Chapter 4
Supply and Demand: Applications and Extensions
OUTLINE
I. The Link Between Resource and Product Markets
A. The markets for resources and products are closely linked.
1. Changes in one will affect the other.
a. An increase (decrease) in resource prices will reduce (increase) supply in the
product market.
b. An increase in product demand will increase the demand for resources used in
production of the good.
II. Economics of Price Controls
A. Price Ceilings
2. The direct effect of a price ceiling below the equilibrium price is a shortage:
quantity demanded exceeds quantity supplied.
B. Secondary Effects of Price Ceilings
1. Reduction in the quality of the good.
3. Lower future supply.
4. Non-price rationing will be of more importance.
C. Effects of Rent Control
1. Shortages and black markets will develop.
3. The quality of housing will deteriorate.
5. Inefficient use of housing will result.
6. Long-term renters will benefit at the expense of newcomers.
D. Price Floor
1. Price floor is a legally established minimum price that buyers must pay.
a. Example: minimum wage
2. The direct effect of a price ceiling below the equilibrium price is a surplus:
quantity supplied exceeds quantity demanded.
E. Minimum Wage Effects
2. Indirect effects.
a. Reduction in non-wage component of compensation.
3. A higher minimum wage does little to help the poor.
III. Black Markets and the Importance of the Legal Structure
A. Black Markets
1. Black market: markets that operate outside the legal system.
a. Either sell illegal items or items at illegal prices or terms.
2. Black markets have a higher incidence of defective products, higher profit rates,
and greater violence.
B. Legal System
1. A legal system that provides secure property rights and unbiased enforcement of
contracts enhances the operation of markets.
IV. The Impact of a Tax
A. Tax incidence
1. The legal assignment of who pays a tax is called the statutory incidence.
a. The actual burden of a tax (actual incidence) may differ substantially.
V. Tax Rates, Tax Revenues, and the Laffer Curve
A. Average Tax Rate
1. Average tax rate equals tax liability divided by taxable income.
a. Progressive tax is one in which the average tax rate rises with income.
b. Proportional tax is one in which the average tax rate stays the same across
income levels.
c. Regressive tax is one in which the average tax rate falls with income.
B. Marginal Tax Rate
1. Marginal tax rate equals change in tax liability divided by change in taxable
income.
C. Tax Rate and Tax Base
2. Tax base the level of the activity that is taxed.
a. The tax base is inversely related to the rate at which the activity is taxed.
D. Laffer Curve
1. Laffer curve illustrates the relationship between tax rates and tax revenues.
a. Laffer curve shows that tax revenues are low for both low– and high-tax rates.
b. The point of maximum tax revenue is not optimal because of high excess
burden.
E. Laffer Curve and Tax Changes in the 1980s
1. During the 1980s, the top marginal income tax rate fell from 70% to 33%.
2, Need to distinguish between changes in tax rates and changes in tax revenues.
Chapter 4/Supply and Demand: Applications and Extensions 57
VI. The Impact of a Subsidy
A. Benefit of a Subsidy
1. The division of a benefit from a subsidy us determined by the relative elasticities of
demand and supply rather than to whom the subsidy is actually paid.
OBJECTIVES
In this chapter, we provide applications of supply and demand analysis in a variety of contexts. The
applications emphasize that trading can take place in many different forms. For example, a market
can be legal or illegal, formal or informal. The first part of the chapter analyzes wage rates within a
supply-and-demand framework. The chapter then discusses the impact of government intervention
IMPORTANT POINTS AND TEACHING SUGGESTIONS
1. An important point in the first application is the connection between markets. That is, changes
2. The rent control discussion of quality changes and the price of a product highlights the
multidimensional nature of economic terms of trade. When monetary prices play a lesser role
3. Attempts to repeal the laws of supply and demand are continually being made by legislative
4. Exhibit four illustrates that minimum wage legislation reduces the quantity of employment
available to low-skill workers. As in the case of other price floors, the minimum wage elevates
5. Critical Analysis question eight provides material that will stimulate classroom discussion of
6. The concept of deadweight loss is both important and elusive. Be sure to emphasize that it
7. The analysis of the burden of a tax under differing price elasticities of demand and supply
8. A good analogy to the tax incidence discussion in the text is the game of dodge ball. The
government throws the balls (taxes) because they want to hit the players (raise revenue, which
can only come from someone in society), and they want to throw balls where they will
9. Since the Laffer curve is merely a reflection of the relative price effects of taxation, we
introduce it in this chapter. Be sure to emphasize that relative price effects reduced the size of
the tax base on both the upward-sloping and the backward-bending portion of the Laffer curve.
10.
rate and his or her marginal tax rate. Of course, the marginal tax rate is more relevant to the
11. A good application of marginal tax rate analysis is to discuss the idea of the importance of the
cumulative marginal tax rates across all tax and subsidy programs. In particular, the cumulative
12. The Laffer curve discussion of marginal tax rates and incentives should be clearly related to
13. To show students the importance of correctly understanding incidence analysis, it is often worth
discussing why there are so many hidden taxes designed to burden people without them being
14. Games one to two will help reinforce the material in chapter 4.
GAMES
1. Ducks in a Row
Type: In-Class demonstration
Topics: price ceilings, subsidies, and unintended consequences
Textbook: Chapter 4: Supply and Demand: Applications and Extensions Materials
Needed: 2 toy ducks, some play money, 3 volunteers
Time: 10 minutes
Class limitations: works in any size class
Purpose
This demonstration illustrates some common problems of government intervention in markets.
Instructions
One volunteer plays the role of the government in a poor country. Give the play money to the
provides the ducks to the shopkeeper. The second volunteer is an urban shopkeeper. The
shopkeeper asks the government for more ducks whenever it is sold out. Give the shopkeeper one
duck. The third volunteer is a consumer. The consumer buys ducks. Give the consumer $1 in play
money. The instructor is a duck farmer. The farmer keeps the second duck.
re expensive at $3
Points for discussion
The instructor, as the duck farmer, controls the game. There are three points to make in this
demonstration.
2. Subsidy. The farmer offers to sell the ducks for $3. The ducks can then be sold in the
3. Black markets. After the farmer sells the duck to government for $3, the duck goes to the
shopkeeper for $1. The farmer buys back the original duck for $1 and resells it to the
government for $3. This can continue until the government runs out of money.
Government intervention in markets can have unintended consequences. The price ceiling initially
decreased the amount of food available in the cities. Subsidies to producers can increase
production, but subsidies create new incentives.
This example is based on subsidies and price ceilings used in southern China. The farmers did buy
& resell poultry to the government.
4.2 A Flat Tax?
Type: In-Class activity
Topics: progressive, regressive, proportional taxes
Textbook: Chapter 4 Supply and Demand: Applications and Extensions
Materials Needed: none
Time: 3 minutes
Class limitations: works in any size class
Purpose
This activity emphasizes the importance of looking at percentages when classifying a tax as
progressive, regressive, or proportional.
Instructions
Tell the class Congress has approved a new tax to fund scientific research on clones. Everyone
will pay $1000.
Ask them is classify this tax as progressive, regressive, or proportional.
Common answers and points for discussion
Many students erroneously see this head tax as proportional. A simple example can show its
regressive nature.
Compare a low income student who earns only $1000 washing dishes at a summer job. to a high
taxes on food or cigarettes.
Chapter 4/Supply and Demand: Applications and Extensions 61
HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS
1. An increase in the demand for housing will raise the demand for carpenters, plumbers, and
2. The imposition of rent control will hurt college students for several reasons. The quality of rental
11. The deadweight loss is the loss of the potential gains of buyers and sellers emanating from
13. A tax on luxury automobiles is not a good idea if the goal is to raise revenue from the rich.