Copyright © 2006 Nelson, a division of Thomson Canada Ltd. 6 Supply, Demand, and Government...

Copyright © 2006 Nelson, a division of Thomson Canada Ltd.

66Supply, Demand, and Government Policies


Learning ObjectivesLearning Objectives

●Examine the effects of government policies that place a ceiling on prices

●Examine the effects of government policies that put a floor under prices

●Consider how a tax on a good affects the price of the good and the quantity sold

●Learn that taxes levied on buyers and taxes levied on sellers are equivalent

●See how the burden of a tax is split between buyers and sellers


Supply, Demand, and Government PoliciesSupply, Demand, and Government Policies

● In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities.

●While equilibrium conditions may be efficient, it may be true that not everyone is satisfied.

●One of the roles of economists is to use their theories to assist in the development of policies.


Policies that Control PricesPolicies that Control Prices

●Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.

●Result in government-created price ceilings and floors. Price CeilingPrice Ceiling : a legal maximummaximum on the price at

which a good can be sold. Price FloorPrice Floor:: a a legal minimumminimum on the price at which

a good can be sold.


How How Price CeilingsPrice Ceilings Affect Market Outcomes Affect Market Outcomes

●Two outcomes are possible when the government imposes a price ceiling: The price ceiling is notis not binding if set aboveabove the

equilibrium price. The price ceiling isis binding if set belowbelow the equilibrium

price, leading to a shortage.

Figure 1 A Market with a Price CeilingFigure 1 A Market with a Price Ceiling

(a) A Price Ceiling That Is Not Binding

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Equilibriumquantity

$4 Priceceiling

Equilibriumprice

Demand

Supply

3

100

Figure 1 A Market with a Price CeilingFigure 1 A Market with a Price Ceiling

Copyright©2003 Southwestern/Thomson Learning

(b) A Price Ceiling That Is Binding


Cones

0

Price ofIce-Cream

Cone

Demand

Supply

2 PriceceilingShortage

75

Quantitysupplied

125

Quantitydemanded

Equilibriumprice

$3


How Price Ceilings Affect Market OutcomesHow Price Ceilings Affect Market Outcomes

●A binding price ceiling, because QD > QS, creates shortages (e.g., Gasoline shortage of the 1970s) non-price rationing (e.g., Long lines, discrimination by

sellers)


● In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the major input in gasoline, so the higher oil prices reduced the supply of gasoline.

● What was responsible for the long gas lines?

CASE STUDYCASE STUDY:: Lines at the Gas Pump Lines at the Gas Pump

• Economists blame government regulations that limited the price oil companies could charge for gasoline.

Figure 2 The Market for Gasoline with a Price CeilingFigure 2 The Market for Gasoline with a Price Ceiling


(a) The Price Ceiling on Gasoline Is Not Binding

Quantity ofGasoline

0

Price ofGasoline

1. Initially,the priceceilingis notbinding . . . Price ceiling

Demand

Supply, S1

P1

Q1

Figure 2 The Market for Gasoline with a Price CeilingFigure 2 The Market for Gasoline with a Price Ceiling


(b) The Price Ceiling on Gasoline Is Binding

Quantity ofGasoline

0

Price ofGasoline

Demand

S1

S2

Price ceiling

QS

4. . . . resultingin ashortage.

3. . . . the priceceiling becomesbinding . . .

2. . . . but whensupply falls . . .

P2

QD

P1

Q1


CASE STUDY:CASE STUDY: Rent Control in the Short Run and Rent Control in the Short Run and Long RunLong Run

●Rent controls are ceilings placed on the rents that landlords may charge their tenants.

●The goal of rent control policy is to help the poor by making housing more affordable.

●One economist called rent control “the best way to destroy a city, other than bombing.”

Figure 3 Rent Control in the Short Run and in the Long RunFigure 3 Rent Control in the Short Run and in the Long Run


(a) Rent Control in the Short Run(supply and demand are inelastic)

Quantity of Apartments

0

Supply

Controlled rent

RentalPrice of

Apartment

Demand

Shortage

Figure 3 Rent Control in the Short Run and in the Long RunFigure 3 Rent Control in the Short Run and in the Long Run


(b) Rent Control in the Long Run(supply and demand are elastic)

0

RentalPrice of

Apartment

Quantity ofApartments

Demand

Supply

Controlled rent

Shortage


How Price Floors Affect Market OutcomesHow Price Floors Affect Market Outcomes

●When the government imposes a price floor, two outcomes are possible. The price floor is notis not binding if set belowbelow the

equilibrium price. The price floor isis binding if set aboveabove the equilibrium

price, leading to a surplus.

Figure 4 A Market with a Price FloorFigure 4 A Market with a Price Floor


(a) A Price Floor That Is Not Binding


Cones

0

Price ofIce-Cream

Cone

Equilibriumquantity

2

Pricefloor

Equilibriumprice

Demand

Supply

$3

100

Figure 4 A Market with a Price FloorFigure 4 A Market with a Price Floor


(b) A Price Floor That Is Binding


Cones

0

Price ofIce-Cream

Cone

Demand

Supply

$4Pricefloor

80

Quantitydemanded

120

Quantitysupplied

Equilibriumprice

Surplus

3



●A price floor prevents supply and demand from moving toward the equilibrium price and quantity.

●When the market price hits the floor, it can fall no further, and the market price equals the floor price.



●A binding price floor causes . . . a surplus because QS > QD. non-price rationingnon-price rationing is an alternative mechanism for

rationing the good, using discrimination criteria.• Examples: The minimum wage, agricultural price

supports


The Minimum WageThe Minimum Wage

●An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labour that any employer may pay.

● Minimum wage rates differ by province. In 2003, minimum wages ranged from a low of $5.90 per hour in Alberta to a high of $8.50 in Nunavut.

Figure 5 How the Minimum Wage Affects the Labour MarketFigure 5 How the Minimum Wage Affects the Labour Market


Quantity ofLabour

Wage

0

Labourdemand

LabourSupply

Equilibriumemployment

Equilibriumwage

(a) A Free Labour Market

Figure 5 How the Minimum Wage Affects the Labour MarketFigure 5 How the Minimum Wage Affects the Labour Market


Quantity ofLabour

Wage

0

LabourSupplyLabour surplus

(unemployment)

Labourdemand

Minimumwage

Quantitydemanded

Quantitysupplied

(b) A Labour Market with a Binding Minimum Wage


TAXESTAXES

●Governments levy taxes to raise revenue for public projects.

●Tax incidence is the distribution of a tax burden


How Taxes on Buyers (and Sellers) How Taxes on Buyers (and Sellers) Affect Market OutcomesAffect Market Outcomes

●Taxes discourage market activity.●When a good is taxed, the

quantity sold is smaller. ●Buyers and sellers share

the tax burden.


Elasticity and Tax IncidenceElasticity and Tax Incidence

●Tax incidenceTax incidence is the manner in which the burden of a tax is shared

among participants in a market. or who bears the burden of a tax.

●Taxes result in a change in market equilibrium.●Buyers pay more and sellers receive less,

regardless on whom the tax is levied.

Figure 6 A Tax on BuyersFigure 6 A Tax on Buyers


Quantity ofIce-Cream Cones

0

Price ofIce-Cream

Cone

Pricewithout

tax

Pricesellersreceive

Equilibrium without taxTax ($0.50)

Pricebuyers

pay

D1

D2

Supply, S1

A tax on buyersshifts the demandcurve downwardby the size ofthe tax ($0.50).

$3.30

90

Equilibriumwith tax

2.803.00

100

Figure 7 A Tax on SellersFigure 7 A Tax on Sellers


2.80

Quantity ofIce-Cream Cones

0

Price ofIce-Cream

Cone

Pricewithout

tax

Pricesellersreceive

Equilibriumwith tax

Equilibrium without tax

Tax ($0.50)

Pricebuyers

payS1

S2

Demand, D1

A tax on sellersshifts the supplycurve upwardby the amount ofthe tax ($0.50).

3.00

100

$3.30

90



●What was the impact of tax? Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.


● If you have ever received a paycheque, you probably noticed that taxes were deducted from the amount you earned.

● One of these taxes is called Employment Insurance (EI)● The federal government uses the revenue from EI tax

to pay for benefits to unemployed workers for training programs and other policies

● EI is an example of a payroll tax, which is a tax on the wages that firms pay their workers.

● In 2003, the total EI tax for the typical worker was about 5% of earnings.

CASE STUDYCASE STUDY:: Can Parliament Distribute the Can Parliament Distribute the Burden of a Payroll Tax?Burden of a Payroll Tax?

Figure 8 A Payroll TaxFigure 8 A Payroll Tax


Quantityof Labour

0

Wage

Labour demand

Labour supply

Tax wedge

Wage workersreceive

Wage firms pay

Wage without tax



● In what proportions is the burden of the tax divided?

●How do the effects of taxes on sellers compare to those levied on buyers?

●The answers to these questions depend on the elasticity of demand and the elasticity of supply.

Figure 9 How the Burden of a Tax Is DividedFigure 9 How the Burden of a Tax Is Divided


Quantity0

Price

Demand

Supply

Tax

Price sellersreceive

Price buyers pay

(a) Elastic Supply, Inelastic Demand

2. . . . theincidence of thetax falls moreheavily onconsumers . . .

1. When supply is more elasticthan demand . . .

Price without tax

3. . . . than on producers.

Figure 9 How the Burden of a Tax Is DividedFigure 9 How the Burden of a Tax Is Divided


Quantity0

Price

Demand

Supply

Tax

Price sellersreceive

Price buyers pay

(b) Inelastic Supply, Elastic Demand

3. . . . than onconsumers.

1. When demand is more elasticthan supply . . .

Price without tax

2. . . . theincidence of the tax falls more heavily on producers . . .


So, how is the burden of the tax divided?

●The burden of a tax falls more heavily on the side of the market that is less elastic.

ELASTICITY AND TAX INCIDENCE ELASTICITY AND TAX INCIDENCE


SummarySummary

●Price controls include price ceilings and price floors. A price ceilingprice ceiling is a legal maximum on the price of a

good or service. An example is rent control. A price floorprice floor is a legal minimum on the price of a

good or a service. An example is the minimum wage.


SummarySummary

●When the government levies a tax on a good, the equilibrium quantity of the good falls.

●A tax on a good places a wedge between the price paid by buyers and the price received by sellers.


SummarySummary

●The incidence of a tax refers to who bears the burden of a tax. does not depend on whether the tax is levied on

buyers or sellers. depends on the price elasticities of supply and

demand.

●The burden tends to fall on the side of the market that is less elastic.

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