Principles of Microeconomics 7. Taxes, Subsidies, and Introduction to Welfare Analysis*

1. Principles of Microeconomics7. Taxes, Subsidies, and Introduction to Welfare Analysis* AkosLada July 29th, 2014 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

2. Lecture 8 - Contents • Review of previous lecture • More on taxes • Willingness to pay and consumer surplus • Costs and producer surplus

3. 1. Review

4. Price controls • Binding vs. non-binding constraints. • Binding price ceilings (e.g. rent control) • Leads to shortage • Effect is more severe in the long run • Rationing, informal market, decrease in quality • Binding price floors (e.g. minimum wage) • Leads to surplus (under the assumptions of the model

5. Quiz: Refer to the labor market graph below. The imposition of an $8 minimum wage would cause tax revenues to increase by $2 per worker. unemployment of 35 labor hours. a labor shortage of 35 labor hours. no change in the equilibrium wage and employment because the minimum wage is not binding.

6. Do you support minimum wage laws? How do you think economists would answer this question? • support strongly • support mildly • have mixed feelings • oppose mildly • oppose strongly

7. Do you support minimum wage laws? How do you think economists would answer this question?1. support strongly2. support mildly3. have mixed feelings4. oppose mildly5. oppose stronglyANSWERS:1. support strongly – 28.4%2. support mildly – 18.9%3. have mixed feelings – 14.4%4. oppose mildly – 17.8%5. oppose strongly – 20.5%SOURCE: Daniel B. Klein and Charlotta Stern. “Economists’ Policy Views and Voting.” Public Choice (2006) 126: 331-342.

8. Taxes • What shifts? • If imposed on buyers, it is equivalent to a decrease in income, shifts the demand curve left • If imposed on sellers, it is equivalent to an increase in input costs, shifts the supply curve left • What is the size of the shift? • The amount of the tax • Tax incidence (who pays for the tax burden) • Whether the tax is charged to the producers or to the sellers is irrelevant – the tax incidence is the same in both cases • What matters is the elasticity of Supply and Demand • If Supply is more inelastic, the larger share of the burden falls on the sellers. • If Demand is more inelastic, the larger share of the burden falls on the buyers

9. 2. More on taxes

10. 1. What shifts? • If imposed on sellers, it is equivalent to an increase in input costs, shifts the supply curve left If imposed on buyers, it is equivalent to a decrease in income, shifts the demand curve to the left P P S0 S0 S0 $10 $10 D0 D0 D1 Q Q 500 500

11. 2.What is the size of the shift? ~ The amount of the tax! ~ For a $ 1.50 tax imposed on buyers… For a $ 1.50 tax imposed on sellers… P P $13.50 S1 S0 S0 $12 $1.5 (tax) $11.50 $10 $10 $1.5 (tax) $8.50 $7.50 D1 D0 D0 $6.00 Q Q 500 500 300 900 300 900

12. 3.Who pays the tax burden? • Whether the tax is charged to the producers or to the sellers is irrelevant the tax incidence is the same in both cases For a $ 1.50 tax imposed on buyers… For a $ 1.50 tax imposed on sellers… Buyers pay $1.00 Buyers pay $1.00 P P S1 S0 S0 Total Tax $1.50 Total Tax $1.50 PB= $11.00 PB= $11.00 P*= $10 P*= $10 $9.50 PS= PS= $9.50 Sellers pay $0.50 Sellers pay $0.50 D0 D0 D1 Q Q 450 450 500 500

13. A tax creates a wedge • … between what goes out of the pocket of the buyers, and what goes into the pocket of the sellers. The wedge is the tax that goes to the government. P S1 S0 Amount Buyers pay = PB Total Tax (wedge) $1.50 P* Amount Sellers receive = PS D0 D1 Q Q*` Q*0

14. Quiz: In the graph below, the after-tax price paid by buyers and price received by sellers are, respectively, $4.00 $6.00 $5.00 $6.00 $6.00 $5.00 $6.00 $4.00 Price paid by buyers Price received by sellers

15. 3.Who pays the tax burden? • What matters is the elasticity of Supply and Demand • ~ those that are more flexible (adaptive) pay less, those that are less flexible pay more ~ If Supply is more inelastic, the larger share of the burden falls on the sellers. • If Demand is more inelastic, the larger share of the burden falls on the buyers Buyers pay more of the tax Buyers pay less of the tax P P Same total Tax S0 S0 Same total Tax PB PB P* P* PS PS Sellers pay less of the tax Sellers pay more of the tax D0 D0 Q Q Q*1 Q*0 Q*1 Q*0

16. Quiz: Suppose the government enacts a tax as shown in the diagram below. The policy will cause the equilibrium price to rise by $2. buyers to bear a higher burden of the tax than sellers. buyers and sellers to each bear a $1 burden of the tax. quantity to fall by 4 units.

17. 3. Willingness to Pay and Consumer Surplus

18. Welfare Economics • Recall, the allocation of resources refers to: • how much of each good is produced • which producers produce it • which consumers consume it • Welfare economics studies how the allocation of resources affects economic well-being. • First, we look at the well-being of consumers.

19. A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good. WTP measures how much the buyer values the good. Willingness to Pay (WTP) Example: 4 buyers’ WTP for an iPod

20. Q:If price of iPod is $200, who will buy an iPod, and what is quantity demanded? WTP and the Demand Curve A: Anthony & Flea will buy an iPod, Chad & John will not. Hence, Qd = 2 when P = $200.

21. WTP and the Demand Curve Derive the demand schedule: P (price of iPod) who buys Qd $301 & up nobody 0 251 – 300 Flea 1 176 – 250 Anthony, Flea 2 126 – 175 Chad, Anthony, Flea 3 0 – 125 John, Chad, Anthony, Flea 4

22. WTP and the Demand Curve P Q

23. About the Staircase Shape… This D curve looks like a staircase with 4 steps – one per buyer. P If there were a huge # of buyers, as in a competitive market, there would be a huge # of very tiny steps, and it would look more like a smooth curve. Q

24. WTP and the Demand Curve At any Q, the height of the D curve is the WTP of the marginal buyer, the buyer who would leave the market if P were any higher. Flea’s WTP Anthony’s WTP Chad’s WTP John’s WTP P Q

25. Consumer Surplus (CS) Consumer surplus is the amount a buyer is willing to pay minus the amount the buyer actually pays: CS = WTP – P Suppose P = $260. Flea’s CS = $300 – 260 = $40. The others get no CS because they do not buy an iPod at this price. Total CS = $40.

26. CS and the Demand Curve Flea’s WTP P P = $260 Flea’s CS = $300 – 260 = $40 Total CS = $40 Q

27. CS and the Demand Curve Flea’s WTP Anthony’s WTP P Instead, suppose P = $220 Flea’s CS = $300 – 220 = $80 Anthony’s CS =$250 – 220 = $30 Total CS = $110 Q

28. 4. Costs and Producer Surplus

29. Cost and the Supply Curve Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost). Includes cost of all resources used to produce good, including value of the seller’s time. Example: Costs of 3 sellers in the lawn-cutting business. A seller will produce and sell the good/service only if the price exceeds his or her cost. Hence, cost is a measure of willingness to sell.

30. Cost and the Supply Curve Derive the supply schedule from the cost data: P Qs $0 – 9 0 10 – 19 1 20 – 34 2 35 & up 3

31. Cost and the Supply Curve P Q

32. Cost and the Supply Curve Chrissy’s cost Janet’s cost Jack’s cost P At each Q, the height of the S curve is the cost of the marginal seller, the seller who would leave the market if the price were any lower. Q

33. Producer Surplus P PS = P – cost Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost Q

34. Producer Surplus and the S Curve Chrissy’s cost Janet’s cost Jack’s cost P PS = P – cost Suppose P = $25. Jack’s PS = $15 Janet’s PS = $5 Chrissy’s PS = $0 Total PS = $20 Total PS equals the area above the supply curve under the price, from 0 to Q. Q

35. PS with Lots of Sellers & a Smooth S Curve Suppose P = $40. At Q = 15(thousand), the marginal seller’s cost is $30, and her producer surplus is $10. Price per pair P S 1000s of pairs of shoes Q The supply of shoes