ECON Exam 2: Elasticity, Taxes, International Trade (Oct 21)

Exam 2 covers Ch 6-8: elasticity, taxes, international trade (+ binding price controls). On paper, closed book, no calculator. Built from the professor's HuskyCT slides and Exam 2 outline.

Elasticity master formula

ε = %ΔQ ÷ %Δ(incentive). It measures how much quantity responds to a change in price or income.

Elastic vs inelastic vs unit elastic (ranges)

|ε| > 1 = elastic (Q responds a lot), |ε| < 1 = inelastic (Q barely moves), |ε| = 1 = unit elastic.

Price elasticity of demand (PED)

%ΔQd ÷ %ΔP. Always negative, so use absolute value. Meaning: buyers' responsiveness / willingness to pay. Steep curve = inelastic, flat curve = elastic.

Total Revenue Test

If demand is elastic: raising price LOWERS total revenue. If inelastic: raising price RAISES total revenue. TR = P × Q. Only raise price when demand is inelastic.

Ambulance example (from slides)

Highly inelastic demand: people pay almost any price in an emergency, so providers can charge thousands.

Income elasticity of demand (IED)

%ΔQd ÷ %ΔIncome. Positive = normal good (>1 luxury, 0-1 necessity). Negative = inferior good (buy less as income rises, e.g. ramen, bus rides).

Cross-price elasticity (CPE)

%ΔQd of A ÷ %ΔP of B. Positive = substitutes (Coke/Pepsi). Negative = complements (cars/gas). Zero = unrelated.

Price elasticity of supply (PES)

%ΔQs ÷ %ΔP. Connects to costs: elastic when producers can ramp up cheaply (spare capacity, easy inputs, more time); inelastic when capacity is fixed (hotel rooms tonight).

Midpoint method

%ΔQ = (Q2 - Q1) ÷ average(Q1, Q2); %ΔP = (P2 - P1) ÷ average(P1, P2).

Progressive tax + example

Share of income paid rises with income. Example: federal income tax.

Regressive tax + example

Share of income paid falls with income. Example: sales tax (takes a bigger share of a low income).

Flat (proportional) tax

Same share of income for everyone.

Excise tax wedge

The tax drives a wedge between the price buyers pay (Pb) and the price sellers keep (Ps). Pb - Ps = tax per unit.

Does it matter who the tax is legally levied on (buyers vs sellers)?

No. The economic outcome (prices, quantity, burden split) is identical either way.

Tax incidence rule

The LESS elastic (more price-insensitive) side of the market bears MORE of the tax.

Tax diagram: where is tax revenue?

Rectangle = tax per unit × Qt, between Ps and Pb, from 0 to Qt.

Tax diagram: where is deadweight loss?

Triangle between the D and S curves, from Qt to Qe. More elastic curves → bigger DWL.

Effect of an excise tax on prices and quantity

Quantity falls (Qt < Qe). Buyers pay more (Pb > Pe). Sellers keep less (Ps < Pe). CS and PS both shrink; the part nobody gets is DWL.

How are households and firms affected by a tax?

Households pay a higher price and buy less; firms receive a lower net price, so revenue and profit fall. (Potterville hotel: $40 tax → guests pay $100 instead of $80, owners net $60.)

Comparative advantage

A country has it in a good when its OPPORTUNITY COST of producing that good is lower than other countries'. Trade on CA makes the world richer.

Gains from trade + the tradeoff

Total surplus rises, but jobs in import-competing industries are lost (the employment tradeoff).

Autarky price (Pa)

The domestic equilibrium price with no trade. Compare it to world price Pw to decide export vs import.

Export case (Pw > Pa): effects

Domestic price rises to Pw. Qd falls, Qs rises. Exports = Qs - Qd. Consumers LOSE, producers GAIN, total surplus rises.

Import case (Pw < Pa): effects

Domestic price falls to Pw. Qd rises, Qs falls. Imports = Qd - Qs. Consumers GAIN, producers LOSE (this is where job losses show up), total surplus rises.

Tariff: effects on price, quantities, imports

Domestic price rises from Pw to Pw + t. Domestic Qs rises, Qd falls, imports shrink.

Tariff diagram: government revenue

Rectangle = tariff × (imports after tariff), between Qs2 and Qd2, from Pw up to Pw+t.

Tariff diagram: deadweight loss

Two triangles: one from overproduction by inefficient domestic firms, one from lost consumption.

Who gains and who loses from a tariff?

Consumers lose, domestic producers gain, government collects revenue, and total surplus falls (DWL).

Binding price ceiling

Set BELOW Pe (e.g. rent control). Qd > Qs → shortage. Draw the line under the intersection, mark Qs and Qd, bracket the gap.

Binding price floor

Set ABOVE Pe (e.g. minimum wage). Qs > Qd → surplus. In a labor market that surplus = unemployment.

Price ceiling set ABOVE Pe

NOT binding - the market still clears at Pe. Nothing changes.

Why price controls create deadweight loss

They block mutually beneficial trades (units between the new Q and Qe that both sides would have gained from).

Diagram-answer rubric (what the professor grades)

1) Label axes (P, Q) and curves (D, S). 2) Mark equilibrium (Pe, Qe). 3) Add the intervention (wedge / world price / ceiling / floor). 4) Mark all relevant prices, quantities, and areas. 5) WRITE the interpretation: who gains, who loses, how households and firms are affected.

Exam 2 coverage

Chapters 6, 7, 8: Elasticity, Taxes, International Trade + one binding price-controls diagram (Ch 5).

Exam 2 format

In class, ON PAPER, closed book, no electronics, no calculator. 5 diagrams to label and interpret in writing + ~5 multiselect on Elasticity, Taxes & Tax Incidence, International Trade & Tariffs.

Q: Price rises 10%, quantity demanded falls 20%. PED? Elastic or inelastic? Effect of raising price on TR?

PED = 20/10 = 2 → elastic. Raising price again LOWERS total revenue.

Q: Income rises 5%, demand for bus passes falls 2%. IED? Type of good?

IED = -2/5 = -0.4 → inferior good.

Q: Price of hot dogs rises 8%, demand for buns falls 4%. CPE? Relationship?

CPE = -4/8 = -0.5 → complements.

Q: Cigarette demand is inelastic. Who bears most of a cigarette tax?

Consumers (smokers) - incidence falls on the less elastic side; they keep buying at the higher price.

Q: US grows wheat at lower opportunity cost than Japan. Who has CA, and what should happen?

The US has CA in wheat. US should specialize and export wheat; Japan specializes where its opportunity cost is lower and imports wheat. Both gain.

Q: World steel price is below the US autarky price. Does the US import or export? Who gains/loses?

Import. Consumers gain; domestic steel producers lose surplus (and jobs); total surplus rises.