2.1A Supply and Demand Model...• Demand is determined by the buyers of a good. Buyer always want to get the lowest price they can! Hence, demand is downward sloping • Supply is

2.1A Supply and Demand Model

What are competitive markets?CompetitiveMarkets:

– Bringtogetherthedecentralizeddecisionsofbuyersandsellers– DecentralizedDecisionsofBuyers:

• Drivethemtotrytogetthelowestpossiblepriceforthegoodstheywant

– DecentralizedDecisionsofSellers:• Drivethemtotrytogetthehighestpossiblepriceforthegoodstheyareselling

Whenthesedecisionscometogether– competitivemarketsyield:– Bestpossiblepricefortheproduct– Producedatthelowestpossiblecost– Mostefficientallocationofresources

What are competitive markets?CompetitiveMarkets:

– Bringtogetherthedecentralizeddecisionsofbuyersandsellers– DecentralizedDecisionsofBuyers:

• Drivethemtotrytogetthelowestpossiblepriceforthegoodstheywant

– DecentralizedDecisionsofSellers:• Drivethemtotrytogetthehighestpossiblepriceforthegoodstheyareselling

Whenthesedecisionscometogether– competitivemarketsyield:– Bestpossiblepricefortheproduct– Producedatthelowestpossiblecost– Mostefficientallocationofresources

What are competitive markets?FundamentalAssumptionsofSupply+DemandModel:

1.OperatingunderPerfectCompetition• Lotsofbuyersandsellers• Goodssoldareidentical• Nocosttoenteringorleavingthemarket

2.Equalaccesstoinformation3.Externalitiesdonotexist

Nosingleeconomicagentcanunilaterallyexertanypricecontrol









What is Demand?

• Demandcomesfromthebuyerofagood/service

• Eachbuyeristryingtogetthelowestpricepossibleforthegood/servicethattheywantQuantityDemanded:Amountofthe

goodbuyerswanttobuyateachpricepoint

What is Demand?

DemandSchedule:givesthequantitydemandedateachprice

Price QuantityDemanded

$5 13$6 12$7 10

What is Demand?• Fromthedemandschedule,wecandeterminethedemand

curve

• DemandCurve:Relationshipbetweenpriceofthegoodandamountpeoplewanttobuyofthegood(quantitydemanded)

• LawofDemand:Aspriceofagooddeclines,peoplewanttobuymoreofit

Qdemanded

Price

Demand

$7

$6

$5

101213

Changes in DemandMovementalongthedemandcurve:• Priceofthegoodhaschangedbutthereisnochangeinthe

willingnessofbuyerstobuythegood

• Pricechanges– movetoanewpointonthedemandcurve(fromAtoB)

Qdemanded

Price

Demand

$7

$5

1013

A

B

Changes in DemandShiftinthedemandcurve:• Somefactorhaschangedthatdirectlyimpactsbuyers’

willingnesstobuythegood

• Demandcurveshifts– ateachpricepointthereisnowanewquantitydemanded

Qdemanded

Price

D.1

$7

1015

A B

D.2

Factors that Shift Demand1.ChangeinIncome

• NormalGoodsSallyjustreceivedaraiseatwork.ShenowbuysStarbuck’s

lattesonherwaytowork.

• InferiorGoodsAfterreceivingherraise,Sallynolongerbuyscoffeeatthegas

stationonherwaytowork.

Qdemanded

Priceoflattes

D.1

$4.50

01

A

D.2

B

Factors that Shift Demand2.ChangeinPriceofRelatedGoods

• Compliments:Goodsthatareconsumedtogether• Ifthepriceofhotdogsincreases,peoplewilldemand(orbuy)lesshotdogbuns

• PriceofGoodAincreases:DemandforGoodBdecreases• PriceofGoodAdecreases:DemandforGoodBincreases

Qdemanded

PriceofHotDogBuns

D.1

$1.50

56D.2

AB

Factors that Shift Demand2.ChangeinPriceofRelatedGoods

• Substitutes: Goodsthatcanbeconsumedintheplaceofanothergood

• Ifthepriceofhotdogsincreases,peoplewilldemand(orbuy)morehamburgers

• PriceofGoodAincreases:DemandforGoodBincreases• PriceofGoodAdecreases:DemandforGoodBdecreases

Qdemanded

PriceofHamburgers

$4.00

78

BA

Factors that Shift Demand3.ChangeinTastesandPreferences

Asitgetscolderoutinthewintermonths,peopleprefer tobuysweatersandjackets.Demandforsweaters increases.4.ChangeinNumberofBuyers

Aslaptopsbecomemorepopularandeasytouse,morepeoplebuythem.Demandforlaptopsincreases.5.ChangeinFutureExpectations

FuturePriceoftheGood:Ifpeopleexpectdiscountedpricesduetoretailersholidaysales,theywillwaittobuythegoods

FutureIncome:Ifacollegestudentsecuresajobthathewillstartinafewmonths,hewillfeelmoreconfidentbuyinganexpensivesuittoday.

What is Supply?

• Supply comes from the seller of a good/service

• Each seller is trying to get the highest price possible for the good/service that they produce

• Quantity Supplied: Amount of the good sellers are willing to sell at each price point

What is Supply?

SupplySchedule:givesthequantitysuppliedateachprice

Price QuantitySupplied

$5 10$6 12$7 13

What is Supply?• Fromthesupplyschedule,wecandeterminethesupplycurve

• SupplyCurve:Relationshipbetweenpriceofthegoodandamountfirmsarewillingtosellofthegood(quantitysupplied)

• LawofSupply:Aspriceofagoodincreases,peoplewanttosellmoreofit

Qsupplied

Price Supply

$7

$6

$5

101213

Changes in SupplyMovementalongthesupplycurve:• Priceofthegoodhaschangedbutthereisnochangeinthe

costofproductionorwillingnesstosellbythefirm

• Pricechanges– movetoanewpointonthesupplycurve(fromAtoB)

Qsupplied

PriceSupply

$7

$5

1013

B

A

Changes in SupplyShiftinthesupplycurve:• Somefactorhaschangedthatdirectlyimpactssellers’

willingnesstosell/producethegood(or)theircostofproduction

• Supplycurveshifts– ateachpricepointthereisnowanewquantitysupplied

Qsupplied

Price S.1

$7

1015

A B

S.2

Factors that Shift Supply1. ChangeinPriceofInputs

Ifthepriceofwoodincreases,thecostofproducingtableswouldincrease.Supplywoulddecrease ateachpricepoint.

Qsupplied

S.2

$100

100150

B A

PriceofTables S.1

Factors that Shift Supply2.ChangeinProductionTechnology

Thereplacementofworkerswithrobotsincarproduction.Supplyincreasesateachpricepoint.

3.ChangeinNumberofSellersMoresellersmeansmoreproductionateachpricepoint.Supplyincreases.

4.ChangeInFutureExpectationsFuturePriceoftheGood:Expectpricetoriseinthefuture– produce/sell

morethenFuturePriceofInputs:Expectinputstobemoreexpensive– produce/sell

moretoday

Key Takeaway• Demandisdeterminedbythebuyersofagood.Buyeralwayswanttogetthelowestpricetheycan!Hence,demandisdownwardsloping

• Supplyisdeterminedbythesellersofthegood.Sellersalwayswanttogetthehighestpricetheycan!Hence,supplyisupwardsloping

• Certainfactorsaffecteachofthecurvesandcausethemtoshift.Theshiftscomefromanunderlyingchangetothe“willingnesstobuy”or“willingnesstosell”.

2.1B Supply, Demand and Market Equilibrium

Market Equilibrium

Supply

Demand

Quantity

Price

P*

Q*

Market Equilibrium

Supply

Demand

Quantity

Price

P*

Qd Qs

P

SURPLUS

Market Equilibrium

Supply

Demand

Quantity

Price

P*

Qd Qs

P

SHORTAGE

Test your UnderstandingConsiderthemarketfororanges.Drawoutthesupplyanddemandcurvesbasedonthefollowingsupplyanddemandschedule:

1. Drawoutthesupplyanddemandcurvesbasedonthisinformation.Whereistheequilibriumpriceandquantity?

2. SupposethereisanexceptionallycoldwinterinFloridawithfrostsruiningmanygroves.Whathappenstothismarket?Illustrateandexplain.

3. Whathappensifthepriceofapplesfalls?Illustrateandexplain.4. Whatifbothscenarioshappensimultaneously?

Price QD QS

$5 10 50

$4 20 40

$3 30 30

$2 40 20

$1 50 10

$0 60 0

Test your Understanding1. Drawoutthesupplyanddemandcurvesbasedonthisinformation.Where isthe

equilibriumpriceandquantity?

Supply

DemandQuantity

Price

$3

30

A

Test your Understanding2.Suppose there isanexceptionallycoldwinter inFloridawithfrosts ruiningmanygroves.Whathappens tothismarket? Illustrate.

S.1

DemandQuantity

Price

$3

30

A

S.2

B$4

25

Test your Understanding3.Whathappensifthepriceofapplesfalls?Illustrateandexplain.

S.1

D.1Quantity

Price

$3

30

A

D.2

B’$2

25

Test your Understanding4.Whatifbothscenarioshappensimultaneously?

S.1

D.1

Quantity

Price

$3

30

A

D.2

B'

10

S.2

B

C

Definitedecreaseinequilibriumquantity

Ambiguouschangeinequilibrium

price

Simultaneous Shifts in Both CurvesSIMULTANEOUS

SHIFTS DemandIncreases

SupplyIncreases

AmbiguousEffectonPrice

QuantityIncreases

S.1

D.1Quantity

Price

Q.1

A

D.2

B

Q.2

S.2

Inthemarketforsweaters:- Winteriscomingandit’sgoingtobeacoldone!(IncreaseinDemand)

- Woolbecomescheaper(IncreaseinSupply)

Simultaneous Shifts in Both Curves

SIMULTANEOUSSHIFTS DemandIncreases

SupplyDecreases

Priceincreases

AmbiguousEffectonQuantity

S.1

D.1Quantity

Price

P.1 AD.2

BP.2

S.2

Inthemarketforcoffee:- FDAsayscoffeecanhelppeoplestayhealthy(IncreaseinDemand)

- AdroughtinEcuadordestroysthecoffeecrops(DecreaseinSupply)

Simultaneous Shifts in Both Curves

SIMULTANEOUSSHIFTS DemandDecreases

SupplyDecreases

AmbiguousEffectonPrice

QuantityDecreases

S.1

D.1

Quantity

Price

Q.1

A

D.2

B

Q.2

S.2

Inthemarketforsnowboards:- Skiinggearisnowcheaperthansnowboardinggear(DecreaseinDemand)

- Afewmajorproducersofsnowboardsdecidetoshifttheirbusinessfocustootherproducts(DecreaseinSupply)

Simultaneous Shifts in Both CurvesSIMULTANEOUS

SHIFTS DemandDecreases

SupplyIncreases

Pricedecreases

AmbiguousEffectonQuantity

S.1

D.1

Quantity

Price

P.1A

D.2

BP.2

S.2

Inthemarketforelectriccars:- Gaspricesfall,peopleprefertokeeptheiroldcars(DecreaseinDemand)

- Innovationsinproductionmakeitcheaperforcompaniestomakeelectriccars(IncreaseinSupply)

Key Takeaway

•MarketEquilibriumbringstogetherthedecentralizeddecisionsofbuyersandsellers• Becauseeachagentislookingoutfortheirownbestinterest– wegettheoptimalresultsinthemodel• ShiftsintheSorDcurvemustcomefromachangeinoneofthefactorsthatchangeeither“willingnesstosell”or“willingnesstobuy”• S-DGraphiscriticalinhelpingusfindequilibriumandanalyze/understandchangesinthemarket.

PrinciplesofMicroeconomicsModule2.1(C)

PriceControls

63

• Inthisvideo,wewilldiscusswhathappenswhenthegovernmentimposesapricecontrolinamarket.Wewillseehowthisdistortstheequilibriumoutcomesinthesupplyanddemandmodel

64

PriceControlsIneconomics,weargue:• Bestpossibleoutcomesoccurwithnogov’tinterference• Yieldsmostefficientallocationofresources• Whenpoliciestocontrolthepriceinterfereinthemarket,theycreatedistortions

Thesedistortions cause:• Shortages• Surpluses

65

WhatarePriceControls?

Pricecontrols• Settingapricemaximum(priceceiling)orpriceminimum(pricefloor)inagivenmarket

• Non-bindingpricecontrol:theequilibriumisnotdistortedandthemarketoutcomesareefficient

• Bindingpricecontrol:theequilibriumcannotbereachedandthemarketoutcomesareinefficient(shortageorsurplus)

66





67





68

TestyourUnderstandingConsidertwolabormarkerswherealawyer’swagerateisapproximately$100/hr andahousecleaner’swagerateisapproximately$8/hr.• Thegovernmentdecidestoimposeaminimumwagelawof$12/hr.

1. Whatimpactdoesthishaveonthemarketforlawyers?Drawoutthesupplyanddemandmodel.

2. Whatimpactdoesthishaveonthemarketforhousecleaners?Drawoutthesupplyanddemandmodel.

69

MinimumWageLaws

Q

PP

Q

MarketforLawyers MarketforHousecleaners

70

$100

$8

S

D

S

D

MarketEquilibrium

MarketEquilibrium

MinimumWageLaws

Q

PP

Q


71

$100

$8

S

D

S

D

PriceFloorMin.Wage

PriceFloorMin.Wage

$12 $12

MinimumWageLaws

Q

PP

Q


72

$100

$8

S

D

S

D

PriceFloorMin.Wage

PriceFloorMin.Wage

$12 $12

Qd =Qs Qd Qs

MinimumWageLaws

Q

PP

Q


73

$100

$8

S

D

S

D

PriceFloorMin.Wage

PriceFloorMin.Wage

$12 $12

Qd =Qs Qd Qs

Qd =Qs:Noeffectofthemarketforlawyers

MinimumWageLaws

Q

PP

Q


74

$100

$8

S

D

S

D

PriceFloorMin.Wage

PriceFloorMin.Wage

$12 $12

Qd =Qs Qd Qs

Qd <Qs:At$12:SurplusofHousecleaners

KeyTakeaways• Governmentpoliciescancausedistortionsinthemarketforgoodsandservicesbypreventingsupplyanddemandtoreachequilibrium

• Thesedistortionscreate• Shortages• Surpluses• Mismatchbetweenpricesforbuyersandsellers

• Policiesareputinplacemanytimesduetothesocialbenefitsoutweighingtheeconomiccosts

75

Principles of MicroeconomicsModule 2.2 (A)

Price Elasticity of Demand and Supply

Ways that Demand and Supply ChangeChangesindemandandsupplycomefrom:– Movementalongthecurve– somefactorchangesthat

doesnotdirectlyaffectthewillingnessofbuyertopayorsellertosell

– Shiftinthecurve– somefactorchangesthatdirectlyaffects thewillingnessofbuyertopayorsellertosell

PriceElasticity

PriceElasticityofDemand:• ByhowmuchdoesQdrespondtoapricechange?

• MovementalongthedemandcurvefromAtoB

• Responsivenessofquantitydemandedtopricechange

PriceElasticityPriceElasticityofSupply:• ByhowmuchdoesQsrespondtoapricechange?

• MovementalongthesupplycurvefromAtoB

• Responsivenessofquantitysuppliedtopricechange

Midpoint Method for Price Elasticity•

Elasticity of CurvesAnychangeinpriceyieldsalargeresponse/adjustment inquantitydemanded:- Luxurygoods:designer jeansà notanecessity

- Gourmetfoods:$15/lbcheeseà manysubstitutes

- KitKatbarsà manysubstitutes

Pa

Pb

Qa Qb

P

Q

ElasticDemand

A

B

Elasticity of Curves

Changeinpriceyieldsasmallresponse/adjustmentinquantitydemanded:

- Medicine- Food- Peakrailroadtickets

Pa

Pb

Qa Qb

P

Q

InelasticDemand

A

B

Elasticity of CurvesChangeinpriceyieldsalargeresponse/adjustmentinquantitysupplied:

• Firmoperatingbelowcapacity

Anychangeinprice– thefirmwillquicklyadjustproduction

Pb

Pa

Qa Qb

P

Q

ElasticSupply

B

A

ElasticityofCurvesChangeinpriceyieldsasmallresponse/adjustmentinquantitysupplied:

• Agricultureintheshorttermcan’timmediatelyproducemore

• Nuclearpower

Pb

Pa

Qa Qb

P

Q

InelasticSupply

A

B

PrinciplesofMicroeconomicsModule2.2(B)

PriceElasticityofDemandandSupply

Price Elasticity of DemandSupposeagrocerystoreownerisdecidingtoincreasethepriceofsmokedsalmonby10%from$11.00to$12.10.Thequantityofsmokesalmonhecansellfallsfrom40unitsto25units.• Whatisthepriceelasticityofdemandforsmokedsalmon?Isitelasticorinelastic?• Canyoucalculatethechangeinthegrocer’srevenueifheincreasesthepriceofsmokedsalmon?(TotalRevenue=PricexQuantity)

Price Elasticity of Demand•



Price Elasticity of DemandNowwhatifthesamegrocerystoreownerisdecidingtoincreasethepriceofbreadby10%from$3.00to$3.30,thequantityofbreadhecansellfallsfrom100unitsto98units.• Whatisthepriceelasticityofdemandforbread?Isitelasticorinelastic?• Canyoucalculatethechangeinthegrocer’srevenueifheincreasesthepriceofbread?(TotalRevenue=PricexQuantity)




Price Elasticity of SupplyNowsupposethatthisgrocerobservesthathisneighborhoodischanging,andmanynewpeoplearemovingin.Thenumberofbuyersisincreasing.• Asaresult,thepriceofhisgoods,onaverageincreasesfrom$5to$7andthequantityofgrocerygoodssuppliedincreasesfrom1000to1250.• Whatisthepriceelasticityofsupply?

Price Elasticity of SupplyNowsupposethatthisgrocerobservesthathisneighborhoodischanging,andmanynewpeoplearemovingin.Thenumberofbuyersisincreasing.• Asaresult,thepriceofhisgoods,onaverageincreasesfrom$5to$7andthequantityofgrocerygoodssuppliedincreasesfrom1000to1250.

PrinciplesofMicroeconomicsModule2.2(C)

PriceElasticityofDemandandSupply

IncomeElasticityofDemandByhowmuchdoesQdrespondtoachangeinincome?

Income ElasticityConsider the popular brand of craft beer: Magic Hat and suppose the average income of a 23 year-old is $45,000. The 23 year-old consumes on average 5 Magic Hats a month. • When his income rises to $50,000, he consumes

9 Magic Hats per month. • What is his income elasticity of demand?• Is this a normal good or an inferior good?

Income ElasticityConsiderthepopularbrandofcraftbeer:MagicHatandsupposetheaverageincomeofa23year-oldis$45,000.The23year-oldconsumesonaverage5MagicHatsamonth.• Whenhisincomerisesto$50,000,heconsumes9MagicHatspermonth.

Cross Price Elasticity of DemandByhowmuchdoesQdrespondtoachangeinthepriceofarelatedgood?

CrossPriceElasticityConsider,onceagain,themarketforbeer.• Whenthepriceofpretzelsmovesfrom$4to$3,theconsumptionofbeerincreasesfrom100unitsto120units.

1. Whatisthecrosspriceelasticityofdemandforbeerwhenthepriceofpretzelsrises?

2. Howarethesemarketsrelated?

Cross Price ElasticityConsider,onceagain,themarketforbeer.• Whenthepriceofpretzelsmovesfrom$4to$3,theconsumptionofbeer

increasesfrom100unitsto120units.

Key Takeaways• Understandingelasticityallowsustoquantifythechangesindemandandsupply.

• Providesanadditionalanalysistounderstandhowresponsiveness quantitydemandedandquantitysuppliedaretopricechanges,incomechangesandchangesinpricesofrelatedgoods.

PrinciplesofMicroeconomicsModule2.3

ConsumerSurplusandProducerSurplus

100

WelfareEconomics• Howtheallocationofresourcesandmarketoutcomesaffecteconomicwell-being

• Reachingequilibrium:maximizeswelfare(inmostcases)

• WelfareEconomics:ConsumerSurplus,ProducerSurplusandTotalSurplus

101

ConsumerSurplus

Willingnesstopay– priceactuallypaid

• Everybuyerhasamaximumpricetheyarewillingtopayforeverygood

• Atlowerprices,hisconsumersurplusislarger– heis“betteroff”becausenotpayinghisfullmaximumprice

102

ConsumerSurplus

Willingnesstopay– priceactuallypaid

• Everybuyerhasamaximumpricetheyarewillingtopayforeverygood

• Atlowerprices,hisconsumersurplusislarger– heis“betteroff”becausenotpayinghisfullmaximumprice

103

ConsumerSurplus

• Ifthepriceofwaterisactually$2.50perbottle,wouldyoubuythewater?

• Ifyourmaxpriceis$5thenyes!Yourconsumersurplus is$2.50

• Ifyourmaxpriceis$2thenno

• Whathappensifthepricefallsto$70perday?

• Ifyourmaxpriceis$100:Yourconsumersurplusrisesto$30

• Ifyous maxpriceis$85– nowyoubuytheticketsandhavepositiveconsumersurplusof$15

Considerwhatyouwouldpayforabottleofwateratasummerconcert

104

$2.50CS

P

Q

ConsumerSurplus

• Ifthepriceofwaterisactually$2.50perbottle,wouldyoubuythewater?

• Ifyourmaxpriceis$5thenyes!Yourconsumersurplus is$2.50

• Ifyourmaxpriceis$2thenno

• Whathappensifthepricefallsto$1.50perday?

• Ifyourmaxpriceis$5:Yourconsumersurplusrisesto$3.50

• Ifyourmaxpriceis$2– nowyoubuythewaterandhavepositiveconsumersurplusof$1

Considerwhatyouwouldpayforabottleofwateratasummerconcert

105

NEWCS$1.50

$2.50CS

P

Q

ProducerSurplusPriceactuallyreceived– willingnesstosell

• Everysellerfacesaminimumvaluetheyarewillingtoaccepttoselltheirgoods

• Thisreflectsthecostofproduction

• Athigherprices,hisproducersurplusislarger– heis“betteroff”fromsellinghisgoodsabovecost

106

ProducerSurplusPriceactuallyreceived– willingnesstosell

• Everysellerfacesaminimumvaluetheyarewillingtoaccepttoselltheirgoods

• Thisreflectsthecostofproduction

• Athigherprices,hisproducersurplusislarger– heis“betteroff”fromsellinghisgoodsabovecost

107

ProducerSurplusConsiderindependentfoodandbeveragevendorsatthesummermusicfestival,eachwiththefollowingwillingnesstosellabottleofwater:

Willingness tosell

VendorA $3.00

VendorB $2.75

VendorC $2.00

108

ProducerSurplus• Ifthepriceofabottleofwateris$2.25,howmanyvendorswillsellwater?

• OnlyvendorC• P.S.willbe$0.25

• Whathappensifthepricerisesto$3.50perbottle?

• Allvendorswillsellwater• PSVendorA:$0.50• PSVendorB:$0.75• PSVendorC:$1.50

109

$2.25

P

Q

PS

ProducerSurplus• Ifthepriceofabottleofwateris$2.25,howmanyvendorswillsellwater?

• OnlyvendorC• P.S.willbe$0.25

• Whathappensifthepricerisesto$3.50perbottle?

• Allvendorswillsellwater• PSVendorA:$0.50• PSVendorB:$0.75• PSVendorC:$1.50

110

$2.25

P

Q

PS

$3.50

NewPS

TotalEconomicSurplus• Combinesconsumersurplusandproducersurplus

TotalSurplus=ValuetoBuyers– CosttoSellers

111

TotalSurplusandFreeMarketOutcomes

• GOODSWILLBEALLOCATEDTO:• Buyerswhovaluethemmosthighly,asmeasuredbytheirwillingnesstopay.

• Sellers whocanproducethematthelowestcost.

Thefreemarketyieldsanequilibriumquantityandpricethatmaximizesbothconsumerandproducersurplus

112

$2.75

P

Q

PS

CS

TotalSurplusandFreeMarketOutcomes

• GOODSWILLBEALLOCATEDTO:• Buyerswhovaluethemmosthighly,asmeasuredbytheirwillingnesstopay.

• Sellers whocanproducethematthelowestcost.

Thefreemarketyieldsanequilibriumquantityandpricethatmaximizesbothconsumerandproducersurplus

113

$2.75

P

Q

PS

CS

KeyTakeaways

• WelfareEconomicsistheanalysisoftheeconomicwell-beingofproducersandconsumers

• Assumethatmarketoutcomesleadtomaximizedtotalsurplus

114

PrinciplesofMicroeconomicsModule2.4

Taxation

115

TaxesintheSupplyandDemandModel

Taxescause:Pricepaidbybuyer>PricereceivedbysellerInsert“wedge”intheSupplyandDemandmodel

Taxwedgecreatesdeadweightloss:Lossoftotalsurplusoreconomicwell-beingasaresultofthepolicy

116

SalesTaxes• Taxesinsertawedgebetweenthepricepaidbybuyers(Pb)andpricereceivedbysellers(Ps)

• Regardlessofwhopaysthetax(sellersorbuyers)bothsharethetaxburden

• Tax=Pb – Ps• Taxrevenue=Tax*Qt• Taxburden(buyer)=Pb – Pe• Taxburden(seller)=Pe - Ps

117

P

Q

PB

PS

TAX

Qt Qe




118

P

Q

PB

PS

TAX

Qt Qe




119

P

Q

PB

PS

TAX

REVE

NUE

Qt Qe

UnderstandingTaxesConsiderthemarketforsocks,wheretheequilibriumpriceofsocksis$5perpairandtheequilibriumquantityis300.Thegovernmentimposesa$1taxonthemarkettobepaidbytheseller,causingafallinthequantitysoldto200.

• Whathappenswhenthetaxisimposed?Drawoutthesupplyanddemandmodelshowingthemarketbeforethetaxandafterthetax

120

UnderstandingTaxes

S

QD

P

121

Pe =$5

Qe =300

UnderstandingTaxes

S

QD

P

122

Pe =$5

Qe =300

Pb =$5.50

Pb =$4.50

Qt =200

Tax:Pb – Ps$1

UnderstandingTaxes

S

QD

P

123

Pe =$5

Qe =300

Pb =$5.50

Pb =$4.50

Qt =200

Tax:Pb – Ps$1

TaxRevenue=Tax*Qt$1*200=$200

HowdotaxesaffectMarketParticipants?

Analyzethefollowingbeforetaxvs.aftertaxisimposed:• ConsumerSurplus• ProducerSurplus• TotalSurplus• GovernmentRevenue

Howdoesthetaxchangeeconomicwelfare?124

ConsumerSurplus

S

QD

P

125

Pe

Qe QD

P

Pe

Qe

BEFORETAXES AFTERTAXES

S

ConsumerSurplus

Pb

Ps

Qt

ConsumerSurplus

ProducerSurplus

S

QD

P

126

Pe

Qe QD

P

Pe

Qe


Pb

Ps

Qt

ProducerSurplus

ProducerSurplus

S

GovernmentTaxRevenue

S

QD

P

127

Pe

Qe QD

P

Pe

Qe


Pb

Ps

Qt

ProducerSurplus

Gov’tTax

Revenue

S

DeadweightLoss

S

QD

P

128

Pe

Qe QD

P

Pe

Qe


Pb

Ps

Qt

ProducerSurplus

S

DWL

ElasticityandtheTaxBurden

129

KeyTakeaways• Wecanthinkoftaxationinthecontextofsupplyanddemandmodelintermsof

• Howitaffectspricesandquantities• Howitaffectseconomicwell-beingviawelfareeconomics

• Sincetaxescausedistortionsinthemarket(taxwedge)theyyieldinefficientmarketoutcomes

• Whydowehavethem?Derivesomebenefitsfromgovernmentrevenue.

130

Documents

2.1A Supply and Demand Model...• Demand is determined by the buyers of a good. Buyer always want to get the lowest price they can! Hence, demand is downward sloping • Supply is