Post on 26-Dec-2015
PPA 723: Managerial Economics
Lecture 4:
Applications of Supply and Demand
Managerial Economics, Lecture 4: Applications of S&D
Outline
Elasticities
Tax Incidence
Rent Control
Managerial Economics, Lecture 4: Applications of S&D
Another Dimension of Demand and Supply:Responsiveness
The slope of a demand curve equals:
The inverse of the slope indicates the magnitude of the response to price.
A more responsive curve (flatter slope) generally means more alternatives in other markets.
change in slope
change in
P P
Q Q
Managerial Economics, Lecture 4: Applications of S&D
Elasticity
The elasticity of demand equals:
The absolute value of the elasticity indicates the magnitude of the response to price.
The value of the elasticity varies along a linear demand curve.
/elasticity
/
Q Q
P P
Managerial Economics, Lecture 4: Applications of S&D
P
Q Q
D
P1
Q1
Slope = “rise”/“run” = P/Q < 0
P
Q
Elasticity = (Q/Q1)/(P/P1) < 0
Slope and Elasticity
Managerial Economics, Lecture 4: Applications of S&D
Large and Small Elasticities
P
Q
S1
S2
DP1
P2
Q2 Q1 QQ1Q2
P1
P2 S2
S1
D
Large Elasticity (│e│)= Responsive Demand
Small Elasticity (│e│)= Unresponsive Demand
P
Managerial Economics, Lecture 4: Applications of S&D
Figure 3.3c Vertical and Horizontal Demand Curves
(c) Individual’s Demand for Insulin
p*
Q * Q, Insulin (doses per day)
p, P
rice
of
insu
lin d
ose
Managerial Economics, Lecture 4: Applications of S&D
Figure 3.2 Elasticity Along the Pork Demand Curve
a /2 = 143a /5 = 57.2
D
a = 286220
Q (Mil. kg of pork/year)0
11.44
a /b = 14.30
3.30
a /(2b) = 7.15
Elastic: e < -1e = –4
Unitary: e = -1
e = –0.3
Inelastic: 0 > e > -1
Perfectly Inelastic: e = 0
Perfectly Elastic: e = - ∞
P (
$ p
er
kg)
-P = P
e = (Q/Q)/(P/P) = (PQ)/(QP)
Q = Q
Managerial Economics, Lecture 4: Applications of S&D
Figure 3.1 How the Effect of a Supply Shock Depends on the Shape of the Demand Curve
(a) (b) (c)
215 2201760
Q, Million kg of pork per year
3.553.30
S1
D1
S 2 e1
e2
2201760
Q, Million kg of pork per year
3.6753.30
S1S2
D2
e1
e2
2202051760
Q, Million kg of pork per year
3.30
S 1S 2
D3e
1
e2
p, $
per
kg
p, $
per
kg
p, $
per
kg
Managerial Economics, Lecture 4: Applications of S&D
Change in Revenue
Q, Quantity per time period
Q1Q2
p1
p2
e1
e2
D
p, P
rice
pe
r u
nit
Original Revenue
New Revenue
Managerial Economics, Lecture 4: Applications of S&D
Elasticity and Revenue
/
/
Q Qe
P P
Revenue R PQ
( )( )R P P Q Q PQ
( )( )( 1)R P Q e
Managerial Economics, Lecture 4: Applications of S&D
Elasticity and Revenue, Continued
When price increases,
Revenue increases if demand is inelastic (|e| < 1)
Revenue decreases if demand is elastic (|e| > 1)
Managerial Economics, Lecture 4: Applications of S&D
Figure 3.4 Elasticity Along the Pork Supply Curve
220 260176
S
h ≈ 0.71
h ≈ 0.66
h ≈ 0.6
h ≈ 0.5
300Q (Million kg of pork per year)
0
3.30
2.20
4.30
5.30
P (
$ p
er
kg)
Managerial Economics, Lecture 4: Applications of S&D
Tax IncidenceA key question about taxes is: Who pays?To answer, must distinguish between:
Legal Incidence, which indicates who is legally obligated to write the check to the government.
Economic Incidence, which indicates whose real income declines due to the tax.
They may not be the same due to tax shifting.
Managerial Economics, Lecture 4: Applications of S&D
The Analysis of Tax Incidence
P
Q
S
S + tax
D
P1
P2
P3
tax Burden on consumers
Burden on firms
Managerial Economics, Lecture 4: Applications of S&D
Figure 3.5 Effect of a $1.05 Specific Tax on the Pork Market Collected from Producers
Q2 = 206 Q1 = 220176
T = $216.3 million
Q, Million kg of pork per year
0
p2 = 4.00
p1 = 3.30p2 – t = 2.95
t = $1.05 S1
e1
e2
S2
D
p, $
per
kg
Managerial Economics, Lecture 4: Applications of S&D
Figure 3.6 Effect of a $1.05 Specific Tax on Pork Collected from Consumers
Q2 = 206 Q1 = 220176
T = $216.3 million
Q, Million kg of pork per year0
p2 = 4.00
p1 = 3.30p2 – t = 2.95
t = $1.05
Wedge, t = $1.05
D1
D2
e1
e2 S
p,
$ p
er
kg
Managerial Economics, Lecture 4: Applications of S&D
Page 64 Solved Problem 3.1
Q, Quantity per time period
Q1Q2
p1
p2 = p1 + 1
S1
S 2
e1
e2
D
t = $1
p, P
rice
pe
r u
nit
Managerial Economics, Lecture 4: Applications of S&D
A Land Tax
Q1 Q (Acres of Land)
R1-T
R1
DS
R (
Re
nt
pe
r A
cre
)
Tax
Managerial Economics, Lecture 4: Applications of S&D
Lessons
A tax falls most heavily on the side of the market with the lowest elasticity (= fewest alternatives).
Economic incidence is determined by market forces, not by legal incidence.
Managerial Economics, Lecture 4: Applications of S&D
Rent Control
Housing affordability is a serious issue in this country:More than half of the poor pay more than
half of their income in rent and utilities.
A few cities try to address this through rent controls, i.e., by setting rent ceilings.
Managerial Economics, Lecture 4: Applications of S&D
Rent Control
R (Rent)
QS1 Q Qd
D
Short-run S
Q (Number of Apartments)
Re
R* Rent ceiling
Long-run S
QS2
Managerial Economics, Lecture 4: Applications of S&D
Effects of Rent Control
Fewer apartments put on the marketDecline in maintenance and hence in the
number of quality-adjusted units
Fewer apartments constructedNew rules for allocating units, with the
poor at a disadvantage
Managerial Economics, Lecture 4: Applications of S&D
LessonsPublic policy can alter prices, but only at
great cost.Market forces are powerful and not easily
overcome!Attempts to alter market outcomes usually
have unintended consequences.The distribution of benefits and costs may
be difficult to control