2. Economics 111.3 Winter 14 February 7 th, 2014 Lecture 12 Ch. 6 (up to p. 138)

3. Conclusion (from Lecture 11) The incidence of a tax does not depend on whether the tax is levied on buyers or sellers.

4. STUDY QUESTION:

6. Taxes

8. The answer to this question depends on the elasticity of demand and the elasticity of supply. In what proportions is the burden of the tax divided?

9. Sales Tax and the Elasticity of Supply Quantity Price 45 50 100 S D Perfectly inelastic supply Seller pays entire tax

10. Sales Tax and the Elasticity of Supply Quantity (thousands of kilograms per week) Price (cents per pound) 10 11 3 5 3 5 S D S + tax Buyer pays entire tax Perfectly Elastic Supply

11. Sales Tax and the Elasticity of Demand Quantity (thousands of marker pens per week) 1 4 1 4 0.90 1.00 S S + tax Sellerpaysentiretax Price (cents per pen) Perfectly elastic demand

12. Sales Tax and the Elasticity of Demand Quantity (thousands of doses per day) Price (dollars per dose) 2.00 2.20 100 D S Perfectly inelastic demand S + tax Buyer pays entire tax

13. Tax Division and Price Elasticity of Demand Four extremes: Perfectly inelastic supply: seller pays Perfectly inelastic supply: seller pays Perfectly elastic supply: buyer pays Perfectly elastic supply: buyer pays Perfectly inelastic demand: buyer pays Perfectly inelastic demand: buyer pays Perfectly elastic demand: seller paysPerfectly elastic demand: seller pays

14. The Rule of Tax Incidence: Generalization The burden tends to fall on the side of the market that is less elastic: The more elastic the supply, the larger is the amount of tax paid by the buyer and vice versa Sales tax is generally applied to items with a low elasticity of demand (alcohol, tobacco, and gasoline): Quantity does not decrease by much; large tax revenue It is unusual to apply sales tax to goods with a high elasticity of demand.

17. Study question The supply of and demand for roses are given by P = 4Q s and P = 12 –2Q d respectively. Answer the following questions: A.Suppose the government decides to tax the suppliers of roses $6 per dozen roses sold. How much tax does Government collect and who pays it? B.Calculate the deadweight loss associated with this $6 tax.

21. Ch. 8 Consumer’s Choice Concept of Utility The Theory of Demand

22. Concept of Utility Utility – satisfaction that we get from consuming some goods and services Cardinal Utility – refers to putting an absolute measure of utility upon goods and services or market baskets (e.g., I like this TWICE AS MUCH as I like that) Ordinal Utility – measures utility only by ranking the consumer’s preferences among goods and market baskets (e.g., I like good “A” more (or less) than good “B”(or the same as good “B”)

23. Cardinal Utility: extra terminology Total utility: total amount of satisfaction Marginal utility: extra satisfaction from consuming one more unit

25. Law of Diminishing Marginal Utility: 1.Gains in satisfaction decline as additional units are consumed 2.This principle does not say you do not enjoy consuming more of a good. 3.It only states that as you consume more of the good, you enjoy additional units less than you enjoyed the initial units. 4.When marginal utility is zero, total utility stops increasing. 5.Beyond this point, marginal utility is negative and total utility decreases.

28. Theory of Consumer Choice A Typical Consumer.… Exhibits rational behavior -Rational means that people prefer more to less and will make choices that give them as much satisfaction as possible. -The analysis of rational choice begins with the premise that rational individuals want as much satisfaction as they can get from their available income. Knows clear-cut preferences

29. Theory of Consumer Choice, cont’d A Typical Consumer.… Responds to price changes Is subject to a budget constraint Makes those choices that have the highest units of utility per dollar spent.

30. The Paradox of Value Why does water, which is essential for life, cost so little? Why do diamonds, which are useless compared to water, cost so much?

31. Carl Menger: 1840-1921 Menger’s solution of the water- diamond paradox: The last need unmet by the loss of a concrete quantity of water, which is valued by the subjective degree of desire would be of far less importance than that of the need unmet by the loss of a concrete quantity of diamonds as diamonds are so few in quantity compared to water

32. The Paradox of Value, cont’d Diamonds have a high price and a high marginal utility, while water has a low price and a low marginal utility. At consumer equilibrium, the marginal utility per dollar spent is the same for diamonds as for water. Utility Maximizing Rule: the consumer’s money income should be allocated so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility

33. Algebraic Restatement of the Utility Maximization Rule MU of product A Price of A MU of product B Price of B =