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Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Supply, Demand, and
Government PoliciesPrinciples of Economics
Chapter 6
N.Gregory Mankiw
© 2002 by Nelson, a division of Thomson Canada Limited
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Overview
The Effects of Price ControlsThe Effects of an Excise Tax
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Supply, Demand and Government Policies
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, i.e. buyer or seller are satisfied.
Hence, market controls!
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Burkhas in Afghanistan
� Once the Taliban was ousted, demand for burkhas fell as many women quit wearing them.
� At P0 quantity supplied > quantity demanded.
� Price fell to P1 until quantity demanded = quantity supplied.
S
P0
Q0Q1
P1 D0
D1
Excess Supply
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Market Price Controls
Are usually enacted when policy-makers believe that the market price is unfair to buyers and sellers.
Result in government policies, i.e. price ceilings and floors.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Government Intervention as Implicit Taxation
� Government intervention in the form of price controls can be viewed as a combination tax and subsidy.
� A price ceiling is an implicit tax on producers and an implicit subsidy to producers that causes a welfare loss identical to the loss from taxation.
� A price floor is a tax on consumers and a subsidy for producers that transfers consumer surplus to producers.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Price Ceilings & Price Floors
A Price Ceiling – is a legally established maximum price
which a seller can charge or a buyer must pay.
A Price Floor– is a legally established minimum price
which a seller can charge or a buyer must pay.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Price Ceilings
When the government imposes a price ceiling (i.e... a legal maximum on the price at which a good can be sold) two outcomes are possible:1 . The price ceiling is not binding.
2 . The price ceiling is a binding constraint on the market, creating Shortages.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Market Impacts of a Price Ceiling
Supply
Demand
Price
Quantity
EquilibriumPrice
EquilibriumQuantity
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
A Non-Binding Price Ceiling
Supply
Demand
Price
Quantity
PE
QE
PriceCeiling
PC
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
A Binding Price Ceiling
Supply
Demand
Price
Quantity
PE
QE
PriceCeiling
PC
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
A Binding Price Ceiling Creates Shortages.
Supply
Demand
Price
Quantity
PE
QE
PC
QS QD
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
A Binding Price Ceiling Creates Shortages.
Supply
Demand
Price
Quantity
PE
QE
PC
QS QD
Shortage
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Market Impacts of a Price CeilingA Binding Price Ceiling creates. . .
– Shortages (i.e... Demand > Supply)Gasoline shortages of the 1970sHousing shortages with rent controls
– Non-Price Rationing - An alternative mechanism for rationing of the good:Long Lines (first-In-Line, friends etc.)Discrimination criteria set by sellerBlack markets
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Price Floors
When the government imposes a price floor (i.e... a legal minimum on the price at which a good can be sold) two outcomes are possible:1 . The price floor is not binding.
2 . The price floor is a binding constraint on the market, creating Surpluses.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
A Non-Binding Price Floor
Supply
Demand
Price
Quantity
PE
QE
PriceFloor
PF
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
A Binding Price Floor
Supply
Demand
Price
Quantity
PE
QE
PriceFloor
PF
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Market Impacts of a Price Floor
A government-imposed market price floor hinders the forces of supply and demand in 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. A binding price floor causes a surplus.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
A Binding Price Floor Creates a Surplus.
Supply
Demand
Price
Quantity
PE
QE
PF
QS QD
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Supply
Demand
Price
Quantity
PE
QE
PF
QS QD
Surplus
A Binding Price Floor Creates a Surplus.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Market Impacts of a Price Floor
A Binding Price Floor creates. . .–Surpluses (i.e. Quantity Supplied >
Quantity Demanded)
–Non-Price Rationing - An alternative mechanism for rationing of the good:Discrimination Criteria
–Examples:Minimum Wage Agricultural Price Supports
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Effect of a Price Ceiling
P0
Q0Quantity
Price
Q1
S
DProducer surplus
Consumer surplus
Welfare loss
P1Price ceiling
Transferred to consumers
F
D
C
E
B
A
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Effect of a Price Floor
P0
Q0Quantity
Price
Q1
S
DProducer surplus
Consumer surplus
Welfare loss
Transferred to producers
F
D
C
E
B
AP1
Price floor
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Government Intervention in the Market
� Buyers look to the government for ways to hold prices down.
� A price ceiling is a government-imposed limit on how high a price can be charged.
� Sellers look to the government for ways to hold prices up.
� A price floor is a government-imposed limit on how low a price can be charged.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
2.50
Shortage
Rent Controls� Rent control is a
price ceiling on rents set by the government.
� Rent control in Paris after World War I created a housing shortage.
� The shortage would have been eliminated if rents had been allowed to rise to $17 per month.
QS QD
S
D
Re
nta
l Pri
ce (
per
mo
nth
)
Quantity of apartments
$17.00
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Minimum Wage� The minimum wage, a
price floor, is set by government specifying the lowest wage a firm can legally pay.
� A minimum wage, Wmin, above the equilibrium wage, We, helps those who are employed, Q2, but hurts those who would have been employed at We, but can no longer find employment, Qe- Q2.
Wmin
We
Q2 Qe Q1
S
D
Quantity of Workers
Wag
e p
er h
ou
r
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Quick Quiz!
Define “price ceiling” and “price floor”
Give an example of each.
Which leads to a shortage, which a surplus? Why?
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Overview
The Effects of Price ControlsThe Effects of an Excise Tax
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Taxes! Taxes! Taxes!What is the purpose of government-
imposed taxes?–To raise government revenues.
–To restrict production of a product.
What is an excise tax?–A “per-unit” tax that’s independent of
the price of the product.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Taxes! Taxes! Taxes!Who pays the tax on a good? The
buyer or the seller?How is the burden of a tax divided
between buyer and seller?When the government levies a tax on a
good, the equilibrium quantity of the good falls. The size of the market for that good shrinks, shifting either the demand or supply curve.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Producer and Consumer Surplus
� Consumer surplus - the value the consumer gets from buying a product, less its price.– It is the area below the demand curve and
above the price.
� Producer surplus – the value the producer sells a product for less the cost of producing it.– It is the area above the supply curve but
below the price the producer receives.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Producer and Consumer SurplusP
rice
S
D
Quantity
0
$10987654321
10987654321
Producer Surplus
Consumer Surplus
CS = ½(5x5) = 12.5 =Area of blue triangle
PS = ½(5x5) = 12.5 =Area of red triangle
The combination of producer and consumersurplus is maximized atmarket equilibrium.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Producer and Consumer SurplusP
rice
S
D
Quantity
0
$10987654321
10987654321
Producer Surplus gains 2x4 = 8 units of lost consumer surplus
If price is $6,Consumer Surplus: CS = 1/2 ($4x4) = $8
Combined consumer and producer surplus decreaseswhen price is above equilibrium.
Lost surplus = ½($2x1) = $1
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Taxation and Government
� For government to operate, it must tax.
� For the market to work, it needs the government.
� Tax rates depend on what goods and services government provides.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Taxes: Impact
Taxes discourage market activity. The quantity of the good sold is smaller than
without the tax. Buyers and sellers
share the tax burden.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Taxes: Impact From a 50 Cent Tax
S1
$3.00
800
D1
Equilibrium without tax
Quantity
Price
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Taxes: Impact From a 50 Cent Tax
S1
$3.00
800
D1
From the sellers viewpoint, the tax
causes the demand curve to
shift down by 50 cents.
$2.80
600
Price
Quantity
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Taxes: Impact From a 50 Cent Tax
S1
$3.00
800
$3.30
600
The tax increasesthe market price
to the buyer...
$2.80
D1
Quantity
Price
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Taxes: Impact From a 50 Cent Tax
S1
$3.00
800
$3.30
600
The tax increasesthe market price
to the buyer...…in this case theprice rises $.30.
$2.80
D1Price
Quantity
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Taxes: Impact From a 50 Cent Tax
S1
$3.00
800
$3.30
600
The tax decreasesthe return to the
seller as the sellergets $.20 less.
$2.80
D1
Quantity
Price
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Taxes: Impact From a 50 Cent Tax
S1
$3.00
800
$3.30
600
The tax makes boththe buyer and the seller worse off!$2.80
D1
Quantity
Price
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
The Incidence of Tax. . .How is the burden of the tax distributed?
Consider a tax levied on sellers of a good. What are the effects of this tax?
How do effects of the tax levied on the seller compare with those of the effects imposed on the buyer?
Depends on Elasticity of Demand and Elasticity of Supply.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
The Incidence of Tax. . .How is the burden of the tax distributed?
The burden of a tax falls on the side of the market with the smaller price elasticity!
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Elasticity and Taxes
The more inelastic the demand and the more elastic the supply results in the consumer paying more of the tax.
The more elastic the demand and the more inelastic the supply results in the supplier paying more of the tax.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Elasticity and Excise Tax Example:A more inelastic demand and more elastic supply.
Supply
Demand
$2.00
250
Price
Quantity
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Elasticity and Excise Tax
S1
Demand
S2
Specific Tax $.20
$2.00
$2.15
200 250
Price
Quantity
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Elasticity and Excise Tax
S1
Demand
S2
Specific Tax $.20
$2.15
$2.00$1.95
200 250
Producer’s burden of tax
Price
Quantity
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Elasticity and Excise Tax
S1
Demand
S2
Specific Tax $.20
$2.15
$2.00$1.95
200 250
Buyer’s burden of tax
Price
Quantity
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Excise Taxes
Quantity of luxury boats
0
Pri
ce o
f lu
xu
ry b
oa
ts
65,000
510
S1
D
S0
A $10,000 excise tax on luxury boats shifts the supply curve up by $10,000.
60,000
420
$70,000
600
At $70,000, there is excess supply of 600- 420 = 180.
The price of the boats rises by less than the tax to $65,000.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Quantity Restrictions
In 1937 New York City limited the numberof taxi licenses to 12,000 to increase the wages of taxi drivers.
Because taxi medallions were limited in supply, as demand for taxi services rose, so did the demand for medallions, increasingtheir price to $2500 by 1947. Today, medallions sell for $300,000!
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
The Costs of Taxation� To determine how much to tax, the
government must determine the costs and benefits of taxation.
� The costs of taxation include:– Direct cost of revenue paid to the
government– Deadweight loss - loss of consumer and
producer surplus that is not gained by the government
– Administrative costs of compliance – resources used by the government to administer the tax and individuals and businesses to comply with it
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Costs of Taxation
S1
P1–t
Quantity
Price
P0
Q0
P1
Q1
Producer surplus
S0
D
Consumer surplus
Deadweight loss
tax
A per unit tax t paid by thesuppliers shifts the supply curve from S0 to S1 and in-creases price to P1 and decreases quantity to Q1.
Consumer surplus is A+B+C before the taxand A after the tax.
Producer surplus is D+E+F before the taxand F after the tax.
Government revenue=B+D
Deadweight loss=C+E
F
ED
CB
A
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
The Benefits of Taxation
� The benefits of taxation are the goods and services that government provides.– Provides a stable set of institutions and rules– Promotes effective and workable competition– Corrects for externalities
– Creates an environment that fosters stability and growth
– Provides public goods– Adjusts for undesirable market results
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Two Principles of Taxation
� The benefits principle – the individuals who receive the benefit of the good or service should pay the tax necessary to supply the good.
� The ability-to-pay principle – individuals who are most able to bear the burden of the tax should pay.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Tax Burden
� The person who physically pays the tax is not necessarily the person who bears the burden of the tax.
� The more inelastic one’s relative demand and supply, the larger the tax burden one will bear.– If demand is more inelastic than supply,
consumers will pay the higher share.
– If supply is more inelastic than demand, suppliers will pay the higher share.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Who Bears the Tax Burden?Demand is elasticEqual burden
Pri
ce o
f lu
xu
ry b
oa
ts
Quantity of luxury boats
0 510
S1D
S0
60
$70
600
50
40P
ric
e o
f lu
xu
ry b
oa
ts
Quantity of luxury boats
0 500
S1D
S0
60
$70
600
50
40
tax
Demand is inelasticLarger consumer burden
590
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Who Bears the Tax Burden?
Supplier pays the tax-Supply shifts
Pri
ce o
f lu
xu
ry b
oa
ts
Quantity of luxury boats
0 510
S1D
S0
60
$70
600
50
40
tax
Pri
ce o
f lu
xu
ry b
oa
ts
Quantity of luxury boats
0 510
D0
S
60
$70
600
50
40
tax
D1
Consumer pays the tax-Demand shifts
Tax burden is independent of who pays the tax.
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Supply, Demand & GovernmentThe economy is governed by two kinds
of laws:–The laws of supply and demand–The laws enacted by government
Price controls and taxes are common in various markets in the economy:–Price Ceilings–Price Floors–Excise Tax
Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition
Overview
The Effects of Price ControlsThe Effects of an Excise Tax