# The Income Effect, Substitution Effect, and Elasticity

## Presentation on theme: "The Income Effect, Substitution Effect, and Elasticity"— Presentation transcript:

The Income Effect, Substitution Effect, and Elasticity
Module Econ: 46 The Income Effect, Substitution Effect, and Elasticity KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module:
How the income and substitution effects explain the law of demand The definition of elasticity, a measure of responsiveness to changes in prices or incomes The importance of the price elasticity of demand, which measures the responsiveness of the quantity demanded to changes in price How to calculate the price elasticity of demand The purpose of this module is to get “behind the scenes” of the demand curve to explain why it is downward sloping and why some demand curves are more responsive to a price change than others. In order to do this, we develop the concepts of income and substitution effects, and price elasticity.

II. Defining Elasticity
Definition of elasticity- Elasticity measures the responsiveness of one variable to changes in another. Law of demand- We know that when price increases, quantity demanded decreases, NOW we want to know “by how much?” Example- What if the price of gasoline doubled? What if the price of pencils doubled? Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

III. Calculating Elasticity
Elasticity is the % change in the dependent variable divided by the % change in the independent variable In symbols, elasticity is %∆dep/%∆ind Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in the price. In symbols: Ed = %ΔQd/ΔP note: we drop the negative sign for Ed only. Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Help students see the connection between the concept of elasticity and the elasticity formula. Use words, then symbols. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another. Ed = %ΔQd/ΔP will often be the starting point when working with elasticity.

IV. The Midpoint Formula
There are problems with calculating percentage changes (if the starting and ending prices are reversed, elasticity is different) The solution: Use the Midpoint formula! %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity %ΔP = 100*(New Price – Old Price)/Average Price Ed = %ΔQd/ΔP Elasticity computations change if the starting and ending prices (or quantities) are reversed. That’s why we use the midpoint formula. Example: If a variable goes from a value of 100 to a value of 110, it is a 10% increase. If the variable were to go from a value of 110 to a value of 100, it is a 9.1% decrease. Because of this, the value of the price elasticity will change, depending upon whether the price is rising or falling. To address this issue, we use the average price and average quantity between two points on a demand curve. This method is called the midpoint method. %ΔP = 100*(New Price – Old Price)/Average Price Likewise with %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity

C. Midpoint Formula Q2-Q1 (Q2+Q1)/2 P2-P1 (P2+P1)/2 If E is Greater than 1 = Elastic If E is Equal to 1 = Unit Elastic If E is Less than 1 = Inelastic = E

Interpreting Price Elasticity of Demand
Econ: 47 Module Interpreting Price Elasticity of Demand KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module:
The difference between elastic and inelastic demand The relationship between elasticity and total revenue Changes in the price elasticity of demand along a demand curve The factors that determine price elasticity of demand The purpose of this module is to show students how to interpret the numerical measure of price elasticity of demand, to show how price elasticity changes along a demand curve, and why this is important. The module also describes the various factors that determine whether demand for a good is price elastic or inelastic.

Interpreting Price Elasticity of Demand
What does the value of elasticity tell us? It indicates how steep or flat the curve will be. Suppose we find that a price elasticity is equal to 10. What does this mean? We need a way to interpret the value of elasticity Take a look at the formula again. Ed = %ΔQd/%ΔP = 10 Now suppose that price were to increase by 1%. And since, Ed = %ΔQd/%1 = 10, we can predict that Qd will fall by a whopping 10%, which is a pretty big response. What would be the largest response to a price increase? Consumers immediately reduce consumption to zero. What would be the largest response to a price decrease? Consumers immediately increase consumption to an infinitely large amount.

What does an Elastic Demand Curve Look Like?
What does elasticity imply about the demand curve? It indicates how steep or flat the curve will be. What does inelastic imply about the demand curve? Vertical. This is an extreme case described as “perfectly inelastic”. For whatever reason, consumers have no response to higher or lower prices. In less than the extreme case, lower elasticity (less elastic/more inelastic) means steeper. Perfectly elastic = horizontal. This is an extreme case described as “perfectly elastic”. For whatever reason, consumers have an infinitely large response to higher or lower prices. In less than the extreme case, higher elasticity (more elastic) implies flatter.

I. Determinants of Elasticity
Factors Determine the Price Elasticity of Demand include: Number of substitutes More Substitutes = More elastic Less Substitutes = More inelastic Luxury or necessity? The less necessary the item = More Elastic The more necessary the item = More Inelastic What Factors Determine the Price Elasticity of Demand? 1. Substitutes for the product: Generally, the more substitutes, the more elastic the demand. If a product has many substitutes, and the price rises, consumers will have an elastic response because they can easily find alternative products. 2. Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand. In the case of a luxury, if the price increases, consumers will just do without and have an elastic response. 3. Share of income spent on the good: Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more. 4. The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes.

Determinants of Elasticity Continued
C. Share of income spent The more expensive relative to budget the item is = More Elastic The less expensive, relative to the budget the item is = More Inelastic D. Time Long Run Demand = More elastic Short Run Demand = More inelastic What Factors Determine the Price Elasticity of Demand? 1. Substitutes for the product: Generally, the more substitutes, the more elastic the demand. If a product has many substitutes, and the price rises, consumers will have an elastic response because they can easily find alternative products. 2. Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand. In the case of a luxury, if the price increases, consumers will just do without and have an elastic response. 3. Share of income spent on the good: Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more. 4. The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes.

Price Elasticity of Demand
Elasticities Price Elasticity of Demand The Determinants of Price Elasticity of Demand: The following factors determine whether demand for a good or service is elastic, unit elastic, or inelastic. The number of substitutes available. The more substitutes, more elastic demand, as consumers can replace a good whose price has gone up with one of its now relatively cheaper substitutes. The proportion of income the purchase of a good represents. If a good represent a higher proportion of a conumer's income, his demand tends to be more elastic. Luxury or necessity? If a good is a necessity, changes in price tend not to affect quantity demand, i.e. demand is inelastic. If it's a luxury that a consumer can go without, consumers tend to be more responsive. If a product is addictive or habit forming, demand tends to be inelastic. The amount of time a consumer has to respond to the price change. If prices remain high over a longer period of time, consumers can find substitutes or learn to live without, so demand is more elastic over time. S P L A T Practice PED: NCEE Activities 17, 18 and 19

II. Elasticity and Total Revenue
A. Total Revenue and Elasticity TR = P x Q Total Revenue Test P↑ TR ↑ = Inelastic Demand P↓ TR ↓ = Inelastic Demand P↑ TR − = Unit Elastic Demand P↓ TR − = Unit Elastic Demand P↑ TR ↓ = Elastic Demand P↓ TR ↑ = Elastic Demand Who cares about the price elasticity of demand for a product? Producers of those products would care! Why? When a firm sells products to consumers, the firm earns something called revenue. The total revenue earned by a firm is equal to the price of the product multiplied by how many units were sold at that price. In other words: TR = Price*Quantity Demanded= P*Qd. Suppose firms want to increase TR by increasing the price. What will happen? Quantity demanded will fall. A rising price and a falling quantity demand have competing influences on total revenue. Will TR go up, go down, or stay the same? It depends upon which effect, the higher price or the lower quantity, is relatively stronger. We can describe these as a price effect and a quantity effect. A price effect. After a price increase, each unit sold sells at a higher price, which tends to raise revenue. A quantity effect. After a price increase, fewer units are sold, which tends to lower revenue. Example 1: Suppose P increases 1%, Qd decreases 5%, a very elastic response. TR will fall, because the downward quantity effect is stronger than the upward price effect. Example 2: Suppose P increases 10%, Qd decreases 5%, an inelastic response. TR will rise, because the downward quantity effect is weaker than the upward price effect. Example 3: Suppose P increases 10%, Qd decreases 10%, a unit elastic response. TR will not change, because the downward quantity effect is equal to the upward price effect.

Price effect (p469) After a price increase, each unit sold sells at a higher price, which tends to raise revenue. Quantity effect After a price increase, fewer units are sold, which tends to lower revenue. Examples: If a good has an elastic demand, quantity effect is stronger than price effect and TR will fall If a good has an inelastic demand, quantity effect is weaker than price effect and TR will rise If a good has a unit elastic demand, quantity effect and price effect are equal and TR will remain the same. Who cares about the price elasticity of demand for a product? Producers of those products would care! Why? When a firm sells products to consumers, the firm earns something called revenue. The total revenue earned by a firm is equal to the price of the product multiplied by how many units were sold at that price. In other words: TR = Price*Quantity Demanded= P*Qd. Suppose firms want to increase TR by increasing the price. What will happen? Quantity demanded will fall. A rising price and a falling quantity demand have competing influences on total revenue. Will TR go up, go down, or stay the same? It depends upon which effect, the higher price or the lower quantity, is relatively stronger. We can describe these as a price effect and a quantity effect. A price effect. After a price increase, each unit sold sells at a higher price, which tends to raise revenue. A quantity effect. After a price increase, fewer units are sold, which tends to lower revenue. Example 1: Suppose P increases 1%, Qd decreases 5%, a very elastic response. TR will fall, because the downward quantity effect is stronger than the upward price effect. Example 2: Suppose P increases 10%, Qd decreases 5%, an inelastic response. TR will rise, because the downward quantity effect is weaker than the upward price effect. Example 3: Suppose P increases 10%, Qd decreases 10%, a unit elastic response. TR will not change, because the downward quantity effect is equal to the upward price effect.

ElElasticity along the Demand Curve
As the price rises, initially total revenue rises because of the inelastic response in quantity demand. However, further price increases eventually cause total revenue to decline because of a larger elastic response. Think about this intuitively: When prices are high, we are more responsive to price changes A 10% increase in a high price makes a BIG difference (e.g. a 10% of a \$100 good is \$10) , so our quantity is very responsive when prices are high. When prices are low, a 10% increase does not make a very big difference (e.g. 10% of a \$1.00 good is only 10 cents), so our quantity is not very responsive. Along the same demand curve, price elasticity is inelastic at low prices and grows more elastic at higher prices.

Margaret Ray and David Anderson
Econ: 48 Module Other Elasticities KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module:
How cross-price elasticity of demand measures the responsiveness of demand for one good to changes in the price of another good. The meaning and importance of the income elasticity of demand, a measure of the responsiveness of demand to changes in income. The significance of the price elasticity of supply, which measures the responsiveness of the quantity supplied to changes in price. The factors that influence the size of these various elasticities. The purpose of this module is to help students to see that other consumer and producer responses can be measured with elasticities.

Other Elasticities Cross-price elasticity of demand
Income elasticity of demand Price elasticity of supply Elasticity is a general concept that can be used to measure the relationship between any two variables. In addition to the price elasticity of demand, economists consider a number of other elasticity measures. Notably, cross-price elasticity, income elasticity, and price elasticity of supply. Economists, governments, and firms are quite interested in how one variable responds to a change in another variable. For example, suppose the price of gasoline were to increase. The producers of large trucks and SUVs will be very interested to know how this might affect sales of these vehicles. A cross-price elasticity of demand would be used to measure this response. Suppose the economy is suffering a recession and personal incomes are lower. The airline and hotel industries would be interested to know how this would affect the demand for air travel and hotel rooms. An income elasticity of demand would be used in this case. On the supply side of the market, producers would like to increase output if the price of their goods was to rise. A price elasticity of supply would be useful in measuring this response.

I. Cross-Price Elasticity of Demand
A. Measures the responsiveness of the demand for good “X” to changes in the price of good “Y” Exy = %∆ Qd of X / %∆ P of Y. Do not use absolute value, the +/- sign is very important. 1. Substitutes (positive) Complements (negative B. The elasticity is measuring the shift of the demand curve Cross-price elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product. Note: remind the students that the demand for good X shifts when the price of related goods changes. This elasticity measures how much that demand curve shifts. If cross elasticity is positive, then X and Y are substitutes. Example: The price of Nike shoes increases 2% and quantity demanded for Converse shoes increases 4%. EConverse, Nike = 4%/2% = 2. If cross elasticity is negative, then X and Y are complements. Example: The price of gasoline increases 20% and quantity demanded for large SUVs decreases by 5%. ESUV,gasoline = -5%/20% = Note: if cross elasticity is zero, then X and Y are unrelated, independent products. Example: if the price of breakfast cereal increased, there would likely be no impact on the quantity of denim jeans demanded.

Cross-Price Elasticity of Demand Continued
C. Examples If cross elasticity is positive, then X and Y are substitutes. Example: The price of Nike shoes increases 2% and quantity demanded for Converse shoes increases 4%. EConverse, Nike = 4%/2% = 2. If the cross elasticity is negative, then X and Y are complements. The price of gasoline increases 20% and quantity demanded for large SUVs decreases by 5%. ESUV,gasoline = -5%/20% = Cross-price elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product. Note: remind the students that the demand for good X shifts when the price of related goods changes. This elasticity measures how much that demand curve shifts. If cross elasticity is positive, then X and Y are substitutes. Example: The price of Nike shoes increases 2% and quantity demanded for Converse shoes increases 4%. EConverse, Nike = 4%/2% = 2. If cross elasticity is negative, then X and Y are complements. Example: The price of gasoline increases 20% and quantity demanded for large SUVs decreases by 5%. ESUV,gasoline = -5%/20% = Note: if cross elasticity is zero, then X and Y are unrelated, independent products. Example: if the price of breakfast cereal increased, there would likely be no impact on the quantity of denim jeans demanded.

II. Income Elasticity of Demand
Measures the responsiveness of demand for a good to changes in income. Ei = %∆ Qd / %∆ I Normal good (positive) Income elastic- positive greater than 1 (luxury goods) Income inelastic- positive but less than 1 (necessities) Inferior good (negative) Income elasticity of demand refers to the percentage change in quantity demanded which results from some percentage change in consumer incomes. Note: remind the students that the demand for good X shifts when the price of related goods changes. This elasticity measures how much that demand curve shifts. A positive income elasticity indicates a normal good. Example: American consumer income falls by 2% and quantity of flights to Europe declines by 8%. Ei = 8%/2% = 4 Note: this example demonstrates a very income-elastic response and this is true of most goods that are considered luxuries. Example: Consumer income rises by 4% and quantity of fresh vegetables purchased increases by 1%. Ei = 1%/4% = .25 Note: this example demonstrates an income-inelastic response that is fairly typical for food and other necessities. A negative income elasticity indicates an inferior good. Example: Consumer income falls by 5% and consumers increase consumption of Spam by 4%. Ei = 4%/(-5%) = -.80 Note: at the height of the most recent economic recession, stronger sales of Spam were responsible for a very profitable quarter for Hormel.

III. Price Elasticity of Supply
Measures the responsiveness of quantity supplied to changes in price. (same as Demand, but using Quantity Supplied instead) Es = %∆ Qs / %∆ P If Es >1, supply is considered elastic. If Es < 1, supply is considered inelastic. If Es = 1, supply is considered unit elastic. The concept of price elasticity also applies to supply. The Law of Supply says that when the price of a good increases, firms will increase quantity supplied. Economists would like to measure how much quantity will increase in response to this higher price. The elasticity formula is the same as that for demand, but we must substitute the word “supplied” for the word “demanded” everywhere in the formula. The same elastic and inelastic distinctions are made. If Es >1, supply is considered elastic. If Es < 1, supply is considered inelastic. If Es = 1, supply is considered unit elastic. The figure below shows an upward sloping supply curve S1, a perfectly elastic (horizontal) supply curve S2 and a perfectly inelastic (vertical) supply curve S3. A vertical supply curve like S3 implies that, even at the highest of prices, there is something that prevents firms from increasing the quantity that they supply. This might be a technological limitation or, in the case of agriculture, a seasonal impossibility. A horizontal supply curve like S2 implies that even the smallest increase in the price would dramatically increase quantity supplied. A small decrease in the price would decrease quantity supplied to zero.

C. Determinants of Price Elasticity of Supply
Availability of inputs If a firm can get inputs (labor, capital, raw materials) into and out of production quickly, the Es will be more elastic. Other factors also determine the price elasticity of supply Availability of inputs If a firm can get inputs (labor, capital, raw materials) into and out of production quickly, the Es will be more elastic. The time period involved is very important in elasticity of supply The “market period” is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. The short‑run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price changes as to how elastic it is. The long‑run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price. Example: Agriculture is a great example of the importance of time. Suppose it is July 2010 and the price of soybeans is soaring. Farmers would love to supply more soybeans at the higher price, but soybean crops have already been planted. The quantity of soybeans that will be supplied at harvest 2010 was basically determined months ago during the spring planting season. So the immediate soybean supply curve is very inelastic or nearly vertical and farmers are incapable of responding to the higher price. However, if the high prices continue in early 2011, farmers will plant more acres of soybeans next year and will supply more soybeans. So the increase in quantity supplied is greater as more time passes and farmers are able to respond.

Example: Think Agriculture and planting seasons
Time The “market period” is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. The short‑run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price changes as to how elastic it is. The long‑run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price. Example: Think Agriculture and planting seasons Other factors also determine the price elasticity of supply Availability of inputs If a firm can get inputs (labor, capital, raw materials) into and out of production quickly, the Es will be more elastic. The time period involved is very important in elasticity of supply The “market period” is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. The short‑run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price changes as to how elastic it is. The long‑run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price. Example: Agriculture is a great example of the importance of time. Suppose it is July 2010 and the price of soybeans is soaring. Farmers would love to supply more soybeans at the higher price, but soybean crops have already been planted. The quantity of soybeans that will be supplied at harvest 2010 was basically determined months ago during the spring planting season. So the immediate soybean supply curve is very inelastic or nearly vertical and farmers are incapable of responding to the higher price. However, if the high prices continue in early 2011, farmers will plant more acres of soybeans next year and will supply more soybeans. So the increase in quantity supplied is greater as more time passes and farmers are able to respond.

Consumer and Producer Surplus
Econ: 49 Module Consumer and Producer Surplus KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module:
The meaning of consumer surplus and its relationship to the demand curve. The meaning of producer surplus and its relationship to the supply curve. The purpose of this module is to show students how to measure the mutual benefit buyers and sellers enjoy when goods are exchanged. Students will learn how consumer and producer surplus emerges from transactions, how to see this surplus in a graph, and how to compute it.

I. Consumer Surplus A. Consumer surplus measures the difference between what a consumer is willing to pay for a good and what he/she actually has to pay. Consumers get all happy and giddy when prices fall. How do we measure this additional happiness? What units would we use to tabulate it? How about a unit of measurement that is easy to observe and compute: money.    Anytime a consumer pays less than his/her willingness to pay, the consumer walks away with that happy feeling that we call consumer surplus.

B. Willingness to Pay Willingness to pay is shown on the demand curve
Difference in what the consumer is willing to pay and how much they have to pay is consumer surplus Willingness to pay is found along the demand curve. Basically the WTP numbers can be used as a demand schedule and graphed like a step-wise demand curve. The height of the rectangles represents the WTP. The difference between what the consumer is willing to pay and what the consumer actually pays is the individual’s consumer surplus. It represents the net gain in happiness for the consumer. We measure it in dollars and call it consumer surplus.

Calculating Consumer Surplus
½ Base x height If there are many buyers of a good, we can smooth out the demand curve to look like the linear demand curves we typically draw. The total consumer surplus would then be seen as the area below the demand curve (WTP) and above the price. The area of the consumer surplus triangle will be ½ (base) (height).

II. Producer Surplus A. Producer surplus measures the difference between the price producers receive for a good and the cost of producing the good. Sellers enjoy higher prices and the benefit they receive is equal to the difference between the price received from the sale and the cost of producing each unit. In fact this cost represents the minimum price the seller must receive to offer that unit to the market. As the price rises higher and higher above this cost, the seller earns more and more benefit: producer surplus.

B. Cost and Producer Surplus
Producer cost is shown by the supply curve The difference between cost what the producer can charge is the producer surplus Producer cost is found along the supply curve. For each unit of output, producer surplus is the difference between price and the cost of producing that unit. The total producer surplus would then be seen as the area above the supply curve (cost) and below the price.

Calculating Producer Surplus
The total producer surplus would then be seen as the area above the supply curve (cost) and below the price. The area of the consumer surplus triangle will be ½ (base) (height).

III. Changes in Price affect Consumer and Producer Surplus
A. If price decreases, Consumer surplus increases (willingness to pay is the same, but the price paid is lower) Producer surplus deceases (costs are the same, but the price received is lower) B. If price increases, Consumer surplus decreases (willingness to pay is the same, but the price paid is higher) Producer surplus increases (costs are the same, but the price received is higher)

Total Surplus = Consumer Surplus + Producer Surplus
Total surplus in the market is equal to consumer surplus plus producer surplus.

Efficiency and Deadweight Loss
Econ: 50 Module Efficiency and Deadweight Loss KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module:
The meaning and importance of total surplus and how it can be used to illustrate efficiency in markets How taxes affect total surplus and can create deadweight loss The purpose of this module is to show that, when competitive markets reach equilibrium, total surplus (the sum of consumer and producer surplus) is maximized. Whenever something distorts the competitive market outcome, like excise taxes, total surplus is not maximized and deadweight loss emerges.

Consumer Surplus, Producer Surplus, And Efficiency
on own Gains from trade The efficiency of markets Equity and Efficiency  When you hear economists hailing the power of markets, they are typically alluding to the ability of markets to provide outcomes that are the most efficient to all other ways of organizing the exchange of goods.

Gains from Trade Any time a consumer makes a purchase from a producer, a trade has been made and both parties expect to gain. Gains from trade are represented by consumer and producer surplus. At the market equilibrium price and quantity, total surplus is the sum of the CS and PS triangles. Economists talk about gains from trade in the abstract, but any time a consumer makes a purchase from a producer, a trade has been made and both parties expect to gain. These gains are the concepts of consumer and producer surplus.

The Efficiency of Markets
No reallocation of consumption among consumers could increase consumer surplus No reallocation of sales among producers could increase producer surplus No change in the quantity traded could increase total surplus A markets is efficient if, once the market has produced its gains from trade, there is no way to make some people better off without making other people worse off. Once the market has reached equilibrium, there is no other way to increase the gains from trade. All of these 3 possible reallocations reduce total surplus and thus reduces efficiency. Summary: An efficient market performs four important functions: 1. It allocates consumption of the good to the potential buyers who most value it, as indicated by the fact that they have the highest willingness to pay. 2. It allocates sales to the potential sellers who most value the right to sell the good, as indicated by the fact that they have the lowest cost. 3. It ensures that every consumer who makes a purchase values the good more than every seller who makes a sale, so that all transactions are mutually beneficial. 4. It ensures that every potential buyer who doesn’t make a purchase values the good less than every potential seller who doesn’t make a sale, so that no mutually beneficial transactions are missed.

Equity and Efficiency Efficiency is not society’s only concern. We are also concerned with equity. What is considered “fair” or “equitable” depends on many factors. Often equity and efficiency are at the root of the debate surrounding taxes. Progressive, regressive, and proportional taxes What is considered “fair” or “equitable” depends on many factors. A market price of \$6 for a gadget may seem completely fair to a person who can afford \$6, but extremely unfair to a person who cannot. Most societies have found it desirable to sacrifice some efficiency to gain a little equity. The book example is designating parking spaces for disabled persons. Most nations have a system of taxation that serves to redistribute some income from the wealthy to the poor. This may not be efficient, but these nations have decided that it is fair. Economists classify three types of taxes according to how they vary with the income of individuals. A tax that rises more than in proportion to income, so that high-income taxpayers pay a larger percentage of their income than low-income taxpayers, is a progressive tax. A tax that rises less than in proportion to income, so that high-income taxpayers pay a smaller percentage of their income than low-income taxpayers, is a regressive tax. A taxes that rises in proportion to income, so that all taxpayers pay the same percentage of their income, is a proportional tax.

I. No Taxes A. In the absence of the tax, supply would equal demand at the equilibrium point E0, with a unit price of P0 and a quantity of Q0 units.

II. Taxes A. A tax on sellers will shift the supply curve to the left.
B. A tax on buyers will shift the demand curve to the left. A tax on sellers: Politicians decide to impose on gasoline tax on sellers, equal to \$1on every gallon of gasoline sold. For sellers, this means that to continue to sell 1 million gallons per day, they must receive \$3 per gallon because \$1 must be sent to the government. In other words, the supply curve shifts upward by \$1, the amount of the tax. A tax on buyers: Politicians decide to impose the \$1 tax on gasoline buyers. Buyers must pay \$1 to the government for every gallon of gasoline that they purchase. This would lower consumer willingness to pay by \$1 for each gallon purchased, which serves to shift the demand curve downward by the amount of the tax.

C. A tax leads to; a decrease in quantity an increase in the price paid by consumers. a decrease in the price received by sellers a “wedge” between the price consumers pay and the price producers receive (equal to the amount of the tax) Example: Imposing an excise tax or per unit tax of t = (Pc–Pp) drives a wedge between the price paid by the consumer (Pc) and the price received by the producer (Pp). As the net price received by the seller falls, less is supplied (movement along the supply curve). The quantity of output falls from its original value (Q1) to its new value (Q2). Market equilibrium shifts from E1 to E2.

A \$2 Tax on Bottled Water Pc Tax=Pc-Pp or \$9-\$7=\$2 Pp Q2 Q1

III. Tax Revenue A. Tax revenue is t x Q2.

A \$2 Tax on Bottled Water Pc Tax=Pc-Pp or \$9-\$7=\$2 Pp
Tax Revenue=T x Q2 or \$2x12 million = \$24million Q2 Q1

IV. Who pays the tax? The upper portion of the revenue rectangle, (Pc– Pe) x Q2, is considered to be the share of the tax that falls on the consumer because he now pays a higher tax-inclusive price. The bottom portion of the rectangle, (Pe– Pp) x Q2, is considered to be the share of the tax that falls on the producer in the form of a lower net-of-tax price and revenue received for selling the product.

A \$2 Tax on Bottled Water Tax=Pc-Pp or \$9-\$7=\$2 Tax Revenue=T x Q2 or
\$2x12 million = \$24million Pc Pe Pp (Pc-Pe)xQ2=tax paid by Consumers (9-8)x12= 12 million dollars Q2 Q1 (Pp-Pe)xQ2=tax paid by Producers (8-7)x12= 12 million dollars

Results of a \$2 Tax on Bottled Water
Reduced Consumer Surplus Tax Revenue Dead Weight Loss Reduced Producer Surplus

V. Elasticity and Tax Incidence
The tax incidence really depends upon the shape of the demand and supply curves. This shape, steep vs. flat, depends upon the price elasticity of demand and supply. A. Tax incidence: the measure of who really pays a tax B. If the demand curve is relatively inelastic and the supply curve is relatively elastic, the buyers will pay the larger share of the excise tax. C. If the demand curve is relatively elastic and the supply curve is relatively inelastic, the sellers will pay the larger share of the excise tax.

VI. The Benefits and Costs of Taxation
Benefits (Revenue) This is not a cost, but a redistribution of surplus from consumers and producers to the government The government then can do what they feel society needs Costs Inefficiency caused by the dead weight loss Is the government using the revenue wisely (normative) Taxes, like all things, come with benefits and costs. The revenue from a tax is equal to the amount of the tax times the number of units sold. The tax revenue collected by the government is not a cost of the tax, it is a redistribution of surplus from consumers and producers to the government. The true cost of the tax is the inefficiency that it creates in the form of deadweight loss.

Margaret Ray and David Anderson
Econ: 51 Module Utility Maximization KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module:
How consumers make choices about the purchase of goods and services Why a consumer’s goal is to maximizing utility Why the principle of diminishing marginal utility applies to the consumption of most goods and services How to use marginal analysis to find the optimal consumption bundle The purpose of this module is to introduce the concept of utility and the theory of consumer choice. Students will learn how utility-maximizing consumers choose to purchase bundles of goods and services, given a budget constraint.

Maximizing utility In the Theory of Consumer Choice, consumers’ goal is to maximize their utility. Why do we demand particular goods and services? Because they make us happy and because we can afford them. Economists refer to this happiness as utility.

I. Utility Utility: a measure of the satisfaction the consumer derives from consumption of goods and services. The principle of diminishing marginal utility- Each successive unit of a good or service consumed adds less to total utility than the previous unit Utility is a subjective notion in economics, we don’t expect to really measure it, but consumers know when utility is rising or falling, and they know when one choice provides more utility than another.

Budgets Good Y Good X The budget line The optimal consumption bundle
The consumer’s challenge is two-fold: Find the bundles of goods that are affordable, given income and prices, and Choose the bundle that provides the highest utility The consumer’s challenge is two-fold: 1. Find the bundles of goods that are affordable, given income and prices, and Choose the bundle that provides the highest utility. Consumers want to maximize utility, but must do so within a budget constraint. Good Y B A C Good X

II. Spending the Marginal Dollar
Marginal utility and MU per dollar Optimal consumption The “utility maximization rule” says that the consumer should spend all of his income on two goods such that: MU/P is equal for both (all) goods. As long as one good provides more utility per dollar than another, the consumer will buy more of the first good; as more of the first product is bought, its marginal utility diminishes until the amount of utility per dollar just equals that of the other product. The “utility maximization rule” says that the consumer should spend all of his income on two goods such that: MU/P is equal for both (all) goods. As long as one good provides more utility per dollar than another, the consumer will buy more of the first good; as more of the first product is bought, its marginal utility diminishes until the amount of utility per dollar just equals that of the other product.

Download ppt "The Income Effect, Substitution Effect, and Elasticity"

Similar presentations