Supply, demand and government policies

In this chapter,
look for the answers to these questions:
What are price ceilings and price floors?
What are some examples of each?
How do price ceilings and price floors affect market outcomes?
How do taxes affect market outcomes?
How do the effects depend on whether
the tax is imposed on buyers or sellers?
What is the incidence of a tax?
What determines the incidence?

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Government Policies That Alter the
Private Market Outcome Price controls
Price ceiling: a legal maximum on the price
of a good or service Example: rent control
Price floor: a legal minimum on the price of
a good or service Example: minimum wage
Taxes
The govt can make buyers or sellers pay a specific amount on each unit bought/sold.
We will use the supply/demand model to see
how each policy affects the market outcome
(the price buyers pay, the price sellers receive, and eq’m quantity).

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
EXAMPLE 1: The Market for Apartments
Eq’m w/o
price controls

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
How Price Ceilings Affect Market Outcomes
A price ceiling above the
eq’m price is
not binding –
has no effect
on the market outcome.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
How Price Ceilings Affect Market Outcomes
The eq’m price ($800) is above the ceiling and therefore illegal.
The ceiling
is a binding constraint
on the price, causes a shortage.
$800

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
How Price Ceilings Affect Market Outcomes
In the long run, supply and demand
are more
price-elastic.
So, the shortage
is larger.
$800
150
450

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Shortages and Rationing
With a shortage, sellers must ration the goods among buyers.
Some rationing mechanisms: (1) Long lines
(2) Discrimination according to sellers’ biases
These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly.
In contrast, when prices are not controlled,
the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal (and thus fair).

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
EXAMPLE 2: The Market for Unskilled Labor
Eq’m w/o price controls

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
How Price Floors Affect Market Outcomes
A price floor below the
eq’m price is
not binding –
has no effect
on the market outcome.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
How Price Floors Affect Market Outcomes
The eq’m wage ($4) is below the floor and therefore
illegal.
The floor
is a binding constraint
on the wage,
causes a
surplus (i.e., unemployment).

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Min wage laws
do not affect
highly skilled workers.
They do affect teen workers.
Studies:
A 10% increase
in the min wage raises teen unemployment
by 1-3%.
The Minimum Wage

A C T I V E L E A R N I N G 1
Price controls
Determine
effects of:
A. $90 price
ceiling
B. $90 price
floor
C. $120 price
floor

A C T I V E L E A R N I N G 1
A. $90 price ceiling
The price falls to $90.
Buyers demand
120 rooms, sellers supply 90, leaving a shortage.

A C T I V E L E A R N I N G 1
B. $90 price floor
Eq’m price is above the floor, so floor is not binding.
P = $100,
Q = 100 rooms.
Price floor

A C T I V E L E A R N I N G 1
C. $120 price floor
The price
rises to $120.
Buyers
demand
60 rooms,
sellers supply 120, causing a surplus.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Evaluating Price Controls
Recall one of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity.
Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices.
Price controls often intended to help the poor,
but often hurt more than help.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Taxes
The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc.
The govt can make buyers or sellers pay the tax.
The tax can be a % of the good’s price,
or a specific amount for each unit sold.
For simplicity, we analyze per-unit taxes only.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
EXAMPLE 3: The Market for Pizza
Eq’m
w/o tax

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
A Tax on Buyers
The price buyers pay
is now $1.50 higher than the market price P.
P would have to fall
by $1.50 to make
buyers willing
to buy same Q
as before.
E.g., if P falls
from $10.00 to $8.50,
buyers still willing to
purchase 500 pizzas.
Effects of a $1.50 per unit tax on buyers
Hence, a tax on buyers shifts the D curve down by the amount of the tax.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
A Tax on Buyers
Effects of a $1.50 per unit tax on buyers
New eq’m:
Q = 450
Sellers
receive
PS = $9.50
Buyers pay
PB = $11.00
Difference between them = $1.50 = tax

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
The Incidence of a Tax:
how the burden of a tax is shared among
market participants
In our example,
buyers pay $1.00 more,
sellers get $0.50 less.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
A Tax on Sellers
Effects of a $1.50 per unit tax on sellers
The tax effectively raises sellers’ costs by
$1.50 per pizza.
Sellers will supply
500 pizzas
only if
P rises to $11.50,
to compensate for
this cost increase.
Hence, a tax on sellers shifts the
S curve up by the amount of the tax.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
A Tax on Sellers
Effects of a $1.50 per unit tax on sellers
New eq’m:
Q = 450
Buyers pay
PB = $11.00
Sellers
receive
PS = $9.50
Difference between them = $1.50 = tax

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
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.
450
PB =
PS =
Tax
The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers!

A C T I V E L E A R N I N G 2
Effects of a tax
Suppose govt imposes a tax on buyers of $30 per room.
Find new
Q, PB, PS,
and incidence of tax.

A C T I V E L E A R N I N G 2
Answers
Q = 80
PB = $110
PS = $80
Incidence
buyers: $10
sellers: $20

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand
It’s easier
for sellers than buyers to leave the market.
So buyers bear most of the burden
of the tax.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply
It’s easier for buyers than sellers to leave the market.
Sellers bear most of the burden of
the tax.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
CASE STUDY: Who Pays the Luxury Tax?
1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc.
Goal of the tax: raise revenue from those
who could most easily afford to pay –
wealthy consumers.
But who really pays this tax?

SUPPLY, DEMAND, AND GOVERNMENT POLICIES
CASE STUDY: Who Pays the Luxury Tax?
The market for yachts
Demand is
price-elastic.
In the short run, supply is inelastic.
Hence,
companies that build yachts pay most of
the tax.

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 eq’m Q.
With less production of pizza, 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.

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.