Copyright © 2004 South-Western 6 Supply, Demand, and Government Policies

Copyright © 2004 South-Western/Thomson Learning 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 Floor A legal minimum on the price at which a good can be sold. Price Ceiling A legal maximum on the price at which a good can be sold.

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 How Price Ceilings Affect Market Outcomes Effects of Price Ceilings A binding price ceiling creates shortages because Q D > Q S. Example: Gasoline shortage of the 1970s non-price rationing Examples: coupons, discrimination by sellers

Figure 2 The Market for Gasoline with a Price Ceiling Copyright©2003 Southwestern/Thomson Learning The Price Ceiling on Gasoline Becomes 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 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.”

Figure 3 Rent Control in the Short Run and in the Long Run Copyright©2003 Southwestern/Thomson Learning (a) Rent Control in the Short Run (supply and demand are inelastic) Quantity of Apartments 0 Supply Controlled rent Rental Price of Apartment Demand Shortage

Figure 3 Rent Control in the Short Run and in the Long Run Copyright©2003 Southwestern/Thomson Learning (b) Rent Control in the Long Run (supply and demand are elastic) 0 Rental Price of Apartment Quantity of Apartments Demand Supply Controlled rent Shortage

Copyright © 2004 South-Western/Thomson Learning 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 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 TAXES Governments levy taxes to raise revenue for public projects. Excise taxes – per unit (gasoline, tobacco, alcohol, hotels, car rentals, telephone service) Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

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 Elasticity and Tax Incidence What was the impact of tax? Taxes reduce market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. Sellers receive lower price, are worse off Buyers pay higher price (including the tax), are worse off

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 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 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