CHAPTER 3 ELASTICITY AND SURPLUS. Monday, September 19, 11

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1 CHATER 3 ELASTICITY AND SURLUS

2 YOU ARE HERE

3 ELASTICITY One of the most important concepts in economics is elasticity The elasticity of demand and elasticity of supply are basically the slope of the supply and demand curve They are very important for determining the magnitudes of interventions Formally Elasticity= % Q % = Q Q = Q Q

4 One kind of annoying thing about this is the and the Q Q If it were just: it would just be the slope of the curve For all intensive purposes this is what it is Ignoring (or conditioning on Q and ) the larger is the slope the larger is the elasticity. Lets focus on the elasticity of demand. I am going to use straight lines because it is the easiest to think about With a linear demand curve elasticity is technically greater at higher prices but lets not worry about that

5 ELASTICITY LABELS Elastic : the condition of demand when the percentage change in quantity is larger than the percentage change in price Inelastic: the condition of demand when the percentage change in quantity is smaller than the percentage change in price Unitary Elastic: the condition of demand when the percentage change in quantity is equal to the percentage change in price

6 Q

7 Medium (Unitary) Elasticity of Demand Q

8 High Elasticity Medium (Unitary) Elasticity of Demand Q

9 erfectly Elastic High Elasticity Medium (Unitary) Elasticity of Demand Q

10 Inelastic erfectly Elastic High Elasticity Medium (Unitary) Elasticity of Demand Q

11 Inelastic erfectly Inelastic erfectly Elastic High Elasticity Medium (Unitary) Elasticity of Demand Q

12 WHY DO WE CARE Economic behavior depends a lot on the elasticity of the demand curve (and of the supply curve) As an example lets think about what happens when the supply curve shifts

13 MEDIUM ELASTICITY

14 MEDIUM ELASTICITY $2.5 $2. $1.5 Supply Old Equilibrium $1. $.5 Demand

15 MEDIUM ELASTICITY $2.5 $2. $1.5 $1. New Supply Supply Old Equilibrium $.5 Demand

16 MEDIUM ELASTICITY $2.5 $2. $1.5 $1. New Supply Supply New Equilibrium Old Equilibrium $.5 Demand

17 MEDIUM ELASTICITY rice rises $2.5 $2. $1.5 New Supply Supply New Equilibrium Old Equilibrium $1. Quantity falls $.5 Demand

18 ERFECTLY ELASTIC DEMAND

19 ERFECTLY ELASTIC DEMAND $2.5 $2. $1.5 $1. Supply Old Equilibrium $.5 Demand

20 ERFECTLY ELASTIC DEMAND $2.5 $2. $1.5 $1. New Supply Supply Old Equilibrium $.5 Demand

21 ERFECTLY ELASTIC DEMAND $2.5 $2. $1.5 $1. New Supply Supply New Equilibrium Old Equilibrium $.5 Demand

22 ERFECTLY ELASTIC DEMAND $2.5 $2. New Supply Supply rice doesn t change $1.5 $1. New Equilibrium Old Equilibrium Quantity decreases a lot $.5 Demand

23 ERFECTLY INELASTIC DEMAND

24 ERFECTLY INELASTIC DEMAND $2.5 $2. $1.5 $1. Supply Old Equilibrium $.5 Demand

25 ERFECTLY INELASTIC DEMAND $2.5 $2. $1.5 $1. New Supply Supply Old Equilibrium $.5 Demand

26 ERFECTLY INELASTIC DEMAND $2.5 $2. $1.5 $1. New Supply Supply New Equilibrium Old Equilibrium $.5 Demand

27 ERFECTLY INELASTIC DEMAND $2.5 $2. New Supply Supply New Equilibrium rice changes a lot $1.5 $1. Old Equilibrium Quantity doesn t change $.5 Demand

28 COMARING ELASTICITIES

29 COMARING ELASTICITIES $2.5 $2. $1.5 $1. $ Large Elasticity

30 COMARING ELASTICITIES $2.5 $2. $1.5 $1. $ Large Elasticity

31 COMARING ELASTICITIES $2.5 $2. $1.5 $1. $ Large Elasticity

32 COMARING ELASTICITIES $2.5 $2. $1.5 $1. $.5 Low Elasticity Large Elasticity

33 COMARING ELASTICITIES $2.5 $2. $1.5 $1. $.5 Low Elasticity Large Elasticity

34 COMARING ELASTICITIES $2.5 $2. $1.5 When Demand is more elastic price change is smaller and quantity change is larger $1. $.5 Low Elasticity Large Elasticity

35 ALTERNATIVE WAYS TO UNDERSTAND ELASTICITY A good for which there are no good substitutes is likely to be one for which you must pay whatever price is charged. It is also likely to be one for which a lower price will not induce substantially greater consumption. Thus, as price changes there is very little change in consumption, i.e. demand is inelastic and the demand curve is steep. Inexpensive goods that take up little of your income can change in price and your consumption will not change dramatically. Thus, at low prices, demand is inelastic.

36 SEEING ELASTICITY THROUGH TOTAL EXENDITURES Total Expenditure Rule: if the price and the amount you spend both go in the same direction then demand is inelastic while if they go in opposite directions demand is elastic.

37 DETERMINANTS OF ELASTICITY Number of and Closeness of Substitutes The more alternatives you have the less likely you are to pay high prices for a good and the more likely you are to settle for something that will do. Time The longer you have to come up with alternatives to paying high prices the more likely it is you will shift to those alternatives. ortion of the Budget The greater the portion of the budget an item takes up, the greater the elasticity is likely to be.

38 Inelastic Goods ELASTICITY EXAMLES rice Elasticity Eggs.6 Food.21 Health Care Services.18 Gasoline (short-run).8 Gasoline (long-run).24 Highway and Bridge Tolls.1 Unit Elastic Good (or close to it) Shellfish.89 Cars 1.14 Elastic Goods Luxury Car 3.7 Foreign Air Travel 1.77 Restaurant Meals 2.27

39 RICE ELASTICITY SULY Identical in concept to elasticity of demand. Formula is the Same It is also related to the slope of the supply curve but is not simply the slope of the supply curve. Terminology is the same

40 Q

41 Medium (Unitary) Elasticity of Supply Q

42 High Elasticity Medium (Unitary) Elasticity of Supply Q

43 High Elasticity Medium (Unitary) Elasticity of Supply erfectly Elastic Q

44 Inelastic High Elasticity Medium (Unitary) Elasticity of Supply erfectly Elastic Q

45 Inelastic erfectly Inelastic High Elasticity Medium (Unitary) Elasticity of Supply erfectly Elastic Q

46 ERFECTLY ELASTIC SULY

47 ERFECTLY ELASTIC SULY $2.5 $2. $1.5 $1. Old Equilibrium $

48 ERFECTLY ELASTIC SULY $2.5 $2. $1.5 $1. Old Equilibrium $

49 ERFECTLY ELASTIC SULY $2.5 $2. New Equilibrium $1.5 $1. Old Equilibrium $

50 ERFECTLY ELASTIC SULY $2.5 $2. New Equilibrium $1.5 $1. Old Equilibrium $

51 ERFECTLY ELASTIC SULY $2.5 $2. New Equilibrium rice doesn t change $1.5 $1. Old Equilibrium Quantity Increases a lot $

52 ERFECTLY INELASTIC SULY

53 ERFECTLY INELASTIC SULY $2.5 $2. $1.5 $1. Old Equilibrium $

54 ERFECTLY INELASTIC SULY $2.5 $2. $1.5 $1. Old Equilibrium $

55 ERFECTLY INELASTIC SULY $2.5 $2. New Equilibrium $1.5 $1. Old Equilibrium $

56 ERFECTLY INELASTIC SULY $2.5 $2. New Equilibrium rice Increases a lot $1.5 $1. Old Equilibrium Quantity doesn t change $

57 COMARING ELASTICITIES

58 COMARING ELASTICITIES $2.5 $2. Low Elasticity $1.5 $1. $

59 COMARING ELASTICITIES $2.5 $2. Low Elasticity $1.5 $1. $

60 COMARING ELASTICITIES $2.5 $2. Low Elasticity $1.5 $1. $

61 COMARING ELASTICITIES $2.5 $2. Low Elasticity High Elasticity $1.5 $1. $

62 COMARING ELASTICITIES $2.5 $2. Low Elasticity High Elasticity $1.5 $1. $

63 COMARING ELASTICITIES $2.5 $2. $1.5 $1. $.5 Low Elasticity High Elasticity When supply is more elastic price change is smaller and quantity change is larger

64 CONSUMER SURLUS I think this is easiest to see in our extensive margin example that we started with Name Willingness to ay Jim $2 Jackie $4 Bill $6 Sally $8 Lisa $1 So for Bill the value of the Ipad is $6. If he could get an Ipad for free this would be worth $6 This gave the demand curve

65 Lisa Sally Bill Jackie Jim

66 Lisa Sally Bill Jackie Jim

67 Lisa Sally Bill Jackie Jim In this case Bill, Sally and Lisa all get their Ipads, Jackie and Jim do not

68 Lisa Sally Bill Jackie Jim In this case Bill, Sally and Lisa all get their Ipads, Jackie and Jim do not The Value to Lisa is $1.

69 Lisa Sally Bill Jackie Jim In this case Bill, Sally and Lisa all get their Ipads, Jackie and Jim do not The Value to Lisa is $1. She pays $6, so her surplus is $4

70 Lisa Sally Bill Jackie Jim In this case Bill, Sally and Lisa all get their Ipads, Jackie and Jim do not The Value to Lisa is $1. She pays $6, so her surplus is $4 Sally s Value is $8 so her surplus is $2

71 Lisa Sally Bill Jackie Jim In this case Bill, Sally and Lisa all get their Ipads, Jackie and Jim do not The Value to Lisa is $1. She pays $6, so her surplus is $4 Sally s Value is $8 so her surplus is $2 Bill s value is $6 so he gets no surplus

72 Total Consumer Surplus: $ Lisa Sally Bill Jackie Jim In this case Bill, Sally and Lisa all get their Ipads, Jackie and Jim do not The Value to Lisa is $1. She pays $6, so her surplus is $4 Sally s Value is $8 so her surplus is $2 Bill s value is $6 so he gets no surplus

73 Now lets think about this in a more more standard (and general) context

74 Now lets think about this in a more more standard (and general) context $2.5 $2. $1.5 $1. $.5 Demand

75 Now lets think about this in a more more standard (and general) context $2.5 $2. $1.5 Total Consumer Value $1. $.5 Demand

76 Now lets think about this in a more more standard (and general) context $2.5 $2. $1.5 Total Consumer Value $1. $ Total that consumers pay Demand

77 Now lets think about this in a more more standard (and general) context $2.5 $2. Consumer Surplus $1.5 Total Consumer Value $1. $ Total that consumers pay Demand

78 Now the firm

79 Now the firm $2.5 $2. $1.5 $1. $.5 Demand

80 Now the firm $2.5 $2. $1.5 Total firms receive in revenue $1. $.5 Demand

81 Now the firm $2.5 $2. $1.5 Total firms receive in revenue $1. $.5 Variable costs to producer Demand

82 Now the firm $2.5 $2. roducer Surplus $1.5 Total firms receive in revenue $1. $.5 Variable costs to producer Demand

83 Total Combined Surplus

84 $2.5 $2. $1.5 $1. Total Combined Surplus $.5 Demand

85 $2.5 $2. $1.5 $1. Total Combined Surplus $.5 Demand

86 MARKET EFFICIENCY One can see from this why people think markets are efficient Suppose rather than having the market choose Q we decided to do it ourselves. Could we do any better in terms of total surplus.

87 Now lets think about this in a more more standard (and general) context What if we chose a lower Q?

88 Now lets think about this in a more more standard (and general) context $2.5 $2. What if we chose a lower Q? $1.5 $1. $

89 Now lets think about this in a more more standard (and general) context What if we chose a lower Q? $2.5 $2. Surplus Now $1.5 Total surplus is lower $1. $

90 Now lets think about this in a more more standard (and general) context What if we chose a lower Q? $2.5 $2. Surplus Now $1.5 $1. $.5 Deadweight Loss Total surplus is lower

91 Now lets think about this in a more more standard (and general) context What if we chose a lower Q? $2.5 $2. $1.5 $1. $.5 Surplus Now Deadweight Loss Total surplus is lower I did not say anything about how surplus is distributed-could be more equitable

92 What if we chose a higher Q?

93 What if we chose a higher Q? $2.5 $2. $1.5 $1. $

94 What if we chose a higher Q? $2.5 $2. $1.5 $1. $

95 What if we chose a higher Q? $2.5 $2. $1.5 $1. This bit is actually negative, Costs are higher than users valuation Thus Total surplus is lower $

96 DO MARKETS ALWAYS WORK WELL? No, for many reasons markets may fail Market Failure: the circumstance where the market outcome is not the economically efficient outcome ossible Sources: Consumption or production can harm an innocent third party. A good may not be one for which a company can profit from selling it though society profits from its existence. The buyer may not be able to make a well-informed choice. A buyer or seller may have too much power over the price.

97 CATEGORIZING GOODS: EXCLUSIVITY AND RIVALRY Exclusivity: the degree to which the consumption of the good can be restricted by a seller to only those who pay for it Rivalry: the degree to which one person s consumption reduces the value of the good for the next consumer

98 RIVATE AND UBLIC GOODS urely private good: a good with the characteristics of both exclusivity and rivalry urely public good: a good with the neither of the characteristics exclusivity and rivalry Excludable public good: a good with the characteristic of exclusivity but not of rivalry Congestible public good: a good with the characteristic of rivalry but not of exclusivity

99 TAXES I am mostly following Guell quite closely However here I will not, I think this is a good time in the course to talk about taxes The book talks about specific aspects in many places in the book I want to make some general points Think about a $1. tax on the good (like gas tax) Very similar to standard sales tax (just a percentage rather than a level)

100 Tax Example $2.5 $2. $1.5 $1. $

101 Tax Example $2.5 $2. $1.5 Before I would have bought 25 units if price was $1.25. Now if price is $.25 it costs me $1.5 so I buy 25 units $1. $

102 Tax Example $2.5 $2. $1.5 Before I would have bought 25 units if price was $1.25. Now if price is $.25 it costs me $1.5 so I buy 25 units $1. $.5 Actual Demand

103 Tax Example $2.5 $2. $1.5 $1. $.5 Before I would have bought 25 units if price was $1.25. Now if price is $.25 it costs me $1.5 so I buy 25 units Demand from consumers perspective Actual Demand

104 Tax Example rice firm gets $2.5 $2. $1.5 $1. $.5 Before I would have bought 25 units if price was $1.25. Now if price is $.25 it costs me $1.5 so I buy 25 units Demand from consumers perspective Actual Demand

105 Tax Example rice firm gets $2.5 $2. $1.5 $1. $.5 Effective price consumer pays Before I would have bought 25 units if price was $1.25. Now if price is $.25 it costs me $1.5 so I buy 25 units Demand from consumers perspective Actual Demand

106 Tax Example Consumer surplus rice firm gets $2.5 $2. $1.5 $1. $.5 Effective price consumer pays Before I would have bought 25 units if price was $1.25. Now if price is $.25 it costs me $1.5 so I buy 25 units Demand from consumers perspective Actual Demand

107 Tax Example Consumer surplus roducer surplus rice firm gets $2.5 $2. $1.5 $1. $.5 Effective price consumer pays Before I would have bought 25 units if price was $1.25. Now if price is $.25 it costs me $1.5 so I buy 25 units Demand from consumers perspective Actual Demand

108 Tax Example Consumer surplus Government revenue roducer surplus rice firm gets $2.5 $2. $1.5 $1. $.5 Effective price consumer pays Before I would have bought 25 units if price was $1.25. Now if price is $.25 it costs me $1.5 so I buy 25 units Demand from consumers perspective Actual Demand

109 Tax Example Consumer surplus Government revenue roducer surplus rice firm gets $2.5 $2. $1.5 $1. $.5 Effective price consumer pays Before I would have bought 25 units if price was $1.25. Now if price is $.25 it costs me $1.5 so I buy 25 units Deadweight loss Demand from consumers perspective Actual Demand

110 INCIDENCE It doesn t matter here at all whether the tax was imposed on the producer or consumer You get exactly the same result either way

111 roducer pays tax

112 roducer pays tax $2.5 $2. $1.5 $1. $

113 roducer pays tax $2.5 $2. $1.5 $1. $.5 New supply curve firms act like price is -$1. Before I would have sold 2 units if price was $1.5. Now if price is $2.5, I get $1.5 so I sell 2 units

114 roducer pays tax $2.5 $2. $1.5 $1. $.5 rice consumer pays New supply curve firms act like price is -$1. Before I would have sold 2 units if price was $1.5. Now if price is $2.5, I get $1.5 so I sell 2 units

115 roducer pays tax $2.5 $2. $1.5 $1. rice consumer pays New supply curve firms act like price is -$1. Before I would have sold 2 units if price was $1.5. Now if price is $2.5, I get $1.5 so I sell 2 units Effective price firm gets $

116 Consumer surplus roducer pays tax $2.5 $2. $1.5 $1. rice consumer pays New supply curve firms act like price is -$1. Before I would have sold 2 units if price was $1.5. Now if price is $2.5, I get $1.5 so I sell 2 units Effective price firm gets $

117 Consumer surplus roducer surplus roducer pays tax $2.5 $2. $1.5 $1. rice consumer pays New supply curve firms act like price is -$1. Before I would have sold 2 units if price was $1.5. Now if price is $2.5, I get $1.5 so I sell 2 units Effective price firm gets $

118 Consumer surplus Government revenue roducer surplus roducer pays tax $2.5 $2. $1.5 $1. rice consumer pays New supply curve firms act like price is -$1. Before I would have sold 2 units if price was $1.5. Now if price is $2.5, I get $1.5 so I sell 2 units Effective price firm gets $

119 Consumer surplus Government revenue roducer surplus roducer pays tax $2.5 $2. $1.5 $1. rice consumer pays New supply curve firms act like price is -$1. Before I would have sold 2 units if price was $1.5. Now if price is $2.5, I get $1.5 so I sell 2 units Dead Weight loss Effective price firm gets $

120 Consumer surplus Government revenue roducer surplus Effective price firm gets $2.5 $2. $1.5 $1. $.5 roducer pays tax rice consumer pays New supply curve firms act like price is -$1. Before I would have sold 2 units if price was $1.5. Now if price is $2.5, I get $1.5 so I sell 2 units Dead Weight loss It is exactly the same as before

121 TAXES AND ELASTICITY A really really important issue here is that the deadweight loss depends upon the elasticity Suppose elasticity of supply or demand were zero There are a bunch of different ways to do this, but suppose elasticity of demand is zero and tax is on producer Then consider the case in which elasticity of supply is zero and tax is on consumer

122 erfectly Inelastic Demand

123 erfectly Inelastic Demand $2.5 $2. $1.5 $1. $

124 erfectly Inelastic Demand $2.5 $2. New supply curve firms act like price is -$1. $1.5 $1. $

125 erfectly Inelastic Demand rice consumer pays $2.5 $2. New supply curve firms act like price is -$1. $1.5 $1. $

126 erfectly Inelastic Demand rice consumer pays $2.5 $2. New supply curve firms act like price is -$1. $1.5 $1. Effective price that firm gets $

127 erfectly Inelastic Demand $2.5 $2. Government revenue rice consumer pays New supply curve firms act like price is -$1. $1.5 $1. Effective price that firm gets $

128 erfectly Inelastic Demand $2.5 $2. Government revenue $1.5 $1. Effective price that firm gets rice consumer pays $.5 I would sell 2 units whether there are taxes or not New supply curve firms act like price is -$

129 erfectly Inelastic Demand $2.5 $2. Government revenue rice consumer pays $1.5 I would sell 2 units whether there are taxes or not New supply curve firms act like price is -$1. $1. Effective price that firm gets $.5 This means there is no deadweight loss

130 erfectly Elastic Supply roducer surplus $2.5 $2. $1.5 $1. $

131 erfectly Elastic Supply $2.5 $2. roducer surplus $1.5 $1. New demand curve Workers act like price is +$1. $

132 erfectly Elastic Supply $2.5 $2. roducer surplus rice firm gets $1.5 $1. $.5 New demand curve Workers act like price is +$

133 erfectly Elastic Supply $2.5 $2. Effective price consumer pays roducer surplus rice firm gets $1.5 $1. $.5 New demand curve Workers act like price is +$

134 erfectly Elastic Supply Government revenue $2.5 $2. Effective price consumer pays roducer surplus rice firm gets $1.5 $1. $.5 New demand curve Workers act like price is +$

135 erfectly Elastic Supply Government revenue $2.5 $2. Effective price consumer pays roducer surplus rice firm gets $1.5 $1. $.5 New demand curve Workers act like price is +$1. No deadweight loss

136 More generally the size of the deadweight loss depends on the elasticity The larger the elasticity the larger the deadweight loss For similar reason the larger the elasticity the smaller the government revenue For that reason Governments should tax things with low elasticity 39

137 Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. New demand curve Workers act like price is +$1. $

138 Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. New demand curve Workers act like price is +$1. $

139 Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. $

140 Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. $

141 Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. $

142 Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. $

143 Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. $

144 Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. $

145 Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. $

146 Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. $

147 Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. $

148 Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. $

149 Think about what happens as elasticity increases? Deadweight Loss Rises and Government Revenue Falls $2.5 $2. $1.5 $1. $

150 Think about what happens as elasticity increases? Deadweight Loss Rises and Government Revenue Falls $2.5 $2. $1.5 $1. $.5 Both are bad so we don t want to tax things that are high elasticity

151 Stop Coddling the Super-Rich Warren Buffett, New York Times, Aug According to a theory I sometimes hear, I should have thrown a fit and refused to invest because of the elevated tax rates on capital gains and dividends. I didn t refuse, nor did others. I have worked with investors for 6 years and I have yet to see anyone not even when capital gains rates were 39.9 percent in shy away from a sensible investment because of the tax rate on the potential gain. 41

Chapter Outline. Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus. Elasticity. Elasticity Labels

Chapter Outline. Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus. Elasticity. Elasticity Labels Chapter Outline Chapter The Concept of Elasticity and Consumer and roducer Surplus ELSTICITY OF EMN LTERNTIVE WYS OF UNERSTNING ELSTICITY MORE ON ELSTICITY CONSUMER N ROUCER SURLUS Elasticity Elasticity: