Supply, Demand and Government Policies Chapter 6 Copyright © 2001 by Harcourt, Inc. All rights reserved.   Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

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... 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

Price Ceilings & Price Floors A legally established maximum price at which a good can be sold. Price Floor A legally established minimum price at which a good can be sold. 4 4

Price Ceilings 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

A Price Ceiling That Is Not Binding... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Price Ceiling That Is Not Binding... Price of Ice-Cream Cone Supply $4 Price ceiling 3 Equilibrium price Demand 100 Quantity of Ice-Cream Cones Equilibrium quantity 6 7

A Price Ceiling That Is Binding... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Price Ceiling That Is Binding... Price of Ice-Cream Cone Supply Equilibrium price $3 2 Price ceiling 75 Quantity supplied 125 Quantity demanded Shortage Demand Quantity of Ice-Cream Cones 7 10

Effects of Price Ceilings A binding price ceiling creates ... shortages because QD > QS. Example: Gasoline shortage of the 1970s nonprice rationing Examples: Long lines, Discrimination by sellers 11 14

What was responsible for the long gas lines? Lines at the Gas Pump In 1973 OPEC raised the price of crude oil in world markets. Because crude oil is the major input used to make gasoline, 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.

The Price Ceiling on Gasoline Is Not Binding... Price of Gasoline 1. Initially, the price ceiling is not binding... Supply $4 Price ceiling P1 Demand Quantity of Gasoline Q1 6 7

The Price Ceiling on Gasoline Is Binding... Price of Gasoline 2. …but when supply falls... S1 P2 Price ceiling 4. …resulting in a shortage. 3. …the price ceiling becomes binding... P1 Demand Quantity of Gasoline Q1 6 7

Rent Control 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

Rent Control in the Short Run... Rental Price of Apartment Supply and demand for apartments are relatively inelastic Supply Controlled rent Shortage Demand Quantity of Apartments 7 10

Rent Control in the Long Run... Because the supply and demand for apartments are more elastic... Rental Price of Apartment Supply …rent control causes a large shortage Controlled rent Shortage Demand Quantity of Apartments 7 10

Price Floors 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

A Price Floor That Is Not Binding... Price of Ice-Cream Cone Supply Equilibrium price $3 Price floor 2 Demand 100 Quantity of Ice-Cream Cones Equilibrium quantity 8 17

A Price Floor That Is Binding... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Price Floor That Is Binding... Price of Ice-Cream Cone Supply Surplus $4 Price floor 80 Quantity demanded 120 Quantity supplied $3 Equilibrium price Demand Quantity of Ice-Cream Cones 8 17

Effects of a Price Floor 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. 15 24

Effects of a Price Floor 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

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.

The Minimum Wage A Free Labor Market Labor supply Labor demand Wage Equilibrium wage Equilibrium employment Labor demand Quantity of Labor

A Labor Market with a Minimum Wage The Minimum Wage A Labor Market with a Minimum Wage Wage Labor supply Labor surplus (unemployment) Minimum wage Quantity demanded Quantity supplied Labor demand Quantity of Labor

Governments levy taxes to raise revenue for public projects. 20 29

What are some potential impacts of taxes? Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. 22 30

Taxes Tax incidence is the study of who bears the burden of a tax. 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

Impact of a 50¢ Tax Levied on Buyers... Copyright © 2001 by Harcourt, Inc. All rights reserved Impact of a 50¢ Tax Levied on Buyers... Price of Ice-Cream Cone Supply, S1 D2 3.00 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). D1 100 Quantity of Ice-Cream Cones 23 33

Impact of a 50¢ Tax Levied on Buyers... Copyright © 2001 by Harcourt, Inc. All rights reserved Impact of a 50¢ Tax Levied on Buyers... Price of Ice-Cream Cone Supply, S1 $3.30 Price buyers pay Equilibrium without tax Tax ($0.50) Price without tax 3.00 2.80 Price sellers receive Equilibrium with tax D1 D2 90 100 Quantity of Ice-Cream Cones 23 38

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

Impact of a 50¢ Tax on Sellers... Copyright © 2001 by Harcourt, Inc. All rights reserved Impact of a 50¢ Tax on Sellers... Price of Ice-Cream Cone A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50). $3.30 Price buyers pay S2 Equilibrium with tax S1 90 Tax ($0.50) 3.00 Price without tax Equilibrium without tax 2.80 Price sellers receive Demand, D1 100 Quantity of Ice-Cream Cones

A Payroll Tax Labor supply Labor demand Wage Wage firms pay Tax wedge Wage without tax Wage workers receive Labor demand Quantity of Labor

The Incidence of Tax 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

Elastic Supply, Inelastic Demand... Price 1. When supply is more elastic than 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 Demand Quantity 32 44

Inelastic Supply, Elastic Demand... 1. When demand is more elastic than supply... Price Supply Price buyers pay Tax 3. ...than on consumers. Price without tax 2. ...the incidence of the tax falls more heavily on producers... Demand Price sellers receive Quantity 32 51

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

Summary 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.

Summary 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.

Summary 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.

Graphical Review

A Price Ceiling That Is Not Binding... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Price Ceiling That Is Not Binding... $4 3 Quantity of Ice-Cream Cones Price of Cone Demand Supply Price ceiling Equilibrium price 100 quantity 6 7

A Price Ceiling That Is Binding... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Price Ceiling That Is Binding... $3 Quantity of Ice-Cream Cones Price of Cone 2 Demand Supply Equilibrium price Price ceiling Shortage 125 Quantity demanded 75 supplied 7 10

The Price Ceiling on Gasoline Is Not Binding... $4 P1 Quantity of Gasoline Price of Q1 Demand Supply Price ceiling 1. Initially, the price ceiling is not binding... 6 7

The Price Ceiling on Gasoline Is Binding... Quantity of Gasoline Price of Q1 Demand S1 Price ceiling S2 2. …but when supply falls... P2 3. …the price ceiling becomes binding... 4. …resulting in a shortage. 6 7

Rent Control in the Short Run... Quantity of Apartments Rental Price of Apartment Demand Supply Controlled rent Shortage Supply and demand for apartments are relatively inelastic 7 10

Rent Control in the Long Run... Quantity of Apartments Rental Price of Apartment Demand Supply Controlled rent Shortage Because the supply and demand for apartments are more elastic... …rent control causes a large shortage 7 10

A Price Floor That Is Not Binding... $3 Quantity of Ice-Cream Cones Price of Cone 100 Equilibrium quantity price Demand Supply Price floor 2 8 17

A Price Floor That Is Binding... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Price Floor That Is Binding... $3 Quantity of Ice-Cream Cones Price of Cone Equilibrium price Demand Supply Price floor $4 120 Quantity supplied 80 demanded Surplus 8 17

The Minimum Wage A Free Labor Market supply demand Wage Equilibrium Quantity of Labor Wage Equilibrium wage demand supply A Free Labor Market employment

A Labor Market with a Minimum Wage The Minimum Wage Minimum wage Quantity of Labor Wage demand supply Quantity supplied demanded Labor surplus (unemployment) A Labor Market with a Minimum Wage

Impact of a 50¢ Tax Levied on Buyers... 3.00 Quantity of Ice-Cream Cones Price of Ice-Cream Cone 100 D1 Supply, S1 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). D2 23 33

Impact of a 50¢ Tax Levied on Buyers... 3.00 Quantity of Ice-Cream Cones Price of Ice-Cream Cone 100 90 $3.30 Price buyers pay D1 D2 Equilibrium with tax Supply, S1 Equilibrium without tax 2.80 sellers receive without tax Tax ($0.50) 23 38

Impact of a 50¢ Tax on Sellers... 3.00 Quantity of Ice-Cream Cones Price of Ice-Cream Cone 100 90 S1 S2 Demand, D1 Price without tax 2.80 Price sellers receive $3.30 Price buyers pay Equilibrium without tax A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50). Tax ($0.50) Equilibrium with tax

A Payroll Tax supply demand Wage Wage firms pay Tax wedge Quantity of Labor Wage Wage without tax demand supply Tax wedge Wage firms pay Wage workers receive

Elastic Supply, Inelastic Demand... Quantity Price Demand Supply Tax 1. When supply is more elastic than demand... 2. ...the incidence of the tax falls more heavily on consumers... 3. ...than on producers. Price without tax Price buyers pay Price sellers receive 32 44

Inelastic Supply, Elastic Demand... Quantity Price Demand Supply Price without tax Tax 1. When demand is more elastic than supply... 2. ...the incidence of the tax falls more heavily on producers... 3. ...than on consumers. Price buyers pay Price sellers receive 32 51