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Last Time & Chap 6

Supply, Demand, and Government


Policies

Last time: We should be able to see how


supply and demand determine the price of a
good and the quantity of the good sold.
Chapter 6: Discusses the impact of government
policies on competitive markets.
ECON&201: Include Taxes
ECON&202: Exclude Taxes

In a free, unregulated market system, market


forces establish equilibrium prices and
equilibrium quantities, where Qs = Qd.
While equilibrium conditions may be efficient,
it may be true that not everyone is satisfied.
Controls on prices are usually enacted when
policymakers believe the market price is unfair
to buyers or sellers.

Copyright 2004 South-Western/Thomson Learning

CONTROLS ON PRICES
Result in government-created price ceilings and
floors.
Interesting example in book:
Ice-eaters think ice-cream is too expensive
Ice-makers think ice-cream is too inexpensive
Both have conflicting interests

Copyright 2004 South-Western/Thomson Learning

Copyright 2004 South-Western/Thomson Learning

CONTROLS ON PRICES
Price Ceiling
A legal maximum on the price at which a good can
be sold (Ice cream-EATERS or Ice-cream-makers)

Price Floor
A legal minimum on the price at which a good can
be sold (Ice cream-eaters or Ice-cream MAKERS)

Lets look at a price ceiling example.

Copyright 2004 South-Western/Thomson Learning

Figure 1 A Market with a Price Ceiling

Figure 1B Market with a Price Ceiling

(a) A Price Ceiling, Non-binding


Price of
Ice-Cream
Cone

(b) A Price Ceiling, Binding


Price of
Ice-Cream
Cone

Supply

$4

Price
ceiling

Supply

Equilibrium
price
Qs

Qd

$3

Equilibrium
price

Qs = Qd

Price
ceiling

Shortage
-50
Demand
100

Quantity of
Ice-Cream
Cones

Equilibrium
quantity

Demand
0

75

125

Quantity
supplied

Quantity
demanded

Quantity of
Ice-Cream
Cones
Copyright2003 Southwestern/Thomson Learning

Figure 1C Market with a Price Floor

Figure 1D Market with a Price Floor

(c) A Price Floor, Binding


Price of
Ice-Cream
Cone

(d) A Price Floor, Non-binding


Price of
Ice-Cream
Cone

+50
Supply

Surplus
$4

Price
floor

$3

Supply

Equilibrium
price

Qs = Qd

$3

Qs
Qd

Equilibrium
price

$2

Price
floor

Demand
0

75

125

Quantity
demanded

Quantity
supplied

Quantity of
Ice-Cream
Cones
Copyright 2004 South-Western/Thomson Learning

Demand
0

100
Equilibrium
quantity

Quantity of
Ice-Cream
Cones
Copyright
2004 South-Western/Thomson
Copyright2003
Southwestern/ThomsonLearning
Learning

Three Case Studies:


All three examples discuss the issue of price
ceiling or price floor.
Gasoline: OPEC reduced supply of oil
Rent Control:
Minimum Wage:

CASE STUDY: Lines at the Gas Pump


. In 1973, OPEC raised the price of crude oil in world
markets by cutting supply. Cutting supply raised oil
prices
What was responsible for the long gas lines
Economists blame government
regulations that limited the price oil
companies could charge for gasoline.

Copyright 2004 South-Western/Thomson Learning

Figure 2a The Market for Gasoline with a Price Ceiling


Before Reduction of Supply

Copyright 2004 South-Western/Thomson Learning

Figure 2b The Market for Gasoline with a Price Ceiling

(a) The Price Ceiling on Gasoline Is Not Binding


Price of
Gasoline

(b) The Price Ceiling on Gasoline Is Binding


Price of
Gasoline

S2
2. . . . but when
supply falls . . .

Supply, S1
1. Initially,
the price
ceiling
is not
binding . . .

S1
P2

Price ceiling

Price ceiling

P1
4. . . .
resulting
in a
shortage.

Demand
0

3. . . . the price
ceiling becomes
binding . . .

P1

Q1

Quantity of
Gasoline
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Demand
0

QS

QD Q1

Quantity of
Gasoline
Copyright2003 Southwestern/Thomson Learning

Gasoline Case Study


What is binding and non-binding?
When the price rises high enough that the maximum
price (price ceiling) is reached or The gasoline
example of long lines would be an example of
binding.
When the price falls low enough that the minimum
price (price floor) is reached.

How did policymakers remedy the situation?


Removed the price ceilings and lines went away.

CASE STUDY: Rent Control in the Short Run


and Long Run

Rent controls are ceilings placed on the rents


that landlords may charge their tenants.
The goal of rent control policy is to help the
poor by making housing more affordable.
When I lived in LA, I lived in a rent control
area. They could only raise my rent by 3%.
One economist called rent control the best way
to destroy a city, other than bombing.

Copyright 2004 South-Western/Thomson Learning

Figure 3a Rent Control in the Short Run and in the Long Run
(a) Rent Control in the Short Run
(supply and demand are inelastic. Initially rent control has small
effect)
Rental
Price of
Supply
Apartment

Copyright 2004 South-Western/Thomson Learning

Figure 3b Rent Control in the Short Run and in the Long Run
(b) Rent Control in the Long Run
(supply and demand are elastic. The curve changes because sellers and
buyers have time to respond, making the curves more elastic)

Supply
Rental
Price of
Apartment
Controlled rent (price ceiling: max price)

Controlled rent
Shortage

Demand

Shortage
Demand
0

Quantity of
Apartments
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Quantity of
Apartments
Copyright2003 Southwestern/Thomson Learning

Rent Control

The Minimum Wage

How do landlords respond to the elastic curve?


Landlords respond to low rents by not building new
apartments and/or fail to maintain existing ones.

What about demand?

An important example of a price floor is the


minimum wage. Minimum wage laws dictate
the lowest price possible for labor that any
employer may pay.

Low rents encourage people to find their own


apartments and induce more people to move into a
city.

The result: tenants get lower rents, but they


also get lower-quality housing.
Copyright 2004 South-Western/Thomson Learning

Figure 5a How the Minimum Wage Affects the Labor


Market (Without a minimum wage).

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Figure 5b How the Minimum Wage Affects the Labor


Market

Labor Market

Labor Market

Wage

Wage

Labor
Supply

Labor surplus
(unemployment)

Labor
Supply (Looking for jobs)

Minimum
wage
Equilibrium
wage

Labor
demand
0

Equilibrium
employment

Labor
Demand (Employers)

Quantity of
Labor
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Quantity
demanded

Quantity
supplied

Quantity of
Labor
Copyright2003 Southwestern/Thomson Learning

How taxes influence Buyers (and Sellers)

Minimum Wage
Labor supply: Individuals looking for work.
Labor demand: Firms determine the demand.
As a result, more workers than jobs available
creating a shortage of jobs (unemployment).
One last point: This shortage would be for
unskilled labor, not for executives or high
management positions. Why?

ECON&202: Stop here!


ECON&201: Continue

Another way that government gets involved


with public policy: Taxes.
Governments levy taxes to raise revenue for
public projects.
Taxes discourage market activity. When a
good is taxed, the quantity sold is smaller.
So, who should be taxed, buyers or sellers?
Buyers pay more and sellers receive less, regardless
of whom the tax is levied on.

Copyright 2004 South-Western/Thomson Learning

Figure 6 A 50 cent Tax on Buyers: Result, buyers pay


more and sellers sell less.
Price of
Ice-Cream
Price
Cone
buyers
pay
$3.30
Price
3.00
2.80
without
tax
Price
sellers
receive

Supply, S1

Equilibrium without tax

Tax ($0.50)

A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).

Equilibrium
with tax

D1
D2
0

90

100

Quantity of
Ice-Cream Cones
Copyright2003 Southwestern/Thomson Learning

Copyright 2004 South-Western/Thomson Learning

Figure 7 A Tax on Sellers: End up with same result, buyers


pay more and sellers sell less.
Price of
Ice-Cream
Price
Cone
buyers
pay
$3.30
3.00
Price
2.80
without
tax

S2

Equilibrium
with tax

S1
Tax ($0.50)

A tax on sellers
shifts the supply
curve upward
by the amount of
the tax ($0.50).

Equilibrium without tax

Price
sellers
receive
Demand, D1
$0.30 CS lost & 0.20 PS lost

90

100

Quantity of
Ice-Cream Cones
Copyright2003 Southwestern/Thomson Learning

Consumer and Producer Surplus in


the Market Equilibrium

Clarification

Tax the people who make the ice-cream (Sellers).


Tax the people who buy the ice-cream (Buyers).
Either way:
Prices goes up and quantity the down.
If you tax the buyer, does the 50 cents tax go straight
to the consumer?

Supply

Price

A = $5

Consumer
surplus

Qs = Qd

Equil.
Price = $4
Producer
surplus

No. Why? Both share the tax burden. If the buyer had to
pay the tax, the consumer would reduce # of ice-cream cones
as if the price was lower than the equilibrium price.
What is the tax generated? Show in graph.

Demand

B= $3

Equilibrium
quantity

Copyright 2004 South-Western/Thomson Learning

Consumer & Producer Surplus

Quantity
Copyright 2004 South-Western/Thomson Learning

Tax: Ideal situation w/ firms and consumers, burdened


shared equally.
Price

Producer Surplus (PS): the amount a seller is paid for


a good minus the sellers cost
The area below the price and above the supply curve
measures the producer surplus in a market.

Consumer Surplus (CS): a buyers willingness to pay


minus the amount the buyer actually pays
The area below the demand curve and above the price
measures the consumer surplus in a market.

Supply

Consumer pays
Tax wedge
Without tax
Firm receives

For more information about Consumer Surplus &


Producer Surplus, see Chapter 7.

Demand
0

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Quantity
of Good
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Figure 9a How the Burden of a Tax Is Divided

Elasticity and Tax Incidence


(a) Elastic Supply, Inelastic Demand

In what proportions is the burden of the tax


divided?
How do the effects of taxes on sellers compare
to those levied on buyers?
The answers to these questions depend on the
elasticity of demand and the elasticity of
supply.

Price
1. When supply is more elastic
than demand . . .
Price buyers pay
Supply
CS lost
Tax

PS lost
Price sellers
receive
3. . . . than
on producers.
0

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2. . . . the
incidence of the
tax falls more
heavily on
consumers . . .

Price without tax

Demand
Quantity

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Figure 9b How the Burden of a Tax Is Divided

ELASTICITY AND TAX INCIDENCE


(b) Inelastic Supply, Elastic Demand
Price
1. When demand is more elastic
than supply . . .
Price buyers pay

So, how is the burden of the tax divided?

Supply
CS lost .

Price without tax

3. . . . than on
consumers.
PS lost

Price sellers
receive

Tax

2. . . . the
incidence of
the tax falls
more heavily
on producers . . .

Demand

The burden of a tax falls more


heavily on the side of the
market that is more inelastic/less elastic.

Quantity
(Last revision: Tuesday, Jan. 10th, 2012)
Copyright2003 Southwestern/Thomson Learning

Copyright 2004 South-Western/Thomson Learning

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