Chapter 6 - Demand and Consumer Choice
Review graphs on pages 137-139.
Opening quotes and questions page 141.
We start the micro material by looking at markets for specific products, specifically the demand side of the market. The next four chapters will look at the supply side or production side of the market.
We look at: 1) interrelationships among markets and 2) the factors that influence demand for specific products. We look at prices - remember the role of prices - they coordinate the $9T of economic activity. Consumer demand, and changes in demand, largely determine prices, along with supply. Prices transmit information - consumer demand, and changes in consumer demand, transmits information to producers. Example: - basketball players salaries vs soccer players salaries. Our tastes/preferences are transmitted by prices - no survey is required - prices do the job invisibly and effortlessly.
Example of changes in tastes/preferences: page 137 - distribution of consumption spending in 1963 vs. 1993. What went up and what went down? Why? We want to try to understand consumer behavior.
FIVE PRINCIPLES OF CONSUMER BEHAVIOR
1. Limited income (scarcity) necessitates choice. Our choices are influenced by, and actually determine, costs. When we choose one alternative, we have to give up something else. Opportunity cost.
2. Consumers make decisions purposefully. In other words, we are careful (ruthless?) shoppers. "We want the most bang for the buck."
3. One good/service can be substituted for another. There are substitutes for everything.
4. Consumers must make decisions without perfect information, but knowledge and past experience will help. Perfect information and perfect foresight are not possible. We make decisions under some uncertainty. We learn from experience - our own and others. Examples: a) Brand names, advertising provide low cost information to consumers. Zagats restaurant directory, travel guides, Internet, etc. b) word-of-mouth for movies, restaurants, courses, etc.
5. The Law of Diminishing Marginal Utility (DMU) applies to consumer behavior: As consumption of a good increases, the marginal, or additional utility (satisfaction) from each additional unit consumed starts to decrease. Marginal utility declines as consumption increases. Example: ice cream - the first scoop of ice cream tastes really good, the second tastes good, but not as good as the first, etc. As we continue to consume more and more ice cream, the marginal utility of each additional unit (scoop) starts to decline.
Example: Buy one pair of jeans at full price, get the second one at 1/2 price.
Marginal Utility and Choice - Our consumption decisions are determined by the costs and benefits of given goods and services. Specifically, we consume goods as long as the MB (marginal benefit) or MU (marginal utility) is greater than the MC (marginal cost). If the benefits (MB) rise or the cost (MC) falls, we will consume more. If the benefits fall, or the cost rises, we will consume less.
Examples: you used to like country-western music but you develop an appreciation of jazz or classical music, so the marginal benefits of an additional jazz CD increases, you buy more. The MB of C-W music declines, so you buy fewer CDs. Prices go up, you buy less. Prices go down, you buy more.
Price Changes and Consumer Choice - The demand curve (schedule) on p. 146 shows various price-quantity demanded combinations for gasoline. The first law of demand says that the amount purchased is inversely related to price. Why?
1. Substitution effect (switching) - as price falls (rises), consumers substitute away from other now more expensive goods toward the now cheaper good. Example: Coke and Pepsi are substitutes for some people. If the price of Pepsi falls, some consumers will switch from Coke to Pepsi.
We consume up until MB(MU) = MC. If price (MC) falls, we increase consumption. However, there is a limit to how much we increase consumption, due to DMU. If gas prices fall from $1.20 to $1.00, consumption increases from 16 gal to 18 gal, but then at that point our MB(MU) is once again equal to MC.
2. Income Effect - If the price of one good falls (rises), a consumer's real income will rise (fall), which will also increase consumption because consumers can now afford more (assuming a constant nominal income). Example: if gas prices fall (rise), that is like an increase (decrease) in real income, we are made better (worse) off.
So the two effects usually reinforce each other. Examples:
If the price of UM-F tuition rises (falls), some students would take fewer (more) classes here because of switching to (from) Mott/MSU (substitution) and because classes are now less (more) affordable (income effect).
TIME COST and CONSUMER CHOICE
The monetary price is just one component of the cost of purchasing a product. Time is a non-monetary part of the total cost. TOTAL COST = $$$$ + Non- monetary costs (TIME, etc.) A lower (higher) time cost, like a lower (higher) money cost, will make a good more (less) attractive.
Examples: a) Convenience stores - money prices are higher, but time price is lower. A carton of milk at Meijer might be $1 and $1.25 at 7-11. The 25 cent difference reflects the difference in time involved in the purchase.
b) Price controls on gasoline in the 1970s caused huge lines at gas stations. The money cost was kept artificially low, below market clearing price, but the waiting time dramatically increased the TOTAL COST ($ + time).
c) Soviet Union - long lines for food, etc. because prices were artificially low.
Also, time-saving products are demanded because of their ability to save valuable time for consumers. Examples: microwave ovens, automatic dishwashers, air travel, prepared foods (deli, TV dinners), snowblowers, bread makers, etc.
Time costs differ among individuals - opportunity costs. Ceteris paribus, high- income consumers would chose more time saving products and fewer time intensive products. Examples: high income consumers would more likely eat in restaurants, travel by air or taxi, have their oil changed, take laundry to a dry cleaner, purchase dishwashers, riding lawnmower and prepared food than low income consumers. Low income consumers might be more likely to travel by bus, walk instead of taking a taxi, prepare food at home more often, iron their own shirts, do dishes by hand, change their own oil, etc.
Point: Money AND time cost both influence consumers behavior. Varies from individual to individual. Cost is subjective. Varies throughout ones life, as our income varies. At 18 you may travel by bus to Florida, at 35 you fly.
We all have our own unique, individual demand curves for the products we buy, reflecting our own personal and subjective tastes and preferences for food, clothing, cars, movies, music, travel, books, hobbies, etc. We are usually more interested in the market demand, which is just the sum of all individual consumers, as a group. GM is interested in the market demand for its vehicles.
Page 147 illustrates how we can go from demand curves for two individuals to the market demand curve. Jones and Smith each have their own unique demand curve. Market demand curve is just the sum of the demand curves for Jones and Smith. With more consumers, the market demand is the demand curve for the entire group of consumers who are in the market for a good.
See page 148. Remember that the market demand curve is the summation of all individual consumers personal demand curves. Everybody has a different subjective value for a good. However, in most markets everybody pays the same exact price, the market price of P1. Many of the consumers actually value the good at more than P1. Some people would still have purchased the good at higher prices like P2 or P3, but they only had to pay P1. For most consumers the MB(MU)>MC(P), meaning that they received a net gain from the transactions. We call this gain CONSUMER SURPLUS (CS).
Examples: a) You go to Burger King and buy a Whopper for $0.99. You probably still would have bought it for $1.50 or $2.00, indicating that you have received CS.
b) You find some great deal at a rummage sale, or buy something on sale, and you are very satisfied with getting a bargain or a great deal. That sense of satisfaction reflects your CS.
CS is directly related to market price. At a lower (higher) price, consumer surplus increases (decreases).
CS AND TOTAL VALUE
Important point: Diamond-Water paradox. Early economists
were puzzled that water was so cheap and diamonds were so expensive, even
though water was necessary for life and diamonds were a luxury. The puzzle
is explained by marginal analysis. Obviously the Total Value of water to
consumers is greater than the Total Value of diamonds. But Market Price
is determined by the cost and value of MARGINAL UNITS, reflecting MU and
DMU. Water is abundant and diamonds are scarce. Because water (diamonds)
is so abundant (scarce), its marginal value/price/cost/MU is very low (high).
a) Total Value of Water > Total Value of Diamonds, but
the Marginal Value of Diamonds > Marginal Value of Water.
b) Market Prices reflect Marginal Values not Total Value. In fact, the demand curve is a MB (MU) curve. This explains why P of Diamonds is greater than the Price of Water.
WHAT CAUSES THE DEMAND CURVE TO SHIFT?
Remember: The demand curve summarizes the relationship between Price and Quantity Demanded ONLY, ceteris paribus for all other factors (income, tastes, etc.). The ONLY thing that will change Qd is a change in PRICE. See page 152. The demand curve summarizes an almost infinite number of P/Qd combinations. "You give me a price, I can tell you the Qd." A change is price is a "movement along the demand curve."
All other factors besides PRICE that affect how much of the product is sold are factors that SHIFT or CHANGE DEMAND. An INCREASE in Demand, is a shift of the entire demand curve to the right and up, a DECREASE in Demand is a shift to left and down. Important: A change in demand vs. a change in Qd. What are the factors that are a) held constant when the demand curve is constructed and b) cause demand to shift when they change?
1. Changes in Income. The demand for most goods ("normal goods") is positively related to income. As income goes up, we increase spending for many goods. Example: you get a big raise, and you buy more CDs, go to more concerts, buy a nicer car, buy more clothes and/or more expensive clothes, eat out in restaurants more often, etc. Some goods are called "inferior goods" - for these products we reduce our purchases as our income rises?
Examples of inferior goods???
2 and #4. Changes in the Distribution of Income and Changes in Demographics (related closely to #4 - demographics). Demand for most goods depends upon whether the demographic factors are favorable or unfavorable for that particular product. As the distribution of income for various age groups changes, demand can shift (increase or decrease).
Example: a) beer purchases are determined by the number of 25-34 yr. old consumers in the market. Wine sales are determined by the number of consumers 35-44 yrs. old. In the late 80s, wine sales increased and beer sales fell because the number of 35-44 yr olds increased and the number of 25-34 yr olds decreased.
b) Sales of blue jeans is determined by consumers 15-24 years old. When this age group declined in the 1980s, jean sales fell.
c) As the population ages, there is shift in demand for medical services, recreation vehicles, vacation travel, retirement housing, nursing homes, etc. In 1950 (1973), avg retirement age was 68.5 (64) years, average life was 67.2 (70.6). Expected years in retirement in 1950 (1973) was 0 (6.6).
3. Changes in Consumer Preferences (changes in taste). Over time consumer tastes and preferences change, sometimes due to education and information, other times just due to fads (fashion, music, TV shows, movies, sports, cigars, etc.)
Examples: a) Because of research and public awareness of health problems from smoking, cigarette smoking is lower, demand has decreased.
b) People are more health conscious, so there has been an increased demand for healthy, low-fat foods (skim milk, chicken), memberships to health clubs, exercise equipment and a decreased demand for high-fat foods (whole milk, steak).
4. Changes in the Price of a RELATED Good - SUBSTITUTE good (competitive product) or a good that is a COMPLEMENT (joint consumption of two or more goods).
Examples of SUBSTITUTES???? Ford and GM vehicles
Example of Complements???? CD Players and CDs
SUBSTITUTES - X and Y are substitute products. If the price of Y goes up (down), demand for X goes up (down), because it is now relatively cheaper (more expensive). If Ford raises (lowers) its prices, the demand for GM goes up (down).
COMPLEMENTS - X and Y are complements. If the price of Y goes up (down), demand for X goes down (up). If the price of CDs falls (rises), the demand for CD players will increase (fall), and vice versa. (Product: Music Listening.) If interest rates increase, the demand for houses will fall. If the price of computers fall, the demand for software will increase.
Service: Transportation. Complementary goods involved???
5. Changes in the Expected (Future) Price of Good. What will happen to the price of a good in the future? If we expect the product to be more expensive in the future, we would want to buy NOW. If we expect the price to get cheaper, we want to wait and buy LATER. The demand curve typically reflects demand NOW.
Examples: a) 1986, bad weather conditions for coffee, there was an expected shortage and higher prices in the future, led to increased demand for coffee NOW, before the price goes way up in the future.
b) Computer prices keep falling and quality keeps getting better, incentive to wait for six months/year to get a better, cheaper computer LATER.
c) Stock prices. If the price of stock is expected to rise, people want to buy now before prices goes even higher. Amazon.com recently sold for $250/share and was expected to go higher, it went to $400/share because everyone wanted to buy now before it went up. The buying pressure drove the price up.
SUMMARY: THUMBNAIL SKETCH PAGE 152.
CONSUMER PREFERENCES - Economists can't explain exactly how preferences are determined - related to issues like consumer psychology. We do know this:
1. Preferences are based on complex human behavior. Preferences are subjective and individual. "De gustibus non disputandum."
2. Advertising has a strong influence on consumer preferences. $160B is spent annually on advertising - we assume that advertising must pay off or firms wouldn't spend so much money on it. Some complaints about advertising?
Wasteful, misleading, manipulative?
1. Advertising is Wasteful. Reply: Advertising transmits information, keeps up informed of new products, facilitates trade and increases efficiency. Consumers are under no obligation to buy advertised products. And if consumers feel that advertised products are more expensive we can always turn to cheaper, unadvertised products - generic brands.
Brand names - what value do they have for consumers? Companies spend millions of dollars to establish a brand name, what is the value for consumers????
What if there was a complete ban on advertising? How would that change your consumption behavior?????
2. Is advertising misleading? Federal and state laws protect consumers from unfair or deceptive advertising. FTC regulates advertising. BBB also helps monitor unfair business practices. Good Housekeeping Seal of Approval. "Caveat emptor."
3. Does advertising manipulate? Firms are profit maximizers, and the most direct route to maximize profits is to appeal directly to the actual preferences of consumers, not try to coerce or re-shape consumers. Resources spent on manipulation could be very wasteful and inefficient, and it could backfire if it causes resentment. Firms are concerned about their image, value of goodwill, most take a long range view. Consumer sovereignty prevails?
ELASTICITY OF DEMAND
We want to understand the dynamics of the market, understand the continual changes that are taking place. The concept of Elasticity is a tool to help us understand and actually quantify or measure dynamic change in the market. The Law of Demand says that if Price goes up (down), Qd goes down (up), but that is very general statement. Elasticity helps us answer the question: HOW MUCH? If Price goes up (down), HOW MUCH will Qd fall (rise)? In other words, how RESPONSIVE are consumers (producers) to PRICE CHANGES??
Elasticity is a quantitative measure of consumer (producer) responsiveness to price changes. Elasticity = responsiveness. If consumers are highly responsive to price changes, demand is said to be ELASTIC. If consumers are not very responsive to price changes, demand is INELASTIC.
ELASTIC: small price increase (decrease) leads to a large decrease (increase) in Qd. (Consumers are VERY responsive to prices).
INELASTIC: large price increase (decrease) leads to only a small decrease (increase) in Qd. (Consumers are not very responsive to prices).
Note: Law of Demand holds in both cases. Specifically, Elasticity (Price Elasticity of Demand) is calculated as:
E = %Qd / %P (E is called the Elasticity Coefficient)
Because of the Law of Demand (Price goes up, Qd ALWAYS goes down), E is ALWAYS negative. Because E is always negative, we usually ignore the negative sign. See page 159.
Example: Price changes from P0 to P1 and Qd changes from Q0 to Q1.
Note: percentage change formula used here is slightly modified in that the denominator is the AVERAGE of the two values (Q0 and Q1), and NOT the original value Q0.
%Qd = (Q0 - Q1) / (Q0 + Q1)/2
%P = (P0 - P1)/ (P0 + P1)/2
E = %Qd/%P
E = (Q0 - Q1)/(Q0 + Q1) (P0 - P1) / (P0 + P1)
E = dQ / (Q0 + Q1) dP / (P0 + P1)
Example: Trina's Cakes are originally selling at $7 and the amount sold is 50 cakes per week. If the price is cut to $6, then 70 cakes per week will be sold? Questions: 1) What is the elasticity coefficient? and 2) Is the demand for Trina's Cakes elastic or inelastic?
E = (50 - 70) / (50 + 70) = - 2.17
(7 - 6) / (7 + 6)
Interpretation: For a 1% change in price, the Qd changes by 2.17%. If prices go up (down) by 1%, the amount purchased will go down (up) by 2.17%.
Economic meaning: When E is > 1, demand is ELASTIC, meaning very responsive to price changes. When E > 1, if price falls (rises) by 1%, Qd goes up (falls) by MORE than 1%. Demand is responsive.
When E < 1, demand is said to be INELASTIC, or relatively UNRESPONSIVE. For a 1% price change, Qd changes by LESS than 1%. Example: cigarettes, other "addictive" products (caffeine?).
If E happens to be exactly equal to 1, demand is said to be UNITARY ELASTIC. For a 1% price change, Qd also changes by exactly 1%.
FIVE General categories of Elasticity on page 157.
1. Perfectly elastic demand curve. (vertical line) This type of demand curve does not really exist - mythical demand curve. It is unrealistic, because is says that at ANY price, consumers will still buy the same amount. Assumes NO substitutes are available, which is NEVER the case, there are substitutes for everything. Violates the Law of Demand. Shown for illustration purposes only.
2. Relatively inelastic demand. Fairly steep demand
curve. Cigarettes for example. Demand is fairly UNRESPONSIVE to Price changes.
Large price increases will only slightly decrease the Qd. Example:
in Canada were raised to $5/pack and the amount purchased only fell slightly.
3. Unitary Elastic demand. For an X% change in Price, Qd changes by exactly X% also.
4. Relatively elastic demand. Usually the case when there are LOTS of good substitutes available - competitive markets. Example: demand for apples is relatively elastic (responsive to price changes) because there LOTS of excellent substitutes available for most people. What are the substitutes for apples????? If price goes up by just a little, consumers buy a lot fewer apples.
5. Perfectly elastic demand curve. Demand for an individual farmer's (Farmer Jones) wheat. If wheat is selling at $3/bushel in world markets, Jones would not accept less than $3/bu (why sell at less than $3 if you can get $3) and Jones would not be able to sell any wheat above $3 (what wheat buyer would be willing to pay more than the market price?). Jones has to accept the market price and has to sell all of his wheat at that price.
WHAT DETERMINES ELASTICITY
Economists have calculated elasticity coefficients for many products, see page 159. There is a wide range of elasticity coefficients, from .1 to 4.6. Some products have very elastic demand, some have very inelastic demand, and some are near unitary elasticity. What factors determine elasticity?
1. Availability of Substitutes - influences elasticity the MOST. Lots of close substitutes = elastic demand, it is easy to switch. Examples: fast food restaurants, lots of choice, easy to switch, very competitive market, lots of specials, price discounts, etc. Discount stores: Wal-Mart, K-Mart, Target, Value City, etc., easy to switch, very competitive. Consumers are extremely price conscious, price sensitive in these markets = elasticity is high, responsiveness to price changes is high.
How has Internet contributed to elasticity?????
Few close substitutes = inelastic demand, hard to switch. Consumers are not as sensitive/responsive for goods/services with inelastic demand. Examples: dental services, medical services, cigarettes, coffee, university education. What close substitutes are available for dental services? Medical services? Tobacco? Coffee? College diploma? When prices go up for these products, the Qd falls, but not too much.
Elasticity also depends on whether the relevant category is defined broadly or narrowly. Example: the demand for cigarettes is inelastic. What about the demand for Marlboro cigarettes? The long-run demand for automobiles is inelastic (few good, close substitutes). What about the demand for Buick Centurys? See page 159.
2. Share of Total Budget Spent on Product also influences elasticity. The smaller (larger) the amount spent (as a % of budget), the more INELASTIC (ELASTIC) the demand. Examples: some products are so cheap that we spend very little on products like toothpicks, salt, matches, etc. If the price of toothpicks doubled, we really wouldn't care because the price is so low, and represents such a small fraction of our total spending.
What products/services do represent a major fraction of our budget???? We are more cost/price conscious of these products?
See page 160. Graphs of elastic demand and inelastic demand. Panel a is ELASTIC demand for ballpoint pens. Why is demand elastic??? If price goes from $1 to $1.50, Qd falls from 100,000/wk to 25,000/wk, Elasticity = -3. (For a 1% increase in price, Qd falls by 3%). Consumers are sensitive/responsive to price changes, demand is Elastic.
Panel b is INELASTIC demand for cigarettes. Why is demand inelastic??? If price goes from $1 to $1.50, Qd only falls from 100m to 90m/week. Elasticity = -.26 (For a 10% increase in price, Qd falls by only 2.6%). Consumers of cigarettes are insensitive/unresponsive to price changes.
TIME and ELASTICITY
Second Law of Demand = Elasticity is greater in the long run than in the short run. In other words, consumers can find more substitutes in the LR than in the SR, given a period of adjustment. Demand curves flatten out over time, become more elastic. Example: price of gasoline rose dramatically in the 1970s. In the short run, consumer's demand for gas was inelastic, but in the long run it became much more elastic as people found ways to reduce consumption of gas? POINT: Given time, you can substitute lower gas consumption for higher gas consumption. How did people reduce gas consumption in the 1970s???
TOTAL EXPENDITURES and ELASTICITY
If we know the elasticity for a product, we then also know what will happen to Total Revenues (TR) or Total Expenditures or Sales Revenue when the price changes. Why would this be important information for GM when they are considering a price change???
TR($) = P($) x Qd (number of units sold)
When demand is inelastic, a large price increase leads to just a small reduction in Qd, so that TR has to go up. Example: when cigarette prices went from $1 to $1.50, TR went from up from $100m ($1 x 100m packs) to $135m ($1.50 x 90m). When demand is INELASTIC, TR goes in the same direction as P. If P goes up (down), TR goes up (down).
When demand is elastic, a small price increase lead to a large reduction in Qd, so that TR goes down. Example: when ballpoint pen prices went from $1 to $1.50, TR went from down from $100,000 ($1 x 100,000) to only $35,000 ($1.50 x 25,000). When demand is ELASTIC, TR goes in the opposite direction. If P goes up (down), TR goes down (up).
See page 162 for a summary.
Measures the responsiveness of demand to a change in income. Measured as:
Income E = %Qd / %Income
A measure that answers the question: For a X% change in income, what % does the Qd change? If income goes up by 10% what happens to the Qd for various products? Income elasticity is USUALLY positive, for goods that we call NORMAL goods, goods whose Income Elasticity is POSITIVE. Income goes up, we buy more normal goods.
Normal goods that are necessities have Income Elasticities between 0 and 1, considered to be LOW Income Elasticities If income goes up by 10%, we spend less than 10% more on necessities, on goods like fuel, electricity, food, tobacco, medical care, etc.
LUXURY Goods are normal goods whose Income Elasticity is positive, but is positive and GREATER than 1. That is, if income goes up by 10%, we increase our spending by MORE than 10% on luxury goods like new cars, fine wines, private education, vacations, leather furniture, air travel, fancy clothes, etc. There are certain luxury goods that we will start to buy when our income goes way up, we spoil ourselves.....
INFERIOR GOODS have a negative income elasticity. If income goes up, we spend less on INFERIOR GOODS like bus travel, cheap cuts of meat, cockroach spray, margarine, etc.
APPLICATION OF ELASTICITY: BURDEN OF TAXATION.
We can use elasticity of demand to help answer the question: If something is taxed, who pays the tax - the buyer or the seller or both? Example: if an excise tax is placed on gas, cigarettes or alcohol, what burden falls on the buyer/consumer and what burden falls on the producer/seller?? See page 164, gas is selling at $1/gal before a 20 cent/gal tax goes into effect. Of the 20 cent/gal tax, how much do consumers (producers) pay?
We assume in this example, that demand for gas is INELASTIC in the short run, so the demand curve is fairly STEEP. The 20 cent/gal excise tax is paid for by the seller, so the Supply curves shifts back by exactly 20 cents. Gas producers, if they can, would like to shift all of the tax onto consumers and raise gas prices to $1.20 ($1 + $0.20). However, we can see in Figure 6-11 that there would be excess supply at $1.20 (point b represents Qs and point a represents Qd, Qs > Qd, surplus of ab).
Gas producers will only be able to raise gas prices by 15 cents to $1.15, and will have to absorb 5 cents of the tax. Of the 20 cent tax, gas consumers will pay 15 cents in the form of higher prices, and gas producers will pay 5 cents in the form of lower net price ($1.15 - 0.20 = $0.95, compared to $1 before the tax).
Of the 20 cent tax, consumers paid 75% (15 cents/20) and producers paid 25% (5 cents/20), so that the burden of taxation falls disproportionately on BUYERS in this case, at least in the SR. Reason: Demand is INELASTIC (unresponsive to price changes).
Page 165 illustrates what happens in the LR, as Demand becomes more elastic (demand curve flattens out), as more substitutes are found by consumers. When gas prices first went from $1 to $1.20, Qd fell from 200m gallons to 194m. Given time to adjust, gas consumption eventually falls to 186m as consumers find substitutes for their previous gas consumption. Producers respond by lowering prices to $1.10, since they can longer sustain a price of $1.15 without having excess supply. Now the sellers are absorbing 10 cents of the tax and buyers are absorbing only 10 cents. Over time, the buyers and sellers of gasoline share equally (50%/50%) in the tax burden (10 cents paid by buyers/10 cents paid by sellers).
POINT: Sellers will try to pass along AS MUCH of the tax as possible to consumers. The more INELASTIC (ELASTIC) the demand, the more (LESS) sellers can get away with shifting the burden of taxation onto buyers. In this case, over time, as demand became more ELASTIC, buyers' share of the tax burden fell.
BURDEN of TAXATION also depends on the ELASTICITY of SUPPLY, as illustrated on page 166. In general we can say this:
If the Elasticity of demand (supply) is greater than the elasticity of supply (demand), SELLERS (BUYERS) pay a larger share of the tax. Rule: Whosever elasticity is greater pays a smaller share of the tax. "He who cares the least wins." Whoever has more substitute alternatives to buy/sell, is in a better bargaining position.
In each case, pages 164-166, the tax resulted in a DWL, reflecting the amount of lost gains from trade because of the lower amount of trade caused by the tax. The tax raises the price, reduces trade, resulting in losses to both buyers and sellers. Some trades that would have benefited both buyer and seller are now lost, resulting in a loss of economic efficiency, lower overall standard of living.
The DWL varies depending on elasticity. When Supply and Demand are both ELASTIC, the DWL is greater (see page 166) than when either Demand or Supply is INELASTIC, see page 164. Implication: From an economic efficiency standpoint, taxes on goods with inelastic demand (or supply) - cigarettes, gas, alcohol - will result in a smaller DWL.
Questions: 1, 3, 10, 12, 18