06.Supply Demand Gov

8/9/2019 06.Supply Demand Gov

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Copyright 2004 South-Western

66Supply, Demand,

and GovernmentPolicies


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Copyright 2004 South-Western/Thomson Learning

Supply, Demand, and GovernmentPolicies

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.


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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.


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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.


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How Price Ceilings Affect Market Outcomes

Two outcomes are possible when the

government imposes a price ceiling:

The price ceiling is notbinding if set above the

equilibrium price.

The price ceiling isbinding if set below the

equilibrium price, leading to a shortage.


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Figure 1 A Market with a Price Ceiling

(a) A Price Ceiling That Is Not Binding

Quantity of

Ice-Cream

Cones

0

Price of

Ice-Cream

Cone

Equilibrium

quantity

$4 Price

ceiling

Equilibrium

price

Demand

Supply

3

100


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Figure 1 A Market with a Price Ceiling

Copyright2003 Southwestern/Thomson Learning

(b) A Price Ceiling That Is Binding

Quantity of

Ice-Cream

Cones

0

Price of

Ice-Cream

Cone

Demand

Supply

2 Price

ceilingShortage

75

Quantity

supplied

125

Quantity

demanded

Equilibriumprice

$3


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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


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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 oilcompanies could charge for

gasoline.


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Figure 2 The Market for Gasoline with a Price Ceiling


(a) The Price Ceiling on Gasoline Is Not Binding

Quantity of

Gasoline

0

Price of

Gasoline

1. Initially,the priceceilingis notbinding . . . Price ceiling

Demand

Supply, S1

P1

Q1


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Figure 2 The Market for Gasoline with a Price Ceiling


(b) The Price Ceiling on Gasoline Is Binding

Quantity of

Gasoline

0

Price of

Gasoline

Demand

S1

S2

Price ceiling

QS

4. . . .resultingin ashortage.

3. . . . the priceceiling becomesbinding . . .

2. . . . but whensupply falls . . .

P2

QD

P1

Q1


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CASE STUDY: Rent Control in the Short Runand 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.


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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)

Quantity of

Apartments

0

Supply

Controlled rent

Rental

Price of

Apartment

Demand

Shortage


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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)

0

Rental

Price of

Apartment

Quantity of

Apartments

Demand

Supply

Controlled rent

Shortage


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How Price Floors Affect Market Outcomes

When the government imposes a price floor,

two outcomes are possible.

The price flooris notbinding if set below the

equilibrium price.

The price floorisbinding if set above the

equilibrium price, leading to a surplus.


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Figure 4 A Market with a Price Floor


(a) A Price Floor That Is Not Binding

Quantity of

Ice-Cream

Cones

0

Price of

Ice-Cream

Cone

Equilibrium

quantity

2

Price

floor

Equilibrium

price

Demand

Supply

$3

100


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Figure 4 A Market with a Price Floor


(b) A Price Floor That Is Binding

Quantity of

Ice-Cream

Cones

0

Price of

Ice-Cream

Cone

Demand

Supply

$4Price

floor

80

Quantity

demanded

120

Quantity

supplied

Equilibrium

price

Surplus

3


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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.


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A binding price floor causes . . .

a surplus because QS > QD.

nonprice rationingis an alternative mechanism for

rationing the good, using discrimination criteria.

Examples: The minimum wage, agricultural price

supports


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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.


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Figure 5 How the Minimum Wage Affects the Labor Market


Quantity of

Labor

Wage

0

Labordemand

LaborSupply

Equilibriumemployment

Equilibriumwage


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Figure 5 How the Minimum Wage Affects the Labor Market


Quantity of

Labor

Wage

0

LaborSupplyLabor surplus

(unemployment)

Labordemand

Minimumwage

Quantitydemanded

Quantitysupplied


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TAXES

Governments levy taxes to raise revenue for

public projects.


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How Taxes on Buyers (and Sellers) AffectMarket Outcomes

Taxes discourage market activity.

When a good is taxed, the

quantity sold is smaller.

Buyers and sellers share

the tax burden.


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Elasticity and Tax Incidence

Tax incidence is the manner in which the

burden of a tax is shared among participants in

a market.


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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.


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Figure 6 A Tax on Buyers


Quantity of

Ice-Cream Cones

0

Price ofIce-Cream

Cone

Price

withouttax

Price

sellers

receive

Equilibrium without taxTax ($0.50)

Price

buyers

pay

D1

D2

Supply, S1

A tax on buyers

shifts the demand

curve downward

by the size of

the tax ($0.50).

$3.30

90

Equilibrium

with tax

2.80

3.00

100


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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.


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Figure 7 A Tax on Sellers


2.80

Quantity of

Ice-Cream Cones

0

Price of

Ice-Cream

Cone

Price

withouttax

Price

sellers

receive

Equilibrium

with tax

Equilibrium without tax

Tax ($0.50)

Price

buyers

payS1

S2

Demand, D1

A tax on sellers

shifts the supply

curve upward

by the amount of

the tax ($0.50).3.00

100

$3.30

90


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Figure 8 A Payroll Tax


Quantity

of Labor

0

Wage

Labor demand

Labor supply

Tax wedge

Wage workers

receive

Wage firms pay

Wage without tax


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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.


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Figure 9 How the Burden of a Tax Is Divided


Quantity0

Price

Demand

Supply

Tax

Price sellersreceive

Price buyers pay

(a) Elastic Supply, Inelastic Demand

2. . . . theincidence of thetax falls more

heavily onconsumers . . .

1. When supply is more elasticthan demand . . .

Price without tax

3. . . . thanon producers.


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Figure 9 How the Burden of a Tax Is Divided


Quantity0

Price

Demand

Supply

Tax

Price sellers

receive

Price buyers pay

(b) Inelastic Supply, Elastic Demand

3. . . . than onconsumers.

1. When demand is more elastic

than supply . . .

Price without tax

2. . . . theincidence of

the tax fallsmore heavilyon producers . . .


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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.

ELASTICITY AND TAX INCIDENCE


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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 theminimum wage.


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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.


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Copyright 2004 South Western/Thomson Learning

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.

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06.Supply Demand Gov