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# Econ 101: Microeconomics

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1. Econ 101: Microeconomics Chapter 4: Working with Supply and Demand: Part 2

2. Total Revenue and Total Expenditure • In the market for a particular good: • Total revenue (TR) is the amount of money sellers take in. • Total expenditure (TE) is the amount of money buyers pay out. • Assuming no excise tax: TR=TE =p x Q = Price x Quantity

3. Elasticity and Total Revenue • When p and Q change as the result of movement along a demand curve, what is the relationship between changes in price and changes in TR? • When p increases, Q decreases, so it is not clear, without more information, how TR is affected. • When p and Q are both changing, percentage change in their product is (approximately) the sum of their individual percentage changes. • Need information about elasticity of demand.

4. Elasticity and Total Revenue • Case 1: • Suppose demand is inelastic ( ) and price increases (quantity decreases). TR = TE = p x Q • Big increase in p combined with small decrease in Q TR = TE increases as the result

5. p For a demand curve that is close to perfectly inelastic, it’s obvious that TR=TE rectangle gets bigger when price increases. Elasticity and Total Revenue • This is easy to remember by visualizing a demand curve close to the limiting case of perfectly inelastic: p2 p1 Q Q2 Q1

6. Elasticity and Total Revenue • Case 2: • Suppose demand is elastic ( ) and price increases (quantity decreases). TR = TE = p x Q • Small increase in p combined with big decrease in Q TR = TE decreases as the result

7. p For a demand curve that is close to perfectly elastic, it’s obvious that TR=TE rectangle gets smaller when price increases. Elasticity and Total Revenue • Once again, visualizing a demand curve close to the limiting case of perfectly elastic: p2 p1 Q2 Q1 Q

8. Elasticity and Total Revenue • Lets summarize the results in the table:

9. Determinants of the Elasticity of Demand • Availability of Substitutes: • Demand is more elastic: • If close substitutes are easy to find and buyers can cut back on purchases of the good in question • Demand is less elastic • If close substitutes are difficult to find and buyers can not cut back on purchases of the good in question • Narrowness of Market: • More narrowly we define a good, easier it is to find substitutes • More elastic is demand for the good • More broadly we define a good • Harder it is to find substitutes and the less elastic is demand for the good • Different things are assumed constant when we use a narrow definition compared with a broader definition

10. Determinants of the Elasticity of Demand • Necessities vs. Luxuries • The more “necessary” we regard an item, the harder it is to find a substitute • Expect it to be less price elastic • The less “necessary” (luxurious) we regard an item, the easier it is to find a substitute • Expect it to be more price elastic • Time Horizon • Short-run elasticity • Measured a short time after a price change • Long-run elasticity • Measured a year or more after a price change • Usually easier to find substitutes for an item in the long run than in the short run • Therefore, demand tends to be more elastic in the long run than in the short run

11. Determinants of the Elasticity of Demand • Importance in the Buyers Budget • The more of their total budgets that households spend on an item • The more elastic is demand for that item • The less of their total budgets that households spend on an item • The less elastic is demand for that item

12. Other Elasticities in Economics • Elasticity is a general concept. Whenever we have one variable (X) that depends on another variable (Y) we can use elasticity to provide unit-free measure of the degree of responsiveness of X to changes in Y. • Elasticities are always ratios of percentage changes.

13. Income Elasticity of Demand • Percentage change in quantity demanded divided by the percentage change in income • With all other influences on demand—including the price of the good—remaining constant • Interpret this number as percentage increase in quantity demanded for each 1% rise in income

14. Income Elasticity of Demand • Income elasticities vs. price elasticities of demand • Price elasticity of demand • Measures effect of change in price of good • Assumes that other influences on demand, including income, remain unchanged • Income elasticity • Measures effect on demand we would observe if income changed and all other influences on demand—including price of the good—remained the same • Instead of letting price vary and holding income constant, now we are letting income vary and holding price constant

15. Income Elasticity of Demand • Another difference between price and income elasticity of demand • Price elasticity measures sensitivity of demand to price as we move along a demand curve from one point to another • Income elasticity tells us relative shift in demand curve—increase in quantity demanded at a given price • While a price elasticity is virtually always negative income elasticity can be positive or negative

16. Income Elasticity of Demand • Economic necessity • Good with an income elasticity of demand between 0 and 1 • Economic luxury • Good with an income elasticity of demand greater than 1 • An implication follows from these definitions • As income rises, proportion of income spent on economic necessities will fall • While proportion of income spent on economic luxuries will rise • But, it is important to remember that economic necessities and luxuries are categorized by actual consumer behavior • Not by our judgment of a good’s importance to human survival

17. Cross-Price Elasticity of Demand • Cross-price elasticity of demand • Percentage change in quantity demanded of one good caused by a 1% change in price of another good • While all other influences on demand remain unchanged • While the sign of the cross-price elasticity helps us distinguish substitutes and complements among related goods • Its size tells us how closely the two goods are related • A large absolute value for EXZ suggests that the two goods are close substitutes or complements • While a small value suggests a weaker relationship

18. Price Elasticity of Supply • Percentage change in quantity of a good supplied that is caused by a 1% change in the price of the good • With all other influences on supply held constant

19. Price Elasticity of Supply • When do we expect supply to be price elastic, and when do we expect it to be price inelastic? • Ease with which suppliers can find profitable activities that are alternatives to producing the good in question • Supply will tend to be more elastic when suppliers can switch to producing alternate goods more easily • When can we expect suppliers to have easy alternatives? Depends on • Nature of the good itself • Narrowness of the market definition—especially geographic narrowness • Time horizon—longer we wait after a price change, greater the supply response to a price change

20. Price Elasticity of Supply • Extreme cases of supply elasticity • Perfectly inelastic supply curve is a vertical line • Many markets display almost completely inelastic supply curves over very short periods of time • Perfectly elastic supply curve is a horizontal line

21. Excise Tax • A tax on a particular good or service is called an excise tax • Shifts market supply curve upward by amount of tax • For each quantity supplied, the new, higher curve tells us firms’ gross price, and the original, lower curve tells us the net price • Who really pays excise taxes? • Buyers and sellers share in the payment of an excise tax • Called tax shifting • Process that causes some of tax collected from one side of market (sellers) to be paid by other side of market (buyers)

22. Tax and Demand Elasticity • In most cases excise tax will be shared by both buyer and seller • For a given supply curve, the more elastic is demand, the more of an excise tax is paid by sellers • The more inelastic is demand, the more of the tax is paid by buyers

23. Tax Incidence and Supply Elasticity • Although there are extreme cases of supply elasticity, in general the following is true • For a given demand curve, the more elastic is supply, the more of an excise tax is paid by buyers • The more inelastic is supply, the more of the tax is paid by sellers