Supply, Demand, andGovernment Policy

Controls on Price – Price Ceiling

Legal maximum on the price at which a good can be sold

• Maximum price for Hamburger• Intent: to protect consumers

Hamburger market with a price ceiling

Price

Quantity0

Demand

100

Price ceiling that is not binding

To the left, the government imposes a price ceiling of $4. Because the price ceiling is above the equilibrium price of $3, the price ceiling has no effect, and the market can reach the equilibrium of supply and demand. In this equilibrium, quantity supplied and quantity demanded both equal 100 burgers. To the right, the government imposes a price ceiling of $2. Because the price ceiling is below the equilibrium price of $3, the market price equals $2. At this price, 125 burgers are demanded and only 75 are supplied, so there is a shortage of 50 burgers.

Price ceiling that is binding

$3

Supply

$4 Price ceiling

Equilibriumprice

Equilibriumquantity

Price

Quantity 0

Demand

$3

Supply

$2 Price ceiling

Equilibriumprice

75

Quantitydemanded

Quantitysupplied

125

Shortage

Controls on Price – Price Ceiling

A price ceiling can affect market outcomes– Not binding

• Above the equilibrium price• No effect

– Binding constraint• Below the equilibrium price• Shortage • Sellers must ration the scarce goods

– When the rationing mechanisms are not desirable

In 1973 OPEC managed to raised the price of crude oil

– by reducing the supply of crude– thus gas supply lowered– Long lines at gas stations, why?– U.S. government regulations: price ceiling on gasoline

• Before OPEC raised the price of crude oil– Equilibrium price of gas was below the price ceiling: no effect

• When the world price of crude oil rose as OPEC reduced the supply of gasoline

– Equilibrium price of gas went above price ceiling: shortage

Price Ceiling: Gas Price Policy in 1973

Price Ceiling: Market for gasoline

Gas Price

Quantity of Gas0

Demand

Q1

Gas Price Ceiling is not binding

The left illustration shows the gas market when the price ceiling is not binding because the equilibrium price, P1, is below the ceiling. The right illustration shows the gasoline market after an increase in the price of crude oil (an input used to make gas) shifts the supply curve to the left from S1 to S2. In an unregulated market, the price would have risen from P1 to P2. The price ceiling prevents this from happening. At the binding price ceiling, consumers are willing to buy QD, but producers of gasoline are willing to sell only QS. The difference between quantity demanded and quantity supplied, QD – QS, measures the gasoline shortage.

P1

Supply, S1

Price ceiling

1. Initially, the price ceiling is not binding …

Demand

S1

Gas Price

Quantity of Gas0 Q1

P1

Price ceiling

S2

P2

2…but when supply falls…

3…the price ceiling becomes binding…

QS QD

4. …resulting in a shortage

Gas Price Ceiling is binding

• Price ceiling: rent control– Local government puts a ceiling on rents– Goal: to help the poor (housing more affordable)– Critique: highly inefficient way to help the poor raise

their standard of living• Adverse effects of rent control in the short run

– Supply and demand for housing is relatively inelastic– Initial small shortage at reduced rents

Price Ceiling: Rent controls

• Adverse effects of rent control in the long run– Supply and demand becomes more elastic

• Landlords will not build new apartments will be less likely to maintain existing ones

• At the binding rent ceiling more people will want to move into a city

• Large shortage of housing

– Non-rent rationing mechanisms• Long waiting lists• Discrimination (children, pets, race, national origin)• Bribes to building superintendents

Price Ceiling: Rent controls

RentalPrice of

Apartment

Quantity of Apartments0

Demand

Rent Control in the Short Run(supply and demand are inelastic)

The left illustration shows the short-run effects of rent control: Because the supply and demand for apartments are relatively inelastic, the price ceiling imposed by a rent-control law causes only a small shortage of housing. The right illustration shows the long-run effects of rent control: Because the supply and demand for apartments are more elastic, rent control causes a large shortage.

Rent Control in the Long Run(supply and demand are elastic)

Supply

Controlled rent

RentalPrice of

Apartment

Quantity of Apartments0

Demand

Supply

Controlled rent

ShortageShortage

Rent control in the short run and the long run

• People respond to incentives– Free markets

• Landlords try to keep their buildings clean and safe• Higher prices

– Rent control shortages & waiting lists• Landlords lose their incentive to respond to tenants’

concerns• Tenants get lower rents & lower-quality housing

• Policymakers: additional regulations– Difficult and costly to enforce

Price Ceiling: Rent controls

Controls on Price – Price Floor

Legal minimum on the price at which a good can be sold• Minimum legal price for Hamburger• Why? Supposedly to protect the

Hamburger industry

Price Floor: Hamburger Market

Price

Quantity0

Demand

100

Price floor that is not binding

In the left illustration, government imposes a price floor of $2. Because this is below the equilibrium price of $3, the price floor has no effect. The market price adjusts to balance supply and demand. At the equilibrium, quantity supplied and quantity demanded both equal 100 burgers. To the right, government imposes a price floor of $4, which is above the equilibrium price of $3. Therefore, the market price equals $4. Because 120 burgers are supplied at this price and only 80 are demanded, there is a surplus of 40 burgers.

Price floor that is binding

$3

Supply

2 Price floor

Equilibriumprice

Equilibriumquantity

Price

Quantity0

Demand

3

Supply

$4Price floor

Equilibriumprice

80

Quantitysupplied

Quantitydemanded

120

Surplus

Controls on Price – Price FloorHow price floors affect market outcomes

– Not binding• Below the equilibrium price• No effect

– Binding constraint• Above the equilibrium price• Surplus • Some seller are unable to sell what they want

• Minimum Wage is the lowest price for labor that any employer may pay

• Fair Labor Standards Act of 1938 to insure workers a minimally adequate standard of living

• 2007: minimum wage = $5.15 per hour• 2010: minimum wage = $7.25 per hour

Price Floor: The minimum wage

• Impact of the minimum wage above equilibrium– Workers with high skills and much experience

• Not affected: Equilibrium wages are above the minimum• Minimum wage is not binding

– Teenage labor: least skilled and least experienced• Low equilibrium wages • Willing to accept a lower wage in exchange for on-the-job

training• Minimum wage is binding

Price Floor: The minimum wage• Market for labor

– Workers (supply of labor)– Firms (demand for labor)

Price Floor: Minimum wage and the labor marketWage

Quantity of Labor

0

Labordemand

Equilibriumemployment

A free labor market

The left illustration shows a labor market in which the wage adjusts to balance labor supply and labor demand. The right illustration shows the impact of a binding minimum wage. Because the minimum wage is a price floor, it causes a surplus: The quantity of labor supplied exceeds the quantity demanded. The result is unemployment.

A Labor Market with a Binding Minimum Wage

Equilibriumwage

Laborsupply

Wage

Quantityof Labor

0

Minimumwage

Quantitydemanded

Quantitysupplied

Labor surplus(unemployment)

Labordemand

Laborsupply

Controls on PricesEvaluating price controls• Markets are usually a good way to organize

economic activity– Economists usually oppose price ceilings and price floors– Prices coordinate economic activity efficiently

• Governments can sometimes improve market outcomes • because of unfair market outcome• aimed at helping the poor• often hurt those they are trying to help • other ways of helping those in need

• rent subsidies• wage subsidies

A tax on sellersPrice

Hamburger

Quantity ofHamburger

0

Demand, D1

90

When a tax of $0.50 is levied on sellers, the supply curve shifts up by $0.50 from S1 to S2. The equilibrium quantity falls from 100 to 90 hamburgers. The price that buyers pay rises from $3.00 to $3.30. The price that sellers receive (after paying the tax) falls from $3.00 to $2.80. Even though the tax is levied on sellers, buyers and sellers share the burden of the tax.

S1

S2

100

$3.30

3.00

2.80

Pricebuyers

pay

Pricewithout

tax

Pricesellersreceive

A tax on sellersshifts the supplycurve upwardby the size ofthe tax ($0.50).

Tax($0.50) Equilibrium without tax

Equilibrium with tax

Tax on Sellers • Tax incidence – a manner in which the burden of a

tax is shared among participants in a market

• How taxes on sellers affect market outcomes– Immediate impact on sellers– Supply curve shifts left– Higher equilibrium price– Lower equilibrium quantity– The tax reduces the size of the market

Taxes on Sellers How taxes on sellers affect market outcomes

– Taxes discourage market activity– Smaller quantity sold– Buyers and sellers share the burden of tax– Buyers pay more

• Worse off

– Sellers receive less• Collects the higher price but pays the tax• Overall: effective price falls• Sellers are worse off

Tax on Buyers

Price

Quantity0

D1

90

When a tax of $0.50 is levied on buyers, the demand curve shifts down by $0.50 from D1 to D2. The equilibrium quantity falls from 100 to 90 hamburgers. The price that sellers receive falls from $3.00 to $2.80. The price that buyers pay (including the tax) rises from $3.00 to $3.30. Even though the tax is levied on buyers, buyers and sellers share the burden of the tax.

Supply, S1

100

$3.30

3.00

2.80

Pricebuyers

pay

Pricewithout

tax

Pricesellersreceive

A tax on buyersshifts the demandcurve downwardby the size ofthe tax ($0.50).

Tax($0.50)

Equilibrium without tax

Equilibrium with tax

D2

Taxes on Buyers

How taxes on buyers affect market outcomes– Demand curve shifts left– Higher equilibrium price– Lower equilibrium quantity– The tax reduces the size of the market

Tax on Buyers • How taxes on buyers affect market outcomes

– Buyers and sellers share the burden of the tax– Sellers get a lower effective price

• Worse off

– Buyers pay a higher market price• Effective price (with tax) rises• Worse off

• Tax levied on sellers and tax levied on buyers are equivalent

1.85%

Earning $200,000 + $1

Income Tax and Labor Markets

Tax rate on this dollar

Federal Income TaxFICA

Kentucky Income TaxMedicare Tax

Warning, if you have a weak stomach, you might want to avoid this slide

28.0%12.4%2.9%

6.2% x 21.45% x 2

6.0%Bowling Green Tax

51.15%

You keep $1 x 49% = .49 cents

Income Tax and Labor Markets

Price

Quantity0

Labor Demand

Labor SupplyCost of laborto business

Wage without tax

Worker wage

Sizeof tax

A tax on a good places a wedge between the wage workers receive and the cost of labor to business. Labor use falls.

Employmentwith tax

Employmentwithout tax

The Tax Burden• Elasticity and tax incidence• Dividing the tax burden

– Very elastic supply and relatively inelastic demand• Sellers – small burden of tax• Buyers – most of the burden

– Relatively inelastic supply and very elastic demand• Sellers – most of the tax burden• Buyers – small burden

How the burden of a tax is divided

Price

Quantity0

Demand

SupplyPrice buyers pay

Price without tax

Price sellersreceive

Tax

When he supply curve is elastic, and the demand curve is inelastic. In this case, the price received by sellers falls only slightly, while the price paid by buyers rises substantially. Thus, buyers bear most of the burden of the tax.

Elastic Supply, Inelastic Demand

1. When supply is more elastic than demand . . .

2. . . . The incidence of the tax falls more heavily on consumers . . .

3. . . . Than on producers.

How the burden of a tax is divided

Price

Quantity0

Demand

Supply

Price buyers pay

Price without tax

Price sellersreceive

Tax

When the supply curve is inelastic, and the demand curve is elastic. In this case, the price received by sellers falls substantially, while the price paid by buyers rises only slightly. Thus, sellers bear most of the burden of the tax.

Inelastic Supply, Elastic Demand

1. When demand is more elastic than supply . . .

3. Than on consumers

2. . . . The incidence of the tax falls more heavily on producers.

The Tax Burden

Tax burden falls more heavily on the side of the market that is less elastic

– Low elasticity of demand• Buyers do not have good alternatives to

consuming this good– Low elasticity of supply

• Sellers do not have good alternatives to producing this good

• The 1990 consumption luxury tax– Goal: to raise revenue from those who could most

easily afford to pay– Luxury items

• Demand is usually quite elastic• Supply is relatively inelastic

• Outcome:– Burden of a tax falls largely on the suppliers

• The American Yacht industry disappeared• In 1993 most of the luxury tax was repealed

Who pays the luxury tax?