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Demand, Supply and Economic Policy
Lecture 4 – academic year 2015/16Introduction to Economics
Dimitri Paolini
Where we are…
• Lecture 1: demand and supply• Lecture 2: the concept of elasticity• Lecture 2: elasticity of demand (high and low)
and total revenue• Lecture 3: demand, supply and elasticity –
exercises and applications
2
What do we do today?
• Economic policy: what is it and how it works?• Price regulation• Taxes and their effects
3
Question of the day
Since 2007, in Italy there exist an institution called Price Overseeing Authority (Garante per l’osservanza dei prezzi).• What does it do?
– Overseeing: it verifies the prices– Coordination: it functions as a bridge
between producers and consumers
QUESTION: Why do we need it?
4
Demand, supply and economic policy
Government can affect market’s functioning in two ways:
• By regulating economic activities (p & q max and min);
• By imposing taxes and subsidies.
5
Price regulation and market equilibrium
In a market with no regulation, market forces establish the equilibrium level of p and q.
Even if the market is in equilibrium, somebody can be unsatisfied (for reasons associated with equity or efficiency).
6
When are prices regulated?
When politicians believe p of a given market to be unequal.
In these cases max or min level of prices is fixed.
Usually, there are efficiency costs (this is the classic trade-off between efficiency and equity!)
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Max and min level of price
Max (min) level •It is max (min) price that a good can be sold at according to law.
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Max level of price
When the government imposes a max level of price, there are two possible consequences:•p max is NOT CONSTRAINING: if the market price is < than p max.•p max is CONSTRAINING: if the market price is > than p max. In this case artificial scarcity is created…
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Max price is NOT CONSTRAINING
10
3
0 100
4 Max Price
Supply
Demand
Price ofice-cream
Ice-creamEquilibrium quantityQuantity of
Equilibrium price
Max price is CONSTRAINING
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3
0 100
Supply
Demand
Price ofice-cream
Ice-creamEquilibrium quantityQuantity of
Equilibrium price
2 Max Price
Max price is CONSTRAINING
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3
0
2 Max Price
Supply
Demand
Price ofice-cream
Ice-creamQuantity of
Equilibrium price
75 125
Scarcity
Quantity Supplied Quantity Demanded
The effects of max p
When it is constraining, a max p …
. . . Generate scarcity QD > QS
Example: Scarcity of petrol in 1970.
. . . Rationing of the good.Example: long queues,
or: seller’s discrimination practices.
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Min level of prices
Two possible consequences:
•p min is NOT CONSTRAINING: if p min < than equilibrium price.
•p min IS CONSTRAINING: if p min > than equilibrium price. In this case excess supply is generated.
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Min price is NOT CONSTRAINING
15
3
0 100
2 Min Price
Supply
Demand
Price ofice-cream
Ice-creamEquilibrium quantityQuantity of
Equilibrium price
Max price is CONSTRAINING
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3
0 100
Supply
Demand
Price ofice-cream
Ice-creamEquilibrium quantityQuantity of
Equilibrium price
4 Min Price
Max price is NOT CONSTRAINING
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3
0
4 Min Price
Supply
Demand
Price ofice-cream
Ice-creamQuantity of
Equilibrium price
75 125
Excess Supply
Quantity SuppliedQuantity Demanded
Effects of a min p
When constraining, min p generates . . .
. . . An excess of supply QS > QD
. . . The resources in excess are wasted
Example: Minimum wage; Subsidies to sustain the price of agricultural goods.
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19
(a) Free labour market
Quantity ofemployed
0
Wage
Equilibriumemployment
(b) Labour market with min wage
0 Quantitydemanded
Quantitysupplied
Min wage
Excess supply of labour
(unemployment)
Equilibrium wage
Labour demand
Labour supply
Quantity ofemployed
Wage
Labour demand
Labour supply
Taxes: Effects
Government uses taxation to finance public expenditure.
But taxes are not neutral in that they can discourage market activities.
When a good is taxed, the quantity that is sold diminishes.
In the majority of the cases, buyers and sellers share the tax burden.
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Legal incidence and economics of taxes
The law establishes who pays the tax (legal incidence). But not who really bears the tax burden (economic incidence).
Let’s see why….
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The tax affects the market equilibrium:– The price for consumers rises, who therefore
reduce the quantity demanded.– The portion of the price earned by sellers
reduces, and therefore they reduce the quantity supplied.
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Legal incidence and economics of taxes
The economic incidence (= how the tax burden is shared between consumers and producers) is independent from the subject who is legally responsible for paying the tax … (that is the legal incidence).
It depends on ED and ES.
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Legal incidence and economics of taxes
The effect of a tax on consumption goods
Initial price of an apple: 1€
Then: consumption tax of 0,10€ for each apple. What happens to the price of apples after tax?
Let’s see the cases:
The prince remains equal to 1€. In this case, the tax is paid ONLY by the producer: the consumer pays 1€; 0,10€ goes to State and only 0,90€ to the producer;
The price rises to 1,10€. Then the tax is paid ONLY by the consumer.
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In the majority of the cases “the true lies in between”: the tax rises both the price to consumers and the price to producers.
Example: the price to consumers can become 1,05 and the price to producers 0,95.
The final price depends on the elasticity of demand and supply.
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The effect of a tax on consumption goods
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3,00
0 100
Demand
Price ofice-cream
Ice-creamQuantity of
The effect of a tax on consumption goods
Supply
Equilibrium without the tax
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3,00
0 100
Supply
Demand
Price ofice-cream
Ice-creamQuantity of
The effect of a tax on consumption goods
A tax on consumption shifts the demand curve leftward
Equilibrium without the tax
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3,00
0 100
Supply
Demand
Price ofice-cream
Ice-creamQuantity of
The effect of a tax on consumption goods
New equilibrium with the tax
A tax on consumption shifts the demand curve leftward
Equilibrium without the tax
290
Supply
Demand
Price ofice-cream
Ice-creamQuantity of
The effect of a tax on consumption goods
New equilibrium with the tax
pD
pS
Tax (t)
Qt
Equilibrium without the tax
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3,00
0 100
Demand
Price ofice-cream
Ice-creamQuantity of
The effect of a tax on consumption goods
Supply
Equilibrium without the tax
31
3,00
0 100
Demand
Price ofice-cream
Ice-creamQuantity of
The effect of a tax on consumption goods
A tax on production (0,50 cents) shifts the supply curve leftward.
Equilibrium without the tax
Supply
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3,00
0 100
Demand
Price ofice-cream
Ice-creamQuantity of
The effect of a tax on consumption goods
Equilibrium without the tax
Supply A tax on production (0,50 cents) shifts the supply curve leftward.
New equilibrium with the tax
330 80
Demand
Price ofice-cream
Ice-creamQuantity of
The effect of a tax on consumption goods
Equilibrium without the tax
Supply
3,30
A tax on production (0,50 cents) shifts the supply curve leftward.
New equilibrium with the tax
Tax (0,50)
2,80
Incidence of taxes
How is the tax burden shared between consumers and producers?
All depends on the elasticity of the demand and supply curves.
The tax burden mainly falls on the less elastic market component.
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Elasticity and incidence of taxes
If the demand is inelastic and the supply is elastic: The tax is paid mainly by the consumer.
If the demand is elastic and the supply is inelastic: The tax is paid mainly by the producer.
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Elastic supply + inelastic demand
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Quantity0
Price
Demand
Supply
Price before tax
Elastic supply + inelastic demand
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Quantity0
Price
Demand
Supply
Price before tax
Tax burden
Price to producer
Price to consumer
Elastic supply + inelastic demand
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Quantity0
Price
Demand
Supply
Price before tax
Tax burden
Price to producer
Price to consumer
1. If the supply is more elastic then the demand...
2. …the tax affects more the consumer...
3. …then the producer.
Inelastic supply + elastic demand
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0 Quantity
Price
Demand
Supply
Price before tax
Inelastic supply + elastic demand
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0 Quantity
Price
Demand
Supply
Price before tax
Tax burden
Price to producer
Price to consumer
Inelastic supply + elastic demand
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0 Quantity
Price
Demand
Supply
Price before tax
Tax burden
Price to producer
Price to consumer
1. If the demand is more elastic than the supply..
2. …the tax impacts more on the producer...
3. …Than on the consumer.
Conclusion
The economy is ruled by two kinds of law:•The law of demand and supply•The laws enacted by the legislator
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Conclusion
Regulated prices include either a minimum or a maximum (or both) level of price.
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Conclusion
Taxes on production and consumption create new equilibrium prices, where consumers and producers share in the tax burden.
The incidence of the tax depends on the elasticity of demand and supply.
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Next lecture
Market efficiency…
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