Econ 200: Lecture 7 October 19, 2017 Poll Everywhere Economic Efficiency Price Ceilings and Floors and Efficiency Start Taxes

Price Ceilings and Price Floors Price ceiling: A legally determined maximum price that sellers can charge. Price floor: A legally determined minimum price that sellers may receive. Price ceilings and floors include: Minimum wages Rent controls Agricultural price controls

Why intervene? Markets gravitate toward equilibrium. When markets work well, prices adjust until the quantity of the good demanded is equal to the quantity supplied. There are three reasons why a government may step in and intervene in a market: Correcting market failures. Changing the distribution of benefits. Encouraging or discouraging consumption of certain goods. Correcting market failures. Our model of demand and supply has so far assumed that markets work efficiently—but in the real world, that’s not always true. For example, sometimes there is only one producer of a good, who faces no competition and can charge an inefficiently high price. Other times, one person’s use of a product or service imposes costs on other people that are not captured in prices paid by the first person, such as the pollution caused by burning the gas in your car. Situations in which the assumption of efficient, competitive markets fails to hold are called market failures. When there is a market failure, intervening can actually increase total surplus. Changing the distribution of surplus. Efficient markets maximize total surplus, but an efficient outcome may still be seen as unfair. For example, even if the job market is efficient, wages can still drop so low that some workers fall below the poverty line while their employers make healthy profits. The government might respond by intervening in the labor market to impose a minimum wage. This policy will change the distribution of surplus, reducing employers’ profits and lifting workers’ incomes. Reasonable people can—and often do—argue about whether a policy that benefits a certain group (such as minimum-wage workers) is justified or not. Our focus will be on accurately describing the benefits and costs of such policies. Encouraging or discouraging consumption. Around the world, many people judge certain products to be “good” or “bad” based on culture, health, religion, or other values. At the extreme, certain “bad” products are banned altogether, such as hard drugs. More often, governments use taxes to discourage people from consuming bad products without banning them altogether. Common examples are cigarettes and alcohol; many governments tax them heavily, with the aim of reducing smoking and drinking. In some cases, minimizing costs imposed on others (such as from pollution or secondhand smoke) is also part of the motivation for discouraging consumption. On the other hand, governments use subsidies to encourage people to consume “good” products or services. For instance, many governments provide public funding for schools to encourage education and for vaccinations to encourage parents to protect their children against disease.

Price Ceilings (on Tortillas) Price ($/lb.) Price ($ / lb.) 1.25 1.25 Producers supply a lower quantity. 1.00 1.00 S S 0.75 0.75 Consumers demand a higher quantity. 0.50 0.50 The left panel illustrates a hypothetical market for tortillas without a price ceiling. The equilibrium price is $0.50 per pound, and the equilibrium quantity is 50 million pounds. Let’s say that the government of Mexico responded to rising tortilla prices by setting a price ceiling of approximately $0.25 per pound, as shown in the right panel. When price falls, consumers will want to buy more tortillas. In this example, the price fell from $0.50 to $0.25, and as a result, quantity demanded increased from 50 million to 75 million pounds. A lower price means fewer producers will be willing to sell tortillas. When the price fell to $0.25, the quantity supplied dropped from 50 million to 25 million pounds. A lower price means higher quantity demanded, but lower quantity supplied. Supply and demand were no longer in equilibrium. The price ceiling created a shortage of tortillas, equal to the 50 million pound difference between the quantities supplied and demanded. Price ceiling 0.25 0.25 Shortage D D 25 50 75 100 25 50 75 100 Quantity of tortillas (millions of lbs.) Quantity of tortillas (millions of lbs.) Efficient market with a price of $0.50 per lb. and 50 million lbs. of tortilla. Inefficient market with a price ceiling set at $0.25 per lb. and 25 million lbs. of tortilla being produced.

Price ceilings continued Did the price ceiling meet the goal of providing low-priced tortillas to consumers? Yes. Consumers were able to buy some tortillas at the low price of $0.25 a pound. No. Consumers wanted to buy three times as many tortillas as producers were willing to supply. How did the price ceiling effect welfare? This question can be answered using differences in consumer surplus and producer surplus before/after government intervention.

Welfare effects of a price ceiling A price ceiling causes a deadweight loss to occur as well as a transfer of welfare from producers to consumers. Price ceiling = $0.25 Reduction in tortillas sold by 25 million. Deadweight loss occurs. Transfer of surplus from producers to consumers. Price ($/lb.) Producer surplus 1.25 Consumer surplus Deadweight loss 1.00 S 0.75 0.50 It should be clear that a price ceiling causes: Total welfare (or surplus) to decrease. Producer surplus to fall. 3) Consumer surplus to either increase or decrease. Whether consumer surplus increases or decreases depends on the whether the deadweight loss is smaller or larger than the transfer. (Or, in this example, whether area 1 is larger or smaller than area 2.) 1 2 0.25 Price ceiling D 25 50 75 100 Quantity of tortillas (millions of lbs.)

Welfare effects of a price ceiling continued Are price ceilings worth the decrease in total surplus? Normative question about which people can disagree. One way to answer is through studying the allocation of tortillas. Because a price ceiling causes a shortage, goods must be rationed. Rationed equally. First-come, first-served basis. Rationed to those who are given preference by the government, or to the friends and family of sellers. Shortages cause people to engage in rent-seeking behavior, such as bribing whoever is in charge of allocating scarce supplies.

Nonbinding price ceiling A price ceiling does not always affect the market outcome if the ceiling is set above the equilibrium price. Over time, if the supply increases sufficiently, the price ceiling may become nonbinding. No effect on market equilibrium. Price ($/lb.) 1.25 1. Supply increases, and the supply curve shifts to the right. 1.00 S 1 0.75 2. At the new equilibrium point, the price is below the price ceiling. Nonbinding means that the ceiling doesn’t “bind” or restrict buyers’ and sellers’ behavior, because the current equilibrium is within the range allowed by the ceiling. In such cases, the equilibrium price and quantity will prevail. 0.50 S 2 0.25 Price ceiling D 25 50 75 100 Quantity of tortillas (millions of lbs.)

Price floors Suppose the U.S. government imposes a price floor on milk. What effect does this have on the market? Price ($/gal.) Price ($/gal.) 4.50 4.50 4.00 S 4.00 S 3.50 3.50 Excess supply 3.00 3.00 Price floor Quantity supplied and quantity demanded move in opposite directions. 2.50 2.50 2.00 2.00 1.50 1.50 1.00 The United States has maintained price floors for dairy products for over 60 years; the Milk Price Support Program began with the Agricultural Act of 1949. D 1.00 D 0.50 0.50 5 1 1 5 2 2 5 3 3 5 5 1 1 5 2 2 5 3 3 5 Quantity of milk (billions of gals.) Quantity of milk (billions of gals.) Efficient market with a price of $2.50 per gallon and 15 million gallons of milk being produced. Inefficient market with a price ceiling set at $3 per gallon and 20 million gallons of milk being produced.

Price floors continued Did the price floor meet the goal of providing support to producers? Yes. Producers were able to sell some milk at a higher price of $3.00 per gallon. No. Some producers may not be able to sell all of their milk because demand no longer meets supply. How did the price floor affect welfare? This question can be answered using the difference in consumer and producer surplus before and after government intervention.

Welfare effects of a price floor A price floor causes a deadweight loss to occur as well as a transfer of welfare from consumers to producers. Suppose the government sets the market price to $3. Reduction in milk sold by 5 million gallons. Deadweight loss occurs (Area 1). Transfer of surplus (Area 2) from consumers to producers. Producer surplus Price ($/gal.) Consumer surplus 4.50 S Deadweight loss 4.00 3.50 3.00 Price floor 2 2.50 1 It should be clear that a price floor causes: Total welfare (or surplus) to decrease. Consumer surplus to fall. Producer surplus to increase or decrease. Whether producer surplus increases or decreases depends on whether the deadweight loss is smaller than the transfer. (Or, in this example, whether area 1 is larger or smaller than area 2.) 2.00 1.50 1.00 0.50 D 5 10 15 20 25 30 35 Quantity of milk (billions of gals.)

Welfare effects of a price floor continued Are price floors worth the decrease in total surplus? Normative question about which people can disagree. One way to answer is through studying how much excess milk will the government have to buy. The answer is the entire amount of excess supply created by the price floor. In the above case, 10 billion gallons will be purchased at $3 per gallon. The cost to maintain the price floor is then $30 billion.

Ineffective price floor A price floor does not always affect the market outcome if the floor is set below the equilibrium price. Suppose the government set the price at $3. Increase in milk sold by 5 million gallons. Over time, if the supply decreases sufficiently, the price floor may become nonbinding. No effect on market equilibrium. Price ($/gal) S 6.00 2 5.50 1. Supply decreases and the supply curve shifts to the left. 5.00 4.50 S 4.00 1 3.50 3.00 In recent years, the market prices for dairy products in the United States have usually been above the price floor. The price floor may become binding, however, in response to changes in the market. Notice that if the price is high and there is excess milk, this may lead to producers decreasing the quantity of milk production. Thus, a price floor may cause LESS milk to be produced than if the market was left to itself. Price floor 2.50 2. At the new equilibrium point, the price is above the price ceiling. 2.00 1.50 1.00 D 0.50 5 1 1 5 2 2 5 3 3 5 Quantity of Milk (billions of gals.)

The Results of Government Price Controls When a government imposes price controls, Some people win, Some people lose, and Deadweight loss (loss of total surplus) will generally occur. Economists seldom recommend price controls, with the possible exception of minimum wage laws. Why minimum wage laws? Equity effects more important than efficiency loss. Empirical evidence shows that this model may be too simple.

Taxes Taxes are the most important method by which governments fund their activities. We will concentrate on per-unit taxes: taxes assessed as a particular dollar amount on the sale of a good or service, as opposed to a percentage tax. source: http://www.gaspricewatch.com/web_gas_taxes.php

The Effect of a Tax on Cigarettes Without the tax: Pe=$5.0 /pack Qe=4 billion packs A $1.00/pack tax on cigarettes shift the supply from S1 to S2 (vertical distance is $1). After the tax: Pe=$5.90/pack Qe-3.7 billion packs Without the tax, market equilibrium occurs at point A. The equilibrium price of cigarettes is $5.00 per pack, and 4 billion packs of cigarettes are sold per year. A $1.00-per-pack tax on cigarettes will cause the supply curve for cigarettes to shift up by $1.00, from S1 to S2. The new equilibrium occurs at point B. The price of cigarettes will increase by $0.90, to $5.90 per pack, and the quantity sold will fall to 3.7 billion packs. The tax on cigarettes has increased the price paid by consumers from $5.00 to $5.90 per pack. Producers receive a price of $5.90 per pack (point B), but after paying the $1.00 tax, they are left with $4.90 (point C). The government will receive tax revenue equal to the green-shaded box. Some consumer surplus and some producer surplus will become tax revenue for the government, and some will become deadweight loss, shown by the yellow-shaded area.

The Effect of a Tax on Cigarettes Consumers pay $5.90 per pack. Producers receive a price of $5.90 per pack After paying the $1.00 tax, they are left with $4.90  Tax revenue = the green shadowed box

Tax Incidence on a Demand and Supply Graph The effect of a $0.10 gas tax: The price consumers pay rises from $3.50 to $3.58. The price sellers receive falls from $3.50 to $3.48. Therefore, consumers pay 8 cents of the 10-cents-per- gallon tax on gasoline, and sellers pay 2 cents. With no tax on gasoline, the price would be $3.50 per gallon, and 144 billion gallons of gasoline would be sold each year. A 10-cents-per-gallon excise tax shifts up the supply curve from S1 to S2, raises the price consumers pay from $3.50 to $3.58, and lowers the price sellers receive from $3.50 to $3.48. Therefore, consumers pay 8 cents of the 10-cents-per-gallon tax on gasoline, and sellers pay 2 cents.

What If the Tax is Collected From Buyers? If a 10-cents-per-gallon tax imposed on consumers, the demand curve shifts down from D1 to D2. In the new equilibrium: Consumers pay $3.58 per gallon Producers receive $3.48 per gallon. This is the same result we saw when producers were responsible for paying the tax! With no tax on gasoline, the demand curve is D1. If a 10-cents-per-gallon tax is imposed that consumers are responsible for paying, the demand curve shifts down by the amount of the tax, from D1 to D2. In the new equilibrium, consumers pay a price of $3.58 per gallon, including the tax. Producers receive $3.48 per gallon. The result is the same as when producers were responsible for paying the tax.

Effects of a tax on buyers and sellers Regardless of whether a tax is imposed on buyers or sellers, there are four identical effects resulting from taxes: Equilibrium quantity falls. Buyers pay more per unit purchased and sellers receive less. A tax wedge forms, equal to the difference between the price paid by buyers and the price received by sellers. The government receives revenue equal to the amount of the tax multiplied by the new equilibrium quantity. The tax causes a deadweight loss. It should be clear to students that regardless of whether a tax is placed on sellers or buyers, the effects are identical.

Tax Incidence: Who Actually Pays for a Tax? In the market for gasoline, the buyers effectively paid 80% of the 10-cents-per-gallon tax, and sellers paid 20%. This is referred to as the tax incidence: the actual division of the burden of a tax between buyers and sellers in a market. What determines this tax incidence?

What Does Determine the Tax Incidence? The incidence of the tax is determined by the relative slopes (or relative elasticity) of the demand and supply curves. A steep (relatively inelastic) demand curve means that buyers pay more of the tax. A shallow (relatively elastic) demand curve means that buyers pay less of the tax.

Tax incidence Suppose the government imposes a $0.20 tax on each unit sold, which the seller must pay. Who bears the burden, or tax incidence, of a tax? Tax incidence is equal to the loss in consumer and producer surplus going to tax revenue. Whichever side of the market is more price elastic will shoulder less of the burden. Price ($) S 2 1 D $0.60 3 25 $0.40 Quantity of Whizbangs (mil.) Buyers pay $0.60, sellers receive $0.40 S 2 1 D $0.54 3 22 $0.34 Price ($) Quantity of Whizbangs (mil.) Buyers pay $0.54, sellers receive $0.34 S 2 1 D $0.66 30 22 $0.46 Buyers pay $0.66, sellers receive $0.46 Price ($) Quantity of Whizbangs (mil.) Since a tax effectively changes the price of a good to both buyers and sellers, the relative responsiveness of supply and demand will determine the tax burden. Essentially, the side of the market that is more price elastic will be more able to adjust to price changes and will shoulder less of the tax burden. In the figure on the left, the tax burden is shared equally, since consumers lose the same amount of surplus as producers. In the middle figure, buyers paid $0.50 before the tax. After the tax, they pay $0.54, so their tax burden is $0.04 per Whizbang. Sellers, on the other hand, receive only $0.34 after the tax, so their tax burden, at $0.16 per Whizbang, is four times as large as that of buyers. In the figure on the right, buyers bear more of the burden than sellers. Buyers pay $0.66 and sellers receive $0.48. The relative tax burden borne by buyers and sellers is called the tax incidence. Equal incidence – The sellers’ tax burden is equal to the buyers’ tax burden. Sellers pay more – The sellers’ tax burden is greater than the buyers’ tax burden. Buyers pay more – The sellers’ tax burden is less than the buyers’ tax burden. Sellers’ tax burden Buyers’ tax burden