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6
Supply, Demand, and
Government Policies
In this chapter, look for the answers to
these questions:
ƒ What are price ceilings and price floors?
What are some examples of each?
PRINCIPLES OF
ƒ How do price ceilings and price floors affect
MICROECONOMICS
market outcomes?
FOURTH EDITION
ƒ How do taxes affect market outcomes?
How does the outcome depend on whether
the tax is imposed on buyers or sellers?
N. G R E G O R Y M A N K I W
ƒ What is the incidence of a tax?
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What determines the incidence?
CHAPTER 6
© 2008 Thomson South-Western, all rights reserved
Government Policies That Alter the
Private Market Outcome
EXAMPLE 1: The Market for Apartments
ƒ Price controls
•
•
P
Rental
price of
apts
Price ceiling: a legal maximum on the price
of a good or service. Example: rent control.
Price floor: a legal minimum on the price of
a good or service. Example: minimum wage.
S
$800
Eq’m
Eq’m w/o
w/o
price
price
controls
controls
ƒ Taxes
•
1
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
The govt can make buyers or sellers pay a
specific amount on each unit bought/sold.
D
We
We will
will use
use the
the supply/demand
supply/demand model
model to
to see
see
how
how each
each policy
policy affects
affects the
the market
market outcome
outcome
(the
(the price
price buyers
buyers pay,
pay, the
the price
price sellers
sellers receive,
receive,
and
eq’
’m quantity).
eq
and
eq’m
quantity).
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
300
Quantity of
apartments
2
How Price Ceilings Affect Market Outcomes
A price ceiling
above the
eq’m price is
not binding –
has no effect
on the market
outcome.
P
Price
ceiling
$800
D
300
CHAPTER 6
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
CHAPTER 6
How Price Ceilings Affect Market Outcomes
The ceiling
is a binding
constraint
on the price,
causes a
shortage.
Q
4
3
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
The eq’m price
($800) is above
the ceiling and
therefore illegal.
S
$1000
Q
CHAPTER 6
P
S
$800
Price
ceiling
$500
shortage
D
250
400
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Q
5
1
Shortages and Rationing
How Price Ceilings Affect Market Outcomes
In the long run,
supply and
demand
are more
price-elastic.
ƒ With a shortage, sellers must ration the goods
P
S
ƒ Some rationing mechanisms: (1) long lines
(2) discrimination according to sellers’ biases
$800
ƒ These mechanisms are often unfair, and inefficient:
Price
ceiling
$500
So, the
shortage
is larger.
shortage
the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal (and thus fair).
6
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
EXAMPLE 2: The Market for Unskilled Labor
Wage
paid to
unskilled
workers
W
CHAPTER 6
$4
D
500
7
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
How Price Floors Affect Market Outcomes
A price floor
below the
eq’m price is
not binding –
has no effect
on the market
outcome.
S
Eq’m
Eq’m w/o
w/o
price
price
controls
controls
the goods do not necessarily go to the buyers who
value them most highly.
ƒ In contrast, when prices are not controlled,
D
Q
450
150
CHAPTER 6
among buyers.
W
S
$4
Price
floor
$3
D
L
500
L
Quantity of
unskilled workers
CHAPTER 6
8
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
CHAPTER 6
How Price Floors Affect Market Outcomes
The eq’m wage ($4)
is below the floor
and therefore
illegal.
The floor
is a binding
constraint
on the wage,
causes a
surplus (i.e.,
unemployment).
CHAPTER 6
W
labor
surplus S
The Minimum Wage
Min wage laws
do not affect
highly skilled
workers.
Price
floor
$5
$4
They do affect
teen workers.
D
400
550
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Studies:
A 10% increase
in the min wage
raises teen
unemployment
by 1-3%.
L
10
9
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
CHAPTER 6
W
unemployment S
Min.
wage
$5
$4
D
400
550
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
L
11
2
ACTIVE LEARNING
Price floors
& ceilings
1:
ACTIVE LEARNING
The market for
hotel rooms
P
140
130
Determine
effects of:
S
120
110
A. $90 price
ceiling
100
B. $90 price
floor
80
C. $120 price
floor
A. $90 price ceiling
90
D
70
60
50
1:
The market for
hotel rooms
P
140
The price
falls to $90.
Buyers
demand
120 rooms,
sellers supply
90, leaving a
shortage.
40
0
Q
50 60 70 80 90 100 110 120 130
S
130
120
110
100
90
Price ceiling
D
80
shortage = 30
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
12
ACTIVE LEARNING
B. $90 price floor
1:
Eq’m price is
above the floor,
so floor is not
binding.
130
P = $100,
Q = 100 rooms.
90
ACTIVE LEARNING
The market for
hotel rooms
P
140
C. $120 price floor
S
120
110
100
80
13
Price floor
D
70
60
1:
P
140
The price
rises to $120.
130
Buyers
demand
60 rooms,
sellers supply
120, causing
a surplus.
110
120
The market for
hotel rooms
surplus = 60
S
Price floor
100
90
80
D
70
60
50
50
40
0
Q
50 60 70 80 90 100 110 120 130
40
0
Q
50 60 70 80 90 100 110 120 130
14
15
Evaluating Price Controls
Taxes
ƒ The govt levies taxes on many goods & services
ƒ Recall one of the Ten Principles:
to raise revenue to pay for national defense,
public schools, etc.
Markets are usually a good way
to organize economic activity.
ƒ Prices are the signals that guide the allocation of
ƒ The govt can make buyers or sellers pay the tax.
society’s resources. This allocation is altered
when policymakers restrict prices.
ƒ The tax can be a % of the good’s price,
or a specific amount for each unit sold.
• For simplicity, we analyze per-unit taxes only.
ƒ Price controls often intended to help the poor,
but often hurt more than help.
CHAPTER 6
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
16
CHAPTER 6
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
17
3
A Tax on Buyers
EXAMPLE 3: The Market for Pizza
Eq’m
Eq’m
w/o
w/o tax
tax
A
A tax
tax on
on
buyers
buyers shifts
shifts
the
the D
D curve
curve
down
down by
by the
the
amount
amount of
of
the
the tax.
tax.
P
S1
$10.00
D1
Q
500
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18
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
CHAPTER 6
P
S1
Tax
$10.00
PS = $9.50
D1
Q
430 500
20
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!
P
What matters
is this:
PB = $11.00
A tax drives
$10.00
a wedge
PS = $9.50
between the
price buyers
pay and the
price sellers
receive.
CHAPTER 6
Tax
$10.00
PS = $9.50
D1
D2
Q
430 500
19
A Tax on Sellers
D2
CHAPTER 6
S1
PB = $11.00
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
A
A tax
tax on
on
sellers
sellers shifts
shifts
the
the S
S curve
curve
up
up by
by the
the
amount
amount of
of
the
the tax.
tax.
how the burden of a tax is shared among
market participants
PB = $11.00
P
The
The price
price
buyers
buyers pay
pay
rises,
rises, the
the
price
price sellers
sellers
receive
receive falls,
falls,
eq’m
eq’m Q
Q falls.
falls.
The Incidence of a Tax:
Because
Because
of
of the
the tax,
tax,
buyers
buyers pay
pay
$1.00
$1.00 more,
more,
sellers
sellers get
get
$0.50
$0.50 less.
less.
Effects of a $1.50 per
unit tax on buyers
S1
Tax
D1
430 500
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Q
Effects of a $1.50 per
unit tax on sellers
P
CHAPTER 6
S1
PB = $11.00
The
The price
price
buyers
buyers pay
pay
rises,
rises, the
the
price
price sellers
sellers
receive
receive falls,
falls,
eq’m
eq’m Q
Q falls.
falls.
S2
Tax
$10.00
PS = $9.50
D1
430 500
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
ACTIVE LEARNING
Effects of a tax
P
140
Suppose govt
imposes a tax
on buyers of
$30 per room.
130
Find new
Q, PB, PS,
and incidence
of tax.
90
Q
21
2:
The market for
hotel rooms
S
120
110
100
80
D
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
22
23
4
ACTIVE LEARNING
Answers
P
140
2:
The market for
hotel rooms
130
Q = 80
Elasticity and Tax Incidence
S
CASE 1: Supply is more elastic than demand
PB = 110
100
PB = $110
90
PS = $80
Buyers’ share
of tax burden
Tax
D
PS = 80
70
Incidence
buyers: $10
sellers: $20
Tax
Price if no tax
PS
50
D
PB
Price if no tax
Tax
PS
Sellers
Sellers bear
bear
most
most of
of the
the
burden
burden of
of
the
the tax.
tax.
D
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
25
ƒ 1990: Congress adopted a luxury tax on yachts,
It’s
It’s easier
easier for
for
buyers
buyers than
than
sellers
sellers to
to
leave
leave the
the
market.
market.
S
CHAPTER 6
CASE STUDY: Who Pays the Luxury Tax?
CASE 2: Demand is more elastic than supply
P
So
So buyers
buyers
bear
bear most
most of
of
the
the burden
burden of
of
the
the tax.
tax.
Q
40
0
Q
50 60 70 80 90 100 110 120 130
Elasticity and Tax Incidence
Sellers’ share
of tax burden
PB
Sellers’ share
of tax burden
60
24
Buyers’ share
of tax burden
It’s
It’s easier
easier for
for
sellers
sellers than
than
S buyers
buyers to
to leave
leave
the
the market.
market.
P
120
private airplanes, furs, expensive cars, etc.
ƒ Goal of the tax: to raise revenue from those
who could most easily afford to pay –
wealthy consumers.
ƒ But who really pays this tax?
Q
CHAPTER 6
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
26
P
Buyers’ share
of tax burden
Sellers’ share
of tax burden
PS
D
Q
CHAPTER 6
allocation of society’s resources.
In
In the
the short
short run,
run,
supply
supply is
is inelastic.
inelastic.
Tax
Hence,
Hence,
companies
companies
that
that build
build
yachts
yachts pay
pay
most
most of
of
the
the tax.
tax.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
27
the Allocation of Resources
ƒ Each of the policies in this chapter affects the
Demand
Demand is
is
price-elastic.
price-elastic.
S
PB
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
CONCLUSION: Government Policies and
CASE STUDY: Who Pays the Luxury Tax?
The market for yachts
CHAPTER 6
28
• Example 1:
a tax on pizza reduces eq’m Q.
With less production of pizza, resources
(workers, ovens, cheese) will become available
to other industries.
• Example 2:
a binding minimum wage causes a
surplus of workers, a waste of resources.
ƒ So, it’s important for policymakers to apply such
policies very carefully.
CHAPTER 6
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
29
5
CHAPTER SUMMARY
CHAPTER SUMMARY
ƒ A tax on a good places a wedge between the
ƒ A price ceiling is a legal maximum on the price of
price buyers pay and the price sellers receive,
and causes the eq’m quantity to fall, whether the
tax is imposed on buyers or sellers.
a good. An example is rent control. If the price
ceiling is below the eq’m price, it is binding and
causes a shortage.
ƒ A price floor is a legal minimum on the price of a
ƒ The incidence of a tax is the division of the
good. An example is the minimum wage. If the
price floor is above the eq’m price, it is binding
and causes a surplus. The labor surplus caused
by the minimum wage is unemployment.
burden of the tax between buyers and sellers,
and does not depend on whether the tax is
imposed on buyers or sellers.
ƒ The incidence of the tax depends on the price
elasticities of supply and demand.
CHAPTER 6
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
30
CHAPTER 6
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
31
6