Learning MicroChapter4
SupplyandDemand:
Applicationsand
Extensions
5 Goals
1) Describe the relationship between
resource and product markets
2) Analyze the impact of government
policies for price controls in markets
3) Determine the effects of a tax in a market
4) Explore the relationship between tax
rates and revenues
5) Identify the effects of a subsidy
TheLinkBetween
ResourceandProduct
Markets
Whats the relationship between
product markets and resource
(input) markets?
An increase (decrease) in demand for a
product will increase (decrease) demand
for resources that make that product
When the product price rises, the resource
price will eventually rise
Graphs:
TheEconomicsofPrice
Controls
2 Kinds of Price Controls:
(1) Price ceiling puts an upper limit on
price; generates a shortage and a
deadweight loss
(2) Price floor puts a lower limit on
price; generates a surplus and a
deadweight loss
Deadweight loss (DWL) = loss of gains
from trade; loss of CS and PS
Price Ceiling Graph:
Price Floor Graph:
TheImpactofaTax
Incidence
(1) Statutory incidence- who is legally
responsible to pay the tax
This is the tax burden- it hinders exchange
This is an administrative detail that is mostly
irrelevant
(2) Actual incidence- who really pays the tax
This is the more important issue
The burden is shared between firms and
consumers
Ways to analyze:
If the tax is legally imposed on sellers,
shift the supply curve
If the tax is legally imposed on buyers,
shift the demand curve
Youll reach the same conclusion either
way
Graph of tax imposed on sellers:
See handout Impact of a Tax 1.pdf
Graph of tax imposed on
buyers:
See handout Impact of a Tax 1.pdf
Scenario: The price of a textbook
is $100. Then a $10 sales tax is
imposed.
What usually happens?
The price (with tax) of the textbook will be
somewhere between $100 and $110.
If $106, consumers pay $6 tax and firms
pay $4 tax.
What determines how the burden
is shared?
The size of the deadweight loss and the
actual burden depend on supply & demand
elasticities
Four scenarios:
See handouts Impact of a tax 2.pdf and
Impact of a tax 3.pdf
Four scenarios:
Summary: more The inelastic group has
the biggest share of the burden
Helpful Study Tool
Tax Impact Process Examples.pdf in
study guides folder in Blackboard
TaxRates,TaxRevenues,
andtheLafferCurve
2 definitions you need to know:
(1) Tax rate
(a) Value (most common); a percent is
applied to the sales price
Example: 7.5% sales tax
(b) Per Unit; an amount is applied to each
unit sale
Example: $1 for every unit sold
Gas taxes
(2) Tax Revenue = rate X sales
The Laffer Curve
Graphical representation of the
relationship between the tax rate and
revenue
Graph:
So what?
Starting at high tax rates, an increase in
the tax rate may actually lower revenue
Starting at high tax rates, larger revenue
may be generated by lowering tax rates
The facts:
Highest marginal tax rates
Using 2008 Internal Revenue Service statistics,
the 2001 tax cuts shifted the income tax burden
up the economic ladder.
In 2000, the top 1% paid 37.4% of all income
taxes vs. 39.4% in 2005.
The top 2% went from 56.5% to 60%
The top 10% from 67.3% to 70.3%
The top 25% from 84% to 86%
The top 50% from 96% to 97%.
TheImpactofaSubsidy
Analysis of Ethanol subsidies
Ethanol- biofuel made from corn to
supplement traditional gasoline (most gas
now contains up to 10% ethanol)
Graph of ethanol:
Analysis of Ethanol subsidies
Secondary effects:
1) increase demand for corn (maybe not an
equal increase in supply of corn) results
in an increase in the price of corn
2) Increase in prices for feed for livestock
plus any consumer good made from corn
So, lower prices for ethanol but higher
prices for milk, soda, and everything else
made with corn
Who receives the biggest
benefit from subsidies?
Ignoring secondary effects, the group with
the smallest elasticity receives the biggest
benefit.
If supply is relatively inelastic and demand
is relatively elastic, then suppliers receive
most (but not all) of the benefit.
If supply is relatively elastic and demand is
relatively inelastic, then consumers
receive most (but not all) of the benefit.
Conclusions:
Taxes and subsidies distort incentives and
create secondary effects which are
sometimes undesirable