1 Chapter 4 Supply and Demand: Applications and Extensions

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Chapter 4Chapter 4

Supply and Demand:Supply and Demand:

Applications and ExtensionsApplications and Extensions

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OverviewOverview

The resource market (particularly the The resource market (particularly the labor market)labor market)

Price Controls: price floors and Price Controls: price floors and ceilings (surpluses and shortages)ceilings (surpluses and shortages)

Impact of a tax Impact of a tax The tax systemThe tax system The Laffer curveThe Laffer curve SubsidiesSubsidies

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The Labor MarketThe Labor Market

Price for labor is called the wage (W)Price for labor is called the wage (W) Quantity of labor is called employment Quantity of labor is called employment

(E)(E)

*Note: works just like the market for *Note: works just like the market for goods, only with a different name for goods, only with a different name for price (wage) and quantity (employment)price (wage) and quantity (employment)

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Labor DemandLabor Demand

1. Firms demand labor1. Firms demand labor

2. Labor demand curve is downward 2. Labor demand curve is downward sloping because as wage decreases, sloping because as wage decreases, firms will want to employ more firms will want to employ more peoplepeople

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Changes in Labor DemandChanges in Labor Demand

1. An increase in labor demand (labor 1. An increase in labor demand (labor demand shifts right)demand shifts right)

2. A decrease in labor demand (labor 2. A decrease in labor demand (labor demand curve shifts left)demand curve shifts left)

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Labor SupplyLabor Supply

1. Workers supply labor1. Workers supply labor

2. Labor supply curve is upward 2. Labor supply curve is upward sloping because as wage increases, sloping because as wage increases, people will want to work more.people will want to work more.

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Changes in Labor SupplyChanges in Labor Supply

1. Increase in labor supply: (labor 1. Increase in labor supply: (labor supply curve shifts right)supply curve shifts right)

2. Decrease in labor supply: (labor 2. Decrease in labor supply: (labor supply curve shifts left)supply curve shifts left)

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Linking the MarketsLinking the Markets

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

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Linking the MarketsLinking the Markets

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

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Price FloorPrice Floor

Price floorPrice floor: A legally established : A legally established minimum price buyers must pay for a minimum price buyers must pay for a good or resourcegood or resource

A price floor above equilibrium price A price floor above equilibrium price creates a surpluscreates a surplus

A price floor below equilibrium price A price floor below equilibrium price does nothing does nothing

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SurplusSurplus

SurplusSurplus: A condition in which the : A condition in which the amount offered for sale is greater amount offered for sale is greater than the amount that buyers will than the amount that buyers will purchase at existing prices.purchase at existing prices.

Also known as excess supply:Also known as excess supply:

Quantity supplied > Quantity Quantity supplied > Quantity demandeddemanded

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Application: Minimum WageApplication: Minimum Wage

The minimum wage is an example of a The minimum wage is an example of a price floor.price floor.

Raising minimum wage increases Raising minimum wage increases excess labor supply (unemployment).excess labor supply (unemployment).

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Price CeilingPrice Ceiling

Price ceilingPrice ceiling: A legally established : A legally established maximum price sellers can charge maximum price sellers can charge for a good or resource for a good or resource

A price ceiling below market A price ceiling below market equilibrium price creates a shortageequilibrium price creates a shortage

A price ceiling above market A price ceiling above market equilibrium price does nothingequilibrium price does nothing

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ShortageShortage

ShortageShortage: a condition in which the : a condition in which the amount offered for sale is less than amount offered for sale is less than the amount demanded by buyers at the amount demanded by buyers at existing prices existing prices

Also known as excess demand:Also known as excess demand:

Quantity demanded > Quantity Quantity demanded > Quantity suppliedsupplied

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Application: Disaster MarketsApplication: Disaster Markets

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Application: Rent ControlApplication: Rent Control

Rent controls lead to shortages as well Rent controls lead to shortages as well as:as:

1.1. Black marketsBlack markets2.2. A decline in the supply of future A decline in the supply of future

rental housingrental housing3.3. A decline in quality of rental housingA decline in quality of rental housing4.4. Non-price methods of rationingNon-price methods of rationing5.5. Inefficient housing match-upsInefficient housing match-ups

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Impact of a TaxImpact of a Tax

A tax on a product will cause the supply A tax on a product will cause the supply curve to shift left by the amount of the curve to shift left by the amount of the tax.tax.

1.1. Raises the price that buyers payRaises the price that buyers pay

2.2. Reduces the amount sellers receiveReduces the amount sellers receive

3.3. Reduces the quantity soldReduces the quantity sold

4.4. Increases government revenueIncreases government revenue

5.5. Creates deadweight lossCreates deadweight loss

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Deadweight lossDeadweight loss

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

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Tax IncidenceTax Incidence

Tax Incidence: Tax Incidence: The way the burden of a The way the burden of a tax is distributed among economic unitstax 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 It does not depend on whom the tax is imposed.imposed.

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Tax IncidenceTax Incidence

Tax incidence Tax incidence doesdoes depend on depend on elasticity:elasticity:

The burden of the tax will fall on those The burden of the tax will fall on those who are relatively inelastic.who are relatively inelastic.

Deadweight loss will be lower if taxes Deadweight loss will be lower if taxes are placed on goods that are relatively are placed on goods that are relatively inelastic. inelastic.

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The Tax SystemThe Tax System

Average tax rate (ATR): the Average tax rate (ATR): the percentage of income paid in taxespercentage of income paid in taxes

ATR = tax liability / taxable ATR = tax liability / taxable incomeincome

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The Tax SystemThe Tax System

3 possibilities:3 possibilities:

1. Progressive tax: average tax rate rises 1. Progressive tax: average tax rate rises with incomewith income

2. Regressive tax: average tax rate falls with 2. Regressive tax: average tax rate falls with incomeincome

3. Proportional tax: average tax rate is the 3. Proportional tax: average tax rate is the same at all income levelssame at all income levels

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The Tax SystemThe Tax System

Marginal tax rate (MTR):Marginal tax rate (MTR): The The additional tax liability a person faces additional tax liability a person faces divided by his or her additional taxable divided by his or her additional taxable income.income.

MTR = change in tax liability / MTR = change in tax liability /

change in taxable incomechange in taxable income

*Note: Marginal tax rates are what is *Note: Marginal tax rates are what is important in personal decision making.important in personal decision making.

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Fairness and EfficiencyFairness and Efficiency

1.1. Is the progressive tax system Is the progressive tax system economically efficient?economically efficient?

2.2. Is the progressive tax system fair?Is the progressive tax system fair?

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The Laffer CurveThe Laffer Curve

The Laffer CurveThe Laffer Curve: A curve illustrating : A curve illustrating the relationship between the tax rate the relationship between the tax rate and tax revenue.and tax revenue.

Higher tax rates will not always lead to Higher tax rates will not always lead to more tax revenue!!more tax revenue!!

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SubsidiesSubsidies

Subsidy: Subsidy: A payment the government A payment the government makes to either the buyer or seller makes to either the buyer or seller when a good or service is purchased when a good or service is purchased or sold.or sold.

ex. Subsidizing treadmillsex. Subsidizing treadmills

*Note: Subsidies are costly*Note: Subsidies are costly

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Farm SubsidiesFarm Subsidies

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ReviewReview

1. Why is labor demand downward sloping?1. Why is labor demand downward sloping?2. Why is labor supply upward sloping?2. Why is labor supply upward sloping?3. What is the effect of a price ceiling (price 3. What is the effect of a price ceiling (price

floor)?floor)?4. What is the impact of a tax?4. What is the impact of a tax?5. Calculate average tax rate and marginal 5. Calculate average tax rate and marginal

tax rate.tax rate.6. Understand the Laffer Curve.6. Understand the Laffer Curve.7. Understand the impacts of a subsidy7. Understand the impacts of a subsidy