Chapter 6 “Supply, Demand and Government Policies”

Principles of Micro Chapter 6: “Supply, Demand and Government Policies” We Will Study:  the effects of government policies that fix the price above or below the equilibrium price  how a tax on a good affects the price of the good and the quantity sold  how the burden of a tax is split between buyers and sellers I.      Controls on Prices In a free market, market forces establish equilibrium prices and quantities. It may be true that not everyone is satisfied in market equilibrium Economists use theories to develop government policies that help change the world for the better Controls on prices are usually enacted when policymakers believe the market price is unfair to buyers or sellers. They result in government-created price ceilings and floors. I.   Controls on Prices price ceiling: a legal maximum on the price at which a good can be sold. Example: rent-control laws sets maximum rent that the landlords can charge price floor: a legal minimum on the price at which a good can be sold. Example: minimum wage law dictates the lowest wage that firms may pay workers How Price Ceilings Affect Market Outcomes  1. 2. Two outcomes are possible when the government imposes a price ceiling: If the price ceiling is set above the equilibrium price, it is not binding and there is no effect on the price or quantity sold The price ceiling is set below the equilibrium price, it is binding and the shortage is created A Market With A Price Ceiling (a) A Price Ceiling That Is Not Binding Price of Ice-Cream Cone Supply $4 Price ceiling 3 Equilibrium price Demand 0 100 Equilibrium quantity Quantity of Ice-Cream Cones A Market With A Price Ceiling (b) A Price Ceiling That Is Binding Price of Ice-Cream Cone Supply Equilibrium price $3 2 Price ceiling Shortage Demand 0 75 125 Quantity supplied Quantity demanded Quantity of Ice-Cream Cones How Price Ceilings Affect Market Outcomes   A Binding Price Ceilings Creates: - shortages because QD > QS Example: Gasoline shortage of the 1970s - mechanism for rationing the good Example: long lines, discrimination by sellers Not all buyers benefit from a price ceiling since some will be unable to purchase the product. CASE STUDY: Lines at the Gas Pump  In 1973, OPEC raised the price of crude oil. 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? • Economists blame government regulations that limited the price oil companies could charge for gasoline. The Market for Gasoline with a Price Ceiling (a) The Price Ceiling on Gasoline Is Not Binding Price of Gasoline Supply, S1 1. Initially, the price ceiling is not binding . . . Price ceiling P1 Demand 0 Q1 Quantity of The Market for Gasoline with a Price Ceiling (b) The Price Ceiling on Gasoline Is Binding Price of Gasoline S2 2. . . . but when supply falls . . . S1 P2 Price ceiling 3. . . . the price ceiling becomes binding . . . P1 4. . . . resulting in a shortage. Demand 0 QS QD Q1 Quantity of Gasoline 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.” Rent Control in the Short-Run (a) Rent Control in the Short Run (supply and demand are inelastic) Rental Price of Apartment Supply Controlled rent Shortage Demand 0 Quantity of Apartments Rent Control in The Long-Run (b) Rent Control in the Long Run (supply and demand are elastic) Rental Price of Apartment Supply Controlled rent Shortage 0 Demand Quantity of Apartments Rent Control in the Short Run and Long Run    Since the supply of apartments is fixed (perfectly inelastic) in the short run and upward sloping (elastic) in the long run, the shortage is much larger in the long run than in the short run. Rent controlled apartments are rationed in a number of ways including long waiting lists, discrimination against minorities and families with children, and even under-the-table payments to landlords. The quality of apartments also suffers due to rent control. How Price Floors Affect Market Outcomes  1. 2. Two outcomes are possible when the government imposes a price floor: If the price floor is lower than the equilibrium price, it is not binding and has no effect on the price or quantity sold. If the price floor is higher than the equilibrium price, the floor is a binding constraint and a surplus is created. A Market With A Price Floor (a) 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 A Market With A Price Floor (b) A Price Floor That Is Binding Price of Ice-Cream Cone Supply Surplus $4 Price floor 3 Equilibrium price Demand 0 80 Quantity demanded Quantity of Quantity Ice-Cream Cones supplied 120 How Price Ceilings Affect Market Outcomes When the market price hits the floor, it can fall no further, and the market price equals the floor price.  A binding price floor causes: - a surplus because QS > QD - the development of a new mechanism for rationing the good, using discrimination criteria  CASE STUDY: The Minimum Wage   An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price for labor that any employer may pay. Consider a labor market in which the wage adjusts to balance labor supply and labor demand How the Minimum Wage Affects the Labor Market Wage Labor surplus (unemployment) Labor Supply Minimum wage Labor demand 0 Quantity demanded Quantity supplied Quantity of Labor How the Minimum Wage Affects the Labor Market    If the minimum wage is above the equilibrium wage in the labor market, a surplus of labor will develop (unemployment). The minimum wage will be a binding constraint only in markets where equilibrium wages are low. Thus, the minimum wage will have its greatest impact on the market for teenagers and other unskilled workers. Evaluating Price Controls   Most economists oppose the use of price ceilings and floors Prices balance supply and demand and thus coordinate economic activity. If prices are set by laws, they obscure the signals that efficiently allocate scarce resources. Price ceilings and price floors often hurt the people they are intended to help. - Rent controls create a shortage of quality housing and provide disincentives for building maintenance. - Minimum wage laws create higher rates of unemployment for teenage and low skilled workers. Taxes   Governments levy taxes to raise revenue for public projects tax incidence: the manner in which the burden of a tax is shared among participants in a market. How Taxes on Buyers Affect Market Outcomes     If the government requires the buyer to pay a certain amount for each unit of a good purchased, this will cause a decrease in demand. The demand curve will shift down by the amount of the tax. The quantity of the good sold will decline. Buyers and sellers will share the burden of the tax; buyers pay more for the good (including the tax) and sellers receive less. How Taxes on Buyers Affect Market Outcomes  1. 2. Two lessons can be learned here: Taxes discourage market activity. When the good is taxed the quantity sold is smaller than before the tax. Buyers and sellers share the burden of a tax. A Tax on Buyers Price of Ice-Cream Price Cone buyers pay $3.30 Tax ($0.50) Price 3.00 without 2.80 Supply,S1 Equilibrium without tax tax Price sellers receive Equilibrium with tax A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). D1 D2 0 90 100 Quantity of Ice-Cream Cones How Taxes on Sellers Affect Market Outcomes     If the government requires the seller to pay a certain amount for each unit of a good purchased, this will cause a decrease in supply. The supply curve will shift up by the amount of the tax. The quantity of the good sold will decline. Buyers and sellers will share the burden of the tax; buyers pay more for the good and sellers receive less (because of the tax). A Tax on Sellers Price of Ice-Cream Price Cone buyers pay $3.30 Price without tax 3.00 2.80 S2 Equilibrium with tax S1 Tax ($0.50) A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50). Equilibrium without tax Price sellers receive Demand, D1 0 90 100 Quantity of Ice-Cream Cones Elasticity and Tax Incidence    In what proportions is the burden of the tax divided? The answer to this question depends on the elasticity of demand and the elasticity of supply. The burden of a tax falls more heavily on the side of the market that is less elastic Elasticity and Tax Incidence   When supply is elastic and demand is inelastic, the largest share of the tax burden falls on consumers. A small elasticity of demand means that buyers do not have good alternatives to consuming this product. When supply is inelastic and demand is elastic, the largest share of the tax burden falls on producers. A small elasticity of supply means that sellers do not have good alternatives to producing this particular good. How The Burden of Tax is Divided (a) Elastic Supply, Inelastic Demand Price 1. When supply is more elastic than demand . . . Price buyers pay Supply Tax Price without tax Price sellers receive 2. . . . the incidence of the tax falls more heavily on consumers . . . 3. . . . than Demand on producers. 0 Quantity How The Burden of Tax is Divided (b) Inelastic Supply, Elastic Demand Price 1. When demand is more elastic than supply . . . Price buyers pay Supply Price without tax 3. . . . than on consumers. Tax Price sellers receive 0 2. . . . the incidence of the tax falls more heavily on producers . . . Demand Quantity 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. 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. 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.