1. Copyright © 2004 South-Western 6 Supply, Demand, and Government Policies

2. Copyright © 2004 South-Western/Thomson Learning Supply, Demand, and Government Policies In 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.

3. Copyright © 2004 South-Western/Thomson Learning 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.

4. Copyright © 2004 South-Western/Thomson Learning CONTROLS ON PRICES Price Ceiling A 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.

5. Copyright © 2004 South-Western/Thomson Learning How Price Ceilings Affect Market Outcomes Two 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.

6. Figure 1 A Market with a Price Ceiling (a) A Price Ceiling That Is Not Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium quantity $4 Price ceiling Equilibrium price Demand Supply 3 100

7. Figure 1 A Market with a Price Ceiling Copyright©2003 Southwestern/Thomson Learning (b) A Price Ceiling That Is Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply 2Price ceiling Shortage 75 Quantity supplied 125 Quantity demanded Equilibrium price $3

8. Copyright © 2004 South-Western/Thomson Learning How Price Ceilings Affect Market Outcomes Effects of Price Ceilings A binding price ceiling creates shortages because Q D > Q S. Example: Gasoline shortage of the 1970s non-price rationing Examples: Long lines, discrimination by sellers

9. Copyright © 2004 South-Western/Thomson Learning 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? CASE STUDY: Lines at the Gas Pump Economists blame government regulations that limited the price oil companies could charge for gasoline.

10. Figure 2 The Market for Gasoline with a Price Ceiling Copyright©2003 Southwestern/Thomson Learning (a) The Price Ceiling on Gasoline Is Not Binding Quantity of Gasoline 0 Price of Gasoline 1. Initially, the price ceiling is not binding... Price ceiling Demand Supply,S1S1 P1P1 Q1Q1

11. Figure 2 The Market for Gasoline with a Price Ceiling Copyright©2003 Southwestern/Thomson Learning (b) The Price Ceiling on Gasoline Is Binding Quantity of Gasoline 0 Price of Gasoline Demand S1S1 S2S2 Price ceiling QSQS 4.... resulting in a shortage. 3.... the price ceiling becomes binding... 2.... but when supply falls... P2P2 QDQD P1P1 Q1Q1

12. Copyright © 2004 South-Western/Thomson Learning 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.”

13. Figure 3 Rent Control in the Short Run and in the Long Run Copyright©2003 Southwestern/Thomson Learning (a) Rent Control in the Short Run (supply and demand are inelastic) Quantity of Apartments 0 Supply Controlled rent Rental Price of Apartment Demand Shortage

14. Figure 3 Rent Control in the Short Run and in the Long Run Copyright©2003 Southwestern/Thomson Learning (b) Rent Control in the Long Run (supply and demand are elastic) 0 Rental Price of Apartment Quantity of Apartments Demand Supply Controlled rent Shortage

15. Copyright © 2004 South-Western/Thomson Learning How Price Floors Affect Market Outcomes When 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.

16. Figure 4 A Market with a Price Floor Copyright©2003 Southwestern/Thomson Learning (a) A Price Floor That Is Not Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium quantity 2 Price floor Equilibrium price Demand Supply $3 100

17. Figure 4 A Market with a Price Floor Copyright©2003 Southwestern/Thomson Learning (b) A Price Floor That Is Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply $4 Price floor 80 Quantity demanded 120 Quantity supplied Equilibrium price Surplus 3

18. Copyright © 2004 South-Western/Thomson Learning How Price Floors Affect Market Outcomes A 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.

19. Copyright © 2004 South-Western/Thomson Learning How Price Floors Affect Market Outcomes A binding price floor causes... a surplus because Q S > Q D. nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria. Examples: The minimum wage, agricultural price supports

20. Copyright © 2004 South-Western/Thomson Learning 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. Currently, the federal minimum wage is $5.15 per hour.

21. Figure 5 How the Minimum Wage Affects the Labor Market Copyright©2003 Southwestern/Thomson Learning Quantity of Labor Wage 0 Labor demand Labor Supply Equilibrium employment Equilibrium wage

22. Figure 5 How the Minimum Wage Affects the Labor Market Copyright©2003 Southwestern/Thomson Learning Quantity of Labor Wage 0 Labor Supply Labor surplus (unemployment) Labor demand Minimum wage Quantity demanded Quantity supplied

23. Copyright © 2004 South-Western/Thomson Learning Minimum Wage What determines who is employed? Who wins and who loses from the minimum wage?

24. Copyright © 2004 South-Western/Thomson Learning TAXES Governments levy taxes to raise revenue for public projects.

25. Copyright © 2004 South-Western/Thomson Learning 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.

26. Copyright © 2004 South-Western/Thomson Learning Elasticity and Tax Incidence Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

27. Copyright © 2004 South-Western/Thomson Learning 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.

28. Figure 6 A Tax on Buyers Copyright©2003 Southwestern/Thomson Learning 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). $3.30 90 Equilibrium with tax 2.80 3.00 100

29. Copyright © 2004 South-Western/Thomson Learning 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.

30. Figure 7 A Tax on Sellers Copyright©2003 Southwestern/Thomson Learning 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). 3.00 100 $3.30 90

31. Copyright © 2004 South-Western/Thomson Learning Employment Taxes Anyone who pays someone more than $1400 a year in wages or salary must deduct employment taxes These are called FICA (Federal Insurance Compensation Act). Consist of 12.4% of earnings for Social Security and 2.9% for Medicare. Currently, the government mandates that the employer pays half and the employee pays half. Does it matter?

32. Copyright © 2004 South-Western/Thomson Learning Announcement Problem Set 2, Q6-8 can be handed in NEXT week if you choose. Remember, you still must prepare for the Midterm, next week, Thursday, March 2. It will be held in class.

33. Figure 8 A Payroll Tax Copyright©2003 Southwestern/Thomson Learning Quantity of Labor 0 Wage Labor demand Labor supply Tax wedge Wage workers receive Wage firms pay Wage without tax

34. Copyright © 2004 South-Western/Thomson Learning Tax Incidence or Burden The incidence or burden of a tax on consumers is the difference in price paid by the consumer with the tax and the price paid by consumer without the tax. The incidence or burden of a tax on producers is the difference in price received by the producer without the tax and the price received by producer with the tax.

35. Copyright © 2004 South-Western/Thomson Learning 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.

36. Figure 9 How the Burden of a Tax Is Divided Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (a) Elastic Supply, Inelastic Demand 2.... the incidence of the tax falls more heavily on consumers... 1. When supply is more elastic than demand... Price without tax 3.... than on producers.

37. Figure 9 How the Burden of a Tax Is Divided Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (b) Inelastic Supply, Elastic Demand 3.... than on consumers. 1. When demand is more elastic than supply... Price without tax 2.... the incidence of the tax falls more heavily on producers...

38. Copyright © 2004 South-Western/Thomson Learning 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. ELASTICITY AND TAX INCIDENCE

39. Copyright © 2004 South-Western/Thomson Learning Taxing the Rich in Bath, England In the eighteenth century, the town of Bath decided to raise revenues by imposing a tax on its wealthiest citizens. It decided to achieve this goal by assessing a “window tax”. At the time, the more wealthy an home-owner, the more windows it had. Thus, the more tax he would pay. How do we show whether the strategy worked? Any guesses about what we see in 18 th century Bath homes today?

40. Copyright © 2004 South-Western/Thomson Learning Short Run Window Supply In the short run, the supply of windows (attached to homes) is fixed. What does the supply curve look like then? P Q Number of Windows

41. Copyright © 2004 South-Western/Thomson Learning Effect of a Tax The owners of houses are effectively suppliers of windows (in houses) on the market. A tax on them could be thought of as a dropping the supply curve down. Uh oh, a problem. P Q Number of Windows

42. Copyright © 2004 South-Western/Thomson Learning Effect of a Tax: Use our past knowledge Remember that the effect of a tax can be shown by shifting either the supply curve OR the demand curve down. Thus... The burden of the tax falls fully on the homeowners (the suppliers here) P Q Number of Windows P’

43. Copyright © 2004 South-Western/Thomson Learning What about over the long run? Over the long run, the supply curve of windows on houses is upward sloping. Given the effect of the tax on suppliers, over time, the supply of windows falls. In fact, many homeowners boarded up their windows. There is excess long run demand until the market finds a new equilibrium. P Q Number of Windows P’

44. Copyright © 2004 South-Western/Thomson Learning 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.

45. Copyright © 2004 South-Western/Thomson Learning 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.

46. Copyright © 2004 South-Western/Thomson Learning 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.

47. Copyright © 2004 South-Western/Thomson Learning Case Study: Government Subsidies, Ethanol Since the 1978 Energy Tax Act the U.S. government has subsidized consumption of ethanol, a hydrocarbon that can be used to power gasoline engines. The subsidy has ranged from 4 to 6 cents a gallon and is now 5.4 cents a gallon. (It is a “tax expenditure” in that it reduces federal fuel taxes by this amount.) In total, the policy has cost the U.S. government over $10 Billion.

48. Copyright © 2004 South-Western/Thomson Learning Case Study: Government Subsidies, Ethanol What are the effects of this subsidy in the ethanol market? Why do we see GM advertising its new yellow/green vehicles? What effect has the policy had on corn farmers? How has it affected U.S. energy consumption? Archer Daniels Midland has given over $3million in soft money to both parties. The subsidy is to consumers not to producers, why would ADM do that?