1
MARKETS IN ACTION
Principles of Microeconomic Theory, ECO 284
John EastwoodCBA 213523-7353e-mail address:
2
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.
3
Learning Objectives (cont.)
Explain how markets for illegal goods work
Explain why farm prices and revenues fluctuate
Explain how speculation limits price fluctuations
4
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.
5
Housing Marketsand Rent Ceilings
San Francisco Earthquake — 1906 How does the market deal with a dramatic
reduction in the supply of housing?
6
The San Francisco Housing Market in 1906
Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
7Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
SS
The San Francisco Housing Market in 1906
8Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
SS
LS
The San Francisco Housing Market in 1906
9Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
SSa
LS
SS
The San Francisco Housing Market in 1906
10Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
SSa
LS
SS
The San Francisco Housing Market in 1906
11Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
SSa
LS
SS
The San Francisco Housing Market in 1906
12Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
SSa
LS
SS
The San Francisco Housing Market in 1906
13Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
SSa
LS
SS
The San Francisco Housing Market in 1906
14Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
LS
SS
The San Francisco Housing Market in 1906
15
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?
16
A Regulated Housing Market
Rent ceilings set above equilibrium have no effect.
Rent ceilings set below equilibrium prevents price from regulating the quantities supplied and demanded.
17
A Rent Ceiling
Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
SSa
Rentceiling
18
A Rent Ceiling
Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
SSa
Rentceiling
SS
Housingshortage
19
A Regulated Housing Market
The ceiling results in two developments
Search activity
Black markets
20
A Regulated Housing Market
Search activity is the time spent looking for someone to do business. Search activity increases when there is a
shortage • an opportunity cost
21
A Regulated Housing Market
Black markets are illegal markets in which the price exceeds the legally imposed price ceiling.
22
Inefficiency of Rent Ceilings
Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
S
Rentceiling
24
30
23Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
Rentceiling
30S
Inefficiency of Rent Ceilings
24Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
Rentceiling
30S
Producersurplus
Inefficiency of Rent Ceilings
25Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
Rentceiling
30S
Producersurplus
Deadweightloss
Inefficiency of Rent Ceilings
26Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
Rentceiling
30S
Producersurplus
Deadweightloss
Consumersurplus
Inefficiency of Rent Ceilings
27
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.
28
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
29
The Labor Market and the Minimum Wage
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.
30
The Labor Market and the Minimum Wage
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.
31
A Market for Low-Skilled Labor
Quantity (millions of hours per year)
Wag
e R
ate
(dol
lars
per
hou
r)
20 21 22 23
3
4
5
6 SS
D
LS
32
A Market for Low-Skilled Labor
Quantity (millions of hours per year)
Wag
e R
ate
(dol
lars
per
hou
r)
20 21 22 23
3
4
5
6 SS
D
LS
DA
33
A Market for Low-Skilled Labor
Quantity (millions of hours per year)
Wag
e R
ate
(dol
lars
per
hou
r)
20 21 22 23
3
4
5
6 SS
D
LS
DA
34
A Market for Low-Skilled Labor
Quantity (millions of hours per year)
Wag
e R
ate
(dol
lars
per
hou
r)
20 21 22 23
3
4
5
6 SS
D
LS
DA
SSA
35
A Market for Low-Skilled Labor
Quantity (millions of hours per year)
Wag
e R
ate
(dol
lars
per
hou
r)
20 21 22 23
3
4
5
6 SS
D
LS
DA
SSA
36
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.
37
Minimum Wage and Unemployment
Quantity (millions of hours per year)
Wag
e R
ate
(dol
lars
per
hou
r)
20 21 22 23
3
4
5
6 SS
DA
38
Minimum Wage and Unemployment
Quantity (millions of hours per year)
Wag
e R
ate
(dol
lars
per
hou
r)
20 21 22 23
3
4
5
6 SS
DA
Minimumwage
a b
Unemployment
39
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.
40
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.
41
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.).
42
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.
43
Taxes
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
44
The Sales Tax
Quantity (thousands of CD players per week)
Pric
e (d
olla
rs p
er p
laye
r)
3 4 5 6
95
100
105
S
DA
110
45
The Sales Tax
Quantity (thousands of CD players per week)
Pric
e (d
olla
rs p
er p
laye
r)
3 4 5 6
95
100
105
110
DA
S
S + tax
$10 tax
46
The Sales Tax
Quantity (thousands of CD players per week)
Pric
e (d
olla
rs p
er p
laye
r)
3 4 5 6
95
100
105
110 S
S + tax
$10 tax
Taxrevenue
DA
47
Elasticity and Slope
ed and slope are inversely related.
e
e
d
d
Q
Q
P
P
Q
Q
P
P
Q
P
P
Q
PQ
P
Q Slope
P
Q
1 1
48
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
P
P
Q Slope
P
Q
1
49
Equal Elasticities, Equal Burdens
Slope of the demand curve = -5/1
Slope of the demand curve = 5/1
Original equilibrium = (5,100)
45
100
5
1ee sd
50
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
51
Sales Tax and the Elasticity of Demand
Quantity (thousands of doses per day)
Pri
ce (d
olla
rs p
er d
ose)
2.00
2.20
100
D
S
Perfectly InelasticDemand
52
Sales Tax and the Elasticity of Demand
Quantity (thousands of doses per day)
Pri
ce (d
olla
rs p
er d
ose)
2.00
2.20
100
D
S
S + taxBuyer paysentire tax
Perfectly InelasticDemand
53
Sales Tax and the Elasticity of Demand
Quantity (thousands of marker pens per week)
Pri
ce (c
ents
per
pen
)
1 4
1.00
S
0.90
Perfectly ElasticDemand
54
Sales Tax and the Elasticity of Demand
Quantity (thousands of marker pens per week)
1 4
0.90
1.00
SS + tax
Sellerpaysentiretax
Pri
ce (c
ents
per
pen
)
Perfectly ElasticDemand
55
Tax Incidence andElasticity of Demand
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.
56
Tax Incidence andElasticity of Demand
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.
57
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
58
Sales Tax and theElasticity of Supply
Quantity (thousands of bottles per week)
Pri
ce (d
olla
rs p
er b
ottl
e)
45
50
100
S
D
Perfectly InelasticSupply
59
Sales Tax and theElasticity of Supply
Quantity (thousands of bottles per week)
Pri
ce (d
olla
rs p
er b
ottl
e)
45
50
100
S
D
Seller paysentire tax
Perfectly InelasticSupply
60
Sales Tax and theElasticity of Supply
Quantity (thousands of pounds per week)
Pri
ce (c
ents
per
pou
nd)
10
11
S
D
Perfectly ElasticSupply
3 5
61
Sales Tax and theElasticity of Supply
Quantity (thousands of pounds per week)
Pri
ce (c
ents
per
pou
nd)
10
11
3 5
S
D
S + taxbuyer paysentire tax
Perfectly ElasticSupply
62
Tax Incidence andElasticity of Supply
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.
63
Tax Incidence andElasticity of Supply
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.
64
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
65
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.
66
Taxes and Efficiency
Quantity (thousands of CD players per week)
Pri
ce (d
olla
rs p
er p
laye
r)
0 1 2 3 4 5 6 7 8 9 10
75
100
130
95
105
D
S
67
Taxes and Efficiency
Quantity (thousands of CD players per week)
Pri
ce (d
olla
rs p
er p
laye
r)
0 1 2 3 4 5 6 7 8 9 10
75
100
130
95
105
D
S
D
S
S + tax
68
Taxes and Efficiency
Quantity (thousands of CD players per week)
Pri
ce (d
olla
rs p
er p
laye
r)
0 1 2 3 4 5 6 7 8 9 10
75
100
130
95
105
D
S
D
S
S + taxConsumersurplus
Producersurplus
69
Taxes and Efficiency
Quantity (thousands of CD players per week)
Pri
ce (d
olla
rs p
er p
laye
r)
0 1 2 3 4 5 6 7 8 9 10
75
100
130
95
105
D
S
D
S
S + tax
Tax Revenue
Consumersurplus
Producersurplus
70
Taxes and Efficiency
Quantity (thousands of CD players per week)
Pri
ce (d
olla
rs p
er p
laye
r)
0 1 2 3 4 5 6 7 8 9 10
75
100
130
95
105
D
S
D
S
S + taxConsumersurplus
Producersurplus
Deadweightloss
Tax Revenue
71
Unit Tax when |ed|> es
0
20
40
60
80
100
120
0 5 10 15 20 25 30 35 40 45 50 55 60
Demand
Supply
S + Tax
Quantity (kegs/day)
Pri
ce (
$/ke
g)
72
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:
73
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: -10 + 2Qe = 60 - Qe
74
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: -10 + 2Qe = 60 - Qe
3Qe = 70
75
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: -10 + 2Qe = 60 - Qe
3Qe = 70
Qe = 23.33 kegs per day (|ed|>1 if Q<30.)
Solve for equilibrium price: Pe =
76
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: -10 + 2Qe = 60 - Qe
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.
77
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
78
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 =
79
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
80
Tax Burden with Demand More Elastic than SupplyAdd 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
Solve for gross price (buyers pay): Pgross =
81
Tax Burden with Demand More Elastic than SupplyAdd 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
Solve for gross price (buyers pay): Pgross = 60 - Qn = 60 - 20 = $40 per keg.
82
Tax Burden with Demand More Elastic than Supply
To solve for net price ($ seller keeps), subtract the tax from the gross price Pnet = Pgross -Tax =
83
Tax Burden with Demand More Elastic than Supply
To solve for net price ($ seller keeps), subtract the tax from the gross price Pnet = Pgross -Tax = $40 - $10 = $30 per keg.
Or, find the net price by substituting Qn into the original supply curve: Pnet = -10 + 2 Qn =
84
Tax Burden with Demand More Elastic than Supply
To solve for net price ($ 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.
85
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.
33.23
67.36
1
11
Q
P
Slopeed
33.23
67.36
2
11
Q
P
Slopees
86
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
P
Q
1 1
1
36 67
2333157
.
..
se Slope
P
Q
1 1
2
36 67
23330 79
.
..
87
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.
88
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.
89
Unit Tax when |ed|< es
0
10
20
30
40
50
60
0 5 10 15 20 25 30 35 40 45 50 55 60
Demand
Supply
S + Tax
Quantity (kegs/day)
Pri
ce (
$/ke
g)
90
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
91
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 =
92
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 =
93
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 = 60 - Qe = 60 - 40 = $20 per keg.
94
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
95
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
1.4Qn = 46
Qn =
96
Tax Burden with Demand Less Elastic than SupplyAdd 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
1.4Qn = 46
Qn = 32.86 kegs per day
Solve for gross price (buyers pay): Pgross =
97
Tax Burden with Demand Less Elastic than SupplyAdd 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
1.4Qn = 46
Qn = 32.86 kegs per day
Solve for gross price (buyers pay): Pgross = 60 - Qn = 60 - 32.86 = $27.14 per keg.
98
Tax Burden with Demand Less Elastic than Supply
To solve for net price ($ 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 =
99
Tax Burden with Demand Less Elastic than Supply
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
100
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
Q
P
Slopees1
Q
P
Slopeed1
101
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
P
Q
1 1
0 4
20
40125
..
de Slope
P
Q
1 1
1
20
400 50.
102
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.
103
Who Pays Most 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.
104
Example with |ed| = es
0
10
20
30
40
50
60
70
80
0 5 10 15 20 25 30 35 40 45 50 55 60
Demand
Supply
S + Tax
Quantity (kegs/day)
Pri
ce (
$/ke
g)
105
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.
When the buyers and sellers have the same elasticities, the tax burden is ___________.
106
Who Pays Most of the Tax?
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.
107
A Workable General Principle
They who respond least to the change in price pay the majority of the tax.
108
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.
109
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.
110
Excess Burden of a Tax
Excess burden = total burden - tax revenueIncludes:
administrative cost compliance cost deadweight loss
Further reading: Chapter 18, pages 398-403.
111
Learning Objectives (cont.)
Explain how markets for illegal goods work
Explain why farm prices and revenues fluctuate
Explain how speculation limits price fluctuations
112
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
113
A Market for a Prohibited Good
Quantity
Pri
ce
Pc
D
S
c
Qc
114
A Market for a Prohibited Good
Quantity
Pri
ce
Pc
D
c
S
S + CBL
a
Qp Qc
Pp
115
A Market for a Prohibited Good
Quantity
Pri
ce
Pc
D
c
Sa
D - CBL
bPp
Qp Qc
116
A Market for a Prohibited Good
Quantity
Pri
ce
Q p Qc
Pc
D
c
S
S + CBL
a
D - CBL
b
d
117
A Market for a Prohibited Good
Quantity
Pri
ce
Q p Qc
Pc
D
c
S
S + CBL
a
D - CBL
b
d
Cost per unitof breakingthe law...…to
buyer…to seller
118
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.
119
Learning Objectives (cont.)
Explain how markets for illegal goods work
Explain why farm prices and revenues fluctuate
Explain how speculation limits price fluctuations
120
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?
121
Stabilizing Farm Revenues
Farm Revenues during a bad harvest Total farm revenue actually increases due to
inelastic demand.
Some farmers, whose entire crop is destroyed,
lose.
Others, whose crop is unaffected, earn
enormous profits.
122
Harvest, Farm Prices,and Farm Revenues
0 5 10 15 20 25
2
4
6
8
Quantity (billions of bushels per year)
Pri
ce (
doll
ar p
er b
ushe
l)MS0
D
Poor Harvest
123
0 5 10 15 20 25
2
4
6
8
Quantity (billions of bushels per year)
Pri
ce (
doll
ar p
er b
ushe
l)MS0
D
MS1
$30 billion
$20billion
$60 billion
Poor Harvest
Harvest, Farm Prices,and Farm Revenues
124
Stabilizing Farm Revenues
Farm Revenues during a bumper harvest Total farm revenue actually decreases due to
inelastic demand.
125
0 5 10 15 20 25
2
4
6
8
Quantity (billions of bushels per year)
Pri
ce (
doll
ar p
er b
ushe
l)MS0
D
Bumper Harvest
Harvest, Farm Prices,and Farm Revenues
126
0 5 10 15 20 25
2
4
6
8
Quantity (billions of bushels per year)
Pri
ce (
doll
ar p
er b
ushe
l)MS0
D
MS2
$40 billion $10billion
$40 billion
Bumper Harvest
Harvest, Farm Prices,and Farm Revenues
127
Learning Objectives (cont.)
Explain how markets for illegal goods work
Explain why farm prices and revenues fluctuate
Explain how speculation limits price fluctuations
128
Stabilizing Farm Revenues
Two institutions designed to stabilize farm revenue
Speculative markets in inventories
Farm price stabilization policy
129
How Inventories LimitPrice Changes
0 5 10 15 20 25
2
4
6
8
Quantity (billions of bushels)
S
D
Pri
ce (
doll
ar p
er b
ushe
l)
Inventory Speculation
130
0 5 10 15 20 25
2
4
6
8
Quantity (billions of bushels)
S
D
Pri
ce (
doll
ar p
er b
ushe
l)Q1
Inventory
5 billion frominventory
Inventory Speculation
How Inventories LimitPrice Changes
131
0 5 10 15 20 25
2
4
6
8
Quantity (billions of bushels)
S
D
Pri
ce (
doll
ar p
er b
ushe
l)Q2
5 billion toinventory
Inventory
Inventory Speculation
How Inventories LimitPrice Changes
132
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.
133
Farm Revenue
Farm Price Stabilization Policy Set production limits Set price floors Hold inventories
134
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