Business Economics

Divya Tuteja
Lecture Notes, IIFT

MBA IB (2020-22)
September, 2020
 Topics
1. Economic Efficiency
2. Production Theory
3. Cost Analysis
4. Managerial Decisions in Competitive Markets
5. Monopoly, Monopolistic Competition and Pricing
with Market Power
6. Strategic Thinking in Oligopoly Markets

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Economic Efficiency

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Session Objectives
• Introduce the concepts of willingness to pay, consumer
surplus and producer surplus, willingness to sell

• Understand the effects of imposing a price ceiling and a

price floor

• Explain the idea of deadweight loss

• Study the impact of a minimum support price

• Analyse the impact of imposition of taxes and subsidies

on the market equilibria

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Introduction
The questions before us are as follows:

• What is allocation of resources?

• Is there a role for the market in the allocation

of resources?

• What is well-being? How do we measure well-

being?

• What is welfare economics? How do we

measure the welfare of market participants?
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Introduction
What is allocation of resources?

Allocation of resources refers to

• How much of the good should be produced?
• Which producers will produce the good?
• Which consumers will consume the good?

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Introduction
Is there a role for the market in the allocation of
resources?

Remember our Principle:

Markets are usually a good way to
organize economic activity.

Market equilibrium reflects the way markets allocate scarce

resources.

•Allocative efficiency is a resource allocation where the value of

the output by sellers matches the value placed on that output
by buyers.
• Buyers and sellers receive benefits from taking part in the market.
• The equilibrium in a market maximizes the total welfare of buyers
and sellers.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Introduction
What is well-being? How do we measure well-being?

Well-being is the happiness or satisfaction with life as reported

by individuals.

• Subjective well-being refers to the way in which people

evaluate their own happiness.
• Such as how they feel about work and leisure.

• Objective well-being refers to measures of the quality of life

and uses indicators developed by researchers
• Such as educational attainment, measures of the standard of
living and life expectancy.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Introduction
What is welfare economics? How can we measure the
welfare of market participants?

Welfare economics studies how the allocation of

resources affects economic well-being.

•Consumer surplus measures economic welfare from the buyers’ side.

•Producer surplus measures economic welfare from the sellers’ side.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Willingness to Pay
A buyer’s willingness to pay for a good is the maximum amount
the buyer will pay for that good.
WTP measures how much the buyer values the good.
The market demand curve depicts the various quantities that buyers
would be willing and able to purchase at different prices.

Name WTP Example:

Aakash $250 4 buyers’ WTP
for an iPod
Charu 175
Feroz 300
Jai 125

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 WTP and the Demand Curve
Q: If the price of an iPod is $200, who will buy an
iPod, and what is the quantity demanded?

Name WTP A: Aakash & Feroz will buy an

Aakash $250 iPod, Charu & Jai will not.

Charu 175 Hence, Qd = 2

when P = $200.
Feroz 300
Jai 125

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 WTP and the Demand Curve
Derive the
P (price
demand who buys Qd
of iPod)
schedule:
$301 & up nobody 0

Name WTP 251 – 300 Feroz 1

Aakash $250 176 – 250 Aakash, Feroz 2

Charu 175 Charu, Aakash,
126 – 175 3
Feroz 300 Feroz
Jai, Charu,
Jai 125 0 – 125 4
Aakash, Feroz

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 WTP and the Demand Curve
P
$350
P Qd
$300
$301 & up 0
$250
$200 251 – 300 1
$150 176 – 250 2
$100 126 – 175 3
$50
0 – 125 4
$0 Q
0 1 2 3 4
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 About the Staircase Shape
P This D curve looks like a staircase
$350 with 4 steps – one per buyer.
$300 If there were a huge # of buyers, as
$250 in a competitive market,

$200 there would be a huge #

of very tiny steps,
$150
and it would look
$100 more like a smooth
$50 curve.

$0 Q
0 1 2 3 4
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 WTP and the Demand Curve
P Feroz’s WTP At any Q,
$350
Aakash’s WTP the height of
$300 the D curve is the
$250 Charu’s WTP WTP of the
$200 Jai’s marginal buyer,
WTP the buyer who
$150
would leave the
$100 market if P were
$50 any higher.
$0 Q
0 1 2 3 4
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 WTP and the Demand Curve
Does WTP depend on the external or macroeconomic
circumstances?
• Demand curve is derived under certain assumptions
including that the macroeconomic scenario is the
same.
• This, however, may not always be the case!!!
• Example: Masks and Sanitizers in COVID-19

Is this good or bad for our business?

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 WTP and the Demand Curve
How can the producer leverage the information on the
WTP?
What about the marketing
strategy in this case?

What about the strategy

regarding the product mix
in such cases?

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Consumer Surplus
Consumer surplus is the amount a buyer is willing to pay
minus the amount the buyer actually pays:
CS = WTP – P

Name WTP Suppose P = $260.

Aakash $250 Feroz’s CS = $300 – 260 = $40.

The others get no CS because they
Charu 175
do not buy an iPod at this price.
Feroz 300
Total CS = $40.
Jai 125

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 CS and the Demand Curve
P Feroz’s WTP P = $260
$350
Feroz’s CS =
$300 $300 – 260 = $40
$250 Total CS = $40
$200
$150
$100
$50
$0 Q
0 1 2 3 4
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 CS and the Demand Curve
P Feroz’s WTP Instead, suppose
$350 P = $220
$300 Aakash’s WTP
Feroz’s CS =
$250 $300 – 220 = $80
$200 Aakash’s CS =
$250 – 220 = $30
$150
Total CS = $110
$100
$50
$0 Q
0 1 2 3 4
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 CS and the Demand Curve
P The lesson:
$350
Total CS equals the
$300
area under
$250 the demand curve
$200 above the price,
from 0 to Q.
$150
$100
$50
$0 Q
0 1 2 3 4
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 CS with lots of buyers and a smooth Demand Curve

Price P The demand for shoes

per pair
$ 60
50
At Q = 5(thousand),
the marginal buyer is 40
willing to pay $50 for
pair of Nike shoes. 30
1000s of pairs
Suppose P = $30. 20 of shoes
Then his consumer 10
surplus = $20. D
0 Q
0 5 10 15 20 25 30

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 CS with lots of buyers and a smooth Demand Curve

CS is the area b/w P P The demand for Nike

and the D curve, shoes
from 0 to Q. $ 60
Recall: area of 50
a triangle equals h
½ x base x height 40
Height = 30
$60 – 30 = $30.
20
So,
CS = ½ x 15 x $30 10
= $225. D
0 Q
0 5 10 15 20 25 30

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 How does a higher price reduce CS?
If P rises to $40, P
CS = ½ x 10 x $20 1. Fall in CS
60
= $100. due to buyers
leaving market
Two reasons for the 50
fall in CS. 40
30

2. Fall in CS due to 20
remaining buyers 10
paying higher P D
0 Q
0 5 10 15 20 25 30

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Is CS a good measure of well-being?
Depends whether consumers are rational or irrational.

For example heroin addicts maybe willing to pay much

higher prices for their habit then they actually do,
creating a large consumer surplus.

In this example policy makers may think the

consumer surplus is not a good measure of
economic well-being.

In most markets consumer surplus reflects economic well-

being.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Practice Problem 1
P Demand curve
A. Find marginal 50
buyer’s WTP at $ 45
Q = 10. 40
B. Find CS for 35
P = $30. 30
Suppose P falls to $20. 25
How much will CS 20
increase due to…
15
C. buyers entering 10
the market 5
D. existing buyers 0
paying lower price
0 5 10 15 20 Q
25
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Practice Problem 1
Demand curve
P
50
A. At Q = 10, marginal
$ 45
buyer’s WTP is $30.
40
B. CS = ½ x 10 x $10 35
= $50
30
P falls to $20. 25
C. CS for the 20
additional buyers 15
= ½ x 10 x $10 = $50 10
D. Increase in CS 5
on initial 10 units 0
= 10 x $10 = $100 0 5 10 15 20 Q
25
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Producer Surplus, Cost and the Willingness to Sell

•Producer surplus is the amount a seller is paid for a good minus

the seller’s cost.

• It measures the benefit to sellers participating in a market.

•Cost is the value of everything a seller must give up to produce a

good.

• Just as consumer surplus is related to the demand curve,

producer surplus is closely related to the supply curve.

• Producer surplus can be measured as the area above the

supply curve and below the price.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Cost and the Supply Curve
• Cost is the value of everything a seller must give up to
produce a good (i.e., opportunity cost).
• Includes cost of all resources used to produce good,
including value of the seller’s time.
• Example: Costs of 3 sellers in the lawn-cutting business.

Name Cost A seller will produce and sell

the good/service only if the
Jasmeet $10
price exceeds his or her cost.
Jeevant 20
Hence, cost is a measure of
Krish 35 willingness to sell.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Cost and the Supply Curve
Derive the supply schedule
from the cost data:
P Qs
Name Cost
$0 – 9 0
Jasmeet $10
10 – 19 1
Jeevant 20
20 – 34 2
Krish 35
35 & up 3

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Cost and the Supply Curve
P
$40 P Qs

$0 – 9 0
$30
10 – 19 1
$20
20 – 34 2

$10 35 & up 3

$0 Q
0 1 2 3

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Cost and the Supply Curve
P
At each Q,
$40 the height of
Krish’s
cost the S curve
$30 is the cost of the
Jeevant’s marginal seller,
$20 cost the seller who
would leave
$10 Jasmeet’s cost the market if
the price were any
$0 Q lower.
0 1 2 3

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Producer Surplus
P PS = P – cost
$40 Producer surplus (PS):
the amount a seller
$30 is paid for a good
minus the seller’s cost
$20

$10

$0 Q
0 1 2 3

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 PS and the Supply Curve
P PS = P – cost
$40
Krish’s
Suppose P = $25.
cost Jasmeet’s PS = $15
$30
Jeevant’s PS = $5
Jeevant’s
$20 cost Krish’s PS = $0

Jasmeet’s cost Total PS = $20

$10
Total PS equals the area
$0 Q above the supply curve
under the price, from 0
0 1 2 3
to Q.
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 PS with lots of Sellers and a smooth S Curve
Price P The supply of Nike
per pair shoes
60
50 S

Suppose P = $40. 40
At Q = 15(thousand), 30
the marginal seller’s 1000s of pairs
cost is $30, 20 of shoes
and her producer 10
surplus is $10.
0 Q
0 5 10 15 20 25 30

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 PS with lots of Sellers and a smooth S Curve
PS is the area b/w P The supply of Nike
P and the S curve, shoes
60
from 0 to Q.
50 S
The height of this
triangle is 40
$40 – 15 = $25.
30
So, h
PS = ½ x b x h 20
= ½ x 25 x $25 10
= $312.50
0 Q
0 5 10 15 20 25 30

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 How a Lower Price reduces PS
If P falls to $30, P 1. Fall in PS
PS = ½ x 15 x $15 60 due to sellers
= $112.50 50
leaving market S
Two reasons for the 40
fall in PS.
30

2. Fall in PS due to 20
remaining sellers 10
getting lower P
0 Q
0 5 10 15 20 25 30

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Practice Problem 2
Supply curve
P
50
A. Find marginal
45
seller’s cost
at Q = 10. 40
35
B. Find total PS for
P = $20. 30
25
Suppose P rises to $30.
Find the increase 20
in PS due to: 15
C. selling 5 10
additional units 5
D. getting a higher price 0
on the initial 10 units 0 5 10 15 20 Q
25
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Practice Problem 2
Supply curve
P
50
A. At Q = 10, 45
marginal cost = $20
40
B. PS = ½ x 10 x $20 35
= $100 30
P rises to $30. 25
C. PS on 20
additional units 15
= ½ x 5 x $10 = $25 10
D. Increase in PS 5
on initial 10 units 0
= 10 x $10 = $100 0 5 10 15 20 Q
25
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 CS, PS and Total Surplus
CS = (value to buyers) – (amount paid by buyers)
= buyers’ gains from participating in the
market
PS = (amount received by sellers) – (cost to sellers)
= sellers’ gains from participating in the market
Total surplus = CS + PS
= total gains from trade in a market
= (value to buyers) – (cost to sellers)

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Market Efficiency
• Consumer surplus and producer surplus may be
used to address the following question:

• Is the allocation of resources determined by free

markets in any way desirable?

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Market’s Allocation of Resources
• In a market economy, the allocation of resources
is decentralized, determined by the interactions
of many self-interested buyers and sellers.

• Is the market’s allocation of resources desirable?

Or would a different allocation of resources make
society better off?

• To answer this, we use total surplus as a measure of

society’s well-being, and we consider whether the
market’s allocation is efficient.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Efficiency
Total
surplus = (value to buyers) – (cost to sellers)
An allocation of resources is efficient if it maximizes total
surplus. Efficiency means:

• The goods are consumed by the buyers who value them most
highly.

• The goods are produced by the producers with the lowest costs.

• Raising or lowering the quantity of a good

would not increase total surplus.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Evaluating the Market Equilibrium
• Three Insights Concerning Market Outcomes

• Free markets allocate the supply of goods to the

buyers who value them most highly, as measured by
their willingness to pay.

• Free markets allocate the demand for goods to the

sellers who can produce them at least cost.

• Free markets produce the quantity of goods that

maximizes the sum of consumer and producer
surplus.

Therefore, the market equilibrium is indeed ‘efficient’.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Evaluating the Market Equilibrium
P
Market eq’m: 60
P = $30
Q = 15,000 50 S
Total surplus 40 CS
= CS + PS
30
Is the market eq’m PS
efficient? 20
10
D
0 Q
0 5 10 15 20 25 30

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Which Buyers Consume?
Every buyer P
whose WTP is
≥ $30 will buy. 60
50 S
Every buyer
whose WTP is
40
< $30 will not. 30
20
So, the buyers who
value the good most 10
highly are the ones D
who consume it. 0 Q
0 5 10 15 20 25 30

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Which Sellers Produce the good?
Every seller whose P
cost is ≤ $30 will 60
produce the good.
50 S

Every seller whose 40

cost is > $30 will not.
30
20
So, the sellers with
the lowest cost 10
produce the good. D
0 Q
0 5 10 15 20 25 30

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Does Equilibrium Q maximize TS?
At Q = 20, P
cost of producing
the marginal unit 60
is $35 50 S
value to the marginal
consumer of the unit 40
is only $20
30
Hence, we can
increase total surplus 20
by reducing Q.
10
This is true at any Q D
greater than 15. 0 Q
0 5 10 15 20 25 30

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Does Equilibrium Q maximize TS?
At Q = 10, P
cost of producing
the marginal unit 60
is $25 50 S
value to the marginal
consumer of the unit 40
is $40
30
Hence, can increase
total surplus 20
by increasing Q.
10
This is true at any Q D
less than 15. 0 Q
0 5 10 15 20 25 30

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Does Equilibrium Q maximize TS?
The market P
eqbm quantity 60
maximizes
total surplus: 50 S
At any other 40
quantity,
we can increase 30
total surplus by
moving toward 20
the market eqbm 10
quantity. D
0 Q
0 5 10 15 20 25 30

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Efficiency and the Equilibrium Quantity
Price
Supply

Value Cost
to to
buyers sellers

Cost Value
to to
sellers buyers Demand

0 Equilibrium Quantity
quantity

Value to buyers is greater Value to buyers is less

than cost to sellers. than cost to sellers.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Government Policies That Alter the
Private Market Outcome
• Price controls
• Price ceiling: a legal maximum on the price
of a good or service. Example: rent control
• Price floor: a legal minimum on the price of
a good or service. Example: minimum wage
• Taxes (Subsidies)
• The govt can make buyers or sellers pay (receive) a
specific amount on each unit.

We will use the supply/demand model to see

how each policy affects the market outcome
(the price buyers pay, the price sellers receive, and
eqbm quantity).
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Example 1: The Market for Apartments

Rental P S
price of
aptts

$800
Eqbm w/o
price
controls
D
Q
300
Quantity
of aptts

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 How Price Ceilings Affect Market Outcomes

A price ceiling P S
above the Price
$1000
eqbm price is ceiling
not binding—
has no effect $800
on the market
outcome.

D
Q
300

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 How Price Ceilings Affect Market Outcomes

The eqbm price P

($800) is above S
the ceiling and
therefore illegal.
The ceiling $800
is a binding
constraint Price
on the price, $500
causes a ceiling
shortage. shortage
D
Q
250 400

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 How Price Ceilings Affect Market Outcomes

In the long run, P S

supply and
demand
are more
price-elastic. $800
So, the shortage Price
is larger. $500
ceiling
shortage
D
Q
150 450

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Example 2: The Market for Unskilled Labor

Wage W S
paid to
unskilled
workers
$6.00
Eqbm w/o
price
controls
D
L
500
Quantity of
unskilled workers

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 How Price Floors Affect Market Outcomes

A price floor W S
below the
eqbm price is
not binding –
has no effect $6.00
on the market
outcome. Price
$5.00
floor

D
L
500

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 How Price Floors Affect Market Outcomes
labor
The eqbm wage ($6) W surplus S
is below the floor Price
and therefore illegal. $7.25 floor

$6.00
The floor is a
binding constraint
on the wage, causes a
surplus (i.e.,
unemployment). D
L
400 550

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Practice Problem 3: Price Controls
The market for
P
140 hotel rooms
Determine S
130
effects of:
120
A. $90 price 110
ceiling 100
B. $90 price 90
floor 80 D
C. $120 price 70
floor 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Practice Problem 3
The market for hotel rooms
P
140
The price falls S
to $90. 130
120
Buyers 110
demand 100
120 rooms, Price ceiling
90
sellers supply 80 D
90, leaving a shortage = 30
70
shortage. 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Practice Problem 3: B. $90 price floor
The market for hotel rooms
P
140
Eqbm price is S
130
above the floor,
120
so floor is not
110
binding.
100
P = $100, 90
Price floor
Q = 100 rooms. 80 D
70
60
50
40
0 Q
50 60 70 80 90 100 110 120 130
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Practice Problem 3: B. $120 price floor
The market for hotel rooms
The price P
140
surplus = 60 S
rises to $120. 130
120
Buyers Price floor
110
demand
100
60 rooms,
90
sellers supply
80 D
120, causing a
70
surplus.
60
50
40
0 Q
50 60 70 80 90 100 110 120 130
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Evaluating Price Controls
• Recall one of the Ten Principles:
Markets are usually a good way
to organize economic activity.

• Prices are the signals that guide the allocation of

society’s resources. This allocation is altered when
policymakers restrict prices.

• Price controls often intended to help the poor,

but often hurt more than help.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 1: Rent Control in the U.S.
• Rent control also gives landlords incentives to forgo
improvements and maintenance in order to cut
costs.

• Because the return on new construction is now

lower, new housing is not constructed as much.

• Conversion to coops becomes more common as a

means to avoid rent-control, thus exacerbating the
shortage.

• Unfair means of allocation replace price allocation.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 1: Rent Control in the U.S.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 2: Price Floor for Farm Products

• The U.S. set in place a price floor for certain

farm products: the price could only go so low.

• The price floor creates a surplus as farmers

produce more than necessary and consumers
buy less than they would at the equilibrium
price.

• The government buys up the surplus to feed low-

income families or to throw away.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 2: Price Floor for Farm Products

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Taxes
• The govt levies taxes on many goods and services
to raise revenue to pay for national defense,
public schools, etc.

• The govt can make buyers or sellers pay the tax.

• The tax can be a % of the good’s price,

or a specific amount for each unit sold.
• For simplicity, we analyze per-unit taxes only.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Import Duty: Badmaash Company
Import Duty is levied by the Customs on any foreign
goods that you import.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Import Duty: Badmaash Company
Advantage? Since demand is strong for foreign goods, buyers
will pay the tax but without tax the profit will be larger!!!

Protagonist comes with an idea to evade the customs duty:

• Reebok shoes are imported in two consignments-one
containing only left shoes and the other containing only
right shoes and sent to different cities.
• Upon arrival, buyer refuses the consignment which is
confiscated and auctioned.
• Other partners pretend to be scrap dealers and buy the
auctioned consignment at throw away rates (much lower
than duty)
• Shoes are paired back together and sold without paying
customs charges.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Example 3: The Market for Pizza

Eqbm
w/o tax P
S1

$10.00

D1

Q
500

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 A Tax on Buyers
Hence,
The a tax
price on buyers
buyers pay Effects of a $1.50 per
shifts
is nowthe D curve
$1.50 higherdown
than unit tax on buyers
by the
the amount
market priceofP.
the tax. P
P would have to fall S1
by $1.50 to make
buyers willing $10.00
Tax
to buy same Q
as before. $8.50
E.g., if P falls D1
from $10.00 to $8.50, D2
buyers still willing to Q
500
purchase 500 pizzas.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 A Tax on Buyers
New eqbm: Effects of a $1.50 per
unit tax on buyers
Q = 450 P
Sellers S1
receive PB = $11.00
Tax
PS = $9.50 $10.00
Buyers pay PS = $9.50
PB = $11.00
D1
Difference
between them D2
Q
= $1.50 = tax 450 500

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Incidence of a Tax
The Incidence of a Tax:
how the burden of a tax is shared among
market participants
P
In our
S1
example, PB = $11.00
Tax
buyers pay $10.00
$1.00 more, PS = $9.50
sellers get
$0.50 less. D1
D2
Q
450 500
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 A Tax on Sellers
The tax effectively raises Effects of a $1.50 per
sellers’ costs by unit tax on sellers
P S2
$1.50 per pizza. $11.50
Tax S1
Sellers will supply
500 pizzas
$10.00
only if
P rises to $11.50,
to compensate for
D1
this cost increase.
Hence, a tax on sellers shifts the Q
S curve up by the amount of the tax. 500

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 A Tax on Sellers
New eqbm: Effects of a $1.50 per
unit tax on sellers
Q = 450 P S2
Buyers pay S1
PB = $11.00 PB = $11.00
Tax
Sellers $10.00
receive PS = $9.50
PS = $9.50
D1
Difference
between them
Q
= $1.50 = tax 450 500

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!
What matters P
is this: S1
PB = $11.00
A tax drives Tax
a wedge $10.00
between the PS = $9.50
price buyers
pay and the
D1
price sellers
receive.
Q
450 500

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Practice Problem 4: Effects of a Tax
The market for
P
140 hotel rooms
Suppose govt S
130
imposes a tax on
120
buyers of $30
110
per room.
100
Find new 90
Q, PB, PS, 80 D
and incidence 70
of tax. 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Practice Problem 4: Effects of a Tax
The market for
P
140 hotel rooms
S
Q = 80 130
120
PB = $110 PB = 110
PS = $80 100
Tax
90
Incidence PS = 80 D
buyers: $10 70
sellers: $20 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand

P It’s easier
for sellers
PB S than buyers
Buyers’ share of
to leave the
tax burden
Tax market.
Price if no tax So buyers
Sellers’ share of bear most of
PS
tax burden the burden
of the tax.
D
Q

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply

P
It’s easier for
S buyers than
Buyers’ share of sellers to
tax burden PB leave the
market.
Price if no tax
Tax Sellers bear
Sellers’ share of most of the
tax burden PS burden of
D the tax.
Q

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 3:Who Pays Luxury Tax?
• 1990: Congress adopted a luxury tax on yachts,
private airplanes, furs, expensive cars, etc.

• Goal: raise revenue from those who could most

easily afford to pay—wealthy consumers.

• But who really pays this tax?

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 3:Who Pays Luxury Tax?
The market for yachts Demand is
price-elastic.
P
S
In the short run,
Buyers’ share of
tax burden PB supply is inelastic.

Tax Hence,
companies
Sellers’ share of
that build
tax burden PS
D yachts pay
most of
Q the tax.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 4: Security Payroll Tax
Prior to 2011, the Social Security payroll tax was 6.2%
taken from workers’ pay and 6.2% paid by employers
(total 12.4%).
The Tax Relief Act (2010) reduced the worker’s portion
from 6.2% to 4.2% in 2011, but left the employer’s
portion at 6.2%.
QUESTION:
Should this change have increased the typical worker’s
take-home pay by exactly 2%, more than 2%, or less
than 2%? Do any elasticities affect your answer?
Explain.
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Case Study 4: Security Payroll Tax
• As long as labor supply and labor demand both have
price elasticity > 0, the tax cut will be shared by
workers and employers, i.e.,
workers’ take-home pay will rise less than 2%.

• The answer does NOT depend on whether labor

demand is more or less elastic than labor supply.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 4: Security Payroll Tax
FOLLOW-UP QUESTION:
Who gets the bigger share of this tax cut, workers or
employers? How do elasticities determine the
answer?

• If labor demand is more elastic than labor supply,

workers get more of the tax cut than employers.
• If labor demand is less elastic than labor supply,
employers get the larger share of the tax cut.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 The Effects of a Tax
P
Eq’m with no tax:
Price = PE
Quantity = QE Size of tax = $T
PB S
Eq’m with
tax = $T per unit: PE
Buyers pay PB PS D
Sellers receive PS
Quantity = QT
Q
QT QE

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 The Effects of a Tax
P

Revenue from tax:

$T x QT Size of tax = $T
PB S

PE

PS D

Q
QT QE

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 The Effects of a Tax
• Next, we apply welfare economics to measure the
gains and losses from a tax.

• We determine consumer surplus (CS),

producer surplus (PS), tax revenue,
and total surplus with and without the tax.

• Tax revenue can fund beneficial services

(e.g., education, roads, police),
so we include it in total surplus.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 The Effects of a Tax
Without a tax, P

CS = A + B + C
PS = D + E + F A
Tax revenue = 0 S
B C
Total surplus PE
= CS + PS D E
=A+B+C D
F
+D+E+F

Q
QT QE

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 The Effects of a Tax
With the tax, P
CS = A
PS = F
A
Tax revenue PB S
=B+D B C
Total surplus D E
=A+B PS D
+D+F F
The tax reduces
total surplus by Q
C+E QT QE

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 The Effects of a Tax
P
C + E is called the
deadweight loss
(DWL) of the tax, A
PB S
the fall in total
B C
surplus that
results from a D E
market distortion, PS D
such as a tax. F

Q
QT QE

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 About the Deadweight Loss
P
Because of the tax,
the units between
QT and QE are not
sold. S
PB
The value of these
units to buyers is
greater than the cost PS D
of producing them,
so the tax prevents
some mutually
Q
beneficial trades. QT QE

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Practice Problem 5
The market for airplane tickets
P
A. Compute $ 400
CS, PS, and
350
total surplus
without a tax. 300
S
250
B. If $100 tax
per ticket, 200
compute 150
D
CS, PS, 100
tax revenue,
50
total surplus,
and DWL. 0 Q
0 25 50 75 100 125
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Practice Problem 5
The market for airplane tickets
P
CS $ 400
= ½ x $200 x 100 350
= $10,000 300
S
PS 250
= ½ x $200 x 100 P = 200
= $10,000 150
D
Total surplus 100
= $10,000 + $10,000 50
= $20,000 0 Q
0 25 50 75 100 125
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Practice Problem 5
P A $100 tax on airplane tickets
CS $ 400
= ½ x $150 x 75 350
= $5,625
300
PS = $5,625 S
PB = 250
Tax revenue 200
= $100 x 75 PS = 150
= $7,500 D
100
Total surplus
50
= $18,750
0 Q
DWL = $1,250
0 25 50 75 100 125
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 What determines the size of DWL?
• Which goods or services should govt tax
to raise the revenue it needs?
• One answer: those with the smallest DWL.
• When is the DWL small vs. large?
Turns out it depends on the price elasticities
of supply and demand.
• Remember:
The price elasticity of demand (or supply) measures
how much QD (or QS) changes
when P changes.
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 DWL and the Elasticity of Supply

When supply P
is inelastic,
S
it’s harder for firms
to leave the market
when the tax
reduces PS.
So, the tax only Size
reduces Q a little, of tax
and DWL is small.
D
Q

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 DWL and the Elasticity of Supply

The more elastic is

P
supply,
the easier for firms
to leave the market
S
when the tax reduces
PS, Size
of tax
the greater Q falls
below the surplus-
maximizing quantity, D
the greater the DWL. Q

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 DWL and the Elasticity of Demand

When demand
P
is inelastic,
S it’s harder for
consumers to leave
Size the market when
of tax
the tax raises PB.
So, the tax only
reduces Q a little,
D and DWL is small.
Q

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 DWL and the Elasticity of Demand
The more elastic is
P demand,
S the easier for buyers
to leave the market
when the tax
Size increases PB,
of tax
the more Q falls
D
below the surplus-
maximizing quantity,
and the greater the
Q
DWL.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Activity

• The government must raise tax revenue to pay for

schools, police, etc. To do this, it can either tax
groceries or meals at fancy restaurants.
• Which should it tax?

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Activity
Groceries or meals at fancy restaurants

Groceries are more of a necessity and therefore less

price-elastic than meals at
fancy restaurants.
So, a tax on restaurant meals would cause a larger
DWL than a tax on groceries.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Practice Problem 6
Would the DWL of a tax be larger if the
tax were on:
A. Breakfast cereal or sunscreen?
B. Hotel rooms in the short run or
hotel rooms in the long run?

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Practice Problem 6
A. Breakfast cereal or sunscreen
Breakfast cereal has more close substitutes than
sunscreen, so demand for breakfast cereal
is more price-elastic than demand for sunscreen.
So, a tax on breakfast cereal would cause a larger
DWL than a tax on sunscreen.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Practice Problem 6
B. Hotel rooms in the short run or long run
The price elasticities of demand and supply
for hotel rooms are larger in the long run than
in the short run.
So, a tax on hotel rooms would cause a larger DWL
in the long run than in the short run.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Digital Services Tax (Aug-Sept 2020)
• What is ‘Digital Services Tax’?
It is a tax imposed on large multi-national enterprises
with revenue derived from the provision of social media
service, a search engine or an online marketplace to users.

• Who has imposed the tax?

European economies including U.K., France, Italy (2-3%)

• Who is expected to be affected?

Apple, Google and Amazon are the leading players in the
market

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Digital Services Tax (Aug-Sept 2020)
• Why was the tax imposed?
European economies have been unhappy with the U.S.
tech firms which make huge money from their citizens
but pay little taxes. However, they have made the
argument that they want to make the brick and mortar
stores more competitive. The U.S. government feels that
the taxes are unfair and discriminatory and target
American firms.

• How have the firms responded to the tax?

They will be raising prices for enterprise customers and
raise the costs for the developers and ultimately the
burden of the tax will be borne by the customers.
Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)
 Subsidies
•A subsidy works opposite to a tax.

•A subsidy is a payment to buyers and sellers to

supplement income or lower costs and which thus
encourages consumption or provides an
advantage to the recipient.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 How Do Subsidies Affect Market Outcomes?
Case Study 7: Impact of a Railway Subsidy

•Using rail travel as an example then subsidies:

• Alter the incentives for people to travel on the train
rather than on the roads.
• Reduces congestion.
• Reduces pollution.
• A subsidy is given to railway companies shifts the supply
curve outwards and lowers the price to buyers and so
increases the amount purchased.
• Both buyers and suppliers share the benefit of the subsidy.
• There are costs associated with subsidies.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 7: Impact of a Railway Subsidy

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 New Industrial Policy: Gujrat Government (Aug 2020)
• What is the ‘New Industrial Policy 2020’ introduced by the
Gujarat Government?
Introduced in August 2020, this policy provides subsidies on
fixed capital investment, land on long-term leases and special
incentives to firms that will relocate their businesses from
other countries to Gujarat.

A capital subsidy of up to 12% of fixed capital investment will

be given to large industries for setting up manufacturing
operations in the state.

In order to address the issue of high price of land in the state,

the government said that industries will get land on long-term
lease of up to 50 years at 6% of the market price.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 New Industrial Policy: Gujrat Government (Aug 2020)

• What is the purpose of the policy?

Creation of employment opportunities, boost manufacturing
and development of the state.

• How is the policy expected to benefit?

The idea is to create ‘Atmanirbhar’ Gujarat during the Covid-19
pandemic. The budgeted expenditure under the policy is
around Rs. 40,000 crores over five years. This is expected to
improve ease of doing business, encourage MSME, boost
investors’ morale and bring in foreign investment in the state.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Problem

The leading producers of aluminum are found in the U.S. with the
largest being MNCs with production, fabrication and distribution
facilities around the world. In recent years, world aluminum
production totaled roughly 25 million metric tons per year. The
largest markets are in North America, Europe and East Asia. The U.S.
is both a major importer and exporter of aluminum. Approximately
one-third of the US supply of aluminum is imported from foreign
producers in the form of primary ingot and scrap. US producers
export more than 10 percent of US production in the form of ingot,
scrap and mill products. The aluminum industry operates about 500
plants in 40 US states and employs nearly 100,000 workers. The US
aluminum industry ranks first in the world in terms of annual
primary aluminum production capacity, accounting for about 6
percent of world supply or over 4 million metric tons of metal.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Problem

Assume that the market supply for aluminum is given by the

equation
𝑄𝑄𝑠𝑠 = −8000 + 8𝑃𝑃
The market demand curve for aluminum is given by the equation
𝑄𝑄𝑑𝑑 = 7000 − 2𝑃𝑃

Find the equilibrium market price and quantity.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Problem

Assume that an industry-wide strike has limited domestic supply to

3000 tons of production. What will the impact on the market price
and DWL?

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 5: Price Supports and Production Quotas

1981 Supply: QS = 1800 + 240P

1981 Demand: QD = 3550 − 266P

Figure

The Wheat Market in 1981

To increase the price to

$3.70, the government
must buy a quantity of
wheat Qg.
By buying 122 million
bushels of wheat, the
government increased 1981 Total demand: QDT = 3550 − 266P + Qg
the market-clearing
Qg= 506P − 1750
price from $3.46 per
bushel to $3.70. Qg= (506)(3.70) − 1750 = 122 million bushels
Loss to consumers = A + B = $624 million
Cost to the government = $3.70 x 122 million = $451.4 million
Total cost of the program = $624 million + $451.4 million = $1075 million
Gain to producers = A + B + C = $638 million

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 5: Price Supports and Production Quotas

1985 Supply: QS = 1800 + 240P

Figure
1985 Demand: QD = 2580 − 194P
The Wheat Market in 1985

In 1985, the demand for

wheat was much lower
than in 1981, because the
market-clearing price
was only $1.80.
To increase the price to
$3.20, the government
bought 466 million
bushels and also
imposed a production
quota of 2425 million
bushels.

2425 = 2580 − 194P + Qg

Qg= −155 + 194P
Qg= −155 + 194($3.20) = 466 million bushels
Cost to the government = ($3.20)(466) = $1491 million

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 6: Price Controls and Natural Gas Shortages

Supply: QS = 15.90 + 0.72PG + 0.05PO

Figure Demand: QD = 0.02 − 0.18PG + 0.69PO
Effects of Natural Gas Price
Controls
The market-clearing price
of natural gas is $6.40 per
mcf, and the
(hypothetical) maximum
allowable price is $3.00.
A shortage of 29.1 − 20.6 =
8.5 Tcf results.
The gain to consumers is
rectangle A minus triangle
B,
and the loss to producers
is rectangle A plus triangle
C.
The deadweight loss is the
sum of triangles B plus C.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Problem Set

Exercises from Ch 9 of Pindyck and Rubinfeld (8e):

Q 1, 2, 4, 5, 9, 10, 13, 14, 15

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Additional Cases

Sources:

1. Case Study 8: P&R

2. Case Study 9: P&R
3. Case Study 10: P&R

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 8: Market for Human Kidneys

Figure
The Market for Kidneys and the Supply: QS = 16,000 + 0.4P
Effect of the National Organ
Transplantation Act Demand: QD = 32,000−0.4P
The market-clearing price is
$20,000; at this price, about
24,000 kidneys per year would
be supplied.
The law effectively makes the
price zero. About 16,000 kidneys
per year are still donated; this
constrained supply is shown as
S’.
The loss to suppliers is given by
rectangle A and triangle C.
If consumers received kidneys at
no cost, their gain would be
given by rectangle A less
triangle B.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 8: Market for Human Kidneys

Figure Supply: QS = 16,000 + 0.4P

The Market for Kidneys and the Demand: QD = 32,000−0.4P
Effect of the National Organ
Transplantation Act (continued)
In practice, kidneys are often
rationed on the basis of
willingness to pay, and many
recipients pay most or all of
the $40,000 price that clears
the market when supply is
constrained.
Rectangles A and D measure
the total value of kidneys
when supply is constrained.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 9: Minimum Prices-Airline Regulation

Figure
Effect of Airline Regulation by the
Civil Aeronautics Board
At price Pmin, airlines would like to
supply Q2, well above the quantity
Q1 that consumers will buy.
Here they supply Q3. Trapezoid D is
the cost of unsold output.
Airline profits may have been lower
as a result of regulation because
triangle C and trapezoid D can
together exceed rectangle A.
In addition, consumers lose A + B.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 9: Minimum Prices
TABLE : Airline Industry Data
1975 1980 1985 1990 1995 2000 2005

Number of Carriers 36 63 102 70 96 94 80

Passenger Load Factor (%) 54 58 61 62 67 72 78
Passenger Mile Rate (Constant
1995 dollars)
.218 .210 .165 .150 .129 .118 .092

Real Cost Index (1995 = 100) 101 122 111 109 100 101 93
Real Fuel Cost Index (1995 =
100)
249 300 204 163 100 125 237

Real Cost Index Corrected for

Fuel Cost Changes
71 73 88 95 100 96 67

By 1981, the airline industry had been completely deregulated. Since that time,
many new airlines have begun service, others have gone out of business, and
price competition has become much more intense. Because airlines have no
control over oil prices, it is more informative to examine a “corrected” real cost
index which removes the effects of changing fuel costs.

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Case Study 10: Impact of a Gasoline Tax (or Subsidy)

Effect of a $1-per-gallon tax:

QD = 150 – 25Pb (Demand)
QS = 60 + 20Ps (Supply)
QD = QS (Supply must equal demand)
Pb – Ps = 1.00 (Government must receive $1.00/gallon)

150 − 25Pb = 60 + 20Ps

Pb = Ps + 1.00
150 − 25(Ps + 1) = 60 + 20Ps
20Ps + 25Ps = 150 – 25 – 60
45Ps = 65, or Ps = 1.44
Q = 150 – (25)(2.44) = 150 – 61, or Q = 89 bg/yr
Annual revenue from the tax tQ = (1.00)(89) = $89 billion per year
Deadweight loss: (1/2) x ($1.00/gallon) x (11 billion gallons/year = $5.5 billion per
year

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)

 Impact of a Tax (or Subsidy)
Gasoline demand: QD = 150 − 25P
Figure Gasoline supply: QS = 60 + 20P
Impact of $1 Gasoline Tax

The price of gasoline at

the pump increases from
$2.00 per gallon to $2.44,
and the quantity sold
falls from 100 to 89 bg/yr.
Annual revenue from the
tax is (1.00)(89) = $89
billion (areas A + D).
The two triangles show
the deadweight loss of
$5.5 billion per year.

What would be the

impact of $1 subsidy on
gasoline?

Tuteja (Lecture Notes, IIFT) Business Economics MBA IB (2020-22)