Tax credit responses part I: Screwdrivers

A number of objections appeared in the comments on my previous post, both here and at Business Insider. Good. You never learn anything from people who agree with you, and I like to learn.

That said, I stand by my original post (mostly), and I want to elaborate a bit.

I will start with the easy part, which is the screwdriver analogy. Crack open any Econ 101 textbook, and somewhere in the first chapter or two you will find a picture like this:

Supply/Demand curve

(Actually, if you remove the labels on the axes and curves, you will find the same picture in pretty much every chapter of every economics textbook. But I digress…)

The upward sloping curve S is a “supply curve”, showing how the quantity Q of screwdrivers supplied varies with the price P; higher price → more supply. (Why do economists put the dependent variable on the horizontal axis? Again, I digress.) The downward sloping curves D1 and D2 are “demand curves”, showing how the quantity of screwdrivers demanded varies with the price; higher price → less demand. D1 and D2 are showing two different relationships between price and demand; that is, they illustrate a “demand shock”. If you are not familiar with this picture and/or my description does not make sense, read the Wikipedia article.

A little thought should convince you that my hypothetical government policy of $1 rebates for screwdrivers corresponds to a sort of “demand shock” that would shift the demand curve straight upward by $1. This would move the supply/demand intersection point — i.e., the “equilibrium” aka. market price — up by some amount greater than $0 and less than $1. In fact, the picture above illustrates this almost perfectly; just change the arrow between “D1” and “D2” to point upward instead of rightward.

But that new price applies in equilibrium. Screwdriver production cannot be ramped up instantly. Over a very short time frame, screwdriver supply is fixed; that is, the supply curve is vertical. So shortly after the rebate policy was enacted, the price would spike by $1. Over time, that higher price would lead to increased supply to bring the price back down to the intersection point of the S and D2 curves. It is only that increase in supply — not, say, “competition” — that would serve to bring the price back down.

This is what I was thinking when I wrote that the rebate would be “a gift to screwdriver sellers” and it “would be shared with buyers only to the extent that it encouraged the production of screwdrivers in excess of natural demand.” The original screwdriver demand curve represents the true economic utility of screwdrivers; screwdrivers have value only because people need them for something. A government-sponsored $1 screwdriver rebate would encourage the production of more screwdrivers than people actually need.

This sort of market distortion is rarely a good idea… As would become apparent when the rebate expired and the glut of unnecessary screwdrivers hit the “new and existing” screwdriver market. Funding such a market distortion with taxpayer money merely adds insult to injury.

In short, I stand by my analysis of the first-time screwdriver buyer tax credit.

5 comments to Tax credit responses part I: Screwdrivers

  • ftobin

    I think I’m a little dense in understanding why the rebate causes a strong demand shock, bringing the price of the screwdrivers up to $6, as you mentioned in the first article. If the net price to the consumer is $5, then there is no increased demand. If non-first time screwdriver buyers are purchasing from the same set as well, then their demand would fall if the price rose.

  • Well, let me see if I can explain.

    You have to remember what a demand curve represents. There is some set of people for whom a screwdriver is worth at least $10. There is a larger set of people for whom a screwdriver is worth at least $9. There is a still larger set for whom a screwdriver is worth at least $8. And so on. That is, the utility of a screwdriver varies among people; for example, a screwdriver is worth more to a professional carpenter in her job than it is to me for occasional use around the house.

    The demand curve plots, for each P, the number of people for whom a screwdriver is worth at least $P. This is the number of people who will buy a screwdriver priced at $P. As you increase P, the number of such people falls.

    Now, if some number of people Q will pay P dollars for a screwdriver with no rebate, how many will pay P+1 dollars with a 1 dollar rebate? Answer: They are exactly the same, because the final cost is identical in both cases. So the Q value plotted at P on curve D1 becomes the Q value plotted at P+1 on curve D2, for all P. That is what I mean by “shifting the curve up by $1”.

    You are sort-of correct that “if the net price to the consumer is $5, then there is no increased demand”. But you are thinking of demand as some fixed quantity rather than as a curve that depends on price. There is no single-quantity “demand”; there is only “the demand at each price”, in the sense of how many people will pay each price. This is what the curve plots, and this is what changes in the presence of the rebate. When the rebate is enacted, the curve shifts so that the demand for screwdrivers at $5 increases. But until the supply increases, that new demand cannot be met… So the price temporarily spikes to $6 to squelch the excess demand and bring it back down to match the available supply. Both before and after the rebate, we are at the same “Q” location on the graph, but the “P” location has gone up by $1.

    As new supply comes on-line, equilibrium is restored, and you can find the new price at the intersection of the S curve with the D2 curve (which is $1 above the D1 curve). Again, this happens as a direct consequence of the increased supply. This new equilibrium price, supply, and demand are all higher than they started.

    If this is still unclear, it might help to consider the extreme case of a $5 (or even $6) rebate, and what that would do to the supply, demand, and price of screwdrivers, both immediately and longer-term…

  • jesse

    I am from Vancouver BC and the movement of the market here is very similar to what is happening in the US, however prices here only dropped about 10% from their record highs in May 2008 and are again approaching their highs again. The rebound in price, IMO, has to do a lot with the availability of credit as while our CHANGE in prices were similar to US markets, we don’t have the 8K tax credit. It is interesting that it seems to be relative, not absolute, price changes that are the same between US and Canadian markets, with low interest rates the common thread.

    It may be as simple as the step function in interest rates caused a mini-bubble, unfortunately what looks to be a temporary one.

  • chuck_starchaser

    Not an economist here, but I’m thinking… You mention that, in the short term, the supply curve is vertical, as it takes time for factories to retool to meet increased the supply of screwdrivers. I think that would be a bit simplistic: A 10% demand increase could be met almost instantly, by asking workers to work an extra hour of over-time, for example. Such rigidity in short-term supply would assume that all factories are already operating at 100% capacity, which is very rarely the case.
    Secondly, it seems to me there’s an even shorter-term factor to consider: stocks. Factories often keep stocks of finished product, precisely as a buffer against possible spikes in demand that can’t be supplied due to short term non-elasticity; or to reduce the costs associated with short term elasticity, such as overtime pay premium. Retailers also usually keep a bit of extra stock. So there are buffers in the system which, in fact, make the supply curve flat (horizontal) in the very short term), If I go to a hardware store looking for a screwdriver and the shelf is empty, and I complain to one of their people about it, the person might say “hold on, let me check at the back”, and comes back with a big box full of screwdrivers for the shelf and hands me one, they don’t charge me extra for the effort; in fact they thank me for pointing out that the shelf was empty.
    In the case of real estate, we have a natural buffer much bigger than any screwdriver stock or warehouse one could imagine. A fall in demand produces its own supply, even if production goes to zero, as people getting desperate to sell are, in a way, “producing” houses for sale. In the case of screwdrivers, if you begin to hate your screwdriver you might throw it to the garbage; but in the case of a house, most people don’t have the luxury to toss their houses iinto a dumpster; they can only get rid of them by selling them.
    In fact, when you consider the issue of mortgages, and the problem of collateral and equity, a drop in the price of houses increases their supply. (Drop in price reduces the value of the collateral, which increases the chance of foreclosure.)
    So, even if all the 8K rebate would do was to increase prices by 8K it would be a good thing, as it would reduce the number of forced foreclosures, if nothing else.
    Note: I’m not defending government policy; at least not intentionally; I just thought these angles needed mentioning.

  • pebird

    The screwdriver analogy works fine IF the market is in equilibrium. But during a demand contraction (oversupply), the D1 is moving to the left – trying to find a bottom – the market is not in equilibrium. The subsidy will slow the contraction to the left.

    If there is no/suppressed demand for screwdrivers, adding a $1 credit doesn’t raise the price instantly, it induces those who were “out of the market” to consider the market. It might very well be that those with suppressed demand still don’t buy, so demand still does not meet supply, continuing to put negative pressure on prices.

    Remember that from the POV of the potential buyer, they view the subsidy as their benefit, so they reduce the cost of the pre-subsidized screwdriver in their calculation. The seller views the subsidy as their benefit, so they are inclined not to reduce the cost further. Remember, there is an oversupply of the screwdrivers, the subsidy does not provide the seller with some monopoly market power – buyers have already decided to exit the market at pre-existing prices.

    For those that exited the market, but are reconsidering, they are expecting the majority of the rebate to their benefit. Remember, they left the market when the price was $5, if they go back with a $1 rebate and the price is $6 – net $5, why would they buy? The price for them HAS to be less than the price when they left the market, it may not need to be equal to the old price less the subsidy, but it must be lower (otherwise they would have purchased pre-subsidy).

    Now if you assume that the buyer cannot leave the market – they MUST buy – then there is no need for a subsidy, nor even a pricing mechanism – there is a monopoly situation and a different supply/demand curves apply.

    If the market is clearing (no excess inventory), then a subsidy does immediately raise the prices. But with a subsidy, if the market does not clear, then the curve will continue to move to the left (reduce prices).

    What the subsidy does is SLOW the decline in prices – the person who is willing to pay something less than $5 but is waiting for the declining price to bottom has to consider if the ongoing price drop will be equal to the benefit they get from the subsidy plus the immediate utility of the screwdriver. The subsidy acts as insurance against further price drops for the buyer.

    Supply/demand curves act really strange during oversupply and deflation periods – you can provide a subsidy beyond the asking price and people will still not buy, they are waiting for the screwdriver companies to go out of business, so they can purchase multiple screwdrivers at pennies on the dollar (beyond what any subsidy could provide) and resell them when demand recovers.

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