for Genious Alert1234 only

Chapter 6: Supply, Demand, and Government Policies

Chapter Objectives Little Picture: learning how price controls (floors, ceilings) and taxes affect the prices

and quantities of goods and services sold in markets.

Big Picture: learning about the effects of price controls and taxes to obtain a better

understanding of microeconomics, i.e., what forces determine the price (and market

quantity) of a good or service.

This chapter is focused on the effect of price controls and taxes on markets.

Price Controls Early in the chapter, Mankiw uses the market model to explain the effects of the two

different controls (price floors and ceilings) on market performance.

Ceilings A price ceiling is an upper barrier to price, a threshold above which the government

does not want price to rise. A price ceiling will be imposed below the level of

equilibrium price since one that is imposed above equilibrium price makes no sense

because it will be economically irrelevant to the market (i.e., non-binding).

An effective (binding) price ceiling will cause a shortage, a long-term market

condition in which the quantity demanded in the market exceeds the quantity

supplied. (A common misstatement of this definition of a shortage is, "when demand

is greater than supply," which makes no sense. If demand [i.e., the entire demand

curve] is greater than supply [i.e., the entire curve] in a particular market, then supply

and demand do not intersect in that market, thus there is no market price and no

quantity of goods traded, therefore really no market! The situation is no different

when supply is greater than demand, such that no quantity or price exists, and hence

there is [again] no real market. Think of a large Ferrari car dealer--with its lowest-

priced car being the Ferrari California at about $200,000--placed into tiny, off-the-

beaten-path Manes, Missouri.]

With ceilings and floors, the correct terminology and concepts are "quantity

demanded" and "quantity supplied." "Demand" and "supply" always refer to the

entire curves, whereas "quantity" refers to the number of goods or services measured

along either the supply or demand curves.)

A shortage caused by a binding ceiling [panel (b) above] creates frustration in a

market. The reason the shortage exists is that there are two effects at work. One, at

the lower government-enforced price on the demand side, additional consumers are

attracted to the market by the artificially low price. This explains the portion of the

shortage that exists beyond the level that would prevail at free-market equilibrium

[100 units in panel (a)]. To see this, notice that in panel (a) above, the free-market

equilibrium quantity is at 100. Notice that with a shortage, quantity demanded rises to

125. We can therefore conclude that 25 additional units are demanded by new

consumers entering the market because the new consumers are attracted by the

artificially low price of $2 set by the government. This is the law of demand at

work: decrease price and you will see quantity demanded (not demand) increase.

Now for the second component of the shortage. Notice that on the supply side of the

market, from panels (a) to (b), quantity supplied drops from 100 to 75. Why? The

law of supply: at the artificially low price, sellers reduce the quantity supplied to the

market as the price per unit falls. Thus, the entire shortage arises because of the sum

of the effects on both the demand and supply sides of the market.

Floors

Floors are the opposite of ceilings, but be careful. One common misguided way

students try to memorize the differences between price floors and ceilings is say to

themselves, "Okay, as I'm sitting here reading this in a room, I look above me and see

a ceiling and look below me and see a floor. Therefore, ceilings are above

equilibrium and floors are below it." Unfortunately, it's exactly the opposite of

that. Instead, look at them on the graph and understand why each is where it is with

respect to equilibrium. In economics, with only a few exceptions, always try to

understand rather than memorize. If you forget something on an exam, it's gone. If

you understand it instead, you can always reason your way through the process to

arrive at the correct answer.

A floor is a government-mandated price set above market equilibrium. Floors are a

threshold below which the government does not want price to fall. A price floor will

always be imposed above the level of equilibrium price since one that is imposed

below equilibrium price makes no sense because it is economically irrelevant. An

effective (binding) price floor will cause a surplus, a long-term condition in which

quantity supplied exceeds quantity demanded. (Again, the usual mis-phrasing of this

definition of a surplus is, "when supply is greater than demand." If supply is ever

greater than demand, the two curves will not intersect at a market equilibrium, there

will be no price, no quantity demanded or supplied, and hence no real market.)

With a surplus there is frustration in the market as well. It, like a ceiling, exists

because of two effects at work. At the artificially higher government-enforced price

on the supply side of the market, firms increase their output because the higher price

makes each good produced more profitable. This explains the portion of the surplus

that exists beyond the level that would prevail in a free market [100 units in panel (a)

below].

Notice in panel (a) above that the free-market equilibrium quantity is 100. With the

surplus illustrated in panel (b), quantity supplied rises to 120. Therefore, 20

additional units are supplied to the market because of the artificially high price. This

is the law of supply at work: at a higher price, producers will supply a greater quantity

of the product to the market.

The second effect at work is on the demand side. From panels (a) to (b), quantity

demanded drops from 100 to 80. At the artificially high price, the product is less

attractive to consumers and therefore they purchase less. Thus, the sum of the two

effects on both sides of the market is responsible for the surplus.

Taxes The second half of the chapter is devoted to the topic of taxes. This analysis is no

more complicated than that of price controls. The difference is that the deconstruction

is more vertical than horizontal. Let's look at a tax on buyers. (The scenario of a tax

on sellers is covered by Mankiw but will be left to you to examine.) Then we'll

examine the effects of a payroll tax and the distribution of the tax burden in a market.

A 50-cent tax on a market equilibrium of 100 ice-cream cones for $3.00 each (above),

reduces demand from D1 to D2. The shift in demand is 50 cents in magnitude, the size

of the tax. (Notice that Mankiw refers to the decrease in demand as a "downward"

shift. Although it doesn't ultimately matter, it's probably better to think of it as a

leftward shift and think of shifts as "left" or "right" rather than up or down since

market curves are derived from individual curves by horizontal summation.)

Market quantity falls from 100 to 90 while price rises from $3.00 to $3.30 for buyers

but falls from $3.00 to $2.80 for sellers. Notice that even though the tax is levied on

buyers, both buyers and sellers bear the cost of the tax.

Notice especially this triangular area in the diagram above:

The top side of this triangle is formed by demand curve D1 while the bottom side is

formed by supply curve S1. The left side of the triangle is just the dotted line that

extends up from the new tax-equilibrium quantity of 90. That area is known as

deadweight loss, which is a social loss to both consumers and firms from a sub-

optimal quantity of goods supplied to the market.

The graph immediately above is not of a goods or services market, but of a labor

market. Notice the units of measurement on the axes of the graph: "Quantity of

Labor" on the horizontal axis and “Wage” on the vertical axis. This particular labor

market shows the effects of a payroll tax. Under such a tax, even though the wage

that firms pay rises, the payroll tax creates a deadweight loss in the labor market that

reduces employment and the wages workers take home. You can see the deadweight-

loss triangle again in the graph immediately above. Here it is if you're still having

trouble seeing it:

The top side of the triangle is formed by a segment of the labor-demand curve while

the bottom side is formed by a segment of the labor-supply curve. The third (vertical)

side is formed by the tax wedge that can be seen clearly in the labor-market figure

immediately above.

The payroll tax is shared by both workers and firms regardless of whether the tax is

levied on workers, firms, or is divided between the two.

The two market graphs above show how a tax burden is distributed between

consumers and firms depending on elasticity. Graph (a) shows that with relatively

inelastic demand and relatively elastic supply, tax incidence is skewed toward

consumers. Graph (b) shows that with relatively elastic demand and relatively

inelastic supply, tax incidence is skewed toward firms.

Chapter Case Studies

1. Lines at the Gas Pump

2. Rent Control in the Short Run and the Long Run

3. The Minimum Wage

4. Can Congress Distribute the Burden of a Payroll Tax?

5. Who Pays the Luxury Tax?

All five of the chapter case studies are must reading. In terms of price ceilings on

gasoline, pay attention to who the American public blamed versus economists.

In many cases rent control appears to be the most efficient technique presently

known to destroy a city—except for bombing—Assar Lindbeck

This is Swedish economist Assar Lindbeck’s famous statement about one of the long-

run effects of rent control: deterioration of urban areas to the point where they look

like war zones.

The minimum wage: pay special attention to who it adversely affects.

While the luxury tax was aimed at punishing the wealthy, they escaped mostly

unscathed while middle-class skilled workers got hammered with layoffs. Why? The

tax torched the sales of the private airplane and boating industries, resulting in

layoffs. Beech Aircraft alone lost $130 million in sales and 480 jobs (Fortune, 9/6/93,

p. 40). One fact about the airplane component of the luxury tax not mentioned by

Mankiw was that the tax was projected to bring in $6 million in revenue. Instead, the

government only received $53,000 and ended up spending $5,100,000 to collect that

sum, which ended up being a 9,522% loss for the government (Business Week, 7/5/93,

p. 14)! Looks like some politicians in Congress could desperately use some lessons

on elasticity and deadweight loss.

Discussion Topics (topics requiring examples are marked with an asterisk *)

Please copy these topics exactly as written--shortening them can cause you to

omit follow-up questions and thus lose points.

1. price floor (use a numerical example)*

2. binding constraints (use a numerical example)* 3. Complete and explain: When the government imposes a _______ on a

competitive market, a ________ of the good arises, and sellers must ration the

scarce goods among the large number of potential buyers.

4. Who did most Americans blame for long lines at U.S. gas pumps in the early 1970s? In contrast, who did economists blame?

5. What effects does rent control have in the short run? The long run? 6. What are the effects of the minimum wage? On which type of worker does it

have the least effect? On which type of worker does it have the most effect?

7. Coffee was a major staple and export crop for the Venezuelan economy for centuries until 2009. What happened to dry up almost all production? What

has similarly happened to many other goods and services in the Venezuelan

economy?

8. tax incidence (use a numerical example)* 9. How do taxes on buyers affect market outcomes? What is the unexpected

implication?

10. What difficulties has the U.S. Congress encountered in attempting to distribute the burden of a payroll tax?

11. Complete and explain: A tax burden falls more heavily on the side of the

market that is less ____.

12. Aimed at the rich, which class was much more affected by the 1990 luxury

tax? What was the ultimate fate of the tax?