1. Chapter 9 The Analysis of Competitive Markets

2. ©2005 Pearson Education, Inc. Chapter 92 Topics to be Discussed Evaluating the Gains and Losses from Government Policies The Efficiency of a Competitive Market Minimum Prices Price Supports and Production Quotas Import Quotas and Tariffs The Impact of a Tax or Subsidy

3. ©2005 Pearson Education, Inc. Chapter 93 Consumer and Producer Surplus When government controls price, some people are better off.  May be able to buy a good at a lower price But, what is the effect on society as a whole?  Is total welfare higher or lower and by how much? A way to measure gains and losses from government policies is needed

4. ©2005 Pearson Education, Inc. Chapter 94 Consumer and Producer Surplus 1.Consumer surplus is the total benefit or value that consumers receive beyond what they pay for the good.  Assume market price for a good is $5  Some consumers would be willing to pay more than $5 for the good  If you were willing to pay $9 for the good and pay $5, you gain $4 in consumer surplus

5. ©2005 Pearson Education, Inc. Chapter 95 Consumer and Producer Surplus The demand curve shows the willingness to pay for all consumers in the market Consumer surplus can be measured by the area between the demand curve and the market price Consumer surplus measures the total net benefit to consumers

6. ©2005 Pearson Education, Inc. Chapter 96 Consumer and Producer Surplus 2.Producer surplus is the total benefit or revenue that producers receive beyond what it cost to produce a good.  Some producers produce for less than market price and would still produce at a lower price  A producer might be willing to accept $3 for the good but get $5 market price  Producer gains a surplus of $2

7. ©2005 Pearson Education, Inc. Chapter 97 Consumer and Producer Surplus The supply curve shows the amount that a producer is willing to take for a certain amount of a good Producer surplus can be measured by the area between the supply curve and the market price Producer surplus measures the total net benefit to producers

8. ©2005 Pearson Education, Inc. Chapter 98 Consumer and Producer Surplus Between 0 and Q 0 producers receive a net gain from selling each product-- producer surplus. Consumer Surplus Quantity Price S D Q0Q0 5 9 Between 0 and Q 0 consumer A receives a net gain from buying the product-- consumer surplus Producer Surplus 3 QDQD QSQS

9. ©2005 Pearson Education, Inc. Chapter 99 Consumer and Producer Surplus To determine the welfare effect of a governmental policy we can measure the gain or loss in consumer and producer surplus. Welfare Effects  Gains and losses to producers and consumers.

10. ©2005 Pearson Education, Inc. Chapter 910 Consumer and Producer Surplus When government institutes a price ceiling, the price of a good can’t to go above that price. With a binding price ceiling, producers and consumers are affected How much they are affected can be determined by measuring changes in consumer and producer surplus

11. ©2005 Pearson Education, Inc. Chapter 911 Consumer and Producer Surplus When price is held too low, the quantity demanded increases and quantity supplied decreases Some consumers are worse off because can no longer buy the good.  Decrease in consumer surplus Some consumers better off because can buy it at a lower price.  Increase in consumer surplus

12. ©2005 Pearson Education, Inc. Chapter 912 Consumer and Producer Surplus Producers sell less at a lower price Some producers are no longer in the market Both of these producer groups lose and producer surplus decreases The economy as a whole is worse off since surplus that used to belong to producers or consumers is simply gone

13. ©2005 Pearson Education, Inc. Chapter 913 The loss to producers is the sum of rectangle A and triangle C. B A C Consumers that can buy the good gain A Price Control and Surplus Changes Quantity Price S D P0P0 Q0Q0 P max Q1Q1 Q2Q2 Consumers that cannot buy, lose B Triangles B and C are losses to society – dead weight loss

14. ©2005 Pearson Education, Inc. Chapter 914 Price controls and Welfare Effects The total loss is equal to area B + C. The deadweight loss is the inefficiency of the price controls – the total loss in surplus (consumer plus producer) If demand is sufficiently inelastic, losses to consumers may be fairly large  This has greater effects in political decisions

15. ©2005 Pearson Education, Inc. Chapter 915 B A P max C Q1Q1 With inelastic demand, triangle B can be larger than rectangle A and consumers suffer net losses from price controls. S D Price Controls With Inelastic Demand Quantity Price P0P0 Q2Q2

16. ©2005 Pearson Education, Inc. Chapter 916 Price Controls and Natural Gas Shortages From example in Chapter 2, 1975 Price controls created a shortage of natural gas. What was the effect of those controls?  Decreases in surplus and overall loss for society  We can measure these welfare effects from the demand and supply of natural gas

17. ©2005 Pearson Education, Inc. Chapter 917 Price Controls and Natural Gas Shortages QS = 14 + 2PG + 0.25PO  Quantity supplied in trillion cubic feet (Tcf) QD = -5PG + 3.75PO  Quantity demanded (Tcf) PG = price of natural gas in $/mcf PO = price of oil in $/b.

18. ©2005 Pearson Education, Inc. Chapter 918 Price Controls and Natural Gas Shortages Using PO = $8/b and QD G = QS G gives equilibrium values for natural gas  P G = $2/mcf and Q G = 20 Tcf Price ceiling was set at $1/mcf Showing this graphically, we can see and measure the effects on producer and consumer surplus

19. ©2005 Pearson Education, Inc. Chapter 919 B A C The gain to consumers is rectangle A minus triangle B, and the loss to producers is rectangle A plus triangle C. SD 2.00 2.40 Price ($/mcf) Quantity (Tcf) 05101520253018 (P max )1.00 Price Controls and Natural Gas Shortages

20. ©2005 Pearson Education, Inc. Chapter 920 Price Controls and Natural Gas Shortages Measuring the Impact of Price Controls  A = (18 billion mcf) x ($1/mcf) = $18 billion  B = (1/2) x (2 b. mcf) x ($0.40/mcf) = $0.4 billion  C = (1/2) x (2 b. mcf) x ($1/mcf) = $1 billion

21. ©2005 Pearson Education, Inc. Chapter 921 Price Controls and Natural Gas Shortages Measuring the Impact of Price Controls in 1975  Change in consumer surplus = A - B = 18 - 0.4 = $17.6 billion Gain  Change in producer surplus = A + C = 18 + 1 = $19.0 billion Loss  Dead Weight Loss = B + C = 0.4 + 1 = $1.4 billion Loss

22. ©2005 Pearson Education, Inc. Chapter 922 The Efficiency of a Competitive Market In the evaluation of markets, we often talk about whether it reaches economic efficiency  Maximization of aggregate consumer and producer surplus Policies such as price controls that cause dead weight losses in society are said to impose an efficiency cost on the economy

23. ©2005 Pearson Education, Inc. Chapter 923 The Efficiency of a Competitive Market If efficiency is the goal, then you can argue leaving markets alone is the answer However, sometimes market failures occur  Prices fail to provide proper signals to consumers and producers  Leads to inefficient unregulated competitive market

24. ©2005 Pearson Education, Inc. Chapter 924 Types of Market Failures 1.Externalities  Costs or benefits that do not show up as part of the market price (e.g. pollution)  Costs or benefits are external to the market 2.Lack of Information  Imperfect information prevents consumers from making utility-maximizing decisions. Government intervention may be desirable in these cases

25. ©2005 Pearson Education, Inc. Chapter 925 The Efficiency of a Competitive Market Other than market failures, unregulated competitive markets lead to economic efficiency What if the market is constrained to a price higher than the economically efficient equilibrium price?

26. ©2005 Pearson Education, Inc. Chapter 926 B A C Price Control and Surplus Changes Quantity Price S D P0P0 Q0Q0 P min Q1Q1 Q2Q2 When price is regulated to be no lower than P min, the deadweight loss given by triangles B and C results.

27. ©2005 Pearson Education, Inc. Chapter 927 The Efficiency of a Competitive Market Deadweight loss triangles, B and C, give a good estimate of efficiency cost of policies that force price above or below market clearing price. Measuring effects of government price controls on the economy can be estimated by measuring these two triangles

28. ©2005 Pearson Education, Inc. Chapter 928 The Market for Human Kidneys The 1984 National Organ Transplantation Act prohibits the sale of organs for transplantation. What has been the impact of the Act? We can measure this using the supply and demand for kidneys from estimated data.  Supply: QS = 8,000 + 0.2P  Demand: QD = 16,000 - 0.2P

29. ©2005 Pearson Education, Inc. Chapter 929 The Market for Human Kidneys Since sale of organs is not allowed, the amount available depends on the amount donated  Supply of donated kidneys is limited to 8000 The welfare effect of this supply constraint can be analyzed using consumer and producer surplus in the kidney market

30. ©2005 Pearson Education, Inc. Chapter 930 The Market for Human Kidneys Suppliers:  Those who supply them are not paid the market price estimated at $20,000 Loss of surplus equal to area A = $160 million  Some who would donate for the equilibrium price do not in the current market Loss of surplus equal to area C = $40 million  Total consumer loss of A + C = $200 million

31. ©2005 Pearson Education, Inc. Chapter 931 The Market for Human Kidneys Recipients:  Since they do not have to pay for the kidney, they gain rectangle A ($140 million) since price is $0  Those who cannot obtain a kidney lose surplus equal to triangle B ($40 million)  Net increase in surplus of recipients of $160 - $40 = $120 million Dead Weight Loss of C + B = $80 million

32. ©2005 Pearson Education, Inc. Chapter 932 The Market for Human Kidneys Other Inefficiency Cost  Allocation is not necessarily to those who value the kidney’s the most.  Price may increase to $40,000, the equilibrium price, with hospitals getting the price.

33. ©2005 Pearson Education, Inc. Chapter 933 D A and D measure the total value of kidneys when supply is constrained. A C The loss to suppliers Is areas A & C. The Market for Kidneys Quantity Price 4,000 0 $10,000 $30,000 $40,000 8,000 S’ B If kidneys are zero cost, consumer gain would be A minus B. S D 12,000 $20,000

34. ©2005 Pearson Education, Inc. Chapter 934 The Market for Human Kidneys Arguments in favor of prohibiting the sale of organs: 1.Imperfect information about donor’s health and screening 2.Unfair to allocate according to the ability to pay Holding price below equilibrium will create shortages Organs versus artificial substitutes

35. ©2005 Pearson Education, Inc. Chapter 935 Minimum Prices Periodically government policy seeks to raise prices above market-clearing levels.  Minimum wage law  Regulation of airlines  Agricultural policies We will investigate this by looking at the minimum wage legislation

36. ©2005 Pearson Education, Inc. Chapter 936 Minimum Prices When price is set above the market clearing price,  Quantity demanded falls  Suppliers may, however, choose to increase quantity supplied in face of higher prices  This causes additional producer losses equal to the total cost of production above quantity demanded

37. ©2005 Pearson Education, Inc. Chapter 937 Minimum Prices Loses in consumer surplus are still the same  Increased price leading to decreased quantity equals area A  Those priced out of the market lose area B Producer surplus similar  Increases from increased price for units sold equal to A  Losses from drop in sales equal to C

38. ©2005 Pearson Education, Inc. Chapter 938 Minimum Prices What if producers expand production to Q2 from the increased price  Since they only sell Q3, there is no revenue to cover the additional production (Q2-Q3)  Supply curve measures MC of production so total cost of additional production is area under the supply curve for the increased production (Q2-Q3) = area D  Total change in producer surplus = A – C – D

39. ©2005 Pearson Education, Inc. Chapter 939 B A The change in producer surplus will be A - C - D. Producers may be worse off. C D Minimum Prices Quantity Price S D P0P0 Q0Q0 Q3Q3 Q2Q2 P min If producers produce Q 2, the amount Q 2 - Q 3 will go unsold. D measures total cost of increased production not sold

40. ©2005 Pearson Education, Inc. Chapter 940 Minimum Wages Wage is set higher than market clearing wage Decreased quantity of workers demanded Those workers hired receive higher wages Unemployment results since not everyone who wants to work at the new wage can

41. ©2005 Pearson Education, Inc. Chapter 941 B The deadweight loss is given by triangles B and C. C A L1L1 L2L2 Unemployment w min Firms are not allowed to pay less than w min. This results in unemployment. S D w0w0 L0L0 The Minimum Wage L w A is gain to workers who find jobs at higher wage

42. ©2005 Pearson Education, Inc. Chapter 942 Airline Regulation Before 1970, airline industry was heavily regulated by the Civil Aeronautics Board (CAB) During 1976-1981 the airline industry in the U.S. changed dramatically as deregulation lead to major changes. Some airlines merged or went out of business as new airlines entered the industry.

43. ©2005 Pearson Education, Inc. Chapter 943 Airline Regulation Although price in the industry fell considerable (helping consumers), profits did not.  Regulation caused significant inefficiencies and artificially high costs We can show the effects of this regulation by looking at the effects on surplus from the controlled prices

44. ©2005 Pearson Education, Inc. Chapter 944 B A C After deregulation: Prices fell to P O. The change in consumer surplus is A + B. Q3Q3 D Area D is the cost of unsold output. Effect of Airline Regulation Quantity Price S D P0P0 Q0Q0 Q1Q1 P min Q2Q2 Prior to deregulation price was at P min. Production was Q 3 hoping to outsell competitors

45. ©2005 Pearson Education, Inc. Chapter 945 Airline Industry Data

46. ©2005 Pearson Education, Inc. Chapter 946 Airline Industry Data Airline industry data show: 1.Long-run adjustment as the number of carriers increased and prices decreased 2.Higher load factors indicating more efficiency 3.Falling rates 4.Real cost increased slightly (adjusted fuel cost) 5.Large welfare gain

47. ©2005 Pearson Education, Inc. Chapter 947 Price Supports Much of agricultural policy is based on a system of price supports.  Price set by government above free-market level and maintained by governmental purchases of excess supply Government can also increase prices through restricting production, directly or through incentives to producers

48. ©2005 Pearson Education, Inc. Chapter 948 Price Supports What are the impacts on consumers, producers and the federal budget? Consumers  Quantity demanded falls and quantity supplied increases  Government buys surplus  Consumers must pay higher price for the good  Loss in consumer surplus equal to A+B

49. ©2005 Pearson Education, Inc. Chapter 949 Price Supports Producers  Gain since they are selling more at a higher price  Producer surplus increases by A+B+D Government  Cost of buying the surplus which is funded by taxes so indirect cost on consumers  Cost to government = (Q 2 -Q 1 )P S

50. ©2005 Pearson Education, Inc. Chapter 950 Price Supports Government may be able to “dump” some of the goods in the foreign markets  Hurts domestic producers that government is trying to help in the first place Total welfare effect of policy  CS +  PS – Govt. cost = D – (Q 2 -Q 1 )P S Society is worse off over all Less costly to simply give farmers the money

51. ©2005 Pearson Education, Inc. Chapter 951 B D A To maintain a price P s the government buys quantity Q g. D + Q g QgQg Price Supports Quantity Price S D P0P0 Q0Q0 PsPs Q2Q2 Q1Q1 E Net Loss to society is E + B

52. ©2005 Pearson Education, Inc. Chapter 952 Production Quotas The government can also cause the price of a good to rise by reducing supply.  Limitations of taxi medallions in New York City  Limitation of required liquor licenses for restaurants

53. ©2005 Pearson Education, Inc. Chapter 953 B A CS reduced by A + B Change in PS = A - C Deadweight loss = BC C Supply Restrictions Quantity Price D P0P0 Q0Q0 S S’ PSPS Q1Q1 Supply restricted to Q 1 Supply shifts to S’ @ Q 1

54. ©2005 Pearson Education, Inc. Chapter 954 Supply Restrictions Incentive Programs  US agricultural policy uses production incentives instead of direct quotas  Government gives farmers financial incentives to restrict supply Acreage limitation programs  Quantity decreases and price increases for the crop

55. ©2005 Pearson Education, Inc. Chapter 955 Supply Restrictions Incentive Program  Gain in PS of A from increased price of amount sold  Loss of PS of C from decreased production  Government pays farmers not to produce  Total  PS = A – C + payments from Govt.  Government must pay enough to keep producers from producing more at the higher price  Equals B+C+D

56. ©2005 Pearson Education, Inc. Chapter 956 B A CS reduced by A + B C Supply Restrictions Quantity Price D P0P0 Q0Q0 S S’ Q1Q1 Cost to government = B + C + D = additional profit made if producing Q 0 at P S PSPS D Change in PS = A + B + D

57. ©2005 Pearson Education, Inc. Chapter 957 Supply Restrictions Which program is more costly?  Both programs have same loss to consumers  Producers are indifferent between programs because end up with same amount in both  Typically acreage limitation program costs society less than price supports maintained by government purchases  However, society better off if government would just give farmers cash

58. ©2005 Pearson Education, Inc. Chapter 958 Supporting the Price of Wheat From previous example, the supply and demand for wheat in 1981 was  Supply: Qs = 1,800 + 240P  Demand: QD = 3,550 - 266P  Equilibrium price and quantity was $3.46 and 2,630 million bushels Government raised the price to $3.70 through government purchases

59. ©2005 Pearson Education, Inc. Chapter 959 Supporting the Price of Wheat How much would the government had to buy to keep price at $3.70  Q DTotal = Q D + Q G = 3,550 -266P + Q G  Q S = Q DT 1,800 + 240P = 3,550 - 266P + Q G Q G = 506P -1,750 At a price of $3.70, government would buy Q G = (506)(3.70) -175=122 million bushels

60. ©2005 Pearson Education, Inc. Chapter 960 D + Q g By buying 122 million bushels the government increased the market-clearing price. 2,688 A B C QgQg P 0 = $3.70 AB consumer loss ABC producer gain S D P 0 = $3.46 2,6301,800 The Wheat Market in 1981 Quantity Price 2,566

61. ©2005 Pearson Education, Inc. Chapter 961 Supporting the Price of Wheat We can quantify the effects on CS  The change in consumer surplus = (-A -B) A = (3.70 - 3.46)(2,566) = $616 million B = (1/2)(3.70-3.46)(2,630-2,566) = $8 million   CS = -$624 million.

62. ©2005 Pearson Education, Inc. Chapter 962 Supporting the Price of Wheat Cost to the government:  $3.70 x 122 million bushels = $451.4 million  Total cost of program = $624 + 451 = $1,075 million Gain to producers  A + B + C = $638 million  Government also paid 30 cents/bushel = $806 million

63. ©2005 Pearson Education, Inc. Chapter 963 Supporting the Price of Wheat In 1985, the situation became worse  Export demand fell and the market clearing price of wheat fell to $1.80/bushel.  Equilibrium quantity was 2231  The actual price, however, was $3.20  To keep price at $3.20, the government had to purchase excess wheat  Government also imposed a production quota of about 2425 million bushels

64. ©2005 Pearson Education, Inc. Chapter 964 Supporting the Price of Wheat 1985 Government Purchase:  2,425 = 2,580 - 194P + QG  QG = -155 + 194P  P = $3.20 -- the support price  QG = -155 + 194($3.20) = 466 million bushels

65. ©2005 Pearson Education, Inc. Chapter 965 The Wheat Market in 1985 Price Quantity 1,800 S D P 0 = $1.80 2,232 To increase the price to $3.20, the government bought 466 million bushels and imposed a production quota of 2,425 bushels. D + Q S 1,959 S’S’ 2,425 P 0 = $3.20 QSQS

66. ©2005 Pearson Education, Inc. Chapter 966 Supporting the Price of Wheat 1985 Government Cost:  Purchase of Wheat = $3.20 x 466 = $1,491 million  80 cent subsidy =.80 x 2,425 = $1,940 million  Total government program cost = $3.5 billion

67. ©2005 Pearson Education, Inc. Chapter 967 Supporting the Price of Wheat 1996 Congress passed the Freedom to Farm law  Goal was to reduce the role of government and make agriculture more market oriented  Eliminated production quotas, gradually reduced government purchases and subsidies through 2003.

68. ©2005 Pearson Education, Inc. Chapter 968 Supporting the Price of Wheat In 2002 Congress and Pres. Bush reversed the effects of the 1996 bill reinstating subsidies for most crops.  Calls for “fixed direct payments”  New bill would cost taxpayers almost $1.1 billion in annual payments to wheat producers alone  2002 farm bill expected to cost taxpayers $190 billion over 10 years Estimated $83 billion over existing programs

69. ©2005 Pearson Education, Inc. Chapter 969 Import Quotas and Tariffs Many countries use import quotas and tariffs to keep the domestic price of a product above world levels  Import quotas: Limit on the quantity of a good that can be imported  Tariff: Tax on an imported good This allows domestic producers to enjoy higher profits Costs to consumers is high

70. ©2005 Pearson Education, Inc. Chapter 970 Import Quotas and Tariffs With lower world price, domestic consumers have incentive to purchase from abroad.  Domestic price falls to world price and imports equal difference between quantity supplied and quantity demanded Domestic industry might convince government to protect industry by eliminating imports  Quota of zero or high tariff

71. ©2005 Pearson Education, Inc. Chapter 971 QSQS QDQD PWPW A BC Quota of zero pushes domestic price to P 0 and imports go to zero. Import Tariff To Eliminate Imports Quantity Price Q0Q0 D P0P0 S In a free market, the domestic price equals the world price P W. Imports Loss to consumers is A+B+C. Gain to producers is A. Dead weight loss: B +C.

72. ©2005 Pearson Education, Inc. Chapter 972 Import Tariff (general case) The increase in price can be achieved by a tariff. Q S increases and Q D decreases Area A is the gain to domestic producers. The loss to consumers is A + B + C + D. DWL = B + C Government Revenue is D = tariff * imports D CB QSQS QDQD Q’ S Q’ D A P* PwPw Q P D S

73. ©2005 Pearson Education, Inc. Chapter 973 Import Quota (general case) If a quota is used, rectangle D becomes part of the profits to foreign producers Consumers lose A+B+C+D Producers gain A Net domestic loss is B + C + D. D CB QSQS QDQD Q’ S Q’ D A P* PwPw Q P D S

74. ©2005 Pearson Education, Inc. Chapter 974 The Sugar Quota Example The world price of sugar has been as low as 4 cents per pound, while in the U.S. the price has been 20-25 cents per pound. Sugar quotas have protected the sugar industry but driven up prices Domestic producers have been better off and so have some foreign producers that have quota rights Consumers are worse off

75. ©2005 Pearson Education, Inc. Chapter 975 The Sugar Quota Example The Impact of a Sugar Quota in 2001  U.S. production = 17.4 billion pounds  U.S. consumption = 20.4 billion pounds  U.S. price = 21.5 cents/pound  World price = 8.3 cents/pound  Price elasticity of US supply = 1.5  Price elasticity of Us demand is –0.3

76. ©2005 Pearson Education, Inc. Chapter 976 Impact of Sugar Quota The data can be used to fit the US supply and demand curves  QS = -8.70+ 1.21P  QD = 26.53 - 0.29P  World price was 24.2 million pounds leading to little domestic supply and most domestic consumption coming from large imports  Government restricted imports to 3 billion pounds raising price to 21.5 cents/pound

77. ©2005 Pearson Education, Inc. Chapter 977 Sugar Quota in 1997 C D B A The cost of the quotas to consumers was A + B + C + D = $2.4b. The gain to producers was area A = $1b. S US D US Price (cents/lb.) 4 8 11 16 20 P W = 8.3 before quota P US = 21.5 after quota Quantity (billions of pounds) 24.2 1.4 17.420.4

78. ©2005 Pearson Education, Inc. Chapter 978 The Impact of a Tax or Subsidy The government wants to impose a $1.00 tax on movies. It can do it two ways  Make the producers pay $1.00 for each movie ticket they sell  Make consumers pay $1.00 when they buy each movie In which option are consumers paying more?

79. ©2005 Pearson Education, Inc. Chapter 979 The Impact of a Tax or Subsidy The burden of a tax (or the benefit of a subsidy) falls partly on the consumer and partly on the producer. How the burden is split between the parties depends on the relative elasticities of demand and supply.

80. ©2005 Pearson Education, Inc. Chapter 980 The Effects of a Specific Tax For simplicity we will consider a specific tax on a good  Tax of a particular amount per unit sold  Federal and state taxes on gas and cigarettes For our example, consider a specific tax of $t per widget sold

81. ©2005 Pearson Education, Inc. Chapter 981 Buyers lose A + B Incidence of a Specific Tax D S B D A C Quantity Price P0P0 Q0Q0 Q1Q1 P S price producers get P b price buyers pay Tax = $1.00 Government gains A + D in tax revenue. Sellers lose D + C The deadweight loss is B + C.

82. ©2005 Pearson Education, Inc. Chapter 982 Incidence of a Specific Tax Four conditions that must be satisfied after the tax is in place: 1.Quantity sold and buyers price, P b, must be on the demand curve Buyers only concerned with what they must pay 2.Quantity sold and sellers price, P S, must be on the supply curve Sellers only concerned with what they receive

83. ©2005 Pearson Education, Inc. Chapter 983 Incidence of a Specific Tax Four conditions that must be satisfied after the tax is in place (cont.): 3.Q D = Q S 4.Difference between what consumers pay and what buyers receive is the tax If we know the demand and supply curves as well as the tax, we can solve for P B, P S, Q D and Q S

84. ©2005 Pearson Education, Inc. Chapter 984 Incidence of a Specific Tax In the previous example, the tax was shared almost equally by consumers and producers If demand is relatively inelastic, however, burden of tax will fall mostly on buyers  Cigarettes If supply is relatively inelastic, the burden of tax will fall mostly on sellers

85. Impact of Elasticities on Tax Burdens Quantity Price S D S D Q0Q0 P0P0 P0P0 Q0Q0 Q1Q1 PbPb PSPS t Q1Q1 PbPb PSPS t Burden on Buyer Burden on Seller

86. ©2005 Pearson Education, Inc. Chapter 986 The Impact of a Tax or Subsidy We can calculate the percentage of a tax borne by consumers using pass-through fraction  E S /(E S - E d )  Tells fraction of tax “passed through” to consumers through higher prices  For example, when demand is perfectly inelastic (Ed = 0), the pass-through fraction is 1 – consumers bear 100% of tax.

87. ©2005 Pearson Education, Inc. Chapter 987 The Effects of a Tax or Subsidy A subsidy can be analyzed in much the same way as a tax.  Payment reducing the buyer’s price below the seller’s price It can be treated as a negative tax. The seller’s price exceeds the buyer’s price. Quantity increases

88. ©2005 Pearson Education, Inc. Chapter 988 D S Effects of a Subsidy Quantity Price P0P0 Q0Q0 Q1Q1 PSPS PbPb Like a tax, the benefit of a subsidy is split between buyers and sellers, depending upon the elasticities of supply and demand. Subsidy

89. ©2005 Pearson Education, Inc. Chapter 989 Effects of a Subsidy The benefit of the subsidy accrues mostly to buyers if E d /E S is small. The benefit of the subsidy accrues mostly to sellers if E d /E S is large. As with a tax, using supply and demand curves, and the size of the subsidy, one can solve for resulting prices and quantities.

90. ©2005 Pearson Education, Inc. Chapter 990 A Tax on Gasoline We can measure the effects of a tax by looking at an example of a gasoline tax The goal of a large gasoline tax is  Raise government revenue  Reduce oil consumption and reduce US dependence on oil imports We will consider a gas tax in the market during mid-1990’s

91. ©2005 Pearson Education, Inc. Chapter 991 A Tax on Gasoline Measuring the Impact of a 50 Cent Gasoline Tax  Intermediate-run E P of demand = -0.5 Q D = 150 - 50P  E P of supply = 0.4 Q S = 60 + 40P  Q S = Q D at $1 and 100 billion gallons per year (bg/yr)

92. ©2005 Pearson Education, Inc. Chapter 992 A Tax on Gasoline With a 50 cent tax Q D = Q S 150 - 50P b = 60 + 40P S 150 - 50(P S + 0.50) = 60 + 40P S P S =.72 P b = P S + 0.50 = $1.22 Q D = Q S = 89 bg/yr

93. ©2005 Pearson Education, Inc. Chapter 993 A Tax on Gasoline With a 50 cent tax  Q falls by 11%  Price to consumers increase by 22 cents per gallon  Producers receive about 20 cents per gallon less  Both producers and consumers were opposed to the tax  Government revenue would be significant at $44.5 billion per year

94. ©2005 Pearson Education, Inc. Chapter 994 C D A Impact of a 50 Cent Gasoline Tax Quantity (billion gallons per year) Price ($ per gallon) 50150 100 P 0 = 1.00 P b = 1.22 P S =.72 89 11 The buyer pays 22 cents of the tax, and the producer pays 28 cents. SD 60 $0.50 Tax Consumer Loss = A + B Producer Loss = C + D Government revenue = A + D = 0.50(89) = $44.5 billion. B