MARKETS IN ACTION

Principles of Microeconomic Theory, ECO 284

John EastwoodCBA 213523-7353e-mail address:

John.Eastwood@nau.edu

Learning Objectives

Explain how price ceilings create shortages and inefficiency

Explain how price floors create surpluses and inefficiency

Explain the effects of the sales tax

Define the total and excess burden of a tax.

Learning Objectives (cont.)

Explain how markets for illegal goods work

Explain why farm prices and revenues fluctuate

Explain how speculation limits price fluctuations

Learning Objectives

Housing Marketsand Rent Ceilings

San Francisco Earthquake — 1906 How does the market deal with a dramatic

reduction in the supply of housing?

The San Francisco Housing Market in 1906

Quantity (thousands of units per month)

0 44 72 100 150

7Quantity (thousands of units per month)

0 44 72 100 150

A Regulated Housing Market

Price ceilings are regulations that make it illegal to charge a price higher than a specified level.

Rent ceilings are price ceilings applied to housing markets.

How does a rent ceiling affectthe housing market?

Rent ceilings set above equilibrium have no effect.

Rent ceilings set below equilibrium prevents price from regulating the quantities supplied and demanded.

A Rent Ceiling

0 44 72 100 150

Rentceiling

A Rent Ceiling

0 44 72 100 150

Rentceiling

Housingshortage

The ceiling results in two developments

Search activity

Black markets

Search activity is the time spent looking for someone to do business. Search activity increases when there is a

shortage • an opportunity cost

Black markets are illegal markets in which the price exceeds the legally imposed price ceiling.

Inefficiency of Rent Ceilings

0 44 72 100 150

Rentceiling

0 44 72 100 150

Rentceiling

0 44 72 100 150

Rentceiling

Producersurplus

0 44 72 100 150

Rentceiling

Producersurplus

Deadweightloss

0 44 72 100 150

Rentceiling

Producersurplus

Deadweightloss

Consumersurplus

Learning Objectives

The Labor Market and the Minimum Wage

Wage rates adjust to make the quantity demanded of labor equal to the quantity supplied Technology has reduced the demand for low-

skilled labor

Short-run There is a given number of people with a given

skill.• Wages must be increased in order to increase the

number of hours worked.

Long-run People can acquire new skills and find new

types of jobs

• If wage rates are too high or low, people will enter or leave this labor market.

• If people can freely enter and leave the labor market, the long-run supply of labor is perfectly elastic.

• The longer the period of adjustment, the greater the elasticity of supply of labor.

A Market for Low-Skilled Labor

Quantity (millions of hours per year)

20 21 22 23

The Minimum Wage

A minimum wage law is a regulation that makes the hiring of labor below a specified wage illegal.

If the minimum wage is set below equilibrium it will have no effect.

If the minimum wage is set above equilibrium, it prevents price from regulating quantity supplied and demanded.

Minimum Wage and Unemployment

20 21 22 23

Minimum Wage and Unemployment

20 21 22 23

Minimumwage

Unemployment

Learning Objectives

Elasticity and the Burden of a Tax

The economic incidence of taxation falls on the persons who suffer reduced purchasing power because of the tax.

The legal incidence falls on the persons who are required by law to pay the tax to the government.

Burden “Shifting”

If a tax is passed on to the consumer in the form of higher prices, we say that the tax is forward-shifted.

A tax is said to be backward-shifted if resource suppliers receive lower factor payments (e.g., workers get lower take home wages, or entrepreneurs earn lower profits.).

Vocabulary

An ad valorem tax is a percentage of price.A specific tax is a fixed amount per unit

sold, e.g., the excise tax we pay on gasoline.

Who Pays the Sales Tax? Suppose a $10 sales tax is imposed on CD

players

There are two prices Including the tax — buyers respond to this

• what they pay -- P gross Excluding the tax — sellers respond to this

• what they receive -- P net

The Sales Tax

Quantity (thousands of CD players per week)

3 4 5 6

The Sales Tax

3 4 5 6

S + tax

$10 tax

The Sales Tax

3 4 5 6

S + tax

$10 tax

Taxrevenue

Elasticity and Slope

ed and slope are inversely related.

Q Slope

Comparing Elasticities @ (Q,P)

If D and S have the same slope, andif D and S cross at a point (Q,P),then their elasticities must be equal!

d se eQ

Q Slope

Equal Elasticities, Equal Burdens

Slope of the demand curve = -5/1

Slope of the demand curve = 5/1

Original equilibrium = (5,100)

1ee sd

Tax Incidence andElasticity of Demand

Two Extremes Perfectly inelastic demand--buyer pays

• Example: Insulin, Salt Perfectly elastic demand--seller pays

• Example: Pink marker pens, Imported paper clips

Sales Tax and the Elasticity of Demand

Quantity (thousands of doses per day)

Perfectly InelasticDemand

Quantity (thousands of doses per day)

S + taxBuyer paysentire tax

Perfectly InelasticDemand

Quantity (thousands of marker pens per week)

Perfectly ElasticDemand

Quantity (thousands of marker pens per week)

SS + tax

Sellerpaysentiretax

Perfectly ElasticDemand

The division of the tax depends upon elasticity. The more ________ the demand, the more the

buyer pays. The more_________ the demand, the more the

seller pays.

The division of the tax depends upon elasticity. The more inelastic the demand, the more the

buyer pays. The more elastic the demand, the more the

seller pays.

Tax Incidence andElasticity of Supply

Two Extremes Perfectly inelastic supply — seller pays

• Example: water from a mineral spring Perfectly elastic supply — buyer pays

• Example: sand used to make silicon used by computer chip makers, aluminum

Sales Tax and theElasticity of Supply

Quantity (thousands of bottles per week)

Perfectly InelasticSupply

Quantity (thousands of bottles per week)

Seller paysentire tax

Perfectly InelasticSupply

Quantity (thousands of pounds per week)

Perfectly ElasticSupply

Quantity (thousands of pounds per week)

S + taxbuyer paysentire tax

Perfectly ElasticSupply

The division of the tax depends upon elasticity. The more__________ the supply, the more the

seller pays.

The more __________ the supply, the more the buyer pays.

The division of the tax depends upon elasticity. The more inelastic the supply, the more the

seller pays.

The more elastic the supply, the more the buyer pays.

Sales Taxes in Practice

Items with low elasticity of demand (alcohol, tobacco, & gasoline) are good sources of tax revenue for the government.

Why?Poor source: 1991 Luxury Tax

Taxes and Efficiency

Inefficiency Due to the difference in price paid by the buyer

and received by the seller the marginal benefit does not equal the marginal cost.

The more inelastic demand or supply, the smaller the decrease in quantity and deadweight loss.

0 1 2 3 4 5 6 7 8 9 10

S + tax

0 1 2 3 4 5 6 7 8 9 10

S + taxConsumersurplus

Producersurplus

0 1 2 3 4 5 6 7 8 9 10

S + tax

Tax Revenue

Consumersurplus

Producersurplus

0 1 2 3 4 5 6 7 8 9 10

S + taxConsumersurplus

Producersurplus

Deadweightloss

Tax Revenue

Unit Tax when |ed|> es

0 5 10 15 20 25 30 35 40 45 50 55 60

Demand

Supply

S + Tax

Quantity (kegs/day)

Tax Burden:|ed| >1 and es< 1.

Demand from Keg Ex: P = $60 - QLet Supply be: P = -10 + 2Q. (es <1.)

Solve for equilibrium quantity:

Solve for equilibrium quantity: -10 + 2Qe = 60 - Qe

3Qe = 70

Qe = 23.33 kegs per day (|ed|>1 if Q<30.)

Solve for equilibrium price: Pe =

3Qe = 70

Qe = 23.33 kegs per day (|ed|>1 if Q<30.)

Solve for equilibrium price: Pe = 60 - Qe = 60 - 23.33 = $36.67 per keg.

Tax Burden with Demand More Elastic than Supply

Add the tax to Supply: P = -10 + 2Q + 10 = 2Q (Now es = 1.)

Solve for new equilibrium quantity, Qn : 2Qn = 60 - Qn

3Qn = 60

Qn = 20 kegs per day

Tax Burden with Demand More Elastic than SupplyAdd the tax to Supply:

P = -10 + 2Q + 10 = 2Q (Now es = 1.)

3Qn = 60

Solve for gross price (buyers pay): Pgross =

Tax Burden with Demand More Elastic than SupplyAdd the tax to Supply:

P = -10 + 2Q + 10 = 2Q (Now es = 1.)

3Qn = 60

Solve for gross price (buyers pay): Pgross = 60 - Qn = 60 - 20 = $40 per keg.

To solve for net price ($ seller keeps), subtract the tax from the gross price Pnet = Pgross -Tax =

To solve for net price ($ seller keeps), subtract the tax from the gross price Pnet = Pgross -Tax = $40 - $10 = $30 per keg.

Or, find the net price by substituting Qn into the original supply curve: Pnet = -10 + 2 Qn =

To solve for net price ($ seller keeps), subtract the tax from the gross price Pnet = Pgross -Tax = $40 - $10 = $30 per keg.

Or, find the net price by substituting Qn into the original supply curve: Pnet = -10 + 2 Qn = -10 + 2(20) = $30 per keg.

Compute|ed| and es

Before the tax Pe = $36.67/keg and Qe = 23.33 kegs/day. The slope of D = -1, while the slope of S = 2.

Slopeed

Slopees

Compute|ed| and es

Before the tax Pe = $36.67/keg and Qe = 23.33 kegs/day. The slope of D = -1, while the slope of S = 2.

de Slope

2333157

se Slope

23330 79

Now Who Pays the Tax?

Consumers now pay ___ per keg $_____ / keg more than before the tax

Vendors now receive ___ per keg, but must pay the ___ per keg tax. Sellers keep only ___ per keg. _____ / keg less than before

Sellers respond ____ to a change in price, so they pay _____ of the tax.

Now Who Pays the Tax?

Consumers now pay $40 per keg $3.33 / keg more than before the tax

Vendors now receive $40 per keg, but must pay the $10 per keg tax. Sellers keep only $30 per keg. $6.67 / keg less than before

Sellers respond less to a change in price, so they pay more of the tax.

Unit Tax when |ed|< es

0 5 10 15 20 25 30 35 40 45 50 55 60

Demand

Supply

S + Tax

Quantity (kegs/day)

Tax Burden:|ed|< 1 and es> 1

Demand from Keg Ex: P = $60 - QLet Supply be: P = 4+ 0.4Q. (es >1.)

Solve for equilibrium quantity: 4+ 0.4Qe = 60 - Qe

1.4Qe = 56

Qe = 40 kegs per day (|ed|<1 if Q>30.)

Solve for equilibrium price: Pe =

1.4Qe = 56

Qe = 40 kegs per day (|ed|<1 if Q>30.)

Solve for equilibrium price: Pe = 60 - Qe = 60 - 40 = $20 per keg.

Tax Burden with Demand Less Elastic than Supply

Add the tax to Supply: P = 4+ 0.4Q + 10 = 14+ 0.4Q (es > 1.)

Solve for new equilibrium quantity, Qn : 14+ 0.4Qn = 60 - Qn

Add the tax to Supply: P = 4+ 0.4Q + 10 = 14+ 0.4Q (es > 1.)

1.4Qn = 46

Tax Burden with Demand Less Elastic than SupplyAdd the tax to Supply:

P = 4+ 0.4Q + 10 = 14+ 0.4Q (es > 1.)

1.4Qn = 46

Qn = 32.86 kegs per day

Solve for gross price (buyers pay): Pgross =

Tax Burden with Demand Less Elastic than SupplyAdd the tax to Supply:

P = 4+ 0.4Q + 10 = 14+ 0.4Q (es > 1.)

1.4Qn = 46

Qn = 32.86 kegs per day

Solve for gross price (buyers pay): Pgross = 60 - Qn = 60 - 32.86 = $27.14 per keg.

To solve for net price ($ seller keeps), subtract the tax from the gross price Pnet = Pgross -Tax =

Or, find the net price by substituting Qn into the original supply curve: Pnet = 4 + 0.4Qn =

To solve for net price ($ seller keeps), subtract the tax from the gross price Pnet = Pgross -Tax = 27.14 - 10 = $17.14

Or, find the net price by substituting Qn into the original supply curve: Pnet = 4 + 0.4Qn = 4 + 0.4(32.86 ) = $17.14

Compute|ed| and es

Before the tax Pe=$20/keg and Qe=40 kegs/day. The slope of D = -1, while the slope of S = 0.4

Slopees1

Slopeed1

Compute|ed| and es

Before the tax Pe=$20/keg and Qe=40 kegs/day. The slope of D = -1, while the slope of S = 0.4

se Slope

de Slope

400 50.

Who Pays Most of the Tax?

Consumers now pay $_____ per keg, $_____ per keg more than before the tax.

Vendors now receive $_____ per keg, but must pay the $___ per keg tax. Sellers keep only $____ per keg, $_____ per keg less than before the tax.

Buyers respond _____ to a change in price, so they pay _____ of the tax.

Consumers now pay $27.14 per keg, $7.14 per keg more than before the tax.

Vendors now receive $27.14 per keg, but must pay the $10 per keg tax. Sellers keep only $17.14 per keg, $2.86 per keg less than before the tax.

Buyers respond less to a change in price, so they pay more of the tax.

Example with |ed| = es

0 5 10 15 20 25 30 35 40 45 50 55 60

Demand

Supply

S + Tax

Quantity (kegs/day)

Consumers now pay $_____ per keg, $_____ per keg more than before the tax.

Vendors now receive $_____ per keg, but must pay the $___ per keg tax. Sellers keep only $____ per keg, $_____ per keg less than before the tax.

When the buyers and sellers have the same elasticities, the tax burden is ___________.

Consumers now pay $40 per keg, $5.00 per keg more than before the tax.

Vendors now receive $40 per keg, but must pay the $10 per keg tax. Sellers keep only $30 per keg, $5.00 per keg less than before the tax.

When the buyers and sellers have the same elasticities, the tax burden is equally shared.

A Workable General Principle

They who respond least to the change in price pay the majority of the tax.

Learning Objectives

Total Burden of a Tax

The amount that, if paid to “taxpayers,” would make them just as well off with the tax as without it.

Excess Burden of a Tax

Excess burden = total burden - tax revenueIncludes:

administrative cost compliance cost deadweight loss

Further reading: Chapter 18, pages 398-403.

Markets for Prohibited Goods

When a good is illegal, the cost of trading in the good increases.

Penalties and policing increase the cost. Decreases supply and/or demand

A Market for a Prohibited Good

Quantity

S + CBL

Quantity

D - CBL

Quantity

Q p Qc

S + CBL

D - CBL

Quantity

Q p Qc

S + CBL

D - CBL

Cost per unitof breakingthe law...…to

buyer…to seller

Markets for Prohibited Goods

Enforcement Price effects depend upon who receives the

most severe penalty — the buyer or seller Today, penalties on sellers are larger

• This causes the equilibrium quantity to decrease and price increases compared to an unregulated market.

Stabilizing Farm Revenues

Farm output fluctuates considerably due to fluctuations in the weather.

How do changes in farm output affect farm prices and farm revenues?

How can farm revenues be stabilized?

Farm Revenues during a bad harvest Total farm revenue actually increases due to

inelastic demand.

Some farmers, whose entire crop is destroyed,

Others, whose crop is unaffected, earn

enormous profits.

Harvest, Farm Prices,and Farm Revenues

0 5 10 15 20 25

Quantity (billions of bushels per year)

Poor Harvest

0 5 10 15 20 25

$30 billion

$20billion

$60 billion

Poor Harvest

Farm Revenues during a bumper harvest Total farm revenue actually decreases due to

inelastic demand.

0 5 10 15 20 25

Bumper Harvest

0 5 10 15 20 25

$40 billion $10billion

$40 billion

Bumper Harvest

Two institutions designed to stabilize farm revenue

Speculative markets in inventories

Farm price stabilization policy

How Inventories LimitPrice Changes

0 5 10 15 20 25

Quantity (billions of bushels)

Inventory Speculation

0 5 10 15 20 25

Inventory

5 billion frominventory

0 5 10 15 20 25

5 billion toinventory

Inventory

Farm Revenue

Speculative markets in inventories do not stabilize farm revenue When price is stabilized, revenue fluctuates as

production fluctuates. Bumper crops bring larger revenues than poor

harvest do.

Farm Revenue

Farm Price Stabilization Policy Set production limits Set price floors Hold inventories

Farm Revenue

Farm Price Stabilization Policy Production limits

• Quotas restrict the quantity produced – can result in higher farm prices

Price floors • set above equilibrium create surpluses

Hold inventories• the government must hold inventory to maintain the

equilibrium price

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