1. The Week Ahead Come to class!Thursday (9/14) -- Attend University Forum on Health Care and then Come to class! Do Homework 5 on ‘Homework Assignment’ by Friday at ??? –Warning!!!! Some numbers in problems change each time you open the assignment!! 1st Midterm Exam in Class -- Next Tuesday, September 19 –Study Guide will be Available on Web on Thursday, September 14

2. Survey of Due Date Times I prefer that homework be due at: a.9 am b.Noon c.5 pm d.midnight

3. Elasticity and Tax Incidence Lecture 7 September 12, 2006

4. In This Lecture Elasticity Concept Price Elasticity and Total Spending Other Elasticity Concepts –Income –Cross Price –Supply elasticity Tax Incidence

5. Survey: Privatization of Toll Roads Do you think that publicly owned toll roads should be leased to private firms for operation? a. No b. Yes

6. Indiana Toll Road The state of Indiana has leased the toll road to a foreign company. The tolls have not been increased for over a decade and the first major initiative for the firm is to raise the tolls for trucks and cars. Will increasing tolls lead to more or less revenues for the firm? Will a 20% increase in tolls, for example, produce more revenues, or is it possible that the toll revenues could fall?

7. Increasing the Toll Gain in Revenue Loss in Revenue Toll Number of Cars D PoPo QoQo P1P1 Q1Q1

8. What is an Elasticity? price elasticity of demandThe answer depends on the price elasticity of demand for trips on the toll road. An elasticity is a measure the responsiveness of an individual’s decision to purchase (or supply) to a change in a factor determining that decision. price elasticity of demandThe price elasticity of demand is the ratio of the percentage change in the quantity demanded to the percentage change in the price of the good. Warning: Note that price elasticities of demand are expressed in absolute values!!!!

9. Computing Price Elasticity (Midpoint Method) Compute Percentage Change in Q D Compute Percentage Change in P Elasticity --- Compute the Ratio Price Donuts Demand $1 $.50 1014

10. What factors determine the value of  D P ?  D P grows larger –When close substitutes are available for the good. Consumers are more likely to shift their consumption to these substitutes as the price of the good rises. –If the good is a necessity or a luxury. If the good is something you ‘need’ then you are less sensitive to price changes than if it is a luxury. –As the time period for adjustment of behavior increases Given more time, substitute consumption goods can be found.

11. Extremes of Elasticity D P Q D P Q Perfectly Elastic DemandPerfectly Inelastic Demand

12. Elasticity and Total Revenue Suppose we know the price elasticity of demand for toll road trips. How is this elasticity related to Total Revenue? When a seller raises the price of a good, there are two countervailing effects in action (except in the rare case of a good with perfectly elastic or perfectly inelastic demand): –A price effect: After a price increase, each unit sold sells at a higher price, which tends to raise revenue. –A sales effect: After a price increase, fewer units are sold, which tends to lower revenue.

13. Elasticity and Total Revenue If demand for a good is elastic (the price elasticity of demand is greater than 1), an increase in price reduces total revenue. In this case, the sales effect is stronger than the price effect. If demand for a good is inelastic (the price elasticity of demand is less than 1), a higher price increases total revenue. In this case, the price effect is stronger than the sales effect. If demand for a good is unit-elastic (the price elasticity of demand is 1), an increase in price does not change total revenue. In this case, the sales effect and the price effect exactly offset each other.

14. The Price Elasticity of Demand Changes Along the Demand Curve

15. Spending = Revenue Total Dollar Spending on a good is equal to Spending = P o Q D o Now consider a given percentage change in the price (  P/P o ). Total dollar spending will increase by the same percentage if customers do not change their quantity purchases. However as the price increases, the customers will reduce their spending by (  Q D /Q o ). Consequently the percentage change in spending will equal (  Spending/Spending o ) = (  P/P o ) - (  Q D /Q o ) Now divide both sides of the above equation by (  P/P)

16. Will Toll Road Rise or Fall? If:  D P > 1 (elastic)revenues will fall  D P = 1 (unitary)revenues will stay the same  D P < 1 (inelastic)revenues will increase

17. Predicting Changes in the Quantity Demanded and Total Revenue Assume initially the price is $10 and the demand for the good is 5 units. If you cut the price to $5, how much will be demanded? –The percentage change in price is equal to (-5)/((10+5)/2)=-5/7.5=-.667 If  D P = 1.50 (  Q D /Q o ) = - (-.667)(1.50) = 1.00 Or increase by 100% If  D P =.50 (  Q D /Q o ) = - (-.667)(.50) =.333 Or Increase by 33.3% price Quantity 10 5 5 Inelastic Demand Elastic Demand

18. What has happened to the quantity demanded? If you know the price elasticity of demand, you can use it to calculate the new Q and Total Revenue: –When using the midpoint method, the percentage change in Q was computed as: –Hence the new level of output (Q 1 ) when we know the percentage change in output (X) is the following (after some algebra)

19. What has happened to total revenue? Initially the total spending was $50 If  D P = 1.50 (elastic) (  Q D /Q o ) = - (-.667)(1.50) = 1.00 Q 1 =5(2+1)/(2-1)=15 Total Revenue = $5(15)=$75 If  D P =.50 (inelastic) (  Q D /Q o ) = - (-.667)(.50) =.333 Q 1 =5(2+.333)/(2-.333)=7 Total Revenue = $5(7)=$35 price Quantity 10 5 5 Inelastic Demand Elastic Demand 715

20. Other Elasticities -- Income Shifts in Demand Curve due to Income changes If  I < 0good is inferior 0 <  I < 1good is normal and a necessity  I > 1good is normal and a luxury

21. Other Elasticities -- Cross Price Shift in Demand Curve due to changes in the price of other goods (OP) If  CP < 0goods are complements  CP > 0goods are substitutes

22. Other Elasticities -- Supply Movement along a Supply Curve as Price changes

23. What makes Suppliers more Price Elastic? The price elasticity of supply tends to be larger when –Inputs are easily available –Greater flexibility in production –There is ample time to adjust production to new conditions Explanation: If the price a good or service rises, a supplier will want to produce more. Increasing production may increase the per unit cost of production. Why? –technology (the fixity of some factors of production) –lack of availability of inputs--then. In these situations, firms will not increase their production as much as when technology is flexible and inputs are easily available. The passage of time may ease both of the constraints.

24. Tax Incidence Initially the market is in equilibrium without the tax, price is P o which is equal to the initial supply and demand price A tax is imposed upon suppliers, consequently the supply curve shifts up by the amount of the tax Excess Demand is created and the price to consumers rises to DP The supply price falls to SP The tax (DP-SP) is borne by consumers by the amount (DP-P o ) and by the suppliers by the amount (P o -SP) S tax D S Price Quantity QoQo PoPo DP SP QTQT

25. Tax Incidence: Different Demand Elasticities D S S tax Price Quantity QoQo PoPo DP SP QTQT D S S tax Price Quantity QoQo PoPo DP SP QTQT Elastic Demand -- Tax Falls on SuppliersInelastic Demand -- Tax Falls on Consumers

26. Different Supply Elasticities D S S tax Price Quantity QoQo PoPo DP SP QTQT D S S tax Price Quantity QoQo PoPo DP SP QTQT Elastic Supply -- Tax Falls on ConsumerInelastic Supply -- Tax Falls on Firm

27. Lessons If demand is more elastic than supply then the tax will fall more upon suppliers because suppliers are less able to avoid tax If supply is more elastic than demand then the tax will fall more upon consumers because consumers less able to avoid tax

28. Sin Taxes D S S tax Price Quantity QoQo PoPo DP SP = QTQT

29. More on Sin Taxes See Robert a Sirico, “The Sin Tax, Economic and Moral Considerations,” at the Acton Institute for the Study of Religion and Liberty, at http://www.acton.org/print.php

30. Conclusions about Sin Taxes Raise effective prices to the consumer Their incidence falls primarily on the consumer. Are unlikely to seriously discourage consumption habits when those habits are seriously desired Will increase government revenue if transactions remain in legal markets May decrease government revenue if people move their business to illegal markets Sets up a moral hazard for policy makers who vacillate between wanting to discourage undesirable behavior and wanting to encourage it for revenue purposes