Taxes, MC pricing, and a wrap-up of supply/demand

Today: Finishing the basic ideas of supply and demand

theory

From subsidies to taxes to MC pricing Last time, we saw that a subsidy did not

work to help high rent in Isla Vista Today, we talk more generally about a

negative subsidy, which is called a tax After taxes, we will talk about MC

pricing Once these topics are done, we will

spend the remaining time reviewing Econ 1 thus far

Taxes Governor Arnold

Schwarzenegger below

Three major reasons to charge taxes Revenue generation The prevention of

harming the environment or other people (see also Externalities, Ch. 12)

Limitation of imports (see also Trade, Ch. 9)

An example: A $1 tax on flashlight suppliers

Before tax: Price is $8.80, and 8 flashlights sold

An example: A $1 tax on flashlight suppliers

With tax: Suppliers must add $1 in additional costs for each flashlight sold

An example: A $1 tax on flashlight suppliers

With tax: New equilibrium

price paid is $9.20 by consumers

New equilibrium revenue kept by suppliers, $8.20

An example: A $1 tax on flashlight suppliers Who “pays” for

the tax? Consumers pay

$0.40 more than before

Suppliers receive $0.60 less than before

What happens with a $1 tax? Summary

Lower quantity sold

Consumers pay more money per unit sold

Sellers receive less money per unit sold

Deadweight loss

Deadweight loss is economic surplus that we lose by the imposition of a tax

To determine deadweight loss, we need to find surplus and tax revenue generated by tax

Any potential surplus not realized is deadweight loss

Surplus and deadweight loss Consumer

surplus (top Δ) Producer surplus

(bottom Δ) Tax revenue

generated (rectangle)

Deadweight loss (right Δ)

Elasticity matters for deadweight loss

An example The smaller the price elasticity of

supply, the smaller the deadweight loss

See Figures 7.16 and 7.17 for visual examples

Marginal cost pricing of public services Governments often provide (or contract

to a private firm) some “essential” services to residents

Back to MB = MC idea

Remember 1st lecture Surplus is typically maximized when

MB = MC Even though services are publicly

provided, MB = MC still applies

Example

Electricity 8 Mwh can be provided by coal @

3¢/Kwh 20 Mwh can be provided by natural gas

@ 5¢/Kwh 10 Mwh can be provided by wind

power @ 9¢/Kwh 6 Mwh can be provided by solar power

@ 15¢/Kwh

Example 8 Mwh (coal) @

3¢/Kwh 20 Mwh (natural gas)

@ 5¢/Kwh 10 Mwh (wind

power) @ 9¢/Kwh 6 Mwh (solar power)

@ 15¢/Kwh

Suppose that at a price of 9¢/Kwh, 30 Mwh were demanded

All coal capacity and natural gas capacity can be used, and 2 Mwh provided by wind

MC pricing tells us to charge 9 ¢/Kwh in order to maximize surplus

Wrap-up and review of supply, demand, and equilibrium We have talked

about many topics related to supply, demand, and equilibrium thus far

Utility Surplus Cost curves Elasticity Price controls Taxes and

subsidies Voluntary

incentives

Wrap-up and review of supply, demand, and equilibrium

In general, we have analyzed efficiency MB = MC principle

Some policies prevent MB = MC principle, lowering efficiency Rent control Taxes and subsidies First-come, first-served

Wrap-up and review of supply, demand, and equilibrium

Many future topics build off of what we have learned thus far

It is important to make sure that you understand the foundation of microeconomics, which we have covered the last three weeks

Marginal analysis

Remember that averages are sometimes important in economics

Marginals are almost always important

Some later topics include why markets sometimes fail Marginal analysis will continue to be

important

Supply, demand, and equilibrium

Remaining time today Your chance to ask questions before

we move on to more advanced topics Review of key equations, tables, and

figures

Energy drinks

# of drinks Total benefit ($) MB ($) Avg. benefit

0 0 N/A5

1 5 53

2 8 4

2.53 10.5 3.5

1.54 12 3

-15 11 2.2

Cost is $2 per drink We should buy the third

energy drink since MB > MC (2.5 > 2)

We should not buy the fourth energy drink since MB < MC (1.5 < 2)

Note that we are NOT maximizing avg. benefit

Supply and Demand

Shift in demand/Movement along the supply curve

The demand curve shifted to the right

There is a movement along the supply curve, since supply does not change

MU of bananas: How many would you eat if they were free?

Banana quantity (bananas/hour)

Total utility (utils/hour)

Marginal utility (utils/banana)

0 0

70

1 70

50

2 120

30

3 150

10

4 160

-10

5 150

From individual demand…

…to market demand

CS from demand curves P = $3 Height of triangle

is ($6 – $3), or $3. Length of triangle

is (6 – 0), or 6 Area of triangle is

one-half times length times height

CS = $9

The area of this triangle is a good approximation of CS

Supply and profits

At P1 positive profits, since TR > TC (P Q > ATC Q)

At P2 negative profits

At P3 firm shuts down (TR is less than VC for all Q)

Marginal analysis: Hire 4 workers/day if phones are $18

# of empl./day

Phones per day

Fixed cost ($/day)

Var. cost ($/day)

Total cost ($/day)

MC ($/phone)

0 0 1000 0 1000

5.00

1 20 1000 100 1100

4.00

2 45 1000 200 1200

10.00

3 55 1000 300 1300

12.50

4 63 1000 400 1400

20.00

5 67 1000 500 1500

(Remember: Check shutdown condition)

Example of producer surplus When P = 25 per

unit, shaded area is producer surplus

Area is a triangle, one-half times length times height: 0.5 10 25 = 125

Price elasticity of demand Calculated by the

percentage change in quantity divided by the percentage change in price

P

QElasticity

%

%

Alternate version for straight-line demand curves

Slope on straight line is ΔP/ΔQ Along a straight line, elasticity is also equal

to P/Q times inverse of the slope (see above)

slopeQ

P

P

Q

Q

P

PP

QQ 1

/

/

Bumper crop of strawberries: Not always good ε = 0.29 inelastic Expenditure goes

DOWN moving from S1 to S2

The bumper crop of strawberries actually hurts farmers collectively

Long-run consequences of rent control: Excess demand Notice that

supplied apartments for rent are cut in half in the long run with rent control

Only 1/3 of the people that want apartments will get them

($100s)

100s units

12

24excess demand

Price ceiling at G: Red triangle is deadweight loss Total surplus is

trapezoid ADFE (at most)

ΔCEF is potential surplus that is never gained

A $1 tax on flashlight suppliers Who “pays” for

the tax? Consumers pay

$0.40 more than before

Suppliers receive $0.60 less than before

Surplus and deadweight loss Consumer

surplus (top Δ) Producer surplus

(bottom Δ) Tax revenue

generated (rectangle)

Deadweight loss (right Δ)