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the responsiveness of the amount
purchased to a change in price.
% Change in
% Q
Price Elasticity quantity demanded
of demand = % Change in Price = % P
- or put more simply -
=
(Q0 - Q1 )
Q0
( P0 - P1 )
P0
=
(Q0 - Q1 )
Q0
X
P0
( P0 - P1 )
PED > 1 Elastic
< 1 Inelastic
= 1 Unit Elastic
Quan Price
1 X 8
2
3
4
5
6
7
8
X
X
X
X
X
X
X
7
6
5
4
3
2
1
Total
Revenue
Elasticity
=
___
=
___
=
___
=
___
=
___
=
___
=
___
___
___
___
___
___
___
___
___
Different Elasticities
• Perfectly inelastic:
An increase in Price results
in no change in Quantity
Mythical
demand
curve
(a)
Quantity/
time
• Relatively inelastic:
A percent increase in Price
results in a smaller % reduction
in Quantity
Demand for
Cigarettes
(b)
Quantity/
time
• Unitary elasticity:
The percent change in quantity
demanded due to an increase in
price is equal to the % change in
price.
Demand curve of
unitary elasticity
(c)
Quantity/
time
=1
Elasticity of Demand
Demand for
Granny Smith
Apples
(d)
• Relatively elastic:
A % increase in Price
leads to a larger %
reduction in Quantity.
Quantity/
time
• Perfectly elastic:
Consumers will buy all of
Farmer Hollings’s wheat at the
market price, but none will be
sold above the market price.
Demand for Farmer
Hollings’s wheat
(e)
Quantity/
time
What affects Elasticity???
1. Available Substitutes
2. Necessity vs Luxury
3. Proportion of Income
4. Time to shop around
What affects Supply Elasticity???
1. Time
a. Market Period
b. Short Run
c. Long Run
Income Elasticity
• the responsiveness of a product’s
demand to a change in income.
% Change in
Income Elasticity quantity demanded
of demand = % Change in Income
• A normal good has a positive
income elasticity of demand.
– As income increases, the demand
for normal goods increases.
• Goods with a negative income
elasticity are inferior goods.
– As income expands, the demand
for inferior goods will decline.
Cross Price Elasticity
• the responsiveness of a product’s demand
to a change in the price of another good.
Cross Price
Elasticity
=
% Change in
Qx
% Change in Py
• A complement has a negative cross
price elasticity.
– As Py increases, the demand for Y decreases,
and demand for goods that are consumed
with Y also decreases.
• A substitute has a positive cross price
elasticity
– As Py increases, the demand for Y decreases,
and demand for goods that can be consumed
instead of Y also decreases.
Consumer Surplus
The total difference between what a consumer is willing to pay and how
much they actually have to pay.
Producer Surplus
The total difference between what a
supplier is willing to provide a good or
service and how much they actually get
for it.
Producer and Consumer Surplus
P
$10
9
8
7
6
5
4
3
2
1
Consumer surplus =
area of lighter triangle =
½($5)(5) = $12.5
S
Producer surplus =
area of darker triangle =
½($5)(5) = $12.5
CS
PS
D
0 1 2 3 4 5 6 7 8
Q
The combination of
producer and consumer
surplus is maximized at
market equilibrium
8-11
The Burden of a Tax
Tax Incidence
•
Who pays a tax is called the incidence.
Buyer
Seller
Impact of a Tax Imposed on Sellers
Price
• If in the used car market a price
of $7,000 would bring the
quantity of used cars demanded
into balance with the quantity
supplied.
• When a $1,000 tax is imposed on
sellers of used cars, the supply
curve shifts vertically by the
$7,400
amount of the tax.
S plus
tax
S
$1000 tax
$7,000
• The new price for used cars is
$7,400 … sellers netting $6,400
($7,400 - $1000 tax).
$6,400
• Consumers end up paying
$7,400
instead of $7,000 and bear $400
of the tax burden.
• Sellers end up receiving $6,400
(after taxes) instead of $7000
and
bear $600 of the tax burden.
D
500
750
# of used
cars
per month
(in
thousands)
Impact of a Tax Imposed on Buyers
Price
• In the same used car market:
• When a $1,000 tax is imposed
on
buyers of used cars, the
demand
curve shifts vertically by the
$7,400
amount of the tax.
• The new price for used cars is
$6,400 …buyers then pay taxes $7,000
of $1000 making the total
$7,400.
$6,400
• Consumers end up paying
$7,400
(after taxes) instead of $7,000
and bear $400 of the tax burden.
• Sellers end up receiving $6,400
instead of $7000 and bear $600
of the tax burden.
S
$1000 tax
D
D minus tax
500
750
# of used
cars
per month
(in
thousands)
Elasticity and Incidence of a Tax
• The actual burden of a tax depends on the
elasticity of supply and demand.
• As supply becomes more inelastic,
then more of the burden will fall on
sellers.
• As demand becomes more inelastic,
then more of the burden will fall on
buyers.
ED
ED + E S
ES
ED + ES
Tax Burden and Elasticity
• Consider the market for Gasoline
and Luxury Boats individually.
• We begin in equilibrium.
• If we impose a $.20 tax on gasoline
suppliers, the supply curve moves
vertically the amount of the tax.
Price goes up $.15 and output falls
by 6 million gallons per week.
• If we impose a $25K tax on Luxury
Boat suppliers, the supply curve
moves vertically the amount of
the tax. Price goes up by $5K and
output falls by 5 thousand units.
• In the gas market, the demand is
relatively more inelastic than its
supply; hence, buyers bear a larger
share of the burden of the tax.
• In the luxury boats market, the
supply curve is relatively more
inelastic than its demand; hence,
sellers bear a larger share of the
tax burden.
Price
S
$1.65
$1.60
$1.55
$1.50
$1.45
Gasolin
e
plus tax
market
S
D
Quantity
(millions
of
gallons)
19 20
4 0
Price
(thousand $)
S plus tax
S
110
Luxury boat
market
100
90
D
80
Quantity
5
1
0
15
(thousand
20 s
of boats)
• An effective price ceiling is a government set price
below the market equilibrium price
• It acts as an implicit tax on producers and an
implicit subsidy to consumers that causes a
welfare loss identical to the loss from taxation
P
S
A price ceiling transfers surplus
from producers to consumers,
generates deadweight loss, and
reduces equilibrium quantity
P0
P1
Price ceiling
Shortage
Q1
Q0
D
Q
• An effective price floor is a government set price above
the market equilibrium
• It acts as a tax on consumers and a subsidy for
producers that transfers consumer surplus to
producers
P
Surplus
S
P1
Price floor
P0
D
Q1
Q0
Q
A price floor transfers surplus
from consumers to producers,
generates deadweight loss, and
reduces equilibrium quantity
The Difference Between Taxes and Price Controls
• Price ceilings create shortages and taxes do not
• Taxes leave people free to choose how much to
supply and consume as long as they pay the tax
• Shortages may also create black markets
Rent Seeking, Politics, and Elasticities
• The possibility of transferring surplus from one set of
individuals to another causes people to spend time and
resources on doing so.
• Lobbying for price controls, which transfer surplus from
one group to another, is an example of rent-seeking
behavior
• Individuals spend money and use resources to lobby
governments to institute policies that increase their own
surplus
• Public choice economists argue that when all rent
seeking and tax consequences are netted out, there is
often not a net gain to the public
Inelastic Demand and Incentives to Restrict Supply
Revenue gained
P
When demand is relatively
inelastic, suppliers have
incentive to restrict
quantity to increase total
revenue
S1
S0
P1
P0
C
Revenue lost
A
B
D
Q1 Q 0
Q
Inelastic Supplies and Incentives to Restrict Prices
• When supply is inelastic, consumers have incentives to
restrict prices
• When supply is inelastic and demand increases, prices
increase causing consumers to lobby for price controls
• Rent control in New York City is an example
Application: Price Floors and Elasticity
The surplus created by a price floor is larger if
demand and supply are elastic
P
P
Surplus
S
Surplus
S
P1
P1
P0
P0
Price floor
D
D
Q1
Q0
Q
Q1 Q0
Q
International Trade
The Trade Sector of the US
Growth:
- In 1975, exports and imports were each
approximately 8% of the U.S. economy.
- In 2008, exports accounted for 11% of GDP and
imports made up 16%.
Major Trading Partners:
- Canada, Mexico, and Japan
-China, Europe
Partner
% Exports % Imports
Canada
20
16
Mexico
12
10
Latin America
11
8
Europe
21
17
OPEC
5
11
23
31
8
7
Pacific Rim
Other
Leading Trading Partners of the U.S.
–––––––– Percent of Total U.S. Trade, 2002 ––––––––
–––––––– Percent of Total U.S. Trade, 2006 –––––
–––
Canada
19.8% 18.5%
Mexico
China
Japan
Germany
United Kingdom
South Korea
Taiwan
France
Malaysia
All other countries
11.9%
9.1%
8.6%
4.9% 4.5%
3.9% 3.4%
3.1% 2.7%
2.5% 2.1%
2.3% 2.1%
1.8% 1.7%
11.5%
11.9%
7.2%
34.4%
32.2%
• Today, Canada, Mexico, China, and Japan are the leading
trading partners with the United States.
• The impact of international trade varies across industries. -some compete effectively, some do not.
The Growth of the U.S. Trade Sector
• Both exports and imports have grown substantially as a share
of the U.S. economy.
• Their growth has accelerated since 1975.
• Reductions in transport and communication costs, as well as
lower trade barriers have contributed to this growth.
Imports
Exports
(% of GDP)
(% of GDP)
20
20
15
15
10
10
5
5
1960 1970 1980 1990 2000 2010 1960
1970 1980 1990 2000 2010
Source: http://www.economagic.com/. The figures are based on data for real imports, exports, and GDP.
Balance of Trade
Percent of GDP
2
The United States has
been running trade
deficits since the 1970s
1
0
-1
-2
-3
-4
-5
-6
-7
1970
1980
1990
2000
2010
Gains from Specialization and Trade
• International trade allows each country to
specialize according to the law of comparative
advantage.
• Each country can produce those goods that it can
produce at a relatively low cost.
• Trading partners can consume a wider variety of
goods than they could produce domestically.
The Benefits from Trade (from
Chapter 2)
Textiles
(yds)
Pakistan specialized in textiles
5,000
4,000
and Belgium specialized in chocolates.
Pakistan
3,000
2,000
Belgium
1,000
1
2
3
4
5
Chocolate (tons)
When they took advantage of their comparative
advantage,
Textiles (yds)
they could trade with
each other for more of
5,000
4,000
both.
Pakistan
3,000
2,000
Belgium
1,000
1
2
3
4
5
Chocolate (tons)
Areca
Guns
12
8
4
0
Butter
0
2
4
6
Bonsai
Guns
16
12
8
4
0
Butter
0
1
2
3
4
Production Possibilities - Mexico
Product
A
B
C
D
E
Avocados
0
20
24
40
60
Soybeans
15
10
9
5
0
1 S = __ A
1 A = __ S
Production Possibilities - US
Product
A
B
C
D
E
1 S = __ A
Avocados
0
30
33
60
90
1 A = __ S
Soybeans
30
20
19
10
0
US should produce?
Mexico should produce?
Terms of Trade? ___ A for ___ S
Gains from Specialization and Trade
• International trade leads to gains from:
• Economies of Scale:
reductions in per-unit costs that often accompany
large-scale production, marketing, and
distribution.
• More Competitive Markets:
Promotes competition in domestic markets and
allows consumers to purchase a wide variety of
goods at economical prices.
A Hard Lesson to Learn
Exports and Imports are Linked
• Exports provide the foreign exchange needed
for the purchase of imports.
• Imports provide trading partners with the
currency needed to purchase exported goods
and services.
• Therefore, restrictions that limit one will also limit
the other.
Foreigners Have a Comparative Advantage
• Consider the international market for manufacturing shoes.
• In the absence of trade, the domestic price would be Pn.
• Since many foreign producers have a comparative advantage in the
production of shoes, international trade leads to lower prices Pw.
U.S. Market
World Market
Price
Sd
Price
Sw
Pn
a
Pw
Dd
Dw
Qn
Shoes
Qw
Shoes
Foreigners Have a Comparative Advantage
• At the price Pw, U.S. consumers demand Qc units of which (Qc
– Qp) are imported.
• Compared to no trade, consumers gain Pn a b Pw,
while domestic producers lose Pn a c Pw.
• A net gain of a b c results.
U.S. Market
World Market
Price
Sd
Price
Sw
a
Pn
Pw
b
c
Sw
Pw
Dd
Dw
U.S. imports
Qp Qn Qc
Shoes
Qw
Shoes
U.S. Has a Comparative Advantage
• The price of soybeans and other internationally traded
commodities is determined by the forces of supply and demand in
the world market.
• If U.S. soybean producers were prohibited from selling to
foreigners, the domestic price would be Pn.
• Free trade permits U.S. soybean producers to sell Qp units at the
higher world price of Pw.
U.S. Market
Sd
Price
Pw
a
b
Sw
World Market
Price
Sw
Pw
c
Pn
Dw
Dd
Qc
Qn
Qp
Soybeans
(bushels)
Qw
Soybeans
(bushels)
U.S.
Has
a
Comparative
Advantage
• At the world price of P , the quantity (Q – Q ) is exported.
w
p
c
• Compared to the no-trade situation, the producers’ gain from the
higher price (Pw b c Pn) exceeds the cost imposed on domestic
consumers (Pw a c Pn) by the triangle (area) a b c.
U.S. Market
Sd
Price
Pw
a
b
Sw
World Market
Price
Sw
Pw
c
Pn
Dw
Dd
U.S. exports
Qc
Qn
Qp
Soybeans
(bushels)
Qw
Soybeans
(bushels)
Varieties of Trade
Restrictions
• Tariffs are taxes governments place on internationally
traded goods (generally imports)
• Quotas are quantity limits placed on imports
• Voluntary restraint agreements are when countries
voluntarily restrict their exports
• An embargo is a total restriction on the import or export of
a good
• Regulatory trade restrictions are government-imposed
procedural rules that limit imports
• Nationalistic appeals, such as “Buy American” can help to
restrict international trade
Tariffs when the domestic country is small
Tariffs decrease imports,
increase domestic production,
and generate tariff revenue
P
Tariff revenue
SDomestic
$3.00
$2.50
PWorld + $0.50Tariff = S’World
PWorld = SWorld
$2.00
Imports’
DDomestic
Q
Imports
9-41
Application: Quotas when the domestic country is small
P
Quotas decrease imports and
increase domestic production
SDomestic
$3.00
Quota = S’World
PWorld = SWorld
$2.50
$2.00
Quota = 50
DDomestic
Q
Imports w/o quota
Trade Restriction Impacts
Price
Price
SDomestic
SDomestic
Import quota:
Imports after tariff
Pw
Q2 – Qd2
P2
Pw+ t
S
U
T
V
Tariff = t
Pw
S
U
T
V
Initial imports
Initial imports
DDomestic
DDomestic
Qd1 Qd2 Q2 Q1
Quantity
(automobiles)
Qd1 Qd2 Q2 Q1
Quantity
(peanuts)
U.S. Tariff Rates: 1890 to the Present
–––––––– U.S. Average Tariff Rate ––––––––
(Duties collected as a share of dutiable imports)
60%
50%
40%
30%
20%
4.5%
10%
1890
1910
1930
1950
1970
1990
2006
Why do Nations Adopt
Trade Restrictions?
1. Unequal internal Distribution of the gains from
trade (move to comparative advantage production)
2. Haggling by companies over gains from trade
3. Haggling by countries over trade restrictions
4. Specialized production:
a. Learn by doing
b. economies of scale.
c. Infant industry argument.
Why do Nations Adopt
Trade Restrictions?
5. Macroeconomic aspects of trade
Limit imports during a recession
6. National Security
7. International politics
8. Increase revenue from tariffs
U.S. Trade with Canada and Mexico
–––––––– U.S. Trade with Canada and Mexico –––––––
–
6%
(Exports and Imports together as a share of GDP)
5%
Canada
4%
3%
Mexico
2%
1%
1980
1985
1990
1995
2000
2005
• U.S. trade with both Canada and Mexico grew rapidly following
the passage of NAFTA.
the pleasure people get from
doing or consuming something
Diminishing Marginal Utility
• After some point, the marginal utility received from
each additional unit of a good decreases with each
additional unit consumed
• As additional units are consumed,
marginal utility decreases, but total
utility continues to increase
• When total utility is at a maximum,
marginal utility is zero
• Beyond this point, total utility decreases
and marginal utility is negative
Total Utility Curve
The total utility
curve is bowed
downward
Utility
70
Marginal Utility Curve
14
60
12
50
10
40
8
30
6
20
4
10
2
1
2
3
4
5
6
7
8
The marginal utility
curve is downward
sloping and graphed
at the halfway point
Utility
Q 0
–2
1
2
3
4
5
6
7
8
Q
MUB
MUN
MUA
=
=
.
.
.
=
PB
PN
PA
Choices are based on comparisons of MU per $
spent on each good until choices are equal.
The Pizza Demand Curve
• The demand for frozen pizzas
reflects the law of diminishing
marginal utility.
• Because marginal utility (MU)
falls with increased consumption,
so does a consumer’s maximum
willingness to pay -- marginal
benefit (MB).
$3.50
John’s demand curve
for frozen pizza
MB1
MB2
$3.00
MB3
Price =
$2.50
• A consumer will purchase until
MB = Price . . . so at $2.50 they
would purchase 3 frozen pizzas
and receive a consumer surplus
shown by the shaded area (above
the price line and below the
demand curve).
MB4 < MB3 < MB2 < MB1
because
MU4 < MU3 < MU2 < MU1
MB4
$2.00
d = MB
1
2
3
Frozen
4 pizzas
per week
Tastes are given
• Implicit in the theory of rational choice is that utility
functions are given, not shaped by society
• Tastes are often significantly
influenced by society
• Conspicuous consumption is the consumption of goods
not for one’s direct pleasure, but to show off to others
• “Given tastes” is the assumption on which an economic
analysis is conducted
1. Organize factors of production and/or
2. Produce goods and services and/or
3. Sell produced goods and services
• A virtual firm organizes production and subcontracts
out all work
• Many of the organizational structures of business are
being separated from the production process