Market Outcomes and Government Policies in Introductory Microeconomics

1. Lecture Notes: Econ 203 Introductory MicroeconomicsLecture/Chapter 6: Supply, demand and govt. policiesM. Cary LeaheyManhattan CollegeFall 2012

2. Goals • This is an applications chapter looking at how well-known govt. policies affect market outcomes. • By “market outcomes,” we mean the impact of policy on price and quantity-our model’s representation of “truth.” • Does the policy have different outcomes if it affects consumer rather than producers or demand rather than supply • We look at the incidence of the tax. By that we mean who bears the burden of the tax. The correct answer might surprise you.

3. Two well known govt. policies Price controls Set a price ceiling or a legal maximum on the price of a good or service. One well known NYC example is rent control Taxes The govt can make buyers/sellers pay a specific extra amount per unit. How can out traditional supply and demand analysis explains the market outcomes-the changes in price and quantity 3

4. Example 1: Price control: the market for apartments Equilibrium w/o price controls P S Rental price of apts $800 D Q 300 Quantity of apts

5. How price ceilings affect market outcomes, I A price ceiling above the equilibrium price is not binding— has no effect on the market outcome. P S Price ceiling $1000 $800 D Q 300

6. How price ceilings affect market outcomes, II The equilibrium price ($800) is above the ceiling and therefore illegal. The ceiling is a binding constrainton the price, causes a shortage. P S Price ceiling $500 shortage D Q 400 250 $800

7. Shortages and rationing With shortages, sellers must ration the goods among buyers by a non-price mechanism. Non-price rationing is unfair and inefficient—long lines and discrimination. Goods do not go to the buyers who value them most highly. Compare this is the (by definition) efficient outcome of the market. 7

8. Example 2: Minimum wage/ the market for unskilled labor Remember that the “price’ of labor is the (real) wage rate. So we will use the same analysis for rent control as for the minimum wage Some background on the minimum wage. The minimum wage is the least amount workers can be paid per hour. The typical minimum wage worker is a younger person without a high school degree. He or she is rarely the only breadwinner in a household. The minimum wage is NOT indexed for inflation. So legislators from time to time ask for an increase in the minimum wage to adjust for the past increases in inflation. In other words changes are made to adjust for the fall in the real minimum wage. The minimum wage has last increased in 2008 to $7.25. It was fallen about 10% in real terms since it was last increased. It down one third from its peak to $9 (2011) dollars in 1980. . 8

9. Example 2: Minimum wage/the market for unskilled labor Equilibrium w/o price controls W S Wage paid to unskilled workers $6.00 D L 500 Quantity of unskilled workers

10. Minimum wage, another price floor, I A price floor below the equilibrium price is not binding – has no effect on the market outcome. W S Price floor $5.00 $6.00 D L 500

11. Minimum wage, another price floor, II The equilibrium wage ($6) is below the floor and therefore illegal. The floor is a binding constrainton the wage, causes a surplus (i.e., unemployment). labor surplus W S Price floor $7.25 $6.00 D L 400 550

12. 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%. Minimum wage, another price floor, III unemp-loyment W S Min. wage $7.25 $6.00 D L 400 550

13. Evaluating price controls Price controls distort or drive a wedge in market signals. They lead to unintended outcomes such as hurting those they intend to help. For example, an increased minimum wage will increase income to low skilled workers but will also increase low skilled employment. How much is open to empirical debate. 13

14. Taxes Taxes are levied on both goods and sellers of goods and services The taxes can be called sales taxes, excise taxes, sin taxes, etc. The tax can be a % of the sellers price (ad valorem) or a fixed amount such as state taxes on gasoline. They can also be a lump sum tax or poll tax which is a tax per person. These taxes were more prevalent in colonial times. Sometime the revenues are allocated to specific activities. 14

15. Example 3: the market for pizza Equilibrium w/o tax P S1 $10.00 D1 Q 500

16. Example 3; a tax on buyers The price buyers pay is now $1.50 higher than the market priceP. P would have to fallby $1.50 to makebuyers willing to buy same Qas before. E.g., if P falls from $10.00 to $8.50,buyers still willing topurchase 500 pizzas. P S1 $10.00 Tax D1 $8.50 D2 Q 500 Hence, a tax on buyers shifts the D curve down by the amount of the tax. Effects of a $1.50 per unit tax on buyers

17. Example 3: a tax on buyers P S1 $11.00 PB = $10.00 Tax PS = $9.50 D1 D2 Q 500 450 Effects of a $1.50 per unit tax on buyers New equilibrium: Q = 450 Sellers receive PS = $9.50 Buyers pay PB = $11.00 Difference between them = $1.50 = tax

18. Example 3: the incidence of a tax: how the burden of a tax is shared among market participants P S1 $11.00 PB = $10.00 Tax $9.50 PS = D1 D2 Q 500 450 In our example, buyers pay $1.00 more, sellers get $0.50 less.

19. Example 3: a tax on sellers P S2 S1 $11.50 $10.00 Tax D1 Q 500 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.

20. Example 3: a tax on sellers P S2 S1 PB = $11.00 $10.00 Tax $9.50 PS = D1 Q 500 450 Effects of a $1.50 per unit tax on sellers New equilibrium: Q = 450 Buyers pay PB = $11.00 Sellers receive PS = $9.50 Difference between them = $1.50 = tax

21. The outcome is the same in either case What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. P S1 $11.00 $10.00 $9.50 D1 Q 500 The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers! PB = Tax PS = 450

22. Elasticity and tax incidence CASE 1: Supply is more elastic than demand P PB S Buyers’ share of tax burden Tax Price if no tax PS Sellers’ share of tax burden D Q It’s easier for sellers than buyers to leave the market. So buyers bear most of the burden of the tax.

23. Elasticity and tax incidence CASE 2: Demand is more elastic than supply P S PB Buyers’ share of tax burden Tax Price if no tax Sellers’ share of tax burden PS D Q It’s easier for buyers than sellers to leave the market. Sellers bear most of the burden of the tax.

24. Case study: who pays the luxury tax? 1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc. Goal: raise revenue from those who could most easily afford to pay—wealthy consumers. But who really pays this tax?

25. Case study: who pays the luxury tax? (II) The market for yachts P S PB Buyers’ share of tax burden Tax Sellers’ share of tax burden PS D Q Demand is price-elastic. In the short run, supply is inelastic. Hence, companies that build yachts pay most of the tax.

26. Summary Price ceiling is a legal maximum of a price of a good or service. One local example is rent control. If the price is below the equilibrium price, then the price is binding and causes a shortage. A price floor is a legal minimum on the price of a good or service. One example is the minimum wage, If the price floor is above the equilibrium price, it is binding and causes a surplus (unemployment). A minimum wage causes incomes to increase for those who keep their jobs but also causes unemployment among unskilled workers. A tax is a wedge between the price buyers pay and sellers receive, causing equilibrium quantity to fall, regardless on whether it falls on buyers or sellers. The incidence or burden of the tax depends on the elasticities of supply and demand. If supply is more elastic, the incidence or burden falls on the buyers rather than the sellers. And vice versa. . 26