Second Edition

Chapter 5 Chapter 5

Elasticity and Its Elasticity and Its ApplicationsApplications

Elasticity of DemandElasticity of Demand

Elasticity of demand - a measure of how responsive the quantity demanded is to a change in price• more responsive equals more elastic.

The slope of the demand curve is related to the elasticity of demand.

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Calculating the Elasticity of DemandCalculating the Elasticity of Demand

Elasticity measures the responsiveness of quantity demanded to changes in price.

P%

Q%

pricein change Percentage

demandedquantity in change PercentageE demand of Elasticity

demanded

d

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Mathematics of Demand ElasticityMathematics of Demand Elasticity

Elasticity of demand is always negative, so we typically drop the negative sign and use absolute value instead.

If the |Ed| < 1, the demand curve is inelastic. If the |Ed| > 1, the demand curve is elastic. If the |Ed| = 1, the demand curve is unit elastic.

A firm’s revenues are equal to price per unit times quantity sold.• Revenue = Price x Quantity

The elasticity of demand directly influences revenues when the price of the good changes.

Total Revenue and the Elasticity of DemandTotal Revenue and the Elasticity of Demand

Total Revenue and the Elasticity of DemandTotal Revenue and the Elasticity of Demand

Knowing the value of the elasticity allows us to understand what happens to total revenue when the price changes.

If…directions oppositein move TR and PP%Q%1E dd

6

direction samein move TR and PP%Q%1E dd

constant is TRP%Q%1E dd

The Elasticity of SupplyThe Elasticity of Supply

Elasticity of supply – measures how responsive the quantity supplied is to the a change in price.• more responsive equals more elastic.

The slope of the supply curve is related to the elasticity of supply.

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Calculating the Elasticity of SupplyCalculating the Elasticity of Supply

Measure of the responsiveness of quantity supplied to a change in price

Computed by

P%

Q%

price in change Percentage

suppliedquantity in change PercentageE supply of Elasticity

supplied

s

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If the Es < 1, the supply curve is inelastic.

If the Es > 1, the supply curve is elastic.

If the Es = 1, the supply curve is unit elastic.

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Mathematics of Supply ElasticityMathematics of Supply Elasticity

Determinants of the ElasticityDeterminants of the Elasticityof Supplyof Supply

Consider two polar casesPicasso painting Toothpicks

PricePrice

QuantityQuantity

Perfectly elastic supplyPerfectly inelastic supply

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Second Edition

Chapter 6 Chapter 6

Taxes and SubsidiesTaxes and Subsidies

Commodity TaxesCommodity Taxes

We will emphasize the following:1. Who ultimately pays the tax is not dependent

on who writes the check

2. Who ultimately pays the tax does depend on the relative elasticities of supply and demand.

3. Commodity taxation raises revenue and creates lost gains from trade (deadweight loss)

Let’s look at each of these in turn.12

Using the Tax WedgeUsing the Tax Wedge

Price of Apples (per basket)

Quantity ofApples (baskets)

Supply

$4

3

2

1

500 700 1,250

2.65

1.65

Demand

200

Tax Wedge = $1

Price buyers pay

Price sellersreceive

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The Burden of the Tax Depends of the The Burden of the Tax Depends of the Elasticities of Supply and DemandElasticities of Supply and Demand

An elastic demand curve means that buyers can substitute

An elastic supply curve means that workers and capital can easily find work in another industry

Result• When demand is more elastic than supply, buyers

pay less of the tax• When supply is more elastic than demand, sellers

pay less of the tax• In other words elasticity = escape

Let’s use the model to show this14

The Burden of the Tax Depends of the The Burden of the Tax Depends of the Elasticities of Supply and DemandElasticities of Supply and Demand

Case I: Demand is more elastic than supplyPrice

Quantity

Supply

DemandTaxWedge

Qno taxQw/tax

Pno tax

Price receivedby sellers

Price paidby buyers

Result:Most of the tax is paidBy sellers

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The Burden of the Tax Depends of the The Burden of the Tax Depends of the Elasticities of Supply and DemandElasticities of Supply and Demand

Case II: Supply is more elastic than demandPrice

Quantity

Supply

Demand

TaxWedge

Qno taxQw/tax

Pno tax

Price receivedby sellers

Price paidby buyers

Result:Most of the tax is paidBy buyers

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A Commodity Tax Raises Revenues A Commodity Tax Raises Revenues and Creates Lost Gains From Tradeand Creates Lost Gains From Trade

PricePrice

QQ

No Tax With Tax

700700

$2.00$2.00

Consumersurplus

Producersurplus

500

Tax wedge

$2.65

$1.65

Consumer surplus

Producersurplus

Governmentrevenue

Deadweightloss

DD

SS

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A Commodity Tax Raises Revenues and A Commodity Tax Raises Revenues and Creates Lost Gains From TradeCreates Lost Gains From Trade

Elasticities of demand and supply determine consumer and producer surplus• The greater these elasticities, the greater will

be the deadweight loss

Let’s use our model to show this.

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Qw/ tax

A Commodity Tax Raises Revenues and A Commodity Tax Raises Revenues and Creates Lost Gains From TradeCreates Lost Gains From Trade

Case I: Elastic Demand

Supply

Price

Quantity

Demand

Pno tax

Pw/tax

Tax wedge

Tax Revenue

Qno tax

Deadweightloss

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Qw/ tax

A Commodity Tax Raises Revenues and A Commodity Tax Raises Revenues and Creates Lost Gains From TradeCreates Lost Gains From Trade

Case II: Inelastic Demand

Supply

Price

Quantity

Demand

Pno tax

Pw/tax

Tax wedge

Tax Revenue

Qno tax

Deadweightloss

Note: Tax rate and Tax revenue are the same as before.Deadweight loss is much smaller.

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Tax Revenue

Qw/ tax

A Commodity Tax Raises Revenues and A Commodity Tax Raises Revenues and Creates Lost Gains From TradeCreates Lost Gains From Trade

Case III: Elastic Supply

Supply

Price

Quantity

Demand

Pno tax

Pw/tax

Tax wedge

Qno tax

Deadweightloss

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Tax Revenue

Qw/ tax

A Commodity Tax Raises Revenues and A Commodity Tax Raises Revenues and Creates Lost Gains From TradeCreates Lost Gains From Trade

Case IV: Inelastic Supply

Supply

Price

Quantity

Demand

Pno tax

Pw/tax

Tax wedge

Qno tax

Deadweightloss

Note: Tax rate and Tax revenue are the same as before.Deadweight loss is smaller.

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SubsidiesSubsidies

A subsidy is a reverse tax Important facts about commodity subsidies

1. Who gets the subsidy does not depend on who gets the check from the government.

2. Who benefits from the subsidy does depend on the relative elasticities of demand and supply.

3. Subsidies…1. Are paid for by taxpayers2. Result in inefficient increases in trade (deadweight

loss) We can use the same wedge shortcut as

before.Let’s use our model to analyze subsidies.

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SubsidiesSubsidiesPrice of apples

Per basket

Quantity of apples(baskets)

Demand

Supply

3

$4

2

1

700 900

Price receivedBy sellers = $2.40

Price paidBy buyers = $1.40

Subsidywedge

Deadweightloss

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Taxes and Subsidies ComparedTaxes and Subsidies Compared

Whoever Bears the Burden of the Tax Receives the Benefits of a Subsidy

Price

Quantity

Supply

Demand

subsidywithQ

Subsidywedge

Taxwedge

Price receivedby sellers

Price paidby buyers

Price paidby buyers

Price receivedby sellers

subsidy notax noP

taxwithQ

subsidy notax noQ

Benefitof subsidyon sellers

Burdenof tax onsellers

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Wage SubsidiesWage Subsidies

Edmund Phelps – Nobel Prize winner• Wage subsidies can be used to increase

employment of low wage workers.• Although costly, they may reduce

Welfare payments. Crime Drug dependency “Rational defeatism”

• A better alternative to the minimum wage.

Let’s analyze a wage subsidy program.26

Wage SubsidiesWage Subsidies

Wage

Quantityof labor

Demandfor labor

Market wage= $10.50

Supply of Labor

Qm

SubsidyWedge = $4

Qs

Wage received by

workers$12

$8

Wage paidby firms

Cost to taxpayers

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TakeawayTakeaway

Taxes decrease the quantity traded. Subsidies increase the quantity traded. The burden of the tax and the benefit of the

subsidy do not depend on who sends or receives the government check.

The side of the market that is more elastic will escape more of the tax and receive less of the benefit of the subsidy.

The greater the elasticity of demand or supply the greater will be the deadweight loss.

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Second Edition

Chapter 8 Chapter 8 Price Ceilings and FloorsPrice Ceilings and Floors

Price CeilingsPrice Ceilings

Price ceiling – a maximum price allowed by law

Five important effects1. Shortages

2. Reductions in product quality

3. Wasteful lines and other search costs

4. A loss in gains from trade

5. A misallocation of resources

Let’s look at each one in turn.30

Price Ceilings Create ShortagesPrice Ceilings Create Shortages

Price of gasolineper gallon

Quantity

Demand

Supply

Market Equilibrium

Controlled Price(ceiling)

Qs Qd

Shortage

31

TotalValue ofWastedtime

Wasteful Lines and Other Search CostsWasteful Lines and Other Search Costs

Quantity

Demand

SupplyMarket Equilibrium

Controlled Price = 1

(ceiling)

Qs Qd

Shortage

Willingness topay for Qs = $3

Price of gasolineper gallon

At the controlled price:Quantity supplied = Qs

Buyers are willing to pay $3/gallonLine will grow until the time cost per gallon $3 - $1 = $2.00/gallon

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Wasted Time and Other Search CostsWasted Time and Other Search Costs

What’s the difference between paying a bribe and waiting in line?• Waiting in line is more wasteful!

A bribe goes to the station owner. Time waiting in line is lost; it benefits no

one.

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TotalValue ofWastedtime

Price Ceilings: Reduce Gains From TradePrice Ceilings: Reduce Gains From Trade

Quantity

Demand

Supply

Market Equilibrium

Controlled Price = 1

(ceiling)

Qs Qd

Shortage

$3

Price of gasolineper gallon

Market price

Lostproducersurplus

Lostconsumersurplus

BB

A

A + B = Lost gainsfrom trade

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Misallocation of ResourcesMisallocation of Resources

Quantity

Demand

Supply

Controlled Price

(ceiling)

Qs Qd

Shortage

$3

Price($)

Highest-valueduses

Lower-valueduses

Least-valueduses

Price control prevents highest valued usesfrom outbidding lower valued uses.Result: some oil flows to lower valued uses

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Price FloorsPrice Floors

Price floor – a minimum price allowed by law

Price floors create:1. Surpluses

2. Lost gains from trade (deadweight loss)

3. Wasteful increases in quality

4. A misallocation of resources

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SurplusesSurpluses

A good example of a price floor is the minimum wage

Workers with very low productivity are most affected by the minimum wage.• Least experienced• Least educated or trained

Low-skilled teenagers are most affected.

Let’s use the labor market model to analyze the minimum wage.

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Minimum Wage Creates a SurplusMinimum Wage Creates a Surplus

Demand for labor

Supply of labor

Marketwage

Wage($/hr)

Quantityof labor(unskilled)

Market employment

Minimumwage

QsQd

Labor surplus(unemployment)

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Minimum Wage Creates Lost Gains From Minimum Wage Creates Lost Gains From TradeTrade

Demand for labor

Supply of labor

Marketwage

Wage($/hr)

Quantityof labor(unskilled)

Market employment

Minimumwage

QsQd

Labor surplus(unemployment)

Lost gains from trade(deadweight loss) = lost consumer surplus + lost producer surplus

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Minimum WageMinimum Wage

Hotly debated in the U.S. • 93.9% of workers < 25 years earn more than

the minimum wage• At best, the minimum wage raises the wages

of some teenagers and young workers whose wages would have increased anyway as they became more skilled.

• At worst, increases in the price of hamburgers can create some teenage unemployment.

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TakeawayTakeaway

You should be able to explain the effects of price ceilings to your uncle.

You should be able to draw a diagram showing the price ceiling, label the shortage, wasteful losses, and the lost gains from trade.

You should understand why a price ceiling reduces product quality and misallocates resources.

You should be able to a similar analysis for price floors.

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Second Edition

End of Chapter 8End of Chapter 8