Topic 2(b) Topic OUTLINE:

2.7 The Market System

MARKET
EFFICIENCY 2.8 Market Failure
& 2.9 Constraint on the Market: Government Intervention
ELASTICITY 2.10 Market Efficiency & Surpluses Maximization
2.11 Elasticity

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2.7: THE MARKET SYSTEM: • Disequilibrium:

• Sta bil ity or e quili br ium i s a
situation when quantity – The condition that exists in a market
demanded and quantity supplied when the plans of buyers do not match
are equal and there is no those sellers;
tendency for price or quantity to
change. – A temporary mismatch between quantity
supplied and quantity demanded as the
market seeks equilibrium.

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2.8: MARKET FAILURE: 1. Imperfect Competition / Monopoly Power:

• An industry in which single firm have some control

1. Imperfect competition / Monopoly Power over price & competition.
2. Public goods • Imperfectly competitive industries give rise to an
3. Externality/ neighborhood effects inefficient allocation of resources.
4. Imperfect information • Market controlled by monopoly.
• Examples:
- Government ownership (Lembaga Air Perak)
- Law & regulation (price control)

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 2. Public Goods 3. Externality/ Neighborhood Effects:
• Goods or services that are non-rival in consumption. • A cons eq uenc e of a n econ omic ac tivity that is
experienced by unrelated third parties. An externality
• Free-rider problem: because people can enjoy the can be either positive or negative.
benefits of public goods whether they pay for them or
not, they are usually unwilling to pay them.
• Examples:
• Examples:
- Air pollution - (negative externality)
- road (transport)
- Ground water pollution from fertilizer use -
- hospital (public health) (negative externality)
- national defense - Attractive garden located near a city provides
- education resident in the area with nice views and fresher air
(positive externality)

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4. Imperfect Information: Adverse Selection:

• The absence of full knowledge • Occur when a buyer or seller enters into an exchange with
another party who has more information.
concerning product characteristic and
available prices. • Examples:

• Adverse selection and moral hazard i. Used car market/ ‘lemon market’: The sellers of used
cars have full information about the real quality of
will occur in the market. their cars.

ii. Insurance Companies generally have kinds of

problems: People (buyer) come in different types
(healthy/unhealthy) and the customers know
something the company doesn’t.
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Moral Hazard:
2.9 CONSTRAINT ON THE MARKET:
• Moral hazard is a situation in which one party gets
involved in a risky event knowing that it is protected (CASE FOR GOVERNMENT INTERVENTION)
against the risk and the other party will incur the cost.
It arises when both the parties have incomplete
information about each other. 1. Price ceiling
2. Price floor
• Example: If your house is insured for its full value,
then if anything happens you do not really lose 3. Ration coupons
anything. Therefore, you have less incentive to
protect against any mishappening. In this case, the
insurance firm bears the losses and the problem of
moral hazard arises.

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 1. Price Ceiling: Price Ceiling:
• Government imposed regulations that prevent
prices form rising above a maximum level set by 6
government. S

Price (per pack)

5 What: Shortage
• To protect consumers from conditions that Why: Qd > Qs
Size: (12 – 4) = 8
could make necessary commodities 4
Adjustment: No
unattainable. 3

• Example: rent control 2 Price Ceiling

• Price is set below the equilibrium price, thus 1 Shortage

=?????
D
will create excess demand (shortage). 0
2 4 6 7 8 10 12 14 16 18

Sugar (Kg per week)

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2. Price Floor: Price Floor:

• Government imposed a regulations that
prevent prices from falling below a minimum 6

level set by government. What?? 5

S
Price (per Kg)

• To adjust unfair low price (price too low). Why??

Size?? 4
Price Floor

• Examples: minimum wage & agricultural Adjustment - No

3
product
• Price is set above the equilibrium price, thus 2

will create excess supply (surplus). 1 D

0 2 4 6
7 8 10 12 14 16 18
Brown Rice (Kg per week)
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3. Ration Coupon: 2.10 MARKET EFFICIENCY

& SURPLUSES MAXIMIZATION
•Tickets or coupon that entitle individual to • Efficient Market (Pareto Optimality):
purchase a certain amount for a given per
– a situation in which the welfare of the
month.
community is at its maximum, and it is
•Everyone would get the same amount therefore impossible to increase the
•Example: Introduced rationing of subsidized welfare of one individual without making
petrol for target groups. another worse off.

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 Consumer Surplus (CS): Producer Surplus (PS):
• T h e mon etar y d iffe re nc e be twee n th e
maximum amount a person is willing to pay • The difference between the current market
for a good and its current market price price and the full cost of production for the
(actually pay). firm.

• Graphically - the area under the market

• Graphically - the area under the demand
cu rve (willin gnes s to pay for th e u nits price (what was paid for those units) and
consumed) and above the market price (what above the supply curve (the total cost of
must be paid for those units). producing those units).

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Consumer Surplus (CS) & Producer Surplus (PS): Deadweight Loss

P S
Consumer
Price (per hamburger)

Surplus –Losses of consumer and producer

Total Surplus (TS):
CS + PS
surplus that are not transferred to
other parties.
P1
Producer
Surplus –Deadweight Loss is the fall in total
surplus.
D
o Q
Q1
Quantity (hamburger) 21 22

Cost of Price Ceiling: Cost of Price Floor:

Price S Price S

A
P1 Price Floor
A B B C
P* P*
C D E
D
P Price Ceiling
E

D D
Quantity Quantity
Qs Q Qd Qd Q* Qs
Before After Changes Deadweight Before After Changes
CS A+B A+C -B + C Loss: B+D CS A+B+C A -B – C Deadweight
PS C+D+E E -C - D Loss: C+E
PS D+E B+D -E + B
Total A+B+C+D+E A+C+E -B - D Total A+B+C+D+E A+B+D -C –E
Surplus 23 Surplus 24

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 CS and PS (Price increase to $6):
Consumer and Producer Surplus
CS = Area A
CS = (½) x base x height PS = (½) x base x height CS = (½) x base x height Combined CS and
CS = (½) x 5 x (10 – 5) CS = (½) x 5 x (5 – 0) CS = (½) x 4 x (10 – 6)
CS = $12.5 CS = $12.5 CS = $8
PS decreases
Area of blue triangle Area of red triangle when price is above
$10 S RM10 S equilibrium.
9 Consumer 9
8 Surplus 8
7 The combination of CS and PS is 7 A Deadweight Loss (DL) = Area C
DL = (½) x (5 – 4) x (6 – 4)
6 maximized at market equilibrium. 6 DL = $1
5 TS = CS + PS 5 B C

4 TS = (12.5 + 12.5) = $25 4

3 3 D PS = Area B + D
2 Producer 2 Area B = (4 x 2) = 8
1 Surplus D 1 D Area D = (1/2) x 4 x 4 = 8
PS = (8 + 8) = $16
0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Quantity Quantity
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2.11 ELASTICITY:
Definition:
What happen to CS and PS if price A general concept used to quantify the
decrease to $4?? response in one variable when another
variable changes.
4 types of elasticity:
(i) Price elasticity of demand (PED)
(ii) Income elasticity of demand (IED)
(iii) Cross price elasticity of demand (CED)
(iv) Price elasticity of supply (PES)
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(i) Price Elasticity of Demand (PED): Calculating Price Elasticity of Demand (PED)

Definition:
PED is a measure of how much the quantity
demanded of a good responds to a change in PED
(Qd 2 Qd1) / Qd1
x100% = Formula Method
the price of that good. ( P 2 P1) / P1

Q 2 Q1
Calculating elasticity using two methods: (Q Q1) / 2 = Midpoint Method
PED 2
x 100 %
(i) Formula method P2 P1
( P2 P1 ) / 2
(ii) Midpoint method
Its value is negative in output markets due to the law of demand.
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 Computing the PED Using Formula Point and • Elimination of minus sign
Midpoint Method
§ Economist normally ignore the minus sign and
1. If the price of concert tickets increase from RM25 to p res ent t he a b s o lu t e va l ue o f t h e el a st i ci t y
RM30 an d the q u anti ty de m an de d of ti cke ts coefficient to avoid an ambiguity.
decrease from 20,000 to 10,000. Calculate price
elasticity of deman d using the formula point • Interpretations of PED
method? Will the answer still the same if we use § Economist classify demand curves according to their
midpoint method? elasticity.
§ There are five cases:
2. If the price of concert tickets decrease from RM35 to – Elastic (PED >1)
RM23 and the quantity demanded of tickets increase – Inelastic (PED <1)
from 20,000 to 35,000. Calculate price elasticity of – Unit elastic (PED =1)
demand using the formula point method? Will the
– Perfectly elas�c (PED = ∞)
answer still the same if we use midpoint method?
– Perfectly inelastic (PED = 0)
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The Price Elasticity of Demand: INELASTIC

The Price Elasticity of Demand: ELASTIC
Price
PED > 1 (Elastic Demand) PED < 1 (Inelastic Demand)
Price •%∆ in Price < %∆ in Qd •%∆ in Price > %∆ in Qd

•P↓ (5%) < Qd ↑ (10%) •P↓ (10%) > Qd ↑ (5%)

•PED = (%∆ in Qd / % in P) ∆P 10% •PED = (%∆ in Qd / % in P)

∆P 5% •PED = [10 / (-5)] = -2 •PED = [5 / (-10)] = - 0.5

5% D
10% D
Quantity Quantity
∆Q ∆Q

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The Price Elasticity of Demand:

The Price Elasticity of Demand: UNIT ELASTIC PERFECTLY ELASTIC & PERFECTLY INELASTIC
Price Price
Price D

PED = 1 (Unit Elastic Demand) 10

10 D
•%∆ in Price = %∆ in Qd

•P↓ (10%) = Qd ↑ (10%) 5

∆P 10
•PED = (%∆ in Qd / % in P)
% 5 10 Quantity 10 Quantity
•PED = [10 / (-10)] = - 1.0
• PED = ∞ (Perfectly Elastic) • PED = 0 (Perfectly Inelastic)
10 D • A situation in which a small percentage • A condition in which the Qd does not
% Quantity change in the price leads to an infinite change even though the price
percentage change in the Qd. changes.
∆Q
•PED = (%∆ in Qd / % in P) •PED = (%∆ in Qd / % in P)
•PED = [100 / (0)] = ∞ •PED = [0 / (100)] = 0
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 Summary: Income Elasticity of Demand (IED):
Definition: Measures the responsiveness of demand to
• (Ed > 1) Elastic : % DP < % DQD changes in income.
• (Ed < 1) Inelastic : % DP > % DQD
(Q 2 Q1) / Q1
• (Ed = 1) Unit Elastic : % DP = % DQD IED x100% = Formula Method
( I 2 I1) / I1
• (Ed = infinite) Perfectly Elastic
Q 2 Q1
• (Ed = 0) Perfectly Inelastic IED
(Q 2 Q1) / 2
x 100 %
= Midpoint Method
I 2 I1
(I 2 I1 ) / 2

Positive sign: Normal goods

Negative sign: Inferior goods
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Cross-Price Elasticity of Demand (CED): Price Elasticity of Supply (PES):

• Definition: Measure the response of demand for a product to a • Definition: measure of the response of quantity supplied to a
change in the price of another good. change in price of that good.

(Qx 2 Qx1) / Qx1 (QS 2 QS1) / QS1

CED x100% = Formula Method PES x100%
( P 2 P1) / P1 = Formula Method
( Py 2 Py1) / Py1

Q X Q X
Q S 2 Q S1
2 1
(Q Q ) / 2 (Q Q ) / 2
x 100 % = Midpoint Method PES x 100 % = Midpoint Method
X X
S 2 S1
CED 2 1
P2 P1
P Y
2 P Y
1
(P Y P Y ) / 2 ( P2 P1 ) / 2
2 1

Positive sign: X and Y are Substitute goods (Py ↑; Qdy↓; DD x↑) Its value is positive in output markets due to the law of supply.
Negative sign: X and Y are Complementary goods(Py ↑; Qdy↓; DD x↓)
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Price Elasticity of Supply (cont.): Summary:

• (ES > 1) Elastic : % DP < % DQS

• (ES < 1) Inelastic : % DP > % DQS
• (ES = 1) Unit Elastic : % DQS = % DP
• (ES = infinite) Perfectly Elastic
• (ES = 0) Perfectly Inelastic

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 QUESTION 1:
Use the diagram below to:

Refresh
(i) Calculate consumer surplus, producer surplus and total
surplus at the equilibrium price.

(ii) If government imposed price floor at RM11, calculate

Your new consumer surplus, producer surplus, total surplus and

deadweight loss.

Mind

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