1 Supply, Demand, and Government Policies6 Supply, Demand, and Government Policies

2 Supply, Demand, and Government PoliciesIn 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. 2 2

3 CONTROLS ON PRICES Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and floors. 3 3

4 CONTROLS ON PRICES Price Ceiling Price FloorA 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. 4 4

5 How Price Ceilings Affect Market OutcomesTwo 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. 5 5

6 Figure 1 A Market with a Price Ceiling(a) A Price Ceiling That Is Not Binding Price of Ice-Cream Cone Supply Demand €4 Price ceiling 3 100 Equilibrium price Quantity of Ice-Cream Equilibrium quantity Cones

7 Figure 1 A Market with a Price Ceiling(b) A Price Ceiling That Is Binding Price of Ice-Cream Cone Supply Demand Equilibrium price €3 2 Price ceiling 75 125 Shortage Quantity of Ice-Cream Quantity supplied Quantity demanded Cones Copyright©2010 South-Western

8 How Price Ceilings Affect Market OutcomesEffects of Price Ceilings A binding price ceiling creates shortages because QD > QS. Example: Rent controls in New York restrict new building non-price rationing Examples: Long queues; discrimination by sellers 11 14

9 CASE STUDY: Rent Control in the Short Run and Long RunRent 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.” 2

10 Figure 2 Rent Control in the Short Run and in the Long Run(a) Rent Control in the Short Run (supply and demand are inelastic) Rental Price of Apartment Supply Demand Controlled rent Shortage Quantity of Apartments Copyright©2010 South-Western

11 Figure 2 Rent Control in the Short Run and in the Long Run(b) Rent Control in the Long Run (supply and demand are elastic) Rental Price of Apartment Supply Demand Controlled rent Shortage Quantity of Apartments Copyright©2010 South-Western

12 How Price Floors Affect Market OutcomesWhen 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. 12 15

13 Figure 3 A Market with a Price Floor(a) A Price Floor That Is Not Binding Price of Ice-Cream Supply Cone Demand Equilibrium price €3 100 2 Price floor Quantity of Ice-Cream Equilibrium quantity Cones Copyright©2010 South-Western

14 Figure 3 A Market with a Price Floor(b) A Price Floor That Is Binding Price of Ice-Cream Supply Cone Demand Surplus €4 Price floor 80 120 3 Equilibrium price Quantity of Ice-Cream Quantity demanded Quantity supplied Cones Copyright©2010 South-Western

15 How Price Floors Affect Market OutcomesA 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. 15 24

16 How Price Floors Affect Market OutcomesA binding price floor causes . . . a surplus because QS > QD. non-price rationing is an alternative mechanism for rationing the good, using discrimination criteria. Examples: The minimum wage, agricultural price supports 15 25

17 The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price for labour that any employer may pay.

18 Figure 4 How the Minimum Wage Affects the Labour MarketSupply labour demand Equilibrium employment wage Quantity of labour Copyright©2010 South-Western

19 Figure 4 How the Minimum Wage Affects the Labour MarketSupply labour demand labour surplus (unemployment) Minimum wage Quantity demanded Quantity supplied Quantity of labour Copyright©2010 South-Western

20 TAXES Governments levy taxes to raise revenue for public projects. 2029

21 How Taxes on Buyers (and Sellers) Affect Market OutcomesTaxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. 22 30

22 Elasticity and Tax IncidenceTax incidence is the manner in which the burden of a tax is shared among participants in a market. 21 31

23 Elasticity and Tax IncidenceTax 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. 21 31

24 Figure 5 A Tax on Buyers €3.30 Price of Ice-Cream Price buyers paySupply, S1 Cone D1 D2 €3.30 90 Equilibrium without tax Tax (€0.50) Price without tax 3.00 100 A tax on buyers shifts the demand curve downward by the amount of the tax (€0.50). 2.80 Equilibrium with tax Price sellers receive Quantity of Ice-Cream Cones Copyright©2010 South-Western

25 Elasticity and Tax IncidenceWhat 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. 22 30

26 Figure 6 A Tax on Sellers Price of Ice-Cream Demand, D1shifts the supply curve upward by the amount of the tax (€0.50). Price buyers pay Cone S2 Equilibrium with tax S1 €3.30 90 Tax (€0.50) Price without tax 3.00 100 Equilibrium without tax 2.80 Price sellers receive Quantity of Ice-Cream Cones Copyright©2010 South-Western

27 Figure 7 A Payroll Tax Wage labour supply Wage firms pay Tax wedgelabour demand Wage firms pay Tax wedge Wage without tax Wage workers receive Quantity of labour Copyright©2010 South-Western

28 Elasticity and Tax IncidenceIn 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 price elasticity of demand and the price elasticity of supply. 29 39

29 Figure 8 How the Burden of a Tax Is Divided(a) Elastic Supply, Inelastic Demand Price 1. When supply is more elastic than demand . . . Demand Price buyers pay Tax the incidence of the tax falls more heavily on consumers . . . Supply Price without tax than on producers. Price sellers receive Quantity Copyright©2010 South-Western

30 Figure 8 How the Burden of a Tax Is Divided(b) Inelastic Supply, Elastic Demand Price 1. When demand is more elastic than supply . . . Demand Price buyers pay Supply Tax than on consumers. Price without tax the incidence of the tax falls more heavily on producers . . . Price sellers receive Quantity Copyright©2010 South-Western

31 ELASTICITY AND TAX INCIDENCESo, 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 price elastic. 30 41

32 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.

33 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.

34 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 price elastic.