Tax Burden in General

1
Tax Burden in General

• Generally, neither demand nor supply is perfectly
  inelastic or perfectly elastic.
• \the tax burden/incidence is split between buyers
  and sellers according to relative elasticities,
  and market conditions. Law makers cannot
  legislate who pays.

2
Addiction and Elasticity

• Nonusers demand for addictive substances is
  elastic.
• High taxes on cigarettes and alcohol limit the
  number of young people who become habitual users
  of these products.
• Existing users demand for addictive substances
  is inelastic.
• High taxes have only a modest effect on the
  quantities consumed by established user, they
  raise revenue from these users.

3
Luxury Tax

• Notice that depending on the goal of the tax
  different types of demand elasticity are
  desirable.
• Raise revenue inelastic demand
• Change behaviour elastic demand
• Who actually bore the burden of this tax?

4
Tax Burden and Elasticity of Demand

• Two extreme cases
• Perfectly inelastic demand
• Perfectly elastic demand

Tax Burden and Elasticity of Supply

• Two extreme cases
• Perfectly inelastic supply
• Perfectly elastic supply

5
Sales Tax and the Elasticity of Demand
S
Tax
S
2.20
Perfectly inelastic demand
Price (dollars per dose)
2.00
Buyer pays entire tax
D
100
Quantity (thousands of doses per day)
6
Sales Tax and the Elasticity of Demand
S
S
D
1.00
Tax
Price (cents per pen)
Perfectly elastic demand
0.90
Seller pays entire tax
4
Quantity (thousands of marker pens per week)
7
Sales Tax and the Elasticity of Supply
S
Perfectly inelastic supply
50
Price (dollars per bottle)
Seller paysentire tax
Tax
45
D
100
Quantity (thousands of bottles per week)
8
Sales Tax and the Elasticity of Supply
Perfectly Elastic Supply
Price (cents per pound)
S
11
Buyer paysentire tax
Tax
10
S
D
3 5
Quantity (thousands of kilograms per week)
9
Who pays the Airport Security Tax?

• Who pays the tax? - Demand Elasticity between
  0.7 and 2.1
• No mention of elasticity of supply but economists
  claim the price will rise by the amount of the
  tax,
• Ie the buyer pays the whole tax, implying a
  perfectly elastic supply schedule.

10
Supply Perfectly Elastic
Original Equilibrium P60, Q1,400
passengers/day
Elasticity of Demand 2.1
100
Elasticity of Demand 0.7
80
72
Price (dollars per trip)
60
S
D1
40
20
D0
1,400
2,100
Quantity (passengers per day)
11
Supply Unit Elastic
Elasticity of Demand 2.1
100
Elasticity of Demand 0.7
S
80
Price (dollars per trip)
60
40
D1
20
Crucial to know demand elasticity supply
elasticity
D0
2,100
1,400
Quantity (passengers per day)
12
A Rent Ceiling Elasticity
S1, SR
Supply in the LR becomes more elastic over
time, increasing the shortage
24
20
Rent (dollars per unit per month)
16
D
12
0 44 72 100 150
Quantity (thousands of units per month)
13
How Long is the Long Run?

• There is no set amount of time that puts a market
  into the long run
• The long run could be a week or a year
• The long run is how long a consumer or firm takes
  to fully adjust to a price change
• Time required to make major changes
• Ie) Give up Pepsi Vanilla, Build more cost
  efficient Pepsi factory, secure a US Pepsi
  Vanilla supplier
• The short run is anything shorter than the long
  run

14
Cross Price Elasticity of Demand

• Weve seen already that demand is affected by the
  price of substitutes and compliments
• An increase in the price of a substitute
  increases demand
• An increase in the price of a complement decrease
  demand
• This effect can be measured using cross price
  elasticity
• If the cross price elasticity is zero, the good
  is neither a complement nor a substitute

15
Cross Price Elasticity of Demand
Change in Price of Y ----------------------------
(Py1 Py2)/2
/
Exy Change in X ---------------
(X1 X2)/2
Substitutes Positive Cross Price
Elasticity Compliments Negative Cross Price
Elasticity
16
Income Elasticity of Demand

• Income Elasticity of demand refers to a
  HORIZONTAL SHIFT in the demand curve resulting
  from an income change
• Price elasticity of demand refers to a MOVEMENT
  ALONG THE DEMAND CURVE in response to a price
  change

17
Income Elasticity of Demand
Change in M ---------------------------- (M1
M2)/2
/
EI Change in Q ---------------
(Q1 Q2)/2
Normal Good Positive Shift/Elasticity Inferior
Good Negative Shift/Elasticity
18
The Theory of Consumer Choice

• The theory of consumer choice attempts to explain
  why consumers choose one good or bundle of goods
  over another good or bundle of goods.

19
The Theory of Consumer Choice

• We are particularly interested in how prices
  affect consumer choice (demand) because
• making choices in response to prices and price
  changes is the basis of the operation of the
  price system.
• Cet. Par.

20
Measuring Satisfaction

• util unit of pleasure.

• utility a number that represents the level of
  satisfaction that the consumer derives from
  consuming a specific quantity of a good.

21
Total Utility, Marginal Utility

• TU (total utility)
• the total amount of satisfaction that you get
  from consuming a product.
• MU (marginal utility)
• the increase in TU that comes about as a result
  of consuming one more unit of the product.

Franks TU MU from country music Total utility
marginal utility of trips to the club per week
22
Marginal Utility

• If one more unit of a good is consumed, the
  marginal utility is equal to the increased
  utility from that extra good
• If more than one additional good is consumed

23
Total and Marginal Utility of Club Trips
10
8
6
Marginal Utility (utils per week)
4
2
0
7
3
4
5
6
2
Performances per Week
24
Law of Diminishing MU

• The MU (marginal utility) of a good or service
  will decline as more units of that good or
  service are consumed.

• Marginal utility is what counts for rational
  consumer decisions.

25
Franks Optimal Choice

• When Frank can go to each activity for free, he
  splits his time between the two to maximize
  utility. At each successive step, he chooses the
  activity with the greatest MU.

26
(1) Per week
(3) Marginal utility (MU)
(2) Total utility
12 22 28 32 34 34
12 10 06 04 02 00
1 2 3 4 5 6
Trips to club
1 2 3 4 5 6
21 33 42 48 51 51
21 12 09 06 03 00
Basketball games
27
Franks Optimal Choice

• ? _night club visits and _ nights at basketball
• for a total satisfaction __ utils.
• In the real world, Frank cannot have whatever he
  wants, he must maximize utility subject to

1.) the income constraint 2.) the nature of
commodity prices
28
Rational Choice
? Spend limited income where satisfaction per
is the greatest.

• MU/ marginal benefit of the decision.
• MU/ marginal cost of the next best alternative
  given up

? choose those items for which MU/ is the
greatest until all income is spent.
29
Franks Optimal Decision

• Suppose Frank has an entertainment
• budget of 21.00
• club tickets 3.00
• basketball tickets 6.00

• Under these circumstances, the best Frank can do
  is
• 1.) allocate (spend) all his income
• so that
• 2.) MU basketball MU club trips
• P basketball P club trips

30
(3) Marginal Utility (MU)
(2) Total Utility
(5) Marginal Utility/ (MU/P)
(4) Price (P)
(1) per week
1 2 3 4 5 6
12 22 28 32 34 34
12 10 06 04 02 00
3.00 3.00 3.00 3.00 3.00 3.00
4.0 3.3 2.0 1.3 0.7 0.0
Trips to Club
Income 21 Pc 3.00 Pb 6.00
1 2 3 4 5 6
21 33 42 48 51 51
21 12 09 06 03 00
6.00 6.00 6.00 6.00 6.00 6.00
3.5 2.0 1.5 1.0 0.5 0.0
Bball games per/wk
31
Franks Optimal Decision

• ? The rational consumer will choose a market
  basket where the MU of the last spent on all
  commodities is the same and all income is spent.
• Why does this maximize utility?

32
Suppose, Frank buys 3 basketball games and 1 club
trip
Franks Optimal Decision
MUBB 1.5 MU club 4 PBB
P club
MBc gt MCb

• Frank is better off to take another club trip and
  give up one basketball game

33
Franks Optimal Decision

• IN GENERAL, the consumer will be in equilibrium
  with his/her choices when
• Income PAQA PBQB ..PzQz
• and

34
Now suppose the price of basketball games falls
to 3.00. What is Franks new equilibrium?
(3) Marginal Utility (MU)
(5) Marginal Utility/ (MU/P)
(2) Total Utility
(4) Price (P)
(1) per week
DERIVING DEMAND
1 2 3 4 5 6
12 22 28 32 34 34
12 10 06 04 02 00
3.00 3.00 3.00 3.00 3.00 3.00
4.0 3.3 2.0 1.3 0.7 0.0
Income 21 Pc 3.00 Pb 3.00
Trips to Club
1 2 3 4 5 6
21 33 42 48 51 51
21 12 09 06 03 00
3.00 3.00 3.00 3.00 3.00 3.00
7 4 3 2 1 0
Bball games per/wk
35
Demand for Bball Games
At a price of 6, 2 games. At a price of 3, 4
games.
36
Example Demand and Utility Maximization

• Find the utility maximizing combination of
  products A B obtainable with an income of 10.
  
• Price of A is 1.00.
• Price of B is 2.00.
• Let the price of B fall to 2.00 and identify two
  points on the demand schedule for B

37
(1) (2) (3) (4) (5) (6) (7)
A
B
Q TU TU
1 2 3 4 5 6
10 18 25 31 36 40
24 44 62 78 90 96
38
Supply, Production Cost

• Firms make the supply decision in order to
  maximize profits
• Profit Total Revenue - Total Cost

• From the viewpoint of the firm the opportunity
  cost is the amount that the firm must pay the
  owners of the factors of production that it
  employs to attract them from their best
  alternative use.
• Price therefore reflects the value of what is
  foregone opportunity cost

39
Explicit Costs
Supply Production Costs

• To calculate a firms Total Costs of production
  include all (opportunity) costs.
• Explicit costs
• Implicit costs

• Costs that arise when money actually changes
  hands
• eg. a bill is paid for utilities, wages, interest
  on a loan..

40

• Implicit Costs

• Costs faced by the owners where no money changes
  hands, no bill is received
• e.g., salary (opportunity cost) given up by
  owner, normal rate of return on the best
  alternative investment (opportunity cost) of
  owners financial capital..

41
Economic Profit

• Economists Accountants calculate profit
  differently
• Economists are interested in studying how firms
  make production pricing decisions. They include
  all costs.

Economic Profit TR - Explicit
Implicit Costs
Accounting Profit

• Accountants are responsible for keeping track of
  the money that flows into and out of firms. They
  focus on explicit costs.

Accounting Profit TR -
Explicit Costs
42
Economic Profit Terminology

• Excess Profit or Economic Profit
• occurs after a normal profit is made or after all
  costs have been covered.
• Breaking Even Zero Economic Profit
• a satisfactory position for a firm because it
  means that normal profits are being achieved.
• Economic Loss
• an economic profit less than zero

43
Profit Economists vs Accountants
Economists View
Accountants View
44
Accounts of Fieldcom Inc.
Total revenue 600 000 LESS explicit
costs Wages salaries 320 000
Materials other 60 000 EQUALS accounting
profit 220 000 LESS implicit costs Forgone
salary, Andrea Martin 75 000
Forgone salary, Ralph Martin 75 000
Interest forgone on invested saving 20
000 EQUALS pure economic profit 50 000
45

• Opportunity Cost of Inputs

• Firms will only operate in an industry if they
  can make a normal rate of return
• Ie Money invested in an interest must earn at
  least as much as it could elsewhere (bank
  account, stock market, GIC)
• Labour must be paid at least as much as it could
  earn elsewhere (an entrepreneur should make
  X/hour)

46
Economics vrs. Accounting Example

• Jack opens up a computer repair business
• After all costs are paid, Jack makes 500/week in
  his business
• By working for someone else, Jack would make
  20/hr or 800/week
• Accounting profit 500
• Economic profit -300
• Economists would advice a change in profession

47
The Firm

• A firm is an organization that brings together
  inputs to produce goods and services for sale

Q f (inputs) Q f (K, L)
FIRM
Inputs
PRODUCTS
48
Technological and Economic Efficiency

• Technological efficiency is attained when the
  firm produces a given output by using the least
  inputs.

Economic efficiency is attained when the cost of
producing a given output is as low as possible.