Exam 1 Study Notes: Supply & Demand, Elasticity, Taxes & Subsidies

Exam 1 Format

• Multiple Choice: Questions will test understanding of concepts.

• Short Answer: Requires concise explanations of economic principles.

• Numerical: Problems involving calculations related to:

  • Opportunity Cost

  • Elasticity

• Supply/Demand Graphs: Analysis and drawing of graphs, including:

  • Isolated shifts (single curve changing).

  • Multiple shifts (both curves changing).

  • Impact of Taxes and Subsidies.

Supply and Demand Shifts

• Examines how changes in underlying factors affect market equilibrium.

• Isolated Shifts: Only one curve (either demand or supply) shifts.

• Multiple Shifts: Both demand and supply curves shift simultaneously.

Determinants of Demand

These are the factors that determine the shape and position of the demand curve:

• Income: As income changes, consumers' ability and willingness to buy goods change.

• Price of all other goods: Refers to prices of substitutes and complements.

• Number of Consumers: A larger consumer base generally leads to higher demand.

• Taste/Preferences: Changes in fashion, fads, or preferences can shift demand.

• Expectations: Consumers' expectations about future prices or availability can influence current demand.

• Complements or Substitutes:

  • Complements: Goods consumed together (e.g., coffee and sugar). An increase in the price of one decreases demand for the other.

  • Substitutes: Goods that can be used in place of one another (e.g., tea and coffee). An increase in the price of one increases demand for the other.

• Definition from Alfred Marshall (1890, Principles of Economics): "When we say that a person’s demand for anything increases, we mean that he will buy more of it than he would before at the same price… A general increase in his demand is an increase throughout the whole list of prices at which he is willing to buy more of it at the current prices.” This highlights that an increase in demand means a willingness to buy more at any given price.

Determinants of Supply

These are the factors that determine the shape and position of the supply curve:

• Change in Technology: Improvements in technology typically reduce production costs and increase supply.

• Changes in Input Prices: The cost of resources used in production (e.g., labor, raw materials, energy) directly affects the profitability of supplying a good.

• Taxes and Subsidies:

  • Taxes: Increase production costs, typically leading to a decrease in supply.

  • Subsidies: Reduce production costs, typically leading to an increase in supply.

• Expectations: Producers' expectations about future prices can influence their current supply decisions.

• Entry or Exit of Producers: An increase in the number of producers increases market supply, while a decrease reduces it.

• Seller’s Willingness to Produce: Factors affecting a seller's motivation or ability to produce.

Summary of Isolated Shifts in Supply and Demand

• Illustrative Example (Demand Increase): If Demand (D) increases and Supply (S) remains unchanged (D1 to D2, S1), the equilibrium price and quantity both increase. (Graph: D1 intersects S1 at point A; D2 intersects S1 at point B, where B is higher and to the right of A).

• Illustrative Example (Demand Decrease): If Demand (D) decreases and Supply (S) remains unchanged (D1 to D2, S1), the equilibrium price and quantity both decrease. (Graph: D1 intersects S1 at point A; D2 intersects S1 at point B, where B is lower and to the left of A).

• Illustrative Example (Supply Increase): If Supply (S) increases and Demand (D) remains unchanged (D1, S1 to S2), the equilibrium price decreases and equilibrium quantity increases. (Graph: D1 intersects S1 at point A; D1 intersects S2 at point B, where B is lower and to the right of A).

• Illustrative Example (Supply Decrease): If Supply (S) decreases and Demand (D) remains unchanged (D1, S1 to S2), the equilibrium price increases and equilibrium quantity decreases. (Graph: D1 intersects S1 at point A; D1 intersects S2 at point B, where B is higher and to the left of A).

Summary of Multiple Shifts in Supply and Demand

When both curves shift, the effect on one equilibrium variable (either price or quantity) is ambiguous (unclear without knowing the magnitude of the shifts).

• Illustrative Example (Increase Demand, Increase Supply): If Demand increases (D1 to D2) and Supply increases (S1 to S2), the equilibrium quantity increases, but the equilibrium price is ambiguous. (Graph: D1 intersects S1 at A; D2 generally shifts right, S2 generally shifts right. Point B, the new intersection, will be to the right of A, but could be higher, lower, or at the same price as A depending on the magnitudes of the shifts).

• Illustrative Example (Increase Demand, Decrease Supply): If Demand increases (D1 to D2) and Supply decreases (S1 to S2), the equilibrium price increases, but the equilibrium quantity is ambiguous. (Graph: D1 intersects S1 at A; D2 shifts right, S2 shifts left. Point B, the new intersection, will be higher than A, but could be to the left, right, or at the same quantity as A).

• Illustrative Example (Decrease Demand, Increase Supply): If Demand decreases (D1 to D2) and Supply increases (S1 to S2), the equilibrium price decreases, but the equilibrium quantity is ambiguous. (Graph: D1 intersects S1 at A; D2 shifts left, S2 shifts right. Point B, the new intersection, will be lower than A, but could be to the left, right, or at the same quantity as A).

• Illustrative Example (Decrease Demand, Decrease Supply): If Demand decreases (D1 to D2) and Supply decreases (S1 to S2), the equilibrium quantity decreases, but the equilibrium price is ambiguous. (Graph: D1 intersects S1 at A; D2 shifts left, S2 shifts left. Point B, the new intersection, will be to the left of A, but could be higher, lower, or at the same price as A).

Elasticity

• Elasticity measures the responsiveness of quantity demanded or supplied to a change in price or other factors.

Elastic vs. Inelastic Demand

• Elastic Demand (|E_d| > 1): Quantity demanded is very responsive to changes in price. A small price change leads to a large change in quantity demanded.

• Inelastic Demand (|E_d| < 1): Quantity demanded is not very responsive to changes in price. A price change leads to a relatively smaller change in quantity demanded.

• Unitary Elastic Demand ($|E_d| = 1$): Quantity demanded changes by the same percentage as the price change.

Factors Determining Demand Elasticity

• **Factors causing Elasticity (|E_d| > 1):

  • More substitutes available.

  • Lower consumer income (for luxury goods).

  • Higher on the demand curve (where percentage change in quantity is larger relative to base quantity, and percentage change in price is smaller relative to base price).

  • Item constitutes a large part of the consumer's budget.

  • Long run (consumers have more time to find substitutes or adjust behavior).

  • Luxuries (easier to forgo).

  • Specific brands (vs. broader good categories, e.g., Dell laptops vs. all laptops).

• **Factors causing Inelasticity (|E_d| < 1):

  • Less substitutes available.

  • Higher consumer income (for goods generally).

  • Lower on the demand curve.

  • Item constitutes a small part of the consumer's budget.

  • Short run (less time to find substitutes or adjust).

  • Necessities (e.g., basic food, medicine).

Primary Factors Determining the Elasticity of Supply

• Less Elastic Supply:

  • Difficult to increase production at a constant cost (e.g., due to limited raw materials or specialized labor).

  • Producers have a large share of the market for inputs, meaning increased production drives up input prices.

  • Local Supply (may face capacity constraints).

  • Short Run (limited ability to adjust production capacity).

• More Elastic Supply:

  • Easy to increase production at constant costs.

  • Producers have a small share of the market for inputs, so increased production doesn't significantly impact input prices.

  • Global Supply (easier to find additional sources).

  • Long Run (sufficient time to expand production facilities, hire more labor, or acquire more inputs).

Calculating the Elasticity of Demand

• Formula: $|E_d| = \frac{\text{Percentage Change in Quantity Demanded}}{\text{Percentage Change in Price}}$

• The formula uses absolute value since the law of demand implies a negative relationship, and economists typically discuss elasticity magnitude.

Elasticity of Demand and Revenue

• Total Revenue ($R$) is calculated as Price ($P$) multiplied by Quantity ($Q$): $R = P \times Q$

• When Demand is Inelastic (|E_d| < 1):

  • Quantity is not very responsive to price changes.

  • Price and Total Revenue move in the same direction.

  • If price increases, revenue increases. If price decreases, revenue decreases.

  • Example: If price drops from $50$ to $40$ for an inelastic good, quantity demanded increases from $20$ to $22$ (hypothetical), revenue changes from $50 \times 20 = 1000$ to $40 \times 22 = 880$. Revenue decreases.

• When Demand is Elastic (|E_d| > 1):

  • Quantity is very responsive to price changes.

  • Price and Total Revenue move in opposite directions.

  • If price increases, revenue decreases. If price decreases, revenue increases.

  • Example: If price drops from $50$ to $40$ for an elastic good, quantity demanded increases from $20$ to $95$ (hypothetical), revenue changes from $50 \times 20 = 1000$ to $40 \times 95 = 3800$. Revenue increases.

• When Demand is Unit Elastic ($|E_d| = 1$):

  • Revenue stays the same when price changes.

USDA Fruit Elasticity Example

• Overall estimated elasticity of demand for the average fruit is about $-0.5$ (inelastic).

• Based on demand elasticity estimates (magnitudes):

  • Most inelastically demanded fruit: Apples (meaning quantity demanded is least responsive to price changes).

  • Most elastically demanded fruit: Oranges (meaning quantity demanded is most responsive to price changes).

  • Fruits for which a 10% drop in price would cause an increase in total revenue: Oranges and Grapefruit. This occurs when demand is elastic (|E_d| > 1). For an inelastic good like apples, a price drop would decrease revenue.

  • Fruits to coupon for the biggest effect on quantity demanded (10% off): Oranges, Grapefruit, and Grapes. These are the most elastic fruits, meaning a price reduction (via coupons) will lead to the largest percentage increase in quantity demanded.

Elasticity and Consumer & Producer Surplus

• Consumer Surplus (CS): The difference between what consumers are willing to pay and what they actually pay.

• Producer Surplus (PS): The difference between the price producers receive and the minimum price they are willing to accept.

• Elastic Demand: Graphically, a flatter demand curve results in:

  • Elastic Supply: Both CS & PS are relatively small.

  • Inelastic Supply: CS is large, PS is small.

• Inelastic Demand: Graphically, a steeper demand curve results in:

  • Elastic Supply: CS is small, PS is large.

  • Inelastic Supply: Both CS & PS are relatively large.

Taxes and Subsidies

The Tax Wedge

• A commodity tax is a tax on transactions, e.g., a sales tax.

• Simplified Analysis:

  1. If a tax is imposed (e.g., $1), the price buyers pay must be$1 more than the price sellers receive.

  2. This $1 "wedge" is driven into the supply and demand diagram, representing the gap between the buyer's price and the seller's price.</p></li><li><p>This effectively shifts either the supply curve (up by the tax amount) or the demand curve (down by the tax amount), leading to a new equilibrium with a lower quantity traded.</p></li><li><p><strong>Example:</strong> If previous equilibrium quantity was$700$and price was$2.00$, a tax of$1$might lead to:</p><ul><li><p>Quantity traded:$500$</p></li><li><p>Buyers pay:$2.65$</p></li><li><p>Sellers receive:$1.65$</p></li><li><p>The difference ($2.65 - 1.65 = 1$) is the tax per unit.</p></li></ul></li></ol></li><li><p><strong>Incidence of Tax:</strong> The burden of the tax (who actually pays it) is independent of whether the tax is legally levied on buyers or sellers. It depends on the relative elasticities of supply and demand.</p><ul><li><p><strong>Rule:</strong> The more elastic side of the market can escape more of the tax. The more inelastic side bears a greater share of the tax burden.</p></li></ul></li></ul><h4 id="85802255-3eee-42ae-b4ce-7f10238f43b5" data-toc-id="85802255-3eee-42ae-b4ce-7f10238f43b5" collapsed="false" seolevelmigrated="true">Commodity Taxes and Surplus</h4><ul><li><p><strong>Without Tax:</strong> Total surplus (CS + PS) is maximized.</p></li><li><p><strong>With Tax:</strong></p><ul><li><p>Consumer surplus decreases.</p></li><li><p>Producer surplus decreases.</p></li><li><p>Government gains <strong>tax revenue</strong> (Tax per unit$ imes$Quantity traded after tax).</p></li><li><p>A <strong>deadweight loss</strong> (DWL) occurs, representing lost gains from trade. This is the value of potential trades that no longer happen due to the tax. It's the triangular area between the supply and demand curves, from the new quantity to the old (tax-free) quantity.</p></li></ul></li></ul><h4 id="e09ecf6a-e5fe-4300-9d9e-0aed7dfdd13e" data-toc-id="e09ecf6a-e5fe-4300-9d9e-0aed7dfdd13e" collapsed="false" seolevelmigrated="true">Elasticity and Deadweight Loss</h4><ul><li><p>The magnitude of the deadweight loss depends on the elasticity of demand and supply.</p></li><li><p><strong>Case 1: Elastic Demand</strong> (flatter demand curve)</p><ul><li><p>A tax leads to a relatively large reduction in quantity traded.</p></li><li><p>Results in a <strong>larger deadweight loss</strong> due to the higher responsiveness of consumers to the price change.</p></li></ul></li><li><p><strong>Case 2: Inelastic Demand</strong> (steeper demand curve)</p><ul><li><p>A tax leads to a relatively small reduction in quantity traded.</p></li><li><p>Results in a <strong>smaller deadweight loss</strong> because consumers are less responsive to the price change.</p></li></ul></li><li><p><strong>Case 3: Elastic Supply</strong> (flatter supply curve)</p><ul><li><p>A tax leads to a relatively large reduction in quantity traded.</p></li><li><p>Results in a <strong>larger deadweight loss</strong> due to the higher responsiveness of producers to the price change.</p></li></ul></li><li><p><strong>Case 4: Inelastic Supply</strong> (steeper supply curve)</p><ul><li><p>A tax leads to a relatively small reduction in quantity traded.</p></li><li><p>Results in a <strong>much smaller deadweight loss</strong> because producers are less responsive to the price change.</p></li></ul></li><li><p><strong>Summary:</strong> Taxes on goods with highly elastic demand or supply generate larger deadweight losses. To minimize deadweight loss, governments tax goods with inelastic demand or supply.</p></li></ul><h4 id="ec3dda5e-e70f-4f99-96c7-d11735ccfc37" data-toc-id="ec3dda5e-e70f-4f99-96c7-d11735ccfc37" collapsed="false" seolevelmigrated="true">Subsidies</h4><ul><li><p>A <strong>subsidy</strong> is a payment by the government to consumers or producers for each unit of a good bought or sold.</p></li><li><p>Similar to a negative tax, it drives a "subsidy wedge" between the price paid by buyers and the price received by sellers.</p><ul><li><p><strong>Example:</strong> A$1$subsidy on apples might result in:</p><ul><li><p>Price received by sellers:$2.40$</p></li><li><p>Price paid by buyers:$1.40$</p></li><li><p>The quantity traded increases beyond the free-market equilibrium.</p></li></ul></li></ul></li><li><p><strong>Impact:</strong></p><ul><li><p>Consumer surplus increases.</p></li><li><p>Producer surplus increases.</p></li><li><p>However, subsidies also create <strong>deadweight loss</strong> because they encourage transactions that cost society more than they benefit society. The cost of the subsidy to taxpayers (subsidy per unit$\times$final quantity) exceeds the gain in CS + PS, leading to an overall reduction in total surplus. (Graphically, DWL for a subsidy is a triangle formed by the intersection of the subsidy-adjusted curves and the original curves).</p></li></ul></li></ul><h4 id="cde57bbc-20e5-4125-ac39-066d7ee59b8c" data-toc-id="cde57bbc-20e5-4125-ac39-066d7ee59b8c" collapsed="false" seolevelmigrated="true">Taxes and Subsidies Compared</h4><ul><li><p>Both taxes and subsidies create a "wedge" between the price buyers pay and the price sellers receive.</p><ul><li><p><strong>Tax Wedge:</strong> <strong>Price paid by buyers$ > $Price received by sellers.</strong> Quantity traded decreases from the no-tax/no-subsidy equilibrium.</p></li><li><p><strong>Subsidy Wedge:</strong> <strong>Price received by sellers$ > $$Price paid by buyers. Quantity traded increases from the no-tax/no-subsidy equilibrium.