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Copyright (c) 2000 by Harcourt Inc. All rights reserved. Next page Slides to Accompany Economics: Public and Private Choice 9th ed. James Gwartney, Richard.

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Presentation on theme: "Copyright (c) 2000 by Harcourt Inc. All rights reserved. Next page Slides to Accompany Economics: Public and Private Choice 9th ed. James Gwartney, Richard."— Presentation transcript:

1 Copyright (c) 2000 by Harcourt Inc. All rights reserved. Next page Slides to Accompany Economics: Public and Private Choice 9th ed. James Gwartney, Richard Stroup, and Russell Sobel Supply and Demand Applications and Extensions Chapter 4

2 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. Wage Rates, Interest Rates, and Exchange Rates

3 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Linkage Between Labor and Product Markets n The markets for resources and products are closely linked. u Changes in one will affect the other. F An increase (decrease) in resource prices will reduce (increase) supply in the product market. F An increase in product demand will increase the demand for resources used in production of the good.

4 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Employment Quantity Resource Prices, Opportunity Cost, and Product Markets S1S1 DrDr Suppose there is a reduction in the supply of young, inexperienced labor S2S2 DpDp S1S1 S2S2 $6.50 $5.25 $2.25 $2.00 E2E2 E1E1 Q2Q2 Q1Q1 Resource Market Product Market In the product market the higher wage will increase the restaurants opportunity cost, causing a reduction in supply, which pushes the wage rates of workers hired by fast-food restaurants upward. leading to higher hamburger prices. PP

5 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Loanable Funds Market and the Interest Rate n The interest rate connects the price of goods today and their price in the future. u The interest rate is the price that must be paid for earlier availability.

6 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Consider the market for loanable funds where the interest rate ( r ) will bring the quantity of loanable funds demanded by borrowers into balance with the quantity supplied by lenders. interest rate Quantity of Loanable Funds r1r1 Q1Q1 D 1 (borrowing) We begin in equilibrium at the lending level Q 1 and interest rate r 1. Q2Q2 An increase in the demand for loanable funds will move D 1 to D 2 The higher interest rate will encourage additional savings, making it possible to fund more borrowing. Increase in the Demand for Loanable Funds Supply (lending) D 2 (borrowing) r2r2 pushing the interest rate up from r 1 to r 2 and borrowing from Q 1 to Q 2

7 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Market for Foreign Exchange n Foreign exchange market is where currency of one country is traded for another. n The exchange rate is measured are the dollar price of foreign currency.

8 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Changes in Exchange Rates n Changes in exchange rates will change the prices of internationally traded goods/services and assets u A lower dollar price of foreign currency will have two effects. F It lower the price of foreign goods to U.S. residents and raise imports. F It will raise the price of U.S. goods to foreigners and lower exports.

9 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. D2D2 (purchases from foreigners) Consider the market for foreign exchange (specifically the Guatemalan quetzal) where the exchange rate (the dollar price per quetzal) will bring the quantity of quetzals demanded into balance with the quantity supplied. exchange rate Quantity of Foreign Exchange.10 Q1Q1 We begin in equilibrium where the dollar price of the quetzal is $.10 (10 cents = 1quetzal). Q2Q2 An increase in the demand of Americans for Guatemalan coffee will also increase the demand for quetzals (with which American importers buy Guatemalan coffee). As a result, the dollar price of the quetzal will rise, as will the number of quetzals that clear the market. Increase in the Demand for Foreign Exchange Supply (sales to foreigners).20 $ price per quetzal D1D1 (purchases from foreigners)

10 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 2. The Economics of Price Controls

11 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Price Ceilings n Price ceiling is a legally established maximum price that sellers may charge. u Example: rent control n The direct effect of a price ceiling below the equilibrium price is a shortage: quantity demanded exceeds quantity supplied.

12 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Price Ceiling D (of rental housing) Consider the market for rental housing where the price (rent) of P 0 would bring the quantity of rental units demanded into balance with the quantity supplied. Price Quantity of Housing Units QSQS When a price ceiling like P 1 pushes the price of the product below the market equilibrium... QDQD... the quantity supplied (Q s )... Because prices are not allowed to direct the market back to equilibrium, non-price elements will become more important. The Impact of a Price Control P0P0 S (of rental housing) P1P1 Shortage exceeds the quantity demanded (Q d ), resulting in a shortage.

13 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Secondary Effects of Price Ceilings n Reduction in the quality of the good. n Inefficient use. n Lower future supply. n Non-price rationing will be of more importance.

14 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Effects of Rent Control n Shortages and black markets will develop. n The future supply of housing will decline. n The quality of housing will deteriorate. n Non-price methods of rationing will increase in importance.

15 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Effects of Rent Control n Inefficient use of housing will result. n Long-term renters will benefit at the expense of newcomers.

16 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Price Floor n Price floor is a legally established minimum price that buyers must pay. u Example: minimum wage n The direct effect of a price ceiling below the equilibrium price is a surplus: quantity supplied exceeds quantity demanded.

17 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Minimum Wage Effects n Direct effect: u Reduces employment of low-skilled labor. n Indirect effects: u Reduction in non-wage component of compensation. u Less on-the-job training. n A higher minimum wage does little to help the poor.

18 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. S (of labor) D (for labor) Minimum Wage Level Consider the market for the labor of of a group of employees where a price (wage) of $4.00 would bring the quantity of labor hours demanded into balance with the quantity supplied. Wage Employment EDED A minimum wage (price floor) of $5.15 would raise the price of the labor above the market equilibrium ESES where the employment supplied (E s ) For those (E d ) who were able to maintain their employment, their earnings would increase. Employment and the Minimum Wage $4.00 Excess Supply exceeds that demanded (E d ), resulting in a employment surplus. $5.15 Those (E s - E d ) who lose their job are pushed into either the unemployment rolls or to a less preferred form of employment.

19 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 3. Black Markets and the Importance of Legal Structure

20 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Black Markets n Black market - markets that operate outside the legal system. u Either sell illegal items or items at illegal prices or terms. n Black markets have a higher incidence of of defective products, higher profit rates, and greater violence.

21 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Legal System n A legal system that provides secure property rights and unbiased enforcement of contracts enhances the operation of markets.

22 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. Analyze the impact of an increase in the minimum wage from the current level to $10.00 per hour. How would the following be affected: (a) Employment in skill categories previously earning less than $10.00 (b) The unemployment rate of teenagers (c) The availability of on-the-job training for low-skill workers (d) The demand for high-skill workers who provide good substitutes for the labor services offered by low-skill workers, who are paid higher wage rates due to the increase in the minimum wage? Questions for Thought: 2. What is the black market? What are some of the main differences in how black markets operate relative to legal markets?

23 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 4. The Impact of a Tax

24 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Tax incidence n The legal assignment of who pays a tax is called the statutory incidence. u The actual burden of a tax (actual incidence) may differ substantially. F The actual burden does not depend who legally pays the tax (statutory incidence).

25 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. S (of used cars) D (for used cars) Consider the market for used cars where a price of $7,000 would bring the quantity of used cars demanded into balance with the quantity supplied. Quantity of Used Cars per Month (in thous.) 500 When a $1,000 tax is imposed on the sellers of used cars, the supply curve moves up vertically by the amount of the tax. 750 The new price in the market for used cars is $7,400... The Impact of a Tax Imposed on Sellers $6,400 (of used cars) S + Tax $7,000 $7,400... while sellers receive $6,400 ($7,400 - $1000 tax = $6,400). The difference between the two is the amount of the tax, $1000. As the consumers end up paying $7,400 instead of $7,000 and bear $400 of the tax burden. Sellers end up receiving $6,400 and bear $600 of the tax burden. $1000 $1000 tax Price

26 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Note that the new quantity of used cars that make the market is 500. Price 500750 The Impact of a Tax Imposed on Sellers $6,400 (of used cars) S + Tax $7,000 $7,400 As only 500,000 cars are being sold instead of the 750,000 from before the tax, the area above the old supply curve and below the demand curve represents the consumer and producer (total) surplus that is lost due to the imposition of the tax. This is called the Deadweight Loss to Society. 500 As consumers are bearing $400 of the tax burden, and as there are 500,000 units being sold per month, the tax revenues derived from the consumers = $200,000,000. As sellers are bearing $600 of the tax burden, and as there are 500,000 units being sold per month, the tax revenues derived from the sellers = $300,000,000. S (of used cars) D (for used cars) Deadweight Loss Tax Revenue from Consumers Tax Revenue from Sellers Quantity of Used Cars per Month (in thous.)

27 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. S (of used cars) D (for used cars) Consider the market for used cars where a price of $7,000 would bring the quantity of used cars demanded into balance with the quantity supplied. When a $1,000 tax is imposed on the buyers of used cars, the demand curve moves down vertically by the amount of the tax. 750 While the sellers of used cars now receive the new market price for used cars, $6,400... The Impact of a Tax Imposed on Buyers $6,400 $7,000 $7,400... buyers pay both the market price and the tax, ($6,400 + $1000 tax = $7,400). The difference between the two is the amount of the tax, $1000. As the consumers end up paying $7,400 instead of $7,000 and bear $400 of the tax burden. Sellers end up receiving $6,400 and bear $600 of the tax burden. $1000 D (for used cars) - Tax $1000 tax 500 Price Quantity of Used Cars per Month (in thous.)

28 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Note that the new quantity of used cars that make the market is 500. 500750 The Impact of a Tax Imposed on Buyers $6,400 $7,000 $7,400 Again the area above the supply curve and below the old demand curve represents the consumer and producer (total) surplus that is lost due to the imposition of the tax, the Deadweight Loss to Society. 500 As consumers are bearing $400 of the tax burden, and as there are 500,000 units being sold per month, the tax revenues derived from the consumers = $200,000,000. As sellers are bearing $600 of the tax burden, and as there are 500,000 units being sold per month, the tax revenues derived from the sellers = $300,000,000. S (of used cars) D (for used cars) Deadweight Loss Tax Revenue from Consumers D (for used cars) - Tax Tax Revenue from Sellers Note that the incidence of the tax is the same regardless of whether it is imposed on buyers or sellers. Quantity of Used Cars per Month (in thous.) Price

29 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Deadweight Loss n Deadweight loss is the loss of gains resulting from the imposition of tax. u It imposes a burden of taxation over the burden of transferring revenues to the government. u It is composed of losses to both buyers and sellers.

30 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Elasticity and Incidence of a Tax n The actual burden of a tax depends on the elasticity of supply and demand. u As supply becomes more inelastic, then more of the burden will fall on sellers. u As demand become more inelastic, then more of the burden will fall on buyers.

31 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Elasticity and the Deadweight Loss n The deadweight loss of tax rises as the elasticity of either the supply curve or demand curve rises.

32 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 6 5 S + Tax Luxury Boots Lets consider the market for Gas and Luxury Boots individually. Note that, as in the graph for the market for gas, when the demand curve is relatively more inelastic than its supply, that buyers bear a larger share of the burden of the tax. 2.00 1.20 $ 100 Gasoline 1 2 3 47 million(s) of gal. per week 100 Tax Burden and Elasticity 1.10 $ 105 $ 80 Price D D S S S + Tax Note that, as in the graph for the market for luxury boots, when the supply curve is relatively more inelastic than its demand, that sellers bear a larger share of the tax burden. We begin in equilibrium. If we were to impose a $.90 tax on gasoline suppliers, the supply curve moves vertically the distance of the tax. Price at the pump goes up by $.80 and output falls by 1 million gal. If we were to impose a $25 tax on Luxury Boot suppliers, the supply curve moves vertically the distance of the tax. Price at the rack go up by $5 and output falls by 1.5 thousand units. thousand(s) of boots per week 755025 56

33 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 5. Tax Rates, Tax Revenues, and the Laffer Curve

34 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Average Tax Rate n Average tax rate equals tax liability divided by taxable income. u Progressive tax is one in which the average tax rate rises with income. u Proportional tax is one in which the average tax rate stays the same across income levels. u Regressive tax is one in which the average tax rate falls with income.

35 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Marginal Tax Rate n Marginal tax rate equals change in tax liability divided by change in taxable income.

36 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Tax Rate and Tax Base n Tax rate is the percentage rate at which an economic activity is taxed. n Tax base the level of the activity that is taxed. u The tax base is inversely related to the rate at which the activity is taxed

37 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Laffer Curve n Laffer curve illustrates the relationship between tax rates and tax revenues. u Laffer Curve shows that tax revenues are low for both high and low tax rates. u The point of maximum tax revenue is not optimal because of high excess burden.

38 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Positive Tax Revenues At a tax rate of 0%, tax revenues would also be equal to $0. Tax Rate Tax Revenues 25% As the tax rate increase from 0% to some pt A, tax revenues increase despite the fact that some individuals are choosing not to work. The Laffer Curve 50% 75% 100% At a tax rate of 100%, nobody would work and thus, again, tax revenues would also be equal to $0. After some pt B, a further increase in the tax rates might actually cause tax revenues to fall. As the Laffer curve illustrates, as tax rates approach pt C tax revenues continue to fall as the tax base shrinks faster than the increase in the tax rate can keep up with. There is no presumption that pt B is the ideal tax rate only that it maximizes the tax revenue in the current period. A B C Max Tax Revenues

39 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Laffer Curve and Tax Changes in the 1980s n During the 1980s, the top marginal income tax rate fell from 70% to 33%. n Need to distinguish between changes in tax rates and changes in tax revenues. u Between 1980 and 1990 real income tax revenue collected from the top 1 percent of earners rose a whopping 51.4 percent

40 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 2. What is the nature of the deadweight loss accompanying taxes? Why is it referred to as an excess burden of the tax? Questions for Thought: 1. What is meant by the incidence of a tax? Explain why the statutory and actual incidence of a tax can be different? 3. Does the Laffer curve indicate that a reduction in tax rates will always lead to a reduction in tax revenues? Should the government attempt to levy a tax rate that would maximize its revenues?

41 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. End Chapter 4


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