PPA 723: Managerial Economics Lecture 4: Applications of Supply and Demand

Managerial Economics, Lecture 4: Applications of S&D Outline Elasticities Tax Incidence Rent Control

Managerial Economics, Lecture 4: Applications of S&D Another Dimension of Demand and Supply: Responsiveness The slope of a demand curve equals: The inverse of the slope indicates the magnitude of the response to price. A more responsive curve (flatter slope) generally means more alternatives in other markets.

Managerial Economics, Lecture 4: Applications of S&D Elasticity The elasticity of demand equals: The absolute value of the elasticity indicates the magnitude of the response to price. The value of the elasticity varies along a linear demand curve.

Managerial Economics, Lecture 4: Applications of S&D Slope and Elasticity P Q D P1 Q1 Slope = “rise”/“run” = P/Q < 0 P Q Elasticity = (Q/Q1)/(P/P1) < 0

Managerial Economics, Lecture 4: Applications of S&D Large and Small Elasticities P Q S1 S2 D P1 P2 Q2 Q1 Large Elasticity (│e│) = Responsive Demand Small Elasticity (│e│) = Unresponsive Demand

Managerial Economics, Lecture 4: Applications of S&D Figure 3.3c Vertical and Horizontal Demand Curves (c) Individual ’ s Demand for Insulin p * p, Price of insulin dose Q * Q , Insulin (doses per day)

Managerial Economics, Lecture 4: Applications of S&D Figure 3.2 Elasticity Along the Pork Demand Curve Perfectly Elastic: e = - ∞ P ($ per kg) a / b = 14.30 Elastic: e < -1 11.44 e = – 4 e = (Q/Q)/(P/P) = (PQ)/(QP) D a /(2 b ) = 7.15 Unitary: e = -1 Inelastic: 0 > e > -1 -P = P Perfectly Inelastic: e = 0 3.30 e = – 0.3 Q = Q a / 5 = 57.2 a / 2 = 143 220 a = 286 Q (Mil. kg of pork/year)

Managerial Economics, Lecture 4: Applications of S&D Figure 3.1 How the Effect of a Supply Shock Depends on the Shape of the Demand Curve (a) (b) (c) D 2 p, $ per kg p, $ per kg p, $ per kg D 1 e e 2 2 3.675 e 3.55 3 2 3.30 3.30 3.30 D e e e S 2 S 2 1 1 S 2 1 S 1 S 1 S 1 176 215 220 176 220 176 205 220 Q , Million kg of pork per year Q , Million kg of pork per year Q , Million kg of pork per year

Managerial Economics, Lecture 4: Applications of S&D Change in Revenue New Revenue e 2 p 2 p, Price per unit e 1 p 1 D Original Revenue Q Q 2 1 Q , Quantity per time period

Managerial Economics, Lecture 4: Applications of S&D Elasticity and Revenue

Managerial Economics, Lecture 4: Applications of S&D Elasticity and Revenue, Continued When price increases, Revenue increases if demand is inelastic (|e| < 1) Revenue decreases if demand is elastic (|e| > 1)

Managerial Economics, Lecture 4: Applications of S&D Figure 3.4 Elasticity Along the Pork Supply Curve S P ($ per kg) 5.30 h ≈ 0.71 4.30 h ≈ 0.66 3.30 h ≈ 0.6 2.20 h ≈ 0.5 176 220 260 300 Q (Million kg of pork per year)

Managerial Economics, Lecture 4: Applications of S&D Tax Incidence A key question about taxes is: Who pays? To answer, must distinguish between: Legal Incidence, which indicates who is legally obligated to write the check to the government. Economic Incidence, which indicates whose real income declines due to the tax. They may not be the same due to tax shifting.

Managerial Economics, Lecture 4: Applications of S&D The Analysis of Tax Incidence P Q S S + tax D P1 P2 P3 tax Burden on consumers Burden on firms

Managerial Economics, Lecture 4: Applications of S&D Figure 3.5 Effect of a $1.05 Specific Tax on the Pork Market Collected from Producers S 2 p, $ per kg e t = $1.05 2 S 1 p = 4.00 2 e 1 p = 3.30 1 T = $216.3 million p – t = 2.95 2 D 176 Q = 206 Q = 220 2 1 Q , Million kg of pork per year

Managerial Economics, Lecture 4: Applications of S&D Figure 3.6 Effect of a $1.05 Specific Tax on Pork Collected from Consumers p, $ per kg e Wedge, 2 t = $1.05 p = 4.00 S 2 e 1 p = 3.30 1 T = $216.3 million p – t = 2.95 2 t = $1.05 D 1 D 2 176 Q = 206 Q = 220 Q , Million kg of pork per year 2 1

Managerial Economics, Lecture 4: Applications of S&D Page 64 Solved Problem 3.1 e 2 p = p + 1 S 2 2 1 p, Price per unit t = $1 e 1 p S 1 1 D Q Q 2 1 Q , Quantity per time period

Managerial Economics, Lecture 4: Applications of S&D A Land Tax S D R (Rent per Acre) R1 Tax R1-T Q1 Q (Acres of Land)

Managerial Economics, Lecture 4: Applications of S&D Lessons A tax falls most heavily on the side of the market with the lowest elasticity (= fewest alternatives). Economic incidence is determined by market forces, not by legal incidence.

Managerial Economics, Lecture 4: Applications of S&D Rent Control Housing affordability is a serious issue in this country: More than half of the poor pay more than half of their income in rent and utilities. A few cities try to address this through rent controls, i.e., by setting rent ceilings.

Managerial Economics, Lecture 4: Applications of S&D Rent Control R (Rent) Short-run S Long-run S e R Rent ceiling R* D QS2 QS1 Q Q d Q (Number of Apartments)

Managerial Economics, Lecture 4: Applications of S&D Effects of Rent Control Fewer apartments put on the market Decline in maintenance and hence in the number of quality-adjusted units Fewer apartments constructed New rules for allocating units, with the poor at a disadvantage

Managerial Economics, Lecture 4: Applications of S&D Lessons Public policy can alter prices, but only at great cost. Market forces are powerful and not easily overcome! Attempts to alter market outcomes usually have unintended consequences. The distribution of benefits and costs may be difficult to control