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Economics for Banking and Insurance - I
PGDM : 2014 – 16 Term 1 (June – September, 2014)
(Lecture 7)
Topics to Be Covered
• Government Intervention and Market Equilibrium Price Ceiling: Rent Control, Minimum Drug Price
Price Floor: Minimum Wage, Minimum Support Price, Minimum Price
Incidence of Tax: Nominal and Economic Incidence
• We will use the supply/demand model to see how each policy affects the market outcome (the price buyers pay, the price sellers receive, and equilibrium quantity).
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Price control and Market Equilibrium
• Price ceiling: a legal maximum on the price of a good or service e.g., rent control
• Price floor: a legal minimum on the price of a good or service e.g., minimum wage
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EXAMPLE 1: The Market for Apartments
Eq’m w/o price controls
P
QD
SRental price of
apts
$800
300Quantity of apartments
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How Price Ceilings Affect Market Outcomes
A price ceiling above the eq’m price is not binding – has no effect on the market outcome.
P
QD
S
$800
300
Price ceiling$1000
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How Price Ceilings Affect Market Outcomes
The eq’m price ($800) is above the ceiling and therefore illegal.The ceiling is a binding constraint on the price, causes a shortage.
P
QD
S
$800
Price ceiling$500
250 400
shortage
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How Price Ceilings Affect Market Outcomes
In the long run, supply and demand are more price-elastic. So, the shortage is larger.
P
QD
S
$800
150
Price ceiling$500
450
shortage
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EXAMPLE 2: The Market for Unskilled Labor
Eq’m w/o price controls
W
LD
SWage paid to
unskilled workers
$4
500Quantity of
unskilled workers
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How Price Floors Affect Market Outcomes
W
LD
S
$4
500
Price floor$3
A price floor below the eq’m price is not binding – has no effect on the market outcome.
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How Price Floors Affect Market Outcomes
W
LD
S
$4
Price floor$5
The eq’m wage ($4) is below the floor and therefore illegal.The floor is a binding constraint on the wage, causes a surplus (i.e., unemployment).
400 550
labor surplus
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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%.
The Minimum Wage
W
LD
S
$4
Min. wage$5
400 550
unemp-loyment
Impact of Minimum Wage on Employment: Examples from Different Studies
• The Effect of the Minimum Wage on Prices (Lemos, Sara (2004))– It is well established in the international literature that minimum wage increases compress the wages distribution. Firms respond to these higher labor costs by
reducing employment, reducing profits, or raising prices. While there are hundreds of studies on the employment effect of the minimum wage, there is less than a handful studies on its profit effects, and only a couple of dozen studies on its price effects. Not only is the literature scanty on the minimum wage price effects, but also it lacks a survey on that. This survey represents an important contribution to the literature because it summarizes and critically compares over twenty price effect studies, providing a benchmark in the literature. This survey further contributes to the literature by offering an input to the recent debate over the direction of employment effects of the minimum wage. With employment and profits not significantly affected, higher prices is an obvious response to a minimum wage increase. Moreover, this survey also contributes to the literature by extending the current understanding on the minimum wage as a policy against inequality and poverty. If the minimum wage does not cause disemployment but causes inflation, it might hurt rather than aid the poor, who disproportionately suffer from inflation.
• The Response of Hours of Work to Increases in the Minimum Wage (Kenneth A. Couch & David C. Wittenburg (2001))– This paper examines the effect of minimum wage increases on the hours of work of teenagers (ages 16 to 19) using monthly data from the Current Population Survey.
Our findings are consistent with the prediction from neoclassical theory that minimum wage increases have a negative effect on labor demand. However, the estimates we provide here for the elasticity of hours of teen labor demanded with respect to the minimum wage suggest that alternative estimates based on aggregate employment consistently understate the total impact of minimum wage increases on teenage labor utilization.
• Employment Effects of the 2009 Minimum Wage Increase: Evidence from State Comparisons of At-Risk Workers (Saul D. Hoffman & Chenglong Ke (2010))
– In July, 2009, the U.S. Federal minimum wage was increased from $6.55 to $7.25. Individuals in some states were unaffected by this increase, since the state minimum wage already exceeded $7.25 and the state minimum was not increased further. The study uses this variation, as well as variation in the actual amount of the increase, to make comparisons of the employment of “at-risk” workers across states with their peers and within states with workers arguably unaffected by the increase. The data come from the 2009 CPS, four and five months before and after the increase. The study finds some evidence that the employment of some at-risk demographic groups declined as a result of the minimum wage increase, but the impacts are not statistically significant. The study also finds that the employment changes were not responsive to the actual amount of the increase.
• Does Raising the Minimum Wage Help the Poor? (Andrew Leigh (2005))– What is the impact of raising the minimum wage on family incomes? Analyzing the characteristics of low wage workers, this study an increase in the minimum wage
reduces hourly wage inequality (recall that zero hourly wages are ignored). Even in the event that an increase in the minimum wage has only a disemployment effect, and has no impact on hourly wages, it will still have the effect of reducing hourly wage dispersion among those who remain employed.
Consumer Surplus● consumer surplus Difference between what a consumer is willing to
pay for a good and the amount actually paid.
Consumer Surplus and Demand
Consumer Surplus
Consumer surplus is the total benefit from the consumption of a product, less the total cost of purchasing it.
Here, the consumer surplus associated with six concert tickets (purchased at $14 per ticket) is given by the yellow-shaded area.
Consumer SurplusConsumer Surplus and Demand
Consumer Surplus Generalized
For the market as a whole, consumer surplus is measured by the area under the demand curve and above the line representing the purchase price of the good.
Here, the consumer surplus is given by the yellow-shaded triangle and is equal to 1/2 × ($20 − $14) × 6500 = $19,500.
Applying Consumer SurplusWhen added over many individuals, it measures the aggregate benefit that consumers obtain from buying goods in a market.
When we combine consumer surplus with the aggregate profits that producers obtain, we can evaluate both the costs and benefits not only of alternative market structures, but of public policies that alter the behavior of consumers and firms in those markets.
To encourage cleaner air, Congress passed the Clean Air Act in 1977 and has since amended it a number of times.
Valuing Cleaner Air
The yellow-shaded triangle gives the consumer surplus generated when air pollution is reduced by 5 parts per 100 million of nitrogen oxide at a cost of $1000 per part reduced.
The surplus is created because most consumers are willing to pay more than $1000 for each unit reduction of nitrogen oxide.
Consumer Surplus
Consumer and Producer Surplus
Consumer A would pay $10 for a good whose market price is $5 and therefore enjoys a benefit of $5.Consumer B enjoys a benefit of $2,and Consumer C, who values the good at exactly the market price, enjoys no benefit.Consumer surplus, which measures the total benefit to all consumers, is the yellow-shaded area between the demand curve and the market price.
Consumer and Producer Surplus
Consumer and Producer Surplus
Producer surplus measures the total profits of producers, plus rents to factor inputs. It is the green-shaded area between the supply curve and the market price.Together, consumer and producer surplus measure the welfare benefit of a competitive market.
Consumer and Producer Surplus (continued)
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Taxes
• The Govt. levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc.
• The Govt. can make buyers or sellers pay the tax.
• The tax can be a specific amount for each unit purchased or sold, known as “per-unit” or “excise” or “quantity” tax
• When the tax is levied on price it is called Price Tax. A price tax is a per-Rupee (as opposed to per-unit) tax. Also known as Ad Valorem tax– Examples: sales tax, interest tax, value-added tax (VAT)
• For simplicity, we will analyze per-unit or quantity or excise taxes only.
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S1
EXAMPLE 3: The Market for Pizza
Eq’m w/o tax P
Q
D1
$10.00
500
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S1
D1
$10.00
500
A Tax on BuyersThe price buyers pay is now $1.50 higher than the market price P. P would have to fallby $1.50 to makebuyers willing to buy same Q as before. E.g., if P falls from $10.00 to $8.50,buyers still willing topurchase 500 pizzas.
P
QD2
Effects of a $1.50 per unit tax on buyers
$8.50
Hence, a tax on buyers shifts the D curve down by the amount of the tax.
Tax
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S1
D1
$10.00
500
A Tax on Buyers
P
QD2
$11.00PB =
$9.50PS =
Tax
Effects of a $1.50 per unit tax on buyers
New eq’m:
Q = 450
Sellers receive PS = $9.50
Buyers pay PB = $11.00
Difference between them = $1.50 = tax 450
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450
S1
The Incidence of a Tax:The burden of a tax is shared among market participants i.e., buyers and sellers
P
Q
D1
$10.00
500
D2
$11.00PB =
$9.50PS =
Tax
In our example, buyers pay $1.00 more, sellers get $0.50 less.
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S1
A Tax on Sellers
P
Q
D1
$10.00
500
S2
Effects of a $1.50 per unit tax on sellers
The tax effectively raises sellers’ costs by $1.50 per pizza.Sellers will supply 500 pizzas only if P rises to $11.50, to compensate for this cost increase.
$11.50
Hence, a tax on sellers shifts the S curve up by the amount of the tax.
Tax
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S1
A Tax on Sellers
P
Q
D1
$10.00
500
S2
450
$11.00PB =
$9.50PS =
Tax
Effects of a $1.50 per unit tax on sellers
New eq’m:
Q = 450
Buyers pay PB = $11.00
Sellers receive PS = $9.50
Difference between them = $1.50 = tax
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S1
The Outcome Is the Same in Both Cases!
What matters is this:A tax drives a wedge between the price buyers pay and the price sellers receive.
P
Q
D1
$10.00
500450
$9.50
$11.00PB =
PS =
Tax
The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers: Tax Equivalence
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Elasticity and Tax IncidenceCASE 1: Supply is more elastic than demand
P
QD
S
Tax
Buyers’ share of tax burden
Sellers’ share of tax burden
Price if no tax
PB
PS
It’s easier for sellers than buyers to leave the market. So buyers bear most of the burden of the tax.
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Elasticity and Tax IncidenceCASE 2: Demand is more elastic than supply
P
Q
D
S
Tax
Buyers’ share of tax burden
Sellers’ share of tax burden
Price if no tax
PB
PS
It’s easier for buyers than sellers to leave the market. Sellers bear most of the burden of the tax.
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Incidence of Tax and Deadweight Loss (DWL)
“Tax Incidence and Efficiency Costs of Taxation”; Emmanuel Saez, University of California, Berkely
The Demand function: and The Supply Function :
Pre-Tax Equilibrium
Equilibrium Quantity and Price:
A unit tax of amount “t” is imposed on buyers.
So, post-tax equilibrium
Therefore, Post-Tax equilibrium Quantity: ; and
Post-Tax Equilibrium Prices:
Effect of an Excise Tax: An Algebraic Approach
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