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The Pizza Demand Curve • The demand for frozen pizzas reflects the law of diminishing marginal utility. • Because marginal utility (MU) falls with increased consumption, $3.50 so does a consumer’s maximum willingness to pay -- marginal $3.00 benefit (MB). • A consumer will purchase Price =$2.50 $2.50 until MB = Price . . . so at $2.50 $2.00 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). MB4 MU4 < MBbecause < MB <MB < MU < MU <MU 3 2 1 3 2 1 John’s demand curve for frozen pizza MB 1 MB MB 2 3 MB 4 d = MB Frozen pizzas per week 1 2 3 4 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. Producer and Consumer Surplus P $10 9 8 7 6 5 4 3 2 1 Consumer surplus = area of red triangle = ½($5)(5) = $12.5 S Producer surplus = area of green triangle = ½($5)(5) = $12.5 CS PS D 0 1 2 3 4 5 6 7 8 Q The combination of producer and consumer surplus is maximized at market equilibrium 8-3 Consumer Surplus Price 5 4 3 2 1 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 The Burden of a Tax Tax Incidence • Who pays a tax is called the incidence. Buyer Seller 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. • When a $1,000 tax is imposed on sellers of used cars, the supply curve shifts vertically by the amount of the tax. • The new price for used cars is $7,400 … sellers netting $6,400 ($7,400 - $1000 tax). • 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. S plus tax S $7,400 $7,000 $1000 tax $6,400 D 500 750 # of used cars per month (in thousands) 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 $6,400 of $1000 making the total $7,400. • Consumers end up paying $7,400 (after taxes) instead of $7,000 and bear $400 of the tax burden. • Sellers end up receiving $6,400 instead of $7000 and bear $600 of the tax burden. $1000 tax D D minus tax 500 750 # of used cars per month (in thousands) 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 becomes more inelastic, then more of the burden will fall on buyers. ED ED + E S ES ED + E S Tax Burden and Elasticity • Consider the market for Gasoline and Luxury Boats individually. • We begin in equilibrium. • 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. • 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. • In the gas market, the demand is relatively more inelastic than its supply; hence, buyers bear a larger share of the burden of the tax. • In the luxury boats market, the supply curve is relatively more inelastic than its demand; hence, sellers bear a larger share of the tax burden. Price Gasoline market S plus tax $1.65 $1.60 $1.55 $1.50 $1.45 S D Quantity (millions of gallons) 194 200 Price (thousand $) S plus tax S 110 Luxury boat market 100 90 D 80 Quantity 5 10 15 (thousands 20 of boats) Government Intervention as Implicit Taxation • Government intervention in the form of price controls can be viewed as a combination tax and subsidy • An effective 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 S A price ceiling transfers surplus from producers to consumers, generates deadweight loss, and reduces equilibrium quantity P0 P1 Price ceiling Shortage Q1 Q0 D Q • An effective 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 Surplus S P1 Price floor P0 D Q1 Q0 Q A price floor transfers surplus from consumers to producers, generates deadweight loss, and reduces equilibrium quantity The Difference Between Taxes and Price Controls • 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 • 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 rentseeking 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 Inelastic Demand and Incentives to Restrict Supply Revenue gained P S1 S0 P1 P0 When demand is relatively inelastic, suppliers have incentive to restrict quantity to increase total revenue C Revenue lost A B Q1 Q0 D Q Inelastic Supplies and Incentives to Restrict Prices • 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 Application: Price Floors and Elasticity The surplus created by a price floor is larger if demand and supply are elastic P P Surplus S Surplus S P1 P P0 1 Price floor P0 D D Q Q 1 0 Q QQ 1 0 Q Long-Run and Short-Run Effects on Price Control P Sshort-run PSR PLR P0 Higher long-run elasticity of supply results in smaller price increases when demand increases Slong-run D0 Q0 QSR QLR D1 Q