Supply, Demand, and Government Policies 6 Supply, Demand, and Government Policies

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. 2 2

PRICE CONTROLS Controls on prices… are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Examples: Rental Housing Market, Labour Market result in government-created price ceilings and floors. 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

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 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 Quantity of Ice-Cream Equilibrium quantity Cones

Figure 1 A Market with a Price Ceiling (b) A Price Ceiling That Is Binding Price of Ice-Cream Cone Supply Demand Equilibrium price €3 2 Price ceiling 75 125 Shortage Quantity of Ice-Cream Quantity supplied Quantity demanded Cones Copyright©2011 South-Western

How Price Ceilings Affect Market Outcomes Effects of Price Ceilings A binding price ceiling creates shortages because QD > QS. Example: Rent controls in New York restrict new building non-price rationing Examples: Long queues; discrimination by sellers 11 14

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

Figure 2 Rent Control in the Short Run and in the Long Run (a) Rent Control in the Short Run (supply and demand are price inelastic) Rental Price of Housing Units Supply Demand Controlled rent Shortage Quantity of Housing Units Copyright©2011 South-Western

Figure 2 Rent Control in the Short Run and in the Long Run (b) Rent Control in the Long Run (supply and demand are price elastic) Rental Price of Housing Units Supply Demand Controlled rent Shortage Quantity of Housing Units Copyright©2011 South-Western

Effects of Rent Controls A binding rent control creates… shortages because QD > QS. Buyers interested in renting a house cant do so! search costs associated with shortages. non-price rationing Long waiting lists Discrimination by sellers (race and children) Black Market long-run effects: reduction in rental housing 11 14

How Price Floors Affect Market Outcomes When the government imposes a price floor, two outcomes are possible: The price floor is not binding if set below the equilibrium price. The price floor is binding if set above the equilibrium price, leading to a surplus. 12 15

Figure 3 A Market with a Price Floor (a) A Price Floor That Is Not Binding Price of Ice-Cream Supply Cone Demand Equilibrium price €3 100 2 Price floor Quantity of Ice-Cream Equilibrium quantity Cones Copyright©2011 South-Western

Figure 3 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 Copyright©2011 South-Western

How Price Floors Affect Market Outcomes A price floor prevents supply and demand from moving toward the equilibrium price and quantity. When the market price hits the floor, it can fall no further, and the market price equals the floor price. Primary result: A binding price floor causes a surplus because QS > QD. 15 24

The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price for labour that any employer may pay. Monthly wage: 1,071 (2014)

Figure 4 How the Minimum Wage Affects the Labour Market Supply labour demand Equilibrium employment wage Quantity of labour Copyright©2011 South-Western

Figure 4 How the Minimum Wage Affects the Labour Market Supply labour demand labour surplus (unemployment) Minimum wage Quantity demanded Quantity supplied Quantity of labour Copyright©2011 South-Western

Effects of Minimum Wages Consequences of the minimum wage are… Reduction in employment level Surplus of labour & Involuntary Unemployment: Everyone who is willing to sell their labor cant do so! Non-price rationing: Discrimination Search costs: Job search is costly and does not guarantee successful results Effective as anti-poverty tool? Not a consensus in the literature! 15 24

TAXES Governments levy taxes to raise revenue for public projects. Taxes discourage market activity. Why? Taxes = An increase in the costs When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.(i.e. Tax Incidence) 20 29

Example: € 0.5 Tax on Ice-cream cones Suppose that the government levies a €0.5 tax on ice-cream cones. Moreover, the government states that the tax is payable by the producers of ice-cream cones. Before the tax, equilibrium price is €3.00 and the equilibrium quantity is 100 cones. What is the impact of the tax on: the equilibrium price and quantity? Consumers and Producers? 21 31

Figure 5 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 Equilibrium with tax S1 €3.30 90 Tax (€0.50) Price without tax 3.00 100 Equilibrium without tax 2.80 Price sellers receive Quantity of Ice-Cream Cones Copyright©2011 South-Western

Figure 6 A Payroll Tax Wage labour supply Wage firms pay Tax wedge labour demand Wage firms pay Tax wedge Wage without tax Wage workers receive Quantity of labour Copyright©2011 South-Western

Taxes result in a change in market equilibrium. Tax Incidence Tax incidence is the manner in which the burden of a tax is shared among market participants. Taxes result in a change in market equilibrium. Buyers pay more and sellers receive less, regardless of whom the tax is levied on. 21 31

Figure 5 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 Equilibrium with tax S1 €3.30 90 Tax (€0.50) Price without tax 3.00 100 Equilibrium without tax 2.80 Price sellers receive Quantity of Ice-Cream Cones Copyright©2011 South-Western

Tax Incidence: Market for Ice-cream cones Tax incidence is the manner in which the burden of a tax is shared among buyers and sellers. Before the tax: Consumers paid: €3.00 Producers received: €3.00 After the tax: Consumers pays: €3.30 Producers receives: €2.80 Government collects €0.5 from the producers Tax Incidence: Buyers pay €0.3 more: (€3.30 - €3.00) (60% of the tax) Sellers receive €0.2 less: (€3.00 - €2.80) (40% of the tax) 21 31

Price Elasticity and Tax Incidence Q: In what proportions is the burden of the tax divided? A: It depends on the price elasticity of demand and the price elasticity of supply. 29 39

Figure 7 How the Burden of a Tax Is Divided (a) Price Elastic Supply, Price Inelastic Demand Price 1. When supply is more price elastic than demand . . . Demand Price buyers pay Tax 2. . . . the incidence of the tax falls more heavily on consumers . . . Supply Price without tax 3. . . . than on producers. Price sellers receive Quantity Copyright©2011 South-Western

Figure 7 How the Burden of a Tax Is Divided (b) Price Inelastic Supply, Price Elastic Demand Price 1. When demand is more price elastic than supply . . . Demand Price buyers pay Supply Tax 3. . . . than on consumers. Price without tax 2. . . . the incidence of the tax falls more heavily on producers . . . Price sellers receive Quantity Copyright©2011 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 price elastic. 30 41