economics the study of how human beings coordinate their wants and desires, given the...
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Economics
The study of how human beings coordinate their wants and
desires, given the decision-making mechanisms, social customs, and political realities of the society.
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Unlimited wants
Limited resources to satisfy wants
Choose between alternatives
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Economic reasoning focuses on the impact of marginal changes.
Decisions will be based on marginal costs
-the cost of buying or making one more unit
and marginal benefits (utility).
- The increase in satisfaction from buying or making one more unit
don’t necessarily consider sunk costs.
MB > MC Do it!
MC > MB Don’t do it!
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a. Someone must give up something if we are to have more scarce goods.
b. The highest valued alternative that must be sacrificed is the opportunity cost of the choice.
The use of scarce resources to produce a good is always costly.
What must be given up to get one more unit of another good or
service
This cla
ss?
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the price mechanism that guides our actions in a market. The invisible hand is an example of a market force.
• If there is a shortage, prices rise• If there is a surplus, prices fall
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a. InductiveMethods
Use facts to develop a modelTake a survey and study the results
b. DeductiveSee if the facts support a hypothesisStart with a theory and see if facts support it
c. Abduction the combination of deduction and induction
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Predicting BehaviorPositive Economic Statements
- relationships that can be tested
- The class is half full
- Unemployment is 6%
- if incomes rise people spend money
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Normative Economic Statements
- statements about “what should be” or make a value judgment
- It is too hot
- Unemployment should be around 4%
- we should raise the minimum wage.
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Art of Economics
- application of knowledge learned in positive economics to the achievement of goals determined in normative economics.
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2. Inverse Relationship - Graph slopes down from left to
right
1. Direct Relationship - Graph slopes up from left to right
Economic graphs
3. Slope Rise Run
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The U.S. Economy in Historical Perspective
The U.S. economic system is a market economy based on private property and the markets in which individuals decide how, what, and for whom to produce
• Markets work through a system of rewards and payments
• Individuals are free to do whatever they want as long as it is legal
• Fluctuations in prices play a central role in coordinating individuals’ wants in a market economy Most economists believe the market
is a good way to coordinate economic activity
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Capitalism and Socialism• Capitalism is an economic system based on the
market in which the ownership of the means of production resides with a small group of individuals (called capitalists)
• Socialism is an economic system based on individuals’ goodwill towards others, not on their own self-interest, and in which, in principle, society decides what, how, and for whom to produce
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Evolving Economic SystemsFeudalism is an economic system based on tradition and
dominated the Western world from the 8th to the 15th century
Mercantilism is an economic system in which the government controls economic activity by doling out the
rights to undertake economic activities and was dominant until the 18th century
During the Industrial Revolution, technology and machines rapidly modernized industrial production
Capitalism
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Dividends
Interest
Proprietor’s Income
Rental Income
Transfer Payments
Wages and Salaries
1.7
4.9
8.4
11.1
13.4
64.7
Source of income %
Social Security
-4.3
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Savings
Spending
Taxes
84
15.2
1.9
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Services
Durable Goods
Non-durable Goods
59
29
12
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proprietorship
partnership
corporation
72.2
7.7
20.1
4.8
7.9
87.3
Type Number
Revenue
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Business: Forms of Business
Advantages Disadvantages
Proprietorship
• Minimum bureaucratic hassle
• Direct control by owner
• Limited ability to get funds• Unlimited personal liability
Partnership• Ability to share work and
risk• Relatively easy to form
• Limited ability to get funds• Unlimited personal liability (even for a partner's blunder)
Corporation
• No personal liability• Increasing ability to get funds
• Ability to avoid personal income taxes
• Legal hassle to organize• Possible double taxation of income
• Monitoring problems
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Government
1. An actor who collects money in taxes and spends that money on projects, such as defense and education
The government plays two general roles in the economy:
3-20
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Government2. A referee who sets the rules that determine
relations between businesses and householdsa. Provide a stable set of institutions and
rules.b. Promote effective and workable
competition.c. Correct for externalities.
e. Provide public goods.
f. Adjust for undesirable market results.
-Enforce contracts and protect property rights
-restrict and regulate monopolies
-pollution
-Enforce contracts and protect property rights
-Employment Act of 1946
-drug busts
d. Ensure economic stability and growth.
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HouseholdsBusinesses
Product Markets
Factor Markets
Resources
Payments $$
Goods and
Services
Business Taxes
Goods and
Services
Income Taxes
Paym
en
ts an
d L
eg
al
Reso
urce
sP
aym
en
ts
Good
s an
d
Serv
ices
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Selling Quantity Price Demanded
$ 3$ 2$ 1
$ 410
254060
15$ 5
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Price
Quantity
$6
$5
$4
$3
$2
$1
10 20 30 40 50 600
Demand
Downsloping left
-Plot the pointsGraphing:
-Connect the dots
to right
Demand
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Shifts in Demand versus Movements Along a Demand
CurveQuantity demanded – is a specific amount that will be demanded per unit of time at a specific price, other things constant
• A change in price changes quantity demanded
• A change in price causes a movement along the demand curve
Demand refers to a schedule of quantities of a good that will be bought per unit of time at various prices, other things constant
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1
Why the curve shifts
2345
Consumer TastesPrice of Other Goods
Society’s Income
Number of Consumers
Consumer ExpectationsTaxes and Subsidies
6
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Selling Quantity Price Supplied
$ 3$ 2$ 1
$ 460
251510
40$ 5
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Price
Quantity
$6
$5
$4
$3
$2
$1
10 20 30 40 50 600
Upsloping right
-Plot the pointsGraphing:
-Connect the dots
to left
Supply
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Selling Quantity Price Demanded Supplied
$ 3$ 2$ 1
$ 410
254060
15$ 5 60
251510
40$ 3 25 25
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Price
Quantity
$6
$5
$4
$3
$2
$1
10 20 30 40 50 600
D
-Plot DemandGraphing:
-Plot Supply
D
S
S
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1 Resource PricesWhy the curve shifts
2 Changes in Technology3 Prices of other goodsTaxes and Subsidies
45 Number of
Producers
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Economic Examples1. Cyclone Larry in Australia
•Destroyed 80% of the banana crop.•Prices went from $1.00 to $2.00 per pound•Supply or Demand problem??
BananaMarket
Quantity
$2.00
DR
S1
Price
Q1Q2
S2
$1.00
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Sales of SUVs in the U.S.
P0
Q1
P1
Increasing gas costs causes the demand curve
to shift left
Average price fell 10%
Price for SUVs fell
from P0 to P1 where
Q demanded = Q supplied
S0
D0
P
QQ0
SUVs
D1
Supply or Demand problem?
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Coffee Beans• fell from $2.00/pound in 1997 to $.50 in 2002
Supply or Demand problem?
Price
Coffee BeanMarket
Q1
Dc
Q2
S1
Quantity
S2
$2.00
$0.50
New growing techniques and the entry of new growers shifted the supply curve.
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Increase in the Demand for Foreign Exchange
0.20
Q1 Q2
Exchange rate($ per quetzal)
Quantity of quetzal exchange
S
D1
U.S. sales to
Guatemala
U.S. purchasesfrom Guatemala
D20.10
• Beginning equilibrium exchange rate: (10 cents = 1quetzal).
• An increase in American demand for Guatemalan coffee will also increase the demand for quetzals
• Equilibrium occurs where the new demand for quetzals D2 just equals the supply S – at $.20 per quetzal with Q2 > Q1 quetzals clearing the market.
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• It stops the price from rising to the equilibrium level.
• Example: rent control• The direct effect of a price ceiling is a shortage:
quantity demanded exceeds quantity supplied.
1. Price Ceilings• Price ceiling is a legally established maximum price that sellers
may charge.
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• Price floor is a legally established minimum price that buyers must pay.
• It stops the price from dropping down to equilibrium level.
• Example: minimum wage• The direct effect of a price floor above the equilibrium price is
a surplus: quantity supplied exceeds quantity demanded.
2. Price Floors
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Excise Taxes
• An excise tax is a tax that is levied on a specific good
• A tariff is an excise tax on an imported good
• The result of taxes and tariffs is an increase in equilibrium prices and reduce equilibrium quantities
• Government impacts markets through taxation
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The price of boats rises by less than the tax to
$70,000
The Effect of an Excise Tax
S0
D0
P
Q
$65,000
510420
The supply curve shifts up by the amount of the tax
Government imposes a $10,000 luxury tax on the
suppliers of boatsS1
Tax = $10,000
Luxury Boats
$60,000
$70,000
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Quantity Restrictions• Government regulates markets with licenses,
which limit entry into a market
• Many professions require licenses, such as doctors, financial planners, cosmetologists, electricians, or taxi cab drivers
• The results of limited number of licenses in a market are increases in wages and an increases in the price of obtaining the license
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The Effect of a Quantity Restriction
QR
D0
12,000
When the demand for taxi services increased, because
the number of taxi licenses was limited, wages increased
Successful lobbying by taxi cab drivers in NYC resulted in quantity
restrictions (medallions)
NYC Taxi Drivers
$15
P(wage)
Q(of drivers)
D1
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Application: The Effect of a Quantity Restriction
QR
D0
12,000
The demand for taxi medallions also increased
because wages were increasing. But because the number of taxi licenses was
limited, the price of a medallion also increased
NYC Taxis Medallions
$400,000
P
Q(of medallions)
D1Initial Fee
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Third-Party-Payer Markets• In third-party-payer markets, the person who receives
the good differs from the person paying for the good
• Equilibrium quantity and total spending can be much higher in third-party-payer markets
• Under a third-party-payer system, the person who chooses how much to purchase doesn’t pay the entire cost
• Goods from a third-party-payer system will be rationed through social and political means
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Third-Party-Payer Markets
D0
10
Health Care
$25
P
Q
$45
$5
S0
18
The consumer pays the entire cost
Total expenditures for 18 units of health care
With a co-payment of $5, consumers demand 18 unitsSellers require $45 per unit for that quantity
…are greater than when…
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Thinking Like a Modern Economist
Economics is what economists do.
— Jacob Viner
CHAPTER
6
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Teach a parrot the words ‘supply’ and ‘demand’ and you have an economist
Thomas Carlyle
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Economic Models• Mathematical e = mc2
• more often use more of an inductive, as opposed to deductive, approach
• or heuristic
expressed informally in wordsCharacteristic
s
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Behavioral vs Traditional Economics
• Traditional –more reliance on relatively simple algebraic or graphical models such as the supply and demand model
-provide simple and clear results, which can highlight issues that behavioral models cannot
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Behavioral vs Traditional Economics
• Behavioral - use a broader set of building blocks than rationality and self-interest
• Act with enlightened self-interest people care about other people as well as themselves
• People behave purposefully - reflecting reasoned but not necessarily rational judgment
• Seem to use real-life situations to explain and illustrate economic concepts
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Empirical Work in Modern Economics
• Modern economics is highly empirical• Both traditional and modern behavioral
economic building blocks rely on experiments and statistical analysis of real world observations
• Econometrics is the statistical analysis of economic data
• An empirical model is a model that statistically discovers a pattern in the data
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Modern Traditional and Behavioral Economists
Earlier Economics
Modern Economics
Modern Behavioral Economists
Modern Traditional Economists
AssumptionsRationalitySelf-Interest
Purposeful behaviorEnlightened self-interest
RationalitySelf-Interest
Approach Deduction
Induction and deduction: emphasis on experimental economics and on empirical models
Induction and deduction: emphasis empirical models
Types of Models
Simple S/D models
All types including complex mathematical models and ACE models
All types including complex mathematical models and ACE models
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the responsiveness of the amount purchased to a change in price.
Price Elasticityof demand =
% Q
% P=
% Change in quantity demanded% Change in Price
- or put more simply -
=
PED > 1 Elastic < 1 Inelastic
= 1 Unit Elastic
)()(
0
10
0
10
P
PP
Q
QQ =
)()(
0 1
0
0
10
P PP
Q
X
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Quan 1
2
3
4
5
6
7
8
Price 8
7
6
5
4
3
2
1
Elasticity
___
___
___
___
___
___
___
Total Revenue
___
___
___
___
___
___
___
___
=
=
=
=
=
=
=
X
X
X
X
X
X
X
X
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(b)
Price
Quantity/time
(a)
Price
Quantity/time
Mythicaldemandcurve
• Perfectly inelastic: An increase in Price
results in no change in Quantity
Different Elasticities
• Relatively inelastic: A percent increase in Price
results in a smaller % reduction in Quantity
Demand for Cigarettes
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(c)
Price
Quantity/time
• Unitary elasticity: The percent change in
quantity demanded due to an increase in price is equal to
the % change in price.
Demand curve of unitary elasticity
= 1
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(d)
Price
Quantity/time
• Relatively elastic: A % increase in Price
leads to a larger % reduction in Quantity.
Elasticity of Demand
(e)
Price
Quantity/time
• Perfectly elastic: Consumers will buy all of Farmer Hollings’s wheat at the market price, but none
will be sold above the market price.
Demand for Granny Smith Apples
Demand for Farmer Hollings’s wheat
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2. Necessity vs Luxury
What affects Elasticity???
3. Proportion of Income
1. Available Substitutes
4. Time to shop around
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a. Market Period
What affects Supply Elasticity???
b. Short Run
1. Time
c. Long Run
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Income Elasticity• the responsiveness of a product’s
demand to a change in income.
Income Elasticityof demand =
% Change in quantity demanded
% Change in Income
• A normal good has a positive income elasticity of demand.– As income increases, the demand
for normal goods increases.• Goods with a negative income
elasticity are inferior goods.– As income expands, the demand
for inferior goods will decline.
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Cross Price Elasticity• the responsiveness of a product’s
demand to a change in the price of another good.
Cross Price Elasticity =
% Change in Qx
% Change in Py
• A complement has a negative cross price elasticity.
– As Py increases, the demand for Y decreases, and demand for goods that are consumed with Y also decreases.
• A substitute has a positive cross price elasticity– As Py increases, the demand for Y decreases,
and demand for goods that can be consumed instead of Y also decreases.
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Consumer SurplusThe total difference between what a consumer is willing to pay and how much they actually have to pay.
Producer SurplusThe total difference between what a supplier is willing to provide a good or service and how much they actually get for it.
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S
D
P
Q
Consumer surplus = area of red triangle =
½($5)(5) = $12.5
Producer surplus = area of green triangle =
½($5)(5) = $12.5
Producer and Consumer Surplus
The combination of producer and consumer surplus is maximized at
market equilibrium
CS
PS
$10987654321
0 1 2 3 4 5 6 7 8
8-64
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The Burden of a Tax
Tax Incidence
• Who pays a tax is called the incidence.
BuyerSeller
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Price
# of used carsper month(in thousands)
D
500 750
$6,400
S plus tax
$7,000
$7,400
S
$1000 tax
Impact of a Tax Imposed on Sellers• If in the used car market a price
of $7,000 would bring the quantity of used cars demanded
into balance with the quantity supplied.
• When a $1,000 tax is imposed on sellers of used cars, the supply curve shifts vertically by the amount of the tax.• The new price for used cars is $7,400 …
• Consumers end up paying $7,400 instead of $7,000 and bear $400 of the tax burden. • Sellers end up receiving $6,400 (after taxes) instead of $7000 and bear $600 of the tax burden.
sellers netting $6,400 ($7,400 - $1000 tax).
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Price
# of used carsper month(in thousands)
D
500 750
$6,400
$7,000
$7,400
S
$1000 tax
Impact of a Tax Imposed on Buyers
• In the same used car market:
• When a $1,000 tax is imposed on buyers of used cars, the demand curve shifts vertically by the amount of the tax.• The new price for used cars is $6,400 …
• Consumers end up paying $7,400 (after taxes) instead of $7,000 and bear $400 of the tax burden. • Sellers end up receiving $6,400
instead of $7000 and bear $600
of the tax burden.
buyers then pay taxes of $1000 making the total $7,400.
D minus tax
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• The actual burden of a tax depends on the elasticity of supply and demand.
• As supply becomes more inelastic, then more of the burden will fall on sellers.
• As demand becomes more inelastic, then more of the burden will fall on buyers.
Elasticity and Incidence of a Tax
ED ES
ED + ES ED + ES
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110
D
Luxury boatmarket
194
80
Gasoline
market
S
$1.60
$1.50$1.45
Quantity(thousands of boats)
Quantity(millions of gallons)
Price
Price(thousand $)
Tax Burden and Elasticity
90
100
5 10 15 20
D
S plus tax
200
$1.55
$1.65S
S plus tax• Consider the market for Gasoline and Luxury Boats individually.
• In the gas market, the demand is relatively more inelastic than its supply; hence, buyers bear a larger share of the burden of the tax.
• In the luxury boats market, the supply curve is relatively more inelastic than its demand; hence, sellers bear a larger share of the tax burden.
• We begin in equilibrium.
• If we impose a $.20 tax on gasoline suppliers, the supply curve moves vertically the amount of the tax. Price goes up $.15 and output falls by 6 million gallons per week.
• If we impose a $25K tax on Luxury Boat suppliers, the supply curve moves vertically the amount of the tax. Price goes up by $5K and output falls by 5 thousand units.
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S
D
P
Q
P0
Q0
A price ceiling transfers surplus from producers to consumers,
generates deadweight loss, and reduces equilibrium quantity
Q1
Price ceilingP1
Shortage
• An effective price ceiling is a government set price below the market equilibrium price
• It acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation
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S
D
P
Q
P0
Q0
A price floor transfers surplus from consumers to producers,
generates deadweight loss, and reduces equilibrium quantity
Q1
Price floorP1
Surplus
• An effective price floor is a government set price above the market equilibrium
• It acts as a tax on consumers and a subsidy for producers that transfers consumer surplus to producers
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The Difference Between Taxes and Price Controls
• Taxes leave people free to choose how much to supply and consume as long as they pay the tax
• Price ceilings create shortages and taxes do not
• Shortages may also create black markets
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Rent Seeking, Politics, and Elasticities
• Individuals spend money and use resources to lobby governments to institute policies that increase their own surplus
• Lobbying for price controls, which transfer surplus from one group to another, is an example of rent-seeking behavior
• Public choice economists argue that when all rent seeking and tax consequences are netted out, there is often not a net gain to the public
• The possibility of transferring surplus from one set of individuals to another causes people to spend time and resources on doing so.
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A
C
B
Inelastic Demand and Incentives to Restrict Supply
S0
D
P
Q
S1
P0
P1
Q0Q1
Revenue gained When demand is
relatively inelastic, suppliers have incentive
to restrict quantity to increase total revenue
Revenue lost
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Inelastic Supplies and Incentives to Restrict Prices
• When supply is inelastic and demand increases, prices increase causing consumers to lobby for price controls
• When supply is inelastic, consumers have incentives to restrict prices
• Rent control in New York City is an example
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Application: Price Floors and Elasticity
S
D
P
Q
P0
P1
S
D
P
Q
P0
Q0Q1
The surplus created by a price floor is larger if demand and supply are elastic
Q0Q1
Surplus
Price floor
Surplus
P1