SUPPLY, DEMAND, AND GOVERNMENT POLICIES

Overview

Economists have two roles:

1. As scientists, they develop and test theories to explain the world around them.

2. As policy advisers, they use their theories to help change the world for the better

Up to this point, we have focused on the role of economists as scientists.

Now we turn to the role of economists as policy advisers

Overview

• In unregulated markets, the market forces of supply and demand determine market prices and quantities.

• Price controls are enacted by the government when it is believed that market prices are unfair to either sellers or consumers.

• Demand and supply analysis can be used to examine the impact of government intervention (such as price controls) in markets.

Price Controls

• Price Ceiling: A maximum legal price above which a good can not be sold.

– Examples: Rent Control, Price Controls on Gas in 1970’s.

• Price Floor: A minimum legal price below which a good can not be sold.

– Examples: Minimum wages, agriculture price supports.

Price Ceilings

Two outcomes are possible when the government imposes a price ceiling:

1. The price ceiling is not binding if set above the equilibrium price.

2. The price ceiling is binding if set below the equilibrium price, leading to a shortage.

A Nonbinding Price CeilingPrice

Quantity

D1

S1

A price ceiling set above the equilibrium price has no effect!

P1

Q1

Maximum Price Allowed by Law

P Max

A Binding Price CeilingPrice

Quantity

D1

S1

P1

Q1

Maximum Price Allowed by Law

P Max

A price ceiling set below the equilibrium price leads to a shortage or excess demand

(QD > QS).

QDQS

Application: OPEC and Lines at Gas Stations in the 1970’s

• In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the major input in gasoline, so the higher oil prices reduced the supply of gasoline. As a result, the price of gasoline rose sharply.

• In response the government placed a price ceiling on gasoline.

• The results was very long lines at gas stations.

Market for Gas Prior to OPEC Oil ShockPrice

Quantity of Gasoline

D1

S1

Prior to the OPEC oil shock, the price ceiling is nonbinding.

P1

Q1

Maximum Price Allowed by Law

P Max

Market for Gas After OPEC Oil ShockPrice

Quantity of Gasoline

D1

S1

P1

Q1

Maximum Price Allowed by Law

P Max

S2

QDQS

The oil shock causes the supply curve for gas to shift left. Now the price ceiling is binding and a shortage of gas results (QD>QS)

Application:The Market for Low-Income Housing

• Background: Rental rates and housing prices in the New Haven Area increased substantially over the last five years. As a result, it has become much more difficult for low-income families to find affordable housing.

• Policy Issue: Suppose you were hired by the Mayor of New Haven to devise an affordable housing strategy for low income families. You are asked to come up with three policy options.

• Policy Options:

• .

• .

• .

Application:The Market for Low-Income Housing

Housing Vouchers for Low-Income Families

Rental Rate

Number of Apartments

S1

Initialequilibrium

A voucher represents an increase in income:

P1

Q1

New equilibriumP2

Q2

D2

D1

A Per-Unit Rent Subsidy for Landlords

Rental Rate

0Number of Apartments

D1

Initial equilibrium

S1

P1

Q1

S2

P2

Q2

New equilibrium

The subsidy causes the supply curve for apartments to shift right, leading to a lower equilibrium price and a higher equilibrium quantity.

Rent Control: Maximum Rent Set Above Equilibrium Price

Rental Rate

Number of Apartments

D1

Equilibrium

S1

A price ceiling set above the equilibrium price has no effect!

P1

Q1

Maximum Rent by Law

P Max

Rent Control: Maximum Rent Set Below Equilibrium Price

Rental Rate

0Number of Apartments

D1

Equilibrium

S1

A price ceiling set below the equilibrium price leads to excess demand.

P1

Q1

Maximum Rent by Law

P Max

QDQS

Consequences of Rent Control

• Tends to reduce the quantity and quality of housing available.

• Tends to bid up rents in uncontrolled sector.

• No incentive to invest in new rental units.

• Creates a black market for apartments.

• In his study, “Who Really Benefits from New York City’s Rent Regulation System?,” Henry Pollakowski concludes: “This study finds that tenants in low- and moderate-income areas receive little or no benefit from rent stabilization, while tenants in more affluent locations are effectively subsidized for a substantial portion of their rent.”

• Also see article by Walter Block on rent control.

Price Floors

When the government imposes a price floor, two outcomes are possible.

1. The price floor is not binding if set below the equilibrium price.

2. The price floor is binding if set above the equilibrium price, leading to a surplus.

A Nonbinding Price Floor

Price

0Quantity

Demand

Equilibrium

Supply

A price floor set below the equilibrium price has no effect.

p1

Q1

Minimum price allowed by Law

p min

A Binding Price Floorprice

0Quantity

Demand

Supply

A price floor set above the equilibrium price resultsin a surplus

P1

Q1

Minimum Price Allowed by Law

P min

QD QS

Excess Supply

Minimum Wage Laws and the Unemployment Rate

An important policy question is: Does an increase in the minimum wage cause an increase in the unemployment rate of low-skilled workers?

Minimum Wage Laws and the Unemployment Rate

wage rate

0Employment

Demand for labor

Equilibrium

Supply of labor

A minimum wage set below the equilibrium wage has no effect.

w1

L1

Minimum wage by Law

w min

Minimum Wage Laws and Unemployment

wage rate

Employment

Demand for Labor

Supply of Labor

A minimum wage set above the equilibrium wage results in unemployment

w1

L1

Minimum wage by Law

w min

LD LS

Unemployment

Minimum Wage Laws and the Unemployment Rate

Overview of Taxation

• Governments levy taxes to raise revenue for public projects.

• Facts about Taxation:

– Taxes discourage market activity.

– When a good is taxed, the quantity sold is smaller.

– Buyers and sellers share the tax burden.

Tax Incidence

• Renters never receive a property tax bill in the mail.

– Does that imply renters pay no property taxes?

• Social Security if financed with a flat tax on earnings. The payroll tax is split equally between employer and employee, with each paying 6.2% of gross wages.

– Does that fact imply employers and employees bear equal burdens of the Social Security tax?

• To answer those questions we need to distinguish between the statutory incidence and economic incidence of a tax.

Tax Incidence

• Statutory Incidence: refers to who is legally responsible for paying the tax.

• Economic Incidence: refers to who bears the burden of a tax. It is the change in the distribution of real private income induced by the tax.

• Tax Shifting: refers to the extent to which the statutory incidence and economic incidence of a tax differ.

A Per-Unit Tax Imposed on Suppliers

Quantity

Price

D1

S1

PD

PS

P1

Q1Qtax

S2

Per-Unit tax paid by Suppliers shifts the supply

curve to the left

Per-Unit Tax

A Per-Unit Tax Imposed on Consumers

Quantity

Price

D1

S1

PD

PS

P1

Q1Qtax

Per-Unit tax paid by Consumers shifts the

demand curve to the left

D1

Per-Unit Tax

Tax Incidence

• Taxes on buyers and sellers are equivalent

• That is, the economic incidence of a tax is independent of the statutory incidence

• Because of that fact it is useful to illustrate the impact of taxes using a tax wedge, rather than shifting either the supply or demand curve.

Tax Incidence and Tax Wedges

Quantity

Price

D1

S1

PD

PS

P1

Q1

A per-unit tax drives a wedge between the price

paid by consumers and the price received by suppliers

Tax Wedge

QTax

Elasticity and Tax Incidence

• The burden of a tax is usually shared by producers and consumers.

• The degree to which the tax is shared depends critically on the elasticity of supply and demand.

• Thus, the economic incidence of a tax depends on the relative elasticity of supply and demand.

– If demand is relatively more elastic than supply, suppliers end up bearing more of the burden of a tax.

– If supply is relatively more elastic than demand, consumers end up bearing more of the burden of a tax.

Tax Incidence when Supply is More Elastic than Demand

Packs of Cigarettes

$/Pack

D

S

PD

PS

P1

Q1Qtax

When supply is more elastic than demand, consumers bear the burden of the tax

Tax Incidence when Demand is More Elastic Than Supply

Quantity of Luxury Boats

Price

D

S

PD

PS

P1

Q1Qtax

When demand is more elastic than supply, producers bear the burden of the tax

Application: The Payroll Tax

• The federal government uses the FICA (Federal Insurance Contribution Act) to finance Social Security and Medicare.

• FICA is a payroll tax since it is deducted directly from your paycheck.

• Currently the payroll tax is 15.3% of earnings.

• According to law, the statutory incidence of the payroll tax is split between workers and employers. Each pays 7.65% of earnings.

• Who bears the burden of the payroll tax?

• Hint: Economists estimate that the supply of labor is much less elastic than the demand for labor.

The Economic Incidence of the Payroll Tax

Quantity of Labor

wage

Demand for Labor

Supply of Labor

wD

wS

w1

L1L2

Because the supply of labor is less elastic than the demand for labor, workers end up paying most of the payroll tax.

Payroll Tax