Supply, Demand and Government Policies Chapter 6 Copyright © 2004 by South-Western,a division of Thomson Learning.

Chapter 6 supply,demand,and government policies Examine the effects of government policies that place a ceiling on prices Examine the effects of government policies that put a floor under prices consider how a tax on a good affects the price of the good and the quantity sold

Learn that taxes levied on buyers and taxes levies on sellers are equivalent See how the burden of a tax is split between buyers and sellers

Key concepts Price ceiling Price floor Tax incidence

Supply, Demand, and Government Policies u In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. u While equilibrium conditions may be efficient, it may be true that not everyone is satisfied. u One of the roles of economists is to use their theories to assist in the development of policies.

Price Controls... u Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. u Result in government-created price ceilings and floors.

Price Ceilings & Price Floors Price Ceiling u A legally established maximum price at which a good can be sold. Price Floor u A legally established minimum price at which a good can be sold.

Price Ceilings 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.

A Price Ceiling That Is Not Binding... $4 3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply Price ceiling Equilibrium price 100 Equilibrium quantity Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

A Price Ceiling That Is Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 2 Demand Supply Equilibrium price Price ceiling Shortage 125 Quantity demanded 75 Quantity supplied Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Effects of Price Ceilings A binding price ceiling creates... shortages because Q D > Q S. u Example: Gasoline shortage of the 1970s nonprice rationing u Examples: Long lines, Discrimination by sellers

Lines at the Gas Pump In 1973 OPEC raised the price of crude oil in world markets. Because crude oil is the major input used to make gasoline, the higher oil prices reduced the supply of gasoline. What was responsible for the long gas lines? Economists blame government regulations that limited the price oil companies could charge for gasoline.

The Price Ceiling on Gasoline Is Not Binding... $4 P1P1 Quantity of Gasoline 0 Price of Gasoline Q1Q1 Demand Supply Price ceiling 1. Initially, the price ceiling is not binding...

The Price Ceiling on Gasoline Is Binding... P1P1 Quantity of Gasoline 0 Price of Gasoline Q1Q1 Demand S1S1 Price ceiling S2S2 2. …but when supply falls... P2P2 3. …the price ceiling becomes binding... 4. …resulting in a shortage.

Rent Control u Rent controls are ceilings placed on the rents that landlords may charge their tenants. u 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.

Rent Control in the Short Run... Quantity of Apartments 0 Rental Price of Apartment Demand Supply Controlled rent Shortage Supply and demand for apartments are relatively inelastic

Rent Control in the Long Run... Quantity of Apartments 0 Rental Price of Apartment Demand Supply Controlled rent Shortage Because the supply and demand for apartments are more elastic... …rent control causes a large shortage

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

A Price Floor That Is Not Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 100 Equilibrium quantity Equilibrium price Demand Supply Price floor 2

A Price Floor That Is Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium price Demand Supply Price floor$4 120 Quantity supplied 80 Quantity demanded Surplus Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Effects of a Price Floor u A price floor prevents supply and demand from moving toward the equilibrium price and quantity. u When the market price hits the floor, it can fall no further, and the market price equals the floor price.

Effects of a Price Floor 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. u Examples: The minimum wage, Agricultural price supports

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.

The Minimum Wage Quantity of Labor 0 Wage Equilibrium wage Labor demand Labor supply A Free Labor Market Equilibrium employment

Minimum wage The Minimum Wage Quantity of Labor 0 Wage Labor demand Labor supply Quantity supplied Quantity demanded Labor surplus (unemployment) A Labor Market with a Minimum Wage

Taxes Governments levy taxes to raise revenue for public projects.

What are some potential impacts of taxes? u Taxes discourage market activity. u When a good is taxed, the quantity sold is smaller. u Buyers and sellers share the tax burden.

Taxes u Tax incidence is the study of who bears the burden of a tax. u Taxes result in a change in market equilibrium. u Buyers pay more and sellers receive less, regardless of whom the tax is levied on.

Impact of a 50¢ Tax Levied on Buyers... 3.00 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 100 D1D1 Supply, S 1 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). D2D2 Copyright © 2001 by Harcourt, Inc. All rights reserved

3.00 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 10090 $3.30 Price buyers pay D1D1 D2D2 Equilibrium with tax Supply, S 1 Equilibrium without tax Impact of a 50¢ Tax Levied on Buyers... 2.80 Price sellers receive Copyright © 2001 by Harcourt, Inc. All rights reserved Price without tax Tax ($0.50)

What was the impact of tax? u Taxes discourage market activity. u When a good is taxed, the quantity sold is smaller. u Buyers and sellers share the tax burden.

3.00 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 100 90 S1S1 S2S2 Demand, D 1 Impact of a 50¢ Tax on Sellers... Price without tax 2.80 Price sellers receive $3.30 Price buyers pay Equilibrium without tax Copyright © 2001 by Harcourt, Inc. All rights reserved A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50). Tax ($0.50) Equilibrium with tax

A Payroll Tax Quantity of Labor 0 Wage Wage without tax Labor demand Labor supply Tax wedge Wage firms pay Wage workers receive

The Incidence of Tax u In what proportions is the burden of the tax divided? u 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.

Elastic Supply, Inelastic Demand... Quantity0 Price Demand Supply Tax 1. When supply is more elastic than demand... 2....the incidence of the tax falls more heavily on consumers... 3....than on producers. Price without tax Price buyers pay Price sellers receive

Inelastic Supply, Elastic Demand... Quantity0 Price Demand Supply Price without tax Tax 1. When demand is more elastic than supply... 2....the incidence of the tax falls more heavily on producers... 3....than on consumers. Price buyers pay Price sellers receive

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.

Summary u Price controls include price ceilings and price floors. u A price ceiling is a legal maximum on the price of a good or service. An example is rent control. u A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage.

Summary u Taxes are used to raise revenue for public purposes. u When the government levies a tax on a good, the equilibrium quantity of the good falls. u A tax on a good places a wedge between the price paid by buyers and the price received by sellers.

Summary u The incidence of a tax refers to who bears the burden of a tax. u The incidence of a tax does not depend on whether the tax is levied on buyers or sellers. u The incidence of the tax depends on the price elasticities of supply and demand.

Graphical Review