Microeconomics 003: Price Elasticity

What is Elasticity?

Elasticity is the sensitivity of quantity of goods demanded or supplied when price changes. It is a measure of the responsiveness of markets.

Theoretically, perfectly inelastic demand means that there is no substitutes for the good. A good approximation is the market for medicine. Therefore the quantity demanded by the consumers will not change no matter how much the price changes.

For perfectly elastic demand, all substitutes are equivalent. A good approximation is the market for sweets. Once the price of a type of sweets changes, the quantity demanded by consumers will change greatly as they will start purchasing sweets from other markets.

Taxes

Amount of taxes raised from goods depends on the elasticity of the goods. Taxes will raise more money when imposed on inelastic goods, as the quantity of goods transacted will not drop as much. Understanding elasticity will help to formulate policies, such as the appropriate amount of government spending to be allocated to healthcare.


Price Elasticity of Demand

This is affected by two factors. One, the Substitution Effect on the good as price changes, and two, the Income Effect on the good as price changes.

The Substitution Effect is unambiguous on almost all goods. As price of a good increases, consumers will look for substitutes, therefore price and quantity are always negatively related under this effect.

The Income Effect is dependent on the type of goods. Price changes affects the spending power of the consumer as it changes their budget constraint, hence creating an income effect. If it is a Normal Good, then an increase in income will lead to more consumption, but not as much, as compared to a Luxury Good. If it is an Inferior Good, then consumption will decrease instead, as income rises.

(Reference: MIT OCW Principles of Microeconomics)

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Microeconomics 002: Demand and Supply

Ah. The great cornerstone of economics. The demand and supply concept basically sums up the majority of our lessons back in school.


Demand and Supply

Demand is the willingness of the consumers to pay for a good. The more expensive the good, the less people want it. Supply is the willingness of the producers to produce a good. The higher the price of the good, the more producers will produce it.

 

ME 01 Demand and Supply

Price is therefore the signalling mechanism that determines how much to produce and consume.


Price Intervention

In general, there are two kinds of price intervention. The price floor set the price above the market equilibrium.

 

ME 02 Price Floor

This aims to benefit the producers, for example a minimum wage law. However, this will result in less demand for the good and excessive supply.

The second kind of intervention is a price ceiling, in which the price is set below the market equilibrium.

 

ME 03 Price Ceiling

This aims to benefit the consumers, for example an oil price cap. However, this will result in shortages due to less supply for the good and excessive demand. As the market is robust, the market will still seek to reach equilibrium above the price ceiling via other means such as the black market.


Costs of Price Intervention

  1. Efficiency Loss – efficiency is achieved when all trades that can make everyone better-off is being made. No one can be made better-off without the expense of others. By preventing the market from reaching equilibrium, the economy is not at the optimal state.
  2. Allocation Inefficiency – consumers who wants the goods the most may not get them. Without price mechanism to allocate the goods, people may resort to other inefficient mechanism, such as the waiting and queuing mechanism.

The benefit of price intervention is equity. Equity is hard to achieve while efficiency is easy. Therefore, the challenge that all policymakers face is the equity-efficiency trade-offs when implementing policies.

(Reference: MIT OCW Principles of Microeconomics)

 

Microeconomics 001: Definition

A Study of Human Behaviour

Scarcity is the key word in Microeconomics, as scarcity affects how firms and individuals make constrained optimsation. Models, such as Consumers and Producers Models, help to study firms and individuals behave.


Key Objectives

Economics aim to answer these three fundamental questions.

  1. What goods and services to produce?
  2. How to produce?
  3. Who gets the goods and services?

Price is the underlying mechanism that answers all these questions. The twin forces that drives economy is Supply and Demand.


Aspects of Economics

There are different approaches in studying the human behaviour of decision making. These approaches may or may not be exclusive.

  • Theoretical Economics – building of economic models that explains behaviour.
  • Empirical Economics – testing of economic models using data and experiments.
  • Positive Economics – seeks to explain how things are.
  • Normative Economics – seeks to advocate how things should be.

There is also the sensitive issue of Efficiency versus Equity. Decisions may be most optimised in terms of resource allocation, but may not be fair or just in the eyes of our society.


Appreciating the concepts

Individuals and firms may not consider economic principles when making decisions, but they behave as-if economic models are driving their decisions.

(Reference: MIT OCW Principles of Microeconomics)