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Tax Burden in General Generally, neither demand nor supply is perfectly inelastic or perfectly elastic. \the tax burden/incidence is split between buyers and sellers according to relative elasticities, and market conditions. Law makers cannot legislate “who pays”. 1 Addiction and Elasticity –Nonusers’ demand for addictive substances is elastic. High taxes on cigarettes and alcohol limit the number of young people who become habitual users of these products. –Existing users’ demand for addictive substances is inelastic. High taxes have only a modest effect on the quantities consumed by established user, they raise revenue from these users. 2 Luxury Tax – Notice that depending on the goal of the tax different types of demand elasticity are desirable. – Raise revenue: inelastic demand – Change behaviour: elastic demand Who actually bore the burden of this tax? 3 Tax Burden and Elasticity of Demand Two extreme cases: • Perfectly inelastic demand: •Perfectly elastic demand: Tax Burden and Elasticity of Supply Two extreme cases: • Perfectly inelastic supply: • Perfectly elastic supply: 4 Sales Tax and the Elasticity of Demand Price (dollars per dose) S’ Tax S 2.20 Perfectly inelastic demand 2.00 Buyer pays entire tax D 100 Quantity (thousands of doses per day) 5 Sales Tax and the Elasticity S’ of Demand Price (cents per pen) S D 1.00 Tax Perfectly elastic demand 0.90 Seller pays entire tax 4 Quantity (thousands of marker pens per week) 6 Sales Tax and the Elasticity of Supply Price (dollars per bottle) S Perfectly inelastic supply 50 45 Tax Seller pays entire tax D 7 100 Quantity (thousands of bottles per week) Price (cents per pound) Sales Tax and the Elasticity of Supply Perfectly Elastic Supply S’ 11 Buyer pays entire tax Tax 10 S D 3 5 Quantity (thousands of kilograms per week) 8 Who pays the Airport Security Tax? Who pays the tax? - Demand Elasticity between 0.7 and 2.1 No mention of elasticity of supply but economists claim the price will rise by the amount of the tax, Ie: the buyer pays the whole tax, implying a perfectly elastic supply schedule. 9 Supply: Perfectly Elastic Original Equilibrium P=$60, Q=1,400 passengers/day Elasticity of Demand = 2.1 Price (dollars per trip) 100 Elasticity of Demand = 0.7 80 72 S+tax 60 S D1 40 20 D0 950 1,230 1,400 2,100 Quantity (passengers per day) 10 Supply: Unit Elastic Elasticity of Demand = 2.1 Price (dollars per trip) 100 Elasticity of Demand = 0.7 80 S+tax S 60 40 D1 20 D0 1,220 1,290 1,400 2,100 Quantity (passengers per day) Crucial to know demand elasticity & supply elasticity 11 Rent (dollars per unit per month) A Rent Ceiling & Elasticity S1, SR Supply in the LR becomes more elastic over time, increasing the shortage S2 24 20 Rent ceiling 16 Housing Housing shortage shortage 12 0 44 72 100 D 150 12 Quantity (thousands of units per month) How Long is the Long Run? There is no set amount of time that puts a market into the long run – The long run could be a week or a year The long run is how long a consumer or firm takes to fully adjust to a price change – Time required to make major changes – Ie) Give up Pepsi Vanilla, Build more cost efficient Pepsi factory, secure a US Pepsi Vanilla supplier The short run is anything shorter than the long run 13 Cross Price Elasticity of Demand We’ve seen already that demand is affected by the price of substitutes and compliments – An increase in the price of a substitute increases demand – An increase in the price of a complement decrease demand This effect can be measured using cross price elasticity If the cross price elasticity is zero, the good is neither a complement nor a substitute 14 Cross Price Elasticity of Demand E xy Percentage change in quantity demanded of X Percentage change in price of Y Exy = Change in X --------------(X1 + X2)/2 / Change in Price of Y ---------------------------(Py1 + Py2)/2 Substitutes – Positive Cross Price Elasticity Compliments – Negative Cross Price Elasticity 15 Income Elasticity of Demand Income Elasticity of demand refers to a HORIZONTAL SHIFT in the demand curve resulting from an income change Price elasticity of demand refers to a MOVEMENT ALONG THE DEMAND CURVE in response to a price change 16 Income Elasticity of Demand E xy Percentage change in quantity demanded Percentage change in income EI= Change in Q --------------(Q1 + Q2)/2 / Change in M ---------------------------(M1 + M2)/2 Normal Good – Positive Shift/Elasticity Inferior Good – Negative Shift/Elasticity 17 The Theory of Consumer Choice • The theory of consumer choice attempts to explain why consumers choose one good or bundle of goods over another good or bundle of goods. 18 The Theory of Consumer Choice • We are particularly interested in how prices affect consumer choice (demand) because –making choices in response to prices and price changes is the basis of the operation of the price system. –Cet. Par. 19 “Measuring” Satisfaction •util: unit of pleasure. • utility: a number that represents the level of satisfaction that the consumer derives from consuming a specific quantity of a good. 20 Total Utility, Marginal Utility • TU (total utility): – the total amount of satisfaction that you get from consuming a product. • MU (marginal utility): – the increase in TU that comes about as a result of consuming one more unit of the product. Frank’s TU & MU from country music: Total utility & marginal utility of trips to the club per week Trips to Club 1 2 3 4 5 6 Total utility 12 22 28 32 34 34 Marginal utility 12 10 6 4 2 0 21 Marginal Utility • If one more unit of a good is consumed, the marginal utility is equal to the increased utility from that extra good • If more than one additional good is consumed: Utility MU Goods 22 Total utility is maximized... 34 Marginal Utility (utils per week) Total Utility (utils per week) Total and Marginal Utility of Club Trips 28 22 0 2 3 4 5 6 7 8 Performances per Week 10 8 6 4 2 0 2 3 4 …where marginal utility equals zero. 5 6 7 Performances per Week 23 Law of Diminishing MU • The MU (marginal utility) of a good or service will decline as more units of that good or service are consumed. •Marginal utility is what counts for rational consumer decisions. 24 Frank’s Optimal Choice • When Frank can go to each activity for free, he splits his time between the two to maximize utility. At each successive step, he chooses the activity with the greatest MU. 25 (1) Per week (2) Total utility (3) Marginal utility (MU) Trips to club 1 2 3 4 5 6 12 22 28 32 34 34 12 10 06 04 02 00 Basketball games 1 2 3 4 5 6 21 33 42 48 51 51 21 12 09 06 03 00 26 Frank’s Optimal Choice • \ _night club visits and _ nights at basketball –for a total satisfaction = __ utils. • In the real world, Frank cannot have whatever he wants, he must maximize utility subject to: 1.) the income constraint 2.) the nature of commodity prices 27 Rational Choice \ Spend limited income where satisfaction per $ is the greatest. –MU/$: marginal benefit of the decision. –MU/$: marginal cost of the next best alternative given up \ choose those items for which MU/$ is the greatest until all income is spent. 28 Frank’s Optimal Decision • Suppose: Frank has an entertainment • budget of $21.00 • club tickets $3.00 • basketball tickets $6.00 • Under these circumstances, the best Frank can do is 1.) allocate (spend) all his income so that 2.) MU basketball = MU club trips P basketball P club trips 29 (1) per week Trips to Club B’ball games per/wk (2) (3) Marginal (4) Total Utility (MU) Price Utility (P)$ (5) Marginal Utility/$ (MU/P) 1 2 3 4 5 6 12 22 28 32 34 34 12 10 06 04 02 00 3.00 3.00 3.00 3.00 3.00 3.00 4.0 3.3 2.0 1.3 0.7 0.0 1 2 3 4 5 6 21 33 42 48 51 51 21 12 09 06 03 00 6.00 6.00 6.00 6.00 6.00 6.00 3.5 2.0 1.5 1.0 0.5 0.0 Income = $21 Pc = $3.00 Pb = $6.00 30 Frank’s Optimal Decision \ The rational consumer will choose a “market basket” where the MU of the last $ spent on all commodities is the same and all income is spent. –Why does this maximize utility? 31 Frank’s Optimal Decision •Suppose, Frank buys 3 basketball games and 1 club trip MUBB = 1.5 PBB MU club = 4 P club MBc > MCb •Frank is better off to take another club trip and give up one basketball game 32 Frank’s Optimal Decision IN GENERAL, the consumer will be in equilibrium with his/her choices when 1. Income = PAQA + PBQB …..+PzQz and 2. MU of good A MU of good B MU of good Z ... price of good A price of good B price of good Z 33 D E R I V I N G D E M A N D Now suppose the price of basketball games falls to $3.00. What is Frank’s new equilibrium? (5) (3) Marginal (2) Marginal (4) (1) per Total Utility (MU) Utility/$ Price week Utility (MU/P) (P)$ Trips to Club B’ball games per/wk 1 2 3 4 5 6 1 2 3 4 5 6 12 22 28 32 34 34 21 33 42 48 51 51 12 10 06 04 02 00 21 12 09 06 03 00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 4.0 3.3 2.0 1.3 0.7 0.0 7 4 3 2 1 0 Income = $21 Pc = $3.00 Pb = $3.00 34 Demand for B’ball Games At a price of $6, 2 games. Price per Unit ($) At a price of $3, 4 games. A reduction in price causes consumers to increase consumption until marginal utility per $ falls 6 3 D 2 Basket ball games 4 35 Example: Demand and Utility Maximization •Find the utility maximizing combination of products A & B obtainable with an income of $10. •Price of A is $1.00. •Price of B is $2.00. •Let the price of B fall to $2.00 and identify two points on the demand schedule for B 36 (1) (2) (3) (4) (5) (6) (7) A B Q TU TU 1 2 3 4 5 6 10 18 25 31 36 40 24 44 62 78 90 96 37 Supply, Production & Cost • Firms make the supply decision in order to maximize profits: Profit =Total Revenue - Total Cost • From the viewpoint of the firm the opportunity cost is the amount that the firm must pay the owners of the factors of production that it employs to attract them from their best alternative use. – Price therefore reflects the value of what 38 is foregone: opportunity cost Supply: Production & Costs • To calculate a firm’s Total Costs of production include all (opportunity) costs. – Explicit costs – Implicit costs Explicit Costs • Costs that arise when money actually changes hands; – eg. a bill is paid for utilities, wages, interest on a loan….. 39 Implicit Costs Costs faced by the owners where no money changes hands, no bill is received; e.g., salary (opportunity cost) given up by owner, normal rate of return on the best alternative investment (opportunity cost) of owner’s financial capital.. 40 Economic Profit • Economists & Accountants calculate profit differently: – Economists are interested in studying how firms make production & pricing decisions. They include all costs. Economic Profit = TR - [Explicit + Implicit Costs] Accounting Profit – Accountants are responsible for keeping track of the money that flows into and out of firms. They focus on explicit costs. Accounting Profit = TR - Explicit Costs 41 Economic Profit Terminology • Excess Profit or Economic Profit • occurs after a normal profit is made or after all costs have been covered. • Breaking Even = Zero Economic Profit • a satisfactory position for a firm because it means that “normal profits” are being achieved. • Economic Loss • an economic profit less than zero 42 Revenue Profit: Economists vs Accountants Economist’s View Accountant’s View Economic Profit Accounting Profit Implicit Costs Explicit Costs Revenue Total Opportunity Cost Explicit Costs 43 Accounts of Fieldcom Inc. Total revenue $600 000 LESS explicit costs Wages & salaries 320 000 Materials & other 60 000 EQUALS accounting profit $ 220 000 LESS implicit costs Forgone salary, Andrea Martin 75 000 Forgone salary, Ralph Martin 75 000 Interest forgone on invested saving 20 000 EQUALS pure economic profit $ 50 000 Opportunity Cost of Inputs Firms will only operate in an industry if they can make a normal rate of return Ie: Money invested in an interest must earn at least as much as it could elsewhere (bank account, stock market, GIC) Labour must be paid at least as much as it could earn elsewhere (an entrepreneur should make $X/hour) 45 Economics vrs. Accounting Example • Jack opens up a computer repair business • After all costs are paid, Jack makes $500/week in his business • By working for someone else, Jack would make $20/hr or $800/week • Accounting profit = $500 • Economic profit = -$300 • Economists would advice a change in profession 46 The Firm • A firm is an organization that brings together inputs to produce goods and services for sale Q = f (inputs) Q = f (K, L) 47 Technological and Economic Efficiency Technological efficiency is attained when the firm produces a given output by using the least inputs. Economic efficiency is attained when the cost of producing a given output is as low as possible. 48