Microeconomics Unit 1 Chapters 4-7

Consumer Surplus o Willingness to pay Maximum price a consumer is willing to buy o Individual consumer surplus- is the net gain to an individual buyer for the purchase of a good. It is the difference of the buyers willingness to pay and price paid. o Consumer Surplus - Is the sum of the individual consumer surpluses of all buyer in a market P Q Price P Q Consumer Surplus ½ base * Height Consumer Surplus

Increase/Decrease in Consumer Surplus P Q Price 1 Price 2 Demand Added Consumer surplus for original buyers Consumer surplus gained by new buyers Original consumer surplus

Producer Surplus Cost - the lowest price at which a seller is willing to sell a good Individual producer surplus – the net gain to an individual seller from selling a good. It is equal to the difference between the price received and the seller cost. o Total Producer surplus – in a market is the sum of the individual producer surplus of all sellers in a market. Q P PRICE PRODUCER SURPLUS PRODUCER SURPLUS ½ BASE * HEIGHT

Gains from trade P Q S CS PS TOTAL SURPLUS This illustrates gains from trade, both buyers and sellers are better off Because of the market.

Efficiency of markets Markets produce gains from trade. Markets are many times efficient o That once a market has produced gains from trade, there is no way to make some people better off without making other people worse off. o Consumer and produce surplus show this. o Ex. If there was committee was devised to increase total surplus away from market equilibrium by deciding who gets and who gives up a good. Reallocate consumption among consumers Reallocate sales among sellers Change the quantity traded.

Efficiency of markets Reallocate consumption among consumers o Or taking a good away from one consumer and giving it to another who may have a lower willingness to pay o Reduces consumer surplus. D S P Q Loss of consumer surplus Equilibrium price

Efficiency of markets Reallocate sales among sellers: the committee might try to increase total surplus by taking sales away from sellers who would of sold their goods in the market equilibrium and instead compelling those who would not have sold their goods. P Q D S Loss in producer surplus

Efficiency of markets Change the quantity traded: the committee will try to either compel people to buy more goods or less goods than the market equilibrium quantity. P Q D S Possible loss of total surplusPossible Loss of Total Surplus Prevented from sale Forced sale

Why Governments Control markets Political pressure to intervene in markets o Regulate price or Price controls Price ceiling – upper limits Price Floor – lower limits o There are always side effects of Price Controls in efficient markets o Price Ceiling typically imposed during crisis War, poor harvest, natural disaster, o WWII, rubber, steel, oil, Rent control in NYC. P Q D Dead weight loss: Loss of surplus due to action or policy that reduces quantity transacted below the efficient level Loss to society because there is a loss in surplus that accrues to no ones gain. EX. Rent control: not all renters make out only the ones with rent control apts. Producer surplus is lost due to lower price S EP

Price controls Inefficient allocation to consumers o People who need a place to live may not be able to find one o Those who have one may have less urgent needs. Wasted resources o People expend money, effort, and time to cope with the shortages caused by price ceilings. Ex. Gas shortage in the 1970’s : hours lost in waiting on gas lines Inefficiently Low Quality: o Sellers offer low quality goods at a low price even though buyers would rather have higher quality and are willing to pay a higher price for it. Ex. Rent control: Landlords have no incentive to provide better conditions because they cannot raise rents but can find tenants easily. Black market o Illegal activity Illegal subletting by tenants.

So Why Price Ceilings They do benefit some people. Also, when price ceiling have been in effect for a long time, buyers may not have a realistic idea of what would happen without them. Lastly government officials often do not understand supply and demand analysis.

Price Floors Price Floor- Lowest price you can pay. o Agriculture o Minimum Wage Used to help some but generate predictable + Undesirable side effects o Not always o Must be above equilibrium price (not Binding) P Q S D Price floor If Binding what happens Depends Gov’t policy Gov’t buys surplus Must find a way to unload produce

Price Floors How do Price Floors cause inefficiency o Creates Dead weight loss – It lowers the amount being sold below equilibrium quantity creation dead weight loss. P Q D S Price Floor Dead weight loss

Price Floors Inefficient allocation of sales among sellers o Ex minimum wage Give a job to reluctant worker Motivated worker willing to work for less but gets shut out due to minimum wage Wasted Resources o Governments who buy surplus goods either destroy or goods go bad. o Can lead to wasted time and effort in finding a job Inefficiency of higher quality o Higher costs to make higher quality of goods

Price Floors Why do we have price floors o Government officials believe that market is poorly described by supply and demand o Imposed because of influential sellers o Gov’t officials don’t understand supply and demand

Controlling Quantity Quotas – regulate the quantity of a good that can be bought and sold o Government imposed o Give only the upper limit o Over time hard to revoke o Create dead weight loss. Wedge Dead weight loss. D S P Q

Elasticity Price Elasticity of Demand or Ed o Law of demand states as price decreases quantity demanded increases o Elasticity tells us by how much or how sensitive a good or service is to price change o Ed = % ^ in quantity demanded / % ^ in Price (Q2-Q1)/Q1 divided BY (P2-P1)/P1 Note law of demand insures that Ed is negative for ease we use the absolute value. If Ed > 1 the good is elastic. Or sensitive to price change o % ^ in quantity demanded is 2 and %^ in Price is 1 Ed= 2 Elastic good If Ed < 1 the good is inelastic o %^ in quantity demanded is 1 and %^ in Price is 2 Ed= ½ or.5 Inelastic good If Ed = 1 the good is unitary elastic o %^ in quantity demanded is 1 and %^ in Price is 1 Ed=1 Unitary elastic

Elasticity Midpoint method USED TO ALLIEVAITE PROBLEMS IN PERSPECTIVE. o Change in Quantity demanded/Average of quantity or Q2-Q1/(Q1+Q2) /2 o DIVIDED BY o Change in price/ Average price or P2-P1/(P1+P2)/2 o EX Gas price in Europe vs. the U.S. European gas price are 3 times more expensive depending on who’s perspective you are you using will change you numbers in original 10-30/30=20/30x100=66.7% 30-10/10=20/10x100=200%

Elasticity Why does Elasticity matter? o Helps predict how price change will affect total revenue for a producer. o Total Revenue = Price x Quantity sold o Raising prices can either generate more revenue or less depending on the price elasticity of demand. Two effects are present when price rise, unless the good is perfectly elastic or perfectly inelastic o Price effect after a price increases, each unit sold sell at a higher price, which tends to raise revenues o Quantity effect after a price increase, fewer units are sold, which tends to lower revenue. o Unit elastic no effect on revenue o Inelastic higher prices increase total revenue. Price effect is stronger o Elastic higher price decreases total revenue. Quantity effect is stronger.

Elasticity Price elasticity of demand changes along the demand curve. o When measuring elasticity you are measuring it at a particular point on the demand curve. P Q TR

Elasticity FACTORS THAT DETERMINE ELASTICITY OF DEMAND o Close substitutes o Necessity or Luxury o Share of income o Time

Elasticity Other types of elasticity o Cross price – measures the effect of price change in one good on the quantity demanded of the other good %^ of Quantity of good A / %^ Price of good B o Positive it a substitute o Negative it is a compliment o Income Elasticity How much demand for a good is affected by changes in consumer incomes. Determines whether a good is an inferior good or a normal good. o % ^ quantity demanded / % ^ income Positive it is a normal good o Income elastic if greater than one ( vacations) o Income inelastic if less than one (food) Negative it is a inferior good o Helps identify growth industries during times of strong growth

Elasticity of Supply Price elasticity of supply o Measure of how responsive of the quantity of a good supplied to price change. % ^ quantity supplied /% ^ in price s o Es >1 elastic o Es <1 inelastic s o Es = 1 unit elastic Perfectly elastic perfectly inelastic P Q P Q

Elasticity of Supply Factors that determine the price elasticity of supply o Availability of inputs o Time

Elasticity and Tax Government Excise Tax o Is a per unit tax on production that results in a vertical shift in the supply curve by the amount of the tax. Why o Increase government revenue o Decrease consumption o Tax incidence The proportion of the tax paid by consumers in the form of a higher price for the taxed good. Price elasticity of demand Gov’t RevDecrease in consumption Incidence of tax paid by consumers Incidence of tax paid by suppliers Ed=LeastMost0%100% Ed>1FallingSizeable<50%>50% Ed<1RisingMinimal>50%<50% Ed=0mostzero100%0%

Elasticity and Tax P Q P Q D D

P Q P Q S S

Supply and excise tax Price elasticity of supply Gov’t Revenue Decrease in consumption Incidence of Tax paid by consumers Incidence of tax paid by producers Es=LeastMost100%0% Es>1FallingSizeableMore than %50Less than 50% Es<1RisingMinimalLess than %50More the %50 Es=0Mostzero0%100

Elasticity and Tax S D Q P S+T p1 p+T q1 qt

Taxes Who pays the Excise Tax o Remember an excise tax is a tax on any unit of a good or service sold. How does it effect Price and Quantity if tax is put on a producer? 5K10K Every price point changes for each quantity by the amount of the tax Pre tax 5,000 at $60 Post tax 5000 at $100 Buyers were expecting to pay 80$ pretax Now have to pay 100$ Tax incidence (who really pays the tax) is split by consumers and producers D S S1

Taxes How does it effect Price and Quantity if tax is put on the consumer? K 10k S D D1 The original equilibrium was 80$ for 10,000 Consumers must pay a 40$ tax Reduces demand by 40$ at every quantity.

Taxes Splitting the tax incidence does not always happen. o More often than not either producer or the consumer will pay more of the tax incidence. It depends on Elasticity Elasticity of supply > Elasticity of demand paid by the consumer Elasticity of demand > Elasticity of supply paid by the producer

Taxes Revenue from the excise tax is calculated as the area of rectangle created on the graph. o Height X Width. $40 X 5,000 = $200,000

Taxes Tax rates can be expressed in $ amounts or % of sale o Sometimes either increasing or reducing the tax rate does not increase or decrease revenue. S S1 D 10K 7.5K REVENUES = P x Q= 20 x 7.5k = 150,000

Tax Cost of taxation o Prevents mutually beneficial transactions from occurring. Some transactions don’t occur that would of because of the higher price The more elastic the curves the greater the dead weight loss for a good. Creates dead weight loss and a loss to the consumer and producer surplus.