Demand, Supply and Economic Policy Lecture 4 – academic year 2015/16 Introduction to Economics Dimitri Paolini

Where we are… Lecture 1: demand and supply Lecture 2: the concept of elasticity Lecture 2: elasticity of demand (high and low) and total revenue Lecture 3: demand, supply and elasticity – exercises and applications 2

What do we do today? Economic policy: what is it and how it works? Price regulation Taxes and their effects 3

Question of the day Since 2007, in Italy there exist an institution called Price Overseeing Authority (Garante per l’osservanza dei prezzi). What does it do? – Overseeing: it verifies the prices – Coordination: it functions as a bridge between producers and consumers QUESTION: Why do we need it? 4

Demand, supply and economic policy Government can affect market’s functioning in two ways: By regulating economic activities (p & q max and min); By imposing taxes and subsidies. 5

Price regulation and market equilibrium In a market with no regulation, market forces establish the equilibrium level of p and q. Even if the market is in equilibrium, somebody can be unsatisfied (for reasons associated with equity or efficiency). 6

When are prices regulated? When politicians believe p of a given market to be unequal. In these cases max or min level of prices is fixed. Usually, there are efficiency costs (this is the classic trade-off between efficiency and equity!) 7

Max and min level of price Max (min) level It is max (min) price that a good can be sold at according to law. 8

Max level of price When the government imposes a max level of price, there are two possible consequences: p max is NOT CONSTRAINING: if the market price is < than p max. p max is CONSTRAINING: if the market price is > than p max. In this case artificial scarcity is created… 9

Max price is NOT CONSTRAINING Max Price Supply Demand Price of ice-cream Ice-cream Equilibrium quantity Quantity of Equilibrium price

Max price is CONSTRAINING Supply Demand Price of ice-cream Ice-cream Equilibrium quantity Quantity of Equilibrium price 2 Max Price

Max price is CONSTRAINING Max Price Supply Demand Price of ice-cream Ice-cream Quantity of Equilibrium price Scarcity Quantity SuppliedQuantity Demanded

The effects of max p When it is constraining, a max p …... Generate scarcity Q D > Q S Example: Scarcity of petrol in Rationing of the good. Example: long queues, or: seller’s discrimination practices. 13

Min level of prices Two possible consequences: p min is NOT CONSTRAINING: if p min < than equilibrium price. p min IS CONSTRAINING: if p min > than equilibrium price. In this case excess supply is generated. 14

Min price is NOT CONSTRAINING Min Price Supply Demand Price of ice-cream Ice-cream Equilibrium quantity Quantity of Equilibrium price

Max price is CONSTRAINING Supply Demand Price of ice-cream Ice-cream Equilibrium quantity Quantity of Equilibrium price 4 Min Price

Max price is NOT CONSTRAINING Min Price Supply Demand Price of ice-cream Ice-cream Quantity of Equilibrium price Excess Supply Quantity SuppliedQuantity Demanded

Effects of a min p When constraining, min p generates An excess of supply Q S > Q D... The resources in excess are wasted Example: Minimum wage; Subsidies to sustain the price of agricultural goods. 18

19 (a) Free labour market Quantity of employed 0 Wage Equilibrium employment (b) Labour market with min wage 0Quantity demanded Quantity supplied Min wage Excess supply of labour (unemployment) Equilibrium wage Labour demand Labour supply Quantity of employed Wage Labour demand Labour supply

Taxes: Effects Government uses taxation to finance public expenditure. But taxes are not neutral in that they can discourage market activities. When a good is taxed, the quantity that is sold diminishes. In the majority of the cases, buyers and sellers share the tax burden. 20

Legal incidence and economics of taxes The law establishes who pays the tax (legal incidence). But not who really bears the tax burden (economic incidence). Let’s see why…. 21

The tax affects the market equilibrium: – The price for consumers rises, who therefore reduce the quantity demanded. – The portion of the price earned by sellers reduces, and therefore they reduce the quantity supplied. 22 Legal incidence and economics of taxes

The economic incidence (= how the tax burden is shared between consumers and producers) is independent from the subject who is legally responsible for paying the tax … (that is the legal incidence). It depends on E D and E S. 23 Legal incidence and economics of taxes

The effect of a tax on consumption goods Initial price of an apple: 1€ Then: consumption tax of 0,10€ for each apple. What happens to the price of apples after tax? Let’s see the cases: a)The prince remains equal to 1€. In this case, the tax is paid ONLY by the producer: the consumer pays 1€; 0,10€ goes to State and only 0,90€ to the producer; b)The price rises to 1,10€. Then the tax is paid ONLY by the consumer. 24

In the majority of the cases “the true lies in between”: the tax rises both the price to consumers and the price to producers. Example: the price to consumers can become 1,05 and the price to producers 0,95. The final price depends on the elasticity of demand and supply. 25 The effect of a tax on consumption goods

26 3, Demand Price of ice-cream Ice-cream Quantity of The effect of a tax on consumption goods Supply Equilibrium without the tax

27 3, Supply Demand Price of ice-cream Ice-cream Quantity of The effect of a tax on consumption goods A tax on consumption shifts the demand curve leftward Equilibrium without the tax

28 3, Supply Demand Price of ice-cream Ice-cream Quantity of The effect of a tax on consumption goods New equilibrium with the tax A tax on consumption shifts the demand curve leftward Equilibrium without the tax

29 0 Supply Demand Price of ice-cream Ice-cream Quantity of The effect of a tax on consumption goods New equilibrium with the tax p D pSpS Tax (t) QtQt Equilibrium without the tax

30 3, Demand Price of ice-cream Ice-cream Quantity of The effect of a tax on consumption goods Supply Equilibrium without the tax

31 3, Demand Price of ice-cream Ice-cream Quantity of The effect of a tax on consumption goods A tax on production (0,50 cents) shifts the supply curve leftward. Equilibrium without the tax Supply

32 3, Demand Price of ice-cream Ice-cream Quantity of The effect of a tax on consumption goods Equilibrium without the tax Supply A tax on production (0,50 cents) shifts the supply curve leftward. New equilibrium with the tax

Demand Price of ice-cream Ice-cream Quantity of The effect of a tax on consumption goods Equilibrium without the tax Supply 3,30 A tax on production (0,50 cents) shifts the supply curve leftward. New equilibrium with the tax Tax (0,50) 2,80

Incidence of taxes How is the tax burden shared between consumers and producers? All depends on the elasticity of the demand and supply curves. The tax burden mainly falls on the less elastic market component. 34

Elasticity and incidence of taxes If the demand is inelastic and the supply is elastic: The tax is paid mainly by the consumer. If the demand is elastic and the supply is inelastic: The tax is paid mainly by the producer. 35

Elastic supply + inelastic demand 36 Quantity 0 Price Demand Supply Price before tax

Elastic supply + inelastic demand 37 Quantity 0 Price Demand Supply Price before tax Tax burden Price to producer Price to consumer

Elastic supply + inelastic demand 38 Quantity 0 Price Demand Supply Price before tax Tax burden Price to producer Price to consumer 1. If the supply is more elastic then the demand …the tax affects more the consumer …then the producer.

Inelastic supply + elastic demand 39 0 Quantity Price Demand Supply Price before tax

Inelastic supply + elastic demand 40 0 Quantity Price Demand Supply Price before tax Tax burden Price to producer Price to consumer

Inelastic supply + elastic demand 41 0 Quantity Price Demand Supply Price before tax Tax burden Price to producer Price to consumer 1. If the demand is more elastic than the supply.. 2. …the tax impacts more on the producer …Than on the consumer.

Conclusion The economy is ruled by two kinds of law: The law of demand and supply The laws enacted by the legislator 42

Conclusion Regulated prices include either a minimum or a maximum (or both) level of price. 43

Conclusion Taxes on production and consumption create new equilibrium prices, where consumers and producers share in the tax burden. The incidence of the tax depends on the elasticity of demand and supply. 44

Next lecture Market efficiency… 45