Supply Demand Government Policies Chapter 6 Copyright

Supply, Demand 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 u In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. u While equilibrium conditions may be efficient, it may be true that not everyone is satisfied. u One of the roles of economists is to use their theories to assist in the development of policies. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Price Controls. . . u. Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. u. Result in government-created price ceilings and floors. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Price Ceilings & Price Floors Price Ceiling u. A legally established maximum price at which a good can be sold. Price Floor u. A legally established minimum price at which a good can be sold. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

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. The price ceiling is binding if set below the equilibrium price, leading to a shortage. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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

Effects of Price Ceilings A binding price ceiling creates. . . ¼ shortages because QD > QS. u Example: Gasoline shortage of the 1970 s ¼ nonprice rationing u Examples: Long lines, Discrimination by sellers Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Lines at the Gas Pump In 1973 OPEC raised the price of crude oil in world markets. Because crude oil is the major input used to make gasoline, 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Price Ceiling on Gasoline Is Not Binding. . . Price of Gasoline 1. Initially, the price ceiling is not binding. . . Supply Price ceiling $4 P 1 Demand 0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Q 1 Quantity of Gasoline

The Price Ceiling on Gasoline Is Binding. . . S 2 Price of Gasoline 2. …but when supply falls. . . S 1 P 2 Price ceiling P 1 3. …the price ceiling becomes binding. . . 4. …resulting in a shortage. Demand 0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Q 1 Quantity of Gasoline

Rent Control u Rent controls are ceilings placed on the rents that landlords may charge their tenants. u The goal of rent control policy is to help the poor by making housing more affordable. u One economist called rent control “the best way to destroy a city, other than bombing. ” Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Rent Control in the Short Run. . . Rental Price of Apartment Supply and demand for apartments are relatively inelastic Controlled rent Shortage Demand 0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Quantity of Apartments

Rent Control in the Long Run. . . Rental Price of Apartment Because the supply and demand for apartments are more elastic. . . Supply …rent control causes a large shortage Controlled rent Shortage Demand 0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Quantity of Apartments

Price Floors When the government imposes a price floor, two outcomes are possible. u 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

A Price Floor That Is Not Binding. . . Price of Ice-Cream Cone Supply Equilibrium price $3 Price floor 2 Demand 0 100 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Equilibrium quantity Quantity of Ice-Cream Cones

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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

Effects of a Price Floor u. A price floor prevents supply and demand from moving toward the equilibrium price and quantity. u. When the market price hits the floor, it can fall no further, and the market price equals the floor price. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Effects of a Price Floor A binding price floor causes. . . ¼ a surplus because QS >QD. ¼ nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria. u. Examples: The minimum wage, Agricultural price supports Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Minimum Wage A Free Labor Market Wage Labor supply Equilibrium wage Labor demand 0 Equilibrium employment Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Quantity of Labor

The Minimum Wage A Labor Market with a Minimum Wage Labor surplus (unemployment) Labor supply Minimum wage Labor demand 0 Quantity demanded Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Quantity supplied Quantity of Labor

What are some potential impacts of taxes? u. Taxes discourage market activity. u. When a good is taxed, the quantity sold is smaller. u. Buyers and sellers share the tax burden. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Taxes u. Tax incidence is the study of who bears the burden of a tax. u. Taxes result in a change in market equilibrium. u. Buyers pay more and sellers receive less, regardless of whom the tax is levied on. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Copyright © 2001 by Harcourt, Inc. All rights reserved Impact of a 50¢ Tax Levied on Buyers. . . Price of Ice-Cream Cone Supply, S 1 3. 00 A tax on buyers shifts the demand curve downward by the size of the tax ($0. 50). D 1 D 2 0 100 Quantity of Ice-Cream Cones

Copyright © 2001 by Harcourt, Inc. All rights reserved 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 D 1 D 2 0 90 100 Quantity of Ice-Cream Cones

What was the impact of tax? u. Taxes discourage market activity. u. When a good is taxed, the quantity sold is smaller. u. Buyers and sellers share the tax burden. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Copyright © 2001 by Harcourt, Inc. All rights reserved Impact of a 50¢ Tax on Sellers. . . Price of Ice-Cream Cone Price buyers pay Price without tax $3. 30 3. 00 2. 80 S 2 Equilibrium with tax S 1 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

A Payroll Tax Wage Labor supply Wage firms pay Wage Tax wedge without tax Wage workers receive Labor demand 0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Quantity of Labor

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 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 Tax Price without tax Price sellers receive 3. . than on producers. 0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 2. . the incidence of the tax falls more heavily on consumers. . . Demand Quantity

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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Demand 2. . the incidence of the tax falls more heavily on producers. . . Quantity

So, how is the burden of the tax divided? The burden of a tax falls more heavily on the side of the market that is less elastic. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Summary u. Price controls include price ceilings and price floors. u A price ceiling is a legal maximum on the price of a good or service. An example is rent control. u. A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Summary u. Taxes are used to raise revenue for public purposes. u. When the government levies a tax on a good, the equilibrium quantity of the good falls. u. A tax on a good places a wedge between the price paid by buyers and the price received by sellers. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Summary u. The incidence of a tax refers to who bears the burden of a tax. u. The incidence of a tax does not depend on whether the tax is levied on buyers or sellers. u. The incidence of the tax depends on the price elasticities of supply and demand. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.