© 2007 Thomson South-Western

CONTROLS ON PRICES Controls on Prices are enacted when … –policymakers believe the market price is unfair to buyers or sellers

© 2007 Thomson South-Western CONTROLS ON PRICES Price Ceiling –A legal maximum on the price at which a good can be sold.

© 2007 Thomson South-Western A Price Ceiling on Tacos??? Price per TacoQ of Tacos Demanded Q of Tacos Supplied

© 2007 Thomson South-Western A Market with a Price Ceiling Quantity of Tacos 0 Price of Taco Demand Supply 3Price ceiling Shortage Quantity supplied Quantity demanded Equilibrium price $ Equilibrium Quantity

© 2007 Thomson South-Western Effects of a Price Ceiling Shortages Q D > Q S Inefficient allocation to consumers Missed opportunities Wasted resources Opportunity cost of looking for a taco Inefficiently low quality Taco suppliers ‘cut corners’ on quality Black Market Goods bought and sold illegally

© 2007 Thomson South-Western CASE STUDY: Lines at the Gas Pump Economists blame government regulations that limited the price oil companies could charge for gasoline. 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. What was responsible for the long gas lines?

© 2007 Thomson South-Western The Market for Gasoline with a Price Ceiling (b) The Price Ceiling on Gasoline Is Binding Quantity of Gasoline 0 Price of Gasoline Demand S1S1 S2S2 Price ceiling QSQS P2P2 QDQD P1P1 Q1Q1 Shortage

© 2007 Thomson South-Western CONTROLS ON PRICES Price Floor –A legal minimum on the price at which a good can be sold.

© 2007 Thomson South-Western A Price Ceiling on Tacos??? Price per TacoQ of Tacos Demanded Q of Tacos Supplied

© 2007 Thomson South-Western A Market with a Price Ceiling Quantity of Tacos 0 Price of Taco Demand Supply 7Price floor Surplus Quantity demanded Quantity supplied Equilibrium price $ Equilibrium Quantity

© 2007 Thomson South-Western Effects of a Price Floor Surplus – Q S > Q D Inefficient allocation of sales among sellers –Missed opportunities Wasted resources Government may have to buy surplus Inefficiently high quality buyers prefer a lower quality good at a lower price Inefficiently low quantity –Fewer people buying tacos so a loss to society Black Market –Bribes of seller or government officials

© 2007 Thomson South-Western CASE STUDY: The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.

© 2007 Thomson South-Western How the Minimum Wage Affects the Labor Market Quantity of Labor Wage 0 Labor demand Labor Supply Equilibrium employment Equilibrium wage

© 2007 Thomson South-Western How the Minimum Wage Affects the Labor Market Quantity of Labor Wage 0 Labor Supply Labor surplus (unemployment) Labor demand Minimum wage Quantity demanded Quantity supplied

© 2007 Thomson South-Western Quantity Controls - Quotas A quota is … an upper limit on the quantity of some good that can be bought or sold. usually controlled by a license

© 2007 Thomson South-Western Example: Ocean Caught Salmon Market What controls how many each salmon boat may catch? Licenses are allocated. Total quota limit reached = ocean caught salmon season is OVER!!!

© 2007 Thomson South-Western Quota Graph Quota S Pd Pe Ps D Qe Q

© 2007 Thomson South-Western Costs of Quantity Controls Inefficiency – missed opportunities Incentives for illegal activities - poaching

© 2007 Thomson South-Western TAXES Governments levy taxes to raise revenue for public projects.

© 2007 Thomson South-Western How Taxes on Buyers (and Sellers) Affect Market Outcomes Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.

© 2007 Thomson South-Western How Taxes on Buyers Affect Market Outcomes Elasticity and tax incidence Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

© 2007 Thomson South-Western How Taxes on Buyers Affect Market Outcomes Elasticity and Tax Incidence Tax 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.

© 2007 Thomson South-Western Figure 6 A Tax on Buyers Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium without tax Tax ($0.50) Price buyers pay D1D1 D2D2 Supply,S1S1 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). $ Equilibrium with tax

© 2007 Thomson South-Western Figure 7 A Tax on Sellers 2.80 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium with tax Equilibrium without tax Tax ($0.50) Price buyers pay S1S1 S2S2 Demand,D1D1 A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50) $

© 2007 Thomson South-Western Elasticity and Tax Incidence What 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.

© 2007 Thomson South-Western Figure 8 A Payroll Tax Quantity of Labor 0 Wage Labor demand Labor supply Tax wedge Wage workers receive Wage firms pay Wage without tax

© 2007 Thomson South-Western Elasticity and Tax Incidence In 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 elasticity of demand and the elasticity of supply.

© 2007 Thomson South-Western Figure 9 How the Burden of a Tax Is Divided Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (a) Elastic Supply, Inelastic Demand the incidence of the tax falls more heavily on consumers When supply is more elastic than demand... Price without tax than on producers.

© 2007 Thomson South-Western Figure 9 How the Burden of a Tax Is Divided Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (b) Inelastic Supply, Elastic Demand than on consumers. 1. When demand is more elastic than supply... Price without tax the incidence of the tax falls more heavily on producers...

© 2007 Thomson South-Western Elasticity and Tax Incidence So, 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 elastic.