Transcript GwartPPT004 - Crawfordsworld

Chapter 4
Supply and Demand —
Applications and Extensions
Slides to Accompany “Economics: Public and Private Choice 9th ed.”
James Gwartney, Richard Stroup, and Russell Sobel
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1. Wage Rates,
Interest Rates,
and Exchange Rates
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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.

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Resource Prices, Opportunity
Cost, and Product Markets
• Suppose there is a reduction in the supply of young, inexperienced
labor which pushes the wage rates of workers hired by fast-food
restaurants upward.
• In the product market the higher wage will increase the restaurant’s
opportunity cost, causing a reduction in supply, leading to higher
hamburger prices.
S2
P
S1
$6.50
$5.25
P
S2
$2.25
S1
$2.00
Dr
Resource
Market
E2
Product
Employment Market
E1
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Dp
Q2 Q1
Quantity
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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.
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Increase in the Demand
for Loanable Funds
• 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.
• We begin in equilibrium at the
lending level Q1 and interest rate r1.
• An increase in the demand for
loanable funds will move D1 to D2
pushing the interest rate up from
r1 to r2 and borrowing from Q1 to Q2
interest
rate
Supply
(lending)
r2
r1
D2
(borrowing)
• The higher interest rate will
encourage additional savings, making
it possible to fund more borrowing.
D1
(borrowing)
Q1 Q 2
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Quantity of
Loanable
Funds
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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.
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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.

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Increase in the Demand
for Foreign Exchange
Supply
• 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.
• We begin in equilibrium where the
dollar price of the quetzal is $.10
(10 cents = 1quetzal).
• 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.
exchange
rate
$ price
per quetzal
(sales to
foreigners)
.20
D2
.10
(purchases
from
foreigners)
(purchases
from
D1 foreigners)
Q1
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Q2
Quantity of
Foreign Exchange
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2. The Economics
of Price Controls
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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.
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The Impact of a Price Control
rental
S (ofhousing)
Price
• 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.
• When a price ceiling like P1 pushes
the price of the product below the
market equilibrium . . .
. . . the quantity supplied (Qs) . . .
exceeds the quantity demanded (Qd),
resulting in a shortage.
• Because prices are not allowed to
direct the market back to equilibrium,
non-price elements will become more
important.
P0
Price
Ceiling
P1
rental
D (ofhousing)
Shortage
QS
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QD
Quantity of
Housing
Units
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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.
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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.
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Effects of Rent Control


Inefficient use of housing will result.
Long-term renters will benefit at the
expense of newcomers.
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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.
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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.
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Employment and the Minimum Wage
Wage
Excess
Supply
• Consider the market for the labor of
of a group of employees where a
price (wage) of $4.00 would bring $5.15
the quantity of labor hours
demanded into balance with the
quantity supplied.
• A minimum wage (price floor) of
$5.15 would raise the price of the
$4.00
labor above the market equilibrium
where the employment supplied (Es)
exceeds that demanded (Ed),
resulting in a employment surplus.
• For those (Ed) who were able to
maintain their employment, their
earnings would increase.
• Those (Es - Ed) who lose their job
are pushed into either the
unemployment rolls or to a less
preferred form of employment.
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S (of labor)
Minimum
Wage
Level
D (for labor)
ED
ES
Employment
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3. Black Markets and
the Importance
of Legal Structure
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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.
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Legal System

A legal system that provides secure
property rights and unbiased
enforcement of contracts enhances the
operation of markets.
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Questions for Thought:
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?
2. What is the black market? What are some of
the main differences in how black markets
operate relative to legal markets?
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4. The Impact of a Tax
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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).
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The Impact of a Tax
used
ImposedPriceon Sellers S(ofcars)
+ Tax
• 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.
$1000 tax
• When a $1,000 tax is imposed on
the sellers of used cars, the supply $7,400
curve moves up vertically by the
amount of the tax.
$7,000
• The new price in the market for
used cars is $7,400 . . .
• . . . while sellers receive $6,400
$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.
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(of used
cars)
S
$1000
D (forcars)used
500 750
Quantity of Used
Cars per Month
(in thous.)
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The Impact of a Tax
used
Imposed on Sellers S(ofcars)
+ Tax
• Note that the new quantity of used
Price
cars that make the market is 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
$7,400
the tax burden, and as there are
500,000 units being sold per
$7,000
month, the tax revenues derived
from the sellers = $300,000,000.
• As only 500,000 cars are being
$6,400
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.
Tax Revenue
from
Consumers
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(of used
cars)
S
Deadweight
Loss
D (forcars)used
Tax Revenue
from
Sellers
500 750
Quantity of Used
Cars per Month
(in thous.)
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The Impact of a Tax
Imposed on Buyers
• Consider the market for used cars
Price
where a price of $7,000 would
bring the quantity of used cars
demanded into balance with the
quantity supplied.
$1000 tax
• When a $1,000 tax is imposed on
the buyers of used cars, the
$7,400
demand curve moves down
vertically by the amount of the tax.
• While the sellers of used cars now $7,000
receive the new market price for
used cars, $6,400 . . .
$6,400
• . . . 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.
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(of used
cars)
S
$1000
D (forcars)used
D (forcars)used - Tax
500 750
Quantity of Used
Cars per Month
(in thous.)
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The Impact of a Tax
Imposed on Buyers
• Note that the new quantity of used
Price
cars that make the market is 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
$7,400
the tax burden, and as there are
500,000 units being sold per
$7,000
month, the tax revenues derived
from the sellers = $300,000,000.
• Again the area above the supply
$6,400
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.
• Note that the incidence of the tax
is the same regardless of whether
it is imposed on buyers or sellers.
Tax Revenue
from
Sellers
Tax Revenue
from
Consumers
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(of used
cars)
S
Deadweight
Loss
D (forcars)used
D (forcars)used - Tax
500 750
Quantity of Used
Cars per Month
(in thous.)
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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.

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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.

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Elasticity and the
Deadweight Loss

The deadweight loss of tax rises as the
elasticity of either the supply curve or
demand curve rises.
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Tax Burden and Elasticity
• Lets consider the market for Gas and
Gasoline
Price
Luxury Boots individually.
• We begin in equilibrium.
2.00
• If we were to impose a $.90 tax on
gasoline suppliers, the supply curve
1.20
moves vertically the distance of the
1.10
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. Price
• 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
$ 105
share of the burden of the tax.
$ 100
• Note that, as in the graph for the
market for luxury boots, when the
$ 80
supply curve is relatively more
inelastic than its demand, that sellers
bear a larger share of the tax burden.
S + Tax
S
D
1 2 3 4 5 6
million(s) of
7 gal.
per week
S + Tax
S
Luxury
Boots
D
25 50 75 100
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thousand(s) of
boots per week
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5. Tax Rates,
Tax Revenues,
and the Laffer Curve
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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.

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Marginal Tax Rate

Marginal tax rate equals change in tax
liability divided by change in taxable
income.
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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
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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.

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The Laffer Curve
• At a tax rate of 0%, tax revenues
Tax
Rate
would also be equal to $0.
• At a tax rate of 100%, nobody
would work and thus, again, tax
100%
revenues would also be equal to $0.
• As the tax rate increase from 0% to
some pt A, tax revenues increase
despite the fact that some
75%
individuals are choosing not to work.
• After some pt B, a further increase
in the tax rates might actually cause
tax revenues to fall.
50%
• 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
25%
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.
C
B
A
PositiveTax
Tax
Positive
Revenues
Revenues
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Max Tax
Revenues
Tax
Revenues
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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
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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?
2. What is the nature of the deadweight loss
accompanying taxes? Why is it referred to as
an “excess burden” of the tax?
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?
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End
Chapter 4
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