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© 2011 Thomson South-Western TAXES • The govt. levies taxes on many goods & services to raise revenue to pay for public services such as national defense and public schools. • The tax can be a % of the good’s price, or a specific amount for each unit sold. – For simplicity, we analyze per-unit taxes only. © 2011 Thomson South-Western Market for Coffee Consider a $6 tax on suppliers Price 20 S2 18 16 14 Tax 12 S1 10 8 6 4 2 0 0 1 2 3 4 5 6 7 8 9 10 Quantity '000 pounds © 2011 Thomson South-Western Results of Tax? • Result 1: Quantity – Quantity demanded declines – new Q = 4 • Result 2: Price – Wedge in price, Pc > Ps – Price paid by consumers increases – Price received by suppliers decreases • Result 3: Tax Revenues – Wedge between price paid by consumers and received by suppliers is the tax revenue © 2011 Thomson South-Western Market for Coffee Consider a $6 tax on suppliers Price 20 S2 18 16 14 Tax 12 10 S1 Tax Revenue 8 6 4 2 0 0 1 2 3 4 5 6 7 8 9 10 Quantity '000 pounds © 2011 Thomson South-Western Results of Tax? • Result 4: Who pays the tax? – Consumers pay? • Pc – P* = $12-$8 = $4 – Producers pay? • P* – Ps = $8 - $6 = $2 – Even though tax is levied on suppliers, consumers are paying more of the tax! © 2011 Thomson South-Western Market for Coffee Consider a $6 tax on consumers (ex/retail tax) Price 20 18 16 D1 14 D2 12 10 8 Tax 6 4 2 0 0 1 2 3 4 5 6 7 8 9 10 Quantity '000 pounds © 2011 Thomson South-Western Results of Tax are the Same! • Result 1: Quantity – Quantity demanded declines – new Q = 4 • Result 2: Price – Wedge in price, Pc > Ps • Result 3: Tax Revenues – Revenues are the same • Result 4: Who pays the tax? – Consumers pay $12-$8 = $4 – Producers pay $8 - $6 = $2 © 2011 Thomson South-Western Who really pays the tax? What does it depend on? Scenario 1: Yachts Stax Scenario 2: Cigarettes Stax S S Pwithout tax Supplier pays most of the tax! Consumer pays most of the tax! © 2011 Thomson South-Western Elasticity and Tax Incidence • More of the tax is borne by the less elastic side of the market – Elasticity Flexibility Avoid the tax! • Coffee Tax Example: – Consumers bear more tax, so consumers must be more inelastic | - 1 | < | 1.4 | © 2011 Thomson South-Western The 2011 payroll tax cut • Prior to 2011, the Social Security payroll tax was 6.2% taken from workers’ pay and 6.2% paid by employers (total 12.4%). • The Tax Relief Act (2010) reduces the worker’s portion from 6.2% to 4.2% (for 2011 only), but leaves the employer’s portion at 6.2%. QUESTION: Will the typical worker’s take-home pay rise by exactly 2%, more than 2%, or less than 2%? Do any elasticities affect your answer? Explain. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2011 Thomson South-Western Answers • As long as labor supply and labor demand both have price elasticity > 0, the tax cut will be shared by workers and employers, i.e., workers’ take-home pay will rise less than 2%. • The answer does NOT depend on whether labor demand is more or less elastic than labor supply. FOLLOW-UP QUESTION: Who gets the bigger share of this tax cut, workers or employers? How do elasticities determine the answer? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2011 Thomson South-Western Answers • If labor demand is more elastic than labor supply, workers get more of the tax cut than employers. • If labor demand is less elastic than labor supply, employers get the larger share of the tax cut. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2011 Thomson South-Western CONTROLS ON PRICES • Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. • Result in government-created price ceilings and price floors. © 2011 Thomson South-Western CONTROLS ON PRICES • Price Ceiling – A legal maximum on the price at which a good can be sold. – Cannot charge a price higher than this price • Price Floor – A legal minimum on the price at which a good can be sold. – Price will not fall below this level © 2011 Thomson South-Western How Price Ceilings Affect Market Outcomes • Two outcomes are possible when the government imposes a price ceiling: • The price ceiling is not binding if set above the equilibrium price. • The price ceiling is binding if set below the equilibrium price, leading to a shortage. © 2011 Thomson South-Western Figure 1 A Market with a Price Ceiling (a) A Price Ceiling That Is Not Binding Price of Ice-Cream Cone Supply $4 Price ceiling 3 The market clears at $3 and the price ceiling has no effect. Equilibrium price Demand 0 100 Equilibrium quantity Quantity of Ice-Cream Cones © 2011 Thomson South-Western Figure 1 A Market with a Price Ceiling (b) A Price Ceiling That Is Binding Price of Ice-Cream Cone Supply Equilibrium price $3 2 Price ceiling Shortage Demand 0 75 125 Quantity supplied Quantity demanded Quantity of Ice-Cream Cones © 2011 Thomson South-Western How Price Ceilings Affect Market Outcomes • Effects of Price Ceilings • A binding price ceiling creates • Shortages because QD > QS. • Example: Gasoline shortage of the 1970s • Nonprice rationing • Examples: Long lines, discrimination by sellers © 2011 Thomson South-Western CASE STUDY: Rent Control in the Short Run and Long Run • Rent controls are ceilings placed on the rents that landlords may charge their tenants. • The goal of rent control policy is to help the poor by making housing more affordable. • One economist called rent control “the best way to destroy a city, other than bombing.” © 2011 Thomson South-Western Figure 3 Rent Control in the Short Run and in the Long Run (a) Rent Control in the Short Run (supply and demand are inelastic) Rental Price of Apartment Supply Controlled rent Shortage Demand 0 Quantity of Apartments © 2011 Thomson South-Western Figure 3 Rent Control in the Short Run and in the Long Run (b) Rent Control in the Long Run (supply and demand are elastic) Rental Price of Apartment Supply Controlled rent Shortage 0 Demand Quantity of Apartments © 2011 Thomson South-Western How Price Floors Affect Market Outcomes • When the government imposes a price floor, two outcomes are possible. • The price floor is not binding if set below the equilibrium price. • The price floor is binding if set above the equilibrium price, leading to a surplus. © 2011 Thomson South-Western Figure 4 A Market with a Price Floor (a) A Price Floor That Is Not Binding Price of Ice-Cream Cone Supply Equilibrium price $3 The government says that icecream cones must sell for at least $2; this legislation has no effect at the current market price. Price floor 2 Demand 0 100 Equilibrium quantity Quantity of Ice-Cream Cones © 2011 Thomson South-Western Figure 4 A Market with a Price Floor (b) A Price Floor That Is Binding Price of Ice-Cream Cone Supply Surplus $4 Price floor 3 Equilibrium price Demand 0 Quantity of Quantity Quantity Ice-Cream Cones demanded supplied © 2011 Thomson South-Western 80 120 How Price Floors Affect Market Outcomes • A price floor prevents supply and demand from moving toward the equilibrium price and quantity. • When the market price hits the floor, it can fall no further, and the market price equals the floor price. • A binding price floor causes . . . • a surplus because QS > QD. © 2011 Thomson South-Western CASE STUDY: The Minimum Wage • An important example of a price floor is the minimum wage. • Minimum wage laws dictate the lowest price possible for labor that any employer may pay. © 2011 Thomson South-Western How Price Floors Affect Market Outcomes The eq’m wage ($6) W is below the floor $7.25 and therefore illegal. $6.00 The floor is a binding constraint on the wage, causes a surplus (i.e., unemployment). labor surplus S Price floor D 400 550 L © 2011 Thomson South-Western The Minimum Wage Min wage laws do not affect highly skilled workers. They do affect teen workers. Studies: A 10% increase in the min wage raises teen unemployment by 1–3%. W unemployment S Min. wage $7.25 $6.00 D 400 550 L © 2011 Thomson South-Western ACTIVE LEARNING Price floors & ceilings P 140 130 Determine effects of: ceiling 90 C. $120 price floor S 110 100 floor The market for hotel rooms 120 A. $90 price B. $90 price 1: 80 D 70 60 50 40 0 Q 50 60 70 80 90 100 110 120 130 © 2011 Thomson South-Western ACTIVE LEARNING A. $90 price ceiling P 140 The price falls to $90. 130 Buyers demand 120 rooms, sellers supply 90, leaving a shortage. 110 1: The market for hotel rooms S 120 100 90 80 Price ceiling D shortage = 30 70 60 50 40 0 Q 50 60 70 80 90 100 110 120 130 © 2011 Thomson South-Western ACTIVE LEARNING B. $90 price floor Eq’m price is above the floor, so floor is not binding. P = $100, Q = 100 rooms. P 140 1: The market for hotel rooms 130 S 120 110 100 90 80 Price floor D 70 60 50 40 0 Q 50 60 70 80 90 100 110 120 130 © 2011 Thomson South-Western ACTIVE LEARNING C. $120 price floor The price rises to $120. Buyers demand 60 rooms, sellers supply 120, causing a surplus. P 140 130 120 110 1: The market for hotel rooms surplus = 60 S Price floor 100 90 80 D 70 60 50 40 0 Q 50 60 70 80 90 100 110 120 130 © 2011 Thomson South-Western Evaluating Price Controls • Recall one of the Ten Principles: Markets are usually a good way to organize economic activity. Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices. Price controls are often intended to help the poor, but they often hurt more than help them: • The min. wage can cause job losses. • Rent control can reduce the quantity and quality of affordable housing. © 2011 Thomson South-Western CONCLUSION: Government Policies and the Allocation of Resources • Each of the policies in this chapter affects the allocation of society’s resources. • Example 1: A tax on pizza reduces eq’m Q. With less production of pizza, resources (workers, ovens, cheese) will become available to other industries. • Example 2: A binding minimum wage causes a surplus of workers, a waste of resources. • So, it’s important for policymakers to apply such policies very carefully. © 2011 Thomson South-Western