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In this chapter you will examine the effects of government policies that place a ceiling on prices, examine the effects of government policies that put a floor under prices, consider how a tax on a good affects the price of the good and the quantity sold, learn that taxes levied on buyers and taxes levied on sellers are equivalent.
Supply, Demand and Government Policies Chapter Copyright © 2001 by Harcourt, Inc All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, Supply, Demand, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities One of the things government can do is to set price controls when the market price is seen as unfair to either buyers or sellers Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Price Ceilings & Price Floors Price Ceiling A legally established maximum price at which a good can be sold. (Rent Controls) Price Floor A legally established minimum price at which a good can be sold. (Price Supports for Agriculture) Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Price Ceilings Two outcomes are possible when the government imposes a price ceiling: The price ceiling is not binding if set above the equilibrium price. The price ceiling is binding if set below the equilibrium price, leading to a shortage. Binding means that there is an economic impact Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc A Price Ceiling That Is Binding Price of IceCream Cone Supply Equilibrium price $3 Price ceiling Shortage Demand 75 Quantity supplied 125 Quantity demanded Quantity of IceCream Cones Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc A Price Ceiling That Is Not Binding Price of IceCream Cone Supply Price ceiling $4 Equilibrium price Demand 100 Equilibrium quantity Quantity of IceCream Cones Effects of Price Ceilings A binding price ceiling creates shortages because QD > QS Example: Gasoline shortage of the 1970s nonprice rationing Examples: Long lines, Discrimination by sellers Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc The Price Ceiling on Gasoline Is Not Binding Price of Gasoline 1. Initially, the price ceiling is not binding Supply Price ceiling $4 P1 Demand Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Q1 Quantity of Gasoline The Price Ceiling on Gasoline Is Binding S2 Price of Gasoline 2. …but when supply falls S1 P2 Price ceiling P1 3. …the price ceiling becomes binding 4. …resulting in a shortage Demand Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Q1 Quantity of Gasoline Rent Control Rent controls are ceilings placed on the rents that landlords may charge their tenants Rent control can make housing more affordable With a price ceiling, you cannot go above the ceiling But what about the landlords? Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Rent Control in the Short Run Rental Price of Apartment Supply Supply and demand for apartments are relatively inelasticWhy is the supply curve vertical? Controlled rent Shortage Demand Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Quantity of Apartments Rent Control in the Long Run Rental Price of Apartment Because the supply and demand for apartments are more elastic What happens in the long run? Supply …rent control causes a large shortage Controlled rent Shortage Demand Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Quantity of Apartments Price Floors When the government imposes a price floor, two outcomes are possible The price floor is not binding if set below the equilibrium price The price floor is binding if set above the equilibrium price, leading to a surplus. Think of price floors as not being able to go below the floor Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc A Price Floor That Is Not Binding Price of IceCream Cone Supply Equilibrium price $3 Price floor Demand Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc 100 Equilibrium quantity Quantity of IceCream Cones Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc A Price Floor That Is Binding Price of IceCream Cone Surplus $4 Supply Price floor $3 Equilibrium price Demand 80 Quantity demanded 120 Quantity supplied Quantity of IceCream Cones Effects of a Price Floor A binding price floor causes . . a surplus because QS >QD. nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria Examples: The minimum wage, Agricultural price supports State Minimum Wages Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc The Minimum Wage Wage A Free Labor Market Labor supply Equilibrium wage Labor demand Equilibrium employment Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Quantity of Labor The Minimum Wage Wage A Labor Market with a Minimum Wage Labor surplus (unemployment) Labor supply Minimum wage Labor demand Quantity demanded Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Quantity supplied Quantity of Labor What are some potential impacts of taxes? Taxes are used to raise money for the government Taxes discourage market activity When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden But who bears the burdentax incidence Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Copyrightâ2001byHarcourt,Inc.Allrightsreserved Impact of a 50Â Tax Levied on Buyers Price of IceCream Cone Price buyers pay Price without tax $3.30 3.00 2.80 Price sellers receive Supply, S1 Equilibrium without tax Tax ($0.50) Equilibrium with tax D1 D2 90 100 Quantity of IceCream Cones Copyright © 2001 by Harcourt, Inc. All rights reserved Impact of a 50¢ Tax on Sellers Price of IceCream Cone Price buyers pay Price without tax $3.30 3.00 2.80 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 90 100 Quantity of IceCream Cones The Incidence of Tax 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Elastic Supply, Inelastic Demand Price 1. When supply is more elastic than demand Price buyers pay Supply Tax Price without tax Price sellers receive 3. than on producers Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc 2. the incidence of the tax falls more heavily on consumers Demand Quantity Inelastic Supply, Elastic Demand 1. When demand is more elastic than supply Price Supply Price buyers pay Price without tax 3. than on consumers Tax Price sellers receive Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Demand 2. the incidence of the tax falls more heavily on producers Quantity .. .Supply, Demand, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities One of the things government can do is to ... Shortage Demand Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Quantity of Apartments Rent Control in the Long Run Rental Price of Apartment Because the supply and demand for ... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc 2. the incidence of the tax falls more heavily on consumers Demand Quantity Inelastic Supply, Elastic Demand 1. When demand is more elastic than supply Price Supply