Semester II, 2022-2023

Jo Seung-gyu
NUS Business School
BMA5001 MANAGERIAL ECONOMICS

Lecture Notes 2

BASICS OF MARKET FORCES, ELASTICITIES AND

WELFARE MEASURES

Part A: Demand & Supply, Market Equilibrium and

Elasticities

Part B: Welfare Measures and Government Intervention

1
 Readings

 Demand, Supply and Market Equilibrium

 Coffee Price Economics and a Latin America’s Story
 Market Forces and Boom-and-Bust Pork Price Cycles in China
 Calling all newspapers – A premium model is your best hope
 COVID-19 and Netflix Pricing
 Rent Control
 Thailand's Rice Saga and Fall of Yingluck Shinawatra

 Video Clip

 Rent Control in NYC (from YouTube)

(https://www.youtube.com/watch?v=R0h8kfA4i_A)

2
PART A:
Demand & Supply, Market Equilibrium
and Elasticities

3
Outline

1. Motivation
2. Demand and Supply
 Market Demand, Market Supply and Market Equilibrium
 Real Life Examples
 Appendix I – Casual Model of Predicting Market Equilibrium
3. Elasticity
 (Own) Price Elasticity of Demand and Applications
 Income Elasticity of Demand
 Cross Price Elasticity of Demand
 Own Price Elasticity of Supply
4. Welfare Measures and Government Intervention
 Motivating Example: Price Controls
 Consumer Surplus and Producer Surplus
 Applications
─ Price Control: Case of Price Floor
─ Sales Tax (GST or VAT)
 Discussion from the Readings
5. Managerial Implications

4
 I. Motivation

• Who Pays the Property Tax?

o Who – landlords or tenants – ultimately bears the burden of a tax?
o What does the tax incidence depend on?
o How would the involved parties be affected, in terms of economic
well-being (i.e. economic welfare)?
o How about the price controls, like price floor or price ceiling?

• Your boss wanted you to increase the sales revenue.

o Ceteris paribus, would you increase the price or decrease it?
o If 10% revenue increase is the target, how much of price
increase/decrease would you need?

• Rent Control
o Under upward pressure on rents, would a rent cap help to stabilize
the housing market? Any downside?
o How would you view the newly introduced rent control in Hong Kong?

5
Outline

1. Motivation

2. Demand and Supply

 Market Demand, Market Supply and Market Equilibrium
 Real Life Example
 Appendix I – Casual Model of Predicting Market
Equilibrium(Separately Uploaded)
3. Elasticity
 (Own) Price Elasticity of Demand
 Income Elasticity of Demand
 Own Price Elasticity of Supply
 Cross Price Elasticity of Demand
4. Welfare Measures and Government Intervention
We first investigate the
 Motivating Example: Price Controls demand and supply at the
 Consumer Surplus and Producer Surplus aggregate level – i.e. market
 Applications level – before we discuss
─ Price Control: Case of Price Floor underlying individual
─ Sales Tax (GST or VAT) consumer’s and firm’s
 Discussion from the Readings behavior later.
5. Managerial Implications

6
 Basic Market Forces: Demand and Supply

There are many dimensions on which we can examine market exchanges.

In our coursework, we will concentrate on two:

─ individual exchanges and

─ exchanges at aggregate (i.e. market) level.

We first investigate the market exchanges at the aggregate – i.e. market –

level and then we will see the underlying individual consumer’s and firm’s
behavior.

■ Reminder:

Distinguish individual and aggregate level:

• Individual (Consumer’s) Demand vs Market Demand

• Individual (Producer’s) Supply vs Market Supply

7
 (Market) Demand Function/Curve

Various quantities of a good that buyers in the market are willing to

purchase at all possible prices over a given time period, given all
the other factors that affect demand decision

 Demand Function for Good X:

DX (or QX or QD) = D(PX : Py , Income, Tastes, Advertising etc)

 Demand Curve for Good X • It usually – not always – slopes downward.

You move up/down along the curve as
Price/Unit price Px changes while the curve shifts as
(PX)
other external factors change.
Demand Curve DX • ‘Desired’ and ‘flow’ level of quantities to be
demanded.
$10 • (important!) A locus of points representing the
maximum prices consumers are willing to pay
for each quantity unit

Quantity/Time Period • Not necessarily linear

100
(QX) 8
 (Market) Supply Function/Curve

Various quantities of a good that sellers in the market are willing to

offer at all possible prices over a given time period, given all the
other factors that affect supply decision

 Supply Function of Good X:

SX (or QX or QS) = S(PX : Py , cost, # of competitors, technology etc)

 Supply Curve of Good X:

• It usually – not always – slopes upward
You move up/down along the curve as
Price/Unit price Px changes while the curve shifts
(PX)
Supply Curve SX
as other external factor change.
• ‘Desired’ and ‘flow’ level of quantities to be
supplied
$10
• A locus of points representing minimum
prices at which firms are willing to sell each
quantity unit.
Quantity/Time Period
100 • Not necessarily linear
(QX)

9
 (Competitive) Market Equilibrium

Market equilibrium price is obtained at a price at which the desired quantity

demanded and desired quantity supplied are equal

• If P = P2, there is a surplus (i.e. excess supply) and

the price would decrease.
P Surplus
D S If P = P3, there is a shortage (i.e. excess demand)
and the price would increase.
P2
E • The market (clearing) equilibrium price and
P1
quantity would be (P1, Q1) at E.
─ Any movement from this price will lead the
P3 market forces to adjust the price back toward
the equilibrium
Shortage ─ This adjustment process is called ‘market
Q mechanism’, ruled by the famous ‘invisible
Q2 Q3 Q1 Q4 Q5 hand’.
─ Transactions occur only at the equilibrium
price, assuming price movement is fast
enough.
10
  Shifts in Demand/Supply
• A change in its own price Px causes a movement along D DX = D(PX : Py , Income, Tastes, Advertising etc)
or S curves.
• When there is a change in non-price factors, the D or S SX = S(PX : Py , costs, # of competitors, technology etc)
curve shifts.

 Shifts in Supply:
 Shifts in Demand:
When there is a change in non-price factors
When there is a change in non-price factors
(given the price of its own good)
(given the price of its own good)

e.g.: Change in Income? e.g.: Change in Cost?

P P SL S0 SR
DL D0 DR

P0
P0

Q Q
QL Q0 QR QL Q0 QR

Note: Distinguish the followings:

• a change in quantity demanded/supplied = ‘a movement along D/S-curve’
• a change in demand/supply = a shift of D/S-curve
11
 Demand Function vs Demand Curve: An Example

Suppose Prof. Jo wrote an econ textbook, whose demand relationship (i.e. function)
has been estimated as follows:

 Demand Function QE = 10,000 – 200 PE + 0.1Y + 50C + 200PU

QE : quantity of textbooks demanded in a semester

PE : price per copy of the textbook
Y : per capita income/budget of students for the semester
C : % of seniors saying Prof. Jo is cool (between 0 to 100)
PU : price of a used textbook (or some other alternatives)

 Demand Curve Suppose Y = $15,000, C = 50 (%), PU = $10

Substituting the known values into the P

demand equation yields a demand curve. 80 PE = 80 – (1/200)QE
It shows how P and Q are negatively
related.

Q
16,000
12
 A Change in Non-Price Variables and Shift of Demand:

QE = 10,000 – 200 PE + 0.1Y + 50C + 200PU

 Suppose, ceteris paribus, PU decreases from $10 to $5.

 To derive the new demand, substitute Y = $15,000, C = 50 (%), and PU = $5.

Then, the new demand curve is PE = 75 – (1/200)QE

80
Old D: PE = 80 – (1/200)QE
75 New D: PE = 75 – (1/200)QE

Q
15,000 16,000

Exercise: What if Y or C increases? (Do your own exercise.)

13
 Real life stories through D-S framework
(Do exercise your own graphical analysis)

Discussion from the readings:

Apply Demand-Supply curves framework to explain the following

cycles:

1. ‘Market Forces and Boom-and-Bust Pork Price Cycles in

China (2011-2018)’

2. ‘Coffee Price Economics and a Latin America’s Story’

Let us do discuss now, starting from the pork story and then
coffee price dynamics.

14
 ‘Market Forces and Boom-and-Bust Pork Price Cycles in China’

Income/Taste Change  D shifts

Thus, Boom-and-Bust Cycle:

Cost Change (and gov’t policy) S shifts

  Story of Boom-and-Bust Cycle at a Glance for the Last Decade (Until pre-COVID-19)
“Over the past 30 years, meat consumption per
capita has quadrupled, due to economic growth”
(PBS News)
12kg/person in 1980
40kg/person in 2016
D shifts right S shifts left
Pork price soars (2011)
“China’s Commerce Ministry planned to release part of
the central government’s 200,000-metric-ton stash of
frozen pork – ‘pork reserve’ – onto the market” (NYT)
“Driven by high pork margins, many farmers have started
to replenish their farms and breed pigs” (Rabobank)
“People are starting to eat more beef, chicken and fish.”
(South China Morning Post)
S shifts right, D shifts left and
pork price stabilized (since 2012)
“2008 global food crisis and bio fuel boom caused a
soybean price surge in 2010. 80% of China’s soybean
consumption is imported, almost all used to feed pigs.
Feed costs are about 70% of the total for swine
production.” (WSJ)
Boom-and-Bust cycle repeats
(2018-2020 US-China trade war and Swine Flu
cause pork price to surge to a record high level.)
China’s pork import reaches its record,
and govn’t plans to release additional pork
reserve, yet demand hardly goes down.
S shifts left and Pork price picks
up again (2015)
“Nearly 100 million hogs and 10 million sows
have been culled over the past 18 months as
smaller producers exited the market amid low
prices and tough competition”(AFR)
16
 Discussion: How about a coffee story?

(from the reading, ‘Coffee Price Economics and a Latin America’s Story’)

17
 In Practice

How do we get market demand curves?

1. survey consumers
2. focus groups or conjoint analysis - to measure people’s
preference as done in marketing
3. conduct econometric estimation and statistically relate P’s and
Q’s (and other external factors)

How do we get market supply curves?

1. ask producers what they’re planning to do

2. forecast cost functions if market is competitive
3. conduct econometric estimation and statistically relate P’s and
Q’s (and other external factors)

18
 APPENDIX
(Please find it separately posted):

‘A CASUAL MODEL TO PREDICT MARKET EQUILIBRIUM’

We will not go over this in class, but please refer to this appendix
separately posted to learn how we can predict a linear demand
curve given a set of limited yet useful information.

Particularly, it will be important to read and understand this appendix

to understand and challenge Case 1 (Mr. Bus King’s Story).

19
Outline

1. Motivation
2. Demand and Supply
 Market Demand, Market Supply and Market Equilibrium
 Real Life Example: Market Forces and Pork Price in China
 Appendix I – Casual Model of Predicting Market Equilibrium

3. Elasticity
 (Own) Price Elasticity of Demand
 Income Elasticity of Demand
 Own Price Elasticity of Supply
 Cross Price Elasticity of Demand
4. Welfare Measures and Government Intervention Elasticity:
 Motivating Example: Price Controls
Percentage change in
 Consumer Surplus and Producer Surplus
one variable resulting
 Applications from a 1-percent
─ Price Control: Case of Price Floor increase in another.
─ Sales Tax (GST or VAT)
 Discussion from the Readings
5. Managerial Implications

20
 Introduction: Elasticities
• Motivation:

You are the manager of a movie theater and would like to improve profits.
Assume all of your costs are fixed (i.e. variable cost = 0). Then you want
to maximize your revenue.
Question: Would you increase the price or decrease the price?

Issue is:
P goes up (down)  QD goes down (up)  Revenue?

Not just magnitude but ‘relative % change’ matters.

Elasticity is the key concept, here.

─ Elasticity simply measures the percentage change in one

variable associated with a one-percent change in another
variable.
─ It is a measure of relative sensitivity of demand/supply to the
changes in environmental variables. Understanding this
sensitivity enables managers to effectively respond to the
environmental changes. 21
 (Own) Price Elasticity of Demand
Percentage change in quantity demanded of a good
resulting from a percentage change in its price.

% change in quantity demanded

eD (or eP or ηp ) =  Advanced Technical Note:
% change in product price
If ∆P is small enough, we can
∆QD QD P ∆QD replace it by
e=
D = ×
∆P P QD ∆P dQD QD P dQD
=eD =
P: initial price level dP P QD dP
QD: initial quantity demanded

Note: Often, we just take the absolute value by adding (–) sign in front :

∆QD QD P ∆QD
(−)
eD = (−)
=
∆P P QD ∆P
22
 Example:
P D: Q = 10 – 2P or
 Demand: Q = 10 – 2P or P = 5 – (1/2)Q P = 5 – (1/2)Q
5 A
 Question: 4 B
If the price decreased from A to B, what is 3
the price elasticity of this demand?:

Q
2 4 10

∆QD QD P ∆QD
Recall e=
D = ×
∆P P QD ∆P

(4 − 2) 2 (2) 2
Thus, ( −)
eD = ( −)
= (−)4
=
(3 − 4) 4 (−1) 4

4
or eD = (−) x (−2) = (−)4
2
23
 Point Elasticity vs Arc Elasticity

Point Elasticity: price elasticity at a Arc Elasticity: price elasticity over a

particular point on the demand curve range of prices.

∆QD QD P ∆QD (Q2 − Q1 ) ( P2 − P1 )

=eD = eD =
∆P P QD ∆P (Q1 + Q2 ) 2 ( P1 + P2 ) 2

Exercise: Given the demand Q = 10 – 2P, compare two (P, Q) observations of A(4, 2) and B(3, 4).

 Point elasticity: P
4 D: Q = 10 – 2P
─ if change was from A to B: eD = ( −2) =−4
2 5 A
3 4 B
─ if change was from B to A: eD = ( −2) =−1.5 3
4

(4 − 2) (3 − 4) Q
 Arc Elasticity: eD = = −2.33
(2 + 4) 2 (4 + 3) 2 2 4 10
24
 Price Elasticity vs Slope (i.e. Gradient) eD (or eP or ηp ) =
% change in quantity demanded
% change in product price
P
∆QD QD P ∆QD
=eD =
P1 B: |eD| >1
∆P P QD ∆P

P2 A: |eD| = 1 (A is the middle point)

●

P3 C: |eD| <1

Q
Q1 Q2 Q3

• If D is linear, the slope is the same along the demand curve but the elasticity
varies along the curve.

A : |eD| = 1 at the middle point on a linear demand (unit elastic)

B : |eD| > 1 (elastic)
C : |eD| < 1 (inelastic)

• When two demand curves with different slopes are compared at the same point,
however, the flatter demand exhibits a higher elasticity.
25
 Special Cases

P D P

Q Q

What is the elasticity for each case?

26
 Price Elasticities in Real Life: Examples

• Own Price Elasticities of Cigarettes (2017, USA):

(─) 1.43 for teenagers
(─) 0.60 for men
(─) 0.76 for young adults
(─) 0.34 for women
(─) 0.32 for adults

• Price (i.e. Fare) Elasticities of Public Transport in Singapore

Source:
Research Paper by NUS, 2010, APEC Economics Seminar,
Hiroshima, Japan 27
 Application: Price Elasticity and Revenue Maximization

Price elasticity gives us a meaningful hint about the relation between price and revenue.

Getting back to the movie theater manager’s problem, suppose that the demand for
movie tickets is given by P = 8 – QD

Demand: P = 8 – QD
P
Price Quantity Total Revenue eD = (P/QD)(dQD/dP)
|eD| >1 8 0 0 -∞
8 7 1 7 -7
|eD| = 1 6 2 12 -3
5 3 15 -1.667
4 4 4 16 -1
|eD| <1 3 5 15 -0.6
2 6 12 -0.333
1 7 7 -0.143
Q 0 8 0 0.000
4 8

28
 To summarize: Revenue Implication of Price Changes:

|eD| Price Total Revenue

>1 (elastic) up down
down up

=1 (unitary) up constant
down constant

<1 (inelastic) up up
down down

(Advanced) Technical Note

Total revenue (TR) = PxQ

To maximize TR, set dTR/dQ = 0 or

d(TR)/dQ = P + Q (dP/dQ) = P + P(Q/P)(dP/dQ)
= P[1 + (Q/P)(dP/dQ)] = P[1 + (1/eD)]
=0
Thus, TR is maximized when eD = -1. 29
 Reality check (Case of New York Times)

Discussion from the reading: ‘Calling all newspapers – A premium model is your best hope’

Consumers abandon print media, preferring free or low-cost sources. In light of

this move away from print, does it make sense for newspapers to cut prices to
stay competitive?

 Issues
Consumer segmentation
─ ‘online readers’ vs ‘print readers’
Online readers’ price elasticity is around (–) 1.8: elastic!
Print readers’ price elasticity is around (–) 0.7: inelastic!
─ Thus, online readers are hardly coming back. So, you are to increase the price.

 Reality Check?
New York Times increased weekday paper price ($1.50  $2.00 in 2009 and $2.50 since 2012) 
Circulation dropped yet circulation revenue improved by 3%.

 Strategic Suggestion?
• A premium model is the hope!

30
 Reality check (Case of Netflix Subscription and COVID-19)
Discussion from the reading:
‘Covid-19 and Netflix Pricing: Customers Willing to Pay
More than Ever for Netflix’

Demand for streaming services has been price-inelastic for years. For
Netflix, its price elasticity before COVID-19 was – 0.6.

• Netflix raised its price in 2019 by $1 or $2 for all plans, yet

subscribers grew by 20% and revenue by 28%.

With the outbreak of COVID-19, customers value streaming services like

Netflix now more than ever, whose price elasticity collapsed to – 0.13.

• In October 2020, Netflix increased it price by $1 or $2 again.

• Its impact on subscription and revenue went up in the beginning
• In 2022, however, Netflix’ lost subscribers and its revenue, due to
changes in external factors.

31
Other Elasticities in Economics

∆QD QD Y ∆QD
 Income Elasticity of Demand (e=
Y): eY =
∆Y Y QD ∆Y

It measures the sensitivity of quantity

 Real Life Examples:
demanded to changes in income. Note that
- Automobiles: 2.98
the sign matters:
- Books: 1.44
- Tobacco: 0.64
─ eY > 0, then called Normal Goods - Margarine: − 0.20
─ eY < 0, then called Inferior Goods - Public Transportation: − 0.36

 Own Price Elasticity of Supply (eS):

It measures the sensitivity of producers’ supply ∆QS QS P ∆QS

of a product to changes in its price. =eS =
∆P P QS ∆P
32
 (Cross Price Elasticity of Demand (eXY):

It measures the sensitivity of quantity ∆Q X Q X PY ∆Q X

demanded for product X to a change in the =eXY =
price of product Y ∆PY PY Q X ∆PY

My Own Experience

- eXY > 0, then called substitutes (Chicken Rice vs Porridge)

- eXY < 0, then called complements (Chicken Rice vs Green Chili)

33
 Application: (At the bar)

• Why do beer bars charge patrons for water but give them peanuts for free?

• How about scotch whisky bars?

 Application: (At Philip Morris & How I Got My Green Mustang^^)

─ Own and cross price elasticities: (-)4 & 0.1

─ Cannibalism?

34
PART B:
Government Interventions and Welfare
Analysis

35
Outline

1. Motivation
2. Demand and Supply
 Market Demand, Market Supply and Market Equilibrium
 Real Life Example: Market Forces and Pork Price in China
 Appendix I – Casual Model of Predicting Market Equilibrium
3. Elasticity
 (Own) Price Elasticity of Demand
 Income Elasticity of Demand
 Own Price Elasticity of Supply
 Cross Price Elasticity of Demand
4. Welfare Measures and Government
Intervention
 Motivating Example: Price Controls
 Consumer Surplus and Producer Surplus
 Applications
─ Price Control: Case of Price Floor
─ Sales Tax (GST or VAT)
 Discussion from the Readings
5. Managerial Implications
36
 Motivating Story: Rent Control in New York City

West Village Townhouse

at 59 Morton Street, NYC

• A 1,000 square-foot unit rents for US$6,300/month

• Another unit of the same size in the same building rents for US$127/month
(Video Clip from Youtube: http://www.youtube.com/watch?v=R0h8kfA4i_A)

 Issue: Would a rent control help the tenants, or harm them?

Below we discuss economics of such a government intervention.

37
 Price Controls
 Price Floor (Minimum Price)
Market equilibrium is at E. Governments may set a minimum price like PF. This
is a price floor situation; prices cannot fall below PF
by government mandate.
P Excess Supply
D S  Practical examples?
PF
 The result is a surplus – i.e. excess supply,
E possibly resulting in black market deals.

Pc  Price Ceiling (Maximum Price)

Excess Demand
Governments may set a maximum price like Pc.
Q This is a price ceiling; prices cannot rise above Pc
by government mandate.

 Practical examples?
 The result is a shortage – i.e. excess demand,
possibly resulting in long lines or rationing of
products or bad quality of the goods/services.
(Black markets may evolve as well.)
38
 ISSUE

 When a price control is introduced, there will be losers

and winners.

 How should we evaluate the winners’ gain and the

losers’ loss?

 Would the winners’ gain outweigh the losers’ loss?

 Let us see how economics measures economic gains and losses.

39
 Welfare Measures: Consumer Surplus (CS) and Producer Surplus (PS)

 Consumer Surplus (CS)

• Consumer surplus is an economic measure of consumer well-being.

• It is measured by the difference between the total amount

consumers are willing to pay for a good or service – i.e. consumer
reservation prices – and the total amount they actually pay.

• At P=$40, consumers want to buy 6 units of

Suppose market price = $40
the good.
P
A • Demand curve measures consumers’
100 maximum willingness to pay, so consumers
are willing to pay area(ABC) + area(BEFC)
D: P=100 - 10Q
But, through the market transaction,
consumers pay only area(BEFC).
P=$40 B C
• Thus, in this example, consumers get to enjoy
consumer surplus:
E F
Q CS = Area (ABC)
0 1 2 3 4 5 6 10
= 0.5(100 – 40)6 = $180
40
 Producer Surplus (PS)

• Producer surplus is an economic measure of producer (or seller) benefits.

• It is measured by the difference between the total amount a producer (or

seller) of a good actually earns and the minimum amount the producer
(or seller) is willing to sell the good for.

• At P=$40, producers (or sellers) want to sell 3

Suppose market price = $40 units of the good.

• Supply curve measures the minimum amount

S: P = 10+10Q sellers are willing to sell the good for, so sellers
P
A C are willing to sell 3 units at the revenue of
P =40 area(BEFC)

But, through the market transaction, sellers sell

the good for area(ABC) + area(BEFC).

B • Thus, in this example, sellers get to enjoy

10 producer surplus:

E F PS = Area (ABC)
Q = 0.5(40 – 10)3 = $45
1 2 3 41
 Applications of CS and PS: Government Intervention Cases
By interfering with the free market mechanism the government creates market biases
that will produce ‘winners’ and ‘losers’ relative to a free market mechanism, as it
happens whenever an external factor distorts the free market transaction.

Using the concept of CS and PS, we can analyze how a government intervention or a
market distortion affects a society’s overall ‘social welfare’.

Effect on Social Welfare in General

= ∆CS + ∆PS + ∆GR(gov’t revenue, if any)

Below, we explore the social welfare effects associated with the following government
interventions:

(1) Price Control:

─ We’ll only investigate the case of Price Floor (Minimum Price)
─ Price Ceiling (Maximum Price) is left as an exercise.

(2) Sales Tax (GST or VAT)

─ Case of a ‘specific’ GST/VAT (fixed amount tax per unit)
(if % tax, it is called ‘ad-valorem’ tax)

42
(i) Welfare Effect of Price Control

Below, we apply the concepts of CS and PS to evaluate the effects of

government intervention through a price floor.

(The case of price ceiling is left as an exercise.)

43
 Economic Effect of a Price Floor
S2 (less elastic)
P
S1

A
Pfloor

B C
PMarket

D E

F
D

Q
Q1 QMarket

Under Pmarket Under Pfloor Effect

CS A+B+C A - (B+C)
PS D+E B+D (B - E)
Social The overall social welfare
A+B+C+D+E A+B+D - (C+E)
Welfare loss of (C+E) is called
‘deadweight loss (DWL)’.

 Further Investigation:
• Is (B-E) greater than, less than, or equal to 0?
• What happens when the supply becomes less elastic, like S2?
• Case of Price Ceilings – do your own exercise through textbook.
44
 (Case 2) Price Support
Qg S
What if the government sets a price floor (or,
Target Price A
rather a target price) at P* and buys up Pfloor
(P*) ● ●
whatever output is needed to maintain the I
B C
price floor: Qg = Q2 – Q1? (This policy is PMarket H
called a Price Support.) D + Qg
D E

F G
Then, the welfare effects are: D
Q
Q1 QMarket Q2

Under Pmarket Under Price Support Effect

CS A+B+C A - (B+C)
PS D+E B+D + (C+E+I) (B+C+I)
Gov’t Exp’ture none - (C+E+F+G+H+I) - (C+E+F+G+H+I) DWL
Social Welfare A+B+C+D+E A+B+D – (F+G+H) - (C+E+F+G+H)

 ‘Price Support’ in real life?

Thailand’s Rice-Pledging Scheme: It cost the country $27.7 billion and
the PM Yingluck Shinawatra an impeachment.
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(2) Welfare Effect of Sales Tax (GST or VAT)

Governments impose taxes – sales tax or VAT or GST – on goods/services

transactions for various objectives. Governments may want to simply gap the
state budget deficit or reallocate the resources to the benefit of the whole
society.

─ A sales tax is a tax paid to a governing body for the sales of certain
goods and services. Usually laws allow (or require) the seller to
collect funds for the tax from the consumer at the point of purchase.

A value-added tax (VAT) or goods and services tax (GST) is a tax

on the amount by which the value of an article has been increased at
each stage of its production or distribution. (7% in Singapore, 6% in
Malaysia)

─ The two taxing systems are not exactly identical but, conceptually,
we will treat them as the same kind.

Here, we will focus on the issue of economic incidence of the tax.

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 Statutory Incidence vs Economic Incidence of the tax • $10 for bread
 (Statutory Tax Incidence) The government wants to • $1 sales tax
impose a $1.00 sales tax (VAT or GST) on cigarettes. It
can do it two ways:
$10 $11
─ Make consumers pay the tax $1.00 for each movie
ticket they buy (US Sales Tax)
─ Make sellers pay the tax $1.00 for each movie ticket cashier
they sell (Singapore GST, Korean/EU VAT) $10 $10

─ The only difference is whether the price tag includes

the tax or not.
$1

 (Economic Tax Incidence) Who gets to bear the tax

after all? $10
$1 $11
─ The burden of a tax (or the benefit of a subsidy)
falls partly on the consumer and partly on the
producer.
─ How the burden is split between the parties
depends on the relative elasticities of demand and
supply. shopper
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 Case of ‘Specific’ Sales Tax/GST/VAT (i.e. a fixed amount of tax per unit)
For simplicity we will consider a specific tax of $1 per pack of cigarette sold, whose
legal duty is statutorily imposed on the sellers (as in EU and Singapore).
 Then the Supply Curve would shift up by $1 (since sellers want to collect
additional $1 from the consumers for each unit.).

(after tax) Welfare Effects

(before tax)
 Buyers lose (A + B)
●
●
●  Sellers lose (D + C)
●  The government earns (A + D)
PS●● in revenue.
 The deadweight loss is (B + C)

 Economic Tax Incidence:

The tax of $1 (or Pb-PS) is split into two parts:
─ (Pb – P0) is buyers’ burden and
─ (P0 - Ps) is sellers’ burden.
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 Elasticity and Economic Tax Incidence
(Who bears more tax burden between consumers and sellers?

More Burden on Buyers More Burden on Sellers

P P
D S

Pb
S
t Pb
P0 P0
PS
t
D
P
S

Q
Q1 Q0 Q1 Q0

 If demand is relatively inelastic, burden of tax will fall mostly on buyers.

 If supply is relatively inelastic, however, the burden of tax will fall mostly
on sellers

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 An Analogy:

Who to tax – sellers or buyers?

 In our above discussion, price (P) was tax-inclusive and thus

statutorily sellers were taxed.

 What if buyers are taxed statutorily (that is, consumers pay tax
in addition to the price on the tag, as in US)?
─ This is to be left as an exercise. (In this case, price (P)
should be exclusive of the tax – i.e. the price consumers
pay to the sellers before tax.)

Technical Point:

To find the new equilibrium, shift up (down) supply (demand) curves

if sellers (buyers) are taxed. Make sure to distinguish the sellers’
price and the buyers’ price depending on the statutory incidences.

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 Discussions from the Readings – Price Controls

 ‘Rent Control (in NYC and Hanoi)’

Video Clip: http://www.youtube.com/watch?v=R0h8kfA4i_A

• ‘Thailand's Rice Saga and Fall of Yingluck Shinawatra’

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Outline

1. Motivation
2. Demand and Supply
 Market Demand, Market Supply and Market Equilibrium
 Real Life Example: Market Forces and Pork Price in China
 Appendix I – Casual Model of Predicting Market Equilibrium
3. Elasticity
 (Own) Price Elasticity of Demand
 Income Elasticity of Demand
 Own Price Elasticity of Supply
 Cross Price Elasticity of Demand
4. Government Intervention and Welfare Analysis
 Motivating Example: Price Controls
 Consumer Surplus and Producer Surplus
 Applications
─ Price Control: Case of Price Floor
─ Sales Tax (GST or VAT)
 Discussion from the Readings
5. Managerial Implications

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 MANAGERIAL IMPLICATIONS

The managerial implications parts are for your self-reading, while

we sometimes may openly discuss it as well.

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  Managerial Implications of Elasticites

Clearly, understanding the various elasticities of their products and those of rivals
can help managers improve firm performance. The following general rules may
help you understand the intuitions underlying the mathematics.

1. Managerial Implications: Own Price Elasticity of Demand:

• Understanding own price elasticities is especially important in price setting

decisions.
Eg. Movie discount for students

• Own price elasticity of demand is a function of several factors:

(i) The more substitutes available, the more own price elastic.
- Diversity in a food court matters. (The Deck vs The Terrace)
- Phillip Morris – Beware of cannibalism

(ii) Managers must recognize that rivals as well as customers will react
to corporate actions, which all affect the elasticities.

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2. Managerial Implications: Income Elasticities

 Income elasticities naturally matter both for market planning and business
level strategies.

Firms whose products have high income elasticities can expect growth in a
generally growing economy, however, will be more vulnerable to business
recessions. Conversely, firms whose products have low income-elasticities
are more recession proof, but they cannot expect the large increase in
sales when the economy is growing.

(Example: old TV vs LED TV, Hyundai Sonata vs A8)

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3. Managerial Implications: Cross Price Elasticities

 Not only the cross price elasticities indicate whether two products are substitutes or
complements but understanding of cross price elasticities is also a vital parameter in
formulating business level strategy and in pricing strategies across a firm’s product lines.

− Own products
Gillette’s razors and blades: complementary relation
Honda’s Stream vs Vezel: substitute relation
− Rival products: Starbucks vs Coffee Beans

 Cross price elasticities are useful in identifying competing products, defining market
boundaries (i.e. how relevant is relevant?), and in pricing as well.

− Unless low enough, managers should not ignore the rival’s products.
− Cross price elasticities are often quoted in anti-trust cases to identify the market
boundaries. (Recall the Staples-Office Depot Merger Case from Lecture Notes 1)

− To smoothen Peak Hour MRT Travel, Would you increase the peak hour MRT fare or
decrease the off-peak hour fare?

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 Managerial Implications of CS and PS

• We are interested in consumer surplus throughout the class because,

the greater the consumer surplus is, the greater is the money left on the
table and the lower is the firm performance. Note that consumers may be
willing to pay a higher price for a good (or service) than that set by
managers. As we will see later, if managers can devise more sophisticated
pricing strategies, they can capture more of the consumer surplus, and
improve firm performance.

We are also interested in producer surplus because

the greater the producer surplus is, the better is the firm’s performance.
(Later, we will show that producer surplus is very closely related to firm
profit, differing only by the firm’s fixed costs).

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END of LECTURE NOTES 2
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