G OVERNMENT P OLICIES Economics 101. W HY GOVERNMENT POLICIES ? In a free, unregulated market system, market forces establish equilibrium prices and exchange.

GOVERNMENT POLICIESEconomics 101

WHY 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.

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.

PRICE CEILING AND PRICE FLOOR

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.

BINDING PRICE CEILING?

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. Sellers must ration the scarce goods

The rationing mechanisms – not desirable

(a) A Price Ceiling That Is Not Binding

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Equilibriumquantity

$4 Priceceiling

Equilibriumprice

Demand

Supply

3

100

Copyright©2003 Southwestern/Thomson Learning

(b) A Price Ceiling That Is Binding


Cones

0

Price ofIce-Cream

Cone

Demand

Supply

2 PriceceilingShortage

75

Quantitysupplied

125

Quantitydemanded

Equilibriumprice

$3

BINDING PRICE CEILING

A binding price ceiling creates shortages because QD > QS.

Example: Gasoline shortage of the 1970s nonprice rationing

Examples: Long lines, discrimination by sellers

CASE: 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?


(a) The Price Ceiling on Gasoline Is Not Binding

Quantity ofGasoline

0

Price ofGasoline

1. Initially,the priceceilingis notbinding . . . Price ceiling

Demand

Supply, S1

P1

Q1


(b) The Price Ceiling on Gasoline Is Binding

Quantity ofGasoline

0

Price ofGasoline

Demand

S1

S2

Price ceiling

QS

4. . . . resultingin ashortage.

3. . . . the priceceiling becomesbinding . . .

2. . . . but whensupply falls . . .

P2

QD

P1

Q1

CASE: RENT CONTROL 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.”


(a) Rent Control in the Short Run(supply and demand are inelastic)

Quantity ofApartments

0

Supply

Controlled rent

RentalPrice of

Apartment

Demand

Shortage


(b) Rent Control in the Long Run(supply and demand are elastic)

0

RentalPrice of

Apartment

Quantity ofApartments

Demand

Supply

Controlled rent

Shortage

BINDING PRICE FLOOR?

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.

FIGURE 4 A MARKET WITH A PRICE FLOOR


(a) A Price Floor That Is Not Binding


Cones

0

Price ofIce-Cream

Cone

Equilibriumquantity

2

Pricefloor

Equilibriumprice

Demand

Supply

$3

100

FIGURE 4 A MARKET WITH A PRICE FLOOR


(b) A Price Floor That Is Binding


Cones

0

Price ofIce-Cream

Cone

Demand

Supply

$4Pricefloor

80

Quantitydemanded

120

Quantitysupplied

Equilibriumprice

Surplus

3

BINDING PRICE FLOOR

A binding price floor causes . . . a surplus because QS > QD. nonprice rationing is an alternative mechanism

for rationing the good, using discrimination criteria. Examples: The minimum wage, agricultural price

supports

CASE: 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.

FIGURE 5 HOW THE MINIMUM WAGE AFFECTS THE LABOR MARKET


Quantity ofLabor

Wage

0

Labordemand

LaborSupply

Equilibriumemployment

Equilibriumwage

FIGURE 5 HOW THE MINIMUM WAGE AFFECTS THE LABOR MARKET


Quantity ofLabor

Wage

0

LaborSupplyLabor surplus

(unemployment)

Labordemand

Minimumwage

Quantitydemanded

Quantitysupplied

TAXES

Governments levy taxes to raise revenue for public projects.

Taxes discourage market activity.When a good is taxed (commodity tax), the

quantity sold is smaller. Buyers and sellers share

the tax burden.

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.

_ Statutory incidence (legal incidence) _ Economic incidence

COMMODITY TAX

Sale Tax Excise Tax

SALE TAX

Sale Tax: a tax on buyer (statutory incidence) Example: USA

Case: $0.50 tax per ice-cream cone bought.

FIGURE 6 A TAX ON BUYERS


Quantity ofIce-Cream Cones

0

Price ofIce-Cream

Cone

Pricewithout

tax

Pricesellersreceive

Equilibrium without taxTax ($0.50)

Pricebuyers

pay

D1

D2

Supply, S1

A tax on buyersshifts the demandcurve downwardby the size ofthe tax ($0.50).

$3.30

90

Equilibriumwith tax

2.803.00

100

WHO ACTUALLY BEARS THE TAX BURDEN?Buyers and sellers share

the tax burden. (economic incidence) In this example, buyers share $0.30 and

sellers share $0.20.

EXCISE TAX

Excise Tax: A Tax on Seller (Statutory incidence)

Example: Taiwan

Case: $0.50 tax per ice-cream cone sold

FIGURE 7 A TAX ON SELLERS


2.80

Quantity ofIce-Cream Cones

0

Price ofIce-Cream

Cone

Pricewithout

tax

Pricesellersreceive

Equilibriumwith tax

Equilibrium without tax

Tax ($0.50)

Pricebuyers

payS1

S2

Demand, D1

A tax on sellersshifts the supplycurve upwardby the amount ofthe tax ($0.50).

3.00

100

$3.30

90

WHO ACTUALLY BEARS THE TAX BURDEN?Buyers and sellers share

the tax burden. (economic incidence) In this example, buyers share $0.30 and

sellers share $0.20.

ELASTICITY AND TAX INCIDENCE

In what proportions is the burden of the tax divided?

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.

FIGURE 9 HOW THE BURDEN OF A TAX IS DIVIDED


Quantity0

Price

Demand

Supply

Tax

Price sellersreceive

Price buyers pay

(a) Elastic Supply, Inelastic Demand

2. . . . theincidence of thetax falls moreheavily onconsumers . . .

1. When supply is more elasticthan demand . . .

Price without tax

3. . . . than on producers.

FIGURE 9 HOW THE BURDEN OF A TAX IS DIVIDED


Quantity0

Price

Demand

Supply

Tax

Price sellersreceive

Price buyers pay

(b) Inelastic Supply, Elastic Demand

3. . . . than onconsumers.

1. When demand is more elasticthan supply . . .

Price without tax

2. . . . theincidence of the tax falls more heavily on producers . . .

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.

ALGEBRA

Demand equation: P=10-Qd Supply equation: P=Qs Demand = Supply 10-Q*=Q*, Q*=5; P*=5 Equilibrium quantity=5, equilibrium price=5

CASE 1: TAX ON SELLER $2/UNIT SOLD

Demand equation: P=10-Qd New supply equation: P-2=Qs Demand = New supply 10-Q**=2+Q**, Q**=4, P**=6 (buyer price),

P**-2=4 (seller price) Buyer shares $1 tax burden Seller shares $1 tax burden

CASE 2: TAX ON BUYER $2/UNIT BOUGHT

New Demand equation: P+2=10-Qd Supply equation: P=Qs New Demand = Supply 8-Q***=Q***, Q***=4, P***=4 (seller price),

P***+2=6 (buyer price) Buyer shares $1 tax burden Seller shares $1 tax burden

QUIZ

Demand is perfectly inelastic and supply is elastic

1. Tax on buyers (sales tax) 2. Tax on sellers (excise tax)

QUIZ

Supply is perfectly inelastic and demand is elastic

1. Tax on buyers (sales tax) 2. Tax on sellers (excise tax)

G OVERNMENT P OLICIES Economics 101. W HY GOVERNMENT POLICIES ? In a free, unregulated market system, market forces establish equilibrium prices and exchange.

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