Microeconomics Exam 10 7 Chapter 6 10 05 2014 Policymakers use taxes to raise revenue for public purposes and to influence market outcomes Controls on Prices Buyers of any good always want a lower price while sellers want a higher price the interests of the two groups conflict If the Ice Cream Eaters are successful in their lobbying they complained that the 3 price is too high for everyone to enjoy a cone a day the government imposes a legal maximum on the price at which ice cream cones can be sold o Because price cannot be allowed to rise above this level the legislated maximum is called a price ceiling o By contrast if Ice Cream makers are successful they complained that 3 at equilibrium price is too low and depressing the incomes of its members the government imposes a legal minimum on the price o Because the price cannot fall below this level the legislated minimum is called a price floor Option 1 of Price Ceiling Outcomes o When the government imposes a price ceiling of 4 a cone and 3 is the equilibrium the price ceiling is not binding o Market forces naturally move the economy to the equilibrium and the price ceiling has no effect on the price or the quantity sold Option 2 of Price Ceiling Outcomes o When the government imposes a price ceiling of 2 a cone and 3 is equilibrium the price ceiling is a binding constraint o The forces of supply and demand tend to move the price toward the equilibrium price but when the market price hits the ceiling it can by law rise no further Thus the market price equals the price ceiling o This causes a shortage o When the government imposes a binding price ceiling gon a competitive market a shortage of the good arises and sellers must ration the scarce goods among the large number of potential buyers Option 1 of a Price Floor Affect Market Outcome o Ice Cream Makers may feel that the 3 equilibrium price is too low The government might institute a price floor If the government imposes a price floor of 2 a cone when the equilibrium price is 3 the price floor is not binding o Market forces naturally move the economy to the equilibrium and the price floor has no effect o If the government imposes a price floor of 4 when the equilibrium price is 3 the price floor is a binding constraint on the market o The forces of supply and demand tend to move the price toward the equilibrium price but when the market price hits the floor it can fall no further o The market price equals the price floor At this floor the quantity of ice cream supplied 120 cones exceeds the quantity demanded 80 Thus a binding price floor causes a surplus o Minimum wage is a great example of a price floor Minimum wage has its greatest impact on the market for teenage labor Teenagers are the least skilled and least experienced workers of the labor force They are also more willing to accept a lower wage in exchange for on the job training Minimum wage is often more binding for teenagers Evaluating Price Controls Governments can sometimes improve market outcomes Price controls are often aimed at helping the poor o Rent control laws help keep rents low but it also discourages landlords from maintaining their buildings and makes housing hard to find o Minimum wage laws may riaise the incomes of some workers but they also cause the other workers to be unemployed Taxes Helping those in need can be accomplished in ways other than o controlling prices o The government can make housing more affordable by paying a fraction of the rent for poor families o Similarly wage subsidies raise the living standards of the working poor without discouraging firms from hiring them All governments use taxes to raise revenue for public projects such as roads schools and national defense At an event to help raise revenue to pay for the event the town decides to place a 50 cent tax on the sale of ice cream cones When the government levies a tax on a good who actually bears the burden of the tax The people buying the good The people selling the good Or if buyers and sellers share the lax burden what determines how the burden is divided Tax incidence the manner in which the burden of a tax is shared among participants in a market How taxes on sellers affect market outcomes o When a tax is levied on sellers of a good Step One the immediate impact of the tax is on the sellers of ice cream Because it does not affect those who are buying it the demand curve does not change However the tax on sellers makes the ice cream business less profitable at any given price so it shifts the Step Two Because the tax on sellers raises the cost of producing and selling ice cream it reduces the quantity supplied at every price The supply curve shifts to the left upward It will shift upwards 50 cent because that is how much the tax is Step Three Because sellers sell less and buyers buy less in the new equilibrium the tax reduces the sieze of the ice cream market How Taxes on Buyers Affect Market Outcomes Implications Who pays the tax Although sellers send the entire tax to the government buyers and sellers share the burden o Taxes discourage market activity When a good is taxed the quantity of the good sold is smaller in the new equilibrium o Byers and sellers share the burden of taxes In the new equilibrium buyers pay more for the good and sellers receive less o Step One The initial impact of the tax is on the demand for ice cream The supply curve is not affected because for any given price of ice cream sellers have the same incentive to provide ice cream to the market However the tax shifts the demand curve for ice cream o Step Two Next determine the direction of the shift Because ice cream is more expensive buyers want less As a result the demand curve shifts to the left downward o Step Three once again the tax on ice cream reduces the size of the ice cream market And once gain buyers and sellers share the burden of the tax o Implications Conclusion taxes levied on sellers and taxes levied on buyers are equivalent Once the market reaches its new equilibrium buyers and sellers share the burden regardless of how the tax is levied Can Congress Distribute the Burden of a Payroll Tax o Payroll tax a tax on the wages that firms pay their workers o The key feature of the payroll tax is that it places a wedge between the wage that firms pay and the wage that workers receive o In the end workers and firms share the burden of the tax much as the legislation requires Elasticity and Tax Incidence When a good is taxed buyers and sellers