Economics for Banking and Insurance - I

PGDM : 2014 16
Term 1 (June September, 2014)
(Lecture 7)

Topics to Be Covered

Government Intervention and Market Equilibrium

Price Ceiling: Rent Control, Minimum Drug Price

Price Floor: Minimum Wage, Minimum Support

Price, Minimum Price

Incidence of Tax: Nominal and Economic

Incidence

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 equilibrium quantity).

Price control and Market Equilibrium

Price ceiling: a legal maximum on the price
of a good or service e.g., rent control

Price floor: a legal minimum on the price of

a good or service e.g., minimum wage

EXAMPLE 1: The Market for Apartments

P

Rental
price of
apts

$800

Eqm w/o
price controls
D
300

Quantity of
apartments
4

How Price Ceilings Affect Market Outcomes

A price ceiling
above the
eqm price is
not binding
has no effect
on the market
outcome.

S
Price
ceiling

$1000
$800

D
300

How Price Ceilings Affect Market Outcomes

The eqm price
($800) is above
the ceiling and
therefore illegal.
The ceiling
is a binding
constraint
on the price,
causes a shortage.

$800
Price
ceiling

$500
shortage
D
250

400

How Price Ceilings Affect Market Outcomes

In the long run,
supply and
demand
are more
price-elastic.
So, the shortage
is larger.

$800
Price
ceiling

$500
shortage
150

450

D
Q

EXAMPLE 2: The Market for Unskilled Labor

Wage
paid to
unskilled
workers

$4

Eqm w/o
price controls
D
500

Quantity of
unskilled workers
8

How Price Floors Affect Market Outcomes

A price floor
below the
eqm price is
not binding
has no effect
on the market
outcome.

$4
Price
floor

$3
D
500

How Price Floors Affect Market Outcomes

The eqm wage ($4) is
below the floor and
therefore
illegal.
The floor
is a binding
constraint
on the wage,
causes a
surplus (i.e.,
unemployment).

labor
surplus S

Price
floor

$5
$4

D
400

10

550

The Minimum Wage

Min wage laws
do not affect
highly skilled
workers.
They do affect teen
workers.

unemployment S

Min.
wage

$5
$4

Studies:
A 10% increase
in the min wage
raises teen
unemployment
by 1-3%.

D
400

11

550

Impact of Minimum Wage on Employment: Examples

from Different Studies

The Effect of the Minimum Wage on Prices (Lemos, Sara (2004))

The Response of Hours of Work to Increases in the Minimum Wage (Kenneth A. Couch & David C. Wittenburg
(2001))

This paper examines the effect of minimum wage increases on the hours of work of teenagers (ages 16 to 19) using monthly data from the Current Population
Survey. Our findings are consistent with the prediction from neoclassical theory that minimum wage increases have a negative effect on labor demand.
However, the estimates we provide here for the elasticity of hours of teen labor demanded with respect to the minimum wage suggest that alternative
estimates based on aggregate employment consistently understate the total impact of minimum wage increases on teenage labor utilization.

Employment Effects of the 2009 Minimum Wage Increase: Evidence from State Comparisons of At-Risk
Workers (Saul D. Hoffman & Chenglong Ke (2010))

It is well established in the international literature that minimum wage increases compress the wages distribution. Firms respond to these higher labor costs by
reducing employment, reducing profits, or raising prices. While there are hundreds of studies on the employment effect of the minimum wage, there is less
than a handful studies on its profit effects, and only a couple of dozen studies on its price effects. Not only is the literature scanty on the minimum wage price
effects, but also it lacks a survey on that. This survey represents an important contribution to the literature because it summarizes and critically compares over
twenty price effect studies, providing a benchmark in the literature. This survey further contributes to the literature by offering an input to the recent debate
over the direction of employment effects of the minimum wage. With employment and profits not significantly affected, higher prices is an obvious response
to a minimum wage increase. Moreover, this survey also contributes to the literature by extending the current understanding on the minimum wage as a policy
against inequality and poverty. If the minimum wage does not cause disemployment but causes inflation, it might hurt rather than aid the poor, who
disproportionately suffer from inflation.

In July, 2009, the U.S. Federal minimum wage was increased from $6.55 to $7.25. Individuals in some states were unaffected by this increase, since the state
minimum wage already exceeded $7.25 and the state minimum was not increased further. The study uses this variation, as well as variation in the actual
amount of the increase, to make comparisons of the employment of at-risk workers across states with their peers and within states with workers arguably
unaffected by the increase. The data come from the 2009 CPS, four and five months before and after the increase. The study finds some evidence that the
employment of some at-risk demographic groups declined as a result of the minimum wage increase, but the impacts are not statistically significant. The
study also finds that the employment changes were not responsive to the actual amount of the increase.

Does Raising the Minimum Wage Help the Poor? (Andrew Leigh (2005))

What is the impact of raising the minimum wage on family incomes? Analyzing the characteristics of low wage workers, this study an increase in the minimum
wage reduces hourly wage inequality (recall that zero hourly wages are ignored). Even in the event that an increase in the minimum wage has only a disemployment effect, and has
no impact on hourly wages, it will still have the effect of reducing hourly wage dispersion among those who remain employed.

Consumer Surplus
consumer surplus Difference between what a consumer is willing to
pay for a good and the amount actually paid.

Consumer Surplus and Demand

Consumer Surplus

Consumer surplus is the

total benefit from the
consumption of a product,
less the total cost of
purchasing it.
Here, the consumer surplus
associated with six concert
tickets (purchased at $14
per ticket) is given by the
yellow-shaded area.

Consumer Surplus
Consumer Surplus and Demand
Consumer Surplus Generalized

For the market as a whole, consumer

surplus is measured by the area under
the demand curve and above the line
representing the purchase price of the
good.
Here, the consumer surplus is given
by the yellow-shaded triangle and is
equal to
1/2 ($20 $14) 6500 = $19,500.

Applying Consumer Surplus

When added over many individuals, it measures the aggregate benefit that
consumers obtain from buying goods in a market.
When we combine consumer surplus with the aggregate profits that producers
obtain, we can evaluate both the costs and benefits not only of alternative
market structures, but of public policies that alter the behavior of consumers
and firms in those markets.

Consumer Surplus
To encourage cleaner air, Congress passed the
Clean Air Act in 1977 and has since amended it a
number of times.

Valuing Cleaner Air

The yellow-shaded triangle gives

the consumer surplus generated
when air pollution is reduced by 5
parts per 100 million of nitrogen
oxide at a cost of $1000 per part
reduced.
The surplus is created because
most consumers are willing to pay
more than $1000 for each unit
reduction of nitrogen oxide.

Consumer and Producer Surplus

Consumer and Producer

Surplus

Consumer A would pay $10

for a good whose market
price is $5 and therefore
enjoys a benefit of $5.

Consumer B enjoys a
benefit of $2,
and Consumer C, who
values the good at exactly
the market price, enjoys no
benefit.

Consumer surplus, which

measures the total benefit to
all consumers, is the yellowshaded area between the
demand curve and the
market price.

Consumer and Producer Surplus

Consumer and Producer

Surplus (continued)

Producer surplus measures

the total profits of producers,
plus rents to factor inputs.
It is the green-shaded area
between the supply curve
and the market price.
Together, consumer and
producer surplus measure
the welfare benefit of a
competitive market.

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 specific amount for each unit purchased or sold,
known as per-unit or excise or quantity tax
When the tax is levied on price it is called Price Tax. A price tax is a
per-Rupee (as opposed to per-unit) tax. Also known as Ad Valorem
tax
Examples: sales tax, interest tax, value-added tax (VAT)
For simplicity, we will analyze per-unit or quantity or excise taxes
only.
18

EXAMPLE 3: The Market for Pizza

Eqm
w/o tax

P
S1
$10.00

D1

500
19

A Tax on Buyers
Hence,
a tax
on buyers
The
price
buyers
pay
is
nowthe
$1.50
higher
thanby
shifts
D curve
down
P
the market
amount price
of theP.tax.
P would have to fall
by $1.50 to make
buyers willing
$10.00
to buy same Q
as before.
$8.50
E.g., if P falls
from $10.00 to $8.50,
buyers still willing to
purchase 500 pizzas.
20

Effects of a $1.50 per

unit tax on buyers
S1
Tax

D1
D2

500

A Tax on Buyers
New eqm:

Effects of a $1.50 per

unit tax on buyers

Q = 450
Sellers
receive
PS = $9.50
Buyers pay
PB = $11.00

P
S1

PB = $11.00

Tax

$10.00
PS = $9.50

D1

Difference
between them
= $1.50 = tax

D2

450 500
21

The Incidence of a Tax:

The burden of a tax is shared among market participants i.e.,
buyers and sellers

In our
example,
buyers pay
$1.00 more,

P
S1

PB = $11.00

Tax

$10.00
PS = $9.50

sellers get
$0.50 less.

D1
D2

450 500
22

A Tax on Sellers
The tax effectively raises
sellers costs by
P
$1.50 per pizza.
$11.50

Sellers will supply

500 pizzas
only if
P rises to $11.50,
to compensate for
this cost increase.

Effects of a $1.50 per

unit tax on sellers
S2
Tax S1

$10.00

D1

Hence, a tax on sellers shifts the

S curve up by the amount of the tax.
23

500

A Tax on Sellers
New eqm:

Effects of a $1.50 per

unit tax on sellers

Q = 450
Buyers pay
PB = $11.00
Sellers
receive
PS = $9.50

S2
S1

PB = $11.00

Tax

$10.00
PS = $9.50

D1

Difference
between them
= $1.50 = tax

450 500
24

The Outcome Is the Same in Both Cases!

The effects on P and Q, and the tax incidence are the same whether
the tax is imposed on buyers or sellers: Tax Equivalence

What matters
is this:
A tax drives
a wedge
between the
price buyers
pay and the
price sellers
receive.

P
S1

PB = $11.00

Tax

$10.00
PS = $9.50

D1

450 500
25

Elasticity and Tax Incidence

CASE 1: Supply is more elastic than demand
Its easier
for sellers
than buyers
to leave the
market.

Buyers share of
tax burden

PB

S
Tax

Price if no tax

Sellers share of
tax burden

So buyers
bear most of
the burden
of the tax.

PS
D
Q
26

Elasticity and Tax Incidence

CASE 2: Demand is more elastic than supply
P

Buyers share of
tax burden

PB

Price if no tax

Sellers share of
tax burden

Its easier for

buyers than
sellers to
leave the
market.

Tax
PS

Sellers bear
most of the
burden of
the tax.

D
Q
27

Incidence of Tax and Deadweight Loss (DWL)

Tax Incidence and Efficiency Costs of Taxation; Emmanuel Saez, University of California, Berkely
28

Effect of an Excise Tax: An Algebraic Approach

The Demand function: P B a bQ d and The Supply Function :P S c dQ s
Pre-Tax Equilibrium P B P S or Q d Q s a bQ c dQ
Equilibrium Quantity and Price: P E

ad bc
ac
and Q E
bd
bd

A unit tax of amount t is imposed on buyers.

So, post-tax equilibrium P B P S t a bQ c dQ t

t
Therefore, Post-Tax equilibrium Quantity:Q Q
; and
bd
b
d
BE
E
SE
E
) t and P P (
) t
Post-Tax Equilibrium Prices:P P (
bd
bd
E
t

E
t