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

CHATER 3 ELASTICITY AND SURLUS

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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

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

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

Medium (Unitary) Elasticity of Demand Q

High Elasticity Medium (Unitary) Elasticity of Demand Q

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

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

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

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

MEDIUM ELASTICITY

MEDIUM ELASTICITY $2.5 $2. $1.5 Supply Old Equilibrium $1. $.5 Demand 1 2 3 4 5

MEDIUM ELASTICITY $2.5 $2. $1.5 $1. New Supply Supply Old Equilibrium $.5 Demand 1 2 3 4 5

MEDIUM ELASTICITY $2.5 $2. $1.5 $1. New Supply Supply New Equilibrium Old Equilibrium $.5 Demand 1 2 3 4 5

MEDIUM ELASTICITY rice rises $2.5 $2. $1.5 New Supply Supply New Equilibrium Old Equilibrium $1. Quantity falls $.5 Demand 1 2 3 4 5

ERFECTLY ELASTIC DEMAND

ERFECTLY ELASTIC DEMAND $2.5 $2. $1.5 $1. Supply Old Equilibrium $.5 Demand 1 2 3 4 5

ERFECTLY ELASTIC DEMAND $2.5 $2. $1.5 $1. New Supply Supply Old Equilibrium $.5 Demand 1 2 3 4 5

ERFECTLY ELASTIC DEMAND $2.5 $2. $1.5 $1. New Supply Supply New Equilibrium Old Equilibrium $.5 Demand 1 2 3 4 5

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 1 2 3 4 5

ERFECTLY INELASTIC DEMAND

ERFECTLY INELASTIC DEMAND $2.5 $2. $1.5 $1. Supply Old Equilibrium $.5 Demand 1 2 3 4 5

ERFECTLY INELASTIC DEMAND $2.5 $2. $1.5 $1. New Supply Supply Old Equilibrium $.5 Demand 1 2 3 4 5

ERFECTLY INELASTIC DEMAND $2.5 $2. $1.5 $1. New Supply Supply New Equilibrium Old Equilibrium $.5 Demand 1 2 3 4 5

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 1 2 3 4 5

COMARING ELASTICITIES

COMARING ELASTICITIES $2.5 $2. $1.5 $1. $.5 1 2 3 4 5 Large Elasticity

COMARING ELASTICITIES $2.5 $2. $1.5 $1. $.5 Low Elasticity Large Elasticity 1 2 3 4 5

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 1 2 3 4 5

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.

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.

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.

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

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

Medium (Unitary) Elasticity of Supply Q

High Elasticity Medium (Unitary) Elasticity of Supply Q

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

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

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

ERFECTLY ELASTIC SULY

ERFECTLY ELASTIC SULY $2.5 $2. $1.5 $1. Old Equilibrium $.5 1 2 3 4 5

ERFECTLY ELASTIC SULY $2.5 $2. New Equilibrium $1.5 $1. Old Equilibrium $.5 1 2 3 4 5

ERFECTLY ELASTIC SULY $2.5 $2. New Equilibrium rice doesn t change $1.5 $1. Old Equilibrium Quantity Increases a lot $.5 1 2 3 4 5

ERFECTLY INELASTIC SULY

ERFECTLY INELASTIC SULY $2.5 $2. $1.5 $1. Old Equilibrium $.5 1 2 3 4 5

ERFECTLY INELASTIC SULY $2.5 $2. New Equilibrium $1.5 $1. Old Equilibrium $.5 1 2 3 4 5

ERFECTLY INELASTIC SULY $2.5 $2. New Equilibrium rice Increases a lot $1.5 $1. Old Equilibrium Quantity doesn t change $.5 1 2 3 4 5

COMARING ELASTICITIES

COMARING ELASTICITIES $2.5 $2. Low Elasticity $1.5 $1. $.5 1 2 3 4 5

COMARING ELASTICITIES $2.5 $2. Low Elasticity High Elasticity $1.5 $1. $.5 1 2 3 4 5

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 1 2 3 4 5

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

15 1125 75 375 Lisa Sally Bill Jackie Jim 1 3 4 5

15 1125 75 375 Lisa Sally Bill Jackie Jim 1 3 4 5 In this case Bill, Sally and Lisa all get their Ipads, Jackie and Jim do not

15 1125 75 375 Lisa Sally Bill Jackie Jim 1 3 4 5 In this case Bill, Sally and Lisa all get their Ipads, Jackie and Jim do not The Value to Lisa is $1.

15 1125 75 375 Lisa Sally Bill Jackie Jim 1 3 4 5 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

15 1125 75 375 Lisa Sally Bill Jackie Jim 1 3 4 5 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

Total Consumer Surplus: $6 15 1125 75 375 Lisa Sally Bill Jackie Jim 1 3 4 5 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

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

Now lets think about this in a more more standard (and general) context $2.5 $2. $1.5 $1. $.5 Demand 1 2 3 4 5

Now lets think about this in a more more standard (and general) context $2.5 $2. $1.5 Total Consumer Value $1. $.5 Demand 1 2 3 4 5

Now lets think about this in a more more standard (and general) context $2.5 $2. $1.5 Total Consumer Value $1. $.5 1 2 3 4 5 Total that consumers pay Demand

Now lets think about this in a more more standard (and general) context $2.5 $2. Consumer Surplus $1.5 Total Consumer Value $1. $.5 1 2 3 4 5 Total that consumers pay Demand

Now the firm

Now the firm $2.5 $2. $1.5 $1. $.5 Demand 1 2 3 4 5

Now the firm $2.5 $2. $1.5 Total firms receive in revenue $1. $.5 Demand 1 2 3 4 5

Now the firm $2.5 $2. $1.5 Total firms receive in revenue $1. $.5 Variable costs to producer 1 2 3 4 5 Demand

Now the firm $2.5 $2. roducer Surplus $1.5 Total firms receive in revenue $1. $.5 Variable costs to producer 1 2 3 4 5 Demand

Total Combined Surplus

$2.5 $2. $1.5 $1. Total Combined Surplus $.5 Demand 1 2 3 4 5

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.

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

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. $.5 1 2 3 4 5

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. $.5 1 2 3 4 5

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 1 2 3 4 5

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 1 2 3 4 5

What if we chose a higher Q?

What if we chose a higher Q? $2.5 $2. $1.5 $1. $.5 1 2 3 4 5

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 $.5 1 2 3 4 5

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.

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

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

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)

Tax Example $2.5 $2. $1.5 $1. $.5 1 2 3 4 5

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 1 2 3 4 5

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 1 2 3 4 5

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 1 2 3 4 5

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 1 2 3 4 5

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 1 2 3 4 5

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 1 2 3 4 5

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 1 2 3 4 5

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 1 2 3 4 5

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 1 2 3 4 5

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

roducer pays tax

roducer pays tax $2.5 $2. $1.5 $1. $.5 1 2 3 4 5

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 1 2 3 4 5

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 1 2 3 4 5

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 $.5 1 2 3 4 5

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 $.5 1 2 3 4 5

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 $.5 1 2 3 4 5

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 $.5 1 2 3 4 5

Consumer surplus Government revenue roducer surplus Effective price firm gets $2.5 $2. $1.5 $1. $.5 roducer pays tax rice consumer pays 1 2 3 4 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 Dead Weight loss It is exactly the same as before

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

erfectly Inelastic Demand

erfectly Inelastic Demand $2.5 $2. $1.5 $1. $.5 1 2 3 4 5

erfectly Inelastic Demand $2.5 $2. New supply curve firms act like price is -$1. $1.5 $1. $.5 1 2 3 4 5

erfectly Inelastic Demand rice consumer pays $2.5 $2. New supply curve firms act like price is -$1. $1.5 $1. $.5 1 2 3 4 5

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 $.5 1 2 3 4 5

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 $.5 1 2 3 4 5

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 -$1. 1 2 3 4 5

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 1 2 3 4 5

erfectly Elastic Supply roducer surplus $2.5 $2. $1.5 $1. $.5 1 2 3 4 5

erfectly Elastic Supply $2.5 $2. roducer surplus $1.5 $1. New demand curve Workers act like price is +$1. $.5 1 2 3 4 5

erfectly Elastic Supply $2.5 $2. roducer surplus rice firm gets $1.5 $1. $.5 New demand curve Workers act like price is +$1. 1 2 3 4 5

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 +$1. 1 2 3 4 5

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. 1 2 3 4 5

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 1 2 3 4 5

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

Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. New demand curve Workers act like price is +$1. $.5 1 2 3 4 5

Think about what happens as elasticity increases? $2.5 $2. $1.5 $1. $.5 1 2 3 4 5

Think about what happens as elasticity increases? Deadweight Loss Rises and Government Revenue Falls $2.5 $2. $1.5 $1. $.5 1 2 3 4 5

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 1 2 3 4 5

Stop Coddling the Super-Rich Warren Buffett, New York Times, Aug. 11 211 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 1976-77 shy away from a sensible investment because of the tax rate on the potential gain. 41