AP Microeconomics REVIEW

Production Possibilities Price/Quantity Controls Consumer/Producer Surplus & Taxation Market Models Elasticity of Demand/Supply

Because societies must CHOOSE between alternatives, economists use a PRODUCTION POSSIBILITIES table to list the different combinations of two products that can be produced with a specific set of resources.

The area along the curve represents MAXIMUM production. 200 guns, 0 butter Guns Butter guns, 200 butter Let’s compare two markets: Guns and Butter.

Given the resources available, if maximum production is equal to 200 units, then For example: Point A represents maximum production of 125 Guns and Guns Butter A 75 pounds of Butter = 200

For example: Point B represents maximum production of 75 Guns and Guns Butter A 125 pounds of Butter. B = Given the resources available, if maximum production is equal to 200 units, then

For example: Point C represents underproduction of 50 Guns and Guns Butter 75 pounds of Butter. C =125 This point underproduces by 75 units A B Given the resources available, if maximum production is equal to 200 units, then

For example: Point D represents impossible production of 150 Guns and Guns Butter 150 pounds of Butter = 300 This point is impossible to produce. D Given the resources available, if maximum production is equal to 200 units, then A B C

1) Natural Disasters P Q In December 2004, the world’s strongest earthquake in 40 years shook the region near the Indonesian archipelago, creating a tsunami wave which killed nearly 200,000 people on three continents, and devastation of resources not counted as yet. This caused the production possibilities curve to shift inward indicating the reduced ability to produce goods and services.

2) Wartime production In the beginning of World War II, the U.S. had considerable unemployment. By quickly employing idle resources, the U.S. economy was able to produce more. P Q P Q U By contrast, the Soviet Union entered the war at capacity production. Their situation required considerable shifting of resources and the standard of living dropped. Butter Guns

Price and Quantity Controls

What happens when prices are “fixed” by the government? Let’s look at a graph which shows the average consumption of beer in the United States.

$4 $3 $2 $1 Beers per week S D E GeGe In this example, the average beers consumed per week is 6 at an average price of $2.50.

$4 $3 $2 $1 Beers per week S D E This chart illustrates the effects upon people if they were forced to go from G e to zero. GeGe You might be willing to pay $4 for your first beer, but price is $2.50 …..now you are $1.50 better off. This is called CONSUMER SURPLUS.

The 9th beer is worth to people what it is worth to people. It is different for everybody.

$4 $3 $2 $1 Beers per week S D E GeGe From the suppliers’ standpoint, they could supply at a lower price but they CAN get more. This is called From the suppliers’ standpoint, they could supply at a lower price but they CAN get more. This is called PRODUCER SURPLUS.

$4 $3 $2 $1 Beers per week S D E GeGe The colored area is the total value to society of the cost of 6 beers. Consumer Surplus Producer Surplus

$4 $3 $2 $1 Beers per week S D E GeGe What if government mandate limited the maximum price of a beer to $1.00? Consumers would want to buy more beer. 10 However, suppliers would not want to produce as much beer. NOTE: Another example of this is the price ceiling on gasoline during the Nixon administration.

$4 $3 $2 $1 Beers per week S D E GeGe If government limited the maximum price of a beer to $1.00, it would create a shortage. If government limited the maximum price of a beer to $1.00, it would create a shortage. shortage REMEMBER: Producers will not want to produce for low prices.

PRICE CEILING PRICE FLOOR equilibrium. The legal maximum price that can be charged is called a PRICE CEILING. A legal minimum price that can be charged is called a PRICE FLOOR. Price ceilings and floors keep markets from reaching equilibrium.

Politically popular ideas include: --$ minimums on inputs (wages). --$ maximums on outputs (prices/rent control). POLITICS vs. ECONOMICS => Politics always wins When POLITICS vs. ECONOMICS => Politics always wins

$4 $3 $2 $1 Beers per week S D E GeGe The government mandating the maximum price of a beer is called a PRICE CEILING. shortage A price ceiling keeps the market from reaching equilibrium.

$4 $3 $2 $1 Beers per week S D E GeGe shortage The shortage created from the price ceiling will result in increased demand. X NOTE: Another example of a price ceiling is rent control.

$4 $3 $2 $1 Beers per week S D E GeGe Four beers is not enough (too little, inefficient) ….This is called DEADWEIGHT loss. What if government mandate limited the maximum number of beers one could drink to 4 per week? Government Mandated Supply

The increased demand and a willingness to pay higher prices will result in a BLACK MARKET for beer. NOTE: This is what happened during prohibition when (legal) supply was limited to zero.

$5 $4 $3 $2 $1 Labor S D E GeGe When the government mandates a the minimum price of something, it is called a PRICE FLOOR. NOTE: The minimum wage is an example of a price floor.

$5 $4 $3 $2 $1 Labor S D E GeGe The minimum wage increases the number of people who want to work (supply of labor) And decreases the number of businesses who want to hire (demand for labor) Creating a SURPLUS of labor. SURPLUS

Those who continue to work are better off. (90%)Those who continue to work are better off. (90%) Some people are worse off (10%)Some people are worse off (10%) Prices rise for some goods using low skilled labor.Prices rise for some goods using low skilled labor. Discrimination is created in the labor market.Discrimination is created in the labor market. Some people leave home to make more money creating larger unemployment and disemployment.Some people leave home to make more money creating larger unemployment and disemployment. RESULTS:

Easy to show overall: Costs > return of benefitsCosts > return of benefits Total welfare higher => those working incur higher costsTotal welfare higher => those working incur higher costs Output will fall => fewer people workingOutput will fall => fewer people working

Extreme case: What would happen if the government raised the minimum wage to $100 an hour?

A price floor stops the market from reaching equilibrium and creates a surplus. A price ceiling stops the market from reaching equilibrium and creates a shortage. CONCLUSION:

Elasticity of Demand

modest price changes lead to very large changes in the quantity purchased Demand for some products is such that consumers are highly responsive to price changes; modest price changes lead to very large changes in the quantity purchased, for example: restaurant meals, steak, cars. ELASTIC The demand for such products is said to be relatively elastic, or simply ELASTIC.

substantial price changes result in only small changes in the amount purchased For other products, consumers are quite unresponsive to price changes; substantial price changes result in only small changes in the amount purchased, for example: salt, milk, soap. INELASTIC For such products, demand is relatively inelastic or simply INELASTIC.

A way to state the equation would be using the Greek letter delta, meaning “change in”……. Q d /Q d Price E d =P/P

Interpretations of E d We can interpret the coefficient of price elasticity of demand as follows: 1) elastic demand 2) inelastic demand 3) unit elasticity

Elastic Demand a specific percentage change in price results in a larger percentage change in quantity demanded Demand is said to be elastic if a specific percentage change in price results in a larger percentage change in quantity demanded. Then E d > 1. elastic Example: If a 2 percent decline in a price results in a 4 percent increase in quantity demanded, then demand is elastic and.04 E d =.02 = 2

PRICEPRICE QUANTITY D2D2D2D2 Relatively elastic demand A small percentage change in price leads to a larger percentage change in quantity demanded. P0P0 P1P1 P 0 Q0Q0 Q1Q1 QdQd E d > 1

perfectly elastic When we say demand is “elastic,” we do not mean that consumers are completely responsive to a price change. In that extreme situation, where a small price reduction would cause buyers to increase their purchases from zero to all they could obtain, economists say demand is perfectly elastic. You will see in later chapters that such a demand applies to a firm, for instance, a blueberry grower, selling its product in a purely competitive market.

PRICEPRICE QUANTITY D2D2D2D2 Perfectly elastic demand A small percentage change in price will change quantity demanded by an infinite amount. P0P0 P1P1 P 0 Q0Q0 Q1Q1 QdQd E d =

Inelastic Demand If a specific percentage change in price is accompanied by a smaller percentage change in quantity demanded, demand is said to be inelastic. Then E d < 1. inelastic Example: If a 3 percent decline in price leads to only a 1 percent increase in quantity demanded, demand is inelastic and.01 E d =.03 =.33

PRICEPRICE QUANTITY D1D1D1D1 Relatively inelastic demand P0P0 P1P1 P 0 Q0Q0 Q1Q1 QdQd A change in price leads to a smaller percentage change in quantity demanded. E d < 1

perfectly inelastic When we say demand is “inelastic,” we do not mean that consumers are completely unresponsive to a price change. In that extreme situtation, where a price change results in no change whatsoever in the quantity demanded, economist say that demand is perfectly inelastic. Examples include an acute diabetic’s demand for insulin or and addict’s demand for heroin.

PRICEPRICE QUANTITY D1D1D1D1 Perfectly inelastic demand P0P0 P1P1 P 0 Q0Q0 = Q 1 The quantity demanded does not change regardless of the percentage change in price. E d = 0

Elastic or Inelastic demand?

PRICEPRICE QUANTITY D1D1D1D1 P0P0 P1P1 0 Q0Q0 Q1Q1 D0D0D0D0 Q2Q2 Relatively inelastic Relatively elastic When a demand curve is relatively steep, such as D 0 in this graph, its price elasticity is relatively inelastic. When a demand curve is relatively flat, such as D 1, its price elasticity is relatively elastic.

Available substitutes Proportion of income Luxuries vs necessities Time What influences the price elasticity of demand?

Elastic Demand and Total Revenue P Q $10 $ B A cb a At point A, total revenue is $400 ($10 x 40), or area a + b. At point B, the total revenue is $500 ($5 x 100), or area b + c. Total revenue has increased by $100. We can also see in the graph that total revenue has increased because the area b + c is greater than area a + b, or c > a. D elastic

Inelastic Demand and Total Revenue P Q $10 $ B A cb a At point A, total revenue is $300 ($10 x 30), or area a + b. At point B, the total revenue is $200 ($5 x 40), or area b + c. Total revenue has decreased by $100. We can also see in the graph that total revenue has decreased because the area a + b is greater than area b + c, or a > c. D inelastic

Applications of Price Elasticity of Demand: 1)Airline tickets (vacationers vs. business class) 2)Early bird specials 3)Movies vs. matinees 4)Drugs and crime 5)Excise taxes on inelastic goods

Price of Drugs Quantity of Drugs D S1S1 S2S2 Q1Q1 Q2Q2 P1P1 P2P2 If the demand for drugs is inelastic then drug “busts” reduce the supply of drugs, which raises the price, and reduces quantity supplied.

Price of Drugs Quantity of Drugs D S1S1 S2S2 Q1Q1 Q2Q2 P1P1 P2P2 Another option is drug education, which reduces demand, which lowers the price, and reduces quantity supplied. S D1D1 D2D2 P1P1 P2P2 Q1Q1 Q2Q2

Elasticity of Supply

The PRICE ELASTICITY OF SUPPLY measures how much the quantity supplied responds to changes in price.

PRICEPRICE QUANTITY S2S2S2S2 Relatively elastic supply A small percentage change in price leads to a larger percentage change in quantity supplieded. P0P0 P1P1 P 0 Q0Q0 Q1Q1 QdQd E d > 1 Supply is said to be elastic if the quantity supplied responds substantially to changes in price.

PRICEPRICE QUANTITY S2S2S2S2 Relatively inelastic supply A small percentage change in price leads to a smaller percentage change in quantity supplieded. P0P0 P1P1 P 0 Q0Q0 Q1Q1 QdQd E d < 1 Supply is said to be inelastic if the quantity supplied responds slightly to changes in price.

Elasticity of Supply is dependant upon the sellers’ flexibility in changing the amount they produce. inelastic For example: Beachfront property in Florida has an inelastic supply because we cannot produce more of it. elastic Manufactured goods such as microwave ovens, televisions, and cars are elastic because the producers can easily adjust production of a good more or less.

How do government policies (taxes) affect market outcomes?

When a tax on tea is levied on consumers, the sellers will share part of the tax burden. PRICE QUANTITY S P0P0 P1P1 0 Q0Q0 Q1Q1 P2P2 E w/o tax D0D0 D1D1 P 0 is the equilibrium price WITHOUT the tax. P 1 is the price sellers will receive. P 2 is the price consumers will pay. ($2.50) ($2.20) ($2.00) ($.50)

$5 $4 $3 $2 $1 Q labor S labor D labor E P labor A payroll tax puts a wedge between the price that workers receive and the amount producers pay.

$5 $4 $3 $2 $1 Q S D E P When supply is more elastic than demand, the burden of the tax falls primarily on consumers. P w/o tax P consumers pay P producers receive

In the late 1980s, Governor Martinez of Florida placed a tax on luxury items in the State of Florida. Why was this tax repealed a few years later??

$5 $4 $3 $2 $1 Q S D E P When demand is more elastic than supply, the burden of the tax falls primarily on producers. P w/o tax P consumers pay P producers receive

Consumer Surplus and Producer Surplus

Suppose I am willing to pay $4 each for 10 widgets. However, the price is $1.50 EACH P Q This results in CONSUMER SURPLUS, which is the difference between D and P D P $2.50 $ $2.50 x 10 $25.00 Price

Consumer Surplus So, Consumer Surplus is the TOTAL BENEFIT consumers receive from having a market in the good P Q D P $2.50 $ $2.50 x 10 $25.00 Price

Now, let’s graph this problem using an economist’s demand curve P Q The equation for this line would be:P = Q If P=0, then Q=__ If Q=0, then P=__ P = (0) P = P = 4 0 = Q+.25Q.25Q = 4.25 Q = 16

The area betweenthe demand ($4.00) and the price ($1.50) is the CONSUMER SURPLUS P Q Mathematically, P 1.50, Q > 0 Area of a triangle = 1/2bh Consumer Surplus = 1/2 (10 x 2.50) = $12.50

So….how much do producers benefit from this transaction?

P Q Suppose that a firm is willing to sell the good for $.50 but the price is $1.50 for 10 widgets. Price Supply (willing to sell cost) PRODUCER SURPLUS is the difference between suppliers price and the price of the product. $1.00

Let’s graph the supply curve on the old graph P Q P =.15Q If the price is set at 1.50, then 1.50 =.15Q = Q S D Price

Remember the area of a triangle = 1/2bh, so… P Q 1/2 (10 x 1.50) = $7.50 = PRODUCER SURPLUS S D Price

In this case, both consumers and producers gain: P Q CS + PS = = $20.00 TOTAL BENEFIT TO SOCIETY S D Price

Now, let’s suppose a tax of $.80 is added to the price of gasoline. This adds to the cost of producing the widgets P Q If 0 widgets, then P = =.80 S D Price If 10 widgets, then P = = 2.30 S1S1

This changes our point of equilibrium P Q S D Price S1S1 What happens to consumer surplus? What happens to producer surplus? What does the pink rectangle represent? TAX REVENUE The green triangle represents DEADWEIGHT loss, or the amount of sales you give up with the higher price.

What is the new Quantity? P Q S D Price S1S1 Demand P = Q SupplyP =.15Q Supply w/tax P =.15Q Q+.25Q =.15Q+.25Q =.40Q =.40Q.40 8 = Q 4-.25Q =.15Q +.80 P =.15(8) +.80 P = 2.00 (8, 2)

P Q S D Price S1S1 (8, 2) Consumers pay: $2 per unit, including the tax….. (they used to pay $1.50) Producers receive after they pay the tax: $ = $1.20 (they used to receive $1.50)

So….who pays the $.80 ? Consumers pay:$.50 Producers pay:$.30 In this case, consumers pay most (BUT NOT ALL) of the tax. Tax incidence depends on the elasticity of demand and the elasticity of supply. In short, whomever is less flexible in adjusting to changes in price will pay more of the tax. Consumers avoid paying the whole of the tax by buying less of the product at a lower quantity.

What is the height for the new Consumer Surplus triangle? P Q S D Price S1S = 2.00 * 8 * 1/2 = $8.00 new CS (compared to $12.50 old CS)

What is the height for the new Producer Surplus triangle? P Q S D Price S1S = h 8 = b $4.80 new PS 1.20 * 8 * 1/2 = $4.80 new PS (compared to $7.50 old PS)

So…..using the equation 1/2bh (area of a triangle) P Q S D Price S1S1 1/2 * 8 * 1.70 = $8.00 = New CS 1/2 * 8 *.80 = $4.80 = New PS.80 * 8 = $6.40 = Tax Amount = $19.20 Total Benefit (compared to $20.00 old TB)

Compare the New Total Benefit of $19.20 to the Old Total Benefit of $ Do excise taxes benefit society?

Economists do not support taxes which do not benefit society, such as excise taxes. Good taxes include: property taxes, income taxes, and estate taxes.

GAINS FROM TRADE: P Q S D Price S1S1 Consumer Surplus = 1/2 * 8 * (4 - 2) = $8.00 Producer Surplus = 1/2 * 8 * ( ) = $4.80 Tax Revenue = $. 80 * 8 = $6.40 GAINS FROM TRADE = = $19.20 Deadweight Loss = = $.80

Even though water is essential for life and diamonds are not, water is cheap and diamonds are expensive? Why?

The answer has to do with the consumer surplus and producer surplus for both products.

Consider the following graphs for CS and PS: DiamondsWater S S D D Inelastic supply curve Elastic supply curve P P