chapter 6 supply, demand, and government policies supply, demand, and government policies 1. price...
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Chapter 6Chapter 6
Supply, Demand, and Supply, Demand, and
Government PoliciesGovernment Policies
Supply, Demand, and Supply, Demand, and
Government PoliciesGovernment Policies
1. Price Ceiling1. Price Ceiling
2. Price Floor2. Price Floor
3. Effect of Taxes3. Effect of Taxes
4. Tax Incidence4. Tax Incidence
1. Price Ceiling1. Price Ceiling
2. Price Floor2. Price Floor
3. Effect of Taxes3. Effect of Taxes
4. Tax Incidence4. Tax Incidence
Objectives1. Learn the consequences of government policies that
impose a ceiling (maximum)price on a market
2. learn the consequences of government policies that impose a floor (minimum)price on a market
3. Understand how a tax on a good affects market equilibrium price and quantity
4. Recognize the equivalence of taxes imposed on buyers and sellers and know how the burden of a tax is divided between buyersand sellers
Supply, Demand and Government Policies
In a “free”, unregulated market system, market forces establish equilibrium
prices and exchange quantities.
While equilibrium conditions may be efficient it may be true that not
everyone, i.e. buyer or seller are satisfied.
Hence, market controls!
Market Price Controls
Are usually enacted when policymakers believe that the market price is unfair to buyers and sellers.
Result in governmental policies, i.e., price ceilings and floors.
Price Ceilings & Price Floors
A Price Ceiling
– is a legally established maximum price which a seller can charge or a buyer must pay.
A Price Floor
– is a legally established minimum price which a seller can charge or a buyer must pay.
Price Ceilings
When the government imposes a price ceiling (i.e... a legal maximum on the price at which a good can be sold) two outcomes are possible:
1 . The price ceiling is not binding.
2 . The price ceiling is a binding constraint on the market, creating Shortages.
Market Impacts of a Price Ceiling
Supply
Demand
Price
Quantity
EquilibriumPrice
EquilibriumQuantity
A Non-Binding Price Ceiling
Supply
Demand
Price
Quantity
PE
QE
PriceCeiling
PC
A Binding Price Ceiling
Supply
Demand
Price
Quantity
PE
QE
PriceCeiling
PC
A Binding Price Ceiling Creates Shortages.
Supply
Demand
Price
Quantity
PE
QE
PC
QS QD
A Binding Price Ceiling Creates Shortages.
Supply
Demand
Price
Quantity
PE
QE
PC
QS QD
Shortage
Market Impacts of a Price Ceiling
A Binding Price Ceiling creates. . .
– Shortages (i.e... Demand > Supply)
Gasoline shortages of the 1970s
– Non-Price Rationing - An alternative mechanism for rationing of the good:
Long Lines (First-In-Line, Figure 6-2)
Discrimination criteria set by seller
Demand
Price ofGasoline
Quantity
P1
0 Q1
S1
Price ceiling
1. Initially, the price ceiling is not binding ...
The Market for Gasolinewith a Price Ceiling
Demand
Price ofGasoline
Quantity0 Q1
P2
S1
S2
P1
Price ceiling
2. ...but when supplyfalls ...
The Market for Gasolinewith a Price Ceiling
Demand
Price ofGasoline
Quantity0 Q1
P2
S1
S2
P1
Price ceiling
3. ...the price ceilingbecomes binding ...
The Market for Gasolinewith a Price Ceiling
Demand
Price ofGasoline
QuantityQs0 QD
Shortage
Q1
P2
S1
S2
P1
Price ceiling
4. Resulting ina shortage
The Market for Gasolinewith a Price Ceiling
Rent Control
Rent controls are ceilings placed on the rents that landlords may charge their tenants.
The goal of rent control policy is to help the poor by making housing more affordable.
One economist called rent control “the best way to destroy a city, other than bombing.”
Rent Control in the Short Run...
Quantity ofApartments
0
Rental Price of
Apartment
Demand
Supply
Controlled rent
Shortage
Supply and demand for apartments
are relatively inelastic
Rent Control in the Long Run...
Quantity ofApartments
0
Rental Price of
Apartment
Demand
Supply
Controlled rent
Shortage
Because the supply and demand for
apartments are more elastic...
…rent control causes a large
shortage
Price Floors
When the government imposes a price floor (i.e... a legal minimum on the price at which a good can be sold) two outcomes are possible:
1 . The price floor is not binding.
2 . The price floor is a binding constraint on the market, creating Surpluses
A Non-Binding Price Floor
Supply
Demand
Price
Quantity
PE
QE
PriceFloor
PF
A Binding Price Floor
Supply
Demand
Price
Quantity
PE
QE
PriceFloor
PF
Market Impacts of a Price Floor
A government imposed market price floor hinders the forces of supply and demand in moving toward the equilibrium price and quantity.
When the market price hits the floor, it can fall no further and the market price equals the floor price. A binding price floor causes a surplus.
A Binding Price Floor Creates a Surplus.
Supply
Demand
Price
Quantity
PE
QE
PF
QS QD
A Binding Price Floor Creates a Surplus.
Supply
Demand
Price
Quantity
PE
QE
PF
QS QD
Surplus
Market Impacts of a Price Floor A Binding Price Floor creates. . .
– Surpluses (i.e. Quantity Supplied > Quantity Demanded)
– Non-Price Rationing - An alternative mechanism for rationing of the good:
Discrimination Criteria
– Examples:
Minimum Wage
Agricultural Price Supports
Labor Supply
Labor Demand
EquilibriumUnemployment
Quantity of Labor
Wage
EquilibriumWage
A Free Labor Market
0
Labor Supply
Labor Demand
Quantityof Labor
Wage
A Labor Market with a BindingMinimum Wage
Quantitysupplied
Quantitydemanded
MinimumWage
0
Quick Quiz!
Define “price ceiling” and “price floor”
Give an exampleof each.
Which leads to a shortage, which a surplus? Why?
Taxes! Taxes! Taxes!
What is the purpose of government imposed taxes?
– To raise government revenues.
– To restrict allocation of a product.
What is an excise tax?
– A “per-unit” tax that’s independent of the price of the product.
Taxes! Taxes! Taxes! Who pays the tax on a good? The
buyer or the seller?
How is the burden of a tax divided between buyer and seller?
When the government levies a tax on a good, the equilibrium quantity of the good falls. The size of the market for that good shrinks, shifting either the demand or supply curve.
Tax Incidence
Tax incidence is the study of who actually bears the burden of taxation
Taxes: Impact
Taxes discourage market activity. The quantity of the good sold is smaller than
without the tax. Buyers and sellers
share the tax burden.
Taxes: Impact From a 50 Cent Tax
S1
$2.00
800
D1
Equilibrium without tax
Taxes: Impact From a 50 Cent Tax
S1
$2.00
800
D1
From the sellers viewpoint, the tax
causes the demand curve to
shift down by 50 cents.
$1.80
600
Taxes: Impact From a 50 Cent Tax
S1
$2.00
800
D1
$2.30
600
The tax increasesthe market price
to the buyer...
$1.80
Taxes: Impact From a 50 Cent Tax
S1
$2.00
800
D1
$2.30
600
The tax increasesthe market price
to the buyer......and decreases
demand.$1.80
Price buyerspay
$3.30
3.00
2.80
90 100 Quantity
Price
Price w/otax
Price sellersreceive
}Tax ($.50)
Demand, D1
S2
S1
A tax on sellers shiftsthe supply curve upwardby the amount of the tax($.50)
Equilibrium without tax
Equilibrium with tax
Figure 6-7A Tax on Sellers
Wage
Quantityof labor
0
Labor demand
Labor supply
Wage firms pay
Wage without tax
Wage workersreceive
{Tax Wedge
Figure 6-8A Payroll Tax
The Burden (incidence) of a Tax is Inversely Related to the Price Elasticities of Demand and Supply
Quantity
Price paid by buyersafter the tax = $2.40
Supply
Price without tax = $2.00
Price received by sellersafter the tax = $1.90
Demand
Price
relatively elastic
relatively inelastic
}$.50 tax
The Burden (incidence) of a Tax is Inversely Related to the Price Elasticities of Demand and Supply
Quantity
Price paid by buyersafter the tax = $2.10
Supply
Price without tax = $2.00
Price received by sellersafter the tax = $1.60
Demand
Pricerelatively inelastic
relatively elastic
}$.50 tax
The Incidence of Tax. . .How is the burden of the tax distributed?
Consider a tax levied on sellers of a good. What are the effects of this tax?
How do effects of the tax levied on the seller compare with those of the effects imposed on the buyer?
Depends on Elasticity of Demand and Elasticity of Supply.
The Incidence of Tax. . .How is the burden of the tax distributed?
The burden of a tax falls on the side of the market with the smaller price elasticity!
Elasticity and Taxes
The more INELASTIC the demand and the more ELASTIC the supply results in the consumer paying more of the tax.
The more ELASTIC the demand and the more INELASTIC the supply results in the supplier paying more of the tax.
Elastic Supply, Inelastic Demand...
Quantity0
Price
Demand
Supply
Tax
1. When supply is moreelastic than demand...
2. ...theincidence of thetax falls moreheavily onconsumers...
3. ...than onproducers.
Price without tax
Price buyers pay
Price sellers receive
Inelastic Supply, Elastic Demand...
Quantity0
Price
Demand
Supply
Price without tax
Tax
1. When demand is moreelastic than supply...
2. ...theincidence of the tax falls more heavily on producers...
3. ...than on consumers.
Price buyers pay
Price sellers receive
Quick Quiz
Show how a tax on car buyers of $1,000 per car affects the quantity of cars sold and the price of cars.
Show how a similar tax on car sellers affects quantity and price.
Summary
Price controls include price ceilings and price floors.
A price ceiling is a legal maximum on the price of a good or service. An example is rent control.
A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage.
Summary
Taxes are used to raise revenue for public purposes.
When the government levies a tax on a good, the equilibrium quantity of the good falls.
A tax on a good places a wedge between the price paid by buyers and the price received by sellers.
Summary
The incidence of a tax refers to who bears the burden of a tax.
The incidence of a tax does not depend on whether the tax is levied on buyers or sellers.
The incidence of the tax depends on the price elasticities of supply and demand.
Supply, Demand & Government The economy is governed by two kinds of
laws:
– The laws of supply and demand
– The laws enacted by government.
Price controls and taxes are common in various markets in the economy:
– Price Ceilings
– Price Floors
– Excise Tax
Case Studies
1. Lines at gas pump - price ceiling
2. Rent control - price ceiling
3. The minimum wage - price floor
4. Burden of a payroll tax - tax incidence
5. Luxury tax - tax incidence