Supply, Demand and Government Policies Chapter 6 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.
Supply, Demand, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. u One of the things government can do is to set price controls when the market price is seen as unfair to either buyers or sellers. u
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Price Ceilings & Price Floors Price Ceiling u
A legally established maximum price at which a good can be sold. (Rent Controls)
Price Floor u
A legally established minimum price at which a good can be sold. (Price Supports for Agriculture)
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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. u The price ceiling is binding if set below the equilibrium price, leading to a shortage. u
u
Binding means that there is an economic impact.
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A Price Ceiling That Is Binding... Price of Ice-Cream Cone
Supply
Equilibrium price $3 Price ceiling
2 Shortage
Demand 0
75 Quantity supplied
125 Quantity demanded
Quantity of Ice-Cream Cones
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A Price Ceiling That Is Not Binding... Price of Ice-Cream Cone
Supply Price ceiling
$4
3 Equilibrium price
Demand 0
100 Equilibrium quantity
Quantity of Ice-Cream Cones
2
Effects of Price Ceilings A binding price ceiling creates ... º shortages because QD > QS. u Example:
Gasoline shortage of the
1970s
º nonprice rationing u Examples:
Long lines, Discrimination
by sellers
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The Price Ceiling on Gasoline Is Not Binding... Price of Gasoline 1. Initially, the price ceiling is not binding...
Supply Price ceiling
$4
P1
Demand 0
Quantity of Gasoline
Q1
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The Price Ceiling on Gasoline Is Binding... S2
Price of Gasoline
2. …but when supply falls...
S1 P2 Price ceiling
P1
3. …the price ceiling becomes binding...
4. …resulting in a shortage.
Demand 0
Q1
Quantity of Gasoline
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Rent Control u Rent
controls are ceilings placed on the rents that landlords may charge their tenants. u Rent control can make housing more affordable. u With a price ceiling, you cannot go above the ceiling. u But what about the landlords? Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Rent Control in the Short Run... Rental Price of Apartment
Supply
Supply and demand for apartments are relatively inelastic-Why is the supply curve vertical? Controlled rent
Shortage
Demand Quantity of Apartments
0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Rent Control in the Long Run... Rental Price of Apartment
Because the supply and demand for apartments are more elastic... What happens in the long run?
Supply
…rent control causes a large shortage
Controlled rent
Shortage
Demand 0
Quantity of Apartments
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Price Floors When the government imposes a price floor, two outcomes are possible. 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. u
u
Think of price floors as not being able to go below the floor.
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A Price Floor That Is Not Binding... Price of Ice-Cream Cone
Supply
Equilibrium price
$3 Price floor
2
Demand 100
0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Equilibrium quantity
Quantity of Ice-Cream Cones
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A Price Floor That Is Binding... Price of Ice-Cream Cone
Surplus $4
Supply
Price floor
$3 Equilibrium price
Demand 0
80
Quantity demanded
120
Quantity supplied
Quantity of Ice-Cream Cones
5
Effects of a Price Floor A binding price floor causes . . . º a surplus because QS >QD. º nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria. uExamples: The minimum wage, Agricultural price supports uState Minimum Wages Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The Minimum Wage Wage
A Free Labor Market Labor supply
Equilibrium wage
Labor demand 0
Equilibrium employment
Quantity of Labor
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The Minimum Wage Wage
A Labor Market with a Minimum Wage Labor surplus (unemployment)
Labor supply
Minimum wage
Labor demand 0
Quantity demanded
Quantity supplied
Quantity of Labor
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What are some potential impacts of taxes? u Taxes are used to raise
money for the government. u Taxes discourage market activity. u When a good is taxed, the quantity sold is smaller. u Buyers and sellers share the tax burden. u But who bears the burden-tax incidence. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
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Impact of a 50¢ Tax Levied on Buyers... Price of Ice-Cream Cone
Price buyers pay Price without tax
$3.30 3.00 2.80
Price sellers receive
Supply, S 1 Equilibrium without tax
Tax ($0.50)
Equilibrium with tax
D1 D2 0
90 100
Quantity of Ice-Cream Cones
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Impact of a 50¢ Tax on Sellers... Price of Ice-Cream Cone Price buyers pay Price without tax
$3.30 3.00 2.80
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
Demand, D 1
0
90 100
Quantity of Ice-Cream Cones
7
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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Elastic Supply, Inelastic Demand... Price
1. When supply is more elastic than demand...
Price buyers pay Supply 2. ...the incidence of the tax falls more heavily on consumers...
Tax Price without tax Price sellers receive 3. ...than on producers.
Demand
0
Quantity
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Inelastic Supply, Elastic Demand... 1. When demand is more elastic than supply...
Price
Supply
Price buyers pay Price without tax
3. ...than on consumers. Tax
Price sellers receive
0
Demand 2. ...the incidence of the tax falls more heavily on producers... Quantity
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