Principles of Microeconomics 6 Price Controls and Taxes
- Slides: 42
Principles of Microeconomics 6. Price Controls and Taxes* Akos Lada July 28 th, 2014 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium Powe. Point
Contents 1. Review of previous lecture 2. The Classroom Parliament 3. Price Control 4. Taxes – an introduction 5. Elasticity and Taxes
1. Review
Different elasticities of demand Price elasticity of demand Income elasticity of demand Cross-price elast. of demand = = = Percentage change in Qd Percentage change in P Percent change in Qd Percent change in income % change in Qd for good 1 % change in price of good 2
Different types of Supply P P Q Q Perfectly inelastic P Perfectly elastic P P 1 Inelastic Q Elastic Q 1 Unit-elastic Q
The Determinants of Supply Elasticity • The more easily sellers can change the quantity they produce, the greater the price elasticity of supply. • Example: Supply of beachfront property is harder to vary and thus less elastic than supply of new cars. • For many goods, price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market.
2. The Classroom Parliament
Proposition MPA-MC 1 Rent Ceiling • Housing is getting too expensive in the Harvard Square area. People working near this zone cannot afford a place to live in the vicinity, and have to travel long hours between home and work every day. Poor families have no alternative but to move away from the neighborhood. • The Classroom Parliament has been given authority to legislate in this jurisdiction. • A people’s representative brings the following proposal for your consideration: Effective today, no housing unit within 5 miles of Harvard Square can charge more than $ 800 plus $ 200 per each additional room (per month).
The Parliament Votes! 1. In favor 2. Against 3. Abstain
Proposition MPA-MC 2 Minimum Wage • Workers with little formal education in Cambridge, MA, are struggling in the midst of this economic recession. Their current income barely allows them to cover their families’ basic needs, and they have to work so much that they don’t have the opportunity to spend quality family time. • The Classroom Parliament has been given authority to legislate in this jurisdiction. • A people’s representative brings the following proposal for your consideration: Effective today, the minimum wage in Cambridge, MA is fixed at $ 9/hour.
The Parliament Votes! 1. In favor 2. Against 3. Abstain
Proposition MPA-MC 3 Fair Allocation of Tax Burden • The Government of the City of Cambridge needs to raise more money in order to speed-up the public works taking place near Harvard Square. • The Classroom Parliament (in a previous session) decided to impose a tax of $1. 50 in one of the best-selling products of this area: Pizza! • A decision remains: Who should be made to bear the burden of the tax? There is two proposals to decide from: The Pizza sellers must pay $1. 50 per pizza to the Local Government at the end of every week. The Pizza buyers must deposit $1. 50 per pizza purchased in a box (placed in each Pizza establishment). The Local Government will collect the money at the end of every week.
The Parliament Votes! 1. Pizza sellers should pay the tax. 2. Pizza buyers should pay the tax 3. Abstain
Price controls
Government Policies That Alter the Private Market Outcome • Price controls • Price ceiling: a legal maximum on the price of a good or service Example: rent control • Price floor: a legal minimum on the price of a good or service Example: minimum wage • Taxes • The government can make buyers or sellers pay a specific amount on each unit bought/sold. We will use the supply/demand model to see how each policy affects the market outcome (the price buyers pay, the price sellers receive, and equilibrium quantity).
Binding and not-binding constraints • A constraint imposed on certain behavior may matter or not at different times • When it matters, we say that the constraint is “binding”
EXAMPLE 1: The Market for 1 Bedroom Apartments Rental price of apts P S $1, 500 Equilibrium without price controls D 300 Q Quantity of apartments
A not binding price ceiling P S A price ceiling $2, 000 above the equilibrium price $1, 500 is not binding – has no effect on the market outcome. Price ceiling D 300 Q
A binding price ceiling The equilibrium price ($1, 500) is above the ceiling and therefore illegal. The ceiling is a binding constraint on the price, causes a shortage. P S $1, 500 Price ceiling $1, 000 shortage 250 400 D Q
Short run vs. Long run In the long run, supply and demand are more price-elastic. So, the shortage is larger. P S $1, 500 Price ceiling $1, 000 shortage 150 450 D Q
Unintended consequences • Rationing: 1. Long lines 2. Discrimination according to sellers’ biases • “Black markets” • Perverse incentives (e. g. decrease in quality of the good)
EXAMPLE 2: The Market for Unskilled Labor Wage paid to unskilled workers W S $7 Equilibrium without price controls D 500 Quantity of unskilled workers L
A non-binding minimum wage A price floor below the equilibrium price is not binding – has no effect on the market outcome. W S $7 Price floor $6 D 500 L
A Binding Minimum Wage The equilibrium wage ($7) is below the floor and therefore illegal. The floor is a binding constraint on the wage, causes a surplus (i. e. , unemployment). W labor surplus S Price floor $9 $7 D 400 550 L
STUDENTS’ TURN: Price controls P The market for hotel rooms S Determine effects of: A. $90 price ceiling D B. $90 price floor C. $120 price floor 0 Q
Answer A. $90 price ceiling P The market for hotel rooms S The price falls to $90. Buyers demand 120 rooms, sellers supply 90, leaving a shortage. Price ceiling shortage = 30 0 D Q
Answer B. $90 price floor P Equilibrium price is above the floor, so floor is not binding. The market for hotel rooms Price floor P = $100, Q = 100 rooms. 0 S D Q
Answer C. $120 price floor P The price rises to $120. The market for hotel rooms surplus = 60 S Price floor Buyers demand 60 rooms, sellers supply 120, causing a surplus. D 0 Q
Taxes, an Introduction
Taxes • The government levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc. • The government can make buyers or sellers pay the tax. • The tax can be a % of the good’s price, or a specific amount for each unit sold. • For simplicity, we analyze perunit taxes only.
EXAMPLE: The Market for Pizza P Equilibrium without tax S 1 $10. 00 D 1 500 Q
A Tax of $1. 50 on Buyers P The price buyers pay is now $1. 50 higher than the market price P. P would have to fall by $1. 50 to make buyers willing to buy same Q as before. E. g. , if P falls from $10. 00 to $8. 50, buyers still willing to purchase 500 pizzas. S 1 $10. 00 Tax $8. 50 D 1 D 2 500 Hence, a tax on buyers shifts the D curve down by the amount of the tax. Q
A Tax on Buyers New equilibrium: Q = 450 Sellers receive PS = $9. 50 Buyers pay PB = $11. 00 Difference between them = $1. 50 = tax P PB = $11. 00 Effects of a $1. 50 per unit tax on buyers Tax S 1 $10. 00 PS = $9. 50 D 1 D 2 450 500 Q
The Incidence of a Tax: how the burden of a tax is shared among market participants In our example, buyers pay $1. 00 more, P PB = $11. 00 Tax S 1 $10. 00 PS = $9. 50 sellers get $0. 50 less. D 1 D 2 450 500 Q
A Tax of $1. 50 on Sellers P The tax effectively raises $11. 50 sellers’ costs by $1. 50 per pizza. Sellers will supply 500 pizzas only if P rises to $11. 50, to compensate for this cost increase. S 2 Tax S 1 $10. 00 Hence, a tax on sellers shifts the S curve up by the amount of the tax. D 1 500 Q
A Tax on Sellers Effects of a $1. 50 per unit tax on sellers New equilibrium: Q = 450 Buyers pay PB = $11. 00 Sellers receive PS = $9. 50 Difference between them = $1. 50 = tax P PB = $11. 00 S 2 Tax S 1 $10. 00 PS = $9. 50 D 1 450 500 Q
The Outcome Is the Same in Both Cases! The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers! What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. P PB = $11. 00 Tax S 1 $10. 00 PS = $9. 50 D 1 450 500 Q
STUDENT’S TURN: Effects of a tax P The market for hotel rooms S Suppose govt imposes a tax on buyers of $30 per room. D Find new Q, PB, PS, and incidence of tax. 0 Q
Answers P The market for hotel rooms S Q = 80 PB = $110 PB = PS = $80 Incidence buyers: $10 sellers: $20 Tax D PS = 0 Q
Elasticity and Taxes
Elasticity and Tax Incidence CASE 1: Supply is more elastic than demand It’s easier for sellers than buyers to leave the market. So buyers bear most of the burden of the tax. P Buyers’ share of tax burden PB Tax Price if no tax Sellers’ share of tax burden S PS D Q
Elasticity and Tax Incidence CASE 2: Demand is more elastic than supply P Buyers’ share of tax burden S PB Price if no tax Sellers’ share of tax burden It’s easier for buyers than sellers to leave the market. Tax PS Sellers bear most of the burden of the tax. D Q
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