GLS1e - Chapter3 by Hikket

Using Supply and
Demand to Analyze
Markets
Chapter Outline
3.1 Consumer and Producer
Surplus: Who Benefits in a
Market?
3.2 Price Regulations
3.3 Quantity Regulations
3.4 Taxes
3.5 Subsidies
3.6 Conclusion
Copyright 2013 Worth Publishers, All Rights Reserved Microeconomics Goolsbee/Levitt/ Syverson 1/e
3-1
Introduction
In this chapter, we use the supply and

demand model to answer the following
questions
How do we measure the benefits that accrue
to producers and consumers in a market?
How do government interventions (e.g.,
taxes) affect markets and the benefits
associated with market exchange?
3-2
Consumer and Producer

Market?
3.1
Consumers benefit from market exchange, otherwise

they would not participate
Consumer surplus The difference between the
amount consumers would be willing to pay for a
good or service and the amount they actually pay
(the market price)
In many cases, this difference is positive, and
consumers experience net benefits from market
exchange
3-3

Market?
3.1
Figure 3.1 Defining Consumer Surplus

Price ($/pound)
$5.50
5
Person As
4.50
consumer
surplus = $1.50 4
3.50
3
Demand
choke price
Total consumer
A
surplus (CS)
B
C
D
Market price
E
D
2
1
0
The consumer at point

E will not buy any
apples because the
market price is too
high
Quantity of
apples (pounds)
3-4

Market?
3.1
Producers benefit from market exchange, otherwise

they would not participate
Producer surplus The difference between the
amount producers are willing to sell goods for and
what they actually receive (the market price)
Producer surplus is not the same as profit, as we will
see in later chapters
3-5

Market?
3.1
Figure 3.2 Defining Producer Surplus

The producer at point Z
will not produce any
Total producer apples because the
price is too low
surplus (PS) market
S
Price ($/pound)
5
4
3.50
Seller V s
3
producer
2.50
surplus = $1.50
2
1.50
1
0
Z
X
Market price
V
Supply
choke price
1
Quantity of
apples (pounds)
3-6
The Market for Cupcakes
figure it out
The weekly supply and demand for cupcakes in a

small town are given as
QS = 30P 20 , QD = 124 18P

where P is the price, in dollars, and quantity is
measured in thousands of cupcakes per week
Answer the following questions:
1.Find the equilibrium price and quantity
2.Calculate consumer and producer surplus at the
equilibrium
3-7
figure it out
1. Remember: Equilibrium is characterized by QS = QD
30P 20 = 124 18P

Combining terms and solving for P yields
48P = 144 P* = $3
And using the equation for demand,
QD = 124 18(3) = 70 = Q* = QS
2. The easiest way to calculate consumer and producer
surplus is with a graph; to do this, we must determine
two points for each curve
Equilibrium price/quantity
Choke prices (where QD /QS are equal to zero)
Why do we need only two points to plot the
demand/supply curves?
3-8
figure it out
We already know one point for each curve: P* = $3.00 ; Q* = 70

Demand choke price: QD = 0 = 124 18P P = $6.89
Supply choke price: QS = 0 = 30P 20 P = $0.67
Price of cupcakes
(dollars)
6.9
S
A
Producer surplus is the area above

1 the price (Area B)
supply but below
PS Area B base height
2
1
70 (3 0.67) $81.55
2
B
0.67
0
Consumer surplus is the area

below demand but above the price
1
(Area A)
CS Area A base height
2
1
70 (6.89 3) $136.15
2
D
70
Surplus is generally measured in
Quantity of cupcakes
dollars
(thousands)
3-9

Market?
3.1
What happens to consumer and producer surplus when there is a

shift in supply or demand?
Imagine a pie shop opens up in the same

town. What will happen to the demand for
cupcakes?
Price of cupcakes
(dollars)
Demand will shift left, resulting in a new

equilibrium of P2 andQ2
E
P1
P2
B
C
Old consumer surplus: A + B + F

New consumer surplus: B + C
What happens to producer surplus?
F
G
Old producer surplus: C + D + E + G

New producer surplus: D
D2
0
What happens to consumer surplus?
Q2
Q1
D1
C has transferred from producers to

consumers
A + E + F + G has disappeared from
Quantity of cupcakes
this market
(thousands)
3-10

Market?
3.1
Figure 3.3 Consumer Surplus and the Elasticity of

Demand
3-11
The Market for Tires
figure it out
The weekly supply and demand for tires in a small town are
given as
QS = 15P 400 , QD = 2,800 25P

where P is the price, in dollars, and quantity is the number
of tires sold weekly. The equilibrium price is $80 per tire,
and 800 tires are sold each week
Suppose an improvement in technology makes tires
cheaper to produce; specifically, suppose the quantity
supplied rises by 200 at every price

1.What is the new supply curve?
2.What are the new equilibrium price and quantity?
3.What happens to consumer and producer surplus?
3-12
figure it out
3-13
figure it out
3-14
figure it out
3-15

Market?
3.1
Figure 3.5 Changes in Surplus from a Supply Shift
3-16
3.2 Price
Regulations
Politicians often call for the direct regulation of

prices on products and services
Price ceiling a regulation that sets the maximum price
that can be legally paid for a good or service
Price floor a regulation that sets the minimum price that
can be legally paid for a good or service (often called a price
support)
What are the effects of price ceilings/floors on

markets?
3-17
3.2 Price
Regulations
Some important terminology

Transfer surplus that moves from producers to
consumers, or vice versa, as a result of a regulation
Deadweight loss (DWL) the reduction in total surplus
that occurs as a result of a market inefficiency
Remember the cupcake example of changing demand due to a pie
shop
Nonbinding price ceiling a price set at a level above the

equilibrium market price
Nonbinding price floor a price set at a level below the
equilibrium market price
3-18
3.2Price Regulations
Figure 3.7 The Effects of a Price Ceiling
Price
($/pizza)
Consumer surplus before

A+B+C
Consumer surplus after
A+B+D
Producer surplus before
D+E+F
Producer surplus afterF
$20
14
A
B
10
8
5
D
F
z DWL = C + E
C
E
x
w
y
Transfer
of PS
to CS
6
Supply
Demand
10 12
20
Quantity of pizzas
(thousands)/month
Shortage
3-19
3.2 Price
Regulations
3.8 Deadweight Loss and Elasticities
3-20
3.2Price Regulations
Figure 3.9 The Effects of a Price Floor
Price
($/per ton)
$1,000
Transfer
of CS to PS
A
x
B
500
D
F
S
y
Price floor
A+B+C
A
D+E+F
Producer surplus afterB + D + F
E
z
D
0
10
20
30
Quantity of peanuts
(millions of tons)
Surplus
3-21
Like price regulations, quantity regulations restrict

the amount of a good or service provided to a
market
Quota a regulation that sets the quantity of a
good or service provided
Often used to limit imports of certain goods; why might a
government pursue an import quota?
Sometimes used to limit exports (e.g., China and rare
earths)
What are the effects of quotas on markets?
3-22
3.3Quantity Regulations
Figure 3.10 The Effects of a Quota

Price
($/tattoo)
S2
$125
Pquota = 100
z
B
P = 50
40
35

A+B+C
A
D+E+F
Producer surplus afterB + D + F
Transfer
of CS to PS
C
E
y
S1
D
F
500
(Quota)
1,500 Quantity of
tattoos/year
3-23
Application
The unintended consequences of
immigration quotas
In October, 2003, Congress reduced the annual
number of H-1B visas from 195,000 to 65,000
Targeted highly skilled workers
Quota had never been binding prior to policy change;
government began denying petitions in 2004
Requires a sponsoring U.S. company (a job offer); foreign
students who pursue a U.S. education have a better
chance of finding a sponsor
Images: FreeDigitalPhotos.net
Visa quotas have been shown to reduce

immigration...
Why would the U.S. pursue this policy?
What other consequences might we
Citation: T. Kato and C. Sparber. 2012. Quotas and Quality: the Effects of H-1B Visa Restrictions on the
see?
Pool of Prospective
Undergraduate Students from Abroad. Forthcoming in The Review of Economics and
Statistics.
3-24
Application
The unintended consequences of
immigration quotas
Kato and Sparber (2013) examined whether this
new policy might have reduced the incentive for
highly qualified students to pursue an education in
the U.S.
Considered SAT scores submitted by foreign students
Used five countries as a control; Australia, Canada,
Chile, Mexico, and Singapore have special status, and
their students can obtain visas similar to H-1B without a
quota
Key findings
Average SAT scores of applicants from foreign countries
affected by the H-1B quota dropped 10 20 points after
2003
Citation: T. Kato and C. Sparber. 2012. Quotas and Quality: the Effects of H-1B Visa Restrictions on the
Pool of Prospective Undergraduate Students from Abroad. Forthcoming in The Review of Economics and
Drop was driven by a reduction in top-quintile scores,
Statistics.
Copyright
2013 Worth Publishers,
All Rights for
Reserved
Microeconomics Goolsbee/Levitt/ Syverson 1/e
implying the policy
reduced
incentive
high-quality
3-25
Government provision of a public good: municipal golf courses

Sometimes, governments attempt to
supplement market supply for things that
benefit communities
Price of a golf
round
Spriv
Stot
P1
Ptot
Qpriv
Q1
Qtot
Q1 + Qgov
What happens to the market for golf when a

local government opens a municipal course?
With only for-profit and private courses, supply is

Spriv and the market equilibrium occurs at Q1 and P1
The municipal course increases the quantity of
rounds available by Qgov , and supply shifts out to Stot
However, quantity supplied only increases to

Qtot because private suppliers are not willing to
supply as much at the new, lower market
price
Private producers reduce quantity supplied to Qpriv ,

Quantity of
rounds
this
effect is known as crowding out
Crowding out
3-26
3.4 Taxes
Taxes are very prevalent in societies

Product markets (VAT; sales taxes)
Labor markets (income taxes; payroll taxes)
Capital markets (capital gains taxes)
How do taxes impact markets?

Some taxes are imposed to correct market failures (see
Chapter 16)
In general, taxes distort market outcomes
How do we describe the effects of taxes?
Example: In 2003, Bostons Mayor Tom Menino proposed

a $0.50 tax on movie tickets
How should this tax (which was ultimately not adopted by the
legislature)Copyright
affect
the market for movie tickets?
2013 Worth Publishers, All Rights Reserved Microeconomics Goolsbee/Levitt/ Syverson 1/e
3-27
3.4Taxes
Figure 3.13 The Effects of a Tax on Boston Movie

Tickets
Price
($/ticket)
$10
Pb = 8.30
P1 = 8.00
Ps = 7.80
6.67
0
Transfer from CS and PS

to government
S2 = S1 + tax
A
y
C
S1
x
B
D
D
E
z
Consumer surplus (CS) before
A+B+
Consumer surplus (CS) after
A
F
C
Producer surplus (PS) before
D+E+F
Producer surplus (PS) after
F
Government revenue B + D
Q2 = 3.4
Q1 = 4
Quantity of tickets
(100,000s)
3-28
3.4 Taxes
We can also describe the effect of a tax on consumer and

producer surplus with equations. Demand and supply for
tickets are given by Q D 20 2 P; Q S 3P 20
where prices are measured in dollars and quantity in hundreds
of thousands of tickets.
occurs
when QD = QS,
20 2Equilibrium
P 3P 20
5 P 40
Before the tax, tickets are $8 1
and 400,000 tickets are sold in Boston
CS Q PDChoke P1
Pre-tax consumer surplus 2
Q D 0 20 2 PDChoke PDChoke $10

where the demand choke price is found by solving
1
CS 400,000 $10 $8 $400,000
2
and consumer
surplus
is equal
to Microeconomics Goolsbee/Levitt/ Syverson 1/e
Copyright
2013 Worth Publishers,
All Rights Reserved
3-29
3.4 Taxes
Pre-tax producer surplus surplus

1
PS Q P1 PSChoke
2
where the supply choke price
Q S 0 3PSChoke 20 PSChoke $6.67
Solving for producer surplus yields
1
PS 400,000 $8 $6.67 $266,667
2
PS CS $666,667
And total surplus
What happens after the tax?
3-30
3.4 Taxes
Pb PS $0.50
Q D Q S 20 2 Pb 3PS 20 20 2 PS 0.50 3PS 20

20 2 PS 1 3PS 20 PS $7.80
Pb PS $0.50 $8.30
Q2 20 2 8.30 340,000
3-31
3.4 Taxes
New consumer surplus

1
CS 340,000 $10 $8.30 $289,000
2
and producer surplus
1
PS 340,000 $7.80 $6.67 $192,100
2
How much revenue has been generated by the tax?
Revenue 0.50Q2 $0.50 340,000 $170,000
And the associated deadweight loss associated with this
tax
distortion
is
1
1
DWL Q1 Q2 Pb Ps 400,000 340,000 $0.50 $15,000
2
2
3-32
3.4 Taxes
Pb PS $1.00
Q D Q S 20 2 Pb 3PS 20 20 2 PS 1.00 3PS 20

20 2 PS 2 3PS 20 PS $7.60; Pb $8.60
Q2 20 2 8.60 2.8
3-33
3.4 Taxes
Consumer surplus CS
1
280,000 $10 $8.60 $196,000
2
1
PS 280,000 $7.60 $6.67 $130,200
and producer surplus
2
How much revenue has been generated by the tax?
Revenue 1.00Q2 $1.00 280,000 $280,000
And the associated deadweight
loss associated with this
tax

1 is
1
distortion
DWL Q1 Q2 Pb Ps 400,000 280,000 $1.00 $60,000
2
2
So, while the tax rate has doubled, deadweight loss has
quadrupled from $15,000 to $60,000, and tax revenues have
Copyright by
2013 Worth
Publishers, (from
All Rights Reserved
Microeconomics to
Goolsbee/Levitt/
Syverson 1/e
only increased
78.5%
$170,000
$280,000)
3-34
3.4 Taxes
Figure 3.14 The Effect of a Larger Tax on Boston

Movie Tickets
3-35
figure it out
Soda Tax
The supply and demand for soda in a market is represented

by
QS = 50P 60 , QD = 12 8P
where P is the price per bottle, in dollars, and Q is in
millions of bottles per year
The current equilibrium price is $1.24, and 2.07 million
bottles are sold per year

1.Calculate the price elasticity of demand and the price
elasticity of supply at the current equilibrium
2.Calculate the share of a tax that will be borne by
consumers and the share borne by producers
3.If a tax of $0.10 per bottle is created, what do buyers now
pay for a bottle? What will sellers receive?
3-36
figure it out
Soda Tax
1. The first step is determining how the subsidy affects

prices
P subsidy P
b
In this problem,
Pb 2 PS
Supply andD demand are givenS by
Q 8, 000 500 Pb ; Q 1, 000 PS 2,500
And substituting
in for PS
S
Q 1, 000 Pb 2 2,500 1, 000 Pb 500
Equating 8,
supply
000 and
500demand,
Pb 1, 000and
Pb solving
500 for
Pb Pb$566.7
3-37
figure it out
Soda Tax

prices
P subsidy P
b
In this problem,
Pb 2 PS
Q 8, 000 500 Pb ; Q 1, 000 PS 2,500
And substituting
in for PS
S
Q 1, 000 Pb 2 2,500 1, 000 Pb 500
Equating 8,
supply
000 and
500demand,
Pb 1, 000and
Pb solving
500 for
Pb Pb$566.7
3-38
Application
Citation: Fisman, R. and S. Wei. 2004. Tax Rates and Tax Evasion: Evidence from Missing Imports in
China. The Journal of Political Economy 112(2): 471496.
3-39
Application
Taxation, tax evasion, and smuggling

The authors find the evasion gap to be positively
correlated with tax rates (i.e., highly taxed
products are likely to be mislabeled, undervalued,
or undercounted)
Evasion is almost entirely due to intentional
mislabeling of products (highly taxed products are
labeled as minimally taxed products)
Evasion is negatively correlated with tax rates on
closely related products (e.g., chickens and
turkeys)... why might this be the case?
Citation: Fisman, R. and S. Wei. 2004. Tax Rates and Tax Evasion: Evidence from Missing Imports in
China. The Journal of Political Economy 112(2): 471496.
3-40
3.4 Taxes
Tax incidence is a term describing who actually bears

the burden of a tax
In the supply and demand model, it does not matter who is
required to pay the tax (e.g., a sales tax vs. a production tax);
tax incidence will be the same in each case!
Consider again the movie theater example
3-41
3.4Taxes
Figure 3.15 Tax Incidence
(a)
Price ($)
(b)
S2
S1
Pb
P1
Ps
Price ($)
Tax = Pb
Ps
S
Pb
P1
Ps
D1
D
Tax = Pb Ps
D2
0
Q2 Q1
Quantity
Q2 Q1
Quantity
3-42
3.4 Taxes
Tax incidence is a term describing who actually bears the

burden of a tax
In the simple model presented here, it does not matter who is
required to pay the tax (e.g., a sales tax vs. a production tax); tax
incidence will be the same in each case!
Tax incidence and elasticities

Elasticities of supply and demand are major determinants of
incidence
In general, when demand is relatively more elastic, producers will
experience more burden, and vice versa
3-43
3.4 Taxes
Elastic demand with inelastic supply
S2
Wage
tax
Demand, on the other hand, may be elastic

due to the presence of substitutes
(outsourcing)
S1
tax
Wb
W1
Ws
L2 L1
Consider the market for labor; workers

(suppliers), are unlikely to extend or cut hours
very much for a large range of wages
Quantity of labor
What happens when the government puts a

tax on earned income?
The tax shifts the labor supply curve up by
the amount of the tax; the new wage is Wb ,
with quantity L2
The wage received by workers, however, is
only Ws
Wb W1 < W1 Ws ; therefore, the incidence of

the tax falls primarily on suppliers of labor
(workers)
3-44
3.4 Taxes
Tax incidence is a term describing who actually bears the

burden of a tax
In the simple model presented here, it does not matter who is
required to pay the tax (e.g., a sales tax vs. a production tax); tax
incidence will be the same in each case!
Tax incidence and elasticities

Elasticities of supply and demand are major determinants of
incidence
In general, when demand is relatively more elastic, producers will
experience more burden, and vice versa
D
A general formula(s) for
incidence as a function of Eelasticities
ES
Share born by consumer
E E
S
Share born by producer
ES ED
3-45
3.4 Taxes
Figure 3.16 Tax Incidence and Elasticities
3-46
figure it out
Soda Tax
The supply and demand for soda in a market is represented

by
QS = 50P 60 , QD = 12 8P
Where P is the price per bottle, in dollars, and Q is in
millions of bottles per year
The current equilibrium price is $1.17, and 2.62 million
bottles are sold per year

1.Calculate the price elasticity of demand and the price
elasticity of supply at the current equilibrium
2.Calculate the share of a tax that will be borne by
consumers and the share borne by producers
3.If a tax of $0.10 per bottle is created, what do buyers now
pay for a bottle? What will sellers receive?
3-47
figure it out
Soda Tax
1. The elasticity of demand and supply are
Q D P
1.17
E
D 8
3.75
P Q
2.62
D
Q
P
1.17
ES
S 50
22.33
P Q
2.62
2. The proportion of a tax borne by buyers and sellers is:

ES
22.33
Share born by buyer S
85.6%
D
22.33 3.75
E E
Share born by seller
ED
ES ED
3.75
14.4%
22.33 3.75
3. If there is a tax of $0.10 per bottle, buyers pay 85.6%, or

$0.0856 per bottle, and sellers pay 14.4%, or $0.0144 per
bottle
3-48
Application
Is it really the case that it does not matter
how a tax is levied?
Economic theory tells us tax incidence does not depend

on who is actually taxed
This assumes consumers treat a dollar of taxation in the
same manner as they treat a dollar of product price
Chetty et al. (2009) show this may not always be true.
Consider the differences between sales taxes and excise
taxes
Sales taxes are usually assessed as a percentage of the retail
price of a good or service, and is added at the point of sale;
determining the total cost before purchasing requires calculation
by the consumer
Excise taxes are usually included in the observed retail price
(e.g., the tax on gasoline or alcohol)
R. Chetty, A.Loony, and K. Kroft. 2009. Salience and Taxation: Theory and Evidence.American Economic Review, 99(4):
11451177.
3-49
Application
Is it really the case that it does not matter

how a tax is levied?
The authors examine this issue in two ways
Field experiment to determine how demand for household
items in a supermarket changes when sales taxes are included in
posted prices
Empirical study of state-level changes in excise and sales taxes
on alcohol between 1970 and 2003
Both approaches reveal that consumers underreact to

sales taxes relative to excise taxes (i.e., lower ED with
respect to sales taxes)
What does this imply for tax incidence?
How should taxes be structured?
What does this imply for economic theory?

Theory is constantly evolving to take into account evidence from
the field and laboratory
R.Chapter
Chetty, A. Loony,
andhighlights
K. Kroft. 2009. Salience
Taxation: Theory
and Evidence.American
Economic Review, 99(4):
17
someandrecent
advances
in behavioral
11451177.
economics
3-50
3.5 Subsidies
Subsidy a payment by the government to a buyer or seller of

a good or service
Subsidies are simply the opposite of a tax
Pb subsidy PS
Governments subsidize many products and production
processes
Producer subsidies ethanol production, research and development
Consumer subsidies education, public transportation
3-51
3.5 Subsidies
Figure 3.17 The Impact of a Producer Subsidy
3-52
Education Grants
figure it out
For years the government has subsidized higher education

through grants; consider the supply and demand for college
credit hours at a local private liberal arts college
QS = 1,000P 2500 , QD = 8,000 500P

where P is the price, in hundreds of dollars, and Q is the
number of credit hours per semester
The current equilibrium price is $700, and 4,500 credit
hours are taken per semester; suppose the government
subsidizes credit hours at a rate of $200 per hour

1.What will happen to the price paid by students, the price
received by the college, and the number of credit hours
completed?
2.What is the cost of the subsidy to the government?
3-53
figure it out
Education Grants

prices
P subsidy P
b
In this problem,
Pb 2 PS
Q 8, 000 500 Pb ; Q 1, 000 PS 2,500
And substituting
in for PS
S
Q 1, 000 Pb 2 2500 1, 000 Pb 500
Equating 8,
supply
000 and
500demand,
Pb 1, 000and
Pb solving
500 for
Pb Pb$566.7
3-54
Education Grants
figure it out
The new producer price is given by
Pb 200 PS PS $766.7
And the quantity of credit hours taken (using demand
equation)
D
Q 8, 000 500 5.667 5,166.5
So, the price paid by consumers has decreased by about

$133, the price received by the college has increased by
about $67, and the number of credit hours consumed has
increased by about 667
Costdid
subsidy
Qthe
$200
667 $133, 400
2.How much
this cost
government?
3-55
3.6
Conclusion
3-56

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Using Supply and

In this chapter, we use the supply and

Consumer and Producer

Consumers benefit from market exchange, otherwise

Consumer and Producer

Figure 3.1 Defining Consumer Surplus

The consumer at point

Consumer and Producer

Producers benefit from market exchange, otherwise

Consumer and Producer

Figure 3.2 Defining Producer Surplus

The Market for Cupcakes

The weekly supply and demand for cupcakes in a

QS = 30P 20 , QD = 124 18P

The Market for Cupcakes

1. Remember: Equilibrium is characterized by QS = QD

30P 20 = 124 18P

The Market for Cupcakes

We already know one point for each curve: P* = $3.00 ; Q* = 70

Producer surplus is the area above

Consumer surplus is the area

Surplus is generally measured in

Consumer and Producer

What happens to consumer and producer surplus when there is a

Imagine a pie shop opens up in the same

Demand will shift left, resulting in a new

Old consumer surplus: A + B + F

What happens to producer surplus?

Old producer surplus: C + D + E + G

What happens to consumer surplus?

C has transferred from producers to

Consumer and Producer

Figure 3.3 Consumer Surplus and the Elasticity of

The Market for Tires

QS = 15P 400 , QD = 2,800 25P

Answer the following questions:

The Market for Tires

The Market for Tires

The Market for Tires

Consumer and Producer

Figure 3.5 Changes in Surplus from a Supply Shift

Politicians often call for the direct regulation of

What are the effects of price ceilings/floors on

Some important terminology

Nonbinding price ceiling a price set at a level above the

Figure 3.7 The Effects of a Price Ceiling

Consumer surplus before

3.8 Deadweight Loss and Elasticities

Figure 3.9 The Effects of a Price Floor

3.3 Quantity Regulations

Like price regulations, quantity regulations restrict

What are the effects of quotas on markets?

Figure 3.10 The Effects of a Quota

Consumer surplus before

Visa quotas have been shown to reduce

3.3 Quantity Regulations

Government provision of a public good: municipal golf courses

What happens to the market for golf when a

With only for-profit and private courses, supply is

However, quantity supplied only increases to

Private producers reduce quantity supplied to Qpriv ,

Taxes are very prevalent in societies

How do taxes impact markets?