Supply, Demand, and In this chapter, look for the answers to

6 Government Policies these questions:

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

ECONOMICS How do price ceilings and price floors affect

market outcomes?
FOURTH EDITION
How do taxes affect market outcomes?
N. G R E G O R Y M A N K I W How does the outcome depend on whether
the tax is imposed on buyers or sellers?
Premium PowerPoint® Slides What is the incidence of a tax?
by Ron Cronovich
What determines the incidence?
2008 update
Modified by Joseph Tao-yi Wang
© 2008 South-Western, a part of Cengage Learning, all rights reserved CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 1

Government Policies That Alter the EXAMPLE 1: The Market for Apartments
Private Market Outcome
Price controls P
• Price ceiling: a legal maximum on the price Rental S
price of
of a good or service. Example: rent control.
apts
• Price floor: a legal minimum on the price of
a good or service. Example: minimum wage. $8000
Eq’m
Eq’m w/o
w/o
Taxes
price
price
• The govt can make buyers or sellers pay a
controls
controls
specific amount on each unit bought/sold.
D
Q
We
We will
will use
use the
the supply/demand
supply/demand modelmodel toto see
see 300
how
how each
each policy
policy affects
affects the
the market
market outcome
outcome Quantity of
(the
(the price
price buyers
buyers pay,
pay, the
the price
price sellers
sellers receive,
receive, apartments
and
and eq’
eq ’m quantity).
eq’m quantity).
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 2 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 3

How Price Ceilings Affect Market Outcomes How Price Ceilings Affect Market Outcomes

A price ceiling P The eq’m price P

S ($8000) is S
above the Price
eq’m price is $10000 above the
ceiling
not binding – ceiling and
$8000 therefore illegal. $8000
has no effect
on the market The ceiling Price
outcome. is a binding $5000
ceiling
constraint
shortage
D on the price, D
Q causes a Q
300 250 400
shortage.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 4 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 5
How Price Ceilings Affect Market Outcomes Shortages and Rationing
With a shortage, sellers must ration the goods
In the long run, P S among buyers.
supply and
demand
Some rationing mechanisms: (1) long lines
are more
(2) discrimination according to sellers’ biases
$8000
price-elastic. These mechanisms are often unfair, and inefficient:
Price the goods do not necessarily go to the buyers who
So, the $5000
ceiling
shortage value them most highly.
shortage
is larger. D In contrast, when prices are not controlled,
Q
150 450 the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal (and thus fair).
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 6 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 7

EXAMPLE 2: Wages of Gov’tal Employee How Price Floors Affect Market Outcomes

W A price floor W
Wage of S S
below the
gov’t
employee eq’m price is
not binding –
20000 has no effect 20000

Eq’m on the market

Eq’m w/o
w/o 16000
Price
price
price outcome. floor
controls
controls
D D
L L
500 500
Quantity of gov’t
employee
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 8 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 9

How Price Floors Affect Market Outcomes The Minimum Wage

labor Min wage laws unemp-
The eq’m wage W surplus S do not affect W loyment S
($20,000) is Price highly skilled Min.
below the floor 30000 30000
floor workers. wage
and therefore
20000 They do affect 20000
illegal.
unskilled workers
The floor (like secretaries).
is a binding What is the form
constraint of unemployment
on the wage, D D
L for governmental L
causes a 400 550 employees in 400 550
surplus (i.e., Taiwan?
Everyone takes the exams!
unemployment).
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 10 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 11
ACTIVE LEARNING 1: ACTIVE LEARNING 1:
Price floors The market for A. $90 price ceiling The market for
P
140 hotel rooms P
140 hotel rooms
& ceilings S S
130 The price 130
Determine 120 falls to $90. 120
effects of: 110 110
Buyers
A. $90 price 100 100
demand Price ceiling
ceiling 90 90
120 rooms,
80 D 80 D
B. $90 price sellers supply shortage = 30
floor 70 70
90, leaving a
60 60
C. $120 price shortage.
50 50
floor
40 40
0 Q 0 Q
50 60 70 80 90 100 110 120 130 50 60 70 80 90 100 110 120 130
12 13

ACTIVE LEARNING 1: ACTIVE LEARNING 1:

B. $90 price floor The market for C. $120 price floor The market for
P
140 hotel rooms P
140 hotel rooms
S surplus = 60 S
Eq’m price is 130 The price 130
above the floor, 120 rises to $120. 120
Price floor
so floor is not 110 110
Buyers
binding. 100 100
demand
P = $100, 90 60 rooms, 90
Price floor
Q = 100 rooms. 80 D sellers supply 80 D
70 120, causing 70
60 a surplus. 60
50 50
40 40
0 Q 0 Q
50 60 70 80 90 100 110 120 130 50 60 70 80 90 100 110 120 130
14 15

Evaluating Price Controls Taxes

Recall one of the Ten Principles: The govt levies taxes on many goods & services
Markets are usually a good way to raise revenue to pay for national defense,
to organize economic activity. public schools, etc.
Prices are the signals that guide the allocation of The govt can make buyers or sellers pay the tax.
society’s resources. This allocation is altered
when policymakers restrict prices. The tax can be a % of the good’s price,
or a specific amount for each unit sold.
Price controls often intended to help the poor,
but often hurt more than help. • For simplicity, we analyze per-unit taxes only.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 16 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 17
EXAMPLE 3: The Market for Pizza A Tax on Buyers
AA tax
tax on
on
buyers Effects of a $45 per
buyers shifts
shifts
Eq’m
Eq’m unit tax on buyers
P the
the DD curve
curve P
w/o
w/o tax
tax down
down byby the
the
S1 S1
amount
amount of of PB = $330
Tax
the
the tax.
tax.
$300 $300
PS = $285
The
The price
price
buyers
buyers paypay
D1 D1
rises,
rises, the
the
price
price sellers
sellers D2
Q Q
500 receive
receive falls,
falls, 430 500
eq’m
eq’m Q Q falls.
falls.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 18 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 19

The Incidence of a Tax: A Tax on Sellers

how the burden of a tax is shared among AA tax
tax on
on
Effects of a $45 per
market participants sellers
sellers shifts
shifts
unit tax on sellers
P the
the SS curve
curve P
Because up S2
Because up by
by the
the
of S1 S1
of the
the tax,
tax, PB = $330 amount
amount of of PB = $330
Tax Tax
buyers
buyers paypay the
the tax.
tax.
$300 $300
$30
$30 more,
more,
PS = $285 PS = $285
sellers
sellers get
get The
The price
price
$15
$15 less.
less. buyers
buyers paypay
D1 D1
rises,
rises, the
the
D2 price
price sellers
sellers
Q Q
430 500 receive
receive falls,
falls, 430 500
eq’m
eq’m Q Q falls.
falls.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 20 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 21

The Outcome Is the Same in Both Cases! ACTIVE LEARNING 2:

The effects on P and Q, and the tax incidence are the Effects of a tax The market for
P
140 hotel rooms
same whether the tax is imposed on buyers or sellers! S
Suppose govt 130
What matters P
imposes a tax 120
is this: S1 on buyers of 110
PB = $330
Tax
A tax drives $30 per room. 100
$300
a wedge 90
PS = $285 Find new
between the 80 D
Q, PB, PS,
price buyers D1 70
and incidence
pay and the 60
of tax.
price sellers 50
Q
receive. 430 500 40
0 Q
50 60 70 80 90 100 110 120 130
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 22 23
ACTIVE LEARNING 2: Elasticity and Tax Incidence
Answers The market for
P
140 hotel rooms CASE 1: Supply is more elastic than demand
S
130
Q = 80 P It’s
It’s easier
easier for
for
120
sellers
sellers than
than
PB = $110 PB = 110 PB
Buyers’ share S buyers
buyers toto leave
leave
100
Tax of tax burden the
the market.
market.
PS = $80 90 Tax
D Price if no tax So
So buyers
buyers
PS = 80
bear
bear most
most of
of
70 Sellers’ share
Incidence PS the
the burden
burden of
of
60 of tax burden
buyers: $10 the
the tax.
tax.
50 D
sellers: $20
40 Q
0 Q
50 60 70 80 90 100 110 120 130
24 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 25

Elasticity and Tax Incidence CASE STUDY: Who Pays the Cigarette Tax?
CASE 2: Demand is more elastic than supply 2006: Taiwan’s Legislative Yuan increased the
It’s
It’s easier
easier for
for cigarette tax by $5.
P
S buyers
buyers than
than Possible “goal” of the tax: to raise revenue from
Buyers’ share sellers
sellers to
to
PB
those who profit from harming other’s health –
of tax burden leave
leave the
the
“evil” cigarette companies.
market.
market.
Price if no tax
Tax
Sellers
Sellers bear
bear But who really pays this tax?
Sellers’ share most
most ofof the
the
of tax burden PS burden
D
burden of of
the
the tax.
tax.
Q

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 26 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 27

CASE STUDY: Who Pays the Cigarett Tax? CONCLUSION: Government Policies and
the Allocation of Resources
The market for Cigarettes
Demand
Demand is is Each of the policies in this chapter affects the
inelastic.
inelastic. allocation of society’s resources.
Buyers’ share P
of tax burden • Example 1: a tax on pizza reduces eq’m Q.
S In
In the
the short
short run,
run,
PB supply With less production of pizza, resources
supply is
is elastic.
elastic.
(workers, ovens, cheese) will become available
Tax Hence,
Hence, to other industries.
Sellers’ share
addicted
addicted
PS smokers
smokers • Example 2: a binding minimum wage causes a
of tax burden
pay
pay most
most surplus of workers, a waste of resources.
D
of
of the
the tax.
tax. So, it’s important for policymakers to apply such
Q
policies very carefully.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 28 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 29
CHAPTER SUMMARY CHAPTER SUMMARY
A price ceiling is a legal maximum on the price of A tax on a good places a wedge between the
a good. An example is rent control. If the price price buyers pay and the price sellers receive,
ceiling is below the eq’m price, it is binding and and causes the eq’m quantity to fall, whether the
causes a shortage. tax is imposed on buyers or sellers.
A price floor is a legal minimum on the price of a The incidence of a tax is the division of the
good. An example is the minimum wage. If the burden of the tax between buyers and sellers,
price floor is above the eq’m price, it is binding and does not depend on whether the tax is
and causes a surplus. The labor surplus caused imposed on buyers or sellers.
by the minimum wage is unemployment.
The incidence of the tax depends on the price
elasticities of supply and demand.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 30 CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 31

Price Control and Taxation Demand and Supply

Supply, Demand and Equilibrium

• Markets are “good”? 140

• Price control is “bad”! 120

100

• Homework: Mankiw, Ch. 6, pp.132-134, 80

Price

Demand
Problem 2, 7, 11 60
Supply 2

40

20

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Quantity

Demand and Supply with Tax Bids and Asks (no restrictions)`
Supply, Demand and Equilibrium

160

140

120

100
Demand
Price

80 Tax Supply
Supply 2
60

40

20

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Quantity
Unbinding/Binding Price Ceiling
Taxing the Consumer/Firm
and Binding Price Floor

Original: 60, 70, 60, 60, 60,40, 60 New: 70, 80, 70, 70, 80 | 80, 80, 70, 90
Supply, Demand and Equilibrium Supply, Demand and Equilibrium

140 140

120 120

100 100

80 80 Demand
Price
Price

Demand Supply 1
Supply 1 Supply 2
60 60

40 40

20 20

0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Quantity Quantity

Price Controls Taxing Producers

Supply, Demand and Equilibrium Supply, Demand and Equilibrium

140 160

120
140

120
100

100
80 Demand
Price

Demand
Price

80 Tax Supply
Supply 2
60 Supply 2
60

40
40

20
20

0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Quantity Quantity
Taxing Consumers
Supply, Demand and Equilibrium

140

120

100

80 Demand
Price

Tax Demand
60 Supply 2

40

20

0
1 2 3 4 5 6 7 8 9 10
Quantity