Chapter 6 Supply, Demand, and Government Policies 2002 by Nelson, a division of Thomson Canada Limited

Chapter 6: Page 2 Examine the effects of government policies that place a ceiling on prices. Examine the effects of government policies that place a floor under prices. Consider how a tax on a good affects the price of the good and the quantity sold. Learn that taxes levied on buyers and taxes levied on sellers are equivalent. See how the burden of a tax is split between buyers and sellers. Examine the effects of government policies that place a ceiling on prices. Examine the effects of government policies that place a floor under prices. Consider how a tax on a good affects the price of the good and the quantity sold. Learn that taxes levied on buyers and taxes levied on sellers are equivalent. See how the burden of a tax is split between buyers and sellers. In this chapter you will…

Chapter 6: Page 3 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. Hence…market controls! One of the roles of economists is to use their theories to assist in the development of 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. Hence…market controls! One of the roles of economists is to use their theories to assist in the development of policies. SUPPLY, DEMAND, AND GOVERNMENT POLICIES

Chapter 6: Page 4 Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and floors. Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and floors. CONTROLS ON PRICES

Chapter 6: Page 5 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. 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. Price Ceilings and Price Floors

Chapter 6: Page 6 When the government imposes a price ceiling (i.e... a legal maximum on the price at which a good can be sold) two outcomes are possible 1)The price ceiling is not binding. 2)The price ceiling is a binding constraint on the market, creating Shortages. When the government imposes a price ceiling (i.e... a legal maximum on the price at which a good can be sold) two outcomes are possible 1)The price ceiling is not binding. 2)The price ceiling is a binding constraint on the market, creating Shortages. How Price Ceiling Affect Market Outcomes

Chapter 6: Page 7 Quantity of Ice-Cream Cones Price of Ice-Cream Cone Demand Supply Equilibrium price $3 (a) A Price Ceiling That is Not Binding (b) A Price Ceiling That is Binding $4 Price ceiling Quantity of Ice-Cream Cones 100 Equilibrium quantity Price of Ice-Cream Cone Demand Supply $2 Price ceiling $3 75 Q S Equilibrium price 125 Q D Shortage 0 0 Figure 6-1: A Market with a Price Ceiling

Chapter 6: Page 8 A binding price ceiling creates – Shortages because Q D > Q S. Examples: Gasoline shortage of the 1970s, housing shortages with rent controls. – Non-price rationing Examples: Long lines, discrimination by sellers, black markets. A binding price ceiling creates – Shortages because Q D > Q S. Examples: Gasoline shortage of the 1970s, housing shortages with rent controls. – Non-price rationing Examples: Long lines, discrimination by sellers, black markets. How Price Ceiling Affect Market Outcomes

Chapter 6: Page 9 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. 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. CASE STUDY: Lines at the Gas Pump

Chapter 6: Page 10 Quantity of Gasoline Price of Gasoline Demand S1S1 (a) A Price Ceiling on Gasoline is Not Binding(b) A Price Ceiling on Gasoline is Binding Price ceiling P1P1 Q1Q Initially the price ceiling is not binding… Quantity of Gasoline Demand S1S1 Price ceiling S2S2 P1P1 Q1Q1 QDQD QSQS P2P2 4.…resulting in a shortage… 2.…but when supply falls… 3.…the price ceiling becomes binding… Figure 6-2: A Market for Gasoline with a Price Ceiling

Chapter 6: Page 11 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. 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. CASE STUDY: Rent Control in the Short Run and Long Run

Chapter 6: Page 12 Quantity of Apartments Rental Price of Apartment Demand Supply (a) Short Run (Supply and Demand are Inelastic) Controlled rent 0 0 (b) Long Run (Supply and Demand are Elastic) Shortage Quantity of Apartments Rental Price of Apartment Demand Supply Controlled rent Shortage Figure 6-3: Rent Control in the Short Run and Long Run

Chapter 6: Page 13 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. 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. How Price Floors Affect Market Outcomes

Chapter 6: Page 14 Quantity of Ice-Cream Cones Price of Ice-Cream Cone Demand Supply Equilibrium price $3 (a) A Price Floor That is Not Binding (b) A Price Floor That is Binding $2 Price Floor Quantity of Ice-Cream Cones 100 Equilibrium quantity Price of Ice-Cream Cone Demand Supply $4 Price ceiling $3 80 Q D Equilibrium price 120 Q S Surplus 0 0 Figure 6-4: A Market with a Price Floor

Chapter 6: Page 15 A Binding Price Floor creates... – Surpluses (i.e. Quantity Supplied > Quantity Demanded) – Non-Price Rationing - An alternative mechanism for rationing of the good: Discrimination Criteria – Examples: Minimum Wage Agricultural Price Supports A Binding Price Floor creates... – Surpluses (i.e. Quantity Supplied > Quantity Demanded) – Non-Price Rationing - An alternative mechanism for rationing of the good: Discrimination Criteria – Examples: Minimum Wage Agricultural Price Supports How Price Floors Affect Market Outcomes

Chapter 6: Page 16 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. CASE STUDY: The Minimum Wage

Chapter 6: Page 17 Labour demand Labour supply Quantity of Labour Wage Labour demand Labour supply Equilibrium wage (a) A Free Labour Market (b) A Labour Market with a Binding Minimum Wage Quantity of Labour Equilibrium employment Wage Minimum wage Labour surplus (unemployment) 0 0 Quantity demanded Quantity supplied Figure 6-5: How the Minimum Wage Affects the Labour Market

Chapter 6: Page 18 What is the purpose of government- imposed taxes? – To raise government revenues. – To restrict production of a product. What is an excise tax? – A per-unit tax thats independent of the price of the product. What is the purpose of government- imposed taxes? – To raise government revenues. – To restrict production of a product. What is an excise tax? – A per-unit tax thats independent of the price of the product. TAXESTAXES

Chapter 6: Page 19 Who pays the tax on a good? The buyer or the seller? How is the burden of a tax divided between buyer and seller? When the government levies a tax on a good, the equilibrium quantity of the good falls. The size of the market for that good shrinks, shifting either the demand or supply curve. Tax incidence: The study of who bears the burden of taxation. Who pays the tax on a good? The buyer or the seller? How is the burden of a tax divided between buyer and seller? When the government levies a tax on a good, the equilibrium quantity of the good falls. The size of the market for that good shrinks, shifting either the demand or supply curve. Tax incidence: The study of who bears the burden of taxation. TAXESTAXES

Chapter 6: Page 20 Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. How Taxes on Buyers (and Sellers) Affect Market Outcomes

Chapter 6: Page 21 D1D1 S1S1 0 Quantity of Ice- Cream Cone Price of Ice-Cream Cone $ D2D2 Equilibrium without tax 90 $2.80 $3.30 Equilibrium with tax Tax ($0.50) Price buyers pay Price without tax Price sellers receive A tax on buyers shifts the demand curve downward by size of the tax ($0.50). Figure 6-6: A Tax on Buyers

Chapter 6: Page 22 D1D1 S1S1 0 Quantity of Ice- Cream Cone Price of Ice-Cream Cone $ Equilibrium without tax $2.80 Equilibrium with tax Tax ($0.50) Price buyers pay Price without tax Price sellers receive A tax on sellers shifts the supply curve upward by an amount of the tax ($0.50). S2S2 90 $3.30 Figure 6-7: A Tax on Sellers

Chapter 6: Page 23 Example: Employment Insurance. A payroll tax places a wedge between the wage the workers receive and the wage the firm pays. Example: Employment Insurance. A payroll tax places a wedge between the wage the workers receive and the wage the firm pays. CASE STUDY: The Burden of a Payroll tax

Chapter 6: Page 24 Quantity of Labour Wage Labour dem and Labour supply Wage without tax 0 Tax wedge Wage firms pay Wage workers receive Figure 6-8: A Payroll Tax

Chapter 6: Page 25 Consider a tax levied on sellers of a good. What are the effects of this tax? How do effects of the tax levied on the seller compare with those of the effects imposed on the buyer? Depends on Elasticity of Demand and Elasticity of Supply. Consider a tax levied on sellers of a good. What are the effects of this tax? How do effects of the tax levied on the seller compare with those of the effects imposed on the buyer? Depends on Elasticity of Demand and Elasticity of Supply. Elasticity and Tax incidence

Chapter 6: Page 26 The burden of a tax falls on the side of the market with the smaller price elasticity! The more inelastic the demand and the more elastic the supply results in the consumer paying more of the tax. The more elastic the demand and the more inelastic the supply results in the supplier paying more of the tax. The burden of a tax falls on the side of the market with the smaller price elasticity! The more inelastic the demand and the more elastic the supply results in the consumer paying more of the tax. The more elastic the demand and the more inelastic the supply results in the supplier paying more of the tax. Elasticity and Tax incidence

Chapter 6: Page 27 Elastic Supply, Inelastic Demand Demand Quantity Price Supply 1. When supply is more elastic than demand … Price buyers pay Price without tax Price sellers receive Tax 3. …than on producers. 2. …the incidence of the tax falls more heavily on consumers… Figure 6-9 a): How the Burden of a Tax is Divided.

Chapter 6: Page 28 Inelastic Supply, Elastic Demand Demand Quantity Price Supply 1. When demand is more elastic than supply … Price buyers pay Price without tax Price sellers receive Tax 3. …than on consumers. 2. …the incidence of the tax falls more heavily on producers… Figure 6-9 b): How the Burden of a Tax is Divided

Chapter 6: Page 29 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. 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. SummarySummary

Chapter 6: Page 30 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. 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. SummarySummary

Chapter 6: Page 31 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. The burden tends to fall on the side of the market that is less elastic. 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. The burden tends to fall on the side of the market that is less elastic. SummarySummary

Chapter 6: Page 32 The End