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Supply, Demand, and Government

6 Policies

PRINCIPLES OF

ECONOMICS
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

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In this chapter, look for the answers to

these questions:
§ What are price ceilings and price floors?
What are some examples of each?
§ How do price ceilings and price floors affect
market outcomes?
§ How do 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 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 1
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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 will use the supply/demand model to see

how each policy affects the market outcome
(the price buyers pay, the price sellers receive,
and eq’m quantity).
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 2
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EXAMPLE 1: The Market for Apartments

Rental P S
price of
apts
$800
Eq’m w/o
price
controls
D
Q
300
Quantity of
apartments
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 3
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How Price Ceilings Affect Market Outcomes

A price ceiling P S
above the Price
eq’m price is $1000
ceiling
not binding –
it has no effect $800
on the market
outcome.

D
Q
300

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 4

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How Price Ceilings Affect Market Outcomes

The eq’m price P S

($800) is above
the ceiling and
therefore illegal.
$800
The ceiling
is a binding Price
$500
constraint ceiling
on the price, shortage
D
and causes Q
250 400
a shortage.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 5

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How Price Ceilings Affect Market Outcomes

In the long run, P S

supply and
demand
are more $800
price-elastic.
Price
So, the $500
ceiling
shortage shortage
is larger. D
Q
150 450

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 6

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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 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 7
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EXAMPLE 2: The Market for Unskilled Labor

Wage W S
paid to
unskilled
workers
$4
Eq’m w/o
price
controls
D
L
500
Quantity of
unskilled workers
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 8
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How Price Floors Affect Market Outcomes

A price floor W S
below the
eq’m price is
not binding –
it has no effect $4
on the market Price
outcome. $3
floor

D
L
500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 9

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How Price Floors Affect Market Outcomes

labor
The eq’m wage ($4) W surplus S
is below the floor Price
and therefore $5
floor
illegal.
The floor $4
is a binding
constraint
on the wage,
and causes D
a surplus L
400 550
(i.e.,
unemployment).

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 10

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The Minimum Wage

Min wage laws unemp-
do not affect W loyment S
highly skilled Min.
$5
wage
workers.
They do affect $4
teen workers.
Studies:
A 10% increase
in the min wage D
L
raises teen 400 550
unemployment
by 1-3%.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 11
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ACTIVE LEARNING 1:
Price floors The market for
P
140 hotel rooms
& ceilings S
130
Determine 120
effects of: 110
A. $90 price 100
ceiling 90
80 D
B. $90 price
floor 70
60
C. $120 price 50
floor
40
0 Q
50 60 70 80 90 100 110 120 130
12
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ACTIVE LEARNING 1:
A. $90 price ceiling The market for
P
140 hotel rooms
S
The price 130
falls to $90. 120
110
Buyers
100
demand Price ceiling
90
120 rooms,
80 D
sellers supply shortage = 30
70
90, leaving a
60
shortage.
50
40
0 Q
50 60 70 80 90 100 110 120 130
13
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ACTIVE LEARNING 1:
B. $90 price floor The market for
P
140 hotel rooms
Eq’m price is S
130
above the floor, 120
so floor is not 110
binding. 100
P = $100, 90
Price floor
Q = 100 rooms. 80 D
70
60
50
40
0 Q
50 60 70 80 90 100 110 120 130
14
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ACTIVE LEARNING 1:
C. $120 price floor The market for
P
140 hotel rooms
The price surplus = 60 S
130
rises to $120. 120
Price floor
Buyers 110
demand 100
60 rooms, 90
sellers supply 80 D
120, causing 70
a surplus. 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
15
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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 often hurt more than help 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 16
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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 amount for each unit sold.
• For simplicity, we analyze per-unit taxes only.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 17

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EXAMPLE 3: The Market for Pizza

Eq’m
w/o tax P
S1

$10.00

D1

Q
500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 18

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A Tax on Buyers
A tax on
buyers shifts Effects of a $1.50 per
the D curve unit tax on buyers
P
down by the
amount of S1
PB = $11.00
Tax
the tax.
$10.00
PS = $9.50
The price
buyers pay
D1
rises, the
price sellers D2
receive falls, Q
430 500
eq’m Q falls.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 19
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The Incidence of a Tax:

how the burden of a tax is shared among
market participants
P
Because
of the tax, S1
PB = $11.00
Tax
buyers pay
$10.00
$1.00 more,
PS = $9.50
sellers get
$0.50 less.
D1
D2
Q
430 500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 20

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A Tax on Sellers
A tax on
sellers shifts Effects of a $1.50 per
the S curve unit tax on sellers
P S2
up by the
amount of S1
PB = $11.00
Tax
the tax.
$10.00
PS = $9.50
The price
buyers pay
D1
rises, the
price sellers
receive falls, Q
430 500
eq’m Q falls. behaviour of sellers

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 21

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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!

What matters P
is this: S1
PB = $11.00
Tax
A tax drives
$10.00
a wedge
PS = $9.50
between the
price buyers
D1
pay and the
price sellers
Q
receive. 430 500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 22

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ACTIVE LEARNING 2:
Effects of a tax The market for
P
140 hotel rooms
Suppose govt S
130
imposes a tax 120
on buyers of 110
$30 per room. 100
90
Find new
Q, PB, PS, 80 D
70
and incidence
60
of tax.
50
40
0 Q
50 60 70 80 90 100 110 120 130
23
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ACTIVE LEARNING 2:
Answers The market for
P
140 hotel rooms
S
130
Q = 80
120
PB = $110 PB = 110
100
Tax
PS = $80 90
PS = 80 D
70
Incidence
60
buyers: $10
50
sellers: $20
40
0 Q
50 60 70 80 90 100 110 120 130
24
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Elasticity and Tax Incidence

CASE 1: Supply is more elastic than demand

P In this case,
buyers bear
PB S most of the
Buyers’ share
of tax burden burden of
Tax
Price if no tax the tax.

Sellers’ share PS buyer pays most

of tax burden of the tax. The
demand is more
D inelastic

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 25

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Elasticity and Tax Incidence

CASE 2: Demand is more elastic than supply

P In this case,
S
sellers bear
Buyers’ share most of the
of tax burden PB
burden of
Price if no tax the tax.
Tax
Sellers’ share The seller pays
most of the
of tax burden PS burden tax

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 26

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Elasticity and Tax Incidence

avoid giving tax

§ 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 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 27

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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 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 28

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CASE STUDY: Who Pays the Luxury Tax?

The market for yachts Demand is

price-elastic.
P
S
In the short run,
Buyers’ share
of tax burden PB supply is inelastic.

Tax Hence,
companies
Sellers’ share
that build
of tax burden PS
D yachts pay
most of
Q the tax.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 29

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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 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 30
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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 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 31

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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 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 32