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Using Supply and Demand to Analyze Markets Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3.

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Presentation on theme: "Using Supply and Demand to Analyze Markets Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3."— Presentation transcript:

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

2 Introduction Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 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?

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

4 3.1 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 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 surplus (CS) 5 B Person A’s 4.50 consumer C 4 surplus = $1.50 D Market price 3.50 E 3 D Quantity of apples (pounds) The consumer at point E will not buy any apples because the market price is too high

5 3.1 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-5 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 3 Consumer and Producer Surplus: Who Benefits in a Market?

6 3.1 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Consumer and Producer Surplus: Who Benefits in a Market? Figure 3.2 Defining Producer Surplus 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 0 Quantity of apples (pounds) The producer at point Z will not produce any apples because the market price is too low

7 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-7 figure it out The Market for Cupcakes The weekly supply and demand for cupcakes in a small town are given as Q S = 30P – 20, Q D = 124 – 18P where P is the price, in dollars, and quantity is measured in thousands of cupcakes per week Answer the following questions: 1. Find the equilibrium price and quantity 2. Calculate consumer and producer surplus at the equilibrium

8 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-8 figure it out 1. Remember: Equilibrium is characterized by Q S = Q D 30P – 20 = 124 – 18P Combining terms and solving for P yields 48P = 144 → P* = $3 And using the equation for demand, Q D = 124 – 18(3) = 70 = Q* = Q S 2. 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 Q D / Q S are equal to zero) Why do we need only two points to plot the demand/supply curves? The Market for Cupcakes

9 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-9 figure it out The Market for Cupcakes We already know one point for each curve: P* = $3.00 ; Q* = 70 Demand choke price: Q D = 0 = 124 – 18P → P = $6.89 Supply choke price: Q S = 0 = 30P – 20 → P = $ Quantity of cupcakes (thousands) 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 0.67 A B D S

10 3.1 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Consumer and Producer Surplus: Who Benefits in a Market? What happens to consumer and producer surplus when there is a shift in supply or demand? 0Quantity of cupcakes (thousands) Price of cupcakes (dollars) 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 P 2 and Q 2 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 S P1P1 Q1Q1 D2D2 D1D1 Q2Q2 P2P2 A B C D E F G

11 3.1 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Consumer and Producer Surplus: Who Benefits in a Market? Figure 3.3 Consumer Surplus and the Elasticity of Demand

12 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-12 figure it out The Market for Tires The weekly supply and demand for tires in a small town are given as Q S = 15P – 400, Q D = 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: 1. What is the new supply curve? 2. What are the new equilibrium price and quantity? 3. What happens to consumer and producer surplus?

13 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-13 figure it out The Market for Tires

14 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-14 figure it out The Market for Tires

15 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-15 figure it out The Market for Tires

16 3.1 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Consumer and Producer Surplus: Who Benefits in a Market? Figure 3.5 Changes in Surplus from a Supply Shift

17 3.2 Price Regulations Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-17 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? 3

18 3.2 Price Regulations Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-18 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 3

19 3.2 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Price Regulations Figure 3.7 The Effects of a Price Ceiling Price Consumer surplus beforeA + B + C ($/pizza) Consumer surplus afterA + B + D $20 Producer surplus beforeD + E + F Producer surplus afterF A DWL = C + E Supply 14 B w C 10 E y D 8 x F 5 Transfer of PS Demand to CS 0 Quantity of pizzas (thousands)/month Shortage z

20 3.2 Price Regulations Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Deadweight Loss and Elasticities 3

21 3.2 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Price Regulations Figure 3.9 The Effects of a Price Floor Price Transfer ($/per ton) of CS to PS S A xyPrice floor $1,000 B Consumer surplus beforeA + B + C C w 500Consumer surplus afterA E Producer surplus beforeD + E + F D Producer surplus afterB + D + F z F D 0 Quantity of peanuts (millions of tons) Surplus

22 3.3 Quantity Regulations Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-22 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? 3

23 3.3 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Quantity Regulations Figure 3.10 The Effects of a Quota Price Consumer surplus beforeA + B + C ($/tattoo) Consumer surplus afterA S2S2 $125 Producer surplus beforeD + E + F Producer surplus afterB + D + F A z P quota = 100 Transfer of CS to PS B C x S1S1 P = 50 E D 40 y D 35 F 0 Quantity of 5001,500 tattoos/year (Quota)

24 Application Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-24 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 3 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.

25 Application Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-25 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 3 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.

26 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Government provision of a public good: municipal golf courses 0 Quantity of rounds Price of a golf round 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 S priv and the market equilibrium occurs at Q 1 and P 1 The municipal course increases the quantity of rounds available by Q gov, and supply shifts out to S tot However, quantity supplied only increases to Q tot because private suppliers are not willing to supply as much at the new, lower market price Private producers reduce quantity supplied to Q priv, this effect is known as “crowding out” S priv P1P1 D Q1Q1 P tot 3.3 Quantity Regulations S tot Q tot Q 1 + Q gov Crowding out Q priv

27 3.4 Taxes Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-27 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? 3

28 3.4 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Taxes Figure 3.13 The Effects of a Tax on Boston Movie Tickets Price ($/ticket) $10 Transfer from CS and PS to government S 2 = S 1 + tax A y P b = 8.30 C S1S1 x B P 1 = 8.00 D D P s = 7.80 E z Consumer surplus (CS) beforeA + B + C Consumer surplus (CS) afterA F Producer surplus (PS) beforeD + E + F Producer surplus (PS) afterF 6.67 Government revenueB + D 0 Quantity of tickets Q 2 = 3.4Q 1 = 4 (100,000s)

29 3.4 Taxes Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-29 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 Q D = Q S, 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 3

30 3.4 Taxes Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-30 Pre-tax producer surplus surplus where the supply choke price Solving for producer surplus yields And total surplus What happens after the tax? 3

31 3.4 Taxes Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-31 Define the after-tax price as The market price (the price buyers pay), P b, is equal to the price the producer received, P S, 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 P S The new market price is and quantity (substitute buyer price into demand function) 3

32 3.4 Taxes Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-32 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 3

33 3.4 Taxes Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-33 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 P S, P b, and Q 2 3

34 3.4 Taxes Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-34 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) 3

35 3.4 Taxes 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

36 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-36 figure it out Soda Tax The supply and demand for soda in a market is represented by Q S = 50P – 60, Q D = 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: 1. Calculate the price elasticity of demand and the price elasticity of supply at the current equilibrium 2. Calculate the share of a tax that will be borne by consumers and the share borne by producers 3. If a tax of $0.10 per bottle is created, what do buyers now pay for a bottle? What will sellers receive?

37 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-37 figure it out 1. The first step is determining how the subsidy affects prices In this problem, Supply and demand are given by And substituting in for P S Equating supply and demand, and solving for P b Soda Tax

38 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-38 figure it out 1. The first step is determining how the subsidy affects prices In this problem, Supply and demand are given by And substituting in for P S Equating supply and demand, and solving for P b Soda Tax

39 Application Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-39 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 3 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.

40 Application Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-40 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 3 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.

41 3.4 Taxes Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-41 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 3

42 3.4 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Taxes Figure 3.15 Tax Incidence (a)(b) Price ($) S2S2 Tax = P b – P s S S1S1 PbPb PbPb P1P1 P1P1 PsPs PsPs D1D1 D D2D2 0 Quantity 0 Q2Q2 Q1Q1 Q2Q2 Q1Q1

43 3.4 Taxes Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-43 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 3

44 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Elastic demand with inelastic supply 0 Quantity of labor Wage 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 W b, with quantity L 2 The wage received by workers, however, is only W s W b –W 1 < W 1 – W s ; therefore, the incidence of the tax falls primarily on suppliers of labor (workers) S2S2 WbWb D L1L1 3.4 Taxes S1S1 tax W1W1 WsWs L2L2

45 3.4 Taxes Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-45 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 3

46 3.4 Taxes Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e Figure 3.16 Tax Incidence and Elasticities

47 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-47 figure it out Soda Tax The supply and demand for soda in a market is represented by Q S = 50P – 60, Q D = 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: 1. Calculate the price elasticity of demand and the price elasticity of supply at the current equilibrium 2. Calculate the share of a tax that will be borne by consumers and the share borne by producers 3. If a tax of $0.10 per bottle is created, what do buyers now pay for a bottle? What will sellers receive?

48 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-48 figure it out 1. The elasticity of demand and supply are 2.The proportion of a tax borne by buyers and sellers is: 3.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 Soda Tax

49 Application Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-49 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 3 R. Chetty, A.Loony, and K. Kroft “Salience and Taxation: Theory and Evidence.”American Economic Review, 99(4): 1145 – 1177.

50 Application Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-50 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 E D 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 3 R. Chetty, A. Loony, and K. Kroft “Salience and Taxation: Theory and Evidence.”American Economic Review, 99(4): 1145 – Images: FreeDigitalPhotos.net

51 3.5 Subsidies Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-51 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 3

52 3.5 Subsidies Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-52 Figure 3.17 The Impact of a Producer Subsidy 3

53 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-53 figure it out Education Grants 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 Q S = 1,000P – 2500, Q D = 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: 1. What will happen to the price paid by students, the price received by the college, and the number of credit hours completed? 2. What is the cost of the subsidy to the government?

54 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-54 figure it out 1. The first step is determining how the subsidy affects prices In this problem, Supply and demand are given by And substituting in for P S Equating supply and demand, and solving for P b Education Grants

55 Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-55 figure it out 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 How much did this cost the government? Education Grants

56 3.6 Conclusion Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson  1/e 3-56 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 3


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