Exam 2 Study Guide
Exam 2 Study Guide EC 110
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This 17 page Study Guide was uploaded by Matt Owens on Wednesday March 4, 2015. The Study Guide belongs to EC 110 at University of Alabama - Tuscaloosa taught by Kent O. Zirlott in Spring2015. Since its upload, it has received 444 views.
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Date Created: 03/04/15
Exam 2 Study Guide Chapter 5 Elasticity A numerical measure of the responsiveness of Qd or Q8 to one of its determinants 0 Measures how much one variable responds to changes in another variable Price Elasticity of Demand Measures how much Qd responds to a change in P o It measures the pricesensitivity of buyers demand 0 How to solve for Price Elasticity of Demand Midpoint Method End value start value 100O midpoint average X 0 The midpoint method is better than the standard method for calculating elasticity because it doesn t matter where you start end but with the standard method you will get different values depending on where you start end The price elasticity of demand is closely related to the slope of the demand curve but it is not equal to the slope of the demand curve The reason for this is because slope is a ration of two changes and elasticity is a ratio of two percentage changes 0 The atter the curve the bigger the elasticity o The steeper the curve the smaller the elasticity 5 Types of Elasticity of Demand 0 1 Elastic Demand P I Price elasticity of demand change in Q gt10 change in P 10 I D curve relatively at I NOT PERFECTLY FLAT I Consumers price quot Q sensitivity relatively high Q1 QZ 39 Elasticity gt1 Q rises more than 10 o 2 Inelastic Demand I Price elasticity of demand change in Q lt10 change in P 10 I D curve relatively steep I Consumers price sensitivity relatively low Q1 622 Q Q rises less than 10 Elasticity lt 1 Percentage change in Q is less than percentage change in price 0 3 Unit Elastic Demand Price elasticity of demand change in Q 10 change inP 10 Elasticity 1 Percentage change in Q equals the percentage change in price o 4 Perfectly Inelastic Demand Price elasticity of demand changeinQ 000 0 change in P 10 D curve perfectly vertical Consumers price sensitivity none Elasticity 0 Example Prescription Medicines o 5 Perfectly Elastic Demand Example 1 Breakfast Cereal vs Sunscreen Price elasticity of demand change in Q any change in P 10 D curve perfectly horizontal Consumers price sensitivity extreme Elasticity infinity If prices changes just a little bit quantity goes to 0 Example Seafood infinity a Q Q Q rises by 10 P D P1 P 2 Q 01 Q changes by 0 p P1 D Q Q1 02 0 changes by any o The prices ofboth of these goods rise by 20 For which good does Qd drop the most Why Breakfast cereal has close substitutes eg pancakes Eggo waf es oatmeal grits so buyers can easily switch if the price rises Sunscreen has no close substitutes so consumers would probably not buy much less if its price rises 0 Lesson Price elasticity is higher when close substitutes are available Example 2 Lucky Brand Jeans vs Clothing 0 The prices ofboth goods rise by 20 For which good does Qd drop the most Why For a narrowly defined good such as Lucky Brand jeans there are many substitutes khakis shorts other denim brands There are fewer substitutes available for broadly defined goods There aren t too many substitutes for clothing other than living in a nudist colony 0 Lesson Price elasticity is higher for narrowly defined goods than broadly defined ones Example 3 Insulin vs Caribbean Cruises o The prices ofboth ofthese goods rise by 20 For which good does Qd drop the most Why To millions of diabetics insulin is a necessity A rise in its price would cause no decrease in Qd A cruise is a luxury If the price rises some people will forego it 0 Lesson Price elasticity is higher for luxuries than for necessities Example 4 Gasoline in the Short Run vs Gasoline in the Long Run 0 The price of gasoline rises 20 Does Qd drop more in the short run or the long run Why There s not much people can do in the short run other than ride the bus or carpool In the long run people can buy smaller cars or live closer to where they work 0 Lesson Price elasticity is higher in the long run than the short run Determinants of Elasticity of Demand 1 The extent to which close substitutes are available 2 Whether a good is a necessity or luxury 3 How broadly or narrowly the good is defined 4 The time horizon elasticity is higher in the long run than the short run Relationship between total revenue and elasticity of demand 0 A price increase has two effects on revenue 0 OOO Higher P means more revenue on each unit you sell Price Effect But you sell fewer units lower Q due to the Law of Demand Quantity Effect o If you raise your price revenue will fall Revenue P x Q o If demand is elastic then price elasticity of demand gt than 1 39 change in Q gt change in P o The fall in revenue from lower Q is greater than the increase in revenue from higher P so revenue falls 0 incregge d f 0 Elastic demand elasticity 18 p rev lgosi ev Q If P 200 Q 12 and revenue to h 9 er revenue 2400 due to 250 o If P 250 Q 8 and revenue V 35355 a lower Q 2000 200 39 quot D Q When D is elastic a price increase causes revenue fall 2 Q T o If demand is inelastic then price elasticity of demand is lt 1 39 change in Q lt change in P o The fall in revenue from lower Q is smaller than the increase in revenue from higher P so revenue rises o In our example suppose that Q only falls to 10 instead of 8 when you raise your price to 250 39nCrEE i and for WWW W sit P to higher P ost revenue due to lower Q Now demand is inelastic elasticity 082 IfP 200 Q 12 and revenue 2400 250 IfP 250 Q 10 and revenue 2500 quot When D is inelastic a price increase causes revenue to rise 0000 200 w 7 o Price Elasticity of Supply measures how much QS responds to a change in P 0 Will not have to calculate on the exam but you will have to know what it is the concept and why we use it o Loosely speaking it measures sellers pricesensitivity The slope of the curve is closely related to price elasticity of supply 0 The atter the curve the bigger the elasticity o The steeper the curve the smaller the elasticity 5 Types of Price Elasticity of Supply 0 Inelastic I Price elasticity of supply change in Q lt10 change in P 10 I S curve relatively steep Q I Sellers price sensitivity relatively low Q1 Q I Elasticity lt 1 Q rises less than 10 0 Unit Elastic I Price elasticity of supply s change inQ 10 P2 7 changeinP 10 P17 I I Elasticity 1 01 a Q Qrises by10 0 Elastic P I Price elasticity of supply 2 S changeinQ gt10 gt 1 P2 39 changeinP 10 P1 2 1 I S curve relatively at I Sellers price sensitivity relatively high Q1 Q2 39 Elasticity gt 1 WM Q rises more than 10 o Perfectly Elastic P I Price elasticity of supply P P g S change in Q any 2 1 0 T infinity 0 change 1n P 0 o I S curve horizontal m h Q I Sellers price sensitivity extreme Q1 92 I Elasticity infinity 335mg 0 Perfectly Inelastic I Price elasticity of supply change in Q 0 change in P 10 I S curve vertical I Sellers price sensitivity none I Elasticity 0 0 changes by 0 Determinants of Elasticity of Supply 0 1 The more easily sellers can change the quantity they produce the greater the price elasticity of supply 0 2 For many goods price elasticity of supply is greater in the long run than in the short run because firms can build new factories or new firms may be able to enter the market s elasticity 15 lt1 Supply often 12 becomes less elasticity 39 elastlc as Q 4 gt1 rlses due to 339jl E Q capac1ty11m1ts 100 200 500 525 Income Elasticity of Demand Measures the response of Qd to a change in consumer income Percent change in Qd 0 Income elasticity of demand Percent change 1n Income 0 Recall from Chapter 4 An increase in income causes an increase in demand for an normal good 0 Hence for normal goods income elasticity gt 0 o For inferior goods income elasticity lt 0 CrossPrice Elasticity of Demand measures the response of demand for one good to changes in the price of another good change in Qd for good 1 CrossPrice Elasticit of Demand 0 y change in price of good 2 o For substitutes crossprice elasticity gt 0 eg an increase in price of beef causes an increase in demand for chicken 0 For complements crossprice elasticity lt 0 eg an increase in price of computers causes decrease in demand for software Chapter 6 Price Ceiling A legal maximum on the price of a good or service 0 Example Rent control Price Floor A legal minimum on the price of a good or service 0 Example Minimum wage Not Binding Has no effect on the market outcome Binding Constraint causes a surplus or a shortage How price ceilings affect market outcomes 0 A price ceiling above the equilibrium is not binding has no effect on the market outcome 0 A price ceiling below the equilibrium is a binding constraint and causes a shortage Shortages and Rationing 0 With a shortage sellers must ration the goods among buyers I Rationing Mechanisms 1 Long lines 2 Discriminations according to sellers biases I Mechanisms are unfair and inefficient I When prices aren t controlled the rationing mechanism is efficient the goods go to the buyers that value them most highly and impersonal thus fair How price oors affect market outcomes 0 A price oor below the equilibrium is not binding has no effect on the market outcome 0 A price oor above the equilibrium is binding and it causes a surplus Sales Tax Tax on buyers Excise Tax Tax on sellers A Tax on Buyers ers Effects of a 150 per 0 Hence a tax on buyers sh1fts the D curve left by the by unusabstaxon amount of the tax P buyers 0 P would have to fall by 150 to make buyers willing to buy same Q as before 0 Eg if P falls from 1000 to 850 buyers still willing to purchase 500 pizzas New Equilibrium E ectsofa 150 per Q 4 0 unit sales tax on Sellers receive P5 950 P buyers Buyers pay Pc 1100 Difference between them 150 tax The Incidence of a Tax How the burden of a tax is shared among market participants In our example 0 Buyers pay 100 more 00000 450 500 0 Sellers get 050 less A Tax on Sellers 0 The tax effectively raises sellers costs by 150 per pizza 0 Sellers will supply 500 pizzas only if P rises to 1150 to compensate for this cost increase 0 Hence a tax on sellers shifts the S curve left by the amount of the tax 0 New Equilibrium Q 450 I Buyers pay Pc 1100 I Sellers receive P5 950 I Difference between them 150 tax The Outcome Is the Same in Both Cases 0 The effects on P and Q and the tax incidence are the same whether the tax is imposed on buyers or sellers 0 What matters is I A tax drives a wedge between the price buyers pay and the price sellers receive Elasticity and Tax Incidence 0 CASE 1 Demand is Inelastic It s easier for sellers than buyers to leave the market Buyers share PC of tax burden n Tax Price if no tax Sellers share PS of tax burden 39 L D Q 0 CASE 2 Demand is More Elastic It s easier for buyers than sellers to leave the market Buyers share of tax burden Price if no tax Sellers share of tax burden ps Effects of a 150 per unit excise tax on sellers rs Vs rs shifts the Q mim r nf the my 500 Effects of a 1 50 per unit excise tax on sellers PC 1100 P8 950 PC 1100 1000 7 Ps 950 7 D 450 500 Chapter 7 Willingness To Pay WTP Willingness to Pay The maximum amount the buyer will pay for that good WTP measures how much the buyer values the good Consumer Surplus CS Consumer surplus is the amount a buyer is willing to pay minus the amount the buyer actually pays 0 CS WTP P CS With Lots of Buyers and a Smooth Demand Curve The demand for shoes At Q 5 thousand the marginal buyer is willing to pay 50 607 for pair of shoes 50 Suppose P 30 40 Then his consumer surplus 20 1O 0 a 0 51015202530 3 The demand for shoes CS is the area above P and below the D curve from 0 to Q Recall Area of a triangle 12 X base X height Height 60 30 30 SoCS12X15X30225 o I D l I io 0 510152025307 How A Higher Price Reduces CS 39 1 Fall nos due to buyers leaving market IfP rises to 40 CS12X10X20 100 Two reasons for the fall in CS 0 1 Fall in CS due to buyers leaving market 0 2 Fall in CS due to remaining buyers paying higher 011 TI IQT P 0515202530 Cost and the Supply Curve Cost is the value of everything a seller must give up to produce a good ie opportunity cost Includes cost of all resources used to produce good including value of the seller s time Example Costs of 3 sellers in the lawn Name COSt cutting business Jack 10 A seller will produce and sell the good service only if the price exceeds his or her cost Janet 20 Hence cost is a measure of willingness to sell Chrissy 35 Derive the supply schedule from the cost data P QS 09 0 0 At each Q the height ofthe S curve is 1049 1 the cost of the marginal seller the seller who would leave the market if the price were any lower 2034 2 35 amp 3 up Producer Surplus PS Producer Surplus The amount a seller is paid for a good minus the seller s cost 0 PSP cost Producer Surplus and the S Curve PS P cost JP F Suppose P 25 40 Cm s Jack s PS 2 15 1 HVCQSt Janet s PS 5 20 Chrissy s PS 10 Total PS 20 Total PS equals the area above the supply 0 rm quot orquot 0 area curve under the price from 0 to Q PS With Lots of Sellers and a Smooth Curve 8 P The supply ofshoes Suppose P 40 50 At Q 15 thousand the marginal seller s cost is 30 and E her producer surplus 10 30 20 10 0 39 I I 3Q 0 51015202530 P The supply of shoes PS is the area between P and the S curve from 0 to Q The height of this triangle is 40 15 25 SoPS12Xbxh o 12 X 25 X 25 0 31250 60 11 Fall in PS due to sellers How a Lower Pr1ce Reduces PS 39 50 leaving market 3 IfPfalls to 30 PS12X15X1511250 BE Two reasons for the fall in PS o 1 Fall in PS due to sellers leaving market 10 0 2 Fall in PS due to remaining sellers getting lower P 0 g Ql CS PS and Total Surplus CS value to buyers amount paid by buyers 0 Buyers gains from participating in the market PS amount received by sellers cost to sellers 0 Sellers gains from participating in the market Total Surplus CS PS 0 Total gains from trade in a market 0 Value to buyers cost to sellers Efficiency Total surplus value to buyers cost to sellers An allocation of resources is efficient if it maximizes total surplus Efficiency means 0 The goods are consumed by the buyers who value them most highly o The goods are produced by the producers with the lowest costs 0 Raising or lowering the quantity of a good would not increase total surplus Evaluating the Market Equilibrium 3 Market equilibrium 0 P 30 0 Q 15000 Total surplus CS PS a o 0 2 I r I r Is the market equ111br1um eff1c1ency O 5 10 20 25 30 Which Buyers Consume the Good 3 Every buyer whose WTP is 2 30 will buy Every buyer whose WTP is lt 30 will not So the buyers who value the good most highly are the ones who consume it 0 V D 6 o 51o 2o 25 30 Which Sellers Produce the Good if 60 50 40 Every seller whose cost is S 30 will produce the good Every seller whose cost is gt 30 will not So the sellers with the lowest cost produce the good Does Equilibrium Q Maximize Total Surplus At Q 20 0 Cost of producing the marginal unit is 35 0 Value to the consumers of the marginal unit is only 20 0 O Hence can increase total surplus by reducing Q This is true at any Q greater than 15 O Y I V o 5 1015720 25 30 At Q 10 0 Cost of producing the marginal unit is 25 0 Value of consumers of the marginal unit is 40 0 Hence can increase total surplus by increasing Q o This is true at any Q less than 15 The market equilibrium quantity maximizes total surplus At any other quantity can increase total surplus by moving toward the market equilibrium quantity D O i l l l l o 5 1020 25 30 Chapter 8 Review A tax 0 Drives a wedge between the price buyers pay and the price sellers receive 0 Raises the price buyers pay and lowers the price sellers receive 0 Reduces the quantity bought and sold These effects are the same whether the tax is imposed on buyers or sellers so we do not make this distinction in this chapter The Effects of a Tax p Equilibrium with no tax 0 Price PE 0 Quantity QE Equilibrium with tax T per unit 0 Buyers pay Pc 0 Sellers receive P5 0 Quantity QT Size of tax T Size of tax T 0 Revenue from tax 0 T X QT PE QT QE Next we apply welfare economics to measure the gains and losses from a tax We determine consumer surplus CS producer surplus PS tax revenue and total surplus with and without the tax Tax revenue can fund beneficial services eg education roads police so we include it in total surplus VV houtatax 0 CS A B C 0 PS D E F 0 Tax revenue 0 0 Total surplus I CS PS I ABCDEF With the tax 0 CSA o PSF 0 Tax Revenue 2 B D 0 Total Surplus I ABDF The tax reduces total surplus by C E o C E is called the deadweight loss DWL of the tax the fall in total surplus that results from a market distortion such as a tax 0 About the Deadweight Loss Because of the tax the units between QT and Q are not sold The value of these units to buyers is greater than the cost of producing them so the tax prevents some mutually beneficial trades What Determines the Size of the DWL Which good or services should government tax to raise the revenue it needs One answer Those with the smallest DWL When is the DWL small vs large 0 Turns out it depends on the price elasticities of supply and demand Recall o The price elasticity of demand or supply measures how much Q or Q5 changes when P changes DWL and the Elasticity of Supply When supply is inelastic 0 It s harder for firms to leave the market when the tax reduces P5 0 So the tax only reduces Q a little and DWL is small The more elastic is supply 0 The easier for firms to leave the market when the tax reduces Ps the greater Q falls below the surplus maximizing quantity the greater the DWL When demand is inelastic 0 It s harder for consumers to leave the market when the tax raises Pc 0 So the tax only reduces Q a little and DWL is small The more elastic is demand 0 The easier for buyers to leave the market when the tax increases Pc the more Q falls below the surplus maximizing quantity and the greater the DWL The Effects of Changing the Size of the Tax Policymakers often change taxes raising some and lowering others Size of tax 5 D What happens to DWL and tax revenue when taxes change WE explore this next DWL and the Size of the Tax Initially the tax is T per unit Doubling the tax causes the DWL to more than double Initially the tax is T per unit Tripling the tax causes the DWL to more than triple Implication Q When tax rates are low raising them doesn t cause much harm and lowering them doesn t bring much bene t initial DWL Summafy When a tax increases DWL rises even more 0 When tax rates are high raising them is very harmful and cutting them is very beneficial Revenue and the Size of the Tax When the tax is small increasing it causes tax revenue to rise When the tax is larger increasing it causes tax revenue to fall 03 C22 TheLa ervae Tax revenue The Laffer Curve shows the relationship between the size of the tax and tax revenue Tax size
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