sss/Principles of Microeconomics

Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part VI

Supply, Demand, and Government Poli ies

� E onomists often take the role of s ientist and poli y adviser. However, it is important that poli y re -

ommendations are made on a solid e onomi footing. This part demonstrates how e onomists analyze the

e�e tiveness and viability of di�erent poli ies.

� In this se tion, we will spe i� ally onsider the impa t of pri e ontrols and taxes.

Governments sometimes try to ontrol pri e:

In ertain situations, Governments believe that the equilibrium pri e may be too high or too low. There are two

primary ways that this pro ess o urs:

1. Pri e Ceiling: A legal maximum on the pri e at whi h a good an be sold.

(a) A pri e eiling an be binding or not.

i. A binding pri e eiling pushes the market away from equilibrium.

2. Pri e Floor: A legal minimum on the pri e at whi h a good an be sold.

(a) A pri e �oor an be binding or not.

i. A binding pri e �oor pushes the market away from equilibrium.

Pri e Ceilings:

Graphs represent a visual way to analyze the e�e t of this poli y:

� As indi ated in the graphs above, a pri e eiling has to be binding to have an e�e t on the market equilibrium

and pri e. If the pri e ontrol is not binding (below the equilibrium pri e), the market will simply move

towards equilibrium as it normally would. The following results ome from the in lusion of pri e ontrols:

� When the government imposes a binding pri e eiling on a ompetitive market, a shortage of

the good arises, and sellers must ration the s ar e goods among the large number of potential

buyers.

� These rationing de isions are undesirable � The situations that arise an be unfair and ine� ient.

The Case of OPEC and Gas Pri es:

� In 1973, the Organization of Petroleum Exporting Countries raised the pri e of rude oil and the results were

in redibly long lines at gas stations.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� The U.S. Government de ided to pla e a pri e eiling on gas (the motivation was likely to try to prote t

onsumers).

� The important question is whether OPEC or the U.S. Government was at the root of this undesirable situation.

� The in rease in the pri e of rude oil aused the supply of gas to shift to the left. This is due to the higher

ost of produ ing gas.

� It was only after this shift that the pri e eiling be ame binding.

� This poli y exa erbated the problem by ausing a severe shortage.

Pri e Floors:

� If a seller is able to make a plea to the Government that the pri e in the market is too low, a pri e �oor may

be ena ted on the market.

� A pri e �oor will only be binding if it is set above the equilibrium pri e.

� A Graph represents a visual way to analyze the e�e t of this poli y:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� Pri e Floors also produ e undesirable out omes.

� A surplus o urs when the pri e is for ed to be higher than the equilibrium. The result is ertain sellers being

unable to sell as they have too many of the good. This is an undesirable situation when ompared to buyers

and sellers intera ting freely in the market.

Minimum Wage Law:

� Minimum wage laws are prevalent in the U.S. and are meant to aid itizens (parti ularly those that are not

well-o�).

� An important aspe t of the labor market is that households are the suppliers of labor and �rms are the

onsumers.

� In other words, the sour e of supply is households and the sour e of demand is �rms. This is opposite of

normal markets.

� The pri e of a worker is the wage that has to be paid to them:

� A graph an demonstrate the results of these minimum wage laws on the market for labor:

� A key element of the labor market is that it is not singular. There are many labor markets for di�erent types

of workers.

� The result of minimum wage law is that there is a surplus in labor. Spe i� ally, there is a surplus of low

skill, low experien e workers (su h as teenagers, and other young people).

� There are onstant debates regarding whether or not minimum wage laws truly improve the plight of the poor

and the unemployed. The answer is not simple.

Taxes:

� All governments use taxes to raise revenue for publi proje ts. An important aspe t of taxes is who bears the

burden of paying.

� Tax In iden e: The manner in whi h the burden of a tax is shared among parti ipants in a market.

How Taxes on Sellers A�e t Market Out omes:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� In the I e Cream market, sellers sell 100 ones of i e ream for $3.00 at the equilibrium. If the government

de ides to levy a tax on the sellers, we an analyze what the e�e t will be �

1. De ide whether the law a�e ts the supply urve of the demand urve - In this ase, the tax is levied on the

sellers (For example they have to pay $.50 to the government for ea h unit that they sell). Therefore the

supply urve not the demand urve will be a�e ted.

2. Determine the dire tion that the urve shifts - Sin e the tax on sellers raises the ost of produ ing a good, it

redu es the quantity supplied at every pri e. The result is a shift of the urve to the left. The length of the

shift will be exa tly equal to the value of the tax. The seller is ompensating for having to pay the tax.

3. We an now ompare equilibrium with the tax to the equilibrium without:

� Taxes inhibit market a tivity - the quantity of the good is smaller in the new equilibrium.

� Buyers and sellers share the burden of the tax. Buyers pay $3.30 while sellers re eive $2.80. In other words,

the buyers bear $.30 of the tax and the sellers bear the other $.20

How Taxes on Buyers A�e t Market Out omes:

� In the I e Cream market, buyers buy 100 ones of i e ream for $3.00 at the equilibrium. If the government

de ides to levy a tax on the buyers, we an analyze what the e�e t will be �

1. De ide whether the law a�e ts the supply urve of the demand urve - In this ase, the tax is levied on the

buyers (For example they have to pay $.50 to the government for ea h unit that they buy). Therefore the

demand urve not the supply urve will be a�e ted.

2. Determine the dire tion that the urve shifts - Sin e the tax on buyers e�e tively raises the ost of pri e of

the good, it redu es the quantity demanded at every pri e. The result is a shift of the urve to the left. The

length of the shift will be exa tly equal to the value of the tax. The buyer is ompensating for having to

pay the tax.

3. We an not ompare the equilibrium with the tax to the equilibrium without:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� Buyers and sellers share the burden of the tax. Buyers pay $3.30 while sellers re eive $2.80

� The result of our analysis is somewhat surprising. Regardless of whether the tax is levied on buyers or sellers,

the out ome is equivalent.

Elasti ity and the Tax In iden e:

It is important to distinguish between how the burden of the tax is borne (do onsumers or produ ers bear a

larger burden of the tax) and who the tax is levied on (the party who �leaves the value of the tax in a bowl upon

transa tion�. Tax in iden e (represents who bears what burden of the tax) will be determined by how elasti the

response of buyers and sellers will be to a hange in pri e. This is due to how taxes dire tly a�e t the pri e in the

market. Whether the tax is levied on buyers or sellers is not important. It is the response to the pri e hange whi h

will ultimately determine who shares the higher burden of the tax:

� When the suppliers or the buyers have less elasti demand, they share the higher burden of the tax.

� The �exibility of the party with an inelasti outlook is low � This is why they share a higher burden of the

tax.

� �Elasti ity measures the willingness of buyers and sellers to leave the market when onditions be ome unfa-

vorable�

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� The more inelasti side has less options and will therefore be less willing to leave the market. Thus, they

are the ones who shoulder a larger portion of the tax burden/in iden e.

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