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Supply, Demand, and Government Policies

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Presentation on theme: "Supply, Demand, and Government Policies"— Presentation transcript:

0 © 2007 Thomson South-Western

1 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. 2 2

2 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. 3 3

3 CONTROLS ON PRICES Price Ceiling Price Floor
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. 4 4

4 Figure 1 A Market with a Price Ceiling
(b) A Price Ceiling That Is Binding Price of Ice-Cream Cone Supply The price ceiling is binding. It changes the market outcome. Demand Equilibrium price $3 2 Price ceiling 75 125 Shortage Quantity of Ice-Cream Quantity supplied Quantity demanded Cones

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

6 How Price Ceilings Affect Market Outcomes
Effects of Price Ceilings A binding price ceiling creates Shortages because QD > QS. 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 11 14

7 CASE STUDY: Binding vs. Non Binding Ceiling
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? Economists blame government regulations that limited the price oil companies could charge for gasoline.

8 The Market for Gasoline with a Price Ceiling
(a) The Price Ceiling on Gasoline Is Not Binding Price of Gasoline Demand Supply, S1 1. Initially, the price ceiling is not binding . . . Price ceiling P1 Q1 Quantity of Gasoline

9 The Market for Gasoline with a Price Ceiling
(b) The Price Ceiling on Gasoline Is Binding Price of S2 Gasoline but when supply falls . . . Demand S1 P2 QS QD Price ceiling resulting in a shortage. the price ceiling becomes binding . . . P1 Q1 Quantity of 5 …and a large change in quantity Gasoline

10 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.” 2

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

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

13 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 QS > QD. nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria. Examples: The minimum wage, agricultural price supports 15 25

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

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

16 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.

17 Figure 5 How the Minimum Wage Affects the Labor Market
Supply Labor demand Equilibrium employment wage Quantity of Labor

18 Figure 5 How the Minimum Wage Affects the Labor Market
Supply Labor demand Labor surplus (unemployment) Minimum wage Quantity demanded Quantity supplied Quantity of Labor

19 How the Minimum Wage Affects the Labor Market
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

20 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.

21 TAXES Governments levy taxes to : raise revenue for public projects
Change market price to reduce trade in a particular good 20 29

22 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. 21 31

23 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. Let’s first consider a tax on buyers. 21 31

24 Figure 6 A Tax on Buyers Price
Price buyers willing to pay before the tax D1 D2 3.00 100 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). Tax ($0.50) $2.5 Quantity of Ice-Cream Cones

25 Figure 6 A Tax on Buyers Price of Ice-Cream Price buyers pay Supply,
Cone D1 D2 $3.30 90 Equilibrium without tax Tax ($0.50) Price without tax 3.00 100 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). 2.80 Equilibrium with tax Price sellers receive Quantity of Ice-Cream Cones

26 Statutory Incidence of the tax
How is a tax imposed on the buyer different from that imposed on the seller?

27 Figure 7 A Tax on Sellers Price Price sellers Accept after the tax
shifts the supply curve upward by the amount of the tax ($0.50). S2 3.50 Tax ($0.50) S1 3.00 100 Price Sellers accept before the tax Quantity of Ice-Cream Cones

28 Figure 7 A Tax on Sellers Price of Ice-Cream Demand, D1
shifts the supply curve upward by the amount of the tax ($0.50). Price buyers pay Cone S2 S1 $3.30 90 Tax ($0.50) Price without tax 3.00 100 2.80 Price sellers receive Quantity of Ice-Cream Cones

29 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.

30 Figure 8 A Payroll Tax Q Price S Price buyers pay Tax wedge
Price without tax Price sellers receive Q Quantity

31 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. 22 30

32 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. 29 39

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

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

35 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. 30 41


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