Basic Microeconomics Day 4 Lecture- Atty. Roentgen Jude Paolo L.

Ignacio

APPLICATIONS OF ELASTICITY

Businesses Passing Costs to consumers

To maximize profits, businesses come up ways to produce goods and services at a

lower cost. In some cases however, the prices of key inputs in which businesses have
no control would rise.

Let us study its effects on elasticity. For example there has been a technological
breakthrough that made the production of a good or service cheaper. These are called
cost saving gains. The graph is illustrated below:

0
Note that cost saving gains would shift the supply curve to the right. In both cases,
consumers will benefit

Graph A shows the effect of cost saving when demand is highly inelastic.
 Because of the shift from S0 to S1 the point of equilibrium changes from E0 to E1.
At this new point Price decreases substantially from P0 to P1 while there is a small
relative increase of quantity sold from Q0 to Q1.
 Generally, when the demand curve is inelastic, consumers will benefit more
because the shift in the supply results in a much lower price for consumers
Graph B shows the effect of cost saving when demand is highly elastic.
 A technological breakthrough in this case will lead to a much greater quantity
sold but the market price is close at the original price

When demand is inelastic, a major breakthrough in technology that increases supply

will cause a drop in a firm’s revenue. The only thing that will incentivize producers to
improve their products or services in demands with inelastic markets is competition.
The demand for agricultural commodities is highly inelastic. This means that an
increase in price will have a lesser effect on demand. This means that a surge in
production can decrease revenue a farmer receives.
The same is also true in industries that extract natural resources such as logging,
mining and oil drilling. This is why a country that mainly focuses on these industries
and fails to develop a robust manufacturing and services sector ends up stuck in the
third world.

Now let us see the effect of elasticity when there has been a rise of prices in key
inputs that causes the supply curve to shift to the left.

Graph A shows the effect of higher costs of inputs when demand is highly inelastic
 A higher price of inputs in highly inelastic demand would make producers shift
costs to consumers in the form of higher prices since the decrease in quantity
demanded is minimal. In effect, consumers suffer by paying a high price for the
same quantity
Graph B shows the effect of higher costs of inputs when demand is highly elastic
 Since producers cannot pass costs to consumers in the form of higher prices,
producers adjust and just produce less. In effect consumers in this case suffer by
buying lower quantities of that product.

As a matter of example let us see the current situation of effects in the price of oil and
the price of flour.

Since the oil has a demand that is highly inelastic, producers just pass the price
increase to consumers and consumers are willing to pay oil for a higher price but at
the same quantity. But minimal habitual changes will occur to an ordinary consumer
that will have a negligible effect on quantity demanded. For example consumers will
only go for essential trips with their private vehicles but opting for public
transportation on longer trips or to non essential trips. This has a negligible overall
effect in the quantity demanded for the oil market since, in the end they’ll still be
using oil when taking the public transportation.
The main product for flour in the Philippines is bread. In the Philippines, the demand
for bread is highly elastic since we prefer eating rice. The only reason before why
people opted to eat bread is because there was a time that bread was cheaper than rice.
In effect, bakers made the size of bread smaller, since they cannot pass on the costs to
consumers.

Elasticity and Tax Incidence

Tax incidence is the analysis or manner of how a tax burden is divided between
consumers and producers. Typically, the tax incidence falls both on cosumers and
producers of the taxed good. However, if one wants to predict whihc group will bear
the most burden, we’ll have to look at the elasticity of demand and supply.

Note that if demand is more inelastic than supply, consumers bear most of the tax
burden and if supply is more inelastic than demand, sellers bear most of the tax
burden. This because when the demand is inelastic, consumers are not very responsive
to price changes, and the quantity demanded reduces only modestly when the tax is
introduced. Now when the supply is inelastic and a tax is introduced, sellers will have
no alternative but to accept the brunt of taxation on their businesses. This is best
illustrated at the graphs below:

Graph A the supply is inelastic and the demand is elastic.

 By introducing a tax, the government essentially creates a wedge between the
price paid by consumers denoted as Pc and the price recieved by producers
denoted as Pp.
 What happens is that, of the total price paid by consumers, part is retained by
sellers and part is paid to the government as a form of tax.
 The distance between Pc and Pp is the tax rate. The new market price is Pc but
sellers will only recieve Pp per unit sold, as they pay Pc-Pp to the government.
 Notice that the new Quantity is at Qt. This means that this increase in taxation
can be interpreted as a shift of the supply curve to the left that lessened quantity
for Qe to Qt
 The total tax revenue is given by the shaded area, which is obtained by
multiplying the tax per unit by the total quantity sold, Qt
 The tax incidence on the consumers is given by the difference between price paid
Pc and initial equilibrium price Pe.
 The tax incidence on sellers is given by the difference between the initial
equilibrium price Pe and the price they recieve after the tax is introduced Pp
Graph B shows a situation where supply is elastic and demand is inelastic
 Without further discussion, it can be seen here that, the part of taxation where
consumers shoulder the burden is greater than the one in Graph A