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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