1 Chapter 4 Supply and Demand: Applications and Extensions

2 Overview The resource market (particularly the labor market) The resource market (particularly the labor market) Price Controls: price floors and ceilings (surpluses and shortages) Price Controls: price floors and ceilings (surpluses and shortages) Impact of a tax Impact of a tax The tax system The tax system The Laffer curve The Laffer curve Subsidies Subsidies

3 The Labor Market Price for labor is called the wage (W) Price for labor is called the wage (W) Quantity of labor is called employment (E) Quantity of labor is called employment (E) *Note: works just like the market for goods, only with a different name for price (wage) and quantity (employment) *Note: works just like the market for goods, only with a different name for price (wage) and quantity (employment)

4 Labor Demand 1. Firms demand labor 2. Labor demand curve is downward sloping because as wage decreases, firms will want to employ more people

5 Changes in Labor Demand 1. An increase in labor demand (labor demand shifts right) 2. A decrease in labor demand (labor demand curve shifts left)

6 Labor Supply 1. Workers supply labor 2. Labor supply curve is upward sloping because as wage increases, people will want to work more.

7 Changes in Labor Supply 1. Increase in labor supply: (labor supply curve shifts right) 2. Decrease in labor supply: (labor supply curve shifts left)

8 Linking the Markets There is a close relationship between the demand for products and the demand for resources used to make those products

9 Linking the Markets when the demand for a product changes, the demand for the resources used to produce it will change in the same direction

10 Price Floor Price floor: A legally established minimum price buyers must pay for a good or resource A price floor above equilibrium price creates a surplus A price floor above equilibrium price creates a surplus A price floor below equilibrium price does nothing A price floor below equilibrium price does nothing

11 Surplus Surplus: A condition in which the amount offered for sale is greater than the amount that buyers will purchase at existing prices. Also known as excess supply: Quantity supplied > Quantity demanded

12 Application: Minimum Wage The minimum wage is an example of a price floor. Raising minimum wage increases excess labor supply (unemployment).

13 Price Ceiling Price ceiling: A legally established maximum price sellers can charge for a good or resource A price ceiling below market equilibrium price creates a shortage A price ceiling below market equilibrium price creates a shortage A price ceiling above market equilibrium price does nothing A price ceiling above market equilibrium price does nothing

14 Shortage Shortage: a condition in which the amount offered for sale is less than the amount demanded by buyers at existing prices Also known as excess demand: Quantity demanded > Quantity supplied

15 Application: Disaster Markets

16 Application: Rent Control Rent controls lead to shortages as well as: 1. Black markets 2. A decline in the supply of future rental housing 3. A decline in quality of rental housing 4. Non-price methods of rationing 5. Inefficient housing match-ups

17 Impact of a Tax A tax on a product will cause the supply curve to shift left by the amount of the tax. 1. Raises the price that buyers pay 2. Reduces the amount sellers receive 3. Reduces the quantity sold 4. Increases government revenue 5. Creates deadweight loss

18 Deadweight loss The loss to society that results from the loss of gains to trade that does not occur because a tax was imposed.

19 Tax Incidence Tax Incidence: The way the burden of a tax is distributed among economic units (also known as the tax burden) (also known as the tax burden) It does not depend on whom the tax is imposed.

20 Tax Incidence Tax incidence does depend on elasticity: The burden of the tax will fall on those who are relatively inelastic. Deadweight loss will be lower if taxes are placed on goods that are relatively inelastic.

21 The Tax System Average tax rate (ATR): the percentage of income paid in taxes ATR = tax liability / taxable income

22 The Tax System 3 possibilities: 1. Progressive tax: average tax rate rises with income 2. Regressive tax: average tax rate falls with income 3. Proportional tax: average tax rate is the same at all income levels

23 The Tax System Marginal tax rate (MTR): The additional tax liability a person faces divided by his or her additional taxable income. MTR = change in tax liability / change in taxable income *Note: Marginal tax rates are what is important in personal decision making.

24 Fairness and Efficiency 1. Is the progressive tax system economically efficient? 2. Is the progressive tax system fair?

25 The Laffer Curve The Laffer Curve: A curve illustrating the relationship between the tax rate and tax revenue. Higher tax rates will not always lead to more tax revenue!!

26 Subsidies Subsidy: A payment the government makes to either the buyer or seller when a good or service is purchased or sold. ex. Subsidizing treadmills *Note: Subsidies are costly

27 Farm Subsidies

28 Review 1. Why is labor demand downward sloping? 2. Why is labor supply upward sloping? 3. What is the effect of a price ceiling (price floor)? floor)? 4. What is the impact of a tax? 5. Calculate average tax rate and marginal tax rate. 6. Understand the Laffer Curve. 7. Understand the impacts of a subsidy