ECON 201 1nd Edition Exam 2 Study Guide Lectures 8 15 Lecture 8 2 11 What is elasticity A measure of the responsiveness of one variable to another What is the price of elasticity of demand The percentage of change in quantity demanded divided by the percentage change in price ED Percentage change in quantity demanded Percentage change in price o o Ed Qd change P change Es Qs change P change When is demand supply elastic Demand supply is elastic if the percentage change in quantity is greater than the percentage change in price E 1 When is demand supply inelastic Demand supply is inelastic if the percentage change in quantity is less than the percentage change in price E 1 Unitary elastic E 1 How do you calculate elasticity Elasticity Q2 Q1 1 2 Q2 Q1 P2 P1 1 2 P1 P2 What are important points to consider for elasticity and supply and demand curves a Two important points to consider 1 Elasticity is related but is not the same as slope 2 Elasticity changes along straight line demand and supply curves b The steeper the curve at a given point the less elastic is supply or demand Perfect elastic E infinity Elastic E 1 Unit elastic E 1 Inelastic E 1 Perfectly inelastic E 0 Lecture 9 2 13 How does substitution effect supply and demand The more substitutes a good has the more elastic supply and demand is The longer the time period considered the more elastic the supply and the same for demand In the long run there are more options for change so it is easier What is total revenue Total quantity sold multiplied by price of good TR PQ What is price discrimination Price discrimination occurs when a firm separates the people with less elastic demand from those with more elastic demand What is the income elasticity of demand The percentage change in demand divided by the percentage change in income o o o o Normal good Ei 0 Luxury good Ei 1 Necessity good Ei 1 Inferior good Ei 0 What is cross price elasticity of demand The percentage change in demand divided by the percentage change in the price of another good When should a supplier raise price The supplier should raise his price when it faces an inelastic demand o Total revenue increases with a price increase because quantity drops proportionally less than price goes up o Since costs also fall profit rises o Ed 1 so increase P will increase TR Lecture 10 2 18 What is consumer surplus It is the value the consumer gets from buying a product less its price It is the area underneath the demand curve and above the price and individual pays What is producer surplus It is the value the producer sells the product for less the cost of producing it It is the area above the supply curve but below the price the producer receives The combination of consumer and producer surplus is as large as it can be at market equilibrium Combined consumer and producer surplus decreases when price is above equilibrium How much should the government tax The cost of taxation include o The direct cost of the revenue paid to the government o The loss of consumer and producer surplus caused by tax the dead weight loss o The cost of administering the tax codes What is statutory incidence It is the legal assignment of who pays a tax The actual burden of a tax actual incidence may differ substantially The actual burden does not depend on who legally pays the tax elastic side takes less burden The Costs of Taxation o A per unit tax shifts supply from S0 to S1 and increases price P1 and decreases quantity to Q1 o Consumer surplus is A B C before the tax and A after the tax o Producer surplus is D E F before the tax and F after the tax o Gov revenue B D The Benefits of Taxation o Provides a stable set of institutions and rules o Promotes effective and workable competition o Corrects for externalities o Creates an environment that fosters economic stability and growth o Provides public goods o Adjusts for undesirable market results What is a benefit principle of taxation The individuals who receive the benefit of a good or service should pay the tax necessary to supply the good What is the ability to pay principle Individuals who are most able to bear the burden of the tax should pay the tax Who bears the burden of a tax a The person who physically pays the tax statutory incidence is not necessarily the person who bears the burden of the tax b Tax Burden change in CS or PS c Burden depends of relative elasticity The more inelastic one s relative supply and demand the larger the tax burden one will bear Lecture 11 2 20 Who bears the burden in Social Security Taxes On average labor supply tends to be less elastic than labor demand so the social security tax burden is primarily on employees Who bears the burden on Sales Tax Demand is inelastic so consumers bear the greater burden of the tax What is a price ceiling A government set price below the market equilibrium price It acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation What is a price floor A government set price above market equilibrium It acts as a tax on consumers and a subsidy for producers that transfers consumer surplus to producers The difference between taxes and price controls o Price ceilings create shortages taxes do not o Taxes leave people free to choose how much they want to supply and consume as long as they pay the tax o Shortages may also create black markets What is a rent seeking activity Rent seeking activities are activities that are designed to transfer surplus from one group to another Lecture 12 2 25 What is the utility theory and individual choice o Choice based on cost and benefit analysis o The pleasure people get from doing or consuming something benefit o Utility the pleasure or satisfaction that one expects to get from consuming a good or a service What is total utility The satisfaction one gets from one s consumption of a product What is marginal utility The extra satisfaction from the consumption of one additional unit of a product above and beyond what you have consumed up to that point Maximizing Utility and Equilibrium You maximize utility for given income o That occurs when the marginal utilities per dollar spent on each of the choices are equal o The cost per additional unit of utility is equal for all goods and the consumer is as well off as it is possible to be Why not buy more Mux Px MUy Py Lecture 13 2 27 The principle of rational choice leads to the law of demand o When the price of a good goes up the