Chapter 6 notes

1. Chapter 6 notes Supply, Demand, and Government Policies

2. 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 • 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.

3. Price Ceilings: Two Possible Outcomes • 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.

4. Figure 1 A Market with a Price Ceiling Supply $4 Price ceiling 3 Equilibrium price Demand 100 Equilibrium quantity (a) A Price Ceiling That Is Not Binding Price of Ice-Cream Cone The market clears at $3 and the price ceiling is ineffective. Quantity of 0 Ice-Cream Cones

5. Figure 1 A Market with a Price Ceiling Supply Equilibrium price $3 2 Price ceiling Shortage Demand 75 125 Quantity Quantity supplied demanded (b) A Price Ceiling That Is Binding Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones

6. Effects of Price Ceilings • A binding price ceiling creates • Shortages because QD > QS. • Example: Gasoline shortage of the 1970s • Nonprice rationing • Examples: Long lines, discrimination by sellers

7. 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? CASE STUDY: Lines at the Gas Pump • Economists blame government regulations that limited the price oil companies could charge for gasoline.

8. Figure 2 The Market for Gasoline with a Price Ceiling Supply, S1 1. Initially, the price ceiling is not Price ceiling binding . . . P1 Demand Q1 (a) The Price Ceiling on Gasoline Is Not Binding Price of Gasoline Quantity of 0 Gasoline

9. Figure 2 The Market for Gasoline with a Price Ceiling S2 2. . . . but when supply falls . . . S1 P2 Price ceiling 3. . . . the price P1 ceiling becomes 4. . . . binding . . . resulting in a Demand shortage. QS QD Q1 (b) The Price Ceiling on Gasoline Is Binding Price of Gasoline Quantity of 0 Gasoline

10. 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.”

11. Figure 3 Rent Control in the Short Run and in the Long Run Supply Controlled rent Shortage Demand (a) Rent Control in the Short Run (supply and demand are inelastic) Rental Price of Apartment Quantity of 0 Apartments

12. Figure 3 Rent Control in the Short Run and in the Long Run Supply Controlled rent Demand Shortage (b) Rent Control in the Long Run (supply and demand are elastic) Rental Price of Apartment Quantity of 0 Apartments

13. 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. • 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.

14. Cont’d • 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

15. Figure 4 A Market with a Price Floor Supply Equilibrium price $3 Price floor 2 Demand 100 Equilibrium quantity The government says that ice-cream cones must sell for at least $2; this legislation is ineffective at the current market price. (a) A Price Floor That Is Not Binding Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones

16. Figure 4 A Market with a Price Floor Supply Surplus $4 Price floor 3 Equilibrium price Demand 80 120 Quantity Quantity demanded supplied (b) A Price Floor That Is Binding Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones

17. CASE STUDY: 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.

18. Figure 5 How the Minimum Wage Affects the Labor Market Labor Supply Equilibrium wage Labor demand Equilibrium employment Wage 0 Quantity of Labor

19. Figure 5 How the Minimum Wage Affects the Labor Market Labor Supply Labor surplus (unemployment) Minimum wage Labor demand Quantity demanded Quantity supplied Wage 0 Quantity of Labor

20. Taxes • Governments levy taxes to raise revenue for public projects • Taxes discourage market activity. • When a good is taxed, the quantity sold is smaller. • Buyers and sellers share the tax burden.

21. 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. • Taxes result in a change in market equilibrium. • Buyers pay more and sellers receive less, regardless of whom the tax is levied on.

22. Figure 6 A Tax on Buyers Price Supply, S1 buyers pay $3.30 Equilibrium without tax Tax ($0.50) 3.00 Price A tax on buyers 2.80 without shifts the demand tax curve downward by the size of Price Equilibrium the tax ($0.50). sellers with tax receive D1 D2 90 100 Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones

23. Figure 7 A Tax on Sellers A tax on sellers Price S2 shifts the supply Equilibrium buyers curve upward with tax pay by the amount of S1 $3.30 the tax ($0.50). Tax ($0.50) 3.00 Price 2.80 without Equilibrium without tax tax Price sellers receive Demand, D1 90 100 Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones

24. Impact of Tax • Taxes discourage market activity. • When a good is taxed, the quantity sold is smaller. • Buyers and sellers share the tax burden.

25. Figure 8 A Payroll Tax Labor supply Wage firms pay Tax wedge Wage without tax Wage workers receive Labor demand Wage Quantity 0 of Labor

26. Elasticity and Tax Incidence • The elasticity of the S and D in the market determine how the burden of the tax is divided. • The burden of a tax falls more heavily on the side of the market that is less elastic.

27. Figure 9 How the Burden of a Tax Is Divided 1. When supply is more 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. (a) Elastic Supply, Inelastic Demand Price Quantity 0

28. Figure 9 How the Burden of a Tax Is Divided 1. When demand is more 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 . . . (b) Inelastic Supply, Elastic Demand Price Quantity 0