the responsiveness of the amount purchased to a change in price. Price Elasticity of demand = %  Q %  P = % Change in quantity demanded % Change in Price - or put more simply - = PED > 1 Elastic < 1 Inelastic = 1 Unit Elastic )()( P PP Q QQ  = ) ( )( P P P Q QQ   X

Quan Price Elasticity ___ Total Revenue ___ = = = = = = = X X X X X X X X

(b) Price Quantity/ time (a) Price Quantity/ time Mythical demand curve Perfectly inelastic: An increase in Price results in no change in Quantity Different Elasticities Relatively inelastic: A percent increase in Price results in a smaller % reduction in Quantity Demand for Cigarettes

(c) Price Quantity/ time Unitary elasticity: The percent change in quantity demanded due to an increase in price is equal to the % change in price. Demand curve of unitary elasticity = 1

(d) Price Quantity/ time Relatively elastic: A % increase in Price leads to a larger % reduction in Quantity. Elasticity of Demand (e) Price Quantity/ time Perfectly elastic: Consumers will buy all of Farmer Hollings’s wheat at the market price, but none will be sold above the market price. Demand for Granny Smith Apples Demand for Farmer Hollings’s wheat

2. Necessity vs Luxury What affects Elasticity??? 3. Proportion of Income 1. Available Substitutes 4. Time to shop around

a. Market Period What affects Supply Elasticity??? b. Short Run 1. Time c. Long Run

Income Elasticity the responsiveness of a product’s demand to a change in income. Income Elasticity of demand = % Change in quantity demanded % Change in Income A normal good has a positive income elasticity of demand. –As income increases, the demand for normal goods increases. Goods with a negative income elasticity are inferior goods. –As income expands, the demand for inferior goods will decline.

Cross Price Elasticity the responsiveness of a product’s demand to a change in the price of another good. Cross Price Elasticity = % Change in Q x % Change in P y A complement has a negative cross price elasticity. –As P y increases, the demand for Y decreases, and demand for goods that are consumed with Y also decreases. A substitute has a positive cross price elasticity –As P y increases, the demand for Y decreases, and demand for goods that can be consumed instead of Y also decreases.

Consumer Surplus The total difference between what a consumer is willing to pay and how much they actually have to pay. Producer Surplus The total difference between what a supplier is willing to provide a good or service and how much they actually get for it.

S D P Q Consumer surplus = area of lighter triangle = ½($5)(5) = $12.5 Producer surplus = area of darker triangle = ½($5)(5) = $12.5 Producer and Consumer Surplus The combination of producer and consumer surplus is maximized at market equilibrium CS PS $

The Burden of a Tax Tax Incidence Who pays a tax is called the incidence. Buyer Seller

Price # of used cars per month (in thousands) D $6,400 S plus tax $7,000 $7,400 S $1000 tax Impact of a Tax Imposed on Sellers If in the used car market a price of $7,000 would bring the quantity of used cars demanded into balance with the quantity supplied. When a $1,000 tax is imposed on sellers of used cars, the supply curve shifts vertically by the amount of the tax. The new price for used cars is $7,400 … Consumers end up paying $7,400 instead of $7,000 and bear $400 of the tax burden. Sellers end up receiving $6,400 (after taxes) instead of $7000 and bear $600 of the tax burden. sellers netting $6,400 ($7,400 - $1000 tax).

Price # of used cars per month (in thousands) D $6,400 $7,000 $7,400 S $1000 tax Impact of a Tax Imposed on Buyers In the same used car market: When a $1,000 tax is imposed on buyers of used cars, the demand curve shifts vertically by the amount of the tax. The new price for used cars is $6,400 … Consumers end up paying $7,400 (after taxes) instead of $7,000 and bear $400 of the tax burden. Sellers end up receiving $6,400 instead of $7000 and bear $600 of the tax burden. buyers then pay taxes of $1000 making the total $7,400. D minus tax

The actual burden of a tax depends on the elasticity of supply and demand. As supply becomes more inelastic, then more of the burden will fall on sellers. As demand becomes more inelastic, then more of the burden will fall on buyers. Elasticity and Incidence of a Tax E D E S E D + E S

110 D Luxury boat market Gasolin e market S $1.60 $1.50 $1.45 Quantity (thousand s of boats) Quantity (millions of gallons) Price Price (thousand $) Tax Burden and Elasticity D S plus tax 20 0 $1.55 $1.65 S S plus tax Consider the market for Gasoline and Luxury Boats individually. In the gas market, the demand is relatively more inelastic than its supply; hence, buyers bear a larger share of the burden of the tax. In the luxury boats market, the supply curve is relatively more inelastic than its demand; hence, sellers bear a larger share of the tax burden. We begin in equilibrium. If we impose a $.20 tax on gasoline suppliers, the supply curve moves vertically the amount of the tax. Price goes up $.15 and output falls by 6 million gallons per week. If we impose a $25K tax on Luxury Boat suppliers, the supply curve moves vertically the amount of the tax. Price goes up by $5K and output falls by 5 thousand units.

S D P Q P0P0 Q0Q0 A price ceiling transfers surplus from producers to consumers, generates deadweight loss, and reduces equilibrium quantity Q1Q1 Price ceiling P1P1 Shortage An effective price ceiling is a government set price below the market equilibrium price It acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation

S D P Q P0P0 Q0Q0 A price floor transfers surplus from consumers to producers, generates deadweight loss, and reduces equilibrium quantity Q1Q1 Price floor P1P1 Surplus An effective price floor is a government set price above the market equilibrium It acts as a tax on consumers and a subsidy for producers that transfers consumer surplus to producers

The Difference Between Taxes and Price Controls Taxes leave people free to choose how much to supply and consume as long as they pay the tax Price ceilings create shortages and taxes do not Shortages may also create black markets

Rent Seeking, Politics, and Elasticities Individuals spend money and use resources to lobby governments to institute policies that increase their own surplus Lobbying for price controls, which transfer surplus from one group to another, is an example of rent-seeking behavior Public choice economists argue that when all rent seeking and tax consequences are netted out, there is often not a net gain to the public The possibility of transferring surplus from one set of individuals to another causes people to spend time and resources on doing so.

A C B Inelastic Demand and Incentives to Restrict Supply S0S0 D P Q S1S1 P0P0 P1P1 Q0Q0 Q1Q1 Revenue gained When demand is relatively inelastic, suppliers have incentive to restrict quantity to increase total revenue Revenue lost

Inelastic Supplies and Incentives to Restrict Prices When supply is inelastic and demand increases, prices increase causing consumers to lobby for price controls When supply is inelastic, consumers have incentives to restrict prices Rent control in New York City is an example

Application: Price Floors and Elasticity S D P Q P0P0 P1P1 S D P Q P0P0 Q0Q0 Q1Q1 The surplus created by a price floor is larger if demand and supply are elastic Q0Q0 Q1Q1 Surplus Price floor Surplus P1P1

International Trade The Trade Sector of the US Growth: - In 1975, exports and imports were each approximately 8% of the U.S. economy. - In 2008, exports accounted for 11% of GDP and imports made up 16%. Major Trading Partners: - Canada, Mexico, and Japan -China, Europe

Canada Mexico Latin America Europe OPEC Pacific Rim Other Partner % Exports % Imports

Today, Canada, Mexico, China, and Japan are the leading trading partners with the United States. The impact of international trade varies across industries. -- some compete effectively, some do not. Leading Trading Partners of the U.S. Taiwan South Korea United Kingdom Germany Japan China Mexico Canada –––––––– Percent of Total U.S. Trade, 2002 –––––––– All other countries Malaysia France 2.5% 3.1% 3.9% 4.9% 8.6% 9.1% 11.9% 19.8% 32.2% 1.8% 2.3% 2.1% 11.9% 2.7% 3.4% 4.5% 7.2% 11.5% 18.5% 34.4% 1.7% 2.1% –––––––– Percent of Total U.S. Trade, 2006 ––––– –––

The Growth of the U.S. Trade Sector Both exports and imports have grown substantially as a share of the U.S. economy. Their growth has accelerated since Reductions in transport and communication costs, as well as lower trade barriers have contributed to this growth. Source: The figures are based on data for real imports, exports, and GDP. Imports (% of GDP) Exports (% of GDP)

Balance of Trade Percent of GDP The United States has been running trade deficits since the 1970s

Gains from Specialization and Trade International trade allows each country to specialize according to the law of comparative advantage. Each country can produce those goods that it can produce at a relatively low cost. Trading partners can consume a wider variety of goods than they could produce domestically.

The Benefits from Trade (from Chapter 2) Chocolate (tons) Textiles (yds) Pakistan specialized in textiles 5,000 4,000 3,000 2,000 1, Belgium Pakistan and Belgium specialized in chocolates.

When they took advantage of their comparative advantage, Chocolate (tons) Textiles (yds) 5,000 4,000 3,000 2,000 1, Belgium Pakistan they could trade with each other for more of both.

Areca Guns Butter Bonsai Guns Butter

Production Possibilities - Mexico ProductABCDE Avocados Soybeans Production Possibilities - US ProductABCDE Avocados Soybeans S = __ A 1 A = __ S US should produce? Mexico should produce? Terms of Trade? ___ A for ___ S

Gains from Specialization and Trade International trade leads to gains from: Economies of Scale: reductions in per-unit costs that often accompany large-scale production, marketing, and distribution. More Competitive Markets: Promotes competition in domestic markets and allows consumers to purchase a wide variety of goods at economical prices.

Exports and Imports are Linked Exports provide the foreign exchange needed for the purchase of imports. Imports provide trading partners with the currency needed to purchase exported goods and services. Therefore, restrictions that limit one will also limit the other. A Hard Lesson to Learn

PnPn QnQn PwPw QwQw Shoes Price SwSw DwDw Shoes Price U.S. Market World Market Foreigners Have a Comparative Advantage Consider the international market for manufacturing shoes. In the absence of trade, the domestic price would be P n. Since many foreign producers have a comparative advantage in the production of shoes, international trade leads to lower prices P w. SdSd DdDd a

DdDd QnQn a SdSd PwPw QwQw Shoes Price SwSw DwDw Shoes Price U.S. Market World Market At the price P w, U.S. consumers demand Q c units of which (Q c – Q p ) are imported. Compared to no trade, consumers gain P n a b P w, while domestic producers lose P n a c P w. A net gain of a b c results. PwPw b c PnPn QpQp QcQc U.S. imports SwSw Foreigners Have a Comparative Advantage

PnPn PwPw QnQn QcQc QpQp a b PwPw QwQw Soybeans (bushels) Price Soybeans (bushels) Price U.S. Market World Market U.S. Has a Comparative Advantage The price of soybeans and other internationally traded commodities is determined by the forces of supply and demand in the world market. If U.S. soybean producers were prohibited from selling to foreigners, the domestic price would be P n. Free trade permits U.S. soybean producers to sell Q p units at the higher world price of P w. SwSw SdSd DdDd c SwSw DwDw

PnPn DdDd PwPw QnQn QcQc QpQp a b c SdSd PwPw QwQw Soybeans (bushels) Price SwSw DwDw SwSw Soybeans (bushels) Price U.S. Market World Market U.S. Has a Comparative Advantage At the world price of P w, the quantity (Q p – Q c ) is exported. Compared to the no-trade situation, the producers’ gain from the higher price (P w b c P n ) exceeds the cost imposed on domestic consumers (P w a c P n ) by the triangle (area) a b c. U.S. exports

Varieties of Trade Restrictions Quotas are quantity limits placed on imports Voluntary restraint agreements are when countries voluntarily restrict their exports Tariffs are taxes governments place on internationally traded goods (generally imports) An embargo is a total restriction on the import or export of a good Regulatory trade restrictions are government-imposed procedural rules that limit imports Nationalistic appeals, such as “Buy American” can help to restrict international trade

S Domestic P Q $2.50 Imports Tariffs when the domestic country is small Tariffs decrease imports, increase domestic production, and generate tariff revenue $3.00 D Domestic P World = S World $2.00 P World + $0.50Tariff = S’ World Imports’ Tariff revenue 9-41

S Domestic P Q $2.50 Imports w/o quota Application: Quotas when the domestic country is small Quotas decrease imports and increase domestic production $3.00 D Domestic P World = S World $2.00 Quota = S’ World Quota = 50

S Quantity (peanuts) Q d1 S Domestic PwPw T UV Q1Q1 Price D Domestic P2P2 Q2Q2 Q d2 Trade Restriction Impacts Initial imports Import quota: Q 2 – Q d2 S Quantity (automobiles) Q d1 S Domestic PwPw T UV Q1Q1 Price D Domestic P w + t Q2Q2 Q d2 Initial imports Tariff = t Imports after tariff

U.S. Tariff Rates: 1890 to the Present 10% –––––––– U.S. Average Tariff Rate –––––––– (Duties collected as a share of dutiable imports) 4.5% 20% 30% 40% 50% 60%

Why do Nations Adopt Trade Restrictions? 1.Unequal internal Distribution of the gains from trade (move to comparative advantage production) 2.Haggling by companies over gains from trade 3.Haggling by countries over trade restrictions 4.Specialized production: a. Learn by doing b. economies of scale. c. Infant industry argument.

Why do Nations Adopt Trade Restrictions? 5. Macroeconomic aspects of trade Limit imports during a recession 6. National Security 7.International politics 8.Increase revenue from tariffs

U.S. trade with both Canada and Mexico grew rapidly following the passage of NAFTA. U.S. Trade with Canada and Mexico –––––––– U.S. Trade with Canada and Mexico ––––––– – (Exports and Imports together as a share of GDP) 1% % 3% 4% 5% 6% Mexico Canada

the pleasure people get from doing or consuming something

Diminishing Marginal Utility As additional units are consumed, marginal utility decreases, but total utility continues to increase When total utility is at a maximum, marginal utility is zero After some point, the marginal utility received from each additional unit of a good decreases with each additional unit consumed Beyond this point, total utility decreases and marginal utility is negative

Utility Q The total utility curve is bowed downward Utility Q Total Utility CurveMarginal Utility Curve The marginal utility curve is downward sloping and graphed at the halfway point –2 0

Choices are based on comparisons of MU per $ spent on each good until choices are equal. MU A PAPA = MU B PBPB =...= MU N PNPN

$2.50 $2.00 Price Frozen pizzas per week $3.00 $3.50 MB 4 MB 3 MB 2 MB 1 <<< MU 4 MU 3 MU 2 MU 1 <<< because d MB = The demand for frozen pizzas reflects the law of diminishing marginal utility. Because marginal utility (MU) falls with increased consumption, so does a consumer’s maximum willingness to pay -- marginal benefit (MB). A consumer will purchase until MB = Price... so at $2.50 they would purchase 3 frozen pizzas and receive a consumer surplus shown by the shaded area (above the price line and below the demand curve). Price = $2.50 The Pizza Demand Curve John’s demand curve for frozen pizza MB 4 MB 3 MB 2 MB 1

Tastes are often significantly influenced by society Implicit in the theory of rational choice is that utility functions are given, not shaped by society Conspicuous consumption is the consumption of goods not for one’s direct pleasure, but to show off to others Tastes are given “Given tastes” is the assumption on which an economic analysis is conducted

1.Organize factors of production and/or 2.Produce goods and services and/or 3.Sell produced goods and services A virtual firm organizes production and subcontracts out all work Many of the organizational structures of business are being separated from the production process