Post on 20-Dec-2015
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Applications of Supply & Demand
Chapter 4
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Model this using a S & D diagram
• But an even bigger problem is the consumers themselves. That's because subsidies make energy practically free in Iran, discouraging any serious energy conservation. Gasoline, for example, costs about 40 cents a gallon at the pump. That's encouraged an explosion of use, as Iranians add new cars while continuing to use fuel-guzzling old models. It has also encouraged a brisk smuggling trade as Iranians buy millions of gallons of fuel at the subsidized price and truck them into neighboring Pakistan, Turkey, Afghanistan and Iraq for sale at market rates.
• Demand has now far outstripped the country's refinery capacity. The government has shelled out at least $7 billion on gasoline imports alone so far this fiscal year, which ends in March. Much of that money was drawn from the country's rainy-day oil surplus fund, which is supposed to be used only on capital projects or during periods when global oil prices are low.
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WSJ, 20feb07
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Price Controls
• Floor
• Ceilings
Who benefits from each: sellers or buyers?
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
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
Figure 2 The Market for Gasoline with a Price Ceiling
Copyright©2003 Southwestern/Thomson Learning
(a) The Price Ceiling on Gasoline Is Not Binding
Quantity ofGasoline
0
Price ofGasoline
1. Initially,the priceceilingis notbinding . . . Price ceiling
Demand
Supply, S1
P1
Q1
Figure 2 The Market for Gasoline with a Price Ceiling
Copyright©2003 Southwestern/Thomson Learning
(b) The Price Ceiling on Gasoline Is Binding
Quantity ofGasoline
0
Price ofGasoline
Demand
S1
S2
Price ceiling
QS
4. . . . resultingin ashortage.
3. . . . the priceceiling becomesbinding . . .
2. . . . but whensupply falls . . .
P2
QD
P1
Q1
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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.”
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
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
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
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
Figure 5 How the Minimum Wage Affects the Labor Market
Copyright©2003 Southwestern/Thomson Learning
Quantity ofLabor
Wage
0
Labordemand
LaborSupply
Equilibriumemployment
Equilibriumwage
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
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
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
Figure 8 A Payroll Tax
Copyright©2003 Southwestern/Thomson Learning
Quantityof Labor
0
Wage
Labor demand
Labor supply
Tax wedge
Wage workersreceive
Wage firms pay
Wage without tax
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 . . .
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 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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Figure 4 The Deadweight Loss
Copyright © 2004 South-Western
Cost tosellersValue to
buyers
Size of tax
Quantity0
Price
Demand
SupplyLost gainsfrom trade
Reduction in quantity due to the tax
Pricewithout tax
Q1
PB
Q2
PS
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Figure 5 Tax Distortions and Elasticities
Copyright © 2004 South-Western
(a) Inelastic Supply
Price
0 Quantity
Demand
Supply
Size of tax
When supply isrelatively inelastic,the deadweight lossof a tax is small.
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Figure 5 Tax Distortions and Elasticities
Copyright © 2004 South-Western
(b) Elastic Supply
Price
0 Quantity
Demand
SupplySizeoftax
When supply is relativelyelastic, the deadweightloss of a tax is large.
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Figure 5 Tax Distortions and Elasticities
Copyright © 2004 South-Western
Demand
Supply
(c) Inelastic Demand
Price
0 Quantity
Size of taxWhen demand isrelatively inelastic,the deadweight lossof a tax is small.
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Figure 5 Tax Distortions and Elasticities
Copyright © 2004 South-Western
(d) Elastic Demand
Price
0 Quantity
Sizeoftax Demand
Supply
When demand is relativelyelastic, the deadweightloss of a tax is large.
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Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
Copyright © 2004 South-Western
Tax revenue
Demand
Supply
Quantity0
Price
Q1
(a) Small Tax
Deadweightloss
PB
Q2
PS
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Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
Copyright © 2004 South-Western
Tax revenue
Quantity0
Price
(b) Medium Tax
PB
Q2
PS
Supply
Demand
Q1
Deadweightloss
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Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
Copyright © 2004 South-Western
Tax
rev
enue
Demand
Supply
Quantity0
Price
Q1
(c) Large Tax
PB
Q2
PS
Deadweightloss
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Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax
Copyright © 2004 South-Western
(a) Deadweight Loss
DeadweightLoss
0 Tax Size
Price
# of textbooks per year (in millions)
100 110
$70
$80
$90
S
The Impact of a Subsidy
• When a $20 per textbook subsidy
is given to students, the demand for textbooks shifts vertically by the amount of the subsidy ($20).• The market price for textbooks rises from $80 to $90. This is the new gross price for students.• With the $20 subsidy, buyers now pay a new net price of $70 per text, $10 less than before.
• Text book buyers only get $10 of the benefits stemming from the subsidy; the supply side of the market enjoys the other $10 of the subsidy in the form of higher textbook prices.
D1
D2(D1 plus subsidy)
$20 subsidy
new grossprice
new netprice
P2 =
P1 =
• 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
• Marginal tax rate: calculated as the change in tax liability divided by the change in taxable income.
• The marginal tax rate is highly important because it determines how much of an additional dollar of income must be paid in taxes (and so, how much one gets to keep). In this way, the marginal tax rate directly impacts an individual’s incentive to earn.
Marginal Tax Rate
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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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• At a tax rate of 0%, tax revenues would also be equal to $0.
Tax rate(percent)
Tax revenues
25
• As the tax rates increase from 0% to some level A, tax revenues increase despite the fact some individuals choose not to work.
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75
100• At a tax rate of 100%, nobody would work, and thus, tax revenues would be equal to $0.
• After some level B, increases in tax rates actually cause tax revenues to fall.• As tax rates approach level C, tax revenues continue to fall. This is because the tax base shrinks faster than the increased revenues from higher tax rates.
• There is no presumption that the level of taxes at B is the ideal tax rate, only that B maximizes the tax revenue in the current period.
Maximum
The Laffer Curve
A
C
B
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1980
1990
87
192
153
58
149 153
Changes in Taxes Paid in the 1980sPersonal Income Taxes Paid(by group, billions of 1982-1984 $)
Top 1% Top 10% Other 90%