Professor Christina Romer. LECTURE 4 EXTENSIONS OF SUPPLY AND DEMAND ANALYSIS January 25, 2018

Transcription

1 Economics 2 Spring 2018 Professor Christina Romer Professor David Romer LECTURE 4 EXTENSIONS OF SUPPLY AND DEMAND ANALYSIS January 25, 2018 I. OVERVIEW II. REVIEW OF THE SUPPLY AND DEMAND FRAMEWORK A. Two sides of the market (example: light trucks) B. Equilibrium C. What shifts the demand curve? D. What shifts the supply curve? III. ELASTICITY A. Price elasticity of demand B. Relationship between elasticity and the slope of the demand curve C. Impact of elasticity on the market outcome D. Demand elasticity and expenditure (example: illegal opioid drugs) 1. Comparison of supply-side and demand-side policies 2. What the simple analysis may be missing E. Price elasticity of supply IV. EFFECTS OF A TAX A. Terminology and set-up (example: gas tax) B. Effects on price and quantity C. Who pays the tax? D. Interaction with demand elasticity E. Government tax revenue

2 Economics 2 Spring 2018 Christina Romer David Romer LECTURE 4 Extensions of Supply and Demand Analysis January 25, 2018

3 Announcements Problem Set 1 is due next Tuesday (January 30). Problem Set Work Session this afternoon (Jan. 25) 4:00 6:00 in 648 Evans Hall Ground Rules: Answers must be in your own words, handwritten, and with acknowledgements to the people you worked with. Graded on a scale of 1 to 10.

4 Announcements Collecting the Problem Sets: They are due at the beginning of lecture. We will have boxes with your GSIs names on them in the middle of the lecture hall (both sides).

5 Announcements Journal article reading for Tuesday (by Esther Duflo): You can access for free through any campus computer, or from off campus using the library proxy (see Don t stress over every word or parts you don t understand. Read for approach and findings; think about relevance to consumer behavior.

6 I. OVERVIEW

7 Plan for the Lecture Review the supply and demand framework. Discuss elasticity. Examine the effect of another government intervention in the market (a tax).

8 II. REVIEW OF SUPPLY AND DEMAND

9 Equilibrium in the Market for Light Trucks P S 1 P 1 Equilibrium Q 1 D 1 Q

10 What Causes the Demand Curve to Shift? In general, anything that changes the desirability of the good at a given price. Change in the price of a complement. Change in tastes; news. Change in the price of a substitute. Change in demographics.

11 Retail Price of Gasoline Index, = Source: Bureau of Labor Statistics.

12 Effect of a Fall in the Price of Gasoline on the Demand for Light Trucks P S 1 P 2 P 1 D 2 Q 1 Q 2 D 1 Q

13 Source: Trucks.com Growth of Light Trucks

14 What Causes the Supply Curve to Shift? In general, anything that changes the additional cost associated with supplying one more unit at a given quantity of the good. Change in the price of an input. Change in technology.

15 Producer Price Index for Iron and Steel Index, 1982= Source: Bureau of Labor Statistics.

16 Effect of a Fall in the Price of Steel on the Supply of Light Trucks P S 1 S 2 P 1 P 2 Q 1 Q 2 D 1 Q

17 III. ELASTICITY

18 Price Elasticity of Demand (ε D ) ε D = Percentage change in quantity demanded Percentage change in price (In absolute value) Elastic ε D > 1 Inelastic ε D < 1 Perfectly inelastic ε D = 0 Perfectly elastic ε D =

19 Relationship between Demand Elasticity and the Slope of the Demand Curve ε D = ΔQ D / Q D ΔP / P ΔQ D = ΔP P Q D 1 P = Slope Q D

20 Slope of the Demand Curve P ΔP ΔP Slope = ΔQD ΔQ D ε D = 1 P Slope Q D D Q

21 Demand Curves P Inelastic P Elastic D 1 D 1 ε D = Q 1 P Slope Q D Q

22 Demand Elasticity Matters for Market Outcomes (Effect of a Shift Out in the Supply Curve) P Inelastic P Elastic S 1 S 2 S 1 S 2 P 1 P 2 P 1 P 2 D 1 D 1 Q 1 Q 2 Q Q 1 Q 2 Q

23 Demand Elasticity Matters for Market Outcomes (Effect of a Shift Out in the Supply Curve) If demand is highly inelastic, a shift in the supply curve leads mainly to a change in price, with little change in quantity. If demand is highly elastic, a shift in the supply curve leads mainly to a change in quantity, with little change in price.

24 Source: National Institute on Drug Abuse; Center for Disease Control.

25 Market for Illegal Opioid Drugs P S 1 P 1 Q 1 D 1 Q

26 Market for Illegal Opioid Drugs (Supply Restriction) P S 2 S 1 P 2 P 1 Q 2 Q 1 D 1 Q

27 Total Expenditure Total Expenditure = Price Quantity Total expenditure and total revenue are the same thing.

28 Demand Elasticity and Expenditure Inelastic (ε D < 1): Total expenditure rises when the supply curve shifts back. Elastic (ε D > 1): Total expenditure falls when the supply curve shifts back.

29 Market for Illegal Opioid Drugs (Increased Drug Treatment) P S 1 P 1 P 2 Q 1 Q 2 D 2 D 1 Q

30 What are some of the complexities that we are ignoring with this analysis?

31 Price Elasticity of Supply (ε S ) ε S = Percentage change in quantity supplied Percentage change in price Elastic ε S > 1 Inelastic ε S < 1 Perfectly inelastic ε S = 0 Perfectly elastic ε S =

32 Supply Curves P Inelastic S 1 P Elastic S 1 Q As with the ε D, the relationship between ε S and the slope of the supply curve is a useful, but crude approximation. Q

33 IV. EFFECTS OF A TAX

34 Effect of a New 50 per Gallon Tax on Gasoline (Physically Collected from Sellers) P S 2 S 1 P 2 P 1 P 2 tax Tax (50 ) Q 2 Q 1 D 1 Q

35 Typical Effects of a Tax Quantity bought and sold declines. Production and consumption are still allocated by price. Price rises by less than the amount of the tax. Both sides pay some of the tax.

36 Demand Elasticity and the Effects of a Tax Inelastic Elastic P S 2 P S 2 Tax S 1 Tax S 1 P 2 P 1 P 2 tax P 2 1 P 2 tax D 1 D 1 Q 2 Q 1 Q Q 2 Q 1 Q

37 Two Ways of Visualizing Tax Revenues P (1) (2) Tax S 2 P S 2 S 1 Tax S 1 P 2 P 2 tax P 2 D 1 D 1 Q 2 Q Q 2 Q

38 Demand Elasticity and the Effects of a Tax A tax will change the equilibrium quantity more, the more elastic demand is. Buyers will pay more of the tax, the less elastic demand is. Government revenue from the tax will be larger, the less elastic demand is.