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

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. 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©2010 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.” Speaking in 1989, Vietnam’s Foreign Minister said: "The Americans couldn't destroy Hanoi, but we have destroyed our city by very low rents. We realized it was stupid and that we must change policy." Discrimination; big shortages in the long run 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 inelastic) Rental Price of Apartment Supply Demand Controlled rent Shortage Quantity of Apartments Copyright©2010 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 elastic) Rental Price of Apartment Supply Demand Controlled rent Shortage Quantity of Apartments Copyright©2010 South-Western

Rent controls in New York City, San Francisco, Los Angeles NYC: over 1 million apartments are rent-regulated “Rent control limits the price a landlord can charge a tenant for rent and also regulates the services the landlord must provide.” "Rent control allows some people to stay in artificially cheap apartments, but only by forcing the people who would have rented them into some other, less desirable place.” “And no one wants to build any new housing except luxury units which will not be controlled.” Deterioration of quality

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©2010 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©2010 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. 15 24

How Price Floors Affect Market Outcomes A binding price floor causes . . . a surplus because QS > QD. non-price 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 for labour that any employer may pay.

Figure 4 How the Minimum Wage Affects the Labour Market Supply labour demand Equilibrium employment wage Quantity of labour Copyright©2010 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©2010 South-Western

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

How Taxes on Buyers (and Sellers) Affect Market Outcomes Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. 22 30

Elasticity and Tax Incidence Tax incidence is the manner in which the burden of a tax is shared among participants in a market. 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

Figure 5 A Tax on Buyers €3.30 Price of Ice-Cream Price buyers pay Supply, S1 Cone D1 D2 €3.30 90 Equilibrium without tax Tax (€0.50) Price without tax 3.00 100 A tax on buyers shifts the demand curve downward by the amount of the tax (€0.50). 2.80 Equilibrium with tax Price sellers receive Quantity of Ice-Cream Cones Copyright©2010 South-Western

Elasticity and Tax Incidence 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

Figure 6 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©2010 South-Western

Figure 7 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©2010 South-Western

Elasticity and Tax Incidence 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 price elasticity of demand and the price elasticity of supply. 29 39

Figure 8 How the Burden of a Tax Is Divided (a) Elastic Supply, Inelastic Demand Price 1. When supply is more 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©2010 South-Western

Figure 8 How the Burden of a Tax Is Divided (b) Inelastic Supply, Elastic Demand Price 1. When demand is more 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©2010 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

Luxury tax On yachts, private planes, furs The D for yachts is quite elastic The S not so elastic Burden borne by yacht suppliers

Controlling quantities—licensing and import restrictions Limit the number of firms in a market by the number of business licenses issued. Taxis, dry cleaners, bars Import restriction—limit the quantity of a good that can be imported—quota

Exercise In the equilibrium in the powdered milk market, the quantity is 100 million units and the price is $9. The price elasticity of D is .80 and the price elasticity of S is 2.50. Suppose the gov’t imposes a minimum price (price floor) of $9.90. Draw a graph to show the effects of price floor At the price floor, the quantity of powdered milk supplied is___, the Q demanded is___, and the excess supply is_____.

Exercise The equilibrium price of gasoline is $3 and the equilibrium quantity is 100 million gallons. Suppose the government sets a price ceiling of $2.90. For producers, each $0.01 change in price changes quantity supplied by 3 million gallons. For consumers, each $0.01 change in price changes Q demanded by 2 million. Draw a graph to show the effects of the price ceiling on the gasoline market. With a price ceiling, find the quantity supplied, Q demanded and the shortage.

Medallions in Boston In 1997 there were 1500 taxi medallions in Boston, each generating a profit of $14000 per year. In 1998 the city announced that it would issue 300 new medallions, auctioning the new medallions to the highest bidders. Even with the new medallions, the number of taxis in the city would still be less than the number in an unregulated market. Your job is to predict the annual profit per medallion after the new medalions are issued.

Assume The cost of providing taxi service is constant at $2 per mile of service The initial P of taxi service (with 1500 medallions) is $2.14 per mile. Each taxi (medallion) provides 100 000 miles of service per year, so 300 new medallions increase the total Q of taxi service from 150 million miles to 180. The slope of the demand curve is -.001 per million miles. Compute the new price of taxi service Compute the new profit per medallion.

Luxury Boat Tax Suppose the luxury boat industry employs 1000 workers and produces 100 boats per month. Suppose a tax on luxury boats increases the equilibrium price from $300,000 to 345,000. The price elasticity of demand for luxury boats is 2.0. The luxury tax increases the equilibrium P of boats by ___%, so it decreases the Q of boats demanded from 100 to___. If builders continue to employ 10 workers per boat, the number of boat workers decreases from 1,000 to___.

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. The burden tends to fall on the side of the market that is less price elastic.