Principles of Microeconomics Chapter 4: Elasticity & Chapter 5: Market Outcomes and Tax Incidence

price elasticity of demand formula

% change in quantity demanded / % change in price

Why do taxes create deadweight loss in otherwise efficient markets?

*Deadweight loss occurs because taxes increase the purchase price, which causes consumers to buy less and producers to supply less. Deadweight loss can be lessened by taxing goods or services that have inelastic demand or supply. *Economists are also concerned about the incidence of taxation. Incidence refers to the burden of taxation on the party who pays the tax through higher prices, regardless of whom the tax is actually imposed on. The incidence is determined by the balance between the elasticity of supply and the elasticity of demand.

How do changes in income and the prices of other goods affect elasticity?

*The income elasticity of demand measures how a change in income affects spending. Normal goods have a positive income elasticity. Inferior goods have a negative income elasticity. *Positive values for the cross-price elasticity mean that two goods are substitutes. Negative values are complements. If the cross-price elasticity is zero, then the two goods are not related to each other.

What are the five determinants of the price elasticity of demand?

1) Availability of substitutes. 2) If the good is a luxury or a necessity. 3) The proportion of income spent on the goods. 4) How much time has elapsed since the time the price changed. 5) The Flexibility of producers.

Income elasticity of demand

A measure of how much the quantity demanded of a good responds to a change in consumers' income, computed as the percentage change in quantity demanded divided by the percentage change in income.

Price elasticity of supply

A measure of the responsiveness of the quantity supplied to a change in price.

Short run

A period of time when consumers can partially adjust their behavior.

Long run

A period of time when consumers have time to fully adjust to market conditions.

Inelastic demand/supply

An increase in price will result in a less than proportionate increase in quantity demanded/supplied. Elasticity will be less than 1.

Explain why slope is different from elasticity.

Because slope measures the ratio between the change in price to the change in quantity demanded. While elasticity is the ratio of the percentage changes.

Example of consumer surplus

Boots Boots Market Price: $80 while Maximum Willingness to Pay is $140; $140-$80 = $60. $60 is the consumer surplus.

If one person pays $80 for a $100 dress, then the producer surplus will be $0 and the consumer surplus will be $20.

But if someone pays $110 for a $100 dress, then the producer surplus will be $10 and the consumer surplus $0.

If the government decided to impose a 50% tax on gray t-shirts, would this policy generate a large increase in tax revenues or a small increase. Use elasticity to explain your answer.

Consider the price elasticity of demand. The tax is only on gray T-shirts, meaning that T-shirt customers who buy other colors can avoid the tax entirely---which means that the demand for gray T-shirts is relatively elastic.

What are consumer surplus and producer surplus?

Consumer surplus is the difference between the willingness to pay for a good or service and the price paid to get it.

Example of producer surplus

If a tutor is willing to tutor for $10 per hour, and the consumer pays them $25 per hour, every hour they earn $15 more than her willingness to sell.

Willingness to Sell (WTS)

Minimum price the seller would voluntarily accept for the good.

How do the price elasticities of demand and supply relate to each other?

The interplay between the price elasticity of demand and the price elasticity of supply determines the magnitude of the resulting price change.

The TV show Extreme Couponing features coupon users who go to extraordinary measures to save money on their weekly purchases. The show follows these coupon users throughout the week as they assemble coupons and scout out stores to see which have the best deals, and then follows them to the store for the big buy. Do extreme "couponers" have extremely elastic demand or extremely inelastic demand? Explain.

The show is called Extreme Couponing for a reason. Ordinary people don't spend more than 20 hours a week trying to find the best deals on grocery items, scouting stores, comparing prices, and make purchases based solely on what's on sale. The persons featured in the show are obsessive about saving money. When the price you pay is the most important determinant of what you buy, demand is extremely elastic.

Immediate run

There is no time for consumers to adjust their behavior.

price elasticity of demand

This element measures the responsiveness of quantity demanded to a change in price.

Elasticity

This element of economics is a measure of the responsiveness of buyers and sellers to changes in price or income.

Total Revenue

This is the amount a firm receives from the sale of goods and services.

Cross-price elasticity of demand

This measures the percentage change in the quantity demanded of one good to the percentage change in the price of a related good.

What is a Market Efficient?

When a(n) distribution of resources maximizes total surplus.

When is a deadweight loss the smallest?

When the demand is perfectly inelastic, the quantity sold is the same before and after the tax. This makes the deadweight loss of the tax zero, because consumers did not change their behavior.

elastic demand/supply

When the percentage change in quantity demanded/supplied is greater than the percentage change in price, so the price elasticity is greater than 1 in absolute value.

Lowering the price creates more

consumer surplus and demand

Total surplus, also known as social welfare

is the sum of consumer surplus and producer surplus

Higher taxes lead to

more deadweight loss, but higher taxes do not always generate more tax revenue.

Excise taxes are

placed on specific products and typically are imposed on goods with inelastic demand.

Lowering the price creates less

producer surplus and quantity supplied.

Incidence

refers to the burden of taxation on the party who pays the tax through higher prices, regardless of whom the tax is actually levied on

Equity

refers to the fairness of the distribution of benefits among the members of a society.

Excise taxes

taxes imposed on a particular good or service

Producer surplus

the difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives

Willingness to Pay (WTP)

the maximum amount that a buyer will pay for a good or service

Deadweight Loss (DWL)

the reduction in total surplus that occurs as a result of market inefficiency.

Welfare economics

the study of how the distribution of resources affects economic well-being