Government Policies Economics 101

Why 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.

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 and 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.

Binding Price Ceiling? 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. Sellers must ration the scarce goods The rationing mechanisms – not desirable

(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

(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©2003 Southwestern/Thomson Learning

Binding Price Ceiling A binding price ceiling creates shortages because QD > QS. Example: Gasoline shortage of the 1970s nonprice rationing Examples: Long lines, discrimination by sellers

Case: Lines at the Gas Pump 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?

(a) The Price Ceiling on Gasoline Is Not Binding Price of Gasoline Demand Supply, S1 1. Initially, the price ceiling is not binding . . . Price ceiling P1 Q1 Quantity of Gasoline Copyright©2003 Southwestern/Thomson Learning

(b) The Price Ceiling on Gasoline Is Binding Price of S2 Gasoline 2. . . . but when supply falls . . . Demand S1 P2 QS QD Price ceiling 4. . . . resulting in a shortage. 3. . . . the price ceiling becomes binding . . . P1 Q1 Quantity of Gasoline Copyright©2003 Southwestern/Thomson Learning

Case: 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.”

(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©2003 Southwestern/Thomson Learning

(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©2003 Southwestern/Thomson Learning

Binding Price Floor? 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.

Figure 4 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©2003 Southwestern/Thomson Learning

Figure 4 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©2003 Southwestern/Thomson Learning

Binding 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

Case: 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.

Figure 5 How the Minimum Wage Affects the Labor Market Supply Labor demand Equilibrium employment wage Quantity of Labor Copyright©2003 Southwestern/Thomson Learning

Figure 5 How the Minimum Wage Affects the Labor Market Supply Labor demand Labor surplus (unemployment) Minimum wage Quantity demanded Quantity supplied Quantity of Labor Copyright©2003 Southwestern/Thomson Learning

Taxes Governments levy taxes to raise revenue for public projects. Taxes discourage market activity. When a good is taxed (commodity tax), the quantity sold is smaller. Buyers and sellers share the tax burden.

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. _ Statutory incidence (legal incidence) _ Economic incidence

Commodity Tax Sale Tax Excise Tax

Sale Tax Sale Tax: a tax on buyer (statutory incidence) Example: USA Case: $0.50 tax per ice-cream cone bought.

Figure 6 A Tax on Buyers Price of Ice-Cream Price buyers pay Supply, 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 size of the tax ($0.50). 2.80 Equilibrium with tax Price sellers receive Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Who actually bears the tax burden? Buyers and sellers share the tax burden. (economic incidence) In this example, buyers share $0.30 and sellers share $0.20.

Excise Tax Excise Tax: A Tax on Seller (Statutory incidence) Example: Taiwan Case: $0.50 tax per ice-cream cone sold

Figure 7 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©2003 Southwestern/Thomson Learning

Who actually bears the tax burden? Buyers and sellers share the tax burden. (economic incidence) In this example, buyers share $0.30 and sellers share $0.20.

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 elasticity of demand and the elasticity of supply.

Figure 9 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©2003 Southwestern/Thomson Learning

Figure 9 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©2003 Southwestern/Thomson Learning

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.

ALGEBRA Demand equation: P=10-Qd Supply equation: P=Qs Demand = Supply 10-Q*=Q*, Q*=5; P*=5 Equilibrium quantity=5, equilibrium price=5

CASE 1: TAX ON SELLER $2/UNIT SOLD Demand equation: P=10-Qd New supply equation: P-2=Qs Demand = New supply 10-Q**=2+Q**, Q**=4, P**=6 (buyer price), P**- 2=4 (seller price) Buyer shares $1 tax burden Seller shares $1 tax burden

CASE 2: TAX ON BUYER $2/UNIT BOUGHT New Demand equation: P+2=10-Qd Supply equation: P=Qs New Demand = Supply 8-Q***=Q***, Q***=4, P***=4 (seller price), P***+2=6 (buyer price) Buyer shares $1 tax burden Seller shares $1 tax burden

Quiz Demand is perfectly inelastic and supply is elastic 1. Tax on buyers (sales tax) 2. Tax on sellers (excise tax)

Quiz Supply is perfectly inelastic and demand is elastic 1. Tax on buyers (sales tax) 2. Tax on sellers (excise tax)