6/5/2014crc microeconomics1. 6/5/2014crc microeconomics2 what did you study last time? chapter 5...

04/10/23 CRC Microeconomics 1

04/10/23 CRC Microeconomics 2

What did you study last time?

Chapter 5Elasticities & Applications

Elasticities Applications

04/10/23 CRC Microeconomics 3

Do you know …

how governments control prices in markets?

what happens when governments impose taxes on markets?

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I. How do governments control prices in markets?

By imposing price ceilings. By imposing price floors.

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A. Price ceilings

What is a price ceiling? What are the consequences of a

price ceiling? Examples of price ceilings

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1. What is a price ceiling (Pc)?

A legal maximum on the price at which a good can be sold.

A price ceiling is not binding if it is higher than the market equilibrium price (Pe).

It is binding if it is lower than Pe.

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Price ceiling (Pc)

P

Q

S

D

EPe=$6

Qe = 60

The demand-supply diagram below shows a market.

$2

20

If the market is free, without any government intervention,

the market will eventually settle at E, with Pe and Qe

being the equilibrium price and quantity.

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Price ceiling (Pc)

P

Q

S

D

EPe=$6

Qe = 60

Now suppose that the government imposes a price ceiling at $8, i.e. Pc = $8.

$2

20

Since Pc = $8 > Pe, this price ceiling does not affect themarket. It is not binding. (The market just ignores it.)

Pc=$8

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Price ceiling (Pc)

P

Q

S

D

EPe=$6

Qe = 60

Now suppose that the government imposes a price ceiling at $4, Pc = $4.

$2

20

Since Pc = $4 < Pe, the market is affected.This price ceiling is binding.

Pc=$4

There is a shortage, which will exist indefinitelyas long as Pc < Pe.

Shortage

The market is inefficient. Resources are misallocated.

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2. What are the consequences of a binding price ceiling?

A perpetual shortage in the market.

Long lines. Discrimination according to

sellers’ bias. Inefficiency and inequity.

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3. Some examples of price ceilings

The U.S. market for gasoline in 1973.

Rent controls.

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U.S. gasoline market

P

Q

S

D

Qe

The demand-supply diagram below showed the U.S.gasoline market in 1973 with a nonbinding price ceiling.

Pc

PeE

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U.S. gasoline market

P

Q

S

D

Qe

In 1973, OPEC raised the price of crude oil in worldmarkets. That caused the U.S. supply of gasoline to fall.

Pc

Pe

S’

E

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U.S. gasoline market

P

Q

S

D

Qe

Pc

Shortage

S’

Pe

The previously nonbinding price ceiling became binding.There were long lines at gas pumps across the country.

E’

E

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R RS S

D DQ Q

Short Run Long Run

Rent controls in the short run and in the long run

In the short run, the demand for and supply of rental units are inelastic.In the long run, both demand and supply are elastic.

A rent control, or price ceiling would cause a small shortage in the short run,but a larger shortage in the long run.

ShortageShortage

Pc

In the end, tenants pay lower rents for low-quality housing.

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B. Price floors

What is a price floor? What are the consequences of a

price floor? Examples of price floors

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1. What is a price floor (Pf)?

A legal minimum on the price at which a good can be sold.

A price floor is not binding if it is lower than the market equilibrium price (Pe).

It is binding if it is higher than Pe.

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Price floor (Pf)

P

Q

S

D

EPe=$6

Qe = 60

The demand-supply diagram below shows a market.

$2

20

If the market is free, without any government intervention,

the market will eventually settle at E, with Pe and Qe

being the equilibrium price and quantity.

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Price floor (Pf)

P

Q

S

D

EPe=$6

Qe = 60

Now suppose that the government imposes a price floor at $4, i.e. Pf = $4.

$2

20

Since Pf = $4 < Pe, this price floor does not affect themarket. It is not binding. (The market just ignores it.)

Pf=$4

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Price floor (Pf)

P

Q

S

D

EPe=$6

Qe = 60

Now suppose that the government imposes a price floor at $8, Pf = $8.

$2

20

Since Pf = $8 > Pe, the market is affected.This price floor is binding.

Pf=$8

There is a surplus, which will exist indefinitelyas long as Pf > Pe.

The market is inefficient. Resources are misallocated.

Surplus

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2. What are the consequences of a binding price floor?

A perpetual surplus in the market. Inefficiency and inequity.

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3. Some examples of price floors

The minimum wage. Price supports for agricultural

products, e.g. milk, cotton, etc.

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The minimum wage (Pf)

W

QL

S

D

EPe=$6

Qe = 30

The demand-supply diagram below shows a marketfor non- and low-skilled workers.

$2

10

Without government intervention, workers wouldearn $6/hr. The total employment is 30 million.

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The minimum wage (Pf)

W

QL

S

D

EPe=$6

Qe = 30

Now suppose that the government sets a minimum wage,or price floor at $8, i.e. Wm = Pf = $8.

$2

10

There is a surplus of labor, which is also calledunemployment, because Qd = 20 < Qs = 40.

Pf=$8

Surplus

Some workers would lose their jobs due to the laws,while some others would not be able to find jobs.

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Price support (Pf)

P

Qm

S

D

EPe=$1.5

Qe = 30

The demand-supply diagram below shows a marketfor milk.

$.5

10

Without government intervention, milk would be sold at$1.5/gallon. The total amount sold is 30 million gallons.

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Price support (Pf)

P

Qm

S

D

EPe=$1.5

Qe = 30

Now suppose that the government sets a price floor,at $2, i.e. Pf = $2.

$.5

10

There is a surplus of milk, because Qd = 20 < Qs = 40.

Pf=$2

Surplus

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Price support (Pf)

P

Qm

S

D

EPe=$1.5

Qe = 30

If the government buys the surplus, milk buyers, whoare also taxpayers, would be hurt twice.

$.5

10

They would pay higher price for milk, and pay taxesso the government could buy the surplus milk.

Pf=$2

Surplus

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C. Are price controls good or bad?

Price controls often hurt those they are trying to help.

When policymakers set prices by legal decrees, they often obscure the signals that normally guide the allocation of society’s scarce resources.

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C. Are price controls good or bad?

Helping those in need can be accomplished in ways other than controlling prices.

e.g. rent subsidies to poor families, and

wage subsidies (earned income tax credit) to the working poor.

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II. What are the effects of taxes on markets?

Important points about taxes Potential impacts of taxes Taxes on buyers vs. taxes on

sellers Tax incidence (the share of tax

burden)

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1. Important points about taxes

Why taxes? Governments levy taxes to raise revenue for public projects, e.g. roads, schools, national defense, etc.

Taxes affect markets in many ways.

Tax incidence: the study of who bear the tax burden.

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2. Potential impacts of taxes

Taxes discourage market activities.

Taxes result in changes of market equilibrium.

When a good is taxed, the quantity sold is smaller.

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2. Potential impacts of taxes

Buyers and sellers share the tax burden.

Generally, buyers pay more, and sellers receive less.

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3. Taxes on buyers vs. taxes on sellers

A tax on buyers shifts the demand curve downward by the tax amount.

A tax on sellers shifts the supply curve upward by the tax amount.

It does not matter on whom the tax is levied, the outcomes are the same.

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a. A tax (t) on buyers

P

Q

S

D

EPe=$6

Qe = 60

The demand-supply diagram below shows a market.

$2

20

If the market is free, without any government intervention,

the market will eventually settle at E, with Pe and Qe

being the equilibrium price and quantity.

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a. A tax (t) on buyers

P

Q

S

D

EPe=$6

Qe = 60

Now suppose that the government imposes a tax of $4 on buyers in the market, i.e. t = $4.

$2

20

The tax shifts the demand curve downward by $4.

DtDt

Et

Sellers now receive $4 per unit, while buyers pay$4 + $4 = $8 per unit.

Ps=$4

Pd=$8

Quantity sold in the market falls to 40 units.

Qt = 40

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a. A tax (t) on buyers

P

Q

S

D

EPe=$6

Qe = 60

The government collects $4x40 = $160 in tax revenue.

$2

20 DtDt

Et

Of the tax amount, buyers pay Td = ($8-$6)x40 = $80, and sellers pay Ts = ($6-$4)x40 = $80.

Ps=$4

Pd=$8

Qt = 40

GTRTd

Ts

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b. A tax (t) on sellers

P

Q

S

D

EPe=$6

Qe = 60

The demand-supply diagram below shows a market.

$2

20

If the market is free, without any government intervention,

the market will eventually settle at E, with Pe and Qe

being the equilibrium price and quantity.

04/10/23 CRC Microeconomics 39

b. A tax (t) on sellers

P

Q

S

D

EPe=$6

Qe = 60

Now suppose that the government imposes a tax of $4 on sellers in the market, i.e. t = $4.

$2

20

The tax shifts the supply curve upward by $4.

St

Et

Sellers now receive $8- $4 = $4 per unit, while buyers pay $8 per unit.

Ps=$4

Pd=$8

Quantity sold in the market falls to 40 units.

Qt = 40

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b. A tax (t) on sellers

P

Q

S

D

EPe=$6

Qe = 60

The government collects $4x40 = $160 in tax revenue.

$2

20

St

Et

Of the tax amount, buyers pay Td = ($8-$6)x40 = $80, and sellers pay Ts = ($6-$4)x40 = $80.

Ps=$4

Pd=$8

The outcomes are identical to the case where taxesare levied on buyers.

Qt = 40

GTRTd

Ts

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c. The general case of a tax

P

Q

S

D

EPe=$6

Qe = 60

The demand-supply diagram below shows a market.

$2

20

If the market is free, without any government intervention,

the market will eventually settle at E, with Pe and Qe

being the equilibrium price and quantity.

04/10/23 CRC Microeconomics 42

c. The general case of a tax

P

Q

S

D

EPe=$6

Qe = 60

Now suppose that the government imposes a tax of $4 on the market, i.e. t = $4.

$2

20

Determine the tax amount as the vertical distancebetween the supply and demand curve.

t

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c. The general case of a tax

P

Q

S

D

EPe=$6

Qe = 60

After the tax, the price paid by buyers is Pd = $8.The price received by sellers is Ps = $8 - $4 = $4.

$2

20

Quantity sold falls to Qt = 40 units.

t

Ps=$4

Pd=$8

Qt = 40

04/10/23 CRC Microeconomics 44

c. The general case of a tax

P

Q

S

D

EPe=$6

Qe = 60

GTR = $4 x 40 = $160

$2

20

Td = $80, and Ts = $80. GT = Td + Ts.

t

Ps=$4

Pd=$8

Qt = 40

GTRTd

Ts

The market produces less due to the tax, becominginefficient.

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4. Tax incidence

Lawmakers can decide whether a tax comes from the buyers’ pockets or the sellers’, but they cannot legislate the true burden of the tax, which depends on the forces of supply and demand.

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4. Tax incidence

The tax burden depends on the relative elasticity of supply and demand. It falls more heavily on the side of the market that is less elastic (i.e. more inelastic).

Rule of thumb: more inelastic => more taxes.

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4. Tax incidence

Examples: Payroll taxes: More taxes paid by

workers because Ed < Es. Taxes on luxury items: More taxes

paid by sellers because Es < Ed.

04/10/23 CRC Microeconomics 48

Summary

Government intervention in markets by price controls results in inefficiency.

Government intervention in markets by taxes, in most cases, also result in inefficiency.

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Now you know …

how governments control prices in markets.

what happens when governments impose taxes on markets.

04/10/23 CRC Microeconomics 50

What will you study next time?

Chapter 7Market Efficiency

Consumer surplus Producer surplus Market efficiency

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