply and demand curves represent very different market phenomena: IB Economics SL: City Honors School Unit 1: Microeconomics Shifts vs. Movement Movements A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa. IB Economics SL: City Honors School Unit 1: Microeconomics Shifts vs. Movement Shifts A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption. IB Economics SL: City Honors School Unit 1: Microeconomics Market Equilibrium Equilibrium and Changes to Equilibrium (3.1 pgs 53-57) Explain, using diagrams, how demand and supply interact to produce market equilibrium. Analyze, using diagrams and with reference to excess demand or excess supply, how changes in the determinants of demand and/or supply result in a new market equilibrium. IB Economics SL: City Honors School Unit 1: Microeconomics Equilibrium* When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at Equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding. IB Economics SL: City Honors School Unit 1: Microeconomics What do you notice about this Graph?* IB Economics SL: City Honors School Unit 1: Microeconomics As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity. In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply. IB Economics SL: City Honors School Unit 1: Microeconomics The Role of the Price Mechanism Resource Allocation (3.3 pgs 64-66) Explain why scarcity necessitates choices that answer the “What to produce?” question. Explain why choice results in an opportunity cost. Explain, using diagrams, that price has a signaling function and an incentive function, which result in a reallocation of resources when prices change as a result of a change in demand or supply conditions. IB Economics SL: City Honors School Unit 1: Microeconomics The Role of the Price Mechanism Opportunity Cost* 1. The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action. 2. The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment - say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% - 2%). IB Economics SL: City Honors School Unit 1: Microeconomics The Role of the Price Mechanism Opportunity Cost The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages. Here's another example: if a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.). In both cases, a choice between two options must be made. It would be an easy decision if you knew the end outcome; however, the risk that you could achieve greater "benefits" (be they monetary or otherwise) with another option is the opportunity cost. IB Economics SL: City Honors School Unit 1: Microeconomics Market Efficiency Consumer Surplus Explain the concept of consumer surplus. Identify consumer surplus on a demand and supply diagram. IB Economics SL: City Honors School Unit 1: Microeconomics Market Efficiency Consumer Surplus* An economic measure of consumer satisfaction, which is calculated by analyzing the difference between what consumers are willing to pay for a good or service relative to its market price. A consumer surplus occurs when the consumer is willing to pay more for a given product than the current market price. IB Economics SL: City Honors School Unit 1: Microeconomics Market Efficiency Consumer Surplus Consumers always like to feel like they are getting a good deal on the goods and services they buy and consumer surplus is simply an economic measure of this satisfaction. For example, assume a consumer goes out shopping for an MP3 player and he or she is willing to spend $250. When this individual finds that the player is on sale for $150, economists would say that this person has a consumer surplus of $100. IB Economics SL: City Honors School Unit 1: Microeconomics Market Efficiency Consumer Surplus Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price). Consumer surplus is shown by the area under the demand curve and above the equilibrium price as in the diagram below.. IB Economics SL: City Honors School Unit 1: Microeconomics Market Efficiency Consumer Surplus Consumer surplus and price elasticity of demand When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that people pay matches what they are willing to pay. In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand does not respond to a price change. Whatever the price, the quantity demanded remains the same. Are there any examples of products that have such zero price elasticity of demand? The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product. This is shown in the next diagram. IB Economics SL: City Honors School Unit 1: Microeconomics Market Efficiency Producer Surplus Explain the concept of producer surplus. Identify producer surplus on a demand and supply diagram. IB Economics SL: City Honors School Unit 1: Microeconomics Market Efficiency Producer Surplus* An economic measure of the difference between the amount that a producer of a good receives and the minimum amount that he or she would be willing to accept for the good. The difference, or surplus amount, is the benefit that the producer receives for selling the good in the market. IB Economics SL: City Honors School Unit 1: Microeconomics Market Efficiency Producer Surplus For example, say a producer is willing to sell 500 widgets at $5 a piece and consumers are willing to purchase these widgets for $8 per widget. If the producer sells all of the widgets to consumers for $8, it will receive $4,000. To calculate the producer surplus, you subtract the amount the producer received by the amount it was willing to accept, (in this case $2,500), and you find a producer surplus of $1,500 ($4,000 - $2,500). IB Economics SL: City Honors School Unit 1: Microeconomics Market Efficiency Producer Surplus* Shown here graphically is the area (Producer Surplus) above the producer's supply curve that it receives at the price point (P(i)). The size of this area increases as the price for the good increases. IB Economics SL: City Honors School Unit 1: Microeconomics Market Efficiency Producer Surplus The level of producer surplus is shown by the area above the supply curve and below the market price and is illustrated in the diagram below Pm is the minimum price that this producer requires to supply the product to the market As the price rises, there is a great incentive to supply – production will expand as a business moves up their supply curve Assuming the the market has reached an equilibrium at quantity Q1 and price P1, then the level of producer surplus is shown by the shaded/labeled area. Total revenue = price per unit x quantity sold = P1 x Q1 IB Economics SL: City Honors School Unit 1: Microeconomics Market Efficiency Allocative Efficiency Explain that the best allocation of resources from society’s point of view is at competitive market equilibrium, where social (community) surplus (consumer surplus and producer surplus) is maximized (marginal benefit = marginal cost). IB Economics SL: City Honors School Unit 1: Microeconomics Theory of Knowledge: Potential Connections To what extent is it true to say that a demand curve is a fictional entity? What assumptions underlie the law of demand? Are these assumptions likely to be true? Does it matter if these assumptions are actually false? IB Economics SL: City Honors School Unit 1: Microeconomics 1.2 Elasticity Price Elasticity of Demand (PED) (4.1 pgs 72-73) Price Elasticity of Demand and its Determinants Explain the concept of price elasticity of demand, understanding that it involves responsiveness of quantity demanded to a change in price, along a given demand curve. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) The degree to which a demand or supply curve reacts to a change in price is the curve's elasticity. Elasticity varies among products because some products may be more essential to the consumer. Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price increases. Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product will become too high. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Price Elasticity of Demand and its Determinants* (4.2 pgs 73-75) Calculate PED using the following equation: PED = percentage change in quantity demanded percentage change in price . If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Values for price elasticity of demand If Ped = 0 demand is perfectly inelastic - demand does not change at all when the price changes – the demand curve will be vertical. If Ped is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the percentage change in price), then demand is inelastic. If Ped = 1 (i.e. the % change in demand is exactly the same as the % change in price), then demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at each price level. If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For example if a 10% increase in the price of a good leads to a 30% drop in demand. The price elasticity of demand for this price change is –3 IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Price Elasticity of Demand and its Determinants State that the PED value is treated as if it were positive although its mathematical value is usually negative. Explain, using diagrams and PED values, the concepts of price elastic demand, price inelastic demand, unit elastic demand, perfectly elastic demand and perfectly inelastic demand. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Price Elasticity of Demand and its Determinants* A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Price Elasticity of Demand and its Determinants Explain the determinants of PED, including the number and closeness of substitutes, the degree of necessity, time and the proportion of income spent on the good. Calculate PED between two designated points on a demand curve using the PED equation above. Explain why PED varies along a straight line demand curve and is not represented by the slope of the demand curve. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Factors affecting price elasticity of demand The number of close substitutes – the more close substitutes there are in the market, the more elastic is demand because consumers find it easy to switch The cost of switching between products – there may be costs involved in switching. In this case, demand tends to be inelastic. For example, mobile phone service providers may insist on a12 month contract. The degree of necessity or whether the good is a luxury – necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Factors affecting price elasticity of demand The proportion of a consumer’s income allocated to spending on the good – products that take up a high % of income will have a more elastic demand The time period allowed following a price change – demand is more price elastic, the longer that consumers have to respond to a price change. They have more time to search for cheaper substitutes and switch their spending. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Factors affecting price elasticity of demand Whether the good is subject to habitual consumption – consumers become less sensitive to the price of the good of they buy something out of habit (it has become the default choice). Peak and off-peak demand - demand is price inelastic at peak times and more elastic at off-peak times – this is particularly the case for transport services. The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Price Elasticity of Demand and its Determinants* As we mentioned previously, the demand curve is a negative slope, and if there is a large decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or service in question is elastic. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Price Elasticity of Demand and its Determinants* Meanwhile, inelastic demand is represented with a much more upright curve as quantity changes little with a large movement in price. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Values for price elasticity of demand If Ped = 0 demand is perfectly inelastic - demand does not change at all when the price changes – the demand curve will be vertical. If Ped is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the percentage change in price), then demand is inelastic. If Ped = 1 (i.e. the % change in demand is exactly the same as the % change in price), then demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at each price level. If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For example if a 10% increase in the price of a good leads to a 30% drop in demand. The price elasticity of demand for this price change is –3 IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Factors affecting price elasticity of demand The number of close substitutes – the more close substitutes there are in the market, the more elastic is demand because consumers find it easy to switch The cost of switching between products – there may be costs involved in switching. In this case, demand tends to be inelastic. For example, mobile phone service providers may insist on a12 month contract. The degree of necessity or whether the good is a luxury – necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand. The proportion of a consumer’s income allocated to spending on the good – products that take up a high % of income will have a more elastic demand IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Factors affecting price elasticity of demand The time period allowed following a price change – demand is more price elastic, the longer that consumers have to respond to a price change. They have more time to search for cheaper substitutes and switch their spending. Whether the good is subject to habitual consumption – consumers become less sensitive to the price of the good of they buy something out of habit (it has become the default choice). Peak and off-peak demand - demand is price inelastic at peak times and more elastic at off-peak times – this is particularly the case for transport services. The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Demand (PED) Demand curves with different price elasticity of demand IB Economics SL: City Honors School Unit 1: Microeconomics Cross Price Elasticity of Demand (XED) Cross Price Elasticity of Demand and its Determinants (4.4 pgs 83-87) Outline the concept of cross price elasticity of demand, understanding that it involves responsiveness of demand for one good (and hence a shifting demand curve) to a change in the price of another good. Calculate XED using the following equation: XED = percentage change in quantity demanded of good x percentage change in price of good y IB Economics SL: City Honors School Unit 1: Microeconomics Cross Price Elasticity of Demand (XED) Cross Price Elasticity of Demand and its Determinants Show that substitute goods have a positive value of XED and complementary goods have a negative value of XED. Explain that the (absolute) value of XED depends on the closeness of the relationship between two goods. IB Economics SL: City Honors School Unit 1: Microeconomics Cross Price Elasticity of Demand (XED) Cross Price Elasticity of Demand and its Determinants Show that substitute goods have a positive value of XED and complementary goods have a negative value of XED. Explain that the (absolute) value of XED depends on the closeness of the relationship between two goods. IB Economics SL: City Honors School Unit 1: Microeconomics Cross price elasticity of demand – analysis diagrams IB Economics SL: City Honors School Unit 1: Microeconomics Cross Price Elasticity of Demand (XED) Cross Price Elasticity of Demand and its Determinants Cross price elasticity (XED) measures the responsiveness of demand for good X following a change in the price of a related good Y. We are looking here at the effect that changes in relative prices within a market have on the pattern of demand. IB Economics SL: City Honors School Unit 1: Microeconomics Cross Price Elasticity of Demand (XED) Applications of Cross Price Elasticity of Demand Examine the implications of XED for businesses if prices of substitutes or complements change. Cross price elasticity (XED) measures the responsiveness of demand for good X following a change in the price of a related good Y. We are looking here at the effect that changes in relative prices within a market have on the pattern of demand. With cross elasticity we make a distinction between substitute and complementary products. IB Economics SL: City Honors School Unit 1: Microeconomics Cross Price Elasticity of Demand (XED) Cross Price Elasticity of Demand and its Determinants Substitutes:* With substitute goods such as brands of cereal, an increase in the price of one good will lead to an increase in demand for the rival product. The cross price elasticity for two substitutes will be positive. For example, the iPhone now provides genuine competition for the PC/Computer in providing users with ‘push technology’ to send all emails through to a mobile device. Another good example is the cross price elasticity of demand for music. Sales of digital music downloads have been soaring with the growth of broadband and falling prices for downloads. As a result, sales of traditional music CD’s are declining at a steep rate. IB Economics SL: City Honors School Unit 1: Microeconomics Cross Price Elasticity of Demand (XED) Cross Price Elasticity of Demand and its Determinants Complements:* Complements are in joint demand The XED for two complements is negative. The stronger the relationship between two products, the higher is the co-efficient of cross-price elasticity of demand. When there is a strong complementary relationship between two products, the cross-price elasticity will be highly negative. An example might be games consoles and software games IB Economics SL: City Honors School Unit 1: Microeconomics Cross Price Elasticity of Demand (XED) Cross Price Elasticity of Demand and its Determinants Pricing for complementary goods:* Popcorn, soft drinks and cinema tickets have a high negative value for cross elasticity– they are strong complements Popcorn has a high markup i.e. pop corn costs pennies to make but sells for more than a pound. If firms have a reliable estimate for XED they can estimate the effect, say, of a two-for-one cinema ticket offer on the demand for popcorn. The additional profit from extra popcorn sales may more than compensate for the lower cost of entry into the cinema. For some movie theatres, the revenue from concessions stalls selling popcorn; drinks and other refreshments can generate as much as 40 per cent of their annual turnover IB Economics SL: City Honors School Unit 1: Microeconomics Income Elasticity of Demand (YED) Income Elasticity of Demand and its Determinants (4.5 Pg 87-90) Outline the concept of income elasticity of demand, understanding that it involves responsiveness of demand (and hence a shifting demand curve) to a change in income. Calculate YED using the following equation: YED = percentage change in quantity demanded percentage change in income IB Economics SL: City Honors School Unit 1: Microeconomics Income Elasticity of Demand (YED) Income Elasticity of Demand and its Determinants Show that normal goods have a positive value of YED and inferior goods have a negative value of YED. Distinguish, with reference to YED, between necessity (income inelastic) goods and luxury (income elastic) goods. IB Economics SL: City Honors School Unit 1: Microeconomics Income Elasticity of Demand (YED) Normal Goods* Normal goods have a positive income elasticity of demand so as consumers’ income rises more is demanded at each price i.e. there is an outward shift of the demand curve Normal necessities have an income elasticity of demand of between 0 and +1 for example, if income increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.4. Demand is rising less than proportionately to income. Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more than proportionate to a change in income – for example a 8% increase in income might lead to a 10% rise in the demand for new kitchens. The income elasticity of demand in this example is +1.25. IB Economics SL: City Honors School Unit 1: Microeconomics Income Elasticity of Demand (YED) Inferior Goods* Inferior goods have a negative income elasticity of demand meaning that demand falls as income rises. Typically inferior goods or services exist where superior goods are available if the consumer has the money to be able to buy it. Examples include the demand for cigarettes, low-priced own label foods in supermarkets and the demand for council-owned properties. IB Economics SL: City Honors School Unit 1: Microeconomics Income Elasticity of Demand (YED) The income elasticity of demand is usually strongly positive for Fine wines and spirits, high quality chocolates and luxury holidays overseas. Sports cars Consumer durables - audio visual equipment, smart-phones Sports and leisure facilities (including gym membership and exclusive sports clubs). IB Economics SL: City Honors School Unit 1: Microeconomics Income Elasticity of Demand (YED) In contrast, income elasticity of demand is lower for Staple food products such as bread, vegetables and frozen foods. Mass transport (bus and rail). Beer and takeaway pizza! Income elasticity of demand is negative (inferior) for cigarettes and urban bus services. IB Economics SL: City Honors School Unit 1: Microeconomics Income Elasticity of Demand (YED) Product ranges and longer term trends Income elasticity of demand will vary within a product range. For example the PED for own-label foods in supermarkets is less for the high-value “finest” food ranges. There is a general downward trend in the income elasticity of demand for many basic products, particularly foodstuffs. One reason is that as a society becomes richer, there are changes in tastes and preferences. What might have been considered a luxury good several years ago might now be regarded as a necessity? How many of you regard a NFL sports subscription or an iPhone, an iPad or a new laptop as a necessity? IB Economics SL: City Honors School Unit 1: Microeconomics Income Elasticity of Demand (YED) Applications of Income Elasticity of Demand Examine the implications for producers and for the economy of a relatively low YED for primary products, a relatively higher YED for manufactured products and an even higher YED for services. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Supply (PES) Price Elasticity of Supply and its Determinants (4.6 pgs 90-94) Explain the concept of price elasticity of supply, understanding that it involves responsiveness of quantity supplied to a change in price along a given supply curve. Calculate PES using the following equation: PES = percentage change in quantity supplied percentage change in price IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Supply (PES) Price Elasticity of Supply and its Determinants Price elasticity of supply (PES) measures the relationship between change in quantity supplied and a change in price. If supply is elastic, producers can increase output without a rise in cost or a time delay If supply is inelastic, firms find it hard to change production in a given time period. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Supply (PES) Price Elasticity of Supply and its Determinants Explain, using diagrams and PES values, the concepts of elastic supply, inelastic supply, unit elastic supply, perfectly elastic supply and perfectly inelastic supply. Explain the determinants of PES, including time, mobility of factors of production, unused capacity and ability to store stocks. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Supply (PES) Price Elasticity of Supply and its Determinants The formula for price elasticity of supply is: Percentage change in quantity supplied divided by the percentage change in price When Pes > 1, then supply is price elastic When Pes < 1, then supply is price inelastic When Pes = 0, supply is perfectly inelastic When Pes = infinity, supply is perfectly elastic following a change in demand IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Supply (PES) Applications of Price Elasticity of Supply Explain why the PES for primary commodities is relatively low and the PES for manufactured products is relatively high. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Supply (PES) Applications of Price Elasticity of Supply What factors affect the elasticity of supply? Spare production capacity: If there is plenty of spare capacity then a business can increase output without a rise in costs and supply will be elastic in response to a change in demand. The supply of goods and services is most elastic during a recession, when there is plenty of spare labour and capital resources. Stocks of finished products and components: If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand - supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher because of scarcity in the market.. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Supply (PES) Applications of Price Elasticity of Supply What factors affect the elasticity of supply? The ease and cost of factor substitution: If both capital and labour are occupationally mobile then the elasticity of supply for a product is higher than if capital and labour cannot easily be switched. A good example might be a printing press which can switch easily between printing magazines and greetings cards. Time period and production speed: Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels. In some agricultural markets the momentary supply is fixed and is determined mainly by planting decisions made months before, and also climatic conditions, which affect the production yield. In contrast the supply of milk is price elastic because of a short time span from cows producing milk and products reaching the market place. IB Economics SL: City Honors School Unit 1: Microeconomics Price Elasticity of Supply (PES) IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Indirect Taxes (5.1 pgs 98-100) Specific (fixed amount) Taxes and Ad Valorem (percentage) Taxes and their Impact on Markets Explain why governments impose indirect (excise) taxes. Distinguish between specific and ad valorem taxes. Draw diagrams to show specific and ad valorem taxes, and analyze their impacts on market outcomes. Discuss the consequences of imposing an indirect tax on the stakeholders in a market, including consumers, producers and the government. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Indirect Taxes Specific (fixed amount) Taxes their Impact on Markets A tax charged a specific amount to be paid for every unit of a good sold. Specific state and federal taxes are also known as ”per unit tax". IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Indirect Taxes Specific (fixed amount) Taxes Examples: Gas Taxes (roughly $1.00 a gallon in NYS) Cigarette Taxes (per pack charge)* Alcohol Taxes (Per Bottle, Case, Barrel charge)* *AKA Sin Taxes IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Indirect Taxes Ad Valorem (percentage) Taxes and their Impact on Markets A tax based on the assessed value of real estate or personal property. Ad valorem taxes can be property tax or even duty on imported items. Property ad valorem taxes are the major source of revenue for state and municipal governments. Municipal property ad valorem taxes are also known as "property taxes". IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Indirect Taxes Ad Valorem (percentage) Taxes Examples: Suburban Property Taxes in WNY (School Levy) Social Security Taxes/FICA 15% (7.5% Individual & 7.5% Employer) Sales Taxes 8.75% in Erie County (NYS Tax is capped at 7%) Property Transfer Taxes (Funding for NFTA) IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies (5.3 pgs 107-112) Impact on Markets Explain why governments provide subsidies, and describe examples of subsidies. Draw a diagram to show a subsidy, and analyse the impacts of a subsidy on market outcomes. Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies* Impact on Markets A Subsidy is a payment from the government to an individual or a firm for the purpose of increasing the purchase or a supply of a good. See Figure 5.9 Subsidy: Simple Case IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies* Impact on Markets The Supply Curve Shifts Right (Downward) by the amount of the Subsidy. Consumers spend less (and get more) than before Increases consumer surplus because it lowers the price paid Producers benefit by receiving much more revenue. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies* Different Types of Producer Subsidy A guaranteed payment on the factor cost of a product – e.g. a guaranteed minimum price offered to farmers such as under the old-style Common Agricultural Policy (CAP). An input subsidy which subsidises the cost of inputs used in production – e.g. an employment subsidy for taking on more workers. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies* Different Types of Producer Subsidy Government grants to cover losses made by a business – e.g. a grant given to cover losses in the railway industry or a loss-making airline. Bail-outs e.g. for financial organisations in the wake of the credit crunch Financial assistance (loans and grants) for businesses setting up in areas of high unemployment – e.g. as part of a regional policy designed to boost employment. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies* Economic and Social Justifications for Subsidies Why might the government be justified in providing financial assistance to producers in certain markets and industries? How valid are the arguments for government subsidies? To keep prices down and control inflation – in the last couple of years several countries have been offering fuel subsidies to consumers and businesses in the wake of the steep increase in world crude oil prices. To encourage consumption of merit goods and services which are said to generate positive externalities (increased social benefits). Examples might include subsidies for investment in environmental goods and services. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies* Economic and Social Justifications for Subsidies Reduce the cost of capital investment projects – which might help to stimulate economic growth by increasing long-run aggregate supply. Subsidies to slow-down the process of long term decline in an industry e.g. fishing or mining Subsidies to boost demand for industries during a recession e.g. the car scrappage scheme IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies* Economic Arguments against Subsidies The economic and social case for a subsidy should be judged carefully on the grounds of efficiency and fairness Might the money used up in subsidy payments be better spent elsewhere? Government subsidies inevitably carry an opportunity cost and in the long run there might be better ways of providing financial support to producers and workers in specific industries. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies* Free market economists argue that subsidies distort the working of the free market mechanism and can lead to government failure where intervention leads to a worse distribution of resources. Distortion of the Market: Subsidies distort market prices – for example, export subsidies distort the trade in goods and services and can curtail the ability of ELDCs to compete in the markets of rich nations. Arbitrary Assistance: Decisions about who receives a subsidy can be arbitrary Financial Cost: Subsidies can become expensive – note the opportunity cost! IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies* Free market economists argue that subsidies distort the working of the free market mechanism and can lead to government failure where intervention leads to a worse distribution of resources. Who pays and who benefits? The final cost of a subsidy usually falls on consumers (or tax-payers) who themselves may have derived no benefit from the subsidy. Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need to restructure – i.e. it delays much needed reforms. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies* Free market economists argue that subsidies distort the working of the free market mechanism and can lead to government failure where intervention leads to a worse distribution of resources. Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments. There are alternatives: It may be possible to achieve the objectives of subsidies by alternative means which have less distorting effects. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies To what extent will a subsidy feed through to lower prices for consumers? A subsidy has the effect of causing an outward shift in the market supply curve for a product IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies A subsidy might be justified if it encourages increased supply and consumption of products that yield high external benefits IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Subsidies Governments view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it. Ronald Reagan, 40th POTUS IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Price Controls (5.4 pgs. 113-116) Price Ceilings (maximum prices): Rationale, Consequences and Examples Explain why governments impose price ceilings, and describe examples of price ceilings, including food price controls and rent controls. Draw a diagram to show a price ceiling, and analyse the impacts of a price ceiling on market outcomes. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Price Controls Price Ceilings (maximum prices): Rationale, Consequences and Examples Examine the possible consequences of a price ceiling, including shortages, inefficient resource allocation, welfare impacts, underground parallel markets and non-price rationing mechanisms. Discuss the consequences of imposing a price ceiling on the stakeholders in a market, including consumers, producers and the government. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Price Controls* Price Ceilings (maximum prices): Rationale, Consequences and Examples Government mandated minimum or maximum prices that can be charged for specified goods. Governments sometimes implement price controls when prices on essential items, such as food or oil, are rising rapidly. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Price Controls Price Ceilings (maximum prices): Rationale, Consequences and Examples History has shown that price controls are, at best, effective only on a very short-term IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Price Controls Price Ceilings (maximum prices): Rationale, Consequences and Examples IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Price Controls Price Ceilings (maximum prices): Rationale, Consequences and Examples Rent control provides another example of the ineffectiveness of price controls. Rent controls, such as those used in New York City, are intended to keep housing prices affordable. Instead, they decrease the supply of rental housing and thereby raise prices of existing rental housing. In a vicious cycle, rent controls discourage new landlords from entering the market and cause existing ones to leave, creating a supply of housing that is less than the free market would allow and causing further upward pressure on housing rental prices. Rent controls also reduce the financial incentives for landlords to maintain and improve their properties, leading to lower quality housing. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Price Controls* Price Ceilings (maximum prices): Rationale, Consequences and Examples Effects of Price Ceilings Shortages Rationing Decreased market size Elimination of allocative efficiency (Society doesn't’t make enough of the desired good) Informal (Black) markets IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Price Controls (5.5 pgs 116-119) Price Floors (minimum prices): Rationale, Consequences and Examples Explain why governments impose price floors, and describe examples of price floors, including price support for agricultural products and minimum wages. Draw a diagram of a price floor, and analyse the impacts of a price floor on market outcomes. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Price Controls Price Floors (minimum prices): Rationale, Consequences and Examples Examine the possible consequences of a price floor, including surpluses and government measures to dispose of the surpluses, inefficient resource allocation and welfare impacts. Discuss the consequences of imposing a price floor on the stakeholders in a market, including consumers, producers and the government. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Price Controls* Price Floors (minimum prices): Rationale, Consequences and Examples When a "price floor" is set, a certain minimum amount must be paid for a good or service. If the price floor is below a market price, no direct effect occurs. If the market price is lower than the price floor, then a surplus will be generated. Minimum wage laws are good examples of price floors. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Price Controls Price Floors (minimum prices): Rationale, Consequences and Examples In many states, the U.S. minimum wage law has no effect, as market wage rates for low-skilled workers are above the U.S. minimum wage rate. In states where the minimum wage is above the market wage rate, the law will increase unemployment for low-skilled workers. Although some low-skilled workers will get higher pay, others will lose their jobs. IB Economics SL: City Honors School Unit 1: Microeconomics 1.3 Government Intervention Price Controls Price Floors (minimum prices): Rationale, Consequences and Examples IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.1 pgs. 123-126) The Meaning of Market Failure Market Failure as a Failure to Allocate Resources Efficiently Analyze the concept of market failure as a failure of the market to achieve allocative efficiency, resulting in an over- allocation of resources (overprovision of a good) or an under-allocation of resources (under-provision of a good) IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.1 pgs. 123-126) The Meaning of Market Failure* What is market failure? Market failure occurs when freely-functioning markets, fail to deliver an efficient allocation of resources. The result is a loss of economic and social welfare. Market failure exists when the competitive outcome of markets is not efficient from the point of view of society as a whole. This is usually because the benefits that the freemarket confers on individuals or businesses carrying out a particular activity diverge from the benefits to society as a whole. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.1 pgs. 123-126)* Markets can fail because: Negative externalities (e.g. the effects of environmental pollution) causing the social cost of production to exceed the private cost. Positive (or beneficial) externalities (e.g. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit Imperfect information means merit goods are under-produced while demerit goods are over-produced or over-consumed IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.1 pgs. 123-126)* Markets can fail because: Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition The private sector in a free-markets cannot profitably supply to consumers pure public goods and quasi-public goods that are needed to meet people’s needs and wants IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.1 pgs. 123-126)* Markets can fail because: Factor immobility causes unemployment hence productive inefficiency Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and consequent social exclusion which the government may choose to change IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.1 pgs. 123-126) Types of Market Failure The Meaning of Externalities Describe the concepts of marginal private benefits (MPB), marginal social benefits (MSB), marginal private costs (MPC) and marginal social costs (MSC). Describe the meaning of externalities as the failure of the market to achieve a social optimum where MSB = MSC. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.1 pgs. 123-126) Market failure results in: Productive inefficiency: Businesses are not maximising output from given factor inputs. This is a problem because the lost output from inefficient production could have been used to satisfy more wants and needs Allocative inefficiency: Resources are misallocated and producing goods and services not wanted by consumers. This is a problem because resources can be put to a better use making products that consumers value more highly IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.2 pgs. 126-133) Negative Externalities of Production and Consumption Explain, using diagrams and examples, the concepts of negative externalities of production and consumption, and the welfare loss associated with the production or consumption of a good or service. Explain that demerit goods are goods whose consumption creates external costs. Evaluate, using diagrams, the use of policy responses, including market-based policies (taxation and tradable permits), and government regulations, to the problem of negative externalities of production and consumption IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.2 pgs. 126-133) “Merit goods” are goods or services that have significant external benefits to society if they are produced and consumed. However, many people in society will not consume merit goods because the private sector charges too high a price that they can afford or are willing to pay. As a result, if it was left to the private sector, merit goods would be under produced and under consumed. The government will usually intervene and provide merit goods free of charge, or subsidised, so that everyone can consume them. Consequently society will be better off as a whole due to the increase in external benefits created by merit goods. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.2 pgs. 126-133)* Negative Externalities of Production and Consumption A Merit Good has two characteristic: People do not realize the true benefit. For example, people underestimate the benefit of education or vaccinations. Usually these goods have positive externalities. Therefore in a free market there will be under consumption of merit goods. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.2 pgs. 126-133)* Examples of Merit Goods: Health Care – people underestimate the benefits of getting a vaccination. If people do get a vaccination, then there will be external benefits to the rest of society because it will help reduce disease in the rest of society. Museums – the educational benefit of museums. Education – People may undervalue benefits of studying. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.2 pgs. 126-133) A “Demerit Good” is a good or service whose consumption is considered unhealthy, degrading, or otherwise socially undesirable due to the perceived negative effects on the consumers themselves. It is over-consumed if left to market forces. Examples of demerit goods include tobacco, alcoholic beverages, recreational drugs, gambling, junk food and prostitution. Because of the nature of these goods, governments often levy taxes on these goods (specifically, sin taxes), in some cases regulating or banning consumption or advertisement of these goods. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.2 pgs. 126-133)* A Demerit Good has two characteristics: A good which harms the consumer. For example, people don’t realise or ignore the costs of doing something e.g. smoking, drugs. Usually these goods also have negative externalities. Therefore in a free market there will be over consumption of these goods. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.2 pgs. 126-133)* Examples of Demerit Goods include: Smoking Drinking Taking drugs (Illegal and /or Illicit) Note: Merit and Demerit Goods involve making a value judgment that something is good or bad for you. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.2 pgs. 126-133)* Private Costs and Social Costs The existence of externalities creates a divergence between private and social costs of production and the private and social benefits of consumption. Social Cost = Social Benefit = Private Cost + External Cost Private Benefit + External Benefit When negative production externalities exist, social costs exceed private cost. This leads to over-production if producers do not take into account the externalities. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.2 pgs. 126-133) External costs from production Production externalities are generated and received in supplying goods and services - examples include noise and atmospheric pollution from factories. External costs from consumption Consumption externalities are generated and received in consumption - examples include pollution from driving cars and motorbikes and externalities created by smoking and alcohol abuse and also the noise pollution created by loud music being played in built-up areas. Negative consumption externalities lead to a situation where the social benefit of consumption is less than the private benefit. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.2 pgs. 126-133) Figure 6.1 Community Surplus Pg. 124 Figure 6.2 Social Benefits and Social Costs Pg. 125 Figure 6.3 Negative Externality of Production Pg. 127 Figure 6.5 Negative Externality of Consumption. Pg 129 Page 130 “Pink Box Questions Page 133 Exercises questions #1, 2, 3 IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.3 pgs. 133-137) Positive Externalities of Production and Consumption Explain, using diagrams and examples, the concepts of positive externalitiesof production and consumption, and the welfare loss associated with the production or consumption of a good or service. Explain that merit goods are goods whose consumption creates external benefits. Evaluate, using diagrams, the use of government responses, including subsidies, legislation, advertising to influence behaviour, and direct provision of goods and services. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.3 pgs. 133-137) Positive Externalities of Production and Consumption Figure 6.8 Positive Externality of Production Pg. 134 Figure 6.10 Positive Consumption Externality Pg. 135 Figure 6.11 Subsidy of Education Pg. 136 IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.3 pgs. 133-137) Positive Externalities of Production and Consumption There are many occasions when the production and/or consumption of a good or a service creates external benefits which boost social welfare. External benefits from development of renewable energy sources such as wind, solar and hydro power Social benefits from the Postal Service. Social benefits to provide free school lunches. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.3 pgs. 133-137) Positive Externalities of Production and Consumption Positive externalities and market failure Where positive externalities exist, the good or service may be under-consumed or under-provided since the free market may fail to value them correctly or take them into account when pricing the product. In the diagram above, the normal market equilibrium is at P1 and Q1 – but if there are external benefits, the Q1 is an output below the level that maximises social welfare. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.4 pgs. 137-139) Lack of Public Goods Using the concepts of rivalry and excludability, and providing examples, distinguish between public goods (non-rivalrous and non- excludable) and private goods (rivalrous and excludable). Explain, with reference to the free rider problem, how the lack of public goods indicates market failure. Discuss the implications of the direct provision of public goods by government. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.4 pgs. 137-139) Public Goods* A public good is often (though not always) under-provided in a free market because of its characteristics of nonrivalry and non-excludability. Examples of Public Goods Public Defense; Armed Services Street Lights, Roads, Public Parks, Bridges Police service, Fire Service, Public Education IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.4 pgs. 137-139) Public goods have two characteristics:* Non-rivalry: This means that when a good is consumed, it doesn’t reduce the amount available for others. – E.g. benefiting from a street light doesn’t reduce light for others, but eating an apple would. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.4 pgs. 137-139) Public goods have two characteristics:* Non-excludability: This occurs when it is not possible to provide a good without it being possible for others to enjoy. E.g erecting a dam to stop flooding, or providing law and order. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.5 pgs. 139-143) Common Access Resources and the Threat to Sustainability Describe, using examples, common access resources. Describe sustainability. Explain that the lack of a pricing mechanism for common access resources means that these goods may be overused/depleted/ degraded as a result of activities of producers and consumers who do not pay for the resources that they use, and that this poses a threat to sustainability . IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.5 pgs. 139-143) Common Access Resources and the Threat to Sustainability* Definition of ’Common Resource' A resource, such as water or pasture, that provides users with tangible benefits. A major concern with common resources is overuse, especially when there are poor socialmanagement systems in place to protect the core resource. Common resources that are not owned by anyone are called open-access resources. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.5 pgs. 139-143) Common Access Resources and the Threat to Sustainability* Overuse of common resources often leads to economic problems such as the tragedy of the commons, where user self-interest leads to the destruction of the resource in the long term, to the disadvantage of everyone. Common Access Resources and Market Failure video clip IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.5 pgs. 139-143)* To define environmental sustainability we must first define sustainability. *Sustainability is the ability to continue a defined behavior indefinitely.* To define what environmental sustainability is we turn to the experts Herman Daly, one of the early pioneers of ecological sustainability, looked at the problem from a maintenance of natural capital viewpoint. In 1990 he proposed that: IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.5 pgs. 139-143) 1. For renewable resources, the rate of harvest should not exceed the rate of regeneration (sustainable yield); 2. [For pollution] The rates of waste generation from projects should not exceed the assimilative capacity of the environment (sustainable waste disposal); and 3. For nonrenewable resources the depletion of the nonrenewable resources should require comparable development of renewable substitutes for that resource. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.5 pgs. 139-143) Common Access Resources and the Threat to Sustainability Explain, using negative externalities diagrams, that economic activity requiring the use of fossil fuels to satisfy demand poses a threat to sustainability. Explain that the existence of poverty in economically less developed countries creates negative externalities through over-exploitation of land for agriculture, and that this poses a threat to sustainability IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Market Failure (6.5 pgs. 139-143) Common Access Resources and the Threat to Sustainability Evaluate, using diagrams, possible government responses to threats to sustainability, including legislation, carbon taxes, cap and trade schemes, and funding for clean technologies. Explain, using examples, that government responses to threats to sustainability are limited by the global nature of the problems and the lack of ownership of common access resources, and that effective responses require international cooperation. IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Theory of Knowledge: Potential Connections: To what extent is the obligation to seek sustainable modes of consumption a moral one? What knowledge issues are involved in assessing the role of technology in meeting future patterns of consumption and decreasing the negative externalities of consumption associated with fossil fuels? What are the knowledge issues involved in determining what is a rational cost to pay for halting climate change? IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Theory of Knowledge: Potential Connections: How could we know if economically more developed countries are morally justified in interfering in the development of economically less developed countries on the grounds of climate change? How can we know when climate change is sufficiently serious to warrant government interfering in the freedom of its citizens to consume? IB Economics SL: City Honors School Unit 1: Microeconomics 1.4 Market failure Theory of Knowledge: Potential Connections: How can we calculate the external costs of producing and running items such as light bulbs or motor vehicles? For example, low energy light bulbs consume less energy but they require more energy to produce, and some brands contain materials that are harmful to the environment such as mercury. Hybrid cars consume less energy to run but consume more energy to produce. What are the problems in knowing whether climate change is produced by human activity?