1

Case Studies Using Demand and Supply Analysis Chapter 7 develops the ability to apply the analysis of Chapter 6 to various cases. 1. Begin by looking over the Objectives listed below. This will tell you the ain points you should be looking for as you read the chapter. !. "ew words or definitions are highlighted in italics in the te#t. Other key points are highlighted in bold type. $nswer the %uestions in the te#t as they are asked. Then& check your answer by reading further in the te#t. '. (ou have ore work with the de and)supply graph in this chapter. Be sure to go over every shift so that you can see the reasons for the . By the end of this chapter& you should have astered the use of this graph. *. +o over the e#a ples of ta# incidence very carefully. ,n each case& you need to e#plain why the incidence of the ta# is either absorbed by the one who pays the ta# or is passed on to so eone else. The e#planation and reasoning are the ost i portant aspects of this topic. -. +o over the case on apart ents carefully. Try to answer all of the %uestions when they are asked. Then& read the answers to check and correct your answers. 6. +o over the case on agriculture carefully. Be sure you can e#plain why the shifts were ade in de and and supply and why the proble of falling far profits resulted. 7. (ou will be given an ,n Class $ssign ent and a .o ework assign ent to illustrate the ain concepts of this chapter. /hen you have finished the te#t and the assign ents& go back to the Objectives below. 0ee if you can answer the %uestions without looking back at the te#t. ,f not& go back and re)read that part of the te#t. Then& try the 1ractice 2ui3 . Objectives for Chapter 7 Case Studies Using Demand and Supply Analysis

$t the end of Chapter 7& you will be able to4 1. 5efine incidence of a ta#. !. 6#plain what deter ines whether the incidence of a ta# is on the buyer or on the seller. '. $pply the analysis of ta# incidence to the case of the sales ta#& to the case of the health care insurance pre iu & to the case of tariffs on foreign products& and to the case of the costs of environ ental regulations *. Co pletely analy3e the case of the rent supple ent progra and the price elasticities of de and and supply. -. Co pletely analy3e the case of a building subsidy progra and the price elasticities of de and and supply. using de and 7 supply analysis using de and 7 supply analysis

6. 8se de and 7 supply analysis as well as the price elasticities of de and and supply to e#plain why $ erican far ers have faced falling prices and profits over the past century.

Chapter 7: Case Studies Using Demand and Supply Analysis

9:ost recent revision ;une !<<6=

Part : !a" #ncidence $s one e#a ple of de and and supply analysis& let us assu e we have a product with the situation shown in the graph below. The price is >1.<< per unit. 1rice 0upply

1.<<

5e and ???????????????????????????????????????? < 2uantity "ow a sales ta# is i posed. !he ta" is charged to the seller. @or every >1.<< of sales& assu e that the seller ust pay ><.<7 to the govern ent. 9"otice that consu ers do not pay sales ta#es. (ou have not paid any sales ta# oney to any govern ent agency. The store pays the sales ta# to the govern ent.= @ro the point of view of the seller& this is an additional cost of production. ,n addition to all other costs& the seller ust also pay the sales ta#. 5o costs of production affect de and or supplyA The answer& as shown in the last chapter& is supply. /ill there be a shift or ove ent along supplyA 0ince the change is caused by so ething other than the price of the product& the answer is a shift. 0ince costs of production are increasing& the good is less profitable& causing supply to decrease. This is a shift to the left& as shown below. 0upply! 1rice 0upply1 1.<7 1.<* 6! 1.<< 61

5e and ???????????????????????????????????????? < 2uantity ,f we read the graph vertically instead of hori3ontally& we can say that the seller would like to raise the price to >1.<7. Then& the seller could pay the ><.<7 in ta# and still have the sa e >1.<<

'

that was earned before the sales ta# was i posed. .owever& due to the law of de and& the seller cannot raise the price to >1.<7. ,f the seller raises the price& the %uantity de anded will fall. ,n this case& e%uilibriu occurs with the new price at >1.<*. $t any higher price& there would be a surplus. /e say that ><.<* is the incidence of the tax on the buyer because the buyer ust pay a ><.<* higher price. /e say that the other ><.<' is the incidence of the tax on the seller because the seller earns ><.<' less that was earned before the sales ta# was i posed 9>1.<* ) ><.<7 B ><.C7=. ,n this e#a ple& ><.<* of the sales ta# was passed along to the buyers as higher prices. This nu ber was& of course& just ade)up. .ow do we know in reality how uch of the sales ta# will be passed along to buyers and how uch ust be absorbed by the sellerA The answer depends mainly on the price elasticity of demand for the product. To illustrate this point& let us take two e#tre e cases. First, assume that the demand for the product is perfectly inelastic$ ,n this case& the de and curve is vertical4 1rice 1.<7 1.<< 6! 61 0upply! 0upply1

5e and ???????????????????????????????????????? < 2uantity /hen the sales ta# is i posed& the seller would like to raise the price to >1.<7. 0ince& in this case& buyers will buy the sa e %uantity at any price& there is no surplus and the price can just rise to >1.<7. If the demand for the product were perfectly inelastic, all of the tax would be shifted on to the buyers; the incidence of the sales tax would be entirely borne by the buyers. "ow let us e#a ine the other e#tre e. Assume that the demand for the product is perfectly elastic$ ,n this case& the de and curve is hori3ontal4

1rice

0upply! 0upply1

1.<<

6!

61

5e and

?????????????????????????????????????? < 2uantity /hen the sales ta# is i posed& the seller would like to raise the price. But when the price rises above >1.<<& no one buys at all. Therefore& the seller cannot raise the priceD the price will end up at >1.<<. In this case, none of the tax can be shifted on to the buyers. We say that the incidence of the sales tax is entirely on the sellers of the product. @ro these e#tre e cases& we can generali3e. The incidence of a sales tax will be more on the buyer (seller the more inelastic (elastic is the demand for the product. %emember &from Chapter '( that the price elasticity of demand depends on the number of substitutes) the time involved) and the price of the product in relation to one*s income$ 0o& we can ake a good guess about the incidence of the 7E sales ta#. $re there good substitutes for products ta#ed under the sales ta#A The answer is Fprobably noF. ,n California& ost consu er ite s are ta#ed under the sales ta# e#cept food& shelter& and health care. 0o the substitutes to paying the sales ta# are to eat ore& live in a ore e#pensive apart ent or ho e& or go to the doctor ore. Of course& there is one other substitute ))) donGt spend at all 9better called saving=. $ reasonable guess is that& if the sales ta# is raised& the %uantity purchased of goods that are ta#ed will fall& but fall very little. 0econd& is the sales ta# high or low in relation to buyersG inco esA $t 7E& the answer is Fprobably lowF for ost people. 9The answer& of course& is very different in countries where sales ta#es reach '<E and up.= If we accept these answers, the !oods taxed under the sales tax ha"e relati"ely inelastic demand and the incidence of the sales tax would be mostly on the buyers. ,n fact& ost econo ists assu e that the incidence of the sales ta# is co pletely on the buyers.
+!est ,our Understanding+. ,n 1CC1& a sales ta# was i posed for the first ti e in California on Fjunk foodsF. This was the so)called Fsnack ta#F. ,t i posed a sales ta# on goods like Twinkies and pret3els. /ould the incidence of this sales ta# be ostly on the buyers of these foods or would it be ostly on the stores that sell the A 6#plain why.

-"ample : .ealth Care ,n the 8nited 0tates& ost people get health insurance as a benefit fro e ployers. 6 ployers pay all& or so e part& of the pre iu to a health insurance provider. But do e ployers actually pay this pre iu or do they shift the cost on to so eone elseA

-mployers have t/o possible /ays to shift the burden of the health insurance cost$ One is to raise prices to consumers. The ability to do this depends on the reaction of consu ers to the price increases. :ost large co panies pay health insurance and therefore would raise their prices. :any s all co panies 9such as restaurants and gas stations= do not pay health insurance and therefore would not raise their prices. ,f consu ers are able to substitute products ade by the s all co panies for those ade by the large co panies& the large co panies would not be able to raise their prices significantly. The incidence of the pre iu would then be on the co panies. .owever& it see s ore reasonable that buyers will not be able to substitute for the products of large co panies very well. 9,f the price of auto obiles increases& will we eat ore in restaurantsA= ,n this case& the large co panies would be able to raise their prices. The incidence of the pre iu s would then be ainly on the consu ers. !he second option for employers is to pass the health insurance cost on to /or0ers as lo/er /ages &actually as reduced raises in the /ages(. @or e#a ple& a worker who earns >'<&<<< per year could have been paid >'-&<<< per year& e#cept that the e ployer also paid >-&<<< for the health insurance pre iu . /ho will ulti ately pay the pre iu is deter ined in this case by the sa e reasoning. /hat will workers do when they find their wages reducedA ,f workers will leave their jobs and find other jobs with higher pay& then the e ployer will not be able to reduce the wages. The e ployer will have to bear the burden of the pre iu . But this see s unlikely. :ost e ployers pay health insurance. :ost workers would have nowhere else to go. $s a result& workers would have to accept the reduced wages. The incidence of the pre iu would then be on the workers. ,n !<<'& there was considerable debate in the 8nited 0tates over forcing e ployers to pay for workersG health insurance. The California legislature debated a proposed law that would re%uire all e ployers with ore than -< e ployees to pay for health insurance for their workers. This ended up as a ballot initiative 9that ulti ately failed=. To ost econo ists& workers pay for their health insurance even if the e ployers actually send the oney to the insurance provider. Wor#ers pay either throu!h hi!her prices for the products they buy or throu!h lower wa!es they recei"e. /orkers believe they are getting health insurance fro their e ployers as a benefit. They do not reali3e that& if the e ployers were not paying for the health insurance& their wages would be higher and the prices of the goods they buy would be lower. -"ample 1: !ariffs $ tariff is a ta# placed on the products of foreign countries sold in the 8nited 0tates. $ssu e& there is a 1<E ta# on foreign) ade auto obiles. /ho would bear the incidence of this ta#A $ssu e that a ;apanese car and a si ilar $ erican car each sell in the 8nited 0tates at a price of >!-&<<<. /ith the 1<E ta# on the ;apanese car 9>!&-<<=& the ;apanese co pany would like to raise the price of its car to >!7&-<<. /hether it can do so or not depends on the price elasticity of de and for ;apanese cars. ,f the de and for ;apanese cars is relatively inelastic& the %uantity de anded will fall very little at the price of >!7&-<<. This eans that buyers do not find ;apanese and $ erican cars to be close substitutes. The incidence of the ta# would be on the car buyers. On the other hand& if the de and for ;apanese cars is relatively elastic& the %uantity of ;apanese cars de anded will fall considerably at the price of >!7&-<<. This eans that buyers will closely substitute between ;apanese and $ erican cars. The ;apanese co pany

will have to charge a price close to >!-&<<< in the 8nited 0tates to be able to co pete. The incidence of the tariff will be on the ;apanese auto obile co panies. ,n technical language& a tariff on a forei!n product that has "ery elastic demand is called an optimal tariff. The price of the foreign product rises very little in the 8nited 0tates. :ost of the tariff is paid by the foreign co pany as reduced profits. The gain& of course& goes to the 8nited 0tates govern ent& who collects the oney. -"ample 2: -nvironmental %egulations $s we will see in a later chapter& free arkets co only lead to e#cessive pollution. This occurs because& fro the point of view of the co pany& polluting is free 9or at least very ine#pensive=. :ost of the costs that result fro pollution are borne by other people ))) people who breathe the air& fish in the water& beco e ill& and so forth. One way to reduce pollution is to force polluters to undertake activities that will reduce their pollutants. These activities are costly. $nother approach is to ta# polluters. @or now& the %uestion concerning us is this4 who actually will pay for the costs of reducing pollutantsA One e#a ple is the tissue industry. The co panies in this industry use raw wood or pulp to anufacture facial tissue& bathroo tissue& disposable diapers& and paper napkins. $s water polluters& they were forced by the 8nited 0tates govern ent to install pollution control e%uip ent. This e%uip ent represents a cost. The co panies would like to recover the oney spent on this e%uip ent by raising the prices of their products to consu ers. /hether they can do so or not depends on the price elasticity of de and for tissue products. :ost studies find that the de and is relatively inelastic. This eans that& when the price rises& buyers will reduce their %uantity de anded of tissue products very little. 92uestion4 using the factors affecting price elasticity of de and& e#plain why the de and for tissue products ight be relatively inelastic.= The incidence of these costs therefore is borne ostly by the buyers of these products& who are paying higher prices. ,f the de and is relatively inelastic& the %uantity produced by the co panies in this industry will fall very littleD as a result& there will be only a s all nu ber of jobs lost. Studies find this to be the case for most industries affected by pollution controls 333 fe/ /or0ers lose jobs but consumers face higher prices. $s we will see& the higher prices paid by consu ers ay actually be desirable for society as a whole.
H!est ,our Understanding+$ 1. There is a Transient Occupancy Ta# of about 1<E in 0an 5iego. This eans that people who stay in a hotel in 0an 5iego pay an additional 1<E of the price of a roo as ta#. 9,f a roo charge is >1<< per night& they pay an additional >1< in ta# to the city.= 8pon who would the incidence of this ta# fall ))) those who stay in hotels 9 ainly tourists and businesspeople= or the hotelsA -"plain /hy$ !. $ recent article esti ated the following for restaurant eals4 The price elasticity of de and B <.1II The price elasticity of supply 7 6.*7 The e%uilibriu price averaged >1<.*7 per eal 9in 1CC! prices= The e%uilibriu %uantity was I.1* billion eals per year. ,f there were a >1.<< per eal ta#& the article esti ated that the new e%uilibriu price would be >11.** per eal and the new e%uilibriu %uantity would be I.<1 billion eals. 0how these facts in the graph. /ho bears ost of the burden of the ta# on restaurant ealsA /hat percent of the ta# do they bearA 8sing the analysis of the chapter& why do you think this is soA

Part 1: Case Using Demand and Supply Analysis

!ry to ans/er the 4uestion first$ !hen) chec0 your ans/er in the reading$ $ssu e there is a well)defined geographic area of a city. The area is co posed e#clusively of apart ents and is populated by low)inco e residents. The people who live in the area tend to stay in that area because 91= they cannot afford to live in other areas of the city& 9!= they prefer to live with people of their own ethnic group& or 9'= there is discri ination against the in other areas of the city. Jents paid are a very high percent of peoplesG inco es. 91= /ould the demand for apart ents in this area be relatively inelastic or relatively elasticA 0tate why. 9!= /ould the supply of apart ents in this area be relatively inelastic or relatively elasticA 0tate why. 9'= 5raw the de and and supply curves as you have described the & showing the initial e%uilibriu price and %uantity. Kabel carefully. 9*= "ow assu e the govern ent creates a rent supplement program. 8nder this progra & the renter is re%uired to pay '<E of inco e in rent. $ny additional rent is paid by the govern ent ))) up to a li it. @or e#a ple& a low)inco e person with an inco e of >1&<<< a onth would be re%uired to pay >'<< in rent 9'<E=. ,f the rent is >-<<& the other >!<< would be paid by the govern ent. $naly3e the results of this progra . 0how the changes on the graph and e#plain what will result. /ho gains and who loses fro this progra A 9-= ,nstead& now assu e that the govern ent decides to provide a building subsidy to people who build apart ents in this low)inco e area. $ certain percent of their costs will be paid by the govern ent. $naly3e the results of this progra . 0how the results on the graph and e#plain what will result.

Ans/er to the Case: 91= /ould the demand for apart ents in this area be relatively inelastic or relatively elasticA 0tate why. The de and for apart ents would be relatively inelastic because there are few substitutes for the apart ents in this area. .owever& you ight argue that de and would be relatively elastic because the rent is a high proportion of the rentersG inco es. $ raise in rent could cause renters to leave the city altogether or to have to live on the streets. 9!= /ould the supply of apart ents in this area be relatively inelastic or relatively elasticA 0tate why. The supply would also be relatively inelastic. The %uestion is asking4 would the %uantity supplied rise just a little or rise greatly if the rents increaseA +iven that this is a low)inco e area and that there is probably not uch free land available& it is likely that the %uantity supplied would increase only a little. 6ven at increased rents& building apart ents in low)inco e areas is not a good invest ent for apart ent owners. 9'= 5raw the de and and supply curves as you have described the & showing the initial e%uilibriu price and %uantity. Kabel carefully. Both de and and supply should be drawn as steep 9unless you argued that de and was relatively elastic=.

1rice 0upply 11 6

5e and ???????????????????????????????????????? < 2uantity 9*= "ow assu e the govern ent creates a rent supplement program. 8nder this progra & the renter is re%uired to pay '<E of inco e in rent. $ny additional rent is paid by the govern ent ))) up to a li it. @or e#a ple& a low)inco e person with an inco e of >1&<<< a onth would be re%uired to pay >'<< in rent 9'<E=. ,f the rent is >-<<& the other >!<< would be paid by the govern ent. $naly3e the results of this progra . 0how the changes on the graph and e#plain what will result. /ho gains and who loses fro this progra A The pay ent by the govern ent can be treated as an increase in income. This affects the de and for apart ents. $n increase in de and would be shown as a shift to the right. This creates a shortage of apart ents. $s a result& rents rise. The %uantity of apart ents supplied also rises. ,f the supply is indeed relatively inelastic& the 4uantity supplied rises very little. The ajor effect is the rise in rents. Jenters gain fro the progra . 5ut most of the gain goes to the o/ners of the apartments. This is not what was intended. The FlosersF are the ta#payers who pay for the progra . 1rice 0upply 1! 11 61 5e and! 5e and1 ???????????????????????????????????????? < 21 2! 2uantity 9-= ,nstead& assu e that the govern ent decides to provide a building subsidy to people who build apart ents in this low)inco e area. $ certain percent of their costs will be paid by the govern ent. $naly3e the results of this progra . 0how the results on the graph and e#plain what will result. The subsidy progra is a decrease in costs of production. /ith lower costs of production& supply increases &shifts to the right(. This creates a surplus& causing apart ent

owners to lo/er the rents$ The %uantity of apart ents supplied increases. ,f de and is relatively inelastic& the largest effect is the reduction in rents$ !he 4uantity supplied increases only a little$ Jenters and apart ent owners gain fro the progra . But in this case& renters gain the ost. 1rice 0upply1 0upply! 11 1! 5e and ???????????????????????????????????????? < 21 2! 2uantity 96= @ro the point of view of i proving housing for the poor& decide for yourself which is the better public policyA Part 2: Case on American Agriculture
!ry to ans/er the 4uestion first$ !hen) chec0 your ans/er in the reading$ Consider the arket for grains. 91= ,s the de and for grains relatively elastic or relatively inelastic with respect to the priceA -"plain /hy$ 9!= ,s the de and for grains relatively elastic or relatively inelastic with respect to inco eA -"plain /hy$ 9'= ,s the supply of grains relatively elastic or relatively inelastic with respect to the priceA -"plain /hy$ 9*= On the graph& draw the de and and supply curves as you have described the . 0how the e%uilibriu price and %uantity. 9-= Over ti e& the de and for wheat has shifted to the right. /hy has this occurredA 96= Over ti e the supply of wheat has shifted to the right. /hy has this happenedA 97= /hich do you believe has shift ore over the past century4 the de and curve or the supply curveA 6#plain why. Then& show these two shifts on the graph. 9I= $s a result of these two shifts& the price of wheat will ???????????? 9rise or fallA= Because of the price elasticity of de and for wheat& total revenues received by far ers will ??????????????????9rise or fallA= The result is that the total profits of far ers will ?????????????????9rise or fallA= 9C= The arket is sending a signal to the far er. /hat is it telling the far er to doA

61

Ans/er to the Case: Begin with the de and for grains. 6ould this demand be relatively elastic or relatively inelastic7 The answer& ost studies show& is relatively inelastic. /hyA One reason is that people are unwilling to substitute fro products ade fro grain& such as bread. $nother reason is that buying grain products is ine#pensive in relation to peopleGs inco es. "ow& consider the supply. 6ould this supply of /heat be relatively elastic or relatively inelastic7 The answer& ost studies show& is relatively inelastic. /hyA ,n a short period of ti e& supply ay be perfectly inelastic. Once the seeds are planted& the supply cannot be adjusted until the ne#t planting. Over a longer ti e& far ers can adjust supply by planting ore or less. But this is li ited by the fact that the far er has only so uch land& barn space& and

1<

achinery. The graph below shows the de and and supply as relatively inelastic. 1rice of +rain 0upply

11

61

5e and ???????????????????????????????????????? < 21 2uantity of +rain Over time) the demand for /heat /ill rise &shift to the right(. /hyA One reason is that population rises 9both because the $ erican population increases and because far ers are able to sell ore in foreign arkets=. $nother is that inco es rise. .owever& according to what is called $n!el%s &aw, the income elasticity of demand for products made from !rains is low. This eans that& as inco es rise& the de and for these products 9and any other food products= rises very little. $ third reason for the shift in de and is that tastes change toward eating ore eat. $s people eat ore eat& the de and for wheat rises. This occurs because about C<E of the sunGs energy is lost if the ani al eats the plant and then a person eats the ani al. .owever& in recent years& tastes ay have caused a leftward shift in de and for wheat as diet)conscious people have tried all)protein diets. Over time) the supply of /heat /ill also rise &shift to the right($ /hyA The cause has been the enor ous technological advances that have increased productivity and lowered costs of production. These technological advances have been the result of the work of universities& agricultural e#tension progra s& and the co panies that sell products to far ers. $ large part of this technological advance has been financed by the federal govern ent. /hich do you believe has e#perienced the greater shift to the rightA The answer has been that the supply has shifted to the ri!ht much more than the demand has shifted to the ri!ht. This is shown in the graph below. The technological advances over the past century have been e#ceptional. If the supply increases more than the demand increases, the result is that the price of wheat must fall$ This indeed has been occurring over the past century. If the price falls, and the demand is relati"ely inelastic, what will happen to the total re"enue recei"ed' The answer is that it falls. $s the price falls& people do not eat that uch ore. /hen total revenue falls& the far er would like to reduce costs to aintain profits. But any of the costs cannot be reduced. The land& buildings& and achinery ust be paid for. :any of the workers are relatives and cannot be laid)off 9although fa ily workers often take part)ti e jobs in the nearest town=. The result is that profits fall.

11

1rice of +rain 0upply1 0upply! 11 1! 61 6! 5e and! 5e and1 ???????????????????????????????????????? < 21 2! 2uantity of /heat The mar#et is sendin! the farmer a si!nal. It is tellin! him or her to lea"e farmin! and do somethin! else. /hat is the far erGs sinA ,t is not that the far er has been inefficient or has ade bad business decisions. The proble is that the far er is too good. @ar ers produce ore food than consu ers want to buy at prices that will allow the far er to ake a profit. To any& this see s unfair. .ow this proble has been dealt with will be considered in the ne#t chapter. Practice 8ui9 for Chapter 7
1. The incidence of as sales ta# will be ore on the buyers of the product if a. the price elasticity of de and is low c. the inco e elasticity of de and is low b. the price elasticity of de and is high d. the cross elasticity of de and is high !. The incidence of a sales ta" is a. buyers b. sellers ost likely on the

'. $n :optimal tariff; is a ta# on i ported goods which have a high a. price elasticity of de and c. price elasticity of supply b. inco e elasticity of de and d. cross elasticity of de and *. ,f there is a rent supplement progra 4 a. rents will rise b. the %uantity of apart ents available will fall -. ,f there is a building subsidy progra & a. rents will rise b. the %uantity of apart ents available will rise c. landlords will be hurt c. landlords will be hurt

6. ,n the case of agriculture& the demand for grain products is likely to be a. relatively elastic b. relatively inelastic c. perfectly elastic 7. ,n the case of agriculture& the supply of grain products is likely to be a. relatively elastic b. relatively inelastic c. perfectly elastic

1!

I. a b

,n the case of agriculture& a. the de and has shifted to the right ore than the supply has shifted to the right b. the de and has shifted to the right less than the supply has shifted to the right c. the de and has shifted to the left ore than the supply has shifted to the left d. the de and has shifted to the left less than the supply has shifted to the left

<$ Because of what happened in %uestion I& the prices of grain products have a. risen b. fallen c. stayed the sa e 1<. The arket is telling far ers to a. produce ore b. e#pand their far s c. leave far ing d. wait for better days

$nswers4 1. $ !. $ '. $ *. $ -. B 6. B 7. B I. B C. B 1<. C