Presentation on theme: "Elasticity and Its Applications"— Presentation transcript:
1Elasticity and Its Applications Chapter 5Elasticity and Its Applications
2Chapter Outline The Elasticity of Demand The Elasticity of Supply Using Elasticities for Quick Predictions (Optional)TakeawayAppendix 1: Using Excel to CalculateElasticitiesAppendix 2: Other Types of Elasticities
3But how much does quantity demanded change when price changes? Elasticity of DemandWe know there is an inverse relationship between price and quantity demanded.But how much does quantity demanded change when price changes?Instructor Notes:
4Elasticity of DemandElasticity of demand - a measure of how responsive the quantity demanded is to a change in pricemore responsive equals more elastic.The slope of the demand curve is related to the elasticity of demand.Let’s see how this works.
5Elasticity of Demand price Price ↑ from $40 to $50: a → b less responsivea → c more responsivecb$50a40Demand E(more elastic)Demand I (less elastic)Quantity2095100
6Determinants of the Elasticity of Demand Ease in finding substitutes ***Easier → greater elasticityTime required to adjust to price changesLong term → more substitutes → greater elasticityThe definition of the commodityNarrow definition → more substitutes → greater elasticityExample: Coffee vs. specific brandNecessities versus LuxuriesShare of budget devoted to the good.Larger share → greater elasticity
7Determinants of the Elasticity of Demand Summary of Determinants of Elasticity of DemandLess ElasticMore ElasticFewer SubstitutesMore SubstitutesShort Run (less time)Long Run (more time)NecessitiesLuxuriesSmall Part of BudgetLarge Part of BudgetInstructor Notes: Table 4.1: Some Factors Determining the Elasticity of Demand
8Mathematics of Demand Elasticity Elasticity of demand is always negative, so we typically drop the negative sign and use absolute value instead.If the |Ed| < 1, the demand curve is inelastic.If the |Ed| > 1, the demand curve is elastic.If the |Ed| = 1, the demand curve is unit elastic.Instructor Notes: Students should note some extreme cases that are not explicitly defined in the text but are often used for simplification:Perfectly Elastic DemandElasticity of demand is infiniteA very small change in price will lead to an infinitely large change in quantity demandedHorizontal demand curvePerfectly Inelastic DemandElasticity of demand is zeroA change in price will cause no change in quantity demanded.Vertical demand curve
9Calculating the Elasticity of Demand Elasticity measures the responsiveness of quantity demanded to changes in price.Usually interpreted using the absolute value:
10Calculating the Elasticity: Midpoint Method We use the midpoint as the base:Let’s work an example.
11Calculating the Elasticity: Midpoint Method Given:What does this number mean?PriceQuantity DemandedPoint a$40100Point b$5020
12Total Revenue and the Elasticity of Demand A firm’s revenues are equal to price per unit times quantity sold.Revenue = Price x QuantityThe elasticity of demand directly influences revenues when the price of the good changes.Instructor Notes:
13Total Revenue and Elasticity of Demand Inelastic DemandElastic DemandPricePriceResult: ↑TRResult: ↓TR$50$504040DemandDemand95100Quantity20100Quantity↓TR due to ↓Qd↑TR due to ↑P
14Total Revenue and the Elasticity of Demand Knowing the value of the elasticity allows us to understand what happens to total revenue when the price changes.If…We can use diagrams to see how this works.
15Total Revenue and Elasticity of Demand: Summary Summary: Total revenue and EdElasticity and RevenueAbsolute Valueof EdNameHow Revenue Changes with Price|Ed | > 1ElasticTR and P move together|Ed | < 1InelasticTR and P move in opposite directions|Ed | = 1Unit ElasticTR remains the same when price changes
16Applications of Elasticity of Demand How the American Farmer has Worked Himself Out of a Job:Increased agricultural productivity has the supply of food BUT the supply of farmers….And their revenues because the demand for most agricultural products is inelastic.
17Which is more elastic, the demand for computers or the demand for Dell computers? Why? The elasticity of demand for eggs has been estimated to be If the price of eggs increases by 10%, what will happen to total revenue of egg producers?To nextTry it!
18They think it’s elastic They think it’s inelastic If a fashionable clothing store raised its prices by 25 percent, what does that tell you about the store’s estimate of the elasticity of demand for its products?They think it’s elasticThey think it’s inelasticTo nextTry it!
19The Elasticity of Supply Elasticity of supply – measures how responsive the quantity supplied is to the a change in price.more responsive equals more elastic.The slope of the supply curve is related to the elasticity of supply.Let’s see how this works.
20The Elasticity of Supply QuantityPrice per UnitElasticity of Supply Captures the Sensitivity of Quantity Supplied to Changes in PriceInelastic SupplyElastic Supply…Causes a Small Increase in Quantity Supplied if Supply is Inelastic$50The Same Price Increase85…Causes a Big Increase in Quantity Supplied if Supply is Elastic170$40Instructor Notes: Figure 4.5 The Same Price Increase Causes a Small Increase in Quantity Supplied If the Supply Curve is Inelastic and a Big Increase in Quantity Supplied Is Inelastic and a Big Increase In Quantity Supplied If the Supply Curve Is Inelastic80
21Determinants of the Elasticity of Supply How much per-unit costs ↑ as production ↑Greater ↑ in per unit costs → ↓ elasticity of supply.Examples:Elasticity of supply tends to be low for raw materials like oil and coal.Elasticity of supply tends to greater for manufactured goodsLocal supply is more elastic than the global supply. Why?
22Determinants of the Elasticity of Supply Consider two polar casesPicasso paintingToothpicksPricePerfectly inelastic supplyPricePerfectly elastic supplyQuantityQuantity
23Mathematics of Supply Elasticity If the Es < 1, the supply curve is inelastic.If the Es > 1, the supply curve is elastic.If the Es = 1, the supply curve is unit elastic.Instructor Notes: Students should note some extreme cases that are not explicitly defined in the text but are often used for simplification:Perfectly Elastic DemandElasticity of demand is infiniteA very small change in price will lead to an infinitely large change in quantity demandedHorizontal demand curvePerfectly Inelastic DemandElasticity of demand is zeroA change in price will cause no change in quantity demanded.Vertical demand curve
24Determinants of the Elasticity of Supply: Summary Primary Factors Determining the Elasticity of SupplyLess ElasticMore ElasticDifficult to increase production at constant unit cost (e.g., some raw materials)Easy to increase production at constant unit cost. (e.g., some manufactured goods)Large share of market for inputsSmall share of market for inputsGlobal supplyLocal supplyShort-runLong-run
25Calculating the Elasticity of Supply Measure of the responsiveness of quantity supplied to a change in priceComputed by
26Calculating the Elasticity: Midpoint Method Again, we use the midpoint as the base
27Applications of Supply Elasticity: Gun Buyback Programs Several cities in the U.S. have spent millions of dollars buying guns with “no questions asked”.ObjectiveReduce the number of guns on the streets in order to…Lower crime rates.Principles of economics predict these programs are unlikely to reduce the number of guns on the streets of these cities. Why?
28Applications of Supply Elasticity: Gun Buyback Programs Demand for guns will increase.Guns will be imported to sell to the police.People will sell old, low quality gunsResultThe supply of guns is perfectly elastic to the city.Price of guns does not increaseNo fewer, but higher quality, guns are on the streets.Let’s use our model to see this.
29Applications of Supply Elasticity: Gun Buyback Programs Price of low quality gunsIncrease in supply = buybackSupply of old, lowquality guns (perfectlyelastic)$84Demand w/buybackDemand w/o buybackQuantity of gunstraded1,0006,000
30Takeaway Elasticities of demand and supply help us quantify… The effects of shifts in the demand and supply curves.How revenues respond to changes in price along a demand curveYou should know how to calculate these elasticities using data on prices and quantities.
34Commodity Taxes We will emphasize the following: Who ultimately pays the tax is not dependent on who writes the checkWho ultimately pays the tax does depend on the relative elasticities of supply and demand.Commodity taxation raises revenue and creates lost gains from trade (deadweight loss)Let’s look at each of these in turn.
35Who Ultimately Pays the Tax Assume a 1$ per basket tax on apples.Government can collect the tax in two ways:From the sellerFrom the buyerIt doesn’t matter which way is chosen.Let’s use our model to analyze each.
36Commodity Tax Collected From the Seller Price of Apples(per basket)Commodity tax = $1Supply shifts up by $1Seller wants to charge $3At $3: Qd < Qs → surplusPrice ↓ → Qd ↑and Qs ↓ → 500Result:Seller’s net price = $1.65Buyer’s net price = $2.65Burden of the taxBuyer - $0.65Seller - $0.35Supply w/tax$43Supply w/o tax$12.6521.651DemandQuantity ofApples (baskets)4005007001,250
37Commodity Tax Collected From the Buyer Price of Apples(per basket)Commodity tax = $1Buyer wants to pay $1.00Demand shifts down by $1At $1: Qd > Qs → shortagePrice ↑→ ↑Qs and Qd ↓ → ↑Qs → 500Result:Buyer’s net price = $2.65Seller’s net price = $1.65Burden of the taxBuyer - $0.65Seller - $0.35Demand w/o tax$4Demandw/tax3Supply2.6521.651$1Quantity ofApples (baskets)2005007001,250
38The Burden of the Tax Depends on the Relative Elasticities of Demand and Supply The Wedge shortcutTax wedge – a vertical line measuring the difference between the price paid by buyers and the price received by sellers.This tool simplifies our analysisThe output where the wedge “fits” between the demand and supply curves tells us…the after tax price consumers paythe after tax price that sellers receive.Let’s go to our model now.
39Using the Tax Wedge Price of Apples (per basket) Quantity of Price buyers pay$43Supply2.6521.651Price sellersreceiveDemandQuantity ofApples (baskets)2005007001,250
40The Burden of the Tax Depends of the Elasticities of Supply and Demand An elastic demand curve means that buyers can substituteAn elastic supply curve means that workers and capital can easily find work in another industryResultWhen demand is more elastic than supply, buyers pay less of the taxWhen supply is more elastic than demand, sellers pay less of the taxIn other words elasticity = escapeLet’s use the model to show this
41The Burden of the Tax Depends of the Elasticities of Supply and Demand Case I: Demand is more elastic than supplyPriceSupplyPrice paidby buyersResult:Most of the tax is paidBy sellersPno taxTaxWedgeDemandPrice receivedby sellersQuantityQw/taxQno tax
42The Burden of the Tax Depends of the Elasticities of Supply and Demand Case II: Supply is more elastic than demandPrice paidby buyersPriceResult:Most of the tax is paidBy buyersSupplyTaxWedgePno taxPrice receivedby sellersDemandQuantityQw/taxQno tax
43The federal luxury tax was repealed in 1993. This pleasure boat seems like a good thing to tax…Or not: The Omnibus Budget Reconciliation Act of 1990 applied a 10% federal luxury tax to the retail sale of luxury goods like pleasure boats with a sales price above $100,000. Expected tax revenue? $9 billion. Reality?The federal luxury tax was repealed in 1993.Sales of boats down 52.7%;Net loss of 30,000 jobs;The federal government paid out > $7 million more in unemployment benefits to those workers than it collected in luxury tax revenues.
44Health Insurance Mandates and Tax Analysis Suppose government mandates that firms buy health insurance for its workers.Think of this as a tax on labor.Who actually pays for the health insurance?Depends which is more elastic: supply or demandThat is, which is easier:For firms to escape the tax by not employing?For workers to escape the tax by not working?
45Health Insurance Mandates and Tax Analysis Firms can escape the tax in lots of waysSubstitute capital for labor.Move operations overseas.Close up shop.It is more difficult for workers to escape the taxMost workers will work at a lower wageThe cost of leaving the labor force is highConclusion: demand is more elastic than supplyResult: most of the tax is paid by workers.
46Who Pays the Cigarette Tax? Because nicotine is addictive, demand is inelastic.Taxes are imposed by states.A manufacture can easily escape these taxes by selling…OverseasOther statesConclusion: Supply elasticity is very highResult: most of tax is paid by buyers.
47Who Pays the Cigarette Tax An interesting testIf buyers pay almost all of the tax, the after tax price paid by sellers must be equal in all states.This table shows that is the case.Year2000Tax per PackAfter tax price paid by buyersAfter tax price receivedby sellersSouth Carolina$0.07$3.35$3.28New Jersey$2.57$6.45$3.88
48A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Lost gains from trade = deadweight lossTax increases reduce consumer and producer surplusLet’s use our model to show this.
49A Commodity Tax Raises Revenues and Creates Lost Gains From Trade PriceNo TaxPriceWith TaxConsumersurplusConsumersurplusTax wedgeSS$2.65Deadweightloss$2.00$2.00$1.65DDProducersurplusGovernmentrevenueProducersurplusQQ700500700
50What is the tax revenue that the government collects from the tax on gadgets? $350$450$100$550$350 = $1 (tax) x 350 (Q sold at the new price)To nextTry it!
51A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Elasticities of demand and supply determine consumer and producer surplusThe greater these elasticities, the greater will be the deadweight lossLet’s use our model to show this.
52A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case I: Elastic DemandPriceTax wedgeDeadweightlossPw/taxTaxRevenuePno taxSupplyDemandQuantityQw/ taxQno tax
53A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case II: Inelastic DemandPriceTax wedgeDeadweightlossPw/taxTaxRevenuePno taxSupplyNote:Tax rate and Tax revenueare the same as before.Deadweight loss is much smaller.DemandQuantityQw/ taxQno tax
54A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case III: Elastic SupplyPriceTax wedgeDeadweightlossPw/taxSupplyTaxRevenuePno taxDemandQuantityQw/ taxQno tax
55A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case IV: Inelastic SupplyNote:Tax rate and Tax revenueare the same as before.Deadweight loss is smaller.PriceTax wedgeSupplyDeadweightlossPw/taxPno taxTaxRevenueDemandQuantityQw/ taxQno tax
56Suppose that the government taxes insulin producers $50 per dose produced. Who is likely to pay this tax?Although the government taxes almost everything, would the government rather tax items that have relatively inelastic or relatively or relatively elastic demands and supplies? Why?To nextTry it!
57Subsidies A subsidy is a reverse tax Important facts about commodity subsidiesWho gets the subsidy does not depend on who gets the check from the government.Who benefits from the subsidy does depend on the relative elasticities of demand and supply.Subsidies…Are paid for by taxpayersResult in inefficient increases in trade (deadweight loss)We can use the same wedge shortcut as before.Let’s use our model to analyze subsidies.
58Subsidies Deadweight loss Price of apples Per basket $4 Supply 3 Price receivedBy sellers = $2.40Subsidywedge2Price paidBy buyers = $1.401Demand700900Quantity of apples(baskets)
59Taxes and Subsidies Compared Whoever Bears the Burden of the Tax Receives the Benefits of a SubsidyPricePrice receivedby sellersBenefitof subsidyon sellersSupplyPrice paidby buyersSubsidywedgePrice paidby buyersBurdenof tax onsellersTaxwedgeDemandPrice receivedby sellersQuantity
60King Cotton and the Deadweight Loss of Water Subsidies Who benefits most from the large agricultural water subsidy?Farmers in California’s Central Valley typically pay $20-$30 an acre-foot for water that costs $200-$500 an acre-footHint: which is more elastic: demand or supply for cotton?California cotton suppliersCalifornia cotton buyersSince supply is less elastic than demand, suppliers will receive more of the benefit of any subsidy.To nextTry it!
61King Cotton and the Deadweight Loss of Water Subsidies Price of CottonSupply ofCalifornia CottonPriceSellersreceiveTotal subsidy paymentsreceived by farmersSubsidy wedgeWorldMarketpriceDemandFor CaliforniaCottonCan you see why sellers ofCotton lobby for subsidies,not buyers?Quantityof CottonQno subsidyQw/subsidy
62Wage Subsidies Edmund Phelps – Nobel Prize winner Wage subsidies can be used to increase employment of low wage workers.Although costly, they may reduceWelfare payments.CrimeDrug dependency“Rational defeatism”A better alternative to the minimum wage.Let’s analyze a wage subsidy program.
63Wage received by workers Wage SubsidiesWageSupplyof LaborWage received by workersCost totaxpayers$12Market wage= $10.50SubsidyWedge = $4$8Wage paidby firmsDemandfor laborQmQsQuantityof labor
64The U.S. government subsidizes college education in the form of Pell grants and lower-cost government Stafford loans. How do these subsidies affect the price of college education? Which is relatively more elastic: supply or demand? Who benefits the most from these subsidies: suppliers (colleges) or demanders of education (students)?To nextTry it!
65If demand of some good is more elastic than supply and a tax is imposed on the consumption of the good, who will bear more of the burden of the tax?Producers, because consumers have a greater ability to change their behavior in response to the tax.Both parties will share the burden equally.Consumers, because they pay the tax out of pocket.The government, because the tax will cause less of the good to be produced and consumed.To nextTry it!
66Takeaway Taxes decrease the quantity traded. Subsidies increase the quantity traded.The burden of the tax and the benefit of the subsidy do not depend on who sends or receives the government check.The side of the market that is more elastic will escape more of the tax and receive less of the benefit of the subsidy.The greater the elasticity of demand or supply the greater will be the deadweight loss.
68Price Ceilings and Floors Chapter 8Price Ceilings and Floors
69Chapter Outline Price Ceilings Rent Control (optional section) Arguments for Price ControlsPrice Floors
70IntroductionAugust 1971 – President Nixon imposed wage and price controls in the U.S.Made it illegal to trade at a higher price even if both buyer and seller agreed to the higher price.Supposed to be in effect for 90 daysHad lasting effects for over 10 yearsWe will show how price controls…Affect a single marketDelink some markets and link other markets in ways that are counterproductive.
71Price Ceilings Price ceiling – a maximum price allowed by law Five important effectsShortagesReductions in product qualityWasteful lines and other search costsA loss in gains from tradeA misallocation of resourcesLet’s look at each one in turn.
72Shortages When the price ceiling is below the market price… Quantity demanded is greater than quantity supplied: Qd > QsWe call this a shortageA shortage is different from scarcityScarcity is reflected in the market priceShortage is due only to a price ceilingThe lower the ceiling price is below the market price, the greater the shortage
73Shortages Shortages appeared soon after prices were frozen in 1971 ↑ demand for housing → ↑ demand for materials (inputs) needed to build housesNormally this would result in ↑ price of inputs → a signal to produce more inputs.With fixed prices, this signal was missing.Shortages of inputs: lumber, steel bars, toilets and other materials were common.Let’s use our model to examine a price ceiling.
74Price Ceilings Create Shortages Price of gasolineper gallonSupplyMarketEquilibriumControlled Price(ceiling)ShortageDemandQsQdQuantity
75ShortagesA shortage of vinyl in 1973 forced Capitol Records to melt down slow sellers so they could keep pressing Beatle’s albums.
76Reductions in QualityOne way to evade price controls is to lower qualityPrinting books on lower quality paperShrinking 2” x 4” lumber to 15/8” x 35/8”Fewer coats of paint on new automobilesSome newspapers switched to a smaller font size.
77Reductions in QualityAnother way to lower quality is to reduce serviceWith a surplus of buyers, sellers have less of an incentive to give good service.Full service gas stations disappeared in 1973.Owners would close whenever they wanted to take a break.
78Reductions in Quality The great matzo ball debate In 1972 George Meany, AFL-CIO boss complained that his favorite soup, Mrs.Adlers, had shrunk from 4 to 3 matzo balls!The chairman of the wage and price commission had his staff count the number of balls in many can’s of Mrs. Adler’s soup.
79Wasteful Lines and Other Search Costs There are other ways of paying for gasSome buyers might try bribing the station ownersAnother way is to be willing to wait in line.Time waiting in line is also a cost.How long will the line get?Let’s answer this question using our model.
80Wasteful Lines and Other Search Costs Price of gasolineper gallonSupplyMarketEquilibriumWillingness topay for Qs = $3TotalValue ofWastedtimeAt the controlled price:Quantity supplied = QsBuyers are willing to pay $3/gallonLine will grow until the time cost per gallon $3 - $1= $2.00/gallonControlledPrice = 1(ceiling)DemandShortageQsQdQuantity
81Wasted Time and Other Search Costs What’s the difference between paying a bribe and waiting in line?Waiting in line is more wasteful!A bribe goes to the station owner.Time waiting in line is lost; it benefits no one.
82Lost Gains From TradeDeadweight loss – total of lost consumer and producer surplus when not all mutually profitable gains from trade are exploited.As long asthere are mutually profitable trades that can be made.Price ceilings create a deadweight lossLet’s go to our model again.
83Price Ceilings: Reduce Gains From Trade Price of gasolineper gallonLostconsumersurplusLostproducersurplusSupply$3A + B = Lost gainsfrom tradeTotalValue ofWastedtimeAMarketEquilibriumMarket priceBControlledPrice = 1(ceiling)DemandShortageQsQdQuantity
84Misallocation of Resources When prices are controlled, resources do not flow to their highest valued uses.Example: When it gets cold in the Northeast, the demand for heating oil goes up.If the price is allowed to rise…There is a greater incentive to produce more heating oil.The incentive to consume less heating oil increases.This provides a signal for more heating oil to be delivered to Maine instead of California.If the price is fixed…Swimming pools in California are heatedHomes in Maine are coldLet’s use our model to show this.
85Misallocation of Resources Price($)Highest-valuedusesSupplyPrice control prevents highest valued usesfrom outbidding lower valued uses.Result: some oil flows to lower valued uses$3Lower-valuedusesControlledPrice(ceiling)Least-valuedusesShortageDemandQsQdQuantity
86The Loss From Random Allocation Let’s ignore wasteful time and search costsThe maximum CS is the area between the demand curve and the controlled price up to the quantity supplied with the controlled price.Because the good is not necessarily allocated to the highest values uses…Consumer surplus will be lessHow much less?Let’s do some reasonable calculationsThis is advanced material and may be skipped
87The Loss From Random Allocation Best case scenarioBuyers with the highest valued uses get in line first.Worst case scenarioAll goods are allocated to the lowest value uses.Random allocation scenarioLet’s assume that goods are allocated randomly with equal probabilities for each user.Suppose: Highest price any buyer is willing to pay = $30; controlled price = $6.Average price consumers would be willing to pay = ½ ($30) + ½ ($6) = $18This is advanced material and may be skipped
88The Loss From Random Allocation: Best Case Scenario Price of gasolineper gallonHighest-valuedusesSupplyWillingness topay for Qs = $3Best Case Scenario:Buyers with the highest valued uses get the goodsCS = total green areaControlledPrice = 1(ceiling)This is advanced material and may be skippedDemandShortageQsQdQuantity
89The Loss From Random Allocation: Worst Case Scenario Price of gasolineper gallonLoss to random allocationSupplyWillingness topay for Qs = $3Worst Case Scenario:Buyers with lower valued uses get the goods.CS = total green areaLower-valuedusesControlledPrice = 1(ceiling)DemandShortageQsQdQuantity
90The Loss From Random Allocation: Equal Probability Scenario Price of gasolineper gallonLoss due to random allocationSupplyWillingness topay for Qs = $3Equal Probability Scenario:Av price = $18CS = total green areaAveragePrice = $18ControlledPrice = 1(ceiling)This is advanced material and may be skippedDemandShortageQsQdQuantity
91The End of Price Controls Controls on most prices were lifted by April 1974Controls on oil prices continued in some form over the next 7 years.“Old oil”-“New oil” and wasteful gamingControls on oil prices ended on the morning of President Reagan’s inauguration day January 20, 1981Oil price ↓ over the next several yearsNo shortages of oil have occurred since.
92Nixon’s price controls set price ceilings below the market price Nixon’s price controls set price ceilings below the market price. What would have happened if the price ceilings had been set above the market prices?Under price controls, why were the shortages of oil in some local markets much more severe than in others?To nextTry it!
93Shortages in the former Soviet Union were very common, but why were there also surpluses of some goods at some times and places?To nextTry it!
94Price Floors Price floor – a minimum price allowed by law Price floors create:SurplusesLost gains from trade (deadweight loss)Wasteful increases in qualityA misallocation of resources
95Surpluses A good example of a price floor is the minimum wage Workers with very low productivity are most affected by the minimum wage.Least experiencedLeast educated or trainedLow-skilled teenagers are most affected.Let’s use the labor market model to analyze the minimum wage.
96Minimum Wage Creates a Surplus ($/hr)Supplyof laborLabor surplus(unemployment)MinimumwageMarketwageDemandfor laborQuantityof labor(unskilled)QdMarketemploymentQs
97Minimum Wage Creates Lost Gains From Trade ($/hr)Supplyof laborLabor surplus(unemployment)MinimumwageLost gains from trade(deadweight loss) = lost consumer surplus + lost producer surplusMarketwageDemandfor laborQuantityof labor(unskilled)QdMarketemploymentQs
98Minimum Wage Hotly debated in the U.S. 93.9% of workers < 25 years earn more than the minimum wageAt best, the minimum wage raises the wages of some teenagers and young workers whose wages would have increased anyway as they became more skilled.At worst, increases in the price of hamburgers can create some teenage unemployment.
99Minimum WageA large increase in the minimum wage will cause serious unemploymentTest Case: Puerto Rico, 1938Congress set the first minimum wage at $0.25/hr.Average wage in U.S. = $0.625/hrCongress forgot to exempt Puerto RicoAverage wage in Puerto Rico = $0.03 to $0.04/hrPuerto Rican firms went bankrupt → devastating unemploymentPuerto Rican politicians begged for exemption
100Minimum Wages in France Firms in France are reluctant to hireMinimum wage is higher than in the U.S.Labor laws make it very difficult to fire workersYounger workers are affected the mostLess productiveRisk of hiring is greaterResult:Unemployment among workers < 25 yrs old was 23% in 2005.
101The European Union guaranteed its farmers that the price of butter will stay above a floor. The floor price is often above the market equilibrium price. What do you think has been the result of this?The U.S. has set a price floor above the equilibrium price. Has this led to shortages or surpluses? How do you think the U.S. government has dealt with this?To nextTry it!
102TakeawayYou should be able to explain the effects of price ceilings to your uncle.You should be able to draw a diagram showing the price ceiling, label the shortage, wasteful losses, and the lost gains from trade.You should understand why a price ceiling reduces product quality and misallocates resources.You should be able to a similar analysis for price floors.