ch06 supply demand and government policies
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Chapter 6Chapter 6
Supply, Demand, and Government
Policies
2002 by Nelson, a division of Thomson Canada Limited2002 by Nelson, a division of Thomson Canada Limited
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Chapter 6: Page 2
• Examine the effects of government policies that place a ceiling on prices.
• Examine the effects of government policies that place 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.
In this chapter you will…In this chapter you will…
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Chapter 6: Page 3
• 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.
• Hence…market controls!• One of the roles of economists is to use
their theories to assist in the development of policies.
SUPPLY, DEMAND, AND SUPPLY, DEMAND, AND GOVERNMENT POLICIES GOVERNMENT POLICIES
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Chapter 6: Page 4
• Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.
• Result in government-created price ceilings and floors.
CONTROLS ON PRICES CONTROLS ON PRICES
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Chapter 6: Page 5
• Price Ceiling – A legal maximum on the price at
which a good can be sold. • Price Floor
– A legal minimum on the price at which a good can be sold.
Price Ceilings and Price FloorsPrice Ceilings and Price Floors
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Chapter 6: Page 6
• When the government imposes a price ceiling (i.e... a legal maximum on the price at which a good can be sold) two outcomes are possible1) The price ceiling is not binding.2) The price ceiling is a binding
constraint on the market, creating Shortages.
How Price Ceiling Affect Market How Price Ceiling Affect Market OutcomesOutcomes
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Chapter 6: Page 7
Quantity of Ice-Cream
Cones
Price of Ice-Cream
Cone
Demand
Supply
Equilibrium price
$3
(a) A Price Ceiling That is Not Binding (b) A Price Ceiling That is Binding
$4Price
ceiling
Quantity of Ice-Cream
Cones
100Equilibrium
quantity
Price of Ice-Cream
Cone
Demand
Supply
$2
Price ceiling
$3
75
QS
Equilibrium price
125
QD
Shortage
0 0
Figure 6-1: A Market with a Price CeilingFigure 6-1: A Market with a Price Ceiling
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Chapter 6: Page 8
• A binding price ceiling creates– Shortages because QD > QS.
• Examples: Gasoline shortage of the 1970s, housing shortages with rent controls.
– Non-price rationing• Examples: Long lines, discrimination by
sellers, black markets.
How Price Ceiling Affect Market How Price Ceiling Affect Market OutcomesOutcomes
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Chapter 6: Page 9
• 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?• Economists blame government regulations that
limited the price oil companies could charge for gasoline.
CASE STUDY:CASE STUDY: Lines at the Gas PumpLines at the Gas Pump
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Chapter 6: Page 10
Quantity of Gasoline
Price of Gasoline
Demand
S1
(a) A Price Ceiling on Gasoline is Not Binding (b) A Price Ceiling on Gasoline is Binding
Price ceiling
P1
Q10 0
1. Initially the price ceiling is not binding…
Quantity of Gasoline
Demand
S1
Price ceiling
S2
P1
Q1QDQS
P2
4.…resulting in a shortage…
2.…but when supply falls…
3.…the price ceiling becomes binding…
Figure 6-2: A Market for Gasoline with a Figure 6-2: A Market for Gasoline with a Price CeilingPrice Ceiling
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Chapter 6: Page 11
• 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.”
CASE STUDY:CASE STUDY: Rent Control in the Short Run Rent Control in the Short Run and Long Runand Long Run
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Chapter 6: Page 12
Quantity of Apartments
Rental Price of
Apartment
Demand
Supply
(a) Short Run (Supply and Demand are Inelastic)
Controlled rent
0 0
(b) Long Run (Supply and Demand are Elastic)
Shortage
Quantity of Apartments
Rental Price of
Apartment
Demand
Supply
Controlled rent
Shortage
Figure 6-3: Rent Control in the Short Run Figure 6-3: Rent Control in the Short Run and Long Runand Long Run
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Chapter 6: Page 13
• When the government imposes a price floor, two outcomes are possible.
• The price floor is not binding if set below the equilibrium price.
• The price floor is binding if set above the equilibrium price, leading to a surplus.
How Price Floors Affect Market How Price Floors Affect Market OutcomesOutcomes
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Chapter 6: Page 14
Quantity of Ice-Cream
Cones
Price of Ice-Cream
Cone
Demand
Supply
Equilibrium price
$3
(a) A Price Floor That is Not Binding (b) A Price Floor That is Binding
$2Price Floor
Quantity of Ice-Cream
Cones
100Equilibrium
quantity
Price of Ice-Cream
Cone
Demand
Supply
$4Price ceiling
$3
80
QD
Equilibrium price
120
QS
Surplus
0 0
Figure 6-4: A Market with a Price FloorFigure 6-4: A Market with a Price Floor
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Chapter 6: Page 15
• A Binding Price Floor creates. . .– Surpluses (i.e. Quantity Supplied >
Quantity Demanded)– Non-Price Rationing - An alternative
mechanism for rationing of the good: Discrimination Criteria
– Examples: Minimum Wage Agricultural Price Supports
How Price Floors Affect Market How Price Floors Affect Market OutcomesOutcomes
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Chapter 6: Page 16
• An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.
CASE STUDY:CASE STUDY: The Minimum WageThe Minimum Wage
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Chapter 6: Page 17
Labour demand
Labour supply
Quantity of Labour
Wage
Labour demand
Labour supply
Equilibrium wage
(a) A Free Labour Market (b) A Labour Market with a Binding Minimum Wage
Quantity of Labour
Equilibrium employment
Wage
Minimum wage
Labour surplus
(unemployment)
0 0 Quantity demanded
Quantity supplied
Figure 6-5: How the Minimum Wage Affects Figure 6-5: How the Minimum Wage Affects the Labour Marketthe Labour Market
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Chapter 6: Page 18
• What is the purpose of government- imposed taxes?
– To raise government revenues.– To restrict production of a product.
• What is an excise tax?– A “per-unit” tax that’s independent of
the price of the product.
TAXESTAXES
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Chapter 6: Page 19
• Who pays the tax on a good? The buyer or the seller?
• How is the burden of a tax divided between buyer and seller?
• When the government levies a tax on a good, the equilibrium quantity of the good falls. The size of the market for that good shrinks, shifting either the demand or supply curve.
• Tax incidence: The study of who bears the burden of taxation.
TAXESTAXES
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Chapter 6: Page 20
• Taxes discourage market activity.• When a good is taxed, the quantity sold
is smaller. • Buyers and sellers share the tax burden.
How Taxes on Buyers (and Sellers) Affect How Taxes on Buyers (and Sellers) Affect Market OutcomesMarket Outcomes
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Chapter 6: Page 21
D1
S1
0 Quantity of Ice-Cream Cone
Price of Ice-Cream
Cone
$3.00
100
D2
Equilibrium without tax
90
$2.80
$3.30
Equilibrium with tax
Tax ($0.50)
Price buyers pay
Price without tax
Price sellers receive
A tax on buyers shifts the demand curve downward by size of the tax ($0.50).
Figure 6-6: A Tax on BuyersFigure 6-6: A Tax on Buyers
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Chapter 6: Page 22
D1
S1
0 Quantity of Ice-Cream Cone
Price of Ice-Cream
Cone
$3.00
100
Equilibrium without tax
$2.80
Equilibrium with tax
Tax ($0.50)
Price buyers pay
Price without tax
Price sellers receive
A tax on sellers shifts the supply curve upward by an amount of the tax ($0.50).
S2
90
$3.30
Figure 6-7: A Tax on SellersFigure 6-7: A Tax on Sellers
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Chapter 6: Page 23
• Example: Employment Insurance.• A payroll tax places a wedge between the
wage the workers receive and the wage the firm pays.
CASE STUDY:CASE STUDY: The Burden of a Payroll taxThe Burden of a Payroll tax
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Chapter 6: Page 24
Quantity of Labour
Wage
Labour demand
Labour supply
Wage without tax
0
Tax wedge
Wage firms pay
Wage workers receive
Figure 6-8: A Payroll TaxFigure 6-8: A Payroll Tax
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Chapter 6: Page 25
• Consider a tax levied on sellers of a good. What are the effects of this tax?
• How do effects of the tax levied on the seller compare with those of the effects imposed on the buyer?
• Depends on Elasticity of Demand and Elasticity of Supply.
Elasticity and Tax incidenceElasticity and Tax incidence
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Chapter 6: Page 26
• The burden of a tax falls on the side of the market with the smaller price elasticity!
• The more inelastic the demand and the more elastic the supply results in the consumer paying more of the tax.
• The more elastic the demand and the more inelastic the supply results in the supplier paying more of the tax.
Elasticity and Tax incidenceElasticity and Tax incidence
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Chapter 6: Page 27
Elastic Supply, Inelastic Demand
Demand
Quantity
Price
Supply
1. When supply is more elastic than demand …
Price buyers pay
Price without tax
Price sellers receive
Tax
3. …than on producers.
2. …the incidence of the tax falls more heavily on consumers…
Figure 6-9 a): How the Burden of a Tax is Figure 6-9 a): How the Burden of a Tax is Divided.Divided.
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Chapter 6: Page 28
Inelastic Supply, Elastic Demand
Demand
Quantity
Price
Supply
1. When demand is more elastic than supply …
Price buyers pay
Price without tax
Price sellers receive
Tax
3. …than on consumers.
2. …the incidence of the tax falls more heavily on producers…
Figure 6-9 b): How the Burden of a Tax is Figure 6-9 b): How the Burden of a Tax is DividedDivided
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Chapter 6: Page 29
• Price controls include price ceilings and price floors.
• A price ceiling is a legal maximum on the price of a good or service. An example is rent control.
• A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage.
SummarySummary
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Chapter 6: Page 30
• Taxes are used to raise revenue for public purposes.
• 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
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Chapter 6: Page 31
• The incidence of a tax refers to who bears the burden of a tax.
• The incidence of a tax does not depend on whether the tax is levied on buyers or sellers.
• The incidence of the tax depends on the price elasticities of supply and demand.
• The burden tends to fall on the side of the market that is less elastic.
SummarySummary
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Chapter 6: Page 32
The EndThe End