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Demand, Supply and
Economic Policy
Lecture 4 – academic year 2014/15
Introduction to Economics
Fabio Landini
Where we are…
• Lecture 1: demand and supply
• Lecture 2: the concept of elasticity
• Lecture 2: elasticity of demand (high and low)
and total revenue
• Lecture 3: demand, supply and elasticity –
exercises and applications
2
What do we do today?
• Economic policy: what is it and how it works?
• Price regulation
• Taxes and their effects
3
Question of the day
Since 2007, in Italy there exist an institution
called Price Overseeing Authority.
• What does it do?
– Overseeing: it verifies the prices
– Coordination: it functions as a bridge
between producers and consumers
QUESTION: Why do we need it?
4
Demand, supply and economic policy
Government can affect market’s functioning in
two ways:
• By regulating economic activities (p & q max
and min);
• By imposing taxes and subsidies.
5
Price regulation and
market equilibrium
In a market with no regulation, market forces
establish the equilibrium level of p and q.
Even if the market is in equilibrium, somebody
can be unsatisfied (for reasons associated with
equity or efficiency).
6
Price regulation and
market equilibrium
[PICTURE CEMENTIFICAZIONE]
7
When are prices regulated?
When politicians believe p of a given market to
be unequal.
In these cases max or min level of prices is fixed.
Usually, there are efficiency costs (this is the
classic trade-off between efficiency and equity!)
8
Max and min level of price
Max (min) level
• It is max (min) price that a good can be sold at
according to law.
9
Max level of price
When the government imposes a max level of
price, there are two possible consequences:
•p max is NOT CONSTRAINING: if the market price is
< than p max.
•p max is CONSTRAINING: if the market price is >
than p max. In this case artificial scarcity is created…
10
Max price is NOT CONSTRAINING
Price of
ice-cream
Supply
Max Price
4
Equilibrium price
3
Demand
0
100
Equilibrium quantity
Quantity of
Ice-cream
11
Max price is CONSTRAINING
Price of
ice-cream
Supply
Equilibrium price
3
2
Max Price
Demand
0
100
Equilibrium quantity
Quantity of
Ice-cream
12
Max price is CONSTRAINING
Price of
ice-cream
Supply
Equilibrium price
3
2
Max Price
Scarcity
0
75
Demand
125
Quantity Supplied Quantity Demanded
Quantity of
Ice-cream
13
The effects of max p
When it is constraining, a max p …
. . . Generate scarcity QD > QS
Example: Scarcity of petrol in 1970.
. . . Rationing of the good.
Example: long queues,
or: seller’s discrimination practices.
14
Min level of prices
Two possible consequences:
• p min is NOT CONSTRAINING: if p min <
than equilibrium price.
• p min IS CONSTRAINING: if p min > than
equilibrium price. In this case excess supply
is generated.
15
Min price is NOT CONSTRAINING
Price of
ice-cream
Supply
Equilibrium price
3
2
Min Price
Demand
0
100
Equilibrium quantity
Quantity of
Ice-cream
16
Max price is CONSTRAINING
Price of
ice-cream
Supply
Min Price
4
Equilibrium price
3
Demand
0
100
Equilibrium quantity
Quantity of
Ice-cream
17
Max price is NOT CONSTRAINING
Price of
ice-cream
Excess
Supply
Supply
Min Price
4
Equilibrium price
3
Demand
0
75
125
Quantity Demanded Quantity Supplied
Quantity of
Ice-cream
18
Effects of a min p
When constraining, min p min generates . . .
. . . An excess of supply QS > QD
. . . The resources in excess are wasted
Example: Minimum wage; Subsidies to sustain
the price of agricultural goods.
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(a) Max rent in the short period
(Supply and demand are inelastic)
(b) Max rent in the long period
(Supply and demand are elastic)
Rent
Rent
Supply
Supply
Max rent
Max rent
Scarcity
Scarcity
Demand
Demand
0
Quantity of
flats
0
Quantity of
flats
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(b) Labour market with min wage
(a) Free labour market
Wage
Wage
Excess supply
of labour
Labour
supply
(unemployment)
Labour
supply
Min wage
Equilibrium
wage
Labour
demand
Labour
demand
0
Equilibrium
employment
Quantity of
employed
0
Quantity
demanded
Quantity
supplied
Quantity of
employed
21
Taxes: Effects
Government uses taxation to finance public
expenditure.
But taxes are not neutral in that they can
discourage market activities.
When a good is taxed, the quantity that is sold
diminishes.
In the majority of the cases, buyers and sellers
share the tax burden.
22
Legal incidence and economics of taxes
The law establishes who pays the tax (legal
incidence). But not who really bears the tax
burden (economic incidence).
Let’s see why….
23
Legal incidence and economics of taxes
The tax affects the market equilibrium:
– The price for consumers rises, who therefore
reduce the quantity demanded.
– The portion of the price earned by sellers
reduces, and therefore they reduce the
quantity supplied.
24
Legal incidence and economics of taxes
The economic incidence (= how the tax burden is
shared between consumers and producers) is
independent from the subject who is legally
responsible for paying the tax … (that is the legal
incidence).
It depends on ED and ES.
25
The effect of a tax on consumption goods
Initial price of an apple: 1€
Then: consumption tax of 0,10€ for each apple. What
happens to the price of apples after tax?
Let’s see the cases:
a) The prince remains equal to 1€. In this case, the
tax is paid ONLY by the producer: the consumer
pays 1€; 0,10€ goes to State and only 0,90€ to the
producer;
b) The price rises to 1,10€. Then the tax is paid ONLY
by the consumer.
26
The effect of a tax on consumption goods
In the majority of the cases “the true lies in
between”: the tax rises both the price to
consumers and the price to producers.
Example: the price to consumers can become 1,05
and the price to producers 0,95.
The final price depends on the elasticity of
demand and supply.
27
The effect of a tax on consumption goods
Hp.: producers respond to price four times more
than consumers (i.e.: ES(p)=4xED(p)).
To maintain the market equilibrium the price to
consumers must rise to 1,08 and the one to
producers must fall to 0,98.
In this way, the price to consumers (+8%) is four
times than the price to producers (-2%), and
thus: quantity demanded = quantity supplied.
28
The effect of a tax on consumption goods
Price of
ice-cream
Supply
3,00
Equilibrium
without the tax
Demand
0
100
Quantity of
Ice-cream
29
The effect of a tax on consumption goods
Price of
ice-cream
Supply
3,00
A tax on
consumption shifts
the demand curve
leftward
Equilibrium
without the tax
Demand
0
100
Quantity of
Ice-cream
30
The effect of a tax on consumption goods
Price of
ice-cream
Supply
3,00
A tax on
consumption shifts
the demand curve
leftward
Equilibrium
without the tax
New equilibrium
with the tax
0
Demand
100
Quantity of
Ice-cream
31
The effect of a tax on consumption goods
Price of
ice-cream
Supply
pD
Tax (t)
Equilibrium
without the tax
pS
New equilibrium
with the tax
0
Qt
Demand
Quantity of
Ice-cream
32
The effect of a tax on consumption goods
33
The effect of a tax on consumption goods
Price of
ice-cream
Supply
3,00
Equilibrium
without the tax
Demand
0
100
Quantity of
Ice-cream
34
The effect of a tax on consumption goods
Price of
ice-cream
Supply A tax on production
(0,50 cents) shifts
the supply curve
leftward.
3,00
Equilibrium
without the tax
Demand
0
100
Quantity of
Ice-cream
35
The effect of a tax on consumption goods
New equilibrium
with the tax
Price of
ice-cream
Supply A tax on production
(0,50 cents) shifts
the supply curve
leftward.
3,00
Equilibrium
without the tax
Demand
0
100
Quantity of
Ice-cream
36
The effect of a tax on consumption goods
New equilibrium
with the tax
Price of
ice-cream
Supply A tax on production
(0,50 cents) shifts
the supply curve
leftward.
3,30
Tax (0,50)
Equilibrium
without the tax
2,80
Demand
0
80
Quantity of
Ice-cream
37
Incidence of taxes
How is the tax burden shared between
consumers and producers?
All depends on the elasticity of the demand and
supply curves.
The tax burden mainly falls on the less elastic
market component.
38
Elasticity and incidence of taxes
If the demand is inelastic and the supply is
elastic: The tax is paid mainly by the consumer.
If the demand is elastic and the supply is
inelastic: The tax is paid mainly by the producer.
39
Elastic supply + inelastic demand
Price
Supply
Price before tax
Demand
0
Quantity
40
Elastic supply + inelastic demand
Price
Price to
consumer
Supply
Tax burden
Price before tax
Price to producer
Demand
0
Quantity
41
Elastic supply + inelastic demand
Price
1. If the supply is more
elastic then the demand...
Price to
consumer
Supply
Tax burden
Price before tax
2. …the tax
affects more the
consumer...
Price to producer
3. …then the Demand
producer.
0
Quantity
42
Inelastic supply + elastic demand
Price
Supply
Price before tax
Demand
0
Quantity
43
Inelastic supply + elastic demand
Price
Supply
Price to consumer
Price before tax
Tax burden
Price to producer
0
Demand
Quantity
44
Inelastic supply + elastic demand
1. If the demand is more
elastic than the supply..
Price
Supply
Price to consumer
Price before tax
Tax burden
Price to producer
3. …Than on the
consumer.
Demand
2. …the tax impacts
more on the producer...
0
Quantity
45
Conclusion
The economy is ruled by two kinds of law:
• The law of demand and supply
• The laws enacted by the legislator
46
Conclusion
Regulated prices include either a minimum
or a maximum (or both) level of price.
47
Conclusion
Taxes on production and consumption create
new equilibrium prices, where consumers
and producers share in the tax burden.
The incidence of the tax depends on the
elasticity of demand and supply.
48
Next lecture
Market efficiency…
49