Supply and Demand — Applications and Extensions

Copyright (c) 2000 by Harcourt Inc.All rights reserved.

Next page

Slides to Accompany “Economics: Public and Private Choice 9th ed.” James Gwartney, Richard Stroup, and Russell Sobel

Supply and Demand — Applications and Extensions

Chapter 4

Jump to first page Copyright (c) 2000 by Harcourt Inc.All rights reserved.

1. Wage Rates, Interest Rates, and Exchange Rates


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.


Employment Quantity

Resource Prices, Opportunity Cost, and Product Markets

S1

Dr

• Suppose there is a reduction in the supply of young, inexperienced labor

S2

Dp

S1

S2

$6.50

$5.25

$2.25

$2.00

E2 E1 Q2 Q1ResourceMarket

ProductMarket

• In the product market the higher wage will increase the restaurant’s opportunity cost, causing a reduction in supply,

which pushes the wage rates of workers hired by fast-food restaurants upward.

leading to higher hamburger prices.

P P


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.


• 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.

interestrate

Quantity ofLoanable

Funds

r1

Q1

D1

(borrowing)

• We begin in equilibrium at the

lending level Q1 and interest rate r1.

Q2

• An increase in the demand for

loanable funds will move D1 to D2

• The higher interest rate will encourage additional savings, making it possible to fund more borrowing.

Increase in the Demand for Loanable Funds

Supply(lending)

D2

(borrowing)

r2

pushing the interest rate up from r1 to r2 and borrowing from Q1 to Q2


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.


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.


D2

(purchasesfrom

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.

exchangerate

Quantity ofForeign Exchange

.10

Q1

• We begin in equilibrium where the dollar price of the quetzal is $.10 (10 cents = 1quetzal).

Q2

• An increase in the demand of Americans for Guatemalan coffee will also increase the demand for quetzals (with which American importers buy Guatemalan coffee).• As a result, the dollar price of the quetzal will rise, as will the number of quetzals that clear the market.

Increase in the Demand for Foreign Exchange

Supply(sales to

foreigners)

.20

$ price per quetzal

D1

(purchasesfrom

foreigners)


2. The Economics of Price Controls


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.


PriceCeiling

D (of rentalhousing)

• 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.

Price

Quantity ofHousing

UnitsQS

• When a price ceiling like P1 pushes the price of the product below the market equilibrium . . .

QD

. . . the quantity supplied (Qs) . . .

• Because prices are not allowed to direct the market back to equilibrium,

non-price elements will become more

important.

The Impact of a Price Control

P0

S (of rentalhousing)

P1Shortage exceeds the quantity demanded (Qd),

resulting in a shortage.


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.


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.


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

expense of newcomers.


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.


Minimum Wage Effects Direct effect:

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.


S (of labor)

D (for labor)

MinimumWageLevel

• 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.

Wage

EmploymentED

• A minimum wage (price floor) of $5.15 would raise the price of the labor above the market equilibrium

ES

where the employment supplied (Es)

• For those (Ed) who were able to maintain their employment, their earnings would increase.

Employment and the Minimum Wage

$4.00

ExcessSupply

exceeds that demanded (Ed), resulting in a employment surplus.

$5.15

• Those (Es - Ed) who lose their job are pushed into either the unemployment rolls or to a less preferred form of employment.


3. Black Markets and the Importance of Legal Structure


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.


Legal System A legal system that provides secure

property rights and unbiased enforcement of contracts enhances the operation of markets.


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 $10.00 (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?

Questions for Thought:

2. What is the black market? What are some of the main differences in how black markets operate relative to legal markets?


4. The Impact of a Tax


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).


S(of usedcars)

D (for usedcars)

• 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.

Quantity of Used Cars per Month

(in thous.)500

• 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.

750

• The new price in the market for used cars is $7,400 . . .

The Impact of a Tax Imposed on Sellers

$6,400

(of usedcars)S + Tax

$7,000

$7,400

• . . . while sellers receive $6,400 ($7,400 - $1000 tax = $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 $6,400 and bear $600 of the tax burden.

$1000

$1000 tax

Price


• Note that the new quantity of used

cars that make the market is 500.

Price

500 750

The Impact of a Tax Imposed on Sellers

$6,400

(of usedcars)S + Tax

$7,000

$7,400

• 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.

500

• As consumers are bearing $400 of the tax burden, and as there are 500,000 units being sold per month, the tax revenues derived from the consumers = $200,000,000.• As sellers are bearing $600 of the tax burden, and as there are 500,000 units being sold per month, the tax revenues derived from the sellers = $300,000,000.

S(of usedcars)

D (for usedcars)

DeadweightLoss

DeadweightLoss

Tax Revenuefrom

Consumers

Tax Revenuefrom

Consumers

Tax Revenuefrom

Sellers

Tax Revenuefrom

SellersQuantity of Used Cars per Month

(in thous.)


S(of usedcars)

D (for usedcars)

• 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.• 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.

750

• While the sellers of used cars now receive the new market price for used cars, $6,400 . . .

The Impact of a Tax Imposed on Buyers

$6,400

$7,000

$7,400

• . . . 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. • Sellers end up receiving $6,400 and bear $600 of the tax burden.

$1000

D (for usedcars) - Tax

$1000 tax

500

Price

Quantity of Used Cars per Month

(in thous.)


• Note that the new quantity of used

cars that make the market is 500.

500 750

The Impact of a Tax Imposed on Buyers

$6,400

$7,000

$7,400

• 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.

500

• As consumers are bearing $400 of the tax burden, and as there are 500,000 units being sold per month, the tax revenues derived from the consumers = $200,000,000.• As sellers are bearing $600 of the tax burden, and as there are 500,000 units being sold per month, the tax revenues derived from the sellers = $300,000,000.

S(of usedcars)

D (for usedcars)

DeadweightLoss

DeadweightLoss

Tax Revenuefrom

Consumers

Tax Revenuefrom

Consumers

D (for usedcars) - Tax

Tax Revenuefrom

Sellers

Tax Revenuefrom

Sellers

• Note that the incidence of the tax is the same regardless of whether it is imposed on buyers or sellers. Quantity of Used

Cars per Month(in thous.)

Price


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.


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.


Elasticity and the Deadweight Loss The deadweight loss of tax rises as the

elasticity of either the supply curve or demand curve rises.


65

S + Tax

LuxuryBoots

• Lets consider the market for Gas and Luxury Boots individually.

• 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.

2.00

1.20

$ 100

Gasoline

1 2 3 4 7 million(s) of gal. per week

100

Tax Burden and Elasticity

1.10

$ 105

$ 80

Price

Price

D

D

S

SS + Tax

• 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.

• We begin in equilibrium.• 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.• 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.

thousand(s) of boots per week 755025

5 6


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


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.


Marginal Tax Rate Marginal tax rate equals change in tax

liability divided by change in taxable income.


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


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.


Positive Tax Revenues

Positive Tax Revenues

• At a tax rate of 0%, tax revenues would also be equal to $0.

TaxRate

Tax Revenues

25%

• 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.

The Laffer Curve

50%

75%

100%• At a tax rate of 100%, nobody would work and thus, again, tax revenues would also be equal to $0.

• After some pt B, a further increase in the tax rates might actually cause tax revenues to fall.• 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.• There is no presumption that pt B is the ideal tax rate only that it maximizes the tax revenue in the current period.

A

B

C

Max Tax Revenues


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


2. What is the nature of the deadweight loss accompanying taxes? Why is it referred to as an “excess burden” of the tax?

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?

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?


EndChapter 4

Documents

Supply and Demand — Applications and Extensions