NAME: ECNS 251 Homework 4 Elasticity, Supply and Demand III. 1. Consider the market for EpiPens.

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1 ECNS 251 Homework 4 Elasticity, Supply and Demand III NAME: 1. Consider the market for EpiPens. a. If this market has very elastic supply and very inelastic demand, how would the burden of a tax on EpiPens be shared between consumers and producers? Use the tools of consumer surplus and producer surplus in your answer. Tax= PC-PP. PC = price consumers pay, PP = price producers receive. The tax reduces quantity from Q0 to Q1. With very elastic supply and very inelastic demand, the burden of the tax will be borne largely by buyers. As Figure A shows, consumer surplus declines considerably, by area A + C (C is not labeled, but is the triangle below the demand curve above P0 between Q1 and Q0), but producer surplus does not fall much at all, just by area B + D (D is not labeled, but is the triangle above the supply curve below P0 between Q1 and Q0). 1

2 b. If this market has very inelastic supply and very elastic demand, how would the burden of a tax on EpiPens be shared between consumers and producers? Contrast your answer with your answer to part (a). Tax= PC-PP. PC = price consumers pay, PP = price producers receive. The tax reduces quantity from Q0 to Q1. With very inelastic supply and very elastic demand, the burden of the tax will be borne largely by sellers. As Figure B shows, consumer surplus does not decline much, just by area by area A + C (C is not labeled, but is the triangle below the demand curve above P0 between Q1 and Q0), while producer surplus falls substantially, by area B + D (D is not labeled, but is the triangle above the supply curve below P0 between Q1 and Q0). Compared to part (a), producers bear much more of the burden of the tax, and consumers bear much less. 2. Suppose that the government imposes a tax on heating oil. a. Would the deadweight loss from this tax likely be greater in the first year after it is imposed, or the fifth year? Explain. The deadweight loss from a tax on heating oil is likely to be greater in the fifth year after it is imposed rather than the first year. In the first year, the elasticity of demand is fairly low, as people who own oil heaters are not likely to get rid of them right away. But over time they may switch to other energy sources and people buying new heaters for their homes will more likely choose gas or electric, so the tax will have a greater impact on quantity. Thus, the deadweight loss of the tax will get larger over time. b. Would the revenue collected from this tax likely be greater in the first year after it is imposed, or the fifth year? Explain. The tax revenue is likely to be higher in the first year after it is imposed than in the fifth year. In the first year, demand is more inelastic, so the quantity does not decline as much and tax revenue is relatively high. As time passes and more people substitute away from oil, the quantity sold declines, as does tax revenue 2

3 3. The cost of producing yoga mats has fallen over the past decade. Let s consider some implications of this fact. a. Draw a supply-and-demand diagram to show the effect of falling production costs on the price and quantity of yoga mats sold. Falling production costs shift out the supply curve to the right (S0 S1). Price falls from P0 to P1 and quantity increases from Q0 to Q1. b. In your diagram, show what happens to consumer surplus and producer surplus. The decline in the price increases consumer surplus from area A to A + B + D + F, an increase in the amount B + D + F. Prior to the shift in supply, producer surplus was areas B + C (the area above the supply curve and below the price). After the shift in supply, producer surplus is areas C + E + G. So producer surplus changes by the amount E + G B, which may be positive or negative. The increase in quantity increases producer surplus, while the decline in the price reduces producer surplus. Because consumer surplus rises by B + D + F and producer surplus rises by E + G B, total surplus rises by D + F+ E + G. 3

4 c. Suppose the supply of yoga mats is very elastic. Who benefits most from falling production costs- consumers or producers of these yoga mats? If the supply of very elastic, then the shift of the supply curve benefits consumers most. To take the most dramatic case, suppose the supply curve were horizontal, as shown in the figure below. Then there is no producer surplus at all. Consumers capture all the benefits of falling production costs, with consumer surplus rising from area A to area A + B. Price per unit A S B S' Quantity per period 4

5 4. Regular skiers at Bridger Bowl have noticed that the parking lot is full and the lift lines are long much more often this season than in earlier seasons. Lindsey, a regular Bridger Bowl skier, suggests that this is because the price of skiing at Moonlight Basin (a nearby ski resort) has risen. Shawn, another regular skier, suggests that it is because Bridger Bowl opened up two new lifts this year. Use supply and demand diagrams to illustrate Lindsey and Shawn's suggestions. What can we expect to happen to Bridger Bowl ski pass prices in the future if Lindsey is right? If Shawn is right? Lindsey is suggesting that since Bridger Bowl and Moonlight Basin are substitutes, the increase in the price of skiing at Moonlight has increased the demand for skiing at Bridger Bowl (and decreased the quantity of skiing demanded at Moonlight Basin). The increased demand increases the quantity of skiers (and drivers/parkers) at Bridger Bowl. As the market adjusts to the change in demand, the equilibrium price will rise from P* to P', and the equilibrium quantity will rise from Q* to Q'. Shawn is suggesting that since Bridger Bowl has increased its lift capacity, they have effectively increased the supply of skiing at Bridger Bowl. The increased supply makes it possible for more skiers (and drivers/parkers) to ski at Bridger Bowl. As the market adjusts to the increase in supply, the equilibrium price will fall from P* to P', and the equilibrium quantity will rise from Q* to Q'. Lindsey's Suggestion Shawn's Suggestion D D Price Per Gallon S D' P* P' Price Per Gallon S S' P* Q* Q* P' Gallons per period Q' Gallons per period Q' 5. Suppose that MSU students have the following demand for on-campus tutoring services during a "regular" week of the semester and during "dead week" (the week before finals week). Price ($/hour) Quantity Demanded (hours/regular week) $15 1,000 2,000 $ ,900 $ ,800 $ ,700 Quantity Demanded (hours/dead week) a. (2 points) In which type of week is the demand for tutoring higher? Why might that be the case? 5

6 The quantity of tutoring hours demanded is much higher at each price during dead week than during "regular" weeks in the semester. This is probably the result of students wanting to increase their use of tutoring to help them prepare for final exams. b. (4 points) What is the price elasticity of demand for tutoring between P=20 and P=$25 during (i) a regular week and (ii) dead week? Elasticity (regular week) [( )/700]/[(25-20)/22.5] =(-200/700)/(5/22.5) =-.286/.222 = Elasticity (dead week) [( )/1850]/[(25-20)/22.5] =(-100/1850)/(5/22.5) =-.054/.222 =-.243 c. (2 points) When is demand more elastic? Why might the elasticity differ across the weeks? Demand is more elastic during regular weeks than during dead week. There are several reasons why this is likely. During regular weeks, students have longer time to adjust to price increases in tutoring, they may also be able to find more substitutes for tutors on campus during regular weeks but not during dead week since most tutoring services are very busy during dead week but less busy during regular weeks. 6. In each case below, calculate the price elasticity of demand, characterize the elasticity (elastic, inelastic, unit elastic) and describe how the price change impacts total revenue. a. When price rises from $7 to $8, quantity demanded falls from 350 to 300 units per week. [( )/325]/[(7-8)/7.5] =(50/325)/(-1/7.5) =.154/-.133 =-1.16 Elastic The increase in price will reduce total revenue 6

7 b. When price rises from $1 to $2, quantity demand falls from 20 to 10 units per week. [(1-2)/1.5]/[(20-10)/15] =(-1/1.5)/(10/15) =-.66/.66 =-1 Unit Elastic The increase in price will not change total revenue c. When price falls from $25 to $20, quantity demanded rises from 1000 to 1050 units per week. [(25-20)/22.5]/[( )/1025] =(5/22.5)/(-50/1025) =.22/-.05 =-4.4 Elastic The decrease in price will increase total revenue 7. In each case below, describe what will happen to total revenue. a. The demand for Yogi Herbal Tea is elastic. Producers lower the price of Yogi Herbal Tea. Total revenue will rise b. The demand for snow tires is inelastic. Producers raise the price of snow tires. Total revenue will rise c. The demand for taxi rides is inelastic. The introduction of Uber lowers the price of taxi rides. If the demand for taxi rides stays the same, total revenue will rise note however that the introduction of Uber is likely to both lower the demand for taxi rides (which would lower total revenue) and also make the demand for taxi rides more elastic (and if this change is enough to convert the elasticity of taxi rides from inelastic to elastic, then a reduction in the price of taxi rides, ceteris paribus, would cause total revenue to rise). 7

8 8. Read, "Germans get little in reward for booking their flights early," (The Economist, 11/27/2017) and answer the following: a. Why would prices of US domestic airline flights rise as the flight date/time gets closer? b. Offer an explanation for why waiting to buy a domestic flight ticket in Britain would save travelers money. c. How does the elasticity of demand for flights for vacationers differ from that of business travelers? d. Why would the penalty for waiting to buy plane tickets be larger "around holiday times"? e. The last paragraph on page 2 is obscured by an ad. What do you think it is likely to say? How does that relate to the elasticity of demand for flights among "sedate" academics versus "fastmoving" business people? 8