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Midterm 2 Review: Elasticity, Taxation, Surplus, and Market Interventions in Macroeconomics

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Elasticity of Demand

Price Elasticity of Demand

The price elasticity of demand measures how much the quantity demanded of a good responds to a change in its price. It is a key concept in understanding consumer behavior and market dynamics.

  • Definition: Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

  • Formula (Midpoint Method):

  • Elastic Demand: Elasticity > 1; quantity demanded changes more than price.

  • Inelastic Demand: Elasticity < 1; quantity demanded changes less than price.

  • Unit Elastic: Elasticity = 1; quantity demanded changes exactly as much as price.

  • Perfectly Elastic/Inelastic: Extreme cases where demand responds infinitely or not at all to price changes.

  • Example: If the price of candy bars rises from $1.00 to $1.50 and quantity demanded increases from 500 to 600, use the midpoint formula to determine elasticity.

Total Revenue and Elasticity

Relationship Between Price Changes and Total Revenue

Total revenue is the total amount received by sellers of a good, calculated as price times quantity sold. The effect of price changes on total revenue depends on the elasticity of demand.

  • If demand is elastic: An increase in price decreases total revenue; a decrease in price increases total revenue.

  • If demand is inelastic: An increase in price increases total revenue; a decrease in price decreases total revenue.

  • Graphical Analysis: Rectangles on a price-quantity graph (such as A, B, D) can represent changes in revenue.

  • Example: If the magnitude of the percentage change in price is smaller than the magnitude of the percentage change in quantity demanded, demand is elastic between those prices.

Tax Incidence and Market Burden

Effects of Taxes on Buyers and Sellers

When a tax is imposed on a good, the burden of the tax is shared between buyers and sellers depending on the relative elasticities of supply and demand.

  • Tax Incidence: The division of the tax burden between buyers and sellers.

  • If demand is more inelastic than supply: Buyers bear more of the tax burden.

  • If supply is more inelastic than demand: Sellers bear more of the tax burden.

  • If both are equally elastic: The burden is shared equally.

  • Example: A $5 per unit tax may be split between buyers and sellers depending on elasticity.

Consumer and Producer Surplus

Willingness to Pay and Surplus Calculation

Consumer surplus is the difference between what buyers are willing to pay and what they actually pay. Producer surplus is the difference between the price sellers receive and their cost of production.

  • Willingness to Pay Table:

Willingness to Pay (First Orange)

Willingness to Pay (Second Orange)

Allison

$2.00

$1.50

Bob

$1.50

$1.00

Charisse

$0.75

$0.25

  • Application: If only one orange can be supplied per day, the market price will be set by the highest willingness to pay.

  • Producer Surplus Table:

Seller

Cost

Abby

$1,000

Bobby

$1,100

Dianne

$1,150

Evaline

$1,200

Carl

$1,250

  • Application: If the price is $1,150, Abby, Bobby, and Dianne would be willing to sell.

Changes in Surplus Due to Market Shifts

Producer Surplus and Supply/Demand Shifts

When supply or demand curves shift, the surplus to existing producers or consumers can change. This is often measured by the area between the old and new curves up to the relevant quantity.

  • Example: If the supply curve shifts from S to S', calculate the increase in producer surplus by the area between the curves for the relevant quantity.

Effects of Taxes on Surplus

Consumer Surplus Reduction Due to Taxation

When a government imposes a tax, consumer surplus is reduced. The reduction can be measured by the area on a supply and demand graph that is lost due to the tax.

  • Example: A $10 per unit tax reduces consumer surplus by the area labeled B + C, or B + C + D + F, depending on the graph.

Deadweight Loss and Elasticity

Taxation and Market Efficiency

Deadweight loss is the loss of total surplus that occurs because the tax discourages mutually beneficial trades. The size of the deadweight loss depends on the elasticities of supply and demand.

  • If demand or supply is relatively elastic: Deadweight loss is larger.

  • If demand or supply is relatively inelastic: Deadweight loss is smaller.

  • Graphical Comparison: Comparing graphs with different elasticities shows the impact on deadweight loss.

Tariffs and Market Outcomes

Effects of Tariffs on Domestic Markets

A tariff is a tax on imported goods. Imposing a tariff affects domestic demand, supply, and surplus areas on the market graph.

  • Graphical Analysis: Areas such as A, B, C, D, E, F on the graph represent changes in surplus and market outcomes due to the tariff.

  • Example: Imposing a tariff shifts the equilibrium and changes the distribution of surplus among consumers, producers, and the government.

*Additional info: Academic context and definitions have been expanded for clarity and completeness. Tables have been reconstructed from the images and text. Equations are provided in LaTeX format as required.*

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