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Chapter 6 Supply, Demand, and Government Policies Ratna K. Shrestha Supply, Demand and Govt. Policies In a “free”, unregulated market system, market forces establish equilibrium prices and quantities. While equilibrium conditions may be efficient, not everyone, i.e. buyer or seller, is satisfied. Hence, government may control the market to help either buyer or seller (often at the expense of other). Examples: (1) Price control and (2) Excise tax, among others. (1) Market Price Controls Are usually enacted when policy-makers believe that the market price is unfair either to buyers or sellers. Result in government policies, i.e. price ceilings and Price floors. Price Ceilings & Price Floors A Price Ceiling is a legally established maximum price which a seller can charge (or a buyer must pay). Examples: rent ceiling, ceiling on the price of gasoline in the US in 1970s. A Price Floor is a legally established minimum price which a buyer must pay. Examples: minimum wage. Price Ceilings When the government imposes a price ceiling two outcomes are possible: 1. The price ceiling is not binding. In this case the ceiling has no effect on the market outcomes. The price ceiling is a binding constraint on the market, creating shortages. 2. A Non-Binding Price Ceiling Price Supply PC Price Ceiling PE Demand QE Quantity A Binding Price Ceiling Price Supply Price Ceiling PE PC Demand QE Quantity A Binding Price Ceiling Creates Shortages. Price Supply PE PC Demand Shortage QS QE QD Quantity Market Impacts of a Price Ceiling A Binding Price Ceiling creates Shortages (i.e... Demand > Supply) Gasoline shortages of the 1970s Housing 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 seller Black markets Case Study: Lines At The Gas Pumps in the US in 1973 S2 (after P of crude oil increase) Price S1 P2 PC P1 Demand Shortage QS QD Q1 Quantity Case Study: Rent Control Short-Run Effect Price Supply With relatively inelastic S and D, Shortage is smaller. PC Shortage Demand Quantity of Apts Case Study: Rent Control Long-Run Effect Price Supply In the long run, both S and D become more elastic and the effect of rent control can be much bigger! PC Shortage Demand Quantity of Apartments Price Floors When the government imposes a price floor, two outcomes are possible: 1. The price floor is not binding. It does not affect the market outcomes. This is the case when the floor is lower than the equilibrium price. For example, if the govt. sets minimum wage at $6 (when the equilibrium wage is $8), it has no effect at all. 2. The price floor is a binding constraint on the market, creating surpluses. A Non-Binding Price Floor Price Supply Price Floor PE PF Demand QE Quantity A Binding Price Floor Price Supply PF Price Floor PE Demand QE Quantity Market Impacts of a Price Floor A government-imposed 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. Examples: Minimum Wage Agricultural Price Supports A Binding Price Floor Creates a Surplus. Wage Supply Wmin W* Surplus Or Unemployment QD QE Demand QS Quantity of Labor Evaluating Price Controls Policy makers control prices because they think the free-market prices are unfair. They are often aimed at helping the poor. Rent control laws try to make housing affordable for the poor. Minimum wage laws are aimed at helping the unskilled workers. Evaluating Price Controls But the irony is price controls often hurt those they are intended to help. Rent control discourages landlords from maintaining their buildings and make housing hard to find. Minimum wage laws cause unemployment and make it difficult for the unskilled workers to find jobs. While those who can maintain their jobs get higher pay, others can lose the jobs they had before. Effect of Minimum Wage in Canada • A law that raises the minimum wage above the market equilibrium wage creates unemployment. • But how much unemployment does it create? • Until recently, most economists believed that a 10% increase in the minimum wage rate decreased teenage employment by between 1 and 3 %. 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 is independent of the price of the product. Example: tax on gasoline. The tax on gasoline is based on quantity. No matter what is the price of a liter of gasoline, the tax/liter is always the same. 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. Taxes: Impact Taxes discourage market activity. The quantity of the good sold is smaller than without the tax. Both buyers and sellers share the tax burden. The question is who bears how much burden? Taxes: Impact From a 50 Cent Tax S1 Price Equilibrium without tax $3.00 D1 800 Quantity Taxes: Impact From a 50 Cent Tax D1 Price S1 From the sellers viewpoint, the tax causes the demand curve to shift down by 50 cents. $3.00 $2.80 600 800 Quantity Taxes: Impact From a 50 Cent Tax Price D1 S1 The tax increases the market price to the buyer…in this case the price rises by $0.30 to $3.30. $3.30 $3.00 $2.80 600 800 Quantity Taxes: Impact From a 50 Cent Tax Price S1 D1 The tax decreases the return to the seller as the seller gets $0.20 less. $3.30 $3.00 $2.80 600 800 Quantity Taxes: Impact From a 50 Cent Tax Price S1 D1 The tax makes both the buyer and the seller worse off! $3.30 $3.00 $2.80 600 800 Quantity 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, not on which side of the market it is imposed. The burden of a tax falls on the side of the market with the smaller price elasticity! 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. Elasticity and Excise Tax Example Price A more inelastic demand and more elastic supply. Supply $2.00 Demand 250 Quantity Elasticity and Excise Tax S2 Price Specific Tax $.20 S1 $2.15 $2.00 Demand 200 250 Quantity Elasticity and Excise Tax Price S2 Specific Tax $.20 S1 $2.15 $2.00 $1.95 Producer’s burden of tax Demand 200 250 Quantity Elasticity and Excise Tax Price S2 Specific Tax $.20 S1 $2.15 Buyer’s burden of tax $2.00 $1.95 Demand 200 250 Quantity Quick Quiz Show how a tax on car buyers of $1,000 per car affects the quantity of cars sold and the price of cars. Show how a similar tax on car sellers affects quantity and price. Hint: The incidence of tax is independent of which side of the market the tax is imposed! How will a $1 tax on land sales be distributed between the landlord and the land buyer?