Bethel University Elasticity Discussion

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The Complete sections should have a minimum word count (total per week) of 1200 words and three scholarly sources.

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1.(a) List and briefly explain, in your own words, the determinants of the price elasticity of demand.

(b) Choose one of the goods from exhibit 6 on page 163 in your text.  Explain whether or not each of the determinants of elasticity would make demand for that good more elastic.

2.Consider the same good you chose in question #1 and the short-run elasticity given for it in exhibit 6.  Using the relationship between elasticity and revenue, explain whether or not the firm will want to raise its price.

3.(a) Would the short-run elasticity of supply for a football stadium be elastic, inelastic, perfectly elastic, or perfectly inelastic?  Explain.  

(b)  Would it be the same for the long-run elasticity of supply?  Why or why not?

4.(a) What happens to consumer and producer surplus after a rent control is established?  Do they increase or decrease?  Explain.

(b) What happens to total welfare?  Be sure to include the concept of deadweight loss in your explanation.

5.(a) Give an example of a normal good.  (Do not use the examples from the text.)  Will the income elasticity of this good be greater than or less than 1?  Explain.

(b) Give an example of an inferior good.  (Do not use the examples from the text.)  Will the income elasticity of this good be greater than or less than 1?  Explain.





1.(a) List and briefly explain, in your own words, the determinants of the price elasticity of demand. (b) Choose one of the goods from exhibit 6 on page 163 in your text. Explain whether or not each of the determinants of elasticity would make demand for that good more elastic. 2.Consider the same good you chose in question #1 and the short-run elasticity given for it in exhibit 6. Using the relationship between elasticity and revenue, explain whether or not the firm will want to raise its price. 3.(a) Would the short-run elasticity of supply for a football stadium be elastic, inelastic, perfectly elastic, or perfectly inelastic? Explain. (b) Would it be the same for the long-run elasticity of supply? Why or why not? 4.(a) What happens to consumer and producer surplus after a rent control is established? Do they increase or decrease? Explain. (b) What happens to total welfare? Be sure to include the concept of deadweight loss in your explanation. 5.(a) Give an example of a normal good. (Do not use the examples from the text.) Will the income elasticity of this good be greater than or less than 1? Explain. (b) Give an example of an inferior good. (Do not use the examples from the text.) Will the income elasticity of this good be greater than or less than 1? Explain.
6 c h a p t e r Elasticities 6.1 Price Elasticity of Demand 6.2 Total Revenue and the Price Elasticity of Demand 6.3 Other Types of Demand Elasticities 6.4 Price Elasticity of Supply s i x If a rock band increases the price it charges for concert tickets, what impact will that have on ticket sales? More precisely, will ticket sales fall a little or a lot? Will the band make more money by lowering the price or by raising the price? This ­chapter will allow you to answer these types of question and more. Some of the results in this chapter may surprise you. A huge flood in the Midwest that destroyed much of this year’s wheat crop would leave W some wheat farmers better off. Ideal weather that led to a bountiful crop of AP Photo/Joel Ryan I L L I S , K A S S A N D R A 2 1 6 1 T S Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 157 chapter 6  Elasticities wheat everywhere would leave wheat farmers worse off. As you will soon find out, these issues hinge importantly on the tools of elasticity. In this chapter, we will also see the importance of elasticity in determining the effects of taxes. If a tax is levied on the seller, will the seller pay all of the taxes? If the tax were levied on the buyer—who pays the larger share of taxes? We will see that elasticity is critical in the determination of tax burden. Elasticities will also help us to more fully understand many policy issues—from illegal drugs to luxury taxes. For example, Congress were to impose a large tax on yachts, what do you think would happen to yacht sales? What would happen to employment in the boat industry? Price Elasticity of Demand What is price elasticity of demand? What determines the price elasticity of demand? W I L In learning and applying the law of demand, we have established the basic fact that quantity L ceteris paribus. But how much does quandemanded changes inversely with change in price, tity demanded change? The extent to which a change in price affects quantity demanded may I vary considerably from product to product and over the various price ranges for the same S product. The price elasticity of demand measures the responsiveness of quantity demanded to a change in price. Specifically, price elasticity, is defined as the percentage change in quan How do we measure consumers’ responses to price changes? tity demanded divided by the percentage change in price, or Price elasticity of demand (ED) = 6.1 K Percentage change in quantity demanded A Percentage change in price price elasticity of demand the measure of the responsiveness of ­quantity demanded to a change in price S quantity demanded show an inverse relaNote that, following the law of demand, price and tionship. For this reason, the price elasticity of S demand is, in theory, always negative. But in practice and for simplicity, this quantity is always expressed A in absolute value terms—that is, as a positive number. It is important to understand the basic intuition behind elasticities, which requires a focus on the percentage 2 changes in quantity demanded and price. 1 Think of elasticity as an elastic rubber band. If the 6 change in quantity demanded is responsive to even a small price, we call it elastic. On the other hand, if 1even a huge change in price results in only a small change in quantity T demanded, then the demand is said to be inelastic. For example, if a 10 percent increase in the price leads S to a 50 percent reduction in the quantity demanded, we say that demand is elastic because the quantity demanded is sensitive to the price change. ED = %ΔQD %ΔP = 50% 10% =5 © Blue Jean Images/Alamy N D Is the Demand Curve Elastic R or Inelastic? A Think of price elasticity like an elastic rubber band. When small price changes greatly affect, or “stretch,” quantity demanded, the demand is elastic, much like a very stretchy rubber band. When large price changes can’t “stretch” demand, however, then demand is i­nelastic, more like a very stiff rubber band. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 158 PART 2   Supply and Demand Demand is elastic in this case because a 10 percent change in price led to a larger (50 percent) change in quantity demanded. Alternatively, if a 10 percent increase in the price leads to a 1 percent reduction in quantity demanded, we say that demand is inelastic because the quantity demanded did not respond much to the price reduction. ED = %ΔQD %ΔP = 1% 10% = 0.10 Demand is inelastic in this case because a 10 percent change in price led to a smaller (1 percent) change in quantity demanded. Types of Demand Curves inelastic when the percentage change in quantity demanded is less than the percentage change in price (ED < 1) unit elastic demand demand with a price ­ lasticity of 1; the e ­percentage change in ­quantity demanded is equal to the percentage change in price section 6.1 Elastic Demand exhibit 1 a. Elastic Demand (ED > 1) Price ED  P2 P1 %QD 0.20  2 %P 0.10 10%P Demand © Cengage Learning 2013 20% QD 0 Q2 Q1 Quantity A small percentage change in price leads to a larger percentage change in quantity demanded. N D R A 2 1 6 1 T S b. Perfectly Elastic Demand (ED = ∞) P1 Demand Price elastic when the percentage change in quantity demanded is greater than the percentage change in price (ED > 1) Economists refer to a variety of demand curves based on the magnitude of their elasticity. A demand curve, or a portionW of a demand curve, can be elastic, inelastic, or unit elastic. Demand is elastic when the I elasticity is greater than 1 (ED > 1)—the quantity demanded changes proportionally more than the price changes. In this case, a given percentage increase L in price, say 10 percent, leads to a larger percentage change in quantity demanded, say 20 LIf the curve is perfectly elastic, the demand curve is horizonpercent, as seen in Exhibit 1(a). tal. The elasticity coefficient isI infinity because even the slightest change in price will lead to a huge change in quantity demanded—for example, a tiny increase in price will cause the quantity demanded to fall to S zero. In Exhibit 1(b), a perfectly elastic demand curve (horizontal) is illustrated. , Demand is inelastic when the elasticity is less than 1; the quantity demanded changes proportionally less than the price changes. In this case, a given percentage (for example, 10 K percent) change in price is accompanied by a smaller (for example, 5 percent) reduction in quantity demanded, as seen in Exhibit 2(a). If the demand curve is perfectly inelastic, A the quantity demanded is the same regardless of the price. The elasticity coefficient is zero S does not respond to a change in price. This relationship is because the quantity demanded illustrated in Exhibit 2(b). S Goods for which ED equals one (ED = 1) are said to have unit elastic demand. In this case, A the quantity demanded changes proportionately to price changes. For example, a 10 percent 0 Quantity A small percentage change in price will change quantity demanded by an infinite amount. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 159 chapter 6  Elasticities section 6.1 Inelastic Demand a. Inelastic Demand (ED < 1) P2 b. Perfectly Inelastic Demand (ED = 0) Demand %QD 0.05 ED    0.5 0.10 %P 10%∆P P2 P1 Price Price 20%P 0 Q2 Demand Q1 W I A change in price leads to a smaller percentage L change in quantity demanded. L I in quanincrease in price will lead to a 10 percent reduction tity demanded. This relationship is illustrated in SExhibit 3. The price elasticity of demand is closely related to the , 0 Q1  Q2 Quantity Quantity The quantity demanded does not change regardless of the percentage change in price. section 6.1 exhibit 3 slope of the demand curve. Generally speaking, the flatter the demand curve passing through a given point, the more elastic the demand. The steeper the demand curve passing K through a given point, the less elastic the demand. P1 ED  10%P %QD 0.10  1 0.10 %P D Price A S Calculating the Price Elasticity S A of Demand: The Midpoint N Method D To get a clear picture of exactly how the price elasticity of demand is calculated, consider the case for aRhypothetical pizza market. Say the price of pizza increasesAfrom $19 to P2 Unit Elastic Demand 10% QD 0 Q2 Q1 Quantity The percentage change in quantity demanded is the same as the percentage change in price that caused it (ED = 1). $21. If we take an average between the old price, $19, and the new price, $21, we can calculate an average price of $20. Exhibit 4 shows that as a result of the increase 2 in the price of pizza, the quantity demanded has fallen from 82 1 million pizzas to 78 million pizzas per year. If we take an average between the old quantity demand, 82 million, and the new quantity 6 demanded of 80 million pizzas per year. demanded, 78 million, we have an average quantity That is, the $2 increase in the price of pizza has1led to a 4-million pizza reduction in quantity demanded. How can we figure out the price elasticity of demand? T You might ask why we are using the average price and average quantity. The answer is that if we did not use the average amounts, weS would come up with different values for the elasticity of demand depending on whether we moved up or down the demand curve. When the change in price and quantity are of significant magnitude, the exact meaning of the term percentage change requires clarification, and the terms price and quantity must be defined more precisely. The issue thus is, should the percentage change be figured on the basis of price and quantity before or after the change has occurred? For example, a price rise from $10 to $15 constitutes a 50 percent change if the original price ($10) is used in figuring Does it matter whether we move up or down the demand curve when we calculate the price elasticity of demand? Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 © Cengage Learning 2013 5% QD P1 © Flying Colours Ltd/Jupiterimages exhibit 2 160 PART 2   Supply and Demand section 6.1 Price per Pizza the percentage ($5/$10), or a 33 percent change if the price after the change ($15) is used ($5/$15). For small changes, the distinction is not important, but for large changes, it is. To avoid this confusion, economists often use this average technique. Specifically, we are actually calculating the elasticity at a midpoint between the old and new prices and quantities. Now to figure out the price elasticity of demand, we must first calculate the percentage change in price. To find the percentage change in price, we take the change in price (ΔP) and divide it by the average price (Pavg). (Note: The Greek letter delta, Δ, means “change in.”) Calculating the Price Elasticity of Demand exhibit 4 B $21 ED = 0.5 at midpoint between A and B Pavg $20 ∆P = $2 A $19 ∆QD = 4 million Percentage change in price = ΔP/Pavg D © Cengage Learning 2013 0 78 80 Qavg 82 In our pizza example, the original price was $19, and the new W price is $21. The change in price (ΔP) is $2, and the average Quantity of Pizzas I price (Pavg) is $20. The percentage change in price can then (millions per month) be calculated as L The price elasticity of demand is found with the formula L Percentage change in price = $2/$20 = 1/10 = 0.10 = 10% ΔQ /Q I ΔP/P SNext, we must calculate the percentage change in quantity demanded. To find the percentage change in quantity , demanded, we take the change in quantity demanded (ΔQD) and divide it by the average D avg avg quantity demanded (Qavg). Percentage change in quantity demanded = ΔQD/Qavg K A quantity demanded was 82 million, and the new quantity In our pizza example, the original demanded is 78 million. The change S in quantity demanded (∆QD) is 4 million, and the average quantity demanded (Qavg) is 80 million. The percentage change in quantity demanded S can then be calculated as Ain Percentage change quantity demanded N = 4 million/80 million = 1/20 = 0.05 = 5% D demand is equal to the percentage change in quantity Because the price elasticity of demanded divided by the percentage R change in price, the price elasticity of demand for pizzas between point A and point B can be shown as A Percentage change in quantity demanded ED = Percentage change in price 2 1 = 4 million/80 million = $2/$20 ΔP/Pavg 6 1/20 5% = = = 0.5 1 1/10 10% T S Determinants of the ΔQD/Qavg The Price Elasticity of Demand Why are demand curves for goods with close ­substitutes more elastic? As you have learned, the elasticity of demand for a specific good refers to movements along its demand curve as its price changes. A lower price will increase quantity demanded, and a higher price will reduce quantity demanded. But what factors will influence the magnitude of Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 161 chapter 6  Elasticities Keith Brofsky/Getty Images the change in quantity demanded in response to a price change? That is, what will make the demand curve relatively more elastic (where QD is responsive to price changes), and what will make the demand curve relatively less elastic (where QD is less responsive to price changes)? For the most part, the price elasticity of demand depends on three factors: (1) the availability of close substitutes, (2) the proportion of income spent on the good, and (3) the amount of time that has elapsed since the price change. Availability of Close Substitutes A Proportion of Income Spent on theNGood The smaller the proportion of income spent on a good, the lower its D elasticity of demand. If the amount spent on a good relative to income R on one’s budget will is small, then the impact of a change in its price also be small. As a result, consumers will respond A less to price changes for small-ticket items than for similar percentage changes in large-ticket items, where a price change could potentially have a large impact on the consumer’s budget. For example, a 50 percent 2 increase in the price of salt will have a much smaller impact on consumers’ behavior than a similar 1 percentage increase in the price of a new automobile. Similarly, a 50 percent increase in the cost of private university 6 tuition will have a greater impact on students’ (and sometimes parents’) 1 budgets than a 50 percent increase in textbook prices. Time If bus fares increase, will ridership fall a little or a lot? It all depends on the price elasticity of demand. If the price e ­ lasticity of demand is elastic, a 50-cent price increase will lead to a relatively large ­reduction in bus travel as riders find viable substitutes. If the price elasticity of demand is inelastic, a 50-cent price increase will lead to a relatively small reduction in bus ridership as riders are not able to find good a ­ lternatives to bus transportation. Stockbyte/Getty Images Goods with close substitutes tend to have more elastic demands. Why? Because if the price of such a good increases, consumers can easily switch to other now relatively lower-priced substitutes. In many examples, such as one brand of root beer as opposed to another, or different brands of gasoline, the ease of substitution will make demand W quite elastic for most individuals. Goods without close substitutes, such as insulin for diabetics, I or emergency medical cigarettes for chain smokers, heroin for addicts, care for those with appendicitis or broken legs, L tend to have inelastic demands. L The degree of substitutability can also depend on whether the good is I such as food, have no a necessity or a luxury. Goods that are necessities, ready substitutes and thus tend to have lowerS elasticities than do luxury items, such as jewelry. When the good is broadly defined, it tends ,to be less elastic than when it is narrowly defined. For example, the elasticity of demand for food, a broad category, tends to be inelastic over a large price range because few K substitutes are available for food. But for a certain type of food, such as A to find a substitute— pizza, a narrowly defined good, it is much easier perhaps tacos, burgers, salads, burritos, or chiliSfries. That is, the demand for a particular type of food is more elastic because more and better substitutes are available than for food as an entireScategory. Unlike most tangible items (such as ­specific types of food or cars), there are few substitutes for a physician and medical care when you have an emergency. Because the number of available ­substitutes is limited, the demand for emergency medical care is relatively inelastic. T S For many goods, the more time that people have to adapt to a new price change, the greater the elasticity of demand. Immediately after a price change, consumers may be unable to locate good alternatives or easily change their consumption patterns. But as time passes, consumers have more time to find or develop suitable substitutes and to plan and implement changes in their patterns of consumption. For example, drivers may not What impact does time have on elasticity? Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. PART 2   Supply and Demand section 6.1 Price of Gasoline Thinkstock Images/Getty Images exhibit 5 Some studies show that a 10 percent increase in the price of cigarettes will lead to a 7 percent reduction in the quantity demanded of youth smoking. In this price range, however, demand is still inelastic at –0.7. Of course, proponents of higher taxes to discourage underage smoking would like to see a more elastic demand, where a 10 percent increase in the price of cigarettes would lead to a reduction in quantity demanded of more than 10 percent. However, compared to adults, younger people are more likely to smoke fewer cigarettes in response to a price change (a tax increase). The elasticity of demand for ­cigarettes for 24- to 26-year-olds is –0.20 and for 27- to 29-year-olds it is –0.09. Short-Run and Long-Run Demand Curves P2 P1 DLR DSR 0 QLR QSR Q1 Quantity of Gasoline W I L L I S , For many goods, such as gasoline, price is much more elastic in the long run than in the short run because buyers have more time to find suitable substitutes or change their consumption patterns. In the short run, the increase in price from P1 to P2 has only a small effect on the quantity demanded for gasoline. In the long run, the effect of the price increase will be much larger. © Cengage Learning 2013 162 K A S respond immediately to an increase in gas prices, perhaps believing it to be temporary. However, if the price persistsS over a longer period, we would expect people to drive less, buy more fuel-efficient cars, move A closer to work, carpool, take the bus, or even bike to work. So for many goods, especially nondurable goods (goods that do not last a long N is generally less elastic than the long-run demand curve, time), the short-run demand curve as illustrated in Exhibit 5. D R Estimated Price Elasticities of Demand A Because of shifts in supply and demand curves, researchers have a difficult task when trying to estimate empirically the price elasticity of demand for a particular good or service. Despite this difficulty, Exhibit26 presents some estimates for the price elasticity of demand for certain goods. As you would expect, certain goods like medical care, air travel, and 1 gasoline are all relatively price inelastic in the short run because buyers have fewer substi6 in the long run is much more sensitive to price (elastic) tutes. On the other hand, air travel because the available substitutes 1 are much more plentiful. Exhibit 6 shows that the price elasticity of demand for air travel is 2.4, which means that a 1 percent increase in price T will lead to a 2.4 percent reduction in quantity demanded. Notice, in each case where the data are available, the estimates S of the long-run price elasticities of demand are greater than the short-run price elasticities of demand. In short, the price elasticity of demand is greater when the price change persists over a longer time periods. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 163 chapter 6  Elasticities exhibit 6 Price Elasticities of Demand for Selected Goods Good Salt Short Run Long Run — 0.1 Air travel 0.1 2.4 Gasoline 0.2 0.7 Medical care and hospitalization 0.3 0.9 Jewelry and watches 0.4 0.7 Physician services 0.6 — Alcohol 0.9 3.6 Movies 0.9 3.7 China, glassware 1.5 2.6 Automobiles 1.9 2.2 4.0 W SOURCES: Adapted from Robert Archibald and Robert Gillingham, I “An Analysis of the Short-Run Consumer Demand for Gasoline Using Household Survey Data,” Review of Economics and Statistics 62 (November 1980): 622–628; Hendrik S. Houthakker and Lester D. Taylor, Consumer Demand in the United States: Analyses and Projections (Cambridge, L Mass.: Harvard University Press, 1970), pp. 56–149; Richard Voith, “The ­Long-Run Elasticity of Demand for Commuter Rail Transportation,” Journal of Urban Economics 30 (November 1991): 360–372. L I S SECTION QUIZ , Chevrolets — © Cengage Learning 2013 section 5.1 1. Price elasticity of demand is defined as the _____________ change in quantity demanded divided by the _____________ change in price. K A c. marginal; percentage S d. percentage; percentage S e. total; total A Demand is said to be _____________ when the quantity demanded is not very responsive to changes in price. N a. independent D b. inelastic c. unit elastic R d. elastic A a. total; percentage b. percentage; marginal 2. 3. When demand is inelastic, a. price elasticity of demand is less than 1. 2 1 resulting from a price change is less than the percentage c. the percentage change in quantity demanded change in price. 6 d. all of the above are correct. 1 Which of the following will not tend to increase the elasticity of demand for a good? T a. an increase in the availability of close substitutes S to adjust to a change in the price b. an increase in the amount of time people have b. consumers are not very responsive to changes in price. 4. c. an increase in the proportion of income spent on the good d. all of the above will increase the elasticity of demand for a good (continued) Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 164 PART 2   Supply and Demand S E C T I O N Q U I Z (Cont.) 5. Which of the following would tend to have the most elastic demand curve? a. automobiles b. Chevrolet automobiles c. (a) and (b) would be the same d. none of the above 6. Price elasticity of demand is said to be greater a. the shorter the period of time consumers have to adjust to price changes. b. the longer the period of time consumers have to adjust to price changes. c. when there are fewer available substitutes. d. when the elasticity of supply is greater. 7. The long-run demand curve for gasoline is likely to be W I b. more inelastic than the short-run demand curve for gasoline. L c. the same as the short-run demand curve for gasoline. L d. more inelastic than the short-run supply of gasoline. Demand curves for goods tend to become more inelastic I a. when more good substitutes for the good are available. S b. when the good makes up a larger portion of a person’s income. , a. more elastic than the short-run demand curve for gasoline. 8. c. when people have less time to adapt to a given price change. d. when any of the above is true. K A 1. What question is the price elasticity of demand designed S to answer? 2. How is the price elasticity of demand calculated? S 3. What is the difference between a relatively price elastic demand curve and a relatively price inelastic A demand curve? Ndemand and the slope at a given point on a 4. What is the relationship between the price elasticity of demand curve? D 5. What factors tend to make demand curves more price elastic? R 6. Why would a tax on a particular brand of cigarettes be less effective at reducing smoking than a tax on all brands of A cigarettes? e. in none of the above situations. 7. Why is the price elasticity of demand for products at a 24-hour convenience store likely to be lower at 2 a.m. than at 2 p.m.? 2 1 6 1 T S 8. Why is the price elasticity of demand for turkeys likely to be lower, but the price elasticity of demand for turkeys at a particular store at Thanksgiving likely to be greater than at other times of the year? Answers: 1. d 2. b 3. d 4. d 5. b 6. b 7. a Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 8. c 165 chapter 6  Elasticities Total Revenue and the Price Elasticity of Demand What is total revenue? 6.2 Does the price elasticity of demand vary along a linear demand curve? What is the relationship between total ­revenue and the price elasticity of demand? How Does the Price Elasticity of Demand Impact Total Revenue? R A When Demand Is Price Elastic ↓TR = ↑P × ↓Q or $400), or area a + b. If the price falls to $5 at point B, the total revenue is $500 ($5 × 100 × $500), or area b + c. Total revenue increased by $100. We can also see in the graph that total revenue increased, because the area b + c is greater than area a + b, or c > a. 2 ↑TR = ↓P × ↑Q 1 6 relatively inelastic (ED < 1), the total reve­ On the other hand, if demand for a good is nue will be lower at lower prices than at higher 1 prices because a given price reduction will be accompanied by a proportionately smaller increase in quantity demanded. For example, T cut (say from $10 to $5) and the quantity as shown in Exhibit 2, if the price of a good is demanded less than doubles (say it increases from S 30 to 40), then total revenue will fall from $300 ($10 × 30 = $300) to $200 ($5 × 40 = $200). Equivalently, if the price increases from $5 to $10 and the quantity demanded falls from 40 to 30, total revenue will increase from $200 to $300. To summarize, then: If the demand curve is inelastic, total revenue will vary directly with a price change. Can the relationship between price and total revenue tell you whether a good is elastic or inelastic? Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 Price The price elasticity of demand for a good also has implications for total revenue. total revenue (TR) Total revenue (TR) is the amount sellers receiveW for a good or service. Total revenue is simply the amount sellers receive for a good or service, the price of the good (P) times the quantity of the I good sold (Q): TR = P × Q. The elasticity ­calculated as the product of demand will help to predict how changes in the price will impact total revenue earned by price times the quantity sold the producer for selling the good. Let’s see howLthis works. In Exhibit 1, we see that when the demandLis price elassection 6.2 tic (ED > 1), total revenues will rise as the price declines, Elastic Demand and Total I exhibit 1 because the percentage increase in the quantity demanded Revenue S For examis greater than the percentage reduction in price. ple, if the price of a good is cut in half (say, from $10 to $5) and the quantity demanded more than doubles (say from 40 to 100), total revenue will rise from $400 ($10 × A $10 40 = $400) to $500 ($5 × 100 = $500). Equivalently, if K the price rises from $5 to $10 and the quantity demanded A a falls from 100 to 40 units, then total revenue will fall from ($200) B 5 $500 to $400. As this example illustrates, ifSthe demand curve is relatively elastic, total revenue will vary DELASTIC S inversely b c with a price change. ($200) ($300) A to total You can see from the following what happens 0 20 40 60 80 100 revenue when demand is price elastic. (Note: The N size of the Quantity price and quantity arrows represents the size of the percentD age changes.) At point A, total revenue is $400 ($10 × 40 = 166 PART 2   Supply and Demand section 6.2 When Demand Is Price Inelastic Inelastic Demand and Total Revenue exhibit 2 ↑TR = ↑P × ↓Q or ↓TR = A Price $10 In this case, the “net” effect on total revenue is reversed but easy to see. (Again, the size of the price and quantity arrows represents the size of the percentage changes.) a 5 0 ($150) B b c ($150) ($50) 10 20 30 DINELASTIC 40 Quantity Price Elasticity Changes along a Linear Demand Curve As already shown (Section 6.1, Exhibit 1), the slopes of W I demand curves can be used to estimate their relative elasticities of demand: The steeper one demand curve is relative to Lanother, the more inelastic it is relative to the other. However, Lexcept for the extreme cases of perfectly elastic and perfectly inelastic curves, great care must be taken when trying to I estimate the degree of elasticity of one demand curve from Sits slope. In fact, as we will soon see, a straight-line demand curve with a constant slope will change elasticity continuously as you move up or down it. , At point A, total revenue is $300 ($10 × 30 = $300), or area a + b. If the price falls to $5 at point B, the total revenue is $200 ($5 × 40 = $200), or area b + c. Total revenue falls by $100. We can also see in the graph that total revenue decreases, because area a + b is greater than area b + c, or a > c. How is it possible that elasticity changes along a straight lined demand curve when the slope is constant? It is because the slope is the ratio of changes in the two variables (price and quantity) while the elasticity is the ratio of percentage changes in the two variables. We can easily demonstrate Kthat the elasticity of demand varies along a linear demand curve by using what we already know about the interrelationship between price and total A S S Elasticities and what you’ve learned A N D Is a poor wheat harvest bad for all farmers and is a great wheat harvest good for all farmers?R (Hint: Assume that demand for wheat is inelastic—A Total Revenue Q the demand for food is generally inelastic.) A 2 Without a simultaneous reduction in demand,1 a reduction in supply from a poor harvest results in6 higher prices. With that, if demand for the wheat is 1 inelastic over the pertinent portion of the demand curve, the price increase will cause farmers’T total revenues to rise. As shown in Exhibit 3(a),S if demand for the crop is inelastic, an increase in price will cause farmers to lose the revenue indicated by area c. They will, however, experience an increase in revenue equal to area a, resulting in an overall increase in total revenue equal to area Courtesy of ROBERT L. SEXTON © Cengage Learning 2013 ↓P × ↑Q a – c. Clearly, if some farmers lose their entire crop because of, say, bad weather, they will be worse (continued) Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 6  Elasticities what you’ve learned Elasticities and Total Revenue (Cont.) off; but collectively, farmers can profit from events that reduce crop size—and they do, because the demand for most agricultural products is inelastic. Interestingly, if all farmers were hurt equally, say losing one-third of their crop, each farmer would be better off. Of course, consumers would be worse off, because the price of agricultural products would be higher. Alternatively, what if phenomenal weather led to record wheat harvests or a technological advance led to more productive wheat farmers? Either event would increase the supply from S1 to S2 in Exhibit 3(b). TheW increase in supply leads to a decrease in price, from P1 to I P2. Because the demand for wheat is inelastic, the L quantity sold of wheat rises less than proportionately to the fall in the price. That is, inLpercentage terms, the price falls more than the quantity exhibit 3 I S , demanded rises. Each farmer is selling a few more bushels of wheat, but the price of each bushel has fallen even more, so collectively wheat farmers will experience a decline in total revenue despite the good news. The same is also true for the many government programs that attempt to help farmers by reducing production—crop restriction programs. These programs, like droughts or floods, tend to help farmers because the demand for food is relatively inelastic. But it hurts consumers who now have to pay a higher price for less food. Farm technology may be good for consumers because it shifts the supply curve to the right and lowers prices. However it may be bad for some small farmers because it could put them out of business. See Exhibit 3(b). Elasticities and Total Revenue K A S S S A N D R E A Poor Harvest a. Total Revenue and Inelastic Demand: A Reduction In Supply P2 E2 a (gain) P1 S2 E1 P1 a (loss) 1 b 0 S1 1 Price of Wheat Price of Wheat S2 Good Harvest b. Total Revenue and Inelastic Demand: An increase Iin Supply c (loss) P2 Demand b c (gain) E2 Demand 0 Q Q 2 Quantity of Wheat Quantity of Wheat 1 6 1 T revenue. Exhibit 4 shows a linear (constant slope) S demand curve. In Exhibit 4(a), we see Q2 Q1 1 2 that when the price falls on the upper half of the demand curve from P1 to P2, and quantity demanded increases from Q1 to Q2, total revenue increases. That is, the new area of total revenue (area b + c) is larger than the old area of total revenue (area a + b). It is also true that if price increased in this region (from P2 to P1), total revenue would fall, because b + c is greater than a + b. In this region of the demand curve, then, there is a negative relationship between price and total revenue. As we discussed earlier, this is characteristic of an elastic demand curve (ED > 1). Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 section 6.2 167 168 PART 2   Supply and Demand section 6.2 Price Elasticity along a Linear Demand Curve exhibit 4 a. Elastic Range ( ) a P2 ED  1; Unit Elastic b Price Price P1 ↓ P = TR ↑ ED  1; Elastic ↑ P = TR ↓ b. Inelastic Range c P3 © Cengage Learning 2013 Demand 0 Q1 ED  1; Unit Elastic ( ↓ P = ↓ TR ED  1; Inelastic ↑ P = ↑ TR d P4 e f Demand 0 Q2 ) Q Q W Quantity I The slope is constant along a linear demand curve, but the elasticity varies. Moving down along the demand L curve, the elasticity is elastic at higher prices and inelastic at lower prices. It is unit elastic between the ­inelastic and elastic ranges. L I S Exhibit 4(b) illustrates what happens to total revenue on the lower half of the same demand curve. When the price, falls from P3 to P4 and the quantity demanded increases from 3 4 Quantity Is a good wheat harvest always good for all wheat farmers? Q3 to Q4, total revenue actually decreases, because the new area of total revenue (area e + f) is less than the old area of total revenue (area d + e). Likewise, it is clear that an increase K in price from P4 to P3 would increase total revenue. In this case, there is a positive relationA ship between price and total revenue, which, as we discussed, is characteristic of an inelastic demand curve (ED < 1). Together, parts (a) and (b) of Exhibit 4 illustrate that, although the S slope remains constant, the elasticity of a linear demand curve changes along the length of S at higher price ranges to relatively inelastic at lower price the curve—from relatively elastic ranges. A what you’ve learned N D Elasticity Varies R Demand Curve A Q 2 Why do economists emphasize elasticity at 1 the current price? 6 1 Because for most demand (and supply)T curves, the price elasticity varies along the curve. S Thus, for most goods we usually refer to a par- A ticular point or a section of the demand (or supply) curves. In Exhibit 5, we see that the upper half of the straight-line demand curve is elastic and the along a Linear lower half is inelastic. Notice on the lower half of the demand curve, a higher (lower) price increases (decreases) total revenue—that is, in this lower region, demand is inelastic. However, on the top half of the demand curve, a lower (higher) price increases (decreases) total revenue—that is, in this region demand is elastic. For example, when the price increases from $2 to $3, the total revenue increases from $32 to $42—an increase in price increases total revenue, so demand is inelastic in this portion of the demand curve. (continued) Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 169 chapter 6  Elasticities what you’ve learned section 6.2 Elasticity Varies along a Linear Demand Curve exhibit 5 Price ($) Elasticity Varies along a Linear Demand Curve (Cont.) $10 9 8 7 6 5 4 3 Elastic Portion of Demand Curve Unit Elastic Inelastic Portion of Demand Curve 2 1 Total Revenue ($) © Cengage Learning 2013 0 $60 50 40 30 20 10 0 2 4 6 8 10 12 14 16 18 20 $ 18 $ $ $ $ 48 50 48 $ $ 42 42 $ 32 32 $ 18 2 4 6 8 10 12 14 16 18 20 SECTION QUIZ W I L Quantity L I S , K A S S Quantity A N D R A But when the price increases from $8 to $9, the total revenue falls from $32 to $18—an increase in price lowers total revenue, so demand is elastic in this portion of the demand curve. Specifically, when the price is high and the quantity demanded is low, this portion of the demand curve is elastic. Why? It is because a $1 reduction in price is a smaller percentage change when the price is high than when it is low. Similarly, an increase in 2 units of output is a larger percentage change when quantity demanded is lower. So we have a relatively small change in price leading to a proportionately greater change in quantity demanded— that is, demand is elastic on this portion of the demand curve. Of course, the opposite is true when the price is low and the quantity demanded is high. Why? It is because a $1 change in price is a larger percentage change when the price is low and an increase in 2 units of output is a smaller percentage change when the quantity demanded is larger. That is, a relatively larger percentage change in price will lead to a relatively smaller change in quantity demanded—demand is relatively inelastic on this portion of the demand curve. 1. When the local symphony recently raised the ticket price for its summer concerts in the park, the symphony was surprised to see that its total revenue had actually decreased. The reason was that the elasticity of demand for tickets was a. unit elastic. b. unit inelastic. c. inelastic. d. elastic. 2. A straight-line demand curve would 2 1 6 1 T S a. have the same elasticity along its entire length. b. have a higher elasticity of demand near its top than near its bottom. c. have a lower elasticity of demand near its bottom than near its top. d. be relatively inelastic at high prices, but relatively elastic at low prices. (continued) Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 170 PART 2   Supply and Demand S E C T I O N Q U I Z (Cont.) 3. Which of the following is a true statement? a. Total revenue is the price of the good times the quantity sold. b. If demand is price elastic, total revenue will vary inversely with a change in price. c. If demand is price inelastic, total revenue will vary in the same direction as a change in price. d. A linear demand curve is more price elastic at higher price ranges and more price inelastic at lower price ranges, and it is unit elastic at the midpoint. e. All of the above are true statements. 4. If demand was relatively inelastic in the short run, but elastic in the long run, a price increase would _____________ total revenue in the short run and _____________ total revenue in the long run. a. increase; increase b. increase; decrease W d. decrease; decrease I L Why does total revenue vary inversely with price if demand is relatively price elastic? L Why does total revenue vary directly with price if demand is relatively price inelastic? I Why is a linear demand curve more price elastic at higher price ranges and more price inelastic at lower price ­ranges? Show would total revenue from its sales change as its price If demand for some good was perfectly price inelastic, changed? , c decrease; increase 1. 2. 3. 4. 5. Assume that both you and Art, your partner in a picture-framing business, want to increase your firm’s total revenue. You argue that in order to achieve this goal, you should lower your prices; Art, on the other hand, thinks that you should raise your prices. What assumptions are each of you making about your firm’s price elasticity of demand? K A S S A N D R A of demand? What is the cross-price elasticity Answers: 1. d 2. b 3. e 4. b 6.3 Other Types of Demand Elasticities What is the income elasticity of demand? The Cross-Price2Elasticity of Demand 1 cross-price elasticity of demand the measure of the impact that a price change of one good will have on the demand of another good The price of a good is not the only factor that affects the quantity consumers will purchase. 6 good demanded is affected by the price of a related good. Sometimes the quantity of one For example, if the price of potato 1 chips falls, what is the impact, if any, on the demand for soda (a complement)? Or if the price of soda increases, to what degree will the demand for T The cross-price elasticity of demand measures both the iced tea (a substitute) be affected? direction and magnitude of the S impact that a price change for one good will have on the demand for another good. Specifically, the cross-price elasticity of demand is defined as the percentage change in the demand of one good (good A) divided by the percentage change in price of another good (good B), or Cross-price elasticity demand = % ∆ in the demand for Good A % ∆ in the price for Good B Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 171 chapter 6  Elasticities The cross-price elasticity of demand indicates not only the degree of the connection between the two variables but also whether the goods in question are substitutes or complements for one another. Calculating the Cross-Price Elasticity of Demand Let’s calculate the cross-price elasticity of demand between soda and iced tea, where a 10 percent increase in the price of soda results in a 20 percent increase in the demand for iced tea. In this case, the cross-price elasticity of demand would be +2 (+20% ÷ +10% = +2). Consumers responded to the soda price increase by buying less soda (moving along the demand curve for soda) and increasing the demand for iced tea (shifting the demand curve for iced tea). In general, if the cross-price elasticity is positive, we can conclude that the two goods are substitutes because the price of one good and the demand for the other move in the same direction. As another example, let’s calculate the cross-price elasticity of demand between potato chips and soda, where a 10 percent decrease in the price of potato chips results in a 30 perW cent increase in the demand for soda. In this case, the cross-price elasticity of demand is I increases as a result of the price decrease, –3 (+30% ÷ –10% = –3). The demand for chips as consumers then purchase additional soda toLwash down those extra bags of salty chips. Potato chips and soda, then, are complements. In general, if the cross-price elasticity is negaL tive, we can conclude that the two goods are complements because the price of one good and the demand for the other move in opposite directions. I Sodas According to economist Jean-Pierre Dube, Coca-Cola is a good substitute K for Pepsi—the cross-price elasticity is a 0.34. In other words, a 10 percent A to an increase in the increase in the price of a Pepsi 12-pack will lead sales of Coca-Cola 12-packs by 3.4 percent. But Ssix-packs of Coca-Cola and Diet Coke are even a better substitute with a cross-price elasticity of S 1.15; a 10 percent increase in the price of a six-pack of Diet Coke will lead to a 11.5 percent increase in the sales ofA six-packs of Coca-Cola. And a 10 percent increase in the price of a 12-pack of Mountain Dew N will lead to a 7.7 percent increase in the sales of 12-packs of Pepsi. The Income Elasticity D R ofADemand iStockphoto.com/jo unruh Cross-Price Elasticity S , and A 10 percent increase in the price of a s­ ix-pack of Diet Coke will lead to a 11.5 percent increase in the sales of six-packs of Coca-Cola. That is a cross-price elasticity of 1.15. Sometimes it is useful to measure how responsive demand is to a change in income. The income elasticity of demand is a measure of the relationship between a relative change in 2 income and the consequent relative change in demand, ceteris paribus. The income elastic1 degree of the connection between the two ity of demand coefficient not only expresses the variables, but it also indicates whether the good6in question is normal or inferior. Specifically, the income elasticity of demand is defined as the percentage change in the demand divided 1 by the percentage change in income, or T Income elasticity of demand = S income elasticity of demand the percentage change in demand divided by the percentage change in consumer’s income %Δ in demand %Δ in income Calculating the Income Elasticity of Demand Let’s calculate the income elasticity of demand for lobster, where a 10 percent increase in income results in a 15 percent increase in the demand for lobster. In this case, the income elasticity of demand is +1.5 (+15% ÷ +10% = +1.5). Lobster, then, is a normal good Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 172 PART 2   Supply and Demand because an increase in income results in an increase in demand. In general, if the income elasticity is positive, then the good in question is a normal good because income and demand move in the same direction. In comparison, let’s calculate the income elasticity of demand for beans, where a 10 percent increase in income results in a 15 percent decrease in the demand for beans. In this case, the income elasticity of demand is –1.5 (–15% ÷ +10% = –1.5). In this example, then, beans are an inferior good because an increase in income results in a decrease in the demand for beans. If the income elasticity is negative, then the good in question is an inferior good because the change in income and the change in demand move in opposite directions. SECTION QUIZ 1. If the cross-price elasticity of demand between two goods is negative, we know that a. they are substitutes. W I c. they are both inferior goods. L d. they are both normal goods. If the income elasticity of demand for good A is 0.5 and L the income elasticity of demand for good B is 1.5, then a. both A and B are normal goods. I b. both A and B are inferior goods. S c. A is a normal good, but B is an inferior good. , d. A is an inferior good, but B is a normal good. b. they are complements. 2. 3. If good X has a negative cross-price elasticity of demand with good Y and good X also has a negative income elasticity of demand, then K A b. X is a substitute for Y, and X is an inferior good. c. X is a complement for Y, and X is a normal good. S d. X is a complement for Y, and X is an inferior good. S Which of the following statements is true? A a. The cross-price elasticity of demand is the percentage change in the demand of one good divided by the ­percentage N change in the price of another good. b. If the sign on the cross-price elasticity is positive, D the two goods are substitutes; if it is negative, the two goods are complements. R c. The income elasticity of demand is the percentage change in demand divided by the percentage change in consumA er’s income. a. X is a substitute for Y, and X is a normal good. 4. d. If the income elasticity is positive, then the good is a normal good; if it is negative, the good is an inferior good. e. All of the above are true statements. 2 1 1. How does the cross-price elasticity of demand tell you whether two goods are substitutes? Complements? 6 2. How does the income elasticity of demand tell you whether a good is normal? Inferior? 3. If the cross-price elasticity of demand between potato1chips and popcorn was positive and large, would popcorn makers benefit from a tax imposed on potato chips? T 4. As people’s incomes rise, why will they spend an increasing portion of their incomes on goods with income ­elasticities S greater than 1 (DVDs) and a decreasing portion of their incomes on goods with income elasticities less than 1 (food)? 5. If people spent three times as much on restaurant meals and four times as much on DVDs as their incomes ­ doubled, would restaurant meals or DVDs have a greater income elasticity of demand? Answers: 1. a 2. a 3. d 4. e Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 173 chapter 6  Elasticities Price Elasticity of Supply What is the price elasticity of supply? How does time affect the supply elasticity? 6.4 How does the relative elasticity of supply and demand determine the tax burden? What is the Price Elasticity of Supply? According to the law of supply, there is a positive relationship between price and quantity supplied, ceteris paribus. But by how much does quantity supplied change as price changes? It is often helpful to know the degree to which a change in price changes the quantity supplied. The price elasticity of supply measures how responsive the quantity sellers are willing and able to sell is to changes in price. In other words, it measures the relative change in the quantity supplied that results from a change inW price. Specifically, the price elasticity of supply (ES) is defined as the percentage change in the quantity supplied divided by the percentI age change in price, or price elasticity of supply the measure of the ­sensitivity of the quantity supplied to changes in price of a good L ES = L %Δ in price I Calculating the Price Elasticity ofSSupply The price elasticity of supply is calculated in much , the same manner as the price elasticity of %Δ in the quantity supplied demand. Consider, for example, the case in which it is determined that a 10 percent increase in the price of artichokes results in a 25 percent increase in the quantity of artichokes supplied after, say, a few harvest seasons. In thisK case, the price elasticity is +2.5 (+25% ÷ +10% = +2.5). This coefficient indicates that each 1 percent increase in the price of artiA chokes induces a 2.5 percent increase in the quantity of artichokes supplied. S S Types of Supply Curves A price elasticity of supply center on whethAs with the elasticity of demand, the ranges of the er the elasticity coefficient is greater than or less Nthan 1. Goods with a supply elasticity that is greater than 1 (ES > 1) are said to be relatively elastic in supply. With that, a 1 percent change in price will result in a greater than 1D percent change in quantity supplied. In our example, artichokes were elastic in supply because R a 1 percent price increase resulted in a 2.5 percent increase in quantity supplied. An example of an elastic supply curve is shown in A Exhibit 1(a). Goods with a supply elasticity that is less than 1 (ES < 1) are said to be inelastic in supply. In other words, a 1 percent change in the 2 price of these goods will induce a proportionately smaller change in the quantity supplied. An example of an inelastic supply curve is 1 shown in Exhibit 1(b). Finally, two extreme cases of price elasticity 6 of supply are perfectly inelastic supply and perfectly elastic supply. In a condition of perfectly inelastic supply, an increase in price will 1 not change the quantity supplied. In this case the elasticity of supply is zero. For example, in a sports arena in the short run (that is, in aTperiod too brief to adjust the structure), the number of seats available will be almost fixed, S say at 20,000 seats. Additional portable seats might be available, but for the most part, even if a higher price is charged, only 20,000 seats will be available. We say that the elasticity of supply is zero, which describes a perfectly inelastic supply curve. Famous paintings, such as Van Gogh’s Starry Night, provide another example: Only one original exists; therefore, only one can be supplied, regardless of price. An example of this condition is shown in Exhibit 1(c). What does it mean if the supply of elasticity is less than 1? greater than 1? Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 174 PART 2   Supply and Demand Travel Bug/Shutterstock.com At the other extreme is a perfectly elastic supply curve, where the elasticity equals infinity, as shown in Exhibit 1(d). In a condition of perfectly elastic supply, the price does not change at all. It is the same regardless of the quantity supplied, and the elasticity of supply is infinite. Firms would supply as much as the market wants at the market price (P1) or above. However, firms would supply nothing below the market price because they would not be able to cover their costs of production. Most cases fall somewhere between the two extremes of perfectly elastic and perfectly inelastic. Immediately after harvest season is over, the supply of pumpkins is inelastic. That is, even if the price for pumpkins rises, say 10 percent, the amount of pumpkins produced will change hardly at all until the next harvest season. Some pumpkins may be grown in greenhouses (at a much higher price to consumers), but most farmers will wait until the next growing season. section 6.4 How Does Time Affect Supply Elasticities? Time is usually critical in supply elasticities (as well as in demand elasticities), because it is more costly for sellers to bring forth and release products in a shorter period. For example, higher wheat prices may cause farmers W to grow more wheat, but big changes cannot occur until the next growing season. That is, immediately after harvest season, the supply ofI wheat is relatively inelastic, but over a longer time extending The Price Elasticity of Supply exhibit 1 a. Elastic Supply (ES > 1) L L I S , b. Inelastic Supply (ES < 1) Supply Supply P1 ES  %QS 0.20  2 %P 0.10 20%QS 0 Q1 Q2 Quantity A change in price leads to a larger percentage change in quantity supplied. c. Perfectly Inelastic Supply (ES = 0) Supply © Cengage Learning 2013 Price P2 20%P P1 0 Q1 Quantity The quantity supplied does not change regardless of the change in price. P2 Price 10%P K A S S A N D R A 10%P P1 %QS 0.05   0.5 ES  %P 0.10 5% QS 0 Q1 Q2 Quantity A change in price leads to a smaller percentage change in quantity supplied. d. Perfectly Elastic Supply (ES = ∞) 2 1 6 1 T S Price Price P2 Supply P1 0 Quantity Even a small percentage change in price will change quantity supplied by an infinite amount. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 175 chapter 6  Elasticities Short-Run and Long-Run Supply Curves exhibit 2 SSR SLR P2 P1 0 Q1 QSR QLR Quantity Who pays the tax? Someone may be legally required W to send For most goods, supply is more elastic in the the check to the government but that is not necessarily the long run than in the short run. For example, if I party that bears the burden of the tax. the price of a certain good increases, firms have The relative elasticity of supply and demand L deteran incentive to produce more but are constrained mines the distribution of the tax burden for a good. As by the size of their plants. In the long run, they L can increase their capacity and produce more. we will see, if demand is relatively less elastic than supply I of the tax in the relevant tax region, the largest portion is paid by the consumer. However, if demandS is relatively more elastic than supply in the relevant tax region, the largest portion of the tax is paid by the producer. In Exhibit 3(a), the pretax equilibrium ,price is $1.00 and the pretax equilibrium quantity is QBT—the quantity before tax. If the government imposes a $0.50 tax on the seller, the supply curve shifts vertically by the amount of the tax (just as if an input K price rose $0.50). When demand is relatively less elastic thanAsupply in the relevant region, the consumer bears more of the burden of the tax. For example, S in Exhibit 3(a), the demand curve is relatively less elastic than the supply curve. In response to the tax, the consumer pays $1.40 per S the tax increase. The producer, however, unit, $0.40 more than the consumer paid before receives $0.90 per unit, which is $0.10 less than A the producer received before the tax. Why does supply tend to In Exhibit 3(b), demand is relatively more elastic than the supply in the relevant region. be more elastic in the long N Here we see that the greater burden of the same $0.50 tax falls on the producer. That is, run than in the short run? D tax, while the consumer only pays $0.10. the producer is now responsible for $0.40 of the In general, then, the tax burden falls on the side Rof the market that is relatively less elastic. A In 1991, Congress levied a 10 percent luxury tax. The tax 2 with sales applied to the “first retail sale” of luxury goods prices above the following thresholds: automobiles 1 $30,000; boats, $100,000; private planes, $250,000; and furs and jew6 forecasted elry, $10,000. The Congressional Budget Office that the luxury tax would raise about $1.5 billion 1 over five years. However, in 1991, the luxury tax raised less than $30 T million in tax revenues. Why? People stopped buying items S subject to the luxury tax. Let’s focus our attention on the luxury tax on yachts. Congress passed this tax thinking that the demand for yachts was relatively inelastic and that the tax would have only a small impact on the sale of new yachts. However, the people in the market for new boats had plenty of substitutes—used boats, boats from other countries, new houses, vacations, and so on. In short, the demand for new yachts was more elastic Elena Elisseeva/Shutterstock.com Yachts, Taxes, and Elasticities © Cengage Learning 2013 Elasticities and Taxes: Combining Supply and Demand Elasticities section 6.4 Price over the next growing period, the supply curve becomes much more elastic. Thus, supply tends to be more elastic in the long run than in the short run, as shown in Exhibit 2. In the short run, firms can increase output by using their existing facilities to a greater capacity, paying workers to work overtime, and hiring additional workers. However, firms will be able to change output much more in the long run when firms can build new factories or close existing ones. In addition, some firms can enter as others exit. In other words, the quantity supplied will be much more elastic in the long run than in the short run. If the demand for yachts is elastic, will most of a luxury tax on yachts get passed on to producers of yachts? And if so, how will that impact employment in the b ­ oat-building industry? Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 176 PART 2   Supply and Demand exhibit 3 Elasticity and the Burden of Taxation a. Demand Is Relatively Less Elastic Than Supply b. Demand Is Relatively More Elastic Than Supply S  $0.50 tax Tax Paid by Consumer S Tax Paid by Producer $0.50 D 0.60 Price Price $0.50 S $1.10 1.00 $1.40 1.00 0.90 S + $0.50 tax Tax Paid by Consumer Tax Paid by Producer Demand W 0 I Q Q Q Q Quantity L Quantity When demand is less elastic (or more inelastic) thanL supply, the tax burden falls primarily on consumers, as shown in (a). When demand is more elastic than supply, as shown in (b), the tax burden falls primarily on I producers. S , than Congress thought. Remember, when demand is relatively more elastic than supply, most 0 AT BT AT BT © Cengage Learning 2013 section 6.4 of the tax is passed on to the seller—in this case, the boat industry (workers and retailers). And supply was relatively inelastic K because boat factories are not easy to change in the short run. So sellers received a lower price for their boats, and sales fell. In the first year after the tax, yacht retailers reported a A 77 percent drop in sales, and approximately 25,000 workers were laid off. The point is thatS incorrectly predicting elasticities can lead to huge social, political, and economic problems. After intense lobbying by industry groups, Congress repealed S the luxury tax on boats in 1993, and on January 1, 2003, the tax on cars finally expired. what you’ve learned Q A A N Farm PricesD Fall over Last Half-Century R A the S1 P In the last half-century, farm prices experienced 2 a steady decline—roughly 2 percent per year. Why? farmers’ incomes fell considerably. That is, the total revenues (P × Q) that farmers collected at the higher price, P1, was much greater, area 0P1 E1Q1, than the total revenue collected by farmers now when prices are lower, P2, at area 0P2 E2Q2. P1 E1 Price 1 6 The demand for farm products grew more slowly than supply. Productivity advances in agri-1 culture caused large increases in supply. AndT because of the inelastic demand for farm products, S S2 E2 P2 D1 0 Q1 D2 Q2 Quantity Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 177 chapter 6  Elasticities Drugs across the Border R A section 4.4 exhibit 4 Price of Illegal Drugs © Cengage Learning 2013 These possible reactions do not mean we should abandon our efforts against illegal drugs. Illegal drugs can impose huge personal and social costs— billions of dollars of lost productivity and immeasurable personal tragedy. However, solely targeting the supply side can have unintended consequences. Policy makers may get their best results by focusing on a reduction in demand—changing user preferences. For example, if drug education leads to a reduction in the demand for drugs, the demand curve will shift to the left—reducing the price and the quantity of illegal drugs exchanged, as shown in Exhibit 5. The remaining drug users, at Q2, will now pay a lower price, P2. This lower price for drugs will lead to fewer drug-related crimes, ceteris paribus. It is also possible that the elasticity of demand for illegal drugs may be more elastic in the long run than the short run. In the short run, as the price rises, the quantity demanded falls less than proportionately because of the addictive nature of illegal drugs (this relationship is also true for goods such as tobacco and alcohol). However, in the long run, the demand for illegal drugs may be more elastic; that is, the higher price may deter many younger, and poorer, people from experimenting with illegal drugs. section 6.4 exhibit 5 Drug Education Reduces Demand Supply Government Effort to Reduce the Supply of Illegal Drugs S2 PB P1 PS Demand 0 illegal drug prices could lead to even greater corruption in law enforcement and the judicial system. Q2 Q1 Quantity of Illegal Drugs 2 1 6 1 T S S1 P1 P2 D2 0 Q2 D1 Q1 Quantity of Illegal Drugs Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 The United States spends billions of dollars a year to halt the importation of illegal drugs across the border. Although these efforts are clearly targeted at suppliers, who really pays the higher enforcement and evasion costs? The government crackdown has increased the probability of apprehension and conviction for drug smugglers. That increase in risk for suppliers increases their cost of doing business, raising the cost of importing and distributing illegal drugs. This would shift the supply curve for illegal drugs to the left, from S1 to S2, as seen in Exhibit 4. For most drug users—addicts, in particular—the W price of drugs such as cocaine and heroin lies in I the highly inelastic region of the demand curve. Because the demand for drugs is relativelyLinelastic in this region, the seller would be able to shift L most of this cost onto the consumer (think of it as simiI lar to the tax shift just discussed). The buyer now has to pay a much higher price, PB, and S the seller receives a slightly lower price, PS. That is, , enforcement efforts increase the price of illegal drugs, but only a small reduction in quantity demanded results from this price increase. Increased Kenforcement efforts may have unintended consequences A due to the fact that buyers bear the majority of S smugthe burden of this price increase. Tighter gling controls may, in fact, result in higher S levels of burglary, muggings, and white-collar crime, A as more cash-strapped buyers search for alternative ways of funding their increasingly N expensive habit. In addition, with the huge financialDrewards in the drug trade, tougher enforcement and higher Price of Illegal Drugs in the 178 PART 2   Supply and Demand Oil Prices what you’ve learned One reason that small changes in supply (or demand) lead to large changes in oil prices and small changes in quantity is because of the inelasticity of demand (and supply) in the short run. Because bringing the production of oil to market takes a long time, the elasticity of supply is relatively low—supply is inelastic. Few substitutes for oil products (e.g., gasoline) are available in the short run, as seen in Exhibit 6(a). However, in the long run, demand and supply are more elastic. At higher prices, consumers will replace gas guzzlers with more fuel-efficient cars, and non-OPEC oil producers will expand exploration and production. Thus, in the long run, when supply and demand are much more elastic, the same size reduction in supply will have a smaller impact on price, as seen in Exhibit 6(b). section 6.4 S2 Price (dollars per barrel) P2 S1 E2 E1 P1 Demand 0 Q2 Q1 Quantity of Oil (million barrels per day) K A S S A N D R A b. Oil Prices in the Long Run S2 P2 S1 E2 E1 P1 Demand 0 Q2 Q1 Quantity of Oil (million barrels per day) © Cengage Learning 2013 a. Oil Prices in the Short Run W I L L I S , Price (dollars per barrel) exhibit 6 SECTION QUIZ 2 1 a. decrease in quantity supplied. 6 b. decrease in supply. c. increase in quantity supplied. 1 d. increase in supply. T If the demand for gasoline is highly inelastic and the supply is highly elastic, and then a tax is imposed on gasoline, S it will be paid 1. For a given increase in price, the greater the elasticity of supply, the greater the resulting 2. a. largely by the sellers of gasoline. b. largely by the buyers of gasoline. c. equally by the sellers and buyers of gasoline. d. by the government. (continued) Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 6  Elasticities 179 S E C T I O N Q U I Z (Cont.) 3. Which of the following statements is true? a. The price elasticity of supply measures the relative change in the quantity supplied that results from a change in price. b. If the supply price elasticity is greater than 1, it is elastic; if it is less than 1, it is inelastic. c. Supply tends to be more elastic in the long run than in the short run. d. The relative elasticity of supply and demand determines the distribution of the tax burden for a good. e. All of the statements above are true. 4. Which of the following statements is true? a. The price elasticity of supply measures the relative change in the quantity supplied that results from a change in price. b. When supply is relatively elastic, a 10 percent change in price will result in a greater than 10 percent change in quantity supplied. c. Goods with a supply elasticity that is less than 1 are called relatively inelastic in supply. W I L 1. What does it mean to say the elasticity of supply for one good is greater than that for another? L 2. Why does supply tend to be more elastic in the long run than in the short run? I determine who bears the greater burden of a tax? 3. How do the relative elasticities of supply and demand S , d. Who bears the burden of a tax has nothing to do with who actually pays the tax at the time of the purchase. e. All of the statements above are true. Answers: 1. c 2. b 3. e 4. e K A S S Fill in the blanks: A 1. The price elasticity of demand measures the N ­responsiveness of quantity _____________ to a D change in price. 2. The price elasticity of demand is defined as the R ­percentage change in _____________ divided byA the percentage change in _____________. 3. If the price elasticity of demand is elastic, it means the quantity demanded changes by a relatively 2 _____________ amount than the price change. 1 4. If the price elasticity of demand is inelastic, it means 6 the quantity demanded changes by a relatively 1 _____________ amount than the price change. T 5. A demand curve or a portion of a demand curve can be relatively _____________, _____________, Sor ­relatively _____________. 6. For the most part, the price elasticity of demand depends on the availability of _____________, the _____________ spent on the good, and the amount of _____________ people have to adapt to a price change. Interactive Summary 7. The elasticity of demand for a Ford automobile would likely be _____________ elastic than the demand for automobiles, because there are more and better substitutes for a certain type of car than for a car itself. 8. The smaller the proportion of income spent on a good, the _____________ its elasticity of demand. 9. The more time that people have to adapt to a new price change, the _____________ the elasticity of demand. The more time that passes, the more time consumers have to find or develop suitable _____________ and to plan and implement changes in their patterns of consumption. 10. When demand is price elastic, total revenues will _____________ as the price declines because the percentage increase in the _____________ is greater than the percentage reduction in price. 11. When demand is price inelastic, total revenues will _____________ as the price declines because the percentage increase in the _____________ is less than the percentage reduction in price. 12. When the price falls on the _____________ half of a straight-line demand curve, demand is relatively Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 180 PART 2   Supply and Demand _____________. When the price falls on the lower half of a straight-line demand curve, demand is ­relatively _____________. 13. The cross-price elasticity of demand is defined as the percentage change in the _____________ _____________ of good A divided by the percentage change in _____________ of good B. 14. The income elasticity of demand is defined as the percentage change in the _____________ by the ­percentage change in _____________. 15. The price elasticity of supply measures the sensitivity of the quantity _____________ to changes in the price of the good. 17. Goods with a supply elasticity that is greater than 1 are called relatively _____________ in supply. 18. When supply is inelastic, a 1 percent change in the price of a good will induce a _____________ 1 ­percent change in the quantity supplied. 19. Time is usually critical in supply elasticities because it is _____________ costly for sellers to bring forth and release products in a shorter period of time. 20. The relative _____________ determines the distribution of the tax burden for a good. 21. If demand is relatively _____________ elastic than supply in the relevant region, the largest portion of a tax is paid by the producer. 16. The price elasticity of supply is defined as the percentage change in the _____________ divided byW the percentage change in _____________. I L L I S , Answers: 1. demanded 2. quantity demanded; price 3. larger 4. smaller 5. elastic; unit elastic; inelastic 6. close substitutes; ­proportion of income; time 7. more 8. lower 9. greater; substitutes 10. rise; quantity demanded 11. fall; quantity demanded 12. upper; ­elastic; inelastic 13. demand; price 14. demand; income 15. supplied 16. quantity supplied; price 17. elastic 18. less than 19. more 20. elasticity of supply and demand 21. more Key Terms and Concepts price elasticity of demand 157 elastic 158 inelastic 158 Section Quiz Answers 6.1 K unit elastic demand 158 A (TR) 165 total revenue cross-priceSelasticity of demand 170  rice Elasticity of P Demand S A N D R A 1. What question is the price elasticity of demand designed to answer? 2 The price elasticity of demand is designed to answer the question: How responsive is quantity demanded 1 to changes in the price of a good? 6 2. How is the price elasticity of demand 1 calculated? The price elasticity of demand is calculated as the T percentage change in quantity demanded, divided by S the percentage change in the price that caused the change in quantity demanded. 3. What is the difference between a relatively price elastic demand curve and a relatively price inelastic demand curve? Quantity demanded changes relatively more than price along a relatively price elastic segment of a income elasticity of demand 171 price elasticity of supply 173 demand curve, while quantity demanded changes relatively less than price along a relatively price inelastic segment of a demand curve. 4. What is the relationship between the price elasticity of demand and the slope at a given point on a demand curve? At a given point on a demand curve, the flatter the demand curve, the more quantity demanded changes for a given change in price, so the greater is the elasticity of demand. 5. What factors tend to make demand curves more price elastic? Demand curves tend to become more elastic, the larger the number of close substitutes available for the good, the larger proportion of income spent on the good, and the greater the amount of time that buyers have to respond to a change in the good’s price. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 6  Elasticities 6. Why would a tax on a particular brand of cigarettes be less effective at ­reducing smoking than a tax on all brands of cigarettes? A tax on one brand of cigarettes would allow smokers to avoid the tax by switching brands rather than by smoking less, but a tax on all brands would raise the cost of smoking any cigarettes. A tax on all brands of cigarettes would therefore be more effective in reducing smoking. 7. Why is the price elasticity of demand for products at a 24-hour convenience store likely to be lower at 2 a.m. than at 2 p.m.? Fewer alternative stores are open at 2 a.m. than at 2 p.m., and with fewer good substitutes, the price elasticity of demand for products at 24-hour ­convenience stores is greater at 2 p.m. W 8. Why is the price elasticity of demand forI turkeys likely to be lower, but the price elasL ticity of demand for turkeys at a particular L store at Thanksgiving likely to be greater than at other times of the year? I For many people, far fewer good substitutes are S acceptable for turkey at Thanksgiving than at other times, so that the demand for turkeys is more inelas, tic at Thanksgiving. But grocery stores looking to attract customers for their entire large Thanksgiving shopping trip also often offer and heavily advertise K turkeys at far better prices than normally. This A means shoppers have available more good substitutes and a more price elastic demand curve forSbuying a turkey at a particular store than usual. S 6.2 Total Revenue and the A N Price Elasticity of Demand D 1. Why does total revenue vary inversely with price if demand is relatively price elastic? R Total revenue varies inversely with price if demand is A relatively price elastic, because the quantity demanded (which equals the quantity sold) changes relatively more than price along a relatively elastic demand 2 curve. Therefore, total revenue, which equals price times quantity demanded (sold) at that price, will 1 change in the same direction as quantity demanded 6 and in the opposite direction from the change in price. 1 2. Why does total revenue vary directly with T price, if demand is relatively price inelastic? Total revenue varies in the same direction as price, S if demand is relatively price inelastic, because the quantity demanded (which equals the quantity sold) changes relatively less than price along a relatively inelastic demand curve. Therefore, total revenue, which equals price times quantity demanded (and sold) at that price, will change in the same direc- tion as price and in the opposite direction from the change in quantity demanded. 3. Why is a linear demand curve more price elastic at higher price ranges and more price inelastic at lower price ranges? Along the upper half of a linear (constant slope) demand curve, total revenue increases as the price falls, indicating that demand is relatively price elastic. Along the lower half of a linear (constant slope) demand curve, total revenue decreases as the price falls, indicating that demand is relatively price inelastic. 4. If demand for some good was perfectly price inelastic, how would total revenue from its sales change as its price changed? A perfectly price inelastic demand curve would be one where the quantity sold did not vary with the price. In such an (imaginary) case, total revenue would increase proportionately with price—a 10 percent increase in price with the same quantity sold would result in a 10 percent increase in total revenue. 5. Assume that both you and Art, your partner in a picture-framing business, want to increase your firm’s total revenue. You argue that in order to achieve this goal, you should lower your prices; Art, on the other hand, thinks that you should raise your prices. What assumptions are each of you making about your firm’s price elasticity of demand? You are assuming that a lower price will increase total revenue, which implies you think the demand for your picture frames is relatively price elastic. Art is assuming that an increase in your price will increase your total revenue, which implies he thinks the demand for your picture frames is relatively price inelastic. 6.3 Other Types of Demand Elasticities 1. How does the cross-price elasticity of demand tell you whether two goods are substitutes? Complements? Two goods are substitutes when an increase (decrease) in the price of one good causes an increase (decrease) in the demand for another good. Substitutes have a positive cross-price elasticity. Two goods are complements when an increase (decrease) in the price of one good decreases (increases) the demand for another food. Complements have a negative cross-price elasticity. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 181 182 PART 2   Supply and Demand 2. How does the income elasticity of demand tell you whether a good is normal? Inferior? If demand for a good increases (decreases) when income rises (falls), it is a normal good and has a positive income elasticity. If demand for a good decreases (increases) when income rises (falls), it is an inferior good and has a negative income ­elasticity. 3. If the cross-price elasticity of demand between potato chips and popcorn was positive and large, would popcorn makers benefit from a tax imposed on potato chips? A large positive cross-price elasticity of demand between potato chips and popcorn indicates that they are close substitutes. A tax on potato chips, which would raise the price of potato chips as a result,W would also substantially increase the demand for I popcorn, increasing the price of popcorn and the quantity of popcorn sold, increasing the profits L of popcorn makers. L 4. As people’s incomes rise, why will they I spend an increasing portion of their incomes on goods with income elasticities greaterS than 1 (DVDs) and a decreasing portion,of their incomes on goods with income elasticities less than 1 (food)? An income elasticity of 1 would mean people K spent the same fraction or share of their income on a particular good as their incomes increase.A An income elasticity greater than 1 would mean S people spent an increasing fraction or share of S their income on a particular good as their incomes increase, and an income elasticity less than 1 A would mean people spent a decreasing fraction or N share of their income on a particular good as their D incomes increase. 5. If people spent three times as much on restaurant meals and four times as much on DVDs as their incomes doubled, would restaurant meals or DVDs have a greater income elasticity of demand? DVDs would have a higher income elasticity of demand (4) in this case than restaurant meals (3). 6.4 Price Elasticity of Supply 1. What does it mean to say the elasticity of supply for one good is greater than that for another? For the elasticity of supply for one good to be greater than for another, the percentage increase in quantity supplied that results from a given percentage change in price will be greater for the first good than for the second. 2. Why does supply tend to be more elastic in the long run than in the short run? Just as the cost of buyers changing their behavior is lower the longer they have to adapt, which leads to long-run demand curves being more elastic than short-run demand curves, the same is true of suppliers. The cost of producers changing their behavior is lower the longer they have to adapt, which leads to long-run supply curves being more elastic than short-run supply curves. 3. How do the relative elasticities of supply and demand determine who bears the greater burden of a tax? When demand is more elastic than supply, the tax burden falls mainly on producers; when supply is more elastic than demand, the tax burden falls mainly on consumers. R A Problems 2 1 you think has a relatively more price elastic demand and identify 1. In each of the following cases, indicate which good the most likely reason, in terms of the determinants 6 of the elasticity of demand (more substitutes, greater share of budget, or more time to adjust). 1 a. cars or Chevrolets b. salt or housing T c. going to a New York Mets game or a Cleveland Indians game S d. natural gas this month or over the course of a year 2. How might your elasticity of demand for copying and binding services vary if your work presentation is next week versus in two hours? 3. The San Francisco Giants want to boost revenues from ticket sales next season. You are hired as an economic consultant and asked to advise the Giants whether to raise or lower ticket prices next year. If the elasticity of demand for Giants game tickets is estimated to be −1.6, what would you advise? If the elasticity of demand equals −0.4? Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 6  Elasticities 183 4. For each of the following pairs, identify which one is likely to exhibit more elastic demand. a. shampoo; Paul Mitchell Shampoo b. air travel prompted by an illness in the family; vacation air travel c. paper clips; an apartment rental d. prescription heart medication; generic aspirin 5. Using the midpoint formula for calculating the elasticity of demand, if the price of a good fell from $42 to $38, what would be the elasticity of demand if the quantity demanded changed from: a. 19 to 21? b. 27 to 33? c. 195 to 205? 6. Explain why using the midpoint formula for calculating the elasticity of demand gives the same result whether price increases or decreases, but using the initial price and quantity instead of the average does not. 7. Why is a more narrowly defined good (pizza) likely to have a greater elasticity of demand than a more broadly defined good (food)? 8. If the elasticity of demand for hamburgers equals W−1.5 and the quantity demanded equals 40,000, predict what will happen to the quantity demanded of hamburgers when the price increases by 10 percent. If the price falls by 5 percent, what I will happen? L 9. Evaluate the following statement: “Along a downward-sloping linear demand curve, the slope and therefore the elasticity of demand are both ‘constant.’” L 10. If the midpoint on a straight-line demand curve Iis at a price of $7, what can we say about the elasticity of demand for a price change from $12 to $10? What about from $6 to $4? S , 11. Assume the following weekly demand schedule for Sunshine DVD Rentals in Cloverdale. Price per DVD $5 a. b. c. 4 K A 2 S 1 S A 0 50 100 150 200 250 N Quantity of DVD (per week) D When Sunshine DVD Rentals lowers its rental price from $4 to $3, what happens to its total revenue? R demand for Sunshine DVD Rentals in Cloverdale elastic or inelastic? Between a price of $4 and a price of $3, is the Between a price of $2 and a price of $1, is the A demand for Sunshine DVD Rentals in Cloverdale elastic or inelastic? 3 12. The Cowtown Hotel is the only first-class hotel in Fort Worth, Texas. The hotel owners hired economics advisors for advice about improving the hotel’s profitability. They suggested the hotel could increase this year’s revenue by raising prices. The 2 owners asked, “Won’t raising prices reduce the quantity of hotel rooms demanded and increase vacancies?” What do you think the advisors replied? Why would they suggest increasing prices? 1 13. A movie production company faces a linear demand curve for its film, and it seeks to maximize total revenue from the 6 film’s distribution. At what level should the price be set? Where is demand elastic, inelastic, or unit elastic? Explain. 1 14. Isabella always spends $50 on red roses each month and simply adjusts the quantity she purchases as the price changes. T for roses? What can you say about Isabella’s elasticity of demand 15. If taxi fares in a city rise, what will happen to the Stotal revenue received by taxi operators? If the fares charged for subway rides, a substitute for taxi rides, do not change, what will happen to the total revenue earned by the subway as a result? 16. Mayor George Henry has a problem. He doesn’t want to anger voters by taxing them because he wants to be reelected, but the town of Gapville needs more revenue for its schools. He has a choice between taxing tickets to professional basketball games or taxing food. If the demand for food is relatively inelastic while the supply is relatively elastic, and if the demand for professional basketball games is relatively elastic while the supply is relatively inelastic, in which case would the tax burden fall primarily on consumers? In which case would the tax burden fall primarily on producers? Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 184 PART 2   Supply and Demand 17. Indicate whether a pair of products are substitutes, complements, or neither based on the following estimates for the cross-price elasticity of demand: a. 0.5. b. –0.5. 18. Using the midpoint formula for calculating the elasticity of supply, if the price of a good rose from $95 to $105, what would be the elasticity of supply if the quantity supplied changed from: a. 38 to 42? b. 78 to 82? c. 54 to 66? 19. Why is an increase in price more likely to decrease the total revenue of a seller in the long run than in the short run? 20. If both supply curves and demand curves are more elastic in the long run than in the short run, how does the incidence of a tax change from the short run to the long run as a result? What happens to the revenue raised from a given tax over time, ceteris paribus? 21. Assume you had the following observations on U.S. intercity rail travel: Between 1990 and 1993 rail travel increased from 17.5 passenger miles per person to 19 passenger W miles per person. At the same time, neither per-mile railroad price or incomes changed but the per-mile price of intercity airline travel increased by 7.5 percent. Between 1995 and I 1998 per capita incomes rose by approximately 13 percent while the price of travel by rail and plane stayed constant. Intercity rail travel was 20 passenger miles per person L in 1995 and 19.5 in 1998. Assuming the demand for travel didn’t change between these periods, L a. calculate the income elasticity of demand for intercity rail travel. I for intercity rail travel. b. calculate the cross-price elasticity of demand c. Indicate whether air travel and rail travel are substitutes or complements. Is intercity rail travel a normal or an S inferior good? , K A S S A N D R A 2 1 6 1 T S Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 7 c h a p t e r s e v e n Market Efficiency and Welfare 7.1 Consumer Surplus and Producer Surplus 7.2 The Welfare Effects of Taxes, Subsidies, and Price Controls Fedorov Oleksiy/Shutterstock.com We can use the tools of consumer and producer surplus to study the welfare effects of government policy—rent ­controls, taxes, and agricultural support prices. To economists, welfare does not mean a government payment to the poor; rather, it is a way that we measure the impact of a policy on a particular group, such as consumers or producers. By calculating the changes in producer and consumer surplus that result from government intervention, we can measure the impact of such policies on buyers and sellers. For example, economists and policy makers may want ­ enefit or be harmed to know how much a consumer or producer might b by a tax or subsidy that alters the equilibrium price and quantity of a good or service. Take W the the price support programs for farmers. The intent is to help poor farmers, not to hurt consumers and taxpayers. However, most I L L I S , K A S S A N D R A 2 1 6 1 T S Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 187 chapter 7  Market Efficiency and Welfare of the farm subsidies go to large corporations, not poor farmers. Between 2002 and 2009, U.S. farmers received an average of $16.4 billion of direct government subsidies per year. In earlier chapters, we saw how the market forces of supply and demand allocate society’s scarce resources. However, we did not discuss whether this outcome was desirable or to whom. Are the price and output that result from the equilibrium of supply and demand right from society’s standpoint? Using the tools of consumer and producer surplus, we can demonstrate the efficiency of a competitive market. In other words, we can show that the equilibrium price and quantity in a competitive market maximize the economic welfare of consumers and producers. Maximizing total surplus (the sum of consumer and producer surplus) leads to an efficient allocation of resources. Efficiency makes the size of the economic pie as large as possible. How we distribute that economic pie (equity) is the subject of future chapters. Efficiency can be measured on objective, positive grounds while equity involves normative analysis. Wtool for measuring consumer and producer Let’s begin by presenting the most widely used welfare. I L L I S , Consumer Surplus and Producer Surplus What is consumer surplus? What is producer surplus? 7.1 How do we measure the total gains from trade? Consumer Surplus to pay more than the market price for an anti-venom shot if you had been bitten by a rattlesnake? Consumer surplus is the 2 is willing monetary difference between the amount a consumer and able to pay for an additional unit of a good 1 and what the consumer actually pays—the market price. Consumer surplus 6 for the whole market is the sum of all the individual consumer 1 the good. surpluses for those consumers who have purchased Courtesy of Robert L. Sexton K In a competitive market, consumers and producers A buy and sell at the market equilibrium price. However, some consumS ers will be willing and able to pay more for the good than they have to. But they would never knowingly S buy something that is worth less to them. That is, what a consumer actually A pays for a unit of a good is usually less than the amount she is willing to pay. For example, would you beN willing to pay more than the market price for a rope ladder D to get out of a burning building? Would you be willing to pay more than the R market price for a tank of gasoline if you had run out of gas on a desolate highway in the desert? Would A you be willing Imagine it is 115 degrees in the shade. Do you think you would get more consumer surplus from your first glass of iced tea than you would from a fifth glass? T S Marginal Willingness to Pay Falls as More Is Consumed Suppose it is a hot day and iced tea is going for $1 per glass, but Julie is willing to pay $4 for the first glass (point a), $2 for the second glass (point b), and $0.50 for the third glass (point c), reflecting the law of demand. How much consumer surplus will Julie receive? First, consumer surplus the difference between the price a consumer is willing and able to pay for an additional unit of a good and the price the consumer actually pays; for the whole market, it is the sum of all the individual consumer surpluses Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 188 PART 3  Market Efficiency, Market Failure, and the Public System © Flying Colours Ltd/Jupiterimages it is important to note the general fact that if the consumer is a buyer of several units of a good, the earlier units will have greater marginal value and therefore create more consumer surplus, because marginal willingness to pay falls as greater quantities are consumed in any period. In fact, you can think of the demand curve as a marginal benefit curve—the additional benefit derived from consuming one more unit. Notice in Exhibit 1 that Julie’s demand curve for iced tea has a step-like shape. This is demonstrated by Julie’s willingness to pay $4 and $2 successively for the first two glasses of iced tea. Thus, Julie will receive $3 of consumer surplus for the first glass ($4 – $1) and $1 of consumer surplus for the second glass ($2 – $1), for a total consumer surplus of $4, as seen in Exhibit 1. Julie will not be willing to purchase the third glass, because her willingness to pay is less than its price ($0.50 versus $1.00). In Exhibit 2, we can easily measure the consumer surplus in the market by using a market demand curve rather than an individual demand curve. In short, the market consumer surplus is the area under the market demand curve and above the market price (the shaded area in Exhibit 2). The market for chocolate contains millions of potential buyers, so we will get a smooth demand curve. That is, each of the million of potential buyers has their own willingness to pay. Because Wthe demand curve represents the marginal benefits consumers receive from consuming an additional unit, we can conclude that all buyers of chocolate I receive at least some consumer surplus in the market because the marginal benefit is greater L area in Exhibit 2. than the market price—the shaded What happens to marginal willingness to pay as greater quantities are consumed in a given period? L I Price Changes and Changes S Consumer Surplus , Imagine that the price of your favorite beverage fell because of an increase in supply. Wouldn’t you feel better off? An increase in supply and a lower price will increase your consumer surplus for each unit K you were already consuming and will also increase your consumer surplus from additional purchases at the lower price. Conversely, a decrease in A supply and increase in price will lower your consumer surplus. Exhibit 3 shows the gainSin consumer surplus associated with, say, a technological advance that shifts the supplyScurve to the right. As a result, equilibrium price falls (from Price of Iced Tea (per glass) exhibit 1 Maximum price willing to pay for 1st glass 3 $3 b 2 Maximum price willing to pay for 2nd glass $1 Market Price 1 c 0.50 0 © Cengage Learning 2013 a $4 Maximum price willing to pay for 3rd glass DIced Tea 1 2 3 Quantity of Iced Tea (glasses per day) Julie receives $3 of consumer surplus for the first glass of iced tea and $1 of consumer surplus for the second glass. Her total consumer surplus is $4. 2 1 6 1 T S section 7.1 exhibit 2 Consumer Surplus for Chocolate: A Smooth-Shaped Demand Curve Consumer surplus in the market Market Price P1 Marginal willingness to pay for last unit 0 Market Demand Q1 Quantity of Chocolate (billions of pounds per year) The area below the market demand curve but above the market price is called consumer surplus. It is represented by the shaded area. The market demand curve is smooth because many buyers ­purchase chocolate each year. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 Julie’s Consumer Surplus for Iced Tea A N D R A Price What happens to ­consumer surplus if there is a decrease in supply? section 7.1 in 189 chapter 7  Market Efficiency and Welfare section 7.1 exhibit 3 Impact of an Increase in Supply on Consumer Surplus A Q1 can now be purchased at a lower price. S1 Producer Surplus P1 P2 0 S2 B C D A lower price makes it advantageous for buyers to expand their purchases. Market Demand Q1 Q2 Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 Price As we have just seen, the difference between what a consumer Quantity W of a good would be willing and able to pay for a given quantity As a result of the increase in supply, the price and what a consumer actually has to pay is called falls from P1 to P2. The initial consumer surplus at I consumer P1 is the area P1AB. The increase in the consumer surplus. The parallel concept for producers is called producer L what a pro­surplus from the fall in price is from P1 to P2. surplus. Producer surplus is the difference between ducer is paid for a good and the cost of producing one unit of L that good. Producers would never knowingly sell a good that is worth more to them than the producer surplus I difference between what asking price. Imagine selling coffee for half of what it cost to produce—you won’t be in business the a producer is paid for a good very long with that pricing strategy. The supply S curve shows the minimum amount that sellers and the cost of producing that must receive to be willing to supply any given quantity; that is, the supply curve reflects the mar- unit of the good; for the mar, ket, it is the sum of all the ginal cost to sellers. The marginal cost is the cost of producing one more unit of a good. In other individual sellers’ producer words, the supply curve is the marginal cost curve, just like the demand curve is the marginal surpluses—the area above the market ­supply curve and benefit curve. Because some units can be produced K at a cost that is lower than the market price, below the market price the seller receives a surplus, or a net benefit, from producing those units. For each unit ­produced, A the producer surplus is the difference between the market price and the marginal cost of produc- marginal cost cost of producing one S price is $4.50. Say the firm’s marginal cost the ing that unit. For example, in Exhibit 4, the market more unit of a good is $2 for the first unit, $3 for the second unit, $4 S for the third section 7.1 unit, and $5 for the fourth unit. Because producer surplus for a A Firm’s Producer Surplus Aprice and the exhibit 4 particular unit is the difference between the market seller’s cost of producing that unit, producer surplus N would be as Supply follows: The first unit would yield $2.50; the second unit would D yield $1.50; the third unit would yield $.50; and the fourth unit R the market would add nothing to producer surplus, because $5 price is less than the seller’s cost. Market A = $4.50 Price When there are a lot of producers, the supply curve is PS1= $2.50 PS2= $1.50 PS3= $.50 4 more or less smooth, like in Exhibit 5. Total producer surplus for the market is obtained by summing all2the producer surpluses of all the sellers—the area above the market supply 3 1 curve and below the market price up to the quantity actually 6 surplus is produced—the shaded area in Exhibit 5. Producer 2 a measurement of how much sellers gain from1trading in the MC1 = $2 MC2 = $3 MC3 = $4 MC4 = $5 market. Producer surplus represent the benefits that lower 1 costs producers receive by selling at the marketTprice. Suppose an increase in market demand causes S the market price to rise, say from P1 to P2; the seller now receives a 0 2 3 4 1 ­higher price per unit, so additional producer surplus is generQuantity (per week) ated. In Exhibit 6, we see the additions to producer surplus. The firm’s supply curve looks like a staircase. Part of the added surplus (area P2DBP1) is due to a higher The marginal cost is under the stair and the price for the quantity already being produced (up to Q1) producer surplus is above the red stair and and part (area DCB) is due to the expansion of output made below the market price for each unit. profitable by the higher price (from Q1 to Q2). © Cengage Learning 2013 Price P1 to P2) and quantity rises (from Q1 to Q2). Consumer surplus then increases from area P1AB to area P2AC, or a gain in consumer surplus of P1BCP2. The increase in consumer surplus has two parts. First, there is an increase in consumer surplus, because Q1 can now be purchased at a lower price; this amount of additional consumer surplus is illustrated by area P1BDP2 in Exhibit 3. Second, the lower price makes it advantageous for buyers to expand their purchases from Q1 to Q2. The net benefit to buyers from expanding their consumption from Q1 to Q2 is illustrated by area BCD. 190 PART 3  Market Efficiency, Market Failure, and the Public System section 7.1 section 7.1 Market Producer Surplus exhibit 5 exhibit 6 $5 A higher price for quantity already being produced Market Price Producer Surplus D P2 Price Price Market Supply Impact of an Increase in Demand on Producer Surplus P1 Market Supply C Expansion of output from Q1 to Q2 made profitable because of higher price B 0 50,000 Quantity per Week The market producer surplus is the shaded area above the supply curve and below the market price up to the quantity produced, 50,000 units. section 7.1 Consumer and Producer Surplus exhibit 7 MB > MC Output too low $8 7 Price 6 5 CS CS CS 2 E PS PS PS D B Market Demand = MB 1 0 1 2 Market Supply = MC C A 4 3 MC > MB Output too high 3 4 5 © Cengage Learning 2013 Quantity (millions of units/year) (MC > MB) Increasing output beyond the competitive equilibrium output, 4 million units, decreases welfare, because the cost of producing this extra output exceeds the value the buyer places on it (MC > MB)—producing 5 million units rather than 4 million units leads to a deadweight loss of area ECD. Reducing output below the competitive equilibrium output level, 4 ­million units, reduces total welfare, because the buyer values the extra output by more than it costs to produce that output—producing 3 million units rather than 4 million units leads to a deadweight loss of area EAB, MB > MC, only at equillibrium, E, is MB = MC. W I L L I S , D1 A 0 Q1 Q2 Quantity A higher market price due to an increase in market demand will increase total producer surplus. The initial producer surplus at P1 is the area ABP1. The increase in producer ­surplus from the higher price is area P2CBP1. Market Efficiency and Producer Kand Consumer Surplus A With the tools of consumer and producer surplus, we can Sbetter analyze the total gains from exchange. The demand Scurve represents a collection of maximum prices that conare willing and able to pay for additional quantities Asumers of a good or service. It also shows the marginal benefits Nderived by consumers. The supply curve represents a collecDtion of minimum prices that suppliers require to be willing and able to supply each additional unit of a good or service. RIt also shows the marginal cost of production. Both are Ashown in Exhibit 7. For example, for the first unit of output, the buyer is willing to pay up to $7, while the seller would have to receive at least $1 to produce that unit. However, the 2equilibrium price is $4, as indicated by the intersection of the 1supply and demand curves. It is clear that the two would gain from getting together and trading that unit, because the con6sumer would receive $3 of consumer surplus ($7 – $4), and 1the producer would receive $3 of producer surplus ($4 – $1). would also benefit from trading the second and third TBoth units of output—in fact, both would benefit from trading Severy unit up to the market equilibrium output. That is, the buyer purchases the good, except for the very last unit, for less than the maximum amount she would have been willing to pay; the seller receives for the good, except for the last unit, more than the minimum amount for which he would have been willing to supply the good. Once the equilibrium output is reached at the equilibrium price, all the mutually Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 © Cengage Learning 2013 D2 191 chapter 7  Market Efficiency and Welfare beneficial trade opportunities between the demander and supplier will have taken place, and the sum of consumer surplus and producer surplus is maximized. This is where the marginal benefit to buyers is equal to the marginal cost to producers. Both buyer and seller are better off from each of the units traded than they would have been if they had not exchanged them. It is important to recognize that, in this case, the total welfare gains to the economy from trade in this good is the sum of the consumer and producer surpluses created. That is, consumers benefit from additional amounts of consumer surplus, and producers benefit from additional amounts of producer surplus. Improvements in welfare come from additions to both consumer and producer surpluses. In competitive markets with large numbers of buyers and sellers, at the market equilibrium price and quantity, the net gains to society are as large as possible. Why would it be inefficient to produce only 3 million units? The demand curve in Exhibit 7 indicates that the buyer is willing to pay $5 for the 3 millionth unit. The supply curve shows that it only costs the seller $3 to produce that unit. That is, as long as the buyer values the extra output by more than it costs to produce that unit, total welfare would increase by expanding output. In fact, if output Wis expanded from 3 million units to 4 million units, total welfare (the sum of consumer and producer surpluses) will increase by area I AEB in Exhibit 7. What if 5 million units are produced? TheLdemand curve shows that the buyer is only willing to pay $3 for the 5 millionth unit. However, the supply curve shows that it would L cost about $5.50 to produce that 5 millionth unit. Thus, increasing output beyond equilibI producing this extra output is greater than rium decreases total welfare, because the cost of total welfare gains the sum of consumer and ­producer surpluses Why is total welfare maximized at the competitive equilibrium output? S , in the Gift Giving and Deadweight Loss K Only about 15 percent of gifts during the holiday are A money. Money fits the description as an efficient S values gift. An efficient gift is one that the recipient at least as much as it costs the giver. S There are a lot of unwanted gifts that A recipients receive during the holidays. What do people do with N their unwanted gifts? Many people exchange or repackage unwanted gifts. Gift cards are D becoming more popular. While they provide less flexibility to R recipients than cash, gift cards might be seen as A less "tacky" than cash. So why don't more people give cash and gift cards? is about $13 billion a year, the difference between the price of the gifts and the value to their recipients. Of course, people may derive satisfaction from trying to pick "the perfect gift." If that is the case, then the deadweight loss would be smaller. In addition, gift giving can provide a signal. If you really love a person, you will try to get enough information and spend enough time to get the right gift. This sends a strong signal that a gift card or money does not provide. If the recipients are adult children, they may already know of your affection for them so sending a gift card or cash might be less offensive. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Newport News Daily Press/MCT/Landov 2 Over the past 20 years, University of Minnesota 1 surProfessor Joel Waldfogel has done numerous veys asking gift recipients about the items 6 they’ve received: Who bought it? What did the buyer pay? 1 What’s the most you would have been willing to pay T that for it? Based on these surveys, he's concluded we value items we receive as gifts 20 percent S less, per dollar spent, than items we buy for ourselves. Given the $65 billion in U.S. holiday spending per year, that means we get $13 billion less in satisfaction than we would receive if we spent that money the usual way on ourselves. That is, deadweight loss 192 PART 3  Market Efficiency, Market Failure, and the Public System deadweight loss net loss of total surplus that results from an action that alters a market equilibrium How do we know when we have achieved market efficiency? the value the buyer places on it. If output is reduced from 5 million units to 4 million units, total welfare will increase by area ECD in Exhibit 7. Not producing the efficient level of output, in this case 4 million units, leads to what economists call a deadweight loss. A deadweight loss is the reduction in both consumer and producer surpluses—it is the net loss of total surplus that results from the misallocation of resources. In a competitive equilibrium, supply equals demand at the equilibrium. This means that the buyers value the last unit of output consumed by exactly the same amount that it cost to produce. If consumers valued the last unit by more than it cost to produce, welfare could be increased by expanding output. If consumers valued the last unit by less than it cost to produce, then welfare could be increased by producing less output. In sum, market efficiency occurs when we have maximized the sum of consumer and producer surplus, when the margin of benefits of the last unit consumed is equal to the marginal cost of productivity, MB = MC. W economic thinkers Alfred Marshall (1842–1924) I Alfred Marshall was born outside of London in 1842.L His father, a domineering man who was a cashierL for the Bank of England, wanted nothing more than I for Alfred to become a minister. But the young Marshall enjoyed math and chess, both of whichS were forbidden by his authoritarian father. When he, was older, Marshall turned down a theological scholarship to Oxford to study at Cambridge, with the financial support of a wealthy uncle. Here he earnedK academic honors in mathematics. Upon graduating,A Marshall set upon a period of self-­ discovery. He S traveled to Germany to study metaphysics, later adopting the philosophy of agnosticism, and movedS on to studying ethics. He found within himself a deepA sorrow and disgust over the condition of society. N He resolved to use his skills to lessen poverty and human suffering, and in wanting to use his math-D ematics in this broader capacity, Marshall soonR developed a fascination with economics. A Marshall became a fellow and lecturer in political economy at Cambridge. He had been teaching2 for nine years when, in 1877, he married a former 1 student, Mary Paley. Because of the university’s celibacy rules, Marshall had to give up his position6 at Cambridge. He moved on to teach at University 1 College at Bristol and at Oxford. But in 1885, the rules were relaxed and Marshall returned toT Cambridge as the Chair in Political Economy, aS position that he held until 1908, when he resigned to devote more time to writing. Before this point in time, economics was grouped with philosophy and the “moral sciences.” Marshall fought all of his life for economics to be set apart as a field all its own. In 1903, Marshall finally succeeded in persuading Cambridge to establish a separate economics course, paving the way for the discipline as it exists today. As this event clearly demonstrates, Marshall exerted a great deal of influence on the development of economic thought in his time. Marshall popularized the heavy use of illustration, real-world examples, and current events in teaching, as well as the modern diagrammatic approach to economics. Relatively early in his career, it was being said that Marshall’s former students occupied half of the economic chairs in the United Kingdom. His most famous student was John Maynard Keynes. Marshall is most famous for refining the marginal approach. He was intrigued by the selfadjusting and self-correcting nature of economic markets, and he was also interested in time—how long did it take for markets to adjust? Marshall coined the analogy that compares the tools of supply and demand to the blades on a pair of scissors—that is, it is fruitless to talk about whether it was supply or demand that determined the market price; rather, one should consider both in unison. After all, the upper blade is not of more importance than the lower when using a pair of scissors to cut a piece of paper. Marshall was also responsible for refining some of the most important tools in economics—elasticity and consumer and producer surplus. Marshall’s book Principles of Economics was published in 1890; immensely popular, the book went into eight editions. Much of the content in Principles is still at the core of microeconomics texts today. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 193 chapter 7  Market Efficiency and Welfare SECTION QUIZ 1. In a supply and demand graph, the triangular area under the demand curve but above the market price is a. the consumer surplus. b. the producer surplus. c. the marginal cost. d. the deadweight loss. e. the net gain to society from trading that good. 2. Which of the following is not true about consumer surplus? a. Consumer surplus is the difference between what consumers are willing to pay and what they actually pay. b. Consumer surplus is shown graphically as the area under the demand curve but above the market price. c. An increase in the market price due to a decrease in supply will increase consumer surplus. W I 3. Which of the following is not true about producer surplus? a. Producer surplus is the difference between L what sellers are paid and their cost of producing those units. b. Producer surplus is shown graphically as the L area under the market price but above the supply curve. in demand will increase producer surplus. c. An increase in the market price due to an increase I d. All of the above are true about producer surplus. S 4. At the market equilibrium price and quantity, the total welfare gains from trade are measured by , d. A decrease in market price due to an increase in supply will increase consumer surplus. a. the total consumer surplus captured by consumers. b. the total producer surplus captured by producers. K d. the consumer surplus minus the producer surplus. A area under the demand curve but above the supply curve is 5. In a supply and demand graph, the triangular S a. the consumer surplus. S b. the producer surplus. A c. the marginal cost. N d. the deadweight loss. D e. the net gain to society from trading that good. 6. Which of the following are true statements? R a. The difference between how much a consumer A is willing and able to pay and how much a consumer has to c. the sum of consumer surplus and producer surplus. pay for a unit of a good is called consumer surplus. b. An increase in supply will lead to a lower price and an increase in consumer surplus; a decrease in supply will lead to a higher price and a decrease in consumer surplus. 7. 2 c. Both (a) and (b) are true. 1 d. None of the above is true. 6 Which of the following are true statements? 1 a. Producer surplus is the difference between what a producer is paid for a good and the cost of producing that good. T b. An increase in demand will lead to a higher market price and an increase in producer surplus; a decrease in demand will lead to a lower market price and S a decrease in producer surplus. c. We can think of the demand curve as a marginal benefit curve and the supply curve as a marginal cost curve. d. Total welfare gains from trade to the economy can be measured by the sum of consumer and producer surpluses. e. All of the above are true statements. (continued) Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 194 PART 3  Market Efficiency, Market Failure, and the Public System S E C T I O N Q U I Z (Cont.) 1. What is consumer surplus? 2. Why do the earlier units consumed at a given price add more consumer surplus than the later units consumed? 3. Why does a decrease in a good’s price increase the consumer surplus from consumption of that good? 4. W  hy might the consumer surplus from purchases of diamond rings be less than the consumer surplus from purchases of far less expensive stones? 5. What is producer surplus? 6. Why do the earlier units produced at a given price add more producer surplus than the later units produced? 7. Why does an increase in a good’s price increase the producer surplus from production of that good? 8. W  hy might the producer surplus from sales of diamond rings, which are expensive, be less than the producer surplus from sales of far less expensive stones? 9. W  hy is the efficient level of output in an industry defined as the output where the sum of consumer and producer ­surplus is maximized? W I 11. Why does an expansion in output beyond the efficient level create a deadweight loss? L L I S , 10. Why does a reduction in output below the efficient level create a deadweight loss? Answers: 1. a 2. c 3. d 4. c 5. e 6. c 7. e 7.2 The Welfare KEffects of Taxes, A Subsidies, and Price Controls S What are the welfare effects of a tax? What are the welfare effects of subsidies? S What is the relationship between a What are the welfare effects of price A ­deadweight loss and price elasticities? ­controls? N D the tools of consumer and producer surplus to measure In the previous section we used the efficiency of a competitiveRmarket—that is, how the equilibrium price and quantity in a competitive market lead to the maximization of aggregate welfare (for both buyers and sellers). Now we can use the A same tools, consumer and producer surplus, to measure the welfare effects the gains and losses associated with government intervention in markets welfare effects of various government programs—taxes and price controls. When economists refer to the welfare effects of a government policy, they are referring to the gains and losses 2 associated with government intervention. This use of the term should not be confused with the more common reference to1a welfare recipient who is getting aid from the government. 6 1 Using Consumer and Producer T the Welfare Effects of a Tax S Surplus to Find To simplify the explanation of elasticity and the tax incidence, we will not complicate the illustration by shifting the supply curve (tax levied on sellers) or demand curve (tax levied on buyers) as we did in Section 6.4. We will simply show the result a tax must cause. The tax is illustrated by the vertical distance between the supply and demand curves at the new after-tax output—shown as the bold vertical line in Exhibit 1. After the tax, the buyers pay a higher price, PB, and the sellers receive a lower price, PS; and the equilibrium quantity of Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 7  Market Efficiency and Welfare 195 A what you’ve learned Should 2We Use Taxes to Reduce 1 Dependency on Foreign Oil? 6 Q 1 T What if we placed a $0.50 tax on gasoline to reduce dependence on foreign oil and to S raise the tax revenue? A producers will share the burden equally. The tax collected would be b + d, but total loss in consumer surplus (b + c) and producer surplus (d + e) would be greater than the gains in tax revenue. Not surprisingly, both consumers and producers fight such a tax every time it is proposed. If the demand and supply curves are both equally elastic, as in Exhibit 2, both consumers and Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 Price the good (both bought and sold) falls from Q1 to Q2. The tax section 7.2 Supply and Demand of a Tax exhibit 1 revenue collected is measured by multiplying the amount of the tax times the quantity of the good sold after the tax is imposed (T × Q2). Supply In Exhibit 2, we can now use consumer and producer surpluses to measure the amount of welfare loss associated with a tax. First, consider the amounts of consumer and proE2 PB ducer surplus before the tax. Before the tax is imposed, the Tax Revenue price is P1 and the quantity is Q1; at that price and output, E1 Tax T  Q2 the amount of consumer surplus is area a + b + c, and the amount of producer surplus is area d + e + f. To get the total PS surplus, or total welfare, we add consumer and producer surpluses, area a + b + c + d + e + f. Without a tax, tax Demand revenues are zero. After the tax, the price the buyer pays is PB, the price the seller receives is PS, and the output falls to Q2.W As a result of Q2 Q1 the higher price and lower output from the tax, consumer I (After Tax) (Before Tax) surplus is smaller—area a. After the tax, sellers receive a L f. However, Quantity lower price, so producer surplus is smaller—area After the tax, the buyers pay a higher price, some of the loss in consumer and producer surpluses L is transPB, and the sellers receive a lower price, PS; ferred in the form of tax revenues to the government, which and the equilibrium quantity of the good (both I can be used to reduce other taxes, fund public projects, or bought and sold) falls from Q1 to Q2. The tax be redistributed to others in society. This transfer S of society’s revenue collected is measured by multiplying resources is not a loss from society’s perspective. The net loss the amount of the tax times that quantity of the , to society can be found by measuring the difference between good sold after the tax is imposed (T × Q2). the loss in consumer surplus (area b + c) plus the loss in producer surplus (area d + e) and the gain in taxK revenue (area b + d). The reduction in total surplus is area c + e, or the shaded area in Exhibit 2. This deadweight loss from the tax is the reduction inAproducer and consumer surpluses minus the tax revenue transferred to the government. S Deadweight loss occurs because the tax reduces the quantity exchanged below the origiS nal output level, Q1, reducing the size of the total surplus realized from trade. The problem How do taxes distort A to buyers is higher than before the tax, so ­market incentives? is that the tax distorts market incentives: The price they consume less; and the price to sellers is lower N than before the tax, so they produce less. These effects lead to deadweight loss, or market inefficiencies—the waste associated with not producing the efficient level of output. ThatDis, the tax causes a deadweight loss because it prevents some mutual beneficial trade between R buyers and sellers. 196 PART 3  Market Efficiency, Market Failure, and the Public System section 7.2 exhibit 2 Welfare Effects of a Tax The net loss to society due to a tax can be found by measuring the difference between the loss in consumer surplus (area b + c) plus the loss in producer surplus (area d + e) and the gain in tax revenue (area b + d). The deadweight loss from the tax is the reduction in the consumer and producer surpluses minus the tax ­revenue transferred to the government, area c + e. a Price b P1 PS Deadweight Loss E2 PB c Tax E1 e d Supply W I L L Q Q (After Tax) (Before Tax) I Quantity S Before Tax , f 0 © Cengage Learning 2013 2 Consumer Surplus Producer Surplus 1 After Tax a a1b1c Change 2b 2 c K b1d b1d A a1b1c1d1e1f a1b1d1f 2c 2 e S S A All taxes lead to deadweight N loss. The deadweight loss is important because if the people are to benefit from the tax, then more than $1 of benefit must be produced from $1 of D government expenditure. For example, if a gasoline tax leads to $100 million in tax revenues Rloss, then the government needs to provide a benefit to the and $20 million in deadweight public of more than $120 million A with the $100 million revenues. f d1e1f Tax Revenue (T 3 Q2) Total Welfare Demand 2d 2 e zero 2 Size of the Deadweight Loss Elasticity and the 1 Does the elasticity affect the size of the deadweight loss? The size of the deadweight loss from a tax, as well as how the burdens are shared between buyers and sellers, depends on6the price elasticities of supply and demand. In Exhibit 3(a) we can see that, other things being1equal, the less elastic the demand curve, the smaller the deadweight loss. Similarly, the less elastic the supply curve, other things being equal, the smaller T the deadweight loss, as shown in Exhibit 3(b). However, when the supply and/or demand Sdeadweight loss becomes larger, because a given tax reduces curves become more elastic, the the quantity exchanged by a greater amount, as seen in Exhibit 3(c). Recall that elasticities measure how responsive buyers and sellers are to price changes. That is, the more elastic the curves are, the greater the change in output and the larger the deadweight loss. Elasticity differences can help us understand tax policy. Goods that are heavily taxed, such as alcohol, cigarettes, and gasoline, often have a relatively inelastic demand curve in the short run, so the tax burden falls primarily on the buyer. It also means that the deadweight Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 197 chapter 7  Market Efficiency and Welfare section 7.2 Elasticity and Deadweight Loss exhibit 3 a. Relatively Inelastic Demand b. Relatively Inelastic Supply c. Relatively Elastic Supply and Demand Supply Supply $0.50 Tax E1 E2 E1 Demand $0.50 Tax E2 Deadweight loss is relatively small. Price Deadweight loss is relatively small. Price Price E2 Deadweight loss is relatively large. Supply E1 $0.50 Tax Demand Demand 0 0 Q Q WQQ Quantity Quantity Quantity I In (a) and (b), we see that when one of theL two curves is relatively price inelastic, the deadweight loss from the tax is relatively small. However, when the supply and/or demand curves become more elastic, the deadLtax reduces the quantity exchanged by a greater amount, as seen weight loss becomes larger, because a given in (c). The more elastic the curves are, theI greater the change in output and the larger the deadweight loss. S , Q2 Q1 2 1 2 1 loss to society is smaller for the tax revenue raised than if the demand curve were more elastic. In other words, because consumers cannot K find many close substitutes in the short run, they reduce their consumption only slightly at the higher after-tax price. Even though A the deadweight loss is smaller, it is still positive, because the reduced after-tax price received S by buyers reduces the quantity exchanged by sellers and the increased after-tax price paid below the previous market equilibrium level. S A N The Welfare Effects of Subsidies D If taxes cause deadweight or welfare losses, do subsidies create welfare gains? For example, R was provided in a particular market? what if a government subsidy (paid by taxpayers) Think of a subsidy as a negative tax. Before the A subsidy, say the equilibrium price was P1 and the equilibrium quantity was Q1, as shown in Exhibit 4. The consumer surplus is area a + b, and the producer surplus is area c + d. The sum of producer and consumer surpluses 2 loss. is maximized (a + b + c + d), with no deadweight In Exhibit 4, we see that the subsidy lowers 1 the price to the buyer to PB and increases the quantity exchanged to Q2. The subsidy results in an increase in consumer surplus from area a + b to area a + b + c + g, a gain of c +6g. And producer surplus increases from area c + d to area c + d + b + e, a gain of b + e.1With gains in both consumer and producer surpluses, it looks like a gain in welfare, right? Not quite. Remember that the government T is paying for this subsidy, and the cost to government (taxpayers) of the subsidy is area b + S e + f + c + g (the subsidy per unit times the number of units subsidized). That is, the cost to government (taxpayers), area b + e + f + c + g, is greater than the gains to consumers, c + g, and the gains to producers, b + e, by area f. Area f is the deadweight or welfare loss to society from the subsidy because it results in the production of more than the competitive market equilibrium, and the market value of that expansion to buyers is less than the marginal cost of producing that expansion to sellers. In short, the market overproduces relative to the efficient level of output, Q1. If taxes cause deadweight loss, why don't subsidies cause welfare gains? Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 0 198 PART 3  Market Efficiency, Market Failure, and the Public System section 7.2 exhibit 4 Welfare Effects of a Subsidy With a subsidy, the price producers receive (PS) is the price consumers pay (PB) plus the subsidy ($S). Because the subsidy leads to the production of more than the efficient level of output Q1, a deadweight loss results. For each unit produced between Q1 and Q2, the supply curve lies above the demand curve, indicating that the marginal benefits to consumers are less than society’s cost of producing those units. Supply Deadweight Loss a PS e Price b E1 P1 c g W d I L LQ Q 0 I Quantity S Before Tax Subsidy , PB © Cengage Learning 2013 1 Consumer Surplus (CS) Producer Surplus (PS) $S: Subsidy per Unit Produced f E2 Demand 2 After Tax Subsidy Change a1b a1b1c1g c1g c1d c1d1b1e b1e K 2b 2 e 2 f 2 c 2 g 2b 2 e 2 f 2 c 2 g A Total Welfare (CS 1 PS 2 G) a1b1c1d a1b1c1d2f 2f S S A N Welfare Effects Price Ceilings and D As we saw in Chapter 5, price controls involve the use of the power of the government to establish prices different fromRthe equilibrium market price that would otherwise prevail. The motivations for price controls A vary with the markets under consideration. A maximum, Government (Taxpayers, G) Do consumers and ­producers both gain with a subsidy if it lowers the price to consumers and raises the price to ­producers? How about taxpayers? zero or ceiling, is often set for goods deemed important, such as housing. A minimum price, or floor, may be set on wages because wages are the primary source of income for most people, or on agricultural products, in2order to guarantee that producers will get a certain minimum price for their products. 1 If a price ceiling (that is, a legally established maximum price) is binding and set below the 6 equilibrium price at PMAX, the quantity demanded will be greater than the quantity supplied at that price, and a shortage will occur. At this price, buyers will compete for the limited supply, Q2. 1 We can see the welfare effects of a price ceiling by observing the change in consumer and T producer surpluses from the implementation of the price ceiling in Exhibit 5. Before the price ceiling, the buyer receives areaSa + b + c of consumer surplus at price P1 and quantity Q1. However, after the price ceiling is implemented at PMAX, consumers can buy the good at a lower price but cannot buy as much as before (they can only buy Q2 instead of Q1). Because consumers can now buy Q2 at a lower price, they gain area d of consumer surplus after the price ceiling. However, they lose area c of consumer surplus because they can only purchase Q2 rather than Q1 of output. Thus, the change in consumer surplus is d – c. In this case, area d is larger than area e and area c and the consumer gains from the price ceiling. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 199 chapter 7  Market Efficiency and Welfare section 7.2 exhibit 5 Welfare Effects of a Price Ceiling Price Deadweight Loss a P2 b P1 PMAX c e d f Supply E1 Price Ceiling E2 Demand W Q Q I Ceiling) (After Price (Before Price Ceiling) Quantity L L Before Price Ceiling After Price Ceiling I a1b1c a1b1d S f d1e1f , a1b1c1d1e1f a1b1d1f 0 Consumer Surplus (CS) Producer Surplus (PS) Total Welfare (CS 1 PS) 1 Change d2c 2d 2 e 2c 2 e If area d is larger than area c, consumers in the aggregate would be better off from the price ceiling. However, any possible gain to consumers will be more than offset by the losses to producers, area d + e. Price ceiling causes a deadweight loss of c + e. K A S The price the seller receives for Q2 is PMAXS(the ceiling price), so producer surplus falls from area d + e + f before the price ceiling to area f after the price ceiling, for a loss of A area d + e. That is, any possible gain to consumers will be more than offset by the losses to N producers. The price ceiling has caused a deadweight loss of area c + e. There is a deadweight loss because less is D sold at Q2 than at Q1; and consumers value those units between Q2 and Q1 by more than it cost to produce them. For example, at Q2, consumers will value the unit at P2, which is R much higher than it cost to produce it—the point on the supply curve at Q2. A 2 and Applications of Consumer 1 Producer Surplus 6 1 If consumers use no additional resources, search costs, or side payments for a rent controlled T unit, the consumer surplus is equal to a + b + d in Exhibit 5. If landlords were able to S be reduced to area a. Landlords are able extract P2 from renters, consumer surplus would Rent Controls to collect higher “rent” using a variety of methods. They might have the tenant slip them a couple hundred dollars each month; they might charge a high rate for parking in the garage; they might rent used furniture at a high rate; or they might charge an exorbitant key price— the price for changing the locks for a new tenant. These types of arrangements take place in so-called black markets—markets where goods are transacted outside the boundaries of the law. One problem is that law-abiding citizens will be among those least likely to find a rental Who gains and who loses with rent controls? Is there a difference between a rent controlled price in the short run versus the long run? Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 2 200 PART 3  Market Efficiency, Market Failure, and the Public System REUTERS/Lucas Jackson unit. Other problems include black market prices that are likely to be higher than the price would be if restrictions were lifted and the inability to use legal means to enforce contracts and resolve disputes. If the landlord is able to charge P2, then the area b + d of consumer surplus will be lost by consumers and gained by the landlord. This redistribution from the buyer to the seller does not change the size of the deadweight loss; it remains area c + e. The measure of the deadweight loss in the price ceiling case may underestimate the true cost to consumers. At least two inefficiencies are not measured. One, consumers may spend a lot of time looking for rental units because vacancy rates will be very low—only Q2 is available and consumers are willing to pay as much as P2 for Q2 units. Two, someone may have been lucky to find a rental unit at the ceiling price, PMAX, but someone who values it more, say at P2, may not be able to find a rental unit. It is important to distinguish between deadweight loss, which measures the overall efficiency loss, and the distribuWtion of the gains and losses from a particular policy. For as a rent control tenant, you may be pleased with I example, the outcome—a lower price than you would ordinarily pay L (a transfer from landlord to tenant) providing that you can L find a vacant rent-controlled unit. Is it possible that removing rent controls in New York City is good economics but bad politics? section 7.2 exhibit 6 I Rent Controls—Short Run versus S Long Run , In the absence of rent control (a price ceiling), the equilibrium price is P1 and the equilibrium quantity is Q1, with K no deadweight loss. However, a price ceiling leads to a A S Deadweight Loss of Rent Control: Short Run vs. Long Run S A a. Deadweight Loss of Rent Control—Short Run b. Deadweight Loss of Rent Control—Long Run N D R S A E1 P1 PC ESR Shortage © Cengage Learning 2013 0 2 1 6 PCeiling 1 T S Deadweight Loss (Short Run) D QSR Q 1 Quantity of Rental Units Price of Rental Units Price of Rental Units SR Deadweight Loss (Long Run) E1 P1 PC ELR Shortage 0 SLR Q LR PCeiling D Q1 Quantity of Rental Units The reduction in rental units in response to the rent ceiling price PC is much smaller in the short run (Q1 to QSR) than in the long run (Q1 to QLR). The deadweight loss is also much greater in the long run than in the short run, as indicated by the shaded areas in the two graphs. In addition, the size of the shortage is much greater in the long run than in the short run. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 201 chapter 7  Market Efficiency and Welfare ­ eadweight loss, but the size of the deadweight loss depends on elasticity: The deadweight d loss is greater in the short run (less elastic supply) than the long run (more elastic supply). Why? A city that enacts a rent control program will not lose many rental units in the next week. That is, even at lowered legal prices, roughly the same number of units will be available this week as last week; thus, in the short run the supply of rental units is virtually fixed—relatively inelastic, as seen in Exhibit 6(a). In the long run, however, the supply of rental units is much more elastic; landlords respond to the lower rental prices by allowing rental units to deteriorate and building fewer new rental units. In the long run, then, the supply curve is much more elastic, as seen in Exhibit 6(b). It is also true that demand becomes more elastic over time as buyers respond to the lower prices by looking for their own apartment (rather than sharing one) or moving to the city to try to rent an apartment below the equilibrium rental price. What economic implications do these varying elasticities have on rent control policies? In Exhibit 6(a), only a small reduction in rental unit availability occurs in the short W price—a move from Q to Q . The corterm as a result of the newly imposed rent control 1 SR responding deadweight loss is small, indicated Iby the shaded area in Exhibit 6(a). However, the long-run response to the rent ceiling price is much larger: The quantity of rental units L falls from Q1 to QLR, and the size of the deadweight loss and the shortage are both larger, as L more harmful in the long run than the seen in Exhibit 6(b). Hence, rent controls are much short run, from an efficiency standpoint. I Price Floors ECS economic content standards Price controls are often advocated by special interest groups. Price controls reduce the quantity of goods and services produced, thus depriving consumers of some goods and services whose value would exceed their cost. S , Since the Great Depression, several agricultural programs have been promoted as K system guarantees a minimum assisting small-scale farmers. Such a price-support price—promising a dairy farmer a price of $4 per A pound for cheese, for example. The reasoning is that the equilibrium price of $3 is too low and would not proS vide enough revenue for small-volume farmers to maintain a “decent” standard S is the lowest price a consumer of living. A price floor sets a minimum price that can legally pay for a good. A In the United States, price floors have been used to increase the price of dairy products, tobacco, corn, peanuts, soybeans and many other goods since the Great Depression. The government sets a price floor 2 that guarantees producers will get a certain price. To ensure the support price, the1government buys as much output as necessary to maintain the price at that level. 6 Who gains and who loses under price-support programs? In Exhibit 7, the 1 floor are at P1 and Q1, respecequilibrium price and quantity without the price tively. Without the price floor, consumer surplus T is area a + b + c, and producer ­surplus is area e + f, for a total surplus of area a + b + c + e + f. S must buy up the excess supTo maintain the price support, the government ply at PS; that is, the quantity QS – Q2. As shown in Exhibit 7, the government purchases are added to the market demand curve (D + government purchases). This additional demand allows the price to stay at the support level. After the price floor is in effect, price rises to PS; output falls to Q2; consumer surplus falls from area a + b + c to area a, a loss of b + c; Some of the loss of consumer godrick/Shutterstock.com N The Welfare Effects of a DPrice Floor When R the Government Buys the Surplus A In an effort to help producers of the cheese commonly grated over spaghetti, fettuccine and other pastas, the Italian government is buying 100,000 wheels of Parmigiano Reggiano and donating them to charity. This is similar to the price floors where the government buys up the surplus. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 202 PART 3  Market Efficiency, Market Failure, and the Public System surplus occurs because at the higher price, PS, some consumers will buy less of the good or not buy the good at all. Consumers also lose area b because they now have to pay a higher price, PS, for Q2 output. However, the policy was not intended to help the consumer, but to help the producer. And it does. Producer surplus increases from area e + f to area b + c + d + e + f, a gain of area b + c + d. If those changes were the end of the story, we would say that producers gained (area b + c + d) more than consumers lost (area b + c), and, on net, society would benefit by area d from the implementation of the price support. However, those changes are not the end of the story. The government (taxpayers) must pay for the surplus it buys, area c + d + f + g + h + i. That is, the cost to government is area c + d + f + g + h + i. The total welfare cost of the program is found by adding the change in consumer surplus (lost area b + c) and the change in producer surplus (gained area b + c + d) and then subtract the government costs. After adding the change in consumer surplus to the change in producer surplus we end up with a + d than we subtract the government costs c + d + f + g + h + i. Assuming no alternative use of the surplus the government purchases, the result is a deadweight loss from the price floor of area c + f + g + h + i. Why? Consumers W are consuming less than the previous market equilibrium output, eliminating mutually beneficial exchanges, while sellers are producing more than is I being consumed, with the excess production stored, destroyed, or exported. If the objective L it be less costly to just give them the money directly rather is to help the farmers, wouldn’t than through price supports? Then L the program would only cost b + c + d. However, price supports may be more palatable from a political standpoint than an outright handout. Wouldn't it cost less to give farmers money directly rather than through price supports? section 7.2 exhibit 7 I S , Welfare Effects of a Price Floor When Government Buys the Surplus Price Ps a b d c P1 h f e g i K A S S A N D R A Supply Price Support Demand + Government Purchases Demand Deadweight Loss (c1f1g1h1i) 0 2 1 Before Price Support 6 After Price Support 1 a a1b1c T b1c1d1e1f e1f zero S2c 2 d 2 f 2 g 2 h 2 i Q2 Q1 QS Quantity Consumer Surplus (CS) Producer Surplus (PS) © Cengage Learning 2013 Government (Taxpayers, G) Total Welfare a1b1c1e1f a 1 b 1 e 2g 2 h 2 i Change 2b 2 c b1c1d 2c 2 d 2 f 2 g 2 h 2 i 2c 2 f 2 g 2 h 2 i After the price support is implemented, the price rises to PS and output falls to Q2; the result is a loss in consumer surplus of area b + c but a gain in producer surplus of area b + c + d. However, these changes are not the end of the story, because the cost to the government (taxpayers), area c + d + f + g + h + i, is greater than the gain to producers, area d, so the deadweight loss is area c + f + g + h + i. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 203 chapter 7  Market Efficiency and Welfare Deficiency Payment Program Another possibility is the deficiency payment program. In Exhibit 8, if the government sets the support price at PS, producers will supply Q2 and sell all they can at the market price, PM. The government then pays the producers a deficiency payment (DP)—the vertical distance between the price the producers receive, PM, and the price they were guaranteed, PS. Producer surplus increases from area c + d to area c + d + b + e, which is a gain of area b + e, because producers can sell a greater quantity at a higher price. Consumer surplus increases from area a + b to area a + b + c + g, which is a gain of area c + g, because consumers can buy a greater quantity at a lower price. The cost to government (Q2 × DP), area b + e + f + c + g, is greater than the gains in producer and consumer surpluses (area b + e + c + g), and the deadweight loss is area f. The deadweight loss occurs because the program increases the output beyond the efficient level of output, Q1. From Q1 to Q2, the marginal cost to sellers for producing the good (the height of the supply curve) is greater than the marginal benefit to consumers (the height of the demand curve). Compare area f in Exhibit 8 with the muchW larger deadweight loss for price supports in Exhibit 7. The deficiency payment program does I not lead to the production of crops that will not be consumed, or to the storage problem we saw with the previous price-support L program in Exhibit 7. The purpose of these farm programs is to help L poor farmers. However, large commercial farms (roughly 10 percent of all farms) receive the bulk of the government subsidies. Small I farms receive less than 20 percent of the farm subsidies. Many other countries around the world also provide subsidies to their farmers. S Are deficiency payment programs more efficient than traditional price supports? , section 7.2 exhibit 8 Welfare Effects of a Deficiency Payment Plan K a Price PS b P1 PM c d A S S A N D R A Supply Deadweight Loss Price Support e E1 Deficiency Payment f g E2 Demand Government (Taxpayers, G) 2 Q 1 Quantity 6 Plan Before 11 b a T c1d Szero Total Welfare (CS 1 PS 2 G) a1b1c1d 0 1 Consumer Surplus (CS) © Cengage Learning 2013 Producer Surplus (PS) Q2 After Plan Change a1b1c1g c1g c1d1b1e b1e 2b 2 e 2 f 2 c 2 g 2b 2 e 2 f 2 c 2 g a1b1c1d2f 2f The cost to government (taxpayers), area b + e + f + c + g, is greater than the gains to producer and consumer surplus, area b + e + c + g. The deficiency payment program increases the output level beyond the efficient output level of Q1. From Q1 to Q2, the marginal cost of producing the good (the height of the supply curve) is greater than the marginal benefit to the consumer (the height of the demand curve)—area f. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 204 PART 3  Market Efficiency, Market Failure, and the Public System SECTION QUIZ 1. In a supply and demand graph, the triangular area between the demand curve and the supply curve lost because of the imposition of a tax, price ceiling, or price floor is a. the consumer surplus. b. the producer surplus. c. the marginal cost. d. the deadweight loss. e. the net gain to society from trading that good. 2. After the imposition of a tax, a. consumers pay a higher price, including the tax. b. consumers lose consumer surplus. c. producers receive a lower price after taxes. d. producers lose producer surplus. W I 3. With a subsidy, a. the price producers receive is the price consumersL pay plus the subsidy. b. the subsidy leads to the production of more than the L efficient level of output. c. there is a deadweight loss. I d. all of the above are true. S 4. In the case of a price floor, if the government buys up the surplus, , a. consumer surplus decreases. e. all of the above occur. b. producer surplus increases. c. a greater deadweight loss occurs than with a deficiency payment system. K A 5. The longer a price ceiling is left below the equilibrium price in a market, the _____________ is the reduction in the quantity exchanged and the _____________ is the resulting S deadweight loss. a. greater; greater S b. greater; smaller A c. smaller; greater N d. smaller; smaller 6. With a deficiency payment program, D a. the government sets the target price at the equilibrium price. R b. producer and consumer surplus falls. A c. there is a deadweight loss because the program increases the output beyond the efficient level of output. d. all of the above are true. d. all of the above are true. 2 1. Could a tax be imposed without a welfare cost? 1 2. How does the elasticity of demand represent the ability of buyers to “dodge” a tax? 6 3. If both supply and demand were highly elastic, how large would the effect be on the quantity exchanged, the tax revenue, and the welfare costs of a tax? 1 4. What impact would a larger tax have on trade in the market? What will happen to the size of the deadweight loss? T 5. What would be the effect of a price ceiling? S 6. What would be the effect of a price floor if the government does not buy up the surplus? 7. What causes the welfare cost of subsidies? 8. Why does a deficiency payment program have the same welfare cost analysis as a subsidy? Answers: 1. d 2. e 3. d 4. d 5. a 6. c Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 7  Market Efficiency and Welfare 205 Interactive Summary Fill in the blanks: 1. The monetary difference between the price a consumer is willing and able to pay for an additional unit of a good and the price the consumer actually pays is called _____________. 2. We can think of the demand curve as a _____________ curve. 3. Consumer surplus for the whole market is shown graphically as the area under the market _____________ (willingness to pay for the units consumed) and above the _____________ (what must Wbe paid for those units). I 4. A lower market price due to an increase in supply L will _____________ consumer surplus. L a 5. A(n) _____________ is the difference between what producer is paid for a good and the cost of producI ing that unit of the good. 6. S We can think of the supply curve as a(n) ____________ , curve. 10. In competitive markets, with large numbers of buyers and sellers at the market equilibrium price and quantity, the net gains to society are _____________ as possible. 11. After a tax is imposed, consumers pay a(n) _____________ price and lose the corresponding amount of consumer surplus as a result. Producers receive a(n) _____________ price after tax and lose the corresponding amount of producer surplus as a result. The government _____________ the amount of the tax revenue generated, which is transferred to others in society. 12. The size of the deadweight loss from a tax, as well as how the burdens are shared between buyers and sellers, depends on the relative _____________. 13. When there is a subsidy, the market _____________ relative to the efficient level of output. 14. Because the _____________ leads to the production of more than the efficient level of output, a(n) _____________ results. 7. Part of the added producer surplus when the price rises as a result of an increase in demand is dueK to a higher price for the quantity _____________ Aof being produced, and part is due to the expansion _____________ made profitable by the higher price. S 15. With a(n) _____________, any possible gain to consumers will be more than offset by the losses to producers. 8. The demand curve represents a collection of S _____________ prices that consumers are willing A and able to pay for additional quantities of a good or service, while the supply curve represents a collecN tion of _____________ prices that suppliers require D to be willing to supply additional quantities of that R good or service. 17. With no alternative use of the government purchases from a price floor, a(n) _____________ will result because consumers are consuming _____________ than the previous market equilibrium output and sellers are producing _____________ than is being consumed. 9. The total welfare gain to the economy from trade A in a good is the sum of the _____________ and _____________ created. 2 1 6 1 T S 16. With a price floor where the government buys up the surplus, the cost to the government is _____________ than the gain to _____________. 18. With a deficiency payment program, the deadweight loss is _____________ than with an agricultural price support program when the government buys the ­surplus. Answers: 1. consumer surplus 2. marginal benefit 3. demand curve; market price 4. increase 5. producer surplus 6. marginal cost 7. already; output 8. maximum; minimum 9. consumer surplus; producer surplus 10. as large 11. higher; lower; gains 12. elasticities of supply and demand 13. overproduces 14. subsidy; deadweight loss 15. price ceiling 16. greater; producers 17. deadweight loss; less; more 18. smaller consumer surplus 187 producer surplus 189 marginal cost 189 total welfare gains 191 Key Terms and Concepts deadweight loss 192 welfare effects 194 Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 206 PART 3  Market Efficiency, Market Failure, and the Public System Section Quiz Answers 7.1  onsumer Surplus and C Producer Surplus 1. What is consumer surplus? Consumer surplus is defined as the monetary difference between what a consumer is willing to pay for a good and what the consumer is required to pay for it. 2. Why do the earlier units consumed at a given price add more consumer surplus than the later units consumed? Because what a consumer is willing to pay for aW good declines as more of that good is consumed, the I difference between what he is willing to pay and the price he must pay also declines for later units. L 3. Why does a decrease in a good’s price L increase the consumer surplus from I ­consumption of that good? S A decrease in a good’s price increases the consumer surplus from consumption of that good by lower, ing the price for those goods that were bought at the higher price and by increasing consumer surplus from increased purchases at the lower price. K 4. Why might the consumer surplus from A ­purchases of diamond rings be less thanS the consumer surplus from purchases of S far less expensive stones? Consumer surplus is the difference between what A people would have been willing to pay for the N amount of the good consumed and what they must pay. Even though the marginal value of less expenD sive stones is lower than the marginal value of a R diamond ring to buyers, the difference between the A total value of the far larger number of less expensive stones purchased and what consumers had to pay may well be larger than that difference for diamond 2 rings. 1 5. What is producer surplus? Producer surplus is defined as the monetary differ6 ence between what a producer is paid for a good 1 and the producer’s cost. T 6. Why do the earlier units produced at a given S price add more producer surplus than the later units produced? Because the earlier (lowest cost) units can be produced at a cost that is lower than the market price, but the cost of producing additional units rises, the earlier units produced at a given price add more producer surplus than the later units produced. 7. Why does an increase in a good’s price increase the producer surplus from ­production of that good? An increase in a good’s price increases the producer surplus from production of that good because it results in a higher price for the quantity already being produced and because the expansion in output in response to the higher price also increases profits. 8. Why might the producer surplus from sales of diamond rings, which are expensive, be less than the producer surplus from sales of far less expensive stones? Producer surplus is the difference between what a producer is paid for a good and the producer’s cost. Even though the price, or marginal value, of a less expensive stone is lower than the price, or marginal value of a diamond ring to buyers, the difference between the total that sellers receive for those stones in revenue and the producer’s cost of the far larger number of less expensive stones produced may well be larger than that difference for diamond rings. 9. Why is the efficient level of output in an industry defined as the output where the sum of consumer and producer surplus is maximized? The sum of consumer surplus plus producer surplus measures the total welfare gains from trade in an industry, and the most efficient level of output is the one that maximizes the total welfare gains. 10. Why does a reduction in output below the efficient level create a deadweight loss? A reduction in output below the efficient level eliminates trades whose benefits would have exceeded their costs; the resulting loss in consumer surplus and producer surplus is a deadweight loss. 11. Why does an expansion in output beyond the efficient level create a deadweight loss? An expansion in output beyond the efficient level involves trades whose benefits are less than their costs; the resulting loss in consumer surplus and producer surplus is a deadweight loss. 7.2 The Welfare Effects of Taxes, Subsidies, and Price Controls 1. Could a tax be imposed without a welfare cost? A tax would not impose a welfare cost only if the quantity exchanged did not change as a result—only Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 7  Market Efficiency and Welfare when supply was perfectly inelastic or in the nonexistent case where the demand curve was perfectly inelastic. In all other cases, a tax would create a welfare cost by eliminating some mutually beneficial trades (and the wealth they would have created) that would otherwise have taken place. 2. How does the elasticity of demand represent the ability of buyers to “dodge” a tax? The elasticity of demand represents the ability of buyers to “dodge” a tax, because it represents how easily buyers could shift their purchases into other goods. If it is relatively low cost to consumers to shift out of buying a particular good when a tax is imposed on it—that is, demand is relatively elastic— they can dodge much of the burden of the tax by shifting their purchases to other goods. If it is relaW tively high cost to consumers to shift out of buying I a particular good when a tax is imposed on it—that is, demand is relatively inelastic—they cannot dodge L much of the burden of the tax by shifting their purL chases to other goods. I 3. If both supply and demand were highly ­elastic, how large would the effect be onS the quantity exchanged, the tax revenue, and , the welfare costs of a tax? The more elastic are supply and/or demand, the larger the change in the quantity exchanged that K would result from a given tax. Given that tax revA enue equals the tax per unit times the number of units traded after the imposition of a tax, the smaller S after-tax quantity traded would reduce the tax revS enue raised, other things equal. Because the greater A change in the quantity traded wipes out more mutually beneficial trades than if demand and/or supply N was more inelastic, the welfare cost in such a case D would also be greater, other things equal. 4. What impact would a larger tax have onR trade in the market? What will happen to Athe size of the deadweight loss? A larger tax creates a larger wedge between the price including tax paid by consumers and the price net 2 of tax received by producers, resulting in a greater 1 increase in prices paid by consumers and a greater decrease in price received by producers, and the laws of supply and demand imply that the quantity exchanged falls more as a result. The number of mutually beneficial trades eliminated will be greater and the consequent welfare cost will be greater as a result. 5. What would be the effect of a price ceiling? A price ceiling reduces the quantity exchanged, because the lower regulated price reduces the quantity sellers are willing to sell. This lower quantity causes a welfare cost equal to the net gains from those exchanges that no longer take place. However, that price ceiling would also redistribute income, harming sellers, increasing the well-being of those who remain able to buy successfully at the lower price, and decreasing the well-being of those who can no longer buy successfully at the lower price. 6. What would be the effect of a price floor if the government does not buy up the surplus? Just as in the case of a tax, a price floor where the government does not buy up the surplus reduces the quantity exchanged, thus causing a welfare cost equal to the net gains from the exchanges that no longer take place. However, that price floor would also redistribute income, harming buyers, increasing the incomes of those who remain able to sell successfully at the higher price, and decreasing the incomes of those who can no longer sell successfully at the higher price. 7. What causes the welfare cost of subsidies? Subsidies cause people to produce units of output whose benefits (without the subsidy) are less than the costs, reducing the total gains from trade. 8. Why does a deficiency payment program have the same welfare cost analysis as a subsidy? Both tend to increase output beyond the efficient level, so that units whose benefits (without the subsidy) are less than the costs, reducing the total gains from trade in the same way; further, the dollar cost of the deficiency payments are equal to the dollar amount of taxes necessary to finance the subsidy, in the case where each increases production the same amount. 6 1 T S Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 207 208 PART 3  Market Efficiency, Market Failure, and the Public System Problems Price of Karate Lessons (per lesson) 1. Refer to the following exhibit. a P0 b P1 d c e f Demand W I L a. If the price of each karate lesson is P , the consumer surplus is equal to what area? b. If the price falls from P to P , the change in Lconsumer surplus is equal to what area? Steve loves potato chips. His weekly demand curve I is shown in the following exhibit. S $5.00 4.50 , Q1 Q0 Quantity of Karate Lessons 0 0 Price of Potato Chips (per bag) 2. a. b. c. 1 4.00 3.50 K A 2.00 S 1.50 S 1.00 Demand 0.50 A 0 1 2 3 4 5 6 7 8 9 10 N Quantity of Potato Chips (per bag) D How much is Steve willing to pay for one bag R of potato chips? How much is Steve willing to pay for a second bag of potato chips? If the actual market price of potato chips isA $2.50, and Steve buys five bags as shown, what is the value of his 3.00 2.50 consumer surplus? d. What is Steve’s total willingness to pay for five bags? 2 1 If demand for apples increased as a result of a news story that highlighted the health benefits of two apples a day, 6 what would happen to producer surplus? How is total surplus (the sum of consumer and 1 producer surpluses) related to the efficient level of output? Using a supply and demand curve, demonstrate that producing less than the equilibrium output will lead to an inefficient T allocation of resources—a deadweight loss. If the government’s goal is to raise tax revenue,S which of the following are good markets to tax? 3. If a freeze ruined this year’s lettuce crop, show what would happen to consumer surplus. 4. 5. 6. a. b. c. d. e. luxury yachts alcohol movies gasoline grapefruit juice Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 7  Market Efficiency and Welfare 7. Which of the following do you think are good markets for the government to tax if the goal is to boost tax ­revenue? Which will lead to the least amount of deadweight loss? Why? a. luxury yachts b. alcohol c. motor homes d. cigarettes e. gasoline f. pizza 8. Elasticity of demand in the market for one-bedroom apartments is 2.0, elasticity of supply is 0.5, the current market price is $1,000, and the equilibrium number of one-bedroom apartments is 10,000. If the government imposes a price ceiling of $800 on this market, predict the size of the resulting apartment shortage. 9. Use the diagram to answer the following questions (a–d). S+T Supply W I L L I S , f $30 Price e d 20 c b 10 a Demand K A a. At the equilibrium price before the tax is imposed, what area represents consumer surplus? What area S ­represents producer surplus? S b. Say that a tax of $T per unit is imposed in the industry. What area now represents consumer surplus? What area represents producer surplus? A c. What area represents the deadweight cost of the tax? N d. What area represents how much tax revenue is raised by the tax? D Use consumer and producer surplus to show the deadweight loss from a subsidy (producing more than the equilibrium output). (Hint: Remember that taxpayers will R have to pay for the subsidy.) Use the diagram to answer the following questions A (a)–(c). Q1 10. 11. Q* Quantity Q2 2 1Supply 6 1 T Price Ceiling S Price a b P1 P2 d c e f E2 E1 Demand 0 QS = Q2 Q1 QD Quantity Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 209 210 PART 3  Market Efficiency, Market Failure, and the Public System a. At the initial equilibrium price, what area represents consumer surplus? What area represents producer surplus? b. After the price ceiling is imposed, what area represents consumer surplus? What area represents producer surplus? c. What area represents the deadweight loss cost of the price ceiling? 12. Use the diagram to answer the following questions (a)–(c). Price a Supply E1 b P1 P2 c e d E2 f g h W 0 I Q Q L Quantity L a. At the competitive output, Q , what area represents the consumer surplus? What area represents the producer surplus? I b. At the larger output, Q , what area represents the consumer surplus? What area represents the producer surplus? Sproducing too much output? c. What area represents the deadweight loss of , brownouts, utility company bankruptcies, and worries about high The 2000–2001 California energy crisis produced Demand 2 1 1 2 13. prices. The California electric power regulatory program imposed price ceilings on electricity sold to consumers. The following exhibit describes the California situation with PS as the price ceiling. Answer the following questions K referring to this exhibit. A S SSupply A N D R A Price a Pe Pc b d c e f Demand 0 a. b. c. d. e. 2 Quantity Electric Power 1 What was the loss imposed on consumers by 6 this price ceiling? What was the loss imposed on producers by this price ceiling? 1 What was the total loss imposed on California by this price ceiling? Using this exhibit, explain the brownouts inTCalifornia. What would have to be true for consumers to support market set prices? Use the exhibit to explain why there S might not be support among consumers for raising prices. QS Qe QD Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Tutor Answer

DrAtticus
School: UT Austin

Attached.

Running head: ELASTICITY

1

Elasticity
Student’s Name
Institution Affiliation

ELASTICITY

2

1. a. Determinants of price elasticity of demand
Availability of close substitutes, time horizon, necessities versus luxuries and definition
of the market are the various determinants of price elasticity of demand. The availability of close
substitutes is a determinant claiming that all products with close substitutes possess more elastic
demand, and people react strongly towards them. Necessities versus luxuries describes that all
necessities constitute an inelastic demand while luxuries are linked to elastic demand. Definition
of the market is a common determinant of price elasticity of demand. Foods in a broader market
would be inelastic since they are hardly replaced, but biscuits serve as elastic market because
there are close substitutes for the product (Syrovatka & Lechanova, 2012). Time horizon as a
determinant of price elasticity explains that market goods become more elastic when exposed to
longer time horizons.
(b) How the determinants of the elasticity would make the demand for alcohol more elastic
From exhibit 6, the chosen good is alcohol. When considering the factor of availability of
substitute goods, alcohol has a close substitute with other carbonated drinks, and this makes
demand of alcohol to be more elastic for it can be substituted with drinks like wine. Whenever
close substitute for a good is present in a particular market, the demand for such product is
relatively more elastic. Whenever the price of alcohol rises, there will be a considerable fall in
demand for alcohol resulting in rise in wine’s de...

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Top quality work from this guy! I'll be back!

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