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Lecture Notes: Econ 203 Introductory Microeconomics
Lecture/Chapter 6: Supply, demand and govt. policies
M. Cary Leahey
Manhattan College
Fall 2012
Goals
• This is an applications chapter looking at how well-known govt.
policies affect market outcomes.
• By “market outcomes,” we mean the impact of policy on price and
quantity-our model’s representation of “truth.”
• Does the policy have different outcomes if it affects consumer rather
than producers or demand rather than supply
• We look at the incidence of the tax. By that we mean who bears the
burden of the tax. The correct answer might surprise you.
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Two well known govt. policies
• Price controls
•
Set a price ceiling or a legal maximum on the price of a good or
service. One well known NYC example is rent control
• Taxes
•
The govt can make buyers/sellers pay a specific extra amount per
unit.
• How can out traditional supply and demand analysis explains the
market outcomes-the changes in price and quantity
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Example 1: Price control: the market for apartments
P
Rental
price of
apts
S
$800
Equilibrium w/o
price controls
D
300
Q
Quantity
of apts
How price ceilings affect market outcomes, I
A price ceiling
above the
equilibrium price
is
not binding—
has no effect
on the market
P
S
Price
ceiling
$1000
$800
outcome.
D
300
Q
How price ceilings affect market outcomes, II
The equilibrium price
($800) is above the
ceiling and therefore
illegal.
The ceiling
is a binding
constraint
on the price, causes
a shortage.
P
S
$800
Price
ceiling
$500
shortage
D
250
400
Q
Shortages and rationing
• With shortages, sellers must ration the goods among buyers by a
non-price mechanism.
• Non-price rationing is unfair and inefficient—long lines and
discrimination. Goods do not go to the buyers who value them most
highly.
• Compare this is the (by definition) efficient outcome of the market.
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Example 2: Minimum wage/ the market for unskilled labor
•
•
•
•
•
Remember that the “price’ of labor is the (real) wage rate. So we will use
the same analysis for rent control as for the minimum wage
Some background on the minimum wage.
The minimum wage is the least amount workers can be paid per hour. The
typical minimum wage worker is a younger person without a high school
degree. He or she is rarely the only breadwinner in a household.
The minimum wage is NOT indexed for inflation. So legislators from time to
time ask for an increase in the minimum wage to adjust for the past
increases in inflation. In other words changes are made to adjust for the fall
in the real minimum wage.
The minimum wage has last increased in 2008 to $7.25. It was fallen about
10% in real terms since it was last increased. It down one third from its
peak to $9 (2011) dollars in 1980.
.
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Example 2: Minimum wage/the market for unskilled labor
Wage
paid to
unskilled
workers
W
S
$6.00
Equilibrium w/o
price controls
D
500
L
Quantity of
unskilled workers
Minimum wage, another price floor, I
A price floor
below the
equilibrium
price is
not binding –
has no effect
on the market
outcome.
W
S
$6.00
Price
floor
$5.00
D
500
L
Minimum wage, another price floor, II
The equilibrium wage
($6) 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
Price
floor
$7.25
$6.00
D
400
550
L
Minimum wage, another price floor, III
Min wage laws
do not affect
highly skilled workers.
They do affect teen
workers.
W
unemployment S
Min.
wage
$7.25
Studies:
$6.00
A 10% increase
in the min wage raises
teen unemployment
by 1–3%.
D
400
550
L
Evaluating price controls
• Price controls distort or drive a wedge in market signals.
• They lead to unintended outcomes such as hurting those they intend
to help.
• For example, an increased minimum wage will increase income to
low skilled workers but will also increase low skilled employment.
How much is open to empirical debate.
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Taxes
• Taxes are levied on both goods and sellers of goods and services
• The taxes can be called sales taxes, excise taxes, sin taxes, etc.
• The tax can be a % of the sellers price (ad valorem) or a fixed
amount such as state taxes on gasoline. They can also be a lump
sum tax or poll tax which is a tax per person. These taxes were
more prevalent in colonial times.
• Sometime the revenues are allocated to specific activities.
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Example 3: the market for pizza
P
Equilibrium
w/o tax
S1
$10.00
D1
500
Q
Example 3; a tax on buyers
Hence, a tax on buyers shifts
TheDprice
buyers
the
curve
downpay
by the
is now $1.50
amount
of thehigher
tax. than the
market price P.
P would have to fall
by $1.50 to make
buyers willing
to buy same Q
as before.
E.g., if P falls
from $10.00 to $8.50,
buyers still willing to
purchase 500 pizzas.
Effects of a $1.50 per
unit tax on buyers
P
S1
$10.00
Tax
$8.50
D1
D2
500
Q
Example 3: a tax on buyers
Effects of a $1.50 per
unit tax on buyers
New equilibrium:
Q = 450
Sellers
receive
PS = $9.50
P
PB = $11.00
Buyers pay
PB = $11.00
Difference between
them
= $1.50 = tax
S1
Tax
$10.00
PS = $9.50
D1
D2
450 500
Q
Example 3: the incidence of a tax:
how the burden of a tax is shared among market participants
In our
example,
buyers pay
$1.00 more,
P
PB = $11.00
S1
Tax
$10.00
PS = $9.50
sellers get
$0.50 less.
D1
D2
450 500
Q
Example 3: a tax on sellers
The tax effectively raises
sellers’ costs by
P
$1.50 per pizza.
$11.50
Sellers will supply
500 pizzas
only if
P rises to $11.50,
to compensate for
this cost increase.
Effects of a $1.50 per
unit tax on sellers
S2
Tax S1
$10.00
Hence, a tax on sellers shifts the
S curve up by the amount of the tax.
D1
500
Q
Example 3: a tax on sellers
Effects of a $1.50 per
unit tax on sellers
New equilibrium:
Q = 450
Buyers pay
PB = $11.00
Sellers
receive
PS = $9.50
Difference
between them
= $1.50 = tax
P
PB = $11.00
S2
S1
Tax
$10.00
PS = $9.50
D1
450 500
Q
The outcome is the same in either case
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!
What matters is
this:
A tax drives
a wedge
between the price
buyers pay and
the price sellers
P
PB = $11.00
S1
Tax
$10.00
PS = $9.50
receive.
D1
450 500
Q
Elasticity and tax incidence
CASE 1: Supply is more elastic than demand
It’s easier
for sellers
than buyers
to leave the
market.
P
Buyers’ share
of tax burden
PB
S
Tax
Price if no tax
Sellers’ share
of tax burden
So buyers
bear most of
the burden
of the tax.
PS
D
Q
Elasticity and tax incidence
CASE 2: Demand is more elastic than supply
P
Buyers’ share
of tax burden
S
PB
Price if no tax
Sellers’ share
of tax burden
It’s easier
for buyers
than sellers
to leave the
market.
Tax
PS
Sellers bear
most of the
burden of
the tax.
D
Q
Case study: who pays the luxury tax?
• 1990: Congress adopted a luxury tax on yachts, private airplanes,
furs, expensive cars, etc.
• Goal: raise revenue from those who could most easily afford to
pay—wealthy consumers.
• But who really pays this tax?
Case study: who pays the luxury tax? (II)
The market for
yachts P
Buyers’ share
of tax burden
Demand is
price-elastic.
S
In the short run,
supply is inelastic.
PB
Tax
Sellers’ share
of tax burden
PS
D
Q
Hence,
companies
that build
yachts pay
most of
the tax.
Summary
• Price ceiling is a legal maximum of a price of a good or service.
One local example is rent control. If the price is below the
equilibrium price, then the price is binding and causes a shortage.
• A price floor is a legal minimum on the price of a good or service.
One example is the minimum wage, If the price floor is above the
equilibrium price, it is binding and causes a surplus
(unemployment). A minimum wage causes incomes to increase for
those who keep their jobs but also causes unemployment among
unskilled workers.
• A tax is a wedge between the price buyers pay and sellers receive,
causing equilibrium quantity to fall, regardless on whether it falls on
buyers or sellers.
• The incidence or burden of the tax depends on the elasticities of
supply and demand. If supply is more elastic, the incidence or
burden falls on the buyers rather than the sellers. And vice versa.
.
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