Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Econ 1023 Principle of Economics: Micro
Chapter 6: Supply, Demand andGovernment Policies
Instructor: Hiroki WatanabeSpring 2013
Watanabe Econ 1023 6 Price Control 1 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
1 Introduction
2 Price Ceiling
3 Rationing
4 Price Floor
5 Taxation
6 Rationing vs Taxation
7 Tax and Elasticity
8 Subsidy
9 Summary
Watanabe Econ 1023 6 Price Control 2 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
1 Introduction
2 Price Ceiling
3 Rationing
4 Price Floor
5 Taxation
6 Rationing vs Taxation
7 Tax and Elasticity
8 Subsidy
9 Summary
Watanabe Econ 1023 6 Price Control 3 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Question 1.1 (Agenda for Chpt 6, 7 and 8)1 Is the equilibrium best outcome that the society
can achieve?2 How does market allocate resources? How does it
compare to other distribution mechanisms?3 What if the gov’t imposes something other than the
equilibrium?
1 Chpt 6: Implementation2 Chpt 7: Evaluation (without tax)3 Chpt 8: Evaluation (with tax)4 Chpt 10: Justification
Watanabe Econ 1023 6 Price Control 4 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
1 Introduction
2 Price CeilingDefinitionsOil Crisis, Worsened
3 Rationing
4 Price Floor
5 Taxation
6 Rationing vs Taxation
7 Tax and Elasticity
8 Subsidy
9 Summary
Watanabe Econ 1023 6 Price Control 5 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Definitions
Discussion 2.1 (Rent Regulation)
Take a listen to Marketplace Clip .1 Why are there rent regulations in the first place?2 Is the housing market in equilibrium with rent
regulations? How do we evaluate?3 Does the market clear (i.e., quantity supplied meets
quantity demanded) with regulations?
Watanabe Econ 1023 6 Price Control 6 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Definitions
Definition 2.2 (Price Control)Price ceiling is a legal maximum on the price atwhich a good can be sold.Price floor is a legal minimum on the price atwhich a good can be sold.
Watanabe Econ 1023 6 Price Control 7 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Definitions
U City: “You can’t charge more than $100 for a sliceof cheesecake.”... sure.
Watanabe Econ 1023 6 Price Control 8 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Definitions
The price ceiling is binding if the set price is belowthe equilibrium price.Otherwise, the price ceiling is ineffective.
Watanabe Econ 1023 6 Price Control 9 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Definitions
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Demand φ(p)Supply s(p)Price Ceiling
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Watanabe Econ 1023 6 Price Control 10 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Definitions
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Demand φ(p)Supply s(p)Price CeilingExcess Demand
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Watanabe Econ 1023 6 Price Control 11 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Oil Crisis, Worsened
Example 2.3 (Oil Price and Price Ceiling (1))
1973, OPEC raised the price of crude oil.Federal gov’t put the price ceiling in response.
1 Why did they enforce price ceiling?2 What happened after price ceiling was set in place?
Price? Transaction volume? Who got to buy gas andwho couldn’t?
Watanabe Econ 1023 6 Price Control 12 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Oil Crisis, Worsened
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Watanabe Econ 1023 6 Price Control 13 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Oil Crisis, Worsened
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Demand φ(p)Supply s(p)Price CeilingNew Supply s
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Excess Demand
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Watanabe Econ 1023 6 Price Control 14 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Oil Crisis, Worsened
Now the price ceiling is binding. Then what?Consider the following example:
Watanabe Econ 1023 6 Price Control 15 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Oil Crisis, Worsened
Example 2.4 (Oil Price and Price Ceiling (2))
There’re 5 commuters who want to buy 10 gallonseach with the following MWTP:
Commuters MWTP
Liz 40Tracy 90Grizz 50
Kenneth 20Jack 110
Find the equilibrium.
Watanabe Econ 1023 6 Price Control 16 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Oil Crisis, Worsened
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MWTP(x)Supply
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Watanabe Econ 1023 6 Price Control 17 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Oil Crisis, Worsened
This won’t work.Breakdown:
1 Find the aggregate demand.1 Sort MWTP from the highest to the lowest (why?)2 Then graph it.
2 Graph the supply.3 Find the equilibrium.
Watanabe Econ 1023 6 Price Control 18 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Oil Crisis, Worsened
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MWTP(x)Supply
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Watanabe Econ 1023 6 Price Control 19 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Oil Crisis, Worsened
Example 2.5 (Oil Price and Price Ceiling (3))
Suppose that we have tighter supply.1 Find the new equilibrium.2 If the gov’t sets the price ceiling at $40, how much
gas will be transacted?
Watanabe Econ 1023 6 Price Control 20 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Oil Crisis, Worsened
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MWTP(x)SupplyNew Supply
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Watanabe Econ 1023 6 Price Control 21 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Oil Crisis, Worsened
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MWTP(x)SupplyNew SupplyPrice Ceiling
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Watanabe Econ 1023 6 Price Control 22 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
1 Introduction
2 Price Ceiling
3 RationingRationing vs Laissez-FaireRent Control
4 Price Floor
5 Taxation
6 Rationing vs Taxation
7 Tax and Elasticity
8 Subsidy
9 Summary
Watanabe Econ 1023 6 Price Control 23 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Rationing vs Laissez-Faire
Price ceiling leaves excess demand.And it can make things even worse:
The commuters who are willing to pay the most arenot necessarily the ones who are in front of the line.
Watanabe Econ 1023 6 Price Control 24 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Rationing vs Laissez-Faire
Example 3.1 (Oil Price and Price Ceiling (4))
Suppose that the commuters are lining up in thefollowing order:
Commuters MWTP
Liz 40Tracy 90Grizz 50
Kenneth 20Jack 110
Who will get gasoline? Does the result seem fair?
Watanabe Econ 1023 6 Price Control 25 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Rationing vs Laissez-Faire
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Watanabe Econ 1023 6 Price Control 26 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Rationing vs Laissez-Faire
Discussion 3.2 (Oil Price and Price Ceiling (5))1 Is price ceiling a good idea?2 Is rationing a good idea? Compare rationing to
market mechanism. How do they allocateresources?
Watanabe Econ 1023 6 Price Control 27 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Rationing vs Laissez-Faire
1 Price is set low at the cost of denying gasoline tosome commuters.
2 The one who gets gasoline is not necessarily theone who is willing to pay the most.
More on this in Chpt 7.
Watanabe Econ 1023 6 Price Control 28 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Rent Control
Question 3.3 (Rent Control)1 How does price ceiling affect short-run and long-run
housing markets?2 When it is binding, how are apartments allocated?
Watanabe Econ 1023 6 Price Control 29 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Rent Control
Why is rent control in place?to help the poor.neighborhood externalities
Highly inefficient way to help the poor raise theirstandard of living
Watanabe Econ 1023 6 Price Control 30 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Rent Control
1 Short-run Effect:Both supply and demand are inelastic.Small excess demand.
Watanabe Econ 1023 6 Price Control 31 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Rent Control
2 Long-run Effect:Supply and demand are more elasticLandlords
Are not building new apartmentsAre failing to maintain existing ones
PeopleInduce more people to move into a city
Large shortage of housing
Watanabe Econ 1023 6 Price Control 32 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Rent Control
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Demand (Short Run)Supply (Short Run)Demand (Long Run)Supply (Long Run)Price CeilingExcess Demand (Long Run)Excess Demand (Short Run)
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Watanabe Econ 1023 6 Price Control 33 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Rent Control
Rationing mechanisms:1 Long waiting lists2 Preference to tenants without children3 Discriminate on the basis of race4 Bribes to building superintendents
Watanabe Econ 1023 6 Price Control 34 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
1 Introduction
2 Price Ceiling
3 Rationing
4 Price FloorPrice FloorMinimum Wage
5 Taxation
6 Rationing vs Taxation
7 Tax and Elasticity
8 Subsidy
9 Summary
Watanabe Econ 1023 6 Price Control 35 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Price Floor
Not binding whenset below the equilibrium priceNo effect on the market
Binding whenset above the equilibrium price
Some sellers are unable to sell what they wantrationing mechanism to allocate resources
Watanabe Econ 1023 6 Price Control 36 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Price Floor
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Demand φ(p)Supply s(p)Price Floor
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Watanabe Econ 1023 6 Price Control 37 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Price Floor
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Demand φ(p)Supply s(p)Price FloorExcess Supply
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Watanabe Econ 1023 6 Price Control 38 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Minimum Wage
Example of price floor: minimum wageLowest price for labor that any employer may payFair Labor Standards Act of 1938
Ensure workers a minimally adequate standard ofliving
Federal minimum wage = $7.25 per hour since 09.Some states mandate minimum wages above thefederal level (MO: $7.25).
Watanabe Econ 1023 6 Price Control 39 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Minimum Wage
Market for labor1 Workers: supply of labor2 Firms: demand for labor1
If minimum wage is above equilibriumExcess supplyHigher income for workers who have jobsLower income for workers who cannot find jobs
1Called derived demand in particular.Watanabe Econ 1023 6 Price Control 40 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Minimum Wage
1 Highly skilled and experienced workers:Not affected, their equilibrium wages are well abovethe minimumPrice floor doesn’t bind.
2 Teenage labor:Least skilled and least experiencedLow equilibrium wagesWilling to accept a lower wage in exchange foron-the-job trainingBinding price floor.
Watanabe Econ 1023 6 Price Control 41 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Minimum Wage
Discussion 4.1 (Teenage Labor Market andMinimum Wage)
What are the consequences of binding minimum wagein the teenage labor market? In particular, how are thelabor rationed?
Watanabe Econ 1023 6 Price Control 42 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Minimum Wage
A 10% increase in the minimum wage depressesteenage employment between 1 and 3%.Some teenagers who are still attending high schoolchoose to drop out and take jobs.Displace other teenagers who had already droppedout of school and who now become unemployed
Watanabe Econ 1023 6 Price Control 43 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Minimum Wage
In a nutshell,1 Market outcome is efficient.2 Gov’t intervention is called for only when
market outcome is not fair (?)externality is present (more on this in Chpt 10).
3 Price control can backfire.
Watanabe Econ 1023 6 Price Control 44 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Minimum Wage
What political interventions are there other thanprice control?
Watanabe Econ 1023 6 Price Control 45 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
1 Introduction
2 Price Ceiling
3 Rationing
4 Price Floor
5 TaxationTax IncidenceTax Levied on BuyersTax Levied on SellersMeasuring Tax IncidencePayroll Tax
6 Rationing vs Taxation
7 Tax and Elasticity
8 Subsidy
9 Summary
Watanabe Econ 1023 6 Price Control 46 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence
Gov’t uses taxes1 to finance public projects.2 and what else?
Watanabe Econ 1023 6 Price Control 47 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence
Definition 5.1 (Tax Incidence)Tax incidence is a manner in which tax burden is splitamong the sellers and buyers.
Why do we have to worry about tax incidence?If the gov’t collect the tax from the sellers, isn’t thatsimply a sellers’ burden,and vice versa for the buyers?
Watanabe Econ 1023 6 Price Control 48 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence
As far as economics is concerned, how tax iscollected doesn’t matter.Suppose that U City collects $5 tax from Jack forthe sales of his cheesecakes.If pre-tax equilibrium price was $10 and post-taxequilibrium price is $15,2 Jack doesn’t bear the taxburden.
1 His revenue used to be $10 for each.2 Now he gets $15 from the sales.3 He sends $5 to U City.4 He’s left with $10 as before.
Then who’s paying this $5 tax?
2This may or may not be $15 as we will see later.Watanabe Econ 1023 6 Price Control 49 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence
It’s Liz (buyer).1 She used to pay $10 for a cheesecake.2 Now she pays $15 for the same cheesecake.
We say: tax incidence falls on Liz for 100% and 0%for Jack.In reality, it’s usually Target and Schnucks etc whopay the tax (in the accounting sense).
Watanabe Econ 1023 6 Price Control 50 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence
Consider the two scenarios:1 Tax collected through Jack (sellers)2 Tax collected through Liz (buyers)
Watanabe Econ 1023 6 Price Control 51 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence
Suppose that the cheesecake market is currently init’s equilibrium with
�
φ(p) = 10 − ps(p) = p.
Watanabe Econ 1023 6 Price Control 52 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence
When examining tax incidence, it is easier to flipthe relationship:
1 MWTP() rather than φ(p).2 RP()3 rather than s(p).
3to be defined on Slide 64 .Watanabe Econ 1023 6 Price Control 53 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence
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Watanabe Econ 1023 6 Price Control 54 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Buyers
Liz is happy to pay $7 for the 3rd slice to leaveherself best off:
MWTP() = − + 10.
Now suppose U City charges $2 for each slice.For the 3rd slice, how much is she willing to pay?
Watanabe Econ 1023 6 Price Control 55 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Buyers
It’s still $7,of which $2 is collected by U Cityand the rest goes to Jack.
Watanabe Econ 1023 6 Price Control 56 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Buyers
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Watanabe Econ 1023 6 Price Control 57 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Buyers
What is the new equilibrium after taxation?Demand that Jack faces drops down by $2 foreach slice.The demand curve shifts down by 2:
Watanabe Econ 1023 6 Price Control 58 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Buyers
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Watanabe Econ 1023 6 Price Control 59 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Buyers
The original equilibrium (E, pE) = (6,6)The new equilibrium level of transaction volume isE = 4 instead of 5.Why doesn’t the 5th slice sell?
1 Jack wants to sell it for $5.2 Liz is happy to pay $5 for it.3 but U City takes $2 away from Liz.
Watanabe Econ 1023 6 Price Control 60 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Buyers
In the new equilibrium,1 = 4 slices are traded.2 Jack faces p = 43 Liz faces p = 6.
Watanabe Econ 1023 6 Price Control 61 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Sellers
Suppose tax is collected through Jack (seller).Recall that for each p, Jack determines the quantity = s(p) to maximize his profit.Flip it: for each quantity , p = RP() marks thelowest price (reservation price) at which Jack iswilling to sell -th slice.
Watanabe Econ 1023 6 Price Control 62 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Sellers
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RP(x)
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Watanabe Econ 1023 6 Price Control 63 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Sellers
Jack can maximize his profit by selling the 4th slicefor $4.If $2 tax is imposed, he still maximizes his profitby selling the 4th slice for $4 (by definition).He charges $6 for the 4th slice, takes $4 and filethe rest ($2) for sales tax.The supply that Liz faces simply shifts up by $2for each slice.
Watanabe Econ 1023 6 Price Control 64 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Sellers
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RP(x)TaxRP(x)+Tax
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Watanabe Econ 1023 6 Price Control 65 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Sellers
Original equilibrium was (E, pE) = (5,5).Post-tax equilibrium consists of
= 4.Jack faces p = 4.Liz faces p = 6.
Watanabe Econ 1023 6 Price Control 66 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Levied on Sellers
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e p
($)
Watanabe Econ 1023 6 Price Control 67 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Measuring Tax Incidence
Note that post-tax equilibrium is independent ofhow tax is imposed.Compute the tax incidence in two ways:
1 Tax on Liz.2 Tax on Jack.
Watanabe Econ 1023 6 Price Control 68 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Measuring Tax Incidence
0 1 2 3 4 5 6 7 80
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slides)
Pric
e p
($)
MWTP(x)MWTP(x)−TaxRP(x)
0 1 2 3 4 5 6 7 80
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slides)
Pric
e p
($)
Watanabe Econ 1023 6 Price Control 69 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Measuring Tax Incidence
Liz: $5 to $6Jack: $5 to $4Tax incidence is fifty on fifty.
Watanabe Econ 1023 6 Price Control 70 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Measuring Tax Incidence
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slides)
Pric
e p
($)
RP(x)RP(x)+TaxMWTP(x)
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slides)
Pric
e p
($)
Watanabe Econ 1023 6 Price Control 71 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Measuring Tax Incidence
Liz: $5 to $6Jack: $5 to $4Tax incidence is fifty on fifty.
Watanabe Econ 1023 6 Price Control 72 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Measuring Tax Incidence
Taxes levied on sellers and taxes levied on buyersare equivalent.Wedge between the price that buyers pay and theprice that sellers receiveis the same, regardless of whether the tax is leviedon buyers or sellers.Shifts the relative position of the supply anddemand curves.Buyers and sellers share the tax burden.
Watanabe Econ 1023 6 Price Control 73 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Payroll Tax
Payroll taxesDeducted from the amount you earned.
By law, the tax burden:Half of the tax - paid by firms out of firms’ revenue.Half of the tax - paid by workers, deducted fromworkers’ paychecks.
Watanabe Econ 1023 6 Price Control 74 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Payroll Tax
Tax incidence analysisPayroll tax is just another tax on a good, where
Good is laborPrice is wage
Introduce payroll taxWage received by workers fallsWage paid by firms rises
Workers and firms share the tax burdenNot necessarily 50-50 as the legislation requires
Watanabe Econ 1023 6 Price Control 75 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Payroll Tax
0 1 2 3 4 5 6 7 80
1
2
3
4
5
6
7
8
9
10
Labor x (hours)
Wag
e p
($)
MWTP(x)RP(x)RP(x)+TaxWorkers′ Tax PaymentFirms′ Tax Payment
0 1 2 3 4 5 6 7 80
1
2
3
4
5
6
7
8
9
10
Labor x (hours)
Wag
e p
($)
Watanabe Econ 1023 6 Price Control 76 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Payroll Tax
0 1 2 3 4 5 6 7 80
1
2
3
4
5
6
7
8
9
10
Labor x (hours)
Wag
e p
($)
MWTP(x)RP(x)RP(x)+TaxWorkers′ Tax BurdenFirms′ Tax Burden
0 1 2 3 4 5 6 7 80
1
2
3
4
5
6
7
8
9
10
Labor x (hours)
Wag
e p
($)
Watanabe Econ 1023 6 Price Control 77 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Payroll Tax
Legislators:1 Can decide whether a tax comes from the buyer’s
pocket or from the seller’s.2 Cannot legislate the true burden of a tax.
Tax incidenceDetermined by the forces of supply and demand.
Watanabe Econ 1023 6 Price Control 78 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
1 Introduction
2 Price Ceiling
3 Rationing
4 Price Floor
5 Taxation
6 Rationing vs Taxation
7 Tax and Elasticity
8 Subsidy
9 Summary
Watanabe Econ 1023 6 Price Control 79 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Recall that price control may give gasoline to thewrong (or improper at least) hands.Do we get into the same situation with taxation,i.e.,
Question 6.1 (Rationing vs Taxation)
How does the distribution mechanism of taxationcompare to that of rationing? Does the person with thehighest willingness to pay still gets the gasoline?
Watanabe Econ 1023 6 Price Control 80 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Example 6.2 (Rationing vs Taxation)
Suppose that consumers are in line for cheesecake inthe following order:
Commuters MWTP
Liz 9Jenna 5Grizz 7
Kenneth 6Tracy 8Angie 4
Dotcom 3Pete 2Lutz 1
The reservation price for cheesecake is RP() = . Asthe mayor of U City, you want your residents to have acheesecake for less than or equal to $4. Which policyshould you adopt, price ceiling or tax on the seller?
Watanabe Econ 1023 6 Price Control 81 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
1 First let’s see if intervention is necessary.
Watanabe Econ 1023 6 Price Control 82 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slices)
Pric
e ($
)
MWTP(x)RP(x)
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slices)
Pric
e ($
)
Watanabe Econ 1023 6 Price Control 83 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
2 Current equilibrium price is $1 higher than whereyou want it to be.
3 First, try price ceiling:
Watanabe Econ 1023 6 Price Control 84 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slices)
Pric
e ($
)
MWTP(x)RP(x)Price Ceiling
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slices)
Pric
e ($
)
Watanabe Econ 1023 6 Price Control 85 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
3 Note that customers do not necessarily line up in adescending order.
4 If customers are served on a first-come, first-servedbasis...
Watanabe Econ 1023 6 Price Control 86 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slices)
Pric
e ($
)
MWTP(x)RP(x)Price Ceiling
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slices)
Pric
e ($
)
Watanabe Econ 1023 6 Price Control 87 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
5 Note that Tracy is willing to pay for $8 and Jennaonly for $5...
6 but a slice is sold to Jenna.
Watanabe Econ 1023 6 Price Control 88 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
7 This wouldn’t happen with taxation.8 The equilibrium price that consumers face will be
$6,9 i.e., Jenna won’t get a slice.4
4I usually shift the reservation price but you can shift whicheveryou like. The result (equilibrium and incidence) won’t change.
Watanabe Econ 1023 6 Price Control 89 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slices)
Pric
e ($
)
MWTP(x)RP(x)RP(x)+Tax
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slices)
Pric
e ($
)
Watanabe Econ 1023 6 Price Control 90 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slices)
Pric
e ($
)
MWTP(x)RP(x)RP(x)+Tax
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slices)
Pric
e ($
)
Watanabe Econ 1023 6 Price Control 91 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Note1 rationing mechanism doesn’t have anything to do
with market mechanism,2 whereas market with tax inherits the distribution
mechanism from free-market mechanism.
Watanabe Econ 1023 6 Price Control 92 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
1 Introduction
2 Price Ceiling
3 Rationing
4 Price Floor
5 Taxation
6 Rationing vs Taxation
7 Tax and ElasticityTax Incidence and ElasticityTax on Luxury Items
8 Subsidy
9 Summary
Watanabe Econ 1023 6 Price Control 93 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence and Elasticity
In Section 5 , we saw that tax incidence doesn’t fall50-50 on the sellers and the buyers.Then how is tax incidence determined?Elasticity is a good indicator.
Watanabe Econ 1023 6 Price Control 94 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence and Elasticity
Proposition 7.1 (Tax Incidence and Elasticity)
Tax burden falls more heavily on the side of the marketthat is less elastic.
Proof.For a sketch of the proof, see figures below. �
Watanabe Econ 1023 6 Price Control 95 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence and Elasticity
0 1 2 3 4 5 6 7 840
41
42
43
44
45
46
47
48
49
50
Cheesecake x (slices)
Pric
e p
($)
MWTP(x)RP(x)RP(x)+TaxTax Incidence on BuyersTax Incidence on Sellers
0 1 2 3 4 5 6 7 840
41
42
43
44
45
46
47
48
49
50
Cheesecake x (slices)
Pric
e p
($)
Watanabe Econ 1023 6 Price Control 96 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence and Elasticity
0 1 2 3 4 5 6 7 838
40
42
44
46
48
50
52
Cheesecake x (slices)
Pric
e p
($)
MWTP(x)RP(x)RP(x)+TaxTax Incidence on BuyersTax Incidence on Sellers
0 1 2 3 4 5 6 7 838
40
42
44
46
48
50
52
Cheesecake x (slices)
Pric
e p
($)
Watanabe Econ 1023 6 Price Control 97 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence and Elasticity
0 1 2 3 4 5 6 7 834
35
36
37
38
39
40
41
42
43
44
45
46
Cheesecake x (slices)
Pric
e p
($)
MWTP(x)RP(x)RP(x)+TaxTax Incidence on BuyersTax Incidence on Sellers
0 1 2 3 4 5 6 7 834
35
36
37
38
39
40
41
42
43
44
45
46
Cheesecake x (slices)
Pric
e p
($)
Watanabe Econ 1023 6 Price Control 98 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax Incidence and Elasticity
1 Elastic demand and less elastic supply:small burden on buyers.large burden on sellers.
2 Elastic demand and more elastic supply:large burden on buyers.small burden on sellers.
Watanabe Econ 1023 6 Price Control 99 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax on Luxury Items
In 1990, new luxury tax was introduced:On yachts, private airplanes, furs, jewelry,expensive carsGoal: to raise revenue from those who could mosteasily afford to pay
Luxury items:Demand - quite elasticSupply - relatively inelastic
Watanabe Econ 1023 6 Price Control 100 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Tax on Luxury Items
Outcome:Burden of a tax fell largely on the suppliersRelatively inelastic supply
In 1993, most of the luxury tax was repealed
Watanabe Econ 1023 6 Price Control 101 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
1 Introduction
2 Price Ceiling
3 Rationing
4 Price Floor
5 Taxation
6 Rationing vs Taxation
7 Tax and Elasticity
8 Subsidy
9 Summary
Watanabe Econ 1023 6 Price Control 102 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Definition 8.1 (Subsidy)
Subsidy is a negative tax.
Watanabe Econ 1023 6 Price Control 103 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slices)
Pric
e p
($)
MWTP(x)RP(x)RP(x)−Subsidy
0 1 2 3 4 5 6 7 8 9 100
1
2
3
4
5
6
7
8
9
10
Cheesecake x (slices)
Pric
e p
($)
Watanabe Econ 1023 6 Price Control 104 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
In the equilibrium with subsidy,1 Jack charges $7 for each slice.2 Liz pays $5 and U City covers the rest.
Watanabe Econ 1023 6 Price Control 105 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
1 Introduction
2 Price Ceiling
3 Rationing
4 Price Floor
5 Taxation
6 Rationing vs Taxation
7 Tax and Elasticity
8 Subsidy
9 Summary
Watanabe Econ 1023 6 Price Control 106 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Price controlDistribution mechanism (rationing vs marketequilibrium)Tax incidence and elasticity
Watanabe Econ 1023 6 Price Control 107 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Airline du Jour
Today’s color theme is provided by courtesy of LufthansaWatanabe Econ 1023 6 Price Control 108 / 109
Intro Price Ceiling Rationing Price Floor Taxation Ration vs Tax Tax & ε Subsidy
Index
derived demand, 40elasticity, 95luxury tax, 100minimum wage, 39payroll tax, 74, 75price ceiling, 7, 27
price floor, 7rationing, 27, 34rent control, 29reservation price, 62subsidy, 103tax incidence, 48, 95
Watanabe Econ 1023 6 Price Control 109 / 109