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

2. Copyright © 2004 South-Western/Thomson Learning 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, policy makers often intervene in markets (for various reasons).

3. Copyright © 2004 South-Western/Thomson Learning Price Controls Price controls are designed to “help”… a.consumers - a cap, price ceiling, is placed on how much sellers can charge b.Sellers – a price floor establishes a minimum price that must be paid by consumers to sellers

4. Copyright © 2004 South-Western/Thomson Learning CONTROLS ON PRICES Price Ceiling A legal maximum on the price at which a good can be sold. Price Floor A legal minimum on the price at which a good can be sold. Again, ceilings designed to help consumers while floors designed to help producers

5. Copyright © 2004 South-Western/Thomson Learning Price Ceilings Two outcomes are possible when the government imposes a price ceiling: The price ceiling is not binding if set above the equilibrium price. The price ceiling is binding if set below the equilibrium price, leading to a shortage. * A non-binding price ceiling is inconsequential, has no impact on market outcome

6. 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

7. 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 nonprice rationing (price is a rationing mechanism) Examples: Long lines, discrimination by sellers, lotteries, coupons * Price ceilings are difficult to enforce

8. 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

9. Copyright © 2004 South-Western/Thomson Learning In 1973, OPEC raised the price of crude oil in world markets. 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? CASE STUDY: Lines at the Gas Pump Economists blame government regulations that limited the price oil companies could charge for gasoline.

10. Figure 2 The Market for Gasoline with a Price Ceiling Copyright©2003 Southwestern/Thomson Learning (a) The Price Ceiling on Gasoline Is Not Binding Quantity of Gasoline 0 Price of Gasoline 1. Initially, the price ceiling is not binding... Price ceiling Demand Supply,S1S1 P1P1 Q1Q1

11. Figure 2 The Market for Gasoline with a Price Ceiling Copyright©2003 Southwestern/Thomson Learning (b) The Price Ceiling on Gasoline Is Binding Quantity of Gasoline 0 Price of Gasoline Demand S1S1 S2S2 Price ceiling QSQS 4.... resulting in a shortage. 3.... the price ceiling becomes binding... 2.... but when supply falls... P2P2 QDQD P1P1 Q1Q1

12. 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.”

13. 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

14. Copyright © 2004 South-Western/Thomson Learning Query Why is the demand for housing downward sloping?

15. 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

16. Copyright © 2004 South-Western/Thomson Learning Price Floors When the government imposes a price floor, two outcomes are possible. The price floor is binding if set above the equilibrium price, leading to a surplus. The price floor is not binding because it is set below the equilibrium price

17. 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

18. Copyright © 2004 South-Western/Thomson Learning How Price Floors Affect Market Outcomes A price floor prevents supply and demand from moving toward the equilibrium price and quantity. When the market price hits the floor, it can fall no further, and the market price equals the floor price.

19. Copyright © 2004 South-Western/Thomson Learning How Price Floors Affect Market Outcomes A binding price floor causes... a surplus because Q S > Q D. nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria. Examples: The minimum wage, agricultural price supports

20. 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.

21. 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

22. 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

23. 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

24. Copyright © 2004 South-Western/Thomson Learning Price ceiling / floor review Ceilings, intended to help consumers, limit or put a “ceiling” on how much sellers can charge Floors, intended to help sellers, mandate a certain minimum price Ceilings lead to shortage Floors lead to surplus

25. Copyright © 2004 South-Western/Thomson Learning TAXES Governments levy taxes to raise revenue for public projects or for transfers. * Dealing here with excise (per unit) taxes

26. Copyright © 2004 South-Western/Thomson Learning Impact of Taxes on Buyers (and Sellers) and Market Outcomes a. Taxes discourage market activity. b. When a good is taxed, the quantity sold is smaller. c. Buyers and sellers share the tax burden.

27. Copyright © 2004 South-Western/Thomson Learning Elasticity and Tax Incidence Tax incidence is the study of who bears the burden of a tax. Taxes result in a change in market equilibrium. Buyers pay more and sellers receive less, regardless of whom the tax is levied on.

28. Copyright © 2004 South-Western/Thomson Learning Tax on buyers Suppose buyers must pay a per-unit tax There is a jar on the counter at the point-of- purchase. The buyer must pay for the item and the tax on the item… Now, at each and every price the consumer will buy less because the tax must be paid in addition to the price for the good – demand curve shifts parallel by the amount of the tax (see graph following)

29. 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). $3.30 90 Equilibrium with tax 2.80 3.00 100

30. Copyright © 2004 South-Western/Thomson Learning Elasticity and Tax Incidence What was the impact of tax? Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.

31. Copyright © 2004 South-Western/Thomson Learning Tax on Sellers Suppose sellers now must pay a tax for each unit they sell – there is a jar on the counter to collect the tax… Now, the supply curve shifts back – parallel shift by the amount of the tax

32. 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). 3.00 100 $3.30 90

33. Copyright © 2004 South-Western/Thomson Learning A Shared Burden Burden of the tax borne by consumers… Burden of the tax borne by sellers… Dead Weight Loss (DWL) and the loss of efficiency (mc does not equal mb) * Expression heard is “how much of the burden of a tax can be pushed onto consumers…”

34. 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

35. Copyright © 2004 South-Western/Thomson Learning Elasticity and Tax Incidence In what proportions is the burden of the tax divided? - How bears a greater burden for the tax, buyers or sellers? The answers to these questions depend on the elasticity of demand and the elasticity of supply.

36. 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 2.... the incidence of the tax falls more heavily on consumers... 1. When supply is more elastic than demand... Price without tax 3.... than on producers.

37. 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 3.... than on consumers. 1. When demand is more elastic than supply... Price without tax 2.... the incidence of the tax falls more heavily on producers...

38. 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

39. Copyright © 2004 South-Western/Thomson Learning Examples/Applications Gas taxes Sin taxes – tobacco and alcohol The luxury tax on yachts in the early 90’s – a debacle b/c the demanders for yachts were sensitive to price (high ticket item and a luxury) Unemployment in boat building industry and perhaps a net loss of revenue for the government

40. Copyright © 2004 South-Western/Thomson Learning 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.

41. Copyright © 2004 South-Western/Thomson Learning 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.

42. Copyright © 2004 South-Western/Thomson Learning Summary The 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.