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Taxes, MC pricing, and a wrap-up of supply/demand Today: Finishing the basic ideas of supply and demand theory From subsidies to taxes to MC pricing Last time, we saw that a subsidy did not work to help high rent in Isla Vista Today, we talk more generally about a negative subsidy, which is called a tax After taxes, we will talk about MC pricing Once these topics are done, we will spend the remaining time reviewing Econ 1 thus far Taxes Three major reasons to charge taxes Revenue generation The prevention of harming the environment or other people (see also Externalities, Ch. 12) Limitation of imports (see also Trade, Ch. 9) Governor Arnold Schwarzenegger below An example: A $1 tax on flashlight suppliers Before tax: Price is $8.80, and 8 flashlights sold An example: A $1 tax on flashlight suppliers With tax: Suppliers must add $1 in additional costs for each flashlight sold An example: A $1 tax on flashlight suppliers With tax: New equilibrium price paid is $9.20 by consumers New equilibrium revenue kept by suppliers, $8.20 An example: A $1 tax on flashlight suppliers Who “pays” for the tax? Consumers pay $0.40 more than before Suppliers receive $0.60 less than before What happens with a $1 tax? Summary Lower quantity sold Consumers pay more money per unit sold Sellers receive less money per unit sold Deadweight loss Deadweight loss is economic surplus that we lose by the imposition of a tax To determine deadweight loss, we need to find surplus and tax revenue generated by tax Any potential surplus not realized is deadweight loss Surplus and deadweight loss Consumer surplus (top Δ) Producer surplus (bottom Δ) Tax revenue generated (rectangle) Deadweight loss (right Δ) Elasticity matters for deadweight loss An example The smaller the price elasticity of supply, the smaller the deadweight loss See Figures 7.16 and 7.17 for visual examples Marginal cost pricing of public services Governments often provide (or contract to a private firm) some “essential” services to residents Back to MB = MC idea Remember 1st lecture Surplus is typically maximized when MB = MC Even though services are publicly provided, MB = MC still applies Example Electricity 8 Mwh can be provided by coal @ 3¢/Kwh 20 Mwh can be provided by natural gas @ 5¢/Kwh 10 Mwh can be provided by wind power @ 9¢/Kwh 6 Mwh can be provided by solar power @ 15¢/Kwh Example 8 Mwh (coal) @ 3¢/Kwh 20 Mwh (natural gas) @ 5¢/Kwh 10 Mwh (wind power) @ 9¢/Kwh 6 Mwh (solar power) @ 15¢/Kwh Suppose that at a price of 9¢/Kwh, 30 Mwh were demanded All coal capacity and natural gas capacity can be used, and 2 Mwh provided by wind MC pricing tells us to charge 9 ¢/Kwh in order to maximize surplus Wrap-up and review of supply, demand, and equilibrium We have talked about many topics related to supply, demand, and equilibrium thus far Utility Surplus Cost curves Elasticity Price controls Taxes and subsidies Voluntary incentives Wrap-up and review of supply, demand, and equilibrium In general, we have analyzed efficiency MB = MC principle Some policies prevent MB = MC principle, lowering efficiency Rent control Taxes and subsidies First-come, first-served Wrap-up and review of supply, demand, and equilibrium Many future topics build off of what we have learned thus far It is important to make sure that you understand the foundation of microeconomics, which we have covered the last three weeks Marginal analysis Remember that averages are sometimes important in economics Marginals are almost always important Some later topics include why markets sometimes fail Marginal analysis will continue to be important Supply, demand, and equilibrium Remaining time today Your chance to ask questions before we move on to more advanced topics Review of key equations, tables, and figures Energy drinks # of drinks Total benefit ($) 0 0 MB ($) Avg. benefit N/A 5 1 5 5 3 2 8 4 2.5 3 10.5 3.5 1.5 4 12 3 -1 5 11 2.2 Cost is $2 per drink We should buy the third energy drink since MB > MC (2.5 > 2) We should not buy the fourth energy drink since MB < MC (1.5 < 2) Note that we are NOT maximizing avg. benefit Supply and Demand Shift in demand/Movement along the supply curve The demand curve shifted to the right There is a movement along the supply curve, since supply does not change MU of bananas: How many would you eat if they were free? Banana quantity (bananas/hour) Total utility (utils/hour) 0 0 Marginal utility (utils/banana) 70 1 70 50 2 120 30 3 150 10 4 160 -10 5 150 From individual demand… …to market demand CS from demand curves P = $3 Height of triangle is ($6 – $3), or $3. Length of triangle is (6 – 0), or 6 Area of triangle is one-half times length times height CS = $9 The area of this triangle is a good approximation of CS Supply and profits At P1 positive profits, since TR > TC (P Q > ATC Q) At P2 negative profits At P3 firm shuts down (TR is less than VC for all Q) Marginal analysis: Hire 4 workers/day if phones are $18 # of empl./day Phones per day Fixed cost ($/day) Var. cost ($/day) Total cost ($/day) 0 0 1000 0 1000 MC ($/phone) 5.00 1 20 1000 100 1100 4.00 2 45 1000 200 1200 10.00 3 55 1000 300 1300 12.50 4 63 1000 400 1400 20.00 5 67 1000 500 1500 (Remember: Check shutdown condition) Example of producer surplus When P = 25 per unit, shaded area is producer surplus Area is a triangle, one-half times length times height: 0.5 10 25 = 125 Price elasticity of demand Calculated by the percentage change in quantity divided by the percentage change in price %Q Elasticity %P Alternate version for straightline demand curves Q / Q P Q P 1 P / P Q P Q slope Slope on straight line is ΔP/ΔQ Along a straight line, elasticity is also equal to P/Q times inverse of the slope (see above) Bumper crop of strawberries: Not always good ε = 0.29 inelastic Expenditure goes DOWN moving from S1 to S2 The bumper crop of strawberries actually hurts farmers collectively Long-run consequences of rent control: Excess demand Notice that supplied apartments for rent are cut in half in the long run with rent control Only 1/3 of the people that want apartments will get them ($100s) 24 excess demand 12 100s units Price ceiling at G: Red triangle is deadweight loss Total surplus is trapezoid ADFE (at most) ΔCEF is potential surplus that is never gained A $1 tax on flashlight suppliers Who “pays” for the tax? Consumers pay $0.40 more than before Suppliers receive $0.60 less than before Surplus and deadweight loss Consumer surplus (top Δ) Producer surplus (bottom Δ) Tax revenue generated (rectangle) Deadweight loss (right Δ)