Principles of Microeconomics 6. Price Controls and Taxes*

1. Principles of Microeconomics6. Price Controls and Taxes* AkosLada July 28th, 2014 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

2. Contents • Review of previous lecture • The Classroom Parliament • Price Control • Taxes – an introduction • Elasticity and Taxes

3. 1. Review

4. Percent change in Qd Income elasticity of demand Percentage change in Qd Price elasticity of demand = = Percent change in income Percentage change in P % change in Qd for good 1 Cross-price elast. of demand = % change in price of good 2 Different elasticities of demand

5. Different types of Supply P P P P P Perfectly inelastic Perfectly elastic Q Q Q Q Q 1 Inelastic Elastic Unit-elastic 1

6. 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.

7. 2. The Classroom Parliament

8. Proposition MPA-MC1Rent 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).

9. In favor Against Abstain The Parliament Votes!

10. Proposition MPA-MC2Minimum 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.

11. In favor Against Abstain The Parliament Votes!

12. Proposition MPA-MC3Fair 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 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 Pizza sellers must pay $1.50 per pizza to the Local Government at the end of every week.

13. Pizza sellers should pay the tax. Pizza buyers should pay the tax Abstain The Parliament Votes!

14. Price controls

15. 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).

16. 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”

17. Equilibrium without price controls P S Rental price of apts $1,500 D Q 300 Quantity of apartments EXAMPLE 1: The Market for 1 Bedroom Apartments

18. P S Price ceiling $2,000 $1,500 D Q 300 A not binding price ceiling A price ceiling above the equilibrium price is not binding – has no effect on the market outcome.

19. The equilibrium price ($1,500) is above the ceiling and therefore illegal. The ceiling is a binding constrainton the price, causes a shortage. P S Price ceiling $1,000 shortage D Q 400 250 A binding price ceiling $1,500

20. In the long run, supply and demand are more price-elastic. So, the shortage is larger. P S Price ceiling $1,000 shortage D Q Short run vs. Long run $1,500 450 150

21. Unintended consequences • Rationing: • Long lines • Discrimination according to sellers’ biases • “Black markets” • Perverse incentives (e.g. decrease in quality of the good)

22. Equilibrium withoutprice controls W S Wage paid to unskilled workers $ 7 D L 500 Quantity of unskilled workers EXAMPLE 2: The Market for Unskilled Labor

23. A price floor below the equilibrium price is not binding – has no effect on the market outcome. W S Price floor $6 $7 D L 500 A non-binding minimum wage

24. The equilibrium wage ($7) is below the floor and therefore illegal. The floor is a binding constrainton the wage, causes a surplus (i.e., unemployment). labor surplus W S Price floor $9 $7 D L 400 550 A Binding Minimum Wage

25. The market for hotel rooms P S D 0 Q STUDENTS’ TURN:Price controls Determine effects of: A. $90 price ceiling B. $90 price floor C. $120 price floor

26. The market for hotel rooms P S Price ceiling D shortage = 30 0 Q Answer A. $90 price ceiling The price falls to $90. Buyers demand 120 rooms, sellers supply 90, leaving a shortage.

27. The market for hotel rooms P S D 0 Q Answer B. $90 price floor Equilibrium price is above the floor, so floor is not binding. P = $100, Q = 100 rooms. Price floor

28. The market for hotel rooms P S surplus = 60 Price floor D 0 Q Answer C. $120 price floor The price rises to $120. Buyers demand 60 rooms, sellers supply 120, causing a surplus.

29. Taxes, an Introduction

30. 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 per-unit taxes only. Taxes

31. Equilibriumwithout tax P S1 $10.00 D1 Q 500 EXAMPLE: The Market for Pizza

32. The 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 Qas before. E.g., if P falls from $10.00 to $8.50,buyers still willing topurchase 500 pizzas. P S1 $10.00 Tax D1 $8.50 D2 Q 500 A Tax of $1.50 on Buyers Hence, a tax on buyers shifts the D curve down by the amount of the tax.

33. P S1 $11.00 PB = $10.00 Tax PS = $9.50 D1 D2 Q 500 450 A Tax on Buyers New equilibrium: Q = 450 Sellers receive PS = $9.50 Buyers pay PB = $11.00 Difference between them = $1.50 = tax Effects of a $1.50 per unit tax on buyers

34. how the burden of a tax is shared among market participants P S1 $11.00 PB = $10.00 Tax $9.50 PS = D1 D2 Q 500 450 The Incidence of a Tax: In our example, buyers pay $1.00 more, sellers get $0.50 less.

35. P S2 S1 $11.50 $10.00 Tax D1 Q 500 A Tax of $1.50 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. Hence, a tax on sellers shifts the S curve up by the amount of the tax.

36. P S2 S1 PB = $11.00 $10.00 Tax $9.50 PS = D1 Q 500 450 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

37. What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. P S1 $11.00 $10.00 $9.50 D1 Q 500 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! PB = Tax PS = 450

38. The market for hotel rooms P S D 0 Q STUDENT’S TURN:Effects of a tax Suppose govt imposes a tax on buyers of $30 per room. Find new Q, PB, PS, and incidence of tax.

39. The market for hotel rooms P S PB = Tax PS = D 0 Q Answers Q = 80 PB = $110 PS = $80 Incidence • buyers: $10 • sellers: $20

40. Elasticity and Taxes

41. CASE 1: Supply is more elastic than demand P PB S Buyers’ share of tax burden Tax Price if no tax PS Sellers’ share of tax burden D Q Elasticity and Tax Incidence It’s easier for sellers than buyers to leave the market. So buyers bear most of the burden of the tax.

42. CASE 2: Demand is more elastic than supply P S PB Buyers’ share of tax burden Tax Price if no tax Sellers’ share of tax burden PS D Q Elasticity and Tax Incidence It’s easier for buyers than sellers to leave the market. Sellers bear most of the burden of the tax.