From the Lectern: Week 3

Last week, we talked about what will affect the behavior of buyers and sellers in a market, and the theoretical reasons why economists care so much. This week, we focus on the issue of how strongly buyers and sellers respond to the incentives around them, and look at some practical issues for why this is important.

As always, we need an example market. For this week, we're going to look at a somewhat more serious example than last week: Processed corn. This market affects the everyday lives of everyone in this room through the two main forms it takes, corn syrup (including the high-fructose variety) and ethanol. Between the sweetener and the fuel additive, most of us don't go a an afternoon without interacting with some form of processed corn. So what happens in this market is, if not more important, at least more relevant to our lives.

Given our example market, we need to say something meaningful about how the responsiveness of behavior is measured. From a mathematical perspective, the easiest and simplest way to show the change in something (for example, how much processed corn people decide to buy) that results from a change in something else (such as the price of processed corn) is by calculating the slope. On our graph of the demand curve, this is just difference between the new and old quantity demand divided by the difference between the new and old price. But there are some problems with thinking about changes this way. First of all, what the number means depends on how we measure price and quantity, so we have to keep careful track of the units.  If quantity is bushels per day and price is dollar per bushel, then the elasticity becomes dollars per day, which is reasonable as far as it goes, but seems kind of awkward. Second, it's tough to tell what number the slope has to reach before we can say the response was "big" or "small." Is - $5,000/day a big slope for the demand curve (recall that the number is negative since the demand curve slopes down)?

To get around these problems, instead of using slope we calculate changes using an engineering concept (yeah, we stole equilibrium from them, too) called elasticity. Elasticity is calculated in such a way that instead of looking at just the change in price, we look at the percentage change in price, and instead of change in quantity, percentage change in quantity. Percentage change means we have a sense of scale: a $1 increase in price is a lot if the price is already $1 (a 100% increase, in fact), but not much if the price is $1,000 (only a 0.1% increase). It also eliminates the issue of units, since a 10% change is a 10% change whether we're measuring in bushels, kilograms, or boots-full.

Elasticity gives us an easy way to identify what counts as a big or small response, too. If the percentage change in quantity is bigger than the percentage change in price, then the elasticity will be more than 1. We call this an elastic demand. If it is smaller, the elasticity will be less than 1 and we say demand is inelastic.

With this method of measurement in mind, there are several different types of elasticities on the demand side. The most important is the one we've been talking about so far, the price elasticity of demand. This tells us how much buyers respond to price changes. We'll consider the practical importance of this more later, but just as an example consider a firm trying to increase its revenue. Firm's total revenue is just the amount they make by selling one item, the price, times the number of items they sell, the quantity demanded. If the corn seller raises its price, we know it's going to sell less corn. But what happens to its revenues? Well, that depends on whether price goes up more than quantity goes down or quantity goes down more than price goes up. In other words, it depends on the price elasticity of demand. If demand is inelastic, then the quantity won't fall much if price goes up, so the firm's revenue increases. If demand is elastic, though, quantity falls a lot, so revenue actually falls. Generally, the more substitutes available, the bigger a part of buyers' income the good is, and the more buyers there are, the more elastic the demand curve will be.

Price elasticity of demand is the most important elasticity on the buyers side, but not the only one. Anything that can shift an individual's demand curve also has an elasticity (except for tastes; we'll see why later on). So there's income elasticity of demand, cross-price elasticity of demand (that's responsiveness to prices of other goods), etc. There's also price elasticity of supply, which is the same as the previous price elasticity but on the other side of the market. Anything that shifts supply curves also has an elasticity (except technology; again, we'll see why later in the class).

Once we understand elasticity, we can begin to consider what happens when the government intervenes in markets. In class, we covered how the strength of effects of government interventions are determined by elasticity, but here I just want to get some basics.

First of all, suppose the government decides that the market price for corn is unfair. They might think it's too high, and thus makes food and alternative fuels too expensive. Alternatively, they could think it's too low, not allowing the good people of America's heartland to make a decent living. The results are similar, so we'll focus on the first case.

If the government thinks the market price for processed corn is too high, a simple way to bring it down is to simply say by law that the price can't go above something lower. We call this maximum legal price a price ceiling. In competitive markets, price ceilings do several things in the market. First of all, at the new government mandated price sellers aren't going to want to bring much to market, but buyers are going to want to buy a lot. This creates a shortage of the good that just won't go away. Second, the amount that gets exchanged in the market is lower than it would be otherwise, since corn processors aren't bringing as much to market; you can't buy what's not there. This means there are units that could have created gains from trade, but don't, creating a deadweight loss. Third, it means that the corn doesn't necessarily go to those who value it the most: whoever is lucky enough to buy corn at the low price wins, and everyone else is left with an empty bag. This could lead people to waste resources either trying to cope with the shortage or trying to sneak to the front of the line somehow. They may even engage in illegal, black market corn sales! Finally, if corn sellers can't be compensated for the good at the market price, they may find ways to increase their revenues by cutting corners on product quality.

Now, for the few buyers who do get to buy corn, this is still a good deal (unless of course they have to pay by waiting in line or bribery). If we looked at a price floor, in which the government decides to keep the price high, all the same problems occur except that (1) there is a persistent surplus of the good rather than a shortage, (2) instead of under-investing in quality, firms will over-invest in quality (I don't know, maybe they'll waste resources making the corn extra shiny), and (3) a few sellers benefit, rather than a few buyers. In both cases, there's a trade-off between helping some people and hurting others.

Because they cause so many obvious economic problems, the US government decided to do away with most of its price controls after the 1970s. The two most prominent exceptions are rent controls, a kind of price ceiling, and minimum wages, a kind of price floor. Instead, the government generally affects markets like the processed corn  market through taxes and subsidies. We'll focus on taxes.

The key thing to keep in mind about taxes is that they don't affect what really matters in markets--what buyers are willing to pay for the goods and the production costs that firms must cover to sell them. They do, however, affect the information prices convey to buyers and sellers, and thus change the incentives to interact with the economy. Taxes create a wedge between the price that buyers have to pay and the price that sellers receive as revenue. When the government imposes taxes on a firm (the results would be the same if they made buyers pay, but it's easier to talk about with firms), the firm has to be able to keep enough after taxes are payed to cover their costs. Because of this, the amount of corn exchanged in the market has to go down until the wedge between supply and demand is equal to the tax (as seen in this clever diagram). Since the wedge means there are units of the good that could create gains from trade but now they don't, taxes create a deadweight loss just like price controls did. However, they at least don't create the surpluses/shortages and quality issues.

Notice, though, that both buyers and sellers get reduced gains from trade, since some of those gains now go to the government as tax revenue. Also notice that firms don't pay the whole tax themselves, since the price they get to keep doesn't fall by the whole tax; firms pass on as much as the price wedge as they can (depends on how much buyers respond to price changes), and then have to cover the rest themselves. So the next time someone says "Don't tax businesses, they'll just pass that along to consumers," you can respond by saying "Actually, they only pass on part." In markets where buyers don't have a lot of other options, like gasoline or tobacco (addictive substance, so I'm told), firms can probably pass on most of it, even if the government tells sellers to pay out of their profits. In markets where buyers  can go elsewhere, like food services or any local businesses, firms will probably end up paying most of the tax, even if the government wants to get the money from rich buyers.

The government could decide to spend tax revenue made elsewhere (lets say from cigarettes) on a subsidy if they want to encourage cheap "food" (and by that I mean corn syrup) and "fuel" (and by that I mean ethanol). This does the exact opposite of the tax, encouraging higher cost firms, firms that would have taken their resources elsewhere under the market price, to join the market. They also encourage low-value consumers, consumers who would have found better things to do with their money than buy corn syrup and ethanol, to join the market. It does this by creating a wedge on the other side of the market price, making buyers pay a low price and sellers receive a high price (once they get paid by both buyers and government). This again distorts the information in prices, so it also creates deadweight loss.

So what's the bottom line? If the demand curve represents how much buyers value a product, and the supply curve represents what it costs firms to produce them, then any intervention by the government makes everyone worse off. Of course, those are a couple of big "ifs." For that reason, the next several weeks will be devoted to supporting the claims about what these curves really mean.