Supply, Demand & Government Policies

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Supply, Demand & Government Policies

  1. 1. Supply, Demand & Government Policies Lecture 5
  2. 2. • In a free market system, market forces establish equilibrium prices and exchange quantities. • One of the roles of economists is to develop theories to assist in the development of policies.
  3. 3. Controls on Prices • Buyers always want lower prices, while sellers want higher prices. • Thus, interests of these two groups conflict. • Controls on prices are usually enacted when policymakers believe the market price is unfair to buyers or sellers. • For this government creates price ceilings and price floors.
  4. 4. Controls on Prices Cont… • 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.
  5. 5. Controls on Prices Cont… How Price Ceilings Affect Market Outcomes: • When govt. imposes price ceiling, following two outcomes are possible: 1. If price is set above the equilibrium price, price ceiling is not binding . • Price ceiling has no effect on the price or quantity sold .
  6. 6. Price Ceiling that is NOT BINDING Price Supply P2 Price Ceiling P1 Equilibrium Price Demand 0 Q Quantity Equilibrium Quantity
  7. 7. Controls on Prices Cont… How Price Ceilings Affect Market Outcomes (Cont.): 2. If price is set below the equilibrium price, price ceiling is a binding constraint. • The forces of demand and supply move price towards equilibrium price. • But when market price hits the ceiling, it can rise no further. • Thus, market price equals price ceiling. • At this price, quantity demanded exceeds quantity supplied, creating shortage for the good.
  8. 8. Price Ceiling that is BINDING Price Supply Equilibrium Price P2 P1 Price Shortage Ceiling Demand 0 Q1 Q2 Quantity Quantity Quantity Supplied Demanded
  9. 9. Controls on Prices Cont… How Price Ceilings Affect Market Outcomes (Cont.): • Therefore, when government imposes a binding price ceiling on a market, shortage of the good arises
  10. 10. Controls on Prices Cont… How Price Floors Affect Market Outcomes: • When govt. imposes price floor, following two outcomes are possible: 1. If price is set below the equilibrium price, price floor is not binding . • Price floor has no effect on the price or quantity sold .
  11. 11. Price Floor that is NOT BINDING Price Supply Equilibrium Price P2 Price Floor P1 Demand 0 Q Quantity Equilibrium Quantity
  12. 12. Controls on Prices Cont… How Price Floors Affect Market Outcomes (Cont.): 2. If price is set above the equilibrium price, price floor is a binding constraint. • The forces of demand and supply move price towards equilibrium price. • But when market price hits the floor, it can fall no further. • Thus, market price equals price floor. • At this price, quantity supplied exceeds quantity demanded, causing surplus for the good.
  13. 13. Price Floor that is BINDING Price Supply Surplus P2 Price Floor P1 Equilibrium Price Demand 0 Q1 Q2 Quantity Quantity Quantity Demanded Supplied
  14. 14. Taxes • Governments use taxes to raise revenue for public projects, such as for: – Roads – Schools – National defense • Taxes affect market activity. • When a good is taxed, the quantity sold is smaller.
  15. 15. Taxes Cont… Important Question • When govt. levies tax on a good, who bears the burden of the tax? Buyers Or Sellers
  16. 16. Taxes Cont… • Economists use the term tax incidence to refer to the distribution of tax burden. • “Tax incidence is the manner in which the burden of a tax is shared among participants in a market”.
  17. 17. Taxes Cont… • Taxes result in a change in market equilibrium. • Buyers pay more and sellers receive less, regardless of whom the tax is levied on.
  18. 18. Taxes Cont… • What is 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.

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