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Chapter 6

Chapter 6. Supply, Demand, and Government Policies . 2002 by Nelson, a division of Thomson Canada Limited. In this chapter you will…. Examine the effects of government policies that place a ceiling on prices. Examine the effects of government policies that place a floor under prices.

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Chapter 6

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  1. Chapter 6 Supply, Demand, and Government Policies 2002 by Nelson, a division of Thomson Canada Limited

  2. In this chapter you will… • Examine the effects of government policies that place a ceiling on prices. • Examine the effects of government policies that place a floor under prices. • Consider how a tax on a good affects the price of the good and the quantity sold. • Learn that taxes levied on buyers and taxes levied on sellers are equivalent. • See how the burden of a tax is split between buyers and sellers.

  3. 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. • Hence…market controls! • One of the roles of economists is to use their theories to assist in the development of policies.

  4. 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.

  5. Price Ceilings and Price Floors • Price Ceiling • A legal maximum on the price at which a good can be sold. • Price Floor • A legalminimum on the price at which a good can be sold.

  6. How Price Ceiling Affect Market Outcomes • When the government imposes a price ceiling (i.e... a legal maximum on the price at which a good can be sold) two outcomes are possible • The price ceiling is not binding. • The price ceiling is a binding constraint on the market, creating Shortages.

  7. Supply Supply Equilibrium price $4 Price ceiling $3 $3 Price ceiling $2 Equilibrium price Shortage Demand Demand 75 QS 125 QD 100 Equilibrium quantity Figure 6-1: A Market with a Price Ceiling (a) A Price Ceiling That is Not Binding (b) A Price Ceiling That is Binding Price of Ice-Cream Cone Price of Ice-Cream Cone 0 0 Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones

  8. How Price Ceiling Affect Market Outcomes • A binding price ceiling creates • Shortages because QD > QS. • Examples: Gasoline shortage of the 1970s, housing shortages with rent controls. • Non-price rationing • Examples: Long lines, discrimination by sellers, black markets.

  9. 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? • Economists blame government regulations that limited the price oil companies could charge for gasoline.

  10. S2 1. Initially the price ceiling is not binding… 2.…but when supply falls… S1 S1 P2 Price ceiling Price ceiling 3.…the price ceiling becomes binding… P1 P1 4.…resulting in a shortage… Demand Demand QS Q1 QD Figure 6-2: A Market for Gasoline with a Price Ceiling (a) A Price Ceiling on Gasoline is Not Binding (b) A Price Ceiling on Gasoline is Binding Price of Gasoline 0 Q1 0 Quantity of Gasoline Quantity of Gasoline

  11. 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.”

  12. Supply Supply Controlled rent Controlled rent Shortage Shortage Demand Demand Figure 6-3: Rent Control in the Short Run and Long Run (a) Short Run (Supply and Demand are Inelastic) (b) Long Run (Supply and Demand are Elastic) Rental Price of Apartment Rental Price of Apartment 0 0 Quantity of Apartments Quantity of 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.

  14. Supply Supply Surplus $4 Equilibrium price Price ceiling $3 $3 Price Floor Equilibrium price $2 Demand Demand 80 QD 120 QS 100 Equilibrium quantity Figure 6-4: A Market with a Price Floor (a) A Price Floor That is Not Binding (b) A Price Floor That is Binding Price of Ice-Cream Cone Price of Ice-Cream Cone 0 0 Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones

  15. How Price Floors Affect Market Outcomes • A Binding Price Floorcreates. . . • Surpluses (i.e. Quantity Supplied > Quantity Demanded) • Non-Price Rationing - An alternative mechanism for rationing of the good: • Discrimination Criteria • Examples: • Minimum Wage • Agricultural Price Supports

  16. 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.

  17. Labour supply Labour surplus (unemployment) Labour supply Minimum wage Equilibrium wage Labour demand Labour demand Quantity supplied Quantity demanded Equilibrium employment Figure 6-5: How the Minimum Wage Affects the Labour Market (a) A Free Labour Market (b) A Labour Market with a Binding Minimum Wage Wage Wage 0 0 Quantity of Labour Quantity of Labour

  18. TAXES • What is the purpose of government- imposed taxes? • To raise government revenues. • To restrict production of a product. • What is an excise tax? • A “per-unit” tax that’s independent of the price of the product.

  19. TAXES • Who pays the tax on a good? The buyer or the seller? • How is the burden of a tax divided between buyer and seller? • When the government levies a tax on a good, the equilibrium quantity of the good falls. The size of the market for that good shrinks, shifting either the demand or supply curve. • Tax incidence: The study of who bears the burden of taxation.

  20. 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.

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

  22. S2 S1 Equilibrium with tax Price buyers pay A tax on sellers shifts the supply curve upward by an amount of the tax ($0.50). $3.30 Price without tax Tax ($0.50) Equilibrium without tax $3.00 $2.80 Price sellers receive D1 90 100 Figure 6-7: A Tax on Sellers Price of Ice-Cream Cone 0 Quantity of Ice-Cream Cone

  23. CASE STUDY:The Burden of a Payroll tax • Example: Employment Insurance. • A payroll tax places a wedge between the wage the workers receive and the wage the firm pays.

  24. Labour supply Wage firms pay Tax wedge Wage without tax Wage workers receive Labour demand Figure 6-8: A Payroll Tax Wage 0 Quantity of Labour

  25. Elasticity and Tax incidence • Consider a tax levied on sellers of a good. What are the effects of this tax? • How do effects of the tax levied on the seller compare with those of the effects imposed on the buyer? • Depends on Elasticity of Demand andElasticity of Supply.

  26. Elasticity and Tax incidence • The burden of a tax falls on the side of the market with the smaller price elasticity! • The moreinelasticthe demand and the more elastic the supply results in the consumer paying more of the tax. • The more elasticthe demand and the moreinelasticthe supply results in the supplier paying more of the tax.

  27. 1. When supply is more elastic than demand … Price buyers pay Supply Tax Price without tax 2. …the incidence of the tax falls more heavily on consumers… Price sellers receive Demand 3. …than on producers. Figure 6-9 a): How the Burden of a Tax is Divided. Price Elastic Supply, Inelastic Demand Quantity

  28. Supply 1. When demand is more elastic than supply … Price buyers pay 3. …than on consumers. Tax Demand Price without tax 2. …the incidence of the tax falls more heavily on producers… Price sellers receive Figure 6-9 b): How the Burden of a Tax is Divided Price Inelastic Supply, Elastic Demand Quantity

  29. Summary • 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.

  30. Summary • 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.

  31. Summary • 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.

  32. The End

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