4 Files 12:47 PM Mon May 16 Insert Draw Layout Review View Unit 3Microec0nomics Name: ELASTICITY Use the space below to take notes during class. Elastic: Unit Elastic: Inelastic: Perfect Elasticity/lnelasticity: Elastic Demand Unit Elastic Demand Inelastic Demand > p , Elastic Supply Unit Elastic Supply Inelastic Supply Welcome back! 1 hour ago > p , 4 Files 12:47 PM Mon May 16 Insert Draw Layout Review View Unit 3Microeconomics Name: MARKET STRUCTURES Use the space below to take notes during class. Perfect Competition: Monopolistic Competition: Differentiated Products: Oligopoly: Collude: Mutual Interdependence: Monopoly: Complete the "Market Structures" assignment in Canvas. \f4 Files 12:47 PM Mon May 16 Insert Draw Layout Review View Unit 3Microec0nomics Name: PRICE CONTROLS Use the space below to take notes during class. Price Controls: Price Ceiling: Price Floor: Subsidy: Price Floor Price Ceiling Complete the "Price Controls\" assignment in Canvas. 4 Files 12:47 PM Mon May 16 Insert Draw Layout Review View Unit 3Microeconomics Name: CONSUMER AND PRODUCER SURPLUS Use the space below to take notes during class. Efficient: Inefficient: Consumer Surplus: Producer Surplus: Total Surplus: Price Quantity 4 Files 12:47 PM Mon May 16 Insert Draw Layout Review View Unit 3Microeconomics Name: TAX INCIDENCE Use the space below to take notes during class. Tax Incidence/burden: Tax Revenue: Both curves unit elastic Supply more inelastic than Demand Demand more inelastic than Supply \f4 Files 12:47 PM Mon May 16 Insert Draw Layout Review View Unit 3Microeconomics Name: DWL PRACTICE Use different colored writing utensils to shade in the areas described below. Calculate the areas when asked to do 50. Remember the area of a triangle is one-half base times height. 1. On the graph to the right, show a price floor :0 51 at $7 and shade in consumer surplus in red. 8 Shade in the producer surplus in blue. Lastly, shade in the deadweight loss in 7 black. Calculate the following; 3 6 a : a. Consumer surplus S 3 b. Producer surplus S 2 1 c. Deadweight loss 3 0 012345678910 Quantity 2. On the graph to the right, show a price ceiling at $3 and shade in consumer surplus in red. Shade in the producer surplus in 1 blue. Lastly, shade in the deadweight loss in black. Calculate the following; a. Consumer surplus S Price b. Producer surplus S c. Deadweight loss 3 OI'NUJ-DU'IUNNOOLD 012345678910 Quantity 4 Files 12:47 PM Mon May 16 Insert Draw Layout Review View Name: Good A H O 3. On the graph, show a $3/unit tax by drawing a $2 curve shifted vertically $3. Shade in consumer surplus in red. Shade in the producer surplus in blue. Lastly, shade in the deadweight loss in black. Calculate the following; a. Total tax revenue 5 b. Consumers' tax burden $ Price Oi'Nwhwmxlookb 012345678910 c. Producers' tax burden 5 Quantity 4. 0n the graph to the right, show a price ceiling at $3 and shade in consumer surplus in red. Shade in the producer surplus in blue. Lastly, shade in the deadweight loss in black. Calculate the following; Good B H O a. Total tax revenue 5 b. Consumers' tax burden S Price c. Producers' tax burden S OHNUJJ>U105H00 012345678910 Quantity 5. Complete the \"Deadweight Loss\" assignment in Canvas 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3lVIicroeconomics Unit 3--Microeconomics Learning Targets: - Differentiate between supply and demand and the resulting impact on equilibrium prices and quantities produced. - Compare and contrast various degrees of competition in markets (e.g., perfect competition, monopolistic competition, oligopoly, monopoly) and how the extent of competition in various markets can affect price, quantity, and variety. 0 Evaluate the intended and unintended costs and benefits (i.e., externalities) of government policies to improve market outcomes and standards of living. Elasticity Anyone who has studied economics knows the law of demand: a higher price will lead to a lower quantity demanded. What you may not know is how much lower the quantity demanded will be. Similarly, the law of supply states that a higher price will lead to a higher quantity supplied. The question is: How much higher? This chapter will explain how to answerthese questions and why they are critically important in the real world. To find answers to these questions, we need to understand the concept of elasticity. Elasticity is an economics concept that measures responsiveness of one variable to changes in another variable. Suppose you drop two items from a second-floor balcony. The first item is a tennis ball. The second item is a brick. Which will bounce higher? Obviously, the tennis ball. We would say that the tennis ball has greater elasticity. We can usefully divide elasticities into three broad categories: elastic, inelastic, and unitary. An elastic demand or elastic supply is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price. Elasticities that are less than one indicate low responsiveness to price changes and correspond to inelastic demand or inelastic supply. Unitary elasticities indicate proportional responsiveness of either demand or supply. Perfect elasticity refers to the extreme case where either the quantity changes by an infinite amount in response to any change in price at all. The resulting curves are horizontal. Perfect inelasticity refers to the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. The resulting curves are vertical. Consider an economic example. Cigarette taxes are an example ofa \"sin tax,\" a tax on something that is bad for you, like alcohol. Governments tax cigarettes at the state and national levels. State taxes range from a low of 17 cents per pack in Missouri to $4.35 per pack in New York. The average state cigarette tax is $1.69 per pack. The 2014 federal tax rate on cigarettes was $1.01 per pack, but in 2015 the Obama Administration proposed raising the federal tax nearly a dollar to $1.95 per pack. The key question is: How much would cigarette purchases decline? Taxes on cigarettes serve two purposes: to raise tax revenue for government and to discourage cigarette consumption. However, if a higher cigarette tax discourages consumption considerably, meaning a greatly reduced quantity of cigarette sales, then the cigarette tax on each pack will not raise much revenue for the government. Alternatively, a higher cigarette tax that does not discourage consumption by much will actually raise more tax revenue for the government. Thus, when a government agency tries to calculate the effects of altering its cigarette tax, it must analyze how much the tax affects the quantity ofcigarettes consumed. This issue reaches beyond governments and taxes. Every firm faces a similar issue. When a firm considers raising the sales price, it must consider how much a price increase will reduce the quantity demanded of what it sells. Conversely, when a firm Access for free at httpszl/openstax.org/books/principles-economics-Ze/pages/t-intr0duction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3-Microeconomics puts its products on sale, it must expect (or hope) that the lower price will lead to a significantly higher quantity demanded. Can Businesses Pass Costs on to Consumers? Most businesses face a day-to-day struggle to figure out ways to produce at a lower cost, as one pathway to their goal of earning higher profits. However, in some cases, the price ofa key input over which the firm has no control may rise. For example, many chemical companies use petroleum as a key input, but they have no control over the world market price for crude oil. Coffee shops use coffee as a key input, but they have no control over the world market price of coffee. Ifthe cost of a key input rises, can the firm pass those higher costs along to consumers in the form of higher prices? Conversely, if new and less expensive ways of producing are invented, can the firm keep the benefits in the form of higher profits, or will the market pressure them to pass the gains along to consumers in the form of lower prices? The price elasticity of demand plays a key role in answering these questions. Imagine that as a consumer of legal pharmaceutical products, you read a newspaper story that a technological breakthrough in the production of aspirin has occurred, so that every aspirin factory can now produce aspirin more cheaply. What does this discovery mean to you? Figure 5.8 illustrates two possibilities. In Figure 5.8 (a), the demand curve is highly inelastic. In this case, a technological breakthrough that shifts supply to the right, from 50 to 51, so that the equilibrium shifts from E0 to E1, creates a substantially lower price for the product with relatively little impact on the quantity sold. In Figure 5.8 (b), the demand curve is highly elastic. In this case, the technological breakthrough leads to a much greater quantity sold in the market at very close to the original price. Consumers benefit more, in general, when the demand curve is more inelastic because the shift in the supply results in a much lower price for consumers. Figure 5.8 Passing along Cost Savings to Consumers Cost-saving gains cause supply to shift out to the right from 50 to 51; that is, at any given price, firms will be willing to supply a greater quantity. If demand is inelastic, as in (a), the result ofthis cost-saving technological improvement will be substantially lower prices. If demand is elastic, as in (b), the result will be only slightly lower prices. Consumers benefit in laICOSI-S-'IVInQ wm Inelastic demand (biCost-sawrewm elastic demand either case, from a greater quantity at a lower price, but the benefit is greater when demand is inelastic, as in (a). Aspirin producers may find themselves in a nasty bind here. The situation in Figure 5.8, with extremely inelastic demand, means that a new invention may cause the price to drop dramatically while quantity changes little. As a result, the new production technology can lead to a drop in the revenue that firms earn from aspirin sales. However, if strong competition exists between aspirin producer, each producer may have little choice but to search for and implement any breakthrough that allows it to reduce production costs. After all, if one firm decides not to implement such a cost-saving technology, other rms that do can drive them out of business. Since demand for food is generally inelastic, farmers may often face the situation in Figure 5.8 (a). That is, a surge in production leads to a severe drop in price that can actually decrease the total revenue that farmers receive. Conversely, poor weather or other conditions that cause a terrible year for farm production can sharply raise prices so that the total revenue that the farmer receives increases. Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/t-intr0duction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3Microeconomics Market Structures Many rms Many rms Few rms One rm Identical Similar but Identical or No similar product not identical similar product products products Perfect Monopolistic Oligopoly Monopoly Competition Competition Figure 7.2 The Spectrum of Competition Firms face different competitive situations. At one extreme perfect competitionmany firms are all trying to sell identical products. At the other extreme monopolyonly one firm is selling the product, and this rm faces no competition. Monopolistic competition and oligopolyfall between the extremes of perfect competition and monopoly. Monopolistic competition is a situation with many firms selling similar, but not identical products. Oligopoly is a situation with few firms that sell identical or similar products. Perfect Competition Firms are in perfect competition when the following conditions occur: (1) many firms produce identical products; (2) many buyers are available to buy the product, and many sellers are available to sell the product; (3) sellers and buyers have all relevant information to make rational decisions about the product that they are buying and selling; and (4) firms can enter and leave the market without any restrictionsin other words, there is free entry and exit into and out of the market. A perfectly competitive firm is known as a price taker, because the pressure of competing firms forces it to accept the prevailing equilibrium price in the market. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors. When a wheat grower, as we discussed in the Bring It Home feature, wants to know the going price of wheat, he or she has to check on the computer or listen to the radio. Supply and demand in the entire market solely determine the market price, not the individual farmer. A perfectly competitive firm must be a very small player in the overall market, so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market. A perfectly competitive market is a hypothetical extreme; however, producers in a number of industries do face many competitor firms selling highly similar goods, in which case they must often act as price takers. Economists often use agricultural markets as an example. The same crops that different farmers grow are largely interchangeable. According to the United States Department of Agriculture monthly reports, in 2015, US. corn farmers received an average price of $6.00 per bushel. A com farmer who attempted to sell at $7.00 per bushel, would not have found any buyers. A perfectly competitive firm will not sell below the equilibrium price either. Why should they when they can sell all they want at the higher price? Other examples of agricultural markets that operate in close to perfectly competitive markets are small roadside produce markets and small organic farmers. Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/1introduction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3Microecon0mics Monopolistic Competition Monopolistic competition involves many firms competing against each other, but selling products that are distinctive in some way. Examples include stores that sell different styles of clothing; restaurants or grocery stores that sell a variety of food; and even products like golf balls or beer that may be at least somewhat similar but differ in public perception because of advertising and brand names. There are over 600,000 restaurants in the United States. When products are distinctive, each firm has a mini- monopoly on its particular style or avor or brand name. However, firms producing such products must also compete with other styles and flavors and brand names. The term \"monopolistic competition\" captures this mixture of mini-monopoly and tough competition, and the following Clear It Up feature introduces its derivation. A firm can try to make its products different from those of its competitors in several ways: physical aspects of the product, location from which it sells the product, intangible aspects of the product, and perceptions of the product. We call products that are distinctive in one of these ways differentiated products. Physical aspects of a product include all the phrases you hear in advertisements: unbreakable bottle, nonstick surface, freezer-to-microwave, non-shrink, extra spicy, newly redesigned for your comfort. A rm's location can also create a difference between producers. For example, a gas station located at a heavily traveled intersection can probably sell more gas, because more cars drive by that corner. A supplier to an automobile manufacturer may find that it is an advantage to locate close to the car factory. Intangible aspects can differentiate a product, too. Some intangible aspects may he promises like a guarantee of satisfaction or money back, a reputation for high quality, services like free delivery, or offering a loan to purchase the product. Finally, product differentiation may occur in the minds of buyers. For example, many people could not tell the difference in taste between common varieties of ketchup or mayonnaise if they were blindfolded but, because of past habits and advertising, they have strong preferences for certain brands. Advertising can play a role in shaping these intangible preferences. The concept of differentiated products is closely related to the degree of variety that is available. If everyone in the economy wore only blue jeans, ate only white bread, and drank only tap water, then the markets for clothing, food, and drink would be much closer to perfectly competitive. The variety of styles, flavors, locations, and characteristics creates product differentiation and monopolistic competition. Oligopoly Many purchases that individuals make at the retail level are produced in markets that are neither perfectly competitive, monopolies, nor monopolistically competitive. Rather, they are oligopolies. oligopoly arises when a small number of large firms have all or most of the sales in an industry. Examples of oligopoly abound and include the auto industry, cable television, and commercial air travel. Oligopolistic firms are like cats in a bag. They can either scratch each other to pieces or cuddle up and get comfortable with one another. If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/t-introduction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3-Microeconomics collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit. We typically characterize oligopolies by mutual interdependence where various decisions such as output, price, and advertising depend on other rm(s)' decisions. Analyzing the choices of oligopolistic firms about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time. A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each has its own drug for reducing high blood pressure, those three rms may become an oligopoly. The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task. Monopoly Many believe that top executives at firms are the strongest supporters of market competition, but this belief is far from the truth. Think about it this way: If you very much wanted to win an Olympic gold medal, would you rather be far better than everyone else, or locked in competition with many athletes just as good as you? Similarly, if you would like to attain a very high level of profits, would you rather manage a business with little or no competition, or struggle against many tough competitors who are trying to sell to your customers? By now, you might have read the chapter on Perfect Competition. In this chapter, we explore the opposite extreme: monopoly. If perfect competition is a market where rms have no market power and they simply respond to the market price, monopoly is a market with no competition at all, and firms have a great deal of market power. In the case of monopoly, one firm produces all of the output in a market. Since a monopoly faces no significant competition, it can charge any price it wishes, subject to the demand curve. While a monopoly, by denition, refers to a single firm, in practice people often use the term to describe a market in which one firm merely has a very high market share. This tends to be the definition that the U.S. Department ofJustice uses. Even though there are very few true monopolies in existence, we do deal with some of those few every day, often without realizing it: The U.S. Postal Service, your electric, and garbage collection companies are a few examples. Some new drugs are produced by only one pharmaceutical firmand no close substitutes for that drug may exist. From the mid-19905 until 2004, the U.S. Department ofJustice prosecuted the Microsoft Corporation for including Internet Explorer as the default web browser with its operating system. The Justice Department's argument was that, since Microsoft possessed an extremely high market share in the industry for operating systems, the inclusion of a free web browser constituted unfair competition to other browsers, such as Netscape Navigator. Since nearly everyone was using Windows, including Internet Explorer eliminated the incentive for consumers to explore other browsers and made it impossible for competitors to gain a foothold in the market. In 2013, the Windows system ran on more than 90% of the most commonly sold personal computers. In 2015, a U.S. federal court tossed out antitrust charges that Google had an agreement with mobile device makers to set Google as the default search engine. Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/'I-introduction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3Microeconomics Externalities Private markets, such as the cell phone industry, offer an efficient way to put buyers and sellers together and determine what goods they produce, how they produce them and who gets them. The principle that voluntary exchange benefits both buyers and sellers is a fundamental building block of the economic way of thinking. However, what happens when a voluntary exchange affects a third party who is neither the buyer nor the seller? As an example, consider a concert producer who wants to build an outdoor arena that will host country music concerts a half-mile from your neighborhood. You will be able to hear these outdoor concerts while sitting on your back porchor perhaps even in your dining room. In this case, the sellers and buyers of concert tickets may both be quite satisfied with their voluntary exchange, but you have no voice in their market transaction. The effect of a market exchange on a third party who is outside or \"external" to the exchange is called an externality. Because externalities that occur in market transactions affect other parties beyond those involved, they are sometimes called spillovers. Externalities can be negative or positive. If you hate country music, then having it waft into your house every night would be a negative externality. lfyou love country music, then what amounts to a series of free concerts would be a positive externality. Pollution as a Negative Externality Pollution is a negative externality. Economists illustrate the social costs of production with a demand and supply diagram. The social costs include the private costs of production that a company incurs and the external costs of pollution that pass on to society. Figure 12.2 shows the demand and supply for manufacturing refrigerators. The demand curve (D) shows the quantity demanded at each price. The supply curve (W shows the quantity of refrigerators that all firms in the industry supply at each price assuming they are taking only their private costs into account and they are allowed to emit pollution at zero cost. The market equilibrium (E0), where quantity supplied equals quantity demanded, is at a price of $650 per refrigerator and a quantity of 45,000 refrigerators. Table 12.2 reflects this information in the rst three columns. Figure 12.2 Taking Social Costs into Account: A 950 Sm. Sm Supply Shift if the firm takes only its own costs 900 of production into account, then its supply curve 650 will be Sprivate, and the market equilibrium will 3 800 occur at E0. Accounting for additional external E 750 (40,000,700) E,'\\ costs of $100 for every unit produced, the firm's E 700 777777777777777 : supply curve will be Ssocial. The new equilibrium 650 r Eo(45,000,650) . 600 : Will occur at 51. 550 l D l 10,000 30,000 50,000 70,000 Refrigerators Access for free at httpszllopensiax.org/books/principles-economics-Ze/pages/1introduction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3Microeconomics Quantity Quantity Supplied before Considering Quantity Supplied after Considering Prlce Demanded Pollution Cost Pollution Cost $600 50,000 30,000 $650 45,000 35,000 $700 40,000 40,000 $750 35,000 45,000 5800 30,000 50,000 $850 25,000 $900 20,000 70,000 60,000 Table12.2 A Supply Shift Caused by Pollution Costs 55,000 However, as a by-product of the metals, plastics, chemicals and energy that refrigerator manufacturers use, some pollution is created. Let's say that, if these pollutants were emitted into the air and water, they would create costs of $100 per refrigerator produced. These costs might occur because of adverse effects on human health, property values, or wildlife habitat, reduction of recreation possibilities, or because of other negative impacts. In a market with no anti-pollution restrictions, firms can dispose of certain wastes absolutely free. Now imagine that rms which produce refrigerators must factor in these external costs of pollutionthat is, the firms have to consider not only labor and material costs, but also the broader costs to society of harm to health and other costs caused by pollution. If the rm is required to pay $100 for the additional external costs of pollution each time it produces a refrigerator, production becomes more costly and the entire supply curve shifts up by $100. As Table 12.2 and Figure 12.2 illustrate, the firm will need to receive a price of $700 per refrigerator and produce a quantity of 40,000and the firm's new supply curve will be 5.3%- The new equilibrium will occur at E1. In short, taking the additional external costs of pollution into account results in a higher price, a lower quantity of production, and a lower quantity of pollution. Remember that the supply curve is based on choices about production that firms make while looking at their marginal costs, while the demand curve is based on the benefits that individuals perceive while maximizing utility. If no externalities existed, private costs would be the same as the costs to society as a whole, and private benefits would be the same as the benefits to society as a whole. Thus, if no externalities existed, the interaction of demand and supply will coordinate social costs and benefits. However, when the externality of pollution exists, the supply curve no longer represents all social costs. Because externalities represent a case where markets no longer consider all social costs, but only some of them, economists commonly refer to externalities as an example of market failure. When there is market failure, the private market fails to achieve efficient output, because either firms do not account for all costs incurred in the production of output and/or consumers do not account for all benefits obtained (a positive externality). In the case of pollution, at the market output, social costs of production exceed social benefits to consumers, and the market produces too much of the product. Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/'I-introduction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3-Microeconomics We can see a general lesson here. If firms were required to pay the social costs of pollution, they would create less pollution but produce less of the product and charge a higher price. In the next lessons, we will explore how governments require firms to account for the social costs of pollution. The Positive Externalities of New Technology Will private firms in a market economy underinvest in research and technology? If a firm builds a factory or buys a piece of equipment, the firm receives all the economic benefits that result from the investments. However, when a firm invests in new technology, the private benefits, or profits, that the rm receives are only a portion of the overall social benefits. The social benefits of an innovation account for the value of all the positive externalities of the new idea or product, whether enjoyed by other companies or society as a whole, as well as the private benefits the firm that developed the new technology receives. As you learned in Environmental Protection and Negative Externalities, positive externalities are beneficial spillovers to a third party, or parties. Consider the example ofthe Big Drug Company, which is planning its research and development budget for the next year. Economists and scientists working for Big Drug have compiled a list of potential research and development projects and estimated rates of return. (The rate of return is the estimated payoff from the project.) The downward-sloping Mcurve represents the firm's demand for financial capital and reflects the company's willingness to borrow to finance research and development projects at various interest rates. Suppose that this firm's investment in research and development creates a spillover benefit to other firms and households. After all, new innovations often spark other creative endeavors that society also values. If we add the spillover benefits society enjoys to the firm's private demand for financial capital, we can draw PM\" that lies above PM- If there were a way for the firm to fully monopolize those social benefits by somehow making them unavailable to the rest of us, the firm's private demand curve would be the same as society's demand curve. According to Figure 13.2 and Table 13.1, if the going rate of interest on borrowing is 8%, and the company can receive the private benefits of innovation only, then the company would finance $30 million. Society, at the same rate of 8%, would find it optimal to have $52 million of borrowing. Unless there is a way for the company to fully enjoy the total benefits, then it will borrow less than the socially optimal level of $52 million. Figure 13.2 Positive Externalities and Technology Big Drug faces a cost of borrowing of 8%. If the firm receives only the private benets of investing in R&D, then we show its demand curve for financial capital by m and the equilibrium will occur at $30 million. Because there are spillover benefits, society would find it optimal to have $52 million of $15 $30 $45352 $50 575 590 investment. Iftl'iefirm could keep the social benets of its investment for itself, its demand curve for nancial capital would be QM and it would be willing to borrow $52 million. 1 0% 8% 5% Rate of Romm 4% 2% I l l i l i l i l i l I i l i l I l i l i l l Quantity of Financial Capital Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/t-intr0duction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3lVIicroeconomics Rate of Return DPrivate (in millions) DSocial (in millions) Tab|e13.1 Return and Demand for Capital Big Drug's original demand for financial capital (93%;) is based on the profits received the firm receives. However, other pharmaceutical firms and health care companies may learn new lessons about how to treat certain medical conditions and are then able to create their own competing products. The social benet ofthe drug takes into account the value of all the drug's positive externalities. If Big Drug were able to gain this social return instead of other companies, its demand for nancial capital would shift to the demand curve 9.5mm and it would be willing to borrow and invest $52 million. However, if Big Drug is receiving only 50 cents of each dollar of social benefits, the firm will not spend as much on creating new products. The amount it would be willing to spend would fall somewhere in between Wand 9.5m Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/t-intr0duction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3-Microeconomics Price Controls Government Influence Governments often act to correct market failures and to account for externalities. In this section, we will explore the outcomes, both anticipated and otherwise, when government does intervene in a market to prevent the price of some good or service from rising \"too high\" or to prevent the price of some good or service from falling \"too low\" or to change the quantity to better reflect socially optimal costs or benets. Economists believe there are a small number of fundamental principles that explain how economic agents respond in different situations. Two ofthese principles are the laws of demand and supply. Governments can pass laws affecting market outcomes, but no law can negate these economic principles. Rather, the principles will become apparent in sometimes unexpected ways, which may undermine the intent of the government policy. This is one of the major conclusions of this section. Controversy sometimes surrounds the prices and quantities established by demand and supply, especially for products that are considered necessities. In some cases, discontent over prices turns into public pressure on politicians, who may then pass legislation to prevent a certain price from climbing \"too high" or falling "too low." The demand and supply model shows how people and firms will react to the incentives that these laws provide to control prices, in ways that will often lead to undesirable consequences. Alternative policy tools can often achieve the desired goals of price control laws, while avoiding at least some of their costs and tradeoffs. Price Ceilings Laws that government enact to regulate prices are called price controls. Price controls come in two avors. A price ceiling keeps a price from rising above a certain level (the \"ceiling\"), while a price floor keeps a price from falling below a given level (the \"floor"). A price ceiling is a legal maximum price that one pays for some good or service. A government imposes price ceilings in order to keep the price of some necessary good or service affordable. For example, in 2005 during Hurricane Katrina, the price of bottled water increased above $5 per gallon. As a result, many people called for price controls on bottled water to prevent the price from rising so high. In this particular case, the government did not impose a price ceiling, but there are other examples of where price ceilings did occur. In many markets for goods and services, demanders outnumber suppliers. Consumers, who are also potential voters, sometimes unite behind a political proposal to hold down a certain price. In some cities, such as Albany, renters have pressed political leaders to pass rent control laws, a price ceiling that usually works by stating that landlords can raise rents by only a certain maximum percentage each year. Some of the best examples of rent control occur in urban areas such as New York, Washington D.C., or San Francisco. Rent control becomes a politically hot topic when rents begin to rise rapidly. Everyone needs an affordable place to live. Perhaps a change in tastes makes a certain suburb or town a more popular 10 Access for free at httpszlfopenstax.org/books/principles-economics-Ze/pages/t-introduction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3Microeconomics place to live. Perhaps locally-based businesses expand, bringing higher incomes and more people into the area. Such changes can cause a change in the demand for rental housing, as Figure 3.21 illustrates. The original equilibrium (E0) lies at the intersection of supply curve SO and demand curve D0, corresponding to an equilibrium price of $500 and an equilibrium quantity of 15,000 units of rental housing. The effect of greater income or a change in tastes is to shift the demand curve for rental housing to the right, as the data in Table 3.7 shows and the shift from D0 to D1 on the graph. In this market, at the new equilibrium E1, the price of a rental unit would rise to $600 and the equilibrium quantity would increase to 17,000 units. 5900 $800 $700 $600 $500 $400 $300 $200 $100 0 Price ceiling set here Excess demand 1 or shortage 1 from price ceiling } Price (dollars In monthly rent) I lllllllllillill 10111213141516171819 20 2122 23 24 Quantity (thousands of rental units} Figure 3.21 A Price Ceiling ExampleRent Control The original intersection of demand and supply occurs at E0. If demand shifts from D0 to D1, the new equilibrium would be at E1unless a price ceiling prevents the price from rising. If the price is not permitted to rise, the quantity supplied remains at 15,000. However, after the change in demand, the quantity demanded rises to 19,000, resulting in a shortage. Original Quantity Supplied Original Quantity Demanded New Quantity Demanded 5400 12,000 18,000 23,000 5500 15,000 15,000 19,000 5600 17,000 13,000 17,000 5700 19,000 11,000 15,000 5800 20,000 10,000 14,000 Table3.7 Rent Control Suppose that a city government passes a rent control law to keep the price at the original equilibrium of $500 for a typical apartment. In Figure 3.21, the horizontal line at the price of 5500 shows the legally xed maximum price set by the rent control law. However, the underlying forces that shifted the 11 Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/t-introduction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3Microeconomics demand curve to the right are still there. At that price ($500), the quantity supplied remains at the same 15,000 rental units, but the quantity demanded is 19,000 rental units. In other words, the quantity demanded exceeds the quantity supplied, so there is a shortage of rental housing. One of the ironies of price ceilings is that while the price ceiling was intended to help renters, there are actually fewer apartments rented out under the price ceiling (15,000 rental units) than would be the case at the market rent of $600 (17,000 rental units). Price ceilings do not simply benefit renters at the expense of landlords. Rather, some renters (or potential renters) lose their housing as landlords convert apartments to coops and condos. Even when the housing remains in the rental market, landlords tend to spend less on maintenance and on essentials like heating, cooling, hot water, and lighting. The first rule of economics is you do not get something for nothingeverything has an opportunity cost. Th us, if renters obtain \"cheaper\" housing than the market requires, they tend to also end up with lower quality housing. Price ceilings are enacted in an attempt to keep prices low for those who need the product. However, when the market price is not allowed to rise to the equilibrium level, quantity demanded exceeds quantity supplied, and thus a shortage occurs. Those who manage to purchase the product at the lower price given by the price ceiling will benefit, but sellers of the product will suffer, along with those who are not able to purchase the product at all. Quality is also likely to deteriorate. Price Floors A price floor is the lowest price that one can legally pay for some good or service. Perhaps the best- known example of a price floor is the minimum wage, which is based on the view that someone working full time should be able to afford a basic standard of living. The federal minimum wage in 2016 was $7.25 per hour, although some states and localities have a higher minimum wage. The federal minimum wage yields an annual income for a single person of $15,080, which is slightly higher than the Federal poverty line of $11,880. As the cost of living rises over time, the Congress periodically raises the federal minimum wage. Price floors are sometimes called "price supports,\" because they support a price by preventing it from falling below a certain level. Around the world, many countries have passed laws to create agricultural price supports. Farm prices and thus farm incomes fluctuate, sometimes widely. Even if, on average, farm incomes are adequate, some years they can be quite low. The purpose of price supports is to prevent these swings. The most common way price supports work is that the government enters the market and buys up the product, adding to demand to keep prices higher than they otherwise would be. According to the Common Agricultural Policy reform passed in 2013, the European Union (EU) will spend about 60 billion euros per year, or 67 billion dollars per year (with the November 2016 exchange rate), or roughly 38% of the EU budget, on price supports for Europe's farmers from 2014 to 2020. Figure 3.22 illustrates the effects of a government program that assures a price above the equilibrium by focusing on the market for wheat in Europe. In the absence of government intervention, the price would adjust so that the quantity supplied would equal the quantity demanded at the equilibrium point E0, with price P0 and quantity (10. However, policies to keep prices high for farmers keeps the price above what would have been the market equilibrium levelthe price Pf shown by the dashed horizontal line in 12 Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/t-intr0duction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3-Microeconomics the diagram. The result is a quantity supplied in excess of the quantity demanded (Q). When quantity supplied exceeds quantity demanded, a surplus exists. Economists estimate that the high-income areas of the world, including the United States, Europe, and Japan, spend roughly $1 billion per day in supporting their farmers. If the government is willing to purchase the excess supply (or to provide payments for others to purchase it), then farmers will benefit from the price floor, but taxpayers and consumers of food will pay the costs. Agricultural economists and policy makers have offered numerous proposals for reducing farm subsidies. In many countries, however, political support for subsidies for farmers remains strong. This is either because the population views this as supporting the traditional rural way of life or because of industry's lobbying power of the agro-business. Excess supply or surplus Price oor set here Figure 3.22 European Wheat Prices: A Price Floor Example The intersection of demand (D) and supply (S) would be at the equilibrium point E0. However, a price floor set at Pf holds the price above E0 and prevents it from falling. The result of the price floor is that the quantity supplied (15 exceeds the quantity demanded Qd. There is excess supply, also called a surplus. Taxes and Subsidies Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on alcoholic beverages that collects about $8 billion per year from producers. Businesses treat taxes as costs. Higher costs decrease supply for the reasons we discussed when we learned about supply. Other examples of policy that can affect cost are the wide array of government regulations that require firms to spend money to provide a cleaner environment or a safer workplace. Complying with regulations increases costs. A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs when the government pays a firm directly or reduces the firm's taxes if the firm carries out certain actions. From the firm's perspective, taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price. Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right. Both taxes and subsidies can be used to account for externalities and encourage markets to reach socially optimal quantities. 13 Access for free at httpszlfopenstax.org/books/principles-economics-Ze/pages/1-intr0duction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3-iVlicroeconomics Consumer and Producer Surplus Consumer Surplus, Producer Surplus, Social Surplus The familiar demand and supply diagram holds within it the concept of economic efficiency. One typical way that economists define efficiency is when it is impossible to improve the situation of one party without imposing a cost on another. Conversely, if a situation is inefficient, it becomes possible to benet at least one party without imposing costs on others. Efficiency in the demand and supply model has the same basic meaning: The economy is getting as much benefit as possible from its scarce resources and all the possible gains from trade have been achieved. In other words, the optimal amount of each good and service is produced and consumed. Consider a market for tablet computers, as Figure 3.23 shows. The equilibrium price is $80 and the equilibrium quantity is 28 million. To see the benefits to consumers, look at the segment of the demand curve above the equilibrium point and to the left. This portion of the demand curve shows that at least some demanders would have been willing to pay more than $80 for a tablet. For example, pointJ shows that if the price were $90, 20 million tablets would be sold. Those consumers who would have been willing to pay $90 for a tablet based on the utility (satisfaction) they expect to receive from it, but who were able to pay the equilibrium price of $80, clearly received a benefit beyond what they had to pay. Remember, the demand curve traces consumers' willingness to pay for different quantities. The amount that individuals would have been willing to pay, minus the amount that they actually paid, is called consumer surplus. Consumer surplus is the area labeled Fthat is, the area above the market price and below the demand curve. S120 $100 $90 Consumer surplus $3" ' Pi-ducf airbus \"\"\" Price $60 G $40 $20 ll Ill 10 14 20 28 30 Quantity (in millions) Figure 3.23 Consumer and Producer Surplus The somewhat triangular area labeled by F shows the area of consumer surplus, which shows that the equilibrium price in the market was less than what many of the consumers were willing to pay. PointJ on the demand curve shows that, even at the price of $90, consumers would have been willing to purchase a quantity of 20 million. The somewhat triangular area labeled by G shows the area of producer surplus, which shows that the equilibrium price received in the 14 Access for free at httpszllopenstax.org/books/principles-economics-2e/pages/1-intr0duction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3-Microeconomics market was more than what many of the producers were willing to accept for their products. For example, point K on the supply curve shows that at a price of 545, firms would have been willing to supply a quantity of 14 million. The supply curve shows the quantity that rms are willing to supply at each price. For example, point K in Figure 3.23 illustrates that, at 545, firms would still have been willing to supply a quantity of 14 million. Those producers who would have been willing to supply the tablets at $45, but who were instead able to charge the equilibrium price of $80, clearly received an extra benefit beyond what they required to supply the product. The extra benefit producers receive from selling a good or service, measured by the price the producer actually received minus the price the producer would have been willing to accept is called producer surplus. In Figure 3.23, producer surplus is the area labeled Gthat is, the area between the market price and the segment of the supply curve below the equilibrium. The sum of consumer surplus and producer surplus is social surplus, also referred to as economic surplus or total surplus. In Figure 3.23 we show social surplus as the area F + G. Social surplus is larger at equilibrium quantity and price than it would be at any other quantity. This demonstrates the economic efficiency of the market equilibrium. In addition, at the efficient level of output, it is impossible to produce greater consumer surplus without reducing producer surplus, and it is impossible to produce greater producer surplus without reducing consumer surplus. 15 Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/t-intr0duction 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View Unit 3Microeconomics Tax Incidence Elasticity also reveals whether firms can pass higher costs that they incur on to consumers. Addictive substances, for which demand is inelastic, are products for which producers can pass higher costs on to consumers. For example, the demand for cigarettes is relatively inelastic among regular smokers who are somewhat addicted. Economic research suggests that increasing cigarette prices by 10% leads to about a 3% reduction in the quantity of cigarettes that adults smoke, so demand for cigarettes is very inelastic. If society increases taxes on companies that produce cigarettes, the result will be, as in Figure 5.9 (a), that the supply curve shifts from SO to 51. However, as the equilibrium moves from E0 to E1, governments mainly pass along these taxes to consumers in the form of higher prices. These higher taxes on cigarettes will raise tax revenue for the government, but they will not much affect the quantity of smoking. If the goal is to reduce the quantity of cigarettes demanded, we must achieve it by shifting this inelastic demand back to the left, perhaps with public programs to discourage cigarette use or to help people to quit. For example, anti-smoking advertising campaigns have shown some ability to reduce smoking. However, if cigarette demand were more elastic, as in Figure 5.9 (b), then an increase in taxes that shifts supply from 50 to 51 and equilibrium from E0 to E1 would reduce the quantity of cigarettes smoked substantially. Youth smoking seems to be more elastic than adult smokingthat is, the quantity of youth smoking will fall by a greater percentage than the quantity of adult smoking in response to a given percentage increase in price. (a) Higher costs with Inelastic demand (b) Higher costs with elastic demand Figure 5.9 Passing along Higher Costs to Consumers Higher costs, like a higher tax on cigarette companies for the example we gave in the text, lead supply to shift to the left. This shift is identical in (a) and (b). However, in (a), where demand is inelastic, companies largely can pass the cost increase along to consumers in the form of higher prices, without much of a decline in equilibrium quantity. In (b), demand is elastic, so the shift in supply results primarily in a lower equilibrium quantity. Consumers suffer in either case, but in (a), they suffer from paying a higher price for the same quantity, while in (b), they suffer from buying a lower quantity (and presumably needing to shift their consumption elsewhere). 16 Access for free at httnszllnnens axnm on s: nnnmn es-emnnmms- eanes/'l-intmriuntinn 4 Files 12:49 PM Mon May 16 Insert Draw Layout Review View The example of cigarette taxes demonstrated that because demand is inelastic, taxes are not effective at reducing the equilibrium quantity of smoking, and they mainly pass along to consumers in the form of higher prices. The analysis, or manner, of how a tax burden is divided between consumers and producers is called tax incidence. Typically, the tax incidence, or burden, falls both on the consumers and producers of the taxed good. However, if one wants to predict which group will bear most of the burden, all one needs to do is examine the elasticity of demand and supply. In the tobacco example, the tax burden falls on the most inelastic side of the market. If demand is more inelastic than supply, consumers bear most of the tax burden, and if supply is more inelastic than demand, sellers bear most ofthe tax burden. The intuition for this is simple. When the demand is inelastic, consumers are not very responsive to price changes, and the quantity demanded reduces only modestly when the tax is introduced. In the case of smoking, the demand is inelastic because consumers are addicted to the product. The government can then pass the tax burden along to consumers in the form of higher prices, without much of a decline in the equilibrium quantity. Similarly, when a government introduces a tax in a market with an inelastic supply, such as, for example, beachfront hotels, and sellers have no alternative than to accept lower prices for their business, taxes do not greatly affect the equilibrium quantity. The tax burden now passes on to the sellers. If the supply was elastic and sellers had the possibility of reorganizing their businesses to avoid supplying the taxed good, the tax burden on the sellers would be much smaller. The tax would result in a much lower quantity sold instead of lower prices received. Figure 5.10 illustrates this relationship between the tax incidence and elasticity of demand and supply. x Fe SI 8 Pc 3 3 E E Pe E 1; Fe 3 L\" Pp '5 x u; pp Tax revenue Qt Qe Quantity Quantity (3) Elastic demand and inelastic supply (b) Elastic supply and inelastic demand Figure 5.10 Elasticity and Tax Incidence An excise tax introduces a wedge between the price paid by consumers (Pc) and the price received by producers (Pp). The vertical distance between Pc and Pp is the amount of the tax per unit. Pe is the equilibrium price prior to introduction of the tax. (a) When the demand is more elastic than supply, the tax incidence on consumers Pc Pe is lower than the tax incidence on producers Pe Pp. (b) When the supply is more elastic than demand, the tax incidence on consumers Pc Pe is larger than the tax incidence on producers Pe Pp. The more elastic the demand and supply curves, the lower the tax revenue. 17 Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/'I-introduction 4 Files 12:50 PM Mon May 16 Insert Draw Layout Review View Unit 3-Microeconomics In Figure 5.10 (a), the supply is inelastic and the demand is elastic, such as in the example of beachfront hotels. While consumers may have other vacation choices, sellers can't easily move their businesses. By introducing a tax, the government essentially creates a wedge between the price paid by consumers Pc and the price received by producers Pp. In other words, of the total price paid by consumers, part is retained by the sellers and part is paid to the government in the form of a tax. The distance between Pc and Pp is the tax rate. The new market price is Pc, but sellers receive only Pp per unit sold, as they pay Pc-Pp to the government. Since we can View a tax as raising the costs of production, this could also be represented by a leftward shift of the supply curve, where the new supply curve would intercept the demand at the new quantity Qt. For simplicity, Figure 5.10 omits the shift in the supply curve. The tax revenue is given by the shaded area, which we obtain by multiplying the tax per unit by the total quantity sold Qt. The tax incidence on the consumers is given by the difference between the price paid Pc and the initial equilibrium price Pe. The tax incidence on the sellers is given by the difference between the initial equilibrium price Pe and the price they receive after the tax is introduced Pp. In Figure 5.10 (a), the tax burden falls disproportionately on the sellers, and a larger proportion of the tax revenue (the shaded area) is due to the resulting lower price received by the sellers than by the resulting higher prices paid by the buyers. Figure 5.10 (b) describes the example of the tobacco excise tax where the supply is more elastic than demand. The tax incidence now falls disproportionately on consumers, as shown by the large difference between the price they pay, Pc, and the initial equilibrium price, Pe. Sellers receive a lower price than before the tax, but this difference is much smaller than the change in consumers' price. From this analysis one can also predict whether a tax is likely to create a large revenue or not. The more elastic the demand curve, the more likely that consumers will reduce quantity instead of paying higher prices. The more elastic the supply curve, the more likely that sellers will reduce the quantity sold, instead of taking lower prices. In a market where both the demand and supply are very elastic, the imposition of an excise tax generates low revenue. Some believe that excise taxes hurt mainly the specific industries they target. For example, the medical device excise tax, in effect since 2013, has been controversial for it can delay industry profitability and therefore hamper start-ups and medical innovation. However, whether the tax burden falls mostly on the medical device industry or on the patients depends simply on the elasticity of demand and supply. 18 Access for free at httpszllopenstax.org/books/principles-economics-2e/pages/1-introduction 4 Files 12:50 PM Mon May 16 Insert Draw Layout Review View Unit 3-Microeconomics Dead Weight Loss lnefficiency of Price Floors and Price Ceilings The imposition of a price floor or a price ceiling will prevent a market from adjusting to its equilibrium price and quantity, and thus will create an inefficient outcome. However, there is an additional twist here. Along with creating inefficiency, price floors and ceilings will also transfer some consumer surplus to producers, or some producer surplus to consumers. Imagine that several firms develop a promising but expensive new drug for treating back pain. If this therapy is left to the market, the equilibrium price will be $600 per month and 20,000 people will use the drug, as shown in Figure 3.24 (a). The original level of consumer surplus is T + U and producer surplus is V + W + X. However, the government decides to impose a price ceiling of $400 to make the drug more affordable. At this price ceiling, firms in the market now produce only 15,000. As a result, two changes occur. First, an inefficient outcome occurs and the total surplus of society is reduced. The loss in social surplus (a.k.a. total surplus) that occurs when the economy produces at an inefficient quantity is called deadweight loss. In a very real sense, it is like money thrown away that benets no one. In Figure 3.24 (a), the deadweight loss is the area U + W. When deadweight loss exists, it is possible for both consumer and producer surplus to be higher, in this case because the price control is blocking some suppliers and demanders from transactions they would both be willing to make. A second change from the price ceiling is that some of the producer surplus is transferred to consumers. After the price ceiling is imposed, the new consumer surplus is T + V, while the new producer surplus is X. In other words, the price ceiling transfers the area of surplus (V) from producers to consumers. Note that the gain to consumers is less than the loss to producers, which is just another way of seeing the deadweight loss. 512 P 5600 P $8 5400 15,000 20,000 . . Q Q (a) Reduced social surplus from a price ceiling (b) Reduced social surplus from a price oor Figure 3.24 Efficiency and Price Floors and Ceilings (a) The original equilibrium price is $600 with a quantity of 20,000. Consumer surplus is T + U, and producer surplus is V + W + X. A price ceiling is imposed at $400, so firms in the market now produce only a quantity of 15,000. As a result, the new consumer surplus is T + V, while the new producer surplus is X. (b) The original equilibrium is $8 at a 19 Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/t-introduction 4 Files 12:50 PM Mon May 16 Insert Draw Layout Review View Unit 3Microeconomics quantity of 1,800. Consumer surplus is G + H H, and producer surplus is | + K. A price floor is imposed at $12, which means that quantity demanded falls to 1,400. As a result, the new consumer surplus is G, and the new producer surplus is H + |. Figure 3.24 (b) shows a price floor example using a string of struggling movie theaters, all in the same city. The current equilibrium is $8 per movie ticket, with 1,800 people attending movies. The original consumer surplus is G + H + J, and producer surplus is | + K. The city government is worried that movie theaters will go out of business, reducing the entertainment options available to citizens, so it decides to impose a price floor of $12 per ticket. As a result, the quantity demanded of movie tickets falls to 1,400. The new consumer surplus is G, and the new producer surplus is H + I. In effect, the price floor causes the area H to be transferred from consumer to producer surplus, but also causes a deadweight loss of] + K. This analysis shows that a price ceiling, like a law establishing rent controls, will transfer some producer surplus to consumerswhich helps to explain why consumers often favor them. Conversely, a price floor like a guarantee that farmers will receive a certain price for their crops will transfer some consumer surplus to producers, which explains why producers often