$2.50 $2.00 Price Frozen pizzas per week $3.00 $3.50 MB 4 MB 3 MB 2 MB 1 <<< MU 4 MU 3 MU 2 MU 1 <<< because d MB = The demand for frozen pizzas reflects the law of diminishing marginal utility. Because marginal utility (MU) falls with increased consumption, so does a consumer’s maximum willingness to pay -- marginal benefit (MB). A consumer will purchase until MB = Price... so at $2.50 they would purchase 3 frozen pizzas and receive a consumer surplus shown by the shaded area (above the price line and below the demand curve). Price = $2.50 The Pizza Demand Curve John’s demand curve for frozen pizza MB 4 MB 3 MB 2 MB 1

Consumer Surplus The total difference between what a consumer is willing to pay and how much they actually have to pay. Producer Surplus The total difference between what a supplier is willing to provide a good or service and how much they actually get for it.

S D P Q Consumer surplus = area of red triangle = ½($5)(5) = $12.5 Producer surplus = area of green triangle = ½($5)(5) = $12.5 Producer and Consumer Surplus The combination of producer and consumer surplus is maximized at market equilibrium CS PS $

Consumer Surplus Price Quantity If the selling price is 3, the consumer surplus for the 1 st item is 5-3=2, plus 4-3=1 for the 2 nd and 3-3=0 for the 3 rd, or 3

The Burden of a Tax Tax Incidence Who pays a tax is called the incidence. Buyer Seller

Price # of used cars per month (in thousands) D $6,400 S plus tax $7,000 $7,400 S $1000 tax Impact of a Tax Imposed on Sellers If in the used car market a price of $7,000 would bring the quantity of used cars demanded into balance with the quantity supplied. When a $1,000 tax is imposed on sellers of used cars, the supply curve shifts vertically by the amount of the tax. The new price for used cars is $7,400 … Consumers end up paying $7,400 instead of $7,000 and bear $400 of the tax burden. Sellers end up receiving $6,400 (after taxes) instead of $7000 and bear $600 of the tax burden. sellers netting $6,400 ($7,400 - $1000 tax).

Price # of used cars per month (in thousands) D $6,400 $7,000 $7,400 S $1000 tax Impact of a Tax Imposed on Buyers In the same used car market: When a $1,000 tax is imposed on buyers of used cars, the demand curve shifts vertically by the amount of the tax. The new price for used cars is $6,400 … Consumers end up paying $7,400 (after taxes) instead of $7,000 and bear $400 of the tax burden. Sellers end up receiving $6,400 instead of $7000 and bear $600 of the tax burden. buyers then pay taxes of $1000 making the total $7,400. D minus tax

The actual burden of a tax depends on the elasticity of supply and demand. As supply becomes more inelastic, then more of the burden will fall on sellers. As demand becomes more inelastic, then more of the burden will fall on buyers. Elasticity and Incidence of a Tax E D E S E D + E S

110 D Luxury boat market Gasoline market S $1.60 $1.50 $1.45 Quantity (thousands of boats) Quantity (millions of gallons) Price Price (thousand $) Tax Burden and Elasticity D S plus tax 200 $1.55 $1.65 S S plus tax Consider the market for Gasoline and Luxury Boats individually. In the gas market, the demand is relatively more inelastic than its supply; hence, buyers bear a larger share of the burden of the tax. In the luxury boats market, the supply curve is relatively more inelastic than its demand; hence, sellers bear a larger share of the tax burden. We begin in equilibrium. If we impose a $.20 tax on gasoline suppliers, the supply curve moves vertically the amount of the tax. Price goes up $.15 and output falls by 6 million gallons per week. If we impose a $25K tax on Luxury Boat suppliers, the supply curve moves vertically the amount of the tax. Price goes up by $5K and output falls by 5 thousand units.

Government Intervention as Implicit Taxation Government intervention in the form of price controls can be viewed as a combination tax and subsidy

S D P Q P0P0 Q0Q0 A price ceiling transfers surplus from producers to consumers, generates deadweight loss, and reduces equilibrium quantity Q1Q1 Price ceiling P1P1 Shortage An effective price ceiling is a government set price below the market equilibrium price It acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation

S D P Q P0P0 Q0Q0 A price floor transfers surplus from consumers to producers, generates deadweight loss, and reduces equilibrium quantity Q1Q1 Price floor P1P1 Surplus An effective price floor is a government set price above the market equilibrium It acts as a tax on consumers and a subsidy for producers that transfers consumer surplus to producers

The Difference Between Taxes and Price Controls Taxes leave people free to choose how much to supply and consume as long as they pay the tax Price ceilings create shortages and taxes do not Shortages may also create black markets

Rent Seeking, Politics, and Elasticities Individuals spend money and use resources to lobby governments to institute policies that increase their own surplus Lobbying for price controls, which transfer surplus from one group to another, is an example of rent- seeking behavior Public choice economists argue that when all rent seeking and tax consequences are netted out, there is often not a net gain to the public The possibility of transferring surplus from one set of individuals to another causes people to spend time and resources on doing so.

A C B Inelastic Demand and Incentives to Restrict Supply S0S0 D P Q S1S1 P0P0 P1P1 Q0Q0 Q1Q1 Revenue gained When demand is relatively inelastic, suppliers have incentive to restrict quantity to increase total revenue Revenue lost

Inelastic Supplies and Incentives to Restrict Prices When supply is inelastic and demand increases, prices increase causing consumers to lobby for price controls When supply is inelastic, consumers have incentives to restrict prices Rent control in New York City is an example

Application: Price Floors and Elasticity S D P Q P0P0 P1P1 S D P Q P0P0 Q0Q0 Q1Q1 The surplus created by a price floor is larger if demand and supply are elastic Q0Q0 Q1Q1 Surplus Price floor Surplus P1P1

Long-Run and Short-Run Effects on Price Control S short-run D1D1 P Q P0P0 P LR Q0Q0 Q LR Higher long-run elasticity of supply results in smaller price increases when demand increases S long-run D0D0 P SR Q SR