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PPA 723: Managerial
Economics
Lecture 4:
Applications of Supply and Demand
Managerial Economics, Lecture 4: Applications of S&D
Outline
Elasticities
Tax Incidence
Rent Control
Managerial Economics, Lecture 4: Applications of S&D
Another Dimension of Demand and Supply:
Responsiveness
 The slope of a demand curve equals:
P change in P
slope 

Q change in Q
 The inverse of the slope indicates the
magnitude of the response to price.
 A more responsive curve (flatter slope) generally
means more alternatives in other markets.
Managerial Economics, Lecture 4: Applications of S&D
Elasticity
 The elasticity of demand equals:
Q / Q
elasticity 
P / P
 The absolute value of the elasticity indicates
the magnitude of the response to price.
 The value of the elasticity varies along a
linear demand curve.
Managerial Economics, Lecture 4: Applications of S&D
Slope and Elasticity
P
Slope = “rise”/“run” = P/Q < 0
P1
P
Elasticity = (Q/Q1)/(P/P1) < 0
Q
D
Q1
Q
Q
Managerial Economics, Lecture 4: Applications of S&D
Large and Small Elasticities
P
P
P2
S2
P2
S2
P1
S1
D
P1
S1
D
Q2
Q1
Large Elasticity (│e│)
= Responsive Demand
Q
Q2
Q1
Q
Small Elasticity (│e│)
= Unresponsive Demand
Managerial Economics, Lecture 4: Applications of S&D
Figure 3.3c Vertical and Horizontal Demand Curves
p, Price of
insulin dose
(c) Individual’s Demand for Insulin
p*
Q*
Q, Insulin (doses per day)
Managerial Economics, Lecture 4: Applications of S&D
P ($ per kg)
Figure 3.2 Elasticity Along the Pork Demand Curve
Perfectly Elastic: e = - ∞
a/b = 14.30
11.44
Elastic: e < -1
e = –4
e = (Q/Q)/(P/P)
= (PQ)/(QP)
D
a /(2b) = 7.15
Unitary: e = -1
Inelastic: 0 > e > -1
-P = P
3.30
e = –0.3
Perfectly Inelastic:
e=0
Q = Q
0
a/5 = 57.2
a/2 = 143
220
a = 286
Q (Mil. kg of pork/year)
Managerial Economics, Lecture 4: Applications of S&D
Figure 3.1 How the Effect of a Supply Shock
Depends on the Shape of the Demand Curve
(b)
3.55
3.30
e2
e1
S1
0
D2
176
215 220
Q, Million kg of pork per year
3.675
3.30
e2
S2
S1
e1
0 176
220
Q, Million kg of pork per year
p, $ per kg
D1
S2
(c)
p, $ per kg
p, $ per kg
(a)
3.30
D3
S2
S1
0
e2
e1
176
205 220
Q, Million kg of pork per year
Managerial Economics, Lecture 4: Applications of S&D
Change in Revenue
p, Price per unit
New Revenue
p2
e2
e1
p1
D
Original Revenue
Q2
Q1
Q, Quantity per time period
Managerial Economics, Lecture 4: Applications of S&D
Elasticity and Revenue
Q / Q
e
P / P
Revenue  R  PQ
R  ( P  P)(Q  Q)  PQ
R  (P)(Q)(e  1)
Managerial Economics, Lecture 4: Applications of S&D
Elasticity and Revenue, Continued
When price increases,
Revenue increases if demand is inelastic
(|e| < 1)
Revenue decreases if demand is elastic
(|e| > 1)
Managerial Economics, Lecture 4: Applications of S&D
P ($ per kg)
Figure 3.4 Elasticity Along the Pork Supply Curve
S
5.30
h ≈ 0.71
4.30
h ≈ 0.66
3.30
2.20
0
h ≈ 0.6
h ≈ 0.5
176
220
260
300
Q (Million kg of pork per year)
Managerial Economics, Lecture 4: Applications of S&D
Tax Incidence
A key question about taxes is: Who pays?
To answer, must distinguish between:
Legal Incidence, which indicates who is
legally obligated to write the check to the
government.
Economic Incidence, which indicates whose
real income declines due to the tax.
They may not be the same due to tax
shifting.
Managerial Economics, Lecture 4: Applications of S&D
The Analysis of Tax Incidence
P
S + tax
S
P2
P1
tax
Burden on consumers
Burden on firms
P3
D
Q
Managerial Economics, Lecture 4: Applications of S&D
p, $ per kg
Figure 3.5 Effect of a $1.05 Specific Tax on the
Pork Market Collected from Producers
S2
e2
p 2 = 4.00
t = $1.05
S1
e1
p 1 = 3.30
p 2 – t = 2.95
T = $216.3 million
D
0
176
Q 2 = 206
Q 1 = 220
Q, Million kg of pork per year
Managerial Economics, Lecture 4: Applications of S&D
p, $ per kg
Figure 3.6 Effect of a $1.05 Specific Tax on
Pork Collected from Consumers
e2
p 2 = 4.00
p 1 = 3.30
p 2 – t = 2.95
Wedge, t = $1.05
S
e1
T = $216.3 million
t = $1.05
D1
D2
0
176
Q 2 = 206
Q 1 = 220
Q, Million kg of pork per year
Managerial Economics, Lecture 4: Applications of S&D
p, Price per unit
Page 64 Solved Problem 3.1
p2 = p1 + 1
e2
S2
e1
p1
t = $1
S1
D
Q2
Q1
Q, Quantity per time period
Managerial Economics, Lecture 4: Applications of S&D
R (Rent per Acre)
A Land Tax
S
D
R1
Tax
R1-T
Q1
Q (Acres of Land)
Managerial Economics, Lecture 4: Applications of S&D
Lessons
A tax falls most heavily on the side of
the market with the lowest elasticity (=
fewest alternatives).
Economic incidence is determined by
market forces, not by legal incidence.
Managerial Economics, Lecture 4: Applications of S&D
Rent Control
Housing affordability is a serious issue in
this country:
More than half of the poor pay more than
half of their income in rent and utilities.
A few cities try to address this through
rent controls, i.e., by setting rent ceilings.
Managerial Economics, Lecture 4: Applications of S&D
Rent Control
Short-run S
R (Rent)
Long-run S
e
R
Rent ceiling
R*
D
QS2
QS1 Q
Qd
Q (Number of Apartments)
Managerial Economics, Lecture 4: Applications of S&D
Effects of Rent Control
Fewer apartments put on the market
Decline in maintenance and hence in the
number of quality-adjusted units
Fewer apartments constructed
New rules for allocating units, with the
poor at a disadvantage
Managerial Economics, Lecture 4: Applications of S&D
Lessons
Public policy can alter prices, but only at
great cost.
Market forces are powerful and not easily
overcome!
Attempts to alter market outcomes usually
have unintended consequences.
The distribution of benefits and costs may
be difficult to control