Economic Analysis Economic Analysis for Businessfor Business

Session VIII: Supply Demand Session VIII: Supply Demand and Government Policies-Iand Government Policies-IInstructorInstructorSandeep BasnyatSandeep Basnyat98418922819841892281Sandeep_basnyat@yahoo.comSandeep_basnyat@yahoo.com

CHAPTER 6 SUPPLY, DEMAND, AND

GOVERNMENT POLICIES

Government Policies That Alter the Private Government Policies That Alter the Private Market OutcomeMarket Outcome

Price controls◦Price ceiling: a legal maximum on the

price of a good or service. Example: rent control.

◦Price floor (Price support): a legal minimum on the price of a good or service. Example: minimum wage.

Taxes and Subsidies◦The govt. can make buyers or sellers pay a

specific amount on each unit bought/sold.

Price Control Policy :Price Control Policy : Rent Control in the Rent Control in the Short Run and Long RunShort 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.”

CHAPTER 6 SUPPLY, DEMAND, AND

GOVERNMENT POLICIES

RENT CONTROL: The Market for RENT CONTROL: The Market for ApartmentsApartments

Eq’m w/o price

controls

Eq’m w/o price

controls

P

QD

SRental price of

apts

$800

300

Quantity of apartments

CHAPTER 6 SUPPLY, DEMAND, AND

GOVERNMENT POLICIES

How Price Ceilings Affect Market How Price Ceilings Affect Market OutcomesOutcomes

A price ceiling above the eq’m price is

not binding – it has no effect on the market outcome.

P

QD

S

$800

300

Price ceiling

$1000

CHAPTER 6 SUPPLY, DEMAND, AND

GOVERNMENT POLICIES

How Price Ceilings Affect Market How Price Ceilings Affect Market OutcomesOutcomesThe eq’m price ($800) is above the ceiling and therefore illegal.The ceiling is a binding constraint on the price, and causes a shortage.

P

QD

S

$800

Price ceiling

$500

250 400

shortage

CHAPTER 6 SUPPLY, DEMAND, AND

GOVERNMENT POLICIES

How Price Ceilings Affect Market How Price Ceilings Affect Market OutcomesOutcomes

In the long run, supply and demand are more price-elastic. So, the shortage is larger.

P

QD

S

$800

150

Price ceiling

$500

450

shortage

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:CASE STUDY: Lines at the Gas Lines at the Gas PumpPump

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

The Market for Gasoline with a Price CeilingThe Market for Gasoline with a Price Ceiling

(a) The Price Ceiling on Gasoline Is Not Binding

Quantity ofGasoline

0

Price ofGasoline

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

Demand

Supply, S1

P1

Q1

The Market for Gasoline with a Price CeilingThe Market for Gasoline with a Price Ceiling

(b) The Price Ceiling on Gasoline Is Binding

Quantity ofGasoline

0

Price ofGasoline

Demand

S1

S2

Price ceiling

QS

4. . . . resultingin ashortage.

3. . . . the priceceiling becomesbinding . . .

2. . . . but whensupply falls . . .

P2

QD

P1

Q1

CHAPTER 6 SUPPLY, DEMAND, AND

GOVERNMENT POLICIES

PRICE FLOOR (PRICE SUPPORT) : PRICE FLOOR (PRICE SUPPORT) : The Market The Market for Unskilled Laborfor Unskilled Labor

Eq’m w/o price

controls

Eq’m w/o price

controls

W

LD

SWage paid to

unskilled workers

$4

500

Quantity of unskilled workers

CHAPTER 6 SUPPLY, DEMAND, AND

GOVERNMENT POLICIES

How Price Floors Affect Market How Price Floors Affect Market Outcomes?Outcomes?

W

LD

S

$4

500

Price floor

$3

A price floor below the eq’m price is not binding – it has no effect on the market outcome.

CHAPTER 6 SUPPLY, DEMAND, AND

GOVERNMENT POLICIES

How Price Floors Affect Market OutcomesHow Price Floors Affect Market Outcomes

W

LD

S

$4

Price floor

$5

The eq’m wage ($4) is below the floor and therefore illegal.The floor is a binding constraint on the wage, and causes a surplus (i.e., unemployment).

400 550

labor surplus

Case Study: The Minimum WageCase Study: The Minimum WageAn 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.

CHAPTER 6 SUPPLY, DEMAND, AND

GOVERNMENT POLICIES

Min wage laws do not affect highly skilled workers.

They do affect teen workers.

Studies: A 10% increase in the min wage raises teen unemployment by 1-3%.

The Minimum WageThe Minimum Wage

W

LD

S

$4

Min. wage

$5

400 550

unemp-loyment

Impact of Minimum Wage Impact of Minimum Wage LawsLaws

•Skills and Experience: No effects or not binding because their equilibrium wage rates are well above minimum wage

•Teenage labour: Least skilled and least experienced. Minimum wage law hits them hard.

• Impact on quantity of labour supplied: Increases the quantity of labor supplied as more teenagers will be interested to work, a result of which they will drop out of schools.

CHAPTER 6 SUPPLY, DEMAND, AND

GOVERNMENT POLICIES

Evaluating the Effects of Price Evaluating the Effects of Price ControlsControls

Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices.

Price controls are often intended to help the poor, but they often hurt more than help them:

• The min. wage can cause job losses.

• Rent control can reduce the quantity and quality of affordable housing.

Numerical ProblemsNumerical ProblemsConsider a market with Demand curve q = 16 − 10p and Supply curve q = −8 + 20p. (Here q is in millions of kgs and p is in dollars/kg)

(a)Determine the market equilibrium price and quantity and the total revenue in this market.

(b)Calculate the price elasticity of demand and the price elasticity of supply at the market equilibrium.

Solved ProblemsSolved ProblemsConsider a market with Demand curve q = 16 − 10p and Supply curve q = −8 + 20p. (Here q is in millions of kgs and p is in dollars per kg.)

(a) Determine the market equilibrium price and quantity and the total revenue in this market.Simultaneously solving the demand and supply equations:

p = $0.80 per kg. and q = 8 million kgs.

Total revenue is: p x q = 0.8 x 8 = $6.4 millions.

(b) Calculate the price elasticity of demand and the price elasticity of supply at the market equilibrium.

The slope of the demand curve is −10, so the price elasticity of demand at the market equilibrium is −10.(0.8/8) = −1.

Similarly, the slope of the supply curve is 20, so the price elasticity of supply at the market equilibrium is 20.(0.8/8)= 2.

Numerical ProblemsNumerical ProblemsConsider a market with Demand curve q = 16 − 10p and Supply curve q = −8 + 20p. (Here q is in millions of kgs and p is in dollars/kg)

c)Suppose the government sets support price of $1 per kg in this market and purchases the surplus at support price. Find the quantity demanded, quantity supplied and government expenditure in this market to implement the policy.

d)Illustrate in diagram the results obtained in part (c).

Numerical ProblemsNumerical ProblemsConsider a market with Demand curve q = 16 − 10p and Supply curve q = −8 + 20p. (Here q is in millions of kgs and p is in dollars/kg)

c)Suppose the government sets support price of $1 per kg in this market and purchases the surplus at support price. Find the quantity demanded, quantity supplied and government expenditure in this market to implement the policy.

At, support price of $1/kg,

Quantity demanded = 16 – 10(1) = 6 million kgs.

Quantity Supplied = - 8 + 20(1) = 12 million kgs.

There will be a surplus of 6 million kgs in the market.

Total Government expenditure = 6 x 1 = $6 million.

CHAPTER 6 SUPPLY, DEMAND, AND

GOVERNMENT POLICIES

(d) Illustration of part c on Price Support (d) Illustration of part c on Price Support PolicyPolicy

W

LD

S

$0.8

Price support (floor)

$1

6 12

Surplus = 6 million kgs.

8

Govt. Spending

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