ECO Chapter 5 & 6
A 3 percent increase in the price of tea causes a 6 percent increase in the demand for coffee. The cross elasticity of demand for coffee with respect to the price of tea is
+2.0
By law, the tax burden
- Half of the tax is paid by firms --> Out of firm's revenue - Half of the tax is paid by workers --> Deducted from workers' paychecks
The income elasticity of demand for a food is roughly 1. A consumer's monthly income is $2,000, of which 20 percent is spent on food. If the income of this consumer doubles, the amount she'll spend on food will be
800 dollars per month
A price ceiling will be binding only if it is set
Below the equilibrium price
Price elasticity of demand = 0
Demand is perfectly inelastic demand curve is vertical
for a price increase, if demand is elastic
TR decreases
elasticity and tax incidence
Very elastic supply and relatively inelastic demand - Sellers bear a small burden of tax - Buyers bear most of the burden Relatively inelastic supply and very elastic demand - Sellers bear most of the tax burden - Buyers bear a small burden
Suppose the price elasticity coefficients of demand are 1.43, .67, 1.11, and .29 for products W, X, Y, and Z respectively. A 1 percent decrease in price will increase total revenue in the case(s) of
W and Y
Fair labor standards act of 1938
ensures workers a minmally adequate standard of living
Necessities
inelastic demand
Necessities - Normal goods
smaller income elasticities
can congress distribute the burden of payroll tax - Lawmakers
- Can decide whether a tax comes from the buyer's pocket or from the seller's - Cannot legislate the true burden of a tax
How taxes on sellers affect market outcomes
- Immediate impact on sellers: shift in supply to the left - Higher equilibrium price - Lower equilibrium quantity - tax reduces the size of the market - taxes discourage market activity - buyers and sellers share burden of tax - buyers pay more, are worse off - sellers receive less, are worse off --> get higher price but pay the tax, overall effective price fall
Tax incidence analysis
- Payroll tax as a tax on a good: --> The good is labor --> The price is the wage
Government uses taxes
- To raise revenue for public projects • Roads, schools, and national defense
If minimum wage is above equilibrium
- Unemployment - Higher income for workers who have jobs - Lower income for workers who cannot find jobs
Introduce payroll tax
- Wage received by workers falls - Wage paid by firms rises - Workers and firms share the tax burden: not necessarily 50/50 as required
How tax on buyers affect market outcomes
- initial impact on the demand: shifts curve to left - lower equilibrium price and quantity - Tax reduces size of market - buyers and sellers share the burden of tax - Sellers get a lower price, are worse off, buyers pay lower market price, are worse off --> effective price (with tax) rises
Taxes levied on sellers and buyers are equivalent
- wedge between the price that buyers pay and the price that sellers receive the same, regardless of whether the tax is levied on buyers or sellers - shifts the relative position of the supply and demand curves --> buyers and sellers share the tax burden
Impact of minimum wage on teenage labor
-Least skilled and least experienced -Low equilibrium wages -Willing to accept a lower wage in exchange for on-the-job training -Minimum wage - binding
Case study:Lines at the gas pump
1973 - OPEC raised the price of crude oil (reduced supply of gasoline, long lines at gas stations) What was responsible for the long gas lines? - OPEC (shortage of gasoline - US Gov't regulations (price ceiling on gasoline) * before OPEC raised price of crude oil, equilibrium price was below the price ceiling, no effect on the market; when price rose, decrease in supply of gasoline, equilibrium price was above price ceiling --> binding price ceiling laws regulating the price of gasoline were repealed
Case Study - Who pays the luxury tax
1990 - congress adopted a new luxury tax (on yachts, private planes, furs, jewelry, expensive cars) with goal of raising revenue from those who could most easily afford to pay With luxury items demand is quite elastic, supply is relatively inelastic Outcome - burden of a tax falls largely on the suppliers --> relatively inelastic supply 1993 -- most of the luxury tax was repealed
2015, federal minimum wage
7.25/hour some states mandate minimum wages above the federal level
Suppose the price elasticity of supply for crude oil is 2.5. How much would price have to rise to increase production by 20 percent
8 percent
The elasticity of supply for a product will be 2 if
A 1 percent decrease in price causes a 2 percent decrease in quantity supplied
Suppose the income elasticity of demand for toys is +2.00. This means that:
A 10 percent increase in income will increase the purchase of toys by 20 percent
Which of the following observations would be consistent with the imposition of a binding price ceiling on a market? After the price ceiling becomes effective, - A smaller quantity of the good is bough and sold - A smaller quantity of the good is demanded - a larger quantity of the good is supplied - the price rises above the previous equilibrium
A smaller quantity of the good is bough and sold
** Which product is most likely to be the most price elastic? Milk, housing, clothing, automobiles
Automobiles
Application - why did OPEC fail to keep price of oil high?
Increase in prices: 1973 - 1974, 1971 - 1981 short-run: supply and demand are inelastic (a decrease in supply: large increase in price) long-run: supply and demand are elastic (a decrease in supply: small increase in price)
If a product has a short-run elasticity of supply equal to zero, then an increase in the demand for the product will
Increase price and leave quantity sold unchanged
Elasticity of supply will increase when
It becomes easier to substitute one factor of production for another in a manufacturing process
Luxuries - Normal goods
Large income elasticities
Application - Can good news for farming be bad news for farmers?
New hybrid of wheat - increase production per acre by 20% - supply curve shifts to right - higher quantity and lower price - demand is inelastic (TR falls) Paradox of public policy - induce farmers not to plant crops
Impact of minimum wage on highly skilled and experienced workers
No effect: their equilibrium wages are well above the minimum minimum wage is not binding
Opponents of the minimum wage
Not the best way to combat poverty - unemployment, encourages teenagers to drop out of school and prevents some unskilled workers from getting on the job training poorly targeted policy
When demand is elastic (elasticity > 1)
P and TR move in opposite directions if P goes up, TR goes down
when demand is inelastic (elasticity < 1)
P and TR move in the same direction if P goes up, TR also goes up
Case study: rent control in the short and long run
Price ceiling - rent control placed ceiling on rents by local gov't with goal of helping the poor by making housing more affordable; criticized for being highly inefficient in helping the poor raise their standard of living Short run - supply and demand for housing are inelastic, small shortage, reduced rents Long run - supply and demand are more elastic - landlords are not building new apartments and failing to maintain existing ones - people find their own apartments, and more people want to move into city - large shortage Rationing done with long waiting lists, preference to tenants without children, discrimination based on race, and bribery to superintendents Policymakers -- additional regulations are difficult and costly to enforce
When a binding price ceiling is imposed on a market
Price no longer serves as a rationing device
How is the burden of a tax divided
Regardless of whether the tax is levied on the buyers or the sellers, the buyers and sellers bear some proportion of the tax burden.
for a price increase, if demand is inelastic
TR increases
Suppose the government has imposed a price ceiling on laptop computers. Which of the following events could transform the price ceiling from one that is not binding into one that is binding?
The number of firms selling laptop computers decreases
Which of the following generalizations is not correct? - The larger an item is in one's budget, the greater the price elasticity of demand. - The price elasticity of demand is greater for necessitates than it is for luxuries - The larger the number of close substitutes available, the greater will be the price elasticity of demand for a particular product - The price elasticity of demand is greater the longer the time period under consideration
The price elasticity of demand is greater for necessitates than it is for luxuries
Midpoint method
Two points: (Q1, P1) and (Q2, P2) Price elasticity of demand = [(Q2 - Q1)/(avg of Q1 and Q2)] / [(P2 - P1) / (avg of P1 and P2)]
Midpoint method - price elasticity of supply
Two points: (Q1, P1) and (Q2, P2) Price elasticity of demand = [(Q2 - Q1)/(avg of Q1 and Q2)] / [(P2 - P1) / (avg of P1 and P2)]
Market for labor
Workers supply labor, firms demand labor
Teenage Labor Market
a 10% increase in minimum wage depresses teenage employment between 1 and 3% some teenagers who are still attending HS choose to drop out and take jobs, displacing other teenagers who had already dropped out of school and who now become unemployed
A price ceiling is
a legal maximum on the price at which a good can be sold
Price ceiling
a legal maximum on the price of what a good can be sold
Price floor
a legal minimum on the price at which a good can be sold minimum wage laws
The cross elasticity of demand between digital cameras and memory cards is likely to be
a negative number
The cross elasticity of demand between Quaker State motor oil and Texaco motor oil is likely to be
a positive number
total revenue (TR)
amount paid by buyers and received by sellers of a good price of the good times the quantity sold (P x Q)
determinants of price elasticity of demand
availability of close substitutes Necessities versus luxuries definition of the market time horizon
France - minimum wage
average income is 30% lower than in US minimum wage is more than 30% higher
A tax on the buyers of personal computer external hard drives encourages
buyers to demand a smaller quantity at every price
To say that a price ceiling is binding is to say that the price ceiling
causes quantity demanded to exceed quantity supplied
A legal maximum on the price at which a good can be sold is called a price
ceiling
linear demand curve
constant slope (rise over run) different price elasticities
The price elasticity of demand for a popular sporting event is 2. If the price of a ticket is this event increases by 10 percent, the quantity of tickets demanded will
decrease by 20 percent
The price elasticity of demand for beef is about .6. Other things equal, this means that a 20 percent increase in the price of beef will cause the quantity of beef demanded to
decrease by approximately 12 percent
A tax on the sellers of coffee will increase the price of coffee paid by buyers,
decrease the effective price of coffee received by sellers, and decrease the equilibrium quantity of coffee
Payroll taxes
deducted from the amount you earned
The state legislature has cut GSU's appropriations. GSU's Board of Regents decides to increase tuition and fees to compensate for the loss of revenue. The board is assuming that the:
demand for education at GSU is inelastic
price elasticity of demand = 1
demand has unit elasticity
price elasticity of demand > 1
demand is elastic
price elasticity of demand < 1
demand is inelastic
Price elasticity of demand = infinity
demand is perfectly elastic demand curve is horizontal
can congress distribute the burden of payroll tax - Tax incidence
determined by the forces of supply and demand
A $0.50 tax levied on the buyers of pomegranate juice will shift the demand curve
downward by exactly $0.50
Markets are usually a good way to organize economic activity
economists usually oppose price ceilings and price floors prices are not the outcome of some haphazard process prices have the crucial job of balancing supply and demand (coordinating economic activity)
A tax imposed on the buyers of a good will lower the
effective price received by sellers and lower the equilibrium quantity
If a 5 percent cut in the price of a product causes quantity demanded to rise by 10 percent, demand is
elastic
Total revenue falls as the price of a good is raised, if the demand for the good is
elastic
luxuries
elastic demand
Movie theaters charge lower prices to see a movie in the afternoon than in the evening because there is an:
elastic demand to see movies in the afternoon
A 4 percent reduction in price of a product has zero effect on the dollar amount of consumer expenditure on the product. The price elasticity of demand is
equal to 1
Tax burden
falls more heavily on the side of the market that is less elastic small elasticity of demand - buyers do not have good alternatives to consuming this good small elasticity of supply - sellers do not have good alternatives to producing this good
Complements
goods that are typically used together negative cross-price elasticity
Substitutes
goods typically used in place of one another positive cross-price elasticity
If the demand for a product increase proportionately faster than the increase in consumers' incomes, then the income elasticity of demand for the product is
greater than zero
Income elasticity of demand
how much the quantity demanded of a good responds in a change in consumers' income percentage change in quantity demanded divided by the percentage change in income
price elasticity of demand
how much the quantity demanded of a good responds to a change in the price of that good
Cross-price elasticity of demand
how much the quantity demanded of one good responds to a change in the price of another percentage change in quantity demanded of the first good divided by the percentage change in price of the second good
Price elasticity of supply
how much the quantity supplied of a good responds to a change in the price of that good percentage change in quantity supplied divided by the percentage change in price depends on the flexibility of sellers to change the amount of the good they produce
Application - Does drug interdiction increase or decrease drug-related crime
increase the number of federal agents devoted to the war on drugs - illegal drugs: supply curve shifts left (higher price and lower quantity) - amount of drug-related crimes (inelastic demand for drugs, higher drugs price--> higher total revenue, increase drug-relate crime Policy of drug education - reduce demand for illegal drugs - left shift of demand curve - lower quantity - lower price - reduce drug-related crime
If in the short run the demand for mass transit is inelastic and in the long run the demand is elastic, then a price increase will ______, but _____
increase total revenue in the short run; decrease total revenue in the long run
If a 10 percent increase in the price of one good results in no change in the quantity demanded of another good, then it can be included that the two goods are
independent goods
When P = 7, Qd = 4000, when P = 5, Qd = 5000. Over the $7 - $5 range, demand is
inelastic
Airlines charge business travelers more than leisure travelers because there is a more
inelastic demand for business travel
To say that a price ceiling is nonbinding is to say that the price ceiling
is set above the equilibrium price
Price floor - Minimum wage
lowest price for labor that any employer must pay
Tax incidence
manner in which the tax burden is shared among participants in a market
elasticity
measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants
When a tax is placed on the buyers of a product, buyers pay
more and sellers receive less than they did before the tax
We would expect demand for Coca-Cola to be ________ than the demand for soft drinks in general.
more elastic
demand is _____ over longer time horizons
more elastic
goods with close substitutes
more elastic demand
narrowly defined markets
more elastic demand
Cross elasticity of demand is
negative for complementary goods
Inferior goods
negative income elasticities
If a tax is levied on the sellers of a product, then the demand curve will
not shift
Computing the price elasticity of demand
percentage change in quantity demanded divided by percentage change in price use absolute value
price of elasticity demand
percentage change in quantity demanded divided by the percentage change in price
Computing price elasticity of supply
percentage change in quantity supplied divided by percentage change in price always positive
If quantity demanded is completely unresponsive to price changes, demand is:
perfectly inelastic
inelastic supply - supply curve different price elasticities
points with high price and high quantity
Elastic demand for linear demand curve
points with high price and low quantity
Inelastic demand for linear demand curve
points with low price and high quantity
elastic supply - supply curve different price elasticities
points with low price and low quantity capacity for production not being used
price controls
policymakers believe that the market price of a good or service is unfair to buyers or sellers can generate inequalities
Normal goods
positive income elasticity
A tax imposed on the sellers of a good will raise the
price paid by buyers and lower the equilibrium quantity
inelastic demand
quantity demanded responds only slightly to changes in price
elastic demand
quantity demanded responds substantially to changes in price
Inelastic supply
quantity supplied responds only slightly to changes in the price
elastic supply
quantity supplied responds substantially to change in the price
Advocates of minimum wage
raise the income of the working poor - workers who earn the minimum wage can afford only a meager standard of living
The coefficient of price elasticity is .2. demand is thus:
relatively inelastic
non-binding price ceiling
set above the equilibrium price no effect on the price or quantity sold
binding constraint price floor
set above the equilibrium price: surplus some sellers are unable to sell what they want rationing mechanisms are not desirable
non-binding price floor
set below equilibrium price no effect on market
Binding constraint - price ceilings
set below the equilibrium price --> shortage sellers must ration the scarce goods rationing mechanisms are long lines, discrimination according to sellers bias
When a binding price ceiling is imposed on a market to benefit buyers
some buyers benefit, and some buyers are harmed
If a 10 percent increase in the price of one good results in an increase of 5 percent in the quantity demanded of another good, then it can be included that the two goods are
substitute goods
A tax on sellers will shift the
supply curve upward by the amount of the tax
Price elasticity of supply > 1
supply is elastic
Price elasticity of supply < 1
supply is inelastic
Economists distinguish among the market period, the short run, and the long run by noting that:
supply is most elastic in the long run, and least elastic in the market period
Price elasticity of supply = infinity
supply is perfectly elastic, supply curve is horizontal
Price elasticity of supply = 0
supply is perfectly inelastic, supply curve is vertical
Price elasticity of supply = 1
supply is unit elastic
Which of the following is not correct? - taxes levied on sellers and taxes levied on buyers are not equivalent - a tax places a wedge between the price that buyers pay and the price that sellers receive - the wedge between the buyers' price and the sellers' price is the same, regardless of whether the tax is levied on buyers or sellers - in the new after-tax equilibrium, buyers and sellers share the burden of the tax
taxes levied on sellers and taxes levied on buyers are not equivalent
The price elasticity of demand
tends to be elastic in high-price ranges and inelastic in low-price ranges
If a price ceiling is not binding, then
the equilibrium price is below the price ceiling
the flatter the demand curve
the greater the price elasticity of demand
Most goods can be classified as normal goods rather than inferior goods. The definition of a normal good suggests that
the income elasticity for the good is greater than 0
A negative income elasticity of demand coefficient indicates that
the product is an inferior good
Which is not characteristic of a product with relatively inelastic demand? - the good is regarded by consumers as a necessity - there are a large number of good substitutes for the good - buyers spend a small percentage of their total income on the product - consumers have had only a short time period to adjust to changes in price
there are a large number of good substitutes for the good
The demand for Cheerios cereal is more price-elastic than the demand for cereals as a whole. This is best explained by the fact that:
there are more substitutes for cheerios than for cereals as a whole
If a price ceiling is not binding , then
there will be no effect on the market price or quantity sold
Determinant of price elasticity of supply
time period - supply is more elastic in the long run
Taxes
to raise revenue for public purposes to influence market outcomes
If demand is unit elastic (elasticity = 1)
total revenue remains constant when price changes
Governments can sometimes improve market outcomes
want to use price controls because of unfair market outcomes and aim to help the poor often hurt those they are trying to help other ways to help -- rent subsidies, wage subsidies (earned income tax credit)