Applying the Supply-and-Demand Model Questions: 1.

cigarettes taxes: how big a tax is needed to discourage a substantial number of people from smoking? 2. health care: if Congress passes a law forcing firms to provide health care, will firms pass on the full amount of these mandatory fees to consumers?

3. condoms: how much of a subsidy is necessary to encourage French consumers to use 70% more condoms?

What-if questions how do equilibrium price and quantity change when an underlying factor changes? use graphs to predict qualitative effects of changes: The direction of change need to know shape of demand and supply curves to determine quantitative change: > amount equilibrium quantity and price change
Shapes of demand and supply curves matter supply shock (25 increase in price of hogs) effect on Canadian processed pork depends on shape of demand curve supply shock causes supply curve of pork to shift left from S1 to S2

Elasticity of demand
Price elasticity of demand: summarize sensitivity of the quantity demanded to price in a single statistic:

Linear demand curve linear demand: Q = a bp elasticity of demand: pork demand curve: Q = 286 20p

Types of elasticities:
elastic: the quantity demanded changes more than in proportion to a change in price inelastic: the quantity demanded changes less than in proportion to a change in price elasticity of demand varies along most linear demand curves

Income elasticity of demand - how quantity of one good changes as income changes

- positive indicates a normal good

- negative indicates an inferior good

Cross-price elasticity of demand - how quantity of one good changes as price of another good changes

- positive indicates goods are substitutes

- negative indicates goods are complements

Price elasticity of supply the responsiveness of producers to changes in product price

supply curve is elastic if > 1 supply curve is inelastic if 0 < < 1

EX: pork supply curve is Q = 88 + 40p so pork supply elasticity is

as price of pork increases by 1%, the quantity supplied rises by nearly two-thirds of a percent

Two types of sales taxes ad valorem tax (the sales tax): for every dollar the consumer spends, the government keeps a fraction, specific (unit) tax: a specified amount, , is collected per unit of output

4 Questions about sales taxes 1. What effect does a specific sales tax have on equilibrium prices and quantity? 2. Are sales taxes assessed on producers "passed along" to consumers? (do consumers pay entire tax?) 3. Do equilibrium price and quantity depend on whether the consumers or producers are taxed? 4. Do both types of sales taxes have the same effect on equilibrium?

Price impact of tax amount by which tax affects equilibrium price depends on elasticities of supply and demand government raises tax by price consumers pay increases by
- dependent upon the elasticity of supply, elasticity of demand, and the size of the price change

Effect of a $1.05 Specific Tax on the Pork Market Collected from Producers
Price increases by $.70 paid by consumer Producers pay the tax and are left with $.35 less amount paid by producers Government receives the tax * amount sold = $216.3 million

Tax incidence: incidence of a tax on consumers is share of tax that consumers pay

Restaurant tax incidence

estimated demand and supply for restaurant meals (Brown 1980): constant elasticity demand curve: = -0.188 constant elasticity supply curve: = 6.47 original equilibrium: Q1 = 8.14 billion meals per year p1 = $10.47 per meal ($1992) -- can you calculate the incidence from a $1 tax?

Incidence specific gasoline taxes

specific taxes federal range from nearly 11 and 20 per gallon state from 7 to 36 per gallon incidence: federal tax every 1 increase retail price up wholesale price down incidence: state tax every 1 increase retail price up 1 no wholesale price effect

Consumer Behavior
Individual decision making
consumers face constraints on their choices consumers maximize their pleasure from consumption subject to constraints

Consumers problem
consumer allocates money over goods: buys a bundle or market basket of goods 2 possible theories of consumer behavior
maximizing behavior random behavior

Assumptions about consumer preferences

1. completeness 2. transitivity 3. more is better

Indifference curve
identifies all the bundles that give the same amount of pleasure or utility

Indifference curve properties

1. bundles on indifference curves farther from the origin are preferred to those on indifference curves closer to the origin 2. there is an indifference curve through every possible bundle 3. indifference curves cannot cross 4. indifference curves slope down

Marginal Rate of Substitution

-- Along an indifference curve a person trades one bundle on an for another by giving up some burritos to gain more pizza the rate of exchange is the marginal rate of substitution -- indicates the

Budget constraint
If a person spends all their income, Y, on pizza and burritos their budget constraint is Y = pBB + pzZ or pBB = expenditure on B burritos pzZ = expenditure on Z pizzas

Change in Price
If one price rises price of pizza doubles: pZ=$2 (up from $1) with the price of burritos and income unchanged slope of the new budget line causes the budget constraint to swing inward opportunity set shrinks

Change in income
if consumer's income, Y, increases from say $50 to $100 parallel shift out of budget line opportunity set grows consumer can buy more of all goods

Budget line meets indifference curves maximize utility subject to the budget constraint

Tangency property at interior optimum, indifference curve is tangent to budget line:

last dollar spent on pizza gives as much extra utility as that spent on burrito Point e maximum utility that can be achieved

Food stamps Are poor people necessarily better off receiving food stamps or a comparable amount of cash? Answer cash gives a greater choice whether that greater choice matters depends on the tastes of poor people (how much food they eat) Points of tangency below and to the right of e both are equivalent Points of tangency above and to the left of e cash is preferred

Deriving Demand Curves trace out the demand curve by holding income and the price of one good (wine) constant and varying the price of another (beer)

example: estimated set of indifference curves for the typical American consumer are bowed away from origin
consumers' tastes (indifference curves) determine the shape of the demand curve (elasticity of demand)

Question
Congress must decide how to aid poor families
child-care program could provide an ad valorem or a specific subsidy (as many states currently do under PRWORA)

alternatively, government could provide an unrestricted lump-sum payment under the major welfare program that could be spent on day care or on all other goods such as food and housing
for a given government expenditure, does the price subsidy or the lumpsum subsidy provide greater benefit to recipients? which increases the demand for day care services by more? which inflicts less cost on other consumers of day care?

Solution
on initial budget constraint is Lo, poor family chooses the bundle e1
with a day-care price subsidy, budget line is LPS; family consumes e2 measure the value of the subsidy to family: calculate how many other goods the family could buy before and after the subsidy (given price of other goods is $1 per unit, these other goods are essentially income, Yo) given family consumes Q2 hours of day care, family could have consumed Yo other goods with the original budget constraint and Y2 with LPS thus, value to family of day-care price subsidy is Y2 Yo lump-sum payment of Y2 Yo, budget constraint LLS goes through e2,but family chooses e3

Firms - an organization that converts inputs (labor, materials, and capital) into outputs (goodsand services)

Objectives conflicting objectives between owners, managers, and other employees employees want to maximize their earnings or utility (most pay for least work) owners want to maximize profit: profit = TR - TC TR = revenue = pq = price x quantity TC = total cost = variable cost + fixed cost Production production process: transform inputs or factors of production into outputs common types of inputs: capital (K): buildings and equipment labor services (L) materials (M): raw goods and processed products

Variability of inputs over time

short run: a period of time so brief that at least one factor of production is fixed

fixed input: a factor that cannot be varied practically in the SR variable input: a factor whose quantity can be changed readily during the relevant time period
long run: lengthy enough period of time that all inputs can be varied firm can more easily adjust its inputs in the long run (LR) than in the short run (SR)

Law of diminishing marginal returns (product) - as a firm increases an input, holding all other inputs and technology constant, the corresponding increases in output will become smaller eventually that is, the marginal product of that input will diminish eventually

Long-run production: Two variable inputs both capital and labor are variable many combinations of L and K produce a given level of output: q = f (L, K) Isoquant curve that shows efficient combinations of labor and capital that can produce a single level of output (quantity)

3 major properties of isoquants -- follow from the assumption that production is efficient: 1. further an isoquant is from the origin, the greater is the level of output 2. isoquants do not cross 3. isoquants slope down Substituting inputs -- slope of an isoquant shows the ability of a firm to substitute one input for another while holding output constant Marginal rate of technical substitution (MRTS) tells how much a firm can increase one input and lower the other so as to stay on an isoquant tells us how many units of K firm can replace with an extra unit of L, holding output constant varies along a curved isoquant

Two-step procedure to choose technology 1. pick all technologically efficient production processes 2. from these technologically efficient production processes, pick the one that is economically efficient (minimizes cost) opportunity cost value of best alternative use of the resource classic example: "There's no such thing as a free lunch" What have you given up to study opportunity costs business costs: only explicit costs (out of pocket) economic costs: explicit cost + implicit cost Short-run cost measures fixed cost (FC): production expense that does not vary with output variable cost (VC): production expense that changes with quantity of output produced total cost (TC): TC = VC + FC Marginal cost (MC) change in cost, C, when output changes by q MC = C/q

Input choice -- choose from all technologically efficient combinations of inputs, the economically efficient combination of inputs

Costs of input bundles isocost: all combinations of inputs that require the same expenditure (cost) with two production inputs: cost is C = wL + rK or

slope of each isocost line is the same: K/L = -w/r

Cost-minimizing rules -- to pick lowest-cost combination of inputs to produce a given level of output: pick bundle of inputs where lowest isocost line touches isoquant isoquant is tangent to isocost line: MRTS = |ratio of the input prices| = w/r

Relative factor price changes cause firm to change the mix of inputs used firm substitutes relatively less expensive inputs for more expensive ones
EX:

original wage = 24 kr, so w/r = 3 new wage = 8 kr, so w/r = 1

kr = krone (Norways Currency)