PPA 723: Managerial Economics

1. PPA 723: Managerial Economics Lecture 4: Applications of Supply and Demand

2. Managerial Economics, Lecture 4: Applications of S&D Outline • Elasticities • Tax Incidence • Rent Control

3. Managerial Economics, Lecture 4: Applications of S&D Another Dimension of Demand and Supply: Responsiveness • The slope of a demand curve equals: • The inverse of the slope indicates the magnitude of the response to price. • A more responsive curve (flatter slope) generally means more alternatives in other markets.

4. Managerial Economics, Lecture 4: Applications of S&D Elasticity • The elasticity of demand equals: • The absolute value of the elasticity indicates the magnitude of the response to price. • The value of the elasticity varies along a linear demand curve.

5. P Slope = “rise”/“run” = P/Q < 0 P1 P Elasticity = (Q/Q1)/(P/P1) < 0 Q D Q1 Q Q Managerial Economics, Lecture 4: Applications of S&D Slope and Elasticity

6. P P P2 S2 P2 S2 P1 S1 P1 S1 D D Q2 Q1 Q Q2 Q1 Q Large Elasticity (│e│) = Responsive Demand Small Elasticity (│e│) = Unresponsive Demand Managerial Economics, Lecture 4: Applications of S&D Large and Small Elasticities

7. Managerial Economics, Lecture 4: Applications of S&D Figure 3.3c Vertical and Horizontal Demand Curves (c) Individual ’ s Demand for Insulin p * p, Price of insulin dose (doses per day) Q * Q , Insulin

8. Managerial Economics, Lecture 4: Applications of S&D Figure 3.2 Elasticity Along the Pork Demand Curve Perfectly Elastic: e = - ∞ P ($ per kg) a / b = 14.30 Elastic: e < -1 11.44 = – 4 e e = (Q/Q)/(P/P) = (PQ)/(QP) D Unitary: e = -1 a /(2 b ) = 7.15 Inelastic: 0 > e > -1 -P = P Perfectly Inelastic: e = 0 3.30 = – 0.3 e Q = Q 0 a / 5 = 57.2 a / 2 = 143 220 a = 286 Q (Mil. kg of pork/year)

9. Managerial Economics, Lecture 4: Applications of S&D Figure 3.1 How the Effect of a Supply Shock Depends on the Shape of the Demand Curve (a) (b) (c) 2 D p, $ per kg p, $ per kg p, $ per kg 1 D e e 2 e 2 3.675 3.55 2 3 D 3.30 3.30 3.30 e e e 2 2 S S 1 1 1 2 S 1 S 1 S 1 S 0 176 220 0 176 205 220 0 176 215 220 Q , Million kg of pork per year Q , Million kg of pork per year Q , Million kg of pork per year

10. Managerial Economics, Lecture 4: Applications of S&D Change in Revenue New Revenue e 2 p 2 p, Price per unit e 1 p 1 D Original Revenue Q Q 2 1 Q , Quantity per time period

11. Managerial Economics, Lecture 4: Applications of S&D Elasticity and Revenue

12. Managerial Economics, Lecture 4: Applications of S&D Elasticity and Revenue, Continued • When price increases, • Revenue increases if demand is inelastic(|e| < 1) • Revenue decreases if demand is elastic(|e| > 1)

13. Managerial Economics, Lecture 4: Applications of S&D Figure 3.4 Elasticity Along the Pork Supply Curve S P ($ per kg) 5.30 ≈ 0.71 h 4.30 ≈ 0.66 h 3.30 ≈ 0.6 h 2.20 ≈ 0.5 h 0 176 220 260 300 Q (Million kg of pork per year)

14. Managerial Economics, Lecture 4: Applications of S&D Tax Incidence • A key question about taxes is: Who pays? • To answer, must distinguish between: • Legal Incidence, which indicates who is legally obligated to write the check to the government. • Economic Incidence, which indicates whose real income declines due to the tax. • They may not be the same due to tax shifting.

15. The Analysis of Tax Incidence P S + tax S P2 tax Burden on consumers P1 Burden on firms P3 D Q Managerial Economics, Lecture 4: Applications of S&D

16. Managerial Economics, Lecture 4: Applications of S&D Figure 3.5 Effect of a $1.05 Specific Tax on the Pork Market Collected from Producers 2 S p, $ per kg e = $1.05 t 1 2 S p = 4.00 2 e 1 p = 3.30 1 = T $216.3 million p – = 2.95 t 2 D 0 176 Q = 206 Q = 220 2 1 Q , Million kg of pork per year

17. Managerial Economics, Lecture 4: Applications of S&D Figure 3.6 Effect of a $1.05 Specific Tax on Pork Collected from Consumers p, $ per kg e Wedge, = $1.05 t 2 S p = 4.00 2 e 1 p = 3.30 = 1 T $216.3 million p – = 2.95 t 2 = $1.05 t 1 D 2 D 0 176 Q = 206 Q = 220 Q , Million kg of pork per year 2 1

18. Managerial Economics, Lecture 4: Applications of S&D Page 64 Solved Problem 3.1 e 2 2 p = p + 1 S 2 1 p, Price per unit = $1 t e 1 1 p S 1 D Q Q 2 1 Q , Quantity per time period

19. Managerial Economics, Lecture 4: Applications of S&D A Land Tax S D R (Rent per Acre) R1 Tax R1-T Q1 Q (Acres of Land)

20. Managerial Economics, Lecture 4: Applications of S&D Lessons • A tax falls most heavily on the side of the market with the lowest elasticity (= fewest alternatives). • Economic incidence is determined by market forces, not by legal incidence.

21. Managerial Economics, Lecture 4: Applications of S&D Rent Control • Housing affordability is a serious issue in this country: • More than half of the poor pay more than half of their income in rent and utilities. • A few cities try to address this through rent controls, i.e., by setting rent ceilings.

22. Managerial Economics, Lecture 4: Applications of S&D Rent Control Short-run S R (Rent) Long-run S e R Rent ceiling R* D Q QS2 Q QS1 d Q (Number of Apartments)

23. Managerial Economics, Lecture 4: Applications of S&D Effects of Rent Control • Fewer apartmentsput on the market • Decline inmaintenanceand hence in the number of quality-adjusted units • Fewer apartmentsconstructed • New rules for allocating units, withthe poor at a disadvantage

24. Managerial Economics, Lecture 4: Applications of S&D Lessons • Public policy can alter prices, but only at great cost. • Market forces are powerful and not easily overcome! • Attempts to alter market outcomes usually have unintended consequences. • The distribution of benefits and costs may be difficult to control