Unit 4: Application of Elasticities Flashcards
Indirect Taxes
mandatory contributions levied on sellers to finance government activities. Sellers are liable by law to pay such a tax. Price increases so that the tax is indirectly paid fully/partially by the customer
e.g. excise duty, VAT
Incidence of tax
Depends on
- PED
- PES
PED>PES (tax)
Sellers’ share of tax burden exceeds that of the buyers as they cannot adjust their supply easily. They bear most of the tax because they cannot increase supply significantly in response to price rise
PED<PES (tax)
Consumers are not very responsive to price changes, hence consumers pay a larger share of the tax burden because they will continue to buy despite price rises.
Tax Illustration
An increase in tax causes the supply curve to shift to the left.
Parallel shift: lump sum tax
Pivot: Percentage tax
Why are taxes imposed?
Taxes are imposed to finance goods which would not be demanded or provided if left to market forces
Why does tax create deadweight loss?
because it distorts the natural functioning of the market by reducing the quantity of goods traded below the socially optimum level. DWL represents the economic inefficiency that occurs due to the tax.
Tax revenue
total amount of money collected by the government through the imposition of taxes
Direct Taxes
taxes levied on income and wealth
Subsidies
payment to individuals/firms from the government to reduce the costs of supplying a commodity. Price consumers pay falls while the price producers receive increases, with the goal of promoting economic activity in specific sectors.
Incidence of a Subsidy
Depends on
- PED
- PES
PED>PES (subsidy)
producers benefit more of the subsidy as consumers are highly responsive to price changes, so the increase in quantity demanded is significant. However, because producers cannot expand production easily, the price received by consumers does not fall much, as they capture a larger share of the subsidy
PED<PES
consumers benefit more from the subsidy as they are less responsive to price changes, so a price decrease leads to a small increase in quantity demanded. Producers can increase production easily which pushes the price further down. As a result, consumers capture more of the subsidy benefit in the form of a lower price.
Subsidy illustration
depicted by a rightwards shift of the supply curve
Why are subsidies given?
subsidies are given to give an incentive to firms to supply a commodity by reducing the cost of producing it
Why does subsidies create deadweight loss?
subsidies create a market outcome where resources are not allocated efficiently. While subsidies benefit both consumers and producers, they also lead to overproduction and overconsumption which reduces overall economic efficiency
Price ceiling (maximum price)
highest price sellers can charge their clients for a commodity
Scope of price ceiling
to protect the vulnerable i.e. low income buyers, from buying items at times of rising prices.
Consequence of price ceiling
Shortage
Extent of shortage
- PED and PES
- Difference between market price and price ceiling
PED and PES (shortage)
Inelastic demand: consumers are less sensitive to price changes, hence a price ceiling leads to a smaller increase in quantity demanded since demand is relatively inelastic. the shortage is smaller because consumers do not drastically increase their demand despite the lower price.
Inelastic supply: producers are less responsive to price changes, hence a price ceiling leads to a smaller decrease in quantity supplied, the shortage is smaller because producers don’t reduce production significantly even at the lower price
Elastic demand: consumers are highly sensitive to price changes, hence a price ceiling leads to a larger increase in quantity demanded, leading to a larger shortage as consumers demand much more at such a low price
Elastic supply: producers are highly sensitive to price changes hence a price ceiling leads to a larger fall in quantity supplied, the shortage is larger as producers drastically reduce production.
Difference between market price and price ceiling
Large gap: high shortage since demand will skyrocket due to the much lower price and supply will drop significantly as producers cannot cover costs or make profits
Small gap: small shortage as demand increases only slightly and supply only falls by a little since producers can still cover some costs and maybe even make a small profit
Price ceiling impact on society
CS: some people being at the right place and at the right time get a product at a cheaper price, others cannot attain it given the shortage
PS: sellers still selling get a lower price, the can sell all they want to sell given the shortage
DWL: market cannot reach equilibrium, since quantity supplied is less than the quantity demanded resulting in unmet consumer needs and producer losses. Society suffers as resources are not being used efficiently
How is supply rationed out during a shortage
- First come first served basis
- Discrimination
- Friendship
- Black market
- Coupons
Illustration of a price ceiling
horizontal line below market equilibrium
Applications of price ceiling
rent control, essential food items, fuel prices, medicine and healthcare services, utilities, public transport, education
Price floor (minimum price)
lowest price sellers can charge their clients for a commodity
Scope of price floor
to protect suppliers at times when equilibrium prices tend to fall due to fluctuations in demand or supply
Consequences of price floors
surplus
Extent of surplus
depends on
- PED and PES
- Difference between market price and price floor
- short run vs long run
- government intervention
PED and PES (surplus)
Inelastic demand: consumers are less sensitive to price changes, hence a price floor leads to a smaller fall in quantity demanded since demand is relatively inelastic. the surplus is smaller because consumers do not drastically decrease their demand despite the higher price.
Inelastic supply: producers are less responsive to price changes, hence a price floor leads to a smaller increase in quantity supplied, the surplus is smaller because producers don’t increase production significantly even at the higher price
Elastic demand: consumers are highly sensitive to price changes, hence a price floor leads to a larger fall in quantity demanded, leading to a larger surplus as consumers demand much less at such a high price
Elastic supply: producers are highly sensitive to price changes hence a price increase leads to a larger increase in quantity supplied, the surplus is larger as producers drastically ramp up production.
Difference between market price and price floor
Large gap: high surplus since demand will fall due to the much higher price and supply will increase significantly as producers can make larger profits
Small gap: small surplus as demand falls slightly and supply only falls by a little
Short-run vs Long-run (surplus)
Short-run: both demand and supply tend to be more inelastic, hence the surplus is smaller as producers cannot easily adjust production and consumers cannot change consumption
Long-run: both demand and supply are more elastic as producers can adjust production capacities and consumers can find alternatives, hence the surplus becomes larger
Government intervention (surplus)
- purchasing the excess supply to prevent waste and stabilize prices
- store or dispose of surplus
- subsidize exports
- quotas to limit supply
- encourage alternative use for surplus goods
The impact on society of a price floor
A price floor prevents the market from reaching equilibrium reducing total welfare. Some consumers who would have purchased at the market price cannot afford the higher price resulting in lost consumer surplus. Producers overproduce creating goods that society does not need, leading to inefficiencies
Applications of price floors
Minimum wage legislation, agricultural policy, alcohol and tobacco prices, international trade, renewable energy, airline pricing, fishing industry, education
