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Supply, Demand, andGovernment Policy
Controls on Price – Price Ceiling
Legal maximum on the price at which a good can be sold
• Maximum price for Hamburger• Intent: to protect consumers
Hamburger market with a price ceiling
Price
Quantity0
Demand
100
Price ceiling that is not binding
To the left, the government imposes a price ceiling of $4. Because the price ceiling is above the equilibrium price of $3, the price ceiling has no effect, and the market can reach the equilibrium of supply and demand. In this equilibrium, quantity supplied and quantity demanded both equal 100 burgers. To the right, the government imposes a price ceiling of $2. Because the price ceiling is below the equilibrium price of $3, the market price equals $2. At this price, 125 burgers are demanded and only 75 are supplied, so there is a shortage of 50 burgers.
Price ceiling that is binding
$3
Supply
$4 Price ceiling
Equilibriumprice
Equilibriumquantity
Price
Quantity 0
Demand
$3
Supply
$2 Price ceiling
Equilibriumprice
75
Quantitydemanded
Quantitysupplied
125
Shortage
Controls on Price – Price Ceiling
A price ceiling can affect market outcomes– Not binding
• Above the equilibrium price• No effect
– Binding constraint• Below the equilibrium price• Shortage • Sellers must ration the scarce goods
– When the rationing mechanisms are not desirable
In 1973 OPEC managed to raised the price of crude oil
– by reducing the supply of crude– thus gas supply lowered– Long lines at gas stations, why?– U.S. government regulations: price ceiling on gasoline
• Before OPEC raised the price of crude oil– Equilibrium price of gas was below the price ceiling: no effect
• When the world price of crude oil rose as OPEC reduced the supply of gasoline
– Equilibrium price of gas went above price ceiling: shortage
Price Ceiling: Gas Price Policy in 1973
Price Ceiling: Market for gasoline
Gas Price
Quantity of Gas0
Demand
Q1
Gas Price Ceiling is not binding
The left illustration shows the gas market when the price ceiling is not binding because the equilibrium price, P1, is below the ceiling. The right illustration shows the gasoline market after an increase in the price of crude oil (an input used to make gas) shifts the supply curve to the left from S1 to S2. In an unregulated market, the price would have risen from P1 to P2. The price ceiling prevents this from happening. At the binding price ceiling, consumers are willing to buy QD, but producers of gasoline are willing to sell only QS. The difference between quantity demanded and quantity supplied, QD – QS, measures the gasoline shortage.
P1
Supply, S1
Price ceiling
1. Initially, the price ceiling is not binding …
Demand
S1
Gas Price
Quantity of Gas0 Q1
P1
Price ceiling
S2
P2
2…but when supply falls…
3…the price ceiling becomes binding…
QS QD
4. …resulting in a shortage
Gas Price Ceiling is binding
• Price ceiling: rent control– Local government puts a ceiling on rents– Goal: to help the poor (housing more affordable)– Critique: highly inefficient way to help the poor raise
their standard of living• Adverse effects of rent control in the short run
– Supply and demand for housing is relatively inelastic– Initial small shortage at reduced rents
Price Ceiling: Rent controls
• Adverse effects of rent control in the long run– Supply and demand becomes more elastic
• Landlords will not build new apartments will be less likely to maintain existing ones
• At the binding rent ceiling more people will want to move into a city
• Large shortage of housing
– Non-rent rationing mechanisms• Long waiting lists• Discrimination (children, pets, race, national origin)• Bribes to building superintendents
Price Ceiling: Rent controls
RentalPrice of
Apartment
Quantity of Apartments0
Demand
Rent Control in the Short Run(supply and demand are inelastic)
The left illustration shows the short-run effects of rent control: Because the supply and demand for apartments are relatively inelastic, the price ceiling imposed by a rent-control law causes only a small shortage of housing. The right illustration shows the long-run effects of rent control: Because the supply and demand for apartments are more elastic, rent control causes a large shortage.
Rent Control in the Long Run(supply and demand are elastic)
Supply
Controlled rent
RentalPrice of
Apartment
Quantity of Apartments0
Demand
Supply
Controlled rent
ShortageShortage
Rent control in the short run and the long run
• People respond to incentives– Free markets
• Landlords try to keep their buildings clean and safe• Higher prices
– Rent control shortages & waiting lists• Landlords lose their incentive to respond to tenants’
concerns• Tenants get lower rents & lower-quality housing
• Policymakers: additional regulations– Difficult and costly to enforce
Price Ceiling: Rent controls
Controls on Price – Price Floor
Legal minimum on the price at which a good can be sold• Minimum legal price for Hamburger• Why? Supposedly to protect the
Hamburger industry
Price Floor: Hamburger Market
Price
Quantity0
Demand
100
Price floor that is not binding
In the left illustration, government imposes a price floor of $2. Because this is below the equilibrium price of $3, the price floor has no effect. The market price adjusts to balance supply and demand. At the equilibrium, quantity supplied and quantity demanded both equal 100 burgers. To the right, government imposes a price floor of $4, which is above the equilibrium price of $3. Therefore, the market price equals $4. Because 120 burgers are supplied at this price and only 80 are demanded, there is a surplus of 40 burgers.
Price floor that is binding
$3
Supply
2 Price floor
Equilibriumprice
Equilibriumquantity
Price
Quantity0
Demand
3
Supply
$4Price floor
Equilibriumprice
80
Quantitysupplied
Quantitydemanded
120
Surplus
Controls on Price – Price FloorHow price floors affect market outcomes
– Not binding• Below the equilibrium price• No effect
– Binding constraint• Above the equilibrium price• Surplus • Some seller are unable to sell what they want
• Minimum Wage is the lowest price for labor that any employer may pay
• Fair Labor Standards Act of 1938 to insure workers a minimally adequate standard of living
• 2007: minimum wage = $5.15 per hour• 2010: minimum wage = $7.25 per hour
Price Floor: The minimum wage
• Impact of the minimum wage above equilibrium– Workers with high skills and much experience
• Not affected: Equilibrium wages are above the minimum• Minimum wage is not binding
– Teenage labor: least skilled and least experienced• Low equilibrium wages • Willing to accept a lower wage in exchange for on-the-job
training• Minimum wage is binding
Price Floor: The minimum wage• Market for labor
– Workers (supply of labor)– Firms (demand for labor)
Price Floor: Minimum wage and the labor marketWage
Quantity of Labor
0
Labordemand
Equilibriumemployment
A free labor market
The left illustration shows a labor market in which the wage adjusts to balance labor supply and labor demand. The right illustration shows the impact of a binding minimum wage. Because the minimum wage is a price floor, it causes a surplus: The quantity of labor supplied exceeds the quantity demanded. The result is unemployment.
A Labor Market with a Binding Minimum Wage
Equilibriumwage
Laborsupply
Wage
Quantityof Labor
0
Minimumwage
Quantitydemanded
Quantitysupplied
Labor surplus(unemployment)
Labordemand
Laborsupply
Controls on PricesEvaluating price controls• Markets are usually a good way to organize
economic activity– Economists usually oppose price ceilings and price floors– Prices coordinate economic activity efficiently
• Governments can sometimes improve market outcomes • because of unfair market outcome• aimed at helping the poor• often hurt those they are trying to help • other ways of helping those in need
• rent subsidies• wage subsidies
A tax on sellersPrice
Hamburger
Quantity ofHamburger
0
Demand, D1
90
When a tax of $0.50 is levied on sellers, the supply curve shifts up by $0.50 from S1 to S2. The equilibrium quantity falls from 100 to 90 hamburgers. The price that buyers pay rises from $3.00 to $3.30. The price that sellers receive (after paying the tax) falls from $3.00 to $2.80. Even though the tax is levied on sellers, buyers and sellers share the burden of the tax.
S1
S2
100
$3.30
3.00
2.80
Pricebuyers
pay
Pricewithout
tax
Pricesellersreceive
A tax on sellersshifts the supplycurve upwardby the size ofthe tax ($0.50).
Tax($0.50) Equilibrium without tax
Equilibrium with tax
Tax on Sellers • Tax incidence – a manner in which the burden of a
tax is shared among participants in a market
• How taxes on sellers affect market outcomes– Immediate impact on sellers– Supply curve shifts left– Higher equilibrium price– Lower equilibrium quantity– The tax reduces the size of the market
Taxes on Sellers How taxes on sellers affect market outcomes
– Taxes discourage market activity– Smaller quantity sold– Buyers and sellers share the burden of tax– Buyers pay more
• Worse off
– Sellers receive less• Collects the higher price but pays the tax• Overall: effective price falls• Sellers are worse off
Tax on Buyers
Price
Quantity0
D1
90
When a tax of $0.50 is levied on buyers, the demand curve shifts down by $0.50 from D1 to D2. The equilibrium quantity falls from 100 to 90 hamburgers. The price that sellers receive falls from $3.00 to $2.80. The price that buyers pay (including the tax) rises from $3.00 to $3.30. Even though the tax is levied on buyers, buyers and sellers share the burden of the tax.
Supply, S1
100
$3.30
3.00
2.80
Pricebuyers
pay
Pricewithout
tax
Pricesellersreceive
A tax on buyersshifts the demandcurve downwardby the size ofthe tax ($0.50).
Tax($0.50)
Equilibrium without tax
Equilibrium with tax
D2
Taxes on Buyers
How taxes on buyers affect market outcomes– Demand curve shifts left– Higher equilibrium price– Lower equilibrium quantity– The tax reduces the size of the market
Tax on Buyers • How taxes on buyers affect market outcomes
– Buyers and sellers share the burden of the tax– Sellers get a lower effective price
• Worse off
– Buyers pay a higher market price• Effective price (with tax) rises• Worse off
• Tax levied on sellers and tax levied on buyers are equivalent
1.85%
Earning $200,000 + $1
Income Tax and Labor Markets
Tax rate on this dollar
Federal Income TaxFICA
Kentucky Income TaxMedicare Tax
Warning, if you have a weak stomach, you might want to avoid this slide
28.0%12.4%2.9%
6.2% x 21.45% x 2
6.0%Bowling Green Tax
51.15%
You keep $1 x 49% = .49 cents
Income Tax and Labor Markets
Price
Quantity0
Labor Demand
Labor SupplyCost of laborto business
Wage without tax
Worker wage
Sizeof tax
A tax on a good places a wedge between the wage workers receive and the cost of labor to business. Labor use falls.
Employmentwith tax
Employmentwithout tax
The Tax Burden• Elasticity and tax incidence• Dividing the tax burden
– Very elastic supply and relatively inelastic demand• Sellers – small burden of tax• Buyers – most of the burden
– Relatively inelastic supply and very elastic demand• Sellers – most of the tax burden• Buyers – small burden
How the burden of a tax is divided
Price
Quantity0
Demand
SupplyPrice buyers pay
Price without tax
Price sellersreceive
Tax
When he supply curve is elastic, and the demand curve is inelastic. In this case, the price received by sellers falls only slightly, while the price paid by buyers rises substantially. Thus, buyers bear most of the burden of the tax.
Elastic Supply, Inelastic Demand
1. When supply is more elastic than demand . . .
2. . . . The incidence of the tax falls more heavily on consumers . . .
3. . . . Than on producers.
How the burden of a tax is divided
Price
Quantity0
Demand
Supply
Price buyers pay
Price without tax
Price sellersreceive
Tax
When the supply curve is inelastic, and the demand curve is elastic. In this case, the price received by sellers falls substantially, while the price paid by buyers rises only slightly. Thus, sellers bear most of the burden of the tax.
Inelastic Supply, Elastic Demand
1. When demand is more elastic than supply . . .
3. Than on consumers
2. . . . The incidence of the tax falls more heavily on producers.
The Tax Burden
Tax burden falls more heavily on the side of the market that is less elastic
– Low elasticity of demand• Buyers do not have good alternatives to
consuming this good– Low elasticity of supply
• Sellers do not have good alternatives to producing this good
• The 1990 consumption luxury tax– Goal: to raise revenue from those who could most
easily afford to pay– Luxury items
• Demand is usually quite elastic• Supply is relatively inelastic
• Outcome:– Burden of a tax falls largely on the suppliers
• The American Yacht industry disappeared• In 1993 most of the luxury tax was repealed
Who pays the luxury tax?