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ECON 101
Corey Van De Waal

  ECON  101  Mid-­‐Term  2  Review     Chapter  4:  Elasticity   • The  price  elasticity  of  demand  is  a  units-­‐free  measure  of  the  responsiveness  of   the  quantity  demanded  of  a  good  to  a  change  in  its  price  when  all  other   influences  on  buyers’  plans  remain  the  same.   • Calculating  Elasticity   • The  price  elasticity  of  demand  is  calculated  by  using  the  formula:     Percentage  change  in  quantity  demanded   Percentage  change  in  price     Test  your  understanding!   1. Suppose  that  the  campus  bookstore  increases  the  price  of  an  economics  text   from  $70  to  $80.  What  is  the  percentage  increase  in  price?     2. Suppose  the  campus  computer  store  lowers  the  price  of  an  iMac  from  $1500  to   $1000.  What  is  the  percentage  decrease  in  price?   • To  calculate  the  price  elasticity  of  demand:   o We  express  the  change  in  price  as  a  percentage  of  the  average  price—the   average  of  the  initial  and  new  price,  and  we  express  the  change  in  the   quantity  demanded  as  a  percentage  of  the  average  quantity  demanded— the  average  of  the  initial  and  new  quantity.         The  percentage  change  in  quantity  demanded,  %DQ,  is  calculated  as  DQ/Q ,  which  is   ave 2/10  =  1/5.   The  percentage  change  in  price,  %DP,  is  calculated  as  DP/P ,  which  is ave1/$20  =  1/20.   The  price  elasticity  of  demand  is     %DQ/  %DP  =  (1/5)/(1/20)       =  20/5       =  4.       Some  things  about  elasticity  to  keep  in  mind!   It  is  the  magnitude,  or  absolute  value,  of  the  measure  that  reveals  how  responsive  the   quantity  change  has  been  to  a  price  change.     If  the  percentage  change  in  the  quantity  demanded  equals  the  percentage  change  in   price  the  price  elasticity  of  demand  equals  1  and  the  good  has  unit  elastic  demand.     Total  Revenue  and  Elasticity   • The  total  revenue  from  the  sale  of  good  or  service  equals  the  price  of  the  good   multiplied  by  the  quantity  sold.   • When  the  price  changes,  total  revenue  also  changes.   • But  a  rise  in  price  doesn’t  always  increase  total  revenue.     • The  change  in  total  revenue  due  to  a  change  in  price  depends  on  the  elasticity  of   demand:     If  demand  is  elastic,  a  1  percent  price  cut  increases  the  quantity  sold  by   more  than  1  percent,  and  total  revenue  increases.     If  demand  is  inelastic,  a  1  percent  price  cut  decreases  the  quantity  sold   by  more  than  1  percent,  and  total  revenues  decreases.     If  demand  is  unit  elastic,  a  1  percent  price  cut  increases  the  quantity  sold   by  1  percent,  and  total  revenue  remains  unchanged.     The  total  revenue  test  is  a  method  of  estimating  the  price  elasticity  of  demand  by   observing  the  change  in  total  revenue  that  results  from  a  price  change  (when  all  other   influences  on  the  quantity  sold  remain  the  same).     If  a  price  cut  increases  total  revenue,  demand  is  elastic.     If  a  price  cut  decreases  total  revenue,  demand  is  inelastic.     If  a  price  cut  leaves  total  revenue  unchanged,  demand  is  unit  elastic.             The  Factors  That  Influence  the  Elasticity  of  Demand   The  elasticity  of  demand  for  a  good  depends  on:    The  closeness  of  substitutes    The  proportion  of  income  spent  on  the  good    The  time  elapsed  since  a  price  change     Cross  Elasticity  of  Demand   • The  cross  elasticity  of  demand  is  a  measure  of  the  responsiveness  of  demand  for  a   good  to  a  change  in  the  price  of  a  substitute  or  a  complement,  other  things   remaining  the  same.   • The  formula  for  calculating  the  cross  elasticity  is:     Percentage  change  in  quantity  demanded   Percentage  change  in  price  of  substitute  or  complement     The  cross  elasticity  of  demand  for    a  substitute  is  positive.    a  complement  is  negative.     Income  Elasticity  of  Demand   • The  income  elasticity  of  demand  measures  how  the  quantity  demanded  of  a   good  responds  to  a  change  in  income,  other  things  remaining  the  same.       • The  formula  for  calculating  the  income  elasticity  of  demand  is   Percentage  change  in  quantity  demanded   Percentage  change  in  income     • If  the  income  elasticity  of  demand  is  greater  than  1,  demand  is  income  elastic  and   the  good  is  a  normal  good.   • If  the  income  elasticity  of  demand  is  greater  than  zero  but  less  than  1,  demand  is   income  inelastic  and  the  good  is  a  normal  good.   • If  the  income  elasticity  of  demand  is  less  than  zero  (negative)  the  good  is  an   inferior  good.     Elasticity  of  Supply     The  elasticity  of  supply  measures  the  responsiveness  of  the  quantity  supplied  to  a   change  in  the  price  of  a  good  when  all  other  influences  on  selling  plans  remain  the  same.     The  elasticity  of  supply  is  calculated  by  using  the  formula:   Percentage  change  in  quantity  supplied   Percentage  change  in  price     The  Factors  That  Influence  the  Elasticity  of  Supply   The  elasticity  of  supply  depends  on     Resource  substitution  possibilities     Time  frame  for  supply  decision     Chapter  5:  Efficiency  and  Equity     Scare  resources  might  be  allocated  by    Market  price    Command    Majority  rule    Contest    First-­‐come,  first-­‐served    Sharing  equally    Lottery    Personal  characteristics    Force   How  does  each  method  work?   Market  Price   When  a  market  allocates  a  scarce  resource,  the  people  who  get  the  resource  are  those  who  are   willing  to  pay  the  market  price.   Most  of  the  scarce  resources  that  y ou  supply  get  allocated  by  market  price.   You  sell  your  labour  services  in  a  market,  and  you  buy  most  of  what  you  consume  in  markets.     For  most  goods  and  services,  the  market  turns  out  to  do  a  good  job.     Command   Command  system  allocates  resources  by  the  ord er  (command)  of  someone  in  authority.   For  example,  if  you  have  a  job,  most  likely  someone  tells  you  what  to  do.  Your  labour  time  is   allocated  to  specific  tasks  by  command.     A  command  system  works  well  in  organizations  with  clear  lines  of  authority  but   badly  in  an   entire  economy     Majority  Rule   Majority  rule  allocates  resources  in  the  way  the  majority  of  voters  choose.   Societies  use  majority  rule  for  some  of  their  biggest  decisions.     For  example,  tax  rates  that  allocate  resources  between  private  and  public  use  and  tax  dollars   between  competing  uses  such  as  defense  and  health  care.     Majority  rule  works  well  when  the  decision  affects  lots  of  people  and  self -­‐interest  must  be   suppressed  to  use  resources  efficiently.     Contest   A  contest  allocates  resources  to  a  w inner  (or  group  of  winners).   The  most  obvious  contests  are  sporting  events  but  they  occur  in  other  arenas:   For  example,  The  Oscars  are  a  type  of  contest.     Contest  works  well  when  the  efforts  of  the  “players”  are  hard  to  monitor  and  reward  directly.     First-­‐Come,  First-­‐Served   A  first-­‐come,  first-­‐served  allocates  resources  to  those  who  are  first  in  line.   Casual  restaurants  use  first -­‐come,  first  served  to  allocate  tables.  Supe rmarkets  also  uses  first-­‐ come,  first-­‐served  at  checkout.     First-­‐come,  first-­‐served  works  best  when  scarce  resources  can  serves  just  one  person  at  a  time   in  a  sequence.     Sharing  Equally   When  a  resource  is  shared  equally,  everyone  gets  the  same  amount  of  it.   You  might  use  this  method  to  share  a  dessert  in  a    restaurant.     To  make  sharing  equally  work,  people  must  be  in  agreement  about  its  use  and  implementation.   It  works  best  for  small  groups  who  share  common  goals  and  ideals.     Lottery   Lotteries  allocate  resources  to  those  with  the  winning  number,  draw  the  lucky  cards,  or  come  up   lucky  on  some  other  gaming  system.   Provincial  lotteries  and  casinos  reallocate  millions  of  dollars  worth  of  goods  and  services  each   year.   But  lotteries  are  more  widespread.  For  example,  they  are  used  to  allocate  landing  slots  at  some   airports.   Lotteries  work  well  when  there  is  no  effective  way  to  distinguish  among  potential  users  of  a   scarce  resource.     Personal  Characteristics   Personal  characteristics  allocate  resources  to  those  with  the  “right”  characteristics.   For  example,  people  choose  marriage  partners  on  the  b asis  of  personal  characteristics.   But  this  method  gets  used  in  unacceptable  ways:  allocating  the  best  jobs  to  white  males  and   discriminating  against  women.     Force   Force  plays  a  role  in  allocating  resources.   For  example,  war  has  played  an  enormous  role  hist orically  in  allocating  resources.     Theft,  taking  property  of  others  without  their  consent,  also  plays  a  large  role.   But  force  provides  an  effective  way  of  allocating  resources —for  the  state  to  transfer  wealth   from  the  rich  to  the  poor  and  establish  the  lega l  framework  in  which  voluntary  exchange  can   take  place  in  markets.     Demand,  Willingness  to  Pay,  and  Value   Value  is  what  we  get,  price  is  what  we  pay.   The  value  of  one  more  unit  of  a  good  or  service  is  its   marginal  benefit .   We  measure  value  as  the   maximum  price  that  a  person  is  willing  to  pay.   But  willingness  to  pay  determines  demand.   A  demand  curve  is  a  marginal  benefit  curve     Individual  Demand  and  Market  Demand   The  relationship  between  the  price  of  a  good  and  the  quantity  demanded  by  one  person  is   called  individual  demand.   The  relationship  between  the  price  of  a  good  and  the  quantity  demanded  by  all  buyers  in  the   market  is  called   market  demand.   Figure  5.1  shows  the  connection  between  individual  demand  and  market  demand.         Consumer  Surplus   Consumer  surplus  is  the  value  of  a  good  minus  the  price  paid  for  it,  summed  over  the  quantity   bought.   It  is  measured  by  the  area  under  the  demand  curve  and  above  the  price  paid,  up  to  the  quantity   bought.   Figure  5.2  on  the  next  slide  shows  the  consumer  surplus  from  pizza   when  the  market  price  is  $1   a  slice.         Supply,  Cost,  and  Minimum  Supply -­‐Price   Cost  is  what  the  producer  gives  up,  price  is  what  the  producer  receives.     The  cost  of  one  more  unit  of  a  good  or  service  is  its   marginal  cost.   Marginal  cost  is  the   minimum  price  that  a  firm  is  willing  to  accept.   But  the  minimum  supply-­‐price  determines  supply.     A  supply  curve  is  a  marginal  cost  curve.     Individual  Supply  and  Market  Supply   The  relationship  between  the  price  of  a  good  and  the  quantity  supplied  by  one  producer  is   called  individual  supply.   The  relationship  between  the  price  of  a  good  and  the  quantity  supplied  by  all  producers  in  the   market  is  called   market  supply.   Figure  5.3  shows  the  connection  between  individual  supply  and  market  supply.       Producer  Surplus   Producer  surplus  is  the  price  received  for  a  good  minus  the  minimum -­‐supply  price  (marginal   cost),  summed  over  the  quantity  sold.   It  is  measured  by  the  area  below  the  market  price  and  above  the  supply  curve,  summed  over   the  quantity  sold.         The  blue  areas  show  his  producer  surplus.   The  red  areas  show  the  cost  of  producing  the  pizzas  sold.       In  equilibrium,  the  quantity  demanded  equals  the  quantity  supplied.       At  the  equilibrium  quantity,  marginal  benefit  equals  marginal  cost,  so  the  quantity  is  the   efficient  quantity.   When  the  efficient  quantity  is  produced,  total  surplus  (the  sum  of  consumer  surplus  and   producer  surplus)  is  maximized.       The  Invisible  Hand     Adam  Smith’s  “invisible  hand”  idea  in  the   Wealth  of  Nations  implied  that  competitive  markets   send  resources  to  their  highest  valued  use  in  society.   Consumers  and  producers  pursue  their  own  self -­‐interest  and  interact  in  markets.   Market  transactions  generate  an  efficient —highest  valued—use  of  resources.     Underproduction  and  Overproduction   Inefficiency  can  occur  because  too  little  of  an  item  is  produced —underproduction—or  too  much   of  an  item  is  produced —overproduction.       If  production  is  restricted  to  5,000  pizzas  a  day,  there  is  underproduction  and  the  quantity  is   inefficient.   A  deadweight  loss  equals  the  decrease  in  total  surplus—the  gray  triangle.   This  loss  is  a  social  loss.     If  production  is  expanded  to  15,000  pizzas  a  day,  a  deadweight  loss  arises  from  overproduction.   This  loss  is  a  social  loss.     Obstacles  to  Efficiency   In  competitive  markets,  underproduction  or  overproduction  arise  when  there  are    Price  and  quantity  regulations    Taxes  and  subsidies    Externalities    Public  goods  and  common  resources    Monopoly    High  transactions  costs         Price  and  Quantity  Regulations   Price  regulations  sometimes  put  a  block  of  the  price  adjustments  and  lead  to  underproduction.   Quantity  regulations   that  limit  the  amount  that  a  farm  is  permitted  to  produce  also  leads  to   underproduction.     Taxes  and  Subsidies   Taxes  increase  the  prices  paid  by  buyers  and  lower  the  prices  received  by  sellers.   So  taxes  decrease  the  quantity  produced  and   lead  to  underproduction.   Subsidies  lower  the  prices  paid  by  buyers  and  increase  the  prices  received  by  sellers.   So  subsidies  increase  the  quantity  produced  and  lead  to  overprodu ction.     Externalities   An  externality  is  a  cost  or  benefit  that  affects  someone  other  than  the  seller  or  the  buyer  of  a   good.     An  electric  utility  creates  an   external  cost  by  burning  coal  that  creates  acid  rain.     The  utility  doesn’t  consider  this  cost  when   it  chooses  the  quantity  of  power  to  produce.   Overproduction  results.     Public  Goods  and  Common  Resources   A  public  good  benefits  everyone  and  no  one  can  be  excluded  from  its  benefits.   It  is  in  everyone’s  self-­‐interest  to  avoid  paying  for  a  public  good  (calle d  the  free-­‐rider  problem),   which  leads  to  underproduction.     A  common  resource  is  owned  by  no  one  but  can  be  used  by  everyone.   It  is  in  everyone’s  self  interest  to  ignore  the  costs  of  their  own  use  of  a  common  resource  that   fall  on  others  (called  tragedy  of  the  commons).   The  tragedy  of  the  commons  leads  to  overproduction.     High  Transactions  Costs   Transactions  costs  are  the  opportunity  cost  of  making  trades  in  a  market.     To  use  the  market  price  as  the  allocator  of  scarce  resources,  it  must  be  worth  bearing   the   opportunity  cost  of  establishing  a  market.   Some  markets  are  just  too  costly  to  operate.   When  transactions  costs  are  high,  the  market  might  underproduce.     Alternatives  to  the  Market   When  a  market  is  inefficient,  can  one  of  the  non -­‐market  methods  of  allo cation  do  a  better  job?   Often,  majority  rule  might  be  used.   But  majority  rule  has  its  own  shortcomings.    A  group  that  pursues  the  self -­‐interest  of  its   members  can  become  the  majority.   Also,  with  majority  rule,  votes  must  be  translated  into  actions  by  burea ucrats  who  have  their   own  agendas.     Utilitarianism  is  the  principle  that  states  that  we  should  strive  to  achieve  “the  greatest   happiness  for  the  greatest  number.”     If  everyone  gets  the  same  marginal  utility  from  a  given  amount  of  income,  and  if  the  marginal   benefit  of  income  decreases  as  income  increases,  then  taking  a  dollar  from  a  richer  person  and   giving  it  to  a  poorer  person  increases  the  total  benefit.     Only  when  income  is  equally  distributed  has  the  greatest  happiness  been  achieved.       Utilitarianism  ignores  the  cost  of  making  income  transfers.   Recognizing  these  costs  leads  to  the   big  tradeoff  between  efficiency  and  fairness.   Because  of  the  big  tradeoff,  John  Rawls  proposed  that  income  should  be  redistributed  to  point   at  which  the  poorest  person  is  as  w ell  off  as  possible.     Symmetry  principle  is  the  requirement  that  people  in  similar  situations  be  treated  similarly.       In  economics,  this  principle  means  equality  of  opportunity,  not  equality  of  income.     Robert  Nozick  suggested  that  fairness  is  based  on  two  rules:    The  state  must  create  and  enforce  laws  that  establish  and  protect  private   property.    Private  property  may  be  transferred  from  one  person  to  another  only  by   voluntary  exchange.   This  means  that  if  resources  are  allocated  efficiently,  they  may  also  be   allocated  fairly.     Chapter  6:  Government  Action  in  Markets   A  Housing  Market  with  a  Rent  Ceiling   Ø A  price  ceiling  or  price  cap  is  a  regulation  that  makes  it  illegal  to  charge  a  price  higher   than  a  specified  level.   Ø When  a  price  ceiling  is  applied  to  a  housing  market  it  is  called  a   rent  ceiling.   Ø If  the  rent  ceiling  is  set  above  the  equilibrium  rent,  it  has  no  effect.  The  market  works  as   if  there  were  no  ceiling.   Ø But  if  the  rent  ceiling  is  set   below  the  equilibrium  rent,  it  has  powerful  effects.       Housing  Shortage   Figure  6.1  shows  the  effects  of  a  rent  ceiling  that  is  set   below  the  equilibrium  rent.   • The  equilibrium  rent  is  $1,000  a  month.   • A  rent  ceiling  is  set  at  $800  a  month.   • So  the  equilibrium  rent  is  in  the  illegal  r egion.   • At  the  rent  ceiling,  the  quantity  of  housing  demanded  exceeds  the  quantity   supplied.   • There  is  a  shortage  of  housing.     Because  the  legal  price  cannot  eliminate  the  shortage,  other  mechanisms  operate:     Search  activity     Black  markets   With  a  housing  shortage,  people  are      willing  to  pay  up  to  $ 1,200  a  month.           Search  Activity   Ø The  time  spent  looking  for  someone  with  whom  to  do  business  is  called   search  activity.   Ø When  a  price  is  regulated  and  there  is  a  shortage,  search  activity   increases.   Ø Search  activity  is  costly  and  the  opportunity  cost  of  housing  equals  its  rent  (regulated)   plus  the  opportunity  cost  of  the  search  activity  (unregulated).   Ø Because  the  quantity  of  housing  is  less  than  the  quantity  in  an  unregulated  market,  the   opportunity  cost  of  housing  exceeds  the  unregulated  rent   Ø   Black  Markets   Ø A  black  market  is  an  illegal  market  that  operates  alongside  a  legal  market  in  which  a   price  ceiling  or  other  restriction  has  been  imposed.   Ø A  shortage  of  housing  creates  a  black  market  in   housing.   Ø Illegal  arrangements  are  made  between  renters  and  landlords  at  rents  above  the  rent   ceiling—and  generally  above  what  the  rent  would  have  been  in  an  unregulated  market.     Inefficiency  of  Rent  Ceilings   Ø A  rent  ceiling  set  below  the  equilibrium  rent   leads  to  an  inefficient  underproduction  of   housing  services.   Ø The  marginal  social  benefit  from  housing  services  exceeds  its  marginal  social  cost  and  a   deadweight  loss  arises.       Ø A  rent  ceiling  decreases  the  quantity  of  housing  supplied  to  less  than  the  effic ient   quantity.   Ø A  deadweight  loss  arises.   Ø Producer  surplus  shrinks.   Ø Consumer  surplus  shrinks.   Ø There  is  a  potential  loss  from  increased  search  activity   A  Labour  Market  with  a  Minimum  Wage   Ø A  price  floor  is  a  regulation  that  makes  it  illegal  to  trade  at  a  price  lower  than  a  specified   level.   Ø When  a  price  floor  is  applied  to  labour  markets,  it  is  called  a   minimum  wage.   Ø If  the  minimum  wage  is  set  below  the  equilibrium  wage  rate,  it  has  no  effect.  The   market  works  as  if  there  were  no  minimum  wage.   Ø If  the  minimum  wage  is  set  above  the  equilibrium  wage  rate,  it  has  powerful  effects.   Ø If  the  minimum  wage  is  set  above  the  equilibrium  wage  rate,  the  quantity  of  labour   supplied  by  workers  exceeds  the  quantity  demanded  by  employers.     Ø There  is  a  surplus  of  labour.   Ø The  quantity  of  labour  hired  at  the  minimum  wage  is   less  than  the  quantity  that  would   be  hired  in  an  unregulat ed  labour  market.   Ø Because  the  legal  wage  rate  cannot  eliminate  the  surplus,  the  mi nimum  wage  creates   unemployment         • The  equilibrium  wage  rate  is  $6  an  hour.   • The  minimum  wage  rate  is  set  at  $7  an  hour.   • So  the  equilibrium  wage  rate  is  in  the  illegal  region.   • The  quantity  of  labour  employed  is  the  quantity  demanded.     Minimum  Wage  Brings  Unemployment   Ø The  quantity  of  labour  supplied  exceeds  the  quantity  demanded  and   unemployment  is  created.   Ø With  only  20  million  hours  demanded,  some  workers  are  willing  to   supply  the  last  hour  demanded  for  $8.         Inefficiency  of  a  Minimum  Wage   Ø A  minimum  wage  leads  to  an  inefficient  outcome.   Ø The  quantity  of  labour  employed  is  less  than  the  efficient  quantity.   Ø The  supply  of  labour  measures  the  marginal  social  cost  of  labour  to   workers  (leisure   forgone).     Ø The  demand  for  labour  measures  the  marginal  social  benefit  from  labour  (value  of   goods  produced).   Figure  6.4  illustrates  this  inefficient  outcome.       Ø A  minimum  wage  set  above  the  equilibrium  wage  decreases  the  quantity  of  labour   employed.   Ø A  deadweight  loss  arises.   Ø The  potential  loss  from  increased  job  search  decreases  both  workers’  surplus  and  firms’   surplus.   Ø The  full  loss  is  the  sum  of  the  red  and  grey  areas.   Taxes   Ø Everything  you  earn  and  most  things  you  buy  are  taxed.   Ø Who  really  pays  these  taxes?   Ø Income  tax  and  the  social  insurance  taxes  are  deducted  from  your  pay,  and  provincial   sales  tax  and  GST  are  added  to  the  price  of  the  most  of  the  things  you  buy,  so  isn’t  it   obvious  that  you  pay  these  taxes?     Ø Isn’t  it  equally  obvious  that  your  employer  pays  the  employer’s  contribution  to  the   social  insurance  tax?   Ø You’re  going  to  discover  that  it  isn’t  obvious  who  pays  a  tax  and  that  lawmakers  don’t   decide  who  will  pay!     Tax  Incidence   Ø Tax  incidence  is  the  division  of  the  burden  of  a  tax  between  buyers  and  sellers.   Ø When  an  item  is  taxed,  its  price  might  rise  by  the  full  amount  of  the  tax,  by  a  lesser   amount,  or  not  at  all.   Ø If  the  price  rises  by  the  full  amount  of  the  tax,  buyers  pay  the  tax.   Ø If  the  price  rise  by  a  lesser  amount  than  the  tax,  buyers  and  sellers  share  the  burden  of   the  tax.   Ø If  the  price  doesn’t  rise  at  all,  sellers  pay  the  tax.     Tax  incidence  doesn’t  depend  on  tax  law!   Ø The  law  might  impose  a  tax  on  buyers  or  sellers,  but  the  outcome  wil l  be  the  same.   Ø To  see  why,  we  look  at  the  tax  on  cigarettes  in  Ontario.   Ø On  February  1,  2006,  Ontario  raised  the  tax  on  the  sales  of  cigarettes  to  $3.90  a  pack  of   25  cigarettes.   Ø What  are  the  effects  of  this  tax?     A  Tax  on  Sellers   Figure  6.5  shows  the  effect s  of  this  tax.   Ø With  no  tax,  the  equilibrium  price  is  $3.00  a  pack.   Ø A  tax  on  sellers  of  $1.50  a  pack  is  introduced.   Ø Supply  decreases  and  the  curve   S  +  tax  on  sellers  shows  the  new  supply  curve.       Ø The  market  price  paid  by  buyers  rises  to  $4.00  a  pack  and  the  quantity  bought  decreases.   Ø The  price  received  by  the  sellers  falls  to  $2.50  a  pack.     So  with  the  tax  of  $1.50  a  pack,  buyers  pay  $1.00  a  pack  more  and  sellers  receive  50¢  a   pack  less   A  Tax  on  Buyers   Ø Again,  with  no  tax,  the  equilibrium  price  is  $3.00  a   pack.   Ø A  tax  on  buyers  of  $1.50  a  pack  is  introduced.   Ø Demand  decreases  and  the  curve   D  −    tax  on  buyers  shows  the  new  demand  curve.           Ø The  price  received  by  sellers  falls  to  $2.50  a  pack  and  the  quantity  decreases.   Ø The  price  paid  by  buyers  rises  to  $4.00  a  pack.     So  with  the  tax  of  $1.50  a  pack,  buyers  pay  $1.00  a  pack  more  and  sellers  receive  50¢  a  pack   less       So,  exactly  as  before  when  sellers  were  taxed:   Buyers  pay  $1.00  of  the  tax.   Sellers  pay  the  other  50¢  of  the  tax.   Tax  incidence  is  the  same  regardless  of  whether  the  law   says  sellers  pay  or  buyers  pay.     Tax  Division  and  Elasticity  of  Demand  (diagrams  below  were  discussed  in  class )   The  division  of  the  tax  between  buyers  and  sellers  depends  on  the  elasticities  of  demand  and   supply.         Case  1:     Case  2:     Case  3:         Case  4:     The  more  inelastic  the  demand,  the  larger  is  the  buyers’  share  of  the  tax.     The  more  elastic  the  supply,  the  larger  i s  the  buyers’  share  of  the  tax.     Taxes  in  Practice   Ø Taxes  usually  are  levied  on  goods  and  services  with  an  inelastic  demand  or  an  inelastic   supply.   Ø Alcohol,  tobacco,  and  gasoline  have  inelastic  demand,  so  the  buyers  of  these  items  pay   most  the  tax  on  them.   Ø Labour  has  a  low  elasticity  of  supply,  so  the  seller —the  worker—pays  most  of  the   income  tax  and  most  of  the  Social  Security  tax.   Taxes  and  Efficiency   Except  in  the  extreme  cases  of  perfectly  inelastic  demand  or  perfectly  inelastic  supply  when  the   quantity  remains  the  same,  imposing  a   tax  creates  inefficiency.   Figure  6.10  shows  the  inefficiency  created  by  a  $20  tax  on  MP3  players.       Ø With  no  tax,  marginal  social  benefit  equals  marginal  social  cost  and  the  market  is   efficient.   Ø Total  surplus  (the  sum  of  consumer  surplus  and  producer  surplus)  is  maximized.   Ø The  tax  decreases  the  quantity,  raises  the  buyers’  price,  and  lowers  the  sellers’  price.       Ø Marginal  social  benefit  exceeds  marginal  social  cost  and  the  tax  is  inefficient.   Ø The  tax  revenue  takes  part  of  the  total  surplus.   Ø The  decreased  quantity  creates  a  deadweight  loss.   Production  Subsidies  and  Quotas  (diagrams  below  were  discussed  in  class )   Intervention  in  markets  for  farm  products  takes  two  main  forms:     Production  quotas     Subsidies   A  production  quota  is  an  upper  limit  to  the  quantity  of  a  good  that  may  be  produced  during  a   specified  period.     A  subsidy  is  a  payment  made  by  the  government  to  a  producer.         Effects  of  a  Quota:         Effects  of  a  subsidy           Chapter  7:  Global  Markets  in  Action   • Imports  are  the  good  and  services  that  we  buy  from  people  in  other  countries.   • Exports  are  the  goods  and  services  we  sell  to  people  in  other  countries.   • What  Drives  International  Trade?   o The  fundamental  force  that  generates  trade  between  nations  is   comparative  advantage.     o The  basis  for  comparative  trade  is  divergent  opportunity  costs  between   countries.     o National  comparative  advantage  as  the  ability  of  a  nation  to  perform  an   activity  or  produce  a  good  or  service  at  a  lower  opportunity  cost  than  any   other  nation.     Imports         Exports         Consumer  Surplus  vs.  Producer  Surplus   -­‐ Who  benefits  more  from  international  trade?                         Imports  with  International  Trade       Exports  with  International  Trade                                 But  wait…  Governments  restrict  international  trade  to  protect  domestic  producers   from  competition.       Governments  use  four  sets  of  tools:    Tariffs    Import  quotas    Other  import  barriers    Export  subsidies     Tariffs   Test  your  understanding:     Your  friend  Brie  studying  Social  Development  Studies  asks  you,  “(your  name),  what   is  a  tariff?”  Using  your  own  words,  define  what  a  tariff  is.  (try  not  to  peek  into  your   textbook)   _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________           Test  your  understanding!  On  the  graph  label  (a)  the  end  consumer  surplus,  (b)  the   end  producer  surplus,  (c)  the  deadweight  losses,  (d)  the  consumer  surplus  that   transferred  to  producer  surplus     -­‐ Note,  some  areas  may  overlap!         Import  Quotas       When  the  Canadian  government  imposes  an  import  tariff  on  imported  T-­‐shirts:     §  Canadian  consumers  of  T-­‐shirts  lose.   §  Canadian  producers  of  T-­‐shirts  gain.   §  Importers  of  T-­‐shirts  gain.     §  Society  loses:  a  deadweight  loss  arises.           Chapter  8:  Utility  and  Demand     Preferences   • A  household’s  preferences  determine  the  benefits  or  satisfaction  a  person  receives   consuming  a  good  or  service.     • The  benefit  or  satisfaction  from  consuming  a  good  or  service  is  called   utility.     Total  Utility   • Total  utility  is  the  total  benefit  a  person  gets  from  the  consumption  of  goods.  Generally,   more  consumption  gives  more  utility.     • Total  utility  from  a  good  increases  as  the  quantity  of  the  good  increases.   • For  example,  as  the  number  of  movies  seen  in  a  month  increases,  total  utility  from   movies  increases.     Marginal  Utility   • Marginal  utility  is  the  change  in  total  utility  that  results  from  a  one -­‐unit  increase  in  the   quantity  of  a  good  consumed.     • As  the  quantity  consumed  of  a  good  increases,  the  marginal  utility  from  consuming  it   decreases.     • We  call  this  decrease  in  marginal  utility  as  the  qua ntity  of  the  good  consumed  increases   the  principle  of  diminishing  marginal  utility .               The  Utility-­‐Maximizing  Choice   • We  can  find  the  utility -­‐maximizing  choice  by  looking  at  the  total  utility  that  arises  from   each  affordable  combination.   • The  utility-­‐maximizing  combination  is  called  a   consumer  equilibrium.       The  Utility-­‐Maximizing  Rule:     • Call  the  marginal  utility  of  movies   MU M   • Call  the  marginal  utility  of  pop   MP     • Call  the  price  of  movies   P .   M   • Call  the  price  of  pop P  .   • The  marginal  utility  per  dollar  from  seeing  movies  is  MU /P M  M   • The  marginal  utility  per  dollar  from  pop  is   MUP/P .P     Total  utility  is  maximized  when:   • MU /P M  MM     P P   If  MU MP > M   /P , P   P    • then  more  on  movies  and  spend  less  on  pop.   • MU deM      and   • MU P increases.   • Only  when        M   M     P  P  MU /P =  MU /P ,     is  it  not  possible  to  reallocate  the  budget  and  increase  total  utility.       Important  things  to  note  about  changes  in  price!!   • A  change  in  the  price  of  one  good  changes  the  demand  for  another  good.     • You’ve  seen  that  if  the  price  of  a  movie  faMls, M  U /P rises,  so  before  the  consumer   changes  the  quantities  consumed,   MU /P > MMU /M     P P • To  restore  consumer  equilibrium  (maximum  total  utility)  the  consumer  decreases  the   quantity  of  pop  consumed  to  drive  up  the   PU  and  restore  MU /P M  MU /PP. P      Other  Changes       A  Rise  in  Income   • When  income  increases,  the  demand  for  a  normal  good  increases.     • Given  the  prices  of  movies  and  pop,  when  Lisa ’s  income  increases  from  $40  a  month  to   $56  a  month,  she  buys  more  movies  and  mor e  pop.   • Movies  and  pop  are  normal  goods.     The  Paradox  of  Value   • The  paradox  of  value  “Why  is  water,  which  is  essential  to  life,  far  cheaper  than   diamonds,  which  are  not  essential? ”  is  resolved  by  distinguishing  between  total  utility   and  marginal  utility.     • We  use  so  much  water  that  the  marginal  utility  from  water  consumed  is  small,  but  the   total  utility  is  large.   • We  buy  few  diamonds,  so  the  marginal  utility  from  diamonds  is  large,  but  the  total   utility  is  small.     Value  and  Consumer  Surplus   The  supply  of  water  is  perfectly  elastic,  so  the  quantity  of  water  consumed  is  large  and  the   consumer  surplus  from  water  is  large.   In  contrast,  the  supply  of  diamonds  in  perfectly  inelastic,  so  the  price  is  high  and  the  consumer   surplus  from  diamonds  is  small.           Behavioral  Economics     Behavioral  economics  studies  the  ways  in  which  limits  on  the  human  brain ’s  ability  to  compute   and  implement  rational  decisions  influences  economic  behavior —both  the  decisions  that  people   make  and  the  consequences  of  those  decisions  for  the  way   markets  work.   There  are  three  impediments  to  rational  choice:     • Bounded  rationality   • Bounded  will-­‐power   • Bounded  self-­‐interest     The  Endowment  Effect     The  endowment  effect  is  the  tendency  for  people  to  value  something  more  highly  simply   because  they  own  it.       Chapter  10:  Organizing  Production     What  is  a  firm?   A  firm  is  an  institution  that  hires  factors  of  production  and  organizes  them  to  produce  and  sell   goods  and  services.     The  Firm’s  Goal   A  firm’s  goal  is  to  maximize  profit.     If  the  firm  fails  to  maximize  its  profit,  the  firm  is  either  eliminated  or  bought  out  by  other  firms   seeking  to  maximize  profit.     Accounting  Profit   Accountants    measure  a  firm’s  profit  to  ensure  that  the  firm  pays  the  correct  amount  of  tax  and   to  show  it  investors  how  their  funds  are  bein g  used.     Profit  equals  total  revenue  minus  total  cost.     Accountants  use  Internal  Revenue  Service  rules  based  on  standards  established  by  the  Financial   Accounting  Standard
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