Ilmu Ekonomi

Pertemuan 4

Prodi PIWAR Politeknik APP Jakarta

Recap on last week

We use consumer and producer surplus to measure the efficiency of the economy. We want the combination of both to be generally bigger.
The two face a constant political battle: consumer wants small prices, producers like high prices.
When market is perfect, intervention often leads to various types of inefficiency

Today

We will learn about one more intervention: tax.
before we go there, it is best to understand elasticity first.

What’s an elasticity?

If you are a business owner, understanding elasticity is important aspect to get maximized profit.
Price elasticity of demand of a good is a concept of how much the demand of that good change its price changes.
- we usually just say elasticity in short.
Maximizing profit requires this knowledge:
- sometimes it is better to sell cheap to gain huge market share, or sell high if niche.

Calculating elasticity

Consider the demand curve on the right.
At \(P_1=10\), the daily traffic is \(Q_1=140\)
When \(P_2=11\), daily traffic drops to \(Q_2=127.3\)

Calculating elasticity

To calculate elasticity of demand, we first calculate:
1. percent change in the quantity demanded
2. percent change in the price
Formula for no.1:

\[ \tag{1} \text{% change in }Q^D=\frac{Q_2^D-Q_1^D}{Q_1^D}\times 100 \]

Formula for no.2:

\[ \tag{2} \text{% change in P}=\frac{P_2-P_1}{P_1}\times 100 \]

Calculating elasticity

for our case, we have:

\[ \begin{align*} Q_1^D&=140 & Q_2^D&=127.3 \\ P_1&=10 & P_2&=11 \end{align*} \]

Thus:

\[ \begin{align} \text{% change in }Q^D &= \frac{127.3-140}{127.3}\times 100 \\ &=-10 \% \end{align} \]

\[ \begin{align} \text{% change in P} &= \frac{11-10}{10}\times 100 \\ &=10\% \end{align} \]

Calculating elasticity

After we get the numbers from {1} and {2}, we use this formula:

\[ \tag{3} \text{Price elasticity of demand}=\frac{\text{% change in }Q^D}{\text{% change in P}} \]

in our case, we have:

\[ \begin{align} \text{Price elasticity of demand}&=\frac{-10\%}{10\%} \\ &=-1 \end{align} \]

Calculating elasticity

Economists are also lazy in writing the minus sign.
Usually we report demand elasticity in absolute term.
- i.e., we drop the minus sign.
However, since most demand curves are downward sloping, it must be negative
- hence we automatically knows what it means even when we report in absolute term.

About percent change

Using percent changes is more useful than absolute changes - Things are usually move on proportion - A wealthy person will feel casual getting 1 million IDR because it’s probably just a small % of her total wealth.

Quantity and prices have many metrics
- kgs, litres, units, pairs, units/day, etc
- IDR, USD, btc, etc.

interpreting elasticity

via GIPHY

Interpreting elasticity

We have seen the elasticity of our toll road case is around 1, but what does this mean?
Note that the elasticity formula has % change in Q at the top, and % change in P at the bottom.
In a sense, the number shows how much quantity change given the price change.
that means, the bigger the number of the price elasticity, the more elastic it is

A market is elastic. So what?

Let’s have a look at different ‘kind’ of elasticities and what they mean

We’ll begin with two extreme cases of elasticity: zero (0) and infinity ( \(\infty\) )

Two extreme cases

Suppose the toll road is the only way to go to work.
- No matter how high the price, people will still need to use it.
- Hence, change in the demand of toll road is zero for any change in price.
Suppose shuttlecocks are priced 10.000 IDR
- If people don’t care about the shuttlecocks’ color, everyone will buy the pink one if the price drop to 9.900
- Everyone won’t buy a single one if the price go up only to 10.100 IDR

Two extreme cases of elasticity

an illustration of perfectly inelastic demand

an illustration of perfectly elastic demand

Types of elasticities

Most goods are somewhere in between.
We usually use elasticity=1 as another important division point.
1 is a useful barrier because when elasticity=1, that means a change in price by 1 % leads to a change in quantity demanded by 1 %
elasticity < 1 means the quantity response less than a change in prices, while elasticity > 1 means the quantity is highly responsive, more than the change in price.

The flatter the curve, the closer its elasticity to \(\infty\)

Types of demand elasticities

Elasticity	meaning
0	perfectly inelastic. Price doesn’t matter
< 1	inelastic. Quantity is less responsive to price changes
1	unit elastic. Quantity change exactly the same as the price change in % terms
>1	elastic. Quantity response heavily to price changes
\(\infty\)	perfectly elastic. A slight increase of price reduces demand to zero

Elasticities vary. So what?

Suppose you wan’t to increase the revenue from the toll road operation, what price will you set?
It is intuitive to think that the higher the price, the better.
- High price \(\Rightarrow\) more revenue
Is there a problem with this logic?
Remember, demand respond to price. High price \(\Rightarrow\) lower demand \(\Rightarrow\) less revenue
The maximum price depends on the demand elasticity

Impact of price increase

Segment A is the Quantity effect of price increase
- Negative effect since fewer units sold
Segment C is the Price effect of price increase
- positive effect since higher price for each unit sold

Impact of price increase

If you are profit oriented, Increasing the price is a good idea if:

\[ B+C > B+A \]

\[ C>A \]

Impact of price increase

In a market with high demand elasticity, the quantity effect outweighs the price effect.
Increasing the price is not so clever if the market’s demand is highly elastic.

Last point on demand elasticity

When elasticity = 1, then \(A=C\)
- hence changing price has no impact on sales revenue.
Profit oriented in the real life may not very realistic
- Governments may want to serve as much people as possible
- In the short run, growth and market cap may be more important than profit.

Last point on demand elasticity

We usually tied elasticity on a price point.
- on our toll road case, our price point is 10.000 IDR
Elasticity may differ in different price point.
- Changing price from 10 to 11 may have different impact compared to changing price from 20 to 21.
  - the first one is an increase of 10%.
  - the second one is an increase of 5%.
  - in absolute term, both are a 1.000 IDR increase.

Last point on demand elasticity

Estimating elasticity is very hard
There are many things also at play:
- different condition in different time
- different buyer with different characteristics behave differently
- Income, taste, etc matters (remember what shifts the demand curve?)

Factors determine demand elasticity

A necessity good tend to have lower elasticity compared to a luxury good.
The availability of close substitutes, like the case with pertamax and shell.
Share of income spent on the good. Rich people may not care with toll road price.
Time. Cigarettes may have low elasticity in the short run because it is so addictive, and adapt later in the long run.

Other types of demand elasticity

Cross price elasticity of demand is how the price of good \(B\) affects a demand of good \(A\).

\[ \tag{4} \text{Cross-Price elasticity}_{A,B}=\frac{\text{% change in }Q_A}{\text{% change in }P_B} \]

When good A and good B are subtitutes, then the effect is negative.
- e.g., Samsung and Xiaomi
When good A and good B are complements, the effect is positive.
- e.g., Samsung and Telkomsel

Other types of demand elasticity

Income elasticity of demand is how the chanage on income affects your demand of good \(A\)

\[ \tag{5} \text{Income elasticity of Demand}_A=\frac{\text{% change in }Q_A}{\text{% change in Income}} \]

It is usually positive if good \(A\) is a normal good.
It is negative if good \(A\) is an inferior good.
- you buy less instant noodle when you’re richer.

Other types of demand elasticity

Income elasticity of demand is how the chanage on income affects your demand of good \(A\)

\[ \tag{5} \text{Income elasticity of Demand}_A=\frac{\text{% change in }Q_A}{\text{% change in Income}} \]

A necessity good is usually income inelastic because you need to buy it no matter what.
A luxury good can be income elastic. You only buy it if your main needs are covered so you can wait for a discount.

Price elasticity of Supply

Supply also have elasticities. As a supplier, you can’t afford to sell expensive if there are high competition.
However, in many cases (such as toll road), entering the market is very hard.
How easy it is to expand (or for new supplier to enter the market) matters to how responsive can supply react to the change in price.

\[ \tag{6} \text{Price elasticity of supply} = \frac{\text{% change in }Q^s}{\text{% change in }P} \]

Two extreme cases of elasticity

.s[an illustration of perfectly inelastic supply]

an illustration of perfectly elastic supply

Two extreme cases of elasticity

In a perfectly inelastic supply case, the market can’t supply more even if the price increase. Toll road is like this: Building more toll road is expensive and takes time. Most times this is monopolized by the government.
In a perfectly elastic supply, the market supply exactly zero when the price go up just by a little. A highly competitive market where all firms operate at the margin may behave this way.
Again, most times, the supply curve is somewhere in between.

What changes supply elasticity?

A market tend to have a highly elastic price elasticity of supply when inputs are abundant and can be converted in and out of producion at a very low cost.
Matters, as price elasticity of supply tend to be higher in the long run. Increasing production capacity may takes time since investing in a new land, building or machine requires time.
- Some goods are even impossible to be increased, hence have zero elasticity. Radio spectrum is one example.

European farm surplus

European Union subsidised their farmers heavily. They probably knew that subsidies create huge surplus (remember last week), but they thought the surplus would not be as big since farming land is limited.

However, EU farmers were able to expand production using things like fertilizers and pesticides, which are readily available inputs.

The benefits and costs of taxation

Excise Tax (cukai)

The government often tax goods in the form of an excise tax.
In Indonesia, some goods have an excise to its purchase:
- Cigarettes & alcohol
- Luxury goods (PPnBM)
You can say that a value-added tax is another form of an excise tax.

How tax works

Tax acts like a price ceiling plus plus floor:
- The government set a higher price for consumers to pay
- At the same time, the producers are forced to produced at a lower price.
A reminder: in a price floor scenario, surplus from consumer transferred to the producer, while in a price ceiling, surplus transferred from producers to consumers.
in tax case, CS and PS are transferred to the government.

The impact of tax

The impact of taxation

The market price is \(P=P_E\)
The price paid by consumers is \(P=P_C\)
Producer receive payment at \(P=P_P\)
The tax per purchased good paid to the government is \(t=P_C-P_P\)

The impact of taxation

Consumer lose \(A+B\)
Producer lose \(C+D\)
The government collects tax revenue \(TR=T \times Q_T\)
This is equals to \(TR=A+C\)
\(B+D=DWL\)

The impact of taxation

As we learn, the tax revenue and the size of DWL depends highly in demand elasticity and supply elasticity of the good.
The less elastic the demand and supply of a good, the higher revenue gained from taxing the good.
- i.e., price effect > quantity effect.
DWL also lower when the demand and/or supply of the good is highly inelastic.

Implication

If the government wants to collect revenue, its best to impose a tax on a good with low elasticities.
If the government wants to change behaviour, tax a good with high elasticities.
Taxing cigarettes to discourage smoking maybe ineffective
- however, it can be used to gain revenue.
Highly inelastic goods may suggest it’s a necessity: people may be unhappy with the tax.

Implication

Same goes with the business people: be careful in increasing price if your product is highly elastically demanded.
Next week, we will have a look a bit more detailed on the supply curve:
- what drives the elasticity of supply.
- Different types of cost.

Some recap before da quiz

Elasticities is very important in determining surpluses: CS, PS, revenues.
Elasticities can be estimated (albeit hard).
Elasticities vary: \(0 \leq 1 \leq \infty\) .
Many factors influence elasticities.
You should be able to use elasticity formula and can draw how tax is calculated and drawn.

Thank You

via GIPHY