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Economics 111.3 Winter 14
February 7th, 2014Lecture 12
Ch. 6 (up to p. 138)
Conclusion (from Lecture 11)
• The incidence of a tax does not depend on whether the tax is levied on buyers or sellers.
STUDY QUESTION:
Taxes
Taxes
The answer to this question depends on the elasticity of demand and the elasticity of supply.
In what proportions is the burden of the tax divided?
Sales Tax and theElasticity of Supply
Quantity
Pri
ce
45
50
100
S
D
Perfectly inelasticsupplySeller
paysentire tax
Sales Tax and the Elasticity of Supply
Quantity (thousands of kilograms per week)
Pri
ce
(cen
ts p
er p
ou
nd
)
10
11
3 5
S
D
S + taxBuyer paysentire tax
Perfectly ElasticSupply
Sales Tax and the Elasticity of Demand
Quantity (thousands of marker pens per week) 1 4
0.90
1.00
SS + tax
Sellerpaysentiretax
Pri
ce
(cen
ts p
er p
en
)
Perfectly elasticdemand
Sales Tax and the Elasticity of Demand
Quantity (thousands of doses per day)
Pri
ce
(do
llars
pe
r d
os
e)
2.00
2.20
100
D
S
Perfectly inelasticdemand
S + taxBuyer paysentire tax
Tax Division and Price Elasticity of Demand
Four extremes:
• Perfectly inelastic supply: seller pays
• Perfectly elastic supply: buyer pays
• Perfectly inelastic demand: buyer pays
•Perfectly elastic demand: seller pays
The Rule of Tax Incidence: Generalization
The burden tends to fall on the side of the market that is less elastic: The more elastic the supply, the larger is the amount of tax paid by the buyer and vice versa
Sales tax is generally applied to items with a low elasticity of demand (alcohol, tobacco, and gasoline): Quantity does not decrease by much; large tax revenue
It is unusual to apply sales tax to goods with a high elasticity of demand.
Study questionThe supply of and demand for roses are given by P = 4Qs and P = 12 –2Qd respectively.Answer the following questions:A. Suppose the government decides to tax the suppliers of
roses $6 per dozen roses sold. How much tax does Government collect and who pays it?
B. Calculate the deadweight loss associated with this $6 tax.
Ch. 8Consumer’s Choice
Concept of Utility The Theory of Demand
Concept of Utility• Utility – satisfaction that we get from
consuming some goods and services• Cardinal Utility – refers to putting an absolute
measure of utility upon goods and services or market baskets (e.g., I like this TWICE AS MUCH as I like that)
• Ordinal Utility – measures utility only by ranking the consumer’s preferences among goods and market baskets (e.g., I like good “A” more (or less) than good “B”(or the same as good “B”)
Cardinal Utility: extra terminology
• Total utility: total amount of satisfaction
• Marginal utility: extra satisfaction from consuming one more unit
Law of Diminishing Marginal Utility:1. Gains in satisfaction decline as additional
units are consumed2. This principle does not say you do not enjoy
consuming more of a good.3. It only states that as you consume more of
the good, you enjoy additional units less than you enjoyed the initial units.
4. When marginal utility is zero, total utility stops increasing.
5. Beyond this point, marginal utility is negative and total utility decreases.
Theory of Consumer ChoiceA Typical Consumer.…• Exhibits rational behavior - Rational means that people prefer more to
less and will make choices that give them as much satisfaction as possible.
- The analysis of rational choice begins with the premise that rational individuals want as much satisfaction as they can get from their available income.
• Knows clear-cut preferences
Theory of Consumer Choice, cont’d
A Typical Consumer.…• Responds to price changes• Is subject to a budget constraint• Makes those choices that have
the highest units of utility per dollar spent.
The Paradox of Value
Why does water, which is essential for life, cost so little?Why do diamonds, which are useless compared to water, cost so much?
Carl Menger: 1840-1921Menger’s solution of the water-diamond paradox: • The last need unmet by the
loss of a concrete quantity of water, which is valued by the subjective degree of desire would be of far less importance than that of the need unmet by the loss of a concrete quantity of diamonds as diamonds are so few in quantity compared to water
The Paradox of Value, cont’dDiamonds have a high price
and a high marginal utility, while water has a low price and a low marginal utility.
At consumer equilibrium, the marginal utility per dollar spent is the same for diamonds as for water.
• Utility Maximizing Rule: the consumer’s money income should be allocated so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility
Algebraic Restatement of theUtility Maximization Rule
MU of product A
Price of A
MU of product B
Price of B=