6 Supply, Demand, and Government Policies PRINCIPLES OF FOURTH EDITION N G R E G O R Y M A N K I W PowerPoint® Slides by Ron Cronovich © 2007 Thomson South-Western, all rights reserved In this chapter, look for the answers to these questions:  What are price ceilings and price floors? What are some examples of each?  How price ceilings and price floors affect market outcomes?  How taxes affect market outcomes? How does the outcome depend on whether the tax is imposed on buyers or sellers?  What is the incidence of a tax? What determines the incidence? CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES Government Policies That Alter the Private Market Outcome  Price controls • • 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  Taxes • The govt can make buyers or sellers pay a specific amount on each unit bought/sold 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 and eq’m eq’m quantity) quantity) CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES EXAMPLE 1: The Market for Apartments P Rental price of apts S $800 Eq’m Eq’m w/o w/o price price controls controls D 300 Q Quantity of apartments CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES How Price Ceilings Affect Market Outcomes A price ceiling above the eq’m price is not binding – it has no effect on the market outcome P S Price ceiling $1000 $800 D 300 CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES Q How Price Ceilings Affect Market Outcomes The eq’m price ($800) is above the ceiling and therefore illegal The ceiling is a binding constraint on the price, and causes a shortage CHAPTER P S $800 Price ceiling $500 shortage 250 D 400 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Q How Price Ceilings Affect Market Outcomes In the long run, supply and demand are more price-elastic So, the shortage is larger P S $800 Price ceiling $500 shortage 150 CHAPTER 450 SUPPLY, DEMAND, AND GOVERNMENT POLICIES D Q Shortages and Rationing  With a shortage, sellers must ration the goods among buyers  Some rationing mechanisms: (1) long lines (2) discrimination according to sellers’ biases  These mechanisms are often unfair, and inefficient: the goods don’t necessarily go to the buyers who value them most highly  In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair) CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES EXAMPLE 2: The Market for Unskilled Labor Wage paid to unskilled workers W S $4 Eq’m Eq’m w/o w/o price price controls controls D 500 L Quantity of unskilled workers CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES How Price Floors Affect Market Outcomes A price floor below the eq’m price is not binding – it has no effect on the market outcome W S $4 Price floor $3 D 500 CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES L 10 EXAMPLE 3: The Market for Pizza Eq’m Eq’m w/o w/o tax tax P S1 $10.00 D1 500 CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES Q 19 A Tax on Buyers 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 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 P PB = $11.00 Effects of a $1.50 per unit tax on buyers S1 Tax $10.00 PS = $9.50 D1 D2 430 500 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Q 20 The Incidence of a Tax: how the burden of a tax is shared among market participants P Because Because of of the the tax, tax, PB = $11.00 buyers buyers pay pay $10.00 $1.00 more, $1.00 more, PS = $9.50 sellers sellers get get $0.50 $0.50 less less S1 Tax D1 D2 430 500 CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES Q 21 A Tax on Sellers 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 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 P PB = $11.00 Effects of a $1.50 per unit tax on sellers S2 Tax S1 $10.00 PS = $9.50 D1 430 500 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Q 22 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 Tax S1 D1 430 500 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Q 23 ACTIVE LEARNING Effects of a tax P Suppose govt imposes a tax on buyers of $30 per room Find new Q, PB, PS, and incidence of tax 2: The market for hotel rooms S D Q 24 ACTIVE LEARNING Answers P 2: The market for hotel rooms S Q = 80 PB = $110 PS = $80 PB = Tax D PS = Incidence buyers: $10 sellers: $20 Q 25 Elasticity and Tax Incidence CASE 1: Supply is more elastic than demand P Buyers’ share of tax burden PB S Tax Price if no tax Sellers’ share of tax burden In In this this case, case, buyers buyers bear bear most most of of the the burden burden of of the the tax tax PS D Q CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES 26 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 In In this this case, case, sellers sellers bear bear most most of of the the burden burden of of the the tax tax Tax PS D Q CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES 27 Elasticity and Tax Incidence  If buyers’ price elasticity > sellers’ price elasticity, buyers can more easily leave the market when the tax is imposed, so buyers will bear a smaller share of the burden of the tax than sellers  If sellers’ price elasticity > buyers’ price elasticity, the reverse is true CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES 28 CASE STUDY: Who Pays the Luxury Tax?  1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc  Goal of the tax: to raise revenue from those who could most easily afford to pay – wealthy consumers  But who really pays this tax? CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES 29 CASE STUDY: Who Pays the Luxury Tax? The market for yachts P Buyers’ share of tax burden Demand Demand is is price-elastic price-elastic S PB In In the the short short run, run, supply supply is is inelastic inelastic Tax Sellers’ share of tax burden PS D Q CHAPTER 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 30 CONCLUSION: Government Policies and the Allocation of Resources  Each of the policies in this chapter affects the allocation of society’s resources • Example 1: a tax on pizza reduces the eq’m quantity of pizza Since the economy is producing fewer pizzas, some 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 policies very carefully CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES 31 CHAPTER SUMMARY  A price ceiling is a legal maximum on the price of 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 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 CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES 32 CHAPTER SUMMARY  A tax on a good places a wedge between the 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  The incidence of a tax is the division of the 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 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 33 [...]... them: • The min wage can cause job losses • Rent control can reduce the quantity and quality of affordable housing CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 17 Taxes  The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc  The govt can make buyers or sellers pay the tax  The tax can be a percentage of the good’s price, or a specific... Price floor Buyers demand 60 rooms, sellers supply 120, causing a surplus D 0 Q 16 Evaluating Price Controls  Recall one of the Ten Principles: Markets are usually a good way to organize economic activity  Prices are the signals that guide the allocation of society’s resources This allocation is altered when policymakers restrict prices  Price controls are often intended to help the poor, but they... price ceiling D B $90 price floor C $120 price floor 0 Q 13 ACTIVE LEARNING A $90 price ceiling P 1: The market for hotel rooms S The price falls to $90 Buyers demand 120 rooms, sellers supply 90, leaving a shortage Price ceiling D shortage = 30 0 Q 14 ACTIVE LEARNING B $90 price floor P 1: The market for hotel rooms Eq’m price is above the floor, so floor is not binding P = $100, Q = 100 rooms Price... good places a wedge between the 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  The incidence of a tax is the division of the 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 ... 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  Taxes • The govt can make... affordable housing CHAPTER SUPPLY, DEMAND, AND GOVERNMENT POLICIES 17 Taxes  The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc  The govt... Controls  Recall one of the Ten Principles: Markets are usually a good way to organize economic activity  Prices are the signals that guide the allocation of society’s resources This allocation is