Principles of Microeconomics Chapter 6 Supply, Demand, & Government Policies

Ch. 6 - Supply, Demand, and Government Policies

6-1 Controls on Prices

• Price ceiling: legislated max price

• Price floor: legislated min price

• How Price Ceilings Affect Market Outcomes

  • If equilibrium price < price ceiling = not binding (market forces move economy to eq.; price ceiling has no effect on price/qty)

  • If equilibrium price > price ceiling = binding constraint (market moves towards eq. But cannot reach it when it reaches the ceiling) → causes shortage 

  • Because of shortage: long lines, sell only based on personal biases (so a price ceiling does not benefit ALL buyers) 

  • GENERAL RESULT: When the government imposes a BINDING price ceiling on a competitive market, there is a SHORTAGE of goods, and sellers must RATION the SCARCE goods among the large # of potential buyers (rationing mechanisms are undesirable) 

  • Examples: gas shortages and rent control 

• How Price Floors Affect Market Outcomes

  • If equilibrium price > price floor = not binding (price floor has no effect)

  • If equilibrium price < price floor = binding constraint (market prices cannot fall further) → causes surplus 

  • Binding price floors can lead to undesirable rationing mechanisms (ex. Sellers who appeal to personal biases of buyers can sell better)

  • Examples: minimum wage (surplus of labor → minimum wage raises income of workers who have jobs, but lowers incomes of would-be worked who are now unemployed)

  • Employment affected by elasticity of demand, unemployment affected by elasticity of demand and supply

  • If unskilled labor is inelastic, a rise in the min wage will INCREASE total wage pay to unskilled labor

• Evaluating Price Controls

  • Legally setting prices → obscures signals that normally guide allocation of resources

  • Rent-control (tries to make housing more affordable, but lowers quality of buildings)

  • Minimum wage (tries to help people escape poverty, but causes other workers to become unemployed)

  • Rent and wage subsidies (ex. Earned income tax credit)

  • Results of Rental-Control Laws:

  • •    Landlords provide less maintenance under rent control and are unlikely to upgrade their units because they cannot pass on these costs to tenants through higher rents. Because of reduced maintenance, quality suffers and housing units deteriorate more quickly.

  • •    Because the profitability of owning and renting apartment units decreases with rent control, landlords construct fewer new units and may even convert existing apartments to more profitable uses. This decreases the number of units available to renters in the future.

  • •    A shortage (excess demand) of housing units may lead renters to make under-the-table payments to secure an apartment. This can lead to the development of a black market for rental units.

  • •    Because price is no longer an effective mechanism of rationing apartments, alternative methods of rationing will emerge, such as screening processes or personal networking connections.

6-2 Taxes

• Tax incidence: how the burden of a tax is distributed among the various people in the economy

• How Taxes on Sellers Affect Market Outcomes

  • Supply curve shifts left

  • To compensate the buyers’ tax, the market price will be that amount higher (although the tax is levied on sellers, BOTH buyers and sellers share the burden of the tax) 

  • If equilibrium quantity falls, the tax reduces the size of the ice cream market

  • Taxes DISCOURAGE market activity (quantity of a good sold is smaller in the new equilibrium)

  • Buyers and sellers SHARE the burden of taxes (buyers pay more, sellers receive less) 

• How Taxes on Buyers Affect Market Outcomes

  • Demand curve shifts left

  • Buyers pay higher than the market price, so they demand a quantity as if the market price was higher than it actually is 

  • Sellers get lower price; buyers pay a lower market price to sellers than previously did, but the EFFECTIVE price rises

  • Taxes levied on sellers IS EQUAL to taxes levied on buyers

  • Buyers and sellers share the burden REGARDLESS of HOW the tax is levied

  • Payroll tax: a tax on the wages that firms pay workers (half paid out of firms’ revenues, half from workers’ paychecks)  

  • 
    

• Elasticity and Tax Incidence

  • Who bears most of the burden of the tax? Buyers if demand curve is inelastic, sellers if supply curve is inelastic (think of how steep the curves are; steeper = less elastic) 

  • Tax burden falls more heavily on the side of the market that is LESS elastic (they have fewer alternatives)

  • Luxury tax - demand is elastic but supply is inelastic, tax burden falls heavier on suppliers