Economics 2 Professor Christina Romer Spring 2018 Professor David Romer

LECTURE 4 EXTENSIONS OF SUPPLY AND DEMAND ANALYSIS January 25, 2018

I. OVERVIEW

II. REVIEW OF THE SUPPLY AND DEMAND FRAMEWORK A. Two sides of the market (example: light trucks) B. Equilibrium C. What shifts the demand curve? D. What shifts the supply curve?

III. ELASTICITY A. Price elasticity of demand B. Relationship between elasticity and the slope of the demand curve C. Impact of elasticity on the market outcome D. Demand elasticity and expenditure (example: illegal opioid drugs) 1. Comparison of supply-side and demand-side policies 2. What the simple analysis may be missing E. Price elasticity of supply

IV. EFFECTS OF A TAX A. Terminology and set-up (example: gas tax) B. Effects on price and quantity C. Who pays the tax? D. Interaction with demand elasticity E. Government tax revenue Economics 2 Christina Romer Spring 2018 David Romer

LECTURE 4 Extensions of Supply and Demand Analysis

January 25, 2018 Announcements

• Problem Set 1 is due next Tuesday (January 30).

• Problem Set Work Session this afternoon (Jan. 25) • 4:00–6:00 in 648 Evans Hall

• Ground Rules: • Answers must be in your own words, handwritten, and with acknowledgements to the people you worked with.

• Graded on a scale of 1 to 10.

Announcements

• Collecting the Problem Sets: • They are due at the beginning of lecture. • We will have boxes with your GSIs’ names on them in the middle of the lecture hall (both sides). Announcements

• Journal article reading for Tuesday (by Esther Duflo): • You can access for free through any campus computer, or from off campus using the library proxy (see http://www.lib.berkeley.edu/using- the-libraries/connect-off-campus). • Don’t stress over every word or parts you don’t understand. • Read for approach and findings; think about relevance to consumer behavior.

I. OVERVIEW Plan for the Lecture

• Review the supply and demand framework.

• Discuss elasticity.

• Examine the effect of another government intervention in the market (a tax).

II. REVIEW OF SUPPLY AND DEMAND Equilibrium in the Market for Light Trucks

P S1

P1 • Equilibrium

Q1 Q What Causes the Demand Curve to Shift?

• In general, anything that changes the desirability of the good at a given price.

• Change in the price of a complement.

• Change in tastes; news.

• Change in the price of a substitute.

• Change in demographics. Retail Price of Gasoline

400

350

300

250

200 84 = 1001982Index, - 84=

150

100 2011-01 2011-07 2012-01 2012-07 2013-01 2013-07 2014-01 2014-07 2015-01 2015-07 2016-01 2016-07 2017-01 2017-07

Source: Bureau of Labor Statistics. Effect of a Fall in the Price of Gasoline on the Demand for Light Trucks P S1

P2 P1

Q1 Q2 Q Growth of Light Trucks

Source: Trucks.com What Causes the Supply Curve to Shift?

• In general, anything that changes the additional cost associated with supplying one more unit at a given quantity of the good.

• Change in the price of an input.

• Change in technology.

Producer Price Index for Iron and Steel

270

250

230

210

Index, 1982=100Index, 190

170

150 2012-01 2012-07 2013-01 2013-07 2014-01 2014-07 2015-01 2015-07 2016-01 2016-07 2017-01 2017-07

Source: Bureau of Labor Statistics. Effect of a Fall in the Price of Steel on the Supply of Light Trucks P S1

P1 P2

Q1Q 2 Q

III. ELASTICITY Price Elasticity of Demand (εD) Percentage change in quantity demanded ε = D Percentage change in price

(In absolute value)

Elastic εD > 1

Inelastic εD < 1

Perfectly inelastic εD = 0

Perfectly elastic εD = ∞ Relationship between Demand Elasticity and the Slope of the Demand Curve

ΔQD / QD ε = D ΔP / P

ΔQD P = • ΔP QD

1 P = • Slope QD

Slope of the Demand Curve P

ΔP Slope = ΔQ ΔP D

ΔQD

D Q 1 P εD = • Slope QD Demand Curves Inelastic Elastic P P

D1 Q Q 1 P εD = • Slope QD Demand Elasticity Matters for Market Outcomes (Effect of a Shift Out in the Supply Curve) Inelastic Elastic P P

S1 S1

S2 S2

P1 P1 P P2 2 D1

Q1Q2 Q Q1 Q2 Q Demand Elasticity Matters for Market Outcomes (Effect of a Shift Out in the Supply Curve)

• If demand is highly inelastic, a shift in the supply curve leads mainly to a change in price, with little change in quantity.

• If demand is highly elastic, a shift in the supply curve leads mainly to a change in quantity, with little change in price. Source: National Institute on Drug Abuse; Center for Disease Control. Market for Illegal Opioid Drugs

P S1

Q1 Q Market for Illegal Opioid Drugs (Supply Restriction) P S2 S1

P2 P1

Q2Q 1 Q Total Expenditure

Total Expenditure = Price • Quantity

• Total expenditure and total revenue are the same thing. Demand Elasticity and Expenditure

• Inelastic (εD < 1): Total expenditure rises when the supply curve shifts back.

• Elastic (εD > 1): Total expenditure falls when the supply curve shifts back. Market for Illegal Opioid Drugs (Increased Drug Treatment) P S1

P1 P2

D2 D1

Q2Q 1 Q What are some of the complexities that we are ignoring with this analysis? Price Elasticity of Supply (εS) Percentage change in quantity supplied ε = S Percentage change in price

Elastic εS > 1

Inelastic εS < 1

Perfectly inelastic εS = 0

Perfectly elastic εS = ∞ Supply Curves Inelastic Elastic P P S1

Q Q

As with the εD, the relationship between εS and the slope of the supply curve is a useful, but crude approximation.

IV. EFFECTS OF A TAX Effect of a New 50¢ per Gallon Tax on Gasoline (Physically Collected from Sellers) P S2 S1

Tax (50¢) P2 P1 P2−tax

Q2Q 1 Q Typical Effects of a Tax

• Quantity bought and sold declines.

• Production and consumption are still allocated by price.

• Price rises by less than the amount of the tax.

• Both sides pay some of the tax. Demand Elasticity and the Effects of a Tax Inelastic Elastic

P S2 P S2 Tax S1 Tax S1

P2 P P2 1 P1 P2−tax P2−tax D1

Q2Q 1 Q Q2 Q1 Q Two Ways of Visualizing Tax Revenues (1) (2) P P S2 S2 Tax S Tax 1 S1

P2 P2

P2−tax

D1 D1

Q2 Q Q2 Q Demand Elasticity and the Effects of a Tax

• A tax will change the equilibrium quantity more, the more elastic demand is.

• Buyers will pay more of the tax, the less elastic demand is.

• Government revenue from the tax will be larger, the less elastic demand is.