1. Supply and Demand — Applications and Extensions
Chapter 4
Supply and Demand — Applications and Extensions

2. 1. Wage Rates, Interest Rates, and Exchange Rates

3. Linkage Between Labor and Product Markets
The markets for resources and products are closely linked.
Changes in one will affect the other.
An increase (decrease) in resource prices will reduce (increase) supply in the product market.
An increase in product demand will increase the demand for resources used in production of the good.

4. Resource Prices, Opportunity Cost, and Product Markets
Suppose there is a reduction in the supply of young, inexperienced labor
which pushes the wage rates of workers hired by fast-food restaurants upward.
In the product market the higher wage will increase the restaurant’s opportunity cost, causing a reduction in supply,
leading to higher hamburger prices. P P S2 S2 Dp Dr S1
$2.25 S1
$6.50
$5.25
$2.00 E2 E1 Q2 Q1
Resource Market
Product Market
Employment
Quantity

5. Loanable Funds Market and the Interest Rate
The interest rate connects the price of goods today and their price in the future.
The interest rate is the price that must be paid for earlier availability.

6. Increase in the Demand for Loanable Funds
interest rate
Consider the market for loanable funds where the interest rate ( r ) will bring the quantity of loanable funds demanded by borrowers into balance with the quantity supplied by lenders.
Supply (lending)
D2 (borrowing)
D (borrowing)
We begin in equilibrium at the lending level Q1 and interest rate r1. r2
An increase in the demand for loanable funds will move D1 to D2 r1
pushing the interest rate up from r1 to r2 and borrowing from Q1 to Q2
The higher interest rate will encourage additional savings, making it possible to fund more borrowing. Q1 Q2
Quantity of Loanable Funds

7. Market for Foreign Exchange
Foreign exchange market is where currency of one country is traded for another.
The exchange rate is measured are the dollar price of foreign currency.

8. Changes in Exchange Rates
Changes in exchange rates will change the prices of internationally traded goods/services and assets
A lower dollar price of foreign currency will have two effects.
It lower the price of foreign goods to U.S. residents and raise imports.
It will raise the price of U.S. goods to foreigners and lower exports.

9. Increase in the Demand for Foreign Exchange
Supply (sales to foreigners)
Consider the market for foreign exchange (specifically the Guatemalan quetzal) where the exchange rate (the dollar price per quetzal) will bring the quantity of quetzals demanded into balance with the quantity supplied.
$ price per quetzal
exchange rate D2
(purchases from foreigners)
.20
We begin in equilibrium where the dollar price of the quetzal is $ (10 cents = 1quetzal).
An increase in the demand of Americans for Guatemalan coffee will also increase the demand for quetzals (with which American importers buy Guatemalan coffee).
.10
As a result, the dollar price of the quetzal will rise, as will the number of quetzals that clear the market. D1
(purchases from foreigners) Q1 Q2
Quantity of Foreign Exchange

10. 2. The Economics of Price Controls

11. Price Ceilings
Price ceiling is a legally established maximum price that sellers may charge.
Example: rent control
The direct effect of a price ceiling below the equilibrium price is a shortage: quantity demanded exceeds quantity supplied.

12. The Impact of a Price ControlS
(of rental housing)
Price
Consider the market for rental housing where the price (rent) of P0 would bring the quantity of rental units demanded into balance with the quantity supplied. P0
When a price ceiling like P1 pushes the price of the product below the market equilibrium . . .
Price Ceiling
. . . the quantity supplied (Qs) . . . P1
exceeds the quantity demanded (Qd),
Shortage D
(of rental housing)
resulting in a shortage.
Because prices are not allowed to direct the market back to equilibrium, non-price elements will become more important. QS QD
Quantity of Housing Units

13. Secondary Effects of Price Ceilings
Reduction in the quality of the good.
Inefficient use.
Lower future supply.
Non-price rationing will be of more importance.

14. Effects of Rent Control
Shortages and black markets will develop.
The future supply of housing will decline.
The quality of housing will deteriorate.
Non-price methods of rationing will increase in importance.

15. Effects of Rent Control
Inefficient use of housing will result.
Long-term renters will benefit at the expense of newcomers.

16. Price Floor
Price floor is a legally established minimum price that buyers must pay.
Example: minimum wage
The direct effect of a price ceiling below the equilibrium price is a surplus: quantity supplied exceeds quantity demanded.

17. Minimum Wage Effects Direct effect: Indirect effects:
Reduces employment of low-skilled labor.
Indirect effects:
Reduction in non-wage component of compensation.
Less on-the-job training.
A higher minimum wage does little to help the poor.

18. Employment and the Minimum Wage
Excess Supply
Consider the market for the labor of of a group of employees where a price (wage) of $4.00 would bring the quantity of labor hours demanded into balance with the quantity supplied. D
(for labor) S
(of labor)
$5.15
Minimum Wage Level
A minimum wage (price floor) of $5.15 would raise the price of the labor above the market equilibrium
$4.00
where the employment supplied (Es)
exceeds that demanded (Ed),
resulting in a employment surplus.
For those (Ed) who were able to maintain their employment, their earnings would increase.
Those (Es - Ed) who lose their job are pushed into either the unemployment rolls or to a less preferred form of employment. ED ES
Employment

19. 3. Black Markets and the Importance of Legal Structure

20. Black Markets
Black market - markets that operate outside the legal system.
Either sell illegal items or items at illegal prices or terms.
Black markets have a higher incidence of of defective products, higher profit rates, and greater violence.

21. Legal System
A legal system that provides secure property rights and unbiased enforcement of contracts enhances the operation of markets.

22. Questions for Thought:
1. Analyze the impact of an increase in the minimum wage from the current level to $10.00 per hour. How would the following be affected: (a) Employment in skill categories previously earning less than $ (b) The unemployment rate of teenagers (c) The availability of on-the-job training for low-skill workers (d) The demand for high-skill workers who provide good substitutes for the labor services offered by low-skill workers, who are paid higher wage rates due to the increase in the minimum wage?
2. What is the black market? What are some of the main differences in how black markets operate relative to legal markets?

23. 4. The Impact of a Tax

24. Tax incidence
The legal assignment of who pays a tax is called the statutory incidence.
The actual burden of a tax (actual incidence) may differ substantially.
The actual burden does not depend who legally pays the tax (statutory incidence).

25. The Impact of a Tax Imposed on Sellers
(of used cars) S
+ Tax
Price
Consider the market for used cars where a price of $7,000 would bring the quantity of used cars demanded into balance with the quantity supplied. S
(of used cars) D
(for used cars)
$1000 tax
$1000
When a $1,000 tax is imposed on the sellers of used cars, the supply curve moves up vertically by the amount of the tax.
$7,400
$7,000
The new price in the market for used cars is $7,
. . . while sellers receive $6, ($7,400 - $1000 tax = $6,400).
$6,400
The difference between the two is the amount of the tax, $1000.
As the consumers end up paying $7,400 instead of $7,000 and bear $400 of the tax burden.
Sellers end up receiving $6, and bear $600 of the tax burden.
500
750
Quantity of Used Cars per Month (in thous.)

26. The Impact of a Tax Imposed on Sellers
(of used cars) S
+ Tax
Price
Note that the new quantity of used cars that make the market is 500.
Tax Revenue from Consumers
As consumers are bearing $400 of the tax burden, and as there are ,000 units being sold per month, the tax revenues derived from the consumers = $200,000,000. S
(of used cars) D
(for used cars)
As sellers are bearing $600 of the tax burden, and as there are ,000 units being sold per month, the tax revenues derived from the sellers = $300,000,000.
$7,400
Deadweight Loss
$7,000
As only 500,000 cars are being sold instead of the 750,000 from before the tax, the area above the old supply curve and below the demand curve represents the consumer and producer (total) surplus that is lost due to the imposition of the tax. This is called the Deadweight Loss to Society.
Tax Revenue from Sellers
$6,400
500
500
750
Quantity of Used Cars per Month (in thous.)

27. The Impact of a Tax Imposed on Buyers
Consider the market for used cars where a price of $7,000 would bring the quantity of used cars demanded into balance with the quantity supplied.
Price S
(of used cars) D
(for used cars)
$1000 tax
When a $1,000 tax is imposed on the buyers of used cars, the demand curve moves down vertically by the amount of the tax.
$7,400 D
(for used cars)
- Tax
$7,000
While the sellers of used cars now receive the new market price for used cars, $6,
$1000
$6,400
. . . buyers pay both the market price and the tax, ($6,400 + $1000 tax = $7,400).
The difference between the two is the amount of the tax, $1000.
As the consumers end up paying $7,400 instead of $7,000 and bear $400 of the tax burden.
500
750
Quantity of Used Cars per Month (in thous.)
Sellers end up receiving $6, and bear $600 of the tax burden.

28. The Impact of a Tax Imposed on Buyers
Tax Revenue from Sellers
Price
Note that the new quantity of used cars that make the market is 500.
Tax Revenue from Consumers
As consumers are bearing $400 of the tax burden, and as there are ,000 units being sold per month, the tax revenues derived from the consumers = $200,000,000. S
(of used cars) D
(for used cars)
As sellers are bearing $600 of the tax burden, and as there are ,000 units being sold per month, the tax revenues derived from the sellers = $300,000,000.
$7,400
Deadweight Loss D
(for used cars)
- Tax
$7,000
Again the area above the supply curve and below the old demand curve represents the consumer and producer (total) surplus that is lost due to the imposition of the tax, the Deadweight Loss to Society.
$6,400
Note that the incidence of the tax is the same regardless of whether it is imposed on buyers or sellers.
500
500
750
Quantity of Used Cars per Month (in thous.)

29. Deadweight Loss
Deadweight loss is the loss of gains resulting from the imposition of tax.
It imposes a burden of taxation over the burden of transferring revenues to the government.
It is composed of losses to both buyers and sellers.

30. Elasticity and Incidence of a 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 become more inelastic, then more of the burden will fall on buyers.

31. Elasticity and the Deadweight Loss
The deadweight loss of tax rises as the elasticity of either the supply curve or demand curve rises.

32. Tax Burden and Elasticity
Lets consider the market for Gas and Luxury Boots individually.
Price
Gasoline
S + Tax
We begin in equilibrium.
2.00
If we were to impose a $.90 tax on gasoline suppliers, the supply curve moves vertically the distance of the tax. Price at the pump goes up by $.80 and output falls by 1 million gal. S
1.20
1.10 D
If we were to impose a $25 tax on Luxury Boot suppliers, the supply curve moves vertically the distance of the tax. Price at the rack go up by $5 and output falls by 1.5 thousand units. 1 2 3 4 5 5 6 6 7
million(s) of gal. per week
Price
S + Tax
Luxury Boots
Note that, as in the graph for the market for gas, when the demand curve is relatively more inelastic than its supply, that buyers bear a larger share of the burden of the tax. S
$ 105
$ 100
Note that, as in the graph for the market for luxury boots, when the supply curve is relatively more inelastic than its demand, that sellers bear a larger share of the tax burden. D
$ 80 25 50 75
100
thousand(s) of boots per week

33. 5. Tax Rates, Tax Revenues, and the Laffer Curve

34. Average Tax Rate
Average tax rate equals tax liability divided by taxable income.
Progressive tax is one in which the average tax rate rises with income.
Proportional tax is one in which the average tax rate stays the same across income levels.
Regressive tax is one in which the average tax rate falls with income.

35. Marginal Tax Rate
Marginal tax rate equals change in tax liability divided by change in taxable income.

36. Tax Rate and Tax Base
Tax rate is the percentage rate at which an economic activity is taxed.
Tax base the level of the activity that is taxed.
The tax base is inversely related to the rate at which the activity is taxed

37. Laffer Curve
Laffer curve illustrates the relationship between tax rates and tax revenues.
Laffer Curve shows that tax revenues are low for both high and low tax rates.
The point of maximum tax revenue is not optimal because of high excess burden.

38. The Laffer Curve
At a tax rate of 0%, tax revenues would also be equal to $0.
Tax Rate
At a tax rate of 100%, nobody would work and thus, again, tax revenues would also be equal to $0.
100%
As the tax rate increase from 0% to some pt A, tax revenues increase despite the fact that some individuals are choosing not to work. C
75%
After some pt B, a further increase in the tax rates might actually cause tax revenues to fall. B
50%
As the Laffer curve illustrates, as tax rates approach pt C tax revenues continue to fall as the tax base shrinks faster than the increase in the tax rate can keep up with.
25% A
There is no presumption that pt B is the ideal tax rate only that it maximizes the tax revenue in the current period.
Positive Tax Revenues
Positive Tax Revenues
Max Tax Revenues
Tax Revenues

39. Laffer Curve and Tax Changes in the 1980s
During the 1980s, the top marginal income tax rate fell from 70% to 33%.
Need to distinguish between changes in tax rates and changes in tax revenues.
Between 1980 and 1990 real income tax revenue collected from the top 1 percent of earners rose a whopping 51.4 percent

40. Questions for Thought:
1. What is meant by the incidence of a tax? Explain why the statutory and actual incidence of a tax can be different?
2. What is the nature of the deadweight loss accompanying taxes? Why is it referred to as an “excess burden” of the tax?
3. Does the Laffer curve indicate that a reduction in tax rates will always lead to a reduction in tax revenues? Should the government attempt to levy a tax rate that would maximize its revenues?

41. End Chapter 4