# Elasticity and Its Applications

## Presentation on theme: "Elasticity and Its Applications"— Presentation transcript:

Elasticity and Its Applications
Chapter 5 Elasticity and Its Applications

Chapter Outline The Elasticity of Demand The Elasticity of Supply
Using Elasticities for Quick Predictions (Optional) Takeaway Appendix 1: Using Excel to Calculate Elasticities Appendix 2: Other Types of Elasticities

But how much does quantity demanded change when price changes?
Elasticity of Demand We know there is an inverse relationship between price and quantity demanded. But how much does quantity demanded change when price changes? Instructor Notes:

Elasticity of Demand Elasticity of demand - a measure of how responsive the quantity demanded is to a change in price more responsive equals more elastic. The slope of the demand curve is related to the elasticity of demand. Let’s see how this works.

Elasticity of Demand price Price ↑ from \$40 to \$50:
a → b less responsive a → c more responsive c b \$50 a 40 Demand E (more elastic) Demand I (less elastic) Quantity 20 95 100

Determinants of the Elasticity of Demand
Ease in finding substitutes *** Easier → greater elasticity Time required to adjust to price changes Long term → more substitutes → greater elasticity The definition of the commodity Narrow definition → more substitutes → greater elasticity Example: Coffee vs. specific brand Necessities versus Luxuries Share of budget devoted to the good. Larger share → greater elasticity

Determinants of the Elasticity of Demand
Summary of Determinants of Elasticity of Demand Less Elastic More Elastic Fewer Substitutes More Substitutes Short Run (less time) Long Run (more time) Necessities Luxuries Small Part of Budget Large Part of Budget Instructor Notes: Table 4.1: Some Factors Determining the Elasticity of Demand

Mathematics 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 Demand Elasticity of demand is infinite A very small change in price will lead to an infinitely large change in quantity demanded Horizontal demand curve Perfectly Inelastic Demand Elasticity of demand is zero A change in price will cause no change in quantity demanded. Vertical demand curve

Calculating the Elasticity of Demand
Elasticity measures the responsiveness of quantity demanded to changes in price. Usually interpreted using the absolute value:

Calculating the Elasticity: Midpoint Method
We use the midpoint as the base: Let’s work an example.

Calculating the Elasticity: Midpoint Method
Given: What does this number mean? Price Quantity Demanded Point a \$40 100 Point b \$50 20

Total Revenue and the Elasticity of Demand
A firm’s revenues are equal to price per unit times quantity sold. Revenue = Price x Quantity The elasticity of demand directly influences revenues when the price of the good changes. Instructor Notes:

Total Revenue and Elasticity of Demand
Inelastic Demand Elastic Demand Price Price Result: ↑TR Result: ↓TR \$50 \$50 40 40 Demand Demand 95 100 Quantity 20 100 Quantity ↓TR due to ↓Qd ↑TR due to ↑P

Total 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.

Total Revenue and Elasticity of Demand: Summary
Summary: Total revenue and Ed Elasticity and Revenue Absolute Value of Ed Name How Revenue Changes with Price |Ed | > 1 Elastic TR and P move together |Ed | < 1 Inelastic TR and P move in opposite directions |Ed | = 1 Unit Elastic TR remains the same when price changes

Applications 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.

Which 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 next Try it!

They 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 elastic They think it’s inelastic To next Try it!

The 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.

The Elasticity of Supply
Quantity Price per Unit Elasticity of Supply Captures the Sensitivity of Quantity Supplied to Changes in Price Inelastic Supply Elastic Supply …Causes a Small Increase in Quantity Supplied if Supply is Inelastic \$50 The Same Price Increase 85 …Causes a Big Increase in Quantity Supplied if Supply is Elastic 170 \$40 Instructor 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 Inelastic 80

Determinants 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 goods Local supply is more elastic than the global supply. Why?

Determinants of the Elasticity of Supply
Consider two polar cases Picasso painting Toothpicks Price Perfectly inelastic supply Price Perfectly elastic supply Quantity Quantity

Mathematics 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 Demand Elasticity of demand is infinite A very small change in price will lead to an infinitely large change in quantity demanded Horizontal demand curve Perfectly Inelastic Demand Elasticity of demand is zero A change in price will cause no change in quantity demanded. Vertical demand curve

Determinants of the Elasticity of Supply: Summary
Primary Factors Determining the Elasticity of Supply Less Elastic More Elastic Difficult 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 inputs Small share of market for inputs Global supply Local supply Short-run Long-run

Calculating the Elasticity of Supply
Measure of the responsiveness of quantity supplied to a change in price Computed by

Calculating the Elasticity: Midpoint Method
Again, we use the midpoint as the base

Applications of Supply Elasticity: Gun Buyback Programs
Several cities in the U.S. have spent millions of dollars buying guns with “no questions asked”. Objective Reduce 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?

Applications 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 guns Result The supply of guns is perfectly elastic to the city. Price of guns does not increase No fewer, but higher quality, guns are on the streets. Let’s use our model to see this.

Applications of Supply Elasticity: Gun Buyback Programs
Price of low quality guns Increase in supply = buyback Supply of old, low quality guns (perfectly elastic) \$84 Demand w/buyback Demand w/o buyback Quantity of guns traded 1,000 6,000

Takeaway 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 curve You should know how to calculate these elasticities using data on prices and quantities.

End of Chapter 5

Chapter 6 Taxes and Subsidies

Chapter Outline Commodity Taxes Subsidies

Commodity Taxes We will emphasize the following:
Who ultimately pays the tax is not dependent on who writes the check Who 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.

Who Ultimately Pays the Tax
Assume a 1\$ per basket tax on apples. Government can collect the tax in two ways: From the seller From the buyer It doesn’t matter which way is chosen. Let’s use our model to analyze each.

Commodity Tax Collected From the Seller
Price of Apples (per basket) Commodity tax = \$1 Supply shifts up by \$1 Seller wants to charge \$3 At \$3: Qd < Qs → surplus Price ↓ → Qd ↑and Qs ↓ → 500 Result: Seller’s net price = \$1.65 Buyer’s net price = \$2.65 Burden of the tax Buyer - \$0.65 Seller - \$0.35 Supply w/tax \$4 3 Supply w/o tax \$1 2.65 2 1.65 1 Demand Quantity of Apples (baskets) 400 500 700 1,250

Commodity Tax Collected From the Buyer
Price of Apples (per basket) Commodity tax = \$1 Buyer wants to pay \$1.00 Demand shifts down by \$1 At \$1: Qd > Qs → shortage Price ↑→ ↑Qs and Qd ↓ → ↑Qs → 500 Result: Buyer’s net price = \$2.65 Seller’s net price = \$1.65 Burden of the tax Buyer - \$0.65 Seller - \$0.35 Demand w/o tax \$4 Demand w/tax 3 Supply 2.65 2 1.65 1 \$1 Quantity of Apples (baskets) 200 500 700 1,250

The Burden of the Tax Depends on the Relative Elasticities of Demand and Supply
The Wedge shortcut Tax wedge – a vertical line measuring the difference between the price paid by buyers and the price received by sellers. This tool simplifies our analysis The output where the wedge “fits” between the demand and supply curves tells us… the after tax price consumers pay the after tax price that sellers receive. Let’s go to our model now.

Using the Tax Wedge Price of Apples (per basket) Quantity of
Price buyers pay \$4 3 Supply 2.65 2 1.65 1 Price sellers receive Demand Quantity of Apples (baskets) 200 500 700 1,250

The Burden of the Tax Depends of the Elasticities of Supply and Demand
An elastic demand curve means that buyers can substitute An elastic supply curve means that workers and capital can easily find work in another industry Result When demand is more elastic than supply, buyers pay less of the tax When supply is more elastic than demand, sellers pay less of the tax In other words elasticity = escape Let’s use the model to show this

The Burden of the Tax Depends of the Elasticities of Supply and Demand
Case I: Demand is more elastic than supply Price Supply Price paid by buyers Result: Most of the tax is paid By sellers Pno tax Tax Wedge Demand Price received by sellers Quantity Qw/tax Qno tax

The Burden of the Tax Depends of the Elasticities of Supply and Demand
Case II: Supply is more elastic than demand Price paid by buyers Price Result: Most of the tax is paid By buyers Supply Tax Wedge Pno tax Price received by sellers Demand Quantity Qw/tax Qno tax

The 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.

Health 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 demand That is, which is easier: For firms to escape the tax by not employing? For workers to escape the tax by not working?

Health Insurance Mandates and Tax Analysis
Firms can escape the tax in lots of ways Substitute capital for labor. Move operations overseas. Close up shop. It is more difficult for workers to escape the tax Most workers will work at a lower wage The cost of leaving the labor force is high Conclusion: demand is more elastic than supply Result: most of the tax is paid by workers.

Who 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… Overseas Other states Conclusion: Supply elasticity is very high Result: most of tax is paid by buyers.

Who Pays the Cigarette Tax
An interesting test If 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. Year 2000 Tax per Pack After tax price paid by buyers After tax price received by sellers South Carolina \$0.07 \$3.35 \$3.28 New Jersey \$2.57 \$6.45 \$3.88

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade
Lost gains from trade = deadweight loss Tax increases reduce consumer and producer surplus Let’s use our model to show this.

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade
Price No Tax Price With Tax Consumer surplus Consumer surplus Tax wedge S S \$2.65 Deadweight loss \$2.00 \$2.00 \$1.65 D D Producer surplus Government revenue Producer surplus Q Q 700 500 700

What 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 next Try it!

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade
Elasticities of demand and supply determine consumer and producer surplus The greater these elasticities, the greater will be the deadweight loss Let’s use our model to show this.

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade
Case I: Elastic Demand Price Tax wedge Deadweight loss Pw/tax Tax Revenue Pno tax Supply Demand Quantity Qw/ tax Qno tax

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade
Case II: Inelastic Demand Price Tax wedge Deadweight loss Pw/tax Tax Revenue Pno tax Supply Note: Tax rate and Tax revenue are the same as before. Deadweight loss is much smaller. Demand Quantity Qw/ tax Qno tax

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade
Case III: Elastic Supply Price Tax wedge Deadweight loss Pw/tax Supply Tax Revenue Pno tax Demand Quantity Qw/ tax Qno tax

A Commodity Tax Raises Revenues and Creates Lost Gains From Trade
Case IV: Inelastic Supply Note: Tax rate and Tax revenue are the same as before. Deadweight loss is smaller. Price Tax wedge Supply Deadweight loss Pw/tax Pno tax Tax Revenue Demand Quantity Qw/ tax Qno tax

Suppose 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 next Try it!

Subsidies A subsidy is a reverse tax
Important facts about commodity subsidies Who 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 taxpayers Result in inefficient increases in trade (deadweight loss) We can use the same wedge shortcut as before. Let’s use our model to analyze subsidies.

Price received By sellers = \$2.40 Subsidy wedge 2 Price paid By buyers = \$1.40 1 Demand 700 900 Quantity of apples (baskets)

Taxes and Subsidies Compared
Whoever Bears the Burden of the Tax Receives the Benefits of a Subsidy Price Price received by sellers Benefit of subsidy on sellers Supply Price paid by buyers Subsidy wedge Price paid by buyers Burden of tax on sellers Tax wedge Demand Price received by sellers Quantity

King 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-foot Hint: which is more elastic: demand or supply for cotton? California cotton suppliers California cotton buyers Since supply is less elastic than demand, suppliers will receive more of the benefit of any subsidy. To next Try it!

King Cotton and the Deadweight Loss of Water Subsidies
Price of Cotton Supply of California Cotton Price Sellers receive Total subsidy payments received by farmers Subsidy wedge World Market price Demand For California Cotton Can you see why sellers of Cotton lobby for subsidies, not buyers? Quantity of Cotton Qno subsidy Qw/subsidy

Wage Subsidies Edmund Phelps – Nobel Prize winner
Wage subsidies can be used to increase employment of low wage workers. Although costly, they may reduce Welfare payments. Crime Drug dependency “Rational defeatism” A better alternative to the minimum wage. Let’s analyze a wage subsidy program.

Wage Subsidies Wage Supply of Labor Wage received by workers Cost to taxpayers \$12 Market wage = \$10.50 Subsidy Wedge = \$4 \$8 Wage paid by firms Demand for labor Qm Qs Quantity of labor

The 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 next Try it!

If 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 next Try it!

Takeaway 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.

End of Chapter 6

Price Ceilings and Floors
Chapter 8 Price Ceilings and Floors

Chapter Outline Price Ceilings Rent Control (optional section)
Arguments for Price Controls Price Floors

Introduction August 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 days Had lasting effects for over 10 years We will show how price controls… Affect a single market Delink some markets and link other markets in ways that are counterproductive.

Price Ceilings Price ceiling – a maximum price allowed by law
Five important effects Shortages Reductions in product quality Wasteful lines and other search costs A loss in gains from trade A misallocation of resources Let’s look at each one in turn.

Shortages When the price ceiling is below the market price…
Quantity demanded is greater than quantity supplied: Qd > Qs We call this a shortage A shortage is different from scarcity Scarcity is reflected in the market price Shortage is due only to a price ceiling The lower the ceiling price is below the market price, the greater the shortage

Shortages Shortages appeared soon after prices were frozen in 1971
↑ demand for housing → ↑ demand for materials (inputs) needed to build houses Normally 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.

Price Ceilings Create Shortages
Price of gasoline per gallon Supply Market Equilibrium Controlled Price (ceiling) Shortage Demand Qs Qd Quantity

Shortages A shortage of vinyl in 1973 forced Capitol Records to melt down slow sellers so they could keep pressing Beatle’s albums.

Reductions in Quality One way to evade price controls is to lower quality Printing books on lower quality paper Shrinking 2” x 4” lumber to 15/8” x 35/8” Fewer coats of paint on new automobiles Some newspapers switched to a smaller font size.

Reductions in Quality Another way to lower quality is to reduce service With 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.

Reductions 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.

Wasteful Lines and Other Search Costs
There are other ways of paying for gas Some buyers might try bribing the station owners Another 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.

Wasteful Lines and Other Search Costs
Price of gasoline per gallon Supply Market Equilibrium Willingness to pay for Qs = \$3 Total Value of Wasted time At the controlled price: Quantity supplied = Qs Buyers are willing to pay \$3/gallon Line will grow until the time cost per gallon \$3 - \$1 = \$2.00/gallon Controlled Price = 1 (ceiling) Demand Shortage Qs Qd Quantity

Wasted 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.

Lost Gains From Trade Deadweight loss – total of lost consumer and producer surplus when not all mutually profitable gains from trade are exploited. As long as there are mutually profitable trades that can be made. Price ceilings create a deadweight loss Let’s go to our model again.

Price Ceilings: Reduce Gains From Trade
Price of gasoline per gallon Lost consumer surplus Lost producer surplus Supply \$3 A + B = Lost gains from trade Total Value of Wasted time A Market Equilibrium Market price B Controlled Price = 1 (ceiling) Demand Shortage Qs Qd Quantity

Misallocation 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 heated Homes in Maine are cold Let’s use our model to show this.

Misallocation of Resources
Price (\$) Highest-valued uses Supply Price control prevents highest valued uses from outbidding lower valued uses. Result: some oil flows to lower valued uses \$3 Lower-valued uses Controlled Price (ceiling) Least-valued uses Shortage Demand Qs Qd Quantity

The Loss From Random Allocation
Let’s ignore wasteful time and search costs The 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 less How much less? Let’s do some reasonable calculations This is advanced material and may be skipped

The Loss From Random Allocation
Best case scenario Buyers with the highest valued uses get in line first. Worst case scenario All goods are allocated to the lowest value uses. Random allocation scenario Let’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) = \$18 This is advanced material and may be skipped

The Loss From Random Allocation: Best Case Scenario
Price of gasoline per gallon Highest-valued uses Supply Willingness to pay for Qs = \$3 Best Case Scenario: Buyers with the highest valued uses get the goods CS = total green area Controlled Price = 1 (ceiling) This is advanced material and may be skipped Demand Shortage Qs Qd Quantity

The Loss From Random Allocation: Worst Case Scenario
Price of gasoline per gallon Loss to random allocation Supply Willingness to pay for Qs = \$3 Worst Case Scenario: Buyers with lower valued uses get the goods. CS = total green area Lower-valued uses Controlled Price = 1 (ceiling) Demand Shortage Qs Qd Quantity

The Loss From Random Allocation: Equal Probability Scenario
Price of gasoline per gallon Loss due to random allocation Supply Willingness to pay for Qs = \$3 Equal Probability Scenario: Av price = \$18 CS = total green area Average Price = \$18 Controlled Price = 1 (ceiling) This is advanced material and may be skipped Demand Shortage Qs Qd Quantity

The End of Price Controls
Controls on most prices were lifted by April 1974 Controls on oil prices continued in some form over the next 7 years. “Old oil”-“New oil” and wasteful gaming Controls on oil prices ended on the morning of President Reagan’s inauguration day January 20, 1981 Oil price ↓ over the next several years No shortages of oil have occurred since.

Nixon’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 next Try it!

Shortages in the former Soviet Union were very common, but why were there also surpluses of some goods at some times and places? To next Try it!

Price Floors Price floor – a minimum price allowed by law
Price floors create: Surpluses Lost gains from trade (deadweight loss) Wasteful increases in quality A misallocation of resources

Surpluses A good example of a price floor is the minimum wage
Workers with very low productivity are most affected by the minimum wage. Least experienced Least educated or trained Low-skilled teenagers are most affected. Let’s use the labor market model to analyze the minimum wage.

Minimum Wage Creates a Surplus
(\$/hr) Supply of labor Labor surplus (unemployment) Minimum wage Market wage Demand for labor Quantity of labor (unskilled) Qd Market employment Qs

Minimum Wage Creates Lost Gains From Trade
(\$/hr) Supply of labor Labor surplus (unemployment) Minimum wage Lost gains from trade (deadweight loss) = lost consumer surplus + lost producer surplus Market wage Demand for labor Quantity of labor (unskilled) Qd Market employment Qs

Minimum Wage Hotly debated in the U.S.
93.9% of workers < 25 years earn more than the minimum wage At 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.

Minimum Wage A large increase in the minimum wage will cause serious unemployment Test Case: Puerto Rico, 1938 Congress set the first minimum wage at \$0.25/hr. Average wage in U.S. = \$0.625/hr Congress forgot to exempt Puerto Rico Average wage in Puerto Rico = \$0.03 to \$0.04/hr Puerto Rican firms went bankrupt → devastating unemployment Puerto Rican politicians begged for exemption

Minimum Wages in France
Firms in France are reluctant to hire Minimum wage is higher than in the U.S. Labor laws make it very difficult to fire workers Younger workers are affected the most Less productive Risk of hiring is greater Result: Unemployment among workers < 25 yrs old was 23% in 2005.

The 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 next Try it!

Takeaway You 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.

End of Chapter 8

Similar presentations