Elasticity

1
Elasticity
the responsiveness of the amount purchased to a
change in price.
- or put more simply -
-
-
-
)
(
)
(
P
P
Q
Q
)
(
P
Q
Q


1
0
1
0
0
1
0
X
-
)
(
P
P
P
Q
Q
1
0
0
0
0
PED gt 1 Elastic lt 1 Inelastic
1 Unit Elastic
2
Elasticity and
Total Revenue ___ ___ ___ ___ ___ ___ ___ ___
Quan 1 2 3 4 5 6 7 8
Price 8 7 6 5 4 3 2 1
Elasticity ___ ___ ___ ___ ___ ___ ___
X X X X X X X X

3
Different Elasticities
4
1
5
Elasticity of Demand
6
Elasticity
What affects Elasticity???
1. Available Substitutes
2. Necessity vs Luxury
3. Proportion of Income
4. Time to shop around
7
Elasticity
What affects Supply Elasticity???
1. Time
a. Market Period
b. Short Run
c. Long Run
8
Income Elasticity

• the responsiveness of a products demand to a
  change in income.

• A normal good has a positive income elasticity of
  demand.

• As income increases, the demand for normal goods
  increases.

• Goods with a negative income elasticity are
  inferior goods.

• As income expands, the demand for inferior goods
  will decline.

9
Cross Price Elasticity

• the responsiveness of a products demand to a
  change in the price of another good.

• A complement has a negative cross price
  elasticity.

• As Py increases, the demand for Y decreases, and
  demand for goods that are consumed with Y also
  decreases.

• A substitute has a positive cross price elasticity

• As Py increases, the demand for Y decreases, and
  demand for goods that can be consumed instead of
  Y also decreases.

10
Consumer Surplus
The total difference between what a consumer is
willing to pay and how much they actually have to
pay.
Producer Surplus
The total difference between what a supplier is
willing to provide a good or service and how much
they actually get for it.
11
Producer and Consumer Surplus
P
Consumer surplus area of lighter
triangle ½(5)(5) 12.5
10 9 8 7 6 5 4 3 2 1
S
Producer surplus area of darker
triangle ½(5)(5) 12.5
CS
PS
The combination of producer and consumer surplus
is maximized at market equilibrium
D
Q
0 1 2 3 4 5 6 7 8
8-11
12

• The Burden of a Tax

Tax Incidence

• Who pays a tax is called the incidence.

Buyer
Seller
13
Impact of a Tax Imposed on Sellers

• If in the used car market a price of 7,000
  would bring the quantity of used cars demanded
  into balance with the quantity supplied.

Price
S

• When a 1,000 tax is imposed on sellers of
  used cars, the supply curve shifts vertically
  by the amount of the tax.

7,400
7,000

• The new price for used cars is 7,400

sellers netting 6,400 (7,400 - 1000
tax).
6,400

• Consumers end up paying 7,400 instead of
  7,000 and bear 400 of the tax burden.

D

• Sellers end up receiving 6,400 (after taxes)
  instead of 7000 and bear 600 of the tax
  burden.

of used carsper month(in thousands)
500
750
14
Impact of a Tax Imposed on Buyers
Price

• In the same used car market

• When a 1,000 tax is imposed on buyers of used
  cars, the demand curve shifts vertically by the
  amount of the tax.

S
7,400

• The new price for used cars is 6,400

7,000
buyers then pay taxes of 1000 making the
total 7,400.
6,400

• Consumers end up paying 7,400 (after taxes)
  instead of 7,000 and bear 400 of the tax
  burden.

D

• Sellers end up receiving 6,400 instead of
  7000 and bear 600 of the tax burden.

of used carsper month(in thousands)
500
750
15
Elasticity and Incidence of a Tax

• The actual burden of a tax depends on the
  elasticity of supply and demand.

• As supply becomes more inelastic, then more of
  the burden will fall on sellers.
• As demand becomes more inelastic, then more of
  the burden will fall on buyers.

ED ES ED ES
ED ES
16
Tax Burden and Elasticity

• Consider the market for Gasoline and Luxury
  Boats individually.

Price
Gasolinemarket
1.65

• We begin in equilibrium.

S
1.60

• If we impose a .20 tax on gasoline
  suppliers, the supply curve moves vertically
  the amount of the tax. Price goes up .15 and
  output falls by 6 million gallons per week.

1.55
1.50
1.45
D
Quantity(millions of gallons)

• If we impose a 25K tax on Luxury Boat
  suppliers, the supply curve moves vertically
  the amount of the tax. Price goes up by 5K
  and output falls by 5 thousand units.

194
200
Price(thousand )
Luxury boatmarket
S
110

• In the gas market, the demand is relatively
  more inelastic than its supply hence, buyers
  bear a larger share of the burden of the tax.

100
90
D

• In the luxury boats market, the supply curve
  is relatively more inelastic than its demand
  hence, sellers bear a larger share of the
  tax burden.

80
Quantity(thousands of boats)
5
10
15
20
17

• An effective price ceiling is a government set
  price below the market equilibrium price

• It acts as an implicit tax on producers and an
  implicit subsidy to consumers that causes a
  welfare loss identical to the loss from taxation

P
A price ceiling transfers surplus from producers
to consumers, generates deadweight loss, and
reduces equilibrium quantity
S
P0
P1
Price ceiling
Shortage
D
Q
Q0
Q1
18

• An effective price floor is a government set
  price above the market equilibrium

• It acts as a tax on consumers and a subsidy for
  producers that transfers consumer surplus to
  producers

P
S
Surplus
P1
Price floor
P0
A price floor transfers surplus from consumers to
producers, generates deadweight loss, and reduces
equilibrium quantity
D
Q
Q0
Q1
19
The Difference Between Taxes and Price Controls

• Price ceilings create shortages and taxes do not

• Taxes leave people free to choose how much to
  supply and consume as long as they pay the tax

• Shortages may also create black markets

20
Rent Seeking, Politics, and Elasticities

• The possibility of transferring surplus from one
  set of individuals to another causes people to
  spend time and resources on doing so.

• Lobbying for price controls, which transfer
  surplus from one group to another, is an example
  of rent-seeking behavior

• Individuals spend money and use resources to
  lobby governments to institute policies that
  increase their own surplus

• Public choice economists argue that when all rent
  seeking and tax consequences are netted out,
  there is often not a net gain to the public

21
Inelastic Demand and Incentives to Restrict
Supply
Revenue gained
P
When demand is relatively inelastic, suppliers
have incentive to restrict quantity to increase
total revenue
S1
S0
P1
C
P0
Revenue lost
A
B
D
Q
Q0
Q1
22
Inelastic Supplies and Incentives to Restrict
Prices

• When supply is inelastic, consumers have
  incentives to restrict prices

• When supply is inelastic and demand increases,
  prices increase causing consumers to lobby for
  price controls

• Rent control in New York City is an example

23
Application Price Floors and Elasticity
The surplus created by a price floor is larger if
demand and supply are elastic
P
P
S
Surplus
Surplus
S
Price floor
P1
P1
P0
P0
D
D
Q
Q
Q0
Q1
Q0
Q1
24
International Trade
The Trade Sector of the US
Growth - In 1975, exports and imports were
each approximately 8 of the U.S. economy. -
In 2008, exports accounted for 11 of GDP and
imports made up 16. Major Trading Partners -
Canada, Mexico, and Japan -China, Europe
25
Who do we trade with?
Partner Exports Imports
Canada Mexico Latin America Europe OPEC Pacific
Rim Other
20 12 11 21 5 23 8
16 10 8 17 11 31 7
26
Leading Trading Partners of the U.S.
Percent of Total U.S. Trade, 2002

Percent of Total U.S. Trade, 2006

Canada
Mexico
China
Japan
Germany
United Kingdom
South Korea
Taiwan
France
Malaysia
All other countries

• Today, Canada, Mexico, China, and Japan are the
  leading trading partners with the United States.
• The impact of international trade varies across
  industries. --some compete effectively, some do
  not.

27
The Growth of the U.S. Trade Sector

• Both exports and imports have grown substantially
  as a share of the U.S. economy.
• Their growth has accelerated since 1975.
• Reductions in transport and communication costs,
  as well as lower trade barriers have contributed
  to this growth.

Imports( of GDP)
Exports( of GDP)
20
20
15
15
10
10
5
5
1960
1970
1980
1990
2000
1960
1970
1980
1990
2000
2010
2010
Source http//www.economagic.com/. The figures
are based on data for real imports, exports, and
GDP.
28
Balance of Trade
Percent of GDP

• 2
• 1
• 0
• 1
• 2
• 3
• 4
• 5
• 6
• 7

The United States has been running trade
deficits since the 1970s
1970 1980 1990 2000
2010
29
Gains from Specialization and Trade

• International trade allows each country to
  specialize according to the law of comparative
  advantage.
• Each country can produce those goods that it can
  produce at a relatively low cost.
• Trading partners can consume a wider variety of
  goods than they could produce domestically.

30
The Benefits from Trade (from Chapter 2)
Textiles (yds)
5,000
4,000
and Belgium specialized in chocolates.
Pakistan
3,000
Belgium
2,000
1,000
Chocolate (tons)
2
3
4
5
1
31
When they took advantage of their comparative
advantage,
Textiles (yds)
they could trade with each other for more
of both.
5,000
4,000
Pakistan
3,000
2,000
Belgium
1,000
Chocolate (tons)
2
3
4
5
1
32
Production Possibilities
Bonsai
Areca

• Guns Butter
• 0
• 2
• 4
• 0 6

• Guns Butter
• 0
• 12 1
• 2
• 3
• 0 4

Guns
Guns
Butter
Butter
33
International Example
Production Possibilities - Mexico
Product A B C D E
Avocados 0 20 24 40 60
Soybeans 15 10 9 5 0
1 S __ A
1 A __ S
Production Possibilities - US
Product A B C D E
Avocados 0 30 33 60 90
Soybeans 30 20 19 10 0
1 S __ A
1 A __ S
US should produce?
Mexico should produce?
Terms of Trade? ___ A for ___ S
34
Gains from Specialization and Trade

• International trade leads to gains from
• Economies of Scalereductions in per-unit costs
  that often accompany large-scale production,
  marketing, and distribution.
• More Competitive MarketsPromotes competition in
  domestic markets and allows consumers to purchase
  a wide variety of goods at economical prices.

35
A Hard Lesson to Learn
Exports and Imports are Linked

• Exports provide the foreign exchange needed for
  the purchase of imports.
• Imports provide trading partners with the
  currency needed to purchase exported goods and
  services.
• Therefore, restrictions that limit one will also
  limit the other.

36
Foreigners Have a Comparative Advantage

• Consider the international market for
  manufacturing shoes.

• In the absence of trade, the domestic price would
  be Pn.

• Since many foreign producers have a comparative
  advantage in the production of shoes,
  international trade leads to lower prices Pw.

U.S. Market
World Market
Pn
Pw
Qn
Qw
37
Foreigners Have a Comparative Advantage

• At the price Pw, U.S. consumers demand Qc units
  of which (Qc Qp) are imported.

• Compared to no trade, consumers gain Pn a b Pw,
  while domestic producers lose Pn a c Pw.
• A net gain of a b c results.

U.S. Market
World Market
Sd
Sw
a
Pn
c
b
Pw
Pw
Dd
Dw
Qn
Qw
Qp
Qc
38
U.S. Has a Comparative Advantage

• The price of soybeans and other internationally
  traded commodities is determined by the forces of
  supply and demand in the world market.

• If U.S. soybean producers were prohibited from
  selling to foreigners, the domestic price would
  be Pn.

• Free trade permits U.S. soybean producers to sell
  Qp units at the higher world price of Pw.

U.S. Market
World Market
a
b
Pw
Pw
Pn
Qn
Qc
Qp
Qw
39
U.S. Has a Comparative Advantage

• At the world price of Pw, the quantity (Qp Qc)
  is exported.

• Compared to the no-trade situation, the
  producers gain from the higher price (Pw b c Pn)
  exceeds the cost imposed on domestic consumers
  (Pw a c Pn) by the triangle (area) a b c.

Sw
U.S. Market
World Market
Sd
a
b
Sw
Pw
Pw
c
Pn
Dw
Dd
Qn
Qc
Qp
Qw
40
Varieties of Trade Restrictions

• Tariffs are taxes governments place on
  internationally traded goods (generally imports)

• Quotas are quantity limits placed on imports

• Voluntary restraint agreements are when countries
  voluntarily restrict their exports

• An embargo is a total restriction on the import
  or export of a good

• Regulatory trade restrictions are
  government-imposed procedural rules that limit
  imports

• Nationalistic appeals, such as Buy American can
  help to restrict international trade

41
Tariffs when the domestic country is small
Tariffs decrease imports, increase domestic
production, and generate tariff revenue
P
Tariff revenue
SDomestic
3.00
PWorld 0.50Tariff SWorld
2.50
PWorld SWorld
2.00
Imports
DDomestic
Q
Imports
9-41
42
Application Quotas when the domestic country is
small
P
Quotas decrease imports and increase domestic
production
SDomestic
3.00
Quota SWorld
2.50
PWorld SWorld
2.00
Quota 50
DDomestic
Q
Imports w/o quota
43
Trade Restriction Impacts
Price
Price
SDomestic
SDomestic


P2
Pw t
Pw
Pw
DDomestic
DDomestic
Quantity(peanuts)
Quantity(automobiles)
Qd1
Qd2
Qd1
Q1
Q2
Qd2
Q1
Q2
44
U.S. Tariff Rates 1890 to the Present
U.S. Average Tariff Rate
(Duties collected as a share of dutiable
imports)
60
50
40
30
20
4.5
10
1890
1910
2006
1990
1970
1950
1930
45
Why do Nations Adopt Trade Restrictions?

• Unequal internal Distribution of the gains from
  trade (move to comparative advantage production)
• Haggling by companies over gains from trade
• Haggling by countries over trade restrictions
• Specialized productiona. Learn by doing
• b. economies of scale.
• c. Infant industry argument.

46
Why do Nations Adopt Trade Restrictions?

• 5. Macroeconomic aspects of trade
• Limit imports during a recession
• 6. National Security
• International politics
• Increase revenue from tariffs

47
U.S. Trade with Canada and Mexico
U.S. Trade with Canada and Mexico
(Exports and Imports together as a share
of GDP)
6
5
Canada
4
3
Mexico
2
1
1980
1990
1985
1995
2000
2005

• U.S. trade with both Canada and Mexico grew
  rapidly following the passage of NAFTA.

48
Individual Choice
1. Rational (about costs)
same cost - greater benefit
same benefit - least cost
2. Utility
the pleasure people get from doing or consuming
something
49
Diminishing Marginal Utility

• After some point, the marginal utility received
  from each additional unit of a good decreases
  with each additional unit consumed

• As additional units are consumed, marginal
  utility decreases, but total utility continues to
  increase

• When total utility is at a maximum, marginal
  utility is zero

• Beyond this point, total utility decreases and
  marginal utility is negative

50
Total Utility Curve
Marginal Utility Curve
The total utility curve is bowed downward
Utility
Utility
The marginal utility curve is downward sloping
and graphed at the halfway point
70
14
60
12
50
10
40
8
30
6
4
20
2
10
Q
Q
0
1 2 3 4 5 6 7 8
1 2 3 4 5 6 7 8
2
51
Maximizing Utility until


. . .

Choices are based on comparisons of MU per
spent on each good until choices are equal.
52
The Pizza Demand Curve

• The demand for frozen pizzas reflects the law of
  diminishing marginal utility.

Price

• Because marginal utility (MU) falls with
  increased consumption, so does a consumers
  maximum willingness to pay -- marginal benefit
  (MB).

3.50
3.00
2.50

• A consumer will purchase until MB Price . .
  .

2.00
so at 2.50 they would purchase
3 frozen pizzas and receive a consumer surplus
shown by the shaded area (above the price line
and below the demand curve).
Frozen pizzasper week
4
2
1
3
53
Tastes are given

• Implicit in the theory of rational choice is that
  utility functions are given, not shaped by society

• Tastes are often significantly influenced by
  society

• Conspicuous consumption is the consumption of
  goods not for ones direct pleasure, but to show
  off to others

• Given tastes is the assumption on which an
  economic analysis is conducted

54
A firm is an economic institution that
transforms factors of production into goods and
services

1. Organize factors of production and/or
2. Produce goods and services and/or
3. Sell produced goods and services

• A virtual firm organizes production and
  subcontracts out all work

• Many of the organizational structures of business
  are being separated from the production process