### Supply and Demand: Applications and Extensions

```The Pizza Demand Curve
• The demand for frozen pizzas
reflects the law of diminishing
marginal utility.
• Because marginal utility (MU)
falls with increased consumption,
\$3.50
so does a consumer’s maximum
willingness to pay -- marginal
\$3.00
benefit (MB).
• A consumer will purchase Price =\$2.50
\$2.50
until
MB = Price . . .
so at \$2.50 \$2.00
they would purchase 3 frozen
area (above the price line and
below the demand curve).
MB4
MU4
< MBbecause
< MB <MB
< MU < MU <MU
3
2
1
3
2
1
John’s demand curve
for frozen pizza
MB
1
MB
MB
2
3
MB
4
d = MB
Frozen
pizzas
per week
1 2 3 4
Consumer Surplus
The total difference between what a
consumer is willing to pay and how much they
actually have to pay.
Producer Surplus
The total difference between what a supplier
is willing to provide a good or service and how
much they actually get for it.
Producer and Consumer Surplus
P
\$10
9
8
7
6
5
4
3
2
1
Consumer surplus =
area of red triangle =
½(\$5)(5) = \$12.5
S
Producer surplus =
area of green triangle =
½(\$5)(5) = \$12.5
CS
PS
D
0 1 2 3 4 5 6 7 8
Q
The combination of
producer and consumer
surplus is maximized at
market equilibrium
8-3
Consumer Surplus
Price
5
4
3
2
1
Quantity
1
2
3
4
5
If the selling price is 3, the consumer
surplus for the 1st item is 5-3=2, plus
4-3=1 for the 2nd and 3-3=0 for the
3rd, or 3
The Burden of a Tax
Tax Incidence
• Who pays a tax is called the incidence.
Seller
Impact of a Tax Imposed on Sellers
Price
• If in the used car market a price
of \$7,000 would bring the
quantity of used cars demanded
into balance with the quantity
supplied.
• When a \$1,000 tax is imposed on
sellers of used cars, the supply
curve shifts vertically by the
amount of the tax.
• The new price for used cars is
\$7,400 … sellers netting \$6,400
(\$7,400 - \$1000 tax).
• Consumers end up paying \$7,400
instead of \$7,000 and bear \$400
of the tax burden.
• Sellers end up receiving \$6,400
(after taxes) instead of \$7000 and
bear \$600 of the tax burden.
S plus tax
S
\$7,400
\$7,000
\$1000 tax
\$6,400
D
500
750
# of used cars
per month
(in thousands)
Impact of a Tax Imposed on Buyers
Price
• In the same used car market:
• When a \$1,000 tax is imposed on
buyers of used cars, the demand
curve shifts vertically by the
amount of the tax.
S
\$7,400
\$7,000
• The new price for used cars is
\$6,400 … buyers then pay taxes
\$6,400
of \$1000 making the total \$7,400.
• Consumers end up paying \$7,400
(after taxes) instead of \$7,000 and
bear \$400 of the tax burden.
• Sellers end up receiving \$6,400
instead of \$7000 and bear \$600
of the tax burden.
\$1000 tax
D
D minus tax
500
750
# of used cars
per month
(in thousands)
Elasticity and Incidence of a Tax
• The actual burden of a tax depends on
the elasticity of supply and demand.
• As supply becomes more inelastic,
then more of the burden will fall on
sellers.
• As demand becomes more inelastic,
then more of the burden will fall on
ED
ED + E S
ES
ED + E S
Tax Burden and Elasticity
• Consider the market for Gasoline
and Luxury Boats individually.
• We begin in equilibrium.
• If we impose a \$.20 tax on gasoline
suppliers, the supply curve moves
vertically the amount of the tax.
Price goes up \$.15 and output falls
by 6 million gallons per week.
• If we impose a \$25K tax on Luxury
Boat suppliers, the supply curve
moves vertically the amount of
the tax. Price goes up by \$5K and
output falls by 5 thousand units.
• In the gas market, the demand is
relatively more inelastic than its
supply; hence, buyers bear a larger
share of the burden of the tax.
• In the luxury boats market, the
supply curve is relatively more
inelastic than its demand; hence,
sellers bear a larger share of the
tax burden.
Price
Gasoline
market
S plus tax
\$1.65
\$1.60
\$1.55
\$1.50
\$1.45
S
D
Quantity
(millions
of gallons)
194 200
Price
(thousand \$)
S plus tax
S
110
Luxury boat
market
100
90
D
80
Quantity
5
10
15
(thousands
20 of boats)
Government Intervention as Implicit
Taxation
• Government intervention in the form of price
controls can be viewed as a combination tax and
subsidy
• An effective price ceiling is a government set price
below the market equilibrium price
• It acts as an implicit tax on producers and an
implicit subsidy to consumers that causes a
welfare loss identical to the loss from taxation
P
S
A price ceiling transfers surplus
from producers to consumers,
reduces equilibrium quantity
P0
P1
Price ceiling
Shortage
Q1
Q0
D
Q
• An effective price floor is a government set price
above the market equilibrium
• It acts as a tax on consumers and a subsidy for
producers that transfers consumer surplus to
producers
P
Surplus
S
P1
Price floor
P0
D
Q1
Q0
Q
A price floor transfers surplus
from consumers to producers,
reduces equilibrium quantity
The Difference Between Taxes and Price Controls
• Price ceilings create shortages and taxes do not
• Taxes leave people free to choose how much to
supply and consume as long as they pay the tax
• Shortages may also create black markets
Rent Seeking, Politics, and Elasticities
• The possibility of transferring surplus from one set
of individuals to another causes people to spend time
and resources on doing so.
• Lobbying for price controls, which transfer surplus
from one group to another, is an example of rentseeking behavior
• Individuals spend money and use resources to lobby
governments to institute policies that increase their
own surplus
• Public choice economists argue that when all rent
seeking and tax consequences are netted out, there
is often not a net gain to the public
Inelastic Demand and Incentives to Restrict Supply
Revenue
gained
P
S1
S0
P1
P0
When demand is
relatively inelastic,
suppliers have incentive
to restrict quantity to
increase total revenue
C
Revenue
lost
A
B
Q1 Q0
D
Q
Inelastic Supplies and Incentives to Restrict Prices
• When supply is inelastic, consumers have incentives to
restrict prices
• When supply is inelastic and demand increases, prices
increase causing consumers to lobby for price controls
• Rent control in New York City is an example
Application: Price Floors and Elasticity
The surplus created by a price floor is larger if
demand and supply are elastic
P
P
Surplus
S
Surplus
S
P1
P
P0
1
Price floor
P0
D
D
Q
Q
1
0
Q
QQ
1
0
Q
Long-Run and Short-Run Effects on Price Control
P
Sshort-run
PSR
PLR
P0
Higher long-run elasticity
of supply results in
smaller price increases
when demand increases
Slong-run
D0
Q0 QSR QLR
D1
Q
```