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Second Edition Chapter 5 Elasticity and Its Applications.

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Presentation on theme: "Second Edition Chapter 5 Elasticity and Its Applications."— Presentation transcript:

1 Second Edition Chapter 5 Elasticity and Its Applications

2 Elasticity of Demand Elasticity of demand - a measure of how responsive the quantity demanded is to a change in price more responsive equals more elastic. The slope of the demand curve is related to the elasticity of demand. 2

3 Calculating the Elasticity of Demand Elasticity measures the responsiveness of quantity demanded to changes in price. 3

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.

5 A firms revenues are equal to price per unit times quantity sold. Revenue = Price x Quantity The elasticity of demand directly influences revenues when the price of the good changes. Total Revenue and the Elasticity of Demand

6 Knowing the value of the elasticity allows us to understand what happens to total revenue when the price changes. If… 6

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. 7

8 Calculating the Elasticity of Supply Measure of the responsiveness of quantity supplied to a change in price Computed by 8

9 If the E s < 1, the supply curve is inelastic. If the E s > 1, the supply curve is elastic. If the E s = 1, the supply curve is unit elastic. 9 Mathematics of Supply Elasticity

10 Determinants of the Elasticity of Supply Consider two polar cases Picasso painting Toothpicks Price Quantity Perfectly elastic supplyPerfectly inelastic supply 10

11 Second Edition Chapter 6 Taxes and Subsidies

12 Commodity Taxes We will emphasize the following: 1.Who ultimately pays the tax is not dependent on who writes the check 2.Who ultimately pays the tax does depend on the relative elasticities of supply and demand. 3.Commodity taxation raises revenue and creates lost gains from trade (deadweight loss) Lets look at each of these in turn. 12

13 Using the Tax Wedge Price of Apples (per basket) Quantity of Apples (baskets) Supply $ , Demand 200 Tax Wedge = $1 Price buyers pay Price sellers receive 13

14 The Burden of the Tax Depends of the Elasticities of Supply and Demand An elastic demand curve means that buyers can substitute An elastic supply curve means that workers and capital can easily find work in another industry Result When demand is more elastic than supply, buyers pay less of the tax When supply is more elastic than demand, sellers pay less of the tax In other words elasticity = escape Lets use the model to show this 14

15 The Burden of the Tax Depends of the Elasticities of Supply and Demand Case I: Demand is more elastic than supply Price Quantity Supply Demand Tax Wedge Q no tax Q w/tax P no tax Price received by sellers Price paid by buyers Result: Most of the tax is paid By sellers 15

16 The Burden of the Tax Depends of the Elasticities of Supply and Demand Case II: Supply is more elastic than demand Price Quantity Supply Demand Tax Wedge Q no tax Q w/tax P no tax Price received by sellers Price paid by buyers Result: Most of the tax is paid By buyers 16

17 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Price Q Q No TaxWith Tax 700 $2.00 Consumer surplus Producer surplus 500 Tax wedge $2.65 $1.65 Consumer surplus Producer surplus Government revenue Deadweight loss DD SS 17

18 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Elasticities of demand and supply determine consumer and producer surplus The greater these elasticities, the greater will be the deadweight loss Lets use our model to show this. 18

19 Q w/ tax A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case I: Elastic Demand Supply Price Quantity Demand P no tax P w/tax Tax wedge Tax Revenue Q no tax Deadweight loss 19

20 Q w/ tax A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case II: Inelastic Demand Supply Price Quantity Demand P no tax P w/tax Tax wedge Tax Revenue Q no tax Deadweight loss Note: Tax rate and Tax revenue are the same as before. Deadweight loss is much smaller. 20

21 Tax Revenue Q w/ tax A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case III: Elastic Supply Supply Price Quantity Demand P no tax P w/tax Tax wedge Q no tax Deadweight loss 21

22 Tax Revenue Q w/ tax A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case IV: Inelastic Supply Supply Price Quantity Demand P no tax P w/tax Tax wedge Q no tax Deadweight loss Note: Tax rate and Tax revenue are the same as before. Deadweight loss is smaller. 22

23 Subsidies A subsidy is a reverse tax Important facts about commodity subsidies 1.Who gets the subsidy does not depend on who gets the check from the government. 2.Who benefits from the subsidy does depend on the relative elasticities of demand and supply. 3.Subsidies… 1.Are paid for by taxpayers 2.Result in inefficient increases in trade (deadweight loss) We can use the same wedge shortcut as before. Lets use our model to analyze subsidies. 23

24 Subsidies Price of apples Per basket Quantity of apples (baskets) Demand Supply 3 $ Price received By sellers = $2.40 Price paid By buyers = $1.40 Subsidy wedge Deadweight loss 24

25 Taxes and Subsidies Compared Whoever Bears the Burden of the Tax Receives the Benefits of a Subsidy Price Quantity Supply Demand Subsidy wedge Tax wedge Price received by sellers Price paid by buyers Price paid by buyers Price received by sellers Benefit of subsidy on sellers Burden of tax on sellers 25

26 Wage Subsidies Edmund Phelps – Nobel Prize winner Wage subsidies can be used to increase employment of low wage workers. Although costly, they may reduce Welfare payments. Crime Drug dependency Rational defeatism A better alternative to the minimum wage. Lets analyze a wage subsidy program. 26

27 Wage Subsidies Wage Quantity of labor Demand for labor Market wage = $10.50 Supply of Labor QmQm Subsidy Wedge = $4 QsQs Wage received by workers $12 $8 Wage paid by firms Cost to taxpayers 27

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. 28

29 Second Edition Chapter 8 Price Ceilings and Floors

30 Price Ceilings Price ceiling – a maximum price allowed by law Five important effects 1.Shortages 2.Reductions in product quality 3.Wasteful lines and other search costs 4.A loss in gains from trade 5.A misallocation of resources Lets look at each one in turn. 30

31 Price Ceilings Create Shortages Price of gasoline per gallon Quantity Demand Supply Market Equilibrium Controlled Price (ceiling) QsQs QdQd Shortage 31

32 Total Value of Wasted time Wasteful Lines and Other Search Costs Quantity Demand Supply Market Equilibrium Controlled Price = 1 (ceiling) QsQs QdQd Shortage Willingness to pay for Qs = $3 Price of gasoline per gallon At the controlled price: Quantity supplied = Q s Buyers are willing to pay $3/gallon Line will grow until the time cost per gallon $3 - $1 = $2.00/gallon 32

33 Wasted Time and Other Search Costs Whats 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. 33

34 Total Value of Wasted time Price Ceilings: Reduce Gains From Trade Quantity Demand Supply Market Equilibrium Controlled Price = 1 (ceiling) QsQs QdQd Shortage $3 Price of gasoline per gallon Market price Lost producer surplus Lost consumer surplus B A A + B = Lost gains from trade 34

35 Misallocation of Resources Quantity Demand Supply Controlled Price (ceiling) QsQs QdQd Shortage $3 Price ($) Highest-valued uses Lower-valued uses Least-valued uses Price control prevents highest valued uses from outbidding lower valued uses. Result: some oil flows to lower valued uses 35

36 Price Floors Price floor – a minimum price allowed by law Price floors create: 1.Surpluses 2.Lost gains from trade (deadweight loss) 3.Wasteful increases in quality 4.A misallocation of resources 36

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 experienced Least educated or trained Low-skilled teenagers are most affected. Lets use the labor market model to analyze the minimum wage. 37

38 Minimum Wage Creates a Surplus Demand for labor Supply of labor Market wage Wage ($/hr) Quantity of labor (unskilled) Market employment Minimum wage QsQs QdQd Labor surplus (unemployment) 38

39 Minimum Wage Creates Lost Gains From Trade Demand for labor Supply of labor Market wage Wage ($/hr) Quantity of labor (unskilled) Market employment Minimum wage QsQs QdQd Labor surplus (unemployment) Lost gains from trade (deadweight loss) = lost consumer surplus + lost producer surplus 39

40 Minimum Wage Hotly debated in the U.S. 93.9% of workers < 25 years earn more than the minimum wage At 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. 40

41 Takeaway You 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. 41

42 Second Edition End of Chapter 8


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