lecture notes: econ 203 introductory microeconomics lecture/chapter 6: supply, demand and govt....
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Lecture Notes: Econ 203 Introductory MicroeconomicsLecture/Chapter 6: Supply, demand and govt. policies
M. Cary LeaheyManhattan College
Fall 2012
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Goals
• This is an applications chapter looking at how well-known govt. policies affect market outcomes.
• By “market outcomes,” we mean the impact of policy on price and quantity-our model’s representation of “truth.”
• Does the policy have different outcomes if it affects consumer rather than producers or demand rather than supply
• We look at the incidence of the tax. By that we mean who bears the burden of the tax. The correct answer might surprise you.
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Two well known govt. policies
• Price controls• Set a price ceiling or a legal maximum on the price of a good or
service. One well known NYC example is rent control
• Taxes• The govt can make buyers/sellers pay a specific extra amount per
unit.
• How can out traditional supply and demand analysis explains the market outcomes-the changes in price and quantity
Example 1: Price control: the market for apartments
Equilibrium w/o price controls
Equilibrium w/o price controls
P
QD
SRental price of
apts
$800
300
Quantity of apts
How price ceilings affect market outcomes, I
A price ceiling above the equilibrium price is not binding— has no effect on the market
outcome.
P
QD
S
$800
300
Price ceiling
$1000
How price ceilings affect market outcomes, II
The equilibrium price ($800) is above the ceiling and therefore illegal.
The ceiling is a binding constraint on the price, causes a shortage.
P
QD
S
$800
Price ceiling
$500
250 400
shortage
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Shortages and rationing
• With shortages, sellers must ration the goods among buyers by a non-price mechanism.
• Non-price rationing is unfair and inefficient—long lines and discrimination. Goods do not go to the buyers who value them most highly.
• Compare this is the (by definition) efficient outcome of the market.
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Example 2: Minimum wage/ the market for unskilled labor
• Remember that the “price’ of labor is the (real) wage rate. So we will use the same analysis for rent control as for the minimum wage
• Some background on the minimum wage.
• The minimum wage is the least amount workers can be paid per hour. The typical minimum wage worker is a younger person without a high school degree. He or she is rarely the only breadwinner in a household.
• The minimum wage is NOT indexed for inflation. So legislators from time to time ask for an increase in the minimum wage to adjust for the past increases in inflation. In other words changes are made to adjust for the fall in the real minimum wage.
• The minimum wage has last increased in 2008 to $7.25. It was fallen about 10% in real terms since it was last increased. It down one third from its peak to $9 (2011) dollars in 1980.
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Example 2: Minimum wage/the market for unskilled labor
Equilibrium w/o price controls
Equilibrium w/o price controls
W
LD
SWage paid to
unskilled workers
$6.00
500
Quantity of unskilled workers
Minimum wage, another price floor, I
W
LD
S
$6.00
500
Price floor
$5.00
A price floor below the equilibrium price is not binding –
has no effect on the market outcome.
Minimum wage, another price floor, II
W
LD
S
$6.00
Price floor
$7.25
The equilibrium wage ($6) is below the floor and therefore illegal.
The floor is a binding constraint on the wage, causes a surplus (i.e., unemployment).
400 550
labor surplus
Min wage laws do not affect highly skilled workers.
They do affect teen workers.
Studies: A 10% increase in the min wage raises teen unemployment by 1–3%.
Minimum wage, another price floor, III
W
LD
S
$6.00
Min. wage
$7.25
400 550
unemp-loyment
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Evaluating price controls
• Price controls distort or drive a wedge in market signals.• They lead to unintended outcomes such as hurting those they
intend to help.• For example, an increased minimum wage will increase income to
low skilled workers but will also increase low skilled employment. How much is open to empirical debate.
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Taxes
• Taxes are levied on both goods and sellers of goods and services• The taxes can be called sales taxes, excise taxes, sin taxes, etc.• The tax can be a % of the sellers price (ad valorem) or a fixed
amount such as state taxes on gasoline. They can also be a lump sum tax or poll tax which is a tax per person. These taxes were more prevalent in colonial times.
• Sometime the revenues are allocated to specific activities.
S1
Example 3: the market for pizza
Equilibrium w/o taxEquilibrium w/o tax
P
Q
D1
$10.00
500
S1
D1
$10.00
500
Example 3; a tax on buyers
The price buyers pay is now $1.50 higher than the
market price P.
P would have to fallby $1.50 to makebuyers willing to buy same Q as before.
E.g., if P falls from $10.00 to $8.50,buyers still willing topurchase 500 pizzas.
P
QD2
Effects of a $1.50 per unit tax on buyers
$8.50
Hence, a tax on buyers shifts the D curve down by the amount of the tax.
Hence, a tax on buyers shifts the D curve down by the amount of the tax.
Tax
S1
D1
$10.00
500
Example 3: a tax on buyers
P
QD2
$11.00PB =
$9.50PS =
Tax
Effects of a $1.50 per unit tax on buyers
New equilibrium:
Q = 450
Sellers receive PS = $9.50
Buyers pay PB = $11.00
Difference between them = $1.50 = tax
450
450
S1
Example 3: the incidence of a tax:how the burden of a tax is shared among market participants
P
Q
D1
$10.00
500
D2
$11.00PB =
$9.50PS =
Tax
In our example,
buyers pay $1.00 more,
sellers get $0.50 less.
S1
Example 3: a tax on sellers
P
Q
D1
$10.00
500
S2
Effects of a $1.50 per unit tax on sellers
The tax effectively raises sellers’ costs by $1.50 per pizza.
Sellers will supply 500 pizzas only if P rises to $11.50, to compensate for this cost increase.
$11.50
Hence, a tax on sellers shifts the S curve up by the amount of the tax. Hence, a tax on sellers shifts the S curve up by the amount of the tax.
Tax
S1
Example 3: a tax on sellers
P
Q
D1
$10.00
500
S2
450
$11.00PB =
$9.50PS =
Tax
Effects of a $1.50 per unit tax on sellers
New equilibrium:
Q = 450
Buyers pay PB = $11.00
Sellers receive PS = $9.50
Difference between them = $1.50 = tax
S1
The outcome is the same in either case
What matters is this:
A tax drives a wedge between the price buyers pay and the price sellers
receive.
P
Q
D1
$10.00
500450
$9.50
$11.00PB =
PS =
Tax
The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers!
Elasticity and tax incidence
CASE 1: Supply is more elastic than demand
P
QD
S
Tax
Buyers’ share of tax burden
Sellers’ share of tax burden
Price if no tax
PB
PS
It’s easier for sellers than buyers to leave the market.
So buyers bear most of the burden of the tax.
It’s easier for sellers than buyers to leave the market.
So buyers bear most of the burden of the tax.
Elasticity and tax incidence
CASE 2: Demand is more elastic than supply
P
Q
D
S
Tax
Buyers’ share of tax burden
Sellers’ share of tax burden
Price if no tax
PB
PS
It’s easier for buyers than sellers to leave the market.
Sellers bear most of the burden of the tax.
It’s easier for buyers than sellers to leave the market.
Sellers bear most of the burden of the tax.
Case study: who pays the luxury tax?
• 1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc.
• Goal: raise revenue from those who could most easily afford to pay—wealthy consumers.
• But who really pays this tax?
Case study: who pays the luxury tax? (II)
The market for yachts
P
Q
D
S
Tax
Buyers’ share of tax burden
Sellers’ share of tax burden
PB
PS
Demand is price-elastic. Demand is price-elastic.
In the short run, supply is inelastic. In the short run, supply is inelastic.
Hence, companies that build yachts pay most of the tax.
Hence, companies that build yachts pay most of the tax.
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Summary
• Price ceiling is a legal maximum of a price of a good or service. One local example is rent control. If the price is below the equilibrium price, then the price is binding and causes a shortage.
• A price floor is a legal minimum on the price of a good or service. One example is the minimum wage, If the price floor is above the equilibrium price, it is binding and causes a surplus (unemployment). A minimum wage causes incomes to increase for those who keep their jobs but also causes unemployment among unskilled workers.
• A tax is a wedge between the price buyers pay and sellers receive, causing equilibrium quantity to fall, regardless on whether it falls on buyers or sellers.
• The incidence or burden of the tax depends on the elasticities of supply and demand. If supply is more elastic, the incidence or burden falls on the buyers rather than the sellers. And vice versa.
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