Post on 30-Mar-2015
20 - 1
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Elasticity of
Supply & Demand
20 - 2
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
HOW MUCH MORE OR LESS?
THE LAW OF DEMAND SAYS...
PRICE ELASTICITY OF DEMAND
Consumers will buy more when prices go down and less when prices go up
Price Elasticity Provides an Answer
20 - 3
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
The percentage change in price
The percentage change in quantity
.10
.20
Elasticity is .5Q
P
P1
P2
Q1Q2
D
Measures Responsiveness to Price Changes
PRICE ELASTICITY OF DEMAND
20 - 4
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
The percentage change in price
The percentage change in quantity
Q
P
P1
P2
Q1Q2
D
Commonly Expressed as…
PRICE ELASTICITY OF DEMAND
% P% Q d
Elasticity is .5
20 - 5
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
The Price-Elasticity Coefficient and Formula
PRICE ELASTICITY OF DEMAND
Ed =
Percentage change in quantitydemanded of product X
Percentage change in priceof product X
Or equivalently…
Ed =Change in quantity demanded of X
Original quantity demanded of X
Change in price of X Original price of X
Elimination of the Minus Sign
20 - 6
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Inelastic 0 < X < 1Typical of necessities one must have
Typical of luxuries one wants
Elastic from 1 < X <
Unit elastic when exactly = 1Quantity change offsets Price change
Price Elasticity is...PRICE ELASTICITY OF DEMAND
20 - 7
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Interpretations of Ed
PRICE ELASTICITY OF DEMAND
Elastic Demand
Ed =.04.02
= 2
Inelastic Demand
Ed =.01.02
= .5
Unit Elasticity
Ed =.02.02
= 1
20 - 8
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Extreme CasesPRICE ELASTICITY OF DEMAND
Perfectly Inelastic Demand
Perfectly Elastic DemandP
0
P
0
D1
Ed = 0
D2
Ed =
Q
Q
20 - 9
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
DETERMINANTS OF PRICEELASTICITY OF DEMAND
•Substitutability•Proportion of Income•Luxuries versus Necessities
•Time
20 - 10
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
More Accurate Calculation – The Midpoint Formula
PRICE ELASTICITY OF DEMAND
Ed =
Change inquantity
Sum ofQuantities/2
Change inprice
Sum ofprices/2
Ed =ΔQ
AVG Q
ΔP
AVG P
20 - 11
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Lemonade Stand
You sell 24 glasses for $.50 each.
P x Q = Total Revenue (TR)
$.50 x 24 = $12 = Total Revenue
-$4 = Total Cost
$8 = Profit
20 - 12
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Total Revenue
• Total Revenue (TR): The total dollars received by a firm for selling a product.
• AKA Consumer Expenditures
20 - 13
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
CIRCULAR FLOW MODEL
BUSINESSES HOUSEHOLDS
RESOURCEMARKET
RESOURCES INPUTS
$ COSTS $ INCOMES
PRODUCTMARKET
GOODS &SERVICES
GOODS &SERVICES
$ CONSUMPTION$ REVENUE
20 - 14
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Q
P
D
When prices are low,
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
So is total revenue
20 - 15
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Q
P
D
Total revenue riseswith price to a
point... TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
20 - 16
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Q
P
D
Total revenue riseswith price to a
point...
then declines
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
20 - 17
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Q
P
D
Total revenue riseswith price to a
point...
then declines
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
20 - 18
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Q
P
D
Total revenue riseswith price to a
point...
then declines
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
20 - 19
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Q
P
D
Total revenue riseswith price to a
point...
then declines
InelasticDemand
InelasticDemand
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
20 - 20
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Q
P
D
Total revenue riseswith price to a
point...
then declines
ElasticDemand
ElasticDemand
InelasticDemand
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
InelasticDemand
20 - 21
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Q
P
D
Total revenue riseswith price to a
point...
then declines
ElasticDemand
ElasticDemand
InelasticDemand
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
InelasticDemand
UnitElastic
20 - 22
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
TOTAL REVENUE TESTAnother way to determine elasticity• P x Q = TR• P and Q move opposite each other• So how do we know what happens
to TR?– If P and TR move together demand is
inelastic– If Q and TR move together demand is
elastic– If TR doesn’t move demand is unit
elastic
20 - 23
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Other Elasticities
20 - 24
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
PRICE ELASTICITY OF SUPPLY
Es=%ΔQS
%ΔP
20 - 25
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Po
P
Q
D1
Qo
An increase indemand withoutenough time tochange supplycauses…
Sm
Immediate Market periodPRICE ELASTICITY OF SUPPLY
20 - 26
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Po
Pm
P
Q
D1
Qo
D2
An increase indemand withoutenough time tochange supplycauses… anincrease in price
Sm
Immediate Market periodPRICE ELASTICITY OF SUPPLY
20 - 27
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Po
P
Q
D1
Qo
Short RunPRICE ELASTICITY OF SUPPLY
An increase indemand withmore elasticsupply causes...
Ss
20 - 28
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Po
P
Q
D1
Qo
D2
Short RunPRICE ELASTICITY OF SUPPLY
Ps
An increase indemand withmore elasticsupply causes...a smallerincrease in price
Ss
Qs
20 - 29
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Po
P
Q
D1
Qo
Long RunPRICE ELASTICITY OF SUPPLY
An increase indemand in thelong run allowsgreater changecausing...
SL
20 - 30
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Po
P
Q
D1
Qo
D2
Long RunPRICE ELASTICITY OF SUPPLY
PL
An increase indemand in thelong run allowsgreater changecausing...
SL
QL
Even more elasticresponse - lessprice increase
20 - 31
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
CROSS PRICE ELASTICITY OF DEMAND
Exy =%ΔQDX
%ΔPY
Positive Sign Goods are SubstitutesNegative Sign Goods are ComplementaryZero or Near-Zero Value Goods are Unrelated
20 - 32
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
INCOME ELASTICITY OF DEMAND
Ei =%ΔQD
%Δ Income
Positive Sign Goods are Normal or Superior
Negative SignGoods are Inferior
20 - 33
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Price Controls
20 - 34
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
PRICE CONTROLS
• Enacted when policymakers believe the market price is unfair to buyers or sellers.
20 - 35
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
CONTROLS ON PRICES
• Price Ceiling – A legal maximum on the price at
which a good can be sold. • Price Floor
– A legal minimum on the price at which a good can be sold.
20 - 36
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
How Price Ceilings Affect Market Outcomes
• Two possibilities:– Not binding (not effective)– Binding (effective)
20 - 37
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
A Market with a Price Ceiling
(a) A Price Ceiling That Is Not Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Equilibriumquantity
$4 Priceceiling
Equilibriumprice
Demand
Supply
3
100
20 - 38
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
A Market with a Price Ceiling
(b) A Price Ceiling That Is Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Demand
Supply
2 PriceceilingShortage
75
Quantitysupplied
125
Quantitydemanded
Equilibriumprice
$3
20 - 39
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
How Price Ceilings Affect Market Outcomes
• A binding price ceiling creates– A shortage because QD > QS.
– Non-price rationing• Long lines• Discrimination
20 - 40
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
CASE STUDY: Lines at the Gas Pump
• In the early 1970s the government placed a price ceiling on gas.
• In 1973, OPEC raised the price of crude oil (input for gas).
20 - 41
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
The Market for Gasoline with a Price Ceiling
(a) The Price Ceiling on Gasoline Is Not Binding
Quantity ofGasoline
0
Price ofGasoline
1. Initially,the priceceilingis notbinding . . . Price ceiling
Demand
Supply, S1
P1
Q1
20 - 42
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
The Market for Gasoline with a Price Ceiling
(b) The Price Ceiling on Gasoline Is Binding
Quantity ofGasoline
0
Price ofGasoline
Demand
S1
S2
Price ceiling
QS
4. . . . resultingin ashortage.
3. . . . the priceceiling becomesbinding . . .
2. . . . but whensupply falls . . .
P2
QD
P1
Q1
20 - 43
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Rent Control
20 - 44
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
How Price Floors Affect Market Outcomes
• Two possibilities:– Not binding– Binding
20 - 45
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
A Market with a Price Floor
(a) A Price Floor That Is Not Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Equilibriumquantity
2
Pricefloor
Equilibriumprice
Demand
Supply
$3
100
20 - 46
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
A Market with a Price Floor
(b) A Price Floor That Is Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Demand
Supply
$4Pricefloor
80
Quantitydemanded
120
Quantitysupplied
Equilibriumprice
Surplus
3
20 - 47
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
How Price Floors Affect Market Outcomes
• A binding price floor causes . . .– A surplus because QS > QD.
– Non-price rationing
20 - 48
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
• Minimum wage laws dictate the lowest price possible for labor that any employer may pay.
CASE STUDY: MINIMUM WAGE
20 - 49
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
How the Minimum Wage Affects the Labor Market
Quantity ofLabor
Wage
0
Labordemand
LaborSupply
Equilibriumemployment
Equilibriumwage
20 - 50
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
How the Minimum Wage Affects the Labor Market
Quantity ofLabor
Wage
0
LaborSupplyLabor surplus
(unemployment)
Labordemand
Minimumwage
Quantitydemanded
Quantitysupplied
20 - 51
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
How Price Controls Affect Total Surplus
A
F
B
D
C
E
Quantity0
Price
Demand
Supply
PF
Q2
PC
PriceFloor
PriceCeiling
P1
Q1
Price
20 - 52
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Price Controls on Drugs
20 - 53
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Taxation & Deadweight Loss
20 - 54
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Application: The Costs of Taxation
Review• Buyers and sellers receive
benefits from taking part in the market.
• The equilibrium in a market maximizes the total welfare of buyers and sellers.
20 - 55
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
THE DEADWEIGHT LOSS OF TAXATION
• When a tax is levied on a good– Price paid by buyers rises– Price received by sellers falls
20 - 56
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
The Effects of a Tax
Size of tax
Quantity0
Price
Price buyerspay
Price sellersreceive
Demand
Supply
Pricewithout tax
Quantitywithout tax
Quantitywith tax
20 - 57
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
How a Tax Affects Market Participants
• A tax places a wedge between the price buyers pay and sellers receive.
• The quantity sold falls below the pre-tax equilibrium.
20 - 58
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
How a Tax Affects Market Participants
• Tax RevenueT = the size of the tax
Q = the quantity of the good sold
T Q = Tax Revenue
20 - 59
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Tax Revenue
Taxrevenue (T × Q)
Size of tax (T)
Quantitysold (Q)
Quantity0
Price
Demand
Supply
Quantitywithout tax
Quantitywith tax
Price buyerspay
Price sellersreceive
20 - 60
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
How a Tax Affects Market Participants
• Changes in Welfare– Deadweight loss is the fall in total
surplus.
20 - 61
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
How a Tax Affects Welfare
A
F
B
D
C
E
Quantity0
Price
Demand
Supply
= PB
Q2
= PS
Pricebuyers
pay
Pricesellers
receive
= P1
Q1
Pricewithout tax
20 - 62
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
DETERMINANTS OF DEADWEIGHT LOSS
• What determines whether the deadweight loss from a tax is large or small?– Elasticities of Demand & Supply– More elastic curves bring more loss
20 - 63
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Tax Incidence
• Who pays for the tax?• The more inelastic curve
pays more
20 - 64
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Tax Distortions and Elasticities
Price
0 Quantity
Demand
Supply
Size of tax
20 - 65
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Tax Distortions and Elasticities
Price
0 Quantity
Demand
SupplySizeoftax
20 - 66
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Tax Distortions and Elasticities
Demand
Supply
Price
0 Quantity
Size of tax
20 - 67
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Tax Distortions and Elasticities
Price
0 Quantity
Sizeoftax Demand
Supply
20 - 68
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
How a Tax Affects Market Participants
• The combined welfare losses to buyers and sellers exceed the revenue raised by the government.
20 - 69
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
The Effects of a Tariff
• A tariff is a tax on goods produced abroad and sold domestically.
• Tariffs raise the price of imported goods by the amount of the tariff.
20 - 70
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
The Effects of a Tariff
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domesticdemand
Pricewith tariff Tariff
Importswithout tariff
Equilibriumwithout trade
Pricewithout tariff
WorldpriceImports
with tariff
QSQS QD QD
20 - 71
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
The Effects of a Tariff
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domesticdemand
Importswithout tariff
Equilibriumwithout trade
Pricewithout tariff
Worldprice
QS QD
Producer surplusbefore tariff
Consumer surplusbefore tariff
20 - 72
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
The Effects of a Tariff
E
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domesticdemand
Pricewith tariff Tariff
Importswithout tariff
Pricewithout tariff
Worldprice
QS
Importswith tariff
QS QD QD
Tariff Revenue
20 - 73
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
The Effects of a Tariff
C
G
A
ED F
B
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domesticdemand
Pricewith tariff Tariff
Importswithout tariff
Pricewithout tariff
WorldpriceImports
with tariff
QSQS QD QD
Deadweight Loss
20 - 74
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Consumer Behavior & Utility Maximization
20 - 75
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
LAW OF DIMINISHINGMARGINAL UTILITY
• Utility • Subjective• Difficult to Quantify•Total Utility•Marginal Utility
graphically examined...
20 - 76
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01
010
Units consumed per meal
Units consumed per meal
30
20
10Tota
l U
tili
ty (
uti
ls)
Mar
gin
al
Uti
lity
(u
tils
)
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
20 - 77
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01
010 10
Units consumed per meal
Units consumed per meal
30
20
10Tota
l U
tili
ty (
uti
ls)
Mar
gin
al
Uti
lity
(u
tils
)
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
20 - 78
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
012
01018
10 8
Units consumed per meal
Units consumed per meal
30
20
10Tota
l U
tili
ty (
uti
ls)
Mar
gin
al
Uti
lity
(u
tils
)
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
20 - 79
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
0123
0101824
10 8 6
0 1 2 3 4 5 6 7
Units consumed per meal
Units consumed per meal
30
20
10Tota
l U
tili
ty (
uti
ls)
Mar
gin
al
Uti
lity
(u
tils
)
10 8 6 4 2 0 -2
1 2 3 4 5 6 7
20 - 80
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01234
010182428
10 8 6 4 Units consumed per meal
Units consumed per meal
30
20
10Tota
l U
tili
ty (
uti
ls)
Mar
gin
al
Uti
lity
(u
tils
)
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
20 - 81
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
012345
01018242830
10 8 6 4 2
Units consumed per meal
Units consumed per meal
30
20
10Tota
l U
tili
ty (
uti
ls)
Mar
gin
al
Uti
lity
(u
tils
)
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
20 - 82
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
0123456
0101824283030
10 8 6 4 2 0
Units consumed per meal
Units consumed per meal
30
20
10Tota
l U
tili
ty (
uti
ls)
Mar
gin
al
Uti
lity
(u
tils
)
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
20 - 83
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01234567
010182428303028
10 8 6 4 2 0 -2
Units consumed per meal
Units consumed per meal
30
20
10Tota
l U
tili
ty (
uti
ls)
Mar
gin
al
Uti
lity
(u
tils
)
10 8 6 4 2 0 -2
TU
MU
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
20 - 84
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01234567
010182428303028
10 8 6 4 2 0 -2
Units consumed per meal
Units consumed per meal
30
20
10Tota
l U
tili
ty (
uti
ls)
Mar
gin
al
Uti
lity
(u
tils
)
10 8 6 4 2 0 -2
TU
MU
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
ObserveDiminishing
MarginalUtility
20 - 85
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
THEORY OF CONSUMER BEHAVIOR
Utility Maximizing Rule
The consumer’s income should be allocated so that the last dollar spent on each product yields the same amount of marginal utility.
Illustrated...
20 - 86
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
First 10 10 24 12
$ 10 income
UTILITY MAXIMIZING COMBINATION
How should the $10 income be allocated?
Unit ofproduct
Product A:Price = $1
Product B:Price = $2
Marginalutility,utils
Marginalutility per
dollar(MU/price)
Marginalutility,utils
Marginalutility per
dollar(MU/price)
20 - 87
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
First 10 10 24 12
$ 10 income
UTILITY MAXIMIZING COMBINATION
Examine the twomarginal utilities
Unit ofproduct
Product A:Price = $1
Product B:Price = $2
Marginalutility,utils
Marginalutility per
dollar(MU/price)
Marginalutility,utils
Marginalutility per
dollar(MU/price)
20 - 88
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
First 10 10 24 12
$ 10 income
UTILITY MAXIMIZING COMBINATION
Examine the twomarginal utilities
…per dollar
Unit ofproduct
Product A:Price = $1
Product B:Price = $2
Marginalutility,utils
Marginalutility per
dollar(MU/price)
Marginalutility,utils
Marginalutility per
dollar(MU/price)
20 - 89
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
First 10 10 24 12
$ 10 income
UTILITY MAXIMIZING COMBINATION
Decision: Buy 1Product B for $2
Unit ofproduct
Product A:Price = $1
Product B:Price = $2
Marginalutility,utils
Marginalutility per
dollar(MU/price)
Marginalutility,utils
Marginalutility per
dollar(MU/price)
20 - 90
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2
$ 10 income
UTILITY MAXIMIZING COMBINATION
What next?
Unit ofproduct
Product A:Price = $1
Product B:Price = $2
Marginalutility,utils
Marginalutility per
dollar(MU/price)
Marginalutility,utils
Marginalutility per
dollar(MU/price)
20 - 91
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2
$ 10 income
UTILITY MAXIMIZING COMBINATION
What next?Buy one of each
Unit ofproduct
Product A:Price = $1
Product B:Price = $2
Marginalutility,utils
Marginalutility per
dollar(MU/price)
Marginalutility,utils
Marginalutility per
dollar(MU/price)
20 - 92
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2
$ 10 income
UTILITY MAXIMIZING COMBINATION
and then...($5 left)
Unit ofproduct
Product A:Price = $1
Product B:Price = $2
Marginalutility,utils
Marginalutility per
dollar(MU/price)
Marginalutility,utils
Marginalutility per
dollar(MU/price)
20 - 93
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2
$ 10 income
UTILITY MAXIMIZING COMBINATION
third unit of product B
Unit ofproduct
Product A:Price = $1
Product B:Price = $2
Marginalutility,utils
Marginalutility per
dollar(MU/price)
Marginalutility,utils
Marginalutility per
dollar(MU/price)
20 - 94
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2
$ 10 income
UTILITY MAXIMIZING COMBINATION
$3 left...
Unit ofproduct
Product A:Price = $1
Product B:Price = $2
Marginalutility,utils
Marginalutility per
dollar(MU/price)
Marginalutility,utils
Marginalutility per
dollar(MU/price)
20 - 95
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2
$ 10 income
UTILITY MAXIMIZING COMBINATION
$3 left...Buy both!
Unit ofproduct
Product A:Price = $1
Product B:Price = $2
Marginalutility,utils
Marginalutility per
dollar(MU/price)
Marginalutility,utils
Marginalutility per
dollar(MU/price)
20 - 96
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2
$ 10 income
UTILITY MAXIMIZING COMBINATION
Income is gone...the last dollar spent on
each good gave the sameutility (8) per dollar
Unit ofproduct
Product A:Price = $1
Product B:Price = $2
Marginalutility,utils
Marginalutility per
dollar(MU/price)
Marginalutility,utils
Marginalutility per
dollar(MU/price)
20 - 97
Price Elasticity of Demand
Determinants of Price Elasticity
Price Elasticity and Total Revenue
Other Elasticities
Price Controls
Taxation & Deadweight Loss
Consumer Utility Maximization
Algebraic Restatement of theUtility Maximization Rule
MU of A
Price of A
MU of B
Price of B=
Consumption Bundles
8 Utils
$1
16 Utils
$2=