Transcript Price Elasticity of Demand

Elasticity Applications – Review: Demand and Supply Curves
Market demand curve: How P
many cans of beer would
consumers purchase
(the quantity demanded),
IF the price of beer were _____, P*
given that everything else
relevant to the demand for beer
remains the same?
Surplus
Shortage
S
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
Market Forces push the actual price to the equilibrium price.
If Actual Price >
< Equilibrium Price
Shifts

Change in something OTHER
THAN the price of beer ITSELF
versus
The demand curve for beer The supply curve for beer
can SHIFT ONLY if
can SHIFT ONLY if
something that affects
something that affects
demand OTHER THAN
supply OTHER THAN
the BEER PRICE changes. the BEER PRICE changes.
Movements along a Curve

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.
Review: Price Elasticity of Demand
Price Elasticity of Demand
If the quantity demanded is
very sensitive to the price

Demand is Elastic

Price elasticity of
demand greater than 1
= Percent change in the quantity demanded
resulting from a 1 percent change in the price
Unit Elastic

Price elasticity of
demand equals 1
If the quantity demanded is
not very sensitive to the price

Demand is Inelastic

Price elasticity of
demand less than 1
Total Revenue = Price  Quantity
P Q
P Q
TR rises
TR falls
TR = P  Q
P Q
P Q
TR falls
TR rises
Warning: Don’t try to memorize these relationships.
Geometric Interpretation of Total Revenue (TR)
Price
TR = P  Q
= Area of the rectangle
What is the height of the rectangle? P
What is the width of the rectangle? Q
P
What is the area of the rectangle? P  Q
D
Q
Quantity
Linear Demand Curves: Slope versus Elasticity
“High” Price
Price
Price
TR = P  Q
Increase in TR
= Area of the rectangle
“Low” Price
Increase in TR
Decrease in TR
P
In net, TR falls
In net, TR rises
Decrease in TR
P
D
Q

P Q
D
Quantity
Q
TR = P  Q falls
P Q
TR = P  Q rises
Quantity demanded is
very sensitive to the price
Quantity demanded is not
very sensitive to the price
Demand Elastic
Slope and elasticity are not equivalent. Why?
Quantity
Demand Inelastic
Price Elasticity of Demand = Percent change in the quantity demanded resulting from a
1 percent change in the price
Effect of the First Persian Gulf War on Crude Oil Prices
Prior to Iraq’s invasion of Kuwait on August 2, 1990, approximately 65 million barrels of crude
oil were produced in the world per day. The price of crude oil was about $17 per barrel.
Kuwait and Iraq produced 5 of the 65 million barrels.
The Security Council of the United Nations responded to the invasion by passing a resolution
requiring nations to boycott Iraqi oil. The Security Council’s action succeeded: no Iraqi or
Kuwaiti oil reached world markets.
Question: Common sense suggests that the price of crude oil should rise and the quantity fall as a
consequence of the boycott. But, can we be more specific?
Market for Crude Oil
Before Iraq’s invasion:
P
65 million barrels were produced per day and the
price was $17 per barrel.
S
After Iraq’s invasion:
S
The supply curve for oil shifts left by 5 million barrels.
At the old equilibrium price, $17, a 5 million
barrel shortage exists

Price rises until a new equilibrium is established.

Quantity falls by less than 5 million barrels.
Price rises.
5
17
Question: Can we be more specific about the price increase?
5
5
D
Q
65
Claim: We can be more specific by applying the
price elasticities.
Market for Crude Oil
P
Price Elasticity of Demand = Percent change
in the quantity demanded resulting from a = .05
1 percent change in the price
Price Elasticity of Supply = Percent change
in the quantity supplied resulting from a
= .10
1 percent change in the price
S
5
17
What was the shortage in percentage terms?
5
65
Price
up by
1%
10%
50%
S
5
5
D
= .0769…  7.5%
Q
Quantity demanded
decreased by
.05%
0.5 %
2.5 %
50%  $17 = $8.50
Quantity supplied
increased by
.10%
1.0 %
5.0 %
65
Portion of shortage
gap eliminated
.15%
1.5%
7.5%
We estimate that the price of crude oil would rise by $8.50 from $17 to
$25 or $26
In reality it rose from $17 to $27 in August.
Minimum Wage Legislation: A Price Floor
Federal Minimum Wage = $7.25/hour
Massachusetts Minimum Wage = $9.00/hour
Market for Low Skilled Labor  Video
Workers firms
Wage
would hire
S
Unemployed
9.00
Workers
seeking a job
4.00
D
Workers
Question: How might we test our logic?
Question: Is the wage for highly skilled labor less than or greater than the minimum
wage? Yes
Question: Will the minimum wage affect unemployment for highly skilled workers? No
Question: As a consequence of the minimum wage, how would the 16-19 unemployment
rate and the unemployment rate for all Americans be related? 16-19 higher
Unemployment Rate
Who is helped?
Low skilled workers who can find a job.
August 2014
All Americans: 5.1%
Who is not helped? Low skilled workers who can’t find a job.
16-18: 16.9%
A Possible Justification for Minimum Wage Legislation: The Total Earned Income of Low
Skilled Workers as a Group
 Video
Claim of many advocates of a higher minimum wage:
Higher minimum wage
A higher minimum wage will not increase low skilled
 Claim
unemployment as a consequence of what we will call the
Increases total income earned by low
indirect earnings effect.
skilled workers as a group
Total
Quantity of

Earned = Wage  Labor
Low skilled workers purchase more
Income
Demanded
goods

?
=
w

L
Firms produce more goods



Employment increases

Wage
Workers firms
Indirect earnings effect mitigates the
would hire
rise in unemployment caused by the
direct effect of a higher minimum wage
D
Workers
Question: What additional
information do we need to
determine if total earned
income will rise or fall?
Answer: Wage Elasticity of Demand
Question: What is the wage elasticity of demand?
Review the definitions of the elasticities that we have already introduced:
Price Elasticity of Demand
= Percent change in the quantity demanded
resulting from a 1 percent change in the price
Income Elasticity of Demand = Percent change in the quantity demanded
resulting from a 1 percent change in the income
Price Elasticity of Supply
= Percent change in the quantity supplied
resulting from a 1 percent change in the price
Wage Elasticity of Demand
= Percent change in the quantity demanded
resulting from a 1 percent change in the wage
Demand is Elastic
Demand is Inelastic

If the quantity demanded is
very sensitive to the wage

If the quantity demanded is
not very sensitive to the wage
w L
Total Earnings
falls
Total Earned
Income
=
w


L

w L
Total Earnings
rises
Hamermesh Empirical Study of Wage Elasticity
Study
Group
Welch and Cunningham (1978)
Baxen and Martin (1991)
Anderson (1977)
Grant (1979)
Hamermesh (1982)
Layard (1982)
Lewis (1985)
Teens
Young
16-24
14-24
14-24
M < 21
F < 18
M < 21
F < 21
Wage elasticity
of Demand
1.34
.51
7.14
9.68
.59
1.25
.31
1.80
4.58
Hamermesh. 1993. Labor Demand. Princeton and Chichester, U.K.: Princeton University Press.
Price Elasticity of Demand
= Percent change in the quantity demanded
resulting from a 1 percent change in the price
If the quantity demanded is
very sensitive to the price

Demand is Elastic

Price elasticity of
demand greater than 1
If the quantity demanded is
not very sensitive to the price
Unit Elastic

Price elasticity of
demand equals 1

Demand is Inelastic

Price elasticity of
demand less than 1
Gasoline Tax
Gasoline Tax Rates
April 2014 (Cents Per Gallon)
State
Ala.
Alaska
Ariz.
Ark.
Calif.
Colo.
Conn.
Del.
Fla.
Ga.
Hawaii
Idaho
Ill.
Ind.
Iowa
Kans.
Ky.
Tax
20.9
12.4
19.0
21.8
52.9
22.0
49.3
23.0
36.0
27.5
48.1
25.0
39.1
40.8
22.0
25.0
30.1
State
La.
Maine
Md.
Mass.
Mich.
Minn.
Miss.
Mo.
Mont.
Nebr.
Nev.
N.H.
N.J.
N.M.
N.Y.
N.C.
N.D.
Tax
20.0
30.0
27.0
26.5
41.4
28.6
18.4
17.3
27.8
27.3
33.2
19.6
14.5
18.9
49.9
37.8
23.0
Federal 18.4
State
Ohio
Okla.
Ore.
Pa.
R.I.
S.C.
S.D.
Tenn.
Tex.
Utah
Vt.
Va.
Wash.
W.Va.
Wis.
Wyo.
D.C.
Tax
28.0
17.0
31.1
41.8
33.0
16.8
22.0
21.4
20.0
24.5
32.1
17.3
37.5
35.7
32.9
24.0
23.5
In Massachusetts, the state tax is 26.5¢:
Total Tax in Mass = 18.4 + 26.5
= 44.9¢
To allow our discussion to progress more
smoothly we will round this off to 40¢.
Total Tax in Mass = $.40
The legal (statutory) incidence of a tax
refers to who is legally obliged to pay the
tax.
Question: Who bears the legal incidence
of the gasoline tax? 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 economic incidence of a tax refers to who is actually burdened by the tax.
Market for Gasoline
Benchmark Case: Suppose
that gasoline were not taxed.
Suppose that a $.40 per gallon tax is imposed on gasoline.
Two notions of the price:
PC = Price from the perspective of the consumer
PF = Price fromThe
the perspective
of the
Claim: “Whenever the government
price appearing
onfirm
the pump.
imposes a tax, firms simply raise the
Tax: PF = PC  Tax
price consumers pay by the amount of
PF = PC  .40
the tax and carry on business as usual.”
PC = 2.40
2.50 P = 2.10
PF = 2.00
2.10


P ($/gallon)
Let’s clean up Quantity Demanded
Quantity Supplied
PC = 2.50
our diagram.
8,000
7,300
7,500
=<
8,000
7,500
Next add the no

tax equilibrium.
PC** = 2.40
Equilibrium
Surplus

.40
PC andPCPFand
continue
PF fallto fall
.40
S Quantity supplied
determined by PF
P*
PF = 2.10
D Quantity demanded
determined by PC
PF** = 2.00
Surplus
QD = 7,300 Q** = 7,500
Q*
QS = 8,000 Q (thousands of gallon per day)
Tax: PF = PC  Tax
PF = PC  .40
Illustrating the effect of a tax.
P ($/gallon)
First, the no tax
equilibrium.
PC = 2.40 P = 2.10
PF = 2.00


Quantity Demanded
Quantity Supplied
8,000
7,500
PC** = 2.40
==

Equilibrium
8,000
7,500
.40
S
P* = 2.10
PF** = 2.00
D
Quantity supplied
determined by PF
Quantity demanded
determined by PC
Q** = 7,500
Q* = 8,000 Q (thousands of gallon per day)
Start
at the no taxquantity
equilibrium
and move left until the vertical gap between the demand and
The equilibrium
decreases.
supply
curves
the amount
the tax. increases, but by less than the full amount of the tax.
The price
fromequals
the perspective
ofof
consumers
The associated quantity is the new equilibrium quantity.
The price from the perspective of firms decreases, but by less than the full amount of the tax.
The
on the
the legal
demand
curve isisthe
equilibrium
price
of consumers.
Evenpoint
though
incidence
entirely
borne by
thefrom
firm,the
theperspective
burden is shared
by both firms
The
point on the supply curve is the equilibrium price from the perspective of firms.
and consumers.
Question: What if the
legal incidence were
borne by the consumer?
P ($/gallon)
PC** = 2.40
P* = 2.10
PF** = 2.00
NB: The relationship between PF and PC
Tax: PC = PF + Tax
is the same as it was when the legal
PC = PF + .40
incidence was borne by the firm.
Solving for PF: PF = PC  .40
Therefore the
PF = 2.00
equilibrium will PC = 2.40 P = 2.10


be the same.
Quantity Demanded
Quantity Supplied
8,000
7,500
==
8,000
7,500

Equilibrium
.40
S Quantity supplied
determined by PF
D
Quantity demanded
determined by PC
Q** = 7,500
Q* = 8,000 Q (thousands 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? Answer: No.
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.
P
Demand is less elastic
than supply
Consumers bear more
of the burden.
PC**
P
Intuition:
The less flexible
group bears more of
the burden.
S
Supply is less elastic
than demand
Firms bear more
of the burden.
S
PC**
Tax
P*
P*
Tax
PF**
D
D
Q**
Q*
PF**
Q
Q
Q**
Q*
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.
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.”
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

Consumers bear more of the burden
Supply less elastic than demand

Firms bear more of the burden
Intuition: The less flexible group bears more of the burden.