Gov and MArket
Supply, Demand,
and Government Policies
CHAPTER
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PowerPoint Slides prepared by:
V. Andreea CHIRITESCU
Eastern Illinois University
N. GREGORY MANKIW PRINCIPLES OF ECONOMICS Eight Edition
N. Gregory Mankiw Principles Of Economics Eight Edition
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Controls on Prices
Price controls
Policymakers believe that the market price of a good or service is unfair to buyers or sellers
Can generate inequities
Taxes
To raise revenue for public purposes
To influence market outcomes
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Controls on Prices
Price ceiling
A legal maximum on the price at which a good can be sold
Rent-control laws
Price floor
A legal minimum on the price at which a good can be sold
Minimum wage laws
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Controls on Prices
How price ceilings affect market outcomes
Not binding
Set above the equilibrium price
No effect on the price or quantity sold
Binding constraint
Set below the equilibrium price: Shortage
Sellers must ration the scarce goods
Rationing mechanisms: long lines, discrimination according to sellers bias
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Figure 1 A Market with a Price Ceiling
In panel (a), the government imposes a price ceiling of $4. Because the price ceiling is above the equilibrium price of $3, the price ceiling has no effect, and the market can reach the equilibrium of supply and demand. In this equilibrium, quantity supplied and quantity demanded both equal 100 cones.
In panel (b), the government imposes a price ceiling of $2. Because the price ceiling is below the equilibrium price of $3, the market price equals $2. At this price, 125 cones are demanded and only 75 are supplied, so there is a shortage of 50 cones.
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Price of Ice-Cream
Cones
Quantity of Ice-Cream Cones
0
Demand
100
(a) A Price Ceiling That Is Not Binding
(b) A Price Ceiling That Is Binding
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Supply
$4
Price ceiling
Equilibrium
price
Equilibrium
quantity
Price of Ice-Cream
Cones
Quantity of Ice-Cream Cones
0
Demand
$3
Supply
2
Price ceiling
Equilibrium
price
75
Quantity
demanded
Quantity
supplied
125
Shortage
Lines at the gas pump
1973, OPEC raised the price of crude oil
Reduced the supply of gasoline
Long lines at gas stations
What was responsible for the long gas lines?
OPEC
Shortage of gasoline
U.S. government regulations
Price ceiling on gasoline
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Lines at the gas pump
Price ceiling on gasoline
Before OPEC raised the price of crude oil
Equilibrium price was below the price ceiling
No effect on the market
When the price of crude oil rose
Decrease in the supply of gasoline
Equilibrium price was above the price ceiling
Binding price ceiling: Severe shortage
Laws regulating the price of gasoline were repealed
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Figure 2 The Market for Gasoline with a Price Ceiling
Panel (a) shows the gasoline market when the price ceiling is not binding because the equilibrium price, P1, is below the ceiling. Panel (b) shows the gasoline market after an increase in the price of crude oil (an input into making gasoline) shifts the supply curve to the left from S1 to S2. In an unregulated market, the price would have risen from P1 to P2. The price ceiling, however, prevents this from happening. At the binding price ceiling, consumers are willing to buy QD, but producers of gasoline are willing to sell only QS. The difference between quantity demanded and quantity supplied, QD – QS, measures the gasoline shortage.
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Price of Gasoline
Quantity of Gasoline
0
Demand
Q1
The Price Ceiling On Gasoline
Is Not Binding
(b) The Price Ceiling On Gasoline
Is Binding
P1
Supply, S1
Price ceiling
1. Initially, the price ceiling is not binding …
Price of Gasoline
Quantity of Gasoline
0
Demand
Q1
P1
S1
Price ceiling
2…but when supply falls…
S2
P2
3…the price ceiling becomes binding…
QS
QD
4. …resulting in a shortage
ASK THE EXPERTS
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Rent Control
“Local ordinances that limit rent increases for some rental housing units, such as in New York and San Francisco, have had a positive impact over the past three decades on the amount and quality of broadly affordable rental housing in cities that have used them.”
Rent control in the short run and the long run
Price ceiling: rent control
Local government places a ceiling on rents
Goal: to help the poor
Making housing more affordable
Critique
Highly inefficient way to help the poor raise their standard of living
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Rent control in the short run and the long run
Adverse effects in the short run
Supply and demand for housing are inelastic in the short run
Small shortage
Reduced rents
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Rent control in the short run and the long run
Adverse effects in the long run
Supply and demand are more elastic
Landlords
Are not building new apartments
Are failing to maintain existing ones
People
Find their own apartments
Induce more people to move into a city
Large shortage of housing
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Rent control in the short run and the long run
Adverse effects in the long run
Rationing mechanisms
Long waiting lists
Preference to tenants without children
Discriminate on the basis of race
Bribes to building superintendents
People respond to incentives
Free markets
Landlords – clean and safe buildings
Higher prices
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Rent control in the short run and the long run
People respond to incentives
Rent control
Shortages and waiting lists
Landlords lose their incentive to respond to tenants’ concerns
Tenants get lower rents and lower-quality housing
Policymakers – additional regulations
Difficult and costly to enforce
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Figure 3 Rent Control in Short Run and in Long Run
Panel (a) shows the short-run effects of rent control: Because the supply and demand curves for apartments are relatively inelastic, the price ceiling imposed by a rent-control law causes only a small shortage of housing.
Panel (b) shows the long-run effects of rent control: Because the supply and demand curves for apartments are more elastic, rent control causes a large shortage.
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Rental Price of Apartment
Quantity of Apartments
0
Demand
(a) Rent Control in the Short Run
(supply and demand are inelastic)
(b) Rent Control in the Long Run
(supply and demand are elastic)
Supply
Controlled rent
Rental Price of Apartment
Quantity of Apartments
0
Demand
Supply
Controlled rent
Shortage
Shortage
Controls on Prices
How price floors affect market outcomes
Not binding
Set below the equilibrium price
No effect on the market
Binding constraint
Set above the equilibrium price: Surplus
Some sellers are unable to sell what they want
Rationing mechanisms: not desirable
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Figure 4 A Market with a Price Floor
In panel (a), the government imposes a price floor of $2. Because this is below the equilibrium price of $3, the price floor has no effect. The market price adjusts to balance supply and demand. At the equilibrium, quantity supplied and quantity demanded both equal 100 cones.
In panel (b), the government imposes a price floor of $4, which is above the equilibrium price of $3. Therefore, the market price equals $4. Because 120 cones are supplied at this price and only 80 are demanded, there is a surplus of 40 cones.
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Price of Ice-Cream
Cone
Quantity of Ice-Cream Cones
0
Demand
100
(a) A Price Floor That Is Not Binding
(b) A Price Floor That Is Binding
$3
Supply
2
Price floor
Equilibrium
price
Equilibrium
quantity
Price of Ice-Cream
Cone
Quantity of Ice-Cream Cones
0
Demand
3
Supply
$4
Price floor
Equilibrium
price
80
Quantity
supplied
Quantity
demanded
120
Surplus
ASK THE EXPERTS
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The Minimum Wage
“If the federal minimum wage is raised gradually to $15-per-hour by 2020, the employment rate for low-wage U.S. workers will be substantially lower than it would be under the status quo.”
The minimum wage
Price floor: minimum wage
Lowest price for labor that any employer may pay
Fair Labor Standards Act of 1938
Ensures workers a minimally adequate standard of living
2015, federal minimum wage, $7.25/hour
Some states mandate minimum wages above the federal level
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The minimum wage
France
Average income is 30% lower than in the U.S.
Minimum wage is more than 30% higher
Market for labor
Workers supply labor
Firms demand labor
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The minimum wage
If minimum wage is above equilibrium
Unemployment
Higher income for workers who have jobs
Lower income for workers who cannot find jobs
Impact of the minimum wage on highly skilled and experienced workers
No effect: their equilibrium wages are well above the minimum
Minimum wage: not binding
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The minimum wage
Impact of the minimum wage on teenage labor
Least skilled and least experienced
Low equilibrium wages
Willing to accept a lower wage in exchange for on-the-job training
Minimum wage: binding
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The minimum wage
Teenage labor market
A 10% increase in the minimum wage depresses teenage employment between 1 and 3%
Some teenagers who are still attending high school choose to drop out and take jobs
Displace other teenagers who had already dropped out of school and who now become unemployed
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Figure 5 How Minimum Wage Affects Labor Market
Panel (a) shows a labor market in which the wage adjusts to balance labor supply and labor demand.
Panel (b) shows the impact of a binding minimum wage. Because the minimum wage is a price floor, it causes a surplus: The quantity of labor supplied exceeds the quantity demanded. The result is unemployment.
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Wage
Quantity
of Labor
0
Labor
demand
Equilibrium
employment
(a) A Free Labor Market
(b) A Labor Market with a
Binding Minimum Wage
Equilibrium
wage
Labor
supply
Wage
Quantity
of Labor
0
Minimum
wage
Quantity
demanded
Quantity
supplied
Labor surplus
(unemployment)
Labor
demand
Labor
supply
The minimum wage
Advocates of the minimum wage
Raise the income of the working poor
Workers who earn the minimum wage can afford only a meager standard of living
Opponents of the minimum wage
Not the best way to combat poverty
Unemployment, encourages teenagers to drop out of school, prevents some unskilled workers from getting on-the-job training
Poorly targeted policy
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Evaluating Price Controls
Markets are usually a good way to organize economic activity
Economists usually oppose price ceilings and price floors
Prices are not the outcome of some haphazard process
Prices have the crucial job of balancing supply and demand
Coordinating economic activity
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Evaluating Price Controls
Governments can sometimes improve market outcomes
Want to use price controls
Because of unfair market outcome
Aimed at helping the poor
Often hurt those they are trying to help
Other ways of helping those in need
Rent subsidies
Wage subsidies (earned income tax credit)
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Taxes
Government uses taxes
To raise revenue for public projects
Roads, schools, and national defense
Tax incidence
Manner in which the burden of a tax is shared among participants in a market
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Taxes
How taxes on sellers affect market outcomes
Immediate impact on sellers: shift in supply
Supply curve shifts left
Higher equilibrium price
Lower equilibrium quantity
The tax reduces the size of the market
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Figure 6 A Tax on Sellers
When a tax of $0.50 is levied on sellers, the supply curve shifts up by $0.50 from S1 to S2. The equilibrium quantity falls from 100 to 90 cones. The price that buyers pay rises from $3.00 to $3.30. The price that sellers receive (after paying the tax) falls from $3.00 to $2.80. Even though the tax is levied on sellers, buyers and sellers share the burden of the tax.
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Price of
Ice-Cream
Cone
Quantity of
Ice-Cream Cones
0
Demand, D1
90
S1
S2
100
$3.30
3.00
2.80
Price
buyers
pay
Price
without
tax
Price
sellers
receive
A tax on sellers
shifts the supply
curve upward
by the size of
the tax ($0.50).
Tax ($0.50)
Equilibrium
without tax
Equilibrium with tax
Taxes
How taxes on sellers affect market outcomes
Taxes discourage market activity
Buyers and sellers share the burden of tax
Buyers pay more, are worse off
Sellers receive less, are worse off
Get the higher price but pay the tax
Overall: effective price fall
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Taxes
How taxes on buyers affect market outcomes
Initial impact on the demand
Demand curve shifts left
Lower equilibrium price
Lower equilibrium quantity
The tax reduces the size of the market
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Figure 7 A Tax on Buyers
When a tax of $0.50 is levied on buyers, the demand curve shifts down by $0.50 from D1 to D2. The equilibrium quantity falls from 100 to 90 cones. The price that sellers receive falls from $3.00 to $2.80. The price that buyers pay (including the tax) rises from $3.00 to $3.30. Even though the tax is levied on buyers, buyers and sellers share the burden of the tax.
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Price of
Ice-Cream
Cone
Quantity of
Ice-Cream Cones
0
D1
90
Supply, S1
100
$3.30
3.00
2.80
Price
buyers
pay
Price
without
tax
Price
sellers
receive
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).
Tax ($0.50)
Equilibrium without tax
Equilibrium with tax
D2
Taxes
How taxes on buyers affect market outcomes
Buyers and sellers share the burden of tax
Sellers get a lower price, are worse off
Buyers pay a lower market price, are worse off
Effective price (with tax) rises
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Taxes
Taxes levied on sellers and taxes levied on buyers are equivalent
Wedge between the price that buyers pay and the price that sellers receive
The same, regardless of whether the tax is levied on buyers or sellers
Shifts the relative position of the supply and demand curves
Buyers and sellers share the tax burden
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Can Congress distribute the burden of a payroll tax?
Payroll taxes
Deducted from the amount you earned
By law, the tax burden:
Half of the tax is paid by firms
Out of firm’s revenue
Half of the tax is paid by workers
Deducted from workers’ paychecks
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Can Congress distribute the burden of a payroll tax?
Tax incidence analysis
Payroll tax as a tax on a good
The good is labor
The price is the wage
Introduce payroll tax
Wage received by workers falls
Wage paid by firms rises
Workers and firms share the tax burden
Not necessarily 50 – 50 as required
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Can Congress distribute the burden of a payroll tax?
Lawmakers
Can decide whether a tax comes from the buyer’s pocket or from the seller’s
Cannot legislate the true burden of a tax
Tax incidence
Determined by the forces of supply and demand
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Figure 8 A Payroll Tax
A payroll tax places a wedge between the wage that workers receive and the wage that firms pay. Comparing wages with and without the tax, you can see that workers and firms share the tax burden. This division of the tax burden between workers and firms does not depend on whether the government levies the tax on workers, levies the tax on firms, or divides the tax equally between the two groups.
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Wage
Quantity of
Labor
0
Labor
demand
Labor
supply
Wage firms pay
Wage without tax
Wage workers
receive
Tax wedge
Taxes
Elasticity and tax incidence
Very elastic supply and relatively inelastic demand
Sellers bear a small burden of tax
Buyers bear most of the burden
Relatively inelastic supply and very elastic demand
Sellers bear most of the tax burden
Buyers bear a small burden
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Figure 9 How the Burden of a Tax Is Divided (a)
In panel (a), the supply curve is elastic, and the demand curve is inelastic. In this case, the price received by sellers falls only slightly, while the price paid by buyers rises substantially. Thus, buyers bear most of the burden of the tax.
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Price
Quantity
0
Demand
Supply
Price buyers pay
Price without tax
Price sellers
receive
Tax
(a) Elastic Supply, Inelastic Demand
1. When supply is more elastic than demand . . .
2. . . . the incidence of the tax falls more heavily on consumers . . .
3. . . . than on producers.
Figure 9 How the Burden of a Tax Is Divided (b)
In panel (b), the supply curve is inelastic, and the demand curve is elastic. In this case, the price received by sellers falls substantially, while the price paid by buyers rises only slightly. Thus, sellers bear most of the burden of the tax.
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Price
Quantity
0
Demand
Supply
Price buyers pay
Price without tax
Price sellers
receive
Tax
(b) Inelastic Supply, Elastic Demand
1. When demand is more elastic than supply . . .
3. than on consumers
2. . . . the incidence of the tax falls more heavily on producers.
Taxes
Tax burden
Falls more heavily on the side of the market that is less elastic
Small elasticity of demand
Buyers do not have good alternatives to consuming this good
Small elasticity of supply
Sellers do not have good alternatives to producing this good
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Who pays the luxury tax?
1990, Congress adopted a new luxury tax
On yachts, private airplanes, furs, jewelry, expensive cars
Goal: to raise revenue from those who could most easily afford to pay
Luxury items
Demand is quite elastic
Supply is relatively inelastic
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Who pays the luxury tax?
Outcome:
Burden of a tax falls largely on the suppliers
Relatively inelastic supply
1993: most of the luxury tax was repealed
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“If this boat were any more expensive, we’d be playing golf.”