1) CONTROLS ON PRICES. Chapter 6. Supply, Demand, and Government Policies. Economists develop theories to explain phenomenon

Supply, Demand, and Government Policies ƒ In a free, unregulated market system, Chapter 6. Supply, Demand, and Government Policies market forces est...
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Supply, Demand, and Government Policies ƒ In a free, unregulated market system,

Chapter 6. Supply, Demand, and Government Policies

market forces establish equilibrium prices and exchange quantities.

ƒ While equilibrium conditions may be

efficient, it may be true that not everyone is satisfied.

ƒ One of the roles of economists is to use their theories to assist in the development of policies.

1) CONTROLS ON PRICES ƒ Economists

– develop theories to explain phenomenon

ƒ Policy advisors.

– use theories to explain the world for the

better

ƒ Two policies

– Price controls (rent-controls, minimum-

wage laws) – Tax (impact of taxes to influence market outcome)

ƒ Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.

ƒ Result in government-created price ceilings and floors.

CONTROLS ON PRICES ƒ Price Ceiling

– A legal maximum on the price at which a

good can be sold.

ƒ Price Floor

– A legal minimum on the price at which a

good can be sold.

Figure 1 A Market with a Price Ceiling

How Price Ceilings Affect Market Outcomes

ƒ 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.

Figure 1 A Market with a Price Ceiling

(a) A Price Ceiling That Is Not Binding Price of Ice-Cream Cone

Price of Ice-Cream Cone

Supply

$4

(b) A Price Ceiling That Is Binding

Price ceiling

Supply

Equilibrium price

3

$3

Equilibrium price

2

Price ceiling

Shortage Demand 0

100 Equilibrium quantity

Quantity of Ice-Cream Cones

Demand 0

75

125

Quantity supplied

Quantity demanded

Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

How Price Ceilings Affect Market Outcomes

How Price Ceilings Affect Market Outcomes

ƒ Effects of Price Ceilings

ƒ Effects of Price Ceilings

ƒ A binding price ceiling creates

- Not all buyers benefit from a price ceiling

– shortages because QD > QS. • Example: Gasoline shortage of the 1970s – nonprice rationing • Examples: Long lines, discrimination by sellers

since some will be unable to purchase the product.

- Rationing mechanism - under price ceiling: inefficient and unfair - under free competitive market: efficient

and fair

CASE STUDY: Lines at the Gas Pump ƒ 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.

ƒ What was responsible for the long gas lines?

• Economists blame government regulations that limited the price oil companies could charge for gasoline.

Figure 2 The Market for Gasoline with a Price Ceiling (a) The Price Ceiling on Gasoline Is Not Binding Price of Gasoline

Supply, S1 1. Initially, the price ceiling is not binding . . .

Price ceiling P1

Demand 0

Q1

Quantity of Gasoline Copyright©2003 Southwestern/Thomson Learning

Figure 2 The Market for Gasoline with a Price Ceiling (b) The Price Ceiling on Gasoline Is Binding Price of Gasoline

S2 2. . . . but when supply falls . . . S1

ƒ The goal of rent control policy is to help

P2

Price ceiling 3. . . . the price ceiling becomes binding . . .

P1 4. . . . resulting in a shortage.

Demand 0

QS

QD Q1

CASE STUDY: Rent Control in the Short Run and Long Run ƒ Rent controls are ceilings placed on the rents that landlords may charge their tenants. the poor by making housing more affordable.

ƒ One economist called rent control “the best way to destroy a city, other than bombing.”

Quantity of Gasoline Copyright©2003 Southwestern/Thomson Learning

Figure 3 Rent Control in the Short Run and in the Long Run

Figure 3 Rent Control in the Short Run and in the Long Run

(a) Rent Control in the Short Run (supply and demand are inelastic) Rental Price of Apartment

(b) Rent Control in the Long Run (supply and demand are elastic) Rental Price of Apartment

Supply

Supply

Controlled rent

Controlled rent Shortage

Demand

Shortage Demand 0

Quantity of Apartments Copyright©2003 Southwestern/Thomson Learning

0

Quantity of Apartments Copyright©2003 Southwestern/Thomson Learning

The effect of rent control

How Price Floors Affect Market Outcomes

ƒ people respond to incentives ƒ free market

ƒ When the government imposes a price

ƒ under rent control

ƒ The price floor is not binding if set below

– keep building clean and safe to get high rents – creates shortages, – waiting lists, discrimination, under-the-table

payments

– lose incentive to respond to tenant’s concerns,

low-quality housing

floor, two outcomes are possible. the equilibrium price.

ƒ The price floor is binding if set above the equilibrium price, leading to a surplus.

ƒ Policy-makers

– make discrimination illegal, require adequate

living condition.

– difficult to enforce, costly.

Figure 4 A Market with a Price Floor

Figure 4 A Market with a Price Floor

(a) A Price Floor That Is Not Binding Price of Ice-Cream Cone

(b) A Price Floor That Is Binding Price of Ice-Cream Cone

Supply

Surplus

Equilibrium price

$4

$3

Price floor

2

3

100 Equilibrium quantity

Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Price floor

Equilibrium price

Demand 0

Supply

Demand 0

80 120 Quantity of Quantity Quantity Ice-Cream Cones demanded supplied Copyright©2003 Southwestern/Thomson Learning

How Price Floors Affect Market Outcomes ƒ A price floor prevents supply and demand from moving toward the equilibrium price and quantity.

ƒ When the market price hits the floor, it can fall

How Price Floors Affect Market Outcomes

ƒ A binding price floor causes . . .

– a surplus because QS > QD. – nonprice rationing is an alternative

mechanism for rationing the good, using discrimination criteria.

no further, and the market price equals the floor price.

The Minimum Wage

ƒ An important example of a price floor is

• Examples: The minimum wage, agricultural price supports

Figure 5 How the Minimum Wage Affects the Labor Market

Wage

the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.

Labor Supply

Equilibrium wage

Labor demand 0

Equilibrium employment

Quantity of Labor Copyright©2003 Southwestern/Thomson Learning

Figure 5 How the Minimum Wage Affects the Labor Market

Minimum wage in the labor market ƒ There are many types of labor markets

Wage

Labor surplus (unemployment)

Labor Supply

Minimum wage

– Skilled vs. unskilled – Impact • 10% increase in min wage => 1 to 3% fall in employment • Affects supply of labor

ƒ Proponents – One way to raise the income of working poor

ƒ Opponents Labor demand 0

Quantity demanded

Quantity supplied

– Unemployment, poorly targeted policy. – Alternative: subsidy

Quantity of Labor Copyright©2003 Southwestern/Thomson Learning

Evaluating Price Controls ƒ Markets are usually a good way to organize economic activity

ƒ If prices are set by laws, they obscure the signals that efficiently allocate scarce resources.

ƒ Price ceilings and price floors often hurt the people they are intended to help.

ƒ Other ways: housing subsidy, wage

subsidy (but with cost of raising tax)

How Taxes on Buyers (and Sellers) Affect Market Outcomes

ƒ Governments levy taxes to raise revenue for public projects.

ƒ Taxes discourage market activity. ƒ When a good is taxed, the

quantity sold is smaller.

ƒ Buyers and sellers share

the tax burden.

Elasticity and Tax Incidence

Elasticity and Tax Incidence

ƒ Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

ƒ Tax incidence is the study of who bears the burden of a tax.

ƒ Taxes result in a change in market

ƒ Who bears the tax burden?

equilibrium.

ƒ Buyers pay more and sellers receive less, regardless of whom the tax is levied on.

Figure 6 A Tax on Buyers

Price of Ice-Cream Price Cone buyers pay $3.30 Price 3.00 2.80 without tax Price sellers receive

Elasticity and Tax Incidence ƒ What was the impact of tax?

Equilibrium without tax

Tax ($0.50)

A tax on buyers shifts the demand curve downward by the size of the tax ($0.50).

Equilibrium with tax

D1 D2 0

90

100

Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. – Buyers and sellers share the tax burden. – –

Supply, S1

Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Figure 7 A Tax on Sellers

Price of Ice-Cream Price Cone buyers pay $3.30 3.00 Price 2.80 without tax

Implication of tax imposition S2

Equilibrium with tax

S1 Tax ($0.50)

A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50).

Equilibrium without tax

Price sellers receive

ƒ Implication – Taxes on buyers and taxes on sellers

are equivalent – tax wedges: the wedge is the same – buyers and sellers share the burden of tax – the only difference is who sends the money to govt

Demand, D1

90

0

100

Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Figure 8 A Payroll Tax

Elasticity and Tax Incidence

ƒ In what proportions is the burden of the

Wage Labor supply

tax divided?

ƒ How do the effects of taxes on sellers compare to those levied on buyers?

Wage firms pay Tax wedge

ƒ The answers to these questions depend

Wage without tax

on the elasticity of demand and the elasticity of supply.

Wage workers receive

Labor demand 0

Quantity of Labor Copyright©2003 Southwestern/Thomson Learning

Figure 9 How the Burden of a Tax Is Divided

Figure 9 How the Burden of a Tax Is Divided

(a) Elastic Supply, Inelastic Demand (b) Inelastic Supply, Elastic Demand Price 1. When supply is more elastic than demand . . .

Price 1. When demand is more elastic than supply . . .

Price buyers pay Supply

Price buyers pay

Supply

Price without tax Tax

2. . . . the incidence of the tax falls more heavily on consumers . . .

Price without tax Price sellers receive 3. . . . than on producers.

Tax

Price sellers receive

Demand

0

Copyright©2003 Southwestern/Thomson Learning

ELASTICITY AND TAX INCIDENCE So, how is the burden of the tax divided?

heavily on the side of the market that is less elastic.

2. . . . the incidence of the tax falls more heavily on producers . . .

Demand

Quantity 0

ƒ The burden of a tax falls more

3. . . . than on consumers.

Quantity

Copyright©2003 Southwestern/Thomson Learning

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