Microeconomics and Policy Analysis PUAF 640

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Microeconomics and Policy Analysis PUAF 640

• Professor Randi Hjalmarsson
• Fall 2009
• Lecture 2

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Class Outline Supply and Demand 2- Chapter
3.3, 11.2, 11.3

• Concept Review Lecture 1
• Mathematical Representation of Supply and Demand
• Consumer and Producer Surplus measures of
  welfare
• Elasticity measures of sensitivity
• Excise tax

3
Brief Review of Concepts

• Why are there Braille dots on keypad buttons of
  drive up cash machines? (EN)
• Most people who use the drive up machines are not
  blind.
• Apply cost-benefit principle.
• Need to compare the costs of producing two types
  of machines to the benefits. (More expensive to
  make two types of machines and not much benefit
  to users).
• Producers, in general, have no incentive to add a
  product feature unless it enhances the products
  value to consumers by more than enough to cover
  its costs.

4
Similar questions for you to think about

• Why can laptops, but not most other appliances,
  operate on any countrys electrical standard?
  (EN)
• Why do 24-hour convenience stores have locks on
  their doors? (EN)
• Why are newspapers but not soft drinks sold in
  vending machines that allow customers to take
  more units out than they pay for? (EN)

5
Supply/Demand Review

• Why do bars often charge patrons for water but
  give peanuts for free? (EN)
• Primary bar product is alcohol. What are
  relationships between alcohol and peanuts and
  water?
• Alcohol and peanuts are complements. Get people
  to consume more peanuts and their demand for
  alcohol will shift out.
• Alcohol and water are substitutes. If people
  consume water, then demand for alcohol will shift
  in.
• Give customers an incentive to consume peanuts
  and disincentive to consume water.

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Mathematical Representation of Supply and Demand

• Typically (problem sets), you will see S/D
  equations in two forms.
• Quantity as a function of price.
• Price as a function of quantity.
• You should be able to work with both forms!
• Graph the curves.
• Solve for equilibrium price and quantity.

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• Quantity as a function of price

• Price as a function of quantity

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Solving for the equilibrium

• Set both equations equal to each other.
• Let QDQS and solve. Report Q and P.
• QDQS
• 3500 1750 P 1400 250P
• 2100 1750P 250P (Substract 1400 from both
  sides)
• 2100 2000P (Add 1750P to both sides)
• P 2100/2000 1.05
• QS 1400 250P 1400 250(1.05)
• Q 1662.5 (Plug P into original S or D
  equation.)

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Graphing the same problem
P
S
2.00
1.05
D
Q
3500
1400
1662.5
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In-Class Exercise

• Given
• Solve for inverse supply and demand.
• Solve for the market clearing equilibrium.

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Consumer Surplus (CS)

• Total amount a consumer is willing to pay minus
  the actual price the consumer does pay for the
  good.
• CS Pw - Pmarket (at each unit of Q)
• Intuition Basically the difference between
  willingness to pay and what you did pay.
• Consumer surplus is therefore a measure of
  consumer satisfaction!
• How well off is the consumer?

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Graphical Representation of CS

• Demand curve indicates your willingness to pay
• CS Area under demand curve but above the market
  price.
• What happens to consumer surplus if price changes?

P
S
CS
P
D
Q
Q
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Lets consider a quota at QQ

• Consumers willing to pay P at Q.
• How much will consumers pay for QQ?
• PQ
• Quota like vertical supply.
• So price ?, quantity ?.
• What happens to CS?
• Decreases.
• Where did lost CS go?
• Rectangle to producer for each unit that he
  previous sold for P, he now gets PQ.
• Dead weight loss pure waste in CS induced by an
  increase in price above efficient level. Nobody
  gets welfare from units between QQand Q

CS2
P
S
CS1
PQ
To the producer
P
Deadweight loss
D
QQ
Q
Q
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Producer Surplus

• Total price determined by the market less what
  the producer would have been willing to sell the
  product at.
• Intuition Difference between the price the
  supplier gets and the price he would have been
  willing to sell at.
• Again, a measure of satisfaction.
• PS Area above supply curve but below market
  price.

P
S
CS
P
D
PS
Q
Q
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Elasticity

• How responsive is demand to changes in price?
• Use concept of price elasticity of demand.
• X and P are the starting values (a specific point
  on the demand curve)
• Elasticity tells us the percentage change in the
  quantity demanded of X due to a percentage change
  in the price of X.
• This is own price elasticity of demand.

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Elasticity Example

• What is elasticity of demand?
• How do you interpret this?
• A 1 decrease in price yields a .8 increase in
  the quantity demanded.
• Elasticity does not equal slope!
• Slope (8-10)/(29-25)-.5

• Initial Point x1 25, P1 10
• Suppose P decreases to 8 and x increases to 29.

P
10
8
D
25
29
x
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What if starting point were different?

• Let P8,X29 be starting point or P1, X1.
• What is the elasticity?
• Elasticity is not constant along a demand curve!
• What sign will elasticity have?
• Always (by definition).

P
10
8
D
25
29
x
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Elasticity Along a Linear Demand Curve

• Elasticity is not constant along a demand curve,
  even a linear demand curve.
• Elasticity at C?
• 0
• Elasticity at A?
• Infinity
• Elasticity at B (some point)?
• 1
• Location of this point depends on slope of the
  demand curve.

P
A
Elasticity gt1
B
Elasticity lt1
C
x
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Also Use Elasticity to Characterize Demand Curve

• Inelastic Demand E lt 1 along majority of demand
  curve
• Quantity demanded is not very sensitive to change
  in price.
• A 1 increase in price yields a less than 1
  decrease in quantity demanded.
• Large change in price yields small change in
  quantity.
• Steep demand curve!

P
D
x
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Characterizing Demand Curves

• Elastic Demand E gt 1 along majority of demand
  curve
• Quantity demanded is relatively sensitive to
  change in price.
• A 1 increase in price yields a more than 1
  decrease in quantity demanded.
• Small change in price yields large change in X.
• Relatively flat demand curves!

P
D
x
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Special Cases

• Perfectly Inelastic E 0
• There is no change in quantity demanded for a 1
  change in price.
• Vertical demand curve.
• Perfectly Elastic E ? 8
• If price increases just a little, quantity
  demanded falls to zero.
• Horizontal demand curve.
• Example - 10 banknote. Nobody wants to pay
  10.01 for it.

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What determines how responsive quantity is to
price (elasticity)?

• Substitutes
• Presence of close substitutes ? more elastic.
• Example Describe demand for Hondas.
• Increase in price of Hondas may result in
  consumers defecting to Toyotas (close
  substitute). So, expect a large change in
  quantity demanded of Hondas.
• Relatively elastic/horizontal demand curve.
• Example Describe demand for insulin.
• Has no close substitutes.
• Increase in price results in little change in
  quantity demanded since there is no choice.
• Relatively inelastic/vertical demand curve.

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What determines elasticity?

• Commoditys share in consumers budget.
• In general, the smaller the fraction of income
  absorbed by a commodity, the less elastic (more
  vertical) the demand curve, all else equal.
• Example metro tickets.
• Expect fairly inelastic demand, since ticket
  price is very small share of budget.
• Example cars.
• Expect more elastic demand, since cost of car is
  larger share of budget.

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What determines elasticity?

• Time frame of the analysis.
• Consider commuter rail prices.
• In the short run
• People have little alternative. So, demand is
  relatively inelastic.
• In the long run
• People can move, find a car pool, buy a car,
  change jobs, etc. They have time to adjust. So,
  demand is more elastic.
• As time frame widens, demand tends to be more
  elastic.

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Other types of elasticity

• Own price elasticity of demand
• Cross price elasticity of demand
• change in quantity demanded of X due to 1
  increase in price of Y.
• Measures relationship between goods.
• Substitutes
• gt0
• Complements
• lt0
• Unrelated
• 0
• There is no (-) sign we care about the sign!

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Other types of elasticity

• Income elasticity of demand
• change in quantity demanded of X due to 1
  increase in income.
• Sign matters!
• Normal good
• if gt0.
• Inferior good
• if lt0.
• Luxury good
• if gt1.
• Examples
• Furs, diamonds, (the obvious)
• Restaurant meals
• Taxis

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Taxes in the S/D Framework

• Excise taxes per unit tax legally levied on
  either consumers (sales tax) or producers
  (production tax).
• Tax incidence
• Statutory incidence who is legally liable for
  the tax.
• Economic incidence who actually bears the
  burden.
• For instance, if a tax is placed on a producer,
  does he pass on the entire burden to the consumer?

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Per Unit Consumer Tax

• Acts like per unit sales tax.
• Shifts demand curve down by the amount of the
  tax.
• Why?
• Initially willing to pay P0 (in total) for Q0.
• With a tax of t, now willing to pay P0-t to
  producer (and t to government).
• Still P0 in total.
• Can make same type of statement for each point on
  demand curve.
• For any consumer to be willing to buy what she
  did before, the market price of the good must be
  lower by the amount of the tax.

P
S0
P0
t
P0-t
D0
D1
Q0
Q
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Per Unit Consumer Tax (contd)

• Tax creates a wedge between the price that
  producers receive, P1, and the price that
  consumers pay, P1 t.
• P1 is the new market price.
• But consumer must pay t on top of that.
• How does equilibrium change with the tax?
• Q1 lt Q0.
• Price suppliers get P1 lt P0.
• Price consumers pay P1t gt P0.
• So economic incidence is shared by consumers and
  producers!

P
S
P1t
P0
P1
D1
D0
Q0
Q1
Q
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The effect on consumer and producer surplus

• CS1 is area under initial demand and above total
  price paid
• Equivalent to area under new demand and above new
  market price.
• CS decreases.
• PS1 is area above supply and below new market
  price, P1.
• PS decreases.
• Where do lost CS/PS go?

P
CS1
S
CS0
P1t
P0
PS0
P1
PS1
D1
D0
Q0
Q1
Q
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Effect of tax on CS/PS (contd)

• Some of lost CS/PS goes to the government
• Tax Revenue tQ1
• Remaining triangle is deadweight loss.
• Nobody (consumer, producer, or government) gets
  welfare from the units between Q0 and Q1.
• Total surplus decreases.
• TS0 CS0PS0
• TS1 CS1PS1Govt Rev
• TS0 TS1 DW

P
S
CS1
Govt Revenue
P1t
DW Loss
P0
P1
PS1
D1
D0
Q0
Q1
Q
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Tax burden depends on elasticity

• Who bears the burden when there is perfectly
  elastic supply?
• Producer gets same price before and after tax.
• Entire burden is born by the consumer.
• PS 0 before and after.
• Lost CS goes to govt and DW loss

CS0 - orange
CS1 orange striped
P
Tax revenue orange dots
P1t
t
S
P0
P1
D1
D0
Q
Q0
Q1
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Who bears the burden with perfectly inelastic
supply?

• Consumer faces same pre and post price. CS does
  not change.
• PS decreases.
• All of lost PS goes to government. (See remaining
  solid shaded rectangle)
• No deadweight loss.
• Economic incidence is completely on the producer
  even though statutory incidence is on consumer.

P
S
P0
P1t
t
P1
D0
Q
Q0
PS0 grey rectangle
PS1 striped rectangle
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Elasticity and Economic Incidence

• In general, the party (consumer or producer) with
  the less elastic curve will bear the greater the
  burden of the tax.

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A production tax

• Works pretty much the same way.
• Think of tax like extra cost of production.
• Shifts supply curve up.
• Since firm pays t to the government, would only
  produce Q0 if receive P0t from consumer.
• What is new equilibrium?

S1
P
S0
t
P0t
P0
D0
Q0
Q
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Production tax (contd)

• As with consumer tax, equilibrium quantity
  decreases.
• P1 market price paid by consumer to producer.
• Consumer faces higher P.
• P1 t total price received by producer
  (receives P1 and gives t to government)
• Rectangle is tax revenue.

S1
P
S0
t
P1
P0
P1-t
D0
Q0
Q1
Q
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Sin Tax Example old midterm example

• A couple of years ago, Congress proposed to
  finance the additional cost of expanding SCHIP
  (child health insurance program) by increasing
  the federal excise tax on cigarettes by 61 cents,
  to 1 per pack.
• Sin taxes such as these are commonly used by the
  government to
• ? consumption of the so-called sinful good
• ? government revenue.
• Will a sin tax of this sort accomplish its two
  aims? Why or why not? Does your answer depend on
  the segment of the population that you are
  considering? Discuss.

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• Tax effectiveness depends on elasticity of
  demand.
• Very inelastic demand ? consumption not very
  sensitive to a tax
• Elastic demand ? consumption very sensitive to
  the tax

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• Complete answer would discuss determinants of
  elasticities (and how they might differ across
  different segments of the population).
• Chain smoker perfectly inelastic? No change in
  consumption, substantial govt revenue
• Addict relatively inelastic Small decrease in
  consumption, substantial govt revenue
• Teen smokers relatively elastic not yet
  addicted and cigarettes make up large part of
  budget, large decrease in consumption but raise
  less revenue

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• Another example see alcopops article