6 Supply, Demand, and Government Policies

Copyright © 2004 South-Western/Thomson Learning 2 Supply, Demand, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. Recall the trade-off between equity and efficiency (Principle #1) 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.

Copyright © 2004 South-Western/Thomson Learning 3 PRICE CONTROLS Usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and price floors.

Copyright © 2004 South-Western/Thomson Learning 4 CONTROLS ON PRICES 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.

Copyright © 2004 South-Western/Thomson Learning 5 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.

Figure 1 A Market with a Price Ceiling (a) A Price Ceiling That Is Not Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium quantity $4 Price ceiling Equilibrium price Demand Supply 3 100

Figure 1 A Market with a Price Ceiling Copyright©2003 Southwestern/Thomson Learning (b) A Price Ceiling That Is Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply 2Price ceiling Shortage 75 Quantity supplied 125 Quantity demanded Equilibrium price $3

Copyright © 2004 South-Western/Thomson Learning 8 How Price Ceilings Affect Market Outcomes Effects of Price Ceilings A binding price ceiling leads to Shortages because Q D > Q S. Examples: Gasoline shortage of the 1970s Rental housing shortages in rent-controlled cities If a shortage for a product occurs (and price cannot adjust to eliminate it), a method for rationing the good must develop. Nonprice rationing Examples: Long lines, discrimination by sellers Not all buyers benefit from a price ceiling since some will be unable to purchase the product.

Copyright © 2004 South-Western/Thomson Learning 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? CASE STUDY: Lines at the Gas Pump Economists blame government regulations that limited the price oil companies could charge for gasoline.

The Market for Gasoline with a Price Ceiling Copyright©2003 Southwestern/Thomson Learning (a) The Price Ceiling on Gasoline Is Not Binding Quantity of Gasoline 0 Price of Gasoline 1. Initially, the price ceiling is not binding... Price ceiling Demand Supply,S1S1 P1P1 Q1Q1

The Market for Gasoline with a Price Ceiling Copyright©2003 Southwestern/Thomson Learning (b) The Price Ceiling on Gasoline Is Binding Quantity of Gasoline 0 Price of Gasoline Demand S1S1 S2S2 Price ceiling QSQS resulting in a shortage the price ceiling becomes binding but when supply falls... P2P2 QDQD P1P1 Q1Q1

Copyright © 2004 South-Western/Thomson Learning 12 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. Why? Long waiting lists Discrimination race, number of children, smoking habits, pets. Bribery superintendents get the bribes equal to the difference between the equilibrium market rent and the controlled rent.

Rent Control in the Short Run Copyright©2003 Southwestern/Thomson Learning In the short run, both supply and demand are inelastic. Therefore, primary effect of rent control is to reduce rent. The shortage is relatively small. Number of Apartments 0 Supply Controlled rent Rental Price of Apartment Demand Shortage

Rent Control in the Long Run Copyright©2003 Southwestern/Thomson Learning In the long run, the local stock of housing and the population can change. Therefore, local supply and demand for rental housing are elastic in the long run.=> Shortage is large. 0 Rental Price of Apartment Number of Apartments Demand Supply Controlled rent Shortage

Copyright © 2004 South-Western/Thomson Learning 15 Rental Market for 2-bedroom apartments in Midtown Atlanta 0 Rental Price of 2 bedroom Apartment Number of 2 bedroom Apartment Units Demand Supply $1,200 20,000 40,000 8,000 Controlled rent Shortage $1,000 Is this rent control policy good for the Georgia Tech Students?

Copyright © 2004 South-Western/Thomson Learning 16 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.

Figure 4 A Market with a Price Floor Copyright©2003 Southwestern/Thomson Learning (a) A Price Floor That Is Not Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium quantity 2 Price floor Equilibrium price Demand Supply $3 100

Figure 4 A Market with a Price Floor Copyright©2003 Southwestern/Thomson Learning (b) A Price Floor That Is Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply $4 Price floor 80 Quantity demanded 120 Quantity supplied Equilibrium price Surplus 3

Copyright © 2004 South-Western/Thomson Learning 19 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.

Copyright © 2004 South-Western/Thomson Learning 20 How Price Floors Affect Market Outcomes 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. Examples: The minimum wage, agricultural price supports

Copyright © 2004 South-Western/Thomson Learning 21 The 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 Copyright©2003 Southwestern/Thomson Learning Quantity of Labor Wage 0 Labor demand Labor Supply Equilibrium employment Equilibrium wage

Figure 5 How the Minimum Wage Affects the Labor Market Copyright©2003 Southwestern/Thomson Learning Quantity of Labor Wage 0 Labor Supply Labor surplus (unemployment) Labor demand Minimum wage Quantity demanded Quantity supplied

Copyright © 2004 South-Western/Thomson Learning 24 TAXES Governments levy taxes to raise revenue for public projects.

Copyright © 2004 South-Western/Thomson Learning 25 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.

Copyright © 2004 South-Western/Thomson Learning 26 Elasticity and Tax Incidence Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

Copyright © 2004 South-Western/Thomson Learning 27 Elasticity and Tax Incidence 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.

Figure 6 A Tax on Buyers Copyright©2003 Southwestern/Thomson Learning Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium without tax Tax ($0.50) Price buyers pay D1D1 D2D2 Supply,S1S1 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). $ Equilibrium with tax

Copyright © 2004 South-Western/Thomson Learning 29 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.

Figure 7 A Tax on Sellers Copyright©2003 Southwestern/Thomson Learning 2.80 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium with tax Equilibrium without tax Tax ($0.50) Price buyers pay S1S1 S2S2 Demand,D1D1 A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50) $

Figure 8 A Payroll Tax Copyright©2003 Southwestern/Thomson Learning Quantity of Labor 0 Wage Labor demand Labor supply Tax wedge Wage workers receive Wage firms pay Wage without tax

Copyright © 2004 South-Western/Thomson Learning 32 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 Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (a) Elastic Supply, Inelastic Demand the incidence of the tax falls more heavily on consumers When supply is more elastic than demand... Price without tax than on producers.

Figure 9 How the Burden of a Tax Is Divided Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (b) Inelastic Supply, Elastic Demand than on consumers. 1. When demand is more elastic than supply... Price without tax the incidence of the tax falls more heavily on producers...

Copyright © 2004 South-Western/Thomson Learning 35 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. ELASTICITY AND TAX INCIDENCE

Copyright © 2004 South-Western/Thomson Learning 36 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.

Copyright © 2004 South-Western/Thomson Learning 37 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.

Copyright © 2004 South-Western/Thomson Learning 38 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 elastic.