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The Week Ahead

The Week Ahead. Thursday (9/14) -- Attend University Forum on Health Care and then Come to class! Do Homework 5 on ‘Homework Assignment’ by Friday at ??? Warning!!!! Some numbers in problems change each time you open the assignment!! 1st Midterm Exam in Class -- Next Tuesday, September 19

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The Week Ahead

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  1. The Week Ahead • Thursday (9/14) -- Attend University Forum on Health Care and then Come to class! • Do Homework 5 on ‘Homework Assignment’ by Friday at ??? • Warning!!!! Some numbers in problems change each time you open the assignment!! • 1st Midterm Exam in Class -- Next Tuesday, September 19 • Study Guide will be Available on Web on Thursday, September 14

  2. Survey of Due Date Times • I prefer that homework be due at: • 9 am • Noon • 5 pm • midnight

  3. Elasticity and Tax Incidence Lecture 7 September 12, 2006

  4. In This Lecture • Elasticity Concept • Price Elasticity and Total Spending • Other Elasticity Concepts • Income • Cross Price • Supply elasticity • Tax Incidence

  5. Survey: Privatization of Toll Roads • Do you think that publicly owned toll roads should be leased to private firms for operation? a. No b. Yes

  6. Indiana Toll Road • The state of Indiana has leased the toll road to a foreign company. The tolls have not been increased for over a decade and the first major initiative for the firm is to raise the tolls for trucks and cars. • Will increasing tolls lead to more or less revenues for the firm? Will a 20% increase in tolls, for example, produce more revenues, or is it possible that the toll revenues could fall?

  7. Toll Gain in Revenue Loss in Revenue D Number of Cars Increasing the Toll P1 Po Q1 Qo

  8. What is an Elasticity? • The answer depends on theprice elasticity of demandfor trips on the toll road. • An elasticity is a measure the responsiveness of an individual’s decision to purchase (or supply) to a change in a factor determining that decision. • The price elasticity of demand is the ratio of the percentage change in the quantity demanded to the percentage change in the price of the good. Warning: Note that price elasticities of demand are expressed in absolute values!!!!

  9. Compute Percentage Change in QD Compute Percentage Change in P Elasticity --- Compute the Ratio Price Demand Donuts Computing Price Elasticity(Midpoint Method) $1 $.50 10 14

  10. What factors determine the value of DP? • DP grows larger • When close substitutes are available for the good. • Consumers are more likely to shift their consumption to these substitutes as the price of the good rises. • If the good is a necessity or a luxury. • If the good is something you ‘need’ then you are less sensitive to price changes than if it is a luxury. • As the time period for adjustment of behavior increases • Given more time, substitute consumption goods can be found.

  11. Extremes of Elasticity P P D D Q Q Perfectly Elastic Demand Perfectly Inelastic Demand

  12. Elasticity and Total Revenue • Suppose we know the price elasticity of demand for toll road trips. How is this elasticity related to Total Revenue? • When a seller raises the price of a good, there are two countervailing effects in action (except in the rare case of a good with perfectly elastic or perfectly inelastic demand): • A price effect: After a price increase, each unit sold sells at a higher price, which tends to raise revenue. • A sales effect: After a price increase, fewer units are sold, which tends to lower revenue.

  13. Elasticity and Total Revenue • If demand for a good is elastic(the price elasticity of demand is greater than 1), an increase in price reduces total revenue. In this case, the sales effect is stronger than the price effect. • If demand for a good is inelastic(the price elasticity of demand is less than 1), a higher price increases total revenue. In this case, the price effect is stronger than the sales effect. • If demand for a good is unit-elastic(the price elasticity of demand is 1), an increase in price does not change total revenue. In this case, the sales effect and the price effect exactly offset each other.

  14. The Price Elasticity of Demand Changes Along the Demand Curve

  15. Spending = Revenue Total Dollar Spending on a good is equal to Spending = Po QDo Now consider a given percentage change in the price (P/Po). Total dollar spending will increase by the same percentage if customers do not change their quantity purchases. However as the price increases, the customers will reduce their spending by (QD/Qo). Consequently the percentage change in spending will equal (Spending/Spendingo) = (P/Po) - (QD/Qo) Now divide both sides of the above equation by (P/P)

  16. Will Toll Road Rise or Fall? If: DP > 1 (elastic) revenues will fall DP = 1 (unitary) revenues will stay the same DP < 1 (inelastic) revenues will increase

  17. Assume initially the price is $10 and the demand for the good is 5 units. If you cut the price to $5, how much will be demanded? The percentage change in price is equal to (-5)/((10+5)/2)=-5/7.5=-.667 If DP = 1.50 (QD/Qo) = - (-.667)(1.50) = 1.00 Or increase by 100% If DP = .50 (QD/Qo) = - (-.667)(.50) = .333 Or Increase by 33.3% Predicting Changes in the Quantity Demanded and Total Revenue price Inelastic Demand 10 Elastic Demand 5 5 Quantity

  18. What has happened to the quantity demanded? If you know the price elasticity of demand, you can use it to calculate the new Q and Total Revenue: • When using the midpoint method, the percentage change in Q was computed as: • Hence the new level of output (Q1) when we know the percentage change in output (X) is the following (after some algebra)

  19. Initially the total spending was $50 If DP = 1.50 (elastic) (QD/Qo) = - (-.667)(1.50) = 1.00 Q1=5(2+1)/(2-1)=15 Total Revenue = $5(15)=$75 If DP = .50 (inelastic) (QD/Qo) = - (-.667)(.50) = .333 Q1=5(2+.333)/(2-.333)=7 Total Revenue = $5(7)=$35 What has happened to total revenue? price Inelastic Demand 10 Elastic Demand 5 7 15 5 Quantity

  20. Other Elasticities -- Income Shifts in Demand Curve due to Income changes If I < 0 good is inferior 0 < I < 1 good is normal and a necessity I > 1 good is normal and a luxury

  21. Other Elasticities -- Cross Price Shift in Demand Curve due to changes in the price of other goods (OP) If CP < 0 goods are complements CP > 0 goods are substitutes

  22. Other Elasticities -- Supply Movement along a Supply Curve as Price changes

  23. What makes Suppliers more Price Elastic? • The price elasticity of supply tends to be larger when • Inputs are easily available • Greater flexibility in production • There is ample time to adjust production to new conditions • Explanation: If the price a good or service rises, a supplier will want to produce more. Increasing production may increase the per unit cost of production. Why? • technology (the fixity of some factors of production) • lack of availability of inputs--then. In these situations, firms will not increase their production as much as when technology is flexible and inputs are easily available. The passage of time may ease both of the constraints.

  24. Initially the market is in equilibrium without the tax, price is Po which is equal to the initial supply and demand price A tax is imposed upon suppliers, consequently the supply curve shifts up by the amount of the tax Excess Demand is created and the price to consumers rises to DP The supply price falls to SP The tax (DP-SP) is borne by consumers by the amount (DP-Po) and by the suppliers by the amount (Po-SP) Stax Price S Po D Qo Quantity Tax Incidence DP SP QT

  25. Tax Incidence:Different Demand Elasticities Stax Stax Price Price S S DP DP Po Po SP SP D D QT QT Qo Quantity Qo Quantity Elastic Demand -- Tax Falls on Suppliers Inelastic Demand -- Tax Falls on Consumers

  26. Different Supply Elasticities Stax Stax Price Price S S DP DP Po Po SP SP D D QT Qo Quantity QT Qo Quantity Elastic Supply -- Tax Falls on Consumer Inelastic Supply -- Tax Falls on Firm

  27. Lessons • If demand is more elastic than supply then the tax will fall more upon suppliers because suppliers are less able to avoid tax • If supply is more elastic than demand then the tax will fall more upon consumers because consumers less able to avoid tax

  28. Sin Taxes Stax Price S DP SP = Po D Qo Quantity QT

  29. More on Sin Taxes • See Robert a Sirico, “The Sin Tax, Economic and Moral Considerations,” at the Acton Institute for the Study of Religion and Liberty, at http://www.acton.org/print.php

  30. Conclusions about Sin Taxes • Raise effective prices to the consumer • Their incidence falls primarily on the consumer. • Are unlikely to seriously discourage consumption habits when those habits are seriously desired • Will increase government revenue if transactions remain in legal markets • May decrease government revenue if people move their business to illegal markets • Sets up a moral hazard for policy makers who vacillate between wanting to discourage undesirable behavior and wanting to encourage it for revenue purposes

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