Principles of Microeconomics 7. Taxes, Subsidies, and Introduction to Welfare Analysis* Akos Lada July 29 th, 2014 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

Lecture 8 - Contents 1.Review of previous lecture 2.More on taxes 3.Willingness to pay and consumer surplus 4.Costs and producer surplus

1. Review

Price controls Binding vs. non-binding constraints. Binding price ceilings (e.g. rent control) Leads to shortage Effect is more severe in the long run Rationing, informal market, decrease in quality Binding price floors (e.g. minimum wage) Leads to surplus (under the assumptions of the model

Quiz: Refer to the labor market graph below. The imposition of an $8 minimum wage would cause 1.tax revenues to increase by $2 per worker. 2.unemployment of 35 labor hours. 3.a labor shortage of 35 labor hours. 4.no change in the equilibrium wage and employment because the minimum wage is not binding.

Do you support minimum wage laws? How do you think economists would answer this question? 1.support strongly 2.support mildly 3.have mixed feelings 4.oppose mildly 5.oppose strongly

Do you support minimum wage laws? How do you think economists would answer this question? 1. support strongly 2. support mildly 3. have mixed feelings 4. oppose mildly 5. oppose strongly ANSWERS: 1. support strongly – 28.4% 2. support mildly – 18.9% 3. have mixed feelings – 14.4% 4. oppose mildly – 17.8% 5. oppose strongly – 20.5% SOURCE: Daniel B. Klein and Charlotta Stern. “Economists’ Policy Views and Voting.” Public Choice (2006) 126:

Taxes 1.What shifts? If imposed on buyers, it is equivalent to a decrease in income, shifts the demand curve left If imposed on sellers, it is equivalent to an increase in input costs, shifts the supply curve left 2.What is the size of the shift? The amount of the tax 3.Tax incidence (who pays for the tax burden) Whether the tax is charged to the producers or to the sellers is irrelevant – the tax incidence is the same in both cases What matters is the elasticity of Supply and Demand If Supply is more inelastic, the larger share of the burden falls on the sellers. If Demand is more inelastic, the larger share of the burden falls on the buyers

2. More on taxes

1. What shifts? If imposed on buyers, it is equivalent to a decrease in income, shifts the demand curve to the left If imposed on sellers, it is equivalent to an increase in input costs, shifts the supply curve left Q P Q P D0D0 S0S0 D0D0 S0S0 $ $ D1D1 S0S0

2.What is the size of the shift? For a $ 1.50 tax imposed on buyers … ~ The amount of the tax! ~ D1D1 For a $ 1.50 tax imposed on sellers … $8.50 $7.50 $6.00 D0D0 S0S0 $ Q P 900 $1.5 (tax) S1S1 $11.50 D0D0 S0S0 $ Q P 300 $12 $13.50 $1.5 (tax) 900

PS=PS= P*= PB=PB= PB=PB= 3.Who pays the tax burden? For a $ 1.50 tax imposed on buyers … D0D0 S0S0 D0D0 S0S0 $ D1D1 S1S1 For a $ 1.50 tax imposed on sellers … $9.50 $11.00 Q P Q P 450 Whether the tax is charged to the producers or to the sellers is irrelevant the tax incidence is the same in both cases PS=PS= Total Tax $1.50 Buyers pay $1.00 Sellers pay $0.50 $10 $9.50 $11.00 Total Tax $1.50 Buyers pay $1.00 Sellers pay $0.50

S1S1 A tax creates a wedge D0D0 S0S0 D1D1 P* Q P … between what goes out of the pocket of the buyers, and what goes into the pocket of the sellers. The wedge is the tax that goes to the government. Amount Buyers pay = P B Q* 0 Q*` Amount Sellers receive = P S Total Tax (wedge) $1.50

Quiz: In the graph below, the after-tax price paid by buyers and price received by sellers are, respectively, Price received by sellersPrice paid by buyers 1.$4.00 $ $5.00 $ $6.00 $ $6.00 $4.00

P* PSPS PBPB Buyers pay less of the tax 3.Who pays the tax burden? If Supply is more inelastic, the larger share of the burden falls on the sellers. D0D0 S0S0 D0D0 S0S0 If Demand is more inelastic, the larger share of the burden falls on the buyers P* Q P Q P Q*0Q*0 What matters is the elasticity of Supply and Demand Same total Tax Sellers pay more of the tax Same total Tax Buyers pay more of the tax Sellers pay less of the tax ~ those that are more flexible (adaptive) pay less, those that are less flexible pay more ~ Q*1Q*1 Q*0Q*0 Q*1Q*1 PSPS PBPB

Quiz: Suppose the government enacts a tax as shown in the diagram below. The policy will cause 1.the equilibrium price to rise by $2. 2.buyers to bear a higher burden of the tax than sellers. 3.buyers and sellers to each bear a $1 burden of the tax. 4.quantity to fall by 4 units.

3. Willingness to Pay and Consumer Surplus

Welfare Economics Recall, the allocation of resources refers to: how much of each good is produced which producers produce it which consumers consume it Welfare economics studies how the allocation of resources affects economic well-being. First, we look at the well-being of consumers.

Willingness to Pay (WTP) A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good. WTP measures how much the buyer values the good. nameWTP Anthony$250 Chad175 Flea300 John125 Example: 4 buyers’ WTP for an iPod

WTP and the Demand Curve Q: If price of iPod is $200, who will buy an iPod, and what is quantity demanded? A: Anthony & Flea will buy an iPod, Chad & John will not. Hence, Q d = 2 when P = $200. nameWTP Anthony$250 Chad175 Flea300 John125

WTP and the Demand Curve Derive the demand schedule: 4 John, Chad, Anthony, Flea 0 – Chad, Anthony, Flea 126 – 175 2Anthony, Flea176 – 250 1Flea251 – 300 0nobody$301 & up QdQd who buys P (price of iPod) nameWTP Anthony$250 Chad175 Flea300 John125

WTP and the Demand Curve PQdQd $301 & up0 251 – – – – 1254 P Q

About the Staircase Shape… This D curve looks like a staircase with 4 steps – one per buyer. P Q If there were a huge # of buyers, as in a competitive market, there would be a huge # of very tiny steps, and it would look more like a smooth curve.

WTP and the Demand Curve At any Q, the height of the D curve is the WTP of the marginal buyer, the buyer who would leave the market if P were any higher. P Q Flea’s WTPAnthony’s WTPChad’s WTPJohn’s WTP

Consumer Surplus (CS) Consumer surplus is the amount a buyer is willing to pay minus the amount the buyer actually pays: CS = WTP – P nameWTP Anthony$250 Chad175 Flea300 John125 Suppose P = $260. Flea’s CS = $300 – 260 = $40. The others get no CS because they do not buy an iPod at this price. Total CS = $40.

CS and the Demand Curve P Q Flea’s WTP P = $260 Flea’s CS = $300 – 260 = $40 Total CS = $40

CS and the Demand Curve P Q Flea’s WTPAnthony’s WTP Instead, suppose P = $220 Flea’s CS = $300 – 220 = $80 Anthony’s CS = $250 – 220 = $30 Total CS = $110

4. Costs and Producer Surplus

Cost and the Supply Curve namecost Jack$10 Janet20 Chrissy35 A seller will produce and sell the good/service only if the price exceeds his or her cost. Hence, cost is a measure of willingness to sell. Cost is the value of everything a seller must give up to produce a good ( i.e., opportunity cost). Includes cost of all resources used to produce good, including value of the seller’s time. Example: Costs of 3 sellers in the lawn-cutting business.

Cost and the Supply Curve 335 & up 220 – – 19 0$0 – 9 QsQs P Derive the supply schedule from the cost data: namecost Jack$10 Janet20 Chrissy35

Cost and the Supply Curve P Q PQsQs $0 – – – & up3

Cost and the Supply Curve P Q At each Q, the height of the S curve is the cost of the marginal seller, the seller who would leave the market if the price were any lower. Chrissy’s cost Janet’s cost Jack’s cost

Producer Surplus P Q Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost PS = P – cost

Producer Surplus and the S Curve P Q PS = P – cost Suppose P = $25. Jack’s PS = $15 Janet’s PS = $5 Chrissy’s PS = $0 Total PS = $20 Janet’s cost Jack’s cost Total PS equals the area above the supply curve under the price, from 0 to Q. Chrissy’s cost

P Q PS with Lots of Sellers & a Smooth S Curve The supply of shoes S 1000s of pairs of shoes Price per pair Suppose P = $40. At Q = 15(thousand), the marginal seller’s cost is $30, and her producer surplus is $10.