Review: Equilibrium and Shifts versus Movements Along

1. Review: Equilibrium and Shifts versus Movements Along P Market demand curve: How many cans of beer would consumers purchase (the quantity demanded), if the price of beer were _____, given that everything else relevant to the demand for beer remains the same? S P* D Market supply curve: How many cans of beer would firms produce (the quantity supplied), if the price of beer were _____, given that everything else relevant to the supply of beer remains the same? Q Q* Equilibrium:Quantity Demanded = Quantity Supplied Shifts Movements along Change in something OTHER THAN the price of beer ITSELF Change in the price of beer ITSELF The slopes of the demand and supply curves for beer capture the effect of a change in the BEER PRICE itself; a change in the price of beer leads to a MOVEMENT ALONG the demand and supply curves for beer The demand curve for beer can SHIFT ONLY if something that affects demand OTHER THAN the BEER PRICE changes. The supply curve for beer can SHIFT ONLY if something that affects supply OTHER THAN the BEER PRICE changes.

2. Review: Price Elasticity of Demand If the quantity demanded is very sensitive to the price If the quantity demanded is not very sensitive to the price Demand is elastic Demand is inelastic Price Elasticity of Demand = Percent change in the quantity demanded resulting from a 1 percent change in the price. Review: Price Elasticity of Supply If the quantity supplied is very sensitive to the price If the quantity supplied is not very sensitive to the price Supply is elastic Supply is inelastic Price Elasticity of Supply = Percent change in the quantity supplied resulting from a 1 percent change in the price. Today’s Goal Convince you that elasticities are not some ivory tower notions that economists have dreamed up to make life difficult for introductory economics students. Instead, elasticities needed to understand important issues in the real world.

3. Elasticity Applications The Libya’s Revolution and the Price of Crude Oil Project: In round numbers, between January 2011 and April 2011 the price of crude oil rose from $85 per barrel to $102. During this time Libya, a major supplier of crude oil to Europe, was in the midst of a revolution. How much of the rise in oil prices can be attributed to Libya’s revolution? Question: How much of the $17 rise in oil prices can be attributed to Libya’s revolution? Oil Producers Take Steps to Return By LIAM PLEVEN And BENOIT FAUCON Wall Street Journal – August 23, 2011 Oil companies active in Libya before the war began gearing up for the challenge of resuming operations in the country on Monday as rebel forces moved closer to taking over Tripoli. . . . A rebel victory could pave the way for restoring the North African nation's production, which hit 1.8 million barrels of day of oil and petroleum products in 2010, according to U.S. figures. But there remain major hurdles, including potential damage to infrastructure and the risk of persistent unrest. Houston-based Marathon Oil Corp. has had "preliminary discussions" with rebels over the condition of facilities where it has interests, with a goal of making a plan to restore production, a company spokesman said. A BP PLC spokesman said Monday the company was committed to returning to Libya "as soon as conditions allow," though it had no time frame. Royal Dutch Shell PLC, Total SA and Repsol YPF SA, also previously active in Libya, declined to say when they might begin production.

4. January 2011: Price of crude oil was $85 90,000 thousand barrels were produce in the world per day Market for Crude Oil P S S Libya was producing about 1,800 thousand barrels of the world’s total. 1,800 January 2011 to April 2011: The Libyan revolution erupts and its oil production ceases. April 2011: The price of crude oil rose to $102 per barrel , an increase of $17. 85 Question: How much of the rise was caused by Libya? 1,800 At the old equilibrium price, $85 per barrel, there is a shortage of 1,800 thousand barrels. 1,800 D In percentage terms, the shortage equals 2 percent: 1,800 = 2% Q 90,000 90,000 Price Elasticity of Demand = Percent change in the quantity demanded resulting from a 1 percent change in the price = .25 Price Elasticity of Supply = Percent change in the quantity supplied resulting from a 1 percent change in the price = .08 Price Quantity demanded Quantity supplied Portion of shortage up by decreased by increased by gap eliminated 1% .25% .08% .33% 3% .75% .24% .99%  1% 6% 2%  $85 = $5.10 Libya caused about a third of the $17 price rise.

5. Gasoline Tax In Massachusetts, the total tax, federal and state, is about 44.9¢: Tax = 18.4 + 26.5 = 44.9 To allow our discussion to progress more smoothly we will round this off to $.40. Claim: “Whenever the government imposes a tax, firms simply raise the price consumers pay by the amount of the tax and carry on business as usual.” The legal (statutory) incidence of a tax refers to who is legally obliged to pay the tax. • The economic incidence of a tax refers to who is actually burdened by the tax.

6. Market for Gasoline Suppose that a $.40 per gallon tax is imposed on gasoline. Benchmark Case: Suppose that gasoline were not taxed. Two notions of the price: PC = Price from the perspective of the consumer PF = Price from the perspective of the firm Claim: “Whenever the government imposes a tax, firms simply raise the price consumers pay by the amount of the tax and carry on business as usual.” The price appearing on the pump. Tax: PF = PC Tax PF= PC .40 PC = 3.80 PF = 3.40  PC = 3.90 PF = 3.50  P = 3.50 P ($/gallon) Let’s clean up our diagram. Quantity DemandedQuantity Supplied PC= 3.90 400=400 380=380 373< 400 Next add the no tax equilibrium. Surplus  Equilibrium PC** = 3.80  PC and PF fall  PC and PF continue to fall .40 .40 Quantity supplied determined by PF S PF= 3.50 P* = 3.50 Quantity demanded determined by PC PF** = 3.40 D Surplus QD= 373 Q** = 380 QS = 400 Q* = 400 Q (millions of gallon per day)

7. Summarizing the effect of a tax. Tax: PF = PC Tax PF= PC .40 First, the no tax equilibrium. P ($/gallon) PC = 3.80 PF = 3.40  P = 3.50 Quantity DemandedQuantity Supplied 380= 380 400=400 PC** = 3.80  Equilibrium .40 S Quantity supplied determined by PF P* = 3.50 Quantity demanded determined by PC PF** = 3.40 D Q** = 380 Q* = 400 Q (millions of gallon per day) Start at the no tax equilibrium and move left until the vertical gap between the demand and supply curves equals the amount of the tax. The equilibrium quantity decreases. The price from the perspective of consumers increases, but by less than the full amount of the tax. The associated quantity is the new equilibrium quantity. The price from the perspective of firms decreases, but by less than the full amount of the tax. The point on the demand curve is the equilibrium price from the perspective of consumers. Even though the legal incidence is entirely borne by the firm, the burden is shared by both firms and consumers. The point on the supply curve is the equilibrium price from the perspective of firms.

8. Question: What if the legal incidence were borne by the consumer? NB: The relationship between PF and PC is the same as it was when the legal incidence was borne by the firm. Tax: PC = PF + Tax PC = PF+ .40 Solving for PF: PF = PC .40 Therefore the equilibrium will be the same. P ($/gallon) P = 3.50 PC = 3.80 PF = 3.40  Quantity DemandedQuantity Supplied PC** = 3.80 380= 380 400=400  Equilibrium .40 S Quantity supplied determined by PF P* = 3.50 Quantity demanded determined by PC PF** = 3.40 D Q** = 380 Q* = 400 Q (millions of gallon per day) The equilibrium quantity decreases. The price from the perspective of consumers increases, but by less than the full amount of the tax. The price from the perspective of firms decreases, but by less than the full amount of the tax. Question: Does the legal incidence of a tax affect the real economic incidence, how the burden of the tax is actually shared? No.

9. Question: Since the legal incidence of a tax does not affect its economic incidence, what does affect the real economic incidence? Claim: The price elasticities of demand and supply. Demand is less elastic than supply Supply is less elastic than demand Consumers bear more of the burden. Firms bear more of the burden. P P Intuition: The less flexible group bears more of the burden. S PC** S PC** Tax P* P* Tax PF** D D PF** Q Q Q** Q* Q** Q*

10. Tax Incidence Summary Question: How does the imposition of a tax affect the equilibrium? The equilibrium quantity decreases. The price from the perspective of consumers increases, but by less than the full amount of the tax. The price from the perspective of firms decreases, but by less than the full amount of the tax. Question: How is the burden of a tax shared? The legal incidence of a tax does not affect the real, economic incidence. The economic incidence of a tax depends on the elasticities of demand and supply. Demand less elastic than supply Supply less elastic than demand Consumers bear more of the burden Firms bear more of the burden Intuition: The less flexible group bears more of the burden.