supply, demand and government

1
Chapter 6
Supply, Demand, and Government Policies Ratna K.
Shrestha
2
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.

3
(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.

4
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.

5
Price Ceilings

• When the government imposes a price ceiling two
  outcomes are possible
• 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.

6
A Non-Binding Price Ceiling
Price
Supply
PC
Price Ceiling
PE
Demand
Quantity
QE
7
A Binding Price Ceiling
Price
Supply
Price Ceiling
PE
PC
Demand
Quantity
QE
8
A Binding Price Ceiling Creates Shortages.
Price
Supply
PE
PC
Demand
Shortage
QE
QS
QD
Quantity
9
Market Impacts of a Price Ceiling

• A Binding Price Ceiling creates
• Shortages (i.e... Demand gt 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

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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
Quantity
QS
QD
Q1
11
Case Study Rent ControlShort-Run Effect
Supply
Price
With relatively inelastic S and D, Shortage is
smaller.
PC
Demand
Shortage
Quantity of Apts
12
Case Study Rent ControlLong-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
Demand
Shortage
Quantity of Apartments
13
Price Floors

• When the government imposes a price floor, two
  outcomes are possible
• 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.
• The price floor is a binding constraint on the
  market, creating surpluses.

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A Non-Binding Price Floor
Price
Supply
Price Floor
PE
PF
Demand
Quantity
QE
15
A Binding Price Floor
Price
Supply
PF
Price Floor
PE
Demand
QE
Quantity
16
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

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A Binding Price Floor Creates a Surplus.
Wage
Supply
Wmin
W
Surplus Or Unemployment
Demand
QE
QD
QS
Quantity of Labor
18
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.

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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.

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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 .

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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.

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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.

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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?

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Taxes Impact From a 50 Cent Tax
S1
Price
Equilibrium without tax
3.00
D1
800
Quantity
25
Taxes Impact From a 50 Cent Tax
D1
S1
Price
From the sellers viewpoint, the tax causes the
demand curve to shift down by 50 cents.
3.00
2.80
800
600
Quantity
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Taxes Impact From a 50 Cent Tax
S1
D1
Price
The tax increases the market price to the
buyerin this case the price rises by 0.30 to
3.30.
3.30
3.00
2.80
800
600
Quantity
27
Taxes Impact From a 50 Cent Tax
S1
D1
Price
The tax decreases the return to the seller as
the sellergets 0.20 less.
3.30
3.00
2.80
800
600
Quantity
28
Taxes Impact From a 50 Cent Tax
S1
D1
Price
The tax makes both the buyer and the seller
worse off!
3.30
3.00
2.80
800
600
Quantity
29
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!

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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.

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Elasticity and Excise Tax Example
A more inelastic demand and more elastic supply.
Price
Supply
2.00
Demand
250
Quantity
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Elasticity and Excise Tax
S2
Price
Specific Tax .20
S1
2.15
2.00
Demand
Quantity
200
250
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Elasticity and Excise Tax
Price
S2
Specific Tax .20
S1
2.15
2.00
Producers burden of tax
1.95
Demand
250
200
Quantity
34
Elasticity and Excise Tax
Price
S2
Specific Tax .20
S1
2.15
2.00
Buyers burden of tax
1.95
Demand
200
250
Quantity
35
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?