Chapter 7 Price Floors, Taxes, and Subsidies

1. Chapter 7 Price Floors, Taxes, and Subsidies

2. Price Floors Policy makers may respond to sellers’ complaints that prices are “too low” by enacting price controls. A Price Flooris a minimum price allowed by law. Price floors impose a minimum price that buyers must pay for goods. Prices cannot legally go lower than the floor.

3. Price Floors Price floors that involve a minimum price above the market price create four important effects. Surpluses Loss of Gains from Trade Wasteful Increases in Quality Misallocation of Resources

4. Surpluses When prices are held above the market price surpluses emerge where the quantity supplied exceeds the quantity demanded. The surplus is measured by the difference between the quantity supplied at the controlled price and the quantity demanded at the controlled price. The higher the controlled price relative to the market equilibrium price, the larger the surplus.

5. Surpluses Price Floors Create Surpluses Price Supply Surplus Controlled Price (Ceiling) Market Price Demand Quantity Qdemanded at the Controlled Price Qsupplied at the Controlled Price Qmarket

6. Lost Gains from Trade Price controls reduce the gains from trade. Price floors set above the market price cause quantity demanded to be less than the market quantity. For output levels below the equilibrium market quantity, consumers value the good (as indicated by the willingness to pay) more than the cost of its production. This represents a gain from trade that would not remain unexploited in a free market. Price floors create a deadweight loss by forcing quantity demanded below the market quantity. Buyers and sellers can both benefit from trade at a lower price, but it is illegal for price to fall.

7. Lost Gains from Trade Price Floors Reduce the Gains from Trade Price Lost Gains from Trade = Lost Consumer Surplus + Lost Producer Surplus Supply Controlled Price (Floor) Surplus Market Price Lost Consumer Surplus Lost Producer Surplus Willingness to Sell Demand Quantity Qmarket Qdemanded Qsupplied

8. Wasteful Increases in Quality Price controls that create surpluses lead to wasteful increases in quality. Surpluses mean that producers will not be able to sell all of their goods. In free markets sellers compete with other sellers by offering a lower price. Since price is not allowed to fall below the price floor, sellers must compete in other ways.

9. Wasteful Increases in Quality Some producers may be willing to make quality investments in order to sell their surplus goods. The maximum quality investment a seller would make is the difference between the controlled price established by the price floor and the willingness to sell. Quality investments require resources that are wasted when consumers are not normally willing to pay for the higher quality. The costs of these investments reduce profits and producer surplus.

10. Wasteful Increases in Quality Price Floors Create Quality Waste Price Supply Deadweight Loss Controlled Price (Floor) Market Equilibrium “Quality” Waste Willingness to Sell Demand Quantity QDemanded at the Controlled Price

11. Misallocation of Resources Price controls misallocate resources by allowing high-cost firms to operate. In free markets sellers with production costs greater than the equilibrium price will be driven out of the market. Price floors allow these sellers to remain in the market employing limited resources that could be used doing something else.

12. The European Union has a minimum legal price for butter, a price floor, that is often above the market equilibrium price. What do you think has been the result of this. • The United States has set a price floor for milk above the equilibrium price. Has this led to shortages or surpluses? How do you think the U.S. government has dealt with this? (Hint: remember the cartons of milk you had in elementary school and high school? What was their price?)

13. Taxes Governments often use taxes to raise revenue to fund various projects. ACommodity Taxis a tax placed on goods. Some truths about commodity taxation: Who pays the tax does not depend on who writes the check to the government; Who pays the tax does depend on the relative elasticities of demand and supply; Commodity taxation raises revenue and creates lost gains from trade (deadweight loss).

14. Taxes Who pays the tax does not depend on who writes the check to the government. The government can collect a commodity tax in either of two different ways: A tax on sellers for every unit supplied; A tax on buyers for every unit purchased. Who must legislatively pay the tax is irrelevant. Commodity taxes have exactly the same effect whether sellers or buyers pay for the tax.

15. A Tax on Sellers A tax on sellers is equivalent to an increase in costs. Such a tax will shift the supply curve up by the amount of the tax. The tax will distort the market so that the price paid by buyers will be different than the price received by sellers. This difference will always equal the tax. Tax = Price Paid by Buyers – Price Received by Sellers

16. A Tax on Sellers A Tax on Sellers Shifts the Supply Curve Up by the Tax Price Supply With Tax tax c Supply No Tax Price Paid by Buyers b Price (No Tax) a tax Price Received by Sellers Demand Quantity Qwith tax Qno tax

17. A Tax on Buyers A tax on buyers lowers the willingness to pay for every quantity demanded. Such a tax will shift the demand curve down by the amount of the tax. The tax will distort the market so that the price paid by buyers will be different than the price received by sellers. This difference will always equal the tax. Tax = Price Paid by Buyers – Price Received by Sellers

18. A Tax on Buyers A Tax on Buyers Shifts the Demand Curve Down by the Tax Price Supply Price Paid by Buyers b tax Price (No Tax) a Price Received by Sellers d tax Demand No Tax e Demand With Tax Quantity Qno tax Qwith tax

19. A Tax on Sellers Equals a Tax on Buyers A Tax on Sellers is the Same as a Tax on Buyers Price Supply With Tax Supply No Tax tax tax Price Paid by Buyers b a Price (No Tax) Price Received by Sellers d tax tax Demand No Tax Quantity Demand With Tax Qwith tax Qno tax

20. The Burden of a Tax Who pays the tax depends on the relative elasticities of supply and demand. A tax creates a wedge between the price paid by buyers and the price received by sellers. Buyers pay a price greater than the market price without a tax while sellers receive a price less than the market price without a tax. The burden of a tax is the portion of the tax paid by buyers and sellers. The lesselastic side of the market will pay the greater share of a tax – bear more of the burden of a tax.

21. The Burden of a Tax When the demand curve is more elastic than the supply curve, sellers will bear a larger burden of a tax. The price the seller receives falls below the market price without the tax more than the price the buyer pays rises above the market price without the tax. The less elastic supply curve implies that it is more difficult for sellers to avoid the tax than it is for buyers.

22. The Burden of a Tax When Demand is More Elastic than Supply Sellers Pay More of the Tax Price Supply Price Paid by Buyers b a Price (No Tax) tax Demand Price Received by Sellers d Quantity Qno tax Qwithtax

23. The Burden of a Tax When the supply curve is more elastic than the demand curve, buyers will bear a larger burden of a tax. The price the buyer pays rises above the market price without the tax more than the price the seller receives falls below the market price without the tax. The less elastic demand curve implies that it is more difficult for buyers to avoid the tax than it is for sellers.

24. The Burden of a Tax When Supply is More Elastic than Demand Buyers Pay More of the Tax Price Price Paid by Buyers b tax a Supply Price (No Tax) d Price Received by Sellers Demand Quantity Qwithtax Qno tax

25. The Burden of a Tax The burden of a tax to buyers can be defined as PBuyers – PNoTax, and the burden to sellers can be defined as PNoTax – Psellers. The burden of the tax then is divided according to the ratio of elasticities:

26. The Burden of a Tax Example: Suppose the elasticity of supply is 2, and the elasticity of demand is 1 (in absolute terms). Buyers will then bear twice as much of the tax as sellers. For a $1 tax, buyers will pay an extra 66.6 cents, and sellers will receive 33.3 cents less.

27. The Burden of a Tax Relative elasticities can play an important role in analyzing tax policy. Health Insurance Mandates and Tax Analysis Mandates requiring employers to provide health insurance to their workers may make employees worse off. Who Pays the Cigarette Tax? If manufacturers of cigarettes can easily escape state taxes, then it’s possible the tax will not discourage smoking.

28. The Burden of a Tax - Extra! The Omnibus Budget Reconciliation Act of 1990 applied a 10% federal luxury tax to the first retail sale of luxury goods such as pleasure boats with a sales price above $100,000. The tax was originally projected to generate revenues of $9 billion over five years after passage. The tax was widely popular among policy makers as a way to shift the burden of deficit reduction to those who can best afford it.

29. The Burden of a Tax - Extra! The results were not what was expected by policy makers: Sales of boats down 52.7%; Net loss of 30,000 jobs; The federal government paid out over $7 million more in unemployment benefits to those workers than it collected in luxury tax revenues. The elasticity of supply for boats was evidently less elastic than the elasticity of demand for boats. The federal luxury tax was quickly repealed in 1993.

30. The Burden of a Tax - Extra! “You had to be an ignoramus to believe the luxury tax was only going to soak the rich. The only people it hurt was working people like myself,” said Judy Ott, an assembly worker at the Viking Yacht Company’s plant in New Jersey. “All these people suffered needlessly because the politicians in Washington needed a symbol to sell the American people a new tax increase,” said Viking’s co-founder Robert T. Healey.

31. The Deadweight Loss of a Tax A commodity tax raises revenue and creates lost gains from trade (deadweight loss). A tax generates revenues for the government. Government will receive tax revenue equal to the quantity of the good purchased times size of the tax. A tax also reduces the gains from trade creating a deadweight loss. A tax creates a wedge between the price that buyers pay and the price that sellers receive. As such, quantity will be less than the equilibrium quantity with no tax leaving unexploited gains from trade (deadweight loss).

32. The Deadweight Loss of a Tax A Tax Generates Revenue and Creates a Deadweight Loss Price Consumer Surplus Producer Surplus Supply Deadweight Loss Price Buyer Pays Tax Revenue Pno tax tax Price Seller Receives Demand Quantity Qno tax Qtax

33. Suppose that the government taxes insulin producers $50 per dose produced. Who is likely to ultimately pay this tax? • Although the government taxes almost everything, would the government rather tax items that have relatively inelastic or relatively elastic demands and supplies?

34. Subsidies A subsidy is a reverse tax where the government gives money to consumers or producers. Some truths about subsidies: Who gets the subsidy does not depend on who receives the check from the government; Who benefits from the subsidy does depend on the relative elasticities of demand and supply; Subsidies must be paid for by taxpayers and create inefficient gains from trade (deadweight loss).

35. Subsidies A subsidy distorts the market so that the price paid by buyers will be different than the price received by sellers. A subsidy reverses the relationship between the price paid by buyers and the price received by sellers with a tax. The price received by sellers will exceed the price paid by buyers. This difference will always equal the subsidy. Subsidy = Price Received by Sellers – Price Paid by Buyers

36. Subsidies A Subsidy Drives a Wedge between the Price Received by Sellers and the Price Paid by Buyers Price Supply Price Received by Sellers Pmarket Subsidy Price Paid by Buyers Demand Quantity Qmarket Qsubsidy

37. The Benefit of Subsidies Who receives the benefit of a subsidy depends on the relative elasticities of supply and demand. The less elastic side of the market will receive the greater share of a subsidy – receive more of the benefit of a subsidy. Whichever side of the market bears the burden of a tax receives the benefit of a subsidy.

38. The Benefit of Subsidies Whoever Bears the Burden of a Tax, Receives the Benefit of a Subsidy Price Supply Price Received by Sellers Price Paid by Buyers subsidy Price Paid by Buyers Price (No Tax or Subsidy) tax Demand Price Received by Sellers Quantity Qwithtax Qwithsubsidy Qno tax or no subsidy

39. The Benefit of Subsidies The benefit of a subsidy to buyers can be defined as PNoSubsidy – PBuyers, and the benefit to sellers can be defined as PSellers – PNoSubsidy. The benefit of the subsidy then is divided according to the ratio of elasticities:

40. Subsidies Just like a tax, a subsidy creates a deadweight loss. In the case of a subsidy, the deadweight loss arises because of non-beneficial trades rather than unexploited gains from trade with a tax. With a subsidy output exceeds the equilibrium level of output. At this quantity the cost of production is greater than the value to consumers. As a result resources are employed that could be used doing something else of greater value. Taxpayers end up paying the difference.

41. Subsidies A Subsidy Creates a Deadweight Loss Price Deadweight Loss Supply Price Received by Sellers Subsidy Pmarket Price Paid by Buyers Demand Qmarket Qsubsidy Quantity

42. Subsidies Relative elasticities can play an important role in analyzing subsidy policy. King Cotton and the Deadweight Loss of Water Subsidies Subsidies can divert scarce resources to lower value uses. Wage Subsidies This type of subsidy, argued by Nobel prize wining economist Edmund Phelps, may increase employment as well as wages for low-skilled workers.

43. The Minimum Wage and Wage Subsidies The minimum wage is the clearest example of a price floor in the United States. Such a policy, however, can hurt low-skilled workers by reducing employment. Some economists believe that a better approach would be to subsidize employers (demanders of labor). This approach leads to a higher wage and a higher level of employment.

44. The Minimum Wage and Wage Subsidies A Minimum Wage Decreases Employment Wage Supply Unemployment Minimum Wage c a Demand Quantity Qdemanded Qmarket Qsupplied

45. The Minimum Wage and Wage Subsidies A Subsidy to Wages Increases Employment Wage Supply b Wage Received by Workers a Subsidy Demand with Subsidy Wage Paid by Firms Demand Quantity Qdemanded Qmarket Qsupplied

46. To promote energy independence, the U.S. government provides a subsidy to corn growers if they convert the corn to ethanol, a fuel used in some cars. Because of this subsidy, what happens to the quantity supplied of ethanol, and what happens to the price received by corn growers and the price paid by ethanol buyers? • The U.S. government subsidizes college education in the form of Pell grants and lower-cost government Stafford loans. How do these subsidies affect the price of college education? Which is relatively more elastic: supply or demand? Who benefits the most from these subsidies, suppliers (colleges) or demanders of education (students)?

47. A price floor is a minimum price allowed by law. • Price floors that involve a minimum price above the market price create four important effects. • Surpluses • Loss of Gains from Trade • Wasteful Increases in Quality • Misallocation of Resources

48. When prices are held above the market price surpluses emerge where the quantity supplied exceeds the quantity demanded. • Price floors reduce the gains from trade by making some mutually profitable trades illegal. • Price floors lead to wasteful increases in quality not valued by consumers. • Price floors misallocate resources by allowing high-cost firms to operate in the market.

49. Governments often use taxes to raise revenue to fund various projects. • Acommodity tax is a tax placed on goods. • Some truths about commodity taxation: • Who pays the tax does not depend on who writes the check to the government; • Who pays the tax does depend on the relative elasticities of demand and supply; • Commodity taxation raises revenue and creates lost gains from trade (deadweight loss).

50. A subsidy is a reverse tax where the government gives money to consumers or producers. • Some truths about subsidies: • Who gets the subsidy does not depend on who receives the check from the government; • Who benefits from the subsidy does depend on the relative elasticities of demand and supply; • Subsidies must be paid for by taxpayers and create inefficient gains from trade (deadweight loss).