Supply and Demand: Applications and Extensions Micro Chapter 4 Supply and Demand: Applications and Extensions

5 Learning Goals Describe the relationship between resource and product markets Analyze the impact of government policies for price controls in markets Determine the effects of a tax in a market Explore the relationship between tax rates and revenues Identify the effects of a subsidy

The Link Between Resource and Product Markets

What’s the relationship between product markets and resource (input) markets? An increase (decrease) in demand for a product will increase (decrease) demand for resources that make that product When the product price rises, the resource price will eventually rise

Graphs: Watch content video: product and resource markets

Q4.1 (MA) An increase in the number of students attending college would tend to decrease the demand for college professors. increase the demand for college professors. decrease the number of college professors employed. increase the number of college professors employed. increase wages of college professors. decrease wages of college professors.

The Economics of Price Controls

2 Kinds of Price Controls: (1) Price ceiling – puts an upper limit on price; generates a shortage and a deadweight loss (2) Price floor – puts a lower limit on price; generates a surplus and a deadweight loss Deadweight loss (DWL) = loss of gains from trade; loss of CS and PS

Price Ceiling Graph: Watch content video: price ceiling graph

Watch video: Jingle All The Way- Effects of a shortage

Dead People Help You Get Gasoline Dead People Help You Get Gasoline. The African nation of Zimbabwe is currently an economic mess, with, among other things, price ceilings on gasoline leading to shortages and long lines at the gas stations. The government has set up priorities for obtaining gasoline, with hearses being priority recipients. Two mortuary workers were arrested for leasing out bodies to motorists, who would take the body to a gas station, claim the hearse’s priority to obtain the gasoline, then return the body to the mortuary to be leased out again. The motorist would then siphon out the purchased gasoline for use in his own private vehicle. This is a natural response of the market to circumventing the shortages. The government created the shortage- and the opportunity for someone to profit from it- and the market responded. Q: Siphoning gasoline is dangerous- poisoning or explosions are possible. Why would anyone accept these risks? Why engage in this method or circumventing the price ceiling?

Watch video: Stossel-rent control

Q4.2 What would happen in a market where a price ceiling was set above equilibrium price? A surplus would occur The shortage would become larger Equilibrium price would become the market price

Q4.3 When a shortage of a good is present due to a price ceiling, the amount supplied will be greater than the amount demanded. the quality of the good will generally improve. non-price factors, such as discrimination or waiting in line, will play a greater role in the allocation of the good. the demand for the product will increase and, thereby, eliminate the shortage.

Price Floor Graph: Watch content video: Price floor graph

As a price floor, a minimum wage restricts the amount of goods, or inputs, that demanders are willing to buy. But what happens if the demand curve shifts to the left? If there were no floor, the price of the good or service would drop as the market moves down along the supply curve, and a new equilibrium price would be established. But with the floor, the price cannot drop- all that can happen is that the leftward shift in the demand curve must lead to a drop in the quantity employed. This is exactly what happens, according to a study of the labor market in Portugal. Among companies with a higher fraction of employees paid at the minimum wage, when demand for the product goes down, these companies are more likely to close down. The floor on wages imposed by the minimum prevents the companies from cutting costs, and the drop in product demand drives them out of business when they can no longer supply at a competitive price. Q: This describes the response of companies that cannot afford to remain in business. What will happen to employment at those companies that stay in business?

Watch video: Stossel-Unintended consequences of minimum wage

Q4.4 If the government imposes a price floor on the market for milk, which of the following will most likely happen? The quantity of milk demanded will increase. The quantity of milk supplied will decrease. There will be a surplus of milk. There will be a shortage of milk.

Q4.5 Both price floors and price ceilings lead to shortages. surpluses. reductions in quality. a reduction in the quantity traded.

Watch video: Stossel-pharmaceutical price controls (optional)

The Impact of a Tax

It’s not often that the incidence of a tax is obviously split between producers and consumers, as the textbooks would suggest is the case. But on the day when the U.S. government reimposed a 10 percent tax on airline tickets, some of the airlines tried to increase fares by 10 percent. Others did not go along, however, and later in the day the companies dropped their fares to 4 percent above where they had been the day before (before the tax was reimposed). The fare increase settled at 4 percent. The consumer paid 40 percent of the new tax, and the producers paid 60 percent- even though the tax was imposed initially on the companies. Q: Why would the airlines be willing to pay 60% of the tax?

Incidence (1) Statutory incidence- who is legally responsible to pay the tax This is the tax burden- it hinders exchange This is an administrative detail that is mostly irrelevant (2) Actual incidence- who really pays the tax This is the more important issue The burden is shared between firms and consumers

Ways to analyze: If the tax is legally imposed on sellers, shift the supply curve If the tax is legally imposed on buyers, shift the demand curve You’ll reach the same conclusion either way

Graph of tax imposed on sellers: See handouts “Impact of a tax 1.pdf”

Graph of tax imposed on buyers: See handouts “Impact of a tax 1.pdf”

Scenario: The price of a textbook is $100 Scenario: The price of a textbook is $100. Then a $10 sales tax is imposed. What usually happens? The price (with tax) of the textbook will be somewhere between $100 and $110. If $106, consumers pay $6 tax and firms pay $4 tax.

Watch video: Snooki tanning tax (optional, just for fun)

What determines how the burden is shared? The size of the deadweight loss and the actual burden depend on supply & demand elasticities

Four scenarios: See handouts “Impact of a tax 2.pdf” and “Impact of a tax 3.pdf” Summary: The more inelastic group has the biggest share of the burden

Q4.6 If a $5,000 tax is placed legally (statutorily) on the sellers of new automobiles and as a result the price of automobiles to consumers rises by $4,000, then the actual burden of the tax falls completely on automobile buyers. falls completely on automobile sellers. is $4,000 on automobile buyers and $1,000 on sellers. is $1,000 on automobile buyers and $4,000 on sellers.

Q4.7 The burden of a tax will fall primarily on sellers when the demand for the product is highly inelastic and the supply is relatively elastic. demand for the product is highly elastic and the supply is relatively inelastic. tax is legally (statutorily) imposed on the seller of the product. tax is legally (statutorily) imposed on the buyer of the product.

Several years ago, the state of Texas surprised the public by creating a tax holiday the weekend before school started. School supplies and related items were temporarily exempted from the 8% state sales tax. Who really benefited from the tax holiday? What was the tax incidence? That depended on how the supply and demand for these items responded to the tax cut and the resulting drop in the net price. It’s hard to believe that demand responded much because by that weekend many people had already bought the back-to-school items. If not, they had to buy them then- an inelastic demand. That would have led to a big drop in the net price: Consumers reaped most of the benefit from the tax holiday. Since then, the state has been offering this holiday annually. People are adjusting their spending patterns accordingly so that now there is a more elastic demand on that weekend. Retail stores, too, can plan around this date all year long and be sure that they reap part of the gains from the temporary tax holiday. Buyers and sellers now share the incidence of the tax cut. Q: What if, instead of a tax holiday, the stores were required to pay the sales tax instead of the consumers. Which net price would be lower, the tax holiday or the store paying the tax? When would purchases be higher, with the tax holiday or with the store paying the tax?

Helpful Study Tool See handout “Tax Impact Process Examples.pdf”

Tax Rates, Tax Revenues, and the Laffer Curve

2 definitions you need to know: (1) Tax rate (a) Value (most common); a percent is applied to the sales price Example: 7.5% sales tax (b) Per Unit; an amount is applied to each unit sale Example: $1 for every unit sold Gas taxes (2) Tax Revenue = rate X sales

Q4.8 When the government increases the tax rate, what happens to tax revenue? Revenues will increase Revenues will decrease It depends

The Laffer Curve Graphical representation of the relationship between the tax rate and revenue Graph: Watch content video: Laffer curve

So what? Starting at high tax rates, an increase in the tax rate may actually lower revenue Starting at high tax rates, larger revenue may be generated by lowering tax rates

Q4.9 According to the Laffer curve, an increase in tax rates will always cause tax revenues to increase. when marginal tax rates are high, an increase in tax rates is likely to cause tax revenues to increase. when marginal taxes are low, an increase in tax rates will probably cause tax revenues to decline. when marginal tax rates are high, a reduction in tax rates may increase tax revenue.

The facts: See article “historical top marginal tax rates.pdf” Using 2008 Internal Revenue Service statistics, the 2001 tax cuts shifted the income tax burden up the economic ladder. In 2000, the top 1% paid 37.4% of all income taxes vs. 39.4% in 2005. The top 2% went from 56.5% to 60% The top 10% from 67.3% to 70.3% The top 25% from 84% to 86% The top 50% from 96% to 97%.

The Impact of a Subsidy

Watch video: Stossel- farm subsidies

Analysis of Ethanol subsidies Ethanol- biofuel made from corn to supplement traditional gasoline (most gas now contains up to 10% ethanol) Graph of ethanol: Watch content video: ethanol

Analysis of Ethanol subsidies Secondary effects: increase demand for corn (maybe not an equal increase in supply of corn) results in an increase in the price of corn Increase in prices for feed for livestock plus any consumer good made from corn So, lower prices for ethanol but higher prices for milk, soda, and everything else made with corn

Watch video: Stossel-Unintended consequences of ethanol subsidies (optional)

Q4.10 The actual benefit of a government subsidy is determined primarily by the elasticities of demand and supply. the legal (or statutory) assignment of the subsidy the number of exchanges that are made possible as a result of the subsidy. whether the subsidy is paid by cash or check.

Q4.11 If a $50 subsidy is legally (statutorily) granted to the sellers of exercise equipment and as a result the price of exercise equipment to consumers falls by $30, the actual benefit of the subsidy goes completely to buyers of exercise equipment. goes completely to sellers of exercise equipment. is $30 to buyers and $20 to sellers. is $20 to buyers and $30 to sellers.

Who receives the biggest benefit from subsidies? Ignoring secondary effects, the group with the smallest elasticity receives the biggest benefit. If supply is relatively inelastic and demand is relatively elastic, then suppliers receive most (but not all) of the benefit. If supply is relatively elastic and demand is relatively inelastic, then consumers receive most (but not all) of the benefit.

Watch video: Stossel-subsidized flood insurance

Conclusions: Taxes and subsidies distort incentives and create secondary effects which are sometimes undesirable

Question Answers: 4.1 = 2, 4 & 5 4.2 = 3 4.3 = 3 4.4 = 3 4.5 = 4 4.6 = 3 4.7 = 2 4.8 = 3 4.9 = 4 4.10 = 1 4.11 = 3