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

3. 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

4. The Link Between Resource and Product Markets

5. What’s the relationship between product markets and resource (input) markets?

6. Wy the Chick-fil-A cows git it rong:

7. 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

8. Graphs:

9. Clicker question next

11. 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.

14. The Economics of Price Controls

15. 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

16. Price Ceiling
Class Activity: Economics is Everywhere 4.1

17. Congressman Howard P. “Buck” McKeon (Republican of California) proposed putting a price ceiling on tuition at public colleges and universities. He would limit the amount that they could increase tuition from one year to the next.
Q: How would his bill, if enacted, affect higher education in the United States?

18. Response from author:
Current students will probably benefit- their tuition in their remaining few years in college will probably rise less rapidly than otherwise. But the bill would also prevent colleges from funding the kinds of quality programs that many students now and in the future might want. Also, better professors will seek jobs in colleges, private ones mainly, that can afford to pay for their services; and public universities won’t be able to maintain facilities as well as in the past. This is really a bill that is designed to make public higher education in the United States more mediocre.

19. Price Ceiling Graph:

21. Video of the effects of shortages:

23. Video: rent control

25. Clicker question next

26. 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

27. Here’s what the market would do:

29. Clicker question next

30. 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.

31. Price Floor Graph:

35. Class Activity: Economics is Everywhere 4.10

36. 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?

37. Video: minimum wage

40. Some other thoughts on minimum wage

41. Some other thoughts on minimum wage

42. Some other thoughts on minimum wage

43. 2 Clicker questions next

44. 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.

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

46. Video: pharmaceutical price controls

48. Extra Credit Clicker question next

49. Q4.6 The National Institutes of Health (NIH) says that of 56 new AIDS drugs, how many came from NIH?15 25 40 50 51

50. Optional Assignment:
Read 3-page article titled “Bandow-Minimum Wage” on Blackboard under Optional Assignments
Hand write your answers on a standard 8.5 x 11 inch piece of paper to the questions found in the document “Optional Assignment Bandow Minimum Wage”
Submit your answers during office hours in before Exam 2

52. The Impact of a Tax

54. Class Activity: Economics is Everywhere 19.10

55. 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?

56. 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

57. 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

58. Graph of tax imposed on sellers:
See handout “Impact of a Tax 1.pdf”

60. Graph of tax imposed on buyers:
See handout “Impact of a Tax 1.pdf”

62. 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 $107, consumers pay $7 tax and firms pay $3 tax.

63. What determines how the burden is shared?
The size of the deadweight loss and the actual burden depend on ____________

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

65. Four scenarios:
See handouts “Impact of a tax 2.pdf” and “Impact of a tax 3.pdf”

67. Four scenarios:
Summary: The more inelastic group has the biggest share of the burden

68. But, wait! Do companies really pay taxes? No, only people pay taxes
In order for the company to be “in business” it must hire people and collect revenue from people
The company is just an intermediary for the government to collect tax revenue

69. How to reconcile with our analysis:
Suppose the elasticities indicate that the consumer pay 20% of the tax and the company pays 80%.
If the company doesn’t really pay the 80%, then who does?
Employees
Suppliers/wholesalers
Owners and/or investors of the company

70. 2 Clicker questions next

71. Q4.7 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.

72. Q4.8 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.

73. Class Activity: Economics is Everywhere 19.9

74. 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?

75. Helpful Study Tool
“Tax Impact Process Examples.pdf” in Supplemental Material folder in Blackboard

76. Taxes change behavior:

78. Tax Rates, Tax Revenues, and the Laffer Curve

80. 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
Clicker question next

81. Q4.9 When the government increases the tax rate, what happens to tax revenue?
Revenues will increase
Revenues will decrease

83. Q4.10 When the government increases the tax rate, what happens to tax revenue?
Revenues will increase
Revenues will decrease
It depends

84. The Laffer Curve
Graphical representation of the relationship between the tax rate and revenue
Graph:

86. 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
Clicker question next

87. Q4.11 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.

88. The facts: Highest marginal tax rates
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%.

90. The Impact of a Subsidy

91. Video: farm subsidies

93. Extra Credit Clicker question next

94. Q4.12 How many acres does the Starr family farm devote to cotton production?

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

97. 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

98. Video: ethanol subsidies

100. Extra Credit Clicker question next

101. Q4.13 What is the current per-gallon ethanol subsidy?
$0.78
$1.78
$2.78
$3.78

102. Optional Assignment:
Read 2-page article titled “WSJ-ethanol vs the world” on Blackboard under Optional Assignments
Hand write your answers on a standard 8.5 x 11 inch piece of paper to the questions found in the document “Optional Assignment WSJ ethanol vs the world”
Submit your answers during office hours before Exam 2

103. 2 Clicker questions next

104. Q4.14 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.

105. Q4.15 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.

106. 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.

107. Video: subsidized flood insurance

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

110. 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