1. Controls on prices a. Price ceiling: price is not allowed to rise above this level. i.

If the price that balances supply and demand is below the ceiling, it is not binding 1. The price ceiling therefore has no effect on the price or quantity sold ii. If the equilibrium price is above the price ceiling, it is a binding constraint on the market 1. Results in a shortage 2. When the shortage develops, some mechanism for rationing will naturally develop a. Long lines b. Sellers could ration according to their own personal biases i. Selling only to friends, relatives, or members of their own racial or ethnic group 3. Not all buyers benefit from price ceilings iii. When the government imposes a binding price ceiling on a competitive market, a shortage of the good arises, and sellers must ration the scarce goods among the large number of potential buyers. iv. The rationing mechanisms that develop under price ceilings are rarely desirable 1. In contrast, the rationing mechanism in a free, competitive market is both efficient and impersonal a. Free markets ration goods with prices b. Price floor: Government imposes a legal minimum on the price i. If the equilibrium is above the floor, the price floor is not binding 1. If it is below the equilibrium price, then it is a binding constraint on the market 2. When the market price hits the floor, it can fall no further a. The market price= the price floor b. The quantity supplied exceeds the quantity demanded i. Binding price floor causes a surplus 3. With a binding price floor a. Some sellers are unable to sell all they want at the market price b. The sellers who appeal to the personal biases of the buyers, perhaps due to racial or familial ties, are better able to sell their goods than those who do not

c. By contrast: in a free market, the price serves as the rationing mechanism, and sellers can sell all they want at the equilibrium price 2. The minimum wage a. The labor market is subject to the forces of supply and demand i. Workers determine the supply of labor ii. Firms determine the demand b. If the minimum wage is above the equilibrium level, the quantity of labor supplied exceeds the quantity demanded. i. The result is unemployment ii. Minimum wage raises the income of those workers who have jobs but lowers the incomes of workers who cannot find jobs c. The economy has many labor markets for different types of workers i. Minimum wage depends on the skill and experience of the worker. 1. Workers with high skills are not affected because their equilibrium wages are well above the minimum a. For these workers, the minimum wage is not binding d. Impact on teenage labor i. Least skilled and least experienced members of the labor force ii. Minimum wage is more often binding for teens than for other members of the labor force e. In addition to altering the quantity of labor demanded, the minimum wage alters the quantity supplied i. Raises in minimum wage increases the number of teenagers who choose to look for jobs f. High minimum wage causes unemployment, encourages teenagers to drop out of school, and prevents some unskilled workers from getting the on the job training they need 3. Evaluating price controls a. When policymakers set prices by legal decree, they obscure the signals that normally guide the allocation of societys resources b. Rent control may keep rents low, but it also discourages landlords from maintaining their buildings and makes housing hard to find c. Subsidy: government paying a fraction of the price i. Rent subsidies do not reduce the quantity of housing supplied and therefore, do not lead to housing shortages ii. Wage subsidies raise the living standards of the working poor without discouraging firms from hiring them 1. Ex. Earned income tax credit, a government program that supplements the incomes of low wage workers iii. Rent and wage subsides cost the government money which requires higher taxes 4. Taxes

5. 6.

7.

8.

a. Tax incidence refers to how the burden of a tax is distributed among the various people who make up the economy Taxes on sellers a. Asdifjaodfjaidjfaildj Taxes on buyers a. Impact of tax affects the demand i. The supply curve is not affected because for any given price, sellers have the same incentive to provide their product to the market b. As a result of the tax, buyers demand a smaller quantity at every price i. Demand curve shifts to the left ii. Because buyers look at their total cost including the tax, they demand a quantity of the icecream as if the market price were $.50 higher than it actually is 1. Thus the tax shifts the demand curve downward from D1 to D2 by the exact size of the tax c. The tax on ice cream reduces the size of the market i. Sellers get a lower price and buyers pay a lower market price to sellers than they did previously, but the effective price rises. d. Implications i. Taxes levied on sellers and taxes levied on buyers are equivalent ii. The wedge between the buyers price and the sellers price is the same, regardless of whether the tax is levied on buyers or sellers. iii. The wedge shifts the relative positions of the supply and demand curves Payroll tax a. A tax on the wages that firms pay their workers b. Half of the tax is paid out of firms revenues, and half is deducted from workers paychecks c. Places a wedge between the wedge that firms pay and the wage that workers receive d. Lawmakers can decide whether a tax comes from the buyers pocket or from the sellers, but they cannot legislate the true burden of a tax Elasticity and tax incidence a. The difference in the two panels is the relative elasticity of supply and demand. b. In a market with a very elastic supply and relatively inelastic demand i. Sellers are responsive to changes in price(curve relatively flat) and buyers are not very responsive (curve relatively steep) ii. The price received by sellers does not fall much, so sellers only carry a small burden iii. The price paid by buyers rises substantially, indicating that buyers bear most of the burden of the tax

c. In a market with a relatively inelastic supply and very elastic demand: i. Sellers are not very responsive to changes in the price (curve is steeper) ii. Buyers are very responsive (curve is flatter) iii. The price paid by buyers does not rise much but the price received by sellers falls substantially 1. Sellers bear most of tax. d. A tax burden falls more heavily on the side of the market that is less elastic e. the elasticity measures the willingness of buyers or sellers to leave the market when conditions become unfavorable. f. A small elasticity of demand means that buyers do not have good alternatives to consuming this particular good. A small elasticity of supply means that sellers do not have good alternatives to producing this particular good. g. When the good is taxed, the side of the market with fewer good alternatives is less willing to leave the market and must, therefore, bear more of the burden of the tax. h. the supply of labor is much less elastic than the demand i. workers rather than firms bear most of the burden of the payroll tax. 9. Who pays the luxury tax? a. the goal of the tax was to raise revenue from those would could most easily afford to pay b. yacht market i. a millionaire can easily not buy a yacht 1. demand is quite elastic 2. could easily spend her money on something else ii. yacht factories are not easily converted to alternative uses, and workers who build yachts are not eager to change careers in response to changing market condition 1. supply is relatively inelastic iii. with the elastic demand and inelastic supply, the burden of the tax falls largely on the suppliers c. the economy is governed by 2 kinds of laws i. the laws of supply and demand and the laws enacted by governments CHAPTER 7 ECON NOTES Welfare economics the study of how the allocation of resources affects economic well-being CONSUMER SURPLUS

1. willingness to pay each buyers maximum is called his willingness to pay and it measures how much that buyer values a good a. each buyer would be eager to buy an item at a price less than his willingness to pay b. he would refuse to buy the album at the price greater than his willingness to pay. c. At a price equal to his willingness to pay, the buyer would be indifferent about buying the good i. If the price is exactly the same as the value he places on the item, he would be equally happy buying it or keeping his money 2. Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it a. Measures the benefit buyers receive from participating in a market b. Total consumer surplus can be calculated by adding up all the individual consumer surplus in the market c. Consumer surplus is closely related to the demand curve for a product d. At any quantity, the price given by the demand curve shows the willingness to pay of the marginal buyer i. The buyer who would leave the market first if the price were any higher e. Because the demand curve reflects buyers willingness to pay, we can also use it to measure consumer surplus f. The area below the demand curve and above the price measures the consumer surplus in a market. a. This is true because the height of the demand curve measures the value buyers place on the good, as measured by their willingness to pay for it. b. The difference between this willingness to pay and the market price is each buyer's consumer surplus. c. Thus, the total area below the demand curve and above the price is the sum of the consumer surplus of all buyers in the market for a good or service. 3. How a lower price raises consumer surplus a. In a market with many buyers, the resulting steps from each buyer dropping out are so small that they form, in essence, a smooth curve b. An increase in consumer surplus is composed to 2 parts i. The CS from those buyers who were already buying Q1 of a good at the higher price of P1 because they are now better off bc they pay a lower price 1. An increase in consumer surplus of existing buyers is the reduction in the amount they pay ii. New buyers enter the market bc they are willing to buy the good at a lower price 4. What consumer surplus measures

a. It measures the benefit that buyers receive from a good as the buyers themselves perceive it b. Consumer surplus is a good measure of economic wellbeing if policymakers want to respect the preferences of buyers c. In some circumstances, policymakers might choose not to care about consumer surplus because they do not respect the preferences that drive buyer behavior d. Consumers are the best judges of how much benefit they receive from the goods they buy e. It is a measure of consumer well being in dollar terms PRODUCER SURPLUS 1. Cost and the willingness to sell a. A worker is willing to take the job if the price he would receive exceeds his cost of doing the work b. cost should be interpreted as the painters opportunity cost i. it includes the painters out of pocket expenses (materials, gas, paying employees) as well as the value that the painter places on his own time ii. basically the value of everything he or she must give up to produce a good iii. a measure of his willingness to sell his services c. each painter would be eager to sell his services at a price greater than his costs, and would refuse to sell his services at a price less than his costs d. at a price exactly equal to his cost, the painter would be indifferent about selling his services i. he would be equally happy getting the job or using his time and energy for another purpose. e. Producer surplus is the amount a seller is paid minus the cost of production i. Measures the benefit sellers receive from participating in a market ii. A measure of producer well being in dollar terms 2. Using the supply curve to measure producer surplus a. Producer surplus is closely related to the supply curve b. The height of the supply curve is related to the sellers costs c. At any quantity, the price given by the supply curve shows the cost of the marginal seller i. The height of the lowest point on the supply curve is the cost for a seller who would leave the market first if the price were any lower. d. the area below the price and above the supply curve measures the producer surplus in a market. i. The height of the supply curve measures sellers' costs, and the difference between the price and the cost of production is each seller's producer surplus.

ii. Thus, the total area is the sum of the producer surplus of all sellers iii. PS is represented as a trapezoid 1. A= 1/2 (h)(a+b) 3. How a higher price raises producer surplus a. When a price raises from P1 to P2 i. Those sellers who were already selling Q1 of the good at the lower price of P1 are better off because they now get more for what they sell ii. Some new sellers enter the market because they are willing to produce the good at the higher price, resulting in an increase in the quantity supplied from Q1 to Q2 4. How a lower price reduces PS a. Some sellers will leave the market after a price fall because their costs now exceed their pay b. The sellers who remain and accept the lower price then make less revenue MARKET EFFICIENCY Consumer surplus and producer surplus are the basic tools that economists use to study the welfare of buyers and sellers in a market. 1. The benevolent social planner a. The benevolent social planner is an all knowing, all powerful, well intentioned dictator b. The planner wants to maximize the economic well being of everyone in society. c. The planner must first decide to how to measure the economic well being of society i. One possible measure is the sum of consumer and producer surplus total surplus d. Consumer surplus= value to buyers- amount paid by buyers e. Producer surplus= amount received by sellers- cost to sellers f. Total surplus= value to buyers- cost to sellers g. If an allocation of resources maximizes total surplus, we say that the allocation exhibits efficiency h. If an allocation is not efficient, then some of the potential gains from trade among buyers and sellers are not being realized i. For example, an allocation is inefficient if a good is not being produced by the sellers with lowest cost 1. In this case, moving production from a high-cost producer to a low-cost producer will lower the total cost to sellers and raise total surplus ii. Similarly, an allocation is inefficient if a good is not being consumed by the buyers who value it most highly 1. In this case, moving consumption of the good from a buyer with a low valuation to a buyer with a high valuation will raise total surplus

The social planner might also care about equality i. Whether the various buyers and sellers in the market have a similar level of economic well being 2. Evaluating the market equilibrium a. The total area between the supply and demand curves up to the point of equilibrium represents the total surplus in the market b. Observations about market outcomes i. Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay ii. Free markets allocate the demand for goods to the sellers who can produce them at the least cost iii. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus c. At any quantity below the equilibrium level such as Q1, the value to the marginal buyer exceeds the cost to the marginal seller. i. As a result, increasing the quantity produced and consumed raises total surplus. ii. This continues to be true until the quantity reaches the equilibrium level. d. Similarly, at any quantity beyond the equilibrium level, such as Q2, the value to the marginal buyer is less than the cost to the marginal seller. i. In this case, decreasing the quantity raises total surplus, and this continues to be true until quantity falls to the equilibrium level a. To maximize total surplus, the social planner would choose the quantity where the supply and demand curves intersect. a. The equilibrium outcome is an efficient allocation of resources b. Centrally planned economies never work very well c. The invisible hand takes all the information about buyers and sellers into account and guides everyone in the market to the best outcome as judged by the standard of economic efficiency CONCLUSION: MARKET EFFICIENCY AND MARKET FAILURE a. Important assumptions a. Markets are perfectly competitive i. A single buyer or seller may be able to control market prices 1. Market power a. Can cause markets to be inefficient because it keeps the price and quantity away from the equilibrium of supply and demand b. The outcome in a market matters only to the buyers and sellers in that market i. In the world, the decisions of buyers and sellers sometimes affect people who are not participants in the market at all

i.

b. Rent control a. Removing rent control increases landlords producer surplus and renters consumer surplus b. But removing rent control also clearly makes things worse for incumbent renters

1. Ex pollution 2. The side effects known as externalities cause welfare in a market to depend on more than just the value to buyers and the cost to the sellers