Taxes, MC pricing, and a wrap-up of supply/demand

1. Taxes, MC pricing, and a wrap-up of supply/demand Today: Finishing the basic ideas of supply and demand theory

2. From subsidies to taxes to MC pricing • Last time, we saw that a subsidy did not work to help high rent in Isla Vista • Today, we talk more generally about a negative subsidy, which is called a tax • After taxes, we will talk about MC pricing • Once these topics are done, we will spend the remaining time reviewing Econ 1 thus far

3. Governor Arnold Schwarzenegger below Three major reasons to charge taxes Revenue generation The prevention of harming the environment or other people (see also Externalities, Ch. 12) Limitation of imports (see also Trade, Ch. 9) Taxes

4. An example: A $1 tax on flashlight suppliers • Before tax: Price is $8.80, and 8 flashlights sold

5. An example: A $1 tax on flashlight suppliers • With tax: Suppliers must add $1 in additional costs for each flashlight sold

6. An example: A $1 tax on flashlight suppliers • With tax: • New equilibrium price paid is $9.20 by consumers • New equilibrium revenue kept by suppliers, $8.20

7. An example: A $1 tax on flashlight suppliers • Who “pays” for the tax? • Consumers pay $0.40 more than before • Suppliers receive $0.60 less than before

8. What happens with a $1 tax? • Summary • Lower quantity sold • Consumers pay more money per unit sold • Sellers receive less money per unit sold

9. Deadweight loss • Deadweight loss is economic surplus that we lose by the imposition of a tax • To determine deadweight loss, we need to find surplus and tax revenue generated by tax • Any potential surplus not realized is deadweight loss

10. Surplus and deadweight loss • Consumer surplus (top Δ) • Producer surplus (bottom Δ) • Tax revenue generated (rectangle) • Deadweight loss (right Δ)

11. Elasticity matters for deadweight loss • An example • The smaller the price elasticity of supply, the smaller the deadweight loss • See Figures 7.16 and 7.17 for visual examples

12. Marginal cost pricing of public services • Governments often provide (or contract to a private firm) some “essential” services to residents

13. Back to MB = MC idea • Remember 1st lecture • Surplus is typically maximized when MB = MC • Even though services are publicly provided, MB = MC still applies

14. Example • Electricity • 8 Mwh can be provided by coal @ 3¢/Kwh • 20 Mwh can be provided by natural gas @ 5¢/Kwh • 10 Mwh can be provided by wind power @ 9¢/Kwh • 6 Mwh can be provided by solar power @ 15¢/Kwh

15. 8 Mwh (coal) @ 3¢/Kwh 20 Mwh (natural gas) @ 5¢/Kwh 10 Mwh (wind power) @ 9¢/Kwh 6 Mwh (solar power) @ 15¢/Kwh Suppose that at a price of 9¢/Kwh, 30 Mwh were demanded All coal capacity and natural gas capacity can be used, and 2 Mwh provided by wind MC pricing tells us to charge 9 ¢/Kwh in order to maximize surplus Example

16. We have talked about many topics related to supply, demand, and equilibrium thus far Utility Surplus Cost curves Elasticity Price controls Taxes and subsidies Voluntary incentives Wrap-up and review of supply, demand, and equilibrium

17. Wrap-up and review of supply, demand, and equilibrium • In general, we have analyzed efficiency • MB = MC principle • Some policies prevent MB = MC principle, lowering efficiency • Rent control • Taxes and subsidies • First-come, first-served

18. Wrap-up and review of supply, demand, and equilibrium • Many future topics build off of what we have learned thus far • It is important to make sure that you understand the foundation of microeconomics, which we have covered the last three weeks

19. Marginal analysis • Remember that averages are sometimes important in economics • Marginals are almost always important • Some later topics include why markets sometimes fail • Marginal analysis will continue to be important

20. Supply, demand, and equilibrium • Remaining time today • Your chance to ask questions before we move on to more advanced topics • Review of key equations, tables, and figures

21. Cost is $2 per drink We should buy the third energy drink since MB > MC (2.5 > 2) We should not buy the fourth energy drink since MB < MC (1.5 < 2) Note that we are NOT maximizing avg. benefit Energy drinks

22. Supply and Demand

23. Shift in demand/Movement along the supply curve • The demand curve shifted to the right • There is a movement along the supply curve, since supply does not change

24. MU of bananas: How many would you eat if they were free?

25. From individual demand…

26. …to market demand

27. CS from demand curves • P = $3 • Height of triangle is ($6 – $3), or $3. • Length of triangle is (6 – 0), or 6 • Area of triangle is one-half times length times height • CS = $9 The area of this triangle is a good approximation of CS

28. Supply and profits • At P1 positive profits, since TR > TC (P  Q > ATC  Q) • At P2 negative profits • At P3 firm shuts down (TR is less than VC for all Q)

29. Marginal analysis: Hire 4 workers/day if phones are $18 • (Remember: Check shutdown condition)

30. Example of producer surplus • When P = 25 per unit, shaded area is producer surplus • Area is a triangle, one-half times length times height: 0.5  10  25 = 125

31. Price elasticity of demand • Calculated by the percentage change in quantity divided by the percentage change in price

32. Alternate version for straight-line demand curves • Slope on straight line is ΔP/ΔQ • Along a straight line, elasticity is also equal to P/Q times inverse of the slope (see above)

33. Bumper crop of strawberries: Not always good • ε = 0.29  inelastic • Expenditure goes DOWN moving from S1 to S2 • The bumper crop of strawberries actually hurts farmers collectively

34. Long-run consequences of rent control: Excess demand ($100s) • Notice that supplied apartments for rent are cut in half in the long run with rent control • Only 1/3 of the people that want apartments will get them excess demand 24 12 100s units

35. Price ceiling at G: Red triangle is deadweight loss • Total surplus is trapezoid ADFE (at most) • ΔCEF is potential surplus that is never gained

36. A $1 tax on flashlight suppliers • Who “pays” for the tax? • Consumers pay $0.40 more than before • Suppliers receive $0.60 less than before

37. Surplus and deadweight loss • Consumer surplus (top Δ) • Producer surplus (bottom Δ) • Tax revenue generated (rectangle) • Deadweight loss (right Δ)