Chapter 5. Second Edition. Elasticity and Its Applications

Transcription

1 Chapter 5 Second Edition Elasticity and Its Applications

2 Chapter Outline The Elasticity of Demand The Elasticity of Supply Using Elasticities for Quick Predictions (Optional) Takeaway Appendix 1: Using Excel to Calculate Elasticities Appendix 2: Other Types of Elasticities 2

3 Elasticity of Demand We know there is an inverse relationship between price and quantity demanded. But how much does quantity demanded change when price changes?

4 Elasticity of Demand Elasticity of demand - a measure of how responsive the quantity demanded is to a change in price more responsive equals more elastic. The slope of the demand curve is related to the elasticity of demand. Let s see how this works. 4

5 Elasticity of Demand price $50 c b Price from $40 to $50: a b less responsive a c more responsive 40 a Demand E (more elastic) Demand I (less elastic) Quantity 5

6 Determinants of the Elasticity of Demand Ease in finding substitutes *** Easier greater elasticity Time required to adjust to price changes Long term more substitutes greater elasticity The definition of the commodity Narrow definition more substitutes greater elasticity Example: Coffee vs. specific brand Necessities versus Luxuries Share of budget devoted to the good. Larger share greater elasticity 6

7 Determinants of the Elasticity of Demand Summary of Determinants of Elasticity of Demand Less Elastic Fewer Substitutes Short Run (less time) Necessities Small Part of Budget More Elastic More Substitutes Long Run (more time) Luxuries Large Part of Budget

8 Mathematics of Demand Elasticity Elasticity of demand is always negative, so we typically drop the negative sign and use absolute value instead. If the Ed < 1, the demand curve is inelastic. If the Ed > 1, the demand curve is elastic. If the Ed = 1, the demand curve is unit elastic.

9 Calculating the Elasticity of Demand Elasticity measures the responsiveness of quantity demanded to changes in price. Elasticity of Percentage change in quantity demanded demand = Ed = Percentage change in price % ΔQdemanded = % ΔP Usually interpreted using the absolute value: E E E d d d > 1 = < 1 = = 1 = Elastic Inelastic Unit Elastic 9

10 Calculating the Elasticity: Midpoint Method We use the midpoint as the base: E d = % ΔQ % ΔPrice demanded = = Q (Q P (P Change in quantity demanded Average quantity Change in price Average price after after after after Q + Q P + P before before before before ) / )/2 2 Let s work an example. 10

11 Calculating the Elasticity: Midpoint Method Given: Price Quantity Demanded Point a $ Point b $50 20 E d = ( ) / ( )/2 = = = 6.0 What does this number mean? 11

12 Total Revenue and the Elasticity of Demand A firm s revenues are equal to price per unit times quantity sold. Revenue = Price x Quantity The elasticity of demand directly influences revenues when the price of the good changes.

13 Total Revenue and Elasticity of Demand Price Inelastic Demand % ΔP > % Δ Q d Price Elastic Demand % ΔP < % Δ Q d Result: TR Result: TR $50 $ Demand Demand 95 Quantity Quantity TR due to Q d TR due to P 13

14 Total Revenue and the Elasticity of Demand Knowing the value of the elasticity allows us to understand what happens to total revenue when the price changes. If P and TR move in opposite directions P % Q % 1 E d d Δ > Δ > We can use diagrams to see how this works. 14 P and TR move in same direction P % Q % 1 E d d Δ < Δ < TR is constant P % Q % 1 E d d Δ = Δ =

15 Total Revenue and Elasticity of Demand: Summary Summary: Total revenue and E d Elasticity and Revenue Absolute Value of E d Name How Revenue Changes with Price E d > 1 Elastic TR and P move together E d < 1 Inelastic TR and P move in opposite directions E d = 1 Unit Elastic TR remains the same when price changes 15

16 Applications of Elasticity of Demand How the American Farmer has Worked Himself Out of a Job: Increased agricultural productivity has the supply of food BUT the supply of farmers. And their revenues because the demand for most agricultural products is inelastic.

17 Try it! Which is more elastic, the demand for computers or the demand for Dell computers? Why? The elasticity of demand for eggs has been estimated to be 0.1. If the price of eggs increases by 10%, what will happen to total revenue of egg producers? To next Try it!

18 Try it! If a fashionable clothing store raised its prices by 25 percent, what does that tell you about the store s estimate of the elasticity of demand for its products? a) They think it s elastic b) They think it s inelastic To next Try it!

19 The Elasticity of Supply Elasticity of supply measures how responsive the quantity supplied is to the a change in price. more responsive equals more elastic. The slope of the supply curve is related to the elasticity of supply. Let s see how this works. 19

20 The Elasticity of Supply Elasticity of Supply Captures the Sensitivity of Quantity Supplied to Changes in Price Price per Unit Inelastic Supply The Same Price Increase $50 $40 Elastic Supply Causes a Small Increase in Quantity Supplied if Supply is Inelastic Quantity Causes a Big Increase in Quantity Supplied if Supply is Elastic

21 Determinants of the Elasticity of Supply How much per-unit costs as production Greater in per unit costs elasticity of supply. Examples: Elasticity of supply tends to be low for raw materials like oil and coal. Elasticity of supply tends to greater for manufactured goods Local supply is more elastic than the global supply. Why? 21

22 Determinants of the Elasticity of Supply Consider two polar cases Picasso painting Price Perfectly inelastic supply Price Toothpicks Perfectly elastic supply Quantity Quantity 22

23 Mathematics of Supply Elasticity If the E s < 1, the supply curve is inelastic. If the E s > 1, the supply curve is elastic. If the E s = 1, the supply curve is unit elastic. 23

24 Determinants of the Elasticity of Supply: Summary Primary Factors Determining the Elasticity of Supply Less Elastic Difficult to increase production at constant unit cost (e.g., some raw materials) Large share of market for inputs Global supply Short-run More Elastic Easy to increase production at constant unit cost. (e.g., some manufactured goods) Small share of market for inputs Local supply Long-run 24

25 Calculating the Elasticity of Supply Measure of the responsiveness of quantity supplied to a change in price Computed by Elasticity of supply = E s = Percentage change in quantity supplied Percentage change in price = % ΔQ supplied % ΔP 25

26 Calculating the Elasticity: Midpoint Method Again, we use the midpoint as the base E s = % ΔQ supplied % ΔPrice = Change in quantity supplied Average quantity Change in price Average price = Q (Q P (P after after after after Q + Q P + P before before before before )/ 2 )/2 26

27 Applications of Supply Elasticity: Gun Buyback Programs Gun buyback programs Several cities in the U.S. have spent millions of dollars buying guns with no questions asked. Objective Reduce the number of guns on the streets in order to Lower crime rates. Principles of economics predict these programs are unlikely to reduce the number of guns on the streets of these cities. Why? 27

28 Applications of Supply Elasticity: Gun Buyback Programs Demand for guns will increase. Guns will be imported to sell to the police. People will sell old, low quality guns Result The supply of guns is perfectly elastic to the city. Price of guns does not increase No fewer, but higher quality, guns are on the streets. Let s use our model to see this. 28

29 Applications of Supply Elasticity: Gun Buyback Programs Price of low quality guns Increase in supply = buyback $84 Supply of old, low quality guns (perfectly elastic) Demand w/buyback 1,000 Demand w/o buyback 6,000 Quantity of guns traded 29

30 Takeaway Elasticities of demand and supply help us quantify The effects of shifts in the demand and supply curves. How revenues respond to changes in price along a demand curve You should know how to calculate these elasticities using data on prices and quantities. 30

31 End of Chapter 5 Second Edition

32 Chapter 6 Second Edition Taxes and Subsidies

33 Chapter Outline Commodity Taxes Subsidies 33

34 Commodity Taxes We will emphasize the following: 1. Who ultimately pays the tax is not dependent on who writes the check 2. Who ultimately pays the tax does depend on the relative elasticities of supply and demand. 3. Commodity taxation raises revenue and creates lost gains from trade (deadweight loss) Let s look at each of these in turn. 34

35 Who Ultimately Pays the Tax Assume a 1$ per basket tax on apples. Government can collect the tax in two ways: From the seller From the buyer It doesn t matter which way is chosen. Let s use our model to analyze each. 35

36 Commodity Tax Collected From the Seller Price of Apples (per basket) $ Supply w/tax Supply w/o tax $1 Demand ,250 Commodity tax = $1 1. Supply shifts up by $1 2. Seller wants to charge $3 3. At $3: Q d < Q s surplus 4. Price Q d and Q s 500 Result: Seller s net price = $1.65 Buyer s net price = $2.65 Burden of the tax Buyer - $0.65 Seller - $0.35 Quantity of Apples (baskets) 36

37 Commodity Tax Collected From the Buyer Price of Apples (per basket) $ Demand w/o tax Demand w/tax 200 $1 Supply ,250 Commodity tax = $1 1. Buyer wants to pay $ Demand shifts down by $1 3. At $1: Q d > Q s shortage 4. Price Qs and Qd Q s 500 Result: Buyer s net price = $2.65 Seller s net price = $1.65 Burden of the tax Buyer - $0.65 Seller - $0.35 Quantity of Apples (baskets) 37

38 The Burden of the Tax Depends on the Relative Elasticities of Demand and Supply The Wedge shortcut Tax wedge a vertical line measuring the difference between the price paid by buyers and the price received by sellers. This tool simplifies our analysis The output where the wedge fits between the demand and supply curves tells us the after tax price consumers pay the after tax price that sellers receive. Let s go to our model now. 38

39 Using the Tax Wedge Price of Apples (per basket) Tax Wedge = $1 $4 Price buyers pay 3 Supply Price sellers receive Demand ,250 Quantity of Apples (baskets) 39

40 The Burden of the Tax Depends of the Elasticities of Supply and Demand An elastic demand curve means that buyers can substitute An elastic supply curve means that workers and capital can easily find work in another industry Result When demand is more elastic than supply, buyers pay less of the tax When supply is more elastic than demand, sellers pay less of the tax In other words elasticity = escape Let s use the model to show this 40

41 The Burden of the Tax Depends of the Elasticities of Supply and Demand Case I: Demand is more elastic than supply Price paid by buyers Price Supply Result: Most of the tax is paid By sellers Tax Wedge P no tax Demand Price received by sellers Q w/tax Q no tax Quantity 41

42 The Burden of the Tax Depends of the Elasticities of Supply and Demand Case II: Supply is more elastic than demand Price paid by buyers Tax Wedge P no tax Price Result: Most of the tax is paid By buyers Supply Price received by sellers Q w/tax Q no tax Demand Quantity 42

43 SEE THE INVISIBLE HAND This pleasure boat seems like a good thing to tax Or not: The Omnibus Budget Reconciliation Act of 1990 applied a 10% federal luxury tax to the retail sale of luxury goods like pleasure boats with a sales price above $100,000. Expected tax revenue? $9 billion. Reality? The federal luxury tax was repealed in Sales of boats down 52.7%; Net loss of 30,000 jobs; The federal government paid out > $7 million more in unemployment benefits to those workers than it collected in luxury tax revenues. B ACK TO

44 Health Insurance Mandates and Tax Analysis Suppose government mandates that firms buy health insurance for its workers. Think of this as a tax on labor. Who actually pays for the health insurance? Depends which is more elastic: supply or demand That is, which is easier: For firms to escape the tax by not employing? For workers to escape the tax by not working? 44

45 Health Insurance Mandates and Tax Analysis Firms can escape the tax in lots of ways Substitute capital for labor. Move operations overseas. Close up shop. It is more difficult for workers to escape the tax Most workers will work at a lower wage The cost of leaving the labor force is high Conclusion: demand is more elastic than supply Result: most of the tax is paid by workers. 45

46 Who Pays the Cigarette Tax? Because nicotine is addictive, demand is inelastic. Taxes are imposed by states. A manufacture can easily escape these taxes by selling Overseas Other states Conclusion: Supply elasticity is very high Result: most of tax is paid by buyers. 46

47 Who Pays the Cigarette Tax An interesting test If buyers pay almost all of the tax, the after tax price paid by sellers must be equal in all states. This table shows that is the case. Year 2000 Tax per Pack After tax price paid by buyers South Carolina $0.07 $3.35 $3.28 New Jersey $2.57 $6.45 $3.88 After tax price received by sellers 47

48 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Lost gains from trade = deadweight loss Tax increases reduce consumer and producer surplus Let s use our model to show this. 48

49 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Price No Tax Consumer surplus S Consumer surplus $2.65 Price With Tax Tax wedge S $2.00 D $2.00 $1.65 Deadweight loss D Producer surplus Producer surplus Government revenue 700 Q Q 49

50 Try it! What is the tax revenue that the government collects from the tax on gadgets? a) $350 b) $450 c) $100 d) $550 To next Try it!

51 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Elasticities of demand and supply determine consumer and producer surplus The greater these elasticities, the greater will be the deadweight loss Let s use our model to show this. 51

52 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case I: Elastic Demand Price Tax wedge P w/tax P no tax Tax Revenue Deadweight loss Supply Demand Q w/ tax Q no tax Quantity 52

53 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case II: Inelastic Demand Price Tax wedge P w/tax P no tax Tax Revenue Demand Deadweight loss Supply Note: Tax rate and Tax revenue are the same as before. Deadweight loss is much smaller. Q w/ tax Q no tax Quantity 53

54 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case III: Elastic Supply Price Tax wedge Deadweight loss P w/tax P no tax Tax Revenue Supply Demand Q w/ tax Q no tax Quantity 54

55 A Commodity Tax Raises Revenues and Creates Lost Gains From Trade Case IV: Inelastic Supply Price Tax wedge Supply Note: Tax rate and Tax revenue are the same as before. Deadweight loss is smaller. P w/tax P no tax Tax Revenue Deadweight loss Demand Q w/ tax Q no tax Quantity 55

56 Try it! Suppose that the government taxes insulin producers $50 per dose produced. Who is likely to pay this tax? Although the government taxes almost everything, would the government rather tax items that have relatively inelastic or relatively or relatively elastic demands and supplies? Why? To next Try it!

57 Subsidies A subsidy is a reverse tax Important facts about commodity subsidies 1. Who gets the subsidy does not depend on who gets the check from the government. 2. Who benefits from the subsidy does depend on the relative elasticities of demand and supply. 3. Subsidies 1. Are paid for by taxpayers 2. Result in inefficient increases in trade (deadweight loss) We can use the same wedge shortcut as before. Let s use our model to analyze subsidies. 57

58 Subsidies 3 Price received By sellers = $2.40 Price of apples Per basket $4 2 Price paid By buyers = $ Deadweight loss Supply Subsidy wedge Demand Quantity of apples (baskets) 58

59 Taxes and Subsidies Compared Whoever Bears the Burden of the Tax Receives the Benefits of a Subsidy Price paid by buyers Tax wedge P no tax no subsidy Price Burden of tax on sellers Benefit of subsidy on sellers Supply Price received by sellers Demand Subsidy wedge Price paid by buyers Price received by sellers Q with tax Q Q no with no subsidy tax subsidy Quantity 59

60 Try it! Who benefits most from the large agricultural water subsidy? Farmers in California s Central Valley typically pay $20-$30 an acre-foot for water that costs $200-$500 an acre-foot Hint: which is more elastic: demand or supply for cotton? a) California cotton suppliers b) California cotton buyers To next Try it!

61 King Cotton and the Deadweight Loss of Price of Cotton Price Sellers receive World Market price Total subsidy payments received by farmers Water Subsidies Supply of California Cotton Subsidy wedge Demand For California Cotton Can you see why sellers of Cotton lobby for subsidies, not buyers? Q no subsidy Q w/subsidy Quantity of Cotton 61

62 Wage Subsidies Edmund Phelps Nobel Prize winner Wage subsidies can be used to increase employment of low wage workers. Although costly, they may reduce Welfare payments. Crime Drug dependency Rational defeatism A better alternative to the minimum wage. Let s analyze a wage subsidy program. 62

63 Wage Subsidies Wage Wage received by workers Cost to taxpayers Supply of Labor $12 Market wage = $10.50 Subsidy Wedge = $4 $8 Wage paid by firms Demand for labor Q m Q s Quantity of labor 63

64 Try it! The U.S. government subsidizes college education in the form of Pell grants and lower-cost government Stafford loans. How do these subsidies affect the price of college education? Which is relatively more elastic: supply or demand? Who benefits the most from these subsidies: suppliers (colleges) or demanders of education (students)? To next Try it!

65 Try it! If demand of some good is more elastic than supply and a tax is imposed on the consumption of the good, who will bear more of the burden of the tax? a) Producers, because consumers have a greater ability to change their behavior in response to the tax. b) Both parties will share the burden equally. c) Consumers, because they pay the tax out of pocket. d) The government, because the tax will cause less of the good to be produced and consumed. To next Try it!

66 Takeaway Taxes decrease the quantity traded. Subsidies increase the quantity traded. The burden of the tax and the benefit of the subsidy do not depend on who sends or receives the government check. The side of the market that is more elastic will escape more of the tax and receive less of the benefit of the subsidy. The greater the elasticity of demand or supply the greater will be the deadweight loss. 66

67 End of Chapter 6 Second Edition

68 Chapter 8 Second Edition Price Ceilings and Floors

69 Chapter Outline Price Ceilings Rent Control (optional section) Arguments for Price Controls Price Floors 69

70 Introduction August 1971 President Nixon imposed wage and price controls in the U.S. Made it illegal to trade at a higher price even if both buyer and seller agreed to the higher price. Supposed to be in effect for 90 days Had lasting effects for over 10 years We will show how price controls Affect a single market Delink some markets and link other markets in ways that are counterproductive. 70

71 Price Ceilings Price ceiling a maximum price allowed by law Five important effects 1. Shortages 2. Reductions in product quality 3. Wasteful lines and other search costs 4. A loss in gains from trade 5. A misallocation of resources Let s look at each one in turn. 71

72 Shortages When the price ceiling is below the market price Quantity demanded is greater than quantity supplied: Q d > Q s We call this a shortage A shortage is different from scarcity Scarcity is reflected in the market price Shortage is due only to a price ceiling The lower the ceiling price is below the market price, the greater the shortage 72

73 Shortages Shortages appeared soon after prices were frozen in 1971 demand for housing demand for materials (inputs) needed to build houses Normally this would result in price of inputs a signal to produce more inputs. With fixed prices, this signal was missing. Shortages of inputs: lumber, steel bars, toilets and other materials were common. Let s use our model to examine a price ceiling. 73

74 Price Ceilings Create Shortages Price of gasoline per gallon Supply Controlled Price (ceiling) Shortage Market Equilibrium Demand Q s Q d Quantity 74

75 Shortages A shortage of vinyl in 1973 forced Capitol Records to melt down slow sellers so they could keep pressing Beatle s albums. 75

76 Reductions in Quality One way to evade price controls is to lower quality Printing books on lower quality paper Shrinking 2 x 4 lumber to 1 5 / 8 x 3 5 / 8 Fewer coats of paint on new automobiles Some newspapers switched to a smaller font size. 76

77 Reductions in Quality Another way to lower quality is to reduce service With a surplus of buyers, sellers have less of an incentive to give good service. Full service gas stations disappeared in Owners would close whenever they wanted to take a break. 77

78 Reductions in Quality The great matzo ball debate In 1972 George Meany, AFL-CIO boss complained that his favorite soup, Mrs. Adlers, had shrunk from 4 to 3matzo balls! The chairman of the wage and price commission had his staff count the number of balls in many can s of Mrs. Adler s soup. 78

79 Wasteful Lines and Other Search Costs There are other ways of paying for gas Some buyers might try bribing the station owners Another way is to be willing to wait in line. Time waiting in line is also a cost. How long will the line get? Let s answer this question using our model. 79

80 Wasteful Lines and Other Search Costs Price of gasoline per gallon Willingness to pay for Qs = $3 Controlled Price = 1 (ceiling) Total Value of Wasted time Market Equilibrium Shortage Supply At the controlled price: Quantity supplied = Q s Buyers are willing to pay $3/gallon Line will grow until the time cost per gallon $3 - $1 = $2.00/gallon Demand Q s Q d Quantity 80

81 Wasted Time and Other Search Costs What s the difference between paying a bribe and waiting in line? Waiting in line is more wasteful! A bribe goes to the station owner. Time waiting in line is lost; it benefits no one. 81

82 Lost Gains From Trade Deadweight loss total of lost consumer and producer surplus when not all mutually profitable gains from trade are exploited. As long as P > consumers are to pay willing sellers are accept willing to there are mutually profitable trades that can be made. Price ceilings create a deadweight loss P Let s go to our model again. 82

83 Price Ceilings: Reduce Gains From Trade Price of gasoline per gallon $3 Market price Controlled Price = 1 (ceiling) Total Value of Wasted time Lost consumer surplus A B Shortage Lost producer surplus Market Equilibrium Supply A + B = Lost gains from trade Demand Q s Q d Quantity 83

84 Misallocation of Resources When prices are controlled, resources do not flow to their highest valued uses. Example: When it gets cold in the Northeast, the demand for heating oil goes up. If the price is allowed to rise There is a greater incentive to produce more heating oil. The incentive to consume less heating oil increases. This provides a signal for more heating oil to be delivered to Maine instead of California. If the price is fixed Swimming pools in California are heated Homes in Maine are cold Let s use our model to show this. 84

85 Misallocation of Resources Price ($) $3 Controlled Price (ceiling) Highest-valued uses Shortage Supply Lower-valued uses Demand Price control prevents highest valued uses from outbidding lower valued uses. Result: some oil flows to lower valued uses Least-valued uses Q s Q d Quantity 85

86 The Loss From Random Allocation Let s ignore wasteful time and search costs The maximum CS is the area between the demand curve and the controlled price up to the quantity supplied with the controlled price. Because the good is not necessarily allocated to the highest values uses Consumer surplus will be less How much less? Let s do some reasonable calculations 86

87 The Loss From Random Allocation Best case scenario Buyers with the highest valued uses get in line first. Worst case scenario All goods are allocated to the lowest value uses. Random allocation scenario Let s assume that goods are allocated randomly with equal probabilities for each user. Suppose: Highest price any buyer is willing to pay = $30; controlled price = $6. Average price consumers would be willing to pay = ½ ($30) + ½ ($6) = $18 87

88 The Loss From Random Allocation: Best Price of gasoline per gallon Case Scenario Highest-valued uses Supply Willingness to pay for Qs = $3 Controlled Price = 1 (ceiling) Shortage Best Case Scenario: Buyers with the highest valued uses get the goods CS = total green area Demand Q s Q d Quantity 88

89 The Loss From Random Allocation: Worst Price of gasoline per gallon Case Scenario Loss to random allocation Supply Willingness to pay for Qs = $3 Controlled Price = 1 (ceiling) Shortage Lower-valued uses Worst Case Scenario: Buyers with lower valued uses get the goods. CS = total green area Demand Q s Q d Quantity 89

90 The Loss From Random Allocation: Equal Price of gasoline per gallon Probability Scenario Loss due to random allocation Supply Willingness to pay for Qs = $3 Average Price = $18 Controlled Price = 1 (ceiling) Shortage Equal Probability Scenario: Av price = $18 CS = total green area Demand Q s Q d Quantity 90

91 The End of Price Controls Controls on most prices were lifted by April 1974 Controls on oil prices continued in some form over the next 7 years. Old oil - New oil and wasteful gaming Controls on oil prices ended on the morning of President Reagan s inauguration day January 20, 1981 Oil price over the next several years No shortages of oil have occurred since. 91

92 Try it! Nixon s price controls set price ceilings below the market price. What would have happened if the price ceilings had been set above the market prices? Under price controls, why were the shortages of oil in some local markets much more severe than in others? To next Try it!

93 Try it! Shortages in the former Soviet Union were very common, but why were there also surpluses of some goods at some times and places? To next Try it!

94 Price Floors Price floor a minimum price allowed by law Price floors create: 1. Surpluses 2. Lost gains from trade (deadweight loss) 3. Wasteful increases in quality 4. A misallocation of resources 94

95 Surpluses A good example of a price floor is the minimum wage Workers with very low productivity are most affected by the minimum wage. Least experienced Least educated or trained Low-skilled teenagers are most affected. Let s use the labor market model to analyze the minimum wage. 95

96 Minimum Wage Creates a Surplus Minimum wage Market wage Wage ($/hr) Labor surplus (unemployment) Supply of labor Q d Market employment Q s Demand for labor Quantity of labor (unskilled) 96

97 Minimum Wage Creates Lost Gains From Minimum wage Market wage Wage ($/hr) Trade Labor surplus (unemployment) Supply of labor Lost gains from trade (deadweight loss) = lost consumer surplus + lost producer surplus Q d Market employment Q s Demand for labor Quantity of labor (unskilled) 97

98 Minimum Wage Hotly debated in the U.S. 93.9% of workers < 25 years earn more than the minimum wage At best, the minimum wage raises the wages of some teenagers and young workers whose wages would have increased anyway as they became more skilled. At worst, increases in the price of hamburgers can create some teenage unemployment. 98

99 Minimum Wage A large increase in the minimum wage will cause serious unemployment Test Case: Puerto Rico, 1938 Congress set the first minimum wage at $0.25/hr. Average wage in U.S. = $0.625/hr Congress forgot to exempt Puerto Rico Average wage in Puerto Rico = $0.03 to $0.04/hr Puerto Rican firms went bankrupt devastating unemployment Puerto Rican politicians begged for exemption 99

100 Minimum Wages in France Firms in France are reluctant to hire Minimum wage is higher than in the U.S. Labor laws make it very difficult to fire workers Younger workers are affected the most Less productive Risk of hiring is greater Result: Unemployment among workers < 25 yrs old was 23% in

101 Try it! The European Union guaranteed its farmers that the price of butter will stay above a floor. The floor price is often above the market equilibrium price. What do you think has been the result of this? The U.S. has set a price floor above the equilibrium price. Has this led to shortages or surpluses? How do you think the U.S. government has dealt with this? To next Try it!

102 Takeaway You should be able to explain the effects of price ceilings to your uncle. You should be able to draw a diagram showing the price ceiling, label the shortage, wasteful losses, and the lost gains from trade. You should understand why a price ceiling reduces product quality and misallocates resources. You should be able to a similar analysis for price floors. 102

103 End of Chapter 8 Second Edition