Principles of Micro Chapter 6: Supply, Demand and Government Policies by Tanya Molodtsova, Fall 2005.

Principles of MicroPrinciples of Micro

Chapter 6: “Supply, Demand and Chapter 6: “Supply, Demand and Government Policies”Government Policies”

by Tanya Molodtsova, Fall 2005

We Will Study:We Will Study:

the effects of government policies the effects of government policies that fix the price above or below that fix the price above or below the equilibrium price the equilibrium price

how a tax on a good affects the how a tax on a good affects the

price of the good and the quantity price of the good and the quantity sold sold

how the burden of a tax is split how the burden of a tax is split between buyers and sellers between buyers and sellers

I.I. Controls on PricesControls on Prices In a free market, market forces In a free market, market forces

establish equilibrium prices and establish equilibrium prices and quantities.quantities.

It may be true that not everyone is It may be true that not everyone is satisfied in market equilibriumsatisfied in market equilibrium

Economists use theories to develop Economists use theories to develop government policies that help change government policies that help change the world for the betterthe world for the better

Controls on prices are usually enacted Controls on prices are usually enacted when policymakers believe the market when policymakers believe the market price is unfair to buyers or sellers. price is unfair to buyers or sellers.

They result in government-created They result in government-created price ceilings and floors.price ceilings and floors.

I.I. Controls on PricesControls on Prices

price ceilingprice ceiling: a legal maximum on : a legal maximum on the price at which a good can be the price at which a good can be sold.sold.

Example: rent-control laws sets Example: rent-control laws sets maximum rent that the landlords can maximum rent that the landlords can chargecharge

price floorprice floor: a legal minimum on the : a legal minimum on the price at which a good can be soldprice at which a good can be sold..

Example: minimum wage law dictates Example: minimum wage law dictates the lowest wage that firms may pay the lowest wage that firms may pay workersworkers

How Price Ceilings Affect How Price Ceilings Affect Market OutcomesMarket Outcomes

Two outcomes are possible when Two outcomes are possible when the government imposes a price the government imposes a price ceiling:ceiling:

1.1. If the price ceiling If the price ceiling is is set set aboveabove the equilibrium price, it the equilibrium price, it is notis not binding and there is no effect on binding and there is no effect on the price or quantity soldthe price or quantity sold

2.2. The price ceiling The price ceiling isis set set belowbelow the the equilibrium price, it equilibrium price, it isis binding and binding and the shortage is createdthe shortage is created

A Market With A Price A Market With A Price CeilingCeiling

(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

A Market With A Price A Market With A Price CeilingCeiling (b) A Price Ceiling That Is Binding

Quantity of

Ice-Cream

Cones

0

Price of

Ice-Cream

Cone

Demand

Supply

2 Price

ceilingShortage

75

Quantity

supplied

125

Quantity

demanded

Equilibrium

price

$3

How Price Ceilings Affect How Price Ceilings Affect Market OutcomesMarket Outcomes

A Binding Price Ceilings Creates:A Binding Price Ceilings Creates:

- shortages because Q- shortages because QDD > Q > QSS

Example: Gasoline shortage of Example: Gasoline shortage of the 1970sthe 1970s

- mechanism for rationing the good- mechanism for rationing the good

Example: long lines, Example: long lines, discrimination by sellersdiscrimination by sellers

Not all buyers benefit from a price Not all buyers benefit from a price ceiling since some will be unable ceiling since some will be unable to purchase the product.to purchase the product.

CASE STUDY:CASE STUDY: Lines at the Gas Lines at the Gas PumpPump

In 1973, OPEC raised the price of In 1973, OPEC raised the price of crude oil. Crude oil is the major crude oil. Crude oil is the major input in gasoline, so the higher oil input in gasoline, so the higher oil prices reduced the supply of prices reduced the supply of gasoline.gasoline.

What was responsible for the long What was responsible for the long gas lines?gas lines?

• Economists blame government regulations that limited the price oil companies could charge for gasoline.

The Market for Gasoline The Market for Gasoline with a Price Ceilingwith a Price Ceiling

(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

The Market for Gasoline with The Market for Gasoline with a Price Ceilinga Price Ceiling

(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 STUDY:CASE STUDY: Rent Control in Rent Control in the Short Run and Long Runthe Short Run and Long Run

Rent controls are ceilings placed Rent controls are ceilings placed on the rents that landlords may on the rents that landlords may charge their tenants.charge their tenants.

The goal of rent control policy is The goal of rent control policy is to help the poor by making to help the poor by making housing more affordable.housing more affordable.

One economist called rent One economist called rent control “the best way to destroy a control “the best way to destroy a city, other than bombing.”city, other than bombing.”

Rent Control in the Short-Rent Control in the Short-RunRun

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

Quantity ofApartments

0

Supply

Controlled rent

RentalPrice of

Apartment

Demand

Shortage

Rent Control in The Long-Rent Control in The Long-RunRun

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

0

RentalPrice of

Apartment

Quantity ofApartments

Demand

Supply

Controlled rent

Shortage

Rent Control in the Short Rent Control in the Short Run and Long RunRun and Long Run

Since the supply of apartments is fixed Since the supply of apartments is fixed (perfectly inelastic) in the short run and (perfectly inelastic) in the short run and upward sloping (elastic) in the long upward sloping (elastic) in the long run, the shortage is much larger in the run, the shortage is much larger in the long run than in the short run.long run than in the short run.

Rent controlled apartments are Rent controlled apartments are rationed in a number of ways including rationed in a number of ways including long waiting lists, discrimination long waiting lists, discrimination against minorities and families with against minorities and families with children, and even under-the-table children, and even under-the-table payments to landlords.payments to landlords.

The quality of apartments also suffers The quality of apartments also suffers due to rent control.due to rent control.

How Price Floors Affect How Price Floors Affect Market OutcomesMarket Outcomes

Two outcomes are possible when the Two outcomes are possible when the government imposes a price floor:government imposes a price floor:

1.1. If the price floor is lower than the If the price floor is lower than the equilibrium price, it is not binding and equilibrium price, it is not binding and has no effect on the price or quantity has no effect on the price or quantity sold. sold.

2.2. If the price floor is higher than the If the price floor is higher than the equilibrium price, the floor is a equilibrium price, the floor is a binding constraint and a surplus is binding constraint and a surplus is created.created.

A Market With A Price A Market With A Price FloorFloor

(a) A Price Floor That Is Not Binding

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Equilibriumquantity

2

Pricefloor

Equilibriumprice

Demand

Supply

$3

100

A Market With A Price A Market With A Price FloorFloor (b) A Price Floor That Is Binding

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Demand

Supply

$4Pricefloor

80

Quantitydemanded

120

Quantitysupplied

Equilibriumprice

Surplus

3

How Price Ceilings Affect How Price Ceilings Affect Market OutcomesMarket Outcomes

When the market price hits the When the market price hits the floor, it can fall no further, and the floor, it can fall no further, and the market price equals the floor price.market price equals the floor price.

A binding price floor causes:A binding price floor causes:

- a surplus because - a surplus because QQSS > > QQDD

- the development of a new - the development of a new mechanism for rationing the good, mechanism for rationing the good, using discrimination criteria using discrimination criteria

CASE STUDY:CASE STUDY: The Minimum The Minimum WageWage

An important example of a price An important example of a price floor is the minimum wage. floor is the minimum wage. Minimum wage laws dictate the Minimum wage laws dictate the lowest price for labor that any lowest price for labor that any employer may pay.employer may pay.

Consider a labor market in which Consider a labor market in which the wage adjusts to balance labor the wage adjusts to balance labor supply and labor demand supply and labor demand

How the Minimum Wage How the Minimum Wage Affects the Labor MarketAffects the Labor Market

Quantity ofLabor

Wage

0

LaborSupply

Labor surplus(unemployment)

Labordemand

Minimumwage

Quantitydemanded

Quantitysupplied

How the Minimum Wage Affects How the Minimum Wage Affects the Labor Marketthe Labor Market If the minimum wage is above the If the minimum wage is above the

equilibrium wage in the labor equilibrium wage in the labor market, a surplus of labor will market, a surplus of labor will develop (unemployment).develop (unemployment).

The minimum wage will be a The minimum wage will be a binding constraint only in markets binding constraint only in markets where equilibrium wages are low.where equilibrium wages are low.

Thus, the minimum wage will Thus, the minimum wage will have its greatest impact on the have its greatest impact on the market for teenagers and other market for teenagers and other unskilled workers.unskilled workers.

Evaluating Price Controls Evaluating Price Controls Most economists oppose the use of Most economists oppose the use of

price ceilings and floorsprice ceilings and floors Prices balance supply and demand Prices balance supply and demand

and thus coordinate economic activity. and thus coordinate economic activity. If prices are set by laws, they obscure If prices are set by laws, they obscure the signals that efficiently allocate the signals that efficiently allocate scarce resources. scarce resources.

Price ceilings and price floors often Price ceilings and price floors often hurt the people they are intended to hurt the people they are intended to help.help.

- Rent controls create a shortage of - Rent controls create a shortage of quality housing and provide quality housing and provide disincentives for building maintenance.disincentives for building maintenance.

- Minimum wage laws create higher - Minimum wage laws create higher rates of unemployment for teenage and rates of unemployment for teenage and low skilled workers.low skilled workers.

TaxesTaxes

Governments levy taxes to raise Governments levy taxes to raise revenue for public projectsrevenue for public projects

tax incidencetax incidence: the manner in : the manner in which the burden of a tax is which the burden of a tax is shared among participants in shared among participants in a market.a market.

How Taxes on Buyers Affect How Taxes on Buyers Affect Market OutcomesMarket Outcomes If the government requires the buyer If the government requires the buyer

to pay a certain amount for each unit to pay a certain amount for each unit of a good purchased, this will cause a of a good purchased, this will cause a decrease in demand.decrease in demand.

The demand curve will shift down by The demand curve will shift down by the amount of the tax. the amount of the tax.

The quantity of the good sold will The quantity of the good sold will decline. decline.

Buyers and sellers will share the Buyers and sellers will share the burden of the tax; buyers pay more for burden of the tax; buyers pay more for the good (including the tax) and the good (including the tax) and sellers receive less.sellers receive less.

How Taxes on Buyers Affect How Taxes on Buyers Affect Market OutcomesMarket Outcomes

Two lessons can be learned Two lessons can be learned here:here:

1.1. Taxes discourage market Taxes discourage market activity. When the good is activity. When the good is taxed the quantity sold is taxed the quantity sold is smaller than before the tax. smaller than before the tax.

2.2. Buyers and sellers share the Buyers and sellers share the burden of a tax. burden of a tax.

A Tax on BuyersA 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

How Taxes on Sellers Affect How Taxes on Sellers Affect Market Outcomes Market Outcomes

If the government requires the seller to If the government requires the seller to pay a certain amount for each unit of a pay a certain amount for each unit of a good purchased, this will cause a good purchased, this will cause a decrease in supply.decrease in supply.

The supply curve will shift up by the The supply curve will shift up by the amount of the tax. amount of the tax.

The quantity of the good sold will The quantity of the good sold will decline. decline.

Buyers and sellers will share the Buyers and sellers will share the burden of the tax; buyers pay more for burden of the tax; buyers pay more for the good and sellers receive less the good and sellers receive less (because of the tax).(because of the tax).

A Tax on SellersA 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)

Pricebuyerspay

S1

S2

Demand, D1

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

3.00

100

$3.30

90

Elasticity and Tax Incidence Elasticity and Tax Incidence

In what proportions is the burden of In what proportions is the burden of the tax divided?the tax divided?

The answer to this question The answer to this question depends on the elasticity of depends on the elasticity of demand and the elasticity of demand and the elasticity of supply.supply.

The burden of a tax falls more The burden of a tax falls more heavily on the side of the heavily on the side of the market that is market that is lessless elastic elastic

Elasticity and Tax IncidenceElasticity and Tax Incidence When supply is elastic and demand is When supply is elastic and demand is

inelastic, the largest share of the tax inelastic, the largest share of the tax burden falls on consumers.burden falls on consumers.

A small elasticity of demand means that A small elasticity of demand means that buyers do not have good alternatives to buyers do not have good alternatives to consuming this product.consuming this product.

When supply is inelastic and demand is When supply is inelastic and demand is elastic, the largest share of the tax elastic, the largest share of the tax burden falls on producers. burden falls on producers.

A small elasticity of supply means that A small elasticity of supply means that sellers do not have good alternatives to sellers do not have good alternatives to producing this particular good. producing this particular good.

How The Burden of Tax is DividedHow The Burden of Tax is Divided

Quantity0

Price

Demand

Supply

Tax

Price sellers

receive

Price buyers pay

(a) Elastic Supply, Inelastic Demand

2. . . . the

incidence of the

tax falls more

heavily on

consumers . . .

1. When supply is more elastic

than demand . . .

Price without tax

3. . . . than

on producers.

How The Burden of Tax is How The Burden of Tax is DividedDivided

Quantity0

Price

Demand

Supply

Tax

Price sellers

receive

Price buyers pay

(b) Inelastic Supply, Elastic Demand

3. . . . than on

consumers.

1. When demand is more elastic

than supply . . .

Price without tax

2. . . . the

incidence of

the tax falls

more heavily

on producers . . .

SummarySummary

Price controls include price ceilings Price controls include price ceilings and price floors.and price floors.

A price ceiling is a legal maximum A price ceiling is a legal maximum on the price of a good or service. on the price of a good or service. An example is rent control.An example is rent control.

A price floor is a legal minimum on A price floor is a legal minimum on the price of a good or a service. the price of a good or a service. An example is the minimum wage.An example is the minimum wage.

SummarySummary

Taxes are used to raise revenue Taxes are used to raise revenue for public purposes.for public purposes.

When the government levies a tax When the government levies a tax on a good, the equilibrium quantity on a good, the equilibrium quantity of the good falls.of the good falls.

A tax on a good places a wedge A tax on a good places a wedge between the price paid by buyers between the price paid by buyers and the price received by sellers.and the price received by sellers.

SummarySummary The incidence of a tax refers to The incidence of a tax refers to

who bears the burden of a tax.who bears the burden of a tax. The incidence of a tax does not The incidence of a tax does not

depend on whether the tax is levied depend on whether the tax is levied on buyers or sellers.on buyers or sellers.

The incidence of the tax depends The incidence of the tax depends on the price elasticities of supply on the price elasticities of supply and demand.and demand.

The burden tends to fall on the side The burden tends to fall on the side of the market that is less elastic.of the market that is less elastic.