Presentation on theme: "Elasticity and Its Applications"— Presentation transcript:
1 Elasticity and Its Applications Chapter 5Elasticity and Its Applications
2 Elasticity of DemandElasticity of demand - a measure of how responsive the quantity demanded is to a change in pricemore responsive equals more elastic.The slope of the demand curve is related to the elasticity of demand.
3 Calculating the Elasticity of Demand Elasticity measures the responsiveness of quantity demanded to changes in price.
4 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 DemandElasticity of demand is infiniteA very small change in price will lead to an infinitely large change in quantity demandedHorizontal demand curvePerfectly Inelastic DemandElasticity of demand is zeroA change in price will cause no change in quantity demanded.Vertical demand curve
5 Total Revenue and the Elasticity of Demand A firm’s revenues are equal to price per unit times quantity sold.Revenue = Price x QuantityThe elasticity of demand directly influences revenues when the price of the good changes.Instructor Notes:
6 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…
7 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.
8 Calculating the Elasticity of Supply Measure of the responsiveness of quantity supplied to a change in priceComputed by
9 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 DemandElasticity of demand is infiniteA very small change in price will lead to an infinitely large change in quantity demandedHorizontal demand curvePerfectly Inelastic DemandElasticity of demand is zeroA change in price will cause no change in quantity demanded.Vertical demand curve
10 Determinants of the Elasticity of Supply Consider two polar casesPicasso paintingToothpicksPricePerfectly inelastic supplyPricePerfectly elastic supplyQuantityQuantity
12 Commodity Taxes We will emphasize the following: Who ultimately pays the tax is not dependent on who writes the checkWho 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.
13 Using the Tax Wedge Price of Apples (per basket) Quantity of Price buyers pay$43Supply2.6521.651Price sellersreceiveDemandQuantity ofApples (baskets)2005007001,250
14 The Burden of the Tax Depends of the Elasticities of Supply and Demand An elastic demand curve means that buyers can substituteAn elastic supply curve means that workers and capital can easily find work in another industryResultWhen demand is more elastic than supply, buyers pay less of the taxWhen supply is more elastic than demand, sellers pay less of the taxIn other words elasticity = escapeLet’s use the model to show this
15 The Burden of the Tax Depends of the Elasticities of Supply and Demand Case I: Demand is more elastic than supplyPriceSupplyPrice paidby buyersResult:Most of the tax is paidBy sellersPno taxTaxWedgeDemandPrice receivedby sellersQuantityQw/taxQno tax
16 The Burden of the Tax Depends of the Elasticities of Supply and Demand Case II: Supply is more elastic than demandPrice paidby buyersPriceResult:Most of the tax is paidBy buyersSupplyTaxWedgePno taxPrice receivedby sellersDemandQuantityQw/taxQno tax
17 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade PriceNo TaxPriceWith TaxConsumersurplusConsumersurplusTax wedgeSS$2.65Deadweightloss$2.00$2.00$1.65DDProducersurplusGovernmentrevenueProducersurplusQQ700500700
18 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Elasticities of demand and supply determine consumer and producer surplusThe greater these elasticities, the greater will be the deadweight lossLet’s use our model to show this.
19 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case I: Elastic DemandPriceTax wedgeDeadweightlossPw/taxTaxRevenuePno taxSupplyDemandQuantityQw/ taxQno tax
20 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case II: Inelastic DemandPriceTax wedgeDeadweightlossPw/taxTaxRevenuePno taxSupplyNote:Tax rate and Tax revenueare the same as before.Deadweight loss is much smaller.DemandQuantityQw/ taxQno tax
21 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case III: Elastic SupplyPriceTax wedgeDeadweightlossPw/taxSupplyTaxRevenuePno taxDemandQuantityQw/ taxQno tax
22 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case IV: Inelastic SupplyNote:Tax rate and Tax revenueare the same as before.Deadweight loss is smaller.PriceTax wedgeSupplyDeadweightlossPw/taxPno taxTaxRevenueDemandQuantityQw/ taxQno tax
23 Subsidies A subsidy is a reverse tax Important facts about commodity subsidiesWho 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 taxpayersResult in inefficient increases in trade (deadweight loss)We can use the same wedge shortcut as before.Let’s use our model to analyze subsidies.
24 Subsidies Deadweight loss Price of apples Per basket $4 Supply 3 Price receivedBy sellers = $2.40Subsidywedge2Price paidBy buyers = $1.401Demand700900Quantity of apples(baskets)
25 Taxes and Subsidies Compared Whoever Bears the Burden of the Tax Receives the Benefits of a SubsidyPricePrice receivedby sellersBenefitof subsidyon sellersSupplyPrice paidby buyersSubsidywedgePrice paidby buyersBurdenof tax onsellersTaxwedgeDemandPrice receivedby sellersQuantity
26 Wage Subsidies Edmund Phelps – Nobel Prize winner Wage subsidies can be used to increase employment of low wage workers.Although costly, they may reduceWelfare payments.CrimeDrug dependency“Rational defeatism”A better alternative to the minimum wage.Let’s analyze a wage subsidy program.
27 Wage received by workers Wage SubsidiesWageSupplyof LaborWage received by workersCost totaxpayers$12Market wage= $10.50SubsidyWedge = $4$8Wage paidby firmsDemandfor laborQmQsQuantityof labor
28 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.
29 Price Ceilings and Floors Chapter 8Price Ceilings and Floors
30 Price Ceilings Price ceiling – a maximum price allowed by law Five important effectsShortagesReductions in product qualityWasteful lines and other search costsA loss in gains from tradeA misallocation of resourcesLet’s look at each one in turn.
31 Price Ceilings Create Shortages Price of gasolineper gallonSupplyMarketEquilibriumControlled Price(ceiling)ShortageDemandQsQdQuantity
32 Wasteful Lines and Other Search Costs Price of gasolineper gallonSupplyMarketEquilibriumWillingness topay for Qs = $3TotalValue ofWastedtimeAt the controlled price:Quantity supplied = QsBuyers are willing to pay $3/gallonLine will grow until the time cost per gallon $3 - $1= $2.00/gallonControlledPrice = 1(ceiling)DemandShortageQsQdQuantity
33 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.
34 Price Ceilings: Reduce Gains From Trade Price of gasolineper gallonLostconsumersurplusLostproducersurplusSupply$3A + B = Lost gainsfrom tradeTotalValue ofWastedtimeAMarketEquilibriumMarket priceBControlledPrice = 1(ceiling)DemandShortageQsQdQuantity
35 Misallocation of Resources Price($)Highest-valuedusesSupplyPrice control prevents highest valued usesfrom outbidding lower valued uses.Result: some oil flows to lower valued uses$3Lower-valuedusesControlledPrice(ceiling)Least-valuedusesShortageDemandQsQdQuantity
36 Price Floors Price floor – a minimum price allowed by law Price floors create:SurplusesLost gains from trade (deadweight loss)Wasteful increases in qualityA misallocation of resources
37 Surpluses A good example of a price floor is the minimum wage Workers with very low productivity are most affected by the minimum wage.Least experiencedLeast educated or trainedLow-skilled teenagers are most affected.Let’s use the labor market model to analyze the minimum wage.
39 Minimum Wage Creates Lost Gains From Trade ($/hr)Supplyof laborLabor surplus(unemployment)MinimumwageLost gains from trade(deadweight loss) = lost consumer surplus + lost producer surplusMarketwageDemandfor laborQuantityof labor(unskilled)QdMarketemploymentQs
40 Minimum Wage Hotly debated in the U.S. 93.9% of workers < 25 years earn more than the minimum wageAt 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.
41 TakeawayYou 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.