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P R I N C I P L E S O F

P R I N C I P L E S O F. F O U R T H E D I T I O N. Supply, Demand, and Government Policies. 6. Government Intervention in Markets: Motivation and Economic Consequences. Price ceilings to help consumers: -- rent control (selected urban areas)

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P R I N C I P L E S O F

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  1. P R I N C I P L E S O F FOURTH EDITION Supply, Demand, and Government Policies 6

  2. Government Intervention in Markets: Motivation and Economic Consequences • Price ceilings to help consumers: -- rent control (selected urban areas) • Price floors to help producers or households: -- farm price supports, minimum wage law, mandated “time and one half” wage for overtime hours • Taxes: -- to raise revenue -- to reduce amount sold of goods -- as “user charge” for consuming a good or service CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  3. How does government market intervention affect markets and how do we evaluate such policies? What are the economic consequences of market intervention? What are the costs and benefits? • What is the incidence of a tax? Who pays a tax?What determines the incidence? • THE BIG ISSUE: Intervention in competitive markets affects how the market system performs, with consequences often affecting buyers, sellers, and multiple markets. Is there a compelling public interest to warrant the intervention? CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  4. Government Policies That Regulate Prices • Price controls • Price ceiling: a legal maximum on the price of a good or service. Example: rent control. • Price floor: a legal minimum on the price of a good or service. Example: minimum wage. • Rent control in College Park: A good idea? • Predicted effects? We will use the supply/demand model to see how each policy affects the market outcome (the price buyers pay, the price sellers receive, and eq’m quantity). CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  5. P S Rental price of apts $800 D Q 300 Quantity of apartments EXAMPLE 1: The Market for Apartments Eq’m w/o price controls CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  6. P S Price ceiling $500 shortage D Q 400 250 How Price Ceilings Affect Market Outcomes The eq’m price ($800) is above the ceiling and therefore illegal. The ceiling is a binding constrainton the price, and causes a shortage. $800 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  7. P S Price ceiling $500 shortage D Q How Price Ceilings Affect Market Outcomes In the long run, supply and demand are more price-elastic. So, the shortage is larger. $800 450 150 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  8. Shortages and Rationing • With a shortage, sellers must ration the goods among buyers. • Some rationing mechanisms: (1) long lines (2) discrimination according to sellers’ biases • These mechanisms are often unfair, and inefficient: the goods don’t necessarily go to the buyers who value them most highly. • In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair). CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  9. Price ceilings and Supply Adjustments • Supply adjustments to price regulation reflects decisions of sellers, who are driven by profit maximization – adjusting their capital investments based on profitability. Government price controls typically do not keep sellers from exiting a market (removing their capital!). • In housing, supply adjustments include: • (a) selling units to owner-occupants • (b) reducing the quality of the unit to fit the price – essentially ‘shifting’ the unit to another market. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  10. History of the Minimum Wage • Enacted 1938, @25 cents/hr, to provide minimum income level for working. Initial level about 35% of the average manufacturing wage. • Increased periodically, reached 50% of ave. manu. Wage in 1970, but then fewer increases, and real value of minimum wage declined since 1980’s. Now about 32% of ave. manu. Wage. • Wage has remained at $5.15/hr since 1998. Real value of minimum wage declined since 1980’s. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  11. Debate over the Minimum Wage • Arguments supporting the minimum wage: fundamental fairness to workers; promotes work; present wage level does not keep a worker out of poverty even if working full time. • Opponents of a higher wage: loss of jobs and unemployment among unskilled; lost work by teenagers deprives teenagers of experience and commitment to work; financial burden on small businesses; higher labor costs increases prices • Democrats vs Republicans on this issue? CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  12. W S Wage paid to unskilled workers $4 D L 500 Quantity of unskilled workers EXAMPLE 2: The Market for Unskilled Labor Eq’m w/o price controls CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  13. W S Price floor $5.15 $7.00 D L 500 How Price Floors Affect Market OutcomesNon-binding in a high income suburb A price floor below the eq’m price is not binding – it has no effect on the market outcome. Many states have set wages ABOVE the federal minimum. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  14. labor surplus W S Price floor $5.15 $4 D L 400 550 How Price Floors Affect Market Outcomes The eq’m wage ($4) is below the floor and therefore illegal. The floor is a binding constrainton the wage, and causes a surplus (i.e., less employment). CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  15. Debate about the Effects • Republicans typically oppose, stressing job losses and burden on small businesses. Republican congressional opposition since 1998, Senate opposing an increase 11 times since. • Democrats typically argue for an increase. • In 2006, Republicans combined increase to $7.25 over three years with an extension of estate tax reductions past 2010 -- expecting Democrats to accept estate tax reductions as part of deal to raise minimum wage. Democrats vote against. In 2007, bill held up over disagreement on including tax breaks for small businesses. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  16. Empirical Evidence • Evidence from many studies of demand and supply curves for labor. Studies of impacts when states have altered their minimum wages, that provides evidence of policy change. • Evidence suggests elasticity is low, .1 to .2, hence job loss would be limited. Inelastic labor demand implies total wage earnings increases (though fewer work!). • Increasing the minimum wage will also increase the wages of a larger group of workers whose skills and wages are somewhat above the minimum wage worker. • Higher wage costs shift the supply curve of producers, hence prices increase in product markets. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  17. Evaluating Price Controls • Recall one of the Ten Principles: Markets are usually a good way to organize economic activity. • Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices. • Price controls are often intended to help the poor, but evaluation of such policies must consider all the consequences and how markets adapt! Economists typically look for a ‘compelling’ public interest to justify intervention in markets. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  18. Taxes • The government levies taxes on many goods & services. Taxes are a source of revenue, and also used to reduce or discourage consumption of selected goods or services. (e.g. cigarette taxes). • The tax can be a percentage of the good’s price, or a specific amount for each unit sold. • For simplicity, we analyze per-unit taxes only. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  19. Illustrative Excise (Sales) Taxes • Federal excise taxes: • Federal gas tax: 18 cents/gallon • Cigarette tax: 39 cents/pack • Beer tax: $18/barrel. (How much for one beer?) • Wine tax: $1.07/gallon • State cigarette taxes: Rhode Island $2.46/pack • New Jersey 2.40 • Maryland (19th)1.00 • Virginia (.30), N.Car., Kentucky, Tenn., Mississippi, Missouri, S.Car (.07)lowest. • Maryland alcohol tax among lowest: $.09/gallon of beer! CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  20. Politics Behind Tax Policy • Federal excise taxes: current level vs. level if adjusted for inflation since 1951! • Current If Adjusted • Beer $18/barrell $55.88 • Wine $1.57/gallon $4.16 • Spirits $12.50/gallon $65.19 • Maryland taxes: beer tax last raised in 1972. Raising Md taxes to national average raises tax revenue by $14 million, from current $23 million level. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  21. The Incidence (who pays) of a tax • The government can impose taxes on either the buyer or seller. • The “statutory incidence” of a tax is the economic agent who is legally responsible to pay the tax. • The “economic incidence’ of a tax is the final distribution of the tax burden between buyer and seller. • Tax shifting occurs in most cases, as the burden of a tax is shared between buyer and seller, even though only one pays. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  22. P S1 $10.00 D1 Q 500 EXAMPLE 3: The Market for Pizza Eq’m w/o tax CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  23. P S1 $11.00 PB = $10.00 Tax $9.50 PS = D1 D2 Q 500 430 A Tax on Buyers 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 The price buyers pay rises, the price sellers receive falls, eq’m Q falls. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  24. P S1 $11.00 PB = $10.00 Tax $9.50 PS = D1 D2 Q 500 430 The Incidence of a Tax: how the burden of a tax is shared among market participants Because of the tax, buyers pay $1.00 more, sellers get $0.50 less. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  25. P S2 S1 $11.00 PB = $10.00 Tax $9.50 PS = D1 Q 500 430 A Tax on Sellers A tax on sellers shifts the S curve up by the amount of the tax. Effects of a $1.50 per unit tax on sellers The price buyers pay rises, the price sellers receive falls, eq’m Q falls. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  26. P S1 $11.00 Tax $10.00 $9.50 D1 Q 500 The Outcome Is the Same in Both Cases! The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers! What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. PB = PS = 430 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  27. The market for hotel rooms P S D 0 Q ACTIVE LEARNING 2: Effects of a tax Suppose govt imposes a tax on buyers of $30 per room. Find new Q, PB, PS, and incidence of tax. 26

  28. The market for hotel rooms P S PB = Tax PS = D 0 Q ACTIVE LEARNING 2: Answers Q = 80 PB = $110 PS = $80 Incidence • buyers: $10 • sellers: $20 27

  29. P PB S Buyers’ share of tax burden Tax Price if no tax PS Sellers’ share of tax burden D Q Elasticity and Tax Incidence CASE 1: Supply is more elastic than demand In this case, buyers bear most of the burden of the tax. Why? Demand is inelastic –i.e. ‘I’ll pay any price!’ CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  30. P S PB Buyers’ share of tax burden Tax Price if no tax Sellers’ share of tax burden PS D Q Elasticity and Tax Incidence CASE 2: Demand is more elastic than supply In this case, sellers bear most of the burden of the tax. Why? Elastic supply: sellers do not cut back! CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  31. Elasticity and Tax Incidence • If buyers’ price elasticity > sellers’ price elasticity, buyers can more easily leave the market when the tax is imposed, so buyers will bear a smaller share of the burden of the tax than sellers. • If sellers’ price elasticity > buyers’ price elasticity, the reverse is true. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  32. CASE STUDY: Who Pays the Luxury Tax? • 1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc. • Goal of the tax: to raise revenue from those who could most easily afford to pay – wealthy consumers. • But who really pays this tax? CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  33. P S PB Buyers’ share of tax burden Tax Sellers’ share of tax burden PS D Q CASE STUDY: Who Pays the Luxury Tax? The market for yachts Demand is price-elastic. In the short run, supply is inelastic. Hence, companies that build yachts pay most of the tax. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  34. CONCLUSION: Government Policies and the Allocation of Resources • Each of the policies in this chapter affects the allocation of society’s resources. • Example 1: a tax on pizza reduces the eq’m quantity of pizza. Since the economy is producing fewer pizzas, some resources (workers, ovens, cheese) will become available to other industries. • Example 2: a binding minimum wage causes a surplus of workers, a waste of resources. • So, it’s important for policymakers to apply such policies very carefully. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  35. CHAPTER SUMMARY • A price ceiling is a legal maximum on the price of a good. An example is rent control. If the price ceiling is below the eq’m price, it is binding and causes a shortage. • A price floor is a legal minimum on the price of a good. An example is the minimum wage. If the price floor is above the eq’m price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

  36. CHAPTER SUMMARY • A tax on a good places a wedge between the price buyers pay and the price sellers receive, and causes the eq’m quantity to fall, whether the tax is imposed on buyers or sellers. • The incidence of a tax is the division of the burden of the tax between buyers and sellers, and does not depend on whether the tax is imposed on buyers or sellers. • The incidence of the tax depends on the price elasticities of supply and demand. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

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