1. © 2007 Thomson South-Western, all rights reserved N. G R E G O R Y M A N K I W PowerPoint ® Slides by Ron Cronovich 6 P R I N C I P L E S O F F O U R T H E D I T I O N Supply, Demand, and Government Policies

2. 1 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Government Intervention in Markets: Motivation  Price ceilings to help consumers (e.g. rent control)  Price floors to help producers (e.g. farm price supports)  Price floors on wages (minimum wage, require “time and one half” for overtime pay)  Sales taxes Raise revenue Reduce amount sold of a good As “user charge” for consuming a good or service.  Consumer protection (product safety, worker safety, prohibiting certain transactions – illegal products/services)

3. 2 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES How does government intervention affect markets and how do we evaluate such policies? What are the economic consequences of market intervention? What are the costs and benefits?  What is the incidence of a tax (i.e. who pays a tax?) What determines “tax incidence”?  THE BIG ISSUE: Intervention in competitive markets affects how the market system performs, with consequences often affecting buyers and sellers. Is there a compelling public interest to warrant the intervention?

4. 3 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Rent Control and Housing Market Outcomes (Would you support rent control in College Park?) The eq’m rent ($800) is above the ceiling and therefore illegal. The ceiling is a binding constraint on the price, and causes a shortage. P Q D S $800 Price ceiling $500 250 400 shortage

5. 4 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Shortages and Rationing  With a shortage, sellers must ration the goods among buyers.  Some rationing mechanisms: (1) wait lists, (2) discrimination according to sellers’ biases (3) side payments (bribes).  These mechanisms are often unfair. They are also inefficient; the goods don’t necessarily go to the buyers who value them most highly.

6. 5 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Price ceilings and Supply Adjustments  Supply adjustments to price regulation reflect decisions of sellers, who are driven by profit maximization – adjusting their capital investments based on profitability. Government can not keep sellers from exiting a market (removing their capital!).  Downward housing supply adjustments include: (a) selling units to owner-occupants (b) reducing the quality of the unit to fit the price – essentially ‘shifting’ the unit to another market.

7. 6 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES History of the Minimum Wage  Enacted 1938, @25 cents/hr, to provide minimum income level for working. Initial level about 35% of the average manufacturing wage.  Increased periodically, reached 50% of average manu. wage in 1970, but fewer increases since 1980’s, and real value of minimum wage declined. Now about 32% of ave. manu. wage.  Wage remained at $5.15/hr from 1998, until 2007 when it was increased to $7.35 by 2009.

8. 7 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Debate over the Minimum Wage  Arguments supporting the minimum wage: fundamental fairness to workers (worker still in poverty if working full time at present min. wage; higher minimum wage promotes work;  Opponents of a higher wage: loss of jobs and unemployment among unskilled; lost work by teenagers deprives teenagers of experience and commitment to work; financial burden on small businesses; higher labor costs increases prices  Democrats vs Republicans on this issue?

9. 8 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES EXAMPLE 2: The Market for Unskilled Labor (in absence of wage laws) Eq’m w/o price controls: $4/hour. W L D S Wage paid to unskilled workers $4 500 Quantity of unskilled workers

10. 9 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES How Price Floors Affect Market Outcomes W L D S $4 Price floor $5.15 The eq’m wage ($4) is below the floor and therefore illegal. The floor is a binding constraint on the wage, and causes a surplus (i.e., less employment). 400 550 labor surplus

11. 10 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Debate about the Effects  Republicans typically oppose, stressing job losses and burden on small businesses. Republican congressional opposition since 1998, Senate opposing an increase 11 times since. Democrats typically argue for an increase.  In 2006, Republicans proposed combining increase to $7.25 over three years with an extension of estate tax reductions past 2010 -- expecting Democrats to accept estate tax reductions as part of deal to raise minimum wage. Democrats vote against !  In 2007, bill passed after Democrats won majority in both houses of Congress.

12. 11 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Empirical Evidence Many studies of D and S supply curves for labor:  Evidence suggests elasticity is low,.1 to.3, hence job loss would be limited. Inelastic labor demand implies total wage earnings increases (though fewer work!).  Increasing the minimum wage also increases the wages workers with only somewhat better skills and wages.  Higher wage costs shift the supply curve of producers, hence prices increase in product markets.

13. 12 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Taxes  The government levies taxes on many goods & services. Taxes are a source of revenue, and also used to reduce or discourage consumption of selected goods or services. (e.g. cigarette taxes).  The tax can be a percentage of the good’s price, or a specific amount for each unit sold. For simplicity, we analyze per-unit taxes only.

14. 13 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES The Politics Behind Tax Policy  Federal excise taxes: current level vs. level if adjusted for inflation since 1951! Resistance to increases!!!  Current tax If Adjusted  Beer $18/barrell $55.88  Wine $1.57/gallon $4.16  Spirits $12.50/gallon $65.19  Maryland taxes: beer tax last raised in 1972. Raising Md. tax to national average raises tax revenue from $23 mill. To $37 mill.  State cigarette taxes (per pack): Rhode Island ($2.46) down to S. Carolina (.07).

15. 14 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES The Incidence (who pays) of a tax  The government can impose taxes on either the buyer or seller.  The “statutory incidence” of a tax is the economic agent who is legally responsible to pay the tax.  The “economic incidence’ of a tax is the final distribution of the tax burden between buyer and seller.  Tax shifting occurs in most cases, as the burden of a tax is shared between buyer and seller, even though only one pays.

16. 15 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES S1S1 EXAMPLE 3: The Market for Pizza Eq’m w/o tax P Q D1D1 $10.00 500

17. 16 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES S1S1 D1D1 $10.00 500 430 A Tax on Buyers A tax on buyers shifts the D curve down by the amount of the tax. P Q D2D2 $11.00 P B = $9.50 P S = Tax Effects of a $1.50 per unit tax on buyers The price buyers pay rises, the price sellers receive falls, eq’m Q falls.

18. 17 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 430 S1S1 The Incidence of a Tax: how the burden of a tax is shared among market participants P Q D1D1 $10.00 500 D2D2 $11.00 P B = $9.50 P S = Tax Because of the tax, buyers pay $1.00 more, sellers get $0.50 less. Because of the tax, buyers pay $1.00 more, sellers get $0.50 less.

19. 18 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES S1S1 A Tax on Sellers A tax on sellers shifts the S curve up by the amount of the tax. P Q D1D1 $10.00 500 S2S2 430 $11.00 P B = $9.50 P S = Tax Effects of a $1.50 per unit tax on sellers The price buyers pay rises, the price sellers receive falls, eq’m Q falls.

20. 19 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES S1S1 The Outcome Is the Same in Both Cases! What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. P Q D1D1 $10.00 500 430 $9.50 $11.00 P B = P S = Tax The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers!

21. A C T I V E L E A R N I N G 2 : Effects of a tax 20 Q P S 0 The market for hotel rooms D Suppose govt imposes a tax on buyers of $30 per room. Find new Q, P B, P S, and incidence of tax.

22. A C T I V E L E A R N I N G 2 : Answers 21 Q P S 0 The market for hotel rooms D Q = 80 P B = $110 P S = $80 Incidence buyers: $10 sellers: $20 Tax P B = P S =

23. 22 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Elasticity and Tax Incidence CASE 1: Supply is more elastic than demand P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden Price if no tax PBPB PSPS In this case, buyers bear most of the burden of the tax. Why? Demand is inelastic –i.e. ‘I’ll pay any price!’

24. 23 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Elasticity and Tax Incidence CASE 2: Demand is more elastic than supply P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden Price if no tax PBPB PSPS In this case, sellers bear most of the burden of the tax. Why? Elastic supply: sellers do not cut back!

25. 24 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Elasticity and Tax Incidence  If buyers’ price elasticity > sellers’ price elasticity, buyers can more easily leave the market when the tax is imposed, so buyers will bear a smaller share of the burden of the tax than sellers.  If sellers’ price elasticity > buyers’ price elasticity, the reverse is true.

26. 25 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES CASE STUDY: Who Pays the Luxury Tax?  1990: In a budget crisis, Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc. (Tax was repealed after a short time.)  Goal of the tax: to raise revenue from those who could most easily afford to pay – wealthy consumers.  But who really pays this tax?

27. 26 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES CASE STUDY: Who Pays the Luxury Tax? The market for yachts P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden PBPB PSPS Demand is price-elastic. In the short run, supply is inelastic. Hence, companies that build yachts pay most of the tax.

28. 27 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Consumer Protection (Poor quality, risks to health and safety of buyers)  Regulation not needed: Consumers have right and the responsibility to assess costs and benefits of goods (‘Buyer Beware.’) Market will drive out bad and unsafe goods. Sue seller if product not meet advertised standards or state laws regarding quality that buyer should presume is present in the good.  Government regulation controlling quality, etc. limits free choices of willing buyers and sellers, imposes burden on sellers, and increases prices

29. 28 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Alternative view: consumer protection is needed (Consumer Product Safety Commission, Food and Drug Administration)  Regulation needed: Too costly for consumers to become informed, sometimes impossible to be an ‘expert’ on everything. Infrequent purchase – I can not afford to buy a bad product and be stuck with it for years. Law suits costly, take time, outcomes uncertain. I may not receive fair compensation for losses.  “I will delegate some of my free choice to regulations, to avoid the costs noted above.”

30. 29 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES CONCLUSION: Government Policies and the Allocation of Resources  Each of the policies in this chapter affects the allocation of society’s resources. Example 1: a tax on pizza reduces the eq’m quantity of pizza. Since the economy is producing fewer pizzas, some resources (workers, ovens, cheese) will become available to other industries. Example 2: a binding minimum wage causes a surplus of workers, a waste of resources.  So, it’s important for policymakers to apply such policies very carefully.

31. 30 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES CHAPTER SUMMARY  A price ceiling is a legal maximum on the price of a good. An example is rent control. If the price ceiling is below the eq’m price, it is binding and causes a shortage.  A price floor is a legal minimum on the price of a good. An example is the minimum wage. If the price floor is above the eq’m price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment.

32. 31 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES CHAPTER SUMMARY  A tax on a good places a wedge between the price buyers pay and the price sellers receive, and causes the eq’m quantity to fall, whether the tax is imposed on buyers or sellers.  The incidence of a tax is the division of the burden of the tax between buyers and sellers, and does not depend on whether the tax is imposed on buyers or sellers.  The incidence of the tax depends on the price elasticities of supply and demand.