Using Supply and Demand to Analyze Markets

Using Supply and Demand to Analyze Markets
3 Chapter Outline 3.1 Consumer and Producer Surplus: Who Benefits in a Market? 3.2 Price Regulations 3.3 Quantity Regulations 3.4 Taxes 3.5 Subsidies 3.6 Conclusion Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Introduction 3 In this chapter, we use the supply and demand model to answer the following questions How do we measure the benefits that accrue to producers and consumers in a market? How do government interventions (e.g., taxes) affect markets and the benefits associated with market exchange? Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.1 Consumer and Producer Surplus: Who Benefits in a Market?
Consumers benefit from market exchange, otherwise they would not participate Consumer surplus – The difference between the amount consumers would be willing to pay for a good or service and the amount they actually pay (the market price) In many cases, this difference is positive, and consumers experience net benefits from market exchange Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Figure 3.1 Defining Consumer Surplus
Consumer and Producer Surplus: Who Benefits in a Market? Figure 3.1 Defining Consumer Surplus Price ($/pound) Demand choke price $5.50 Total consumer A 5 surplus (CS) Person A’s B 4.50 consumer C 4 surplus = $1.50 D 3.50 Market price E 3 D 2 The consumer at point E will not buy any apples because the market price is too high 1 Quantity of 1 2 3 4 5 apples (pounds) Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.1 Consumer and Producer Surplus: Who Benefits in a Market?
Producers benefit from market exchange, otherwise they would not participate Producer surplus – The difference between the amount producers are willing to sell goods for and what they actually receive (the market price) Producer surplus is not the same as profit, as we will see in later chapters Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Figure 3.2 Defining Producer Surplus
3.1 3 Consumer and Producer Surplus: Who Benefits in a Market? Figure 3.2 Defining Producer Surplus The producer at point Z will not produce any apples because the market price is too low Price ($/pound) Total producer 5 surplus (PS) S 4 Z 3.50 Market price Seller V ’s Y 3 producer X 2.50 surplus = $1.50 W 2 V 1.50 Supply 1 choke price Quantity of 1 2 3 4 5 apples (pounds) Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

figure it out The Market for Cupcakes QS = 30P – 20 , QD = 124 – 18P
The weekly supply and demand for cupcakes in a small town are given as QS = 30P – 20 , QD = 124 – 18P where P is the price, in dollars, and quantity is measured in thousands of cupcakes per week Answer the following questions: Find the equilibrium price and quantity Calculate consumer and producer surplus at the equilibrium Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

figure it out The Market for Cupcakes 30P – 20 = 124 – 18P
Remember: Equilibrium is characterized by QS = QD 30P – 20 = 124 – 18P Combining terms and solving for P yields 48P = 144 → P* = $3 And using the equation for demand, QD = 124 – 18(3) = 70 = Q* = QS The easiest way to calculate consumer and producer surplus is with a graph; to do this, we must determine two points for each curve Equilibrium price/quantity Choke prices (where QD /QS are equal to zero) Why do we need only two points to plot the demand/supply curves? Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

figure it out The Market for Cupcakes
We already know one point for each curve: P* = $3.00 ; Q* = 70 Demand choke price: QD = 0 = 124 – 18P → P = $6.89 Supply choke price: QS = 0 = 30P – 20 → P = $0.67 Price of cupcakes (dollars) Consumer surplus is the area below demand but above the price (Area A) Producer surplus is the area above supply but below the price (Area B) Surplus is generally measured in dollars 6.9 S A 3 B 0.67 D 70 Quantity of cupcakes (thousands) Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.1 Consumer and Producer Surplus: Who Benefits in a Market? 3
What happens to consumer and producer surplus when there is a shift in supply or demand? Imagine a pie shop opens up in the same town. What will happen to the demand for cupcakes? Demand will shift left, resulting in a new equilibrium of P2 andQ2 What happens to consumer surplus? Old consumer surplus: A + B + F New consumer surplus: B + C What happens to producer surplus? Old producer surplus: C + D + E + G New producer surplus: D C has transferred from producers to consumers A + E + F + G has disappeared from this market Price of cupcakes (dollars) E A S B F P1 C G P2 D D2 D1 Q2 Q1 Quantity of cupcakes (thousands) Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Figure 3.3 Consumer Surplus and the Elasticity of Demand
3.1 Consumer and Producer Surplus: Who Benefits in a Market? 3 Figure 3.3 Consumer Surplus and the Elasticity of Demand Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

figure it out The Market for Tires QS = 15P – 400 , QD = 2,800 – 25P
The weekly supply and demand for tires in a small town are given as QS = 15P – 400 , QD = 2,800 – 25P where P is the price, in dollars, and quantity is the number of tires sold weekly. The equilibrium price is $80 per tire, and 800 tires are sold each week Suppose an improvement in technology makes tires cheaper to produce; specifically, suppose the quantity supplied rises by 200 at every price Answer the following questions: What is the new supply curve? What are the new equilibrium price and quantity? What happens to consumer and producer surplus? Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

figure it out The Market for Tires
Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Figure 3.5 Changes in Surplus from a Supply Shift
3.1 Consumer and Producer Surplus: Who Benefits in a Market? 3 Figure 3.5 Changes in Surplus from a Supply Shift Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.2 Price Regulations 3 Politicians often call for the direct regulation of prices on products and services Price ceiling – a regulation that sets the maximum price that can be legally paid for a good or service Price floor – a regulation that sets the minimum price that can be legally paid for a good or service (often called a price support) What are the effects of price ceilings/floors on markets? Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.2 Price Regulations Some important terminology
Transfer – surplus that moves from producers to consumers, or vice versa, as a result of a regulation Deadweight loss (DWL) – the reduction in total surplus that occurs as a result of a market inefficiency Remember the cupcake example of changing demand due to a pie shop Nonbinding price ceiling – a price set at a level above the equilibrium market price Nonbinding price floor – a price set at a level below the equilibrium market price 1…surplus that moves from producers to consumers, or… fixed I don’t like the way these questions are presented as bullets. Bullets should be more parallel. See suggestion for setting off questions on slide #8. fixed Change ceiling to floor in the definition of the price floor. fixed Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Figure 3.7 The Effects of a Price Ceiling
3.2 3 Price Regulations Figure 3.7 The Effects of a Price Ceiling Price Consumer surplus before A + B + C ($/pizza) Consumer surplus after A + B + D $20 Producer surplus before D + E + F Producer surplus after F A z DWL = C + E Supply 14 B C w 10 D E y 8 x F 5 Transfer of PS Demand to CS Quantity of pizzas 6 10 12 20 (thousands)/month Shortage Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.8 Deadweight Loss and Elasticities
3.2 Price Regulations 3 3.8 Deadweight Loss and Elasticities 1…surplus that moves from producers to consumers, or… fixed I don’t like the way these questions are presented as bullets. Bullets should be more parallel. See suggestion for setting off questions on slide #8. fixed Change ceiling to floor in the definition of the price floor. fixed Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Figure 3.9 The Effects of a Price Floor
3.2 3 Price Regulations Figure 3.9 The Effects of a Price Floor Price Transfer ($/per ton) of CS to PS S A x y Price floor $1,000 B C w Consumer surplus before A + B + C 500 Consumer surplus after A E D Producer surplus before D + E + F Producer surplus after B + D + F z F D Quantity of peanuts 10 20 30 (millions of tons) Surplus Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.3 Quantity Regulations 3 Like price regulations, quantity regulations restrict the amount of a good or service provided to a market Quota – a regulation that sets the quantity of a good or service provided Often used to limit imports of certain goods; why might a government pursue an import quota? Sometimes used to limit exports (e.g., China and rare earths) What are the effects of quotas on markets? Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Figure 3.10 The Effects of a Quota
3.3 3 Quantity Regulations Figure The Effects of a Quota Price Consumer surplus before A + B + C ($/tattoo) S2 Consumer surplus after A $125 Producer surplus before D + E + F Producer surplus after B + D + F A z Pquota = 100 Transfer of CS to PS B C x S1 P = 50 D E 40 y D 35 F Quantity of 500 1,500 tattoos/year (Quota) Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Application 3 The unintended consequences of immigration quotas
In October, 2003, Congress reduced the annual number of H-1B visas from 195,000 to 65,000 Targeted highly skilled workers Quota had never been binding prior to policy change; government began denying petitions in 2004 Requires a sponsoring U.S. company (a job offer); foreign students who pursue a U.S. education have a better chance of finding a sponsor Visa quotas have been shown to reduce immigration... Why would the U.S. pursue this policy? What other consequences might we see? Images: FreeDigitalPhotos.net Citation: T. Kato and C. Sparber “Quotas and Quality: the Effects of H-1B Visa Restrictions on the Pool of Prospective Undergraduate Students from Abroad.” Forthcoming in The Review of Economics and Statistics. Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Application 3 The unintended consequences of immigration quotas
Kato and Sparber (2013) examined whether this new policy might have reduced the incentive for highly qualified students to pursue an education in the U.S. Considered SAT scores submitted by foreign students Used five countries as a “control”; Australia, Canada, Chile, Mexico, and Singapore have special status, and their students can obtain visas similar to H-1B without a quota Key findings Average SAT scores of applicants from foreign countries affected by the H-1B quota dropped 10– 20 points after 2003 Drop was driven by a reduction in top-quintile scores, implying the policy reduced incentive for high-quality applicants Images: FreeDigitalPhotos.net Citation: T. Kato and C. Sparber “Quotas and Quality: the Effects of H-1B Visa Restrictions on the Pool of Prospective Undergraduate Students from Abroad.” Forthcoming in The Review of Economics and Statistics. Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.3 Quantity Regulations 3 Government provision of a public good: municipal golf courses Sometimes, governments attempt to supplement market supply for things that benefit communities What happens to the market for golf when a local government opens a municipal course? With only for-profit and private courses, supply is Spriv and the market equilibrium occurs at Q1 and P1 The municipal course increases the quantity of rounds available by Qgov , and supply shifts out to Stot However, quantity supplied only increases to Qtot because private suppliers are not willing to supply as much at the new, lower market price Private producers reduce quantity supplied to Qpriv , this effect is known as “crowding out” Price of a golf round Spriv Stot P1 Ptot D Qpriv Q1 Qtot Q1 + Qgov Quantity of rounds Crowding out Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.4 Taxes Taxes are very prevalent in societies
Product markets (VAT; sales taxes) Labor markets (income taxes; payroll taxes) Capital markets (capital gains taxes) How do taxes impact markets? Some taxes are imposed to correct market failures (see Chapter 16) In general, taxes distort market outcomes How do we describe the effects of taxes? Example: In 2003, Boston’s Mayor Tom Menino proposed a $0.50 tax on movie tickets How should this tax (which was ultimately not adopted by the legislature) affect the market for movie tickets? Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Figure 3.13 The Effects of a Tax on Boston Movie Tickets
3.4 3 Taxes Figure The Effects of a Tax on Boston Movie Tickets Price ($/ticket) $10 Transfer from CS and PS to government S2 = S1 + tax A y Pb = 8.30 C S1 B x P1 = 8.00 D D Ps = 7.80 z E Consumer surplus (CS) before A + B + C F Consumer surplus (CS) after A Producer surplus (PS) before D + E + F Producer surplus (PS) after F 6.67 Government revenue B + D Quantity of tickets Q2 = 3.4 Q1 = 4 (100,000s) Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.4 Taxes 3 We can also describe the effect of a tax on consumer and producer surplus with equations. Demand and supply for tickets are given by where prices are measured in dollars and quantity in hundreds of thousands of tickets. Equilibrium occurs when QD = QS, Before the tax, tickets are $8 and 400,000 tickets are sold in Boston Pre-tax consumer surplus where the demand choke price is found by solving and consumer surplus is equal to Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.4 Taxes 3 Pre-tax producer surplus surplus
where the supply choke price Solving for producer surplus yields And total surplus What happens after the tax? Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.4 Taxes 3 Define the after-tax price as
The market price (the price buyers pay), Pb , is equal to the price the producer received, PS , plus the tax. To find the new equilibrium, substitute this expression into the demand equation Why do we not substitute into the supply equation? Solving for PS The new market price is and quantity (substitute buyer price into demand function) Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.4 Taxes 3 New consumer surplus and producer surplus
How much revenue has been generated by the tax? And the associated deadweight loss associated with this distortion is Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.4 Taxes 3 Deadweight loss (DWL) is the loss in total surplus generated any time a policy creates a market distortion DWL associated with taxes is often referred to as “excess burden” The size of DWL increases at an increasing rate with the difference between the pre- and post-policy equilibrium quantities Big taxes create more DWL than little taxes Consider the movie example, but with a $1.00 tax Solving for PS , Pb , and Q2 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.4 Taxes 3 Consumer surplus and producer surplus
How much revenue has been generated by the tax? And the associated deadweight loss associated with this distortion is So, while the tax rate has doubled, deadweight loss has quadrupled from $15,000 to $60,000, and tax revenues have only increased by 78.5% (from $170,000 to $280,000) Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Figure 3.14 The Effect of a Larger Tax on Boston Movie Tickets
3.4 Taxes 3 Figure 3.14 The Effect of a Larger Tax on Boston Movie Tickets Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

figure it out Soda Tax QS = 50P – 60 , QD = 12 – 8P
The supply and demand for soda in a market is represented by QS = 50P – 60 , QD = 12 – 8P where P is the price per bottle, in dollars, and Q is in millions of bottles per year The current equilibrium price is $1.24, and 2.07 million bottles are sold per year Answer the following questions: Calculate the price elasticity of demand and the price elasticity of supply at the current equilibrium Calculate the share of a tax that will be borne by consumers and the share borne by producers If a tax of $0.10 per bottle is created, what do buyers now pay for a bottle? What will sellers receive? Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

figure it out Soda Tax The first step is determining how the subsidy affects prices In this problem, Supply and demand are given by And substituting in for PS Equating supply and demand, and solving for Pb Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Application 3 Taxation, tax evasion, and smuggling
When monitoring technology is imperfect, the presence of taxes may create an incentive to cheat Fisman and Wei (2004) attempt to unravel the relationship between differing tariff rates and smuggling in China Consider the “evasion gap”: The difference between exports to China (recorded in Hong Kong) and imports as reported by China With no evasion, the numbers should be the same Images: FreeDigitalPhotos.net Citation: Fisman, R. and S. Wei “Tax Rates and Tax Evasion: Evidence from “Missing Imports” in China.” The Journal of Political Economy 112(2): 471–496. Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Application 3 Taxation, tax evasion, and smuggling
The authors find the evasion gap to be positively correlated with tax rates (i.e., highly taxed products are likely to be mislabeled, undervalued, or undercounted) Evasion is almost entirely due to intentional mislabeling of products (highly taxed products are labeled as minimally taxed products) Evasion is negatively correlated with tax rates on closely related products (e.g., chickens and turkeys)... why might this be the case? Images: FreeDigitalPhotos.net Citation: Fisman, R. and S. Wei “Tax Rates and Tax Evasion: Evidence from “Missing Imports” in China.” The Journal of Political Economy 112(2): 471–496. Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.4 Taxes 3 Tax incidence is a term describing who actually bears the burden of a tax In the supply and demand model, it does not matter who is required to pay the tax (e.g., a sales tax vs. a production tax); tax incidence will be the same in each case! Consider again the movie theater example Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.4 Taxes Figure 3.15 Tax Incidence 3 (a) (b) Price ($) Price ($) S2
Tax = Pb – Ps S1 S Pb Pb P1 P1 Ps Ps D D1 D2 Tax = Pb – Ps Quantity Quantity Q2 Q1 Q2 Q1 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.4 Taxes 3 Tax incidence is a term describing who actually bears the burden of a tax In the simple model presented here, it does not matter who is required to pay the tax (e.g., a sales tax vs. a production tax); tax incidence will be the same in each case! Consider again the movie theater example Tax incidence and elasticities Elasticities of supply and demand are major determinants of incidence In general, when demand is relatively more elastic, producers will experience more burden, and vice versa Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.4 Taxes 3 Elastic demand with inelastic supply S2 S1 D
Consider the market for labor; workers (suppliers), are unlikely to extend or cut hours very much for a large range of wages Demand, on the other hand, may be elastic due to the presence of substitutes (outsourcing) What happens when the government puts a tax on earned income? The tax shifts the labor supply curve up by the amount of the tax; the new wage is Wb , with quantity L2 The wage received by workers, however, is only Ws Wb –W1 < W1 – Ws ; therefore, the incidence of the tax falls primarily on suppliers of labor (workers) S2 Wage tax S1 Wb W1 tax D Ws L2 L1 Quantity of labor Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.4 Taxes 3 Tax incidence is a term describing who actually bears the burden of a tax In the simple model presented here, it does not matter who is required to pay the tax (e.g., a sales tax vs. a production tax); tax incidence will be the same in each case! Consider again the movie theater example Tax incidence and elasticities Elasticities of supply and demand are major determinants of incidence In general, when demand is relatively more elastic, producers will experience more burden, and vice versa A general formula(s) for incidence as a function of elasticities Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Figure 3.16 Tax Incidence and Elasticities
3.4 Taxes 3 Figure 3.16 Tax Incidence and Elasticities Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

figure it out Soda Tax QS = 50P – 60 , QD = 12 – 8P
The supply and demand for soda in a market is represented by QS = 50P – 60 , QD = 12 – 8P Where P is the price per bottle, in dollars, and Q is in millions of bottles per year The current equilibrium price is $1.17, and 2.62 million bottles are sold per year Answer the following questions: Calculate the price elasticity of demand and the price elasticity of supply at the current equilibrium Calculate the share of a tax that will be borne by consumers and the share borne by producers If a tax of $0.10 per bottle is created, what do buyers now pay for a bottle? What will sellers receive? Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

figure it out Soda Tax The elasticity of demand and supply are
The proportion of a tax borne by buyers and sellers is: If there is a tax of $0.10 per bottle, buyers pay 85.6%, or $ per bottle, and sellers pay 14.4%, or $ per bottle Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Application 3 Is it really the case that it does not matter how a tax is levied? Economic theory tells us tax incidence does not depend on who is actually taxed This assumes consumers treat a dollar of taxation in the same manner as they treat a dollar of product price Chetty et al. (2009) show this may not always be true. Consider the differences between sales taxes and excise taxes Sales taxes are usually assessed as a percentage of the retail price of a good or service, and is added at the point of sale; determining the total cost before purchasing requires calculation by the consumer Excise taxes are usually included in the observed retail price (e.g., the tax on gasoline or alcohol) Images: FreeDigitalPhotos.net R. Chetty, A.Loony, and K. Kroft “Salience and Taxation: Theory and Evidence.”American Economic Review, 99(4): 1145–1177. Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Application 3 Is it really the case that it does not matter how a tax is levied? The authors examine this issue in two ways “Field experiment” to determine how demand for household items in a supermarket changes when sales taxes are included in posted prices Empirical study of state-level changes in excise and sales taxes on alcohol between 1970 and 2003 Both approaches reveal that consumers underreact to sales taxes relative to excise taxes (i.e., lower ED with respect to sales taxes) What does this imply for tax incidence? How should taxes be structured? What does this imply for economic theory? Theory is constantly evolving to take into account evidence from the field and laboratory Chapter 17 highlights some recent advances in behavioral economics Images: FreeDigitalPhotos.net R. Chetty, A. Loony, and K. Kroft “Salience and Taxation: Theory and Evidence.”American Economic Review, 99(4): 1145–1177. Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.5 Subsidies 3 Subsidy – a payment by the government to a buyer or seller of a good or service Subsidies are simply the opposite of a tax Governments subsidize many products and production processes Producer subsidies – ethanol production, research and development Consumer subsidies – education, public transportation Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Figure 3.17 The Impact of a Producer Subsidy
3.5 Subsidies 3 Figure 3.17 The Impact of a Producer Subsidy Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

figure it out Education Grants QS = 1,000P – 2500 , QD = 8,000 – 500P
For years the government has subsidized higher education through grants; consider the supply and demand for college credit hours at a local private liberal arts college QS = 1,000P – , QD = 8,000 – 500P where P is the price, in hundreds of dollars, and Q is the number of credit hours per semester The current equilibrium price is $700, and 4,500 credit hours are taken per semester; suppose the government subsidizes credit hours at a rate of $200 per hour Answer the following questions: What will happen to the price paid by students, the price received by the college, and the number of credit hours completed? What is the cost of the subsidy to the government? Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

figure it out Education Grants
The first step is determining how the subsidy affects prices In this problem, Supply and demand are given by And substituting in for PS Equating supply and demand, and solving for Pb Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

figure it out Education Grants The new producer price is given by
And the quantity of credit hours taken (using demand equation) So, the price paid by consumers has decreased by about $133, the price received by the college has increased by about $67, and the number of credit hours consumed has increased by about 667 How much did this cost the government? Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

3.6 Conclusion 3 This chapter examined the supply and demand model in more detail, and analyzed how government policies affect markets In the next few chapters, we examine the microeconomic underpinnings of demand and supply In Chapter 4, we introduce the concept of utility, which provides context for understanding how consumers make consumption decisions Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e

Using Supply and Demand to Analyze Markets

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