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Unformatted text preview: Principles of Economics I
Economics 101 Announcements Readings: Chapter 6 Today Chapter 8 Wednesday Discussion Sections this week New assignment available on CTools Quiz What are supply and demand functions good for? Provide quantitative predictions about market outcomes Examples: Predict prices/sales volumes Predict sizes of changes in price/sales volume due to market shocks Example Demand: Supply: Qd = 100 4 P Qs = 20 + 2 P Equilibrium: Qd = Qs 100 4 P = 20 + 2P 6 P = 120 P = 20 Q = 20 Example
P Supply: Q = 20 + 2P Slope = 1/2 25 20 Demand: Q = 100 4P Slope = 1/4 10 20 20 100 Q Comparative Statics
P Supply: Qs = a + bP Q/P = b P1 P P0 Demand: Qd = c dP + eY Q0 Q Q1 Q Comparative Statics Supply: Demand: QS = a + bP Qd = c dP + eY Suppose b, c, d and e > 0 b > 0 Supply is upward sloping d > 0 Demand is downward sloping e > 0 Good is normal If income (Y) increases, then P increases That increase will be large when e is large and when b is small Q increases That increase will be large when e is large and when b is large Taxation
P Supply Pc = Pp + tPc t P0 Pp Q Q1 Q0 Demand Q Taxation With a $t/unit tax imposed Pc rises Pp falls Q falls To know the extent of these changes, we need to know details about the supply and demand functions Specifically, we need information about the relative slopes of the two curves Example: Taxing a good in fixed supply
P Supply Pc = P0 t Pp Demand Q0 Q Example: Taxing a good with infinitely elastic supply
P Pc = P0 + t Pp = P0 Deadweight Loss Supply Q Q1 Demand Q0 Q Example: Taxing a good with perfectly inelastic demand
P Pc = P0 + t t Pp = P0 Supply Demand Q0 Q Example: Taxing a good with infinitely elastic demand
P Supply Pc = P0 t Pp = P0 t Q Q1 Demand Deadweight Loss Q0 Q Tax Incidence Tax incidence: the portion of tax paid by a given set of agents (consumers or producers) The incidence of the tax depends on the relative slopes of the supply and demand curves When demand is less sensitive to price changes than supply, consumers bear more of the tax burden When supply is less sensitive to price changes than demand, producers bear more of the tax burden Taxation
P Supply Pc=Pp+t P0 Pp Q Q1 Deadweight Loss t Demand Q0 Q Deadweight Loss of the Tax Tax distorts output from the efficient level Deadweight loss is the lost social surplus as a consequence of this distortion: DWL = Q * t * (1/2) The size of the DWL depends on Q Q will tend to be smaller when supply or demand is less elastic E.g. when either supply or demand is perfectly inelastic, Q = 0 and there is no DWL Taxation: relatively inelastic S and D functions
P Supply Pc=Pp+t P0 Pp Q Q1 Q0 Deadweight Loss t Demand Q Taxation: relatively elastic S and D functions
P Supply Pc=Pp+t P0 t Pp Q Q1 Q1 Q0 Deadweight Loss Demand Q Which Goods to Tax? If we wish to raise revenue at lowest efficiency cost: Tax goods with relatively inelastic supply curves Tax goods with relatively inelastic demand curves Suppliers pay the taxes Well organized interest groups lobby against these taxes Examples: cigarettes, gas, staple foods Often politically unattractive Comparing Price-Sensitivity of Different Demand Function 1. Flash drives: Qd = 2,000,000 100,000 P Two demand functions: 2. Hard drives: Qd = 3,000 2P Qd measured in Mb; P in $/Mb Qd measured in Tb; P in $/Tb Which is most sensitive to changes in price? Difficulty due to the units in which the slope coefficients are measured A Unit-free Measure of Price Sensitivity If Qd = a + b P b = change in units of Q (quant. demanded) in response to a 1 unit increase in P i.e. b = Q / P Price Elasticity of Demand: %change in Qd in response to a 1% increase in P i.e. = %Q/%P = Q/Q = Q . P P/P P Q Price Elasticity of Demand Note: Price elasticity of demand is always negative As demand curves slope downward We say that demand is Elastic if 1 > > Inelastic if 1 < < 0 Unit elastic if = 1 Example Suppose Budwheezer sells beer in two markets
1. 2. Market 1: 1 = 1.75 Market 2: 2 = 0.8 Raising prices in either market will lead to lost sales Raising prices in market 1 will result in the greater loss in the proportion of sales Revenue = Price * Quantity Suppose we raise price by 1% Quantity falls by % What effect does this have on revenue?
Raising P by 1% increases Rev. by 1% (keeping Q fixed) Decreasing Q by % reduces Rev. by ||% (keeping P fixed) ________________________________________________ Both effects together Rev. increases by (1 ||)% Both effects together i.e. Revenue increases only if demand is inelastic Revenue decreases if demand is elastic In Market 1, = 1.75 < 1 In Market 2, = 0.8 > 1 Demand is elastic raising prices will lower revenue in this market Demand is elastic Demand is inelastic raising prices will increase revenue in this market Demand is inelastic Price Elasticity of Demand If Qd = a + b P = %Q/%P Price Elasticity of Demand: = Q . P P Q = b.P/Q = b P/(a + bP) = (a + bP a)/(a + bP) = 1 a/Q Remember, 0 Q a, so that 0 < < Price Elasticity of Demand
Small % change Elastic portion of the demand curve Elasticity close to 1 < < Elasticity = 1 Inelastic portion of the demand curve Big % change 0 < < 1 Elasticity close to 0 Q Big % change Small % change Price Elasticity of Demand At what point does = 1? = %Q/%P If = 1 a/Q = 1 Then Q = a/2 = Q . P P Q = b.P/Q = b P/(a + bP) = 1 a/Q Price Elasticity of Demand
P a/|b| Elastic portion of the demand curve 1 < < Slope=1/b < 0 a/2|b| = 1 Inelastic portion of the demand curve 0 < < 1 a/2 a Q Elasticity A general concept linking %changes in two variables Examples: Price elasticity of supply: ps = % change in quantity supplied % change in price Elasticity A general concept linking %changes in two variables Examples: Income elasticity of demand: Yd = % change in quantity demanded % change in income > 0: normal good < 0: inferior good Elasticity A general concept linking %changes in two variables Examples: CrossPrice elasticity of demand: zx = % change in quantity of X demanded % change in price of Z If > 0: X and Z are substitutes If < 0: X and Z are complements Elasticity A general concept linking %changes in two variables Examples: Wage elasticity of supply: WS = % change in quantity supplied % change in wages ...
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