Supply, Demand, and Government Policies In a free, unregulated market system,
Chapter 6. Supply, Demand, and Government Policies
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.
1) CONTROLS ON PRICES Economists
– develop theories to explain phenomenon
Policy advisors.
– use theories to explain the world for the
better
Two policies
– Price controls (rent-controls, minimum-
wage laws) – Tax (impact of taxes to influence market outcome)
Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.
Result in government-created price ceilings and floors.
CONTROLS ON PRICES Price Ceiling
– 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.
Figure 1 A Market with a Price Ceiling
How Price Ceilings Affect Market Outcomes
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
Effects of Price Ceilings
Effects of Price Ceilings
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 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?
• 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
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 Rent controls are ceilings placed on the rents that landlords may charge their tenants. the poor by making housing more affordable.
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
people respond to incentives free market
When the government imposes a price
under rent control
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.
The price floor is binding if set above the equilibrium price, leading to a surplus.
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 A price floor prevents supply and demand from moving toward the equilibrium price and quantity.
When the market price hits the floor, it can fall
How Price Floors Affect Market Outcomes
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
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 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
Proponents – One way to raise the income of working poor
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 Markets are usually a good way to organize economic activity
If prices are set by laws, they obscure the signals that efficiently allocate scarce resources.
Price ceilings and price floors often hurt the people they are intended to help.
Other ways: housing subsidy, wage
subsidy (but with cost of raising tax)
How Taxes on Buyers (and Sellers) Affect Market Outcomes
Governments levy taxes to raise revenue for public projects.
Taxes discourage market activity. When a good is taxed, the
quantity sold is smaller.
Buyers and sellers share
the tax burden.
Elasticity and Tax Incidence
Elasticity and 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.
Taxes result in a change in market
Who bears the tax burden?
equilibrium.
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 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
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
In what proportions is the burden of the
Wage Labor supply
tax divided?
How do the effects of taxes on sellers compare to those levied on buyers?
Wage firms pay Tax wedge
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
The burden of a tax falls more
3. . . . than on consumers.
Quantity
Copyright©2003 Southwestern/Thomson Learning