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Lecture VI: Supply and Demand in Practice I. Price Controls A. Price Ceiling i. in theory Price Ceiling – an upper limit set on a price P Supply Curve (S) Not binding PC Excess demand - shortage PE Binding PC Demand Curve (D) Q QD* QE QS* - if set above equilibrium, not binding - if set below equilibrium, it is binding Binding – a price control is said to be “binding” or effective if it keeps the price in the market from reaching the equilibrium price level Results of a binding price ceiling is a SHORTAGE - the government is the economic agency that can legally set price controls and hinder the natural market processes ii. Application – rent control IMPACT of Binding Rent Controls a. - shortage – excess demand b. - black markets or underground market transactions c. - entrance fees – people getting kicked out a lot d. - higher search costs for apartments since there is a shortage e. - declines in the quality and maintenance of rental housing f. - large deserted apartment complexes in inner cities g. - future supply will decline – no incentive for new construction h. – the creation of a rent control regulator commission B. Price Floor – a lower limit set on a price i. in theory P Supply Curve (S) Binding PF Excess supply - surplus PE Not Binding PF Demand Curve (D) Q QD* QE QS* - if set above equilibrium, binding Results in a surplus ii. an application – the minimum wage 8/98 Congress passed a law to raise the minimum wage to $5.25 Impact of Price Floors II. Excise Taxes – a tax imposed on some specific good When these taxes are imposed on imported goods they are called tariffs Tariff – a tax on some specific imported good Consider a standard supply/demand framework for luxury boats in the US P $70,000 $65,000 (S1) (S0) $10,000 $60,000 (D) Q QET QE - suppose that an excise tax of $10,000 per boat is imposed by the government and collected from the supplier - the producer will view this tax as a $10,000 increase in the cost of production - the supply curve will shift up by $10,000, the direction of the price (the vertical axis) - if the initial equilibrium price is $60,000, the producer would like the new equilibrium price to be $70,000 so they can pass the entire amount of the tax to the consumer - but with the interaction of supply and demand, the new equilibrium turns out to be at $65,000. This means only half of the tax burden could be passed off to consumers - the tax results in a higher equilibrium price and a lower equilibrium quantities III. Quotas – sometimes the gov’t alters the market process by limiting the amount of foreign goods that can be imported into the US Quota: a quantitative restriction on the amount that one country can export to another P Quota (S0) PQ Surplus (?) PmE (D) Q QQ QE A quota acts as a fence that prevents the market from moving to the right on the quantity axis RESULT: A higher price than market equilibrium A lower quantity than market equilibrium