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1. What are the two main functions that prices perform in market economies? How do they address the three main questions: what gets produced, how are they produced, and who gets the products? How do prices transmit information about changing consumer wants and resource availability? In market economies, prices answer the three main questions that any economic system must address. Prices do this by performing two main functions: rationing the goods and services that are produced and allocating the resources used to produce them. The question of who gets the goods and services that are produced is answered by the rationing function that prices perform. Products are rationed according to willingness and ability to pay the market prices for products. The questions of what gets produced and how they are produced are answered by the allocative function that prices perform. Prices transmit information between consumers and producers. Changes in consumers' desires and changing resource scarcity are signaled by the changing prices of goods and resources. 2. How do prices ration goods? Why must goods be rationed? What are other means of rationing besides price? Are these other methods fairer than using price? All scarce goods must be rationed somehow. Because goods are not freely available to everyone who wants them, some people will get certain goods and others will not. Rationing invariably discriminates against someone. Rationing by price discriminates against people with a low ability or willingness to pay the market price. Sometimes, other rationing mechanisms are employed, such as queuing. 3. If the price of a good is kept below the market price through the use of a government-imposed price control, how can the total cost end up exceeding the supposedly higher market price? When employing other ways of rationing goods, we should keep in mind that every rationing mechanism discriminates against someone and can result in wasted resources. For example, queuing often leads to long lines and wasted time and discriminates against people on the basis of the opportunity cost of their time. The total cost will often exceed what would have been paid in a free market. 4. How can supply and demand be used as a tool for analysis? The basic logic of supply and demand is a powerful tool for analysis. For example, supply and demand analysis show that an oil import tax will reduce the quantity of oil demanded, increase domestic production and generate revenues for the government. 5. How is market efficiency related to demand and supply? Supply and demand curve be used to illustrate the idea of market efficiency, an important aspect of normative economics. 6. What is Consumer Surplus? Consumer surplus is the difference between maximum amount a person is willing to pay for a good and the current market price. 7. What is Producer Surplus? Producer Surplus is the difference between the current market price and the full cost of production at each output level. 8. When are producer and consumer surpluses maximized? Producer and consumer surpluses are maximized at free market equilibrium in competitive markets. 9. What happens to consumer surplus if goods are over or under produced? The is a loss in both consumer and producer surplus and this is referred to as a deadweight loss. 10. What is elasticity? Elasticity is a general measure of responsiveness. If one variable A changes in response to changes in another variable B, the elasticity of A with respect to B is equal to the percentage change in A divided by the percentage change in B. 11. How is the slope of the demand curve related to responsiveness? The slope of a demand curve is an inadequate measure of responsiveness, because its value depends on the units of measurement used. For this reason, elasticities are calculated using percentages. 12. What is price elasticity of demand and what are its extremes? The price elasticity of demand lets us know the percentage change we could expect in the quantity demanded of a good for a 1% change in price. Perfectly inelastic demand does not respond to price changes, its numerical value is zero. Perfectly elastic demand for a product drops to zero when there is a very small price increase. Unitary elastic demand describes a relationship in which the percentage change in the quantity of a product demanded is the same as the percentage change in price; its numerical value is -1. Elastic demand is demand in which the percentage change in the quantity of a product demanded is larger than the percentage change in price. Inelastic demand is demand in which the percentage change in the quantity of a product demanded is smaller than the percentage change in price. 13. What happens to total revenue if demand is elastic and price increases? A price increase will cause total revenue to fall as the quantity demanded will fall by a larger amount than the price rose. 14. What happens to total revenue if demand is elastic and price decreases? A price increase will cause total revenue to rise as the quantity demanded will rise by a larger amount than the price fell. 15. What does the elasticity of demand depend upon? The elasticity of demand depends upon the availability of substitutes, the importance of the item in individual budgets, and the time frame in question. 16. What are other important elasticity measures? Other important elasticity measures are: (1) income elasticity which measures the responsiveness of the quantity demanded with respect to changes in income; (2) cross price elasticity of demand which measures the responsiveness of the quantity demanded of one good with respect to changes in the price of another good, (3) elasticity of supply which measures the responsiveness of the quantity supplied of a good with respect to changes in the price of that good; and (4) elasticity of labor supply which measures the responsiveness of the quantity of labor supplied of a good with respect to changes in the price labor.
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