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1 2. Demand and Supply The following materials are taken from Chap. 3 to Chap. 7 of Economics, 2 nd ed., Krugman and Wells(2009), Worth Palgrave MaCmillan. 1 of 42

2 2. Demand and Supply, and Market Equilibrium 1) Demand and Supply 2) Consumer and Producer Surplus 3) Price and Quantity Control 4) Elasticity 5) Tax 2 of 42

3 WHAT YOU WILL LEARN IN THIS CHAPTER 1) Demand and Supply What a competitive market is and how it is described by the supply and demand model What the demand curve and supply curve are The difference between movements along a curve and shifts of a curve How the supply and demand curves determine a market s equilibrium price and equilibrium quantity In the case of a shortage or surplus, how price moves the market back to equilibrium 3 of 42

4 Supply and Demand A competitive market: Many buyers and sellers Same good or service The supply and demand model is a model of how a competitive market works. Five key elements: Demand curve Supply curve Demand and supply curve shifts Market equilibrium Changes in the market equilibrium 4 of 42

5 Demand Schedule A demand schedule shows how much of a good or service consumers will want to buy at different prices. Demand Schedule for Coffee Beans Price of coffee beans (per pound) \$ Quantity of coffee beans demanded (billions of pounds) of 42

6 Demand Curve Price of coffee bean (per gallon) \$ A demand curve is the graphical representation of the demand schedule; it shows how much of a good or service consumers want to buy at any given price As price rises, the quantity demanded falls Demand curve, D Quantity of coffee beans (billions of pounds) 6 of 42

7 An Increase in Demand An increase in the population and other factors generate an increase in demand a rise in the quantity demanded at any given price. This is represented by the two demand schedules - one showing demand in 2002, before the rise in population, the other showing demand in 2006, after the rise in population. Demand Schedules for Coffee Beans Price of coffee beans (per pound) \$ Quantity of coffee beans demanded (billions of pounds) in 2002 in of 42

8 An Increase in Demand Increase in population more coffee drinkers Price of coffee beans (per gallon) \$ Demand curve in Demand curve in 2002 D 1 D Quantity of coffee beans (billions of pounds) A shift of the demand curve is a change in the quantity demanded at any given price, represented by the change of the original demand curve to a new position, denoted by a new demand curve. 8 of 42

9 Movement Along the Demand Curve Price of coffee beans (per gallon) \$ A A shift of the demand curve C B A movement along the demand curve is a change in the quantity demanded of a good that is the result of a change in that good s price. is not the same thing as a movement along the demand curve D 1 D Quantity of coffee beans (billions of pounds) 9 of 42

10 Shifts of the Demand Curve Price Increase in demand An decrease increase in demand, means a leftward rightward shift of of the demand curve: at any given price, consumers demand a larger smaller quantity than before. (D1 D2) (D1 D3) Decrease in demand D 3 D 1 D 2 Quantity 10 of 42

11 What Causes a Demand Curve to Shift? Changes in the Prices of Related Goods Substitutes: Two goods are substitutes if a fall in the price of one of the goods makes consumers less willing to buy the other good. Complements: Two goods are complements if a fall in the price of one good makes people more willing to buy the other good. 11 of 42

12 What Causes a Demand Curve to Shift? Changes in Income Normal Goods: When a rise in income increases the demand for a good - the normal case - we say that the good is a normal good. Inferior Goods: When a rise in income decreases the demand for a good, it is an inferior good. Changes in Tastes Changes in Expectations change in the prices of related goods or services change in the number of consumers 12 of 42

13 Individual Demand Curve and the Market Demand Curve The market demand curve is the horizontal sum of the individual demand curves of all consumers in that market. (a) Darla s Individual Demand Curve (b) Dino s Individual Demand Curve (c) Market Demand Curve Price of coffee beans (per pound) Price of coffee beans (per pound) Price of coffee beans (per pound) \$2 \$2 \$ D Market D Darla D Dino Quantity of coffee Quantity of coffee beans (pounds) beans (pounds) Quantity of coffee beans (pounds) 13 of 42

14 Supply Schedule A supply schedule shows how much of a good or service would be supplied at different prices. Supply Schedule for Coffee Beans Price of coffee beans (per pound) Quantity of coffee beans supplied (billions of pounds) \$ of 42

15 Supply Curve Price of coffee beans (per pound) \$ As price rises, the quantity supplied rises. Supply curve, S A supply curve shows graphically how much of a good or service people are willing to sell at any given price Quantity of coffee beans (billions of pounds) 15 of 42

16 An Increase in Supply The entry of Vietnam into the coffee bean business generated an increase in supply a rise in the quantity supplied at any given price. This event is represented by the two supply schedules one showing supply before Vietnam s entry, the other showing supply after Vietnam came in. Supply Schedule for Coffee Beans Price of coffee beans Quantity of beans supplied (billions of pounds) (per pound) Before entry After entry \$ of 42

17 An Increase in Supply Price of coffee beans (per pound) Vietnam enters coffee bean business more coffee producers \$ A movement along the supply curve S 1 S 2 is not the same thing as a shift of the supply curve Quantity of coffee beans (billions of pounds) A shift of the supply curve is a change in the quantity supplied of a good at any given price. 17 of 42

18 Movement Along the Supply Curve Price of coffee beans (per pound) \$ A movement along the supply curve S 1 S B A C is not the same thing as a shift of the supply curve Quantity of coffee beans (billions of pounds) A movement along the supply curve is a change in the quantity supplied of a good that is the result of a change in that good s price. 18 of 42

19 Shifts of the Supply Curve Price Decrease in supply S 3 S 1 S 2 Increase in supply Any increase decrease in supply means a rightward leftward shift of of the the supply curve: at any given price, there is an increase decrease in in the quantity supplied. (S1 S2) S3) Quantity 19 of 42

20 What Causes a Supply Curve to Shift? Changes in input prices An input is a good that is used to produce another good. Changes in the prices of related goods and services Changes in technology Changes in expectations Changes in the number of producers 20 of 42

21 Individual Supply Curve and the Market Supply Curve The market supply curve is the horizontal sum of the individual supply curves of all firms in that market. Price of coffee beans (per pound) \$2 (a) Mr. Figueroa s Individual Supply Curve S Figueroa Price of coffee beans (per pound) \$2 (b) Mr. Bien Pho s Individual Supply Curve S Bien Pho Price of coffee beans (per pound) \$2 (c) Market Supply Curve S Market Quantity of coffee beans (pounds) Quantity of coffee beans (pounds) Quantity of coffee beans (pounds) 21 of 42

22 Supply, Demand and Equilibrium Equilibrium in a competitive market: when the quantity demanded of a good equals the quantity supplied of that good. The price at which this takes place is the equilibrium price (a.k.a. market-clearing price): Every buyer finds a seller and vice versa. The quantity of the good bought and sold at that price is the equilibrium quantity. 22 of 42

23 Market Equilibrium Price of coffee beans (per pound) \$ Supply Market equilibrium occurs at point E, where the supply curve and the demand curve intersect. Equilibrium price 1.00 E Equilibrium Demand Equilibrium quantity Quantity of coffee beans (billions of pounds) 23 of 42

24 Surplus Price of coffee beans (per pound) \$ Surplus E Supply There is a surplus of a good when the quantity supplied exceeds the quantity demanded. Surpluses occur when the price is above its equilibrium level Demand Quantity demanded Quantity supplied Quantity of coffee beans (billions of pounds) 24 of 42

25 Shortage Price of coffee beans (per pound) \$ E Supply There is a shortage of a good when the quantity demanded exceeds the quantity supplied. Shortages occur when the price is below its equilibrium level Shortage Demand Quantity supplied Quantity demanded Quantity of coffee beans (billions of pounds) 25 of 42

26 Equilibrium and Shifts of the Demand Curve Price of coffee beans An increase in demand Supply Price rises P 2 P 1 E 1 E 2 leads to a movement along the supply curve due to a higher equilibrium price and higher equilibrium quantity D 2 D 1 Q 1 Q 2 Quantity rises Quantity of coffee beans 26 of 42

27 Equilibrium and Shifts of the Supply Curve Price of coffee beans S 2 S 1 A decrease in supply P 2 E 2 Price rises P 1 E 1 leads to a movement along the demand curve due to a higher equilibrium price and lower equilibrium quantity Demand Q 2 Q 1 Quantity of coffee beans Quantity falls 27 of 42

28 Technology Shifts of the Supply Curve Price An increase in supply S 1 S 2 leads to a movement along the demand curve to a lower equilibrium price and higher equilibrium quantity. Price falls P 1 P 2 E 1 E 2 Technological innovation: In the early 1970s, engineers learned how to put microscopic electronic components onto a silicon chip; progress in the technique has allowed ever more components to be put on each chip. Demand Q 1 Q 2 Quantity increases Quantity 28 of 42

29 Simultaneous Shifts of Supply and Demand (a) One possible outcome: Price Rises, Quantity Rises Price of coffee Small decrease in supply S 2 S 1 P 2 E 2 Two The increase opposing in forces determining demand dominates the the equilibrium decrease in quantity. supply. E 1 P 1 D 2 D 1 Large increase in demand Q 1 Q 2 Quantity of coffee 29 of 42

30 Simultaneous Shifts of Supply and Demand (b) Another Possibility Outcome: Price Rises, Quantity Falls Price of coffee P 2 Large decrease in supply E 2 S 2 S 1 Two opposing forces determining the equilibrium quantity. P 1 E 1 Small increase in demand D 1 D 2 Q 2 Q 1 Quantity of coffee 30 of 42

31 Simultaneous Shifts of Supply and Demand We can make the following predictions about the outcome when the supply and demand curves shift simultaneously: Simultaneous Shifts of Supply and Demand Supply Increases Supply Decreases Demand Increases Price: ambiguous Quantity: up Price: up Quantity: ambiguous Demand Decreases Price: down Quantity: ambiguous Price: ambiguous Quantity: down 31 of 42

32 2) Consumer and Producer Surplus How much benefit do producers and consumers receive from the existence of a market? How is the welfare of consumers and producers affected by changes in market prices? How are these concepts related to the demand and supply curve? Consumer Surplus Producer Surplus Cost Market Failure 32 of 42

33 Consumer Surplus and the Demand Curve A consumer s willingness to pay for a good is the maximum price at which he or she would buy that good. Individual consumer surplus is the net gain to an individual buyer from the purchase of a good. It is equal to the difference between the buyer s willingness to pay and the price paid. 33 of 42

34 The Demand Curve for Used Textbooks Price of book \$59 Aleisha Potential buyers Willingness to pay 45 Brad Aleisha Brad \$ Claudia Darren Claudia Darren Edwina Edwina D Quantity of books A consumer s willingness to pay for a good is the maximum price at which he or she would buy that good. 34 of 42

35 Willingness to Pay and Consumer Surplus Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good. The term consumer surplus is often used to refer to both individual and total consumer surplus. 35 of 42

36 Consumer Surplus in the Used Textbook Market Price of book Aleisha s consumer surplus: \$59-\$39=\$29 \$ Aleisha Brad Claudia Brad s consumer surplus: \$45-\$30=\$15 Darren Claudia s consumer surplus: \$35-\$30=\$5 Edwina Price = \$30 The total consumer surplus is given by the entire shaded area - the sum of the individual consumer surpluses of Aleisha, Brad, and Claudia - equal to \$29 + \$15 + \$5 = \$49. D Quantity of books 36 of 42

37 Consumer Surplus Price of computers The total consumer surplus generated by purchases of a good at a given price is equal to the area below the demand curve but above that price. Consumer surplus \$1,500 Price = \$1,500 D 0 1 million Quantity of computers 37 of 42

38 How Changing Prices Affect Consumer Surplus A fall in the price of a good increases consumer surplus through two channels: A gain to consumers who would have bought at the original price and A gain to consumers who are persuaded to buy by the lower price. 38 of 42

39 Consumer Surplus and a Fall in the Price of Used Textbooks Price of book \$59 Aleisha Increase in Aleisha s consumer surplus 45 Brad Increase in Brad s consumer surplus 35 Claudia Increase in Claude s consumer surplus Darren Original price = \$30 New price = \$20 10 Edwina Darren s consumer surplus D Quantity of books 39 of 42

40 A Fall in the Market Price Increases Consumer Surplus Price of computers \$5,000 Increase in consumer surplus to original buyers Consumer surplus gained by new buyers 1,500 D 0 200,000 1 million Quantity of computers 40 of 42

41 Producer Surplus and the Supply Curve A potential seller s cost is the lowest price at which he or she is willing to sell a good. Individual producer surplus is the net gain to a seller from selling a good. It is equal to the difference between the price received and the seller s cost. Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good. 41 of 42

42 The Supply Curve for Used Textbooks Price of book S Potential sellers Cost \$45 Engelbert Engelbert Donna \$ Donna Carlos Betty Carlos Andrew Betty 5 Andrew Quantity of books 42 of 42

43 Producer Surplus in the Used Textbook Market Price of book S \$45 Engelbert Carlos Donna Carlos s producer surplus Price = \$ Andrew Betty Andrew s producer surplus Betty s producer surplus Quantity of books 43 of 42

44 Producer Surplus Price of wheat (per bushel) S The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price. \$5 Producer surplus Price = \$5 0 1 million Quantity of wheat (bushels) 44 of 42

45 Changes in Producer Surplus When the price of a good rises, producer surplus increases through two channels: The gains of those who would have supplied the good even at the original, lower price and The gains of those who are induced to supply the good by the higher price. 45 of 42

46 A Rise in the Price Increases Producer Surplus Price of wheat (per bushel) Increase in producer surplus to original sellers Consumer surplus gained by new sellers S \$ million 1.5 million Quantity of wheat (bushels) 46 of 42

47 Putting It Together: Total Surplus The total surplus generated in a market is the total net gain to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus. The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity. 47 of 42

48 Total Surplus Price of book S Equilibrium price \$30 Consumer surplus Producer surplus E D 0 1,000 Equilibrium quantity Quantity of books 48 of 42

49 3) Price and Quantity Control The meaning of price controls and quantity controls, two kinds of government interventions in markets. How price and quantity controls create problems and can make a market inefficient. What deadweight loss is. Why the predictable side effects of intervention in markets often lead economists to be skeptical of its usefulness. Who benefits and who loses from market interventions, and why they are used despite their well-known problems. 49 of 42

50 Why Governments Control Prices The market price moves to the level at which the quantity supplied equals the quantity demanded. BUT this equilibrium price does not necessarily please either buyers or sellers. Therefore, the government intervenes to regulate prices by imposing price controls, which are legal restrictions on how high or low a market price may go. Price ceiling is the maximum price sellers are allowed to charge for a good or service. Price floor is the minimum price buyers are required to pay for a good or service. 50 of 42

51 Price Ceilings Price ceilings are typically imposed during crises wars, harvest failures, natural disasters because these events often lead to sudden price increases that hurt many people but produce big gains for a lucky few. Examples: U.S. Government imposed ceilings on aluminum and steel during World War II Rent control in New York 51 of 42

52 The Market for Apartments in the Absence of Government Controls Monthly rent (per apartment) \$1,400 1,300 S Monthly rent (per apartment) Quantity of apartments (millions) Quantity demanded Quantity supplied 1,200 1,100 1, E D \$1,400 1,300 1,200 1,100 1, Quantity of apartments (millions) 52 of 42

53 The Effects of a Price Ceiling Monthly rent (per apartment) \$1,400 S 1,200 E 1, A B Price ceiling 600 Housing shortage of 400,000 apartments caused by price ceiling D Quantity of apartments (millions) 53 of 42

54 How Price Ceilings Cause Inefficiency Inefficiently Low Quantity Deadweight loss is the loss in total surplus that occurs whenever an action or a policy reduces the quantity transacted below the efficient market equilibrium quantity Inefficient Allocation to Customers Wasted Resources Inefficiently Low Quality Black Markets 54 of 42

55 A Price Ceiling Causes Inefficiently Low Quantity Monthly rent (per apartment) \$1,400 1,200 Deadweight loss from fall in number of apartments rented S 1, E Price ceiling 600 D Quantity supplied with rent control Quantity supplied without rent control Quantity of apartments (millions) 55 of 42

56 Winners and Losers from Rent Control Monthly rent (per apartment) (a) Before Rent Control Monthly rent (per apartment) (b) After Rent Control \$1,400 Consumer surplus S \$1,400 Consumer surplus Consumer surplus transferred from producers S 1,200 1,000 E 1,200 1,000 E Price ceiling Producer surplus D 600 Producer surplus Deadweight loss D Quantity of apartments (millions) Quantity of apartments (millions) 56 of 42

57 How Price Ceilings Cause Inefficiency Price ceilings often lead to inefficiency in the form of inefficient allocation to consumers: people who want the good badly and are willing to pay a high price don t get it, and those who care relatively little about the good and are only willing to pay a low price do get it. Price ceilings typically lead to inefficiency in the form of wasted resources: people expend money, effort and time to cope with the shortages caused by the price ceiling. Price ceilings often lead to inefficiency in that the goods being offered are of inefficiently low quality: sellers offer low-quality goods at a low price even though buyers would prefer a higher quality at a higher price. 57 of 42

58 Price Floors Sometimes governments intervene to push market prices up instead of down. The minimum wage is a legal floor on the wage rate, which is the market price of labor. Just like price ceilings, price floors are intended to help some people but generate predictable and undesirable side effects. 58 of 42

59 The Market for Butter in the Absence of Government Controls Price of butter (per pound) Price of butter (per pound) Quantity of butter (millions of pounds) Quantity demanded Quantity supplied \$ E S \$1.40 \$ 1.30 \$ 1.20 \$ 1.10 \$ 1.00 \$ 0.90 \$ 0.80 \$ 0.70 \$ D Quantity of butter (millions of pounds) 59 of 42

60 The Effects of a Price Floor Price of butter (per pound) \$1.40 Butter surplus of 3 million pounds caused by price floor S A E B Price floor D Quantity of butter (millions of pounds) 60 of 42

61 How a Price Floor Causes Inefficiency The persistent surplus that results from a price floor creates missed opportunities inefficiencies that resemble those created by the shortage that results from a price ceiling. These include: Deadweight loss from inefficiently low quantity Inefficient allocation of sales among sellers Wasted resources Inefficiently high quality Temptation to break the law by selling below the legal price 61 of 42

62 A Price Floor Causes Inefficiently Low Quantity Price of butter (per pound) \$1.40 S Deadweight loss E Price floor D Quantity demanded with price floor Quantity demanded without price floor Quantity of butter (millions of pounds) 62 of 42

63 How a Price Floor Causes Inefficiency Price floors lead to inefficient allocation of sales among sellers: those who would be willing to sell the good at the lowest price are not always those who actually manage to sell it. Price floors often lead to inefficiency in that goods of inefficiently high quality are offered: sellers offer high-quality goods at a high price, even though buyers would prefer a lower quality at a lower price. 63 of 42

64 Ceilings, Floors and Quantities A price ceiling pushes the price of a good down. A price floor pushes the price of a good up. Both floors and ceilings reduce the quantity bought and sold. If sellers don t want to sell as much as buyers want to buy, it s the sellers who determine the actual quantity sold, because buyers can t force unwilling sellers to sell and vice versa. 64 of 42

65 The Market for Taxi Rides in the Absence of Government Controls Fare (per ride) Quantity of rides (millions per year) Fare (per ride) Quantity demanded Quantity supplied \$7.00 S \$ \$ E D \$ 6.00 \$ 5.50 \$ 5.00 \$ 4.50 \$ 4.00 \$ 3.50 \$ Quantity of rides (millions per year) 65 of 42

66 Effect of a Quota on the Market for Taxi Rides Fare (per ride) \$7.00 Deadweight S loss 6.50 A 6.00 The 5.50 wedge E B D Quota Fare (per ride) \$7.00 \$ 6.50 \$ 6.00 \$ 5.50 \$ 5.00 \$ 4.50 \$ 4.00 \$ 3.50 \$ 3.00 Quantity of rides (millions per year) Quantity demanded Quantity supplied Quantity of rides (millions per year) 66 of 42

67 The Anatomy of Quantity Controls A quantity control, or quota, drives a wedge between the demand price and the supply price of a good; that is, the price paid by buyers ends up being higher than that received by sellers. The difference between the demand and supply price at the quota limit is the quota rent, the earnings that accrue to the license-holder from ownership of the right to sell the good. It is equal to the market price of the license when the licenses are traded. 67 of 42

68 The Costs of Quantity Controls Deadweight loss because some mutually beneficial transactions don t occur. Incentives for illegal activities. 68 of 42

69 4) Elasticity What is the definition of elasticity? What is the meaning and importance of: price elasticity of demand? income elasticity of demand? price elasticity of supply? What factors influence the size of these various elasticities? How the cross-price elasticity of demand measures the responsiveness of demand for one good to changes in the price of another good 69 of 42

70 Defining and Measuring Elasticity The price elasticity of demand is the ratio of the percent change in the quantity demanded to the percent change in the price as we move along the demand curve (dropping the minus sign). 70 of 42

71 The Price Elasticity of Demand 71 of 42

72 Demand for Vaccinations Price of vaccination \$21 B When price rises to \$21 per barrel, world demand falls to 9.9 million barrels per day (point B). 20 A D Quantity of vaccinations (millions) 72 of 42

73 Calculating the Price Elasticity of Demand 73 of 42

74 Some Estimated Price Elasticities of Demand Good Price elasticity Inelastic demand Eggs 0.1 Beef 0.4 Stationery 0.5 Gasoline 0.5 Price elasticity of demand<1 Elastic demand Housing 1.2 Restaurant meals 2.3 Airline travel 2.4 Foreign travel 4.1 Price elasticity of demand>1 74 of 42

75 Interpreting the Price Elasticity of Demand Two Extreme Cases of Price Elasticity of Demand: Demand is perfectly inelastic when the quantity demanded does not respond at all to changes in the price. When demand is perfectly inelastic, the demand curve is a vertical line. Demand is perfectly elastic when any price increase will cause the quantity demanded to drop to zero. When demand is perfectly elastic, the demand curve is a horizontal line. 75 of 42

76 Two Extreme Cases of Price Elasticity of Demand Price of shoelaces (per pair) (a) Perfectly Inelastic Demand: Price Elasticity of Demand = 0 D 1 An increase in price \$3 \$2 leaves the quantity demanded unchanged. 0 1 Quantity of shoelaces (billions of pairs per year) 76 of 42

77 Two Extreme Cases of Price Elasticity of Demand (b) Price Elastic Demand: Price Elasticity of Demand = Price of pink tennis balls (per dozen) At any price above \$5, quantity demanded is zero At exactly \$5, consumers will buy any quantity \$5 D 2 At any price below \$5, quantity demanded is infinite 0 Quantity of tennis balls (dozens per year) 77 of 42

78 Interpreting the Price Elasticity of Demand Demand is elastic if the price elasticity of demand is greater than 1. Demand is inelastic if the price elasticity of demand is less than 1. Demand is unit-elastic if the price elasticity of demand is exactly of 42

79 Unit Elasticity of Demand (a) Unit-Elastic Demand: Price Elasticity of Demand = 1 Price of crossing A 20% increase in the price... \$ B A D , generates a 20% decrease in the quantity of crossings demanded. Quantity of crossings (per day) 79 of 42

80 Inelastic Demand Price of crossing (b) Inelastic Demand: Price Elasticity of Demand = 0.5 A 20% increase in the price... \$ B A D , generates a 10% decrease in the quantity of crossings demanded. Quantity of crossings (per day) 80 of 42

81 Elastic Demand Price of crossing (c) Elastic Demand: Price Elasticity of Demand = 2 A 20% increase in the price... \$ B A D ,200 generates a 40% decrease in the quantity of crossings demanded. Quantity of crossings (per day) 81 of 42

82 What Factors Determine the Price Elasticity of Demand? Price Elasticity of Demand is determined by: Whether Close Substitutes Are Available Whether the Good Is a Necessity or a Luxury Share of Income Spent on the Good Time 82 of 42

83 Other Demand Elasticities: Cross-Price Elasticity The cross-price elasticity of demand between two goods measures the effect of the change in one good s price on the quantity demanded of the other good. It is equal to the percent change in the quantity demanded of one good divided by the percent change in the other good s price. The Cross-Price Elasticity of Demand between Goods A and B 83 of 42

84 Cross-Price Elasticity Goods are substitutes when the cross-price elasticity of demand is positive. Goods are complements when the cross-price elasticity of demand is negative. 84 of 42

85 The Income Elasticity of Demand The income elasticity of demand is the percent change in the quantity of a good demanded when a consumer s income changes divided by the percent change in the consumer s income. 85 of 42

86 Normal Goods and Inferior Goods When the income elasticity of demand is positive, the good is a normal good - that is, the quantity demanded at any given price increases as income increases. When the income elasticity of demand is negative, the good is an inferior good - that is, the quantity demanded at any given price decreases as income increases. 86 of 42

87 Measuring the Price Elasticity of Supply The price elasticity of supply is a measure of the responsiveness of the quantity of a good supplied to the price of that good. It is the ratio of the percent change in the quantity supplied to the percent change in the price as we move along the supply curve. 87 of 42

88 Two Extreme Cases of Price Elasticity of Supply (a) Price of cell phone frequency Perfectly Inelastic Supply: Price Elasticity of Supply = 0 (b) Perfectly Elastic Supply: Price Elasticity of Supply = Price of pizza S 1 An increase in price \$3,000 2, leaves the quantity supplied unchanged Quantity of cell phone frequencies At any price above \$12, quantity supplied is infinite. At any price below \$12, quantity supplied is zero. \$12 0 At exactly \$12, producers will produce any quantity S 2 Quantity of pizzas 88 of 42

89 Two Extreme Cases of Price Elasticity of Supply There is perfectly inelastic supply when the price elasticity of supply is zero, so that changes in the price of the good have no effect on the quantity supplied. A perfectly inelastic supply curve is a vertical line. There is perfectly elastic supply when even a tiny increase or reduction in the price will lead to very large changes in the quantity supplied, so that the price elasticity of supply is infinite. A perfectly elastic supply curve is a horizontal line. 89 of 42

90 5) Taxes The effects of taxes on supply and demand What determines who really bears the burden of a tax The costs and benefits of taxes, and why taxes impose a cost that is larger than the tax revenue they raise 90 of 42

91 The Economics of Taxes: A Preliminary View An excise tax is a tax on sales of a good or service. Excise taxes: raise the price paid by buyers and reduce the price received by sellers Excise taxes also drive a wedge between the two. Examples: Excise tax levied on sales of taxi rides and excise tax levied on purchases of taxi rides. 91 of 42

92 The Supply and Demand for Hotel Rooms in Potterville Price of hotel room \$ S Equilibrium price B E D ,000 10,000 15,000 Equilibrium quantity Quantity of hotel rooms 92 of 42

93 An Excise Tax Imposed on Hotel Owners Price \$ Supply curve shifts upward by the amount of the tax A S 2 S 1 Excise tax = \$40 per room 80 E B D ,000 10,000 15,000 Quantity of hotel rooms 93 of 42

94 An Excise Tax Imposed on Hotel Guests Price Excise tax = \$40 per room \$ A Demand curve shifts downward by the amount of the tax E S B D 1 20 D 2 0 5,000 10,000 15,000 Quantity of hotel rooms 94 of 42

95 Tax Incidence The incidence of a tax is a measure of who really pays it. Who really bears the tax burden (in the form of higher prices to consumers and lower prices to sellers) does not depend on who officially pays the tax. Depending on the shapes of supply and demand curves, the incidence of an excise tax may be divided differently. The wedge between the demand price and supply price becomes the government s tax revenue. 95 of 42

96 An Excise Tax Paid Mainly By Consumers Excise tax = \$1 per gallon Price of gasoline (per gallon) \$2.95 Tax burden falls mainly on consumers When the price elasticity of demand is low and the price elasticity of supply is high, the burden of an excise tax falls mainly on consumers S D 0 Quantity of gasoline (gallons) 96 of 42

97 An Excise Tax Paid Mainly by Producers Excise tax = \$5 per parking space Price of parking space \$ S D When the price elasticity of demand is high and the price elasticity of supply is low, the burden of an excise tax falls mainly on producers Tax burden falls mainly on producers 0 Quantity of parking spaces 97 of 42

98 Tax Incidence Putting It Together When the price elasticity of demand is higher than the price elasticity of supply, an excise tax falls mainly on producers. When the price elasticity of supply is higher than the price elasticity of demand, an excise tax falls mainly on consumers. So elasticity not who officially pays the tax determines the incidence of an excise tax. 98 of 42

99 The Revenue from an Excise Tax Price of hotel room \$140 The tax revenue collected is: Tax revenue = \$40 per room 5,000 rooms = \$200, A S Excise tax = \$40 per room 80 Area = tax revenue E B The area of the shaded rectangle is: Area = Height Width = \$40 per room 5,000 rooms = \$200,000 D 0 6 5,000 10,000 15,000 Quantity of hotel rooms 99 of 42

100 The Revenue from an Excise Tax The general principle is: The revenue collected by an excise tax is equal to the area of the rectangle whose height is the tax wedge between the supply and demand curves and whose width is the quantity transacted under the tax. 100 of 42

101 Tax Rates and Revenue A tax rate is the amount of tax people are required to pay per unit of whatever is being taxed. In general, doubling the excise tax rate on a good or service won t double the amount of revenue collected, because the tax increase will reduce the quantity of the good or service transacted. In some cases, raising the tax rate may actually reduce the amount of revenue the government collects. 101 of 42

102 Tax Rates and Revenue Price of hotel room (a) An excise tax of \$20 Price of hotel room (b) An excise tax of \$60 \$140 \$ Excise tax = \$20 per room Area = tax revenue E S D Excise tax = \$60 per room Area = tax revenue E S D ,000 7,500 10,000 15,000 Quantity of hotel rooms 0 2,500 5,000 10,000 15,000 Quantity of hotel rooms 102 of 42

103 A Tax Reduces Consumer and Producer Surplus A fall in the price of a good generates a gain in consumer surplus. Similarly, a price increase causes a loss to consumers. So it s not surprising that in the case of an excise tax, the rise in the price paid by consumers causes a loss. Meanwhile, the fall in the price received by producers leads to a fall in producer surplus. A tax reduces both, the CS and the PS. 103 of 42

104 A Tax Reduces Consumer and Producer Surplus P r i c e Fall in consumer surplus due to tax S P C Excise tax = T P E A C B F E P P Fall in producer surplus due to tax D Q T Q E Quantity 104 of 42

105 The Deadweight Loss of a Tax Although consumers and producers are hurt by the tax, the government gains revenue. The revenue the government collects is equal to the tax per unit sold, T, multiplied by the quantity sold, Q T. But a portion of the loss to producers and consumers from the tax is not offset by a gain to the government. The deadweight loss caused by the tax represents the total surplus lost to society because of the tax that is, the amount of surplus that would have been generated by transactions that now do not take place because of the tax. 105 of 42

106 The Deadweight Loss of a Tax Price Deadweight loss S P C Excise tax = T P E E P P D Q T Q E Quantity 106 of 42

107 The Deadweight Loss of a Tax Using a triangle to measure deadweight loss is a technique used in many economic applications. For example, triangles are used to measure the deadweight loss produced by types of taxes other than excise taxes. They are also used to measure the deadweight loss produced by monopoly, another kind of market distortion. Deadweight-loss triangles are often used to evaluate the benefits and costs of public policies besides taxation such as whether to impose stricter safety standards on a product. 107 of 42

108 Cost of Collecting Taxes The administrative costs of a tax are the resources used by government to collect the tax, and by taxpayers to pay it, over and above the amount of the tax, as well as to evade it. The total inefficiency caused by a tax is the sum of its deadweight loss and its administrative costs. The general rule for economic policy is that, other things equal, a tax system should be designed to minimize the total inefficiency it imposes on society. 108 of 42

109 Deadweight Loss and Elasticities (a) Elastic Demand (b) Inelastic Demand Price S Price S Deadweight loss is larger when demand is elastic P C Excise tax = T P C P E E D Excise tax = T P E P P E Deadweight loss is smaller when demand is inelastic P P D Q T Q E Quantity Q T Q E Quantity 109 of 42

110 Deadweight Loss and Elasticities (c) Elastic Supply (d) Inelastic Supply Price Price S P C Deadweight loss is larger when supply is elastic Excise tax = T S P C P E P P E Excise tax = T P E E Deadweight loss is smaller when supply is inelastic P P D D Q T Q E Quantity Q T Q E Quantity 110 of 42

111 Deadweight Loss and Elasticities To minimize the efficiency costs of taxation, one should choose to tax only those goods for which demand or supply, or both, is relatively inelastic. For such goods, a tax has little effect on behavior because behavior is relatively unresponsive to changes in the price. 111 of 42

112 Deadweight Loss and Elasticities In the extreme case in which demand is perfectly inelastic (a vertical demand curve), the quantity demanded is unchanged by the imposition of the tax. As a result, the tax imposes no deadweight loss. Similarly, if supply is perfectly inelastic (a vertical supply curve), the quantity supplied is unchanged by the tax and there is also no deadweight loss. 112 of 42

113 Deadweight Loss and Elasticities If the goal in choosing whom to tax is to minimize deadweight loss, then taxes should be imposed on goods and services that have the most inelastic response that is, goods and services for which consumers or producers will change their behavior the least in response to the tax. 113 of 42

114 You think you pay high taxes? Taxes (percent of GDP) 60% % 50.4% % 36.0% % 26.4% U.S. Japan Canada Britain France Sweden 114 of 42

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