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SUPPLY, DEMAND, AND GOVERNMENT POLICIES

SUPPLY, DEMAND, AND GOVERNMENT POLICIES. Chapter 6. What we learn now?. In Ch.2 we mentioned two roles for economists: As scientists they try explain the world As policymakers they try to change the world Ch.4 and Ch.5 analysed objectively how supply and demand works in markets

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SUPPLY, DEMAND, AND GOVERNMENT POLICIES

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  1. SUPPLY, DEMAND, AND GOVERNMENT POLICIES Chapter 6

  2. What we learn now? • In Ch.2 we mentioned two roles for economists: • As scientists they try explain the world • As policymakers they try to change the world • Ch.4 and Ch.5 analysed objectively how supply and demand works in markets • In Ch.6 we analyse various types of government policy towards the markets • To that purpose we will only use tools of supply and demand that we just developed • The analysis will yield some surprising insights about how markets work • Common sense and economic analysis may give opposing advise to policymakers

  3. Supply, demand, and government • In a free, unregulated market system, market forces establish equilibrium prices andquantities • The market equilibrium may be efficient, but it may not leave everyone satisfied • Those who consider themselves to be losing from the market outcomes will ask for government to intervene in the market • The government intervention in the markets may take several ways, depending on the circumstances • We will look at two different cases of direct government involvement in markets: • Price controls • Taxes levied on goods and services

  4. Price controls • Price control: government sets an upper or lower limit (or both) to the price of good or service • Price controls are often used in many countries • Price controls are enacted by governments because there is a demand for them from some sections of the public • Who, either as buyers or sellers feel that the existing market price is unfair to them • We will distinguish between two types of controls • Price Ceiling: a legally established maximum priceat which a good can be sold. • Price Floor:a legally established minimum priceat which a good can be sold

  5. Price ceilings • Price ceilings limit the maximum price that sellers can charge to their customers • In other words, market price can be lower but can not be higher than the price fixed by government • Two outcomes are possible when the government imposes a price ceiling • The price ceiling is not binding if it is setabove the equilibrium price • It will have no impact on the market • The price ceiling is binding if it is setbelowthe equilibrium price • It will lead to shortages in the market as demand exceeds supply at that price

  6. A price ceiling that is not binding Price of Ice-Cream Cone Supply $4 Price ceiling 3 Equilibrium price Demand 0 100 Quantity of Ice-Cream Cones Equilibrium quantity

  7. Price of Ice-Cream Cone Supply Equilibrium price $3 2 Price ceiling Shortage Demand 0 75 125 Quantity of Ice-Cream Cones Quantity supplied Quantity demanded A price ceiling that is binding

  8. Effects of price ceilings • A price ceiling prevents the price to rise further even if demand is high • A binding price ceiling creates shortages because QD > QS. • Example: there was a margarine shortage in Turkey during 1978-79 crisis because the price was fixed too low to cover the costs of producers • Shortages result in non-price rationing such as long lines in front of the shops, discrimination by sellers and as a rule the formation of a “black market” • In Turkey there was a black market for dollars before 1980s because the government had fixed the exchange rate below the market equilibrium rate

  9. Price ceiling on gasoline (a) The Price Ceiling on Gasoline Is Not Binding (b) The Price Ceiling on Gasoline Is Binding Price of Price of S 2 Gasoline Gasoline 2. ...but when supply falls... Supply, S S 1 1 1. Initially, P 2 the price ceiling is not Price ceiling Price ceiling binding... 3. ...the price P P 1 1 ceiling becomes 4. ... binding... resulting in a Demand Demand shortage. 0 Q Quantity of 0 Q Q Q Quantity of 1 S D 1 Gasoline Gasoline A fall in supply turns an unbinding price ceiling into a binding ceiling and causes shortages of gasoline

  10. Rent control: short and long run (a) Rent Control in the Short Run (b) Rent Control in the Long Run (supply and demand are inelastic) (supply and demand are elastic) Rental Rental Price of Price of Supply Apartment Apartment Supply Controlled rent Controlled rent Demand Shortage Shortage Demand 0 Quantity of 0 Quantity of Apartments Apartments Controling rents cause bigger shortages in the long run because new construction becomes unattractive, reducing long run supply

  11. Price floors • Price floors set the minimum price that buyers must pay for a product • Market price can be higher but not below the price set by the government • When the government imposes a price floor, again two outcomes are possible • The price floor is not binding if it is setbelow the equilibrium price • It has no effect on the market • The price floor is binding if it is set abovetheequilibrium price • It leads to a surplusbecause demand is less than supply at that price

  12. A price floor that is not binding Price of Ice-Cream Cone Supply Equilibrium price $3 Price floor 2 Demand 0 100 Quantity of Ice-Cream Cones Equilibrium quantity

  13. Price of Ice Cream Cones Supply Surplus $4 Price floor 3 Equilibrium price Demand 0 80 120 Quantity of Ice Cream Cones Quantity demanded Quantity Supplied A price floor that is binding

  14. Effects of a price floor • A price floor prevents price to fall even if demand is very low • When the market price hits the floor, itcan fall no further, and the market priceequals the floor price • A binding price floor causes a surplus of supply over demand because at that price QS > QD. • Agricultural support prices are typical examples • When set above market levels, they result in large unsold stocks (tobacco?) • Minimum wage laws also set price floors for wages • Binding minimum wages prevent wages to go down and therefore cause unemployment

  15. (a) A Free Labor Market (b) A Labor Market with a Binding Minimum Wage Wage Wage Labor Labor supply supply Labor surplus (unemployment) Minimum wage Equilibrium wage Labor Labor demand demand 0 Equilibrium Quantity of 0 Quantity Quantity Quantity of employment Labor demanded supplied Labor Minumum wage law and employment Minimum wage legislation increases both the real wage of employed and the number of unemployed

  16. Taxes: impact • Taxes levied on goods and services are called indirect taxes • The amount of tax fixed by the government is added to the price and paid everytime the good is sold • Taxes discourage market activity • When a good is taxed, the quantity sold is smaller • Buyers and sellers share the tax burden • Tax incidence is the study of who bears the burden of a tax • Taxes result in a change in market equilibrium • Buyers pay more and sellers receive less, regardless of whom the tax is levied on

  17. Impact of a 50¢ tax on buyers Price of Ice-Cream Cone Supply, S1 3.00 D1 0 100 Quantity of Ice-Cream Cones

  18. Impact of a 50¢ tax on buyers Price of Ice-Cream Cone Supply, S1 Price buyers pay $3.30 Equilibrium without tax 3.00 2.80 Price sellers receive Equilibrium with tax D1 D2 0 90 100 Quantity of Ice-Cream Cones

  19. Price of Ice-Cream Cone Quantity of Ice-Cream Cones Impact of a 50¢ tax on sellers S1 3.00 Demand, D1 0 100

  20. Price of Ice-Cream Cone Quantity of Ice-Cream Cones Impact of a 50¢ tax on sellers A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50). Price buyers pay S2 Equilibrium with tax S1 $3.30 Tax ($0.50) Price without tax 3.00 2.80 Equilibrium without tax Price sellers receive Demand, D1 0 90 100

  21. The incidence of tax • Tax incidence tries to establish who pays the tax in the end? • In other words, in what proportions is the burden of the tax divided between buyers and sellers? • Alternatively, how do the effects of taxes on sellers compare to those levied on buyers? • This is an opportunity for us to see how the measure of elasticity can be used in economics • Because the answers to these questions depends on the elasticity of demand and the elasticity of supply. • We shall show that the burden of a tax falls more heavily on the side of the market that is less elastic

  22. Elasticity and tax incidence • Elasticity enters the picture because total revenue in the market depends on the price elasticity of demand and price elasticity of supply • We can distinguish among three major cases • If demand is inelasticwhile supply is elastic, then a larger share of the tax will fall on the buyers • If demand is elastic while supply is inelestic, then a larger share of the tax will fall on the sellers • If demand and supply are unit elastic, buyers and seller will share the tax burden equally • The government is able to target correctly those whom it wishes to pay the tax when the price elasticities of demand and supply are known

  23. Elastic supply, inelastic demand Price Supply Price without tax Demand 0 Quantity

  24. Elastic supply, inelastic demand Price 1. When supply is more elastic than demand... Price buyers pay Supply 2. ...the incidence of the tax falls more heavily on consumers... Tax Price without tax Price sellers receive Demand 3. ...than on producers. 0 Quantity

  25. Inelastic supply, elastic demand Price Supply Price without tax Demand 0 Quantity

  26. Inelastic supply, elastic demand 1. When demand is more elastic than supply... Price Price buyers pay Supply Price without tax 3. ...than on consumers. Tax Demand Price sellers receive 2. ...the incidence of the tax falls more heavily on producers... 0 Quantity

  27. Taxing luxuries or necessities? • There is always a demand from the public to tax luxuries but not necessities • Taxing goods that are considered luxuries is popular both with the public and governments • Unfortunately luxury goods usually have high price elasticity of demand (bigger than 1) • Therefore taxes reduce the consumption of luxuries • Tax revenue is much lower than expected • In turn, necessities have low price elasticity of demand (smaller than 1) • And yield high tax revenues to the government • In order to obtain revenues the government ends up by taxing necessities in Turkey

  28. Conclusion • The economy is governed by two kinds of laws: • The laws of supply and demand. • The laws enacted by government • Prices can be controled by ceilings or floors • Price ceilings cause shortages and black market • Price floors result in surpluses and unsold stoks held by the government • Taxes raise revenue to the government • Taxes create new price equilibriums in which buyers and sellers share the tax • The incidence of the tax depends on the price elasticity of demand and supply • Necessities are taxed to get more revenue

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