Micro Chapter 4
Supply and Demand: Applications
and Extensions
5 Learning Goals
1) Describe the relationship between
resource and product markets
2) Analyze the impact of government
policies for price controls in markets
3) Determine the effects of a tax in a market
4) Explore the relationship between tax
rates and revenues
5) Identify the effects of a subsidy
The Link Between Resource
and Product Markets
What’s the relationship between
product markets and resource
(input) markets?
An increase (decrease) in demand for a
product will increase (decrease) demand
for resources that make that product
When the product price rises, the resource
price will eventually rise
Watch content video: product and
resource markets
Q4.1 (MA) An increase in the number of students
attending college would tend to
decrease the demand for college professors.
increase the demand for college professors.
decrease the number of college professors employed.
increase the number of college professors employed.
increase wages of college professors.
decrease wages of college professors.
The Economics of Price
2 Kinds of Price Controls:
(1) Price ceiling – puts an upper limit on
price; generates a shortage and a
deadweight loss
(2) Price floor – puts a lower limit on price;
generates a surplus and a deadweight
Deadweight loss (DWL) = loss of gains
from trade; loss of CS and PS
Price Ceiling Graph:
Watch content video: price ceiling graph
Watch video: Jingle All The Way- Effects
of a shortage
Dead People Help You Get Gasoline. The African nation
of Zimbabwe is currently an economic mess, with,
among other things, price ceilings on gasoline leading to
shortages and long lines at the gas stations. The
government has set up priorities for obtaining gasoline,
with hearses being priority recipients. Two mortuary
workers were arrested for leasing out bodies to
motorists, who would take the body to a gas station,
claim the hearse’s priority to obtain the gasoline, then
return the body to the mortuary to be leased out again.
The motorist would then siphon out the purchased
gasoline for use in his own private vehicle. This is a
natural response of the market to circumventing the
shortages. The government created the shortage- and
the opportunity for someone to profit from it- and the
market responded.
Q: Siphoning gasoline is dangerous- poisoning or
explosions are possible. Why would anyone accept
these risks? Why engage in this method or
circumventing the price ceiling?
Watch video: Stossel-rent control
Q4.2 What would happen in a market where
a price ceiling was set above equilibrium
1. A surplus would occur
2. The shortage would become larger
3. Equilibrium price would become the
market price
Q4.3 When a shortage of a good is present due to
a price ceiling,
the amount supplied will be greater than the amount
the quality of the good will generally improve.
non-price factors, such as discrimination or waiting in
line, will play a greater role in the allocation of the
the demand for the product will increase and, thereby,
eliminate the shortage.
Price Floor Graph:
Watch content video: Price floor graph
As a price floor, a minimum wage restricts the amount of
goods, or inputs, that demanders are willing to buy. But
what happens if the demand curve shifts to the left? If
there were no floor, the price of the good or service
would drop as the market moves down along the supply
curve, and a new equilibrium price would be established.
But with the floor, the price cannot drop- all that can
happen is that the leftward shift in the demand curve
must lead to a drop in the quantity employed. This is
exactly what happens, according to a study of the labor
market in Portugal. Among companies with a higher
fraction of employees paid at the minimum wage, when
demand for the product goes down, these companies
are more likely to close down. The floor on wages
imposed by the minimum prevents the companies from
cutting costs, and the drop in product demand drives
them out of business when they can no longer supply at
a competitive price.
Q: This describes the response of companies that
cannot afford to remain in business. What will happen to
employment at those companies that stay in business?
Watch video: Stossel-Unintended
consequences of minimum wage
Q4.4 If the government imposes a price floor
on the market for milk, which of the following
will most likely happen?
The quantity of milk demanded will increase.
The quantity of milk supplied will decrease.
There will be a surplus of milk.
There will be a shortage of milk.
Q4.5 Both price floors and price ceilings
lead to
reductions in quality.
a reduction in the quantity traded.
Watch video: Stossel-pharmaceutical
price controls (optional)
The Impact of a Tax
It’s not often that the incidence of a tax is obviously
split between producers and consumers, as the
textbooks would suggest is the case. But on the
day when the U.S. government reimposed a 10
percent tax on airline tickets, some of the airlines
tried to increase fares by 10 percent. Others did
not go along, however, and later in the day the
companies dropped their fares to 4 percent above
where they had been the day before (before the tax
was reimposed). The fare increase settled at 4
percent. The consumer paid 40 percent of the new
tax, and the producers paid 60 percent- even
though the tax was imposed initially on the
Q: Why would the airlines be willing to pay 60% of
the tax?
(1) Statutory incidence- who is legally
responsible to pay the tax
This is the tax burden- it hinders exchange
This is an administrative detail that is mostly
(2) Actual incidence- who really pays the tax
This is the more important issue
The burden is shared between firms and
Ways to analyze:
If the tax is legally imposed on sellers, shift
the supply curve
If the tax is legally imposed on buyers,
shift the demand curve
You’ll reach the same conclusion either
Graph of tax imposed on
See handouts “Impact of a tax 1.pdf”
Graph of tax imposed on
See handouts “Impact of a tax 1.pdf”
Scenario: The price of a textbook
is $100. Then a $10 sales tax is
What usually happens?
The price (with tax) of the textbook will be
somewhere between $100 and $110.
If $106, consumers pay $6 tax and firms
pay $4 tax.
Watch video: Snooki tanning tax (optional,
just for fun)
What determines how the burden
is shared?
The size of the deadweight loss and the
actual burden depend on supply & demand
Four scenarios:
See handouts “Impact of a tax 2.pdf” and
“Impact of a tax 3.pdf”
Summary: The more inelastic group has
the biggest share of the burden
Q4.6 If a $5,000 tax is placed legally (statutorily) on
the sellers of new automobiles and as a result the
price of automobiles to consumers rises by $4,000,
then the actual burden of the tax
1. falls completely on automobile buyers.
2. falls completely on automobile sellers.
3. is $4,000 on automobile buyers and $1,000 on
4. is $1,000 on automobile buyers and $4,000 on
Q4.7 The burden of a tax will fall primarily on
sellers when the
1. demand for the product is highly inelastic and
the supply is relatively elastic.
2. demand for the product is highly elastic and
the supply is relatively inelastic.
3. tax is legally (statutorily) imposed on the seller
of the product.
4. tax is legally (statutorily) imposed on the buyer
of the product.
Several years ago, the state of Texas surprised the public by
creating a tax holiday the weekend before school started.
School supplies and related items were temporarily exempted
from the 8% state sales tax. Who really benefited from the tax
holiday? What was the tax incidence? That depended on
how the supply and demand for these items responded to the
tax cut and the resulting drop in the net price. It’s hard to
believe that demand responded much because by that
weekend many people had already bought the back-to-school
items. If not, they had to buy them then- an inelastic demand.
That would have led to a big drop in the net price: Consumers
reaped most of the benefit from the tax holiday. Since then,
the state has been offering this holiday annually. People are
adjusting their spending patterns accordingly so that now there
is a more elastic demand on that weekend. Retail stores, too,
can plan around this date all year long and be sure that they
reap part of the gains from the temporary tax holiday. Buyers
and sellers now share the incidence of the tax cut.
Q: What if, instead of a tax holiday, the stores were required to
pay the sales tax instead of the consumers. Which net price
would be lower, the tax holiday or the store paying the tax?
When would purchases be higher, with the tax holiday or with
the store paying the tax?
Helpful Study Tool
See handout “Tax Impact Process
Tax Rates, Tax Revenues,
and the Laffer Curve
2 definitions you need to know:
(1) Tax rate
– (a) Value (most common); a percent is
applied to the sales price
Example: 7.5% sales tax
– (b) Per Unit; an amount is applied to each
unit sale
Example: $1 for every unit sold
Gas taxes
(2) Tax Revenue = rate X sales
Q4.8 When the government increases the tax rate,
what happens to tax revenue?
1. Revenues will increase
2. Revenues will decrease
3. It depends
The Laffer Curve
Graphical representation of the
relationship between the tax rate and
Watch content video: Laffer curve
So what?
Starting at high tax rates, an increase in
the tax rate may actually lower revenue
Starting at high tax rates, larger revenue
may be generated by lowering tax rates
Q4.9 According to the Laffer curve,
1. an increase in tax rates will always cause tax revenues to
2. when marginal tax rates are high, an increase in tax rates is
likely to cause tax revenues to increase.
3. when marginal taxes are low, an increase in tax rates will
probably cause tax revenues to decline.
4. when marginal tax rates are high, a reduction in tax rates
may increase tax revenue.
The facts:
See article “historical top marginal tax rates.pdf”
Using 2008 Internal Revenue Service statistics,
the 2001 tax cuts shifted the income tax burden
up the economic ladder.
In 2000, the top 1% paid 37.4% of all income
taxes vs. 39.4% in 2005.
The top 2% went from 56.5% to 60%
The top 10% from 67.3% to 70.3%
The top 25% from 84% to 86%
The top 50% from 96% to 97%.
The Impact of a Subsidy
Watch video: Stossel- farm subsidies
Analysis of Ethanol subsidies
Ethanol- biofuel made from corn to
supplement traditional gasoline (most gas
now contains up to 10% ethanol)
Graph of ethanol:
Watch content video: ethanol
Analysis of Ethanol subsidies
Secondary effects:
1) increase demand for corn (maybe not an
equal increase in supply of corn) results
in an increase in the price of corn
2) Increase in prices for feed for livestock
plus any consumer good made from corn
So, lower prices for ethanol but higher
prices for milk, soda, and everything else
made with corn
Watch video: Stossel-Unintended
consequences of ethanol subsidies
Q4.10 The actual benefit of a government subsidy
is determined primarily by
1. the elasticities of demand and supply.
2. the legal (or statutory) assignment of the
3. the number of exchanges that are made
possible as a result of the subsidy.
4. whether the subsidy is paid by cash or check.
Q4.11 If a $50 subsidy is legally (statutorily) granted
to the sellers of exercise equipment and as a result
the price of exercise equipment to consumers falls by
$30, the actual benefit of the subsidy
goes completely to buyers of exercise equipment.
goes completely to sellers of exercise equipment.
is $30 to buyers and $20 to sellers.
is $20 to buyers and $30 to sellers.
Who receives the biggest
benefit from subsidies?
Ignoring secondary effects, the group with
the smallest elasticity receives the biggest
If supply is relatively inelastic and demand
is relatively elastic, then suppliers receive
most (but not all) of the benefit.
If supply is relatively elastic and demand is
relatively inelastic, then consumers
receive most (but not all) of the benefit.
Watch video: Stossel-subsidized flood
Taxes and subsidies distort incentives and
create secondary effects which are
sometimes undesirable
Question Answers:
4.1 = 2, 4 & 5
4.2 = 3
4.3 = 3
4.4 = 3
4.5 = 4
4.6 = 3
4.7 = 2
4.8 = 3
4.9 = 4
4.10 = 1
4.11 = 3

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