## The Pizza Demand Curve

The demand for frozen pizzas reflects the law of diminishing marginal utility.

John’s

demand curve

for frozen pizza

Because marginal utility (MU) falls with increased consumption, so does a consumer’s maximum willingness to pay -- marginal benefit (MB).

\$3.50

\$3.00

1 MB 2 MB MB

A consumer will purchase until MB = Price . . . they would purchase 3 frozen pizzas and receive a so at \$2.50 consumer surplus shown by the shaded area (above the price line and below the demand curve).

\$2.00

3 4 MB

= Frozen per week

MB 4 < MB 3 < MB 2

because

< MB 1

1 2 3 4

MU 4 < MU 3 < MU 2 < MU 1

## 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.

What Consumer Surplus and Producer Surplus Measure Consumer surplus measures the net benefit to consumers from participating in a market rather than the total benefit.

Consumer surplus in a market is equal to the total benefit received by consumers minus the total amount they must pay to buy the good or service. Similarly, producer surplus measures the net producers from participating in a market.

benefit received by Producer surplus in a market is equal to the total amount firms receive from consumers minus the cost of producing the good or service.

### Producer and Consumer Surplus Marginal Cost to Producer equals Marginal Benefit to Consumers

P \$10 9 8 7 6 5 4 3 2 1 CS PS 0 1 2 3 4 5 6 7 8 S D Q Consumer surplus = area of blue triangle = ½(\$5)(5) = \$12.5

Producer surplus = area of red triangle = ½(\$5)(5) = \$12.5 The combination of producer and consumer surplus is maximized at market equilibrium

### Inefficiency

P \$10 9 8 7 6 5 4 3 2 1 CS PS 0 1 2 3 4 5 6 7 8 S D Q At Q = 3, consumers want more, and producers want to supply more At Q = 8, consumers want less and producers are willing to supply less.

Only at equilibrium are producer and consumer surplus maximized.

Deadweight loss is the reduction in economic surplus resulting from a market not being in competitive equilibrium.

Economic surplus is maximized when a market is in competitive equilibrium. When a market is not in equilibrium, there is a deadweight loss. When the price of chai tea is \$2.20 instead of \$2.00, consumer surplus declines from an amount equal to the sum of areas A, B, and C to just area A. Producer surplus increases from the sum of areas D and E to the sum of areas B and D.

At competitive equilibrium, there is no deadweight loss. At a price of \$2.20, there is a deadweight loss equal to the sum of areas C and E.

2 nd 1 st

3 rd 4 th

st

nd

rd

## Government Intervention in the Market: Price Controls

• • •

### Price floor

is a legally established minimum price that buyers must pay.

It stops the price from dropping down to equilibrium level.

• Example: minimum wage The direct effect of a price floor above the equilibrium price is a

### surplus

: quantity supplied exceeds quantity demanded.

### The Impact of a Price Floor

• A price floor like P

1

sets a Price causing quantity supplied Q

D

… to exceed quantity demanded Q

S

resulting in a

surplus

.

P 1 P 0 Surplus S

Non-price factors will become more important than

prices

in determining where scarce goods go.

Q

D

Price floor

Q

S

D

Quantity

### Minimum Wage Effects

• • Direct effect: • Reduces employment of low-skilled labor.

Indirect effects: • Reduction in non-wage component of • • compensation.

Less on-the-job training.

May encourage students to drop out of •

### Employment and the Minimum Wage

• If a price (wage) of \$4.00 could bring

equilibrium

.

Price

(wage)

Excess supply S

• A

minimum wage

employed (E

1

(price floor)

), but would reduce \$ 5.15

\$ 4.00

Minimum wage level • Those who lose their job (E to E

1

) would be pushed into

0

other less preferred form of employment.

E

1

E

0

D

Quantity

(employment)

### Price ceiling

is a legally established maximum price that sellers may charge.

• It stops the price from rising to the equilibrium level.

• • Example: rent control The direct effect of a price ceiling is a

### shortage

: quantity demanded exceeds quantity supplied.

### The Impact of a Price Ceiling

Price

(rent)

S

• In the

rental housing

market the price

(rent) P

0 would

bring the quantity of rental units

demanded

into balance with the quantity

supplied

.

• A

price ceiling

like

P 1

sets a price below equilibrium …

P 0 P 1

quantity demanded

Q D

Shortage

exceeds quantity supplied

Q S

… resulting in a

shortage

.

Rental housing market

D

Price ceiling

Q

S

Q

D

Quantity of housing units

### Effects of Rent Control

• • • The future supply of housing will decline.

The quality of housing will deteriorate.

Non-price methods of rationing will increase in importance.

• Long-term renters will benefit at the expense of newcomers.

## The Impact of a Tax

### Tax Incidence

• Who pays a tax is called the

incidence

.

### 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

.

\$7,400 \$7,000 \$6,400 500 750

S

plus tax

S

\$1000 tax

D

# 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.

\$7,400 \$7,000 • The new price for used cars is \$6,400 … buyers then pay taxes 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

.

\$6,400

S

\$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 buyers.

### 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 relatively more inelastic

is than its

supply

• In the ; hence, buyers bear a larger share of the burden of the tax.

luxury boats

market, the

supply

curve is

relatively more inelastic

than its tax burden.

demand

; hence, sellers bear a larger share of the Price \$1.65

\$1.60

\$1.55

\$1.50

\$1.45

Price

(thousand \$)

110 100 90 80 5 194 200

S

plus tax

D S

plus tax

S

10 15

S Gasoline market

Quantity

(millions of gallons)

Luxury boat market D

20 Quantity

(thousands of boats)

1.

a.

it is easier for those with higher incomes to wait in line.

b.

higher prices does not.

c.

output.

d.

Which of the following is a major disadvantage of setting the price of a good below equilibrium and using waiting in line rather than price to ration the good?

Compared to price rationing, waiting in line is unfair since Waiting in line imposes a cost on the consumer; paying Both waiting in line and higher prices are costly to consumers, but unlike the payment of a higher price, waiting in line does not provide suppliers with an incentive to expand future Waiting in line benefits consumers at the expense of producers.

2.

When a price floor is above the equilibrium price, a.

so there will be a shortage.

b.

c.

quantity demanded will exceed quantity supplied, quantity supplied will exceed quantity demanded, so there will be a surplus.

the market will be in equilibrium.

d.

This is a trick question because price floors are generally set below the equilibrium price.

3. Rent control applies to about two-thirds of the private rental housing in New York City. Economic theory suggests that the below-equilibrium prices established by rent controls would a.create a surplus of rental housing.

b.promote a rapid increase in the future supply of housing.

c.result in poor service and quality deterioration of many rental units.

d.lead to a reduction in housing discrimination against minorities.

4. Which of the following is the most likely result of an increase in the minimum wage?

a.an increase in the employment of unskilled workers b.a decrease in the number of workers seeking minimum wage jobs c.an increase in the demand for unskilled workers d.a decrease in the employment of unskilled workers

5.

The benefit of a subsidy will go primarily to sellers when the a.

supply is relatively elastic.

b.

the supply is relatively inelastic.

c.

d.

demand for the product is highly inelastic and demand for the product is highly elastic and subsidy is legally (statutorily) granted to the seller of the product.

subsidy is legally (statutorily) granted to the buyer of the product.

6.

If there was an increase in the excise tax imposed on beer suppliers, what would be the effect on the equilibrium price and quantity of beer?

a.

price increases; quantity decreases b.

c.

d.

price decreases; quantity decreases price increases; quantity increases price decreases; quantity increases

7.

likely it is that the a.

The more elastic the supply of a product, the more burden of a tax on the product will fall on sellers.

b.

c.