IGAD y la región del Cuerno de África (CdA)

Chapters 3 and 4 lay the foundation for the stu-dents’ knowledge of supply and demand and elastic-ity. Knowing these elements is essential for further study of economics and is a prerequisite for all the chapters that follow.

Before we discuss the various building blocks that will complete the study of managerial economics, this appendix endeavors to reinforce the concepts of sup-ply and demand and of elasticity in two ways:

1. Some specific applications of supply and demand are discussed, including the effects of price controls, and excise taxes.

2. Various actual situations as reported in the press are introduced and discussed, and it is shown that the materials we have just learned can be applied to ana-lyze these situations.

interference with the price mechanism

In Chapter 3, we discuss the movement toward equi-librium in both the short and long run. A change in demand or supply will call forth actions that will cause equilibrium to occur at a new supply–demand intersection. It is shown that in the short run, price changes will eliminate shortages or surpluses. In the long run, resources in the economy shift from the production of one product to another in response to changes in demand. The shift away from one equilib-rium and the move to a new equilibequilib-rium will proceed when these movements are permitted to occur freely and are not impeded by any outside interference.

Thus, when the supply of corn decreased and price rose so the market cleared at this new price—that is, at the new intersection of supply and demand—there was nothing inhibiting this change from taking place.

However, with present economic institutions, free movement of prices is not always allowed. At least three times in the last 70 years,²³ price controls were imposed in the United States. Prices on various prod-ucts were set (or fixed at existing levels), and these products could not be sold at prices higher than those prescribed by government. Such a policy is usually

referred to as setting a price ceiling. If the price ceiling for a product is set at the prevailing equilibrium level, then the ceiling will have no effect (until a change in circumstances dictated a higher price). But if the price were set below the equilibrium price,²⁴ then, as explained in Chapter 3, a shortage would result.

In Figure 4A.1, the equilibrium price is P0 and the quantity sold (and clearing the market) at this price is Q 0. If for some reason the price winds up at P1 un-der free-market conditions (i.e., no price controls), the price will rise until the equilibrium price (P0) is again reached. But if the price is prescribed to be no higher than P1,²⁵ the movement toward equilibrium

P

23During World War II, the Korean War, and again in 1971.

24It is obvious that a ceiling set above the equilibrium price would be meaningless.

25Price ceilings can be enforced by the government imposing fines or even prison sentences on violators. Such punishment would have appeared rather lenient to some of our ancestors.

During the times of price controls in ancient Egypt, Greece, and Rome, the death sentence was the penalty for breaking price control laws. The edict of Diocletian in A.D. 301 imposed the death sentence on those selling at prices higher than decreed, as well as on those buying at such prices (Robert L. Schuettinger and Eamonn F. Butler, Forty Centuries of Wage and Price Controls, Washington, DC: Heritage Foundation, 1979, p. 23).

100

will not take place. Only Q 1 will be supplied while Q 2

is demanded at the lower price, so a shortage of mag-nitude Q1 - Q2 will be established. Thus, only the consumers in the interval 0 - Q1 will be able to buy this particular product. What will be the result of this forced disequilibrium? Possibly consumers will try to shift their demand to other products, causing a pres-sure on the other products’ prices. If these products are also price controlled, shortages of these other goods will occur.

There is another possible result. Because only Q 1 units of the product will be supplied at price P1, these units could be purchased at price P2 along the demand curve. Consumers would be willing to pay P2, a price higher than the equilibrium price, P0, for the limited quantity Q 1. Thus, a strong pres-sure on the price will be exerted, and somewhere in this process the difference between P1 and P2 will be paid to the suppliers.

An example of such a case was the price of au-tomobiles after World War II. A ceiling price below the price level that would have cleared the market was imposed on new cars. This low price caused automobile manufacturers to limit their produc-tion. However, consumers were paying high prices for these cars in the way of a dealer’s premium.

They may also have received lower trade-in prices on their old automobiles or may have bought their new car as a “used” one because second-hand cars were not price controlled. The price they actually paid was indeed higher than it could have been if the manufacturers had charged a higher list price.²⁶ Similarly, where rent ceilings have been imposed many people end up paying a bonus to the superin-tendent or to a rental agent.

Another example precedes those just discussed by more than 150 years. During the Revolutionary War, the legislature of Pennsylvania imposed limits on prices of goods sold to the military and was thus instrumental in creating extreme shortages of food for George Washington’s army at Valley Forge.²⁷

We can also present a more recent example.

The African country of Zimbabwe experienced extreme hyperinflation, sometimes estimated at 10,000 percent per year. In the middle of 2007, Robert Mugabe, the country’s president, issued an or-der slashing prices in half. In response to this oror-der,

“Zimbabwe’s economy is at a halt.” As reported by

the New York Times, “meat is virtually nonexistent,”

“gasoline is nearly unobtainable,” and “[hospital]

patients are dying for lack of basic medical supplies.”

Manufacturing has slowed because businesses can-not produce goods for less than their government-imposed sales prices. “It appears … that not even an unchallenged autocrat can repeal the laws of supply and demand.”²⁸

On the other side of the price control coin are price floors. In such cases, a price is established be-low which the product or service may not be sold.

An excellent example of a price floor is the legal minimum wage. Employers are not allowed to pay their workers less than the established minimum, so they must therefore deal with the disturbance to a price equilibrium.²⁹

If the equilibrium wage (e.g., per hour) for some unskilled work were to be at level W0 as shown in Figure 4A.2, but the law stated that a wage lower than W1 is illegal, then a surplus of labor Q2 - Q1

would exist. In the absence of the minimum wage law, wages would drop to W0, and the quantity sup-plied and demanded of labor would meet at Q 0. Thus all workers offering themselves for employ-ment at that wage would be hired.

26Milton Friedman, Price Theory: A Provisional Text, Hawthorne, NY: Aldine, 1962, p. 18.

27Schuettinger and Butler, Forty Centuries, p. 41.

28Michael Wines, “Caps on Prices Only Deepen Zimbabweans’

Misery,” New York Times, July 28, 2007.

29Wages are, of course, the price of labor, so it is quite correct to discuss minimum wages under the topic of price floors.

W

But if the wage cannot fall below W1, what will happen? The unemployed will look for work else-where. If the minimum wage prevails in all types of employment, they would not be able to find work.

However, there are still some forms of employment in the United States that are not covered by law. A person can also become self-employed, in which case minimum wages do not apply.³⁰

The effect of increases in minimum wages on employment has been widely studied by economists for many years. In the past, most economists agreed that increases in minimum wages had a negative effect on employment, especially in the case of young and unskilled workers. Unemployment has generally been the highest among teenage work-ers, many of whom have dropped out of school and acquired few if any skills.³¹ However, several recent studies have questioned the traditional find-ings, concluding that minimum wage increases have not necessarily led to decreased employment.³² Although the new studies cast doubt on the tradi-tional hypothesis, it is much too early to dismiss it.

Much additional research is necessary to clarify the effect that increases in minimum wages have on employment.³³

Several additional points should be made re-garding the impact of minimum wages. Even if an increase in the minimum does have a negative effect on employment, workers who remain em-ployed at the higher wage will benefit. The workers can be found in the interval 0 - Q1.³⁴ Second, the short-run effects of an increased legal minimum are probably stronger than the long-run effects. As time passes, the wage levels in the economy will rise (ei-ther due to inflation or in real terms), and at some point the minimum wage may approach the free-market equilibrium wage. A third point also appears worth mentioning. Because an increase in the mini-mum wage must be passed by the legislature (the U.S. Congress in the case of a federal minimum), it is a part of the political process. Legislators may be reluctant to enact a minimum wage increase if it would increase unemployment. Thus, such legisla-tion may be passed only if it would appear to have a minimal effect.

The incidence of Taxes

From the viewpoint of the economics of the firm, one important example of applied analysis using supply and demand curves and elasticities is in the area of the incidence or effect of excise taxes on the prices and quantities of products.

An excise tax is a tax imposed as a specific amount per unit of product. It is also sometimes re-ferred to as a specific tax, as compared with a sales tax, which is levied as a percent of the price of the product or service. The federal excise tax on gaso-line as of this writing is 18.4 cents per gallon. The sales tax, which is usually collected by states and lo-cal communities, in the city of Phoenix, Arizona, for example, is 9.3 percent of the price of a product.

Sales taxes are often referred to as ad valorem taxes.

We could discuss the incidence of either ad valorem or specific taxes, but we choose the latter for our analysis. The principles and applications are simi-lar, but a specific tax provides a simpler and more straightforward illustration.

A numerical example aids in this exposition.

Table 4A.1 shows the demand and supply schedules for a particular product. The equilibrium price is

$4. At this price, 15 units will be demanded, and

30At the risk of sounding facetious, the extreme case of self-employment is unself-employment.

31Among many studies, see, for instance, C. Brown, C. Gilroy, and A. Kohen, “The Effect of the Minimum Wage on Employ-ment and UnemployEmploy-ment,” Journal of Economic Literature, 20 (June 1982), pp. 487–528; B. S. Frey, W. Pommerehne, F. Schneider, and G. Gilbert, “Consensus and Dissension among Economists: An Empirical Inquiry,” American Economic Review, 74 (December 1984), pp. 986–94; T. G. Moore, “The Effect of Minimum Wages on Teenage Unemployment Rates,” Journal of Political Economy, July/August 1971, pp. 897–902. A more recent study that finds negative effects on employment is D. Deere, K. M. Murphy, and F. Welch, “Employment and the 1990–1991 Minimum Wage Hike,” American Economic Review Papers and Pro-ceedings, 85 (May 1995), pp. 232–37.

32See, for instance, D. Card and A. B. Krueger, “Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania,” American Economic Review, 84 (September 1994), pp. 772–84; D. Card, “Do Minimum Wages Reduce Employment? A Case Study of California, 1987–89,” In-dustrial and Labor Relations Review, 46 (October 1992), pp. 38–54;

L. F. Katz and A. B. Krueger, “The Effect of the Minimum Wage on the Fast-Food Industry,” Industrial and Labor Relations Review, 46 (October 1992), pp. 6–21; State Minimum Wages and Employ-ment in Small Businesses, Fiscal Policy Institute, April 21, 2004.

33A good summary of the recent research and an analysis of vari-ous hypotheses regarding the effect of minimum wages on em-ployment is M. Zavodny, “Why Minimum Wage Hikes May Not Reduce Employment,” Economic Review, Federal Reserve Bank of Atlanta, 83, 2 (second quarter 1998), pp. 18–28.

34It is an interesting decision, implicitly made by the U.S.

Congress when it passes a law increasing the minimum wage, whether the overall welfare of the country will be increased if some part of the labor force has its wages improved while an-other part has its income lowered.

15 units will be supplied, thus clearing the market.³⁵ The demand and supply curves are shown in Figure 4A.3a, where an equilibrium at P = 4 and Q = 15 can be observed.

Now suppose the government imposes an excise tax of $1 per unit, which it will collect from the sell-ers. The effect is to shift the supply curve up by the unit tax. The shift can be thought of in the following way: Before the enactment of the tax, suppliers of-fered to sell 20 units at $5. But now, for the producers

to obtain $5 per unit, these products will have to be sold at $6 apiece (of which $1 will be remitted to the government).³⁶ In effect, the production cost for this good has risen by $1 per unit. The last column in Table 4A.1 shows the new supply schedule.

The important question to be asked is, What will be the market-clearing price and quantity after the imposition of the new excise tax? An easy answer would be $1 more than before, or $5. Certainly, the suppliers would prefer not to receive less per unit

35An arithmetic solution can be obtained as follows: the equa-tion of the demand curve for the schedule shown in Table 4A.1 is Q_D= 35- 5P, and the equation for the supply curve is

Table 4A.1 Demand and Supply and Tax Incidence

Quantity Supplied

Figure 4A.3 The Influence of an Excise Tax on Supply and Demand

than they had been getting before the tax. But this is not the correct answer, except in very rare cases.³⁷ The new intersection will be at $4.50, and the quan-tity will be 12.5 units.³⁸

Thus, sellers will receive only $3.50 per unit after the imposition of the tax, and consumers will be pay-ing 50 cents more than before. In economic jargon, 50 cents of the tax has been shifted forward to consum-ers, and 50 cents has been shifted back to the produc-ers. This new equilibrium is shown in Figure 4A.3b.

How the incidence of the tax is distributed be-tween the two parties to the transaction depends on the elasticity of the supply and demand curves. The more elastic the demand curve, the larger will be the portion of the tax that the supplier has to bear. In Figure 4A.4a, we repeat the demand and supply curves previously shown and add a second demand curve, which (be-fore the tax) also intersects the supply curve at $4 and 15 units but at all other points is flatter (more elastic) than the original demand function. In Figure 4A.4b, the tax is added on to the supply curve. With the new demand curve, the equilibrium price is $4.42, and the quantity demanded is just above 12 units.³⁹

37This will occur where the demand curve is perfectly inelastic.

38Using our equations,

35 - 5P = -10 + 5P 45 = 10P 4.5 = P

The effect of the tax on the equilibrium quan-tity is of significance to the government unit levy-ing the tax. It is obvious that a government settlevy-ing a new (or increasing an old) excise tax is taking such action to increase its revenue. However, if the de-mand curve for the particular product is very elas-tic, the erosion of the revenue base will cut short the amount of revenue the government expects to collect. In the present case, the government would have collected $12.50 in revenue with the original demand curve and only $12.08 for the more elastic demand curve. Had the demand curve been per-fectly inelastic (vertical), then not only would the entire tax have been shifted to the consumer, but government revenue would have been $15 because the number of units sold would have remained at 15.

Thus, a government would prefer to enact an excise tax on a product with low demand elasticity.⁴⁰

Some of the more familiar excise taxes are those on tobacco and alcohol. Because the consumption of these products is not considered desirable by today’s

39The equation for the more elastic demand curve is QD= 43- 7P and the equilibrium price is

43 - 7P = -10 + 5P 53 = 12P 4.4167 = P

40You have certainly been subjected to a tax increase in some prod-uct you consume, whether it was tobacco, gasoline, or alcohol, to mention just three products on which excise taxes are levied by both federal and local governments. You will probably recall that on the day the tax was increased, the price of, say, gasoline, rose by the pre-cise amount of the tax. This is because, first of all, the increase may have been relatively small in comparison to the total price, so the demand curve may be quite inelastic in this relatively narrow price range. Second, as we have already learned, demand elasticity tends to be lowest in the very short run, so the tax may be completely (or almost completely) shifted to the consumer at first. But as time passes, there may be a series of small price decreases, or—and this is the more likely scenario in an inflationary environment—prices may not rise as quickly as they otherwise would have.

P

Figure 4A.4 Effect of Demand Elasticity on Equilibrium

standards, tobacco and alcohol are frequently among the first to be selected when additional taxes are con-templated. All states, as well as the federal govern-ment, impose an excise tax on these two products.

In some cases, the amount of the tax on each unit is greater than 50 percent of the total price of the product. Because of the low esteem in which these products are held by a large segment of the popula-tion, opposition to the imposition of a tax (or an ad-ditional tax) is generally not great (except by the two industries involved). These taxes are often referred to as “sin” taxes. But would it have been attractive to levy such high excise taxes on these two products had the demand curve for them been very elastic?⁴¹ Prob-ably not, because the tax base would have eroded significantly. Therefore, the government unit that wants to achieve what is popularly known as a “rev-enue enhancement” will find it considerably more favorable to enact an excise tax on products whose demand elasticity in the range of the tax increase is relatively low. Tobacco and alcohol seem to fit this category well. Thus, a government unit can claim to be taxing “undesirable” commodities and at the same time help to maximize its revenue.

Among the many proposals to fight the large fed-eral deficits of the late 1980s was the imposition of a

Among the many proposals to fight the large fed-eral deficits of the late 1980s was the imposition of a