Mocroeconomics Notes Week2 Presentation

Fundamentals of Microeconomics
Vikas Gupta
Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 1
Price Elasticity of Demand
• The price elasticity of demand measures how much the quantity demanded responds to a change in
price. Demand for a good is said to be elastic if the quantity demanded responds substantially to
changes in the price. Demand is said to be inelastic if the quantity demanded responds only slightly to
changes in the price
What influences elasticity of demand:

• Availability of Close Substitutes: Goods with close substitutes tend to have more elastic demand
because it is easier for consumers to switch from that good to others
• Necessities versus Luxuries: Necessities tend to have inelastic demands, whereas luxuries have elastic
demands
• Definition of the Market: The elasticity of demand in any market depends on how we draw the
boundaries of the market. Narrowly defined markets tend to have more elastic demand than broadly
defined markets
• Time Horizon: Goods tend to have more elastic demand over longer time horizons, because people can
switch to substitutes in long run
Calculation of Price Elasticity of Demand
Price elasticity of demand =
Example:
Demand for ice cream is 10 cones when price is $2 per cone. The demand falls to 8 cones when
the price increases to $3 per cone. Calculate the price elasticity of demand?
Elasticity = [(8-10)/10] / [(3-2)/2] = -20%/ 50% = -0.4 ==è Inelastic demand
Note: Elasticity is usually written as absolute numbers (0.4)
Calculation of Price Elasticity of Demand
Now calculate the elasticity when the price falls from $ 3 to $2, and demand increases from 8 to 10
cones. Is the answer again 0.4?
No – the answer now is [(10-8)/8] / [(2-3)/3] = 25% / -33% = -0.75. è Because of change in base case
The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities
Since Elasticity changes at different points on the demand curve (due to denominator changes), it is
very possible that elasticity has different number when P goes from P1 to P2, vs when it goes from P2
to P1. That’s why a Mid Point Method is used to calculate elasticity which uses average price and
average demand (P1+P2)/2 and (D1+D2)/2 as denominators.
Price elasticity of demand = (Q2 - Q1) (P2 - P1)
[(Q2 +Q1)/2] [(P2 + P1)/2]
Types of Elasticity - Varieties of Demand Curves
Price elasticity of demand measures how much quantity demanded responds to changes in the price,
it is closely related to the slope of the demand curve.
Rule of thumb:
• The flatter the demand curve that passes through a given point, the greater the price elasticity of
demand.
• The steeper the demand curve that passes through a given point, the smaller the price elasticity of
demand.
• As Elasticity rises – the Demand curve gets flatter.
• Perfectly Inelastic demand (0) – Demand curve is vertical, no change on Quantity Demanded due
to Price
• Inelastic demand (<1) – Change in Quantity Demanded is less than change in Price
• Unit Elasticity (1) - Change in Quantity Demanded is equal to change in Price
• Elastic demand (>1) - Change in Quantity Demanded is more than change in Price
• Perfectly Elastic demand (infinity) – Demand curve is horizontal, so extremely price sensitive
Demand Curves and Elasticities
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Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition
Total Revenue
Total revenue is the amount paid by buyers and received by sellers of the good. In any market, total
revenue is P * Q, the price of the good times the quantity of the good sold.
Total Revenue and Price Elasticity of Demand
Total Revenue changes as you move along the Demand curve. The shape (elasticity) of Demand curve
determines the changes in Total Revenue.
• When demand is inelastic (a price

elasticity less than 1), price and
total revenue move in the same
direction.
• When demand is elastic (a price
elasticity greater than 1), price
and total revenue move in
opposite directions.
• If demand is unit elastic (a price
elasticity exactly equal to 1), total
revenue remains constant when
the price changes.
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Price Elasticity along Linear Demand Curve
Elasticity varies along a linear Demand Curve - Even though the slope of a linear demand curve is
constant, the elasticity is not. This is true because the slope is the ratio of changes in the two variables,
whereas the elasticity is the ratio of percentage changes in the two variables.
At high Price, low Quantities =
Demand is elastic
At low Price, high Quantities =

Demand is inelastic
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Other Demand Elasticities
Income elasticity of demand - measure of how much the quantity demanded of a good responds to a
change in consumers’ income
For Normal goods - Income elasticity of demand is positive

For Inferior goods - Income elasticity of demand is negative
Cross Price elasticity of demand - measure of how much the quantity demanded of one good
responds to a change in the price of another good
For Substitute goods - Cross price elasticity of demand is positive

For Complement goods - Cross price elasticity of demand is negative
Elasticity of Supply
• The price elasticity of supply measures how much the quantity supplied responds to changes in the
price. Supply of a good is said to be elastic if the quantity supplied responds substantially to
changes in the price. Supply is said to be inelastic if the quantity supplied responds only slightly to
changes in the price
price elasticity of supply =
What Influences elasticity of supply:

• Flexibility of Sellers: to change the supply, which depends on the type of good and investment that
goes in for production of goods
• Time Horizon: Goods tend to have more elastic supply over longer time horizons, because sellers
can adapt to changes by changing production set up and entry/exit to markets
Types of Elasticity - Varieties of Supply Curves
• Price elasticity of supply measures how much quantity supplied responds to changes in the price, it
is closely related to the slope of the supply curve.
Rule of thumb:
• The flatter the supply curve that passes through a given point, the greater the price elasticity of
supply.
• The steeper the supply curve that passes through a given point, the smaller the price elasticity of
supply.
• As Elasticity rises – the Supply curve gets flatter.
• Perfectly Inelastic supply (0) – Supply curve is vertical, no change on Quantity Supplied due to
Price
• Inelastic supply (<1) – Change in Quantity Supplied is less than change in Price
• Unit Elasticity (1) - Change in Quantity Supplied is equal to change in Price
• Elastic supply (>1) - Change in Quantity Supplied is more than change in Price
• Perfectly Elastic supply (infinity) – Supply curve is horizontal, so extremely price sensitive
Supply Curves and Elasticities
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Price Elasticity along the Supply Curve
Elasticity varies along the Supply Curve – The elasticity of Supply is not constant, but varies along the
curve. This is driven by firms’ readiness to increase supply using spare capacity (in case of low quantities),
but for higher quantities it requires bigger investment to increase production capacity.
At low Quantities = Supply is elastic At high Quantities = Supply is inelastic
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Case Study : OPEC (Organization of Petroleum Exporting
Countries)
• 1970s – OPEC cartel decided to raise world oil prices to increase their income. To accomplish this,
they reduced the quantity of oil they supplied.
• 1970-1980 – Price of oil more than doubled, thus more income for OPEC
• 1980-85 – Price of oil declined by 10%, and then OPEC found it hard to maintain their agreement
on supply restrictions
• 1990 – Price (adjusted for inflation) was at par with 1970 price
• 2000s – Price spiked due to Chinese economic boom, fell during 2008-09 economic crisis and then
increased again
Questions:
1. Why did OPEC decide to reduce supply and what effect did it have in short run (5-10 years)?
2. Why was OPEC not able to maintain the advantage over a long run (>10 years)?
3. Draw the Demand and Supply curves for short and long run to explain these occurrences.
Case Study : OPEC (Organization of Petroleum Exporting
Countries)
Government Policies – Controls on Prices
Price Ceiling
• A legal maximum on the price at which a good can be sold. (eg: cap on rent)
• It can be binding (ceiling below the Equilibrium price,) or non-binding (ceiling above the
Equilibrium price).
• When the government imposes a binding price ceiling on a competitive market, a
shortage of the good arises, and sellers must ration the scarce goods among the large
number of potential buyers.
• The rationing mechanisms that develop under price ceilings are rarely desirable. Long
lines are inefficient because they waste buyers’ time. Discrimination according to seller
bias is both inefficient (because the good does not necessarily go to the buyer who
values it most highly) and potentially unfair. By contrast, the rationing mechanism in a
free, competitive market is both efficient and impersonal.
Government Policies – Controls on Prices
Price Floor
• A legal minimum on the price at which a good can be sold. (eg: minimum wage)
• It can be binding (floor above the Equilibrium price,) or non-binding (floor below the
Equilibrium price).
• Binding price floor causes a surplus as the sellers are producing more than the demand.
Just as the shortages resulting from price ceilings can lead to undesirable rationing
mechanisms, so can the surpluses resulting from price floors.
• In the case of a price floor, some sellers are unable to sell all they want at the market
price. The sellers who appeal to the personal biases of the buyers, perhaps due to racial
or familial ties, are better able to sell their goods than those who do not.
• By contrast, in a free market, the price serves as the rationing mechanism, and sellers can
sell all they want at the equilibrium price.
Price Ceiling
Price ceiling if not binding, does not cause any impact on Demand and Supply. But if the ceiling is
binding (price below the equilibrium price) then ceiling prevents price to rise to Equilibrium levels in
case of a supply reduction, thus demand is more than the supply, causing a shortage.
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Exercise - Rent Control
In many cities, the local government places a ceiling on rents that landlords may charge
their tenants. The goal of this policy is to help the poor by making housing more
affordable.
• Is rent control an inefficient way to help the poor raise their standard of living?
• What are the impacts of rent control in short run and long run?
• Draw the Demand and Supply graphs for rent control to explain the short and long run
impact.
• Does this policy benefit the tenants or landlords in the long run?
Note: remember to consider that building additional houses takes time, so in the short run
the supply is fixed, and also people have considerations other than rent to decide where
they would live.
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Exercise – Rent Control
In short run – Demand and
Supply are inelastic, so rent
control helps to reduce rents
In long run –. Supply is elastic

because landlords don’t have
incentive to supply housing at
cheaper rental returns, and
Demand is elastic as lower
rents attract more tenants
Result is
- Housing shortage
- Discrimination in allotment
- Unfair practices
- Reduced quality of housing
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Minimum Wage
Without government
intervention, free market
balances labor supply and
demand
If binding Minimum wages

imposed on labor market,
• Labor supply exceeds
demand, thus increasing
unemployment
• Incentivizes teenagers to
drop out of college to work
• Lack of incentive to upskill,
reduces quality of labor
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Taxes
“In this world nothing can be said to be certain, except death and taxes" - Benjamin Franklin, 1979
Tax incidence - the manner in which the burden of a tax is shared among participants in a
market.
Government taxes individual buyers, sellers, corporates in various forms - income tax,
corporate tax, Goods and Services tax, excise, customs duty, gift tax…
Key Questions
• When the government levies a tax on a good, who actually bears the burden of the tax?
The people buying the good? The people selling the good?
• Or if buyers and sellers share the tax burden, what determines how the burden is
divided?
• Can the government simply legislate the division of the burden, or is the division
determined by more fundamental market forces?
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Tax on Seller
• Tax makes sellers less
motivated to sell so supply
curve shifts left
• New Equilibrium price is
higher (but increase is less
than tax amount)
• Buyers pay higher price,
and Sellers receive less than
before (due to tax they pay
to government)
• Tax burden shared by both
buyer and seller
24
Tax on Buyer
• Tax makes buyers less
motivated to buy so
demand curve shifts left
• New Equilibrium price is
lower (but decrease is less
than tax amount)
• Buyers pay lower price to
seller (plus tax to
government), and sellers
receive less than before
• Tax burden shared by both
buyer and seller
25
Payroll Tax
Payroll tax is levied on both firm and employee (50-50). Consider social security tax (USA), or PF (India)
• Payroll tax places a Tax

Wedge between the wages
firms pay and what
employee receives
• So, the firm pays more and
employee receives less than
if there was no payroll tax
• Outcome would be same
even if entire tax was levied
on employee or firm
26
Tax Burden
• Taxes levied on sellers and taxes levied on buyers are equivalent.
• In both cases, the tax places a wedge between the price that buyers pay and the price
that sellers receive.
• The wedge between the buyers’ price and the sellers’ price is the same, regardless of
whether the tax is levied on buyers or sellers.
• In either case, the wedge shifts the relative position of the supply and demand curves. In
the new equilibrium, buyers and sellers share the burden of the tax.
• The only difference between taxes on sellers and taxes on buyers is who sends the
money to the government.
Question - How is the tax burden divided between Buyers and Seller?
27
How is Tax Burden divided between Buyer and Seller?
• If Supply is more elastic than Demand : Buyer bears more of tax burden
• If Demand is more elastic than Supply : Seller bears more of tax burden
• Elasticity measures willingness to change, so if Supply is elastic, then sellers have
alternatives to sell and so they leave market if tax is high, thus leaving buyers to foot tax
burden. Vice versa if Demand is elastic. 28
Welfare Economics
• Welfare economics - Study of how the allocation of resources affects economic well-
being. The aim is to understand how the society can maximize the total welfare for all
consumers and all producers.
• Consumer Surplus - The amount a buyer is willing to pay for a good minus the amount
the buyer actually pays for it. It measures the perceived benefit of good to the buyer. It is
a good measure of economic well-being from the perspective of buyers.
• Producer Surplus - The amount a seller is paid minus the cost of production. It measures
the benefit sellers receive from participating in a market. It’s the difference between the
price received by the producer minus the cost they put to give their services (called
opportunity cost - the value of everything seller gives up to produce the good).
• Total surplus - The total value to buyers of the goods, as measured by their willingness to
pay, minus the total cost to sellers of providing those goods.
If an allocation of resources maximizes total surplus, we say that the allocation exhibits
efficiency.
The equilibrium of supply and demand in a market maximizes the total benefits received by buyers
and sellers.
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Willingness to Pay
Willingness to Pay is the maximum amount a consumer would pay for the good, or alternatively the price
above which the marginal consumer would be ready to walk away
30
Consumer Surplus
• Height of Demand curve is consumer’s willingness to pay, consumer will buy if price is lower
• At any quantity, the price given by the demand curve shows the willingness to pay of the marginal
buyer, the buyer who would leave the market first if the price were any higher.
• The area below the demand curve and above the price measures the consumer surplus in a market
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Effect of Price on Consumer Surplus
• The area below the demand curve and above the price measures the consumer surplus in a market
• If price reduces from P1 to P2, existing consumer enjoys bigger surplus
• Also, new consumers enter market increasing the total consumer surplus
32
Willingness to Sell
Willingness to Sell is the minimum amount a seller would be ok to receive for the good, or alternatively
the price below which the marginal seller would be ready to walk away
33
Supply Schedule
34
Producer Surplus
• Height of Supply curve is producer’s (seller’s) costs, so seller will sell if price was higher
• At any quantity, the price given by the supply curve shows the cost of the marginal seller, the seller
who would leave the market first if the price were any lower. .
• The area above the supply curve and below the price measures the producer surplus in a market
35
Effect of Price on Producer Surplus
• The area above the supply curve and below the price measures the producer surplus in a market
• If price increases from P1 to P2, existing producer enjoys bigger surplus
• Also, new sellers enter market increasing the total producer surplus
36
Total Surplus
Total Surplus = Consumer
surplus + Producer surplus
So Total Surplus = Value to

buyers - Cost to sellers
The area between

Demand curve and Supply
curve represents the Total
Surplus
If an allocation of
resources maximizes total
surplus, the allocation
exhibits efficiency.
37
Market Equilibrium – the most efficient outcome
1. Free markets allocate the supply of goods to the buyers who value them most highly, as measured by
their willingness to pay.
2. Free markets allocate the demand for goods to the sellers who can produce them at the lowest cost.
3. Free markets produce the quantity of goods that maximizes the sum of consumer and producer
surplus.
The market outcome maximizes the sum of consumer and producer surplus, and so the equilibrium
outcome is an efficient allocation of resources.
However, this is based on two assumptions that may not always be true (causing Market Failures):
1. Markets are perfectly competitive - In many markets, a single buyer or seller (or small group of them)
may control the prices (called Market Power), which makes the markets to be inefficient.
2. Market outcome matters only to Buyers and Sellers - There are other stakeholders that may impact or
be impacted by the market. These side effects (Externalities) make total welfare to be more than just
value of buyers and cost to sellers. So even the efficient equilibrium can be inefficient for society as
whole.
Government policies aim to correct market failures and maximize the welfare for society as a whole
38
Tax Revenue
• Government collects tax revenue which is used for welfare of society as a whole
• Total tax Revenue = Size of Tax * Quantity Sold with tax
• Tax reduces the quantity sold, and price paid by buyers is higher and received by sellers is lower
(than Equilibrium without tax)
39
Taxation and Welfare – Deadweight Loss
Deadweight Loss - The fall in total surplus that results when tax (or some other policy) distorts a market outcome.
• Tax introduces Tax Revenue

as additional component of
Total Surplus
• Consumer Surplus decreases
due to higher price they pay
and lower quantity they buy
• Producer surplus decreases
due to lower price and lower
quantity they sell
• Tax revenue captures part of
surplus lost, but not all
• The losses to buyers and
sellers exceed tax revenue
raised by the government,
resulting in Deadweight Loss
which is a loss to society
40
Elasticity and Deadweight Loss
If Supply is inelastic, reduction in market
due to sellers dropping out is relatively
less, so deadweight loss is small
If Supply is elastic, reduction in market
due to sellers dropping out is more likely,
so deadweight loss is large
If Demand is inelastic, reduction in
market due to buyers dropping out is
relatively less, so deadweight loss is small
If Demand is elastic, reduction in market
due to buyers dropping out is more
likely, so deadweight loss is large
The greater the elasticities of supply

and demand, the greater the
deadweight loss of a tax.
41
Size of Tax and Deadweight Loss
• Consumer and Producer surplus both decrease as taxes increase

• Initially Tax revenue increases, but after a certain high tax rate, tax revenue falls
• As Taxes increase, the Deadweight Loss keeps increasing
• At a very high tax rate, many buyers stop buying and sellers stop selling, thus Tax revenue also falls
significantly resulting in a very large Deadweight loss
42
The Laffer Curve
• A small tax has small deadweight loss,
and small tax revenue. As the tax grows
the tax revenue and deadweight loss
also grow.
• But at a very high tax, the size of market
shrinks significantly (people stop
buying/selling) so tax revenue starts
declining and deadweight loss gets very
large.
• This is the Laffer curve* which shows the
optimal tax rate until which the
government can maximize tax revenue.
*By Economist Arthur Laffer
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Fundamentals of Microeconomics

What influences elasticity of demand:

Price elasticity of demand =

Note: Elasticity is usually written as absolute numbers (0.4)

• When demand is inelastic (a price

At low Price, high Quantities =

For Normal goods - Income elasticity of demand is positive

For Substitute goods - Cross price elasticity of demand is positive

price elasticity of supply =

What Influences elasticity of supply:

At low Quantities = Supply is elastic At high Quantities = Supply is inelastic

In long run –. Supply is elastic

If binding Minimum wages

• Payroll tax places a Tax

So Total Surplus = Value to

The area between

• Tax introduces Tax Revenue

The greater the elasticities of supply

• Consumer and Producer surplus both decrease as taxes increase

*By Economist Arthur Laffer

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