Economics 111.3 Winter 14

February 7th, 2014Lecture 12

Ch. 6 (up to p. 138)

Conclusion (from Lecture 11)

• The incidence of a tax does not depend on whether the tax is levied on buyers or sellers.

STUDY QUESTION:

Taxes

Taxes

The answer to this question depends on the elasticity of demand and the elasticity of supply.

In what proportions is the burden of the tax divided?

Sales Tax and theElasticity of Supply

Quantity

Pri

ce

45

50

100

S

D

Perfectly inelasticsupplySeller

paysentire tax

Sales Tax and the Elasticity of Supply

Quantity (thousands of kilograms per week)

Pri

ce

(cen

ts p

er p

ou

nd

)

10

11

3 5

S

D

S + taxBuyer paysentire tax

Perfectly ElasticSupply

Sales Tax and the Elasticity of Demand

Quantity (thousands of marker pens per week) 1 4

0.90

1.00

SS + tax

Sellerpaysentiretax

Pri

ce

(cen

ts p

er p

en

)

Perfectly elasticdemand

Sales Tax and the Elasticity of Demand

Quantity (thousands of doses per day)

Pri

ce

(do

llars

pe

r d

os

e)

2.00

2.20

100

D

S

Perfectly inelasticdemand

S + taxBuyer paysentire tax

Tax Division and Price Elasticity of Demand

Four extremes:

• Perfectly inelastic supply: seller pays

• Perfectly elastic supply: buyer pays

• Perfectly inelastic demand: buyer pays

•Perfectly elastic demand: seller pays

The Rule of Tax Incidence: Generalization

The burden tends to fall on the side of the market that is less elastic: The more elastic the supply, the larger is the amount of tax paid by the buyer and vice versa

Sales tax is generally applied to items with a low elasticity of demand (alcohol, tobacco, and gasoline): Quantity does not decrease by much; large tax revenue

It is unusual to apply sales tax to goods with a high elasticity of demand.

Study questionThe supply of and demand for roses are given by P = 4Qs and P = 12 –2Qd respectively.Answer the following questions:A. Suppose the government decides to tax the suppliers of

roses $6 per dozen roses sold. How much tax does Government collect and who pays it?

B. Calculate the deadweight loss associated with this $6 tax.

Ch. 8Consumer’s Choice

Concept of Utility The Theory of Demand

Concept of Utility• Utility – satisfaction that we get from

consuming some goods and services• Cardinal Utility – refers to putting an absolute

measure of utility upon goods and services or market baskets (e.g., I like this TWICE AS MUCH as I like that)

• Ordinal Utility – measures utility only by ranking the consumer’s preferences among goods and market baskets (e.g., I like good “A” more (or less) than good “B”(or the same as good “B”)

Cardinal Utility: extra terminology

• Total utility: total amount of satisfaction

• Marginal utility: extra satisfaction from consuming one more unit

Law of Diminishing Marginal Utility:1. Gains in satisfaction decline as additional

units are consumed2. This principle does not say you do not enjoy

consuming more of a good.3. It only states that as you consume more of

the good, you enjoy additional units less than you enjoyed the initial units.

4. When marginal utility is zero, total utility stops increasing.

5. Beyond this point, marginal utility is negative and total utility decreases.

Theory of Consumer ChoiceA Typical Consumer.…• Exhibits rational behavior - Rational means that people prefer more to

less and will make choices that give them as much satisfaction as possible.

- The analysis of rational choice begins with the premise that rational individuals want as much satisfaction as they can get from their available income.

• Knows clear-cut preferences

Theory of Consumer Choice, cont’d

A Typical Consumer.…• Responds to price changes• Is subject to a budget constraint• Makes those choices that have

the highest units of utility per dollar spent.

The Paradox of Value

Why does water, which is essential for life, cost so little?Why do diamonds, which are useless compared to water, cost so much?

Carl Menger: 1840-1921Menger’s solution of the water-diamond paradox: • The last need unmet by the

loss of a concrete quantity of water, which is valued by the subjective degree of desire would be of far less importance than that of the need unmet by the loss of a concrete quantity of diamonds as diamonds are so few in quantity compared to water

The Paradox of Value, cont’dDiamonds have a high price

and a high marginal utility, while water has a low price and a low marginal utility.

At consumer equilibrium, the marginal utility per dollar spent is the same for diamonds as for water.

• Utility Maximizing Rule: the consumer’s money income should be allocated so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility

Algebraic Restatement of theUtility Maximization Rule

MU of product A

Price of A

MU of product B

Price of B=