Ch. 6 Supply, Demand, and Government Policies

This chapter offers our first look at government policies, which use only the tools of supply and demand. As you will see, the analysis yields some surprising insights. Policies often have effects that their architects did not intend or anticipate.

We have been considering the way markets work under normal conditions. Sometimes, markets are not allowed to work. Not everyone may be happy with the outcome of the free-market process. This means that the price is not allowed to move to the equilibrium level. Two such conditions are price ceilings and price floors.

Price Ceilings: The maximum price a good can be legally.
If the price ceiling is larger tha the market price there is no direct effect. If the price ceiling is below the market price, shortage occurs as quantity demanded rises the quantity supplied. As a result, for it to be effective, the price must be different from that of a free market.

A good example is rent. For instance, in New York City (rent control is a price ceiling on rent), when soldiers were coming back from World War II and starting families, but stopped receiving pay, many couldn’t deal with the high cost. The government put in price controls, so the soldiers and their families were able to pay their rent and keep their homes. However, the price ceiling increased the quantity demanded for apartments and lowered the quantity supplied, meaning that all available apartments were rapidly taken, until there were none left for any late-comers. Price ceilings create shortages, but saves people likeexternal image 300px-Non-binding-price-ceiling.svg.png the soldiers mentioned.
external image 300px-Binding-price-ceiling.svg.png

However, subsequent problems can occur.
Shortage of houses->discrimination in distributing the limited number of houses
- Many of people want houses-> no incentive for suppliers to keep house clean-> low quality houses








www.wikipedia.com
Price Floor- The minimum price a good can be sold legally. It's different from price ceiliing because its purpose it to impede the excess waning of price. As a result, for it to be effective, its price should be larger than the equilibrium price. Yet, if it is below the equilibrium, it causes surplus.


A good example of a price floor is minimum wage laws. They specifying the lowest wage a company can pay an emploexternal image 200px-Surplus_from_Price_Floor.svg.pngyee. When the minimum wagexternal image 200px-Ineffective_Price_Floor.svg.pnge is set higher than the equilibrium market price for unskilled labor, a surplus of labor is created. A minimum wage above the equilibrium wage would induce employers to hire fewer workers as well as cause more people to enter the labor market and make more money. The equilibrium wage for a worker would be dependent upon the worker's skill sets along with market conditions.



However, these have problems just like price ceilings do.
-Unemployment increases
-Teenagers drop out of school

http://upload.wikimedia.org/wikipedia/en/thumb/a/aa/Ineffective_Price_Floor.svg/200px-Ineffective_Price_Floor.svg.png
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TAXES

Tax incidence: the share of tax burden among people in the market
TAX IS OFTEN USED FOR PUBLIC BENEFITS

WHO HAS THE BURDEN OF THESE TAXES? BUYERS? SELLERS?

How taxes on buyers affect market outcomes
When tax is imposed on the buyers of the market, its affect is determined by:
1. Effect on supply or demand curve
2. The direction of the shift
3. Effect on equilibrium
For example,i0140000.jpg
How do we determine the effects of tax on buyers?
Step one: Is the effect on the supply or the demand curve?
The effect is on the demand curve because the tax is imposed on the buyers. However, the supply curve is not affected since their incentives of selling does not alter due to the tax on the buyers. Therefore, the tax shifts the demand curve.
Step two: Which direction does it shift?
We determined that the tax levied on buyers shifts the demand curve. Now, we need to determine, which way it shifts. As said in the previous chapters, price has a big effect on the buyers’ incentives to purchase a certain good. Here, due to the tax, the buyers have to pay more for the same product
. Therefore, according to the law of demand, as the price goes up, the quantity demanded decreases. As a result, the demand curve shifts to the left.
*The demand curve shifts down/ to the right as much as the size of the tax levied.
Step three: Does it affect the equilibrium?
Evidently, as the demand curve shifts down, the equilibrium also changes. As the quantity demanded falls, the price falls as well. The reason is because tax on the buyers increases the price paid, but decreases the price received by the sellers. As a result, the sellers sell less, while the buyers buy less. Hence, it shrinks the equilibrium.
*Tax is a negative effect on the market. When a product is taxed the quantity demanded decreases
*Tax burden is shared by both buyers and sellers since in the new equilibrium due to tax, buyers pay more and sellers receive less.

How Taxes on Sellers Affect Market Outcomes

When tax is imposed on the buyers of the market, its affect is determined by:
1. Effect on supply or demand curve
2. The direction of the shift
3. Effect on equilibrium
For example,
How do we determine the effects of tax on buyers?
Step one: Is the effect on the supply or the demand curve?i0160000.jpg
The effect is on the supply curve because the tax is directly levied on the producers. Therefore, since they don’t benefit as much as without tax, they produce less. Yet, since the price the buyers pay for the product is the same, the quantity demanded remains the same.
Step two: Which direction does it shift?
The supply curve shifts to the less since the cost of producing increases, so the quantity supplied decreases. It shifts the exact amount of tax imposed on the sellers.
Step three: Does it affect the equilibrium?
Since the supply curve shifted, the equilibrium also changed. Due to the decrease in the quantity supplied the market also shrinks. As a result, both buyers and sellers share the tax burden.

Elasticity and Tax Incidence

When tax is imposed on either buyers or sellers, they both share the burden of the tax.
HOWEVER, what determines the size of the tax the sellers pay and the buyers pay?
The answer is ELASTICITY!
Although both buyers and sellers share the burden of tax, the side of the market that is less elastic bear more burden from tax. The reason is because when something is inelastic, it means that people's incentives are not heavily manipulated by the change in price because usually, there aren't alternatives for that particular product. As result, even when tax is imposed, their demand or supply does not change sufficiently; therefore, they bear more burden from tax.
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Elastic Supply, Inelastic Demand

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Inelastic Supply, Elastic Demand

Since the supply is inelastic and demand is elstic (figure on left), the sellers bear more tax burden than the buyers. On the right figure, since the supply is elastic and demand is inelastic, the buyers bear more tax burden.

Questions&Answers








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