ECON EXAM 3

demand and supply elasticity and tax burden, who it falls on and how to apply it to questions

When a microeconomics question doesn't give you numbers for elasticity, it is usually giving you clues through who bears the greater burden of a tax.

You can figure out the elasticities by looking at a simple rule: The side of the market that is less elastic gets stuck paying more of the tax.

• Whichever group sees the bigger price change relative to the pre-tax price. If the tax is $10 and the price consumers pay goes up by $7 (meaning they absorb $7 of the burden), while producers only absorb $3 of the drop in their net price:

  • Consumers are paying the larger share of the tax ($7 vs. $3).

  • Therefore, consumers (demand) are less elastic than producers (supply).

• so, If supply is less elastic, that automatically means demand is more elastic than supply.

elastic and what it means for behavior

Highly sensitive to price changes. If a tax raises the price, people immediately stop buying (or producers stop making) the good in large numbers, causing a massive drop in quantity.

inelastic and what it means for behavior

Unsensitive to price changes. People or producers need this good, so even if a tax raises the price, they keep buying and selling close to the exact same quantity as before

availability of substitutes and elastic demand

More substitutes usually means more elastic demand

neccessity vs luxury

Necessities tend to be more inelastic; luxuries tend to be more elastic.

time horizon and elasticity

Demand usually becomes more elastic over time as consumers find alternatives.

market definition of a good and elastic demand

A narrowly defined good tends to have more substitutes and more elastic demand.

price elasticity of demand

% change in quantity demanded ÷ % change in price

greater than 1=elastic

less than 1= inelastic

equal to 1=unit elastic

use the absolute value when classifying elasticity.

income elasticity of demand

% change in quantity supplied ÷ % change in price

the sign matters!

• Income elasticity positive → normal good.

• Income elasticity negative → inferior good.

cross price elasticity of demand

% change in quantity demanded of good X ÷ % change in price of good Y

• Cross-price elasticity positive → substitutes.

• Cross-price elasticity negative → complements.

how to calculate elasticity

Use the midpoint method when your class asks for percentage changes between two values:

For example, price increases from $10 to $12, and quantity demanded decreases from 100 to 80.

• Percentage change in quantity = (-20/90 *100= -22.22%)

• Percentage change in price = (2/11*100=18.18%)

• PED = (-22.22/18.18= -1.22)

total revenue if demand is elastic

if price increases, total revenue falls

if price decreases, total revenue rises

whatever price does, total revenue goes opposite way when ELASTIC

total revenue if demand is inelastic

if price increases, total revenue increases

if price decreases, total revenue decreases

whatever price does, total revenue moves in the SAME direction when INELASTIC

consumer surplus

The difference between what buyers are willing to pay and what they actually pay. On a graph, it is above the market price and below the demand curve.

producer surplus

The difference between the price sellers receive and the minimum price they would accept. On a graph, it is below the market price and above the supply curve.

total economic surplus

Consumer surplus + producer surplus

market efficency

A competitive market is efficient when it maximizes total economic surplus, assuming no market failures.

For the standard competitive-market model without externalities, an increase in supply or demand generally increases total surplus by allowing more mutually beneficial trades.

deadweight loss

the total surplus lost when mutually beneficial trades no longer occur.

• A tax reduces the quantity traded below the efficient equilibrium quantity.

• The resulting deadweight loss is the surplus lost by both buyers and sellers that is not collected as tax revenue.

• the side of the market that is more inelastic bears more of the tax burden.

The loss in total surplus resulting from a market distortion (such as a tax).

• It is the loss to buyers and sellers, not offset by an increase in government revenue.

• IMPORTANT POINT: Recall from class that we now include government revenue in our calculation of total surplus.

• Calculating deadweight loss: area of a triangle if the S & D curves are linear.

per-unit tax

a fixed amount of tax charged for every unit of a good sold

ex. A $1 tax on every pack of cigarettes.

tax incidence/burden

refers to the way the burden of a tax is shared among market participants

tax wedge

The difference between the price buyers pay and the price sellers receive. This makes

modeling a per-unit tax relatively easy (no need to shift the demand or supply curve)

How the burden of a tax is divided (or the tax incidence) depends on:

• the relative elasticities of supply and demand

• NOT on whether the tax is levied on buyers or sellers

it equals the buyer's price minus the seller's price. For a per-unit tax, that difference equals the tax amount.

how a tax works

Imagine a good originally sells for $10, and the government imposes a $2 tax per unit.

After the tax, it's possible that:

• Buyers pay $11.

• Sellers receive $9.

• The tax wedge is $2.

The buyer pays $1 more, and the seller receives $1 less than before. They share the tax burden equally in this example.

The government receives $2 per unit, even though neither side individually bears the entire $2 burden.

how the burden of a tax falls on the side of the market that is more inelastic (or less elastic)

• When supply is more elastic than demand (i.e., demand is more inelastic), the tax incidence falls more heavily on consumers.

• When demand is more elastic than supply (i.e., supply is more inelastic), the tax incidence falls more heavily on producers

Why? The more inelastic side has less flexibility to change its behavior when the tax changes prices.

positive externality

external benefit

ex. health care, education

Key result: The market tends to produce or consume too little of the good.

externality

the uncompensated impact of one person’s (or firm’s) actions on the well-being of a bystander.

negative externality

external cost

ex. pollution, smoking, noise pollution

Key result: The market tends to produce or consume too much of the good.

market supply curve= private costs to producers

The supply curve represents the costs that businesses themselves have to pay to produce a good.

Imagine a farm selling eggs. The farmer has to pay for:

• Chicken feed

• Labor

• Housing and equipment

• Veterinary care

These are the farmer's private costs because the farmer pays them directly.

The supply curve shows how much producers are willing to sell at different prices based on their production costs.

market demand curve= private value to consumers

The demand curve represents how much consumers value a good — in other words, the maximum price they're willing to pay.

Imagine you want to buy a dozen eggs.

• You'd pay up to $8 for them.

• If the price is $5, you're happy to buy them.

• If the price is $10, you probably won't buy them.

Your private value is $8 because that's the maximum amount you'd personally be willing to pay.

explanation on positive and negative externalities and how it relates to the market

Without externalities, the market equilibrium is where supply and demand intersect. Assuming no other market failures, this is the socially efficient quantity.

The regular supply and demand curves show private costs and values. When externalities exist, we must account for the additional costs or benefits to society to find the socially optimal quantity.

negative externality equation

Social Cost = Private Cost + External Cost

• The social cost curve lies to the left of the supply curve (like a decrease in supply)

• The optimal quantity occurs where the social cost curve intersects the demand curve

• The market equilibrium occurs where private supply intersects demand.

The socially optimal quantity (what should happen) is lower than the market quantity.

The market quantity (what actually happens) ends up greater than the socially optimal amount

positive externality equation

Social Value = Private Value + External Benefit

• The social value curve lies to the right of the demand curve (like an increase in demand)

• The optimal quantity occurs where the social value curve intersects the supply curve

• The market equilibrium occurs where supply intersects private demand, The socially optimal quantity occurs where supply intersects social value.

The socially optimal quantity (what should happen) is higher than the market quantity.

The market quantity (what actually happens) is lower than the socially optimal amount

How do we achieve the social optimum

Internalize the externality

this is: altering markets so that people and firms take into account the external effects

of their actions.

externalities can be fixed either privately, through bargaining, or publicly, through government action.

social cost vs social value

used in positive and negative externality equations

social cost: supply curve, Adds any extra costs imposed on other people. Associated with a negative externality, such as pollution.

social value: demand curve, Adds any extra benefits received by other people. Associated with a positive externality, such as education.

private solutions to an externality

Private parties can bargain with each other until the optimal

quantity is achieved.

• Requires well-defined property rights: it must be clear who has the right to do what.

• Transaction costs: (the costs that parties incur while bargaining with each other) must be low or zero, meaning bargaining must be easy and inexpensive.

public solutions to an externality

Regulation: Government sets rules or limits, ex. limiting how much pollution a factory can release

Tax: used for negative externalities to discourage harmful production (pollution)

Subsidy: used for positive externalities, ex. subsidizing education or vaccinations to encourage more consumption

two characteristics of goods:

excludability and rivalry

excludable and nonexcludable good

Excludable good: a person can be prevented from using it (You want to enter a Clemson football game, but you need a ticket. If you don't have one, you can be kept out)

Non-excludable good: a person cannot be prevented from using it

rival good and nonrival good

Rival good: one person’s use of the good diminishes the availability (maybe not

completely) of the good to others.

Non-rival good: one person’s use does not diminish the availability to others

private goods are

excludable and rival

people be prevented from using the good and one person's use of good leaves less available for others

ex. a sandwich

public goods are

nonexcludable and nonrival

people cannot be prevented from using the good, one person’s use of the good does not leave less for others

ex. national defense (protects people whether or not each person directly pays for it), research, knowledge

Too little gets produced!

common goods are

nonexcludable and rival

ex. fish in the ocean (If everyone catches as many fish as possible the fish population can decline), hunted animals, public parks, congested roads

Too much gets used!

free rider

Someone who receives the benefit of a public good but does not pay for it ⇒ decreases the incentive to produce public goods ⇒ free markets may underproduce public goods

Potential solutions:

• Government can provide or subsidize the public good

• Copyrights

• Patents

tragedy of the commons

common resources get used more than is socially desired. That is, when one person uses the common resource, that use reduces its availability to everyone.

Potential solutions:

• Government regulation to limit use (fishing/hunting licenses)

• Privatize the common resource into a private good

a firms objective and an economic objective when determining profit

Firm’s objective: Maximize profit, where Profit = Total Revenue – Total Cost

Economics objective: Total Cost is broken down into explicit and implicit costs

economic profit subtracts costs that accounting profit ignores.

explicit costs

money the business actually pays out

• Employee wages

• Rent for a store

• Ingredients or supplies

• Electricity bills

implicit costs

the value of an opportunity the business gives up

• The salary you could have earned at another job

• Rent you could have earned by renting out a building you own

• Interest you could have earned by keeping your money in a savings account instead of investing it in your business

accounting profit

Total Revenue – Explicit Costs

economic profit

Total Revenue – (Explicit Costs + Implicit Costs)

fixed costs

costs that do not vary with output (quantity)

ex. store rent, insurance

variable costs

costs that do vary with output (quantity)

ex. ingredients, packaging, hourly labor that varies with production

production function

the relationship between the quantity of an input and the quantity of output.

Shows how inputs (like workers) turn into output (like cupcakes).

marginal product of labor

The increase in output from an additional worker

The extra output produced by hiring one additional worker.

diminishing marginal product

the marginal product of an input (in this case labor) declines as the quantity of the input increases.
As more workers are added, each additional worker eventually contributes less extra output, assuming other inputs stay fixed.

total cost curve

the relationship between output and total cost

tells us all total costs

average fixed cost equation

fixed cost/quantity

average variable cost

variable cost/quantity

average total cost

total cost/quantity

average total cost also equals the average fixed cost plus average variable cost

it is “U-shaped” – it declines at low levels of output, and then starts to rise

marginal cost

the increase in total cost that arises from an extra unit of production

Extra cost of producing more

marginal cost= Change in total cost / Change in Quantity

• eventually, marginal cost MUST rise

• Typically rises as output increases because diminishing marginal product means each extra unit becomes more expensive to produce.

A firm’s total cost is $400 when it produces 20 units and $460 when it produces 25 units.

What is the marginal cost per additional unit over this range?

example problem: A firm’s total cost is $400 when it produces 20 units and $460 when it produces 25 units. What is the marginal cost per additional unit over this range?

answer → $12, ($460-400)/(25-20)=$12 per unit

key concepts about cost curves

1. The marginal cost curve eventually rises with the quantity of output once diminishing marginal product sets in.

2. The average variable cost and average total cost curves are U-shaped

3. Whenever marginal cost is less than average total cost, average total cost is falling.

4. Whenever marginal cost is more than average total cost, average total cost is rising

5. The marginal cost curve crosses the average total cost curve at its minimum

why marginal curve eventually rises when diminishing marginal product sets in

• "Sets in" marks the exact threshold or quantity of output where that extra productivity peaks and starts to decline. For example, if adding the 3rd worker gives you 10 extra boxes, but the 4th worker only adds 6 extra boxes because people start crowding the equipment, diminishing marginal product has set in.

• Why Marginal Cost Rises: Because each new worker or input is now producing less than before, you have to spend more money on labor/inputs to squeeze out that same next unit of output. Therefore, the marginal cost of production starts climbing upward.

The four rules professors love to test with Marginal Cost and Average Total Cost

• If MC is below ATC, ATC falls.

  • The extra unit costs less than the current average, pulling the average down.

• If MC is above ATC, ATC rises.

  • The extra unit costs more than the current average, pulling the average up.

• MC crosses ATC at ATC's minimum.

  • The marginal cost curve intersects the average total cost curve at its lowest point.

• MC eventually rises.

  • Diminishing marginal product eventually makes additional production more costly.

ex. A firm's average total cost is $20 per unit. The marginal cost of producing one more unit is $15. What happens to average total cost? → ATC falls