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© 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

© 2007 Thomson South-Western


Supply demand and government policies

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.


Controls on prices

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.


Controls on prices1

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.


How price ceilings affect market outcomes

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.


Figure 1 a market with a price ceiling

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


Figure 1 a market with a price ceiling1

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


How price ceilings affect market outcomes1

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


Case study lines at the gas pump

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.


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

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


Figure 2 the market for gasoline with a price ceiling1

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


Case study rent control in the short run and long run

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.”


Figure 3 rent control in the short run and in the long run

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


Figure 3 rent control in the short run and in the long run1

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


How price floors affect market outcomes

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.


Figure 4 a market with a price floor

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


Figure 4 a market with a price floor1

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


How price floors affect market outcomes1

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.


How price floors affect market outcomes2

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


Case study the minimum wage

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.


Figure 5 how the minimum wage affects the labor market

Labor

Supply

Equilibrium

wage

Labor

demand

Equilibrium

employment

Figure 5 How the Minimum Wage Affects the Labor Market

Wage

0

Quantity of

Labor


Figure 5 how the minimum wage affects the labor market1

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


Taxes

TAXES

  • Governments levy taxes to raise revenue for public projects.


How taxes on buyers and sellers affect market outcomes

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.


How taxes on buyers affect market outcomes

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.


How taxes on buyers affect market outcomes1

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.


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

Figure 6 A Tax on Buyers

Price of

Ice-Cream

Cone

Quantity of

0

Ice-Cream Cones


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

Figure 7 A Tax on Sellers

Price of

Ice-Cream

Cone

Quantity of

0

Ice-Cream Cones


Elasticity and tax incidence

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.


Figure 8 a payroll tax

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


Elasticity and tax incidence1

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.


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.

Figure 9 How the Burden of a Tax Is Divided

(a) Elastic Supply, Inelastic Demand

Price

Quantity

0


Figure 9 how the burden of a tax is divided1

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


Elasticity and tax incidence2

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.


2007 thomson south western

  • 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.


2007 thomson south western

  • 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.


2007 thomson south western

  • 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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