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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Supply, Demand, and Government Policies u In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. u One of the things government can do is to set price controls when the market price is seen as unfair to either buyers or sellers.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Price Ceilings & Price Floors Price Ceiling u A legally established maximum price at which a good can be sold. (Rent Controls) Price Floor u A legally established minimum price at which a good can be sold. (Price Supports for Agriculture)

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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. u The price ceiling is binding if set below the equilibrium price, leading to a shortage. u Binding means that there is an economic impact.

A Price Ceiling That Is Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 2 Demand Supply Equilibrium price Price ceiling Shortage 125 Quantity demanded 75 Quantity supplied 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 0 Price of Ice-Cream Cone Demand Supply Price ceiling Equilibrium price 100 Equilibrium quantity Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Effects of Price Ceilings A binding price ceiling creates... shortages because Q D > Q S. u Example: Gasoline shortage of the 1970s nonprice rationing u Examples: Long lines, Discrimination by sellers

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Price Ceiling on Gasoline Is Not Binding... $4 P1P1 Quantity of Gasoline 0 Price of Gasoline Q1Q1 Demand Supply Price ceiling 1. Initially, the price ceiling is not binding...

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Price Ceiling on Gasoline Is Binding... P1P1 Quantity of Gasoline 0 Price of Gasoline Q1Q1 Demand S1S1 Price ceiling S2S2 2. …but when supply falls... P2P2 3. …the price ceiling becomes binding …resulting in a shortage.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Rent Control u Rent controls are ceilings placed on the rents that landlords may charge their tenants. u Rent control can make housing more affordable. u With a price ceiling, you cannot go above the ceiling. u But what about the landlords?

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Rent Control in the Short Run... Quantity of Apartments 0 Rental Price of Apartment Demand Supply Controlled rent Shortage Supply and demand for apartments are relatively inelastic-Why is the supply curve vertical?

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Rent Control in the Long Run... Quantity of Apartments 0 Rental Price of Apartment Demand Supply Controlled rent Shortage Because the supply and demand for apartments are more elastic... What happens in the long run? …rent control causes a large shortage

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Price Floors When the government imposes a price floor, two outcomes are possible. u The price floor is not binding if set below the equilibrium price. u The price floor is binding if set above the equilibrium price, leading to a surplus. u Think of price floors as not being able to go below the floor.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Price Floor That Is Not Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 100 Equilibrium quantity Equilibrium price Demand Supply Price floor 2

A Price Floor That Is Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium price Demand Supply Price floor$4 120 Quantity supplied 80 Quantity demanded Surplus Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Effects of a Price Floor 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. uExamples: The minimum wage, Agricultural price supports uState Minimum WagesState Minimum Wages

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Minimum Wage Quantity of Labor 0 Wage Equilibrium wage Labor demand Labor supply A Free Labor Market Equilibrium employment

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Minimum wage The Minimum Wage Quantity of Labor 0 Wage Labor demand Labor supply Quantity supplied Quantity demanded Labor surplus (unemployment) A Labor Market with a Minimum Wage

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. What are some potential impacts of taxes? u Taxes are used to raise money for the government. u Taxes discourage market activity. u When a good is taxed, the quantity sold is smaller. u Buyers and sellers share the tax burden. u But who bears the burden-tax incidence.

3.00 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone $3.30 Price buyers pay D1D1 D2D2 Equilibrium with tax Supply, S 1 Equilibrium without tax Impact of a 50¢ Tax Levied on Buyers Price sellers receive Copyright © 2001 by Harcourt, Inc. All rights reserved Price without tax Tax ($0.50)

3.00 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone S1S1 S2S2 Demand, D 1 Impact of a 50¢ Tax on Sellers... Price without tax 2.80 Price sellers receive $3.30 Price buyers pay Equilibrium without tax Copyright © 2001 by Harcourt, Inc. All rights reserved A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50). Tax ($0.50) Equilibrium with tax

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Incidence of Tax u In what proportions is the burden of the tax divided? u 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.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Elastic Supply, Inelastic Demand... Quantity0 Price Demand Supply Tax 1. When supply is more elastic than demand the incidence of the tax falls more heavily on consumers than on producers. Price without tax Price buyers pay Price sellers receive

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Inelastic Supply, Elastic Demand... Quantity0 Price Demand Supply Price without tax Tax 1. When demand is more elastic than supply the incidence of the tax falls more heavily on producers than on consumers. Price buyers pay Price sellers receive