Presentation on theme: "Chapter 6: “Supply, Demand and Government Policies”"— Presentation transcript:
1 Chapter 6: “Supply, Demand and Government Policies” Principles of Microby Tanya Molodtsova, Fall 2005Chapter 6: “Supply, Demand and Government Policies”
2 We Will Study:the effects of government policies that fix the price above or below the equilibrium pricehow a tax on a good affects the price of the good and the quantity soldhow the burden of a tax is split between buyers and sellers
3 I. Controls on PricesIn a free market, market forces establish equilibrium prices and quantities.It may be true that not everyone is satisfied in market equilibriumEconomists use theories to develop government policies that help change the world for the betterControls on prices are usually enacted when policymakers believe the market price is unfair to buyers or sellers.They result in government-created price ceilings and floors.
4 I. Controls on Pricesprice ceiling: a legal maximum on the price at which a good can be sold.Example: rent-control laws sets maximum rent that the landlords can chargeprice floor: a legal minimum on the price at which a good can be sold.Example: minimum wage law dictates the lowest wage that firms may pay workers
5 How Price Ceilings Affect Market Outcomes Two outcomes are possible when the government imposes a price ceiling:If the price ceiling is set above the equilibrium price, it is not binding and there is no effect on the price or quantity soldThe price ceiling is set below the equilibrium price, it is binding and the shortage is created
6 A Market With A Price Ceiling (a) A Price Ceiling That Is Not BindingQuantity ofIce-CreamConesPrice ofConeEquilibriumquantity$4PriceceilingpriceDemandSupply3100
7 A Market With A Price Ceiling (b) A Price Ceiling That Is BindingQuantity ofIce-CreamConesPrice ofConeDemandSupply2PriceceilingShortage75Quantitysupplied125demandedEquilibriumprice$3
8 How Price Ceilings Affect Market Outcomes A Binding Price Ceilings Creates:- shortages because QD > QSExample: Gasoline shortage of the 1970s- mechanism for rationing the goodExample: long lines, discrimination by sellersNot all buyers benefit from a price ceiling since some will be unable to purchase the product.
9 CASE STUDY: Lines at the Gas Pump In 1973, OPEC raised the price of crude oil. 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?Economists blame government regulations that limited the price oil companies could charge for gasoline.
10 The Market for Gasoline with a Price Ceiling (a) The Price Ceiling on Gasoline Is Not BindingQuantity ofGasolinePrice of1. Initially,the priceceilingis notbinding . . .Price ceilingDemandSupply,S1P1Q1
11 The Market for Gasoline with a Price Ceiling (b) The Price Ceiling on Gasoline Is BindingQuantity ofGasolinePrice ofDemandS1S2Price ceilingQSresultingin ashortage.the priceceiling becomesbinding . . .but whensupply falls . . .P2QDP1Q1
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.”
13 Rent Control in the Short-Run (a) Rent Control in the Short Run(supply and demand are inelastic)Quantity ofApartmentsSupplyControlled rentRentalPrice ofApartmentDemandShortage
14 Rent Control in The Long-Run (b) Rent Control in the Long Run(supply and demand are elastic)RentalPrice ofApartmentQuantity ofApartmentsDemandSupplyControlled rentShortage
15 Rent Control in the Short Run and Long Run Since the supply of apartments is fixed (perfectly inelastic) in the short run and upward sloping (elastic) in the long run, the shortage is much larger in the long run than in the short run.Rent controlled apartments are rationed in a number of ways including long waiting lists, discrimination against minorities and families with children, and even under-the-table payments to landlords.The quality of apartments also suffers due to rent control.
16 How Price Floors Affect Market Outcomes Two outcomes are possible when the government imposes a price floor:If the price floor is lower than the equilibrium price, it is not binding and has no effect on the price or quantity sold.If the price floor is higher than the equilibrium price, the floor is a binding constraint and a surplus is created.
17 A Market With A Price Floor (a) A Price Floor That Is Not BindingQuantity ofIce-CreamConesPrice ofConeEquilibriumquantity2PricefloorpriceDemandSupply$3100
18 A Market With A Price Floor (b) A Price Floor That Is BindingQuantity ofIce-CreamConesPrice ofConeDemandSupply$4Pricefloor80Quantitydemanded120suppliedEquilibriumpriceSurplus3
19 How Price Ceilings Affect Market Outcomes 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 because QS > QD- the development of a new mechanism for rationing the good, using discrimination criteria
20 CASE STUDY: The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price for labor that any employer may pay.Consider a labor market in which the wage adjusts to balance labor supply and labor demand
21 How the Minimum Wage Affects the Labor Market Quantity ofLaborWageSupplyLabor surplus(unemployment)demandMinimumwageQuantitydemandedsupplied
22 How the Minimum Wage Affects the Labor Market If the minimum wage is above the equilibrium wage in the labor market, a surplus of labor will develop (unemployment).The minimum wage will be a binding constraint only in markets where equilibrium wages are low.Thus, the minimum wage will have its greatest impact on the market for teenagers and other unskilled workers.
23 Evaluating Price Controls Most economists oppose the use of price ceilings and floorsPrices balance supply and demand and thus coordinate economic activity. If prices are set by laws, they obscure the signals that efficiently allocate scarce resources.Price ceilings and price floors often hurt the people they are intended to help.- Rent controls create a shortage of quality housing and provide disincentives for building maintenance.- Minimum wage laws create higher rates of unemployment for teenage and low skilled workers.
24 Taxes Governments levy taxes to raise revenue for public projects tax incidence: the manner in which the burden of a tax is shared among participants in a market.
25 How Taxes on Buyers Affect Market Outcomes If the government requires the buyer to pay a certain amount for each unit of a good purchased, this will cause a decrease in demand.The demand curve will shift down by the amount of the tax.The quantity of the good sold will decline.Buyers and sellers will share the burden of the tax; buyers pay more for the good (including the tax) and sellers receive less.
26 How Taxes on Buyers Affect Market Outcomes Two lessons can be learned here:Taxes discourage market activity. When the good is taxed the quantity sold is smaller than before the tax.Buyers and sellers share the burden of a tax.
27 A Tax on Buyers Quantity of Ice-Cream Cones Price of Ice-Cream Cone Price ofIce-CreamConePricewithouttaxsellersreceiveEquilibrium without taxTax ($0.50)buyerspayD1D2Supply,S1A tax on buyersshifts the demandcurve downwardby the size ofthe tax ($0.50).$3.3090Equilibriumwith tax2.803.00100
28 How Taxes on Sellers Affect Market Outcomes If the government requires the seller to pay a certain amount for each unit of a good purchased, this will cause a decrease in supply.The supply curve will shift up by the amount of the tax.The quantity of the good sold will decline.Buyers and sellers will share the burden of the tax; buyers pay more for the good and sellers receive less (because of the tax).
29 A Tax on Sellers 2.80 Quantity of Ice-Cream Cones Price of Ice-Cream Price ofIce-CreamConePricewithouttaxsellersreceiveEquilibriumwith taxEquilibrium without taxTax ($0.50)buyerspayS1S2Demand,D1A tax on sellersshifts the supplycurve upwardby the amount ofthe tax ($0.50).3.00100$3.3090
30 Elasticity and Tax Incidence In what proportions is the burden of the tax divided?The answer to this question depends on the elasticity of demand and the elasticity of supply.The burden of a tax falls more heavily on the side of the market that is less elastic
31 Elasticity and Tax Incidence When supply is elastic and demand is inelastic, the largest share of the tax burden falls on consumers.A small elasticity of demand means that buyers do not have good alternatives to consuming this product.When supply is inelastic and demand is elastic, the largest share of the tax burden falls on producers.A small elasticity of supply means that sellers do not have good alternatives to producing this particular good.
32 How The Burden of Tax is Divided QuantityPriceDemandSupplyTaxPrice sellersreceivePrice buyers pay(a) Elastic Supply, Inelastic Demandtheincidence of thetax falls moreheavily onconsumers . . .1. When supply is more elasticthan demand . . .Price without taxthanon producers.
33 How The Burden of Tax is Divided QuantityPriceDemandSupplyTaxPrice sellersreceivePrice buyers pay(b) Inelastic Supply, Elastic Demandthan onconsumers.1. When demand is more elasticthan supply . . .Price without taxtheincidence ofthe tax fallsmore heavilyon producers . . .
34 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.
35 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.
36 SummaryThe 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.