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CHAPTE R 5 Elasticity and its Application Microeonomics PRINCIPLES OF N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich © 2009 South-Western, a part of Cengage Learning, all rights r...

CHAPTE R 5 Elasticity and its Application Microeonomics PRINCIPLES OF N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich © 2009 South-Western, a part of Cengage Learning, all rights reserved CHAPTE R 6 Supply, Demand, and Government Policies Microeonomics PRINCIPLES OF N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich © 2009 South-Western, a part of Cengage Learning, all rights reserved In this chapter, look for the answers to these questions:  What are price ceilings and price floors? What are some examples of each?  How do price ceilings and price floors affect market outcomes?  How do taxes affect market outcomes? How do the effects depend on whether the tax is imposed on buyers or sellers?  What is the incidence of a tax? What determines the incidence? 3  Government Policies That Alter the Private Market Outcome  Price controls  Price ceiling: a legal maximum on the price of a good or service Example: rent control  Price floor: a legal minimum on the price of a good or service Example: minimum wage  Taxes  The govt can make buyers or sellers pay a specific amount on each unit bought/sold. We We will will use use the the supply/demand supply/demand model model to to see see how how each each policy policy affects affects the the market market outcome outcome (the (the price price buyers buyers pay, pay, the the price price sellers sellers receive, receive, and and eq’m eq’m quantity). quantity). SUPPLY, DEMAND, AND GOVERNMENT POLICIES 4 EXAMPLE 1: The Market for Apartments Rental P S price of apts $800 Eq’m Eq’m w/o w/o price price controls controls D Q 300 Quantity of apartments SUPPLY, DEMAND, AND GOVERNMENT POLICIES 5  How Price Ceilings Affect Market Outcomes A price ceiling P S above the Price eq’m price is $1000 ceiling not binding – has no effect $800 on the market outcome. D Q 300 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 6  How Price Ceilings Affect Market Outcomes The eq’m price P S ($800) is above the ceiling and therefore illegal. $800 The ceiling is a binding Price $500 constraint ceiling on the price, shortage D causes a Q 250 400 shortage. SUPPLY, DEMAND, AND GOVERNMENT POLICIES 7  How Price Ceilings Affect Market Outcomes In the long run, P S supply and demand are more $800 price-elastic. Price So, the $500 ceiling shortage shortage is larger. D Q 150 450 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 8  Shortages and Rationing  With a shortage, sellers must ration the goods among buyers.  Some rationing mechanisms: (1) Long lines (2) Discrimination according to sellers’ biases  These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly.  In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair). SUPPLY, DEMAND, AND GOVERNMENT POLICIES 9 EXAMPLE 2: The Market for Unskilled Labor Wage W S paid to unskilled workers $4 Eq’m Eq’m w/o w/o price price controls controls D L 500 Quantity of unskilled workers SUPPLY, DEMAND, AND GOVERNMENT POLICIES 10  How Price Floors Affect Market Outcomes A price floor W S below the eq’m price is not binding – has no effect $4 on the market Price outcome. $3 floor D L 500 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 11  How Price Floors Affect Market Outcomes labor The eq’m wage ($4) W surplus S is below the floor Price $5 and therefore floor illegal. $4 The floor is a binding constraint on the wage, D causes a L surplus (i.e., 400 550 unemployment). SUPPLY, DEMAND, AND GOVERNMENT POLICIES 12  The Minimum Wage Min wage laws unemp- do not affect W loyment S Min. highly skilled $5 wage workers. They do affect $4 teen workers. Studies: A 10% increase in the min wage D L raises teen 400 550 unemployment by 1-3%. SUPPLY, DEMAND, AND GOVERNMENT POLICIES 13 ACTIVE LEARNING 1 Price controls The market for P 140 hotel rooms 130 S Determine 120 effects of: 110 A. $90 price 100 ceiling 90 B. $90 price 80 D floor 70 C. $120 price 60 floor 50 40 050 60 70 80 90 100 110 120 130 Q 14 ACTIVE LEARNING 1 A. $90 price ceiling The market for P 140 hotel rooms The price S 130 falls to $90. 120 Buyers 110 demand 100 120 rooms, 90 Price ceiling sellers supply 80 D 90, leaving a shortage = 30 70 shortage. 60 50 40 050 60 70 80 90 100 110 120 130 Q 15 ACTIVE LEARNING 1 B. $90 price floor The market for P 140 hotel rooms Eq’m price is 130 S above the floor, 120 so floor is not 110 binding. 100 P = $100, 90 Price floor Q = 100 rooms. 80 D 70 60 50 40 050 60 70 80 90 100 110 120 130 Q 16 ACTIVE LEARNING 1 C. $120 price floor The market for P 140 hotel rooms The price S 130 surplus = 60 rises to $120. 120 Buyers 110 Price floor demand 100 60 rooms, 90 sellers supply 80 D 120, causing a 70 surplus. 60 50 40 050 60 70 80 90 100 110 120 130 Q 17  Evaluating Price Controls  Recall one of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity.  Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices.  Price controls often intended to help the poor, but often hurt more than help. SUPPLY, DEMAND, AND GOVERNMENT POLICIES 18  Taxes  The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc.  The govt can make buyers or sellers pay the tax.  The tax can be a % of the good’s price, or a specific amount for each unit sold.  For simplicity, we analyze per-unit taxes only. SUPPLY, DEMAND, AND GOVERNMENT POLICIES 19 EXAMPLE 3: The Market for Pizza Eq’m Eq’m P w/o w/o tax tax S1 $10.00 D1 Q 500 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 20  A Tax on Buyers The Hence,price Hence, buyers aa tax tax on pay on buyers buyers Effects of a $1.50 per is nowthe shifts shifts $1.50 the D higher D curve curve than left left by by unit sales tax on the the market amountprice amount of of theP.tax. the tax. P buyers P would have to fall S1 by $1.50 to make buyers willing $10.00 Tax to buy same Q as before. $8.50 E.g., if P falls D1 from $10.00 to $8.50, D2 buyers still willing to Q 500 purchase 500 pizzas. SUPPLY, DEMAND, AND GOVERNMENT POLICIES 21  A Tax on Buyers Effects of a $1.50 per New eq’m: unit sales tax on Q = 450 P buyers Sellers S1 receive PC = $11.00 Tax PS = $9.50 $10.00 Buyers pay PS = $9.50 PC = $11.00 D1 Difference between them D2 Q = $1.50 = tax 450 500 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 22  The Incidence of a Tax: how the burden of a tax is shared among market participants P In our S1 example, PC = $11.00 Tax buyers pay $10.00 $1.00 more, PS = $9.50 sellers get $0.50 less. D1 D2 Q 450 500 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 23  A Tax on Sellers Effects of a $1.50 per The tax effectively raises unit excise tax on sellers’ costs by sellers P S2 $1.50 per pizza. $11.50 Tax S1 Sellers will supply 500 pizzas $10.00 only if P rises to $11.50, to compensate for this cost increase. D1 Hence, Hence, aa tax tax on on sellers sellers shifts shifts the the Q 500 S curve S curve left left by by the the amount amount of of the the tax. tax. SUPPLY, DEMAND, AND GOVERNMENT POLICIES 24  A Tax on Sellers Effects of a $1.50 per New eq’m: unit excise tax on Q = 450 sellers P S2 Buyers pay S1 PC = $11.00 PC = $11.00 Tax Sellers $10.00 receive PS = $9.50 PS = $9.50 D1 Difference between them Q = $1.50 = tax 450 500 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 25 The Outcome Is the Same in Both Cases ! The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers! What matters P is this: S1 PC = $11.00 Tax A tax drives $10.00 a wedge PS = $9.50 between the price buyers D1 pay and the price sellers Q receive. 450 500 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 26 ACTIVE LEARNING 2 Effects of a tax The market for P 140 hotel rooms Suppose govt 130 S imposes a tax 120 on buyers of 110 $30 per room. 100 Find new 90 Q, PC, PS, 80 D and incidence 70 of tax. 60 50 40 050 60 70 80 90 100 110 120 130 Q  Elasticity and Tax Incidence CASE 1: Demand is inelastic. P It’s It’s easier easier for for sellers sellers PC S than than buyers buyers Buyers’ share of tax burden to to leave leave the the Tax market. market. Price if no tax So So buyers buyers Sellers’ share bear bear most most ofof PS of tax burden the the burden burden of of the the tax. tax. D Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 28 ACTIVE LEARNING 2 Answers The market for P 140 hotel rooms 130 S Q = 80 120 PC = $110 PC = 110 100 PS = $80 Tax 90 PS = 80 D Incidence 70 buyers: $10 60 sellers: $20 50 40 050 60 70 80 90 100 110 120 130 Q  Elasticity and Tax Incidence CASE 2: Demand is more elastic P It’s It’s easier easier S for for buyers buyers Buyers’ share than than sellers sellers of tax burden PC to to leave leave thethe market. market. Price if no tax Tax Sellers Sellers bear bear Sellers’ share most most of of the the of tax burden PS burden burden of of D the the tax. tax. Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 30 CASE STUDY: Who Pays the Luxury Tax?  1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc.  Goal of the tax: raise revenue from those who could most easily afford to pay – wealthy consumers.  But who really pays this tax? SUPPLY, DEMAND, AND GOVERNMENT POLICIES 31 CHAPTE R 7 Consumers, Producers, and the Efficiency of Markets Microeonomics PRINCIPLES OF N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich © 2009 South-Western, a part of Cengage Learning, all rights reserved In this chapter, look for the answers to these questions:  What is consumer surplus? How is it related to the demand curve?  What is producer surplus? How is it related to the supply curve?  Do markets produce a desirable allocation of resources? Or could the market outcome be improved upon? 33  Welfare Economics  Recall, the allocation of resources refers to:  how much of each good is produced  which producers produce it  which consumers consume it  Welfare economics studies how the allocation of resources affects economic well-being.  First, we look at the well-being of consumers. CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 34  Willingness to Pay (WTP) A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good. WTP measures how much the buyer values the good. name WTP Example: Anthony $250 4 buyers’ WTP for an iPod Chad 175 Flea 300 John 125 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 35  WTP and the Demand Curve Q: If price of iPod is $200, who will buy an iPod, and what is quantity demanded? A: Anthony & Flea will buy an iPod, Chad & John will not. name WTP Hence, Qd = 2 Anthony $250 when P = $200. Chad 175 Flea 300 John 125 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 36  WTP and the Demand Curve Derive the P (price demand who buys Qd of iPod) schedule: $301 & up nobody 0 name WTP 251 – 300 Flea 1 Anthony $250 176 – 250 Anthony, Flea 2 Chad 175 Chad, Anthony, 126 – 175 3 Flea 300 Flea John, Chad, John 125 0 – 125 4 Anthony, Flea CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 37  WTP and the Demand Curve P $350 P Qd $300 $250 $301 & up 0 $200 251 – 300 1 $150 176 – 250 2 $100 126 – 175 3 $50 0 – 125 4 $0 Q 0 1 2 3 4 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 38  About the Staircase Shape… P This D curve looks like a staircase $350 with 4 steps – one per buyer. $300 If there were a huge # of buyers, $250 as in a competitive market, $200 there would be a huge # of very tiny steps, $150 and it would look $100 more like a smooth $50 curve. $0 Q 0 1 2 3 4 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 39  WTP and the Demand Curve P At any Q, $350 Flea’s WTP the height of $300 Anthony’s WTP the D curve is $250 the WTP of the Chad’s WTP marginal buyer, $200 John’s WTP the buyer who $150 would leave the market if P were $100 any higher. $50 $0 Q 0 1 2 3 4 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 40  Consumer Surplus (CS) Consumer surplus is the amount a buyer is willing to pay minus the amount the buyer actually pays: CS = WTP – P name WTP Suppose P = $260. Anthony $250 Flea’s CS = $300 – 260 = $40. The others get no CS because Chad 175 they do not buy an iPod at this Flea 300 price. John 125 Total CS = $40. CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 41  CS and the Demand Curve P Flea’s WTP P = $260 $350 Flea’s CS = $300 $300 – 260 = $40 $250 Total CS = $40 $200 $150 $100 $50 $0 Q 0 1 2 3 4 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 42  CS and the Demand Curve P Flea’s WTP Instead, suppose $350 P = $220 $300 Anthony’s WTP Flea’s CS = $250 $300 – 220 = $80 $200 Anthony’s CS = $250 – 220 = $30 $150 Total CS = $110 $100 $50 $0 Q 0 1 2 3 4 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 43  CS and the Demand Curve P $350 The lesson: $300 Total CS equals the area under $250 the demand curve $200 above the price, from 0 to Q. $150 $100 $50 $0 Q 0 1 2 3 4 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 44 CS with Lots of Buyers & a Smooth D Curve At Q = 5(thousand), Price P The demand for shoes the marginal buyer per pair 60 $ is willing to pay $50 for pair of shoes. 50 Suppose P = $30. 40 Then his consumer 30 surplus = $20. 1000s of pairs 20 of shoes 10 D 0 Q 0 5 10 15 20 25 30 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 45 CS with Lots of Buyers & a Smooth D Curve CS is the area The demand for shoes P above P and below the D curve, from 0 $ 60 to Q. 50 h Recall: area of 40 a triangle equals 30 ½ x base x height 20 Height = $60 – 30 = $30. 10 D So, 0 Q CS = ½ x 15 x $30 0 5 10 15 20 25 30 = $225. CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 46  How a Higher Price Reduces If P rises to $40, CS P CS = ½ x 10 x $20 60 1. Fall in CS = $100. due to buyers 50 leaving market Two reasons for the fall in CS. 40 30 2. Fall in CS due to 20 remaining buyers 10 D paying higher P 0 Q 0 5 10 15 20 25 30 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 47  ACTIVE LEARNING 1 Consumer surplus 50 demand curve P A. Find marginal $ 45 buyer’s WTP at 40 Q = 10. 35 B. Find CS for 30 P = $30. 25 Suppose P falls to $20. 20 How much will CS 15 increase due to… 10 C. buyers entering 5 the market 0 D. existing buyers paying lower price 0 5 10 15 20 Q 25 48  ACTIVE LEARNING 1 Answers 50 P demand curve A. At Q = 10, marginal $ 45 buyer’s WTP is $30. 40 B. CS = ½ x 10 x $10 35 = $50 30 P falls to $20. 25 20 C. CS for the 15 additional buyers 10 = ½ x 10 x $10 = $50 5 D. Increase in CS 0 on initial 10 units = 10 x $10 = $100 0 5 10 15 20 Q 25 49  Cost and the Supply Curve  Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost).  Includes cost of all resources used to produce good, including value of the seller’s time.  Example: Costs of 3 sellers in the lawn-cutting business. name cost A seller will produce and sell the good/service only if the Jack $10 price exceeds his or her cost. Janet 20 Hence, cost is a measure of Chrissy 35 willingness to sell. CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 50  Cost and the Supply Curve P Qs Derive the supply schedule from the cost data: $0 – 9 0 10 – 19 1 20 – 34 2 name cost 35 & up 3 Jack $10 Janet 20 Chrissy 35 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 51  Cost and the Supply Curve P $40 P Qs $0 – 9 0 $30 10 – 19 1 $20 20 – 34 2 $10 35 & up 3 $0 Q 0 1 2 3 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 52  Cost and the Supply Curve P $40 At each Q, Chrissy’s the height of the S curve $30 cost is the cost of the Janet’s marginal seller, $20 cost the seller who would leave $10 Jack’s cost the market if the price were $0 Q any lower. 0 1 2 3 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 53  Producer Surplus P PS = P – cost $40 Producer surplus (PS): the amount a seller $30 is paid for a good minus the seller’s cost $20 $10 $0 Q 0 1 2 3 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 54  Producer Surplus and the S Curve P PS = P – cost $40 Suppose P = $25. Chrissy’s $30 Jack’s PS = $15 cost Janet’s PS = $5 Janet’s $20 cost Chrissy’s PS = $0 Total PS = $20 $10 Jack’s cost Total Total PS PS equals equals the the $0 Q area above the supply area above the supply 0 1 2 3 curve curve under under the the price, price, from from 00 to to Q. Q. CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 55  PS with Lots of Sellers & a Smooth S Curve Suppose P = $40. Price P The supply of shoes per pair At Q = 15(thousand), 60 the marginal seller’s 50 S cost is $30, 40 and her producer surplus is $10. 30 1000s of pairs 20 of shoes 10 0 Q 0 5 10 15 20 25 30 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 56 PS with Lots of Sellers & a Smooth S Curve PS is the area b/w The supply of shoes P P and the S curve, 60 from 0 to Q. 50 S The height of this triangle is 40 $40 – 15 = $25. 30 So, h 20 PS = ½ x b x h = ½ x 25 x $25 10 = $312.50 0 Q 0 5 10 15 20 25 30 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 57  How a Lower Price Reduces PS If P falls to $30, P 1. Fall in PS PS = ½ x 15 x $15 60 due to sellers = $112.50 50 leaving market S Two reasons for 40 the fall in PS. 30 2. Fall in PS due to 20 remaining sellers 10 getting lower P 0 Q 0 5 10 15 20 25 30 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 58  CS, PS, and Total Surplus CS = (value to buyers) – (amount paid by buyers) = buyers’ gains from participating in the market PS = (amount received by sellers) – (cost to sellers) = sellers’ gains from participating in the market Total surplus = CS + PS = total gains from trade in a market = (value to buyers) – (cost to sellers) CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 59 ACTIVE LEARNING 2 Answers 50 P supply curve A. At Q = 10, 45 marginal cost = $20 40 B. PS = ½ x 10 x $20 35 = $100 30 P rises to $30. 25 C. PS on 20 additional units 15 = ½ x 5 x $10 = $25 10 D. Increase in PS 5 on initial 10 units 0 = 10 x $10 = $100 0 5 10 15 20 Q 25 60  Efficiency Total surplus = (value to buyers) – (cost to sellers) An allocation of resources is efficient if it maximizes total surplus. Efficiency means:  The goods are consumed by the buyers who value them most highly.  The goods are produced by the producers with the lowest costs.  Raising or lowering the quantity of a good would not increase total surplus. CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 61 ACTIVE LEARNING 2 Producer surplus 50 P supply curve A. Find marginal 45 seller’s cost 40 at Q = 10. 35 B. Find total PS for 30 P = $20. 25 Suppose P rises to $30. 20 Find the increase 15 in PS due to… 10 C. selling 5 additional units 5 D. getting a higher price 0 on the initial 10 units 0 5 10 15 20 Q 25 62  Which Sellers Produce the Good? Every seller whose P cost is ≤ $30 will 60 produce the good. 50 S Every seller whose cost is > $30 will 40 not. 30 So, the sellers with 20 the lowest cost produce the good. 10 D 0 Q 0 5 10 15 20 25 30 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 63  Does Eq’m Q Maximize Total Surplus? At Q = 10, P cost of producing 60 the marginal unit is $25 50 S value to consumers 40 of the marginal unit is $40 30 Hence, can increase 20 total surplus 10 by increasing Q. D This is true at any Q 0 Q less than 15. 0 5 10 15 20 25 30 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 64  CONCLUSION  This chapter used welfare economics to demonstrate one of the Ten Principles: Markets are usually a good way to organize economic activity.  Important note: We derived these lessons assuming perfectly competitive markets.  In other conditions we will study in later chapters, the market may fail to allocate resources efficiently… CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 65  CONCLUSION  Such market failures occur when:  a buyer or seller has market power – the ability to affect the market price.  transactions have side effects, called externalities, that affect bystanders. (example: pollution)  We’ll use welfare economics to see how public policy may improve on the market outcome in such cases.  Despite the possibility of market failure, the analysis in this chapter applies in many markets, and the invisible hand remains extremely important. CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 66  Does Eq’m Q Maximize Total Surplus? The market P eq’m quantity 60 maximizes 50 S total surplus: 40 At any other quantity, 30 can increase 20 total surplus by moving toward 10 D the market eq’m 0 Q quantity. 0 5 10 15 20 25 30 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 67  The free market vs. central planning  Suppose resources were allocated not by the market, but by a central planner who cares about society’s well-being.  To allocate resources efficiently and maximize total surplus, the planner would need to know every seller’s cost and every buyer’s WTP for every good in the entire economy.  This is impossible, and why centrally-planned economies are never very efficient. CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 68  The Market’s Allocation of Resources  In a market economy, the allocation of resources is decentralized, determined by the interactions of many self-interested buyers and sellers.  Is the market’s allocation of resources desirable? Or would a different allocation of resources make society better off?  To answer this, we use total surplus as a measure of society’s well-being, and we consider whether the market’s allocation is efficient. (Policymakers also care about equality, though are focus here is on efficiency.) CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 69  Adam Smith and the Invisible Hand Passages from The Wealth of Nations, 1776 “Every individual…neither intends to promote the public interest, nor knows how much he is promoting it…. He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes Adam Smith, that of the society more effectually than 1723-1790 when he really intends to promote it.” CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 70  Does Eq’m Q Maximize Total Surplus? At Q = 20, P cost of producing 60 the marginal unit is $35 50 S value to consumers 40 of the marginal unit is only $20 30 Hence, can increase 20 total surplus 10 by reducing Q. D This is true at any Q 0 Q greater than 15. 0 5 10 15 20 25 30 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 71  Evaluating the Market Equilibrium Market eq’m: P P = $30 60 Q = 15,000 50 S Total surplus = CS + PS 40 CS Is the market eq’m 30 efficient? PS 20 10 D 0 Q 0 5 10 15 20 25 30 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 72  The Free Market vs. Govt Intervention  The market equilibrium is efficient. No other outcome achieves higher total surplus.  Govt cannot raise total surplus by changing the market’s allocation of resources.  Laissez faire (French for “allow them to do”): the notion that govt should not interfere with the market. CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 73  Adam Smith and the Invisible Hand Passages from The Wealth of Nations, 1776 “Man has almost constant occasion for the help of his brethren, and it is vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their own advantage to do for him what he requires of them… It is not from the benevolence of the butcher, the brewer, or the baker that Adam Smith, we expect our dinner, but from their 1723-1790 regard to their own interest…. CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 74  Which Buyers Consume the Good? Every buyer P whose WTP is 60 ≥ $30 will buy. 50 S Every buyer whose WTP is 40 < $30 will not. 30 So, the buyers 20 who value the 10 good most highly D are the ones who 0 Q consume it. 0 5 10 15 20 25 30 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 75 CHAPTER SUMMARY  The height of the S curve is sellers’ cost of producing the good. Sellers are willing to sell if the price they get is at least as high as their cost.  Producer surplus is the difference between what sellers receive for a good and their cost of producing it.  On the graph, producer surplus is the area between P and the S curve. 76 CHAPTER SUMMARY  To measure of society’s well-being, we use total surplus, the sum of consumer and producer surplus.  Efficiency means that total surplus is maximized, that the goods are produced by sellers with lowest cost, and that they are consumed by buyers who most value them.  Under perfect competition, the market outcome is efficient. Altering it would reduce total surplus. 77 CHAPTER SUMMARY  The height of the D curve reflects the value of the good to buyers—their willingness to pay for it.  Consumer surplus is the difference between what buyers are willing to pay for a good and what they actually pay.  On the graph, consumer surplus is the area between P and the D curve. 78 CHAPTE R 8 Application: The Costs of Taxation Microeonomics PRINCIPLES OF N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich © 2009 South-Western, a part of Cengage Learning, all rights reserved CHAPTE R 8 Application: The Costs of Taxation Microeonomics PRINCIPLES OF N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich © 2009 South-Western, a part of Cengage Learning, all rights reserved In this chapter, look for the answers to these questions: How does a tax affect consumer surplus, producer surplus, and total surplus?  What is the deadweight loss of a tax?  What factors determine the size of this deadweight loss?  How does tax revenue depend on the size of the tax? 81  Review  A tax  drives a wedge between the price buyers pay and the price sellers receive.  raises the price buyers pay and lowers the price sellers receive.  reduces the quantity bought & sold.  These effects are the same whether the tax is imposed on buyers or sellers, so we do not make this distinction in this chapter. APPLICATION: THE COSTS OF TAXATION 82  The Effects of a Tax P Eq’m with no tax: Price = PE Quantity = QE Size of tax = $T PC S Eq’m with tax = $T per unit: PE Buyers pay PC PS D Sellers receive PS Quantity = QT Q QT QE APPLICATION: THE COSTS OF TAXATION 83  The Effects of a Tax P Revenue from tax: $ T x QT Size of tax = $T PC S PE PS D Q QT QE APPLICATION: THE COSTS OF TAXATION 84  The Effects of a Tax  Next, we apply welfare economics to measure the gains and losses from a tax.  We determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax.  Tax revenue can fund beneficial services (e.g., education, roads, police) so we include it in total surplus. APPLICATION: THE COSTS OF TAXATION 85  The Effects of a Tax P Without a tax, CS = A + B + C PS = D + E + F A Tax revenue = 0 S B C Total surplus PE D E = CS + PS =A+B+C D F +D+E+F Q QT QE APPLICATION: THE COSTS OF TAXATION 86  The Effects of a Tax P With the tax, CS = A PS = F A Tax revenue PC S =B+D B C Total surplus D E =A+B PS D +D+F F The tax reduces total surplus by Q C+E QT QE APPLICATION: THE COSTS OF TAXATION 87  The Effects of a Tax P C + E is called the deadweight loss (DWL) of the tax, A PC S the fall in total B C surplus that results from a D E market distortion, PS D such as a tax. F Q QT QE APPLICATION: THE COSTS OF TAXATION 88  About the Deadweight Loss Because of the tax, P the units between QT and QE are not sold. S PC The value of these units to buyers is greater than the cost PS D of producing them, so the tax prevents some mutually beneficial trades. Q QT QE APPLICATION: THE COSTS OF TAXATION 89 ACTIVE LEARNING 1 The market for Analysis of tax P airplane tickets A. Compute $ 400 CS, PS, and 350 total surplus 300 without a tax. S 250 B. If $100 tax 200 per ticket, compute 150 D CS, PS, 100 tax revenue, 50 total surplus, 0 Q and DWL. 0 25 50 75 100 125 90 ACTIVE LEARNING 1 The market for Answers to A P airplane tickets CS $ 400 = ½ x $200 x 100 350 = $10,000 300 S PS 250 = ½ x $200 x 100 P = 200 = $10,000 150 D Total surplus 100 = $10,000 + $10,000 50 = $20,000 0 Q 0 25 50 75 100 125 91 ACTIVE LEARNING 1 A $100 tax on Answers to B P airplane tickets CS $ 400 = ½ x $150 x 75 350 = $5,625 300 PS = $5,625 S PC = 250 Tax revenue 200 = $100 x 75 PS = 150 = $7,500 D 100 Total surplus 50 = $18,750 0 Q DWL = $1,250 0 25 50 75 100 125 92  What Determines the Size of the DWL?  Which goods or services should govt tax to raise the revenue it needs?  One answer: those with the smallest DWL.  When is the DWL small vs. large? Turns out it depends on the price elasticities of supply and demand.  Recall: The price elasticity of demand (or supply) measures how much QD (or QS) changes when P changes. APPLICATION: THE COSTS OF TAXATION 93  DWL and the Elasticity of Supply The The more more elastic elastic is is P supply, supply, the the easier easier for for firms firms to to leave leave the the market market S when when thethe tax tax reduces Size reduces P PSS,, of tax the the greater greater QQ falls falls below below the the surplus- surplus- maximizing maximizing quantity, quantity, D the the greater greater the the DWL. DWL. Q APPLICATION: THE COSTS OF TAXATION 94  DWL and the Elasticity of Demand P When When demand demand is is inelastic, inelastic, S it’s it’s harder harder for for consumers consumers to to Size leave leave the the market market of tax when when thethe taxtax raises raises P PCC.. So, So, the the tax tax only only D reduces reduces Q Q aa little, little, Q and and DWL DWL isis small. small. APPLICATION: THE COSTS OF TAXATION 95  DWL and the Elasticity of Demand The The more more elastic elastic is is P demand, demand, S the the easier easier for for buyers buyers to to leave leave the the market market when when thethe tax tax Size increases increases P PCC,, of tax the the more more Q Q falls falls D below below the the surplus- surplus- maximizing maximizing quantity, quantity, and and the the greater greater the the Q DWL. DWL. APPLICATION: THE COSTS OF TAXATION 96  DWL and the Elasticity of Supply When When supply supply P is is inelastic, inelastic, S it’s it’s harder harder for for firms firms to to leave leave the the market market when when thethe tax tax reduces reduces P PSS.. Size So, So, the the tax tax only only of tax reduces reduces Q Q aa little, little, and D and DWL DWL isis small. small. Q APPLICATION: THE COSTS OF TAXATION 97 ACTIVE LEARNING 2 Elasticity and the DWL of a tax Would the DWL of a tax be larger if the tax were on: A. Breakfast cereal or sunscreen? B. Hotel rooms in the short run or hotel rooms in the long run? C. Groceries or meals at fancy restaurants? 98 ACTIVE LEARNING 2 Answers A. Breakfast cereal or sunscreen From Chapter 5: Breakfast cereal has more close substitutes than sunscreen, so demand for breakfast cereal is more price-elastic than demand for sunscreen. So, a tax on breakfast cereal would cause a larger DWL than a tax on sunscreen. 99 ACTIVE LEARNING 2 Answers B. Hotel rooms in the short run or long run From Chapter 5: The price elasticities of demand and supply for hotel rooms are larger in the long run than in the short run. So, a tax on hotel rooms would cause a larger DWL in the long run than in the short run. 100 ACTIVE LEARNING 2 Answers C. Groceries or meals at fancy restaurants From Chapter 5: Groceries are more of a necessity and therefore less price-elastic than meals at fancy restaurants. So, a tax on restaurant meals would cause a larger DWL than a tax on groceries. 101 ACTIVE LEARNING 3 Discussion question  The government must raise tax revenue to pay for schools, police, etc. To do this, it can either tax groceries or meals at fancy restaurants.  Which should it tax? 102  How Big Should the Government Be?  A bigger government provides more services, but requires higher taxes, which cause DWLs.  The larger the DWL from taxation, the greater the argument for smaller government.  The tax on labor income is especially important; it’s the biggest source of govt revenue.  For the typical worker, the marginal tax rate (the tax on the last dollar of earnings) is about 40%.  How big is the DWL from this tax? It depends on elasticity…. APPLICATION: THE COSTS OF TAXATION 103  How Big Should the Government Be?  If labor supply is inelastic, then this DWL is small.  Some economists believe labor supply is inelastic, arguing that most workers work full-time regardless of the wage. APPLICATION: THE COSTS OF TAXATION 104  How Big Should the Government Be? Other economists believe labor taxes are highly distorting because some groups of workers have elastic supply and can respond to incentives:  Many workers can adjust their hours, e.g., by working overtime.  Many families have a 2nd earner with discretion over whether and how much to work.  Many elderly choose when to retire based on the wage they earn.  Some people work in the “underground economy” to evade high taxes. APPLICATION: THE COSTS OF TAXATION 105  DWL and the Size of the Tax P Initially, the tax is new T per unit. DWL Doubling the tax S causes the DWL 2T T to more than double. D initial DWL Q Q2 Q1 APPLICATION: THE COSTS OF TAXATION 106 The Effects of Changing the Size of the Tax  Policymakers often change taxes, raising some and lowering others.  What happens to DWL and tax revenue when taxes change? We explore this next…. APPLICATION: THE COSTS OF TAXATION 107  DWL and the Size of the Tax P Initially, the tax is new T per unit. DWL Tripling the tax S causes the DWL 3T T to more than triple. D initial DWL Q Q3 Q1 APPLICATION: THE COSTS OF TAXATION 108  DWL and the Size of the Tax Implication Implication Summary When When tax tax rates rates are are When a tax increases, low, low, raising raising them them DWL rises even more. doesn’t DWL doesn’t cause cause much much harm, harm, andand lowering lowering them them doesn’t doesn’t bring bring much much benefit. benefit. When When tax tax rates rates are are high, high, raising raising them them isis very very harmful, harmful, and and cutting cutting them them isis very very beneficial. Tax size beneficial. APPLICATION: THE COSTS OF TAXATION 109  Revenue and the Size of the Tax When the P tax is small, increasing it causes tax PC S revenue to rise. PC 2T T PS D PS Q Q2 Q1 APPLICATION: THE COSTS OF TAXATION 110  Revenue and the Size of the Tax P PC PC S When the 3T 2T tax is larger, increasing it D causes tax PC revenue to fall. PS Q Q3 Q2 APPLICATION: THE COSTS OF TAXATION 111  Revenue and the Size of the Tax The Laffer curve Tax The Laffer curve shows the relationship revenue between the size of the tax and tax revenue. Tax size APPLICATION: THE COSTS OF TAXATION 112 CHAPTER SUMMARY  The price elasticities of demand and supply measure how much buyers and sellers respond to price changes. Therefore, higher elasticities imply higher DWLs.  An increase in the size of a tax causes the DWL to rise even more.  An increase in the size of a tax causes revenue to rise at first, but eventually revenue falls because the tax reduces the size of the market. 113 CHAPTER SUMMARY  A tax on a good reduces the welfare of buyers and sellers. This welfare loss usually exceeds the revenue the tax raises for the govt.  The fall in total surplus (consumer surplus, producer surplus, and tax revenue) is called the deadweight loss (DWL) of the tax.  A tax has a DWL because it causes consumers to buy less and producers to sell less, thus shrinking the market below the level that maximizes total surplus. 114 In this chapter, look for the answers to these questions: What is elasticity? What kinds of issues can elasticity help us understand?  What is the price elasticity of demand? How is it related to the demand curve? How is it related to revenue & expenditure?  What is the price elasticity of supply? How is it related to the supply curve?  What are the income and cross-price elasticities of demand? 115  A scenario… You You design design websites websites for for local local businesses. businesses. You You charge charge $200 $200 per per website, website, and and currently currently sell sell 12 12 websites websites per per month. month. Your Your costs costs are are rising rising (including (including the the opportunity opportunity cost cost of of your your time), time), so so you you consider consider raising raising the the price price to to $250. $250. The The law law of of demand demand says says that that you you won’t won’t sell sell as as many many websites websites ifif you you raise raise your your price. price. How How many many fewer fewer websites? websites? How How much much will will your your revenue revenue fall, fall, or or might might itit increase? increase? 116  Elasticity  Basic idea: Elasticity measures how much one variable responds to changes in another variable.  One type of elasticity measures how much demand for your websites will fall if you raise your price.  Definition: Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of its determinants. ELASTICITY AND ITS APPLICATION 117  Price Elasticity of Demand Price elasticity Percentage change in Qd = of demand Percentage change in P  Price elasticity of demand measures how much Qd responds to a change in P.  Loosely speaking, it measures the price- sensitivity of buyers’ demand. ELASTICITY AND ITS APPLICATION 118  Price Elasticity of Demand Price elasticity Percentage change in Qd = of demand Percentage change in P P Example: P rises Price elasticity P2 by 10% P1 of demand D equals 15% Q = 1.5 Q2 Q1 10% Q falls by 15% ELASTICITY AND ITS APPLICATION 119  Price Elasticity of Demand Price elasticity Percentage change in Qd = of demand Percentage change in P P Along Along aa DD curve, curve, PP and and QQ move move inin opposite opposite directions, directions, P2 which which would would make make price price elasticity P1 elasticity negative. negative. We D We will will drop drop the the minus minus sign sign and and report report all all price price Q elasticities Q2 Q1 elasticities as as positive positive numbers. numbers. ELASTICITY AND ITS APPLICATION 120  Calculating Percentage Changes Standard method of computing the Demand for percentage (%) change: your websites P end value – start value x 100% start value B $250 A Going from A to B, $200 the % change in P equals D ($250–$200)/$200 = 25% Q 8 12 ELASTICITY AND ITS APPLICATION 121  Calculating Percentage Changes Problem: The standard method gives Demand for different answers depending your websites on where you start. P From A to B, B P rises 25%, Q falls 33%, $250 A elasticity = 33/25 = 1.33 $200 From B to A, D P falls 20%, Q rises 50%, Q elasticity = 50/20 = 2.50 8 12 ELASTICITY AND ITS APPLICATION 122  Calculating Percentage Changes  So, we instead use the midpoint method: end value – start value x 100% midpoint  The midpoint is the number halfway between the start & end values, the average of those values.  It doesn’t matter which value you use as the “start” and which as the “end” – you get the same answer either way! ELASTICITY AND ITS APPLICATION 123  Calculating Percentage Changes  Using the midpoint method, the % change in P equals $250 – $200 x 100% = 22.2% $225  The % change in Q equals 12 – 8 x 100% = 40.0% 10  The price elasticity of demand equals 40/22.2 = 1.8 ELASTICITY AND ITS APPLICATION 124 ACTIVE LEARNING 1 Calculate an elasticity Use the following information to calculate the price elasticity of demand for theme park tickets: if P = $70, Qd = 5000 if P = $90, Qd = 3000 125 ACTIVE LEARNING 1 Answers Use midpoint method to calculate % change in Qd (5000 – 3000)/4000 = 50% % change in P ($90 – $70)/$80 = 25% The price elasticity of demand equals 50% = 2.0 25% 126  What determines price elasticity? To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example:  Suppose the prices of both goods rise by 20%.  The good for which Qd falls the most (in percent) has the highest price elasticity of demand. Which good is it? Why?  What lesson does the example teach us about the determinants of the price elasticity of demand? ELASTICITY AND ITS APPLICATION 127 EXAMPLE 1: Breakfast cereal vs. Sunscreen  The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why?  Breakfast cereal has close substitutes (e.g., pancakes, Eggo waffles, oatmeal, grits), so buyers can easily switch if the price rises.  Sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises.  Lesson: Price elasticity is higher when close substitutes are available. ELASTICITY AND ITS APPLICATION 128 EXAMPLE 2: “Lucky Brand Jeans” vs. “Clothing”  The prices of both goods rise by 20%. For which good does Qd drop the most? Why?  For a narrowly defined good such as Lucky Brand jeans, there are many substitutes (khakis, shorts, other denim brands).  There are fewer substitutes available for broadly defined goods. (There aren’t too many substitutes for clothing, other than living in a nudist colony.)  Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones. ELASTICITY AND ITS APPLICATION 129 EXAMPLE 3: Insulin vs. Caribbean Cruises  The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why?  To millions of diabetics, insulin is a necessity. A rise in its price would cause no decrease in Qd.  A cruise is a luxury. If the price rises, some people will forego it.  Lesson: Price elasticity is higher for luxuries than for necessities. ELASTICITY AND ITS APPLICATION 130 EXAMPLE 4: Gasoline in the Short Run vs. Gasoline in the Long Run  The price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why?  There’s not much people can do in the short run, other than ride the bus or carpool.  In the long run, people can buy smaller cars or live closer to where they work.  Lesson: Price elasticity is higher in the long run than the short run. ELASTICITY AND ITS APPLICATION 131  The Determinants of Price Elasticity: A Summary The The price price elasticity elasticity of of demand demand depends depends on: on:  the the extent extent to to which which close close substitutes substitutes are are available available  whether whether the the good good is is aa necessity necessity or or aa luxury luxury  how how broadly broadly or or narrowly narrowly the the good good is is defined defined  the the time time horizon horizon –– elasticity elasticity is is higher higher in in the the long long run run than than the the short short run run ELASTICITY AND ITS APPLICATION 132  The Variety of Demand Curves  The price elasticity of demand is closely related to the slope of the demand curve but it is not equal to the slope of the demand curve. The reason for this is because slope is a ratio of two changes and elasticity is a ratio of two % changes.  Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity.  Five different classifications of D curves.… ELASTICITY AND ITS APPLICATION 133 “Perfectly inelastic demand” (one extreme case) Price elasticity % change in Q 0% = = =0 % change in P 10% of demand D curve: P D vertical P1 Consumers’ price sensitivity: P2 none P falls Q Elasticity: by 10% Q1 0 Q changes by 0% ELASTICITY AND ITS APPLICATION 134 “Inelastic demand” Price elasticity % change in Q < 10% = = 1 % change in P 10% of demand D curve: P relatively flat P1 Consumers’ price sensitivity: P2 D relatively high P falls Q Elasticity: by 10% Q1 Q2 >1 Q rises more than 10% ELASTICITY AND ITS APPLICATION 137 “Perfectly elastic demand” (the other extreme) Price elasticity % change in Q any % = = = infinity % change in P 0% of demand D curve: P horizontal P2 = P1 D Consumers’ price sensitivity: extreme P changes Q Elasticity: by 0% Q1 Q2 infinity Q changes by any % ELASTICITY AND ITS APPLICATION 138 Elasticity of a Linear Demand Curve P The slope 200% of a linear $30 E = = 5.0 40% demand 67% curve is 20 E = = 1.0 67% constant, but its 40% 10 E = = 0.2 elasticity 200% is not. $0 Q 0 20 40 60 ELASTICITY AND ITS APPLICATION 139  Price Elasticity and Total Revenue  Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue = P x Q  A price increase has two effects on revenue:  Higher P means more revenue on each unit you sell.  But you sell fewer units (lower Q), due to Law of Demand.  Which of these two effects is bigger? It depends on the price elasticity of demand. ELASTICITY AND ITS APPLICATION 140  Price Elasticity and Total Revenue Price elasticity Percentage change in Q = of demand Percentage change in P Revenue = P x Q  If demand is elastic, then price elast. of demand > 1 % change in Q > % change in P  The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls. ELASTICITY AND ITS APPLICATION 141  Price Elasticity and Total Revenue Elastic demand increased Demand for (elasticity = 1.8) P revenue due your websiteslost to higher P revenue If P = $200, due to Q = 12 and $250 lower Q revenue = $2400. $200 If P = $250, D Q = 8 and revenue = $2000. When D is elastic, Q 8 12 a price increase causes revenue to fall. ELASTICITY AND ITS APPLICATION 142  Price Elasticity and Total Revenue Price elasticity Percentage change in Q = of demand Percentage change in P Revenue = P x Q  If demand is inelastic, then price elast. of demand < 1 % change in Q < % change in P  The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises.  In our example, suppose that Q only falls to 10 (instead of 8) when you raise your price to $250. ELASTICITY AND ITS APPLICATION 143  Price Elasticity and Total Now, demand is Revenue increased Demand for inelastic: revenue due your websites elasticity = 0.82 P to higher P lost If P = $200, revenue due to Q = 12 and $250 lower Q revenue = $2400. $200 If P = $250, Q = 10 and D revenue = $2500. When D is inelastic, Q 10 12 a price increase causes revenue to rise. ELASTICITY AND ITS APPLICATION 144 ACTIVE LEARNING 2 Elasticity and expenditure/revenue A. What happens to total revenue if the elasticity of demand for Alabama football tickets is equal to 1 and the price of the tickets increases 25%? B. Pharmacies raise the price of insulin by 10%. Does total revenue on insulin rise or fall? C. As a result of a fare war, the price of a luxury cruise falls 20%. Does luxury cruise companies’ total revenue rise or fall? 145 ACTIVE LEARNING 2 Answers A. With an elasticity equal to 1, the tickets’ elasticity of demand is “unit” elastic. This means there will be no change in total revenue (stays the same) since price and quantity demanded are changing by the same percentages. P increases 25%, QD falls 25%, TR remains the same. B. Pharmacies raise the price of insulin by 10%. Does total revenue on insulin rise or fall? Since demand is perfectly inelastic, Q will not fall, so revenue rises. 146 ACTIVE LEARNING 2 Answers C. As a result of a fare war, the price of a luxury cruise falls 20%. Does luxury cruise companies’ total revenue rise or fall? Revenue = P x Q The fall in P reduces revenue, but Q increases, which increases revenue. Which effect is bigger? Since demand is elastic, Q will increase more than 20%, so revenue rises. 147 APPLICATION: Does Drug Interdiction Increase or Decrease Drug-Related Crime?  One side effect of illegal drug use is crime: Users often turn to crime to finance their habit.  We examine two policies designed to reduce illegal drug use and see what effects they have on drug-related crime.  For simplicity, we assume the total dollar value of drug-related crime equals total expenditure on drugs.  Demand for illegal drugs is inelastic, due to addiction issues. ELASTICITY AND ITS APPLICATION 148  Policy 1: Interdiction Interdiction new value of drug- reduces the Price of related crime supply of Drugs S2 D1 drugs. S1 Since demand P2 for drugs is inelastic, initial value P1 P rises propor- of drug- tionally more related than Q falls. crime Result: an increase in Q2 Q1 Quantity total spending on drugs, of Drugs and in drug-related crime ELASTICITY AND ITS APPLICATION 149  Policy 2: Education new value of drug- Education Price of related crime reduces the Drugs demand for D2 D1 drugs. S P and Q fall. P1 initial value Result: of drug- A decrease in P2 related total spending crime on drugs, and in drug-related Q2 Q1 Quantity crime. of Drugs ELASTICITY AND ITS APPLICATION 150  Price Elasticity of Supply Price elasticity Percentage change in Qs = of supply Percentage change in P  Price elasticity of supply measures how much Qs responds to a change in P.  Loosely speaking, it measures sellers’ price-sensitivity.  Again, use the midpoint method to compute the percentage changes. ELASTICITY AND ITS APPLICATION 1