Ch06macmic,d&s g ov,t policy

Principles of Microeconomics & Principles of Macroeconomics: Ch.6 Second Canadian Edition

Supply, Demand, and

Government PoliciesPrinciples of Economics

Chapter 6

N.Gregory Mankiw

© 2002 by Nelson, a division of Thomson Canada Limited


Overview

The Effects of Price ControlsThe Effects of an Excise Tax


Supply, 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, i.e. buyer or seller are satisfied.

Hence, market controls!


Burkhas in Afghanistan

� Once the Taliban was ousted, demand for burkhas fell as many women quit wearing them.

� At P0 quantity supplied > quantity demanded.

� Price fell to P1 until quantity demanded = quantity supplied.

S

P0

Q0Q1

P1 D0

D1

Excess Supply


Market Price Controls

Are usually enacted when policy-makers believe that the market price is unfair to buyers and sellers.

Result in government policies, i.e. price ceilings and floors.


Government Intervention as Implicit Taxation

� Government intervention in the form of price controls can be viewed as a combination tax and subsidy.

� A price ceiling is an implicit tax on producers and an implicit subsidy to producers that causes a welfare loss identical to the loss from taxation.

� A price floor is a tax on consumers and a subsidy for producers that transfers consumer surplus to producers.


Price Ceilings & Price Floors

A Price Ceiling – is a legally established maximum price

which a seller can charge or a buyer must pay.

A Price Floor– is a legally established minimum price

which a seller can charge or a buyer must pay.


Price Ceilings

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 possible:1 . The price ceiling is not binding.

2 . The price ceiling is a binding constraint on the market, creating Shortages.


Market Impacts of a Price Ceiling

Supply

Demand

Price

Quantity

EquilibriumPrice

EquilibriumQuantity


A Non-Binding Price Ceiling

Supply

Demand

Price

Quantity

PE

QE

PriceCeiling

PC


A Binding Price Ceiling

Supply

Demand

Price

Quantity

PE

QE

PriceCeiling

PC


A Binding Price Ceiling Creates Shortages.

Supply

Demand

Price

Quantity

PE

QE

PC

QS QD


A Binding Price Ceiling Creates Shortages.

Supply

Demand

Price

Quantity

PE

QE

PC

QS QD

Shortage


Market Impacts of a Price CeilingA Binding Price Ceiling creates. . .

– Shortages (i.e... Demand > Supply)Gasoline shortages of the 1970sHousing shortages with rent controls

– Non-Price Rationing - An alternative mechanism for rationing of the good:Long Lines (first-In-Line, friends etc.)Discrimination criteria set by sellerBlack markets


Price Floors

When the government imposes a price floor (i.e... a legal minimum on the price at which a good can be sold) two outcomes are possible:1 . The price floor is not binding.

2 . The price floor is a binding constraint on the market, creating Surpluses.


A Non-Binding Price Floor

Supply

Demand

Price

Quantity

PE

QE

PriceFloor

PF


A Binding Price Floor

Supply

Demand

Price

Quantity

PE

QE

PriceFloor

PF


Market Impacts of a Price Floor

A government-imposed market price floor hinders the forces of supply and demand in 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.


A Binding Price Floor Creates a Surplus.

Supply

Demand

Price

Quantity

PE

QE

PF

QS QD


Supply

Demand

Price

Quantity

PE

QE

PF

QS QD

Surplus

A Binding Price Floor Creates a Surplus.


Market Impacts of a Price Floor

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


Effect of a Price Ceiling

P0

Q0Quantity

Price

Q1

S

DProducer surplus

Consumer surplus

Welfare loss

P1Price ceiling

Transferred to consumers

F

D

C

E

B

A


Effect of a Price Floor

P0

Q0Quantity

Price

Q1

S

DProducer surplus

Consumer surplus

Welfare loss

Transferred to producers

F

D

C

E

B

AP1

Price floor


Government Intervention in the Market

� Buyers look to the government for ways to hold prices down.

� A price ceiling is a government-imposed limit on how high a price can be charged.

� Sellers look to the government for ways to hold prices up.

� A price floor is a government-imposed limit on how low a price can be charged.


2.50

Shortage

Rent Controls� Rent control is a

price ceiling on rents set by the government.

� Rent control in Paris after World War I created a housing shortage.

� The shortage would have been eliminated if rents had been allowed to rise to $17 per month.

QS QD

S

D

Re

nta

l Pri

ce (

per

mo

nth

)

Quantity of apartments

$17.00


Minimum Wage� The minimum wage, a

price floor, is set by government specifying the lowest wage a firm can legally pay.

� A minimum wage, Wmin, above the equilibrium wage, We, helps those who are employed, Q2, but hurts those who would have been employed at We, but can no longer find employment, Qe- Q2.

Wmin

We

Q2 Qe Q1

S

D

Quantity of Workers

Wag

e p

er h

ou

r


Quick Quiz!

Define “price ceiling” and “price floor”

Give an example of each.

Which leads to a shortage, which a surplus? Why?


Overview



Taxes! Taxes! Taxes!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.


Taxes! Taxes! Taxes!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.


Producer and Consumer Surplus

� Consumer surplus - the value the consumer gets from buying a product, less its price.– It is the area below the demand curve and

above the price.

� Producer surplus – the value the producer sells a product for less the cost of producing it.– It is the area above the supply curve but

below the price the producer receives.


Producer and Consumer SurplusP

rice

S

D

Quantity

0

$10987654321

10987654321

Producer Surplus

Consumer Surplus

CS = ½(5x5) = 12.5 =Area of blue triangle

PS = ½(5x5) = 12.5 =Area of red triangle

The combination of producer and consumersurplus is maximized atmarket equilibrium.


Producer and Consumer SurplusP

rice

S

D

Quantity

0

$10987654321

10987654321

Producer Surplus gains 2x4 = 8 units of lost consumer surplus

If price is $6,Consumer Surplus: CS = 1/2 ($4x4) = $8

Combined consumer and producer surplus decreaseswhen price is above equilibrium.

Lost surplus = ½($2x1) = $1


Taxation and Government

� For government to operate, it must tax.

� For the market to work, it needs the government.

� Tax rates depend on what goods and services government provides.


Taxes: Impact

Taxes discourage market activity. The quantity of the good sold is smaller than

without the tax. Buyers and sellers

share the tax burden.


Taxes: Impact From a 50 Cent Tax

S1

$3.00

800

D1

Equilibrium without tax

Quantity

Price



S1

$3.00

800

D1

From the sellers viewpoint, the tax

causes the demand curve to

shift down by 50 cents.

$2.80

600

Price

Quantity



S1

$3.00

800

$3.30

600

The tax increasesthe market price

to the buyer...

$2.80

D1

Quantity

Price



S1

$3.00

800

$3.30

600

The tax increasesthe market price

to the buyer...…in this case theprice rises $.30.

$2.80

D1Price

Quantity



S1

$3.00

800

$3.30

600

The tax decreasesthe return to the

seller as the sellergets $.20 less.

$2.80

D1

Quantity

Price



S1

$3.00

800

$3.30

600

The tax makes boththe buyer and the seller worse off!$2.80

D1

Quantity

Price


The Incidence of Tax. . .How is the burden of the tax distributed?

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.


The Incidence of Tax. . .How is the burden of the tax distributed?

The burden of a tax falls on the side of the market with the smaller price elasticity!


Elasticity and Taxes

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 Excise Tax Example:A more inelastic demand and more elastic supply.

Supply

Demand

$2.00

250

Price

Quantity


Elasticity and Excise Tax

S1

Demand

S2

Specific Tax $.20

$2.00

$2.15

200 250

Price

Quantity



S1

Demand

S2

Specific Tax $.20

$2.15

$2.00$1.95

200 250

Producer’s burden of tax

Price

Quantity



S1

Demand

S2

Specific Tax $.20

$2.15

$2.00$1.95

200 250

Buyer’s burden of tax

Price

Quantity


Excise Taxes

Quantity of luxury boats

0

Pri

ce o

f lu

xu

ry b

oa

ts

65,000

510

S1

D

S0

A $10,000 excise tax on luxury boats shifts the supply curve up by $10,000.

60,000

420

$70,000

600

At $70,000, there is excess supply of 600- 420 = 180.

The price of the boats rises by less than the tax to $65,000.


Quantity Restrictions

In 1937 New York City limited the numberof taxi licenses to 12,000 to increase the wages of taxi drivers.

Because taxi medallions were limited in supply, as demand for taxi services rose, so did the demand for medallions, increasingtheir price to $2500 by 1947. Today, medallions sell for $300,000!


The Costs of Taxation� To determine how much to tax, the

government must determine the costs and benefits of taxation.

� The costs of taxation include:– Direct cost of revenue paid to the

government– Deadweight loss - loss of consumer and

producer surplus that is not gained by the government

– Administrative costs of compliance – resources used by the government to administer the tax and individuals and businesses to comply with it


Costs of Taxation

S1

P1–t

Quantity

Price

P0

Q0

P1

Q1

Producer surplus

S0

D

Consumer surplus

Deadweight loss

tax

A per unit tax t paid by thesuppliers shifts the supply curve from S0 to S1 and in-creases price to P1 and decreases quantity to Q1.

Consumer surplus is A+B+C before the taxand A after the tax.

Producer surplus is D+E+F before the taxand F after the tax.

Government revenue=B+D

Deadweight loss=C+E

F

ED

CB

A


The Benefits of Taxation

� The benefits of taxation are the goods and services that government provides.– Provides a stable set of institutions and rules– Promotes effective and workable competition– Corrects for externalities

– Creates an environment that fosters stability and growth

– Provides public goods– Adjusts for undesirable market results


Two Principles of Taxation

� The benefits principle – the individuals who receive the benefit of the good or service should pay the tax necessary to supply the good.

� The ability-to-pay principle – individuals who are most able to bear the burden of the tax should pay.


Tax Burden

� The person who physically pays the tax is not necessarily the person who bears the burden of the tax.

� The more inelastic one’s relative demand and supply, the larger the tax burden one will bear.– If demand is more inelastic than supply,

consumers will pay the higher share.

– If supply is more inelastic than demand, suppliers will pay the higher share.


Who Bears the Tax Burden?Demand is elasticEqual burden

Pri

ce o

f lu

xu

ry b

oa

ts


0 510

S1D

S0

60

$70

600

50

40P

ric

e o

f lu

xu

ry b

oa

ts


0 500

S1D

S0

60

$70

600

50

40

tax

Demand is inelasticLarger consumer burden

590


Who Bears the Tax Burden?

Supplier pays the tax-Supply shifts

Pri

ce o

f lu

xu

ry b

oa

ts


0 510

S1D

S0

60

$70

600

50

40

tax

Pri

ce o

f lu

xu

ry b

oa

ts


0 510

D0

S

60

$70

600

50

40

tax

D1

Consumer pays the tax-Demand shifts

Tax burden is independent of who pays the tax.


Supply, Demand & GovernmentThe economy is governed by two kinds

of laws:–The laws of supply and demand–The laws enacted by government

Price controls and taxes are common in various markets in the economy:–Price Ceilings–Price Floors–Excise Tax


Overview


Economy & Finance

Ch06macmic,d&s g ov,t policy