1 Applications of Supply & Demand Chapter 4. 2 Model this using a S & D diagram But an even bigger...

1

Applications of Supply & Demand

Chapter 4

2

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

4

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


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


(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


(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

9

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


(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


(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


(a) A Price Floor That Is Not Binding


Cones

0

Price ofIce-Cream

Cone

Equilibriumquantity

2

Pricefloor

Equilibriumprice

Demand

Supply

$3

100

Figure 4 A Market with a Price Floor


(b) A Price Floor That Is Binding


Cones

0

Price ofIce-Cream

Cone

Demand

Supply

$4Pricefloor

80

Quantitydemanded

120

Quantitysupplied

Equilibriumprice

Surplus

3

14

Minimum Wage

Figure 5 How the Minimum Wage Affects the Labor Market


Quantity ofLabor

Wage

0

Labordemand

LaborSupply

Equilibriumemployment

Equilibriumwage

Figure 5 How the Minimum Wage Affects the Labor Market


Quantity ofLabor

Wage

0

LaborSupplyLabor surplus

(unemployment)

Labordemand

Minimumwage

Quantitydemanded

Quantitysupplied

17

Taxes

Figure 6 A Tax on Buyers


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


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


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


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


Quantity0

Price

Demand

Supply

Tax


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.

24

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


25

Recall …

Consumer Surplus:

Area under demand curve and above price line.

Producer Surplus:

Area above supply curve and below price line.

26

Figure 3 How a Tax Effects Welfare


A

F

B

D

C

E

Quantity0

Price

Demand

Supply

= PB

Q2

= PS

Pricebuyers

pay

Pricesellers

receive

= P1

Q1

Pricewithout tax

27

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


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

29

Figure 5 Tax Distortions and Elasticities


(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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(b) Elastic Supply

Price

0 Quantity

Demand

SupplySizeoftax

When supply is relativelyelastic, the deadweightloss of a tax is large.

31



Demand

Supply

(c) Inelastic Demand

Price

0 Quantity

Size of taxWhen demand isrelatively inelastic,the deadweight lossof a tax is small.

32



(d) Elastic Demand

Price

0 Quantity

Sizeoftax Demand

Supply

When demand is relativelyelastic, the deadweightloss of a tax is large.

33

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes


Tax revenue

Demand

Supply

Quantity0

Price

Q1

(a) Small Tax

Deadweightloss

PB

Q2

PS

34



Tax revenue

Quantity0

Price

(b) Medium Tax

PB

Q2

PS

Supply

Demand

Q1

Deadweightloss

35



Tax

rev

enue

Demand

Supply

Quantity0

Price

Q1

(c) Large Tax

PB

Q2

PS

Deadweightloss

36

Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax


(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

40

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.

• 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.

50

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

43

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%

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