1. Chapter 6 Supply, Demand, and Government Policies Supply, Demand, and Government Policies 1. Price Ceiling 2. Price Floor 3. Effect of Taxes 4. Tax Incidence 1. Price Ceiling 2. Price Floor 3. Effect of Taxes 4. Tax Incidence

2. Objectives 1. Learn the consequences of government policies that impose a ceiling (maximum) price on a market 2. learn the consequences of government policies that impose a floor (minimum) price on a market 3. Understand how a tax on a good affects market equilibrium price and quantity 4. Recognize the equivalence of taxes imposed on buyers and sellers and know how the burden of a tax is divided between buyers and sellers

3. Supply, Demand and Government Policies In a “free”, unregulated market system, market forces establish equilibrium prices and exchange quantities. While equilibrium conditions may be efficient it may be true that not everyone, i.e. buyer or seller are satisfied. Hence, market controls!

4. Market Price Controls u Are usually enacted when policymakers believe that the market price is unfair to buyers and sellers. u Result in governmental policies, i.e., price ceilings and floors.

5. Price Ceilings & Price Floors u A Price Ceiling – is a legally established maximum price which a seller can charge or a buyer must pay. u A Price Floor – is a legally established minimum price which a seller can charge or a buyer must pay.

6. Price Ceilings u When the government imposes a price ceiling (i.e... a legal maximum on the price at which a good can be sold) two outcomes are possible: 1. The price ceiling is not binding. 2. The price ceiling is a binding constraint on the market, creating Shortages.

7. Market Impacts of a Price Ceiling Supply Demand Price Quantity Equilibrium Price Equilibrium Quantity

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

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

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

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

12. Market Impacts of a Price Ceiling u A Binding Price Ceiling creates... – Shortages (i.e... Demand > Supply) v Gasoline shortages of the 1970s – Non-Price Rationing - An alternative mechanism for rationing of the good: v Long Lines (First-In-Line, Figure 6-2) v Discrimination criteria set by seller

13. Demand Price of Gasoline Quantity P1P1 0Q1Q1 S1S1 Price ceiling 1. Initially, the price ceiling is not binding... The Market for Gasoline with a Price Ceiling

14. Demand Price of Gasoline Quantity 0Q1Q1 P2P2 S1S1 S2S2 P1P1 Price ceiling 2....but when supply falls... The Market for Gasoline with a Price Ceiling

15. Demand Price of Gasoline Quantity 0Q1Q1 P2P2 S1S1 S2S2 P1P1 Price ceiling 3....the price ceiling becomes binding... The Market for Gasoline with a Price Ceiling

16. Demand Price of Gasoline Quantity QsQs 0QDQD Shortage Q1Q1 P2P2 S1S1 S2S2 P1P1 Price ceiling 4. Resulting in a shortage The Market for Gasoline with a Price Ceiling

17. Rent Control u Rent controls are ceilings placed on the rents that landlords may charge their tenants. u The goal of rent control policy is to help the poor by making housing more affordable. u One economist called rent control “the best way to destroy a city, other than bombing.”

18. Rent Control in the Short Run... Quantity of Apartments 0 Rental Price of Apartment Demand Supply Controlled rent Shortage Supply and demand for apartments are relatively inelastic

19. Rent Control in the Long Run... Quantity of Apartments 0 Rental Price of Apartment Demand Supply Controlled rent Shortage Because the supply and demand for apartments are more elastic... …rent control causes a large shortage

20. Price Floors u When the government imposes a price floor (i.e... a legal minimum on the price at which a good can be sold) two outcomes are possible: 1. The price floor is not binding. 2. The price floor is a binding constraint on the market, creating Surpluses

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

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

23. Market Impacts of a Price Floor u A government imposed market price floor hinders the forces of supply and demand in moving toward the equilibrium price and quantity. u 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.

24. A Binding Price Floor Creates a Surplus. Supply Demand Price Quantity PEPE QEQE PFPF QSQS QDQD

25. A Binding Price Floor Creates a Surplus. Supply Demand Price Quantity PEPE QEQE PFPF QSQS QDQD Surplus

26. Market Impacts of a Price Floor u A Binding Price Floor creates... – Surpluses (i.e. Quantity Supplied > Quantity Demanded) – Non-Price Rationing - An alternative mechanism for rationing of the good: v Discrimination Criteria – Examples: v Minimum Wage v Agricultural Price Supports

27. Labor Supply Labor Demand Equilibrium Unemployment Quantity of Labor Wage Equilibrium Wage A Free Labor Market 0

28. Labor Supply Labor Demand Quantity of Labor Wage A Labor Market with a Binding Minimum Wage Quantity supplied Quantity demanded Minimum Wage 0

29. Quick Quiz! u Define “price ceiling” and “price floor” u Give an example of each. u Which leads to a shortage, which a surplus? Why?

30. Taxes! Taxes! Taxes! u What is the purpose of government imposed taxes? – To raise government revenues. – To restrict allocation of a product. u What is an excise tax? – A “per-unit” tax that’s independent of the price of the product.

31. Taxes! Taxes! Taxes! u Who pays the tax on a good? The buyer or the seller? u How is the burden of a tax divided between buyer and seller? u 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.

32. Tax Incidence u Tax incidence is the study of who actually bears the burden of taxation

33. Taxes: Impact Taxes discourage market activity. The quantity of the good sold is smaller than without the tax. Buyers and sellers share the tax burden.

34. Taxes: Impact From a 50 Cent Tax S1S1 $2.00 800 D1D1 Equilibrium without tax

35. Taxes: Impact From a 50 Cent Tax S1S1 $2.00 800 D1D1 From the sellers viewpoint, the tax causes the demand curve to shift down by 50 cents. $1.80 600

36. Taxes: Impact From a 50 Cent Tax S1S1 $2.00 800 D1D1 $2.30 600 The tax increases the market price to the buyer... $1.80

37. Taxes: Impact From a 50 Cent Tax S1S1 $2.00 800 D1D1 $2.30 600 The tax increases the market price to the buyer......and decreases demand. $1.80

38. Price buyers pay $3.30 3.00 2.80 90100Quantity Price Price w/o tax Price sellers receive } Tax ($.50) Demand, D 1 S2S2 S1S1 A tax on sellers shifts the supply curve upward by the amount of the tax ($.50) Equilibrium without tax Equilibrium with tax Figure 6-7 A Tax on Sellers

39. Wage Quantity of labor 0 Labor demand Labor supply Wage firms pay Wage without tax Wage workers receive { Tax Wedge Figure 6-8 A Payroll Tax

40. The Burden (incidence) of a Tax is Inversely Related to the Price Elasticities of Demand and Supply Quantity Price paid by buyers after the tax = $2.40 Supply Price without tax = $2.00 Price received by sellers after the tax = $1.90 Demand Price relatively elastic relatively inelastic } $.50 tax

41. The Burden (incidence) of a Tax is Inversely Related to the Price Elasticities of Demand and Supply Quantity Price paid by buyers after the tax = $2.10 Supply Price without tax = $2.00 Price received by sellers after the tax = $1.60 Demand Price relatively inelastic relatively elastic } $.50 tax

42. The Incidence of Tax...How is the burden of the tax distributed? u Consider a tax levied on sellers of a good. What are the effects of this tax? u How do effects of the tax levied on the seller compare with those of the effects imposed on the buyer? u Depends on Elasticity of Demand and Elasticity of Supply.

43. The Incidence of Tax...How is the burden of the tax distributed? The burden of a tax falls on the side of the market with the smaller price elasticity!

44. Elasticity and Taxes u The more INELASTIC the demand and the more ELASTIC the supply results in the consumer paying more of the tax. u The more ELASTIC the demand and the more INELASTIC the supply results in the supplier paying more of the tax.

45. Elastic Supply, Inelastic Demand... Quantity0 Price Demand Supply Tax 1. When supply is more elastic than demand... 2....the incidence of the tax falls more heavily on consumers... 3....than on producers. Price without taxPrice buyers payPrice sellers receive

46. Inelastic Supply, Elastic Demand... Quantity0 Price Demand Supply Price without tax Tax 1. When demand is more elastic than supply... 2....the incidence of the tax falls more heavily on producers... 3....than on consumers. Price buyers payPrice sellers receive

47. Quick Quiz u Show how a tax on car buyers of $1,000 per car affects the quantity of cars sold and the price of cars. u Show how a similar tax on car sellers affects quantity and price.

48. Summary u Price controls include price ceilings and price floors. u A price ceiling is a legal maximum on the price of a good or service. An example is rent control. u A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage.

49. Summary u Taxes are used to raise revenue for public purposes. u When the government levies a tax on a good, the equilibrium quantity of the good falls. u A tax on a good places a wedge between the price paid by buyers and the price received by sellers.

50. Summary u The incidence of a tax refers to who bears the burden of a tax. u The incidence of a tax does not depend on whether the tax is levied on buyers or sellers. u The incidence of the tax depends on the price elasticities of supply and demand.

51. Supply, Demand & Government u The economy is governed by two kinds of laws: – The laws of supply and demand – The laws enacted by government. u Price controls and taxes are common in various markets in the economy: – Price Ceilings – Price Floors – Excise Tax

52. Case Studies 1. Lines at gas pump - price ceiling 2. Rent control - price ceiling 3. The minimum wage - price floor 4. Burden of a payroll tax - tax incidence 5. Luxury tax - tax incidence