Chapter 6: Supply, Demand and Government...

Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy

Econ 1023 Principle of Economics: Micro

Chapter 6: Supply, Demand andGovernment Policies

Instructor: Hiroki WatanabeSpring 2013

Watanabe Econ 1023 6 Price Control 1 / 109


1 Introduction

2 Price Ceiling

3 Rationing

4 Price Floor

5 Taxation

6 Rationing vs Taxation

7 Tax and Elasticity

8 Subsidy

9 Summary



1 Introduction

2 Price Ceiling

3 Rationing

4 Price Floor

5 Taxation



8 Subsidy

9 Summary



Question 1.1 (Agenda for Chpt 6, 7 and 8)1 Is the equilibrium best outcome that the society

can achieve?2 How does market allocate resources? How does it

compare to other distribution mechanisms?3 What if the gov’t imposes something other than the

equilibrium?

1 Chpt 6: Implementation2 Chpt 7: Evaluation (without tax)3 Chpt 8: Evaluation (with tax)4 Chpt 10: Justification



1 Introduction

2 Price CeilingDefinitionsOil Crisis, Worsened

3 Rationing

4 Price Floor

5 Taxation



8 Subsidy

9 Summary



Definitions

Discussion 2.1 (Rent Regulation)

Take a listen to Marketplace Clip .1 Why are there rent regulations in the first place?2 Is the housing market in equilibrium with rent

regulations? How do we evaluate?3 Does the market clear (i.e., quantity supplied meets

quantity demanded) with regulations?


http://www.marketplace.org/topics/your-money/how-far-does-250k-go-new-york-city


Definitions

Definition 2.2 (Price Control)Price ceiling is a legal maximum on the price atwhich a good can be sold.Price floor is a legal minimum on the price atwhich a good can be sold.



Definitions

U City: “You can’t charge more than $100 for a sliceof cheesecake.”... sure.



Definitions

The price ceiling is binding if the set price is belowthe equilibrium price.Otherwise, the price ceiling is ineffective.



Definitions

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Demand φ(p)Supply s(p)Price Ceiling

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Definitions

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Demand φ(p)Supply s(p)Price CeilingExcess Demand

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Oil Crisis, Worsened

Example 2.3 (Oil Price and Price Ceiling (1))

1973, OPEC raised the price of crude oil.Federal gov’t put the price ceiling in response.

1 Why did they enforce price ceiling?2 What happened after price ceiling was set in place?

Price? Transaction volume? Who got to buy gas andwho couldn’t?




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Demand φ(p)Supply s(p)Price Ceiling

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Demand φ(p)Supply s(p)Price CeilingNew Supply s

2(p)

Excess Demand

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Now the price ceiling is binding. Then what?Consider the following example:





There’re 5 commuters who want to buy 10 gallonseach with the following MWTP:

Commuters MWTP

Liz 40Tracy 90Grizz 50

Kenneth 20Jack 110

Find the equilibrium.




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MWTP(x)Supply

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This won’t work.Breakdown:

1 Find the aggregate demand.1 Sort MWTP from the highest to the lowest (why?)2 Then graph it.

2 Graph the supply.3 Find the equilibrium.




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MWTP(x)Supply

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Suppose that we have tighter supply.1 Find the new equilibrium.2 If the gov’t sets the price ceiling at $40, how much

gas will be transacted?




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MWTP(x)SupplyNew Supply

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MWTP(x)SupplyNew SupplyPrice Ceiling

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1 Introduction

2 Price Ceiling

3 RationingRationing vs Laissez-FaireRent Control

4 Price Floor

5 Taxation



8 Subsidy

9 Summary



Rationing vs Laissez-Faire

Price ceiling leaves excess demand.And it can make things even worse:

The commuters who are willing to pay the most arenot necessarily the ones who are in front of the line.





Suppose that the commuters are lining up in thefollowing order:

Commuters MWTP

Liz 40Tracy 90Grizz 50

Kenneth 20Jack 110

Who will get gasoline? Does the result seem fair?




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MWTP(x)New SupplyPrice Ceiling

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Discussion 3.2 (Oil Price and Price Ceiling (5))1 Is price ceiling a good idea?2 Is rationing a good idea? Compare rationing to

market mechanism. How do they allocateresources?




1 Price is set low at the cost of denying gasoline tosome commuters.

2 The one who gets gasoline is not necessarily theone who is willing to pay the most.

More on this in Chpt 7.



Rent Control

Question 3.3 (Rent Control)1 How does price ceiling affect short-run and long-run

housing markets?2 When it is binding, how are apartments allocated?



Rent Control

Why is rent control in place?to help the poor.neighborhood externalities

Highly inefficient way to help the poor raise theirstandard of living



Rent Control

1 Short-run Effect:Both supply and demand are inelastic.Small excess demand.



Rent Control

2 Long-run Effect:Supply and demand are more elasticLandlords

Are not building new apartmentsAre failing to maintain existing ones

PeopleInduce more people to move into a city

Large shortage of housing



Rent Control

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Demand (Short Run)Supply (Short Run)Demand (Long Run)Supply (Long Run)Price CeilingExcess Demand (Long Run)Excess Demand (Short Run)

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Rent Control

Rationing mechanisms:1 Long waiting lists2 Preference to tenants without children3 Discriminate on the basis of race4 Bribes to building superintendents



1 Introduction

2 Price Ceiling

3 Rationing

4 Price FloorPrice FloorMinimum Wage

5 Taxation



8 Subsidy

9 Summary



Price Floor

Not binding whenset below the equilibrium priceNo effect on the market

Binding whenset above the equilibrium price

Some sellers are unable to sell what they wantrationing mechanism to allocate resources



Price Floor

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Demand φ(p)Supply s(p)Price Floor

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Price Floor

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Demand φ(p)Supply s(p)Price FloorExcess Supply

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Minimum Wage

Example of price floor: minimum wageLowest price for labor that any employer may payFair Labor Standards Act of 1938

Ensure workers a minimally adequate standard ofliving

Federal minimum wage = $7.25 per hour since 09.Some states mandate minimum wages above thefederal level (MO: $7.25).



Minimum Wage

Market for labor1 Workers: supply of labor2 Firms: demand for labor1

If minimum wage is above equilibriumExcess supplyHigher income for workers who have jobsLower income for workers who cannot find jobs

1Called derived demand in particular.Watanabe Econ 1023 6 Price Control 40 / 109


Minimum Wage

1 Highly skilled and experienced workers:Not affected, their equilibrium wages are well abovethe minimumPrice floor doesn’t bind.

2 Teenage labor:Least skilled and least experiencedLow equilibrium wagesWilling to accept a lower wage in exchange foron-the-job trainingBinding price floor.



Minimum Wage

Discussion 4.1 (Teenage Labor Market andMinimum Wage)

What are the consequences of binding minimum wagein the teenage labor market? In particular, how are thelabor rationed?



Minimum Wage

A 10% increase in the minimum wage depressesteenage employment between 1 and 3%.Some teenagers who are still attending high schoolchoose to drop out and take jobs.Displace other teenagers who had already droppedout of school and who now become unemployed



Minimum Wage

In a nutshell,1 Market outcome is efficient.2 Gov’t intervention is called for only when

market outcome is not fair (?)externality is present (more on this in Chpt 10).

3 Price control can backfire.



Minimum Wage

What political interventions are there other thanprice control?



1 Introduction

2 Price Ceiling

3 Rationing

4 Price Floor

5 TaxationTax IncidenceTax Levied on BuyersTax Levied on SellersMeasuring Tax IncidencePayroll Tax



8 Subsidy

9 Summary



Tax Incidence

Gov’t uses taxes1 to finance public projects.2 and what else?



Tax Incidence

Definition 5.1 (Tax Incidence)Tax incidence is a manner in which tax burden is splitamong the sellers and buyers.

Why do we have to worry about tax incidence?If the gov’t collect the tax from the sellers, isn’t thatsimply a sellers’ burden,and vice versa for the buyers?



Tax Incidence

As far as economics is concerned, how tax iscollected doesn’t matter.Suppose that U City collects $5 tax from Jack forthe sales of his cheesecakes.If pre-tax equilibrium price was $10 and post-taxequilibrium price is $15,2 Jack doesn’t bear the taxburden.

1 His revenue used to be $10 for each.2 Now he gets $15 from the sales.3 He sends $5 to U City.4 He’s left with $10 as before.

Then who’s paying this $5 tax?

2This may or may not be $15 as we will see later.Watanabe Econ 1023 6 Price Control 49 / 109


Tax Incidence

It’s Liz (buyer).1 She used to pay $10 for a cheesecake.2 Now she pays $15 for the same cheesecake.

We say: tax incidence falls on Liz for 100% and 0%for Jack.In reality, it’s usually Target and Schnucks etc whopay the tax (in the accounting sense).



Tax Incidence

Consider the two scenarios:1 Tax collected through Jack (sellers)2 Tax collected through Liz (buyers)



Tax Incidence

Suppose that the cheesecake market is currently init’s equilibrium with

�

φ(p) = 10 − ps(p) = p.



Tax Incidence

When examining tax incidence, it is easier to flipthe relationship:

1 MWTP() rather than φ(p).2 RP()3 rather than s(p).

3to be defined on Slide 64 .Watanabe Econ 1023 6 Price Control 53 / 109


Tax Incidence

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Tax Levied on Buyers

Liz is happy to pay $7 for the 3rd slice to leaveherself best off:

MWTP() = − + 10.

Now suppose U City charges $2 for each slice.For the 3rd slice, how much is she willing to pay?




It’s still $7,of which $2 is collected by U Cityand the rest goes to Jack.




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MWTP(x)TaxMWTP(x)−Tax

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What is the new equilibrium after taxation?Demand that Jack faces drops down by $2 foreach slice.The demand curve shifts down by 2:




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The original equilibrium (E, pE) = (6,6)The new equilibrium level of transaction volume isE = 4 instead of 5.Why doesn’t the 5th slice sell?

1 Jack wants to sell it for $5.2 Liz is happy to pay $5 for it.3 but U City takes $2 away from Liz.




In the new equilibrium,1 = 4 slices are traded.2 Jack faces p = 43 Liz faces p = 6.



Tax Levied on Sellers

Suppose tax is collected through Jack (seller).Recall that for each p, Jack determines the quantity = s(p) to maximize his profit.Flip it: for each quantity , p = RP() marks thelowest price (reservation price) at which Jack iswilling to sell -th slice.




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RP(x)

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Jack can maximize his profit by selling the 4th slicefor $4.If $2 tax is imposed, he still maximizes his profitby selling the 4th slice for $4 (by definition).He charges $6 for the 4th slice, takes $4 and filethe rest ($2) for sales tax.The supply that Liz faces simply shifts up by $2for each slice.




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RP(x)TaxRP(x)+Tax

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Original equilibrium was (E, pE) = (5,5).Post-tax equilibrium consists of

= 4.Jack faces p = 4.Liz faces p = 6.




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Measuring Tax Incidence

Note that post-tax equilibrium is independent ofhow tax is imposed.Compute the tax incidence in two ways:

1 Tax on Liz.2 Tax on Jack.




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Liz: $5 to $6Jack: $5 to $4Tax incidence is fifty on fifty.




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Liz: $5 to $6Jack: $5 to $4Tax incidence is fifty on fifty.




Taxes levied on sellers and taxes levied on buyersare equivalent.Wedge between the price that buyers pay and theprice that sellers receiveis the same, regardless of whether the tax is leviedon buyers or sellers.Shifts the relative position of the supply anddemand curves.Buyers and sellers share the tax burden.



Payroll Tax

Payroll taxesDeducted from the amount you earned.

By law, the tax burden:Half of the tax - paid by firms out of firms’ revenue.Half of the tax - paid by workers, deducted fromworkers’ paychecks.



Payroll Tax

Tax incidence analysisPayroll tax is just another tax on a good, where

Good is laborPrice is wage

Introduce payroll taxWage received by workers fallsWage paid by firms rises

Workers and firms share the tax burdenNot necessarily 50-50 as the legislation requires



Payroll Tax

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MWTP(x)RP(x)RP(x)+TaxWorkers′ Tax PaymentFirms′ Tax Payment

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Payroll Tax

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MWTP(x)RP(x)RP(x)+TaxWorkers′ Tax BurdenFirms′ Tax Burden

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Payroll Tax

Legislators:1 Can decide whether a tax comes from the buyer’s

pocket or from the seller’s.2 Cannot legislate the true burden of a tax.

Tax incidenceDetermined by the forces of supply and demand.



1 Introduction

2 Price Ceiling

3 Rationing

4 Price Floor

5 Taxation



8 Subsidy

9 Summary



Recall that price control may give gasoline to thewrong (or improper at least) hands.Do we get into the same situation with taxation,i.e.,

Question 6.1 (Rationing vs Taxation)

How does the distribution mechanism of taxationcompare to that of rationing? Does the person with thehighest willingness to pay still gets the gasoline?



Example 6.2 (Rationing vs Taxation)

Suppose that consumers are in line for cheesecake inthe following order:

Commuters MWTP

Liz 9Jenna 5Grizz 7

Kenneth 6Tracy 8Angie 4

Dotcom 3Pete 2Lutz 1

The reservation price for cheesecake is RP() = . Asthe mayor of U City, you want your residents to have acheesecake for less than or equal to $4. Which policyshould you adopt, price ceiling or tax on the seller?



1 First let’s see if intervention is necessary.



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2 Current equilibrium price is $1 higher than whereyou want it to be.

3 First, try price ceiling:



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3 Note that customers do not necessarily line up in adescending order.

4 If customers are served on a first-come, first-servedbasis...



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5 Note that Tracy is willing to pay for $8 and Jennaonly for $5...

6 but a slice is sold to Jenna.



7 This wouldn’t happen with taxation.8 The equilibrium price that consumers face will be

$6,9 i.e., Jenna won’t get a slice.4

4I usually shift the reservation price but you can shift whicheveryou like. The result (equilibrium and incidence) won’t change.



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Note1 rationing mechanism doesn’t have anything to do

with market mechanism,2 whereas market with tax inherits the distribution

mechanism from free-market mechanism.



1 Introduction

2 Price Ceiling

3 Rationing

4 Price Floor

5 Taxation


7 Tax and ElasticityTax Incidence and ElasticityTax on Luxury Items

8 Subsidy

9 Summary



Tax Incidence and Elasticity

In Section 5 , we saw that tax incidence doesn’t fall50-50 on the sellers and the buyers.Then how is tax incidence determined?Elasticity is a good indicator.




Proposition 7.1 (Tax Incidence and Elasticity)

Tax burden falls more heavily on the side of the marketthat is less elastic.

Proof.For a sketch of the proof, see figures below. �




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MWTP(x)RP(x)RP(x)+TaxTax Incidence on BuyersTax Incidence on Sellers

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1 Elastic demand and less elastic supply:small burden on buyers.large burden on sellers.

2 Elastic demand and more elastic supply:large burden on buyers.small burden on sellers.



Tax on Luxury Items

In 1990, new luxury tax was introduced:On yachts, private airplanes, furs, jewelry,expensive carsGoal: to raise revenue from those who could mosteasily afford to pay

Luxury items:Demand - quite elasticSupply - relatively inelastic



Tax on Luxury Items

Outcome:Burden of a tax fell largely on the suppliersRelatively inelastic supply

In 1993, most of the luxury tax was repealed



1 Introduction

2 Price Ceiling

3 Rationing

4 Price Floor

5 Taxation



8 Subsidy

9 Summary



Definition 8.1 (Subsidy)

Subsidy is a negative tax.



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MWTP(x)RP(x)RP(x)−Subsidy

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In the equilibrium with subsidy,1 Jack charges $7 for each slice.2 Liz pays $5 and U City covers the rest.



1 Introduction

2 Price Ceiling

3 Rationing

4 Price Floor

5 Taxation



8 Subsidy

9 Summary



Price controlDistribution mechanism (rationing vs marketequilibrium)Tax incidence and elasticity



Airline du Jour

Today’s color theme is provided by courtesy of LufthansaWatanabe Econ 1023 6 Price Control 108 / 109

http://www.lufthansa.com


Index

derived demand, 40elasticity, 95luxury tax, 100minimum wage, 39payroll tax, 74, 75price ceiling, 7, 27

price floor, 7rationing, 27, 34rent control, 29reservation price, 62subsidy, 103tax incidence, 48, 95


Chapter 6: Supply, Demand and Government...

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Transcript of Chapter 6: Supply, Demand and Government...