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Modern Principles:
Microeconomics
Tyler Cowen
and Alex Tabarrok
Chapter 7
Price Floors, Taxes,
and Subsidies
Copyright © 2010 Worth Publishers • Modern Principles: Microeconomics • Cowen/Tabarrok
Price Floors
• Policy makers may respond to sellers’
complaints that prices are “too low” by
enacting price controls.
• A Price Floor is a minimum price allowed
by law.
 Price floors impose a minimum price that
buyers must pay for goods.
 Prices cannot legally go lower than the floor.
Slide 2 of 50
Price Floors
• Price floors that involve a minimum price
above the market price create four
important effects.
1.
2.
3.
4.
Surpluses
Loss of Gains from Trade
Wasteful Increases in Quality
Misallocation of Resources
Slide 3 of 50
Surpluses
1. When prices are held above the market
price surpluses emerge where the quantity
supplied exceeds the quantity demanded.
 The surplus is measured by the difference
between the quantity supplied at the controlled
price and the quantity demanded at the
controlled price.
 The higher the controlled price relative to the
market equilibrium price, the larger the surplus.
Slide 4 of 50
Surpluses
Price Floors Create Surpluses
Price
Supply
Surplus
Controlled Price
(Ceiling)
Market
Price
Demand
Quantity
Qdemanded at the
Controlled Price
Qmarket
Qsupplied at the
Controlled Price
Slide 5 of 50
Lost Gains from Trade
2. Price controls reduce the gains from trade.



•
Price floors set above the market price cause quantity
demanded to be less than the market quantity.
For output levels below the equilibrium market
quantity, consumers value the good (as indicated by
the willingness to pay) more than the cost of its
production.
This represents a gain from trade that would not
remain unexploited in a free market.
Price floors create a deadweight loss by forcing
quantity demanded below the market quantity.

Buyers and sellers can both benefit from trade at a
lower price, but it is illegal for price to fall.
Slide 6 of 50
Lost Gains from Trade
Price Floors Reduce the Gains from Trade
Price
Lost Gains from Trade
= Lost Consumer Surplus
+ Lost Producer Surplus
Supply
Controlled
Price
(Floor)
Market
Price
Surplus
Lost
Consumer
Surplus
Lost
Producer
Surplus
Willingness
to Sell
Demand
Quantity
Qdemanded
Qmarket
Qsupplied
Slide 7 of 50
Wasteful Increases in Quality
3. Price controls that create surpluses lead to
wasteful increases in quality.
 Surpluses mean that producers will not be able
to sell all of their goods.
 In free markets sellers compete with other
sellers by offering a lower price.
 Since price is not allowed to fall below the
price floor, sellers must compete in other ways.
Slide 8 of 50
Wasteful Increases in Quality
•
Some producers may be willing to make quality
investments in order to sell their surplus goods.



The maximum quality investment a seller would make
is the difference between the controlled price
established by the price floor and the willingness to
sell.
Quality investments require resources that are
wasted when consumers are not normally willing to
pay for the higher quality.
The costs of these investments reduce profits and
producer surplus.
Slide 9 of 50
Wasteful Increases in Quality
Price Floors Create Quality Waste
Price
Deadweight Loss
Supply
Controlled
Price (Floor)
“Quality”
Waste
Market Equilibrium
Willingness
to Sell
Demand
Quantity
QDemanded at the
Controlled Price
Slide 10 of 50
Misallocation of Resources
4. Price controls misallocate resources by
allowing high-cost firms to operate.
 In free markets sellers with production costs
greater than the equilibrium price will be driven
out of the market.
 Price floors allow these sellers to remain in the
market employing limited resources that could
be used doing something else.
Slide 11 of 50
CHECK YOURSELF
 The European Union has a minimum legal price
for butter, a price floor, that is often above the
market equilibrium price. What do you think has
been the result of this.
 The United States has set a price floor for milk
above the equilibrium price. Has this led to
shortages or surpluses? How do you think the
U.S. government has dealt with this? (Hint:
remember the cartons of milk you had in
elementary school and high school? What was
their price?)
Slide 12 of 50
Taxes
• Governments often use taxes to raise revenue to
fund various projects.
• A Commodity Tax is a tax placed on goods.
• Some truths about commodity taxation:
1. Who pays the tax does not depend on who writes the
check to the government;
2. Who pays the tax does depend on the relative
elasticities of demand and supply;
3. Commodity taxation raises revenue and creates lost
gains from trade (deadweight loss).
Slide 13 of 50
Taxes
1. Who pays the tax does not depend on
who writes the check to the government.
 The government can collect a commodity tax in
either of two different ways:
• A tax on sellers for every unit supplied;
• A tax on buyers for every unit purchased.
 Who must legislatively pay the tax is irrelevant.
 Commodity taxes have exactly the same effect
whether sellers or buyers pay for the tax.
Slide 14 of 50
A Tax on Sellers
• A tax on sellers is equivalent to an increase
in costs.
 Such a tax will shift the supply curve up by the
amount of the tax.
 The tax will distort the market so that the price
paid by buyers will be different than the price
received by sellers.
 This difference will always equal the tax.
• Tax = Price Paid by Buyers – Price Received by
Sellers
Slide 15 of 50
A Tax on Sellers
A Tax on Sellers Shifts the Supply Curve Up by the Tax
Price
Supply With Tax
c
Price Paid by
Buyers
tax
Supply No Tax
b
Price (No Tax)
a
tax
Price Received
by Sellers
Demand
Quantity
Qwith tax Qno tax
Slide 16 of 50
A Tax on Buyers
• A tax on buyers lowers the willingness to
pay for every quantity demanded.
 Such a tax will shift the demand curve down by
the amount of the tax.
 The tax will distort the market so that the price
paid by buyers will be different than the price
received by sellers.
 This difference will always equal the tax.
• Tax = Price Paid by Buyers – Price Received by
Sellers
Slide 17 of 50
A Tax on Buyers
A Tax on Buyers Shifts the Demand Curve Down by the Tax
Price
Supply
Price Paid by
Buyers
b
tax
Price (No Tax)
a
Price Received by
Sellers
d
tax
e
Qwith tax
Demand With Tax
Demand
No Tax
Quantity
Qno tax
Slide 18 of 50
A Tax on Sellers Equals a Tax on Buyers
A Tax on Sellers is the Same as a Tax on Buyers
Supply With Tax
Price
Supply No Tax
tax
tax
Price Paid by
Buyers
b
a
Price (No Tax)
Price Received
by Sellers
d
tax
tax
Demand No Tax
Demand With Tax
Quantity
Qwith tax Qno tax
Slide 19 of 50
The Burden of a Tax
2. Who pays the tax depends on the relative
elasticities of supply and demand.
 A tax creates a wedge between the price paid
by buyers and the price received by sellers.
• Buyers pay a price greater than the market price
without a tax while sellers receive a price less than
the market price without a tax.
 The burden of a tax is the portion of the tax
paid by buyers and sellers.
 The less elastic side of the market will pay the
greater share of a tax – bear more of the
burden of a tax.
Slide 20 of 50
The Burden of a Tax
• When the demand curve is more elastic
than the supply curve, sellers will bear a
larger burden of a tax.
 The price the seller receives falls below the
market price without the tax more than the
price the buyer pays rises above the market
price without the tax.
 The less elastic supply curve implies that it is
more difficult for sellers to avoid the tax than it
is for buyers.
Slide 21 of 50
The Burden of a Tax
When Demand is More Elastic than Supply Sellers Pay More of
the Tax
Price
Supply
Price Paid
by Buyers
b
a
Price (No Tax)
tax
Price Received
by Sellers
Demand
d
Quantity
Qwith tax
Qno tax
Slide 22 of 50
The Burden of a Tax
• When the supply curve is more elastic than
the demand curve, buyers will bear a larger
burden of a tax.
 The price the buyer pays rises above the
market price without the tax more than the
price the seller receives falls below the market
price without the tax.
 The less elastic demand curve implies that it is
more difficult for buyers to avoid the tax than it
is for sellers.
Slide 23 of 50
The Burden of a Tax
When Supply is More Elastic than Demand Buyers Pay More of the
Tax
Price
Price Paid
by Buyers
b
a
tax
Supply
Price (No Tax)
d
Price Received
by Sellers
Demand
Quantity
Qwith tax
Qno tax
Slide 24 of 50
The Burden of a Tax
• The burden of a tax to buyers can be
defined as PBuyers – PNoTax, and the burden
to sellers can be defined as PNoTax – Psellers.
• The burden of the tax then is divided
according to the ratio of elasticities:
ES
Burden to Buyers PBuyers  PNoTax


.
Burden to Sellers
PNoTax  PSellers ED
Slide 25 of 50
The Burden of a Tax
• Example:
 Suppose the elasticity of supply is 2, and the
elasticity of demand is 1 (in absolute terms).
 Buyers will then bear twice as much of the tax
as sellers.
• For a $1 tax, buyers will pay an extra 66.6 cents,
and sellers will receive 33.3 cents less.
Slide 26 of 50
The Burden of a Tax
• Relative elasticities can play an important
role in analyzing tax policy.
 Health Insurance Mandates and Tax Analysis
• Mandates requiring employers to provide health
insurance to their workers may make employees
worse off.
 Who Pays the Cigarette Tax?
• If manufacturers of cigarettes can easily escape
state taxes, then it’s possible the tax will not
discourage smoking.
Slide 27 of 50
The Burden of a Tax - Extra!
• The Omnibus Budget Reconciliation Act of
1990 applied a 10% federal luxury tax to the first
retail sale of luxury goods such as pleasure boats
with a sales price above $100,000.
• The tax was originally projected to generate
revenues of $9 billion over five years after
passage.
• The tax was widely popular among policy makers
as a way to shift the burden of deficit reduction to
those who can best afford it.
Slide 28 of 50
The Burden of a Tax - Extra!
• The results were not what was expected by policy
makers:
 Sales of boats down 52.7%;
 Net loss of 30,000 jobs;
 The federal government paid out over $7 million more
in unemployment benefits to those workers than it
collected in luxury tax revenues.
• The elasticity of supply for boats was evidently
less elastic than the elasticity of demand for
boats.
• The federal luxury tax was quickly repealed in
1993.
Slide 29 of 50
The Burden of a Tax - Extra!
• “You had to be an ignoramus to believe the
luxury tax was only going to soak the rich. The
only people it hurt was working people like
myself,” said Judy Ott, an assembly worker at the
Viking Yacht Company’s plant in New Jersey.
• “All these people suffered needlessly because
the politicians in Washington needed a symbol to
sell the American people a new tax increase,”
said Viking’s co-founder Robert T. Healey.
Slide 30 of 50
The Deadweight Loss of a Tax
3. A commodity tax raises revenue and creates lost
gains from trade (deadweight loss).
 A tax generates revenues for the government.
• Government will receive tax revenue equal to the quantity of
the good purchased times size of the tax.
 A tax also reduces the gains from trade creating a
deadweight loss.
• A tax creates a wedge between the price that buyers pay and
the price that sellers receive.
• As such, quantity will be less than the equilibrium quantity with
no tax leaving unexploited gains from trade (deadweight loss).
Slide 31 of 50
The Deadweight Loss of a Tax
A Tax Generates Revenue and Creates a Deadweight Loss
Price
Consumer
Surplus
Producer
Surplus
Deadweight
Loss
Price
Buyer Pays
Tax
Revenue
tax
Pno tax
Supply
Price
Seller Receives
Demand
Quantity
Qtax
Qno tax
Slide 32 of 50
CHECK YOURSELF
Suppose that the government taxes insulin
producers $50 per dose produced. Who is
likely to ultimately pay this tax?
Although the government taxes almost
everything, would the government rather
tax items that have relatively inelastic or
relatively elastic demands and supplies?
Slide 33 of 50
Subsidies
• A subsidy is a reverse tax where the government
gives money to consumers or producers.
• Some truths about subsidies:
1. Who gets the subsidy does not depend on who
receives the check from the government;
2. Who benefits from the subsidy does depend on the
relative elasticities of demand and supply;
3. Subsidies must be paid for by taxpayers and create
inefficient gains from trade (deadweight loss).
Slide 34 of 50
Subsidies
• A subsidy distorts the market so that the
price paid by buyers will be different than
the price received by sellers.
 A subsidy reverses the relationship between
the price paid by buyers and the price received
by sellers with a tax.
• The price received by sellers will exceed the price
paid by buyers.
 This difference will always equal the subsidy.
• Subsidy = Price Received by Sellers – Price Paid by
Buyers
Slide 35 of 50
Subsidies
A Subsidy Drives a Wedge between the Price Received by
Sellers and the Price Paid by Buyers
Price
Supply
Price Received by
Sellers
Pmarket
Subsidy
Price Paid
by Buyers
Demand
Quantity
Qmarket
Qsubsidy
Slide 36 of 50
The Benefit of Subsidies
• Who receives the benefit of a subsidy
depends on the relative elasticities of
supply and demand.
 The less elastic side of the market will receive
the greater share of a subsidy – receive more
of the benefit of a subsidy.
• Whichever side of the market bears the burden of a
tax receives the benefit of a subsidy.
Slide 37 of 50
The Benefit of Subsidies
Whoever Bears the Burden of a Tax, Receives the Benefit of a
Subsidy
Price
Supply
Price Received
by Sellers
Price Paid by
Buyers
Price (No Tax
or Subsidy)
subsidy
tax
Price Paid
by Buyers
Demand
Price Received
by Sellers
Quantity
Qwith tax
Qno tax or
no subsidy
Qwith subsidy
Slide 38 of 50
The Benefit of Subsidies
• The benefit of a subsidy to buyers can be
defined as PNoSubsidy – PBuyers, and the
benefit to sellers can be defined as PSellers –
PNoSubsidy.
• The benefit of the subsidy then is divided
according to the ratio of elasticities:
ES
Benefit to Buyers PNoSubsidy  PBuyers


.
Benefit to Sellers
PSellers  PNoSubsidy ED
Slide 39 of 50
Subsidies
• Just like a tax, a subsidy creates a deadweight
loss.
 In the case of a subsidy, the deadweight loss arises
because of non-beneficial trades rather than
unexploited gains from trade with a tax.
 With a subsidy output exceeds the equilibrium level of
output.
• At this quantity the cost of production is greater than the value
to consumers.
• As a result resources are employed that could be used doing
something else of greater value.
• Taxpayers end up paying the difference.
Slide 40 of 50
Subsidies
A Subsidy Creates a Deadweight Loss
Price
Deadweight Loss
Supply
Price Received
by Sellers
Subsidy
Pmarket
Price Paid
by Buyers
Demand
Quantity
Qmarket
Qsubsidy
Slide 41 of 50
Subsidies
• Relative elasticities can play an important
role in analyzing subsidy policy.
 King Cotton and the Deadweight Loss of Water
Subsidies
• Subsidies can divert scarce resources to lower
value uses.
 Wage Subsidies
• This type of subsidy, argued by Nobel prize wining
economist Edmund Phelps, may increase
employment as well as wages for low-skilled
workers.
Slide 42 of 50
The Minimum Wage and Wage Subsidies
• The minimum wage is the clearest example of a
price floor in the United States.
• Such a policy, however, can hurt low-skilled
workers by reducing employment.
• Some economists believe that a better approach
would be to subsidize employers (demanders of
labor).
 This approach leads to a higher wage and a higher
level of employment.
Slide 43 of 50
The Minimum Wage and Wage Subsidies
A Minimum Wage Decreases Employment
Wage
Supply
Unemployment
Minimum
Wage
c
a
Demand
Qdemanded
Qmarket
Qsupplied
Quantity
Slide 44 of 50
The Minimum Wage and Wage Subsidies
A Subsidy to Wages Increases Employment
Wage
Supply
b
Wage
Received by
Workers
a
Subsidy
Demand with Subsidy
Wage
Paid by
Firms
Demand
Quantity
Qdemanded Qmarket
Qsupplied
Slide 45 of 50
CHECK YOURSELF
 To promote energy independence, the U.S.
government provides a subsidy to corn growers if
they convert the corn to ethanol, a fuel used in some
cars. Because of this subsidy, what happens to the
quantity supplied of ethanol, and what happens to the
price received by corn growers and the price paid by
ethanol buyers?
 The U.S. government subsidizes college education in
the form of Pell grants and lower-cost government
Stafford loans. How do these subsidies affect the
price of college education? Which is relatively more
elastic: supply or demand? Who benefits the most
from these subsidies, suppliers (colleges) or
demanders of education (students)?
Slide 46 of 50
Takeaway
• A price floor is a minimum price allowed by law.
• Price floors that involve a minimum price above
the market price create four important effects.
1.
2.
3.
4.
Surpluses
Loss of Gains from Trade
Wasteful Increases in Quality
Misallocation of Resources
Slide 47 of 50
Takeaway
• When prices are held above the market price
surpluses emerge where the quantity supplied
exceeds the quantity demanded.
• Price floors reduce the gains from trade by
making some mutually profitable trades illegal.
• Price floors lead to wasteful increases in quality
not valued by consumers.
• Price floors misallocate resources by allowing
high-cost firms to operate in the market.
Slide 48 of 50
Takeaway
• Governments often use taxes to raise revenue to
fund various projects.
• A commodity tax is a tax placed on goods.
• Some truths about commodity taxation:



Who pays the tax does not depend on who writes the
check to the government;
Who pays the tax does depend on the relative
elasticities of demand and supply;
Commodity taxation raises revenue and creates lost
gains from trade (deadweight loss).
Slide 49 of 50
Takeaway
• A subsidy is a reverse tax where the government
gives money to consumers or producers.
• Some truths about subsidies:
1. Who gets the subsidy does not depend on who
receives the check from the government;
2. Who benefits from the subsidy does depend on the
relative elasticities of demand and supply;
3. Subsidies must be paid for by taxpayers and create
inefficient gains from trade (deadweight loss).
Slide 50 of 50