Supply, Demand, and Government Policies 8 Supply, Demand, and Government Policies For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Market Outcomes In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. While equilibrium conditions may be efficient, but they may not always be fair. Governments seek to influence unfair markets. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 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. 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. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 3 3

How Price Ceilings Affect Market Outcomes When the government imposes a price ceiling there are two possible outcomes: 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. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 5 5

Figure 1 A Market with a Price Ceiling (a) A Price Ceiling That Is Not Binding Price of flats per sq m Supply Demand €40 Price ceiling 30 5 000 Equilibrium price Quantity of rental accommodation (000 sq m) Equilibrium quantity

Figure 1 A Market with a Price Ceiling (b) A Price Ceiling That Is Binding Price of flats per sq m Supply Demand Equilibrium price €30 20 Price ceiling 4 000 6 000 Shortage Quantity of rental accommodation (000 sq m) Quantity supplied Quantity demanded

How Price Ceilings Affect Market Outcomes Effects of Price Ceilings A binding price ceiling creates Shortages because QD > QS. Example: Rent controls in a city may restrict new building. Non-price rationing. Examples: Long queues; discrimination by sellers. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 11 14

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.” For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 2

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

Figure 2b 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 ]

How Price Floors Affect Market Outcomes When the government imposes a price floor there are two 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. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 12 15

Figure 3a. A Market with a Price Floor (a) A Price Floor That Is Not Binding Price of alcohol per unit (€) Supply Demand Equilibrium price €0.35 5 0.25 Price floor Quantity of alcohol per unit (millions) Equilibrium quantity

Figure 3b. A Market with a Price Floor (b) A Price Floor That Is Binding Price of alcohol per unit (€) Supply Demand Surplus €0.45 Price floor 3 6 0.35 Equilibrium price Quantity of alcohol per unit (millions) Quantity demanded Quantity supplied

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. A binding price floor causes . . . a surplus because QS > QD. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 15 24

Taxes Governments levy taxes to raise revenue for public projects. However Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 20 29

There Are Many Different Types Of Tax A direct tax is levied on income and wealth Indirect tax is levied on the sale of goods and services. A specific tax is a set amount per unit of expenditure, for example, €0.75 per litre of petrol or €2.50 on a bottle of whisky. An ad valorem tax is expressed as a percentage, for example a 10 per cent tax. Tax incidence is the manner in which the burden of a tax is shared among participants in a market. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 22 30

How Taxes on Sellers Affect Market Outcomes A Specific Tax where the government requires the seller to pay a certain amount for each good sold. Supply curve shifts up by the amount of the tax. Quantity sold falls. Even though the tax is levied on sellers, buyers and sellers will share the burden of the tax; buyers pay more for the good and sellers receive less (because of the tax) A tax on sellers places a wedge between the price buyers pay and the price sellers receive. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 21 31

Figure 4 The Effects of a Specific Tax of €0.50 For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 5 The Tax Burden on Buyers and Sellers For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

How Taxes on Sellers Affect Market Outcomes An ad valorem tax on sellers. Like the specific tax, the buyers and sellers will share the burden of the tax Supply curve shifts up but not by a parallel amount. For example if VAT is introduced at 20% then: A product costing €20 means the seller pays €4 VAT. A product costing €50 means the seller pays €10 VAT. At low prices, the amount of the tax paid is relatively low but 20 per cent of higher prices means the seller has to give more to the government. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 21 31

Figure 6a. The Effects of an Ad Valorem tax When a tax of 20 per cent is levied on sellers, the supply curve shifts to the left from S1 to S2. At low prices, the amount of the tax paid is relatively low For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 6b. The Effects of an Ad Valorem tax At higher prices the seller has to give more to the government. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Elasticity and Tax Incidence Implications of tax. Taxes result in a change in market equilibrium. Taxes discourage market activity. Buyers pay more and sellers receive less, regardless of whom the tax is levied on. Buyers and sellers share the tax burden. Tax incidence is the manner in which the burden of a tax is shared among market participants. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 21 31

Price Elasticity and Tax Incidence The way the burden of the tax divided depends on the price elasticity of demand and the price elasticity of supply. In general, a tax burden falls more heavily on the side of the market that is less price elastic. A low price elasticity of demand means buyers do not have good alternatives to consuming the product. A low price elasticity of supply means sellers do not have good alternatives to producing this good. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 29 39

Figure 7a. 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 For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 7b 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 For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Subsidies A subsidy is the opposite to a tax. A subsidy is a payment to buyers and sellers to supplement income or lower costs and which thus encourages consumption or provides an advantage to the recipient. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 22 30

How Subsidies Affect Market Outcomes Using rail travel as an example then subsidies: Alter the incentives for people to travel on the train rather than on the roads. Reduces congestion. Reduces pollution. A subsidy is given to railway companies shifts the supply curve outwards and lowers the price to buyers and so increases the amount purchased. Both buyers and suppliers share the benefit of the subsidy. There are costs associated with subsidies. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 22 30

Figure 8 A Subsidy To Railway Companies For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

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. 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. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Summary A tax on a good places a wedge between the price paid by buyers and the price received by sellers. The incidence of a tax refers to who bears the burden of a tax. The incidence of the tax depends on the price elasticities of supply and demand. The burden tends to fall on the side of the market that is less price elastic. The incidence of a tax does not depend on whether the tax is levied on buyers or sellers. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Summary Subsidies are the opposite to taxes. Subsidies to sellers shift the supply curve to the right, lowers price to buyers and increases the amount purchased. Both suppliers and buyers gain from subsidies. Subsidies cost money, usually the taxpayer For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017