CHAPTER 4:

MARKET EFFICIENCY & ELASTICITY

3.1 The Market System

3.2 Constraint on the Market: Government Intervention

3.3 Market Efficiency & Surpluses Maximization

3.4 Elasticity

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 Output (Product) Market

DD & SS Interaction

Changes in DD / SS:
Equilibrium Price &
Quantity Production
Utility (excluded)
Consumer surplus Market System Supplier surplus
Factors effect DD Market Efficiency Factors effect SS
Elasticity Government Elasticity
Intervention Market structure
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 3.1 The Market System

Stability or equilibrium point:

supply = demand

This situation achieved and re-achieved after

disequilibrium through the an important
functions of the market (price system):

PRICE RATIONING

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Price Rationing:
Definition:
i. Allocates output to consumers and resources to
firms through price adjustment.
ii. Price rationing when Qty DD > Qty SS (shortage)
iii. Allocation based on willingness & ability to pay
(answering the “for whom to produce” problem).
Figure: Price Rationing

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 Note:
Price rationing is consider as market oriented approach
because:
i. Allocates through open market
ii. No government intervention

Weaknesses (market failure): Inability to recognize that

each society have the right, necessity or needs to certain
type of outputs like health care, accommodation, basic
food and safety

lottery approach, political

Use non- approach and mixed approach
market / non-
pricing approach
government intervention
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Situations of Market failure:
a) External benefit:
i. Free-riders
ii. Road (transport), hospital (public health), dam
(flood/electricity)
b) External cost:
i. Negative effect/cost to others
ii. Pollution
c) Imperfect information:
i. Seller has more info than buyer
ii. “Lemon market” & info disclosure
d) Imperfect competition:
i. Market controlled by monopoly, cartel, illegal co-
operation
ii. Government ownership, law & regulation 6
 3.2 Constraint on the Market:
Case for Government Intervention

a) Price ceiling:
i. Maximum price sellers may charge
ii. To control unjust high price
iii. Excess demand (Ration coupon as complement
action to control DD)
iv. Emerging of black market

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b) Ration coupon:
i. Ticket/coupon entitle individual to purchase
ii. Coupons trading – alike price rationing
iii. Serve as redistributing income

c) Favored customer:
i. Special treatment
ii. Results in hidden cost

d) Waiting in line (Queuing):

i. Product cost = cost of waiting
ii. A form of deadweight loss

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e) Price floor:
i. Minimum price for buying – selling
ii. To adjust unfair low price
iii. Excess of supply (government has to buy up
excess)
iv. Alternative: subsidization
Figure: Price Floor: Minimum Wages
f) Other restriction:
i. Price control
ii. Licensing
iii. Taxes
iv. Quota

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3.3 Market Efficiency & Surpluses Maximization

What is “Efficient Market”?:

i. Pareto efficient: A market is efficient if there is no

way to make any person better off without hurting
anybody else. (Relate to PPF)
ii. Relate to PPF: Reduce production of product “Y” to
increase production of product “X”.

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What is “Consumer Surplus”?:
i. Extra value individual received
ii. What people willing to pay
iii. Maximum amount willing to pay minus current
market price

Figure: Consumer Surplus

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What is “Producer Surplus”?:
i. Extra value producer received
ii. What producer pay for the right to sell at current
price
iii. Minimum amount willing to sell minus current
market price
Figure: Producer Surplus

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Surplus maximization:

i. Market efficient = maximize sum of consumer &

producer surpluses
ii. Achieved when DD = SS

Figure: Surplus maximization

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Deadweight loss:
i. Losses of consumer and producer surplus that are
not transferred to other parties
ii. Occur from over or under production
Figure: Deadweight loss over production

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 3.4 Elasticity
A measure of how “responsive” demand is to some
change in price or income:

i. The slop of a demand function (∆q/∆p)

ii. The slope of the demand curve (∆p/∆q)
iii. Elasticity method
Figure Demand Curve Slope & Responsiveness

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Elasticity is a general concept to:

i. quantify the response in one variable when another

variable changes
ii. measure the percentage change in one variable
brought about by a 1 percent change in some other
variable
iii. Elasticity is unit free

Type of elasticity:
i. Price elasticity of demand
ii. Income elasticity
iii. Cross-price elasticity

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Price elasticity of demand calculation: How responsive
consumers are to changes in the price of a product

ε = [(∆q/q)*100%] / [(∆p/p)*100%] ………… (Equation 3.1)

= (∆q/q)*100% * (p/∆p)*(1/100%)

ε = (p/q)*(∆q/∆p) …………… (Equation 3.2)

Slope of
Ratio of demand
price to multiply
function
quantity 17
 Example: Use Figure 3.7 (a) & (b). Assumed price
decrease from P1 = $3 to P2 = $2.

For Figure 3.7 (a):

ε = (p/q)*(∆q/∆p) …………… (Equation 3.2)
= (3/5)*[(10 – 5)/(2 – 3)]
=–3
or

Same answer for Figure 3.7 (b):

proving that different unit of measurement did
not effect elasticity.
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 BUT different answer if assumed price increase
from P1 = $2 to P2 = $3.

Solution: Mid-point formula

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 NOTE: Which one is more elastic?

More elastic Less elastic

In negative
value
–5 –4 –3 –2 –1

Less elastic More elastic

In absolute
value
1 2 3 4 5

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Table shows values & types for elasticity of demand

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Elasticity of linear demand curve:
i. Change from point to point
ii. Decrease when move downward
iii. Elastic at upper range, inelastic at lower range

Figure: Elasticity of a Linear Demand Curve

Elasticity= -10

Elasticity= -0.375

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Calculus proving (No. 1):
Consider a linear demand curve, q = a – bp
i. The slope = – b
ii. If q = 0; p = a / b (price intercept)
ε = (p/q)*(∆q/∆p) …………… (Equation 3.2)
= (p/q)* (– b)
= [p / (a – bp)]* [– b] (›› q = a – bp)

– 1 = [p / (a – bp)]* [– b] (unitary elasticity)

– 1 = (– bp) / (a – bp)
bp = (a – bp)
2bp = a
p = a / 2b
(middle point)

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Calculus proving (No. 2):

Linear demand curve, q = a – bp

At price axis intercept, q = 0 & p = a / b
ε = (p/q)*(∆q/∆p) …………… (Equation 3.2)
= [(a/b) / 0]* (– b)
=∞ (›› infinity elasticity at price intercept)

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Calculus proving (No. 3):

Linear demand curve, q = a – bp

At quantity axis intercept, p = 0 & q = a
ε = (p/q)*(∆q/∆p) …………… (Equation 3.2)
= (0/a)*(– b)
=0 (›› zero elasticity at qty intercept)

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 Cross price elasticity:
Measure of the response of the quantity of one good
demanded to a change in the price of another good

ε = [(∆q/q)*100%] / [(∆p’/p’)*100%]

For substitute product: ε(p’) positive (the price of one product and
quantity demanded for another product move in the same direction)

For complement product: ε(p’) negative (the price of one product

and quantity demanded for another product move in the opposite direction)

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Others elasticity:

Elasticity of supply is a measure of the response of

quantity of a good supplied to a change in price of that
good. Its value is likely to be positive in output markets
due to the law of supply.

Elasticity of labor supply is a measure of the response of

labor supplied to a change in the price of labor

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