Chapter 6 Supply Demand and Government Policies

Seventh Edition
Economics
Principles of
Wojciech Gerson (1831-1901)

N. Gregory Mankiw
CHAPTER Supply, Demand, and

6 Government Policies
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In this chapter,
look for the answers to these questions
• What are price ceilings and price floors?

What are some examples of each?
• How do price ceilings and price floors affect
market outcomes?
• How do taxes affect market outcomes?
How do the effects depend on whether
the tax is imposed on buyers or sellers?
• What is the incidence of a tax?
What determines the incidence?
Government Policies That Alter the
Private Market Outcome
 Price controls
 Price ceiling: a legal maximum on the price
of a good or service Example: rent control
 Price floor: a legal minimum on the price of
a good or service Example: minimum wage
 Taxes
 The govt can make buyers or sellers pay a
specific amount on each unit.
We will use the supply/demand model to see

how each policy affects the market outcome
(the price buyers pay, the price sellers receive,
and eq’m quantity). 2
EXAMPLE 1: The Market for Apartments
Rental P S
price of
apts
$800
Eq’m w/o
price
controls
D
Q
300
Quantity
of apts
3
How Price Ceilings Affect Market Outcomes
A price ceiling P
above the S
Price
eq’m price is $1000
ceiling
not binding—
has no effect $800
on the market
outcome.
D
Q
300
4
The eq’m price P S

($800) is above
the ceiling and
therefore illegal.
The ceiling $800
is a binding Price
constraint $500
ceiling
on the price, shortage
causes a D
shortage. Q
250 400
5
In the long run, P S

supply and
demand
are more
$800
price-elastic.
So, the Price
$500
shortage ceiling
is larger. shortage
D
Q
150 450
6
Shortages and Rationing
 With a shortage, sellers must ration the goods
among buyers.
 Some rationing mechanisms: (1) Long lines
(2) Discrimination according to sellers’ biases
 These mechanisms are often unfair, and
inefficient: the goods do not necessarily go to the
buyers who value them most highly.
 In contrast, when prices are not controlled,
the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal (and thus fair).
7
EXAMPLE 2: The Market for Unskilled Labor
Wage W S
paid to
unskilled
workers
$6.00
Eq’m w/o
price
controls
D
L
500
Quantity of
unskilled workers
8
How Price Floors Affect Market Outcomes
A price floor W
below the S
eq’m price is
not binding –
has no effect $6.00
on the market
outcome. Price
$5.00
floor
D
L
500
9
How Price Floors Affect Market Outcomes
labor
The eq’m wage ($6) W surplus S
is below the floor Price
and therefore $7.25
floor
illegal.
The floor $6.00
is a binding
constraint
on the wage,
causes a D
surplus (i.e., L
400 550
unemployment).
10
The Minimum Wage
Min wage laws unemp-
do not affect W loyment S
highly skilled Min.
$7.25
workers. wage
They do affect $6.00

teen workers.
Studies:
A 10% increase
in the min wage D
raises teen L
400 550
unemployment
by 1–3%.
11
ACTIVE LEARNING 1
Price controls The market for
P
140 hotel rooms
S
130
Determine
120
effects of:
110
A. $90 price 100
ceiling 90
B. $90 price 80 D
floor 70
C. $120 price 60
floor 50
40
0 Q
50 60 70 80 90 100 110 120 130
ACTIVE LEARNING 1
A. $90 price ceiling The market for
P
140 hotel rooms
The price S
falls to $90. 130
120
Buyers 110
demand 100
120 rooms, Price ceiling
90
sellers supply 80 D
90, leaving a shortage = 30
70
shortage. 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
ACTIVE LEARNING 1
B. $90 price floor The market for
P
140 hotel rooms
Eq’m price is S
130
above the floor,
120
so floor is not
110
binding.
100
P = $100, 90
Q = 100 rooms. Price floor
80 D
70
60
50
40
0 Q
50 60 70 80 90 100 110 120 130
ACTIVE LEARNING 1
C. $120 price floor The market for
The price P
140 hotel rooms
surplus = 60 S
rises to $120. 130
120
Buyers Price floor
110
demand
100
60 rooms,
90
sellers supply
80 D
120, causing a
70
surplus.
60
50
40
0 Q
50 60 70 80 90 100 110 120 130
Evaluating Price Controls
 Recall one of the Ten Principles from Chapter 1:
Markets are usually a good way
to organize economic activity.
 Prices are the signals that guide the allocation of
society’s resources. This allocation is altered
when policymakers restrict prices.
 Price controls often intended to help the poor,
but often hurt more than help.
16
Taxes
 The govt levies taxes on many goods & services
to raise revenue to pay for national defense,
public schools, etc.
 The govt can make buyers or sellers pay the tax.
 The tax can be a % of the good’s price,
or a specific amount for each unit sold.
 For simplicity, we analyze per-unit taxes only.
17
EXAMPLE 3: The Market for Pizza
Eq’m
w/o tax P
S1
$10.00
D1
Q
500
18
A Tax on Buyers
Hence,
The a tax
price on buyers
buyers pay Effects of a $1.50 per
shifts
is nowthe D curve
$1.50 down
higher than unit tax on buyers
by the
the amount
market ofP.
price the tax. P
P would have to fall S1
by $1.50 to make
buyers willing $10.00
Tax
to buy same Q
as before. $8.50
E.g., if P falls D1
from $10.00 to $8.50, D2
buyers still willing to Q
500
purchase 500 pizzas.
19
A Tax on Buyers
New eq’m: Effects of a $1.50 per
unit tax on buyers
Q = 450 P
Sellers S1
receive PB = $11.00
Tax
PS = $9.50 $10.00
Buyers pay PS = $9.50
PB = $11.00
D1
Difference
between them D2
= $1.50 = tax Q
450 500
20
The Incidence of a Tax:
how the burden of a tax is shared among
market participants
P
In our
S1
example, PB = $11.00
Tax
buyers pay $10.00
$1.00 more, PS = $9.50
sellers get
$0.50 less. D1
D2
Q
450 500
21
A Tax on Sellers
The tax effectively raises Effects of a $1.50 per
sellers’ costs by unit tax on sellers
P S2
$1.50 per pizza. $11.50
Tax S1
Sellers will supply
500 pizzas
$10.00
only if
P rises to $11.50,
to compensate for
this cost increase. D1
Hence, a tax on sellers shifts the Q

S curve up by the amount of the tax. 500
22
A Tax on Sellers
New eq’m: Effects of a $1.50 per
unit tax on sellers
Q = 450 P S2
Buyers pay S1
PB = $11.00 PB = $11.00
Tax
Sellers $10.00
receive PS = $9.50
PS = $9.50
D1
Difference
between them
= $1.50 = tax Q
450 500
23
The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!
What matters P
is this: S1
PB = $11.00
A tax drives Tax
a wedge $10.00
between the PS = $9.50
price buyers
pay and the D1
price sellers
receive. Q
450 500
24
ACTIVE LEARNING 2
Effects of a tax The market for
P
140 hotel rooms
Suppose govt S
130
imposes a tax
120
on buyers of
110
$30 per room.
100
Find new 90
Q, PB, PS, 80 D
and incidence 70
of tax. 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
ACTIVE LEARNING 2
Answers The market for
P
140 hotel rooms
S
130
Q = 80
120
PB = $110 PB = 110
PS = $80 100
Tax
90
PS = 80 D
Incidence
70
buyers: $10 60
sellers: $20 50
40
0 Q
50 60 70 80 90 100 110 120 130
Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand
P
It’s easier
for sellers
PB S
than buyers
Buyers’ share
to leave the
of tax burden
Tax market.
Price if no tax So buyers
Sellers’ share
bear most of
PS
of tax burden the burden
of the tax.
D
Q
27
Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply
It’s easier
P
S for buyers
Buyers’ share than sellers
of tax burden PB to leave the
market.
Price if no tax
Tax Sellers bear
Sellers’ share most of the
of tax burden PS burden of
D the tax.
Q
28
CASE STUDY: Who Pays the Luxury Tax?
 1990: Congress adopted a luxury tax on yachts,
private airplanes, furs, expensive cars, etc.
 Goal: raise revenue from those who could most
easily afford to pay—wealthy consumers.
 But who really pays this tax?
29
CASE STUDY: Who Pays the Luxury Tax?
The market for yachts Demand is
price-elastic.
P
S
In the short run,
Buyers’ share
of tax burden PB supply is inelastic.
Tax Hence,
companies
Sellers’ share
that build
of tax burden PS
D yachts pay
most of
Q the tax.
30
ACTIVE LEARNING 3
The 2011 payroll tax cut
Prior to 2011, the Social Security payroll tax was 6.2%
taken from workers’ pay and 6.2% paid by employers
(total 12.4%).
The Tax Relief Act (2010) reduced the worker’s
portion from 6.2% to 4.2% in 2011, but left the
employer’s portion at 6.2%.
QUESTION:
Should this change have increased the typical
worker’s take-home pay by exactly 2%, more than
2%, or less than 2%? Do any elasticities affect
your answer? Explain.
ACTIVE LEARNING 3
Answers
 As long as labor supply and labor demand both
have price elasticity > 0, the tax cut will be shared
by workers and employers, i.e.,
workers’ take-home pay will rise less than 2%.
 The answer does NOT depend on whether labor
demand is more or less elastic than labor supply.
FOLLOW-UP QUESTION:
Who gets the bigger share of this tax cut, workers
or employers? How do elasticities determine the
answer?
ACTIVE LEARNING 3
Answers to follow-up question
 If labor demand is more elastic than labor supply,
workers get more of the tax cut than employers.
 If labor demand is less elastic than labor supply,
employers get the larger share of the tax cut.
CONCLUSION: Government Policies and the
Allocation of Resources
 Each of the policies in this chapter affects the
allocation of society’s resources.
 Example 1: A tax on pizza reduces eq’m Q.
With less production of pizza, resources
(workers, ovens, cheese) will become available
to other industries.
 Example 2: A binding minimum wage causes
a surplus of workers, a waste of resources.
 So, it’s important for policymakers to apply such
policies very carefully.
34
Summary
• A price ceiling is a legal maximum on the price of
a good. An example is rent control. If the price
ceiling is below the eq’m price, it is binding and
causes a shortage.
• A price floor is a legal minimum on the price of a
good. An example is the minimum wage. If the
price floor is above the eq’m price, it is binding
and causes a surplus. The labor surplus caused
by the minimum wage is unemployment.
Summary
• A tax on a good places a wedge between the
price buyers pay and the price sellers receive,
and causes the eq’m quantity to fall, whether the
tax is imposed on buyers or sellers.
• The incidence of a tax is the division of the
burden of the tax between buyers and sellers,
and does not depend on whether the tax is
imposed on buyers or sellers.
• The incidence of the tax depends on the price
elasticities of supply and demand.

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How do price ceilings and price floors affect market outcomes?

How do taxes affect market outcomes? How do the effects depend on whether the tax is imposed on buyers or sellers?

Seventh Edition

Wojciech Gerson (1831-1901)

CHAPTER Supply, Demand, and

• What are price ceilings and price floors?

We will use the supply/demand model to see

The eq’m price P S

In the long run, P S

They do affect $6.00

Hence, a tax on sellers shifts the Q

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