Sessions 9 & 10

Sessions 9 & 10 Supply, Demand & Government Policies (With inputs from N. Gregory Mankiw: Principles of Economics, 4th Edition, Chapter 6)

Session Objectives: 

What are price ceilings and price floors? What are some examples of each?

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How do price ceilings and price floors affect market outcomes?

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How do taxes affect market outcomes? How does the outcome depend on whether the tax is imposed on buyers or sellers?

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What is the incidence of a tax? What determines the incidence? Dr. Jaydeep Mukherjee Ravenshaw University

An Overview 

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

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

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

Dr. Jaydeep Mukherjee Ravenshaw University

Controls on Prices 

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

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Result in government-created price ceilings and floors.

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Price Ceiling 

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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. Dr. Jaydeep Mukherjee Ravenshaw University

Price Ceiling: Rent Control Rental Price of Apts.

Consider a common example of rent control Rent controls are ceilings placed on the rents that landlords may charge their tenants.

S

Rs.1000

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

D 500

We begin by showing the market for apartments in equilibrium (before the government imposes any price controls). Dr. Jaydeep Mukherjee Ravenshaw University

Quantity of Apts.

Price Ceiling: Rent Control A price ceiling above the equilibrium price is not binding. The market clears at Rs.1000 and the price ceiling is ineffective.

Rental Price of Apts.

S

Rs.1200 Rs.1000

Just because landlords are allowed to charge Rs.1200 rent doesn’t mean they will – if they do, they won’t be able to rent all of their apartments – a surplus will result, causing downward pressure on the price (rent). There’s no law that prevents the price (rent) from falling, so it does fall until the surplus is gone and equilibrium is reached (at P = Rs.1000 and Q = 500). Dr. Jaydeep Mukherjee Ravenshaw University

D 500

Quantity of Apts.

Price Ceiling: Rent Control The eq’m price (Rs.1000) is above the ceiling and therefore illegal. The ceiling is a binding constraint on the price, and causes a shortage.

Rental Price of Apts.

S

Rs.1000

The actual quantity of apartments Rs.800 rented equals 250, and there is a shortage equal to 500 (the difference between the quantity demanded, 750, and the quantity supplied, 250.

Dr. Jaydeep Mukherjee Ravenshaw University

Shortage 250

500

D 750

Quantity of Apts.

Price Ceiling: Rent Control In the long run, supply and demand are more price-elastic. So, the shortage is larger. WHY??

Rental Price of Apts.

S

Rs.1000

Quick Activity:

Rs.800

For a product, supply and demand functions are estimated as follows: Qs = 300 + 10P Qd = 500 –15P. If the government fixes a price ceiling of Rs.15 for the product, then what will be its impact on the market.

Dr. Jaydeep Mukherjee Ravenshaw University

Shortage 100

500

D 900 Quantity of Apts.

Shortages and Rationing 

With a shortage, sellers must ration the goods among buyers.

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Some rationing mechanisms: (1) long lines, and (2) discrimination according to sellers’ biases, and even under-the-table payments to landlords

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These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly.

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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). Dr. Jaydeep Mukherjee Ravenshaw University

Price Floor: Minimum Wage Now we switch gears and look at the effects of a price floor. We illustrate this concept using the example of the minimum wage. The “price” of labor is more commonly known as the wage, which we measure on the vertical axis of our supply-demand diagram. Along the horizontal axis, we measure the quantity of labor (number of workers). The demand for unskilled labor comes from firms. The supply comes from workers.

W

S

Rs.50

D 500

L

We focus on unskilled labor because the minimum wage is not relevant for higher skilled, higher wage workers.

Dr. Jaydeep Mukherjee Ravenshaw University

Price Floor: Minimum Wage A price floor below the eq’m price is not binding – has no effect on the market outcome.

W

S

At a wage of Rs.40, the quantity of unskilled workers that firms wish to hire exceeds the Rs.50 quantity of unskilled workers that are Rs.40 looking for jobs, resulting in shortages. But the minimum wage law does not stop the wage from rising above Rs.40. So, in response to this shortage, the wage will rise until the shortage disappears – which occurs at the equilibrium wage of Rs.50. The equilibrium wage is perfectly legal when the price floor (i.e. minimum wage) is below it. Dr. Jaydeep Mukherjee Ravenshaw University

D 500

L

Price Floor: Minimum Wage W

Now, the minimum wage exceeds the equilibrium wage. The equilibrium wage (or any wage below Rs.60) is illegal. Rs.60 In this case, the actual wage will be Rs.60. It will not be lower, because any lower wage isRs.50 illegal. It will not be higher, because at any higher wage, the surplus would be even greater. The actual number of unskilled workers with jobs equals 400. 550 want jobs, but firms are only willing to hire 400, leaving a surplus (i.e. unemployment) of 150 workers. A surplus of anything – especially labor represents wasted resources. Dr. Jaydeep Mukherjee Ravenshaw University

Surplus

S

D 400 500 550

L

Evaluating Price Controls 

Recall one of the Ten Principles: Markets are usually a good way to organize economic activity.

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Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices.

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Price controls often intended to help the poor, but often hurt more than help

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We have seen that the minimum wage can cause job losses, and rent control can reduce the quantity and quality of affordable housing. Both policies make the poor worse off

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If prices are set by laws, they obscure the signals that efficiently allocate scarce resources. Dr. Jaydeep Mukherjee Ravenshaw University

Taxes 

The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc.

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The govt can make buyers or sellers pay the tax.

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The tax can be a % of the good’s price, or a specific amount for each unit sold.

• For simplicity, we analyze per-unit taxes only. Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

Dr. Jaydeep Mukherjee Ravenshaw University

Taxes on Buyers: Market for Pizza Consider the market for pizza

Price of Pizza

S

Rs.10

We begin by showing the market for apartments in equilibrium (before the government imposes any taxes).

Dr. Jaydeep Mukherjee Ravenshaw University

D 500

Quantity of Pizza

Taxes on Buyers: Market for Pizza Price of The government makes buyers pay a Pizza Rs.1.50 on each pizza they purchase. The new demand curve (in red, labeled D2) reflects buyers’ demand as a Pb = Rs.11 function of the after-tax price. The Rs.10 original demand curve (D1) still reflectsP = Rs.9.50 s buyers’ demand as a function of the total price – inclusive of the tax.

At each quantity, the height of the original (blue) D curve is still the maximum that buyers will pay for that quantity, while the height of the new (red) D curve is the maximum that buyers will pay sellers for that quantity, given that buyers also must pay the tax. At any Q, the vertical distance between the blue and red D curves equals the tax. Dr. Jaydeep Mukherjee Ravenshaw University

S

Taxes

D2 430

500

D1 Quantity of Pizza

Taxes on Buyers: Market for Pizza The price buyers pay rises, the price sellers receive falls, eq’m Q falls

Price of Pizza

S

Taxes

Pb = Rs.11 Rs.10 Ps = Rs.9.50

The burden of a tax is shared among market participants. Because of the tax, buyers pay Re.1.00 more, sellers get Re.0.50 less.

Dr. Jaydeep Mukherjee Ravenshaw University

D2 430

500

D1 Quantity of Pizza

Taxes on Sellers: Market for Pizza The government makes sellers pay a Rs.1.50 on each pizza they sell. The new supply curve (in red, labeled S2) reflects sellers’ supply as a function of the after-tax price.

Price of Pizza

S2

Taxes

Pb = Rs.11 Rs.10 Ps = Rs.9.50

Making sellers pay a Rs.1.50 tax on each unit they sell is equivalent to a Rs.1.50 increase in the cost of producing each pizza. Anything that increases production costs causes the S curve to shift up: In order for sellers to be willing to supply the same quantity as before, they must receive a higher price to compensate them for the increase in their costs. Dr. Jaydeep Mukherjee Ravenshaw University

S1

D 430

500

Quantity of Pizza

Taxes on Buyers & Sellers: A Comparison The Outcome Is the Same in Both Cases! 

Whether the government makes buyers or sellers pay the tax, all of the effects are the same: - the price buyers pay rises (in this case to Rs.11) - the price sellers receive falls (to Rs.9.50) - the equilibrium quantity falls (to 430) - the incidence of the tax is the same (here, buyers pay Re.1 of the tax, while sellers pay Re.0.50 of the tax on each unit)

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The equivalence of taxes on buyers and taxes on sellers means that we can ignore whether the tax is imposed on buyers or sellers.

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What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. Dr. Jaydeep Mukherjee Ravenshaw University

Tax Incidence and Elasticity 

Tax incidence is not affected by whether the government makes buyers or sellers pay the tax. What, then, does determine tax incidence?

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It is elasticity – specifically, the price elasticities of supply and demand Two Possibilities:

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supply is more price-elastic than demand

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demand is more price-elastic than supply Dr. Jaydeep Mukherjee Ravenshaw University

Case 1: Supply is more price-elastic than demand 

Sellers are relatively more responsive to changes in price, and the supply curve is less steep than the demand curve.

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Buyers have relatively fewer alternatives, so they have to “eat” most of the price increase caused by the imposition of the tax.

Result 

Greater burden borne by buyers Dr. Jaydeep Mukherjee Ravenshaw University

Case 2: Demand is more price-elastic than supply 

buyers are relatively more price-sensitive, and the demand curve is less steep than the supply curve.

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Buyers have relatively more alternatives, so they can avoid most of the tax. Sellers are less flexible, so they have to “eat” a greater share of the price increase caused by the tax.

Result 

Greater burden borne by sellers Dr. Jaydeep Mukherjee Ravenshaw University

Final Thoughts Who pays the luxury tax? 

Demand for Mercedes (and other luxury items) is priceelastic: if the price of yachts rises, rich consumers can easily avoid the tax by spending their millions on some other luxury item.

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Supply of Mercedes is less elastic, especially in the short run. It is difficult for the companies that build Mercedes to re-tool their factories and reeducate their workers to produce some other product.

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Hence, companies that build Mercedes (and companies that sell other luxury items) pay most of the tax, and the rich pay relatively little of it.

Dr. Jaydeep Mukherjee Ravenshaw University