Supply, Demand, and Government Policies Outline:  Analyze various types of government policy using tools of demand and supply –Policies controlling prices (rent control, minimum wage laws) –Policies generating revenues (taxation) –Recall that Markets are a good way to organize economic activity –Recall that governments can sometimes improve market outcomes

Policy- Controls on Prices Lines at the Gas Pump  Price controls are enacted as market price is considered to be unfair to sellers or buyers –Price ceiling is a legal maximum on the price at which the good can be sold (to benefit buyers ) –Price floor is a legal minimum on the price at which a good can be sold (to benefit sellers)  Effects of price ceiling vary depending on whether the price is binding or not –A binding price ceiling on a competitive market creates a shortage of the good and results in sellers rationing the good –Rationing mechanisms are often inefficient and unfair

Policy- Controls on Prices Rent Control in the SR and LR  Controlled rent in the SR results in small shortage in housing. Why?  Controlled rent in the LR results in a large shortage. Why?  In a free market, the price of housing (rent) adjusts to eliminate housing shortages and undesirable landlord behavior

Policy- Controls on Prices Price Floors  The effect of a price floor on market outcome depends on whether the price floor is binding or not –Binding price floor creates a surplus of the good/service in the market  Case study: Binding minimum wage creates labor surplus and results in unemployment  Other options to achieve similar goals: –Rent subsidies –Wage subsidies

Policy- Taxes and Market Outcome  Taxes are levied by all levels of government to influence market outcomes and to raise revenue  Tax incidence is the study of who bears the burden of taxation –Who bears the burden of the tax? (buyers/ sellers) –What determines how the burden is divided? (elasticity)  Impact of a tax on a buyer on market outcome –Taxes discourage market activity –Buyers and sellers share the burden of the tax

Policy- Taxes and Market Outcome  Impact of a tax on a seller on market outcome –Taxes discourage market activity –Buyers and sellers share the burden of the tax  Conclusions: –Taxes on buyers and taxes on sellers are equivalent –Taxes shift the relative position of supply and demand curves and drive a wedge between the price buyers pay and the price that sellers receive –A tax on buyers means that buyers send the money to the government  Burden of a payroll tax ( a larger burden is on workers despite the legislated division of burden)

Elasticity and Tax Incidence  Tax incidence depends on the price elasticities of supply and demand  Case #1:Market with elastic supply and inelastic demand –Tax incidence is higher on the buyers (buyers bear a higher burden of the tax)  Case#2: Market with inelastic supply and elastic demand –Tax incidence is higher on the sellers  Conclusions: –A tax burden falls more heavily on the side of the market that is less elastic –Hint: Elasticity also measures the willingness of buyers/ sellers to leave the market in adverse conditions