Supply, Demand, and Government Policies PDF

Supply, Demand, and Government 6 Policies Copyright © 2011 Cengage Learning  Supply, Demand, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities....

Supply, Demand, and Government 6 Policies Copyright © 2011 Cengage Learning  Supply, Demand, and Government Policies In a free, unregulated market system, 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. Copyright © 2011 Cengage Learning  CONTROLS ON PRICES Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and floors. Copyright © 2011 Cengage Learning  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. Copyright © 2011 Cengage Learning 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. Copyright © 2011 Cengage Learning Figure 1 A Market with a Price Ceiling (a) A Price Ceiling That Is Not Binding Price of Ice-Cream Cone Supply €4 Price ceiling 3 Equilibrium price Demand 0 100 Quantity of Equilibrium Ice-Cream quantity Cones Figure 1 A Market with a Price Ceiling (b) A Price Ceiling That Is Binding Price of Ice-Cream Cone Supply Equilibrium price €3 2 Price Shortage ceiling Demand 0 75 125 Quantity of Quantity Quantity Ice-Cream supplied demanded Cones Copyright©2011 South-Western  How Price Ceilings Affect Market Outcomes Effects of Price Ceilings A binding price ceiling creates shortages because QD > QS. Example: Rent controls in New York restrict new building non-price rationing Examples: Long queues; discrimination by sellers Copyright © 2011 Cengage Learning 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 goal of rent control policy is to help the poor by making housing more affordable. One economist called rent control “the best way to destroy a city, other than bombing.” Copyright © 2011 Cengage Learning Figure 2 Rent Control in the Short Run and in the Long Run (a) Rent Control in the Short Run (supply and demand are price inelastic) Rental Price of Housing Supply Units Controlled rent Shortage Demand 0 Quantity of Housing Units Copyright©2011 South-Western Figure 2 Rent Control in the Short Run and in the Long Run (b) Rent Control in the Long Run (supply and demand are price elastic) Rental Price of Housing Units Supply Controlled rent Shortage Demand 0 Quantity of Housing Units Copyright©2011 South-Western How Price Floors Affect Market Outcomes When the government imposes a price floor, two outcomes are possible. The price floor is not binding if set below the equilibrium price. The price floor is binding if set above the equilibrium price, leading to a surplus. Copyright © 2011 Cengage Learning Figure 3 A Market with a Price Floor (a) A Price Floor That Is Not Binding Price of Ice-Cream Cone Supply Equilibrium price €3 Price floor 2 Demand 0 100 Quantity of Equilibrium Ice-Cream quantity Cones Copyright©2011 South-Western Figure 3 A Market with a Price Floor (b) A Price Floor That Is Binding Price of Ice-Cream Cone Supply Surplus €4 Price floor 3 Equilibrium price Demand 0 80 Quantity of 120 Quantity Quantity Ice-Cream demanded supplied Cones Copyright©2011 South-Western 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 no further, and the market price equals the floor price. A binding price floor causes... a surplus because QS > QD. Copyright © 2011 Cengage Learning The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price for labour that any employer may pay. Copyright © 2011 Cengage Learning Figure 4 How the Minimum Wage Affects the Labour Market Wage labour Supply Equilibrium wage labour demand 0 Equilibrium Quantity of employment labour Copyright©2011 South-Western Figure 4 How the Minimum Wage Affects the Labour Market Wage labour labour surplus Supply (unemployment) Minimum wage labour demand 0 Quantity Quantity Quantity of demanded supplied labour Copyright©2011 South-Western  TAXES Governments levy taxes to raise revenue for public projects. Copyright © 2011 Cengage Learning How Taxes on Sellers Affect Market Outcomes Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. Copyright © 2011 Cengage Learning Price Elasticity and Tax Incidence Tax incidence is the manner in which the burden of a tax is shared among participants in a market. Copyright © 2011 Cengage Learning Price Elasticity and Tax Incidence Tax incidence is the manner in which the burden of a tax is shared among market participants. Taxes result in a change in market equilibrium. Buyers pay more and sellers receive less, regardless of whom the tax is levied on. Copyright © 2011 Cengage Learning  Figure 5 A Tax on Sellers Price of Ice-Cream A tax on sellers Price Cone Equilibrium S2 shifts the supply buyers with tax curve upward pay by the amount of €3.30 S1 Tax (€0.50) the tax (€0.50). Price 3.00 without 2.80 Equilibrium without tax tax Price sellers receive Demand, D1 0 90 100 Quantity of Ice-Cream Cones Copyright©2011 South-Western Price Elasticity and Tax Incidence What was the impact of tax? Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. Copyright © 2011 Cengage Learning  Figure 6 A Payroll Tax Wage labour supply Wage firms pay Tax wedge Wage without tax Wage workers receive labour demand 0 Quantity of labour Copyright©2011 South-Western Price Elasticity and Tax Incidence In what proportions is the burden of the tax divided? The answer to this question depends on the price elasticity of demand and the price elasticity of supply. Copyright © 2011 Cengage Learning  Figure 7 How the Burden of a Tax Is Divided (a) Price Elastic Supply, Price Inelastic Demand Price 1. When supply is more price elastic than demand... Price buyers pay Supply Tax 2.... the incidence of the Price without tax tax falls more heavily on Price sellers consumers... receive 3.... than Demand on producers. 0 Quantity Copyright©2011 South-Western  Figure 7 How the Burden of a Tax Is Divided (b) Price Inelastic Supply, Price Elastic Demand Price 1. When demand is more price elastic than supply... Price buyers pay Supply Price without tax 3.... than on consumers. Tax 2.... the Demand Price sellers incidence of receive the tax falls more heavily on producers... 0 Quantity Copyright©2011 South-Western ELASTICITY AND TAX INCIDENCE 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 price elastic. Copyright © 2011 Cengage Learning  Summary Price controls include price ceilings and price floors. A price ceiling is a legal maximum on the price of a good or service. An example is rent control. A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage. Copyright © 2011 Cengage Learning  Summary Taxes are used to raise revenue for public purposes. When the government levies a tax on a good, the equilibrium quantity of the good falls. A tax on a good places a wedge between the price paid by buyers and the price received by sellers. Copyright © 2011 Cengage Learning  Summary The incidence of a tax refers to who bears the burden of a tax. The incidence of the tax depends on the price elasticities of supply and demand. The burden tends to fall on the side of the market that is less price elastic. The incidence of a tax does not depend on whether the tax is levied on buyers or sellers. Copyright © 2011 Cengage Learning