Jocelyn Tan 2006518281 Study Note 5, 6, & 7 PDF

Jocelyn Tan (2006518281)
💸
Mr. Armand Omar Moies
Intro to Economics - Study note 5, 6, & 7
Elasticity and Taxation
Defining and Measuring Elasticity 🌸

1
Elasticity → a general measure of responsiveness that can be used to answer such questions.
2
Price elasticity of demand → the ratio of the percent change in the quantity demanded to the
percent change in the price as it moves along the demand curve.
Calculating the Price Elasticity of Demand 🔮

First Method
Change in quantity demanded
% change in quantity demanded = Initial quantity demanded x 100
Change in price
% change in price = Initial price x 100
Law of demand 💢
“Demand curves are downward sloping, so price and quantity demanded always move in
opposite directions.”
Second Method (Midpoint)

Change in X
% change in X = Average value of X x 100
Starting value of X + F inal value of X

The average value of X = 2
Interpreting the Price Elasticity of Demand 🐳

Perfectly Inelastic vs Perfectly Elastic
Perfectly Inelastic when

↪ the quantity demanded does not respond at all to changes in the price (demand curve is a
vertical line).
Perfectly Elastic when
↪ any price increase will cause the quantity demanded to drop to zero (demand curve is a
horizontal line).
Demand is elastic if the price elasticity of demand is > 1, inelastic if the price elasticity of
demand is < 1, and unit-elastic if the price elasticity of demand = 1.
Total revenue → the total value of sales of a good or service.
Total revenue = Price x Quantity sold
When a seller raises the price of a good, 2 countervailing effects are:

1. A price effect
After a price increase, each unit sold sells at a higher price (tends to raise revenue).
2. A quantity effect
After a price increase, fewer units are sold (tends to lower revenue).
The price elasticity of demand tells about what happens to total revenue due to the price effect
and quantity effect.
● Demand is unit-elastic (price elasticity =1), an increase in price does not change total
revenue; quantity effect and price effect exactly offset each other.
● Demand is inelastic (price elasticity <1), a higher price increases total revenue; the
price effect is stronger than the quantity effect.
● Demand is elastic (price elasticity >1), an increase in price reduces total revenue; the
quantity effect is stronger than the price effect.
In conclusion,
Unit-elastic → the two effects exactly balance (a fall in price has no effect on total revenue).
Inelastic → the price effect dominates the quantity effect (a fall in price reduces total revenue).
Elastic → the quantity effect dominates the price effect (a fall in price increases total revenue).
🌀
Price Elasticity Along the Demand Curve
What factors determine the price elasticity of demand?

● The Availability of Close Substitutes
● Whether the Good Is a Necessity of a Luxury
● Share of Income Spent on the Good
● Time Elapsed Since Price Change
The Cross-Price Elasticity of Demand ❎

3
Cross-price elasticity of demand → measure the effect of the change in one good’s price on the
quantity demanded of the other goods.
The cross-price elasticity of demand between goods A and B

% change in quantity of A demanded
= % change in price of B
4
Income elasticity of demand → the percent change in the quantity of a good demanded when a
consumer’s income changes divided by the percent change in the consumer’s income.
The income elasticity of demand

% change in quantity demanded
= % change in income
Definitions relate directly to the sign of the income elasticity of demand

❖ When the income elasticity of demand is positive, the good is a normal good (the
quantity demanded increases, income increases).
❖ When the income elasticity of demand is negative, the good is an inferior good (the
quantity demanded decreases, income increases).
Income-elastic = if the income elasticity of demand for that good is greater than 1.
Income-inelastic = if the income elasticity of demand for that good is less than 1.
The Price Elasticity of Supply 🔆

5
Price elasticity of supply → a measure of the responsiveness of the quantity of a good supplied
to the price of that good.
% change in quantity supplied

Price elasticity of supply = % change in price
Perfectly inelastic supply when

↪ the price elasticity of supply is zero so that change in price has no effect on the quantity
supplied (vertical line).
Perfectly elastic supply when

↪ a tiny increase/reduction in the price will lead to very large changes in the quantity supplied so
the price elasticity of supply is infinite (horizontal line).
What factors determine the price elasticity of supply?

❖ The availability of inputs
❖ Time
The Benefits and Costs of Taxation 💥

Tax revenue = Area of the shaded rectangle
Principle
“The revenue collected by an excise tax is equal to the area of the rectangle whose height is the
tax wedge between the supply and demand curves and whose width is the quantity transacted
under the tax.”
6
Tax rate → the amount of tax people are required to pay per unit of whatever is being taxed.
The tax revenue generated by a tax depends on the tax rate and on the number of units
transacted with the tax.
🍎
The Costs of Taxation
Excise taxes cause inefficiency in the form of deadweight loss because they discourage some
mutually beneficial transactions.
7
Administrative costs → the resources used by the government to collect the tax, and by
taxpayers to pay it, over and above the amount of the tax, as well as to evade it.
The deadweight loss from an excise tax arises because it prevents some mutually beneficial
transactions from occurring.
The larger the number of transactions that are prevented by the tax, the larger the deadweight
loss.
📈
Behind the Supply Curve: Inputs and Costs

The Production Function 📕
1
Production function → the relationship between the quantity of inputs a firm uses and the
quantity of output it produces.
A firm’s production function underlies its cost curves.
2
Fixed input → an input whose quantity is fixed for a period of time and cannot be varied.
3
Variable input → an input where whose quantity the firm can vary at any time.
4
Long run → the time period in which all inputs can be varied.
5
Short run → the time period in which at least one input is fixed.
6
Total product curve → how the quantity of output depends on the quantity of the variable input,
for a given quantity of the fixed input.
7
Marginal product (of an input) → the additional quantity of output that is produced by using one
more unit of that input.
The marginal product of labor = Change in quantity of output produced by one additional unit of
labor
Change in quantity of output

Marginal product of labor = Change in quantity of labor
Q
MPL = L
There are “diminishing returns to an input” when

↳ an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a
decline in the marginal product of that input.
“Other things equal” proposition

Each successive unit of input will raise production less than the last if the quantity of all other
inputs is held fixed.
From the Production Function to Cost Curves 🍊

8
Fixed cost (FC) → a cost that does not depend on the quantity of output produced (cost of the
fixed input).
Fixed cost = “overhead cost”
9
Variable cost (VC) → a cost that depends on the quantity of output produced (cost of the
variable input).
10
Total cost (TC) → the sum of the fixed cost and the variable cost of producing that quantity of
output.
Total cost = Fixed cost + Variable cost ( TC = FC + VC)

Marginal Cost and Average Cost 🌝

11
Marginal cost → the additional cost incurred by producing one more unit of that good/service.
Change in total cost

Marginal cost = Change in quantity of output
MC = TQC
12
Average cost → total cost divided by quantity of output produced.
T otal cost TC
ATC = Quantity of output = Q
U-shaped average total cost curve falls at low levels of output, then rises at higher levels.
13
Average fixed cost → the fixed cost per unit of output.
14
Average variable cost → the variable cost per unit of output.
F ixed cost FC
AFC = Quantity of output = Q
V ariable cost VC
AVC = Quantity of output = Q
The increasing output has 2 opposing effects on average total cost:

● The spreading effect
The larger the output, the greater the quantity of output over which fixed cost is spread,
leading to lower average fixed cost.
● The diminishing returns effect
The larger the output, the greater the amount of variable input required to produce
additional units, leading to higher average variable cost.
15
Minimum Average Total Cost → the quantity of output at which average total cost is
lowest—the bottom of the U-shaped average total cost curve.
❖ At the minimum-cost output, average total cost is equal to marginal cost.

❖ At output less than the minimum-cost output, marginal cost is less than average total
cost and average total cost is falling.
❖ At output greater than the minimum-cost output, marginal cost is greater than average
total cost and average total cost is rising.
🐢
Short-Run vs Long-Run Costs
In the long run, a producer can change its fixed input and its level of fixed cost. By accepting
higher fixed cost, a firm can lower its variable cost for any given output level, and vice versa.
16
Long-run average total cost curve → the relationship between output and average total cost
when fixed cost has been chosen to minimize average total cost for each level of output.
Returns to Scale❄
Increasing, Decreasing & Constant returns to scale
Increasing returns to scale (economies of scale)

↪ when long-run average total cost declines as output increases.
Decreasing returns to scale (diseconomies of scale)

↪ when long-run average total cost increases as output increases.
Constant returns to scale

↪ when long-run average total cost is constant as output increases.
Sources of increasing return:

1. Specialization
A larger scale of operation means that individual workers can limit themselves to more
specialized tasks, becoming more skilled and efficient at doing them.
2. Large initial setup cost
Some industries (auto manufacturing, electricity generating, or petroleum refining)
incurring a high fixed cost in the form of plant and equipment is necessary to produce
any output.
3. Software development (network externality)

When the value of the good to an individual is greater when a large number of other
people also use that good.
🏅
Perfect Competition and the Supply Curve
1
Price-taking producer → a producer whose actions have no effect on the market price of the
good or service it sells.
2
Price-taking consumer → a consumer whose actions have no effect on the market price of the
good or service a person buys.
Defining Perfect Competition 🐨

3
Perfectly competitive market → a market in which all market participants are price-takers.
4
Perfectly competitive industry → an industry in which producers are price-takers.
Two Necessary Conditions for Perfect Competition
1. It must contain many producers, none of whom has a large market share.
Market share → the fraction of the total industry output accounted for by that producer’s
output.
2. The industry output is a standardized product (commodity).
Standardized product → when consumers regard
An industry has free entry and exit

↪ when new producers easily enter into an industry and existing producers can easily leave that
industry.
🌹
Production and Profits
Total revenue (TR) = market price (P) x quantity of output (Q)
Profit = total revenue (TR) - total cost (TC)
5
Marginal benefit → the additional benefit derived from producing one more unit of that good or
service.
Principle of marginal analysis

“The optimal amount of an activity is the quantity at which marginal benefit equals marginal
cost.”
6
Marginal revenue → the change in total revenue generated by an additional unit of output.
Change in total revenue

Marginal revenue = Change in quantity of output
MR = TQR
Based on optimal output rule,

↪ profit is maximized by producing the quantity of output at which the marginal revenue of the
last unit produced is equal to its marginal cost.
Based on the price-taking firm’s optimal output rule,

↪ a price-taking firm’s profit is maximized by producing the quantity of output at which the market
price is equal to the marginal cost of the last unit produced.
Marginal revenue curve = how marginal revenue varies as output varies.
In effect, the individual firm faces a horizontal, perfectly elastic demand curve for its output—an
individual demand curve for its output that is equivalent to its marginal revenue curve.
7
Economic profit → revenue minus the opportunity cost of resources used.
8
Explicit cost → a cost that requires an outlay of money.
9
Implicit cost → a cost that does not require an outlay of money; measured by the value, in
dollar terms, of benefits that are forgone.
10
Accounting profit → equal to revenue minus explicit cost (usually larger than economic profit).
● The firm is profitable when the firm produces a quantity at which TR > TC.
● The firm breaks even when the firm produces a quantity at which TR = TC.
● The firm incurs a loss when the firm produces a quantity at which TR < TC.
P rof it TR TC
Q
= Q (average revenue) x Q (average total cost)
❖ The firm is profitable when the firm produces a quantity at which P > ATC.
❖ The firm breaks even when the firm produces a quantity at which P = ATC.
❖ The firm incurs a loss when the firm produces a quantity at which P < ATC.
Profit = TR x TC = (P ATC) x Q
11
Break-even price → the market price at which it earns zero profit.
➢ The producer is profitable when the market price exceeds minimum average total cost.
➢ The producer breaks even when the market price equals minimum average total cost.
➢ The producer is unprofitable when the market price is less than minimum average total
cost.
🚙
The Short-Run Production Decision
Consideration of 2 cases:
1. When the market price is below minimum average variable cost.
2. When the market price is greater than or equal to minimum average variable cost.
A firm will cease production in the short run if the market price falls below the shut-down price.
Shut-down price = minimum average variable cost.
12
Sunk cost → a cost that has already been incurred and is nonrecoverable.
A sunk cost should be ignored in decisions about future actions.
13
Short-run individual supply curve → how an individual producer’s profit-maximizing output
quantity depends on the market price, tacking fixed cost as given.
The Industry Supply Curve ⛵

14
Industry supply curve → the relationship between the price of a good and the total output of
the industry as a whole.
15
Short-run industry supply curve → the quantity supplied by an industry depends on the market
price given a fixed number of producers.
16
Short-run market equilibrium → the quantity supplied equals the quantity demanded, taking
the number of producers as given.
17
Long-run market equilibrium → the quantity supplied equals the quantity demanded, given that
sufficient time has elapsed for entry into and exit from the industry to occur.
18
Long-run industry supply curve → the quantity supplied responds to the price once producers
have had time to enter or exit the industry.
In the long-run market equilibrium of a competitive industry, profit maximization leads each firm
to produce at the same marginal cost (equal to market price).
Free entry and exit → each firm earns zero economic profit—producing the output
corresponding to its minimum average total cost.

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Jocelyn Tan (2006518281)

Elasticity and Taxation

Defining and Measuring Elasticity​ 🌸

Calculating the Price Elasticity of Demand​ 🔮

Second Method (Midpoint)

Starting value of X + F inal value of X

Interpreting the Price Elasticity of Demand​ 🐳

Perfectly Inelastic when

Total revenue → the total value of sales of a good or service.

Total revenue = Price x Quantity sold

When a seller raises the price of a good, 2 countervailing effects are:

Price Elasticity Along the Demand Curve​

What factors determine the price elasticity of demand?

The Cross-Price Elasticity of Demand​ ❎

The cross-price elasticity of demand between goods A and B

The income elasticity of demand

Definitions relate directly to the sign of the income elasticity of demand

The Price Elasticity of Supply​ 🔆

% change in quantity supplied

Perfectly inelastic supply when

Perfectly elastic supply when

What factors determine the price elasticity of supply?

The Benefits and Costs of Taxation​ 💥

The Costs of Taxation​

Behind the Supply Curve: Inputs and Costs​

A firm’s production function underlies its cost curves.

Change in quantity of output

There are “diminishing returns to an input” when

“Other things equal” proposition

From the Production Function to Cost Curves​ 🍊

Fixed cost = “overhead cost”

Total cost = Fixed cost + Variable cost ( TC = FC + VC)

Marginal Cost and Average Cost​ 🌝

Change in total cost

The increasing output has 2 opposing effects on average total cost:

❖ At the minimum-cost output, average total cost is equal to marginal cost.

Short-Run vs Long-Run Costs​

Increasing, Decreasing & Constant returns to scale

Increasing returns to scale (economies of scale)

Decreasing returns to scale (diseconomies of scale)

Constant returns to scale

Sources of increasing return:

3. Software development (network externality)

Perfect Competition and the Supply Curve​

Defining Perfect Competition​ 🐨

Two Necessary Conditions for Perfect Competition

An industry has free entry and exit

Production and Profits​

Total revenue (TR) = market price (P) x quantity of output (Q)

Profit = total revenue (TR) - total cost (TC)

Principle of marginal analysis

Change in total revenue

Based on optimal output rule,

Based on the price-taking firm’s optimal output rule,

Marginal revenue curve = how marginal revenue varies as output varies.

The Short-Run Production Decision​

Shut-down price = minimum average variable cost.

A sunk cost should be ignored in decisions about future actions.

The Industry Supply Curve​ ⛵

You might also like

Defining and Measuring Elasticity 🌸

Calculating the Price Elasticity of Demand 🔮

Interpreting the Price Elasticity of Demand 🐳

Price Elasticity Along the Demand Curve

The Cross-Price Elasticity of Demand ❎

The Price Elasticity of Supply 🔆

The Benefits and Costs of Taxation 💥

The Costs of Taxation

Behind the Supply Curve: Inputs and Costs

From the Production Function to Cost Curves 🍊

Marginal Cost and Average Cost 🌝

Short-Run vs Long-Run Costs

Perfect Competition and the Supply Curve

Defining Perfect Competition 🐨

Production and Profits

The Short-Run Production Decision

The Industry Supply Curve ⛵