SUPPLY, DEMAND, AND GOVERNMENT POLICIES

Overview Economists have two roles: 1.As scientists, they develop and test theories to explain the world around them. 2.As policy advisers, they use their theories to help change the world for the better Up to this point, we have focused on the role of economists as scientists. Now we turn to the role of economists as policy advisers

Overview In unregulated markets, the market forces of supply and demand determine market prices and quantities. Price controls are enacted by the government when it is believed that market prices are unfair to either sellers or consumers. Demand and supply analysis can be used to examine the impact of government intervention (such as price controls) in markets.

Price Controls Price Ceiling: A maximum legal price above which a good can not be sold. –Examples: Rent Control, Price Controls on Gas in 1970’s. Price Floor: A minimum legal price below which a good can not be sold. –Examples: Minimum wages, agriculture price supports.

Price Ceilings Two outcomes are possible when the government imposes a price ceiling: 1.The price ceiling is not binding if set above the equilibrium price. 2.The price ceiling is binding if set below the equilibrium price, leading to a shortage.

A Nonbinding Price Ceiling Price Quantity D1D1 S1S1 A price ceiling set above the equilibrium price has no effect! P1P1 Q1Q1 Maximum Price Allowed by Law P Max

A Binding Price Ceiling Price Quantity D1D1 S1S1 P1P1 Q1Q1 Maximum Price Allowed by Law P Max A price ceiling set below the equilibrium price leads to a shortage or excess demand (Q D > Q S ). QDQD QSQS

Application: OPEC and Lines at Gas Stations in the 1970’s In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the major input in gasoline, so the higher oil prices reduced the supply of gasoline. As a result, the price of gasoline rose sharply. In response the government placed a price ceiling on gasoline. The results was very long lines at gas stations.

Market for Gas Prior to OPEC Oil Shock Price Quantity of Gasoline D1D1 S1S1 Prior to the OPEC oil shock, the price ceiling is nonbinding. P1P1 Q1Q1 Maximum Price Allowed by Law P Max

Market for Gas After OPEC Oil Shock Price Quantity of Gasoline D1D1 S1S1 P1P1 Q1Q1 Maximum Price Allowed by Law P Max S2S2 QDQD QSQS The oil shock causes the supply curve for gas to shift left. Now the price ceiling is binding and a shortage of gas results (Q D >Q S )

Application: The Market for Low-Income Housing Background: Rental rates and housing prices in the New Haven Area increased substantially over the last five years. As a result, it has become much more difficult for low-income families to find affordable housing.

Policy Issue: Suppose you were hired by the Mayor of New Haven to devise an affordable housing strategy for low income families. You are asked to come up with three policy options. Policy Options:... Application: The Market for Low-Income Housing

Housing Vouchers for Low-Income Families Rental Rate Number of Apartments S1S1 Initial equilibrium A voucher represents an increase in income: P1P1 Q1Q1 New equilibrium P2P2 Q2Q2 D2D2 D1D1

A Per-Unit Rent Subsidy for Landlords Rental Rate 0 Number of Apartments D1D1 Initial equilibrium S1S1 P1P1 Q1Q1 S2S2 P2P2 Q2Q2 New equilibrium The subsidy causes the supply curve for apartments to shift right, leading to a lower equilibrium price and a higher equilibrium quantity.

Rent Control: Maximum Rent Set Above Equilibrium Price Rental Rate Number of Apartments D1D1 Equilibrium S1S1 A price ceiling set above the equilibrium price has no effect! P1P1 Q1Q1 Maximum Rent by Law P Max

Rent Control: Maximum Rent Set Below Equilibrium Price Rental Rate 0 Number of Apartments D1D1 Equilibrium S1S1 A price ceiling set below the equilibrium price leads to excess demand. P1P1 Q1Q1 Maximum Rent by Law P Max QDQD QSQS

Consequences of Rent Control Tends to reduce the quantity and quality of housing available. Tends to bid up rents in uncontrolled sector. No incentive to invest in new rental units. Creates a black market for apartments. In his study, “Who Really Benefits from New York City’s Rent Regulation System?,” Henry Pollakowski concludes: “This study finds that tenants in low- and moderate-income areas receive little or no benefit from rent stabilization, while tenants in more affluent locations are effectively subsidized for a substantial portion of their rent.”Who Really Benefits from New York City’s Rent Regulation System?,” Also see article by Walter Block on rent control.Walter Block

Price Floors When the government imposes a price floor, two outcomes are possible. 1.The price floor is not binding if set below the equilibrium price. 2.The price floor is binding if set above the equilibrium price, leading to a surplus.

A Nonbinding Price Floor Price 0 Quantity Demand Equilibrium Supply A price floor set below the equilibrium price has no effect. p1p1 Q1Q1 Minimum price allowed by Law p min

A Binding Price Floor price 0 Quantity Demand Supply A price floor set above the equilibrium price results in a surplus P1P1 Q1Q1 Minimum Price Allowed by Law P min QDQD QSQS Excess Supply

Minimum Wage Laws and the Unemployment Rate An important policy question is: Does an increase in the minimum wage cause an increase in the unemployment rate of low-skilled workers?

Minimum Wage Laws and the Unemployment Rate wage rate 0 Employment Demand for labor Equilibrium Supply of labor A minimum wage set below the equilibrium wage has no effect. w1w1 L1L1 Minimum wage by Law w min

Minimum Wage Laws and Unemployment wage rate Employment Demand for Labor Supply of Labor A minimum wage set above the equilibrium wage results in unemployment w1w1 L1L1 Minimum wage by Law w min LDLD LSLS Unemployment

Minimum Wage Laws and the Unemployment Rate

Overview of Taxation Governments levy taxes to raise revenue for public projects. Facts about Taxation: –Taxes discourage market activity. –When a good is taxed, the quantity sold is smaller. –Buyers and sellers share the tax burden.

Tax Incidence Renters never receive a property tax bill in the mail. –Does that imply renters pay no property taxes? Social Security if financed with a flat tax on earnings. The payroll tax is split equally between employer and employee, with each paying 6.2% of gross wages. –Does that fact imply employers and employees bear equal burdens of the Social Security tax? To answer those questions we need to distinguish between the statutory incidence and economic incidence of a tax.

Tax Incidence Statutory Incidence: refers to who is legally responsible for paying the tax. Economic Incidence: refers to who bears the burden of a tax. It is the change in the distribution of real private income induced by the tax. Tax Shifting: refers to the extent to which the statutory incidence and economic incidence of a tax differ.

A Per-Unit Tax Imposed on Suppliers Quantity Price D1D1 S1S1 PDPD PSPS P1P1 Q1Q1 Q tax S2S2 Per-Unit tax paid by Suppliers shifts the supply curve to the left Per-Unit Tax

A Per-Unit Tax Imposed on Consumers Quantity Price D1D1 S1S1 PDPD PSPS P1P1 Q1Q1 Q tax Per-Unit tax paid by Consumers shifts the demand curve to the left D1D1 Per-Unit Tax

Tax Incidence Taxes on buyers and sellers are equivalent That is, the economic incidence of a tax is independent of the statutory incidence Because of that fact it is useful to illustrate the impact of taxes using a tax wedge, rather than shifting either the supply or demand curve.

Tax Incidence and Tax Wedges Quantity Price D1D1 S1S1 PDPD PSPS P1P1 Q1Q1 A per-unit tax drives a wedge between the price paid by consumers and the price received by suppliers Tax Wedge Q Tax

Elasticity and Tax Incidence The burden of a tax is usually shared by producers and consumers. The degree to which the tax is shared depends critically on the elasticity of supply and demand. Thus, the economic incidence of a tax depends on the relative elasticity of supply and demand. –If demand is relatively more elastic than supply, suppliers end up bearing more of the burden of a tax. –If supply is relatively more elastic than demand, consumers end up bearing more of the burden of a tax.

Tax Incidence when Supply is More Elastic than Demand Packs of Cigarettes $/Pack D S PDPD PSPS P1P1 Q1Q1 Q tax When supply is more elastic than demand, consumers bear the burden of the tax

Tax Incidence when Demand is More Elastic Than Supply Quantity of Luxury Boats Price D S PDPD PSPS P1P1 Q1Q1 Q tax When demand is more elastic than supply, producers bear the burden of the tax

Application: The Payroll Tax The federal government uses the FICA (Federal Insurance Contribution Act) to finance Social Security and Medicare. FICA is a payroll tax since it is deducted directly from your paycheck. Currently the payroll tax is 15.3% of earnings. According to law, the statutory incidence of the payroll tax is split between workers and employers. Each pays 7.65% of earnings. Who bears the burden of the payroll tax? Hint: Economists estimate that the supply of labor is much less elastic than the demand for labor.

The Economic Incidence of the Payroll Tax Quantity of Labor wage Demand for Labor Supply of Labor wDwD wSwS w1w1 L1L1 L2L2 Because the supply of labor is less elastic than the demand for labor, workers end up paying most of the payroll tax. Payroll Tax