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17.08.2009
CHAPTER
6
In this chapter,
look for the answers to these questions:
Supply, Demand, and
Government Policies
 What are price ceilings and price floors?
What are some examples of each?
 How do price ceilings and price floors affect
Economics
i
PRINCIPLES OF
market outcomes?
N. Gregory Mankiw
 How do taxes affect market outcomes?
How do the effects depend on whether
the tax is imposed on buyers or sellers?
Premium PowerPoint Slides
by Ron Cronovich
 What is the incidence of a tax?
What determines the incidence?
1
© 2009 South-Western, a part of Cengage Learning, all rights reserved
Government Policies That Alter the
Private Market Outcome
EXAMPLE 1: The Market for Apartments
 Price controls
 Price ceiling: a legal maximum on the price

P
Rental
price of
apts
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
price
controls
 Taxes
T
 The govt can make buyers or sellers pay a
specific amount on each unit bought/sold.
D
We will use the supply/demand model to see
how each policy affects the market outcome
(the price buyers pay, the price sellers receive,
and eq’m quantity).
300
Q
Quantity of
apartments
2
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
3
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
How Price Ceilings Affect Market Outcomes
How Price Ceilings Affect Market Outcomes
A price ceiling
above the
eq’m price is
not binding –
has no effect
on the market
outcome.
The eq’m price
($800) is above
the ceiling and
therefore illegal.
P
S
Price
ceiling
$1000
$800
D
300
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
The ceiling
is a binding
constraint
on the price,
causes a
shortage.
Q
4
P
S
$800
Price
ceiling
$500
shortage
D
250
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
400
Q
5
1
17.08.2009
Shortages and Rationing
How Price Ceilings Affect Market Outcomes
In the long run,
supply and
demand
are more
price-elastic.
 With a shortage, sellers must ration the goods
P
S
(2) Discrimination according to sellers’ biases
$800
 These mechanisms are often unfair, and inefficient:
Price
ceiling
$500
So, the
shortage
is larger.
among buyers.
 Some rationing mechanisms: (1) Long lines
shortage
 In contrast, when prices are not controlled,
D
Q
450
150
the goods do not necessarily go to the buyers who
value them most highly.
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
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
$4
E ’ w/o
Eq’m
/
price
controls
D
500
7
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
W
S
$4
Price
floor
$3
D
L
500
L
Quantity of
unskilled workers
8
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
The Minimum Wage
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).
W
labor
surplus S
Min wage laws
do not affect
highly skilled
workers.
Price
floor
$5
$4
They do affect
teen workers.
workers
D
400
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
550
9
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Studies:
A 10% increase
in the min wage
raises teen
unemployment
by 1-3%.
L
10
W
unemployment S
Min.
wage
$5
$4
D
400
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
550
L
11
2
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ACTIVE LEARNING
Price controls
1
The market for
hotel rooms
P
140
Determine
effects of:
ACTIVE LEARNING
130
The price
falls to $90.
S
120
100
90
B. $90 price
floor
80
C. $120 price
floor
60
D
70
130
S
110
100
90
Price ceiling
80
shortage = 30
70
D
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
12
40
0
Q
50 60 70 80 90 100 110 120 130
13
B. $90 price floor
P = $100,
Q = 100 rooms.
The market for
hotel rooms
50
ACTIVE LEARNING
Eq’m price is
above the floor,
so floor is not
binding.
P
140
120
Buyers
demand
120 rooms,
sellers supply
90, leaving a
shortage.
110
A. $90 p
price
ceiling
1
A. $90 price ceiling
1
ACTIVE LEARNING
The market for
hotel rooms
P
140
130
C. $120 price floor
The price
rises to $120.
S
120
Buyers
demand
60 rooms,
sellers supply
120, causing a
surplus.
110
100
90
80
Price floor
D
70
60
1
P
140
130
The market for
hotel rooms
surplus = 60
120
110
S
Price floor
100
90
80
D
70
60
50
50
40
0
Q
50 60 70 80 90 100 110 120 130
14
40
0
Q
50 60 70 80 90 100 110 120 130
15
Evaluating Price Controls
Taxes
 The govt levies taxes on many goods & services
 Recall one of the Ten Principles from Chapter 1:
to raise revenue to pay for national defense,
public schools, etc.
Markets are usually a good way
to organize economic activity.
 Prices are the signals that guide the allocation of
 The govt can make buyers or sellers pay the tax.
society’s resources. This allocation is altered
when policymakers restrict prices.
 The
Th tax
t can be
b a % off the
th good’s
d’ price,
i
or a specific amount for each unit sold.
 For simplicity, we analyze per-unit taxes only.
 Price controls often intended to help the poor,
but often hurt more than help.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
16
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
17
3
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A Tax on Buyers
EXAMPLE 3: The Market for Pizza
Eq’m
w/o tax
The
price
buyers
pay
Hence,
a tax
on buyers
is
nowthe
$1.50
higher
than
shifts
D curve
down
the
market
price
by the
amount
ofP.
the tax.
P
S1
D1
Q
18
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
A Tax on Buyers
Q = 450
Sellers
receive
PS = $9.50
Buyers pay
PB = $11.00
D1
E.g., if P falls
from $10.00 to $8.50,
buyers still willing to
purchase 500 pizzas.
D2
S1
buyers pay
$1.00 more,
$10.00
$
PS = $9.50
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P
S1
PB = $11.00
Tax
$10.00
$
PS = $9.50
sellers get
$0.50 less.
D1
D1
D2
D2
Q
450 500
20
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Sellers will supply
500 pizzas
onl if
only
P rises to $11.50,
to compensate for
this cost increase.
Q = 450
S2
Tax S1
Buyers pay
PB = $11.00
Sellers
receive
PS = $9.50
D1
500
Effects of a $1.50 per
unit tax on sellers
New eq’m:
$10.00
$
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
21
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
A Tax on Sellers
Effects of a $1.50 per
unit tax on sellers
Hence, a tax on sellers shifts the
S curve up by the amount of the tax.
Q
450 500
A Tax on Sellers
The tax effectively raises
sellers’ costs by
P
$1.50 per pizza.
$11.50
Q
500
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
In our
example,
Tax
Difference
between them
= $1.50 = tax
Tax
how the burden of a tax is shared among
market participants
P
PB = $11.00
S1
The Incidence of a Tax:
Effects of a $1.50 per
unit tax on buyers
New eq’m:
P
P would have to fall
by $1.50 to make
$10.00
$
buyers willing
to buy same Q
as before.
$8.50
$10.00
$
500
Effects of a $1.50 per
unit tax on buyers
Q
22
P
PB = $11.00
S2
S1
Tax
$10.00
$
PS = $9.50
Difference
between them
= $1.50 = tax
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
D1
450 500
Q
23
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17.08.2009
The Outcome Is the Same in Both Cases!
What matters
is this:
S1
A tax drives
a wedge
d
between the
price buyers
pay and the
price sellers
receive.
Tax
$
$10.00
PS = $9.50
D1
450 500
Q
ACTIVE LEARNING
Answers
P
140
PB = 110
100
PS = $80
90
The market for
hotel rooms
90
70
60
40
0
Q
50 60 70 80 90 100 110 120 130
Tax
PB
S
Tax
Price if no tax
D
Sellers’ share
of tax burden
60
PS
D
50
Q
PB
Tax
PS
private airplanes, furs, expensive cars, etc.
 Goal of the tax: raise revenue from those
who could most easily afford to pay –
wealthy
y consumers.
 But who really pays this tax?
Sellers bear
most of the
burden of
the tax.
D
27
 1990: Congress adopted a luxury tax on yachts,
It’s easier
for buyers
than sellers
to leave the
market
market.
S
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
CASE STUDY: Who Pays the Luxury Tax?
CASE 2: Demand is more elastic than supply
Price if no tax
It’s easier
for sellers
than buyers
to leave the
market.
k t
So buyers
bear most of
the burden
of the tax.
P
70
P
D
80
S
Elasticity and Tax Incidence
Sellers’ share
of tax burden
100
CASE 1: Supply is more elastic than demand
40
0
Q
50 60 70 80 90 100 110 120 130
Buyers’ share
of tax burden
110
50
Buyers’ share
of tax burden
PS = 80
Incidence
buyers: $10
sellers: $20
120
Find new
Q, PB, PS,
and incidence
of tax.
120
PB = $110
S
Elasticity and Tax Incidence
2
130
Q = 80
The market for
hotel rooms
130
24
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
2
P
140
Suppose govt
imposes a tax
on buyers of
$30 per room.
P
PB = $11.00
ACTIVE LEARNING
Effects of a tax
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!
Q
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
28
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
29
5
17.08.2009
CONCLUSION: Government Policies and
CASE STUDY: Who Pays the Luxury Tax?
The market for yachts
P
Buyers’ share
of tax burden
 Each of the policies in this chapter affects the
Demand is
price-elastic.
allocation of society’s resources.
S
In the short run,
supply is inelastic.
PB
Tax
Sellers’ share
of tax burden
the Allocation of Resources
PS
D
Q
Hence,
companies
that build
yachts pay
most of
the tax.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
 Example 1: A tax on pizza reduces eq’m Q.
With less production of pizza, resources
(workers ovens
(workers,
ovens, cheese) will become available
to other industries.
 Example 2: A binding minimum wage causes
a surplus of workers, a waste of resources.
 So, it’s important for policymakers to apply such
policies very carefully.
30
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
CHAPTER SUMMARY
CHAPTER SUMMARY
 A price ceiling is a legal maximum on the price of a
 A tax on a good places a wedge between the price
31
buyers pay and the price sellers receive, and
causes the eq’m quantity to fall, whether the tax is
imposed on buyers or sellers
sellers.
good. An example is rent control. If the price
ceiling is below the eq’m price, it is binding and
causes a shortage
shortage.
 The incidence of a tax is the division of the burden
 A price floor is a legal minimum on the price of a
of the tax between buyers and sellers, and does
not depend on whether the tax is imposed on
buyers or sellers.
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.
 The incidence of the tax depends on the price
32
elasticities of supply and demand.
33
6