Chapter 6 Supply, Demand and Government Policies

Controls on Prices Price Ceiling: Legal maximum on the price at which a good can be sold Price Floor: Legal minimum on the price at which a good can be sold

How Price Ceilings affect Market Outcomes Two outcomes: 1. If price ceiling is higher than or equal to equilibrium price, it is not binding and has no effect on the price or quantity sold

How Price Ceilings Affect Market Outcomes 2. If the price ceiling is lower than the equilibrium price, the ceiling is a binding constraint and a shortage is created

Results of Binding Price Ceiling If shortage occurs (and price can’t be adjusted), a method for rationing the good must be developed Not all buyers benefit from a price ceiling because some will be unable to purchase the product

Case Studies Lines at the Gas Pump Rent Control in Short Run & Long Run

Price Floors If price floor is lower than or equal to the equilibrium price, it is not binding and has no effect on the price or quantity sold

Price Floors If the price floor is higher than the equilibrium price, the floor is a binding constraint and a surplus is created

Case Study The Minimum Wage

Tax Incidence Who bears the burden of taxation?

Taxes on Buyers Does it affect supply and/or demand? Demand curve shifts left/down by the amount of the tax Amount = tax

Who pays the tax on buyers? Because market price falls when tax is introduced, sellers receive less than when market worked freely. Buyers now pay more with the tax, so they are worse off as well. So… taxes discourage market activity (Q drops) and buyers + sellers share burden of taxes.

Taxes on Sellers Does it affect supply or demand? The Supply curve shifts left/upward by exactly the size of the tax

Who pays the tax on sellers? With upward supply shift, equilibrium quantity will fall and price that buyers pay will go up, but the amount sellers receive after paying the tax will go down. Thus taxes on buyers and taxes on sellers are equivalent – both buyers & sellers share the burden of the tax

Payroll Taxes

Elasticity and Tax Incidence General rule: Tax burden falls more heavily on the side of the market that is less elastic Therefore, it is not very likely that a tax will be split 50-50

Luxury Taxes Who really pays the tax?

Using the graph for market X, what would there be if the gov’t imposed an effective price ceiling? Shortage of AB Surplus of AB Shortage of IH Surplus of IH Shortage of GE

Using the same graph, what would there be if the gov’t imposed an effective price floor on the market? Shortage of AB Surplus of AB Shortage of IH Surplus of IH Shortage of GE

A tax on producers will: Increase demand, causing P & Q to rise Increase supply, causing P & Q to rise Decrease supply, causing P to rise & Q to fall Decrease demand, causing P to rise and Q to fall Decrease supply, causing both P & Q to fall

A tax on consumers will: Shift supply to the left, raising P & lowering Q Shift demand to right, raising both P & Q Shift demand to the left, lowering both P & Q Shift supply to the right, lowering P & raising Q Shift demand to the left, lowering P & raising Q

The more inelastic the supply curve and the more elastic the demand curve, the: More of the tax the producer will pay More of the tax the consumer will pay More the tax will be split equally between the consumer & producer Less likely the tax will have an effect on price None of the above