1 Elasticity and Surplus Chapter 3

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=

4 One kind of annoying thing about this is the P and the 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 P) 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 P Q Medium (Unitary) Elasticity of Demand High Elasticity Perfectly Elastic Inelastic Perfectly Inelastic

7 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

8 Medium Elasticity P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Supply Old Equilibrium New Equilibrium New Supply Price rises Quantity falls

9 Perfectly elastic Demand P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Supply Old Equilibrium New Equilibrium New Supply Price doesn’t change Quantity decreases a lot

10 Perfectly Inelastic Demand P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Supply Old Equilibrium New Equilibrium New Supply Price changes a lot Quantity doesn’t change

11 Comparing Elasticities P Q/t $2.50 $2.00 $1.50 $1.00 $ Large Elasticity Low Elasticity When Demand is more elastic price change is smaller and quantity change is larger

12 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.

13 Seeing Elasticity Through Total Expenditures 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.

14 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. Portion of the Budget The greater the portion of the budget an item takes up, the greater the elasticity is likely to be.

15 Elasticity Examples Inelastic GoodsPrice Elasticity Eggs0.06 Food0.21 Health Care Services0.18 Gasoline (short-run)0.08 Gasoline (long-run)0.24 Highway and Bridge Tolls0.10 Unit Elastic Good (or close to it) Shellfish0.89 Cars1.14 Elastic Goods Luxury Car3.70 Foreign Air Travel1.77 Restaurant Meals2.27

16 Price Elasticity Supply 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

17 P Q Medium (Unitary) Elasticity of Supply High Elasticity Perfectly Elastic Inelastic Perfectly Inelastic

18 Perfectly elastic Supply P Q/t $2.50 $2.00 $1.50 $1.00 $ Old Equilibrium New Equilibrium Price doesn’t change Quantity Increases a lot

19 Perfectly Inelastic Supply P Q/t $2.50 $2.00 $1.50 $1.00 $ Old Equilibrium New Equilibrium Price Increases a lot Quantity doesn’t change

20 Comparing Elasticities P Q/t $2.50 $2.00 $1.50 $1.00 $ Low Elasticity High Elasticity When supply is more elastic price change is smaller and quantity change is larger

21 Consumer Surplus I think this is easiest to see in our extensive margin example that we started with NameWillingness to Pay Jim$200 Jackie$400 Bill$600 Sally$800 Lisa$1000 So for Bill the value of the Ipad is $600. If he could get an Ipad for free this would be worth $600 This gave the demand curve

22 In this case Bill, Sally and Lisa all get their Ipads, Jackie and Jim do not Lisa Sally Bill Jackie Jim The Value to Lisa is $1000.She pays $600, so her surplus is $400 Sally’s Value is $800 so her surplus is $200 Bill’s value is $600 so he gets no surplus Total Consumer Surplus: $600

23 Now lets think about this in a more more standard (and general) context P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Total Consumer Value Consumer Surplus Total that consumers pay

24 Now the firm P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Total firms receive in revenue Variable costs to producer Producer Surplus

P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Total Combined Surplus

26 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.

27 Now lets think about this in a more more standard (and general) context P Q/t $2.50 $2.00 $1.50 $1.00 $ What if we chose a lower Q? Surplus Now Total surplus is lower Deadweight Loss I did not say anything about how surplus is distributed-could be more equitable

P Q/t $2.50 $2.00 $1.50 $1.00 $ What if we chose a higher Q? Thus Total surplus is lower This bit is actually negative, Costs are higher than users valuation

29 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 Possible 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.

30 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

31 Private and Public Goods Purely private good: a good with the characteristics of both exclusivity and rivalry Purely 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

32 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 $1.00 tax on the good (like gas tax) Very similar to standard sales tax (just a percentage rather than a level)

P Q/t $2.50 $2.00 $1.50 $1.00 $ Tax Example Before I would have bought 25 units if price was $1.25. Now if price is $0.25 it costs me $1.50 so I buy 25 units Price firm gets Effective price consumer pays Consumer surplus Producer surplus Government revenue Deadweight loss Actual Demand Demand from consumers perspective

34 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

P Q/t $2.50 $2.00 $1.50 $1.00 $ Producer pays tax New supply curve firms act like price is P-$1.00 Before I would have sold 20 units if price was $1.50. Now if price is $2.50, I get $1.50 so I sell 20 units Effective price firm gets Price consumer pays Consumer surplus Producer surplus Government revenue Dead Weight loss It is exactly the same as before

36 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

P Q/t $2.50 $2.00 $1.50 $1.00 $ Perfectly Inelastic Demand New supply curve firms act like price is P-$1.00 Price consumer pays Government revenue I would sell 20 units whether there are taxes or not This means there is no deadweight loss Effective price that firm gets

P Q/t $2.50 $2.00 $1.50 $1.00 $ Perfectly Elastic Supply New demand curve Workers act like price is P+$1.00 Price firm gets Effective price consumer pays Producer surplus Government revenue No deadweight loss

39 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

P Q/t $2.50 $2.00 $1.50 $1.00 $ New demand curve Workers act like price is P+$1.00 Think about what happens as elasticity increases? Deadweight Loss Rises and Government Revenue Falls Both are bad so we don’t want to tax things that are high elasticity

41 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 60 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.”