Micro Chapter 4 Supply and Demand: Applications and Extensions

5 Learning Goals 1)Describe the relationship between resource and product markets 2)Analyze the impact of government policies for price controls in markets 3)Determine the effects of a tax in a market 4)Explore the relationship between tax rates and revenues 5)Identify the effects of a subsidy

The Link Between Resource and Product Markets

What’s the relationship between product markets and resource (input) markets? An increase (decrease) in demand for a product will increase (decrease) demand for resources that make that product When the product price rises, the resource price will eventually rise

Graphs:

The Economics of Price Controls

2 Kinds of Price Controls: (1) Price ceiling – puts an upper limit on price; generates a shortage and a deadweight loss (2) Price floor – puts a lower limit on price; generates a surplus and a deadweight loss Deadweight loss (DWL) = loss of gains from trade; loss of CS and PS

Price Ceiling Graph:

Price Floor Graph:

The Impact of a Tax

Incidence (1) Statutory incidence- who is legally responsible to pay the tax This is the tax burden- it hinders exchange This is an administrative detail that is mostly irrelevant (2) Actual incidence- who really pays the tax This is the more important issue The burden is shared between firms and consumers

Ways to analyze: If the tax is legally imposed on sellers, shift the supply curve If the tax is legally imposed on buyers, shift the demand curve You’ll reach the same conclusion either way

Graph of tax imposed on sellers: See handout “Impact of a Tax 1.pdf” Impact of a Tax 1.pdfImpact of a Tax 1.pdf

Graph of tax imposed on buyers: See handout “Impact of a Tax 1.pdf” Impact of a Tax 1.pdfImpact of a Tax 1.pdf

Scenario: The price of a textbook is $100. Then a $10 sales tax is imposed. What usually happens? The price (with tax) of the textbook will be somewhere between $100 and $110. If $106, consumers pay $6 tax and firms pay $4 tax.

What determines how the burden is shared? The size of the deadweight loss and the actual burden depend on supply & demand elasticities The size of the deadweight loss and the actual burden depend on supply & demand elasticities

Four scenarios: See handouts “Impact of a tax 2.pdf” and “Impact of a tax 3.pdf” Impact of a tax 2.pdfImpact of a tax 3.pdfImpact of a tax 2.pdfImpact of a tax 3.pdf

Four scenarios: Summary: The more inelastic group has the biggest share of the burden

Helpful Study Tool “Tax Impact Process Examples.pdf” in study guides folder in Blackboard

Tax Rates, Tax Revenues, and the Laffer Curve

2 definitions you need to know: (1) Tax rate –(a) Value (most common); a percent is applied to the sales price Example: 7.5% sales tax –(b) Per Unit; an amount is applied to each unit sale Example: $1 for every unit sold Gas taxes Gas taxes (2) Tax Revenue = rate X sales

The Laffer Curve Graphical representation of the relationship between the tax rate and revenue Graph:

So what? Starting at high tax rates, an increase in the tax rate may actually lower revenue Starting at high tax rates, larger revenue may be generated by lowering tax rates

The facts: Highest marginal tax rates Highest marginal tax rates Using 2008 Internal Revenue Service statistics, the 2001 tax cuts shifted the income tax burden up the economic ladder. In 2000, the top 1% paid 37.4% of all income taxes vs. 39.4% in The top 2% went from 56.5% to 60% The top 10% from 67.3% to 70.3% The top 25% from 84% to 86% The top 50% from 96% to 97%.

The Impact of a Subsidy

Analysis of Ethanol subsidies Ethanol- biofuel made from corn to supplement traditional gasoline (most gas now contains up to 10% ethanol) Graph of ethanol:

Analysis of Ethanol subsidies Secondary effects: 1)increase demand for corn (maybe not an equal increase in supply of corn) results in an increase in the price of corn 2)Increase in prices for feed for livestock plus any consumer good made from corn So, lower prices for ethanol but higher prices for milk, soda, and everything else made with corn

Who receives the biggest benefit from subsidies? Ignoring secondary effects, the group with the smallest elasticity receives the biggest benefit. If supply is relatively inelastic and demand is relatively elastic, then suppliers receive most (but not all) of the benefit. If supply is relatively elastic and demand is relatively inelastic, then consumers receive most (but not all) of the benefit.

Conclusions: Taxes and subsidies distort incentives and create secondary effects which are sometimes undesirable