Flashcards in Week 4 - gov't policies and welfare Deck (18)

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1

## define price celling

### A legal maximum on the price at which a good can be sold

2

## what does a price celling create

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a shortage no higher than $5

Therefore as price decreases demand increases causing a shortage

Lower price of good = lower incentive for suppliers to sell (inelastic)

Lost consumer surplus

• Lost producer surplus

• Lower quantity traded

• Less consumed

• Some producer surplus is transferred

• Most importantly, tends to adversely affect the very people it is meant to protect! –Unintended consequence

3

## define a price floor

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A legal minimum on the price at which a good can be sold

creates surplus

4

## 3 intended objective of taxes

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1. Health objective

2. Fiscal objectives

3. User-pays objective

5

## define deadweight loss

### A reduction in the total surplus that results from a market distortion such as a tax or a monopoly price

6

## 3 insights concerning market outcomes

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1. Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay.

2. Free markets allocate the demand for goods to the sellers who can produce them at least cost.

3. Free markets produce the quantity of goods that maximises the sum of consumer and producer surplus.

Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it.

Social planner must also consider trade off between equity + efficiency

This policy of leaving well enough alone goes by the French expression laissez‐faire.

7

## define world price

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The price of a good that prevails in the world market for that good

The price of a good or service in a domestic country determined by domestic demand and supply

- if the world price of a good is lower than the domestic price one may become a importer as they offer a better price

- once trade is alloered the domestic price will fall to equal the world price (importing

8

## draw effects of tariff on graph

### :P

9

## reasons for free trade

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- Jobs argument – short term

- National security – e.g. during war access to key resources

- Infant industries – can create a system of dependency and inefficiency

- Unfair competition

10

## willingness to pay formula

### Willingness to pay = Consumer Surplus + Pay

11

## Consumer surplus formula

### Consumer surplus = Willingness to Pay – Paid

12

## Understand all this weeks graphs

### Consumer surplus = Willingness to Pay – Paid

13

## Price elasticity of demand: Define and distinguish between price elasticity of demand and income elasticity of demand. Explain factors that determine each.

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Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good, calculated as the percentage change in quantity demanded divided by the percentage change in price.

Factors that determine price elasticity are the availability of substitutes, whether the good is a luxury or a necessity, the time horizon and also the market boundaries.

Income elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in consumers’ income, calculated as the percentage change in quantity demanded divided by the percentage change in income.

Factors that determine income elasticity are whether or not the good is a normal good or inferior good and also if the good is a necessity or a luxury good.

14

## Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a packet of cigarettes currently costs $8 and the government wants to reduce smoking by 20 percent, by how much should it increase the price?

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First, we obtain the necessary percentage change in price, and then use this to calculate the absolute change in price.

As the own-price elasticity is the percentage change in quantity demanded divided by the percentage change in price, we have 0.4 = %ΔQcig / %ΔPcig, which yields %ΔPcig

= %ΔQcig / 0.4; since the government targets a 20% reduction in the quantity of smoking, %ΔPcig = 20/0.4 = 50.

The government would increase the price by 50% in order to reduce smoking by 20%. As the current price is $8, a 50% increase is $4, so the price increases to $12. On an exam or in the assignment, this suffices.

For those more algebraically inclined, note that if we use the midpoint method, then we would search for a price that is a 50% difference in price. If we call this price p2, then we want 0.5 = (p2 - 8) / ((p2 +8)/2) = (p2 - 8) / (0.5p2 + 4). Multiplying both sides by the denominator, we have 0.25p2 + 2 = p2 - 8. Subtracting 0.25p2 from both sides and adding 8 to both sides gives 10 = 0.75p2. Dividing both sides by 0.75 gives p2 = 40/3 = 13.33.

15

## If the government permanently increases the price of cigarettes, will the policy have a larger effect on smoking one year from now or five years from now?

### The time horizon is positively correlated with the elasticity; the longer the period, the easier it is for consumers to adjust or make substitutes. Thus, the effect is likely to be larger five years hence than one year hence.

16

## Studies also find that teenagers have a higher price elasticity than do adults. Why might this be true? On one graph, show the demands for a typical adult smoker and a typical teenage smoker that are consistent with this observation.

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Teenagers generally have a smaller income. Because they are limited in where they can licitly smoke, they tend to be more casual and more easily switch between smoking cigarettes and consuming other substances.

If the two demand curves intersect, then the flatter demand curve is more elastic.

Alternatively, it is plausible that teenagers have lower demand than adults, which could be depicted as an inward shift. If the shift were parallel, then the same price change results in the same absolute change in quantity; because the base of the inner demand curve is smaller, this same absolute change is a larger percentage change in quantity demanded, which is then consistent with greater elasticity.

Thus, the typical teenager's demand curve could be either demand curve below in blue or dark blue. Note that the prices are 6 and 8, and for the adult, the quantities are Q0 and Qa, whereas those for the teens are either Q0` and Q1`, or Q0 and Qt1.

Look at one teen demand at a time: for the blue demand, note that Q1t`-Q0t`=Q1a-Q0, but the teen's base is smaller and so the percentage change in quantity is larger; therefore, greater elasticity. For the dark blue demand, note that Q1t-Q0 > Q1a - Q0 and so the percentage change in quantity is larger (the "base" quantity rises 0.5 units for each unit that the change rises); therefore, greater elasticity.

17

## Two drivers – Tom and Jerry – each drive up to a petrol station. Before looking at the price, each places an order. Tom says: “I’d like 10 litres of petrol.” Jerry says: “I’d like $10 of petrol.” What is each driver’s price elasticity of demand?

### Tom’s price elasticity of demand is zero, since he wants the same quantity regardless of the price. Jerry’s price elasticity of demand is one, since he spends the same amount on gas, no matter what the price, which means his percentage change in quantity is equal to the percentage change in price.

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