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PART I: REVIEW

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Economics is a SOCIAL SCIENCE so it seeks to explain something about SOCIETY Fundamental Economic Problem: SCARCITY Daily activities Possessions you enjoy The surroundings in w/c you live Many of the activities we enjoy require TIME as well as MONEY .

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Economics is the study of how individuals allocate their scarce resources efficiently in order to satisfy their unlimited needs and wants. Ultimate goal of a: consumer maximize utility producer maximize profit

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Basic Limitations: scarce time scarce spending power Because of the scarcities of TIME & SPENDING POWER, each of us is forced to make CHOICES ECONOMICS IS THE STUDY OF CHOICE AND SCARCITY.

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SUPPLY, DEMAND, AND GOVERNMENT POLICIES 4 ECONOMICS MICROECONOMICS MACROECONOMICS small big is the study of how people make decisions and how these decisions interact. is the study of the nation’s economy as a whole.

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SUPPLY, DEMAND, AND GOVERNMENT POLICIES 5 MICROECONOMICS MACROECONOMICS 1. Should I go to college or get a job? 1.How many people are employed in the economy as a whole this year? 2. What determines the salary that Citibank offers to a new college graduate? 2.What determines the overall salary levels paid to workers in a given year? 3. What determines the cost to a college of offering a new course? 3.What determines the overall level of prices in the economy as a whole? 4. What government policies should be adopted to make it easier for low- income students to afford college? 4. What government policies should be adopted to promote employment and growth in the economy as a whole? 5. What determines the number of iPhones exported to France? 5. What determines the overall trade in goods, services, and financial assets between the United States and the rest of the world?

Supply and Demand Together: 

P Q Supply and Demand Together D S Equilibrium : P has reached the level where quantity supplied equals quantity demanded

Equilibrium price:: 

D S P Q Equilibrium price: P Q D Q S $0 24 0 1 21 5 2 18 10 3 15 15 4 12 20 5 9 25 6 6 30 the price that equates quantity supplied with quantity demanded

Equilibrium quantity:: 

D S P Q Equilibrium quantity: P Q D Q S $0 24 0 1 21 5 2 18 10 3 15 15 4 12 20 5 9 25 6 6 30 the quantity supplied and quantity demanded at the equilibrium price

Surplus (a.k.a. excess supply):: 

P Q D S Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Surplus Example: If P = $5, then Q D = 9 lattes and Q S = 25 lattes resulting in a surplus of 16 lattes

Surplus (a.k.a. excess supply):: 

P Q D S Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Facing a surplus, sellers try to increase sales by cutting price. This causes Q D to rise Surplus …which reduces the surplus. and Q S to fall…

Surplus (a.k.a. excess supply):: 

P Q D S Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Facing a surplus, sellers try to increase sales by cutting price. This causes Q D to rise and Q S to fall. Surplus Prices continue to fall until market reaches equilibrium.

Shortage (a.k.a. excess demand):: 

P Q D S Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied Example: If P = $1, then Q D = 21 lattes and Q S = 5 lattes resulting in a shortage of 16 lattes Shortage

Shortage (a.k.a. excess demand):: 

P Q D S Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied Facing a shortage, sellers raise the price, causing Q D to fall …which reduces the shortage. and Q S to rise, Shortage

Shortage (a.k.a. excess demand):: 

P Q D S Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied Facing a shortage, sellers raise the price, causing Q D to fall and Q S to rise. Shortage Prices continue to rise until market reaches equilibrium.

Three Steps to Analyzing Changes in Eq’m: 

THE MARKET FORCES OF SUPPLY AND DEMAND 15 Three Steps to Analyzing Changes in Eq’m To determine the effects of any event, 1. Decide whether event shifts S curve, D curve, or both. 2. Decide in which direction curve shifts. 3. Use supply-demand diagram to see how the shift changes eq’m P and Q .

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SUPPLY, DEMAND, AND GOVERNMENT POLICIES 16

Supply, Demand, and Government Policies: 

Supply, Demand, and Government Policies E conomics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 6

In this chapter, look for the answers to these questions:: 

In this chapter, look for the answers to these questions: What are price ceilings and price floors? What are some examples of each? How do price ceilings and price floors affect market outcomes? How do taxes affect market outcomes? How do the effects depend on whether the tax is imposed on buyers or sellers? What is the incidence of a tax? What determines the incidence? 18

Government Policies That Alter the Private Market Outcome: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 19 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 govt 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 eq’m quantity).

EXAMPLE 1: The Market for Apartments: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 20 EXAMPLE 1: The Market for Apartments Eq’m w/o price controls P Q D S Rental price of apts $800 300 Quantity of apartments

How Price Ceilings Affect Market Outcomes: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 21 How Price Ceilings Affect Market Outcomes A price ceiling above the eq’m price is not binding – has no effect on the market outcome. P Q D S $800 300 Price ceiling $1000

How Price Ceilings Affect Market Outcomes: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 22 How Price Ceilings Affect Market Outcomes The eq’m price ($800) is above the ceiling and therefore illegal. The ceiling is a binding constraint on the price, causes a shortage. P Q D S $800 Price ceiling $500 250 400 shortage

How Price Ceilings Affect Market Outcomes: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 23 How Price Ceilings Affect Market Outcomes In the long run, supply and demand are more price-elastic. So, the shortage is larger. P Q D S $800 150 Price ceiling $500 450 shortage

Shortages and Rationing: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 24 Shortages and Rationing With a shortage, sellers must ration the goods among buyers. Some rationing mechanisms: (1) Long lines (2) Discrimination according to sellers’ biases These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly. In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair).

EXAMPLE 2: The Market for Unskilled Labor: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 25 EXAMPLE 2: The Market for Unskilled Labor Eq’m w/o price controls W L D S Wage paid to unskilled workers $4 500 Quantity of unskilled workers

How Price Floors Affect Market Outcomes: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 26 How Price Floors Affect Market Outcomes W L D S $4 500 Price floor $3 A price floor below the eq’m price is not binding – has no effect on the market outcome.

How Price Floors Affect Market Outcomes: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 27 How Price Floors Affect Market Outcomes W L D S $4 Price floor $5 The eq’m wage ($4) is below the floor and therefore illegal. The floor is a binding constraint on the wage, causes a surplus ( i.e., unemployment). 400 550 labor surplus

The Minimum Wage: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 28 Min wage laws do not affect highly skilled workers. They do affect teen workers. Studies: A 10% increase in the min wage raises teen unemployment by 1-3%. The Minimum Wage W L D S $4 Min. wage $5 400 550 unemp-loyment

A C T I V E L E A R N I N G 1 Price controls: 

A C T I V E L E A R N I N G 1 Price controls Q P S 0 The market for hotel rooms D Determine effects of: A . $90 price ceiling B . $90 price floor C. $120 price floor 29

A C T I V E L E A R N I N G 1 A. $90 price ceiling: 

A C T I V E L E A R N I N G 1 A. $90 price ceiling Q P S 0 The market for hotel rooms D The price falls to $90. Buyers demand 120 rooms, sellers supply 90, leaving a shortage. shortage = 30 Price ceiling 30

A C T I V E L E A R N I N G 1 B. $90 price floor: 

A C T I V E L E A R N I N G 1 B. $90 price floor Q P S 0 The market for hotel rooms D Eq’m price is above the floor, so floor is not binding. P = $100, Q = 100 rooms. Price floor 31

A C T I V E L E A R N I N G 1 C. $120 price floor: 

A C T I V E L E A R N I N G 1 C. $120 price floor Q P S 0 The market for hotel rooms D The price rises to $120. Buyers demand 60 rooms, sellers supply 120, causing a surplus. surplus = 60 Price floor 32

Evaluating Price Controls: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 33 Evaluating Price Controls Recall one of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices. Price controls often intended to help the poor, but often hurt more than help.

Taxes: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 34 Taxes The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc. The govt 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.

EXAMPLE 3: The Market for Pizza: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 35 S 1 EXAMPLE 3: The Market for Pizza Eq’m w/o tax P Q D 1 $10.00 500

A Tax on Buyers: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 36 S 1 D 1 $10.00 500 A Tax on Buyers The price buyers pay is now $1.50 higher than the market price P . P would have to fall by $1.50 to make buyers willing to buy same Q as before. E.g. , if P falls from $10.00 to $8.50, buyers still willing to purchase 500 pizzas. P Q D 2 Effects of a $1.50 per unit tax on buyers $8.50 Hence, a tax on buyers shifts the D curve down by the amount of the tax. Tax

A Tax on Buyers: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 37 S 1 D 1 $10.00 500 A Tax on Buyers P Q D 2 $11.00 P B = $9.50 P S = Tax Effects of a $1.50 per unit tax on buyers New eq’m: Q = 450 Sellers receive P S = $9.50 Buyers pay P B = $11.00 Difference between them = $1.50 = tax 450

The Incidence of a Tax:: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 38 450 S 1 The Incidence of a Tax: how the burden of a tax is shared among market participants P Q D 1 $10.00 500 D 2 $11.00 P B = $9.50 P S = Tax In our example, buyers pay $1.00 more, sellers get $0.50 less.

A Tax on Sellers: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 39 S 1 A Tax on Sellers P Q D 1 $10.00 500 S 2 Effects of a $1.50 per unit tax 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. $11.50 Hence, a tax on sellers shifts the S curve up by the amount of the tax. Tax

A Tax on Sellers: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 40 S 1 A Tax on Sellers P Q D 1 $10.00 500 S 2 450 $11.00 P B = $9.50 P S = Tax Effects of a $1.50 per unit tax on sellers New eq’m: Q = 450 Buyers pay P B = $11.00 Sellers receive P S = $9.50 Difference between them = $1.50 = tax

The Outcome Is the Same in Both Cases!: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 41 S 1 The Outcome Is the Same in Both Cases ! What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. P Q D 1 $10.00 500 450 $9.50 $11.00 P B = P S = Tax The effects on P and Q , and the tax incidence are the same whether the tax is imposed on buyers or sellers!

A C T I V E L E A R N I N G 2 Effects of a tax: 

A C T I V E L E A R N I N G 2 Effects of a tax Q P S 0 The market for hotel rooms D Suppose govt imposes a tax on buyers of $30 per room. Find new Q , P B , P S , and incidence of tax.

A C T I V E L E A R N I N G 2 Answers: 

A C T I V E L E A R N I N G 2 Answers Q P S 0 The market for hotel rooms D Q = 80 P B = $110 P S = $80 Incidence buyers: $10 sellers: $20 Tax P B = P S =

Elasticity and Tax Incidence: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 44 Elasticity and Tax Incidence CASE 1: Supply is more elastic than demand P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden Price if no tax P B P S It’s easier for sellers than buyers to leave the market. So buyers bear most of the burden of the tax.

Elasticity and Tax Incidence: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 45 Elasticity and Tax Incidence CASE 2: Demand is more elastic than supply P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden Price if no tax P B P S It’s easier for buyers than sellers to leave the market. Sellers bear most of the burden of the tax.

CASE STUDY: Who Pays the Luxury Tax?: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 46 CASE STUDY: Who Pays the Luxury Tax? 1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc. Goal of the tax: raise revenue from those who could most easily afford to pay – wealthy consumers. But who really pays this tax?

CASE STUDY: Who Pays the Luxury Tax?: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 47 CASE STUDY: Who Pays the Luxury Tax? The market for yachts P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden P B P S Demand is price-elastic. In the short run, supply is inelastic. Hence, companies that build yachts pay most of the tax.

CONCLUSION: Government Policies and the Allocation of Resources: 

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 48 CONCLUSION: Government Policies and the Allocation of Resources Each of the policies in this chapter affects the allocation of society’s resources. Example 1: A tax on pizza reduces eq’m Q . With less production of pizza, resources (workers, ovens, cheese) will become available to other industries. Example 2: A binding minimum wage causes a surplus of workers, a waste of resources. So, it’s important for policymakers to apply such policies very carefully.

CHAPTER SUMMARY: 

CHAPTER SUMMARY A price ceiling is a legal maximum on the price of a good. An example is rent control. If the price ceiling is below the eq’m price, it is binding and causes a shortage. A price floor is a legal minimum on the price of a good. An example is the minimum wage. If the price floor is above the eq’m price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment. 49

CHAPTER SUMMARY: 

CHAPTER SUMMARY A tax on a good places a wedge between the price buyers pay and the price sellers receive, and causes the eq’m quantity to fall, whether the tax is imposed on buyers or sellers. The incidence of a tax is the division of the burden of the tax between buyers and sellers, and does not depend on whether the tax is imposed on buyers or sellers. The incidence of the tax depends on the price elasticities of supply and demand. 50