Principles of Microeconomics
6. Price Controls and Taxes*
Akos Lada
July 28th, 2014
* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint
Contents
1. Review of previous lecture
2. The Classroom Parliament
3. Price Control
4. Taxes – an introduction
5. Elasticity and Taxes
1. Review
Different elasticities of demand
Price elasticity of
demand
=
Income elasticity of
=
demand
Cross-price elast.
of demand
=
Percentage change in Qd
Percentage change in P
Percent change in Qd
Percent change in income
% change in Qd for good 1
% change in price of good 2
Different types of Supply
P
P
Q
Perfectly inelastic
P
Q
Perfectly elastic
P
P
1
Inelastic
Q
Elastic
Q
1
Unit-elastic
Q
The Determinants of Supply Elasticity
• The more easily sellers can
change the quantity they produce,
the greater the price elasticity of
supply.
• Example: Supply of beachfront
property is harder to vary and thus
less elastic than
supply of new cars.
• For many goods, price elasticity
of supply is greater in the long
run than in the short run, because
firms can build new factories,
or new firms may be able to enter
the market.
2. The Classroom
Parliament
Proposition MPA-MC1
Rent Ceiling
•
Housing is getting too expensive in the Harvard Square area. People
working near this zone cannot afford a place to live in the vicinity, and
have to travel long hours between home and work every day. Poor
families have no alternative but to move away from the neighborhood.
•
The Classroom Parliament has been given authority to legislate in this
jurisdiction.
•
A people’s representative brings the following proposal for your
consideration:
Effective today, no housing unit within 5 miles of
Harvard Square can charge more than $ 800 plus $ 200
per each additional room (per month).
The Parliament Votes!
1. In favor
2. Against
3. Abstain
0%
1
2
3
Proposition MPA-MC2
Minimum Wage
• Workers with little formal education in Cambridge, MA, are
struggling in the midst of this economic recession. Their
current income barely allows them to cover their families’ basic
needs, and they have to work so much that they don’t have the
opportunity to spend quality family time.
• The Classroom Parliament has been given authority to legislate
in this jurisdiction.
• A people’s representative brings the following proposal for your
consideration:
Effective today, the minimum wage in Cambridge,
MA is fixed at $ 9/hour.
The Parliament Votes!
1. In favor
2. Against
3. Abstain
0%
1
2
3
Proposition MPA-MC3
Fair Allocation of Tax Burden
• The Government of the City of Cambridge needs to raise more
money in order to speed-up the public works taking place near
Harvard Square.
• The Classroom Parliament (in a previous session) decided to
impose a tax of $1.50 in one of the best-selling products of this
area: Pizza!
• A decision remains: Who should be made to bear the burden of
the tax? There is two proposals to decide from:
The Pizza sellers must pay $1.50
per pizza to the Local
Government at the end of every
week.
The Pizza buyers must deposit $1.50
per pizza purchased in a box (placed
in each Pizza establishment) . The
Local Government will collect the
money at the end of every week.
The Parliament Votes!
1. Pizza sellers should pay the
tax.
2. Pizza buyers should pay the
tax
3. Abstain
0%
1
2
3
Price controls
Government Policies That Alter the
Private Market Outcome
• Price controls
• Price ceiling: a legal maximum on the price
of a good or service Example: rent control
• Price floor: a legal minimum on the price of
a good or service Example: minimum wage
• Taxes
• The government can make buyers or sellers pay a specific
amount on each unit bought/sold.
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).
Binding and not-binding
constraints
• A constraint imposed on certain behavior
may matter or not at different times
• When it matters, we say that the constraint
is “binding”
EXAMPLE 1: The Market for 1 Bedroom
Apartments
Rental
price of
apts
P
S
$1,500
Equilibrium
without
price controls
D
300
Q
Quantity of
apartments
A not binding price ceiling
P
S
A price ceiling
$2,000
above the
equilibrium price
$1,500
is
not binding –
has no effect
on the market
outcome.
Price
ceiling
D
300
Q
A binding price ceiling
The equilibrium
price ($1,500) is
above the ceiling
and therefore
illegal.
P
S
$1,500
The ceiling
$1,000
is a binding
constraint
on the price,
causes a shortage.
Price
ceiling
shortage
250
400
D
Q
Short run vs. Long run
In the long run,
supply and demand
are more
price-elastic.
So, the shortage
is larger.
P
S
$1,500
Price
ceiling
$1,000
shortage
150
450
D
Q
Unintended consequences
• Rationing:
1. Long lines
2. Discrimination according to sellers’ biases
• “Black markets”
• Perverse incentives (e.g. decrease in quality of the good)
EXAMPLE 2: The Market for Unskilled Labor
Wage
paid to
unskilled
workers
Equilibrium
without
price controls
W
S
$7
D
L
500
Quantity of
unskilled workers
A non-binding minimum wage
A price floor below the
equilibrium price is
not binding –
has no effect
on the market outcome.
W
S
$7
Price
floor
$6
D
500
L
A Binding Minimum Wage
The equilibrium wage
($7) is below the floor
and therefore
illegal.
The floor
is a binding
constraint
on the wage,
causes a
surplus (i.e.,
unemployment).
W
labor
surplus
S
Price
floor
$9
$7
D
400
550
L
STUDENTS’ TURN:
Price controls
P
140
Determine
effects of:
A. $90 price
ceiling
130
The market for
hotel rooms
S
120
110
100
90
B. $90 price
floor
80
C. $120 price
floor
60
D
70
50
40
0
Q
50 60 70 80 90 100 110 120 130
Answer A. $90 price ceiling
P
140
The price falls
to $90.
Buyers
demand
120 rooms,
sellers supply
90, leaving a
shortage.
The market for
hotel rooms
130
S
120
110
100
90
80
Price ceiling
shortage = 30
D
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
Answer B. $90 price floor
P
140
The market for
hotel rooms
130
Equilibrium
price is above
the floor, so
floor is not
binding.
P = $100,
Q = 100 rooms.
S
120
110
100
90
80
Price floor
D
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
Answer C. $120 price floor
P
140
The price
rises to $120.
Buyers
demand
60 rooms,
sellers supply
120, causing a
surplus.
130
120
110
The market for
hotel rooms
surplus = 60
S
Price floor
100
90
80
D
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
Taxes, an Introduction
Taxes
• The government levies taxes on
many goods & services to raise
revenue to pay for national
defense, public schools, etc.
• The government can make
buyers or sellers pay the tax.
• The tax can be a % of the
good’s price,
or a specific amount for each
unit sold.
• For simplicity, we analyze perunit taxes only.
EXAMPLE: The Market for Pizza
P
Equilibrium
without tax
S1
$10.00
D1
500
Q
A Tax of $1.50 on Buyers
P
The price buyers pay
is now $1.50 higher than
the market price P.
P would have to fall
by $1.50 to make
buyers willing
to buy same Q
as before.
E.g., if P falls
from $10.00 to $8.50,
buyers still willing to
purchase 500 pizzas.
S1
$10.00
Tax
$8.50
D1
D2
500
Hence, a tax on buyers shifts the D curve
down by the amount of the tax.
Q
A Tax on Buyers
New equilibrium:
Q = 450
Sellers
receive
PS = $9.50
Buyers pay
PB = $11.00
Difference
between them
= $1.50 = tax
P
PB = $11.00
Effects of a $1.50 per
unit tax on buyers
Tax
S1
$10.00
PS = $9.50
D1
D2
450 500
Q
The Incidence of a Tax:
how the burden of a tax is shared among market participants
In our
example,
buyers pay
$1.00 more,
P
PB = $11.00
Tax
S1
$10.00
PS = $9.50
sellers get
$0.50 less.
D1
D2
450 500
Q
A Tax of $1.50 on Sellers
The tax effectively raises
P
$11.50
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.
S2
Tax S1
$10.00
Hence, a tax on sellers shifts the
S curve up by the amount of the tax.
D1
500
Q
A Tax on Sellers
Effects of a $1.50 per
unit tax on sellers
New equilibrium:
Q = 450
Buyers pay
PB = $11.00
Sellers
receive
PS = $9.50
Difference
between them
= $1.50 = tax
P
PB = $11.00
S2
Tax
S1
$10.00
PS = $9.50
D1
450 500
Q
The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the same
whether the tax is imposed on buyers or sellers!
What matters is
this:
P
PB = $11.00
A tax drives
$10.00
a wedge
PS = $9.50
between the
price buyers pay
and the price
sellers receive.
Tax
S1
D1
450 500
Q
STUDENT’S TURN:
Effects of a tax
P
140
130
The market for
hotel rooms
S
Suppose govt
120
imposes a tax on
110
buyers of $30
100
per room.
90
Find new
Q, PB, PS,
and incidence of
tax.
80
D
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
Answers
P
140
Q = 80
PB = $110
PS = $80
130
S
120
PB = 110
100
90
Incidence
buyers: $10
sellers: $20
The market for
hotel rooms
PS = 80
Tax
D
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
Elasticity and Taxes
Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand
It’s easier
for sellers
than buyers
to leave the
market.
So buyers
bear most of
the burden
of the tax.
P
Buyers’ share of
tax burden
PB
Tax
Price if no tax
Sellers’ share of
tax burden
S
PS
D
Q
Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply
P
Buyers’ share of
tax burden
S
PB
Price if no tax
Sellers’ share of
tax burden
It’s easier for
buyers than
sellers to
leave the
market.
Tax
PS
Sellers bear
most of the
burden of
the tax.
D
Q