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© 2007 Thomson South-Western. Supply, Demand, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices.

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Presentation on theme: "© 2007 Thomson South-Western. Supply, Demand, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices."— Presentation transcript:

1 © 2007 Thomson South-Western

2 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.

3 © 2007 Thomson South-Western CONTROLS ON PRICES Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and floors.

4 © 2007 Thomson South-Western CONTROLS ON PRICES Price Ceiling –A legal maximum on the price at which a good can be sold. Price Floor –A legal minimum on the price at which a good can be sold.

5 © 2007 Thomson South-Western 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 The price ceiling is binding. It changes the market outcome.

6 © 2007 Thomson South-Western 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 The market clears at $3 and the price ceiling is ineffective.

7 © 2007 Thomson South-Western 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 There are buyers willing to pay a higher price at which sellers willing to supply the market, however market transactions at that price are considered illegal. Examples: Long lines, discrimination by sellers

8 CASE STUDY: Binding vs. Non Binding Ceiling 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 © 2007 Thomson South-Western 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 © 2007 Thomson South-Western 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 resulting in a shortage the price ceiling becomes binding but when supply falls... P2P2 QDQD P1P1 Q1Q1 5 …and a large change in quantity

11 © 2007 Thomson South-Western CASE STUDY: Rent Control in the Short Run and Long Run 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.

12 © 2007 Thomson South-Western 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

13 © 2007 Thomson South-Western 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

14 How Price Floors Affect Market Outcomes A price floor prevents supply and demand from moving toward the equilibrium price and quantity. A binding price floor causes... a surplus because Q S > Q D. nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria. Examples: The minimum wage, agricultural price supports

15 © 2007 Thomson South-Western A Market with a Price Floor (b) A Price Floor That Is Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply $4 Price floor 80 Quantity demanded 120 Quantity supplied Equilibrium price Surplus 3

16 © 2007 Thomson South-Western A Market with a Price Floor (a) A Price Floor That Is Not Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium quantity 2 Price floor Equilibrium price Demand Supply $3 100 The government sets a $2 minimum price for ice cream. The legislation is ineffective.

17 © 2007 Thomson South-Western CASE STUDY: The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.

18 © 2007 Thomson South-Western Figure 5 How the Minimum Wage Affects the Labor Market Quantity of Labor Wage 0 Labor demand Labor Supply Equilibrium employment Equilibrium wage

19 © 2007 Thomson South-Western Figure 5 How the Minimum Wage Affects the Labor Market Quantity of Labor Wage 0 Labor Supply Labor surplus (unemployment) Labor demand Minimum wage Quantity demanded Quantity supplied

20 © 2007 Thomson South-Western The minimum wage results in an increase in the quantity supplied of workers and a decline in the quantity demanded. Unemployment results as workers who are willing to work at the min wage are more than the jobs offered How the Minimum Wage Affects the Labor Market

21 © 2007 Thomson South-Western Who gets to work at the minimum wage? The answer will determine the distributional impact of the policy Several researches suggests that employers when faced with a larger labor pool under the minimum wage law, can discriminate between workers. Teenagers tend to be discriminated against due to their limited training and education relative to others in the pool Similarly for women and minorities.

22 © 2007 Thomson South-Western TAXES Governments levy taxes to : –raise revenue for public projects –Change market price to reduce trade in a particular good

23 © 2007 Thomson South-Western How Taxes Affect Market Outcomes Tax incidence Tax incidence is the manner in which the burden of a tax is shared among participants in a market. Tax incidence is the study of who bears the burden of a tax. Taxes result in a change in market equilibrium.

24 © 2007 Thomson South-Western How Taxes Affect Market Outcomes When a tax is imposed there are two prices of interest: The price that the buyers pay. The price that sellers receive. The difference between the two is the tax. Lets first consider a tax on buyers.

25 © 2007 Thomson South-Western Figure 6 A Tax on Buyers Quantity of Ice-Cream Cones 0 Price Tax ($0.50) Price buyers willing to pay before the tax D1D1 D2D2 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). $

26 © 2007 Thomson South-Western Figure 6 A Tax on Buyers Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium without tax Tax ($0.50) Price buyers pay D1D1 D2D2 Supply,S1S1 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). $ Equilibrium with tax

27 © 2007 Thomson South-Western Statutory Incidence of the tax How is a tax imposed on the buyer different from that imposed on the seller?

28 © 2007 Thomson South-Western Figure 7 A Tax on Sellers 3.50 Quantity of Ice-Cream Cones 0 Price Sellers accept before the tax Tax ($0.50) Price sellers Accept after the tax S1S1 S2S2 A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50)

29 © 2007 Thomson South-Western Figure 7 A Tax on Sellers 2.80 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Tax ($0.50) Price buyers pay S1S1 S2S2 Demand,D1D1 A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50) $

30 © 2007 Thomson South-Western How are they different? A $t tax imposed on the buyer has the same effect as a $t tax imposed on the sellers –The price received by the seller is the same. –The price paid by the buyer is the same. –The tax creates a wedge between the supply and demand curves. –The burden of the tax is shared between buyers and sellers.

31 © 2007 Thomson South-Western Figure 8 A Payroll Tax Quantity 0 Price D S Tax wedge Price sellers receive Price buyers pay Price without tax Q

32 © 2007 Thomson South-Western 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.

33 © 2007 Thomson South-Western 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.

34 © 2007 Thomson South-Western 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 the incidence of the tax falls more heavily on consumers When supply is more elastic than demand... Price without tax than on producers.

35 © 2007 Thomson South-Western 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 than on consumers. 1. When demand is more elastic than supply... Price without tax the incidence of the tax falls more heavily on producers...

36 © 2007 Thomson South-Western 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.


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