Key Economic Principles: Elasticity, Equilibrium, and Market Structures

Posted on Jan 22, 2025 in Economics

Key Economic Concepts

Part 1 – Percentage Change & Elasticity

% Change: ((End Value – Start Value) / Start Value) * 100%
Midpoint Method: ((End Value – Start Value) / Average of Values) * 100%

Price Elasticity of Demand

(Always positive):

Determines the steepness of the demand curve.
% Change in Quantity Demanded / % Change in Price

If demand is inelastic: price change = small change in demand (essential goods).
If demand is elastic: small price change = large change in demand (non-essential goods).

Income Elasticity of Demand

(Negative or positive):

Normal goods: positive (more income = more demand). Ex: jewelry.
Inferior goods: negative (more income = less demand). Ex: public transportation.
Necessities: close to 0. Ex: housing, healthcare.

Equilibrium & Tax Incidence

Equilibrium: Quantity where demand and supply curves intersect.
Tax Incidence: How tax burden is distributed.
When demand is more elastic than supply, tax falls more on suppliers.
When supply is more elastic than demand, tax falls more on buyers.

New Price After Tax

If demand is inelastic, seller raises prices, passing the tax to the buyer.
If demand is elastic, seller lowers the price, tax is divided.
New Price for Buyers after tax: New Price for sellers after tax + tax.
When tax is imposed on buyers: Decrease in equilibrium quantity and price. Demand curve shifts left.
New Price for Sellers after tax: Price at equilibrium point.
When tax is imposed on sellers: Decrease in equilibrium quantity and increase in equilibrium price. Supply curve shifts left.
New equilibrium after tax: Quantity where the shifted supply curve meets the demand curve.

10 Principles of Economics

People face trade-offs.
Cost of something is what you give up to get it.
Rational people think at the margin.
People respond to incentives.
Trade can make everyone better off.
Markets are a good way to allocate resources.
Governments can improve market outcomes.
Standard of living depends on a country’s production.
Prices rise when government prints too much money.
Society faces a short-run trade-off between inflation and unemployment.

Marginal Cost: Cost for producing one more unit.
Central Planning: Government guiding economic activity.

Invisible Hand: Decisions of households and firms lead to desirable market outcomes.

Market Failure: When the market fails to allocate resources efficiently.

Output: Goods and services.

Normative Statements: What something should be.

Positive Statements: How things are.

Competitive Market: No individual has a significant impact.

Demand Curve: Usually slopes downward.

Supply Curve: Usually slopes upward.

Price Controls

Price Ceiling: Government-imposed price maximum.
- Binding: Max price below equilibrium (quantity demanded > quantity supplied).
- Non-binding: Max price above equilibrium. No effect.
Price Floor: Government-imposed price minimum.
- Binding: Min price above equilibrium (quantity supplied > quantity demanded).
- Non-binding: Min price below equilibrium. No effect.

Efficiency: Size of the economic pie; Equality: How it’s divided.

Part 2 – Welfare Economics

How resource allocation affects economic well-being.

Surplus

Consumer Surplus: Buyers’ willingness to pay minus the actual price. Formula: 0.5 * base * height. Area below the demand curve.
Producer Surplus: Sellers’ money made minus the cost to make it. Formula: same as CS. Area above supply curve but below market price line.
CS = Value to buyers – Amount paid by buyers.
PS = Amount paid to sellers – cost to sellers.
Total Surplus = Value to buyers – cost to sellers.

Revenue & Profit

Total Revenue = Quantity * Price.
Profit = Revenue – Cost.
Explicit Cost: Ex: salaries.
Implicit Cost: Ex: time (ignored by accountants).
Total Cost = Explicit Cost + Implicit Cost.
Accounting Profit = Total revenue – explicit cost.

Production & Costs

Production Function: Relationship between quantity of inputs and quantity of output.
Marginal Product of Labor = Change in Quantity / Change in Labor.
Diminishing Marginal Product: MPL decreases as # of workers increases.
Total-Cost Curve: Relationship between quantity and costs. Steeper as output increases.
Total Cost = Fixed Cost + Variable Cost.
Average x Cost = xCost / Quantity.

Economies of Scale

Economies of Scale: Average Total Cost falls as Quantity increases.
Constant Returns to Scale: Average Total Cost stays as Quantity increases.
Diseconomies of Scale: Average Total Cost rises as Quantity increases.

Competitive Markets

Marginal Revenue = Product price.
If MR > MC, increase Quantity for profit.
If MC > MR, decrease Quantity for profit.
Change in profit = MR – MC.

Shutdown & Exit

Shutdown: Short-term decision to not produce.
Exit: Long-term decision to leave the market.
Company should shutdown if Total Revenue < Variable Cost, or Price < Average Variable Cost.
In the long run, all factors are variable; in the short run, at least one factor is fixed.
A firm will enter the market when Price > Average Total Cost.
If Price > Long Run Average Total Cost, the firm produces Quantity on the Marginal Cost curve.
If Price < Long Run Average Total Cost, the firm exits in the long run.
Total Revenue = Price * Quantity.
Total Cost = Average Total Cost * Quantity.
Quantity is the value where Marginal Revenue = Marginal Cost.
Same with Average Total Cost and Price.
Profit = Total Revenue – Total Cost = (Price – Average Total Cost) * Quantity.

Market Dynamics

If existing firms earn positive income, new firms enter, short-run market supply shifts right, Price falls, reducing profits and entry.
If existing firms earn negative income, some firms exit, short-run market supply shifts left, Price rises, reducing remaining firms’ losses.
Long-run equilibrium: entry or exit is complete. Remaining firms earn zero profit (Price = lowest Average Total Cost).
Firms making zero economic profit stay in the market because accounting profit is positive.

Competitive Market Characteristics

No company holds a substantial market share.
Industry output is standardized.
Freedom of entry and exit.

Profit-maximizing quantity is when Marginal Revenue = Marginal Cost.
Short-run supply curve is steep due to constraints on fixed inputs.
Long-run supply curve is elastic due to more flexibility in adjusting inputs and ease of entry and exit.

Part 3 – Monopoly & Market Power

A monopoly has market power, unlike a competitive firm.

Monopoly Causes

Barriers to entry.
Single firm owns a key resource.
Government gives one firm the exclusive right to produce a good.
Natural monopoly: a single firm can produce the entire market quantity at lower cost.

Competitive vs. Monopoly Firms

Competitive Firm: Price taker, perfectly elastic demand, market demand curve is flat. Price = Marginal Revenue. Has a supply curve.
Monopoly Firm: Price maker, market power, downward sloping demand curve, quantity and price are jointly determined by Marginal Cost, Marginal Revenue, and demand curve, no supply curve.

Monopoly Revenue

Increasing Quantity has 2 effects on revenue:

Output effect: higher output increases revenue.
Price effect: lower price decreases revenue.

Profit maximization where Marginal Revenue = Marginal Cost.
Monopolist’s profit = (Price – Average Total Cost) * Quantity.
In the competitive equilibrium: Price = Marginal Cost, total surplus is maximized.
In the monopoly equilibrium: Price > Marginal Revenue = Marginal Cost, Deadweight loss.

Price Discrimination & Other Market Structures

Price Discrimination: Selling the same good at different prices to different buyers.
Oligopoly: Few sellers offer similar products.
Monopolistic Competition: Many firms sell similar but not identical products.

Monopolistic Competition

Many sellers competing over customers, not price takers, downward sloping demand curve.
Free entry and exit, price: on the demand curve.
If Price > Average Total Cost: profit; If Price < Average Total Cost: loss.

Short-Run & Long-Run Dynamics

If monopolistically competitive firms are making profit in the short run:

New firms enter, increasing the number of products.
Reduces demand faced by each firm, demand curve shifts left, prices fall.
Each firm’s profit declines to 0.

If losses in the short run, some firms exit, remaining firms enjoy higher demand and prices. Entry and exit occur until Price = Average Total Cost and profit = 0. Monopolistic competition is less efficient than perfect competition. Monopolistic: Price > Marginal Cost, perfect: Price = Marginal Cost. A firm’s willingness to pay for advertising may signal the quality of product to consumers.