Transcript Lecture Week 06

Tax Burden in General

Generally, neither demand nor supply is
perfectly inelastic or perfectly elastic.
\the tax burden/incidence is split
between buyers and sellers according
to relative elasticities, and market
conditions. Law makers cannot
legislate “who pays”.
1
Addiction and Elasticity
–Nonusers’ demand for addictive substances is
elastic.
 High taxes on cigarettes and alcohol limit the
number of young people who become
habitual users of these products.
–Existing users’ demand for addictive substances
is inelastic.
 High taxes have only a modest effect on the
quantities consumed by established user,
they raise revenue from these users.
2
Luxury Tax
– Notice that depending on the goal of the
tax different types of demand elasticity
are desirable.
– Raise revenue: inelastic demand
– Change behaviour: elastic demand

Who actually bore the burden of this
tax?
3
Tax Burden and Elasticity of Demand
Two extreme cases:
• Perfectly inelastic demand:
•Perfectly elastic demand:
Tax Burden and Elasticity of Supply
Two extreme cases:
• Perfectly inelastic supply:
• Perfectly elastic supply:
4
Sales Tax and the Elasticity of
Demand
Price (dollars per dose)
S’
Tax
S
2.20
Perfectly inelastic
demand
2.00
Buyer pays
entire tax
D
100
Quantity
(thousands of doses per day)
5
Sales Tax and the Elasticity
S’
of Demand
Price (cents per pen)
S
D
1.00
Tax
Perfectly elastic
demand
0.90
Seller pays
entire tax
4
Quantity (thousands of marker pens per week)
6
Sales Tax and the Elasticity of
Supply
Price (dollars per bottle)
S
Perfectly
inelastic
supply
50
45
Tax
Seller pays
entire tax
D
7
100 Quantity (thousands of bottles per week)
Price (cents per pound)
Sales Tax and the Elasticity
of Supply Perfectly Elastic
Supply
S’
11
Buyer pays
entire tax
Tax
10
S
D
3
5
Quantity (thousands of
kilograms per week)
8
Who pays the Airport
Security Tax?



Who pays the tax? - Demand Elasticity between 0.7
and 2.1
No mention of elasticity of supply but economists
claim the price will rise by the amount of the tax,
Ie: the buyer pays the whole tax, implying a
perfectly elastic supply schedule.
9
Supply: Perfectly Elastic
Original Equilibrium
P=$60,
Q=1,400
passengers/day
Elasticity of
Demand = 2.1
Price (dollars per trip)
100
Elasticity of
Demand = 0.7
80
72
S+tax
60
S
D1
40
20
D0
950
1,230
1,400
2,100
Quantity (passengers per day)
10
Supply: Unit Elastic
Elasticity of
Demand = 2.1
Price (dollars per trip)
100
Elasticity of
Demand = 0.7
80
S+tax
S
60
40
D1
20
D0
1,220
1,290
1,400
2,100
Quantity (passengers per day)
Crucial to know
demand
elasticity &
supply elasticity
11
Rent (dollars per unit per month)
A Rent Ceiling &
Elasticity
S1, SR
Supply in the LR
becomes more
elastic over time,
increasing the
shortage
S2
24
20
Rent ceiling
16
Housing
Housing
shortage
shortage
12
0
44
72
100
D
150
12
Quantity (thousands of units per month)
How Long is the Long Run?

There is no set amount of time that puts a
market into the long run
– The long run could be a week or a year

The long run is how long a consumer or firm
takes to fully adjust to a price change
– Time required to make major changes
– Ie) Give up Pepsi Vanilla, Build more cost efficient
Pepsi factory, secure a US Pepsi Vanilla supplier

The short run is anything shorter than the
long run
13
Cross Price Elasticity of Demand

We’ve seen already that demand is affected
by the price of substitutes and compliments
– An increase in the price of a substitute increases
demand
– An increase in the price of a complement decrease
demand


This effect can be measured using cross price
elasticity
If the cross price elasticity is zero, the good is
neither a complement nor a substitute
14
Cross Price Elasticity of Demand
E xy 
Percentage change in quantity demanded of X
Percentage change in price of Y
Exy = Change in X
--------------(X1 + X2)/2
/
Change in Price of Y
---------------------------(Py1 + Py2)/2
Substitutes – Positive Cross Price Elasticity
Compliments – Negative Cross Price Elasticity
15
Income Elasticity of Demand


Income Elasticity of demand refers to a
HORIZONTAL SHIFT in the demand curve
resulting from an income change
Price elasticity of demand refers to a
MOVEMENT ALONG THE DEMAND CURVE in
response to a price change
16
Income Elasticity of Demand
E xy 
Percentage change in quantity demanded
Percentage change in income
EI= Change in Q
--------------(Q1 + Q2)/2
/
Change in M
---------------------------(M1 + M2)/2
Normal Good – Positive Shift/Elasticity
Inferior Good – Negative Shift/Elasticity
17
The Theory of Consumer Choice
• The theory of consumer choice
attempts to explain why
consumers choose one good or
bundle of goods over another
good or bundle of goods.
18
The Theory of Consumer Choice
• We are particularly interested in how
prices affect consumer choice
(demand) because
–making choices in response to
prices and price changes is the
basis of the operation of the price
system.
–Cet. Par.
19
“Measuring” Satisfaction
•util: unit of pleasure.
• utility: a number that represents
the level of satisfaction that the
consumer derives from consuming
a specific quantity of a good.
20
Total Utility, Marginal Utility
• TU (total utility):
– the total amount of
satisfaction that you
get from consuming a
product.
• MU (marginal utility):
– the increase in TU
that comes about as
a result of consuming
one more unit of the
product.
Frank’s TU & MU from
country music: Total utility &
marginal utility of trips to the
club per week
Trips
to Club
1
2
3
4
5
6
Total
utility
12
22
28
32
34
34
Marginal
utility
12
10
6
4
2
0
21
Marginal Utility
• If one more unit of a good is consumed, the
marginal utility is equal to the increased utility
from that extra good
• If more than one additional good is consumed:
Utility
MU 
Goods
22
Total utility is
maximized...
34
Marginal Utility (utils per week)
Total Utility (utils per week)
Total and Marginal Utility of Club Trips
28
22
0
2
3 4 5 6 7 8
Performances per Week
10
8
6
4
2
0
2 3
4
…where marginal
utility equals zero.
5
6
7
Performances per Week
23
Law of Diminishing MU
• The MU (marginal utility) of a good or
service will decline as more units of
that good or service are consumed.
•Marginal utility is what counts for
rational consumer decisions.
24
Frank’s Optimal Choice
• When Frank can go to each activity for
free, he splits his time between the
two to maximize utility. At each
successive step, he chooses the
activity with the greatest MU.
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(1) Per
week
(2) Total
utility
(3) Marginal
utility (MU)
Trips
to
club
1
2
3
4
5
6
12
22
28
32
34
34
12
10
06
04
02
00
Basketball
games
1
2
3
4
5
6
21
33
42
48
51
51
21
12
09
06
03
00
26
Frank’s Optimal Choice
• \ _night club visits and _ nights at
basketball
–for a total satisfaction = __ utils.
• In the real world, Frank cannot have
whatever he wants, he must maximize
utility subject to:
1.) the income constraint
2.) the nature of commodity prices
27
Rational Choice
\ Spend limited income where
satisfaction per $ is the greatest.
–MU/$: marginal benefit of the decision.
–MU/$: marginal cost of the next best
alternative given up
\ choose those items for which
MU/$ is the greatest until all
income is spent.
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Frank’s Optimal Decision
• Suppose: Frank has an entertainment
• budget of
$21.00
• club tickets
$3.00
• basketball tickets
$6.00
• Under these circumstances, the best
Frank can do is
1.) allocate (spend) all his income
so that
2.) MU basketball = MU club trips
P basketball
P club trips
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(1) per
week
Trips
to
Club
B’ball
games
per/wk
(2) (3) Marginal (4)
Total Utility (MU) Price
Utility
(P)$
(5)
Marginal
Utility/$
(MU/P)
1
2
3
4
5
6
12
22
28
32
34
34
12
10
06
04
02
00
3.00
3.00
3.00
3.00
3.00
3.00
4.0
3.3
2.0
1.3
0.7
0.0
1
2
3
4
5
6
21
33
42
48
51
51
21
12
09
06
03
00
6.00
6.00
6.00
6.00
6.00
6.00
3.5
2.0
1.5
1.0
0.5
0.0
Income =
$21
Pc =
$3.00
Pb =
$6.00
30
Frank’s Optimal Decision
\ The rational consumer will choose a
“market basket” where the MU of the last
$ spent on all commodities is the same
and all income is spent.
–Why does this maximize utility?
31
Frank’s Optimal Decision
•Suppose, Frank buys 3 basketball
games and 1 club trip
MUBB = 1.5
PBB
MU club = 4
P club
MBc > MCb
•Frank is better off to take another club trip
and give up one basketball game
32
Frank’s Optimal Decision
IN GENERAL, the consumer will be in
equilibrium with his/her choices when
1. Income = PAQA + PBQB …..+PzQz
and
2.
MU of good A
MU of good B
MU of good Z

 ... 
price of good A price of good B
price of good Z
33
D
E
R
I
V
I
N
G
D
E
M
A
N
D
Now suppose the price of basketball games falls to
$3.00. What is Frank’s new equilibrium?
(5)
(3)
Marginal
(2)
Marginal
(4)
(1) per Total Utility (MU)
Utility/$
Price
week
Utility
(MU/P)
(P)$
Trips
to
Club
B’ball
games
per/wk
1
2
3
4
5
6
1
2
3
4
5
6
12
22
28
32
34
34
21
33
42
48
51
51
12
10
06
04
02
00
21
12
09
06
03
00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
4.0
3.3
2.0
1.3
0.7
0.0
7
4
3
2
1
0
Income =
$21
Pc =
$3.00
Pb =
$3.00
34
Demand for B’ball Games
At a price of $6, 2 games.
Price per Unit ($)
At a price of $3, 4 games.
A reduction in price
causes consumers to
increase consumption
until marginal utility
per $ falls
6
3
D
2
Basket ball games
4
35
Example: Demand and Utility Maximization
•Find the utility maximizing combination
of products A & B obtainable with an
income of $10.
•Price of A is $1.00.
•Price of B is $2.00.
•Let the price of B fall to $2.00 and
identify two points on the demand
schedule for B
36
(1) (2) (3) (4)
(5) (6) (7)
A
B
Q
TU
TU
1
2
3
4
5
6
10
18
25
31
36
40
24
44
62
78
90
96
37
Supply, Production & Cost
• Firms make the supply decision in order to
maximize profits:
Profit =Total Revenue - Total Cost
• From the viewpoint of the firm the
opportunity cost is the amount that the firm
must pay the owners of the factors of
production that it employs to attract them
from their best alternative use.
– Price therefore reflects the value of what
38
is foregone: opportunity cost
Supply: Production & Costs
• To calculate a firm’s Total Costs of
production include all (opportunity) costs.
– Explicit costs
– Implicit costs
Explicit Costs
• Costs that arise when money actually
changes hands;
– eg. a bill is paid for utilities, wages,
interest on a loan…..
39
Implicit Costs
Costs faced by the owners where no
money changes hands, no bill is received;
 e.g., salary (opportunity cost) given up
by owner, normal rate of return on the
best alternative investment (opportunity
cost) of owner’s financial capital..
40
Economic Profit
• Economists & Accountants calculate profit differently:
– Economists are interested in studying how
firms make production & pricing decisions.
They include all costs.
Economic Profit =
TR - [Explicit + Implicit Costs]
Accounting Profit
– Accountants are responsible for keeping track
of the money that flows into and out of firms.
They focus on explicit costs.
Accounting Profit =
TR - Explicit Costs
41
Economic Profit Terminology
• Excess Profit or Economic Profit
• occurs after a normal profit is made or after all
costs have been covered.
• Breaking Even = Zero Economic Profit
• a satisfactory position for a firm because it
means that “normal profits” are being achieved.
• Economic Loss
• an economic profit less than zero
42
Revenue
Profit: Economists vs Accountants
Economist’s
View
Accountant’s
View
Economic
Profit
Accounting
Profit
Implicit
Costs
Explicit
Costs
Revenue
Total
Opportunity
Cost
Explicit
Costs
43
Accounts of Fieldcom Inc.
Total revenue
$600 000
LESS explicit costs
Wages & salaries
320 000
Materials & other
60 000
EQUALS accounting profit
$ 220 000
LESS implicit costs
Forgone salary, Andrea Martin
75 000
Forgone salary, Ralph Martin
75 000
Interest forgone on invested saving
20 000
EQUALS pure economic profit
$ 50 000
Opportunity Cost of Inputs
Firms will only operate in an industry if
they can make a normal rate of return
 Ie: Money invested in an interest must
earn at least as much as it could
elsewhere (bank account, stock market,
GIC)
 Labour must be paid at least as much
as it could earn elsewhere (an
entrepreneur should make $X/hour) 45
Economics vrs. Accounting Example
• Jack opens up a computer repair business
• After all costs are paid, Jack makes
$500/week in his business
• By working for someone else, Jack would
make $20/hr or $800/week
• Accounting profit = $500
• Economic profit = -$300
• Economists would advice a change in
profession
46
The Firm
• A firm is an organization that brings
together inputs to produce goods and
services for sale
Q = f (inputs)
Q = f (K, L)
47
Technological and Economic
Efficiency
Technological efficiency is attained
when the firm produces a given output
by using the least inputs.
Economic efficiency is attained when the
cost of producing a given output is as low
as possible.
48