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Applications of Supply and Demand
Chapter 4
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Price Controls
• Floor
• Ceilings
Who benefits from each: sellers or buyers?
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Figure 1 A Market with a Price Ceiling
(a) A Price Ceiling That Is Not Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Equilibriumquantity
$4 Priceceiling
Equilibriumprice
Demand
Supply
3
100
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Figure 1 A Market with a Price Ceiling
Copyright©2003 Southwestern/Thomson Learning
(b) A Price Ceiling That Is Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Demand
Supply
2 PriceceilingShortage
75
Quantitysupplied
125
Quantitydemanded
Equilibriumprice
$3
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Price Gouging
• What is the difference between price gouging and acting in accordance with the laws of supply and demand?
• Should it be illegal?
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Rent Control
Ceiling or floor?
Rationale?
One economist called rent control “the best way to destroy a city, other than bombing.”
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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 ofApartments
0
Supply
Controlled rent
RentalPrice of
Apartment
Demand
Shortage
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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
RentalPrice of
Apartment
Quantity ofApartments
Demand
Supply
Controlled rent
Shortage
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• Shortages and black markets will develop.• The future supply of housing will decline.• The quality of housing will deteriorate.• Non-price methods of rationing will
increase in importance.
Effects of Rent Control
• Inefficient use of housing will result.• Long-term renters will benefit at the
expense of newcomers.
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Figure 4 A Market with a Price Floor
Copyright©2003 Southwestern/Thomson Learning
(a) A Price Floor That Is Not Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Equilibriumquantity
2
Pricefloor
Equilibriumprice
Demand
Supply
$3
100
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Figure 4 A Market with a Price Floor
Copyright©2003 Southwestern/Thomson Learning
(b) A Price Floor That Is Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Demand
Supply
$4Pricefloor
80
Quantitydemanded
120
Quantitysupplied
Equilibriumprice
Surplus
3
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Minimum Wage
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Figure 5 How the Minimum Wage Affects the Labor Market
Copyright©2003 Southwestern/Thomson Learning
Quantity ofLabor
Wage
0
Labordemand
LaborSupply
Equilibriumemployment
Equilibriumwage
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Figure 5 How the Minimum Wage Affects the Labor Market
Copyright©2003 Southwestern/Thomson Learning
Quantity ofLabor
Wage
0
LaborSupplyLabor surplus
(unemployment)
Labordemand
Minimumwage
Quantitydemanded
Quantitysupplied
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Taxes & Subsidies
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Figure 6 A Tax on Buyers
Copyright©2003 Southwestern/Thomson Learning
Quantity ofIce-Cream Cones
0
Price ofIce-Cream
Cone
Pricewithout
tax
Pricesellersreceive
Equilibrium without taxTax ($0.50)
Pricebuyers
pay
D1
D2
Supply, S1
A tax on buyersshifts the demandcurve downwardby the size ofthe tax ($0.50).
$3.30
90
Equilibriumwith tax
2.803.00
100
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Figure 7 A Tax on Sellers
Copyright©2003 Southwestern/Thomson Learning
2.80
Quantity ofIce-Cream Cones
0
Price ofIce-Cream
Cone
Pricewithout
tax
Pricesellersreceive
Equilibriumwith tax
Equilibrium without tax
Tax ($0.50)
Pricebuyers
payS1
S2
Demand, D1
A tax on sellersshifts the supplycurve upwardby the amount ofthe tax ($0.50).
3.00
100
$3.30
90
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Figure 9 How the Burden of a Tax Is Divided
Copyright©2003 Southwestern/Thomson Learning
Quantity0
Price
Demand
Supply
Tax
Price sellersreceive
Price buyers pay
(a) Elastic Supply, Inelastic Demand
2. . . . theincidence of thetax falls moreheavily onconsumers . . .
1. When supply is more elasticthan demand . . .
Price without tax
3. . . . than on producers.
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Figure 9 How the Burden of a Tax Is Divided
Copyright©2003 Southwestern/Thomson Learning
Quantity0
Price
Demand
Supply
Tax
Price sellersreceive
Price buyers pay
(b) Inelastic Supply, Elastic Demand
3. . . . than onconsumers.
1. When demand is more elasticthan supply . . .
Price without tax
2. . . . theincidence of the tax falls more heavily on producers . . .
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Tax Revenue
If tax is $T per unit, tax revenue equals …
TQ
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Figure 2 Tax Revenue
Copyright © 2004 South-Western
Taxrevenue (T × Q)
Size of tax (T)
Quantitysold (Q)
Quantity0
Price
Demand
Supply
Quantitywithout tax
Quantitywith tax
Price buyerspay
Price sellersreceive
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Recall …
Consumer Surplus:
Area under demand curve and above price line.
Producer Surplus:
Area above supply curve and below price line.
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Figure 3 How a Tax Effects Welfare
Copyright © 2004 South-Western
A
F
B
D
C
E
Quantity0
Price
Demand
Supply
= PB
Q2
= PS
Pricebuyers
pay
Pricesellers
receive
= P1
Q1
Pricewithout tax
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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.
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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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Tax rate(percent)
Tax revenues
25
50
75
100
Maximum
The Laffer Curve
A
C
B
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• 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
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• Marginal tax rate: calculated as the change in tax liability divided by the change in taxable income.
• What is the tax on the last dollar earned?
Marginal Tax Rate
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Marginal Tax Rate2003 Tax Table Continued
If line 40(taxableincome) is
And you are
Atleast
Butlessthan
Single Marriedfilingjointly
Marriedfilingseparately
Head of a house-hold
$32,000
Your tax is …
32000320503210032150
32200322503230032350
32400324503250032550
32050321003215032200
32250323003235032400
32450325003255032600
4816482948414854
4866487948914904
4916492949414954
4101411141194126
4134414141494156
4164417141794186
4816482948414854
4866487948914904
4916492949414954
4304431143194326
4334434143494356
4364437143794386
• An excerpt from the 2003 federal income tax table is shown here.• Note, for single individuals,
as income increases from $32,000 to $32,100 …
• In this range, what is the individual’s marginal tax rate?
• What is the individual’s average income tax rate?
their tax liability increases from $4,816 to $4,841.