Unit 2: Supply, Demand, and Consumer Choice

Unit 2: Supply, Demand, and Consumer Choice 1

DEMAND DEFINED What is Demand? Demand is the different quantities of goods that consumers are willing and able to buy at different prices. (Ex: You are able to purchase diapers, but if you aren t willing to buy then there is NO demand) What is the Law of Demand? There is an INVERSE relationship between price and quantity demanded 2

LAW OF DEMAND As Price Falls Quantity Demanded Rises As Price Rises Quantity Demanded Falls Price Quantity Demanded 3

Example of Demand I am willing to sell several A s in AP Economics. How much will you pay? Price Quantity Demanded Demand Schedule 4

Why does the Law of Demand occur? The law of demand is the result of three separate behavior patterns that overlap: 1.The Substitution effect 2.The Income effect 3.The Law of Diminishing Marginal Utility We will define and explain each 5

Why does the Law of Demand occur? 1. The Substitution Effect If the price goes up for a product, consumer buy less of that product and more of another substitute product (and vice versa) 2. The Income Effect If the price goes down for a product, the purchasing power increases for consumers - allowing them to purchase more. 6

Why does the Law of Demand occur? 3. Law of Diminishing Marginal Utility U- TIL- IT- Y Utility = Satisfaction We buy goods because we get utility from them The law of diminishing marginal utility states that as you consume more units of any good, the additional satisfaction from each additional unit will eventually start to decrease In other words, the more you buy of ANY GOOD the less satisfaction you get from each new unit. Discussion Questions: 1. What does this have to do with the Law of Demand? 2. How does this effect the pricing of businesses? 7

Can you see the Law of Diminishing Marginal Utility in Disneyland s pricing strategy?

2010 Question 36 9

Graphing Demand 10

The Demand Curve A demand curve is a graphical representation of a demand schedule. The demand curve is downward sloping showing the inverse relationship between price (on the y-axis) and quantity demanded (on the x-axis) When reading a demand curve, assume all outside factors, such as income, are held constant. (This is called ceteris paribus) Let s draw a new demand curve for cereal 11

GRAPHING DEMAND Demand Schedule Price of Cereal $5 Price Quantity Demanded 4 $5 10 3 $4 20 $3 30 2 $2 50 1 Demand $1 80 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 12

Where do you get the Market Demand? Billy Jean Other Individuals Market Price Q Demd Price Q Demd Price Q Demd Price Q Demd $5 1 $4 2 $3 3 $2 5 $1 7 $5 0 $4 1 $3 2 $2 3 $1 5 $5 9 $4 17 $3 25 $2 42 $1 68 $5 10 $4 20 $3 30 $2 50 $1 80 P P P P $3 $3 $3 $3 3 D Q 2 D Q 25 D Q 30 D Q

Shifts in (Overall) Demand CHANGES IN (OVERALL) DEMAND Ceteris paribus- all other things held constant. When the ceteris paribus assumption is dropped, Changes movement no in longer price occurs along the demand curve. Rather, the entire demand curve shifts. DON T shift A shift means that at the same prices, more people are the willing (overall) and able curve! to purchase that good. This is a change (shift) in (overall) demand, not a change in quantity demanded 14

Change in (overall) Demand Demand Schedule Price of Cereal $5 Quantity Price Demanded $5 10 $4 20 $3 30 4 What if cereal 3 makes you smarter? 2 $2 50 $1 80 1 o 10 20 30 40 50 60 70 80 Quantity of Cereal Demand Q 15

Change in Demand Demand Schedule Price of Cereal $5 Price Quantity Demanded 4 $5 10 3 $4 20 $3 30 2 $2 50 1 Demand $1 80 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 16

Change in (overall) Demand Demand Schedule Price of Cereal $5 Price Quantity Demanded 4 $5 10 30 3 $4 20 40 $3 30 50 2 $2 50 70 1 Demand $1 80 100 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 17

Change in (overall) Demand Demand Schedule Price Quantity Demanded $5 10 30 $4 20 40 $3 30 50 Price of Cereal $5 4 3 2 Increase in (overall) Demand Prices didn t change but people want MORE cereal D 2 $2 50 70 1 Demand $1 80 100 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 18

Change in (overall) Demand Demand Schedule Price of Cereal $5 Quantity Price Demanded $5 10 $4 20 $3 30 4 What if cereal 3 causes baldness? 2 $2 50 $1 80 1 o 10 20 30 40 50 60 70 80 Quantity of Cereal Demand Q 19

Change in (overall) Demand Demand Schedule Price of Cereal $5 Price Quantity Demanded 4 $5 10 $4 20 $3 30 $2 50 3 2 1 Demand $1 80 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 20

Change in (overall) Demand Demand Schedule Price of Cereal $5 Price Quantity Demanded 4 $5 10 0 $4 20 5 $3 30 20 $2 50 30 3 2 1 Demand $1 80 60 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 21

Change in (overall) Demand Demand Schedule Price Quantity Demanded $5 10 0 $4 20 5 $3 30 20 Price of Cereal $5 4 3 2 Decrease in (overall) Demand Prices didn t change but people want LESS cereal $2 50 30 1 D 2 Demand $1 80 60 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 22

Change in (overall) Demand Demand Schedule Price of Cereal $5 Quantity Price Demanded $5 10 $4 20 $3 30 4 What if the price 3 of MILK goes up? 2 $2 50 $1 80 1 o 10 20 30 40 50 60 70 80 Quantity of Cereal Demand Q 23

What Causes a Shift in (overall) Demand? 5 Shifters (Determinants) of Demand: 1.Tastes and Preferences 2.Number of Consumers 3.Price of Related Goods 4.Income 5.Future Expectations Changes in PRICE DON T shift the curve. It only causes movement ALONG the curve. 24

Prices of Related Goods The (overall) demand curve for one good can be affected by a change in the price of ANOTHER related good. 1. Substitutes are goods used in place of one another. If the price of one increases, the (overall) demand for the other will increase (or vice versa) Ex: If price of Pepsi falls, demand for Coke will 2. Complements are two goods that are bought and used together. If the price of one increase, the (overall) demand for the other will fall. (or vice versa) Ex: If price of skis falls, demand for ski boots will... 25

Income The incomes of consumer change the (overall) demand, but how depends on the type of good. 1. Normal Goods As income increases, (overall) demand increases As income falls, (overall) demand decreases Ex: Luxury cars, sea food, jewelry, homes 2. Inferior Goods As income increases, (overall) demand decreases As income falls, (overall) demand increases Ex: Top Ramen, used cars, used clothes 26

Inferior Goods 27

Practice Questions 1. Which of the following will cause the demand for milk to decrease? A. Increase in the price of a substitute B. A decrease in income assuming that milk is a normal good C. A decrease in the price of milk D. An increase in the price of milk E. A decrease in the price of a complementary good 28

Practice Questions 2. Which of the following will cause the quantity demanded of milk to decrease? A. Increase in the price of a substitute B. A decrease in income assuming that milk is a normal good C. A decrease in the price of milk D. An increase in the price of milk E. A decrease in the price of a complementary good 29

Change in Qd vs. Change in (overall) Demand Price of Cereal P $3 $2 There are two ways to increase quantity from 10 to 20 A C B 1. A to B is a change in quantity demand (due to a change in price) 2. A to C is a change in (overall) demand (shift the curve) D 2 o 10 20 Quantity of Cereal D 1 Q Cereal

Practice First, identify the determinant (shifter) then decide if (overall) demand will increase or decrease 1 2 3 4 5 6 7 8 Shifter Increase or Decrease Left or Right 31

Practice Identify the determinant (shifter) then decide if demand will increase or decrease Hamburgers (a normal good) 1. Population boom 2. Incomes fall due to recession 3. Price of tacos, a substitute, decreases 4. Price increases to $5 for hamburgers 5. New health craze- No ground beef 6. Hamburger restaurants announce that they will significantly increase prices NEXT month 7. Price of fries, a complement, increases 8. Restaurants lower price of burgers to $.50 32

Supply 33

Supply Defined What is supply? Supply is the different quantities of a good that sellers are willing and able to sell (produce) at different prices. What is the Law of Supply? There is a DIRECT (or positive) relationship between price and quantity supplied. As price increases, the quantity producers make increases As price falls, the quantity producers make falls. Why? Because, at higher prices profit seeking firms have an incentive to produce more. EXAMPLE: Mowing Lawns 34

Example of Supply You own an lawn mower and you are willing to mow lawns. How many lawns will you mow at these prices? Supply Schedule Price per lawn mowed $1 $5 $20 $50 $100 $1000 Quantity Supplied 35

GRAPHING SUPPLY Supply Schedule Price of Cereal $5 Supply Price Quantity Supplied 4 $5 50 3 $4 40 $3 30 2 $2 20 1 $1 10 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 36

GRAPHING SUPPLY Supply Schedule Price of Cereal $5 Supply Quantity Price Supplied $5 50 What 4 if new companies 3 start making $4 40 $3 30 2 cereal? $2 20 1 $1 10 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 37

Change in Supply Supply Schedule Price of Cereal $5 Supply Price Quantity Supplied 4 $5 50 3 $4 40 $3 30 2 $2 20 1 $1 10 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 38

Change in Supply Supply Schedule Price of Cereal $5 Supply Price Quantity Supplied 4 $5 50 70 3 $4 40 60 $3 30 50 2 $2 20 40 1 $1 10 30 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 39

Change in Supply Supply Schedule Price of Cereal $5 Supply S 2 Price Quantity Supplied 4 $5 50 70 $4 40 60 $3 30 50 $2 20 40 3 2 1 Increase in Supply Prices didn t change but there is MORE cereal produced $1 10 30 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 40

Change in Supply Supply Schedule Price of Cereal $5 Supply Price Quantity Supplied $5 50 What 4 if a drought destroys 3 corn and wheat $4 40 $3 30 2 crops? $2 20 1 $1 10 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 41

Change in Supply Supply Schedule Price of Cereal $5 Supply Price Quantity Supplied 4 $5 50 3 $4 40 $3 30 2 $2 20 1 $1 10 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 42

Change in Supply Supply Schedule Price of Cereal $5 Supply Price Quantity Supplied 4 $5 50 30 3 $4 40 20 $3 30 10 2 $2 20 1 1 $1 10 0 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 43

Change in Supply Supply Schedule Price of Cereal $5 S 2 Supply Price Quantity Supplied 4 $5 50 30 $4 40 20 $3 30 10 $2 20 1 3 2 1 Decrease in Supply Prices didn t change but there is LESS cereal produced $1 10 0 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 44

Change in Supply Supply Schedule Price of Cereal $5 Supply Price Quantity Supplied $5 50 $4 40 $3 30 4 What if cereal companies 3 find a quicker way to make 2 cereal? $2 20 1 $1 10 o 10 20 30 40 50 60 70 80 Quantity of Cereal Q 45

6 Shifters (Determinants) of Supply 1. Prices/Availability of inputs (resources) 2. Number of Sellers 3. Technology 4. Government Action: Taxes & Subsidies Subsidies A subsidy is a government payment that supports a business or market. Subsidies cause the supply of a good to increase. 5. Opportunity Taxes Cost of Alternative Regulation The government can reduce the supply Production of some goods by placing an excise tax on them. An excise tax is a tax on the production or sale of a good. 6. Expectations of Future Profit Regulation occurs when the government steps into a market to affect the price, quantity, or quality of a good. Regulation usually raises costs. Changes in PRICE don t shift the curve. It only causes movement along the curve. 46

Practice Questions 1. Which of the following will cause the quantity supplied for milk to decrease? A. Decrease in the price of a key resource B. A decrease in the number of milk producers C. A decrease in the price of milk D. An increase in the price of milk E. A subsidy for milk producers 47

Supply Practice First, identify the determinant (shifter) then decide if supply will increase or decrease 1 2 3 4 5 6 Shifter Increase or Decrease Left or Right 48

Supply Practice 1. Which determinant (SHIFTER)? 2. Increase or decrease? 3. Which direction will curve shift? Hamburgers 1. Mad cow disease kills 20% of cows 2. Price of hamburgers increase 30% 3. Government taxes burger producers 4. Restaurants can produce burgers and/or tacos. A demand increase causes the price for tacos to increase 500% 5. New bun baking technology cuts production time in half 6. Minimum wage increases to $20 49

Putting Supply and Demand Together!!! 50

Supply and Demand are put together to determine equilibrium price and equilibrium quantity Demand Schedule P Qd $5 10 $4 20 $3 30 P $5 4 3 2 S Supply Schedule P Qs $5 50 $4 40 $3 30 $2 50 1 D $2 20 $1 80 o 10 20 30 40 50 60 70 80 Q $1 10 51

Supply and Demand are put together to determine equilibrium price and equilibrium quantity Demand Schedule P Qd $5 10 $4 20 $3 30 P $5 4 3 2 S Equilibrium Price = $3 (Qd=Qs) Supply Schedule P Qs $5 50 $4 40 $3 30 $2 50 1 D $2 20 $1 80 o 10 20 30 40 50 60 70 80 Q $1 10 Equilibrium Quantity is 30 52

Supply and Demand are put together to determine equilibrium price and equilibrium quantity Demand Schedule P Qd $5 10 $4 20 $3 30 P $5 4 3 2 S What if the price increases to $4? Supply Schedule P Qs $5 50 $4 40 $3 30 $2 50 1 D $2 20 $1 80 o 10 20 30 40 50 60 70 80 Q $1 10 53

Demand Schedule P Qd $5 10 $4 20 $3 30 At $4, there is disequilibrium. The quantity demanded is less than quantity supplied. P $5 4 3 2 Surplus (Qd<Qs) S How much is the surplus at $4? Answer: 20 Supply Schedule P Qs $5 50 $4 40 $3 30 $2 50 1 D $2 20 $1 80 o 10 20 30 40 50 60 70 80 Q $1 10 54

How much is the surplus if the price is $5? Demand Schedule P $5 S Supply Schedule P Qd 4 P Qs $5 10 $4 20 $3 30 3 2 What if the price Answer: 40 decreases to $2? $5 50 $4 40 $3 30 $2 50 1 D $2 20 $1 80 o 10 20 30 40 50 60 70 80 Q $1 10 55

Demand Schedule P Qd $5 10 $4 20 $3 30 $2 50 $1 80 At $2, there is disequilibrium. The quantity demanded is greater than quantity supplied. P $5 4 3 2 1 o Shortage (Qd>Qs) S How much is the shortage at $2? Answer: 30 10 20 30 40 50 60 70 80 D Q Supply Schedule P Qs $5 50 $4 40 $3 30 $2 20 $1 10 56

How much is the shortage if the price is $1? Demand Schedule P $5 S Supply Schedule P Qd 4 P Qs $5 10 $4 20 3 Answer: 70 $5 50 $4 40 $3 30 2 $3 30 $2 50 1 D $2 20 $1 80 o 10 20 30 40 50 60 70 80 Q $1 10 57

Demand Schedule P Qd $5 10 $4 20 $3 30 The FREE MARKET system automatically pushes the price toward equilibrium. P $5 4 3 2 Supply S Schedule When there is a surplus, producers P Qs lower prices When there is a shortage, producers raise prices $5 50 $4 40 $3 30 $2 50 1 D $2 20 $1 80 o 10 20 30 40 50 60 70 80 Q $1 10 58

Review 1. Explain the Law of Demand 2. Explain the Law of Supply 3. Identify the 5 shifters of demand 4. Identify the 6 shifters of supply 5. Define Subsidy 6. Explain why price DOESN T shift the curve 7. Define Equilibrium 8. Define Shortage 9. Define Surplus 10.Identify 10 stores in the mall 59

2008 Audit Exam

Shifting Supply and Demand 61

Supply and Demand Analysis Easy as 1, 2, 3 1. Before the change: Draw supply and demand Label original equilibrium price and quantity 2. The change: Did it affect supply or demand first? Which determinant caused the shift? Draw increase or decrease 3. After change: Label new equilibrium What happens to Price? (increase or decrease) What happens to Quantity? (increase or decrease) Let s Practice! 62

S&D Analysis Practice 1. Before Change (Draw equilibrium) 2. The Change (S or D, Identify Shifter) 3. After Change (Price and Quantity After) Analyze Hamburgers 1. Price of sushi (a substitute) increases 2. New grilling technology cuts production time in half 3. Price of burgers falls from $3 to $1. 4. Price for ground beef triples 5. Human fingers found in multiple burger restaurants. 63

Double Shifts Suppose the (overall) demand for sports cars decreased at the SAME TIME as production technology improved. Use S&D Analysis to show what will happen to PRICE and QUANTITY. If TWO curves shift at the same time, EITHER price OR quantity will be indeterminate. 64

Example of Voluntary Exchange Ex: You want to buy a truck so you go to the local dealership. You are willing to spend up to $20,000 for a new 4x4. The seller is willing to sell this truck for no less than $15,000. After some negotiation you buy the truck for $18,000. Analysis: Buyer Maximum- $20,000 Seller s Minimum- $15,000 Price- $18,000 Consumer s Surplus- $2,000 Producer s Surplus- $3,000 65

Voluntary Exchange Terms Consumer Surplus is the difference between what you are willing to pay and what you actually pay. CS = Buyer s Maximum Price Producer s Surplus is the difference between the price the seller received and how much they were willing to sell it for. PS = Price Seller s Minimum 66

Consumer and Producer s Surplus P $10 8 6 $5 4 2 CS Calculate the area of: 1. Consumer Surplus 2. Producer Surplus 3. Total Surplus PS S 1. CS= $25 2. PS= $20 3. Total= $45 1 D 2 4 6 8 10 Q 67

Trade and Taxes 68

Review P $22 20 18 16 CS Calculate the area of: 1. Consumer Surplus 2. Producer Surplus 3. Total Surplus PS S 1. CS= $40 2. PS= $20 3. Total= $60 14 20 D Q 69

Limits on Trade World Price- Countries can buy products at their own domestic price or they can buy the products at a cheaper world price Tariff- Tax on imports that increases the world price Quota- a limit on number of imports. Purpose of tariffs and quotas: To protect domestic producers from a cheaper world price. To prevent domestic unemployment 70

International Trade and Quotas This graphs show the domestic supply and demand for grain. The letters represent area. Identify the following: 1. CS with no trade 2. PS with no trade 3. Amount we import at world price (P W ) 4. PS if we trade at world price (P W ) 5. CS if we trade at world price (P W ) 6. If government tariff leads to a world price of P T, how much is imported and what is the CS and PS?

Excise Taxes Excise Tax = A per unit tax on producers For every unit made, the producer must pay $ NOT a Lump Sum (one time only)tax The goal is for them to make less of the goods that the government deems dangerous or unwanted. Ex: Cigarettes sin tax Alcohol sin tax Environmentally Unsafe Products Etc. 75

Excise Taxes Supply Schedule P Qs $5 140 $4 120 $3 100 $2 80 P $5 4 3 2 Government sets a $2 per unit tax on Cigarettes S $1 60 1 D 40 60 80 100 120 140 Q 76

Excise Taxes Supply Schedule P Qs $5 $7 140 $4 $6 120 $3 $5 100 $2 $4 80 P $5 4 3 2 Government sets a $2 per unit tax on Cigarettes S $1 $3 60 1 D 40 60 80 100 120 140 Q 77

Supply Schedule P Qs $5 $7 140 $4 $6 120 $3 $5 100 $2 $4 80 Excise Taxes P $5 4 3 2 S TAX S Tax is the vertical distance between supply curves $1 $3 60 1 D 40 60 80 100 120 140 Q 78

Identify the following: 1. Price before tax 2. Price consumers pay after tax 3. Price producers get after tax 4. Total tax revenue for the government before tax 5. Total tax revenue for the government after tax Excise Taxes P $5 4 3 2 1 S 40 60 80 100 120 140 S TAX D Q 79

Tax Practice 1. CS Before Tax 2. PS Before Tax 3. CS After Tax 4. PS After Tax 5. Tax Revenue for Government 6. Deadweight Loss assuming society wants Q2 produced 7. Amount of tax revenue producers pay

2012 Question 18 81

2012 Question 19 82

P Excise Tax S $14 12 11 8 D 10 12 Q

P c P p P $14 12 11 8 Excise Tax D S tax S Calculate 1. Tax Per Unit 2. Total Tax Revenue 3. Amount of Tax paid by consumers 4. Amount of Tax paid by producers 5. Total Expenditures 6. Total Revenue for firms 10 12 Q

Excise Tax Calculate 1. CS Before Tax 2. Total Expenditures Before Tax 3. Tax Per Unit 4. Total Tax Revenue that goes to Government 5. Amount of Tax paid by consumers 6. Amount of Tax paid by producers 7. Total Expenditures after tax 8. Total Revenue for firms after tax 9. CS After Tax 10. DWL

Tax Incidence Who ends up paying for an excise tax? 87

EXCISE TAX ON MILK P $10 8 Demand- Inelastic Supply- Unitary S 6 5 4 $2 TAX on Producers 2 D 8 10 Q 88

P $10 $6.50 =P consumers $4.50 = P producers EXCISE TAX ON MILK 8 7 6 5 4 Amount Consumers Pay Amount Producers Pay S 1 S $2 TAX on Producers 2 D 910 Quantity Doesn t Fall VERY Much!!! Q 89

EXCISE TAX ON BEEF P $10 8 6 5 4 2 Demand- Elastic Supply- Unitary S $2 TAX on Producers D 8 10 Q 90

EXCISE TAX ON BEEF P $10 S 1 P c P p 8 6 5 4 2 S $2 TAX on Producers DWL? D 7 10 Quantity Falls A lot!!! Q 91

P P consumers = $7 $10 P producers = $4 8 7 6 5 4 2 EXCISE TAX CS After S 1 S 1. Tax per Unit? 2. Total Tax Revenue? 3. Tax paid by consumers? 4. Tax paid by producers? 5. Total spending? 6. Revenue for businesses? D 20 30 Q 92

P P consumers = $7 $10 P producers = $4 8 7 6 5 4 2 EXCISE TAX CS After S 1 S 1. Tax per Unit = $3 2. Total Tax Revenue = $60 3. Tax Paid by Consumers = $40 4. Tax Paid by Producers = $20 5. Total Spending = $140 6. Revenue for Businesses=$80 D 20 30 Q 93

Tax Incidence (Who pays?) S T D S S T S D S T S D S T S D S T D S Perfectly Inelastic Relatively Inelastic Unit Elastic Relatively Elastic Perfectly Elastic Tax burden paid entirely by consumers Tax burden mostly on consumers Tax burden shared by consumers and producers Tax burden mostly on producers Tax burden paid entirely by producers 94

2008 Audit Exam

Consumer and Producer s Surplus P $10 8 6 $5 4 2 CS Calculate the area of: 1. Consumer Surplus 2. Producer Surplus 3. Total Surplus PS S 1. CS= $25 2. PS= $20 3. Total= $45 1 D 2 4 6 8 10 Q 96

Unit 2: Supply, Demand, and Consumer Choice 97

Government Involvement #1-Price Controls: Floors and Ceilings #2-Import Quotas #3-Subsidies #4-Excise Taxes 98

#1-PRICE CONTROLS Who likes the idea of having a price ceiling on gas so prices will never go over $2 per gallon? 99

Maximum legal price a seller can charge for a product. Goal: Make affordable by keeping price from reaching Eq. Does this policy help consumers? Result: BLACK MARKETS P $5 4 3 2 1 Price Ceiling Gasoline Shortage (Qd>Qs) S To have an effect, a price ceiling must be below equilibrium Price Ceiling D o Q 10 20 30 40 50 60 70 80 100

Price Floor Minimum legal price a seller can sell a product. Goal: Keep price high by keeping price from falling to Eq. P Corn $ S Surplus To have (Qd<Qs) an effect, 4 a price floor must be 3 Price Floor Does this policy help corn producers? above equilibrium 2 1 D o Q 10 20 30 40 50 60 70 80 101

Practice Questions 1. Which of the following will occur if a legal price floor is placed on a good below its free market equilibrium? A. Surpluses will develop B. Shortages will develop C. Underground markets will develop D. The equilibrium price will ration the good E. The quantity sold will increase 2. Which of the following statements about price control is true? A. A price ceiling causes a shortage if the ceiling price is above the equilibrium price B. A price floor causes a surplus if the price floor is below the equilibrium price C. Price ceilings and price floors result in a misallocation of resources D. Price floors above equilibrium cause a shortage 102

Are Price Controls Good or Bad? To be efficient a market must maximize consumer and producer surplus P S Price FLOOR P c CS PS DEADWEIGHT LOSS The Lost CS and PS. INEFFICIENT! D Q floor Q e Q 103

Are Price Controls Good or Bad? To be efficient a market must maximize consumer and producer surplus P S CS P c PS D Q e 104

Are Price Controls Good or Bad? To be efficient a market must maximize consumer and producer surplus P S CS P c PS D Q e 105

Are Price Controls Good or Bad? To be efficient a market must maximize consumer and producer surplus P S P c Price CEILING CS PS DEADWEIGHT LOSS The Lost CS and PS. INEFFICIENT! D Q ceiling Q e 106

#2 Import Quotas A quota is a limit on number of imports. The government sets the maximum amount that can come in the country. Purpose: To protect domestic producers from a cheaper world price. To prevent domestic unemployment 110

International Trade and Quotas Identify the following: 1. CS with no trade 2. PS with no trade 3. CS if we trade at world price (P W ) 4. PS (domestic) if we trade at world price (P W ) 5. Amount we import at world price (P W ) This graphs show the domestic supply and demand for grain. The letters represent area. 6. If the government sets a quota on imports of Q 4 - Q 2, what happens to CS and PS?

#3 Subsidies The government gives producers money. The goal is for them to make more of the goods that the government thinks are important. Ex: Agriculture (to prevent famine) Pharmaceutical Companies Environmentally Safe Vehicles FAFSA 112

Result of Subsidies to Corn Producers Price of Corn S S Subsidy P e P 1 Price Down Quantity Increases Everyone Wins, Right? D o Q e Q 1 Q Quantity of Corn 113

114

#4 Excise Taxes Excise Tax = A per unit tax on producers For every unit made, the producer must pay $ NOT a Lump Sum (one time only)tax The goal is for them to make less of the goods that the government deems dangerous or unwanted. Ex: Cigarettes sin tax Alcohol sin tax Tariffs on imported goods Environmentally Unsafe Products Etc. 115

Excise Taxes Supply Schedule P Qs $5 140 $4 120 $3 100 $2 80 P $5 4 3 2 Government sets a $2 per unit tax on Cigarettes S $1 60 1 D o 40 60 80 100 120 140 Q 116

Excise Taxes Supply Schedule P Qs $5 $7 140 $4 $6 120 $3 $5 100 $2 $4 80 P $5 4 3 2 Government sets a $2 per unit tax on Cigarettes S $1 $3 60 1 D o 40 60 80 100 120 140 Q 117

Supply Schedule P Qs $5 $7 140 $4 $6 120 $3 $5 100 $2 $4 80 Excise Taxes P $5 4 3 2 S Tax S Tax is the vertical distance between supply curves $1 $3 60 1 D o 40 60 80 100 120 140 Q 118

120

Tax Practice 1. CS Before Tax 2. PS Before Tax 3. CS After Tax 4. PS After Tax 5. Tax Revenue for Government 6. Dead Weight Loss due to tax 7. Amount of tax revenue producers pay 121

P Excise Tax S $14 12 11 8 D 10 12 Q

P $14 Excise Tax S tax S Answers 1. $3 2. $30 3. $20 4. $10 5. $140 6. $110 12 11 8 D 10 12 Q

P $8 $6 $5 $4 $2 Excise Tax D 6 9 S tax S Calculate 1. CS Before Tax 2. PS Before Tax 3. Total Surplus Before Tax 4. CS After Tax 5. PS After Tax 6. Tax Revenue to the Government 7. Dead Weight Loss After Tax 8. Between the two points, is demand inelastic, elastic, or unit elastic? Q

P $8 $6 $5 $4 $2 Excise Tax D S tax S Answers 1. $13.5 2. $13.5 3. $27 4. $6 5. $6 6. $12 7. $3 8. Relatively elastic Total Revenue Test $5x9=$45 $6X6=$36 Price went up and TR went down 6 9 Q

THE LAW OF DEMAND SAYS... Consumers will buy more when prices go down and less when prices go up HOW MUCH MORE OR LESS? DOES IT MATTER? 127

Elasticity Elasticity shows how sensitive quantity is to a change in price.

4 Types of Elasticity 1. Elasticity of Demand 2. Elasticity of Supply 3. Cross-Price Elasticity (Substitutes vs. Complementary) 4. Income Elasticity (Normal or Inferior)

Price Elasticity of Demand (PED) Price Elasticity of Demand- Measurement of consumers responsiveness to a change in price. What will happen if price increase? How much will it effect Quantity Demanded Who cares? Used by firms to help determine prices and sales Used by the government to decide how to tax

Inelastic

Inelastic Demand INelastic Demand= Quantity is INsensitive to a change in price. If price increases, quantity demanded will fall a little If price decreases, quantity demanded increases a little. In other words, people will continue to buy it. Examples: Gasoline Milk Diapers 20% 5% A INELASTIC demand curve is steep! (looks like an I ) Chewing Gum Medical Care Toilet paper

Inelastic Demand General Characteristics of INelastic Goods: Few Substitutes Necessities Small portion of income Required now, rather than later Elasticity coefficient less than 1 20% 5%

Elastic

Elastic Demand Elastic Demand = Quantity is sensitive to a change in price. If price increases, quantity demanded will fall a lot If price decreases, quantity demanded increases a lot. In other words, the amount people buy is sensitive to price. Copyright ACDC Leadership 2015 An ELASTIC demand curve is flat! Examples: Soda Boats Beef Real Estate Pizza Gold

Elastic Demand General Characteristics of Elastic Goods: Many Substitutes Luxuries Large portion of income Plenty of time to decide Elasticity coefficient greater than 1

Elastic or Inelastic? Beef- Gasoline- Real Estate- Medical Care- Electricity- Gold- Elastic- 1.27 INelastic -.20 Elastic- 1.60 INelastic -.31 INelastic -.13 Elastic - 2.6 What about the demand for insulin for diabetics? What if % change in quantity demanded equals % change in price? Perfectly INELASTIC (Coefficient = 0) Unit Elastic (Coefficient =1) 45 Degrees

Elasticity Visualized D D D D D D Perfectly Inelastic Relatively Inelastic Unit Elastic Relatively Elastic Perfectly Elastic Elasticity Coefficient Elasticity Coefficient Elasticity Coefficient Elasticity Coefficient Elasticity Coefficient 0 <1 1 >1 138

Total Revenue (P x Q) Relatively Inelastic Relatively Elastic S 1 S S 1 S D D 1. What happens to quantity for each when price increases? 2. What happens to total revenue for each when price increases? 139

Total Revenue Test Uses elasticity to show how changes in price will affect total revenue (TR). Ex: If the demand for gas is inelastic, what will happen to total revenue for gas stations if price increases? Inelastic Demand- Price increase causes TR to increase Price decrease causes TR to decrease Elastic Demand- Price increase causes TR to decrease Price decrease causes TR to increase Unit Elastic- Price changes and TR remains unchanged

Is the range between A and B, elastic, inelastic, or unit elastic? 10 x 100 =$1000 Total Revenue 5 x 225 =$1125 Total Revenue 50% A B Price decreased and TR increased, so Demand is ELASTIC 125%

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Cross-Price Elasticity of Demand Cross-Price elasticity of demand shows how sensitive a product is to a change in price of another good It shows if two goods are substitutes or complements % change in quantity of product b % change in price of product a P increases 20% Q increases 40% Q decreases 40% If coefficient is positive (shows direct relationship) then the goods are substitutes If coefficient is negative (shows inverse relationship) then the goods are complements

2008 udit Question 34

2010 Question 6 145

Income-Elasticity of Demand Income elasticity of demand shows how sensitive a product is to a change in INCOME It shows if goods are normal or inferior % change in quantity % change in income Income increases 20%, and quantity decreases 15% then the good is a INFERIOR GOOD If coefficient is positive (shows direct relationship) then the good is normal If coefficient is negative (shows inverse relationship) then the good is inferior Ex: If income falls 10% and quantity falls 20%

Practice Questions 1. If the cross price elasticity coefficient of goods A and B is -5 and the income elasticity of good A is 2, which of the following is true? A. A decrease in the price of good A will decrease the demand for good B B. An increase in income will decrease the demand for good A C. Goods A and B are substitutes D. Good B is an inferior good E. An increase in the price of A will decrease the demand for good B 147

Price Elasticity of Supply Price Elasticity of Supply- Elasticity of supply shows how sensitive producers are to a change in price. Elasticity of supply is based on time limitations. Producers need time to produce more. INelastic = Insensitive to a change in price (Steep curve) Most goods have INelastic supply in the short-run Elastic = Sensitive to a change in price (Flat curve) Most goods have elastic supply in the long-run Perfectly Inelastic Supply= Q doesn t change Set quantity supplied (Vertical line)

Practice Questions 1. Which of the following must be true for original Michelangelo sculptures? A. The demand is relatively elastic B. The supply is perfectly elastic C. The demand is perfectly inelastic D. The supply is perfectly inelastic E. The demand is perfectly elastic 149

Practice 150

1996 Micro FRQ #2 The Toledo arena holds a maximum of 40,000 people. Each year the circus performs in front of a sold out crowd. (a) Analyze the effect on each of the following of the addition of a fantastic new death-defying trapeze act that increases the demand for tickets. (i)the price of tickets (ii)the quantity of tickets sold (b) The city of Toledo institutes an effective price ceiling on tickets. Explain where the price ceiling would be set. Explain the impact of the ceiling on each of the following. (i) The quantity of tickets demanded (ii) The quantity of tickets supplied (c) Will everyone who attends the circus pay the ceiling price set by the city of Toledo. Why or why not? 151

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Consumer Choice and Utility Maximization 154

Thinking at the Margin # Times Watching Movie Marginal Utility Price 1st $30 $10 2nd $15 $10 3rd $5 $10 Total $50 $30 Would you see the movie three times? Notice that the total benefit is more than the total cost but you would NOT watch the movie the 3 rd time.

Calculate Marginal Utility # of Slices of Pizza Total Utility (in dollars) 0 0 1 8 2 14 3 19 4 23 5 25 6 26 7 26 Marginal Utility/Benefit 8 24 How many pizzas would you buy if the price per slice was $2? 156

Calculate Marginal Utility # of Slices of Pizza Total Utility (in dollars) Marginal Utility/Benefit 0 0 0 1 8 8 2 14 6 3 19 5 4 23 4 5 25 2 6 26 1 7 26 0 8 24-2 Marginal Cost How many pizzas would you buy if the price per slice was $2? $2 $2 $2 $2 $2 $2 $2 $2 $2 157

Calculate Marginal Utility # of Slices of Pizza Total Utility (in dollars) Marginal Utility/Benefit 0 0 0 You will continue to 1 8 8 2 14 6 consume until 3 19 5 Marginal Benefit = 4 23 4 5 25 2 Marginal Cost 6 26 1 7 26 0 8 24-2 Marginal Cost How many pizzas would you buy if the price per slice was $2? 2 2 2 2 2 2 2 2 2 158

CONSUMER BEHAVIOR You plan to take a vacation and want to maximize your utility. Based on the information below, which should you choose? Destination Marginal Utility (In Utils) Price Tahiti 3000 $3,000 Chicago 1000 $500 Marginal Utility Per Dollar 1 Util 2 Utils 159

CONSUMER BEHAVIOR You plan to take a vacation and want to maximize your utility. Based on the info below, which should you choose? Destination Marginal Utility (In Utils) Price Tahiti 3000 $3,000 Chicago 1000 $500 Marginal Utility Per Dollar 1 Util 2 Utils Calculating Marginal Utility Per Dollar allows you to compare products with different prices. 160

$10 $5 Utility Maximization # Times Going Marginal Utility (Movies) MU/P (Price =$10) Marginal Utility (Go Carts) 1st 30 10 2nd 20 5 3rd 10 2 4th 5 1 MU/P (Price =$5) If you only have $25, what combination of movies and go carts maximizes your utility?

$10 $5 Utility Maximization # Times Going Marginal Utility (Movies) MU/P (Price =$10) Marginal Utility (Go Carts) MU/P (Price =$5) 1st 30 $3 10 $2 2nd 20 $2 5 $1 3rd 10 $1 2 $.40 4th 5 $.50 1 $.20 If you only have $25, what combination of movies and go carts maximizes your utility?

Utility Maximizing Rule The consumer s money should be spent so that the marginal utility per dollar of each good equals each other. MUx = MUy P x P y Assume apples cost $1 each and oranges cost $2 each. If the consumer has $7, identify the combination that maximizes utility. 165

2008 Audit Exam

Utility Maximizing Rule The utility maximizing rule assumes that you always consume where MU/P for each product is equal 169