1. Government Policies
Economics 101

2. Why 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. 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. Price Ceiling and Price Floor
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. Binding Price Ceiling?
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.
Sellers must ration the scarce goods
The rationing mechanisms – not desirable

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

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

8. Binding Price Ceiling A binding price ceiling creates
shortages because QD > QS.
Example: Gasoline shortage of the 1970s
nonprice rationing
Examples: Long lines, discrimination by sellers

9. Case: Lines at the Gas Pump
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?

10. (a) The Price Ceiling on Gasoline Is Not Binding
Price of
Gasoline
Demand
Supply, S1
1. Initially,
the price
ceiling
is not
binding . . .
Price ceiling P1 Q1
Quantity of
Gasoline
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11. (b) The Price Ceiling on Gasoline Is Binding
Price of S2
Gasoline
but when
supply falls . . .
Demand S1 P2 QS QD
Price ceiling
resulting
in a
shortage.
the price
ceiling becomes
binding . . . P1 Q1
Quantity of
Gasoline
Copyright©2003 Southwestern/Thomson Learning

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

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

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

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

18. Binding Price Floor A binding price floor causes . . .
a surplus because QS > QD.
nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria.
Examples: The minimum wage, agricultural price supports

19. Case: 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.

20. Figure 5 How the Minimum Wage Affects the Labor Market
Supply
Labor
demand
Equilibrium
employment
wage
Quantity of
Labor
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21. Figure 5 How the Minimum Wage Affects the Labor Market
Supply
Labor
demand
Labor surplus
(unemployment)
Minimum
wage
Quantity
demanded
Quantity
supplied
Quantity of
Labor
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22. Taxes Governments levy taxes to raise revenue for public projects.
Taxes discourage market activity.
When a good is taxed (commodity tax), the quantity sold is smaller.
Buyers and sellers share the tax burden.

23. Tax Incidence
Tax incidence is the manner in which the burden of a tax is shared among participants in a market.
Tax incidence is the study of who bears the burden of a tax.
_ Statutory incidence (legal incidence)
_ Economic incidence

24. Commodity Tax
Sale Tax
Excise Tax

25. Sale Tax Sale Tax: a tax on buyer (statutory incidence) Example: USA
Case: $0.50 tax per ice-cream cone bought.

26. Figure 6 A Tax on Buyers Price of Ice-Cream Price buyers pay Supply,
Cone D1 D2
$3.30 90
Equilibrium without tax
Tax ($0.50)
Price
without
tax
3.00
100
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).
2.80
Equilibrium
with tax
Price
sellers
receive
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

27. Who actually bears the tax burden?
Buyers and sellers share the tax burden. (economic incidence)
In this example, buyers share $0.30 and sellers share $0.20.

28. Excise Tax Excise Tax: A Tax on Seller (Statutory incidence)
Example: Taiwan
Case: $0.50 tax per ice-cream cone sold

29. Figure 7 A Tax on Sellers Price of Ice-Cream Demand, D1
shifts the supply
curve upward
by the amount of
the tax ($0.50).
Price
buyers
pay
Cone S2
Equilibrium
with tax S1
$3.30 90
Tax ($0.50)
Price
without
tax
3.00
100
Equilibrium without tax
2.80
Price
sellers
receive
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

30. Who actually bears the tax burden?
Buyers and sellers share the tax burden. (economic incidence)
In this example, buyers share $0.30 and sellers share $0.20.

31. 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.

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

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

34. 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.

35. ALGEBRA Demand equation: P=10-Qd Supply equation: P=Qs Demand = Supply
10-Q*=Q*, Q*=5; P*=5
Equilibrium quantity=5, equilibrium price=5

36. CASE 1: TAX ON SELLER $2/UNIT SOLD
Demand equation: P=10-Qd
New supply equation: P-2=Qs
Demand = New supply
10-Q**=2+Q**, Q**=4, P**=6 (buyer price), P**- 2=4 (seller price)
Buyer shares $1 tax burden
Seller shares $1 tax burden

37. CASE 2: TAX ON BUYER $2/UNIT BOUGHT
New Demand equation: P+2=10-Qd
Supply equation: P=Qs
New Demand = Supply
8-Q***=Q***, Q***=4, P***=4 (seller price), P***+2=6 (buyer price)
Buyer shares $1 tax burden
Seller shares $1 tax burden

38. Quiz Demand is perfectly inelastic and supply is elastic
1. Tax on buyers (sales tax)
2. Tax on sellers (excise tax)

39. Quiz Supply is perfectly inelastic and demand is elastic
1. Tax on buyers (sales tax)
2. Tax on sellers (excise tax)