11

Tax Burden in GeneralTax Burden in General

Generally, neither demand nor supply Generally, neither demand nor supply is perfectly inelastic or perfectly is perfectly inelastic or perfectly elastic.elastic.

the tax burden/incidence is split the tax burden/incidence is split between buyers and sellers between buyers and sellers according to relative elasticities, according to relative elasticities, and market conditions. Law and market conditions. Law makers cannot legislate “who makers cannot legislate “who pays”.pays”.

22

Addiction and ElasticityAddiction and Elasticity

–Nonusers’ demand for addictive substances Nonusers’ demand for addictive substances is is elasticelastic. .

High taxes on cigarettes and alcohol limit High taxes on cigarettes and alcohol limit the number of young people who become the number of young people who become habitual users of these products. habitual users of these products.

–Existing users’ demand for addictive Existing users’ demand for addictive substances is substances is inelasticinelastic..

High taxes have only a modest effect on High taxes have only a modest effect on the quantities consumed by established the quantities consumed by established user, they raise revenue from these users.user, they raise revenue from these users.

33

Luxury TaxLuxury Tax

– Notice that depending on the goal of Notice that depending on the goal of the tax different types of demand the tax different types of demand elasticity are desirable.elasticity are desirable.

– Raise revenue: inelastic demandRaise revenue: inelastic demand– Change behaviour: elastic demandChange behaviour: elastic demand

Who actually bore the burden of Who actually bore the burden of this tax?this tax?

44

Tax Burden and Elasticity of Tax Burden and Elasticity of DemandDemandTwo extreme cases:

• Perfectly inelastic demand:

•Perfectly elastic demand:

Two extreme cases:

• Perfectly inelastic supply:

• Perfectly elastic supply:

Tax Burden and Elasticity of Supply

55

Sales Tax and the Elasticity of Sales Tax and the Elasticity of DemandDemand

Quantity (thousands of doses per day)

Pri

ce (

dolla

rs p

er

dose

)

2.00

2.20

100

D

S

Perfectly inelasticdemand

Tax

S’

Buyer pays entire tax

66

Sales Tax and the Sales Tax and the Elasticity of DemandElasticity of Demand

Quantity (thousands of marker pens per week) 4

0.90

1.00

S

Pri

ce (

cen

ts p

er

pen

)

Perfectly elasticdemand

D

Tax

S’

Seller paysentire tax

77

Sales Tax and the Elasticity of Sales Tax and the Elasticity of SupplySupply

Quantity (thousands of bottles per week)

Pri

ce (

dolla

rs p

er

bottl

e)

45

50

100

S

D

Perfectly inelasticsupply

Tax

Seller paysentire tax

88

Sales Tax and the Sales Tax and the Elasticity of SupplyElasticity of Supply

Quantity (thousands of kilograms per week)

Pri

ce (

cen

ts p

er

pou

nd)

10

11

3 5

S

D

Perfectly ElasticSupply

S’

TaxBuyer paysentire tax

99

Who pays the Airport Who pays the Airport Security Tax?Security Tax?

Who pays the tax? - Demand Elasticity between Who pays the tax? - Demand Elasticity between 0.7 and 2.10.7 and 2.1

No mention of elasticity of supply but No mention of elasticity of supply but economists claim the price will rise by the economists claim the price will rise by the amount of the tax, amount of the tax,

Ie: the buyer pays the whole tax, implying a Ie: the buyer pays the whole tax, implying a perfectly elastic supply schedule.perfectly elastic supply schedule.

1010

Supply: Perfectly Supply: Perfectly ElasticElastic

Quantity (passengers per day)

Pri

ce (

dolla

rs p

er

trip

)

60

100

D0

72

40

20

S

S+tax80

950 1,230 1,400 2,100

D1

Elasticity of Demand = 2.1

Elasticity of Demand = 0.7

Original EquilibriumP=$60, Q=1,400 passengers/day

1111

Supply: Unit ElasticSupply: Unit Elastic

Quantity (passengers per day)

Pri

ce (

dolla

rs p

er

trip

)

60

100

D0

40

20

S80

1,2901,400

2,100

D1

S+tax

1,220

Elasticity of Demand = 2.1

Elasticity of Demand = 0.7

Crucial to know demand elasticity & supply elasticity

1212

A Rent Ceiling & A Rent Ceiling & ElasticityElasticity

Quantity (thousands of units per month)

Re

nt (

dolla

rs p

er u

nit

per

mon

th)

0 44 72 100 150

12

16

20

24

D

Rent ceiling

S1, SR

Housingshortage

S2

Housingshortage

Supply in the LR becomes more elastic over time, increasing the shortage

1313

How Long is the Long How Long is the Long Run?Run?

There is no set amount of time that puts a There is no set amount of time that puts a market into the long runmarket into the long run– The long run could be a week or a yearThe long run could be a week or a year

The long run is how long a consumer or firm The long run is how long a consumer or firm takes to fully adjust to a price changetakes to fully adjust to a price change– Time required to make major changes Time required to make major changes – Ie) Give up Pepsi Vanilla, Build more cost Ie) Give up Pepsi Vanilla, Build more cost

efficient Pepsi factory, secure a US Pepsi Vanilla efficient Pepsi factory, secure a US Pepsi Vanilla suppliersupplier

The short run is anything shorter than the The short run is anything shorter than the long runlong run

1414

Cross Price Elasticity of Cross Price Elasticity of DemandDemand

We’ve seen already that demand is affected We’ve seen already that demand is affected by the price of substitutes and complimentsby the price of substitutes and compliments– An increase in the price of a substitute increases An increase in the price of a substitute increases

demanddemand– An increase in the price of a complement An increase in the price of a complement

decrease demanddecrease demand This effect can be measured using cross This effect can be measured using cross

price elasticityprice elasticity If the cross price elasticity is zero, the good If the cross price elasticity is zero, the good

is neither a complement nor a substituteis neither a complement nor a substitute

1515

Change in Price of Y

----------------------------

(Py1 + Py2)/2

/

Cross Price Elasticity of Cross Price Elasticity of DemandDemand

Percentage change in price of Y

Percentage change in quantity demanded of XxyE

Exy = Change in X

---------------

(X1 + X2)/2

Substitutes – Positive Cross Price Elasticity

Compliments – Negative Cross Price Elasticity

1616

Income Elasticity of DemandIncome Elasticity of Demand

Income Elasticity of demand refers to a Income Elasticity of demand refers to a HORIZONTAL SHIFT in the demand curve HORIZONTAL SHIFT in the demand curve resulting from an income changeresulting from an income change

Price elasticity of demand refers to a Price elasticity of demand refers to a MOVEMENT ALONG THE DEMAND CURVE MOVEMENT ALONG THE DEMAND CURVE in response to a price changein response to a price change

1717

Change in M

----------------------------

(M1 + M2)/2

/

Income Elasticity of Income Elasticity of DemandDemand

Percentage change in income

Percentage change in quantity demandedxyE

EI= Change in Q

---------------

(Q1 + Q2)/2

Normal Good – Positive Shift/Elasticity

Inferior Good – Negative Shift/Elasticity

18

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.

19

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.

20

“Measuring” Satisfaction

• utility: a number that represents the level of satisfaction that the consumer derives from consuming a specific quantity of a good.

•util: unit of pleasure.

21

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

Tripsto Club

Totalutility

Marginalutility

123456

122228323434

12106420

22

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:

Goods

UtilityMU

23

Total and Marginal Utility of Club Trips

Performances per Week

Mar

gina

l Util

ity (

utils

per

wee

k)0

3 4 5 6 7

2

4

6

8

10

Performances per Week

To

tal U

tility

(u

tils

pe

r w

eek)

0 2 3 4 5 6 7 8

22

28

34Total utility ismaximized...

…where marginalutility equals zero.

2

24

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.

25

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.

26

(1) Perweek

(3) Marginalutility (MU)

(2) Totalutility

123456

122228323434

121006040200

Trips toclub

Basketball games

123456

213342485151

211209060300

27

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

28

Rational Choice

–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.

Spend limited income where satisfaction per $ is the greatest.

29

Frank’s Optimal Decision

• 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

• Suppose: Frank has an entertainment

• budget of $21.00

• club tickets $3.00

• basketball tickets $6.00

30

(1) per week

(2)TotalUtility

(3) MarginalUtility (MU)

(4)Price(P)$

(5) MarginalUtility/$(MU/P)

123456

122228323434

121006040200

3.003.003.003.003.003.00

4.03.32.01.30.70.0

Trips

to

Club

B’ball

games

per/wk

123456

213342485151

211209060300

6.006.006.006.006.006.00

3.52.01.51.00.50.0

Income =$21

Pc = $3.00

Pb = $6.00

31

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?

32

MUBB = 1.5 MU club = 4

PBB P club

•Suppose, Frank buys 3 basketball games and 1 club trip

Frank’s Optimal Decision

•Frank is better off to take another club trip and give up one basketball game

MBc > MCb

33

IN GENERAL, the consumer will be in equilibrium with his/her choices when

1. Income = PAQA + PBQB …..+PzQz

and

Frank’s Optimal Decision

Z good of price

Z good of

B good of price

B good of

Agood of price

Agood of MU MU MU ...2.

34

(1) per week

(2)TotalUtility

(3) MarginalUtility (MU)

(4)Price(P)$

(5) MarginalUtility/$(MU/P)

123456

122228323434

121006040200

3.003.003.003.003.003.00

4.03.32.01.30.70.0

Trips

to

Club

B’ball

games

per/wk

123456

213342485151

211209060300

3.003.003.003.003.003.00

743210

Income =$21

Pc = $3.00

Pb = $3.00

Now suppose the price of basketball games falls to $3.00. What is Frank’s new equilibrium?

DERIVING DEMAND

35

Demand for B’ball Games

Basket ball games

Pric

e pe

r U

nit

($)

D

6

2

3

4

A reduction in pricecauses consumers to increase consumptionuntil marginal utilityper $ falls

At a price of $6, 2 games.

At a price of $3, 4 games.

36

•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

Example: Demand and Utility MaximizationExample: Demand and Utility Maximization

37

(1) (2) (3) (4) (5) (6) (7)

Q TU TUA B

123456

101825313640

244462789096

38

Supply, Production & 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 is foregone: opportunity cost

• Firms make the supply decision in order to maximize profits:

Profit =Total Revenue - Total Cost

39

Explicit Costs• Costs that arise when money actually changes

hands;

– eg. a bill is paid for utilities, wages, interest on a loan…..

• To calculate a firm’s Total Costs of production include all (opportunity) costs.

– Explicit costs– Implicit costs

Supply: Production & Costs

40

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..

41

Economic Profit

Economic Profit = TR - [Explicit + Implicit Costs]

• Economists & Accountants calculate profit differently:

– Economists are interested in studying how firms make production & pricing decisions. They include all costs.

Accounting Profit = TR - Explicit Costs

Accounting Profit– Accountants are responsible for keeping track

of the money that flows into and out of firms. They focus on explicit costs.

42

• 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

Economic Profit Terminology

43

TotalOpportunityCost

Revenue

EconomicProfit

ImplicitCosts

ExplicitCosts

Revenue

AccountingProfit

ExplicitCosts

Economist’sView

Accountant’sView

Profit: Economists vs Accountants

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

45

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)

46

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

47

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)

48

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.