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Supply, Demand, and Government Policy
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Controls on Price – Price Ceiling
Legal maximum on the price at which a good can be sold Maximum price for Hamburger Intent: to protect consumers
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Hamburger market with a price ceiling
Price ceiling that is not binding Price ceiling that is binding Price Price Supply Supply Demand Demand $4 Price ceiling Equilibrium price $3 $3 Equilibrium price 100 $2 Price ceiling 75 125 Shortage Equilibrium quantity Quantity supplied Quantity demanded Quantity Quantity To the left, the government imposes a price ceiling of $4. Because the price ceiling is above the equilibrium price of $3, the price ceiling has no effect, and the market can reach the equilibrium of supply and demand. In this equilibrium, quantity supplied and quantity demanded both equal 100 burgers. To the right, the government imposes a price ceiling of $2. Because the price ceiling is below the equilibrium price of $3, the market price equals $2. At this price, 125 burgers are demanded and only 75 are supplied, so there is a shortage of 50 burgers.
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Controls on Price – Price Ceiling
A price ceiling can affect market outcomes Not binding Above the equilibrium price No effect Binding constraint Below the equilibrium price Shortage Sellers must ration the scarce goods When the rationing mechanisms are not desirable
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Price Ceiling: Gas Price Policy in 1973
In 1973 OPEC managed to raised the price of crude oil by reducing the supply of crude thus gas supply lowered Long lines at gas stations, why? U.S. government regulations: price ceiling on gasoline Before OPEC raised the price of crude oil Equilibrium price of gas was below the price ceiling: no effect When the world price of crude oil rose as OPEC reduced the supply of gasoline Equilibrium price of gas went above price ceiling: shortage
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Price Ceiling: Market for gasoline
Gas Price Ceiling is not binding Gas Price Ceiling is binding Gas Price Demand S1 Gas Price Quantity of Gas Q1 P1 Price ceiling 1. Initially, the price ceiling is not binding … 2…but when supply falls… S2 Demand Supply, S1 P2 Price ceiling QS QD 3…the price ceiling becomes binding… 4. …resulting in a shortage P1 Q1 Quantity of Gas The left illustration shows the gas market when the price ceiling is not binding because the equilibrium price, P1, is below the ceiling. The right illustration shows the gasoline market after an increase in the price of crude oil (an input used to make gas) shifts the supply curve to the left from S1 to S2. In an unregulated market, the price would have risen from P1 to P2. The price ceiling prevents this from happening. At the binding price ceiling, consumers are willing to buy QD, but producers of gasoline are willing to sell only QS. The difference between quantity demanded and quantity supplied, QD – QS, measures the gasoline shortage.
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Price Ceiling: Rent controls
Local government puts a ceiling on rents Goal: to help the poor (housing more affordable) Critique: highly inefficient way to help the poor raise their standard of living Adverse effects of rent control in the short run Supply and demand for housing is relatively inelastic Initial small shortage at reduced rents
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Price Ceiling: Rent controls
Adverse effects of rent control in the long run Supply and demand becomes more elastic Landlords will not build new apartments will be less likely to maintain existing ones At the binding rent ceiling more people will want to move into a city Large shortage of housing Non-rent rationing mechanisms Long waiting lists Discrimination (children, pets, race, national origin) Bribes to building superintendents
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Rent control in the short run and the long run
(supply and demand are inelastic) Rent Control in the Long Run (supply and demand are elastic) Rental Price of Apartment Rental Price of Apartment Supply Demand Supply Demand Controlled rent Controlled rent Shortage Shortage Quantity of Apartments Quantity of Apartments The left illustration shows the short-run effects of rent control: Because the supply and demand for apartments are relatively inelastic, the price ceiling imposed by a rent-control law causes only a small shortage of housing. The right illustration shows the long-run effects of rent control: Because the supply and demand for apartments are more elastic, rent control causes a large shortage.
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Price Ceiling: Rent controls
People respond to incentives Free markets Landlords try to keep their buildings clean and safe Higher prices Rent control shortages & waiting lists Landlords lose their incentive to respond to tenants’ concerns Tenants get lower rents & lower-quality housing Policymakers: additional regulations Difficult and costly to enforce
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Controls on Price – Price Floor
Legal minimum on the price at which a good can be sold Minimum legal price for Hamburger Why? Supposedly to protect the Hamburger industry
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Price Floor: Hamburger Market
Price floor that is not binding Price floor that is binding Price Price Surplus Supply Demand Supply Demand $4 Price floor 80 120 $3 3 Equilibrium price 100 Equilibrium price 2 Price floor Equilibrium quantity Quantity demanded Quantity supplied Quantity Quantity In the left illustration, government imposes a price floor of $2. Because this is below the equilibrium price of $3, the price floor has no effect. The market price adjusts to balance supply and demand. At the equilibrium, quantity supplied and quantity demanded both equal 100 burgers. To the right, government imposes a price floor of $4, which is above the equilibrium price of $3. Therefore, the market price equals $4. Because 120 burgers are supplied at this price and only 80 are demanded, there is a surplus of 40 burgers.
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Controls on Price – Price Floor
How price floors affect market outcomes Not binding Below the equilibrium price No effect Binding constraint Above the equilibrium price Surplus Some seller are unable to sell what they want
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Price Floor: The minimum wage
Minimum Wage is the lowest price for labor that any employer may pay Fair Labor Standards Act of 1938 to insure workers a minimally adequate standard of living 2007: minimum wage = $5.15 per hour 2010: minimum wage = $7.25 per hour
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Price Floor: The minimum wage
Market for labor Workers (supply of labor) Firms (demand for labor) Impact of the minimum wage above equilibrium Workers with high skills and much experience Not affected: Equilibrium wages are above the minimum Minimum wage is not binding Teenage labor: least skilled and least experienced Low equilibrium wages Willing to accept a lower wage in exchange for on-the-job training Minimum wage is binding
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Price Floor: Minimum wage and the labor market
A free labor market A Labor Market with a Binding Minimum Wage Wage Wage Labor supply Labor supply Labor surplus (unemployment) Labor demand Labor demand Minimum wage Quantity demanded Quantity supplied Equilibrium wage Equilibrium employment Quantity of Labor Quantity of Labor The left illustration shows a labor market in which the wage adjusts to balance labor supply and labor demand. The right illustration shows the impact of a binding minimum wage. Because the minimum wage is a price floor, it causes a surplus: The quantity of labor supplied exceeds the quantity demanded. The result is unemployment.
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Controls on Prices Evaluating price controls
Markets are usually a good way to organize economic activity Economists usually oppose price ceilings and price floors Prices coordinate economic activity efficiently Governments can sometimes improve market outcomes because of unfair market outcome aimed at helping the poor often hurt those they are trying to help other ways of helping those in need rent subsidies wage subsidies
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A tax on sellers Price Hamburger A tax on sellers shifts the supply
curve upward by the size of the tax ($0.50). Demand, D1 Equilibrium with tax S2 Price buyers pay S1 $3.30 Price without tax Tax ($0.50) 90 3.00 Equilibrium without tax 100 2.80 Price sellers receive Quantity of Hamburger When a tax of $0.50 is levied on sellers, the supply curve shifts up by $0.50 from S1 to S2. The equilibrium quantity falls from 100 to 90 hamburgers. The price that buyers pay rises from $3.00 to $3.30. The price that sellers receive (after paying the tax) falls from $3.00 to $2.80. Even though the tax is levied on sellers, buyers and sellers share the burden of the tax.
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Tax on Sellers Tax incidence – a manner in which the burden of a tax is shared among participants in a market How taxes on sellers affect market outcomes Immediate impact on sellers Supply curve shifts left Higher equilibrium price Lower equilibrium quantity The tax reduces the size of the market
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Taxes on Sellers How taxes on sellers affect market outcomes
Taxes discourage market activity Smaller quantity sold Buyers and sellers share the burden of tax Buyers pay more Worse off Sellers receive less Collects the higher price but pays the tax Overall: effective price falls Sellers are worse off
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Tax on Buyers Price Equilibrium with tax Price Supply, S1 buyers pay
D1 Equilibrium with tax Price buyers pay Supply, S1 Equilibrium without tax D2 $3.30 Price without tax Tax ($0.50) 90 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). 3.00 100 2.80 Price sellers receive Quantity When a tax of $0.50 is levied on buyers, the demand curve shifts down by $0.50 from D1 to D2. The equilibrium quantity falls from 100 to 90 hamburgers. The price that sellers receive falls from $3.00 to $2.80. The price that buyers pay (including the tax) rises from $3.00 to $3.30. Even though the tax is levied on buyers, buyers and sellers share the burden of the tax.
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Taxes on Buyers How taxes on buyers affect market outcomes
Demand curve shifts left Higher equilibrium price Lower equilibrium quantity The tax reduces the size of the market
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Tax on Buyers How taxes on buyers affect market outcomes
Buyers and sellers share the burden of the tax Sellers get a lower effective price Worse off Buyers pay a higher market price Effective price (with tax) rises Tax levied on sellers and tax levied on buyers are equivalent
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Income Tax and Labor Markets
Warning, if you have a weak stomach, you might want to avoid this slide Earning $200,000 + $1 Tax rate on this dollar Federal Income Tax 28.0% FICA 12.4% 6.2% x 2 Medicare Tax 2.9% 1.45% x 2 Kentucky Income Tax 6.0% Bowling Green Tax 1.85% 51.15% You keep $1 x 49% = .49 cents
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Income Tax and Labor Markets
Price Labor Demand Cost of labor to business Labor Supply Employment with tax Size of tax Wage without tax Employment without tax Worker wage Quantity A tax on a good places a wedge between the wage workers receive and the cost of labor to business. Labor use falls.
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The Tax Burden Elasticity and tax incidence Dividing the tax burden
Very elastic supply and relatively inelastic demand Sellers – small burden of tax Buyers – most of the burden Relatively inelastic supply and very elastic demand Sellers – most of the tax burden Buyers – small burden
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How the burden of a tax is divided
Elastic Supply, Inelastic Demand Price 1. When supply is more elastic than demand . . . Demand Supply Price buyers pay Tax The incidence of the tax falls more heavily on consumers . . . Price without tax Price sellers receive Than on producers. Quantity When he supply curve is elastic, and the demand curve is inelastic. In this case, the price received by sellers falls only slightly, while the price paid by buyers rises substantially. Thus, buyers bear most of the burden of the tax.
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How the burden of a tax is divided
Inelastic Supply, Elastic Demand Price 1. When demand is more elastic than supply . . . Demand Supply Price buyers pay Tax 3. Than on consumers Price without tax The incidence of the tax falls more heavily on producers. Price sellers receive Quantity When the supply curve is inelastic, and the demand curve is elastic. In this case, the price received by sellers falls substantially, while the price paid by buyers rises only slightly. Thus, sellers bear most of the burden of the tax.
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The Tax Burden Tax burden falls more heavily on the side of the market that is less elastic Low elasticity of demand Buyers do not have good alternatives to consuming this good Low elasticity of supply Sellers do not have good alternatives to producing this good
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Who pays the luxury tax? The 1990 consumption luxury tax Outcome:
Goal: to raise revenue from those who could most easily afford to pay Luxury items Demand is usually quite elastic Supply is relatively inelastic Outcome: Burden of a tax falls largely on the suppliers The American Yacht industry disappeared In 1993 most of the luxury tax was repealed
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