Book cover for Microeconomics

Microeconomics

Jeffrey M. Perloff

ISBN #9781292056531

7th Edition

753 Questions

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Homework Questions

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Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

This section emphasizes the importance of understanding the shapes of supply and demand curves in predicting market outcomes following economic shocks such as tax changes or input price increases. The concept of elasticity is central, as it quantifies the responsiveness of quantity supplied and demanded to price changes, ultimately determining who bears the tax burden. Real-world examples like the gasoline tax debates and the avocado market illustrate how these theoretical concepts translate into practical outcomes.

Learning Objectives

1

Explain how shifts in supply and demand curves affect market equilibrium, particularly in relation to shocks such as changes in input prices or taxes.

2

Analyze the role of price elasticity of demand and supply in determining the quantitative effects of economic shocks.

3

Assess the impact of government policies, including gasoline taxes and sales taxes, on consumers and producers.

4

Demonstrate the use of supply-and-demand analysis to evaluate real-world issues like tax incidence and market responses.

Key Concepts

CONCEPT

DEFINITION

Supply Curve

A graph showing the relationship between the price of a good and the quantity supplied by producers. Its shape determines how much the equilibrium quantity changes when the supply shifts.

Demand Curve

A graph showing the relationship between the price of a good and the quantity demanded by consumers. The slope of this curve indicates how sensitive consumers are to price changes.

Price Elasticity of Demand

A measure of how much the quantity demanded responds to a change in price. It is summarized by a single number that indicates demand sensitivity.

Price Elasticity of Supply

A measure of how much the quantity supplied responds to a change in price, indicating the sensitivity of suppliers to price changes.

Tax Incidence

The analysis of the effect of a particular tax on the distribution of economic welfare between buyers and sellers, often influenced by the elasticity of demand and supply.

Example Problems

Example 1

Using graphs similar to those in Figure 3.1 , illustrate how the effect of a demand shock depends on the shape of the supply curve. Consider supply curves that are horizontal, linear upward sloping, linear downward sloping, and vertical.

Example 2

During football weekends, many people travel to South Bend, Indiana, to see a Notre Dame football game. Hotel prices are much higher on football weekends than during the other 341 days of the year-particularly in years when Notre Dame is expected to have a winning season. Use a supply and-demand diagram to illustrate why, when the demand curve shifts to the right, the prices of hotel rooms shoot up. (Hint: Carefully explain the shape of the supply curve, taking into account what happens when capacity is reached, such as occurs when all hotel rooms are filled.)

Example 3

Six out of ten teens no longer use watches to tell time-they've turned to cell phones and iPods. Sales of inexpensive watches dropped $12 \%$ from 2004 to $2005,$ and sales of teen favorite, Fossil, Inc., fell $19 \% .$ Sales dropped $9 \%$ in $2009,$ during the Great Recession. However, sales rose by $9 \%$ in both 2010 and 2011 and by $4 \%$ in $2012 .$ During all of these ups and downs, the price of inexpensive watches has not changed substantially. What can you conclude about the shape of the supply curve? Illustrate these events using a graph.

Example 4

After a major freeze destroyed many Californian crops, the price of celery increased several hundred percent. What can you conclude about the shape of its supply curve? The price increase was more moderate for avocados because they can be imported from other countries. Use a graph to explain why the ability to import avocados moderated the price increase.

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Step-by-Step Explanations

QUESTION

How does a 55¢ increase in the price of fertilizer affect the equilibrium price and quantity of avocados?

STEP-BY-STEP ANSWER:

Step 1: Identify that the increase in fertilizer price causes an increase in production costs, leading to a leftward shift in the supply curve from S1 to S2.
Step 2: Recognize that with a leftward shift in supply and a downward sloping demand curve (D1), the equilibrium quantity falls from 80 to 72 million pounds.
Step 3: Note that the reduced supply causes a movement upward along the demand curve resulting in an increase in the equilibrium price from $2.00 to $2.20 per pound.
Final Answer: The shock leads to a decrease in the equilibrium quantity of avocados and an increase in the equilibrium price, thereby hurting consumers.

Supply Shock (Avocado Example)

QUESTION

How does the elasticity of demand and supply determine who bears the burden of a gasoline tax?

STEP-BY-STEP ANSWER:

Step 1: Recall that tax incidence depends on how sensitive consumers (demand elasticity) and producers (supply elasticity) are to price changes.
Step 2: Understand that if demand is relatively inelastic compared to supply, consumers will bear a larger share of the tax burden through higher prices.
Step 3: Conversely, if supply is more inelastic, producers will absorb more of the tax burden, resulting in a smaller increase in consumer prices.
Final Answer: The party (consumers or producers) with the less elastic curve (i.e., less sensitive to price changes) ultimately bears the larger share of the tax burden.

Tax Incidence on Gasoline

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Common Mistakes

  • Ignoring the impact of elasticity when analyzing tax incidence, leading to an oversimplified view of who pays the tax.
  • Assuming that the effects of shocks are uniform regardless of the shape of the demand or supply curve.
  • Mixing up the short-run and long-run responses to a tax or supply shock, resulting in incorrect predictions about market adjustments.
  • Overlooking the fact that shifts in the supply or demand curve can have different magnitude effects depending on curve sensitivity.