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© 2007 Thomson South-Western

© 2007 Thomson South-Western. Supply, Demand, and 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.

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© 2007 Thomson South-Western

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  1. © 2007 Thomson South-Western

  2. Supply, Demand, and 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.

  3. 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.

  4. CONTROLS ON PRICES • 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.

  5. How Price Ceilings Affect Market Outcomes • 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.

  6. Supply $4 Price ceiling 3 Equilibrium price Demand 100 Equilibrium quantity Figure 1 A Market with a Price Ceiling (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

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

  8. How Price Ceilings Affect Market Outcomes • 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

  9. 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.

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

  11. 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 Figure 2 The Market for Gasoline with a Price Ceiling (b) The Price Ceiling on Gasoline Is Binding Price of Gasoline Quantity of 0 Gasoline

  12. CASE STUDY: Rent Control in the Short Run and Long Run • 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.”

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

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

  15. 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.

  16. Supply Equilibrium price $3 Price floor 2 Demand 100 Equilibrium quantity Figure 4 A Market with a Price Floor 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

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

  18. How Price Floors Affect Market Outcomes • 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.

  19. How Price Floors Affect Market Outcomes • 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

  20. 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.

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

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

  23. TAXES • Governments levy taxes to raise revenue for public projects.

  24. How Taxes on Buyers (and Sellers) Affect Market Outcomes • Taxes discourage market activity. • When a good is taxed, the quantity sold is smaller. • Buyers and sellers share the tax burden.

  25. How Taxes on Buyers Affect Market Outcomes • Elasticity and tax incidence • Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

  26. How Taxes on Buyers Affect Market Outcomes • Elasticity and Tax Incidence • 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.

  27. 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 Figure 6 A Tax on Buyers Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones

  28. 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 Figure 7 A Tax on Sellers Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones

  29. Elasticity and Tax Incidence • What was the impact of tax? • Taxes discourage market activity. • When a good is taxed, the quantity sold is smaller. • Buyers and sellers share the tax burden.

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

  31. 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.

  32. 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. Figure 9 How the Burden of a Tax Is Divided (a) Elastic Supply, Inelastic Demand Price Quantity 0

  33. 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 . . . Figure 9 How the Burden of a Tax Is Divided (b) Inelastic Supply, Elastic Demand Price Quantity 0

  34. Elasticity and Tax Incidence 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.

  35. Price controls include price ceilings and price floors. • A price ceiling is a legal maximum on the price of a good or service. • An example is rent control. • A price floor is a legal minimum on the price of a good or a service. • An example is the minimum wage.

  36. Taxes are used to raise revenue for public purposes. • When the government levies a tax on a good, the equilibrium quantity of the good falls. • A tax on a good places a wedge between the price paid by buyers and the price received by sellers.

  37. The incidence of a tax refers to who bears the burden of a tax. • The incidence of a tax does not depend on whether the tax is levied on buyers or sellers. • The incidence of the tax depends on the price elasticities of supply and demand. • The burden tends to fall on the side of the market that is less elastic.

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