Chapter 6 Supply, Demand, and Government Policies Ratna K. Shrestha

Supply, Demand and Govt. Policies  In a “free”, unregulated market system, market forces establish equilibrium prices and quantities.  While equilibrium conditions may be efficient, not everyone, i.e. buyer or seller, is satisfied.  Hence, government may control the market to help either buyer or seller (often at the expense of other).  Examples: (1) Price control and (2) Excise tax, among others.

(1) Market Price Controls  Are usually enacted when policy-makers believe that the market price is unfair either to buyers or sellers.  Result in government policies, i.e. price ceilings and Price floors.

Price Ceilings & Price Floors  A Price Ceiling  is a legally established maximum price which a seller can charge (or a buyer must pay).  Examples: rent ceiling, ceiling on the price of gasoline in the US in 1970s.  A Price Floor  is a legally established minimum price which a buyer must pay.  Examples: minimum wage.

Price Ceilings  When the government imposes a price ceiling two outcomes are possible: 1. The price ceiling is not binding. In this case the ceiling has no effect on the market outcomes. 2. The price ceiling is a binding constraint on the market, creating shortages.

A Non-Binding Price Ceiling Supply Demand Price Quantity PEPE QEQE Price Ceiling PCPC

A Binding Price Ceiling Supply Demand Price Quantity PEPE QEQE Price Ceiling PCPC

A Binding Price Ceiling Creates Shortages. Supply Demand Price Quantity PEPE QEQE PCPC QSQS QDQD Shortage

Market Impacts of a Price Ceiling  A Binding Price Ceiling creates  Shortages (i.e... Demand > Supply)  Gasoline shortages of the 1970s  Housing shortages with rent controls  Non-Price Rationing - An alternative mechanism for rationing of the good:  Long Lines (first-In-line, friends etc.)  Discrimination criteria set by seller  Black markets

Case Study: Lines At The Gas Pumps in the US in 1973 S 2 (after P of crude oil increase) Demand Price Quantity P2P2 P1P1 PCPC QSQS QDQD Shortage Q1Q1 S1S1

Case Study: Rent Control Short-Run Effect Supply Demand Price Quantity of Apts PCPC Shortage With relatively inelastic S and D, Shortage is smaller.

Case Study: Rent Control Long-Run Effect Supply Demand Price Quantity of Apartments PCPC Shortage In the long run, both S and D become more elastic and the effect of rent control can be much bigger!

Price Floors  When the government imposes a price floor, two outcomes are possible: 1. The price floor is not binding. It does not affect the market outcomes. This is the case when the floor is lower than the equilibrium price. For example, if the govt. sets minimum wage at $6 (when the equilibrium wage is $8), it has no effect at all. 2. The price floor is a binding constraint on the market, creating surpluses.

A Non-Binding Price Floor Supply Demand Price Quantity PEPE QEQE Price Floor PFPF

A Binding Price Floor Supply Demand Price Quantity PEPE QEQE Price Floor PFPF

Market Impacts of a Price Floor  A government-imposed price floor hinders the forces of supply and demand in 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. A binding price floor causes a surplus.  Examples:  Minimum Wage  Agricultural Price Supports

Supply Demand Wage Quantity of Labor W* QEQE W min QSQS QDQD Surplus Or Unemployment A Binding Price Floor Creates a Surplus.

Evaluating Price Controls  Policy makers control prices because they think the free-market prices are unfair. They are often aimed at helping the poor.  Rent control laws try to make housing affordable for the poor.  Minimum wage laws are aimed at helping the unskilled workers.

Evaluating Price Controls  But the irony is price controls often hurt those they are intended to help.  Rent control discourages landlords from maintaining their buildings and make housing hard to find.  Minimum wage laws cause unemployment and make it difficult for the unskilled workers to find jobs. While those who can maintain their jobs get higher pay, others can lose the jobs they had before.

A law that raises the minimum wage above the market equilibrium wage creates unemployment. But how much unemployment does it create? Until recently, most economists believed that a 10% increase in the minimum wage rate decreased teenage employment by between 1 and 3 %. Effect of Minimum Wage in Canada

Taxes! Taxes! Taxes!  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 that is independent of the price of the product. Example: tax on gasoline. The tax on gasoline is based on quantity. No matter what is the price of a liter of gasoline, the tax/liter is always the same.

Taxes! Taxes! Taxes!  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.

Taxes: Impact  Taxes discourage market activity. The quantity of the good sold is smaller than without the tax.  Both buyers and sellers share the tax burden.  The question is who bears how much burden?

Taxes: Impact From a 50 Cent Tax S1S1 $ D1D1 Equilibrium without tax Quantity Price

Taxes: Impact From a 50 Cent Tax S1S1 $ D1D1 From the sellers viewpoint, the tax causes the demand curve to shift down by 50 cents. $ Price Quantity

Taxes: Impact From a 50 Cent Tax S1S1 $ $ The tax increases the market price to the buyer…in this case the price rises by $0.30 to $3.30. $2.80 D1D1 Price Quantity

Taxes: Impact From a 50 Cent Tax S1S1 $ $ The tax decreases the return to the seller as the seller gets $0.20 less. $2.80 D1D1 Quantity Price

Taxes: Impact From a 50 Cent Tax S1S1 $ $ The tax makes both the buyer and the seller worse off! $2.80 D1D1 Quantity Price

The Incidence of Tax How is the burden of the tax distributed?  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, not on which side of the market it is imposed.  The burden of a tax falls on the side of the market with the smaller price elasticity!

Elasticity and Taxes  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 Excise Tax Example Supply Demand $ Price Quantity A more inelastic demand and more elastic supply.

Elasticity and Excise Tax S1 Demand S2 Specific Tax $.20 $2.00 $ Price Quantity

Elasticity and Excise Tax S1 Demand S2 Specific Tax $.20 $2.15 $2.00 $ Producer’s burden of tax Price Quantity

Elasticity and Excise Tax S1 Demand S2 Specific Tax $.20 $2.15 $2.00 $ Buyer’s burden of tax Price Quantity

Quick Quiz  Show how a tax on car buyers of $1,000 per car affects the quantity of cars sold and the price of cars.  Show how a similar tax on car sellers affects quantity and price. Hint: The incidence of tax is independent of which side of the market the tax is imposed!  How will a $1 tax on land sales be distributed between the landlord and the land buyer?