QuestionDiscussion Question 1

The law of demand states that a fall in the price of a good raises the quantity demanded, and the increase in price leads to a decrease in quantity demanded. The price elasticity of demand measures the responsiveness of the quantity demanded to a change in price. Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price, and the percentage change in quantity demanded is greater than the percentage change in price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price, which indicates that the percentage in price is greater than the percentage in quantity demanded.

However, the extent of responsiveness of quantity demanded to a change in price depends on the nature of a particular good or service in the market. The price elasticity of demand partly depends on the availability of close substitutes. When a large number of substitutes are available, consumers respond to a higher price of a good by buying more of the substitute goods and less of the relatively more expensive good. In addition, goods or services that are considered necessities tend to have less elastic (more inelastic) demand, whereas goods or services that are considered luxuries have more elastic (less inelastic) demands.

• Explain why the demand for the good or service provided by the organization you work for is elastic or inelastic. How does this influence pricing decisions?
• Provide examples on how the availability of close substitutes affects price elasticity of demand.
• Give specific examples of necessities or luxuries, and explain how they affect price elasticity of goods or services.

Externalities come about when individuals impose costs on or provide benefits to others but do not consider those costs and benefits when deciding how much to consume or produce. Thus externality is a cost or benefit received by a person not involved in a market transaction, and therefore not reflected in the market price of the commodity being transacted. There are two types of externalities: positive externalities and negative externalities.

A positive externality exists when an individual or firm making an economic decision does not receive the full benefit of the decision. In this case, the social benefit is greater than the benefit that goes to the individual or firm.

A negative externality occurs when an individual or firm making a decision does not have to pay the full cost of the decision. If a good has a negative externality, then the cost to society is greater than the cost consumer is paying for it.

Both positive and negative externalities result in market inefficiencies unless proper action is taken.

• Describe your understanding of externalities by providing an example of a positive externality and a negative externality.
• Why do positive and negative externalities lead to inefficiency in the market economy?
• How can externalities be addressed using the private sector to reduce market distortions of externalities?
• What government policies help deal with positive and negative externalities by reducing inefficiency?

Unit 2 Case Study

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