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John’s demand curve for frozen pizza. MB 1. MB 2. MB 3. Price =. $2.50. MB 4. d. =. MB. <. <. <. MB 4. MB 3. MB 2. MB 1. because. <. <. <. MU 4. MU 3. MU 2. MU 1. The Pizza Demand Curve. The demand for frozen pizzas reflects the law of diminishing marginal utility.

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2 50

John’sdemand curvefor frozen pizza

MB1

MB2

MB3

Price =

$2.50

MB4

d

=

MB

<

<

<

MB4

MB3

MB2

MB1

because

<

<

<

MU4

MU3

MU2

MU1

The Pizza Demand Curve

  • The demand for frozen pizzas reflects the law of diminishing marginal utility.

  • Because marginal utility (MU) falls with increased consumption, so does a consumer’s maximum willingness to pay -- marginal benefit (MB).

Price

$3.50

$3.00

  • A consumer will purchase

  • untilMB = Price . . .

$2.50

$2.00

so at $2.50 they would purchase 3 frozen pizzas and receive a consumer surplus shown by the shaded area (above the price line and below the demand curve).

Frozen pizzasper week

1

2

4

3


2 50

Consumer Surplus

The total difference between what a consumer is willing to pay and how much they actually have to pay.

Producer Surplus

The total difference between what a supplier is willing to provide a good or service and how much they actually get for it.


2 50

Producer and Consumer Surplus

P

Consumer surplus = area of red triangle = ½($5)(5) = $12.5

$10

9

8

7

6

5

4

3

2

1

S

Producer surplus = area of green triangle = ½($5)(5) = $12.5

CS

PS

The combination of producer and consumer surplus is maximized at market equilibrium

D

Q

0 1 2 3 4 5 6 7 8

8-3


2 50

Consumer Surplus

  • Price Quantity

  • 1

  • 2

  • 3

  • 4

  • 5

  • If the selling price is 3, the consumer surplus for the 1st item is 5-3=2, plus 4-3=1 for the 2nd and 3-3=0 for the 3rd, or 3


2 50

The Burden of a Tax

Tax Incidence

  • Who pays a tax is called the incidence.

Buyer

Seller


2 50

Splus tax

$1000 tax

Impact of a Tax Imposed on Sellers

Price

  • If in the used car market a price of $7,000 would bring the quantity of used cars demanded into balance with the quantity supplied.

S

  • When a $1,000 tax is imposed on sellers of used cars, the supply curve shifts vertically by the amount of the tax.

$7,400

$7,000

  • The new price for used cars is $7,400 …

sellers netting $6,400 ($7,400 - $1000 tax).

$6,400

D

  • Consumers end up paying $7,400 instead of $7,000 and bear $400 of the tax burden.

  • Sellers end up receiving $6,400 (after taxes) instead of $7000 and bear $600 of the tax burden.

# of used carsper month(in thousands)

500

750


2 50

$1000 tax

Dminus tax

Impact of a Tax Imposed on Buyers

Price

  • In the same used car market:

  • When a $1,000 tax is imposed on buyers of used cars, the demand curve shifts vertically by the amount of the tax.

S

$7,400

$7,000

  • The new price for used cars is $6,400 …

buyers then pay taxes of $1000 making the total $7,400.

$6,400

  • Consumers end up paying $7,400 (after taxes) instead of $7,000 and bear $400 of the tax burden.

D

  • Sellers end up receiving $6,400 instead of $7000 and bear $600 of the tax burden.

# of used carsper month(in thousands)

500

750


2 50

The actual burden of a tax depends on the elasticity of supply and demand.

Elasticity and Incidence of a Tax

  • As supply becomes more inelastic, then more of the burden will fall on sellers.

  • As demand becomes more inelastic, then more of the burden will fall on buyers.

ED ES

ED + ES ED + ES


2 50

S supply and demand.plus tax

S plus tax

Tax Burden and Elasticity

  • Consider the market for Gasolineand Luxury Boatsindividually.

Price

Gasolinemarket

$1.65

  • We begin in equilibrium.

S

$1.60

  • If we impose a $.20 tax on gasoline suppliers, the supply curve moves vertically the amount of the tax. Price goes up $.15 and output falls by 6 million gallons per week.

$1.55

$1.50

$1.45

D

Quantity(millions of gallons)

  • If we impose a $25K tax on Luxury Boat suppliers, the supply curve moves vertically the amount of the tax. Price goes up by $5K and output falls by 5 thousand units.

194

200

Price(thousand $)

Luxury boatmarket

S

110

  • In the gasmarket, the demand isrelatively more inelasticthan its supply; hence, buyers bear a larger share of the burden of the tax.

100

90

D

  • In the luxury boatsmarket, thesupply curve is relatively more inelasticthan its demand; hence, sellers bear a larger share of the tax burden.

80

Quantity(thousands of boats)

5

10

15

20


Government intervention as implicit taxation
Government Intervention as Implicit Taxation supply and demand.

  • Government intervention in the form of price controls can be viewed as a combination tax and subsidy


2 50

  • An effective supply and demand.price ceiling is a government set price below the market equilibrium price

  • It acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation

P

A price ceiling transfers surplus from producers to consumers, generates deadweight loss, and reduces equilibrium quantity

S

P0

P1

Price ceiling

Shortage

D

Q

Q1

Q0


2 50

  • An effective supply and demand.price floor is a government set price above the market equilibrium

  • It acts as a tax on consumers and a subsidy for producers that transfers consumer surplus to producers

P

S

Surplus

P1

Price floor

P0

A price floor transfers surplus from consumers to producers, generates deadweight loss, and reduces equilibrium quantity

D

Q

Q1

Q0


The difference between taxes and price controls
The Difference Between Taxes and Price Controls supply and demand.

  • Price ceilings create shortages and taxes do not

  • Taxes leave people free to choose how much to supply and consume as long as they pay the tax

  • Shortages may also create black markets


Rent seeking politics and elasticities
Rent Seeking, Politics, and Elasticities supply and demand.

  • The possibility of transferring surplus from one set of individuals to another causes people to spend time and resources on doing so.

  • Lobbying for price controls, which transfer surplus from one group to another, is an example of rent-seeking behavior

  • Individuals spend money and use resources to lobby governments to institute policies that increase their own surplus

  • Public choice economists argue that when all rent seeking and tax consequences are netted out, there is often not a net gain to the public


2 50

Inelastic Demand and Incentives to Restrict Supply supply and demand.

Revenue gained

P

When demand is relatively inelastic, suppliers have incentive to restrict quantity to increase total revenue

S1

S0

P1

C

P0

Revenue lost

A

B

D

Q

Q1

Q0


Inelastic supplies and incentives to restrict prices
Inelastic Supplies and Incentives to Restrict Prices supply and demand.

  • When supply is inelastic, consumers have incentives to restrict prices

  • When supply is inelastic and demand increases, prices increase causing consumers to lobby for price controls

  • Rent control in New York City is an example


2 50

Application: Price Floors and Elasticity supply and demand.

The surplus created by a price floor is larger if demand and supply are elastic

P

P

S

Surplus

Surplus

S

Price floor

P1

P1

P0

P0

D

D

Q

Q

Q1

Q0

Q1

Q0


2 50

Long-Run and Short-Run Effects on Price Control supply and demand.

P

Higher long-run elasticity of supply results in smaller price increases when demand increases

Sshort-run

PSR

Slong-run

PLR

P0

D1

D0

Q

Q0

QSR

QLR


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