Elasticity and Its Applications Chapter 5 Elasticity and Its Applications

Elasticity of Demand Elasticity of demand - a measure of how responsive the quantity demanded is to a change in price more responsive equals more elastic. The slope of the demand curve is related to the elasticity of demand.

Calculating the Elasticity of Demand Elasticity measures the responsiveness of quantity demanded to changes in price.

Mathematics of Demand Elasticity Elasticity of demand is always negative, so we typically drop the negative sign and use absolute value instead. If the |Ed| < 1, the demand curve is inelastic. If the |Ed| > 1, the demand curve is elastic. If the |Ed| = 1, the demand curve is unit elastic. Instructor Notes: Students should note some extreme cases that are not explicitly defined in the text but are often used for simplification: Perfectly Elastic Demand Elasticity of demand is infinite A very small change in price will lead to an infinitely large change in quantity demanded Horizontal demand curve Perfectly Inelastic Demand Elasticity of demand is zero A change in price will cause no change in quantity demanded. Vertical demand curve

Total Revenue and the Elasticity of Demand A firm’s revenues are equal to price per unit times quantity sold. Revenue = Price x Quantity The elasticity of demand directly influences revenues when the price of the good changes. Instructor Notes:

Total Revenue and the Elasticity of Demand Knowing the value of the elasticity allows us to understand what happens to total revenue when the price changes. If…

The Elasticity of Supply Elasticity of supply – measures how responsive the quantity supplied is to the a change in price. more responsive equals more elastic. The slope of the supply curve is related to the elasticity of supply.

Calculating the Elasticity of Supply Measure of the responsiveness of quantity supplied to a change in price Computed by

Mathematics of Supply Elasticity If the Es < 1, the supply curve is inelastic. If the Es > 1, the supply curve is elastic. If the Es = 1, the supply curve is unit elastic. Instructor Notes: Students should note some extreme cases that are not explicitly defined in the text but are often used for simplification: Perfectly Elastic Demand Elasticity of demand is infinite A very small change in price will lead to an infinitely large change in quantity demanded Horizontal demand curve Perfectly Inelastic Demand Elasticity of demand is zero A change in price will cause no change in quantity demanded. Vertical demand curve

Determinants of the Elasticity of Supply Consider two polar cases Picasso painting Toothpicks Price Perfectly inelastic supply Price Perfectly elastic supply Quantity Quantity

Chapter 6 Taxes and Subsidies

Commodity Taxes We will emphasize the following: Who ultimately pays the tax is not dependent on who writes the check Who ultimately pays the tax does depend on the relative elasticities of supply and demand. Commodity taxation raises revenue and creates lost gains from trade (deadweight loss) Let’s look at each of these in turn.

Using the Tax Wedge Price of Apples (per basket) Quantity of Price buyers pay $4 3 Supply 2.65 2 1.65 1 Price sellers receive Demand Quantity of Apples (baskets) 200 500 700 1,250

The Burden of the Tax Depends of the Elasticities of Supply and Demand An elastic demand curve means that buyers can substitute An elastic supply curve means that workers and capital can easily find work in another industry Result When demand is more elastic than supply, buyers pay less of the tax When supply is more elastic than demand, sellers pay less of the tax In other words elasticity = escape Let’s use the model to show this

The Burden of the Tax Depends of the Elasticities of Supply and Demand Case I: Demand is more elastic than supply Price Supply Price paid by buyers Result: Most of the tax is paid By sellers Pno tax Tax Wedge Demand Price received by sellers Quantity Qw/tax Qno tax

The Burden of the Tax Depends of the Elasticities of Supply and Demand Case II: Supply is more elastic than demand Price paid by buyers Price Result: Most of the tax is paid By buyers Supply Tax Wedge Pno tax Price received by sellers Demand Quantity Qw/tax Qno tax

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Price No Tax Price With Tax Consumer surplus Consumer surplus Tax wedge S S $2.65 Deadweight loss $2.00 $2.00 $1.65 D D Producer surplus Government revenue Producer surplus Q Q 700 500 700

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Elasticities of demand and supply determine consumer and producer surplus The greater these elasticities, the greater will be the deadweight loss Let’s use our model to show this.

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case I: Elastic Demand Price Tax wedge Deadweight loss Pw/tax Tax Revenue Pno tax Supply Demand Quantity Qw/ tax Qno tax

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case II: Inelastic Demand Price Tax wedge Deadweight loss Pw/tax Tax Revenue Pno tax Supply Note: Tax rate and Tax revenue are the same as before. Deadweight loss is much smaller. Demand Quantity Qw/ tax Qno tax

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case III: Elastic Supply Price Tax wedge Deadweight loss Pw/tax Supply Tax Revenue Pno tax Demand Quantity Qw/ tax Qno tax

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case IV: Inelastic Supply Note: Tax rate and Tax revenue are the same as before. Deadweight loss is smaller. Price Tax wedge Supply Deadweight loss Pw/tax Pno tax Tax Revenue Demand Quantity Qw/ tax Qno tax

Subsidies A subsidy is a reverse tax Important facts about commodity subsidies Who gets the subsidy does not depend on who gets the check from the government. Who benefits from the subsidy does depend on the relative elasticities of demand and supply. Subsidies… Are paid for by taxpayers Result in inefficient increases in trade (deadweight loss) We can use the same wedge shortcut as before. Let’s use our model to analyze subsidies.

Subsidies Deadweight loss Price of apples Per basket $4 Supply 3 Price received By sellers = $2.40 Subsidy wedge 2 Price paid By buyers = $1.40 1 Demand 700 900 Quantity of apples (baskets)

Taxes and Subsidies Compared Whoever Bears the Burden of the Tax Receives the Benefits of a Subsidy Price Price received by sellers Benefit of subsidy on sellers Supply Price paid by buyers Subsidy wedge Price paid by buyers Burden of tax on sellers Tax wedge Demand Price received by sellers Quantity

Wage Subsidies Edmund Phelps – Nobel Prize winner Wage subsidies can be used to increase employment of low wage workers. Although costly, they may reduce Welfare payments. Crime Drug dependency “Rational defeatism” A better alternative to the minimum wage. Let’s analyze a wage subsidy program.

Wage received by workers Wage Subsidies Wage Supply of Labor Wage received by workers Cost to taxpayers $12 Market wage = $10.50 Subsidy Wedge = $4 $8 Wage paid by firms Demand for labor Qm Qs Quantity of labor

Takeaway Taxes decrease the quantity traded. Subsidies increase the quantity traded. The burden of the tax and the benefit of the subsidy do not depend on who sends or receives the government check. The side of the market that is more elastic will escape more of the tax and receive less of the benefit of the subsidy. The greater the elasticity of demand or supply the greater will be the deadweight loss.

Price Ceilings and Floors Chapter 8 Price Ceilings and Floors

Price Ceilings Price ceiling – a maximum price allowed by law Five important effects Shortages Reductions in product quality Wasteful lines and other search costs A loss in gains from trade A misallocation of resources Let’s look at each one in turn.

Price Ceilings Create Shortages Price of gasoline per gallon Supply Market Equilibrium Controlled Price (ceiling) Shortage Demand Qs Qd Quantity

Wasteful Lines and Other Search Costs Price of gasoline per gallon Supply Market Equilibrium Willingness to pay for Qs = $3 Total Value of Wasted time At the controlled price: Quantity supplied = Qs Buyers are willing to pay $3/gallon Line will grow until the time cost per gallon $3 - $1 = $2.00/gallon Controlled Price = 1 (ceiling) Demand Shortage Qs Qd Quantity

Wasted Time and Other Search Costs What’s the difference between paying a bribe and waiting in line? Waiting in line is more wasteful! A bribe goes to the station owner. Time waiting in line is lost; it benefits no one.

Price Ceilings: Reduce Gains From Trade Price of gasoline per gallon Lost consumer surplus Lost producer surplus Supply $3 A + B = Lost gains from trade Total Value of Wasted time A Market Equilibrium Market price B Controlled Price = 1 (ceiling) Demand Shortage Qs Qd Quantity

Misallocation of Resources Price ($) Highest-valued uses Supply Price control prevents highest valued uses from outbidding lower valued uses. Result: some oil flows to lower valued uses $3 Lower-valued uses Controlled Price (ceiling) Least-valued uses Shortage Demand Qs Qd Quantity

Price Floors Price floor – a minimum price allowed by law Price floors create: Surpluses Lost gains from trade (deadweight loss) Wasteful increases in quality A misallocation of resources

Surpluses A good example of a price floor is the minimum wage Workers with very low productivity are most affected by the minimum wage. Least experienced Least educated or trained Low-skilled teenagers are most affected. Let’s use the labor market model to analyze the minimum wage.

Minimum Wage Creates a Surplus ($/hr) Supply of labor Labor surplus (unemployment) Minimum wage Market wage Demand for labor Quantity of labor (unskilled) Qd Market employment Qs

Minimum Wage Creates Lost Gains From Trade ($/hr) Supply of labor Labor surplus (unemployment) Minimum wage Lost gains from trade (deadweight loss) = lost consumer surplus + lost producer surplus Market wage Demand for labor Quantity of labor (unskilled) Qd Market employment Qs

Minimum Wage Hotly debated in the U.S. 93.9% of workers < 25 years earn more than the minimum wage At best, the minimum wage raises the wages of some teenagers and young workers whose wages would have increased anyway as they became more skilled. At worst, increases in the price of hamburgers can create some teenage unemployment.

Takeaway You should be able to explain the effects of price ceilings to your uncle. You should be able to draw a diagram showing the price ceiling, label the shortage, wasteful losses, and the lost gains from trade. You should understand why a price ceiling reduces product quality and misallocates resources. You should be able to a similar analysis for price floors.

End of Chapter 8