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Chapter 6

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Chapter 6

  1. 1. Chapter 6 What are price ceilings and price floors? What are some examples of each? How do price ceilings and price floors affect market outcomes? How do taxes affect market outcomes? How does the outcome depend on whether the tax is imposed on buyers or sellers? What is the incidence (rate/range of influence/occurrence) of a tax? What determines the incidence?SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  2. 2. Government Policies That Alter the Private Market Outcome Price Controls – Price Ceiling: a legal maximum on the price of a good or service. Example: rent control. – Price Floor: a legal minimum on the price of a good or service. Example: minimum wage. Taxes – The Government can make buyers or sellers pay a specific amount on each unit bought/sold.SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  3. 3. EXAMPLE 1: The Market for Apartments Rental P S price of apartments $800 Equilibrium without price D Q controls 300 Quantity of apartmentsSUPPLY, DEMAND, AND GOVERNMENT POLICIES
  4. 4. How Price Ceilings Affect Market Outcomes P S Price $1000 A price ceiling Ceiling $800 above the equilibrium price is not binding – has no effect D Q on the market 300 outcome. SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  5. 5. How Price Ceilings Affect Market Outcomes P The equilibrium S price ($800) is above the ceiling and $800 therefore illegal. Price The ceiling $500 Ceiling is a binding Shortage constraint D on the price, Q 250 400 causes a shortage. SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  6. 6. How Price Ceilings Affect Market Outcomes P S In the long run, supply and demand $800 are more price-elastic. $500 Price Therefore, the Ceiling Shortage shortage D will be larger. Q 150 450 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  7. 7. Shortages and Rationing With a shortage, sellers must ration the goods among buyers. Some rationing mechanisms: (1) long lines (2) discrimination according to sellers’ biases These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly. In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair).SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  8. 8. EXAMPLE 2: The Market for Unskilled Labor Wage W S paid to unskilled workers $4 Equilibrium without D price L controls 500 Quantity of unskilled workersSUPPLY, DEMAND, AND GOVERNMENT POLICIES
  9. 9. How Price Floors Affect Market Outcomes W S A price floor below the equilibrium price is $4 not binding – Price $3 has no effect floor on the market D outcome. L 500SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  10. 10. How Price Floors Affect Market Outcomes LaborThe equilibrium W Surplus Swage ($4) is below Price $5the floor and Floortherefore illegal. $4The floor is abinding constrainton the wage,causes a surplus D(i.e.,unemployment). L 400 550SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  11. 11. The Minimum Wage Unemployment W S MinimumMinimum wage $5 Wagelaws do not affecthighly skilled $4workers.Often, they affectteen workers. D L 400 550SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  12. 12. Price Floors & Ceilings The market for P 140 hotel roomsDetermine S 130effects of: 120 A. $90 price 110 ceiling 100 B. $90 price floor 90 80 D C. $120 price floor 70 60 50 40 0 Q 50 60 70 80 90 100 110 120 130 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  13. 13. A. $90 Price Ceiling The market for P 140 hotel rooms S The price 130 falls to $90. 120 110 Buyers 100 demand Price ceiling 90 120 rooms, 80 D sellers supply shortage = 30 70 90, leaving a 60 shortage. 50 40 0 Q 50 60 70 80 90 100 110 120 130SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  14. 14. B. $90 Price Floor The market for P 140 hotel rooms S 130 Equilibrium price is above 120 the floor, so the 110 floor is not 100 binding. 90 Price floor P = $100, 80 D Q = 100 rooms. 70 60 50 40 0 Q 50 60 70 80 90 100 110 120 130 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  15. 15. C. $120 price floor The market for P 140 hotel rooms surplus = 60 S 130 The price 120 rises to $120. Price floor 110 Buyers 100 demand 60 rooms, 90 sellers supply 80 D 120, causing a 70 surplus. 60 50 40 0 Q 50 60 70 80 90 100 110 120 130 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  16. 16. Evaluating Price Controls Recall one of the Ten Principles of Economics: Markets are usually a good way to organize economic activity. Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices. Price controls often intended to help the poor, but often hurt more than help.SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  17. 17. Taxes  The Government levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc.  The Government can make buyers or sellers pay the tax.  The tax can be a % of a good’s price, or a specific amount for each unit sold. – For simplicity, we will analyze per-unit taxes only.SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  18. 18. EXAMPLE 3: The Market for PizzaEquilibrium P S1without tax $10.00 D1 Q 500SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  19. 19. A Tax on BuyersA tax onbuyers shifts Effects of a $1.50 perthe D curve unit tax on buyersdown by the Pamount of the S1 PB = $11.00tax. Tax $10.00The price PS = $9.50buyers payrises, the price D1sellers receive D2falls, Q 430 500equilibrium Qfalls. SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  20. 20. The Incidence of a Tax: How the burden of a tax is shared among market participants P As a result of S1 PB = $11.00 the tax, Tax buyers pay $10.00 $1.00 more, PS = $9.50 and sellers receive D1 $0.50 less. D2 Q 430 500 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  21. 21. A Tax on SellersA tax on Effects of a $1.50 persellers shifts unit tax on sellersthe S curve up P S2by the amount S1of the tax. PB = $11.00 Tax $10.00 PS = $9.50The price buyerspay rises, theprice sellers D1receive falls,equilibrium Q Q 430 500falls.SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  22. 22. The Outcome Is the Same in Both Cases!The effects on P and Q, and the tax incidence are thesame whether the tax is imposed on buyers or sellers! PWhat S1matters is PB = $11.00 Taxthis: $10.00A tax drives PS = $9.50a wedge D1between theprice buyers Qpay and the 430 500price sellersreceive. AND GOVERNMENT POLICIESSUPPLY, DEMAND,
  23. 23. Effects of a Tax The market for P 140 hotel rooms Suppose the S 130 Government 120 imposes a tax 110 on buyers of 100 $30 per room. 90 Find new Q, PB, PS, 80 D and incidence of 70 tax. 60 50 40 0 Q 50 60 70 80 90 100 110 120 130 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  24. 24. A C T I V E L E A R N I N G 2: The market forAnswers P 140 hotel rooms S 130PB = $110 120Q = 80 PB = 110 100 TaxPS = $80 90 PS = 80 D 70 Incidence 60 Buyers: $10 50 Sellers: $20 40 0 Q 50 60 70 80 90 100 110 120 130 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  25. 25. Elasticity and Tax IncidenceCASE 1: Supply is more elastic than demand P It is easier for sellers than buyers PB S to leave theBuyers’ share market.of tax burden Tax Therefore, buyers Price if no tax bear most of the Sellers’ share burden of the tax. PS of tax burden D QSUPPLY, DEMAND, AND GOVERNMENT POLICIES
  26. 26. Elasticity and Tax IncidenceCASE 2: Demand is more elastic than supply It is easier for P buyers than S sellers to leaveBuyers’ share PB the market.of tax burden Sellers bear Price if no tax Tax most of theSellers’ share burden ofof tax burden the tax. PS D QSUPPLY, DEMAND, AND GOVERNMENT POLICIES
  27. 27. CASE STUDY: Who Pays the Luxury Tax? 1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc. Goal of the tax: to raise revenue from those who could most easily afford to pay – wealthy consumers. But who really pays this tax? SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  28. 28. CASE STUDY: Who Pays the Luxury Tax? The market for yachts Demand is price-elastic. P S In the short run, Buyers’ share of tax burden PB supply is inelastic. Tax Hence, companies Sellers’ share that build of tax burden PS D yachts pay most of Q the tax. SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  29. 29. CONCLUSION: Government Policies and the Allocation of Resources Each of the policies in this chapter affects the allocation of society’s resources. – Example 1: A tax on pizza reduces equilibrium Q. With less production of pizza, resources (workers, ovens, cheese) will become available to other industries. – Example 2: A binding minimum wage causes a surplus of workers, and a waste of resources. It is important for policymakers to apply such policies very carefully.SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  30. 30. CHAPTER SUMMARY  A price ceiling is a legal maximum on the price of a good. An example is rent control. If the price ceiling is below the equilibrium price, it is binding and causes a shortage.  A price floor is a legal minimum on the price of a good. An example is the minimum wage. If the price floor is above the equilibrium price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment.SUPPLY, DEMAND, AND GOVERNMENT POLICIES
  31. 31. CHAPTER SUMMARY A tax on a good places a wedge between the price buyers pay and the price sellers receive, and causes the equilibrium quantity to fall, whether the tax is imposed on buyers or sellers. The incidence of a tax is the division of the burden of the tax between buyers and sellers, and does not depend on whether the tax is imposed on buyers or sellers. The incidence of the tax depends on the price elasticities of supply and demand.SUPPLY, DEMAND, AND GOVERNMENT POLICIES

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