Chapter 5

1. Chapter 5 Elasticity and Its Applications

2. Chapter Outline • The Elasticity of Demand • The Elasticity of Supply • Using Elasticities for Quick Predictions (Optional) • Takeaway • Appendix 1: Using Excel to Calculate Elasticities • Appendix 2: Other Types of Elasticities

3. Elasticity of Demand • We know there is an inverse relationship between price and quantity demanded. • But how much does quantity demanded change when price changes?

4. Elasticity 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. Let’s see how this works.

5. Elasticity of Demand price • Price ↑ from $40 to $50: • a → b less responsive • a → c more responsive c b $50 a 40 Demand E (more elastic) Demand I (less elastic) Quantity 20 95 100

6. Determinants of the Elasticity of Demand • Ease in finding substitutes *** • Easier → greater elasticity • Time required to adjust to price changes • Long term → more substitutes → greater elasticity • The definition of the commodity • Narrow definition → more substitutes → greater elasticity • Example: Coffee vs. specific brand • Necessities versus Luxuries • Share of budget devoted to the good. • Larger share → greater elasticity

7. Determinants of the Elasticity of Demand • Summary of Determinants of Elasticity of Demand

8. Mathematics 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 isinelastic. • If the |Ed| > 1, the demand curve is elastic. • If the |Ed| = 1, the demand curve is unit elastic.

9. Calculating the Elasticity of Demand • Elasticity measures the responsiveness of quantity demanded to changes in price. • Usually interpreted using the absolute value:

10. Calculating the Elasticity: Midpoint Method • We use the midpoint as the base: Let’s work an example.

11. Calculating the Elasticity: Midpoint Method • Given: • What does this number mean?

12. Total Revenue and the Elasticity of Demand • 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.

13. Total Revenue and Elasticity of Demand Inelastic Demand Elastic Demand Price Price Result: ↑TR Result: ↓TR $50 $50 40 40 Demand Demand Quantity 100 Quantity 20 95 100 ↓TR due to ↓Qd ↑TR due to ↑P

14. Total 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… We can use diagrams to see how this works.

15. Total Revenue and Elasticity of Demand: Summary • Summary: Total revenue and Ed

16. Applications of Elasticity of Demand • How the American Farmer has Worked Himself Out of a Job: • Increased agricultural productivity has the supply of food BUT the supply of farmers…. • And their revenues because the demand for most agricultural products is inelastic.

17. To next Try it! • Which is more elastic, the demand for computers or the demand for Dell computers? Why? • The elasticity of demand for eggs has been estimated to be 0.1. If the price of eggs increases by 10%, what will happen to total revenue of egg producers?

18. To next Try it! If a fashionable clothing store raised its prices by 25 percent, what does that tell you about the store’s estimate of the elasticity of demand for its products? They think it’s elastic They think it’s inelastic

19. The 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. Let’s see how this works.

20. The Elasticity of Supply Elasticity of Supply Captures the Sensitivity of Quantity Supplied to Changes in Price Price per Unit Inelastic Supply Elastic Supply $50 The Same Price Increase $40 Quantity 85 170 …Causes a Small Increase in Quantity Supplied if Supply is Inelastic 80 …Causes a Big Increase in Quantity Supplied if Supply is Elastic

21. Determinants of the Elasticityof Supply • How much per-unit costs ↑ as production ↑ • Greater ↑ in per unit costs → ↓ elasticity of supply. • Examples: • Elasticity of supply tends to be low for raw materials like oil and coal. • Elasticity of supply tends to greater for manufactured goods • Local supply is more elastic than the global supply. Why?

22. Determinants of the Elasticityof Supply • Consider two polar cases Picasso painting Toothpicks Price Price Perfectly inelastic supply Perfectly elastic supply Quantity Quantity

23. Mathematics of Supply Elasticity • 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.

24. Determinants of the Elasticity of Supply: Summary

25. Calculating the Elasticity of Supply • Measure of the responsiveness of quantity supplied to a change in price • Computed by

26. Calculating the Elasticity: Midpoint Method • Again, we use the midpoint as the base

27. Applications of Supply Elasticity: Gun Buyback Programs • Gun buyback programs • Several cities in the U.S. have spent millions of dollars buying guns with “no questions asked”. • Objective • Reduce the number of guns on the streets in order to… • Lower crime rates. • Principles of economics predict these programs are unlikely to reduce the number of guns on the streets of these cities. Why?

28. Applications of Supply Elasticity: Gun Buyback Programs • Demand for guns will increase. • Guns will be imported to sell to the police. • People will sell old, low quality guns • Result • The supply of guns is perfectly elastic to the city. • Price of guns does not increase • No fewer, but higher quality, guns are on the streets. Let’s use our model to see this.

29. Applications of Supply Elasticity: Gun Buyback Programs Price of low quality guns Increase in supply = buyback Supply of old, low quality guns (perfectly elastic) $84 Demand w/buyback Demand w/o buyback Quantity of guns traded 1,000 6,000

30. Takeaway • Elasticities of demand and supply help us quantify… • The effects of shifts in the demand and supply curves. • How revenues respond to changes in price along a demand curve • You should know how to calculate these elasticities using data on prices and quantities.

31. End of Chapter 5

32. Chapter 6 Taxes and Subsidies

33. Chapter Outline • Commodity Taxes • Subsidies

34. Commodity Taxes • We will emphasize the following: • Who ultimately pays the tax is not dependent on who writes the check • Who ultimately pays the tax does depend on the relative elasticities of supply and demand. • Commodity taxation raises revenue and creates lost gains from trade (deadweight loss) Let’s look at each of these in turn.

35. Who Ultimately Pays the Tax • Assume a 1$ per basket tax on apples. • Government can collect the tax in two ways: • From the seller • From the buyer • It doesn’t matter which way is chosen. Let’s use our model to analyze each.

36. Commodity Tax Collected From the Seller Price of Apples (per basket) • Commodity tax = $1 • Supply shifts up by $1 • Seller wants to charge $3 • At $3: Qd < Qs → surplus • Price ↓ → Qd↑and Qs ↓→ 500 • Result: • Seller’s net price = $1.65 • Buyer’s net price = $2.65 • Burden of the tax • Buyer - $0.65 • Seller - $0.35 Supply w/tax $4 3 Supply w/o tax $1 2.65 2 1.65 1 Demand Quantity of Apples (baskets) 400 500 700 1,250

37. Commodity Tax Collected From the Buyer Price of Apples (per basket) • Commodity tax = $1 • Buyer wants to pay $1.00 • Demand shifts down by $1 • At $1: Qd > Qs → shortage • Price ↑→ ↑Qs and Qd ↓ → ↑Qs → 500 • Result: • Buyer’s net price = $2.65 • Seller’s net price = $1.65 • Burden of the tax • Buyer - $0.65 • Seller - $0.35 Demand w/o tax $4 Demand w/tax 3 Supply 2.65 2 1.65 1 $1 Quantity of Apples (baskets) 200 500 700 1,250

38. The Burden of the Tax Depends on the Relative Elasticities of Demand and Supply • The Wedge shortcut • Tax wedge – a vertical line measuring the difference between the price paid by buyers and the price received by sellers. • This tool simplifies our analysis • The output where the wedge “fits” between the demand and supply curves tells us… • the after tax price consumers pay • the after tax price that sellers receive. Let’s go to our model now.

39. Using the Tax Wedge Price of Apples (per basket) Tax Wedge = $1 Price buyers pay $4 3 Supply 2.65 2 1.65 Price sellers receive 1 Demand Quantity of Apples (baskets) 200 500 700 1,250

40. The Burden of the Tax Depends of the Elasticities 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 this

41. The Burden of the Tax Depends of the Elasticities of Supply and Demand Case I: Demand is more elastic than supply Price Supply Price paid by buyers Result: Most of the tax is paid By sellers Pno tax Tax Wedge Demand Price received by sellers Quantity Qw/tax Qno tax

42. The Burden of the Tax Depends of the Elasticities of Supply and Demand Case II: Supply is more elastic than demand Price paid by buyers Price Result: Most of the tax is paid By buyers Supply Tax Wedge Pno tax Price received by sellers Demand Quantity Qno tax Qw/tax

43. This pleasure boat seems like a good thing to tax… Or not: The Omnibus Budget Reconciliation Act of 1990 applied a 10% federal luxury tax to the retail sale of luxury goods like pleasure boats with a sales price above $100,000. Expected tax revenue? $9 billion. Reality? The federal luxury tax was repealed in 1993. • Sales of boats down 52.7%; • Net loss of 30,000 jobs; • The federal government paid out > $7 million more in unemployment benefits to those workers than it collected in luxury tax revenues.

44. Health Insurance Mandates and Tax Analysis • Suppose government mandates that firms buy health insurance for its workers. • Think of this as a tax on labor. • Who actually pays for the health insurance? • Depends which is more elastic: supply or demand • That is, which is easier: • For firms to escape the tax by not employing? • For workers to escape the tax by not working?

45. Health Insurance Mandates and Tax Analysis • Firms can escape the tax in lots of ways • Substitute capital for labor. • Move operations overseas. • Close up shop. • It is more difficult for workers to escape the tax • Most workers will work at a lower wage • The cost of leaving the labor force is high • Conclusion: demand is more elastic than supply • Result: most of the tax is paid by workers.

46. Who Pays the Cigarette Tax? • Because nicotine is addictive, demand is inelastic. • Taxes are imposed by states. • A manufacture can easily escape these taxes by selling… • Overseas • Other states • Conclusion: Supply elasticity is very high • Result: most of tax is paid by buyers.

47. Who Pays the Cigarette Tax • An interesting test • If buyers pay almost all of the tax, the after tax price paid by sellers must be equal in all states. • This table shows that is the case.

48. A Commodity Tax Raises Revenues and Creates Lost Gains From Trade • Lost gains from trade = deadweight loss • Tax increases reduce consumer and producer surplus Let’s use our model to show this.

49. A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Price Price No Tax With Tax Consumer surplus Consumer surplus Tax wedge S S $2.65 Deadweight loss $2.00 $2.00 $1.65 D D Producer surplus Government revenue Producer surplus Q Q 700 500 700

50. To next Try it! What is the tax revenue that the government collects from the tax on gadgets? $350 $450 $100 $550