1. 1 Applications of Supply & Demand Chapter 4

2. 2 Model this using a S & D diagram But an even bigger problem is the consumers themselves. That's because subsidies make energy practically free in Iran, discouraging any serious energy conservation. Gasoline, for example, costs about 40 cents a gallon at the pump. That's encouraged an explosion of use, as Iranians add new cars while continuing to use fuel-guzzling old models. It has also encouraged a brisk smuggling trade as Iranians buy millions of gallons of fuel at the subsidized price and truck them into neighboring Pakistan, Turkey, Afghanistan and Iraq for sale at market rates. Demand has now far outstripped the country's refinery capacity. The government has shelled out at least $7 billion on gasoline imports alone so far this fiscal year, which ends in March. Much of that money was drawn from the country's rainy-day oil surplus fund, which is supposed to be used only on capital projects or during periods when global oil prices are low.

3. 3 WSJ, 20feb07

4. 4 Price Controls Floor Ceilings Who benefits from each: sellers or buyers?

5. Figure 1 A Market with a Price Ceiling (a) A Price Ceiling That Is Not Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium quantity $4 Price ceiling Equilibrium price Demand Supply 3 100

6. Figure 1 A Market with a Price Ceiling Copyright©2003 Southwestern/Thomson Learning (b) A Price Ceiling That Is Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply 2Price ceiling Shortage 75 Quantity supplied 125 Quantity demanded Equilibrium price $3

7. Figure 2 The Market for Gasoline with a Price Ceiling Copyright©2003 Southwestern/Thomson Learning (a) The Price Ceiling on Gasoline Is Not Binding Quantity of Gasoline 0 Price of Gasoline 1. Initially, the price ceiling is not binding... Price ceiling Demand Supply,S1S1 P1P1 Q1Q1

8. Figure 2 The Market for Gasoline with a Price Ceiling Copyright©2003 Southwestern/Thomson Learning (b) The Price Ceiling on Gasoline Is Binding Quantity of Gasoline 0 Price of Gasoline Demand S1S1 S2S2 Price ceiling QSQS 4.... resulting in a shortage. 3.... the price ceiling becomes binding... 2.... but when supply falls... P2P2 QDQD P1P1 Q1Q1

9. 9 Rent Control Ceiling or floor? Rationale? One economist called rent control “the best way to destroy a city, other than bombing.”

10. Figure 3 Rent Control in the Short Run and in the Long Run Copyright©2003 Southwestern/Thomson Learning (a) Rent Control in the Short Run (supply and demand are inelastic) Quantity of Apartments 0 Supply Controlled rent Rental Price of Apartment Demand Shortage

11. Figure 3 Rent Control in the Short Run and in the Long Run Copyright©2003 Southwestern/Thomson Learning (b) Rent Control in the Long Run (supply and demand are elastic) 0 Rental Price of Apartment Quantity of Apartments Demand Supply Controlled rent Shortage

12. Figure 4 A Market with a Price Floor Copyright©2003 Southwestern/Thomson Learning (a) A Price Floor That Is Not Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium quantity 2 Price floor Equilibrium price Demand Supply $3 100

13. Figure 4 A Market with a Price Floor Copyright©2003 Southwestern/Thomson Learning (b) A Price Floor That Is Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply $4 Price floor 80 Quantity demanded 120 Quantity supplied Equilibrium price Surplus 3

14. 14 Minimum Wage

15. Figure 5 How the Minimum Wage Affects the Labor Market Copyright©2003 Southwestern/Thomson Learning Quantity of Labor Wage 0 Labor demand Labor Supply Equilibrium employment Equilibrium wage

16. Figure 5 How the Minimum Wage Affects the Labor Market Copyright©2003 Southwestern/Thomson Learning Quantity of Labor Wage 0 Labor Supply Labor surplus (unemployment) Labor demand Minimum wage Quantity demanded Quantity supplied

17. 17 Taxes

18. Figure 6 A Tax on Buyers Copyright©2003 Southwestern/Thomson Learning Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium without tax Tax ($0.50) Price buyers pay D1D1 D2D2 Supply,S1S1 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). $3.30 90 Equilibrium with tax 2.80 3.00 100

19. Figure 7 A Tax on Sellers Copyright©2003 Southwestern/Thomson Learning 2.80 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium with tax Equilibrium without tax Tax ($0.50) Price buyers pay S1S1 S2S2 Demand,D1D1 A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50). 3.00 100 $3.30 90

20. Figure 8 A Payroll Tax Copyright©2003 Southwestern/Thomson Learning Quantity of Labor 0 Wage Labor demand Labor supply Tax wedge Wage workers receive Wage firms pay Wage without tax

21. Figure 9 How the Burden of a Tax Is Divided Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (b) Inelastic Supply, Elastic Demand 3.... than on consumers. 1. When demand is more elastic than supply... Price without tax 2.... the incidence of the tax falls more heavily on producers...

22. Figure 9 How the Burden of a Tax Is Divided Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (a) Elastic Supply, Inelastic Demand 2.... the incidence of the tax falls more heavily on consumers... 1. When supply is more elastic than demand... Price without tax 3.... than on producers.

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24. 24 Figure 2 Tax Revenue Copyright © 2004 South-Western Tax revenue (T × Q) Size of tax (T ) Quantity sold (Q) Quantity 0 Price Demand Supply Quantity without tax Quantity with tax Price buyers pay Price sellers receive

25. 25 Recall … Consumer Surplus: Area under demand curve and above price line. Producer Surplus: Area above supply curve and below price line.

26. 26 Figure 3 How a Tax Effects Welfare Copyright © 2004 South-Western A F B D C E Quantity 0 Price Demand Supply = PBPB Q2Q2 = PSPS Price buyers pay Price sellers receive = P1P1 Q1Q1 Price without tax

27. 27 Deadweight Loss The fall in total surplus that results from a market distortion, such as a tax. Buyers have an incentive to consume less and sellers an incentive to produce less.

28. 28 Figure 4 The Deadweight Loss Copyright © 2004 South-Western Cost to sellers Value to buyers Size of tax Quantity 0 Price Demand Supply Lost gains from trade Reduction in quantity due to the tax Price without tax Q1Q1 PBPB Q2Q2 PSPS

29. 29 Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (a) Inelastic Supply Price 0Quantity Demand Supply Size of tax When supply is relatively inelastic, the deadweight loss of a tax is small.

30. 30 Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (b) Elastic Supply Price 0 Quantity Demand Supply Size of tax When supply is relatively elastic, the deadweight loss of a tax is large.

31. 31 Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western Demand Supply (c) Inelastic Demand Price 0 Quantity Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small.

32. 32 Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (d) Elastic Demand Price 0 Quantity Size of tax Demand Supply When demand is relatively elastic, the deadweight loss of a tax is large.

33. 33 Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Copyright © 2004 South-Western Tax revenue Demand Supply Quantity 0 Price Q1Q1 (a) Small Tax Deadweight loss PBPB Q2Q2 PSPS

34. 34 Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Copyright © 2004 South-Western Tax revenue Quantity 0 Price (b) Medium Tax PBPB Q2Q2 PSPS Supply Demand Q1Q1 Deadweight loss

35. 35 Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Copyright © 2004 South-Western Tax revenue Demand Supply Quantity 0 Price Q1Q1 (c) Large Tax PBPB Q2Q2 PSPS Deadweight loss

36. 36 Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax Copyright © 2004 South-Western (a) Deadweight Loss Deadweight Loss 0 Tax Size

37. Price # of textbooks per year (in millions) 100110 $70 $80 $90 S The Impact of a Subsidy When a $20 per textbook subsidy is given to students, the demand for textbooks shifts vertically by the amount of the subsidy ($20). The market price for textbooks rises from $80 to $90. This is the new gross price for students. With the $20 subsidy, buyers now pay a new net price of $70 per text, $10 less than before. Text book buyers only get $10 of the benefits stemming from the subsidy; the supply side of the market enjoys the other $10 of the subsidy in the form of higher textbook prices. D 1 D2D2 (D 1 plus subsidy) $20 subsidy new gross price new net price P 2 = P 1 =

38. The average tax rate equals tax liability divided by taxable income. –A progressive tax is one in which the average tax rate rises with income. –A proportional tax is one in which the average tax rate stays the same across income levels. –A regressive tax is one in which the average tax rate falls with income. Average Tax Rate

39. Marginal tax rate: calculated as the change in tax liability divided by the change in taxable income. The marginal tax rate is highly important because it determines how much of an additional dollar of income must be paid in taxes (and so, how much one gets to keep). In this way, the marginal tax rate directly impacts an individual’s incentive to earn. Marginal Tax Rate

40. 40 Ronald Reagan’s Deadweight Loss I came into the Big Money making pictures during WWII. You could only make four pictures and then you were in the top bracket. So we all quit working after four pictures and went off to the country.

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42. At a tax rate of 0%, tax revenues would also be equal to $0. Tax rate (percent) Tax revenues 25 As the tax rates increase from 0% to some level A, tax revenues increase despite the fact some individuals choose not to work. 50 75 100 At a tax rate of 100%, nobody would work, and thus, tax revenues would be equal to $0. After some level B, increases in tax rates actually cause tax revenues to fall. As tax rates approach level C, tax revenues continue to fall. This is because the tax base shrinks faster than the increased revenues from higher tax rates. There is no presumption that the level of taxes at B is the ideal tax rate, only that B maximizes the tax revenue in the current period. Maximum The Laffer Curve A C B

43. 43 1980 1990 87 192 153 58 149 153 Changes in Taxes Paid in the 1980s Personal Income Taxes Paid (by group, billions of 1982-1984 $) Top 1% Top 10% Other 90%