| UNIT ONE |
CHAPTER 4
Supply and Demand: Applications and Extensions
I. Wage
Rates, Interest Rates, and Exchange Rates
A.
Linkage Between Labor and Product Markets
1.
The markets for resources and products are closely linked.
a.
Changes in one will affect the other.
(1)
An increase (decrease) in resource prices will reduce (increase) supply
in the product market.
(2)
An increase in product demand will increase the demand for resources used
in production of the good.
B.
Loanable Funds Market and the Interest Rate
1.
The interest rate connects the price of goods today and their price in
the future.
a.
The interest rate is the price that must be paid for earlier
availability.
C.
Market for Foreign Exchange
1.
Foreign exchange market is where currency of one country is traded for
another.
2.
The exchange rate is measured are the dollar price of foreign currency.
D.
Changes in Exchange Rates
1.
Changes in exchange rates will change the prices of internationally
traded goods/services and assets
2.
A lower dollar price of foreign currency will have two effects.
a.
It lowers the price of foreign goods to U.S. residents and raises
imports.
b.
It will raise the price of U.S. goods to foreigners and lower exports.
II.
Economics of Price Controls
A.
Price Ceilings
1.
Price ceiling is a legally established maximum price that sellers may
charge.
a.
Example: rent control
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.
2.
Inefficient use.
3.
Lower future supply.
4.
Nonprice rationing will be of more importance.
C.
Effects of Rent Control
1.
Shortages and black markets will develop.
2.
The future supply of housing will decline.
3.
The quality of housing will deteriorate.
4.
Nonprice methods of rationing will increase in importance.
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
1.
Direct effect:
a.
Reduces employment of low-skilled labor.
2.
Indirect effects:
a.
Reduction in nonwage component of compensation.
b.
Less on-the-job training.
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
1. Tax rate is
the percentage rate at which an economic activity is taxed
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.
