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6 Supply, Demand, and Government Policies In this chapter, look for the answers to these questions: What are price ceilings and price floors? What are some examples of each? PRINCIPLES OF ECONOMICS How do price ceilings and price floors affect market outcomes? FOURTH EDITION 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 Premium PowerPoint® Slides by Ron Cronovich 2008 update Modified by Joseph Tao-yi Wang What is the incidence of a tax? What determines the incidence? CHAPTER 6 © 2008 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 • • 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. 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 2 Price ceiling $8000 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 ($8000) is above the ceiling and therefore illegal. S $10000 Q Quantity of apartments How Price Ceilings Affect Market Outcomes P S $8000 The govt can make buyers or sellers pay a specific amount on each unit bought/sold. A price ceiling above the eq’m price is not binding – has no effect on the market outcome. P Eq’m Eq’m w/o w/o price price controls controls Taxes • 1 SUPPLY, DEMAND, AND GOVERNMENT POLICIES CHAPTER 6 P S $8000 Price ceiling $5000 shortage D 250 400 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Q 5 Shortages and Rationing How Price Ceilings Affect Market Outcomes In the long run, supply and demand are more price-elastic. So, the shortage is larger. P among buyers. Some rationing mechanisms: (1) long lines (2) discrimination according to sellers’ biases $8000 Price ceiling $5000 shortage D Q 450 150 CHAPTER 6 With a shortage, sellers must ration the goods S the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair). EXAMPLE 2: Wages of Gov’tal Employee Wage of gov’t employee W CHAPTER 6 20000 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. In contrast, when prices are not controlled, 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES These mechanisms are often unfair, and inefficient: W S 20000 Price floor 16000 D L 500 L Quantity of gov’t employee CHAPTER 6 8 SUPPLY, DEMAND, AND GOVERNMENT POLICIES CHAPTER 6 How Price Floors Affect Market Outcomes The eq’m wage ($20,000) 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 30000 9 SUPPLY, DEMAND, AND GOVERNMENT POLICIES W unemployment S Min. wage 30000 They do affect 20000 unskilled workers (like secretaries). 20000 D 400 550 SUPPLY, DEMAND, AND GOVERNMENT POLICIES What is the form of unemployment for governmental employees in Taiwan? L 10 CHAPTER 6 D 400 550 L Everyone takes the exams! SUPPLY, DEMAND, AND GOVERNMENT POLICIES 11 ACTIVE LEARNING Price floors & ceilings 1: ACTIVE LEARNING The market for hotel rooms P 140 130 Determine effects of: 110 100 B. $90 price floor 80 C. $120 price floor S 120 A. $90 price ceiling 1: A. $90 price ceiling 90 D 70 60 50 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 1: B. $90 price floor 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 S 110 100 Price floor 1: C. $120 price floor 120 80 13 D 70 60 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 The govt levies taxes on many goods & services 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. 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 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. 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 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 $300 D1 Q 500 CHAPTER 6 18 SUPPLY, DEMAND, AND GOVERNMENT POLICIES CHAPTER 6 S1 Tax $300 PS = $285 D1 D2 Q 430 500 CHAPTER 6 20 SUPPLY, DEMAND, AND GOVERNMENT POLICIES The Outcome Is the Same in Both Cases! CHAPTER 6 Tax $300 PS = $285 D1 D2 Q 430 500 19 S1 Tax D1 430 500 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Effects of a $45 per unit tax on sellers P PB = 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. CHAPTER 6 Q S2 S1 $330 Tax $300 PS = $285 D1 430 500 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 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! P What matters is this: PB = $330 A tax drives $300 a wedge PS = $285 between the price buyers pay and the price sellers receive. S1 $330 A Tax on Sellers P $330 PB = 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 = 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 $30 $30 more, more, sellers sellers get get $15 $15 less. less. Effects of a $45 per unit tax on buyers 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 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 PB Tax Price if no tax Sellers’ share of tax burden 60 PS 50 D Elasticity and Tax Incidence PB Price if no tax Sellers’ share of tax burden 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 Who Pays the Cigarette Tax? 2006: Taiwan’s Legislative Yuan increased the 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: 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 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 cigarette tax by $5. Possible “goal” of the tax: to raise revenue from those who profit from harming other’s health – “evil” cigarette companies. But who really pays this tax? Q CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES The market for Cigarettes Buyers’ share of tax burden supply supply is is elastic. elastic. Tax Hence, Hence, addicted addicted smokers smokers pay pay most most of of the the tax. tax. PS D SUPPLY, DEMAND, AND GOVERNMENT POLICIES • 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. So, it’s important for policymakers to apply such Q CHAPTER 6 27 allocation of society’s resources. S In In the the short short run, run, PB SUPPLY, DEMAND, AND GOVERNMENT POLICIES the Allocation of Resources Each of the policies in this chapter affects the Demand Demand is is inelastic. inelastic. P CHAPTER 6 CONCLUSION: Government Policies and Who Pays the Cigarett Tax? CASE STUDY: Sellers’ share of tax burden 26 policies very carefully. 28 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 29 CHAPTER SUMMARY CHAPTER SUMMARY A tax on a good places a wedge between the 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. A price floor is a legal minimum on the price of a 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. The incidence of the tax depends on the price elasticities of supply and demand. CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 30 CHAPTER 6 Price Control and Taxation SUPPLY, DEMAND, AND GOVERNMENT POLICIES Demand and Supply Supply, Demand and Equilibrium • Markets are “good”? • Price control is “bad”! 140 120 100 80 Price • Homework: Mankiw, Ch. 6, pp.132-134, Problem 2, 7, 11 Demand Supply 2 60 40 20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity Demand and Supply with Tax Supply, Demand and Equilibrium 160 140 120 Price 100 Demand 80 Tax Supply Supply 2 60 40 20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity Bids and Asks (no restrictions)` 31 Unbinding/Binding Price Ceiling and Binding Price Floor Taxing the Consumer/Firm Original: 60, 70, 60, 60, 60,40, 60 New: 70, 80, 70, 70, 80 | 80, 80, 70, 90 Supply, Demand and Equilibrium Supply, Demand and Equilibrium 140 140 120 120 100 100 80 Demand Supply 1 Demand Price Price 80 Supply 1 60 60 40 40 20 20 Supply 2 0 0 1 2 3 4 5 6 7 8 9 1 10 2 3 4 5 6 7 8 9 10 Quantity Quantity Price Controls Taxing Producers Supply, Demand and Equilibrium Supply, Demand and Equilibrium 140 160 120 140 120 100 100 Demand Supply 2 Price Price 80 Demand 80 Tax Supply Supply 2 60 60 40 40 20 20 0 0 1 2 3 4 5 6 Quantity 7 8 9 10 1 2 3 4 5 6 Quantity 7 8 9 10 Taxing Consumers Supply, Demand and Equilibrium 140 120 100 80 Price Demand Tax Demand Supply 2 60 40 20 0 1 2 3 4 5 6 Quantity 7 8 9 10