How to Study for Chapter 7 Case Studies Using Demand and Supply Analysis

Chapter 7 develops the ability to apply the analysis of Chapter 6 to various cases.
1. Begin by looking over the Objectives listed below. This will tell you the ain points you
should be looking for as you read the chapter.
!. "ew words or definitions are highlighted in italics in the te#t. Other key points are
highlighted in bold type. $nswer the %uestions in the te#t as they are asked. Then& check
your answer by reading further in the te#t.
'. (ou have ore work with the deand)supply graph in this chapter. Be sure to go over every
shift so that you can see the reasons for the. By the end of this chapter& you should have
astered the use of this graph.
*. +o over the e#aples of ta# incidence very carefully. ,n each case& you need to e#plain why
the incidence of the ta# is either absorbed by the one who pays the ta# or is passed on to
soeone else. The e#planation and reasoning are the ost iportant aspects of this topic.
-. +o over the case on apartents carefully. Try to answer all of the %uestions when they are
asked. Then& read the answers to check and correct your answers.
6. +o over the case on agriculture carefully. Be sure you can e#plain why the shifts were ade
in deand and supply and why the proble of falling far profits resulted.
7. (ou will be given an ,n Class $ssignent and a .oework assignent to illustrate the ain
concepts of this chapter. /hen you have finished the te#t and the assignents& go back to the
Objectives below. 0ee if you can answer the %uestions without looking back at the te#t. ,f
not& go back and re)read that part of the te#t. Then& try the 1ractice 2ui3 .
Objectives for Chapter 7 Case Studies Using Demand and Supply Analysis
$t the end of Chapter 7& you will be able to4
1. 5efine incidence of a ta#.
!. 6#plain what deterines whether the incidence of a ta# is on the buyer or on the seller.
'. $pply the analysis of ta# incidence to the case of the sales ta#& to the case of the health care
insurance preiu& to the case of tariffs on foreign products& and to the case of the costs of
environental regulations
*. Copletely analy3e the case of the rent suppleent progra using deand 7 supply analysis
and the price elasticities of deand and supply.
-. Copletely analy3e the case of a building subsidy progra using deand 7 supply analysis
and the price elasticities of deand and supply.
6. 8se deand 7 supply analysis as well as the price elasticities of deand and supply to
e#plain why $erican farers have faced falling prices and profits over the past century.
1
Chapter 7 Case Studies Using Demand and Supply Analysis
9:ost recent revision ;une !<<6=
!art " #a$ %ncidence

$s one e#aple of deand and supply analysis& let us assue we have a product with the
situation shown in the graph below. The price is >1.<< per unit.
1rice
0upply

1.<< 6

5eand
????????????????????????????????????????
< 2uantity
"ow a sales ta# is iposed. #he ta$ is charged to the seller. @or every >1.<< of sales& assue
that the seller ust pay ><.<7 to the governent. 9"otice that consuers do not pay sales ta#es.
(ou have not paid any sales ta# oney to any governent agency. The store pays the sales ta#
to the governent.= @ro the point of view of the seller& this is an additional cost of
production. ,n addition to all other costs& the seller ust also pay the sales ta#. 5o costs of
production affect deand or supplyA The answer& as shown in the last chapter& is supply. /ill
there be a shift or oveent along supplyA 0ince the change is caused by soething other than
the price of the product& the answer is a shift. 0ince costs of production are increasing& the good
is less profitable& causing supply to decrease. This is a shift to the left& as shown below.
0upply!
1rice
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1.<7
1.<* 6!
1.<< 61

5eand
????????????????????????????????????????
< 2uantity
,f we read the graph vertically instead of hori3ontally& we can say that the seller would like to
raise the price to >1.<7. Then& the seller could pay the ><.<7 in ta# and still have the sae >1.<<
!
that was earned before the sales ta# was iposed. .owever& due to the law of deand& the seller
cannot raise the price to >1.<7. ,f the seller raises the price& the %uantity deanded will fall. ,n
this case& e%uilibriu occurs with the new price at >1.<*. $t any higher price& there would be a
surplus. /e say that ><.<* is the incidence of the tax on the buyer because the buyer ust pay a
><.<* higher price. /e say that the other ><.<' is the incidence of the tax on the seller because
the seller earns ><.<' less that was earned before the sales ta# was iposed 9>1.<* ) ><.<7 B
><.C7=.
,n this e#aple& ><.<* of the sales ta# was passed along to the buyers as higher prices. This
nuber was& of course& just ade)up. .ow do we know in reality how uch of the sales ta# will
be passed along to buyers and how uch ust be absorbed by the sellerA The answer depends
mainly on the price elasticity of demand for the product. To illustrate this point& let us take two
e#tree cases. First, assume that the demand for the product is perfectly inelastic& ,n this case&
the deand curve is vertical4
1rice 0upply!
0upply1
1.<7 6!

1.<< 61

5eand
????????????????????????????????????????
< 2uantity
/hen the sales ta# is iposed& the seller would like to raise the price to >1.<7. 0ince& in this
case& buyers will buy the sae %uantity at any price& there is no surplus and the price can just rise
to >1.<7. If the demand for the product were perfectly inelastic, all of the tax would be shifted
on to the buyers; the incidence of the sales tax would be entirely borne by the buyers.
"ow let us e#aine the other e#tree. Assume that the demand for the product is
perfectly elastic& ,n this case& the deand curve is hori3ontal4
'
1rice 0upply!
0upply1

1.<< 6! 61 5eand
??????????????????????????????????????
< 2uantity
/hen the sales ta# is iposed& the seller would like to raise the price. But when the price rises
above >1.<<& no one buys at all. Therefore& the seller cannot raise the priceD the price will end up
at >1.<<. In this case, none of the tax can be shifted on to the buyers. We say that the
incidence of the sales tax is entirely on the sellers of the product.
@ro these e#tree cases& we can generali3e. The incidence of a sales tax will be more on
the buyer (seller the more inelastic (elastic is the demand for the product. 'emember (from
Chapter )* that the price elasticity of demand depends on the number of substitutes+ the
time involved+ and the price of the product in relation to one,s income& 0o& we can ake a
good guess about the incidence of the 7E sales ta#. $re there good substitutes for products ta#ed
under the sales ta#A The answer is Fprobably noF. ,n California& ost consuer ites are ta#ed
under the sales ta# e#cept food& shelter& and health care. 0o the substitutes to paying the sales ta#
are to eat ore& live in a ore e#pensive apartent or hoe& or go to the doctor ore. Of
course& there is one other substitute ))) donGt spend at all 9better called saving=. $ reasonable
guess is that& if the sales ta# is raised& the %uantity purchased of goods that are ta#ed will fall& but
fall very little. 0econd& is the sales ta# high or low in relation to buyersG incoesA $t 7E& the
answer is Fprobably lowF for ost people. 9The answer& of course& is very different in countries
where sales ta#es reach '<E and up.= If we accept these answers, the !oods taxed under the
sales tax ha"e relati"ely inelastic demand and the incidence of the sales tax would be mostly
on the buyers. ,n fact& ost econoists assue that the incidence of the sales ta# is copletely
on the buyers.
-#est .our Understanding-.
,n 1CC1& a sales ta# was iposed for the first tie in California on Fjunk foodsF. This was the so)called
Fsnack ta#F. ,t iposed a sales ta# on goods like Twinkies and pret3els. /ould the incidence of this sales
ta# be ostly on the buyers of these foods or would it be ostly on the stores that sell theA 6#plain
why.
/$ample " Health Care
,n the 8nited 0tates& ost people get health insurance as a benefit fro eployers.
6ployers pay all& or soe part& of the preiu to a health insurance provider. But do
eployers actually pay this preiu or do they shift the cost on to soeone elseA
*
/mployers have two possible ways to shift the burden of the health insurance cost& One
is to raise prices to consumers. The ability to do this depends on the reaction of consuers to
the price increases. :ost large copanies pay health insurance and therefore would raise their
prices. :any sall copanies 9such as restaurants and gas stations= do not pay health insurance
and therefore would not raise their prices. ,f consuers are able to substitute products ade by
the sall copanies for those ade by the large copanies& the large copanies would not be
able to raise their prices significantly. The incidence of the preiu would then be on the
copanies. .owever& it sees ore reasonable that buyers will not be able to substitute for the
products of large copanies very well. 9,f the price of autoobiles increases& will we eat ore in
restaurantsA= ,n this case& the large copanies would be able to raise their prices. The incidence
of the preius would then be ainly on the consuers.
#he second option for employers is to pass the health insurance cost on to wor0ers as
lower wages (actually as reduced raises in the wages*. @or e#aple& a worker who earns
>'<&<<< per year could have been paid >'-&<<< per year& e#cept that the eployer also paid
>-&<<< for the health insurance preiu. /ho will ultiately pay the preiu is deterined in
this case by the sae reasoning. /hat will workers do when they find their wages reducedA ,f
workers will leave their jobs and find other jobs with higher pay& then the eployer will not be
able to reduce the wages. The eployer will have to bear the burden of the preiu. But this
sees unlikely. :ost eployers pay health insurance. :ost workers would have nowhere else
to go. $s a result& workers would have to accept the reduced wages. The incidence of the
preiu would then be on the workers.
,n !<<'& there was considerable debate in the 8nited 0tates over forcing eployers to pay for
workersG health insurance. The California legislature debated a proposed law that would re%uire
all eployers with ore than -< eployees to pay for health insurance for their workers. This
ended up as a ballot initiative 9that ultiately failed=. To ost econoists& workers pay for their
health insurance even if the eployers actually send the oney to the insurance provider.
Wor#ers pay either throu!h hi!her prices for the products they buy or throu!h lower wa!es
they recei"e. /orkers believe they are getting health insurance fro their eployers as a
benefit. They do not reali3e that& if the eployers were not paying for the health insurance& their
wages would be higher and the prices of the goods they buy would be lower.
/$ample 1 #ariffs
$ tariff is a ta# placed on the products of foreign countries sold in the 8nited 0tates. $ssue&
there is a 1<E ta# on foreign)ade autoobiles. /ho would bear the incidence of this ta#A
$ssue that a ;apanese car and a siilar $erican car each sell in the 8nited 0tates at a price
of >!-&<<<. /ith the 1<E ta# on the ;apanese car 9>!&-<<=& the ;apanese copany would like to
raise the price of its car to >!7&-<<. /hether it can do so or not depends on the price elasticity of
deand for ;apanese cars. ,f the deand for ;apanese cars is relatively inelastic& the %uantity
deanded will fall very little at the price of >!7&-<<. This eans that buyers do not find
;apanese and $erican cars to be close substitutes. The incidence of the ta# would be on the car
buyers. On the other hand& if the deand for ;apanese cars is relatively elastic& the %uantity of
;apanese cars deanded will fall considerably at the price of >!7&-<<. This eans that buyers
will closely substitute between ;apanese and $erican cars. The ;apanese copany will have to
-
charge a price close to >!-&<<< in the 8nited 0tates to be able to copete. The incidence of the
tariff will be on the ;apanese autoobile copanies.
,n technical language& a tariff on a forei!n product that has "ery elastic demand is called an
optimal tariff. The price of the foreign product rises very little in the 8nited 0tates. :ost of the
tariff is paid by the foreign copany as reduced profits. The gain& of course& goes to the 8nited
0tates governent& who collects the oney.
/$ample 2 /nvironmental 'egulations
$s we will see in a later chapter& free arkets coonly lead to e#cessive pollution. This
occurs because& fro the point of view of the copany& polluting is free 9or at least very
ine#pensive=. :ost of the costs that result fro pollution are borne by other people ))) people
who breathe the air& fish in the water& becoe ill& and so forth. One way to reduce pollution is to
force polluters to undertake activities that will reduce their pollutants. These activities are costly.
$nother approach is to ta# polluters. @or now& the %uestion concerning us is this4 who actually
will pay for the costs of reducing pollutantsA
One e#aple is the tissue industry. The copanies in this industry use raw wood or pulp to
anufacture facial tissue& bathroo tissue& disposable diapers& and paper napkins. $s water
polluters& they were forced by the 8nited 0tates governent to install pollution control
e%uipent. This e%uipent represents a cost. The copanies would like to recover the oney
spent on this e%uipent by raising the prices of their products to consuers. /hether they can
do so or not depends on the price elasticity of deand for tissue products. :ost studies find that
the deand is relatively inelastic. This eans that& when the price rises& buyers will reduce their
%uantity deanded of tissue products very little. 92uestion4 using the factors affecting price
elasticity of deand& e#plain why the deand for tissue products ight be relatively inelastic.=
The incidence of these costs therefore is borne ostly by the buyers of these products& who are
paying higher prices. ,f the deand is relatively inelastic& the %uantity produced by the
copanies in this industry will fall very littleD as a result& there will be only a sall nuber of
jobs lost. Studies find this to be the case for most industries affected by pollution controls 333
few wor0ers lose jobs but consumers face higher prices. $s we will see& the higher prices
paid by consuers ay actually be desirable for society as a whole.
H#est .our Understanding-&
1. There is a Transient Occupancy Ta# of about 1<E in 0an 5iego. This eans that people who stay in a
hotel in 0an 5iego pay an additional 1<E of the price of a roo as ta#. 9,f a roo charge is >1<< per
night& they pay an additional >1< in ta# to the city.= 8pon who would the incidence of this ta# fall )))
those who stay in hotels 9ainly tourists and businesspeople= or the hotelsA /$plain why&
!. $ recent article estiated the following for restaurant eals4
The price elasticity of deand B <.1II The price elasticity of supply 7 6.*7
The e%uilibriu price averaged >1<.*7 per eal 9in 1CC! prices=
The e%uilibriu %uantity was I.1* billion eals per year.
,f there were a >1.<< per eal ta#& the article estiated that the new e%uilibriu price would
be >11.** per eal and the new e%uilibriu %uantity would be I.<1 billion eals. 0how
these facts in the graph. /ho bears ost of the burden of the ta# on restaurant ealsA /hat percent of
the ta# do they bearA 8sing the analysis of the chapter& why do you think this is soA
6
!art 1 Case Using Demand and Supply Analysis
#ry to answer the 4uestion first& #hen+ chec0 your answer in the reading&
$ssue there is a well)defined geographic area of a city. The area is coposed e#clusively of
apartents and is populated by low)incoe residents. The people who live in the area tend to stay in that
area because 91= they cannot afford to live in other areas of the city& 9!= they prefer to live with people of
their own ethnic group& or 9'= there is discriination against the in other areas of the city. Jents paid
are a very high percent of peoplesG incoes.
91= /ould the demand for apartents in this area be relatively inelastic or relatively elasticA 0tate why.
9!= /ould the supply of apartents in this area be relatively inelastic or relatively elasticA 0tate why.
9'= 5raw the deand and supply curves as you have described the& showing the initial
e%uilibriu price and %uantity. Kabel carefully.
9*= "ow assue the governent creates a rent supplement program. 8nder this progra& the renter is
re%uired to pay '<E of incoe in rent. $ny additional rent is paid by the governent ))) up to a liit.
@or e#aple& a low)incoe person with an incoe of >1&<<< a onth would be re%uired to pay >'<< in
rent 9'<E=. ,f the rent is >-<<& the other >!<< would be paid by the governent. $naly3e the results of
this progra. 0how the changes on the graph and e#plain what will result. /ho gains and who loses
fro this prograA
9-= ,nstead& now assue that the governent decides to provide a building subsidy to people who build
apartents in this low)incoe area. $ certain percent of their costs will be paid by the governent.
$naly3e the results of this progra. 0how the results on the graph and e#plain what will result.
Answer to the Case
91= /ould the demand for apartents in this area be relatively inelastic or relatively elasticA
0tate why.
The deand for apartents would be relatively inelastic because there are few substitutes for
the apartents in this area. .owever& you ight argue that deand would be relatively elastic
because the rent is a high proportion of the rentersG incoes. $ raise in rent could cause renters
to leave the city altogether or to have to live on the streets.
9!= /ould the supply of apartents in this area be relatively inelastic or relatively elasticA 0tate
why.
The supply would also be relatively inelastic. The %uestion is asking4 would the %uantity
supplied rise just a little or rise greatly if the rents increaseA +iven that this is a low)incoe area
and that there is probably not uch free land available& it is likely that the %uantity supplied
would increase only a little. 6ven at increased rents& building apartents in low)incoe areas is
not a good investent for apartent owners.
9'= 5raw the deand and supply curves as you have described the& showing the initial
e%uilibriu price and %uantity. Kabel carefully.
Both deand and supply should be drawn as steep 9unless you argued that deand was
relatively elastic=.
7
1rice
0upply
11 6

5eand
????????????????????????????????????????
< 2uantity
9*= "ow assue the governent creates a rent supplement program. 8nder this progra& the
renter is re%uired to pay '<E of incoe in rent. $ny additional rent is paid by the governent
))) up to a liit. @or e#aple& a low)incoe person with an incoe of >1&<<< a onth would be
re%uired to pay >'<< in rent 9'<E=. ,f the rent is >-<<& the other >!<< would be paid by the
governent. $naly3e the results of this progra. 0how the changes on the graph and e#plain
what will result. /ho gains and who loses fro this prograA
The payent by the governent can be treated as an increase in income. This affects the
deand for apartents. $n increase in deand would be shown as a shift to the right. This
creates a shortage of apartents. $s a result& rents rise. The %uantity of apartents supplied
also rises. ,f the supply is indeed relatively inelastic& the 4uantity supplied rises very little.
The ajor effect is the rise in rents. Jenters gain fro the progra. 5ut most of the gain goes
to the owners of the apartments. This is not what was intended. The FlosersF are the ta#payers
who pay for the progra.
1rice
0upply

1!

11 61
5eand!
5eand1
????????????????????????????????????????
< 21 2! 2uantity
9-= ,nstead& assue that the governent decides to provide a building subsidy to people who
build apartents in this low)incoe area. $ certain percent of their costs will be paid by the
governent. $naly3e the results of this progra. 0how the results on the graph and e#plain
what will result.
The subsidy progra is a decrease in costs of production. /ith lower costs of
production& supply increases (shifts to the right*. This creates a surplus& causing apartent
I
owners to lower the rents& The %uantity of apartents supplied increases. ,f deand is
relatively inelastic& the largest effect is the reduction in rents& #he 4uantity supplied
increases only a little& Jenters and apartent owners gain fro the progra. But in this case&
renters gain the ost.
1rice
0upply1
0upply!

11 61
1!
5eand
????????????????????????????????????????
< 21 2! 2uantity
96= @ro the point of view of iproving housing for the poor& decide for yourself which is the
better public policyA
!art 2 Case on American Agriculture
#ry to answer the 4uestion first& #hen+ chec0 your answer in the reading&
Consider the arket for grains. 91= ,s the deand for grains relatively elastic or relatively inelastic with
respect to the priceA /$plain why& 9!= ,s the deand for grains relatively elastic or relatively inelastic
with respect to incoeA /$plain why& 9'= ,s the supply of grains relatively elastic or relatively inelastic
with respect to the priceA /$plain why& 9*= On the graph& draw the deand and supply curves as you
have described the. 0how the e%uilibriu price and %uantity. 9-= Over tie& the deand for wheat has
shifted to the right. /hy has this occurredA 96= Over tie the supply of wheat has shifted to the right.
/hy has this happenedA 97= /hich do you believe has shift ore over the past century4 the deand curve
or the supply curveA 6#plain why. Then& show these two shifts on the graph. 9I= $s a result of these two
shifts& the price of wheat will ???????????? 9rise or fallA= Because of the price elasticity of deand for
wheat& total revenues received by farers will ??????????????????9rise or fallA= The result is that the
total profits of farers will ?????????????????9rise or fallA= 9C= The arket is sending a signal to the
farer. /hat is it telling the farer to doA
Answer to the Case
Begin with the deand for grains. 6ould this demand be relatively elastic or relatively
inelastic7 The answer& ost studies show& is relatively inelastic. /hyA One reason is that
people are unwilling to substitute fro products ade fro grain& such as bread. $nother reason
is that buying grain products is ine#pensive in relation to peopleGs incoes.
"ow& consider the supply. 6ould this supply of wheat be relatively elastic or relatively
inelastic7 The answer& ost studies show& is relatively inelastic. /hyA ,n a short period of
tie& supply ay be perfectly inelastic. Once the seeds are planted& the supply cannot be
adjusted until the ne#t planting. Over a longer tie& farers can adjust supply by planting ore
or less. But this is liited by the fact that the farer has only so uch land& barn space& and
C
achinery. The graph below shows the deand and supply as relatively inelastic.
1rice of +rain
0upply

11 61
5eand
????????????????????????????????????????
< 21 2uantity of +rain
Over time+ the demand for wheat will rise (shift to the right*. /hyA One reason is that
population rises 9both because the $erican population increases and because farers are able
to sell ore in foreign arkets=. $nother is that incoes rise. .owever& according to what is
called $n!el%s &aw, the income elasticity of demand for products made from !rains is low.
This eans that& as incoes rise& the deand for these products 9and any other food products=
rises very little. $ third reason for the shift in deand is that tastes change toward eating ore
eat. $s people eat ore eat& the deand for wheat rises. This occurs because about C<E of
the sunGs energy is lost if the anial eats the plant and then a person eats the anial. .owever& in
recent years& tastes ay have caused a leftward shift in deand for wheat as diet)conscious
people have tried all)protein diets.
Over time+ the supply of wheat will also rise (shift to the right*& /hyA The cause has
been the enorous technological advances that have increased productivity and lowered costs of
production. These technological advances have been the result of the work of universities&
agricultural e#tension progras& and the copanies that sell products to farers. $ large part of
this technological advance has been financed by the federal governent.
/hich do you believe has e#perienced the greater shift to the rightA The answer has been that
the supply has shifted to the ri!ht much more than the demand has shifted to the ri!ht. This is
shown in the graph below. The technological advances over the past century have been
e#ceptional. If the supply increases more than the demand increases, the result is that the
price of wheat must fall& This indeed has been occurring over the past century. If the price
falls, and the demand is relati"ely inelastic, what will happen to the total re"enue recei"ed'
The answer is that it falls. $s the price falls& people do not eat that uch ore. /hen total
revenue falls& the farer would like to reduce costs to aintain profits. But any of the costs
cannot be reduced. The land& buildings& and achinery ust be paid for. :any of the workers
are relatives and cannot be laid)off 9although faily workers often take part)tie jobs in the
nearest town=. The result is that profits fall.
1<
1rice of +rain
0upply1
0upply!

11 61
1! 6!

5eand!
5eand1
????????????????????????????????????????
< 21 2! 2uantity of /heat
The mar#et is sendin! the farmer a si!nal. It is tellin! him or her to lea"e farmin! and do
somethin! else. /hat is the farerGs sinA ,t is not that the farer has been inefficient or has
ade bad business decisions. The proble is that the farer is too good. @arers produce ore
food than consuers want to buy at prices that will allow the farer to ake a profit. To any&
this sees unfair. .ow this proble has been dealt with will be considered in the ne#t chapter.
!ractice 8ui9 for Chapter 7
1. The incidence of as sales ta# will be ore on the buyers of the product if
a. the price elasticity of deand is low c. the incoe elasticity of deand is low
b. the price elasticity of deand is high d. the cross elasticity of deand is high
!. The incidence of a sales ta$ is ost likely on the
a. buyers b. sellers
'. $n :optimal tariff; is a ta# on iported goods which have a high
a. price elasticity of deand c. price elasticity of supply
b. incoe elasticity of deand d. cross elasticity of deand
*. ,f there is a rent supplement progra4
a. rents will rise b. the %uantity of apartents available will fall c. landlords will be hurt
-. ,f there is a building subsidy progra&
a. rents will rise b. the %uantity of apartents available will rise c. landlords will be hurt
6. ,n the case of agriculture& the demand for grain products is likely to be
a. relatively elastic b. relatively inelastic c. perfectly elastic
7. ,n the case of agriculture& the supply of grain products is likely to be
a. relatively elastic b. relatively inelastic c. perfectly elastic
11
I. ,n the case of agriculture&
a a. the deand has shifted to the right ore than the supply has shifted to the right
b. the deand has shifted to the right less than the supply has shifted to the right
b c. the deand has shifted to the left ore than the supply has shifted to the left
d. the deand has shifted to the left less than the supply has shifted to the left
C. Because of what happened in %uestion I& the prices of grain products have
a. risen b. fallen c. stayed the sae
1<. The arket is telling farers to
a. produce ore b. e#pand their fars c. leave faring d. wait for better days
$nswers4 1. $ !. $ '. $ *. $ -. B 6. B 7. B I. B C. B 1<. C
1!