PPA 723: Managerial Economics Lecture 4: Applications of Supply and Demand

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


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


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


P

Q Q

D

P1

Q1

Slope = “rise”/“run” = P/Q < 0

P

Q

Elasticity = (Q/Q1)/(P/P1) < 0

Slope and Elasticity


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


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


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


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


3.6753.30

S1S2

D2

e1

e2

2202051760


3.30

S 1S 2

D3e

1

e2

p, $

per

kg

p, $

per

kg

p, $

per

kg


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


Elasticity and Revenue

/

/

Q Qe

P P

Revenue R PQ

( )( )R P P Q Q PQ

( )( )( 1)R P Q e


Elasticity and Revenue, Continued

When price increases,

Revenue increases if demand is inelastic (|e| < 1)

Revenue decreases if demand is elastic (|e| > 1)


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)


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.


The Analysis of Tax Incidence

P

Q

S

S + tax

D

P1

P2

P3

tax Burden on consumers

Burden on firms


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


0

p2 = 4.00

p1 = 3.30p2 – t = 2.95

t = $1.05 S1

e1

e2

S2

D

p, $

per

kg


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


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


A Land Tax

Q1 Q (Acres of Land)

R1-T

R1

DS

R (

Re

nt

pe

r A

cre

)

Tax


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.


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.


Rent Control

R (Rent)

QS1 Q Qd

D

Short-run S

Q (Number of Apartments)

Re

R* Rent ceiling

Long-run S

QS2


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


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

Documents

PPA 723: Managerial Economics Lecture 4: Applications of Supply and Demand