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: Supply, Demand, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. While.

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Presentation on theme: ": Supply, Demand, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. While."— Presentation transcript:

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3 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 is satisfied. One of the roles of economists is to use their theories to assist in the development of policies.

4 How Price Ceilings Affect Market Outcomes Two outcomes are possible when the government imposes a price ceiling: The price ceiling is not binding ( ) if set above the equilibrium price. The price ceiling is binding if set below the equilibrium price, leading to a shortage.

5 Figure 1 A Market with a Price Ceiling (a) A Price Ceiling That Is Not Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium quantity $4 Price ceiling Equilibrium price Demand Supply 3 100 The market clears at $3 and the price ceiling is ineffective.

6 Figure 1 A Market with a Price Ceiling (b) A Price Ceiling That Is Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply 2Price ceiling Shortage 75 Quantity supplied 125 Quantity demanded Equilibrium price $3

7 How Price Ceilings Affect Market Outcomes Effects of Price Ceilings A binding price ceiling creates Shortages because Q D > Q S. Example: Gasoline shortage of the 1970s Nonprice rationing Examples: Long lines, discrimination by sellers

8 CASE STUDY: Lines at the Gas Pump Economists blame government regulations that limited the price oil companies could charge for gasoline. 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. What was responsible for the long gas lines?

9 Figure 2 The Market for Gasoline with a Price Ceiling (a) The Price Ceiling on Gasoline Is Not Binding Quantity of Gasoline 0 Price of Gasoline 1. Initially, the price ceiling is not binding... Price ceiling Demand Supply,S1S1 P1P1 Q1Q1

10 Figure 2 The Market for Gasoline with a Price Ceiling (b) The Price Ceiling on Gasoline Is Binding Quantity of Gasoline 0 Price of Gasoline Demand S1S1 S2S2 Price ceiling QSQS 4.... resulting in a shortage. 3.... the price ceiling becomes binding... 2.... but when supply falls... P2P2 QDQD P1P1 Q1Q1

11 Price Restrictions Price Ceilings The maximum legal price that can be charged Examples: Gasoline prices in the 1970s Housing in New York City Proposed restrictions on ATM fees Price Floors The minimum legal price that can be charged. Examples: Minimum wage Agricultural price supports

12 Full Economic Price The dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price. P F = P c + (P F - P C ) P F = full economic price P C = price ceiling P F - P C = nonpecuniary price

13 An Example from the 1970s Ceiling price of gasoline - $1 3 hours in line to buy 15 gallons of gasoline Opportunity cost: $5/hr Total value of time spent in line: 3 $5 = $15 Non-pecuniary price per gallon: $15/15=$1 Full economic price of a gallon of gasoline: $1+$1=2

14 Housing Markets and Rent Ceilings The 1906 earthquake in San Francisco left 200,000 peoplemore than half the cityhomeless. By the time the San Francisco Chronicle started publishing again, a month after the earthquake, there was not a single mention of a housing shortage. The classified advertisements listed many more houses and flats for rent than the advertisements for houses and flats wanted. How did the market achieve this outcome?

15 Housing Markets and Rent Ceilings The Market Response to a Decrease in Supply Figure 6.1 shows the San Francisco housing market before the earthquake. The quantity of housing was 100,000 units and the rent was $16 a month at the intersection of D and SS.

16 Housing Markets and Rent Ceilings The earthquake decreased the supply of housing and the supply curve shifted leftward to SS A. The rent increased to $20 a month and the quantity decreased to 72,000 units.

17 Housing Markets and Rent Ceilings Long-Run Adjustments The long-run supply of housing is perfectly elastic at $16 a month. With the rent above $16 a month, new houses and apartments are built.

18 Housing Markets and Rent Ceilings, The quantity of housing increases and the rent falls to the pre-earthquake levels (other things remaining the same).

19 Housing Markets and Rent Ceilings A Regulated Housing Market A price ceiling is a regulation that makes it illegal to charge a price higher than a specified level. When a price ceiling is applied to a housing market it is called a rent ceiling. If the rent ceiling is set above the equilibrium rent, it has no effect. The market works as if there were no ceiling. But if the rent ceiling is set below the equilibrium rent, it has powerful effects.

20 Housing Markets and Rent Ceilings the effects of a rent ceiling that is set below the equilibrium rent. The equilibrium rent is $20 a month. A rent ceiling is set at $16 a month. So the equilibrium rent is in the illegal region.

21 Housing Markets and Rent Ceilings At the rent ceiling, the quantity of housing demanded exceeds the quantity supplied and there is a housing shortage.

22 Housing Markets and Rent Ceilings With a housing shortage, people are willing to pay $24 a month. Because the legal price cannot eliminate the shortage, other mechanisms operate: search activity ( ) black markets

23 Figure 3 Rent Control in the Short Run and in the Long Run (a) Rent Control in the Short Run (supply and demand are inelastic) Quantity of Apartments 0 Supply Controlled rent Rental Price of Apartment Demand Shortage

24 Figure 3 Rent Control in the Short Run and in the Long Run (b) Rent Control in the Long Run (supply and demand are elastic) 0 Rental Price of Apartment Quantity of Apartments Demand Supply Controlled rent Shortage

25 Housing Markets and Rent Ceilings Search Activity The time spent looking for someone with whom to do business is called search activity. When a price is regulated and there is a shortage, search activity increases. Search activity is costly and the opportunity cost of housing equals its rent (regulated) plus the opportunity cost of the search activity (unregulated). Because the quantity of housing is less than the quantity in an unregulated market, the opportunity cost of housing exceeds the unregulated rent.

26 Housing Markets and Rent Ceilings Black Markets A black market is an illegal market that operates alongside a legal market in which a price ceiling or other restriction has been imposed. A shortage of housing creates a black market in housing. Illegal arrangements are made between renters and landlords at rents above the rent ceilingand generally above what the rent would have been in an unregulated market.

27 Housing Markets and Rent Ceilings Inefficiency of Rent Ceilings A rent ceiling leads to an inefficient use of resources. The quantity of rental housing is less than the efficient quantity and there is a deadweight loss, A rent ceiling is also, usually, unfair. It does not generally benefit the poor. Rather, it hurts the mobile newcomers and favors the less mobile, established residents.

28 Impact of a Price Floor Price Quantity S D P* Q* QSQS QdQd Surplus PFPF

29 Comparative Static Analysis How do the equilibrium price and quantity change when a determinant of supply and/or demand change?

30 The Labor Market and the Minimum Wage New, labor-saving technologies become available every year, which mainly replace low-skilled labor. Does the persistent decrease in the demand for low-skilled labor depress the wage rates of these workers? The immediate effect of these technological advances is a decrease in the demand for low-skilled labor, a fall in the wage rate, and a decrease in the quantity of labor supplied. Figure 6.4 on the next slide illustrates this immediate effect.

31 The Labor Market and the Minimum Wage A decrease in the demand for low-skilled labor is shown by a leftward shift of the demand curve. A new labor market equilibrium arises at a lower wage rate and a smaller quantity of labor employed.,

32 The Labor Market and the Minimum Wage In the long run, people get trained to do higher-skilled jobs. The supply of low-skilled labor decreases, which is shown by a leftward shift of the short-run supply curve.,,,

33 The Labor Market and the Minimum Wage If long-run supply is perfectly elastic, the equilibrium wage rate returns to its initial level (other things remaining the same).

34 The Labor Market and the Minimum Wage The Minimum Wage A price floor is a regulation that makes it illegal to trade at a price lower than a specified level. When a price floor is applied to labor markets, it is called a minimum wage. If the minimum wage is set below the equilibrium wage rate, it has no effect. The market works as if there were no minimum wage. If the minimum wage is set above the equilibrium wage rate, it has powerful effects.

35 The Labor Market and the Minimum Wage If the minimum wage is set above the equilibrium wage rate, the quantity of labor supplied by workers exceeds the quantity demanded by employers. There is a surplus of labor. Because employers cannot be forced to hire a greater quantity than they wish, the quantity of labor hired at the minimum wage is less than the quantity that would be hired in an unregulated labor market. Because the legal wage rate cannot eliminate the surplus, the minimum wage creates unemployment.

36 The Labor Market and the Minimum Wage The equilibrium wage rate is $4 an hour. The minimum wage rate is set at $5 an hour. So the equilibrium wage rate is in the illegal region.

37 The Labor Market and the Minimum Wage The quantity of labor employed is the quantity demanded. The quantity of labor supplied exceeds the quantity demanded. Unemployment is the gap between the quantity demanded and the quantity supplied.

38 The Labor Market and the Minimum Wage The Minimum Wage in Practice The United States has passed the Fair Standards Labor Act, which currently sets the minimum wage at $5.15 per hour. This minimum wage has historically fluctuated between 35 percent and 50 percent of the average wage of production workers. Most economists believe that minimum wage laws increase the unemployment rate of low-skilled younger workers.

39 Consumer Surplus ( ): The value consumers get from a good but do not have to pay for.

40 I got a great deal! That company offers a lot of bang for the buck! Dell provides good value. Total value greatly exceeds total amount paid. Consumer surplus is large.

41 I got a lousy deal! That car dealer drives a hard bargain! I almost decided not to buy it! They tried to squeeze the very last cent from me! Total amount paid is close to total value. Consumer surplus is low.

42 Price Quantity D 10 8 6 4 2 1 2 3 4 5 Consumer Surplus: The value received but not paid for Consumer Surplus: The Discrete Case

43 Consumer Surplus: The Continuous Case Price $ Quantity D 10 8 6 4 2 1 2 3 4 5 Value of 4 units Consumer Surplus Total Cost of 4 units

44 Producer Surplus ( ): The amount producers receive in excess of the amount necessary to induce them to produce the good. Price Quantity S0S0 Producer Surplus Q*Q* P*P*

45 Market Equilibrium Balancing supply and demand Q x S = Q x d Steady-state

46 (equilibrium)

47 Taxes Who Pays a Sales Tax? Demand and supply analysis shows how the buyer and the seller share the payment of a tax. Buyers respond to the price with the tax, because that is the price they must pay. Sellers respond to the price without the tax, because that is the price they receive. The tax is a wedge between the price paid and price received, which changes the incentives faced by buyers and sellers.

48 Elasticity and Tax Incidence What was the impact of tax? Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.

49 Taxes the effects of a sales tax on CD players. The equilibrium price with no tax is $100. A tax of $10 per CD player is introduced. The curve S + tax shows the new supply curve.

50 Taxes The vertical distance between the original supply curve and the supply curve with the tax is equal to the amount of the sales tax. Buyers would have to pay $110 to induce firms to offer the original quantity for sale.

51 Taxes The tax changes the equilibrium price and quantity. The quantity decreases. The price paid by the buyer rises to $105 and the price received by the seller falls to $95.

52 Taxes The government collects a tax revenue on the decreased quantity. The buyer and the seller share the tax payment. In this example, they share it equally. But it doesnt always turn out that way.

53 Taxes The division of the tax between the buyer and the seller depends on the elasticities of demand and supply. Tax Division and Elasticity of Demand To see the effect of the elasticity of demand on the division of the tax payment, we look at two extreme cases. Perfectly inelastic demand: the buyer pays the entire tax. Perfectly elastic demand: the seller pays the entire tax. The more inelastic the demand, the larger is the buyers share of the tax.

54 Taxes In this figure, demand is perfectly inelasticthe demand curve is vertical.,, When a tax is imposed on this good, the buyer pays the entire tax.

55 Taxes In this figure, demand is perfectly elasticthe demand curve is horizontal. When a tax is imposed on this good, the seller pays the entire tax.,,

56 Taxes Tax Division and Elasticity of Supply To see the effect of the elasticity of supply on the division of the tax payment, we again look at two extreme cases. Perfectly inelastic supply: the seller pays the entire tax. Perfectly elastic supply: the buyer pays the entire tax. The more elastic the supply, the larger is the buyers share of the tax.

57 Taxes In this figure, supply is perfectly inelasticthe supply curve is vertical. When a tax is imposed on this good, the seller pays the entire tax.,,

58 Taxes In this figure, supply is perfectly elasticthe supply curve is horizontal. When a tax is imposed on this good, the buyer pays the entire tax.,,

59 Taxes Sales Taxes in Practice Taxes usually are levied on goods and services with an inelastic demand. The quantity purchased does not decrease by much after the tax is imposed. The government collects relatively larger tax receipts.

60 Taxes Taxes and Efficiency Except in the extreme cases of perfectly inelastic demand or supply when the quantity remains the same, imposing a tax creates inefficiency. Figure 6.9 shows the inefficiency created by a $10 tax on CD players.

61 Taxes With no tax, the market is efficient and the sum of consumer surplus and producer surplus is maximized. A tax shifts the supply curve, decreases the equilibrium quantity, raises the price to the buyer, and lowers the price to the seller.

62 Taxes The tax revenue takes part of the consumer surplus and producer surplus. The decreased quantity creates a deadweight loss.

63 Elasticity and Tax Incidence In what proportions is the burden of the tax divided? How do the effects of taxes on sellers compare to those levied on buyers? The answers to these questions depend on the elasticity of demand and the elasticity of supply.

64 Figure 9 How the Burden of a Tax Is Divided Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (a) Elastic Supply, Inelastic Demand 2.... the incidence of the tax falls more heavily on consumers... 1. When supply is more elastic than demand... Price without tax 3.... than on producers.

65 Figure 9 How the Burden of a Tax Is Divided Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (b) Inelastic Supply, Elastic Demand 3.... than on consumers. 1. When demand is more elastic than supply... Price without tax 2.... the incidence of the tax falls more heavily on producers...

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67 P*=6 2.5 0.5 P Q* Q Q Q*

68 Elasticity and Tax Incidence So, how is the burden of the tax divided? The burden of a tax falls more heavily on the side of the market that is less elastic.

69 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.

70 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.

71 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. The burden tends to fall on the side of the market that is less elastic.


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