# 6/5/2014CRC Microeconomics1. 6/5/2014CRC Microeconomics2 What did you study last time? Chapter 5 Elasticities & Applications Elasticities Applications.

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6/5/2014CRC Microeconomics1

6/5/2014CRC Microeconomics2 What did you study last time? Chapter 5 Elasticities & Applications Elasticities Applications

6/5/2014CRC Microeconomics3 Do you know … how governments control prices in markets? what happens when governments impose taxes on markets?

6/5/2014CRC Microeconomics4 I. How do governments control prices in markets? By imposing price ceilings. By imposing price floors.

6/5/2014CRC Microeconomics5 A. Price ceilings What is a price ceiling? What are the consequences of a price ceiling? Examples of price ceilings

6/5/2014CRC Microeconomics6 1. What is a price ceiling (Pc)? A legal maximum on the price at which a good can be sold. A price ceiling is not binding if it is higher than the market equilibrium price (Pe). It is binding if it is lower than Pe.

6/5/2014CRC Microeconomics7 Price ceiling (Pc) P Q S D E Pe=\$6 Qe = 60 The demand-supply diagram below shows a market. \$2 20 If the market is free, without any government intervention, the market will eventually settle at E, with Pe and Qe being the equilibrium price and quantity.

6/5/2014CRC Microeconomics8 Price ceiling (Pc) P Q S D E Pe=\$6 Qe = 60 Now suppose that the government imposes a price ceiling at \$8, i.e. Pc = \$8. \$2 20 Since Pc = \$8 > Pe, this price ceiling does not affect the market. It is not binding. (The market just ignores it.) Pc=\$8

6/5/2014CRC Microeconomics9 Price ceiling (Pc) P Q S D E Pe=\$6 Qe = 60 Now suppose that the government imposes a price ceiling at \$4, Pc = \$4. \$2 20 Since Pc = \$4 < Pe, the market is affected. This price ceiling is binding. Pc=\$4 There is a shortage, which will exist indefinitely as long as Pc < Pe. Shortage The market is inefficient. Resources are misallocated.

6/5/2014CRC Microeconomics10 2. What are the consequences of a binding price ceiling? A perpetual shortage in the market. Long lines. Discrimination according to sellers bias. Inefficiency and inequity.

6/5/2014CRC Microeconomics11 3. Some examples of price ceilings The U.S. market for gasoline in 1973. Rent controls.

6/5/2014CRC Microeconomics12 U.S. gasoline market P Q S D Qe The demand-supply diagram below showed the U.S. gasoline market in 1973 with a nonbinding price ceiling. Pc Pe E

6/5/2014CRC Microeconomics13 U.S. gasoline market P Q S D Qe In 1973, OPEC raised the price of crude oil in world markets. That caused the U.S. supply of gasoline to fall. Pc Pe S E

6/5/2014CRC Microeconomics14 U.S. gasoline market P Q S D Qe Pc Shortage S Pe The previously nonbinding price ceiling became binding. There were long lines at gas pumps across the country. E E

6/5/2014CRC Microeconomics15 Rent controls in the short run and in the long run In the short run, the demand for and supply of rental units are inelastic. In the long run, both demand and supply are elastic. A rent control, or price ceiling would cause a small shortage in the short run, but a larger shortage in the long run. Shortage Pc In the end, tenants pay lower rents for low-quality housing.

6/5/2014CRC Microeconomics16 B. Price floors What is a price floor? What are the consequences of a price floor? Examples of price floors

6/5/2014CRC Microeconomics17 1. What is a price floor (Pf)? A legal minimum on the price at which a good can be sold. A price floor is not binding if it is lower than the market equilibrium price (Pe). It is binding if it is higher than Pe.

6/5/2014CRC Microeconomics18 Price floor (Pf) P Q S D E Pe=\$6 Qe = 60 The demand-supply diagram below shows a market. \$2 20 If the market is free, without any government intervention, the market will eventually settle at E, with Pe and Qe being the equilibrium price and quantity.

6/5/2014CRC Microeconomics19 Price floor (Pf) P Q S D E Pe=\$6 Qe = 60 Now suppose that the government imposes a price floor at \$4, i.e. Pf = \$4. \$2 20 Since Pf = \$4 < Pe, this price floor does not affect the market. It is not binding. (The market just ignores it.) Pf=\$4

6/5/2014CRC Microeconomics20 Price floor (Pf) P Q S D E Pe=\$6 Qe = 60 Now suppose that the government imposes a price floor at \$8, Pf = \$8. \$2 20 Since Pf = \$8 > Pe, the market is affected. This price floor is binding. Pf=\$8 There is a surplus, which will exist indefinitely as long as Pf > Pe. The market is inefficient. Resources are misallocated. Surplus

6/5/2014CRC Microeconomics21 2. What are the consequences of a binding price floor? A perpetual surplus in the market. Inefficiency and inequity.

6/5/2014CRC Microeconomics22 3. Some examples of price floors The minimum wage. Price supports for agricultural products, e.g. milk, cotton, etc.

6/5/2014CRC Microeconomics23 The minimum wage (Pf) W QLQL S D E Pe=\$6 Qe = 30 The demand-supply diagram below shows a market for non- and low-skilled workers. \$2 10 Without government intervention, workers would earn \$6/hr. The total employment is 30 million.

6/5/2014CRC Microeconomics24 The minimum wage (Pf) W QLQL S D E Pe=\$6 Qe = 30 Now suppose that the government sets a minimum wage, or price floor at \$8, i.e. Wm = Pf = \$8. \$2 10 There is a surplus of labor, which is also called unemployment, because Qd = 20 < Qs = 40. Pf=\$8 Surplus Some workers would lose their jobs due to the laws, while some others would not be able to find jobs.

6/5/2014CRC Microeconomics25 Price support (Pf) P Qm S D E Pe=\$1.5 Qe = 30 The demand-supply diagram below shows a market for milk. \$.5 10 Without government intervention, milk would be sold at \$1.5/gallon. The total amount sold is 30 million gallons.

6/5/2014CRC Microeconomics26 Price support (Pf) P Qm S D E Pe=\$1.5 Qe = 30 Now suppose that the government sets a price floor, at \$2, i.e. Pf = \$2. \$.5 10 There is a surplus of milk, because Qd = 20 < Qs = 40. Pf=\$2 Surplus

6/5/2014CRC Microeconomics27 Price support (Pf) P Qm S D E Pe=\$1.5 Qe = 30 If the government buys the surplus, milk buyers, who are also taxpayers, would be hurt twice. \$.5 10 They would pay higher price for milk, and pay taxes so the government could buy the surplus milk. Pf=\$2 Surplus

6/5/2014CRC Microeconomics28 C. Are price controls good or bad? Price controls often hurt those they are trying to help. When policymakers set prices by legal decrees, they often obscure the signals that normally guide the allocation of societys scarce resources.

6/5/2014CRC Microeconomics29 C. Are price controls good or bad? Helping those in need can be accomplished in ways other than controlling prices. e.g. rent subsidies to poor families, and wage subsidies (earned income tax credit) to the working poor.

6/5/2014CRC Microeconomics30 II. What are the effects of taxes on markets? Important points about taxes Potential impacts of taxes Taxes on buyers vs. taxes on sellers Tax incidence (the share of tax burden)

6/5/2014CRC Microeconomics31 1. Important points about taxes Why taxes? Governments levy taxes to raise revenue for public projects, e.g. roads, schools, national defense, etc. Taxes affect markets in many ways. Tax incidence: the study of who bear the tax burden.

6/5/2014CRC Microeconomics32 2. Potential impacts of taxes Taxes discourage market activities. Taxes result in changes of market equilibrium. When a good is taxed, the quantity sold is smaller.

6/5/2014CRC Microeconomics33 2. Potential impacts of taxes Buyers and sellers share the tax burden. Generally, buyers pay more, and sellers receive less.

6/5/2014CRC Microeconomics34 3. Taxes on buyers vs. taxes on sellers A tax on buyers shifts the demand curve downward by the tax amount. A tax on sellers shifts the supply curve upward by the tax amount. It does not matter on whom the tax is levied, the outcomes are the same.

6/5/2014CRC Microeconomics35 a. A tax (t) on buyers P Q S D E Pe=\$6 Qe = 60 The demand-supply diagram below shows a market. \$2 20 If the market is free, without any government intervention, the market will eventually settle at E, with Pe and Qe being the equilibrium price and quantity.

6/5/2014CRC Microeconomics36 a. A tax (t) on buyers P Q S D E Pe=\$6 Qe = 60 Now suppose that the government imposes a tax of \$4 on buyers in the market, i.e. t = \$4. \$2 20 The tax shifts the demand curve downward by \$4. DtDt DtDt EtEt Sellers now receive \$4 per unit, while buyers pay \$4 + \$4 = \$8 per unit. Ps=\$4 Pd=\$8 Quantity sold in the market falls to 40 units. Qt = 40

6/5/2014CRC Microeconomics37 a. A tax (t) on buyers P Q S D E Pe=\$6 Qe = 60 The government collects \$4x40 = \$160 in tax revenue. \$2 20 DtDt DtDt EtEt Of the tax amount, buyers pay Td = (\$8-\$6)x40 = \$80, and sellers pay Ts = (\$6-\$4)x40 = \$80. Ps=\$4 Pd=\$8 Qt = 40 GTR Td Ts

6/5/2014CRC Microeconomics38 b. A tax (t) on sellers P Q S D E Pe=\$6 Qe = 60 The demand-supply diagram below shows a market. \$2 20 If the market is free, without any government intervention, the market will eventually settle at E, with Pe and Qe being the equilibrium price and quantity.

6/5/2014CRC Microeconomics39 b. A tax (t) on sellers P Q S D E Pe=\$6 Qe = 60 Now suppose that the government imposes a tax of \$4 on sellers in the market, i.e. t = \$4. \$2 20 The tax shifts the supply curve upward by \$4. StSt EtEt Sellers now receive \$8- \$4 = \$4 per unit, while buyers pay \$8 per unit. Ps=\$4 Pd=\$8 Quantity sold in the market falls to 40 units. Qt = 40

6/5/2014CRC Microeconomics40 b. A tax (t) on sellers P Q S D E Pe=\$6 Qe = 60 The government collects \$4x40 = \$160 in tax revenue. \$2 20 StSt EtEt Of the tax amount, buyers pay Td = (\$8-\$6)x40 = \$80, and sellers pay Ts = (\$6-\$4)x40 = \$80. Ps=\$4 Pd=\$8 The outcomes are identical to the case where taxes are levied on buyers. Qt = 40 GTR Td Ts

6/5/2014CRC Microeconomics41 c. The general case of a tax P Q S D E Pe=\$6 Qe = 60 The demand-supply diagram below shows a market. \$2 20 If the market is free, without any government intervention, the market will eventually settle at E, with Pe and Qe being the equilibrium price and quantity.

6/5/2014CRC Microeconomics42 c. The general case of a tax P Q S D E Pe=\$6 Qe = 60 Now suppose that the government imposes a tax of \$4 on the market, i.e. t = \$4. \$2 20 Determine the tax amount as the vertical distance between the supply and demand curve. t

6/5/2014CRC Microeconomics43 c. The general case of a tax P Q S D E Pe=\$6 Qe = 60 After the tax, the price paid by buyers is Pd = \$8. The price received by sellers is Ps = \$8 - \$4 = \$4. \$2 20 Quantity sold falls to Qt = 40 units. t Ps=\$4 Pd=\$8 Qt = 40

6/5/2014CRC Microeconomics44 c. The general case of a tax P Q S D E Pe=\$6 Qe = 60 GTR = \$4 x 40 = \$160 \$2 20 Td = \$80, and Ts = \$80. GT = Td + Ts. t Ps=\$4 Pd=\$8 Qt = 40 GTR Td Ts The market produces less due to the tax, becoming inefficient.

6/5/2014CRC Microeconomics45 4. Tax incidence Lawmakers can decide whether a tax comes from the buyers pockets or the sellers, but they cannot legislate the true burden of the tax, which depends on the forces of supply and demand.

6/5/2014CRC Microeconomics46 4. Tax incidence The tax burden depends on the relative elasticity of supply and demand. It falls more heavily on the side of the market that is less elastic (i.e. more inelastic). Rule of thumb: more inelastic => more taxes.

6/5/2014CRC Microeconomics47 4. Tax incidence Examples: Payroll taxes: More taxes paid by workers because Ed < Es. Taxes on luxury items: More taxes paid by sellers because Es < Ed.

6/5/2014CRC Microeconomics48 Summary Government intervention in markets by price controls results in inefficiency. Government intervention in markets by taxes, in most cases, also result in inefficiency.

6/5/2014CRC Microeconomics49 Now you know … how governments control prices in markets. what happens when governments impose taxes on markets.

6/5/2014CRC Microeconomics50 What will you study next time? Chapter 7 Market Efficiency Consumer surplus Producer surplus Market efficiency

6/5/2014CRC Microeconomics51

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