Demand, Supply and Economic Policy

1. Demand, Supply and Economic Policy Lecture 4 – academic year 2013/14 Introduction to Economics Fabio Landini

2. Where we are… • Lecture 1: demand and supply • Lecture 2: the concept of elasticity • Lecture 2: elasticity of demand (high and low) and total revenue • Lecture 3: demand, supply and elasticity – exercises and applications

3. What do we do today? • Economic policy: what is it and how it works? • Price regulation • Taxes and their effects

4. Question of the day Since 2007, in Italy there exist an institution called Price Overseeing Authority. • What does it do? • Overseeing: it verifies the prices • Coordination: it functions as a bridge between producers and consumers QUESTION: Why do we need it?

5. Demand, supply and economic policy Government can affect market’s functioning in two ways: • By regulating economic activities (p & q max and min); • By imposing taxes and subsidies.

6. Price regulation and market equilibrium In a market with no regulation, market forces establish the equilibrium level of p and q. Even if the market is in equilibrium, somebody can be unsatisfied (for reasons associated with equity or efficiency).

7. Price regulation and market equilibrium

8. When are prices regulated? When politicians believe p of a given market to be unequal. In these cases max or min level of prices is fixed. Usually, there are efficiency costs (this is the classic trade-off between efficiency and equity!)

9. Max and min level of price Max (min) level • It is max (min) price that a good can be sold at according to law.

10. Max level of price When the government imposes a max level of price, there are two possible consequences: • p max is NOT CONSTRAINING: if the market price is < than p max. • p max is CONSTRAINING:if the market price is > than p max. In this case artificial scarcityis created…

11. Max price is NOT CONSTRAINING Price of ice-cream Supply Max Price 4 3 Equilibrium price Demand 0 100 Quantity of Ice-cream Equilibrium quantity

12. Max price is CONSTRAINING Price of ice-cream Supply 3 Equilibrium price 2 Max Price Demand 0 100 Quantity of Ice-cream Equilibrium quantity

13. Max price is CONSTRAINING Price of ice-cream Supply 3 Equilibrium price 2 Max Price Scarcity Demand 75 125 0 Quantity of Ice-cream Quantity Supplied Quantity Demanded

14. The effects of max p When it is constraining, a max p … . . . Generate scarcity QD > QS Example: Scarcity of petrol in 1970. . . . Rationing of the good. Example: long queues, or: seller’s discrimination practices.

15. Min level of prices Two possible consequences: • p min is NOT CONSTRAINING: if p min < than equilibrium price. • p min IS CONSTRAINING: if p min > than equilibrium price. In this case excess supply is generated.

16. Min price is NOT CONSTRAINING Price of ice-cream Supply 3 Equilibrium price 2 Min Price Demand 0 100 Quantity of Ice-cream Equilibrium quantity

17. Max price is CONSTRAINING Price of ice-cream Supply 4 Min Price 3 Equilibrium price Demand 0 100 Quantity of Ice-cream Equilibrium quantity

18. Max price is NOT CONSTRAINING Price of ice-cream Excess Supply Supply Min Price 4 3 Equilibrium price Demand 75 125 0 Quantity of Ice-cream Quantity Demanded Quantity Supplied

19. Effects of a min p When constraining, min p min generates . . . . . . An excess of supply QS > QD . . . The resources in excess are wasted Example: Minimum wage; Subsidies to sustain the price of agricultural goods.

20. (a) Max rent in the short period (Supply and demand are inelastic) (b) Max rent in the long period (Supply and demand are elastic) Rent Rent Supply Supply Max rent Max rent Scarcity Demand Scarcity Demand Quantity of flats 0 0 Quantity of flats

21. (b) Labour market with min wage (a) Free labour market Wage Wage Excess supply of labour Labour supply Labour supply (unemployment) Min wage Equilibrium wage Labour demand Labour demand Quantity of 0 Quantity of 0 Quantity Quantity Equilibrium employment employed employed demanded supplied

22. Taxes: Effects Government uses taxation to finance public expenditure. But taxes are not neutral in that they can discourage market activities. When a good is taxed, the quantity that is sold diminishes. In the majority of the cases, buyers and sellers share the tax burden.

23. Legal incidence and economics of taxes The law establishes who pays the tax (legal incidence). But not who really bears the tax burden (economic incidence). Let’s see why….

24. Legal incidence and economics of taxes The tax affects the market equilibrium: • The price for consumers rises, who therefore reduce the quantity demanded. • The portion of the price earned by sellers reduces, and therefore they reduce the quantity supplied.

25. Legal incidence and economics of taxes The economic incidence (= how the tax burden is shared between consumers and producers) is independent from the subject who is legally responsible for paying the tax … (that is the legal incidence). It depends on ED and ES.

26. The effect of a tax on consumption goods Initial price of an apple: 1€ Then: consumption tax of 0,10€ for each apple. What happens to the price of apples after tax? Let’s see the cases: • The prince remains equal to 1€. In this case, the tax is paid ONLY by the producer: the consumer pays 1€; 0,10€ goes to State and only 0,90€ to the producer; • The price rises to 1,10€. Then the tax is paid ONLY by the consumer.

27. The effect of a tax on consumption goods In the majority of the cases “the true lies in between”: the tax rises both the price to consumers and the price to producers. Example: the price to consumers can become 1,05 and the price to producers 0,95. The final price depends on the elasticity of demand and supply.

28. The effect of a tax on consumption goods Hp.: producers respond to price four times more than consumers (i.e.: ES(p)=4xED(p)). To maintain the market equilibrium the price to consumers must rise to 1,08 and the one to producers must fall to 0,98. In this way, the price to consumers (+8%) is four times than the price to producers (-2%), and thus: quantity demanded = quantity supplied.

29. The effect of a tax on consumption goods Price of ice-cream Supply 3,00 Equilibrium without the tax Demand Quantity of 0 100 Ice-cream

30. The effect of a tax on consumption goods Price of ice-cream A tax on consumption shifts the demand curve leftward Supply 3,00 Equilibrium without the tax Demand Quantity of 0 100 Ice-cream

31. The effect of a tax on consumption goods Price of ice-cream A tax on consumption shifts the demand curve leftward Supply 3,00 Equilibrium without the tax New equilibrium with the tax Demand Quantity of 0 100 Ice-cream

32. The effect of a tax on consumption goods Price of ice-cream Supply pD Tax (t) Equilibrium without the tax pS New equilibrium with the tax Demand Quantity of 0 Qt Ice-cream

33. The effect of a tax on consumption goods

34. The effect of a tax on consumption goods Price of ice-cream Supply 3,00 Equilibrium without the tax Demand Quantity of 0 100 Ice-cream

35. The effect of a tax on consumption goods Price of ice-cream A tax on production (0,50 cents) shifts the supply curve leftward. Supply 3,00 Equilibrium without the tax Demand Quantity of 0 100 Ice-cream

36. The effect of a tax on consumption goods New equilibrium with the tax Price of ice-cream A tax on production (0,50 cents) shifts the supply curve leftward. Supply 3,00 Equilibrium without the tax Demand Quantity of 0 100 Ice-cream

37. The effect of a tax on consumption goods New equilibrium with the tax Price of ice-cream A tax on production (0,50 cents) shifts the supply curve leftward. Supply 3,30 Tax (0,50) Equilibrium without the tax 2,80 Demand Quantity of 0 80 Ice-cream

38. Incidence of taxes How is the tax burden shared between consumers and producers? All depends on the elasticity of the demand and supply curves. The tax burden mainly falls on the less elastic market component.

39. Elasticity and incidence of taxes If the demand is inelastic and the supply is elastic: The tax is paid mainly by the consumer. If the demand is elastic and the supply is inelastic: The tax is paid mainly by the producer.

40. Elastic supply + inelastic demand Price Supply Price before tax Demand 0 Quantity

41. Elastic supply + inelastic demand Price Price to consumer Supply Tax burden Price before tax Price to producer Demand 0 Quantity

42. Elastic supply + inelastic demand Price 1. If the supply is more elastic then the demand... Price to consumer Supply Tax burden 2. …the tax affects more the consumer... Price before tax Price to producer Demand 3. …then the producer. 0 Quantity

43. Inelastic supply + elastic demand Price Supply Price before tax Demand 0 Quantity

44. Inelastic supply + elastic demand Price Supply Price to consumer Price before tax Tax burden Price to producer Demand 0 Quantity

45. Inelastic supply + elastic demand 1. If the demand is more elastic than the supply.. Price Supply Price to consumer 3. …Than on the consumer. Price before tax Tax burden Price to producer Demand 2. …the tax impacts more on the producer... 0 Quantity

46. Conclusion The economy is ruled by two kinds of law: • The law of demand and supply • The laws enacted by the legislator

47. Conclusion Regulated prices include either a minimum or a maximum (or both) level of price.

48. Conclusion Taxes on production and consumption create new equilibrium prices, where consumers and producers share in the tax burden. The incidence of the tax depends on the elasticity of demand and supply.

49. Next lecture Market efficiency…