R GLENN HUBBARD OBRIEN ANTHONY PATRICK Macroeconomics FOURTH

R. GLENN HUBBARD O’BRIEN ANTHONY PATRICK Macroeconomics FOURTH EDITION

CHAPTER 4 Economic Efficiency, Government Price Setting, and Taxes Chapter Outline and Learning Objectives 4. 1 Consumer Surplus and Producer Surplus 4. 2 The Efficiency of Competitive Markets 4. 3 Government Intervention in the Market: Price Floors and Price Ceilings 4. 4 The Economic Impact of Taxes APPENDIX: Quantitative Demand Supply Analysis © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 of 40

Should the Government Control Apartment Rents? • Rent control puts a legal limit on the rent that landlords can charge for an apartment. • Market-determined rents are usually far above controlled rents. • Although rent control laws are intended to make housing more affordable for people with low incomes, high-income people can end up benefiting. • AN INSIDE LOOK AT POLICY on page 122 discusses a legal battle between Oscar-winning actress Faye Dunaway and the landlord of her rentcontrolled New York City apartment. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 3 of 40

Economics in Your Life Does Rent Control Make It Easier for You to Find an Affordable Apartment? Suppose you have job offers in two cities. One factor in deciding which job to accept is whether you can find an affordable apartment. See if you can answer this question by the end of the chapter: If one city has rent control, are you more likely to find an affordable apartment in that city, or would you be better off looking for an apartment in a city without rent control? © 2013 Pearson Education, Inc. Publishing as Prentice Hall 4 of 40

Price ceiling A legally determined maximum price that sellers may charge. Price floor A legally determined minimum price that sellers may receive. When the government imposes a price ceiling or a price floor, the amount of economic surplus in a market is reduced. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 5 of 40

Consumer Surplus and Producer Surplus 4. 1 LEARNING OBJECTIVE Distinguish between the concepts of consumer surplus and producer surplus. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 6 of 40

Consumer Surplus Consumer surplus The difference between the highest price a consumer is willing to pay for a good or service and the price the consumer actually pays. Marginal benefit The additional benefit to a consumer from consuming one more unit of a good or service. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 7 of 40

Figure 4. 1 Deriving the Demand Curve for Chai Tea With four consumers in the market for chai tea, the demand curve is determined by the highest price each consumer is willing to pay. For prices above $6, no tea is sold because $6 is the highest price any consumer is willing to pay. For prices of $3 and below, every one of the four consumers is willing to buy a cup of tea. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 8 of 40

Figure 4. 2 Measuring Consumer Surplus Panel (a) shows the consumer surplus for Theresa, Tom, and Terri when the price of tea is $3. 50 per cup. Theresa’s consumer surplus is equal to the area of rectangle A and is the difference between the highest price she would pay—$6—and the market price of $3. 50. Tom’s consumer surplus is equal to the area of rectangle B, and Terri’s consumer surplus is equal to the area of rectangle C. Total consumer surplus in this market is equal to the sum of the areas of rectangles A, B, and C, or the total area below the demand curve and above the market price. In panel (b), consumer surplus increases by the shaded area as the market price declines from $3. 50 to $3. 00. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 9 of 40

Figure 4. 3 Total Consumer Surplus in the Market for Chai Tea The demand curve tells us that most buyers of chai tea would have been willing to pay more than the market price of $2. 00. For each buyer, consumer surplus is equal to the difference between the highest price he or she is willing to pay and the market price actually paid. Therefore, the total amount of consumer surplus in the market for chai tea is equal to the area below the demand curve and above the market price. Consumer surplus represents the benefit to consumers in excess of the price they paid to purchase the product. The total amount of consumer surplus in a market is equal to the area below the demand curve and above the market price. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 10 of 40

Making the Connection The Consumer Surplus from Broadband Internet Service The demand curve shows the marginal benefit consumers received in 2006 from subscribing to a broadband Internet service rather than using dialup or doing without access to the Internet. The area below the demand curve and above the $36 price line represents the difference between the price consumers would have paid and the $36 they did pay. The shaded area on the graph represents the total consumer surplus in the market for broadband Internet service, which was estimated to be $890. 5 million per month. My. Econ. Lab Your Turn: Test your understanding by doing related problem 1. 9 at the end of this chapter. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 11 of 40

Producer Surplus Marginal cost The additional cost to a firm of producing one more unit of a good or service. Producer surplus The difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 12 of 40

Figure 4. 4 a Measuring Producer Surplus Panel (a) shows Heavenly Tea’s producer surplus. Producer surplus is the difference between the lowest price a firm would be willing to accept and the price it actually receives. The lowest price Heavenly Tea is willing to accept to supply a cup of tea is equal to its marginal cost of producing that cup. When the market price of tea is $2. 00, Heavenly receives producer surplus of $0. 75 on the first cup (the area of rectangle A), $0. 50 on the second cup (rectangle B), and $0. 25 on the third cup (rectangle C). © 2013 Pearson Education, Inc. Publishing as Prentice Hall 13 of 40

Figure 4. 4 b Measuring Producer Surplus In panel (b), the total amount of producer surplus tea sellers receive from selling chai tea can be calculated by adding up for the entire market the producer surplus received on each cup sold. In the figure, total producer surplus is equal to the area above the supply curve and below the market price, shown in red. The total amount of producer surplus in a market is equal to the area above the market supply curve and below the market price. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 14 of 40

What Consumer Surplus and Producer Surplus Measure Consumer surplus measures the net benefit to consumers from participating in a market rather than the total benefit. Consumer surplus in a market is equal to the total benefit received by consumers minus the total amount they must pay to buy the good or service. Similarly, producer surplus measures the net benefit received by producers from participating in a market. Producer surplus in a market is equal to the total amount firms receive from consumers minus the cost of producing the good or service. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 15 of 40

The Efficiency of Competitive Markets 4. 2 LEARNING OBJECTIVE Understand the concept of economic efficiency. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 16 of 40

Figure 4. 5 Marginal Benefit Equals Marginal Cost Only at Competitive Equilibrium In a competitive market, equilibrium occurs at a quantity of 15, 000 cups and a price of $2. 00 per cup, where marginal benefit equals marginal cost. This is the economically efficient level of output because every cup has been produced where the marginal benefit to buyers is greater than or equal to the marginal cost to producers. Equilibrium in a competitive market results in the economically efficient level of output, where marginal benefit equals marginal cost. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 17 of 40

Economic surplus The sum of consumer surplus and producer surplus. Figure 4. 6 Economic Surplus Equals the Sum of Consumer Surplus and Producer Surplus The economic surplus in a market is the sum of the blue area, representing consumer surplus, and the red area, representing producer surplus. Equilibrium in a competitive market results in the greatest amount of economic surplus, or total net benefit to society, from the production of a good or service. Economic efficiency A market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and in which the sum of consumer surplus and producer surplus is at a maximum. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 18 of 40

Deadweight loss The reduction in economic surplus resulting from a market not being in competitive equilibrium. Figure 4. 7 When a Market Is Not in Equilibrium, There Is a Deadweight Loss Economic surplus is maximized when a market is in competitive equilibrium. When a market is not in equilibrium, there is a deadweight loss. When the price of chai tea is $2. 20 instead of $2. 00, consumer surplus declines from an amount equal to the sum of areas A, B, and C to just area A. Producer surplus increases from the sum of areas D and E to the sum of areas B and D. At competitive equilibrium, there is no deadweight loss. At a price of $2. 20, there is a deadweight loss equal to the sum of areas C and E. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 19 of 40

Government Intervention in the Market: Price Floors and Price Ceilings 4. 3 LEARNING OBJECTIVE Explain the economic effect of government-imposed price floors and price ceilings. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 20 of 40

Price Floors: Government Policy in Agricultural Markets Figure 4. 8 The Economic Effect of a Price Floor in the Wheat Market If wheat farmers convince the government to impose a price floor of $3. 50 per bushel, the amount of wheat sold will fall from 2. 0 billion bushels per year to 1. 8 billion. If we assume that farmers produce 1. 8 billion bushels, producer surplus then increases by the red rectangle A—which is transferred from consumer surplus— and falls by the yellow triangle C. Consumer surplus declines by the red rectangle A plus the yellow triangle B. There is a deadweight loss equal to the yellow triangles B and C, representing the decline in economic efficiency due to the price floor. In reality, a price floor of $3. 50 per bushel will cause farmers to expand their production from 2. 0 billion to 2. 2 billion bushels, resulting in a surplus of wheat. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 21 of 40

Making the Price Floors in Labor Markets: The Debate over Minimum Wage Policy Connection Supporters of the minimum wage see it as a way of raising the incomes of low-skilled workers. Opponents argue that it results in fewer jobs and imposes large costs on small businesses. Whatever the extent of employment losses from the minimum wage, because it is a price floor, it will cause a deadweight loss. My. Econ. Lab Your Turn: Test your understanding by doing related problem 3. 12 at the end of this chapter. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 22 of 40

Price Ceilings: Government Rent Control Policy in Housing Markets Figure 4. 9 The Economic Effect of a Rent Ceiling Without rent control, the equilibrium rent is $1, 500 per month. At that price, 2, 000 apartments would be rented. If the government imposes a rent ceiling of $1, 000, the quantity of apartments supplied falls to 1, 900, 000, and the quantity of apartments demanded increases to 2, 100, 000, resulting in a shortage of 200, 000 apartments. Don’t Let This Happen to You Don’t Confuse “Scarcity” with “Shortage” There is no shortage of most scarce goods. My. Econ. Lab Your Turn: Test your understanding by doing related problem 3. 15 at the end of this chapter. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 23 of 40

Price Ceilings: Government Rent Control Policy in Housing Markets Figure 4. 9 The Economic Effect of a Rent Ceiling Without rent control, the equilibrium rent is $1, 500 per month. At that price, 2, 000 apartments would be rented. If the government imposes a rent ceiling of $1, 000, the quantity of apartments supplied falls to 1, 900, 000, and the quantity of apartments demanded increases to 2, 100, 000, resulting in a shortage of 200, 000 apartments. Producer surplus equal to the area of the blue rectangle A is transferred from landlords to renters, and there is a deadweight loss equal to the areas of yellow triangles B and C. Black market A market in which buying and selling take place at prices that violate government price regulations. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 24 of 40

Solved Problem 4. 3 What’s the Economic Effect of a Black Market for Apartments? Suppose that competition among tenants results in the black market rent rising to $2, 000 per month. Use a graph showing the market for apartments, noting any differences in consumer surplus, producer surplus, and deadweight loss. Solving the Problem Step 1: Review the chapter material. Step 2: Draw a graph similar to Figure 4. 9, with the addition of the black market price. Step 3: Analyze the changes from Figure 4. 9. Producer surplus has increased by an amount equal to rectangles A and E, and consumer surplus has declined by the same amount. Deadweight loss is equal to triangles B and C, the same as in Figure 4. 9. The remaining consumer surplus is the blue triangle D. Eventually, the market could even end up at the competitive equilibrium. My. Econ. Lab Your Turn: For more practice, do related problem 3. 14 at the end of this chapter. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 25 of 40

The Results of Government Price Controls: Winners, Losers, and Inefficiency When the government imposes price floors or price ceilings, three important results occur: • Some people win. • Some people lose. • There is a loss of economic efficiency. Positive and Normative Analysis of Price Ceilings and Price Floors Our analysis of rent control and of the federal farm programs in this chapter is positive analysis. Whether these programs are desirable or undesirable is a normative question. Whether the gains to the winners more than make up for the losses to the losers and decline in economic efficiency is a matter of judgment and not strictly an economic question. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 26 of 40

The Economic Impact of Taxes 4. 4 LEARNING OBJECTIVE Analyze the economic impact of taxes. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 27 of 40

The Effect of Taxes on Economic Efficiency Figure 4. 10 The Effect of a Tax on the Market for Cigarettes Without the tax, market equilibrium occurs at point A. The equilibrium price of cigarettes is $4. 00 per pack, and 4 billion packs of cigarettes are sold per year. A $1. 00 -per-pack tax on cigarettes will cause the supply curve for cigarettes to shift up by $1. 00, from S 1 to S 2. The new equilibrium occurs at point B. The price of cigarettes will increase by $0. 90, to $4. 90 per pack, and the quantity sold will fall to 3. 7 billion packs. The tax on cigarettes has increased the price paid by consumers from $4. 00 to $4. 90 per pack. Producers receive a price of $4. 90 per pack (point B), but after paying the $1. 00 tax, they are left with $3. 90 (point C). The government will receive tax revenue equal to the green shaded box. Some consumer surplus and some producer surplus will become tax revenue for the government, and some will become deadweight loss, shown by the yellow-shaded area. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 28 of 40

Tax incidence The actual division of the burden of a tax between buyers and sellers in a market. Determining Tax Incidence on a Demand Supply Graph Figure 4. 11 The Incidence of a Tax on Gasoline With no tax on gasoline, the price would be $3. 00 per gallon, and 144 billion gallons of gasoline would be sold each year. A 10 -cents-per-gallon excise tax shifts up the supply curve from S 1 to S 2, raises the price consumers pay from $3. 00 to $3. 08, and lowers the price sellers receive from $3. 00 to $2. 98. Therefore, consumers pay 8 cents of the 10 -cents-pergallon tax on gasoline, and sellers pay 2 cents. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 29 of 40

Solved Problem 4. 4 When Do Consumers Pay All of a Sales Tax Increase? A student makes the following statement: “If the federal government raises the sales tax on gasoline by $0. 25, then the price of gasoline will rise by $0. 25. Consumers can’t get by without gasoline, so they have to pay the whole amount of any increase in the sales tax. ” Under what circumstances will the student’s statement be true? Solving the Problem Step 1: Review the chapter material. Step 2: Draw a graph like Figure 4. 11 to illustrate the circumstances when consumers will pay all of an increase in a sales tax. Step 3: Use the graph to evaluate the situation. The graph shows that consumers will pay all of an increase in a sales tax only if the demand curve is a vertical line. Because the demand curve for gasoline is not a vertical line, this is an unrealistic scenario. My. Econ. Lab Your Turn: For more practice, do related problem 4. 7 at the end of the chapter. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 30 of 40

Does It Make a Difference Whether the Government Collects a Tax from Buyers or Sellers? Figure 4. 12 The Incidence of a Tax on Gasoline Paid by Buyers With no tax on gasoline, the demand curve is D 1. If a 10 -cents-per-gallon tax is imposed that consumers are responsible for paying, the demand curve shifts down by the amount of the tax, from D 1 to D 2. In the new equilibrium, consumers pay a price of $3. 08 per gallon, including the tax. Producers receive $2. 98 per gallon. This is the same result we saw when producers were responsible for paying the tax. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 31 of 40

Making the Is the Burden of the Social Security Tax Really Shared Equally between Workers and Firms? Connection The burden of the tax falls almost entirely on workers in both panels. The forces of demand supply working in the labor market, and not Congress, determine the incidence of the tax. My. Econ. Lab Your Turn: Test your understanding by doing related problems 4. 8 and 4. 9 at the end of this chapter. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 32 of 40

Economics in Your Life Does Rent Control Make It Easier for You to Find an Affordable Apartment? At the beginning of the chapter, we posed the following question: If you have two job offers in different cities, one with rent control and one without, will you be more likely to find an affordable apartment in the city with rent control? Although rent control can keep rents lower than they might otherwise be, it can also lead to a permanent shortage of apartments. You may have to search for a long time to find a suitable apartment, and landlords may even ask you to give them payments “under the table, ” which would make your actual rent higher than the controlled rent. Finding an apartment in a city without rent control should be much easier, although the rent may be higher. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 33 of 40

AN INSIDE LOOK AT POLICY . . . and the Rent-Controlled Apartment Goes to. . . Actress Faye Dunaway! The effect of rent control laws on the supply of affordable apartments. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 34 of 40

Appendix Quantitative Demand Supply Analysis LEARNING OBJECTIVE Use quantitative demand supply analysis. Demand Supply Equations Suppose that the demand for apartments in New York City is QD=3, 000− 1, 000 P and the supply of apartments is QS=− 450, 000+1, 300 P. Equilibrium condition: Solve for the equilibrium monthly apartment rent: © 2013 Pearson Education, Inc. Publishing as Prentice Hall 35 of 40

Find the equilibrium quantity of apartments rented: Calculate the values for rent by setting QD and QS equal to zero and solving for price: and: © 2013 Pearson Education, Inc. Publishing as Prentice Hall 36 of 40

Figure 4 A. 1 Graphing Supply and Demand Equations After statistically estimating supply and demand equations, we can use the equations to draw supply and demand curves. In this case, the equilibrium rent for apartments is $1, 500 per month, and the equilibrium quantity of apartments rented is 1, 500, 000. The supply equation tells us that at a rent of $346, the quantity of apartments supplied will be zero. The demand equation tells us that at a rent of $3, 000, the quantity of apartments demanded will be zero. The areas representing consumer surplus and producer surplus are also indicated on the graph. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 37 of 40

Calculating Consumer Surplus and Producer Surplus Suppose the city imposes a rent ceiling of $1, 000 per month. Calculate the quantity of apartments that will actually be rented: Find the price on the demand curve when the quantity of apartments is 850, 000: © 2013 Pearson Education, Inc. Publishing as Prentice Hall 38 of 40

Figure 4 A. 2 Calculating the Economic Effect of Rent Controls Once we have estimated equations for the demand supply of rental housing, a diagram can guide our numeric estimates of the economic effects of rent control. Consumer surplus falls by an amount equal to the area of the yellow triangle B and increases by an amount equal to the area of the blue rectangle A. The difference between the values of these two areas is $213, 750, 000. Producer surplus falls by an amount equal to the area of the blue rectangle A plus the area of the yellow triangle C. The value of these two areas is $587, 500, 000. The remaining producer surplus is equal to the area of triangle D, or $278, 000. Deadweight loss is equal to the area of triangle B plus the area of triangle C, or $373, 750, 000. © 2013 Pearson Education, Inc. Publishing as Prentice Hall 39 of 40

The following table summarizes the results of the analysis (the values are in millions of dollars): Consumer Surplus Producer Surplus Deadweight Loss Competitive Equilibrium Rent Control $1, 125 $1, 338. 75 $865. 50 $278 $0 $373. 75 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 40 of 40