Using Supply and Demand to Analyze Markets Copyright © 2013 Worth Publishers, All Rights Reserved Microeconomics Goolsbee/Levitt/ Syverson 1/e 3.

Using Supply and Demand to Analyze

Markets

Copyright © 2013 Worth Publishers, All Rights Reserved Microeconomics Goolsbee/Levitt/ Syverson 1/e

3Chapter Outline

3.1 Consumer and Producer Surplus: Who Benefits in a Market?

3.2 Price Regulations

3.3 Quantity Regulations

3.4 Taxes

3.5 Subsidies

3.6 Conclusion

3-1

Introduction

Copyright © 2013 Worth Publishers, All Rights Reserved Microeconomics Goolsbee/Levitt/ Syverson 1/e 3-2

3In this chapter, we use the supply and demand model to answer the following questions

•How do we measure the benefits that accrue to producers and consumers in a market?

•How do government interventions (e.g., taxes) affect markets and the benefits associated with market exchange?

3.1


Consumers benefit from market exchange, otherwise they would not participate•Consumer surplus – The difference between the amount consumers would be willing to pay for a good or service and the amount they actually pay (the market price)

In many cases, this difference is positive, and consumers experience net benefits from market exchange

3Consumer and Producer Surplus: Who Benefits in a Market?

3.1



Figure 3.1 Defining Consumer Surplus

Price ($/pound) Demandchoke price$5.50 Total consumerA surplus (CS)5 BPerson A’s 4.50consumer C4surplus = $1.50 D Market price3.50 E3 D210 Quantity of1 2 3 4 5 apples (pounds)

The consumer at point E will not buy any apples because the market price is too high

3.1


Producers benefit from market exchange, otherwise they would not participate•Producer surplus – The difference between the amount producers are willing to sell goods for and what they actually receive (the market price)

Producer surplus is not the same as profit, as we will see in later chapters


3.1



Figure 3.2 Defining Producer Surplus

Price ($/pound) Total producer5 surplus (PS) S4 Z3.50 Market priceSeller V ’s Y3producer X2.50surplus = $1.50 W2 V1.50 Supply1 choke price0 Quantity of1 2 3 4 5 apples (pounds)

The producer at point Z will not produce any apples because the market price is too low


figure it outThe Market for Cupcakes

The weekly supply and demand for cupcakes in a small town are given asQS = 30P – 20 , QD = 124 – 18Pwhere P is the price, in dollars, and quantity is measured in thousands of cupcakes per week

Answer the following questions:

1.Find the equilibrium price and quantity

2.Calculate consumer and producer surplus at the equilibrium


figure it out

1. Remember: Equilibrium is characterized by QS = QD 30P – 20 = 124 – 18PCombining terms and solving for P yields48P = 144 → P* = $3And using the equation for demand, QD = 124 – 18(3) = 70 = Q* = QS 2. The easiest way to calculate consumer and producer

surplus is with a graph; to do this, we must determine two points for each curve• Equilibrium price/quantity• Choke prices (where QD /QS are equal to zero)

Why do we need only two points to plot the demand/supply curves?

The Market for Cupcakes


figure it outThe Market for Cupcakes

We already know one point for each curve: P* = $3.00 ; Q* = 70Demand choke price: QD = 0 = 124 – 18P → P = $6.89Supply choke price: QS = 0 = 30P – 20 → P = $0.67

0 70 Quantity of cupcakes (thousands)

Price of cupcakes (dollars)

3

6.9

Consumer surplus is the area below demand but above the price (Area A)

Producer surplus is the area above supply but below the price (Area B)

Surplus is generally measured in dollars

0.67

heightbaseACS 2

1 Area

15.136$)389.6(702

1

heightbaseBPS 2

1 Area

55.81$)67.03(702

1

AB

D

S

3.1



What happens to consumer and producer surplus when there is a shift in supply or demand?

0 Quantity of cupcakes (thousands)

Price of cupcakes (dollars)

Imagine a pie shop opens up in the same town. What will happen to the demand for cupcakes?

Demand will shift left, resulting in a new equilibrium of P2 andQ2What happens to consumer surplus? •Old consumer surplus: A + B + F•New consumer surplus: B + CWhat happens to producer surplus? •Old producer surplus: C + D + E + G•New producer surplus: DC has transferred from producers to consumersA + E + F + G has disappeared from this market

SP1

Q1D2 D1Q2

P2

A

B

C

D

E

F

G

3.1



Figure 3.3 Consumer Surplus and the Elasticity of Demand


figure it outThe Market for Tires

The weekly supply and demand for tires in a small town are given as QS = 15P – 400 , QD = 2,800 – 25Pwhere P is the price, in dollars, and quantity is the number of tires sold weekly. The equilibrium price is $80 per tire, and 800 tires are sold each week

Suppose an improvement in technology makes tires cheaper to produce; specifically, suppose the quantity supplied rises by 200 at every price


1.What is the new supply curve?

2.What are the new equilibrium price and quantity?

3.What happens to consumer and producer surplus?







3.1



Figure 3.5 Changes in Surplus from a Supply Shift



Politicians often call for the direct regulation of prices on products and services•Price ceiling – a regulation that sets the maximum price that can be legally paid for a good or service•Price floor – a regulation that sets the minimum price that can be legally paid for a good or service (often called a price support)

What are the effects of price ceilings/floors on markets?

3



Some important terminology

Transfer – surplus that moves from producers to consumers, or vice versa, as a result of a regulation

Deadweight loss (DWL) – the reduction in total surplus that occurs as a result of a market inefficiency•Remember the cupcake example of changing demand due to a pie shop

Nonbinding price ceiling – a price set at a level above the equilibrium market price

Nonbinding price floor – a price set at a level below the equilibrium market price

3

3.2


3Price Regulations

Figure 3.7 The Effects of a Price CeilingPrice Consumer surplus before A + B + C($/pizza) Consumer surplus after A + B + D$20 Producer surplus before D + E + FProducer surplus after FA DWL = C + E Supply14 B wC10 E yD8 xF5 Transferof PS Demandto CS0 Quantity of pizzas6 10 12 20 (thousands)/monthShortage

z



3.8 Deadweight Loss and Elasticities

3

3.2


3Price Regulations

Figure 3.9 The Effects of a Price FloorPrice Transfer($/per ton) of CS to PS SA x y Price floor$1,000 B Consumer surplus before A + B + CC w500 Consumer surplus after AE Producer surplus before D + E + FD Producer surplus after B + D + FzF

D0 Quantity of peanuts10 20 30 (millions of tons)Surplus



Like price regulations, quantity regulations restrict the amount of a good or service provided to a market

Quota – a regulation that sets the quantity of a good or service provided•Often used to limit imports of certain goods; why might a government pursue an import quota?•Sometimes used to limit exports (e.g., China and rare earths)

What are the effects of quotas on markets?

3

3.3


3Quantity Regulations

Figure 3.10 The Effects of a QuotaPrice Consumer surplus before A + B + C($/tattoo) Consumer surplus after AS2$125 Producer surplus before D + E + FProducer surplus after B + D + FA zPquota = 100 Transferof CS to PSB C x S1P = 50 ED40 y D35 F0 Quantity of500 1,500 tattoos/year(Quota)

Application


The unintended consequences of immigration quotas

In October, 2003, Congress reduced the annual number of H-1B visas from 195,000 to 65,000•Targeted highly skilled workers•Quota had never been binding prior to policy change; government began denying petitions in 2004•Requires a sponsoring U.S. company (a job offer); foreign students who pursue a U.S. education have a better chance of finding a sponsor

Visa quotas have been shown to reduce immigration...

Why would the U.S. pursue this policy? What other consequences might we

see?

Images: FreeDigitalPhotos.net

3

Citation: T. Kato and C. Sparber. 2012. “Quotas and Quality: the Effects of H-1B Visa Restrictions on the Pool of Prospective Undergraduate Students from Abroad.” Forthcoming in The Review of Economics and Statistics.

Application


The unintended consequences of immigration quotas

Kato and Sparber (2013) examined whether this new policy might have reduced the incentive for highly qualified students to pursue an education in the U.S.•Considered SAT scores submitted by foreign students•Used five countries as a “control”; Australia, Canada, Chile, Mexico, and Singapore have special status, and their students can obtain visas similar to H-1B without a quota

Key findings•Average SAT scores of applicants from foreign countries affected by the H-1B quota dropped 10– 20 points after 2003•Drop was driven by a reduction in top-quintile scores, implying the policy reduced incentive for high-quality applicants


3

Citation: T. Kato and C. Sparber. 2012. “Quotas and Quality: the Effects of H-1B Visa Restrictions on the Pool of Prospective Undergraduate Students from Abroad.” Forthcoming in The Review of Economics and Statistics.


3Government provision of a public good: municipal golf courses

0 Quantity of rounds

Price of a golf round

Sometimes, governments attempt to supplement market supply for things that benefit communities

What happens to the market for golf when a local government opens a municipal course?•With only for-profit and private courses, supply is Spriv and the market equilibrium occurs at Q1 and P1•The municipal course increases the quantity of rounds available by Qgov , and supply shifts out to StotHowever, quantity supplied only increases to Qtot because private suppliers are not willing to supply as much at the new, lower market price•Private producers reduce quantity supplied to Qpriv , this effect is known as “crowding out”

Spriv

P1

DQ1

Ptot


Stot

Qtot Q1 + Qgov Crowding out

Qpriv

3.4 Taxes


Taxes are very prevalent in societies•Product markets (VAT; sales taxes)•Labor markets (income taxes; payroll taxes)•Capital markets (capital gains taxes)

How do taxes impact markets?•Some taxes are imposed to correct market failures (see Chapter 16)•In general, taxes distort market outcomes •How do we describe the effects of taxes?

Example: In 2003, Boston’s Mayor Tom Menino proposed a $0.50 tax on movie tickets•How should this tax (which was ultimately not adopted by the legislature) affect the market for movie tickets?

3

3.4


3Taxes

Figure 3.13 The Effects of a Tax on Boston Movie TicketsPrice($/ticket)$10 Transfer from CS and PSto government S2 = S1 + taxA yPb = 8.30 C S1xBP1 = 8.00 D DPs = 7.80 Ez Consumer surplus (CS) beforeA + B + CConsumer surplus (CS) afterAF Producer surplus (PS) beforeD + E + FProducer surplus (PS) after F6.67 Government revenue B + D

0 Quantity of ticketsQ2 = 3.4 Q1 = 4 (100,000s)

3.4 Taxes


We can also describe the effect of a tax on consumer and producer surplus with equations. Demand and supply for tickets are given by

where prices are measured in dollars and quantity in hundreds of thousands of tickets. Equilibrium occurs when QD = QS, Before the tax, tickets are $8 and 400,000 tickets are sold in Boston

Pre-tax consumer surplus

where the demand choke price is found by solving

and consumer surplus is equal to

3

1Choke2

1PPQCS D

10$2200 ChokeChoke DDD PPQ

000,400$8$10$000,4002

1CS

203 ;220 PQPQ SD

405203220 PPP

3.4 Taxes


Pre-tax producer surplus surplus

where the supply choke price

Solving for producer surplus yields

And total surplus

What happens after the tax?

3 Choke12

1SPPQPS

67.6$2030 ChokeChoke SSS PPQ

667,266$67.6$8$000,4002

1PS

667,666$CSPS

3.4 Taxes


350.0$ Sb PP

20350.0220203220 SSSbSD PPPPQQ

80.7$2031220 SSS PPP

30.8$50.0$ Sb PP

000,34030.82202 Q

3.4 Taxes


New consumer surplus

and producer surplus

How much revenue has been generated by the tax?

And the associated deadweight loss associated with this distortion is

3

000,170$000,34050.0$50.0Revenue 2 Q

000,289$30.8$10$000,3402

1CS

100,192$67.6$80.7$000,3402

1PS

000,15$50.0$000,340000,4002

1

2

121

tax

sb PPQQDWL

3.4 Taxes


3

00.1$ Sb PP

20300.1220203220 SSSbSD PPPPQQ

60.8$ ;60.7$2032220 bSSS PPPP

8.260.82202 Q

3.4 Taxes


Consumer surplus

and producer surplus

How much revenue has been generated by the tax?

And the associated deadweight loss associated with this distortion is

So, while the tax rate has doubled, deadweight loss has quadrupled from $15,000 to $60,000, and tax revenues have only increased by 78.5% (from $170,000 to $280,000)

3

000,280$000,28000.1$00.1Revenue 2 Q

000,196$60.8$10$000,2802

1CS

200,130$67.6$60.7$000,2802

1PS

000,60$00.1$000,280000,4002

1

2

121

tax

sb PPQQDWL

3.4 Taxes


3Figure 3.14 The Effect of a Larger Tax on Boston

Movie Tickets


figure it outSoda Tax

The supply and demand for soda in a market is represented by QS = 50P – 60 , QD = 12 – 8Pwhere P is the price per bottle, in dollars, and Q is in millions of bottles per year

The current equilibrium price is $1.24, and 2.07 million bottles are sold per year


1.Calculate the price elasticity of demand and the price elasticity of supply at the current equilibrium

2.Calculate the share of a tax that will be borne by consumers and the share borne by producers3.If a tax of $0.10 per bottle is created, what do buyers now pay for a bottle? What will sellers receive?


figure it out

1. The first step is determining how the subsidy affects prices

In this problem,

Supply and demand are given by

And substituting in for PS

Equating supply and demand, and solving for Pb

Soda Tax

Sb PP subsidy

Sb PP 2

8,000 500 ; 1,000 2,500D Sb SQ P Q P

1,000 2 2,500 1,000 500Sb bQ P P

8,000 500 1,000 500 $566.7b b bP P P


figure it out


In this problem,




Soda Tax

Sb PP subsidy

Sb PP 2

8,000 500 ; 1,000 2,500D Sb SQ P Q P

1,000 2 2,500 1,000 500Sb bQ P P

8,000 500 1,000 500 $566.7b b bP P P

Application



3

Citation: Fisman, R. and S. Wei. 2004. “Tax Rates and Tax Evasion: Evidence from “Missing Imports” in China.” The Journal of Political Economy 112(2): 471–496.

Application


Taxation, tax evasion, and smuggling

The authors find the evasion gap to be positively correlated with tax rates (i.e., highly taxed products are likely to be mislabeled, undervalued, or undercounted)

Evasion is almost entirely due to intentional mislabeling of products (highly taxed products are labeled as minimally taxed products)

Evasion is negatively correlated with tax rates on closely related products (e.g., chickens and turkeys)... why might this be the case? Images: FreeDigitalPhotos.net

3

Citation: Fisman, R. and S. Wei. 2004. “Tax Rates and Tax Evasion: Evidence from “Missing Imports” in China.” The Journal of Political Economy 112(2): 471–496.

3.4 Taxes


Tax incidence is a term describing who actually bears the burden of a tax•In the supply and demand model, it does not matter who is required to pay the tax (e.g., a sales tax vs. a production tax); tax incidence will be the same in each case! •Consider again the movie theater example

3

3.4


3Taxes

Figure 3.15 Tax Incidence

(a) (b)Price ($) Price ($)S2 Tax = Pb – Ps SS1

Pb PbP1 P1Ps Ps D1D D2Tax = Pb – Ps 0 Quantity 0 QuantityQ2 Q1 Q2 Q1

3.4 Taxes


Tax incidence is a term describing who actually bears the burden of a tax•In the simple model presented here, it does not matter who is required to pay the tax (e.g., a sales tax vs. a production tax); tax incidence will be the same in each case! •Consider again the movie theater example

Tax incidence and elasticities•Elasticities of supply and demand are major determinants of incidence•In general, when demand is relatively more elastic, producers will experience more burden, and vice versa

3


3Elastic demand with inelastic supply

0 Quantity of labor

Wage

Consider the market for labor; workers (suppliers), are unlikely to extend or cut hours very much for a large range of wages

Demand, on the other hand, may be elastic due to the presence of substitutes (outsourcing)

What happens when the government puts a tax on earned income?•The tax shifts the labor supply curve up by the amount of the tax; the new wage is Wb , with quantity L2The wage received by workers, however, is only Ws Wb –W1 < W1 – Ws ; therefore, the incidence of the tax falls primarily on suppliers of labor (workers)

S2

Wb D

L1

3.4 Taxes

S1tax

W1Ws

L2

tax

3.4 Taxes


Tax incidence is a term describing who actually bears the burden of a tax•In the simple model presented here, it does not matter who is required to pay the tax (e.g., a sales tax vs. a production tax); tax incidence will be the same in each case! •Consider again the movie theater example

Tax incidence and elasticities•Elasticities of supply and demand are major determinants of incidence•In general, when demand is relatively more elastic, producers will experience more burden, and vice versa

A general formula(s) for incidence as a function of elasticities

3

DS

S

EE

E

consumerby born Share

DS

D

EE

E

producerby born Share

3.4 Taxes


3Figure 3.16 Tax Incidence and Elasticities


figure it outSoda Tax

The supply and demand for soda in a market is represented by QS = 50P – 60 , QD = 12 – 8PWhere P is the price per bottle, in dollars, and Q is in millions of bottles per year

The current equilibrium price is $1.17, and 2.62 million bottles are sold per year


1.Calculate the price elasticity of demand and the price elasticity of supply at the current equilibrium

2.Calculate the share of a tax that will be borne by consumers and the share borne by producers3.If a tax of $0.10 per bottle is created, what do buyers now pay for a bottle? What will sellers receive?


figure it out

1. The elasticity of demand and supply are

2. The proportion of a tax borne by buyers and sellers is:

3. If there is a tax of $0.10 per bottle, buyers pay 85.6%, or $0.0856 per bottle, and sellers pay 14.4%, or $0.0144 per bottle

Soda Tax

75.362.2

17.18

D

DD

Q

P

P

QE

33.2262.2

17.150

S

SS

Q

P

P

QE

%6.8575.333.22

33.22buyerby born Share

DS

S

EE

E

%4.1475.333.22

75.3sellerby born Share

DS

D

EE

E

Application


Is it really the case that it does not matter how a tax is levied?

Economic theory tells us tax incidence does not depend on who is actually taxed

This assumes consumers treat a dollar of taxation in the same manner as they treat a dollar of product price

Chetty et al. (2009) show this may not always be true. Consider the differences between sales taxes and excise taxes•Sales taxes are usually assessed as a percentage of the retail price of a good or service, and is added at the point of sale; determining the total cost before purchasing requires calculation by the consumer•Excise taxes are usually included in the observed retail price (e.g., the tax on gasoline or alcohol)


3

R. Chetty, A.Loony, and K. Kroft. 2009. “Salience and Taxation: Theory and Evidence.”American Economic Review, 99(4): 1145–1177.

Application


Is it really the case that it does not matter how a tax is levied?

The authors examine this issue in two ways•“Field experiment” to determine how demand for household items in a supermarket changes when sales taxes are included in posted prices•Empirical study of state-level changes in excise and sales taxes on alcohol between 1970 and 2003

Both approaches reveal that consumers underreact to sales taxes relative to excise taxes (i.e., lower ED with respect to sales taxes)•What does this imply for tax incidence?•How should taxes be structured?

What does this imply for economic theory?•Theory is constantly evolving to take into account evidence from the field and laboratory•Chapter 17 highlights some recent advances in behavioral economics

3

R. Chetty, A. Loony, and K. Kroft. 2009. “Salience and Taxation: Theory and Evidence.”American Economic Review, 99(4): 1145–1177.


3.5 Subsidies


Subsidy – a payment by the government to a buyer or seller of a good or service•Subsidies are simply the opposite of a tax

Governments subsidize many products and production processes•Producer subsidies – ethanol production, research and development•Consumer subsidies – education, public transportation

3

Sb PP subsidy

3.5 Subsidies


Figure 3.17 The Impact of a Producer Subsidy

3


figure it outEducation Grants

For years the government has subsidized higher education through grants; consider the supply and demand for college credit hours at a local private liberal arts collegeQS = 1,000P – 2500 , QD = 8,000 – 500Pwhere P is the price, in hundreds of dollars, and Q is the number of credit hours per semester

The current equilibrium price is $700, and 4,500 credit hours are taken per semester; suppose the government subsidizes credit hours at a rate of $200 per hour


1.What will happen to the price paid by students, the price received by the college, and the number of credit hours completed?

2.What is the cost of the subsidy to the government?


figure it out


In this problem,




Education Grants

Sb PP subsidy

Sb PP 2

8,000 500 ; 1,000 2,500D Sb SQ P Q P

1,000 2 2500 1,000 500Sb bQ P P

8,000 500 1,000 500 $566.7b b bP P P


figure it out

The new producer price is given by

And the quantity of credit hours taken (using demand equation)

So, the price paid by consumers has decreased by about $133, the price received by the college has increased by about $67, and the number of credit hours consumed has increased by about 667

2.How much did this cost the government?

Education Grants

7.766$002 SSb PPP

8,000 500 5.667 5,166.5DQ

Cost subsidy $200 667 $133,400Q

3.6 Conclusion


3

Using Supply and Demand to Analyze Markets Copyright © 2013 Worth Publishers, All Rights Reserved Microeconomics Goolsbee/Levitt/ Syverson 1/e 3.

Documents

market price producer

producer surplus price

consumer surplus price

d market price

market exchange

worth publishers

surplus cs

price regulations