Sessions 9 & 10

8/14/2019 Sessions 9 & 10

1/23

Sessions 9 & 10

Supply, Demand &Government Policies

(With inputs from N. Gregory Mankiw: Principles of Economics, 4th Edition, Chapter 6)

8/14/2019 Sessions 9 & 10

2/23

Dr. Jaydeep MukherjeeRavenshaw University

Session Objectives:

What are price ceilings and price floors? What aresome examples of each?

How do price ceilings and price floors affect marketoutcomes?

How do taxes affect market outcomes? How doesthe outcome depend on whether the tax is imposed

on buyers or sellers?

What is the incidence of a tax? What determines theincidence?

8/14/2019 Sessions 9 & 10

3/23


An Overview In a free, unregulated market system, market forces

establish equilibrium prices and exchange quantities.

While equilibrium conditions may be efficient, it maybe true that not everyone is satisfied.

One of the roles of economists is to use their theoriesto assist in the development of policies.

8/14/2019 Sessions 9 & 10

4/23


Controls on Prices

Are usually enacted when policymakers believe themarket price is unfair to buyers or sellers.

Result in government-created price ceilings andfloors.

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.

8/14/2019 Sessions 9 & 10

5/23


Price Ceiling: Rent Control

Quantity

of Apts.

RentalPrice ofApts.

Consider a common example ofrent control

Rent controls are ceilings placed

on the rents that landlords maycharge their tenants.

The goal of rent control policy isto help the poor by makinghousing more affordable.

We begin by showing the market forapartments in equilibrium (before thegovernment imposes any pricecontrols).

D

S

Rs.1000

500

8/14/2019 Sessions 9 & 10

6/23



Quantity

of Apts.

RentalPrice ofApts.

A price ceiling above theequilibrium price is not binding.The market clears at Rs.1000and the price ceiling is

ineffective.

Just because landlords are allowed to chargeRs.1200 rent doesnt mean they will if theydo, they wont be able to rent all of theirapartments a surplus will result, causing

downward pressure on the price (rent).Theres no law that prevents the price (rent)from falling, so it does fall until the surplus isgone and equilibrium is reached (at P =Rs.1000 and Q = 500).

D

S

Rs.1000

500

Rs.1200

8/14/2019 Sessions 9 & 10

7/23



Quantity

of Apts.

RentalPrice ofApts.

The eqm price (Rs.1000) is abovethe ceiling and therefore illegal.The ceiling is a binding constraintonthe price, and causes a shortage.

The actual quantity of apartmentsrented equals 250, and there is ashortage equal to 500 (the differencebetween the quantity demanded, 750,and the quantity supplied, 250.

D

S

Rs.1000

500

Rs.800

Shortage

250 750

8/14/2019 Sessions 9 & 10

8/23



Quantity

of Apts.

RentalPrice ofApts.

In the long run, supply and demandare more price-elastic. So, theshortage is larger.WHY??

D

S

Rs.1000

500

Rs.800

Shortage

100 900

Quick Activity:

For a product, supply and demandfunctions are estimated as follows:

Qs = 300 + 10P

Qd = 500 15P.If the government fixes a price ceiling ofRs.15 for the product, then what will beits impact on the market.

8/14/2019 Sessions 9 & 10

9/23


Shortages and Rationing

With a shortage, sellers must ration the goodsamong buyers.

Some rationing mechanisms: (1) long lines, and (2)

discrimination according to sellers biases, and evenunder-the-table payments to landlords

These mechanisms are often unfair, and inefficient:the goods do not necessarily go to the buyers whovalue them most highly.

In contrast, when prices are not controlled, therationing mechanism is efficient (the goods go tothe buyers that value them most highly) andimpersonal (and thus fair).

8/14/2019 Sessions 9 & 10

10/23


Price Floor: Minimum Wage

L

WNow we switch gears and look at theeffects of a price floor. We illustratethis concept using the example of theminimum wage.

The price of labor is morecommonly known as the wage, whichwe measure on the vertical axis ofour supply-demand diagram. Alongthe horizontal axis, we measure thequantity of labor (number of

workers). The demand for unskilledlabor comes from firms. The supplycomes from workers. We focus on unskilled labor because

the minimum wage is not relevantfor higher skilled, higher wageworkers.

D

S

Rs.50

500

8/14/2019 Sessions 9 & 10

11/23



L

WA price floor below the eqm price is notbinding has no effect on the marketoutcome.

At a wage of Rs.40, the quantity of unskilledworkers that firms wish to hire exceeds thequantity of unskilled workers that arelooking for jobs, resulting in shortages.

But the minimum wage law does not stopthe wage from rising above Rs.40. So, inresponse to this shortage, the wage will riseuntil the shortage disappears which occursat the equilibrium wage of Rs.50. Theequilibrium wage is perfectly legal when theprice floor (i.e. minimum wage) is below it.

D

S

Rs.50

500

Rs.40

8/14/2019 Sessions 9 & 10

12/23



L

WNow, the minimum wage exceeds theequilibrium wage. The equilibrium wage(or any wage below Rs.60) is illegal.

In this case, the actual wage will be Rs.60. Itwill not be lower, because any lower wage isillegal. It will not be higher, because atany higher wage, the surplus would be evengreater. The actual number of unskilledworkers with jobs equals 400. 550 wantjobs, but firms are only willing to hire 400,

leaving a surplus (i.e. unemployment) of150 workers.

A surplus of anything especially laborrepresents wasted resources.

D

S

Rs.50

500

Rs.60

Surplus

400 550

8/14/2019 Sessions 9 & 10

13/23


Evaluating Price Controls

Recall one of the Ten Principles:Markets are usually a good wayto organize economic activity.

Prices are the signals that guide the allocation of societysresources. This allocation is altered when policymakers restrictprices.

Price controls often intended to help the poor, but often hurtmore than help

We have seen that the minimum wage can cause job losses, and

rent control can reduce the quantity and quality of affordablehousing. Both policies make the poor worse off

If prices are set by laws, they obscure the signals that efficientlyallocate scarce resources.

8/14/2019 Sessions 9 & 10

14/23


Taxes

The govt levies taxes on many goods & services to raiserevenue to pay for national defense, public schools, etc.

The govt can make buyers or sellers pay the tax.

The tax can be a % of the goods price, or a specific amountfor each unit sold.

For simplicity, we analyze per-unit taxes only.

Tax incidenceis the manner in which the burden ofa tax is shared among participants in a market.

8/14/2019 Sessions 9 & 10

15/23


Taxes on Buyers: Market for Pizza

Quantity

of Pizza

Price ofPizza

Consider the market for pizza

We begin by showing the market forapartments in equilibrium (before thegovernment imposes any taxes).

D

S

Rs.10

500

8/14/2019 Sessions 9 & 10

16/23



Quantity

of Pizza

Price ofPizza

The government makes buyers pay aRs.1.50 on each pizza they purchase.The new demand curve (in red, labeledD2) reflects buyers demand as a

function of the after-tax price. Theoriginal demand curve (D1) still reflects

buyers demand as a function of thetotal price inclusive of the tax.

At each quantity, the height of the original(blue) D curve is still the maximum that

buyers will pay for that quantity, while theheight of the new (red) D curve is themaximum that buyers will pay sellers for thatquantity, given that buyers also must pay thetax. At any Q, the vertical distance betweenthe blue and red D curves equals the tax.

D1

S

Rs.10

500

D2

Pb = Rs.11

Ps = Rs.9.50

Taxes

430

8/14/2019 Sessions 9 & 10

17/23



Quantity

of Pizza

Price ofPizza

The price buyers pay rises, theprice sellers receive falls, eqm Qfalls

The burden of a tax is shared amongmarket participants. Because of the tax,

buyers pay Re.1.00 more, sellers getRe.0.50 less.

D1

S

Rs.10

500

D2

Pb = Rs.11

Ps = Rs.9.50

Taxes

430

8/14/2019 Sessions 9 & 10

18/23


Taxes on Sellers: Market for Pizza

Quantity

of Pizza

Price ofPizza

The government makes sellers pay aRs.1.50 on each pizza they sell. Thenew supply curve (in red, labeled S2)

reflects sellers supply as a function of

the after-tax price.

Making sellers pay a Rs.1.50 tax on each unitthey sell is equivalent to a Rs.1.50 increasein the cost of producing each pizza. Anythingthat increases production costs causes the S

curve to shift up: In order for sellers to bewilling to supply the same quantity as before,they must receive a higher price tocompensate them for the increase in theircosts.

D

S1

Rs.10

500

Pb = Rs.11

Ps = Rs.9.50

Taxes

430

S2

8/14/2019 Sessions 9 & 10

19/23


Taxes on Buyers & Sellers: A Comparison

The Outcome Is the Same in Both Cases!

Whether the government makes buyers or sellers pay the tax, all ofthe effects are the same:

- the price buyers pay rises (in this case to Rs.11)

- the price sellers receive falls (to Rs.9.50)

- the equilibrium quantity falls (to 430)

- the incidence of the tax is the same (here, buyers pay Re.1 of thetax, while sellers pay Re.0.50 of the tax on each unit)

The equivalence of taxes on buyers and taxes on sellers means thatwe can ignore whether the tax is imposed on buyers or sellers.

What matters is this: A tax drives a wedge between the price buyerspay and the price sellers receive.

8/14/2019 Sessions 9 & 10

20/23


Tax Incidence and Elasticity

Tax incidence is not affected by whether thegovernment makes buyers or sellers pay the tax.

What, then, does determine tax incidence?

It is elasticity specifically, the price elasticities ofsupply and demand

Two Possibilities:

supply is more price-elastic than demand

demand is more price-elastic than supply

8/14/2019 Sessions 9 & 10

21/23


Case 1:

Supply is more price-elastic than demand

Sellers are relatively more responsive to changes

in price, and the supply curve is less steep thanthe demand curve.

Buyers have relatively fewer alternatives, so theyhave to eat most of the price increase caused bythe imposition of the tax.

Result

Greater burden borne by buyers

8/14/2019 Sessions 9 & 10

22/23


Case 2:

Demand is more price-elastic than supply

buyers are relatively more price-sensitive, and the demand

curve is less steep than the supply curve. Buyers have relatively more alternatives, so they can avoid

most of the tax. Sellers are less flexible, so they have toeat a greater share of the price increase caused by thetax.

Result

Greater burden borne by sellers

8/14/2019 Sessions 9 & 10

23/23

Documents

Sessions 9 & 10