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Lect06

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  • 1. Supply, Demand and Government Policies Chapter 6
  • 2. 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 is satisfied. One of the roles of economists is to use their theories to assist in the development of policies.
  • 3. Price Controls... Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and floors.
  • 4. Price Ceilings & Price Floors Price Ceiling A legally established maximum price at which a good can be sold. Price Floor A legally established minimum price at which a good can be sold.
  • 5. 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.
  • 6. A Price Ceiling That Is Not Binding... Price of Ice-Cream Cone Supply Price ceiling $4 3 Equilibrium price Demand 0 100 Equilibrium quantity Quantity of Ice-Cream Cones
  • 7. A Price Ceiling That Is Binding... Price of Ice-Cream Cone Supply Equilibrium price $3 Price ceiling 2 Shortage Demand 0 75 Quantity supplied 125 Quantity demanded Quantity of Ice-Cream Cones
  • 8. Effects of Price Ceilings A binding price ceiling creates ... … shortages because QD > QS. Example: Gasoline shortage of the 1970s … nonprice rationing Examples: Long lines, Discrimination by sellers
  • 9. The Price Ceiling on Gasoline Is Not Binding... Price of Gasoline 1. Initially, the price ceiling is not binding... Supply Price ceiling $4 P1 Demand 0 Q1 Quantity of Gasoline
  • 10. The Price Ceiling on Gasoline Is Binding... S2 Price of Gasoline 2. …but when supply falls... S1 P2 Price ceiling P1 3. …the price ceiling becomes binding... 4. …resulting in a shortage. Demand 0 Q1 Quantity of Gasoline
  • 11. Rent Control 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.”
  • 12. Rent Control in the Short Run... Rental Price of Apartmen t Supply Supply and demand for apartments are relatively inelastic Controlled rent Shortage Demand 0 Quantity of Apartments
  • 13. Rent Control in the Long Run... Rental Price of Apartmen t Because the supply and demand for apartments are more elastic... Supply …rent control causes a large shortage Controlled rent Shortage 0 Demand Quantity of Apartments
  • 14. Price Floors When the government imposes a price floor, two outcomes are possible. The price floor is not binding if set below the equilibrium price. The price floor is binding if set above the equilibrium price, leading to a surplus.
  • 15. A Price Floor That Is Not Binding... Price of Ice-Cream Cone Supply Equilibrium price $3 Price floor 2 Demand 0 100 Equilibrium quantity Quantity of Ice-Cream Cones
  • 16. A Price Floor That Is Binding... Price of Ice-Cream Cone Surplus $4 Supply Price floor $3 Equilibrium price Demand 0 80 Quantity demanded 120 Quantity supplied Quantity of Ice-Cream Cones
  • 17. Effects of a Price Floor 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.
  • 18. Effects of a Price Floor A binding price floor causes . . . … a surplus because QS >QD. nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria. … Examples: The minimum wage, Agricultural price supports
  • 19. 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.
  • 20. The Minimum Wage Wage A Free Labor Market Labor supply Equilibrium wage Labor demand 0 Equilibrium employment Quantity of Labor
  • 21. The Minimum Wage Wage A Labor Market with a Minimum Wage Labor surplus (unemployment) Labor supply Minimum wage Labor demand 0 Quantity demanded Quantity supplied Quantity of Labor
  • 22. Taxes Governments levy taxes to raise revenue for public projects.
  • 23. What are some potential impacts of taxes? Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.
  • 24. Taxes 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.
  • 25. Impact of a 50¢ Tax Levied on Buyers... Price of Ice-Cream Cone Supply, S 1 3.00 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). D1 D2 0 100 Quantity of Ice-Cream Cones
  • 26. Impact of a 50¢ Tax Levied on Buyers... Price of Ice-Cream Cone Price buyers pay Price without tax $3.30 3.00 2.80 Price sellers receive Supply, S 1 Equilibrium without tax Tax ($0.50) Equilibrium with tax D1 D2 0 90 100 Quantity of Ice-Cream Cones
  • 27. 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.
  • 28. Impact of a 50¢ Tax on Sellers... Price of Ice-Cream Cone Price buyers pay Price without tax $3.30 3.00 2.80 A tax on sellers shifts S2 the supply curve upward S1 by the amount of the tax ($0.50). Equilibrium without tax Equilibrium with tax Tax ($0.50) Price sellers receive Demand, D 1 0 90 100 Quantity of Ice-Cream Cones
  • 29. A Payroll Tax Wage Labor supply Wage firms pay Wage Tax wedge without tax Wage workers receive Labor demand 0 Quantity of Labor
  • 30. The Incidence of Tax In what proportions is the burden of the tax divided? How do the effects of taxes on sellers compare to those levied on buyers? The answers to these questions depend on the elasticity of demand and the elasticity of supply.
  • 31. Elastic Supply, Inelastic Demand... Price 1. When supply is more elastic than demand... Price buyers pay Supply Tax Price without tax Price sellers receive 3. ...than on producers. 0 2. ...the incidence of the tax falls more heavily on consumers... Demand Quantity
  • 32. Inelastic Supply, Elastic Demand... 1. When demand is more elastic than supply... Price Supply Price buyers pay Price without tax 3. ...than on consumers. Tax Price sellers receive 0 Demand 2. ...the incidence of the tax falls more heavily on producers... Quantity
  • 33. 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.
  • 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. 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.