1. Demand, Supply, and Government policies
Econ 100
Lecture 8
Government's effect on prices through price ceilings, price floors, taxes, and subsidies:
Demand, Supply, and Government policies

2. The government may find it necessary to affect prices (and quantities bought and sold) in markets, either to protect the buyers or the sellers or to change the quantities produced or consumed.
These can be done either directly (by imposing price controls) or indirectly (by imposing taxes or subsidies). And price controls can take the form of price ceilings or price floors.
Now we will examine these one after another.

3. Price ceilings
A price ceiling is a maximum price imposed by the government that the actual price in a market is not allowed to exceed. The purpose is to protect buyers from paying too high a price for the good.
If the ceiling is set above the equilibrium price, it will not have any effect on the actual market price and actual quantity sold (it will not be binding).
If the ceiling is set below the equilibrium price, the actual price will be equal to the price ceiling,
and, at this price, QD will exceed QS, and an excess demand or a shortage will result.

4. Effects of a price ceiling (in the short run)
Some buyers will be able to buy all they want at a lower price than before, but some other buyers will be able to buy much less than they are willing to or not buy at all.
Those buyers may be willing to pay (and some sellers will be asking for) a higher price to be paid under the table which will bring the actual price closer to the equilibrium price.
Since QS is not enough, rationing (some mechanism to distribute the available quantity among all the buyers) will be necessary (queues, waiting lists, discrimination, government certificates or stamps).

5. Effects of a price ceiling (in the long run)
Price elasticities of both demand and supply are higher in the long run. This means that QS which is already lower than the equilibrium Q will fall even more in the long run than in the short run (possibly because some producers and sellers will leave the market).
Similarly, QD which is already higher than the equilibrium Q will rise even more in the long run than in the short run.
Consequently, the shortage may increase over time.

6. Example: Rent control In the short run,
the supply of rental houses or flats will be perfectly inelastic and the demand for them will be relatively inelastic.
The effect of rent control will be to reduce rents (so that those who do find a house or flat to rent will pay lower rents)...
at the cost of creating a relatively small shortage which means that a relatively small number of people will not be able to find any houses or flats to rent.

7. In the long run,
Landlords will have less of incentives to maintain the rental houses and flats in good condition, and the quality of buildings for rent will decrease.
Also, the supply of rental houses or flats will be relatively more elastic and the quantity supplied at the controlled rent will decrease more. That is because some rental houses will be converted to be used or employed for other purposes (because landlords will not find renting them as houses profitable enough anymore) or because the supply of rental houses will increase at a much slower rate than the demand for rental houses which will keep increasing as the population increases (because potential landlords will spend less money on buying new houses to rent and construction of new residential housing will slow down).

8. Similarly, the demand for rental houses or flats will be relatively more elastic and the quantity demanded at the controlled rent will increase more. That is because low rents will encourage more people to rearrange their lives and begin to search for rental houses and flats (enter the market for rental houses from the buyer side) instead of sharinghouses and flats and because as population grows over time more people will have to search for rental places at any rent.
As a result of QS decreasing and QD increasing more, the shortage will grow, and all the effects of a shortage (higher prices paid under the table, discrimination) will begin to occur.

9. Price floors
A price floor is a minimum price imposed by the government that the actual price in a market is not allowed to fall below. The purpose is to protect sellers from receiving too low a price for the good.
If the floor is set below the equilibrium price, it will not have any effect on the actual market price and actual quantity sold (it will not be binding).
If the floor is set above the equilibrium price, the actual price will be equal to the price floor,
and, at this price, QS will exceed QD, and an excess supply or a surplus will result.

10. Effects of a price floor (in the short run)
Some sellers will be able to sell all they want at a higher price than before, but some other sellers will be able to sell much less than they are willing to or not sell at all.
Those sellers may be willing to ask for (and some buyers will be offering) a lower price to be paid under the table which will bring the actual price closer to the equilibrium price.
Since QS is too much, rationing (some mechanism to divide the quantity to be sold among all the sellers) will be necessary. (Example: Mafia?)

11. Effects of a price floor (in the long run)
Price elasticities of both demand and supply are higher in the long run. This means that QS which is already higher than the equilibrium Q will rise even more in the long run than in the short run (possibly because some producers and sellers attracted by the high price but not yet discouraged by the rationing will enter the market).
Similarly, QD which is already lower than the equilibrium Q will fall even more in the long run than in the short run,
Consequently, the surplus may increase over time.

12. Example: Minimum wage
Consider a market for a certain type of (low-skilled) labor.
Buyers: employers looking for workers to hire
Sellers: workers looking for employers to sell their labor to
Quantity demanded: number of workers employers are willing to hire over a given period of time (amount of labor demanded)
Quantity supplied: number of workers who are willing to work over a given period of time (amount of labor supplied)
Price (of labor): wage rate (wage per hour or month)

13. When a minimum wage is imposed, it will have to be higher than the equilibrium wage rate in order that it is binding and be meaningful.
Then, amount of labor demanded (by employers) will be less than the amount of labor supplied (by workers).
The difference will be a surplus of labor = unemployment among the workers seeking jobs in this market (which may be large if, for example, demand for labor is highly elastic).
Therefore, while some workers will be protected from being paid too low a wage, some other workers will not be able to find any jobs at the going wage rate.

14. Other possible effects of minimum wages may be:
Workers illegally hired and paid a wage that is less then the minimum wage as well the equilibrium wage (as a result of amount of labor supplied being now more than the amount of labor that would be supplied at the equilibrium)
Discrimination between workers in hiring based on race, ethnicity, sex, or age.

15. But let us go back to the main effect of minimum wage, namely the fact that, while some workers will be protected from being paid too low a wage, some other workers will not be able to find any jobs at the going wage rate.
That some workers being protected from being paid to low a wage is the purpose why minimum wage is imposed and it can be seen as the benefit from the minimum wage.
And that some other workers will not be able to find any jobs at the going wage rate (because minimum wage creates some unemployment) can be seen as one of the costs of minimum wage.

16. What can we say about this cost of minimum wage, that is, the size of the unemployment?
Notice that unemployment arises because, as the minimum wage is imposed,
(1) amount of labor supplied increases, and
(2) amount of labor demanded decreases.
Therefore, the amount of labor created by the minimum wage can be seen as composed of two parts.

17. Let us denote
the amount of labor supplied at the minimum wage by LS(Wmin),
the amount of labor demanded at the minimum wage by LD(Wmin), and
the amount of labor at the equilibrium wage by Le.
Then,
amount of unemployment because of the increase in labor supplied = LS(Wmin) – Le
amount of unemployment because of the decrease in labor demanded = Le – LD(Wmin)

18. The first one of the these represents the number of people who were not employed before but who were not looking for jobs either. They entered the labor market because of the higher wages due to the minimum wage. This number depends on the wage elasticity of labor supply.
The second one of the above represents the number of people who were employed before but who have lost their jobs because the amount of labor demanded has decreased after wages have increased due to the minimum wage. This number depends on the wage elasticity of labor demand.

19. Since the second one is the direct effect of minimum wage on unemployment, one may ask what can be said about its size, or about the wage elasticity of demand for labor.
It turns out that the answer to this question depends on, among other things, the price elasticity of demand for the goods produced by labor.
Let us try to see why. For simplicity, suppose there is only one good that is produced by the labor of workers who are earning the wage on which a minimum wage is imposed, and this good is bought and sold in a perfectly competitive market.

20. Consider first the market for this good
Consider first the market for this good. Before the minimum wage is imposed, the price of the good is P1, and the quantity produced and sold is Q1A, at the prevailing demand for and supply of this good. This happens when the market for labor is in equilibrium and the wage rate is wA and labor supplied as well as labor demanded (and hence labor employed) is L1A.
When the minimum wage is imposed, the wage rate will increase (say, to wB). Since labor is an input for the good that is produced by this labor and the wage rate is the price of an input, the supply curve for the good produced by this type of labor will shift to left.

21. Suppose for a second that the price of the good did not change
Suppose for a second that the price of the good did not change. If that were the case, the quantity supplied of the good would fall to Q1B, and, since less labor is necessary to produce a smaller quantity, the amount of labor demanded would fall to L1B.
These two amounts of labor L1A and L1B are precisely on the demand for labor curve
(which, as we can see, is drawn with the assumption that other things including the price of the good produced by labor are constant along the demand for labor curve).

22. But the price of the good can not remain unchanged
But the price of the good can not remain unchanged. As the wage rate increases from wA to wB and the supply curve of the good produced shifts to left, there will be a shortage and the price of the good will increase until the shortage is eliminated, say, at a new equilibrium price P2 (at which the equilibrium quantity is Q2).
Consequently, the quantity supplied of the good will also increase (from Q1B to Q2B), and, since more labor is necessary to produce this larger quantity, the amount of labor demanded will also increase (from L1B to L2).

23. It should be clear by now that the combination of the wage rate wB and the amount of labor L2 is also on a demand for labor curve, in fact it is on the demand for labor curve drawn assuming that the price of the good is equal to P2 (and on this curve there lies also the combination of wA and the amount of labor necessary to produce the quantity supplied of the good when the price of the good is equal to P2 but the wage rate is equal to wA).
But the important point is that, whereas the amount of unemployment consisting of workers who lose their jobs because of the imposition of the minimum wage appears to be equal to L1A – L1B and relatively large as the price of the good remains unchanged, ...

24. it will be equal to L1A – L2 and relatively smaller since the price of the good will not remain unchanged, and
the more inelastic the demand for the good produced by labor, the larger will be quantity produced after the minimum wage rate is imposed (Q2) and the closer will it be to the quantity produced before the minimum wage rate is imposed (Q1A), and, similarly, the closer will the amount of labor demanded after the minimum wage (L2) to the amount of labor demanded before minimum wage (L1A)
which means that the smaller will the number of workers who lose their jobs because of the minimum wage.

25. The considerations above also indicate that the minimum wage will have some effects on the markets for goods produced by the labor whose wages are imposed a minimum on, and these effects must be taken into account and assessed.
These effects can be analysed also but we will have to wait for such analyses until we develop more tools.

26. Taxes
Governments collect taxes not only to finance their spending but also to affect market outcomes (prices and quantities).
The form of tax that is used to affect the market outcome for a specific good (or service) would be a sales tax imposed on the sales of that good.
It may be relatively easy to tell (by analysis or by intuition) how the price and quantity sold of the good will be affected by a sales tax. But should the tax be imposed on the sellers or on the buyers? How different will the effect be or would it not matter?

27. A tax imposed on the sellers
Let us first consider the case of the tax being imposed on the sellers of the good.
Suppose the tax is expressed as a monetary value per unit sold of the good. Denote this amount by T.
Since the tax is imposed on the sellers, there is no immediate effect on the buyers.
Their demand curve is unchanged and as the market price increases or decreases, quantity demanded by the buyers will decrease or increase along the same demand curve.

28. But the sellers will pay T units of money to the government for every unit sold of the good. This means that, if the price of the good is P, they will receive P – T from the sale of every unit of the good.
As the price received by the sellers falls from P to P – T, quantity supplied by the sellers will also fall at any P. This will appear as a leftward (or upward) shift in the supply curve. Since T is a payment by the sellers, it affects the S curve as if there is an increase (equal to T per unit) in costs or in the price of an input.
Another way of looking at this upward shift in the supply curve is as follows: ...

29. Suppose the sellers were willing to sell a certain quantity Q at a market price of P before any tax is imposed. In order that they continue to supply the same quantity Q after the tax is imposed, the price received by the sellers must stay the same at P, which means that the market price has to rise to P + T so that the sellers still receive (P + T) – T = P.
But if the market price has to increase by T at any Q so that the same Q is supplied, this means that the supply curve shifts up by T at any Q. Notice that the new supply curve is parallel to the initial curve.

30. We can now consider the new market equilibrium that will result from the imposed tax and compare it with the initial equilibrium. Let the equilibrium price and quantity without the tax be Pe and Qe, respectively.
After a tax of T liras per unit are imposed, the D curve stays the same, but the S curve shifts up by T.
In the new equilibrium, the market price rises (to P*) and the quantity falls (to Q*) along the D curve. And for each unit of the good sold, buyers pay P* to the sellers, and sellers pay T out of P* to the government and receive P* – T themselves. Notice that P* – T is less than Pe.

31. We observe that, since the quantity is lower in the new equilibrium, some buyers may have stopped buying this good. But those who do remain in the market will pay a higher price than before. Similarly, some sellers may have stopped selling this good. But those who do remain in the market will receive a lower price than before.
In other words, buyers pay now P* instead of Pe before, which means that they pay P* – Pe more than before.
Also, sellers receive now P* – T instead of Pe before, which means that they receive Pe – (P* – T) less than before.

32. It follows that part of T which is equal to P
It follows that part of T which is equal to P* – Pe is paid by the buyers and the remaining part which is equal to Pe – (P* – T) is paid by the sellers.
Even though the tax was imposed on the sellers, the burden of the tax is shared between sellers and buyers.
This is because the tax imposed (on the sellers) of the amount T per unit causes the market equilibrium change in such a way that P increases and Q decreases but P does not increase by T, it increases by less than T.
Would the conclusion be different if the tax was imposed on buyers instead of sellers?

33. A tax imposed on the buyers
Let us now consider the case of the tax being imposed on the buyers of the good.
Again, suppose the tax is expressed as a monetary value per unit sold of the good, and denote this amount by T.
Since the tax is imposed on the buyers, there is no immediate effect on the sellers.
Their supply curve is unchanged and as the market price increases or decreases, quantity supplied by the sellers will increase or decrease along the same supply curve.

34. But the buyers will pay T units of money to the government for every unit bought of the good. This means that, if the price of the good is P, they will pay P + T at the purchase of every unit of the good.
As the price paid by the buyers rises from P to P + T, quantity demanded by the buyers will also fall at any P. This will appear as a leftward (or downward) shift in the demand curve.
Another way of looking at this downward shift in the demand curve is as follows: ...

35. Suppose the buyers were willing to buy a certain quantity Q at a market price of P before any tax is imposed. In order that they continue to demand the same quantity Q after the tax is imposed, the price paid by the buyers must stay the same at P, which means that the market price has to fall to P – T so that the sellers still pay (P – T) + T = P.
But if the market price has to decrease by T at any Q so that the same Q is demanded, this means that the demand curve shifts down by T at any Q. Notice that the new demand curve is parallel to the initial curve.

36. We can now consider the new market equilibrium that will result from the imposed tax and compare it with the initial equilibrium. Let the equilibrium price and quantity without the tax be Pe and Qe, respectively.
After a tax of T liras per unit are imposed, the S curve stays the same, but the D curve shifts down by T.
In the new equilibrium, the market price falls (to P*) and the quantity falls (to Q*) along the S curve. And for each unit of the good sold, buyers pay P* to the sellers and T to the government so that they pay P* + T in total. Notice that P* + T is larger than Pe.

37. We observe that, since the quantity is lower in the new equilibrium, some buyers may have stopped buying this good. But those who do remain in the market will pay a higher price than before. Similarly, some sellers may have stopped selling this good. But those who do remain in the market will receive a lower price than before.
In other words, buyers pay now P* + T instead of Pe before, which means that they pay P* + T – Pe more than before.
Also, sellers receive now P* instead of Pe before, which means that they receive Pe – P* less than before.

38. It follows that part of T which is equal to P
It follows that part of T which is equal to P* + T – Pe is paid by the buyers and the remaining part which is equal to Pe – P* is paid by the sellers.
Even though the tax was imposed on the buyers, the burden of the tax is shared between sellers and buyers.
This is because the tax imposed (on the buyers) of the amount T per unit causes the market equilibrium change in such a way that P decreases and Q decreases but P does not decrease by T, it decreases by less than T.

39. That the burden of the tax is shared between buyers and sellers is the same conclusion as in the case when the tax was imposed on buyers instead of sellers.
Furthermore, notice that, regardless the S curve shifts up by T or the D curve shifts down by T, Q decreases in such a way that a wedge equal to T is introduced between the price paid by buyers and received by sellers along the initial D and S curves. Hence,
the price paid by the buyers when T is imposed on buyers is the same as when T is imposed on sellers,
the price received by the sellers when T is imposed on buyers is the same as when T is imposed on sellers,

40. and the burden of the tax Is shared the same way regardless of whether the tax is imposed on buyers or sellers.
In order to refer to the manner in which the burden of the tax is shared between buyers and sellers, the term “tax incidence” is used.
We have seen that the tax incidence does not depend on whether the tax is imposed on buyers or on sellers.
What does the tax incidence depend on?

41. What the tax incidence depends on
Consider a market in which the D and S curves have exactly the same price elasticity (the elasticity may be large or small but suppose that E of D is equal to E of S).
In this case, the imposition of a tax by any T will cause the price paid by buyers to increase by exactly the same amount by which the price received by sellers decreases.
Therefore half of T will be paid by buyers and the other half by sellers. In that sense, the burden of the tax will be shared equally by both parties.

42. Now, suppose the S curve remains the same but the D curve is steeper so that it is more inelastic than the S curve (in other words, E of D is smaller than E of S).
In this case, the imposition of a tax by any T will cause the price paid by buyers to increase by more than the amount by which the price received by sellers decreases.
Therefore more than half of T will be paid by buyers and less than half by sellers. In that sense, the burden of the tax will be born more by buyers than by sellers.

43. Finally, return to the initial D and S curves and now suppose that the D curve remains the same but the S curve is steeper so that it is more inelastic than the D curve (in other words, E of D is larger than E of S).
In this case, the imposition of a tax by any T will cause the price paid by buyers to increase by less than the amount by which the price received by sellers decreases.
Therefore less than half of T will be paid by buyers and more than half by sellers. In that sense, the burden of the tax will be born more by sellers than by buyers.

44. We can conclude that the incidence will fall more heavily on those whose price elasticity is relatively lower.
So, if the D in a market is relatively more inelastic compared to the S, buyers will pay a larger fraction of the tax,
and, if the S is relatively more inelastic, the sellers will pay a larger fraction of the tax,
regardless of whom the tax is imposed on.
What is the reason for this?

45. Example: Market for sailboats
Suppose that the government in a country considers taking some measures to change the seriously unequal income distribution in some favorable way. One measure considered is to impose a tax on the buyers in markets for luxury items (since mostly rich people buy luxuries) such as sailboats. Is this a good idea?
First, regardless of whom the tax is imposed on, it will be paid both by buyers and sellers.
Second, the luxury goods typically have high price elasticities of demand (they are relatively more elastic) ...

46. and if the producers are operating relatively close to their capacity, their supply will be probably inelastic.
Under such conditions, price elasticity of D for sailboats will be larger than that of S of them, and a larger fraction of the tax will be paid by producers than by buyers, and
The government will end up taxing producers (who may or may not be earning high incomes) instead of consumers with high income.

47. Subsidies
A subsidy is the opposite of a tax: If a subsidy is imposed on someone, the government pays the amount of the subsidy to whom it is imposed on.
Therefore, the effects of a subsidy are like the effects of a tax except that they are opposite of those the tax.
To see these effects, suppose the subsidy is given to the sellers, and it is expressed as a monetary value per unit sold of the good. Denote this amount by U.
Since the subsidy is given to the sellers, there is no immediate effect on the buyers and the demand curve is unchanged.

48. But the sellers will be paid U units of money by the government for every unit sold of the good. This means that, if the price of the good is P, they will receive P + U from the sale of every unit of the good.
As the price received by the sellers rises from P to P + U, quantity supplied by the sellers will also rise at any P. This will appear as a rightward (or downward) shift in the supply curve. Since U is a payment to the sellers, it affects the S curve as if there is a decrease (equal to U per unit) in costs or in the price of an input.
Notice that the S curve shifts down by U at any Q, and the new supply curve is parallel to the initial curve.

49. Now compare the new market equilibrium that will result from the imposed subsidy with the initial equilibrium. Let the equilibrium price and quantity without the subsidy be Pe and Qe, respectively.
After a subsidy of U liras per unit are imposed, the D curve stays the same, but the S curve shifts down by U.
In the new equilibrium, the market price falls (to P*) and the quantity rises (to Q*) along the D curve. And for each unit of the good sold, buyers pay P* and the government pays U to the sellers, and sellers receive P* + U in total. Notice that P* + U is more than Pe.

50. We observe that, since the quantity is higher in the new equilibrium, there may be some new buyers in the market. But those who were already in the market will pay a lower price than before. Similarly, there may be some new sellers. But those who were already in the market will receive a higher price than before.
In other words, buyers pay now P* instead of Pe before, which means that they pay Pe – P* less than before.
Also, sellers receive now P* + U instead of Pe before, which means that they receive P* + U – Pe more than before.

51. It follows that part of U which is equal to Pe – P
It follows that part of U which is equal to Pe – P* is paid to the buyers and the remaining part which is equal to P* + U – Pe is paid to the sellers.
Even though the subsidy was given to the sellers, the benefit of the subsidy is shared between sellers and buyers.
This is because the subsidy given of the amount U per unit causes the market equilibrium change in such a way that P decreases and Q increases but P does not decrease by U, it decreases by less than U.
Would the conclusion be different if the tax was given to buyers instead of sellers?

52. If the subsidy is given to buyers, the S curve does not change but the D curve shifts right (or up, and the magnitude of the upward shift is equal to U), and
the conclusion that the subsidy is shared between buyers and sellers can be shown to be true regardless of whether the subsidy was imposed on buyers or on sellers.
Furthermore, notice that, regardless the S curve shifts down by U or the D curve shifts up by U, Q increases in such a way that a wedge equal to U is introduced between the price paid by buyers and the price received by seller along the initial D and S curves. Hence,

53. the price paid by the buyers when U is given to buyers is the same as when U is given to sellers,
the price received by the sellers when U is given to buyers is the same as when U is given to sellers,
and the subsidy is shared the same way regardless of whether it is given to buyers or sellers.
Finally, one can also show that the manner in which the subsidy is shared between buyers and sellers depends on the relative price elasticities of D and S curves of the specific good bought and sold in that market.

54. If the D in a market is relatively more inelastic compared to the S, buyers will receive a larger fraction of the subsidy,
and, if the S is relatively more inelastic, the sellers will receive a larger fraction of the subsidy,
regardless of whom the subsidy is given to.
What is the reason for this?