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ECO2201 - Slides - 2.4 - Government Policies
ECO2201 - Slides - 2.4 - Government Policies
C h a p t e r 6 : S u p p l y, D e m a n d , a n d G o v e r n m e n t
Policies
Supply, Demand,
and Government Policies
Lesson 2.4
Road Map
1. Overview
2. Price Ceiling: PC
3. Price Floor: PF
4. Taxes
5. Market Clearing through Prices
Review & Exercises
2
1. Overview
• So far, we assume that the market is perfectly competitive and
hence the price is given.
• Moreover, it is assumed that the government plays no role in the
market: it does not intervene either price or quantity. Thus, market
forces (demand and supply) lead the market to equilibrium price
(and quantity.)
• Practically, several governments all over the world adopt a
minimum wage law (stating the lowest possible wage firms have to
pay their workers).
3
1. Overview
• The minimum wage set by these governments are likely not the same
as the equilibrium wage determined by the market forces (demand
and supply).
• This kind of action that the governments pursue is called government
market intervention.
• What are the consequences of such an action (e.g. on price and
quantity)?
– We can use the demand‐supply framework to examine the
consequences of such an action (e.g. on price and quantity)
4
1. Overview
• Types of Government Market Intervention
1. Price control
• Imposing a limit on the price of goods and services.
• Two types of limit: (1) price ceiling: PC and (2) price floor: PF.
2. Taxes
• Imposing a tax on goods and services (government can make buyers or
sellers pay a specific amount on each unit)
– Note that in this lesson, we will only focus on price controls and tax . But in
practice, there are other forms of government market intervention such as
quantity restrictions, subsidies, and third‐party‐payer markets.
5
1. Overview
• These government market interventions often lead to
inefficient allocation of resources.
• This is not surprising given that the action prevents the
market to reach an equilibrium price and quantity.
6
2. Price Ceiling (PC)
• Price ceiling (PC) is the maximum legal limit on
P
S
price (a suppressed price) that all sellers can
charge for their goods and services, by which the
government suppresses the price.
Peq=$800
• The government usually sets ceiling prices on
PC=$500
necessity goods of which equilibrium prices are so Shortage
D
high that many people cannot afford.
250 450 Q
• E.g. rent controls, borrowing interest rates, food
QS QD
price controls during the flood crisis
• https://www.youtube.com/watch?v=1EzY4Vl460U
7
Example 1: The Market for Apartments
Rental price of P
apartments S
Equilibrium without
price controls
$800
D
Q
300 Quantity
of apartments
8
2. Price Ceiling (PC)
Effectiveness of price ceiling
What will happen when PC > Peq? P Price
S
Maximum price the sellers can charge ceiling
is at $1000, but everyone in the $1000
market (including the sellers) will just
be happy to trade at the equilibrium $800
price of $800.
o That is, the price ceiling of $1000 is
not effective (not binding), and people
will just ignore it.
o The market is at the equilibrium, no D
shortage or surplus. 300 Q
Hence, Price Ceilings has no effect on
the market outcome.
9
2. Price Ceiling (PC)
Effectiveness of price ceiling
What will happen when PC< P S
Peq?
• Maximum price the sellers can charge
is at $500
$800
• the equilibrium price ($800) is above Price
ceiling
the ceiling and therefore illegal.
• This means the rental price is cheaper $500
than it should have been
shortage
• We should see a shortage of D
apartments (QD > QS). Q
250 400
Hence, the price ceiling is effective
(binding), causes a shortage.
10
2. Price Ceiling (PC)
Effectiveness of price ceiling
• The effectiveness of price ceiling depends on where it is set.
• Effective price ceiling must be below equilibrium price: PC ≤ Peq
• Ineffective price ceiling is when it is set higher than the equilibrium
price: PC > Peq.
– The price ceiling is not binding.
– All sellers are perfectly fine if price ceiling is set above the equilibrium
price (PC > Peq), and the market will reach the equilibrium (no shortage or
surplus) again.
11
2. Price Ceiling (PC)
Effectiveness of PC
P P ($/unit)
S S
PC
Peq Peq
PC
Shortage D D
QS Qeq QD Q Qeq Q
0 0
Effective (or binding) Price Ceiling Ineffective Price Ceiling
Total goods bought and sold = min(QD, QS) Total goods bought and sold = Qeq
= QS
12
2. Price Ceiling (PC)
Consequences of price ceiling
i. Shortage of Goods
– Because effective PC ≤ Peq, amount of goods being bought and sold is
min(QD, QS) = QS (i.e. too little is produced given the suppressed price.)
ii. Making sellers unhappy due to lower revenue.
iii. Not all consumers will be happy because only some of them can purchase
things cheaper.
– Rationing problem: Difficult to determine how to ration the limited output for
the consumers. (e.g. first‐come, first‐served basis?)
– Black markets: The good is illegally sold at a higher price than the PC.
13
3. Price Floor (PF)
• Price floor (PF) is the minimum price (an P
S
elevated price) that all sellers can charge for Surplus
their goods and services, by which the PF =$7.25
• The government usually sets price floor on
the goods of special interest groups, but the
D
equilibrium price is so low that it provides 400 550
Q
insufficient income for them. QD QS
• E.g. rice price guarantee and minimum wage.
14
3. Price Floor (PF)
Effectiveness of price floor
P S
What will happen when PF < Peq?
o Minimum price the sellers can charge is at
$5, but everyone in the market (including $6 Price
the sellers) will just be happy to trade at
floor
the equilibrium price of $6.
$5
o That is, the price floor of $5 is not
effective, and people will just ignore it.
D
o The market is at an equilibrium, no
shortage or surplus. 500 Q
A price floor below the equilibrium price
is not effective (not binding) – has no
effect on the market outcome.
15
3. Price Floor (PF)
Effectiveness of price floor Price
What will happen when PF > Peq? P surplus S floor
• Minimum price the sellers can charge is $7.25
at $7.25,
$6.00
• The equilibrium price ($6) is below the
floor and therefore illegal.
• This means the price is higher than it
should have been.
D
• We should see surplus of (QS > Qd). 400 550 Q
This price floor is effective (binding) causes
a surplus.
16
3. Price Floor (PF)
Effectiveness of price floor
• The effectiveness of price floor depends on where it is set.
• Effective price floor must be above equilibrium price: PF ≥ Peq
• Ineffective price floor is when it is set lower than the equilibrium
price: PF < Peq.
– The price floor is not binding.
– All buyers will be perfectly fine with paying cheaper for the goods, and
the market will adjust itself back to the equilibrium (no shortage or
surplus).
17
3. Price Floor (PF)
Effectiveness of price floor
P P
Surplus S S
PF
Peq Peq
PF
D D
0 QD Qeq QS Q 0 Qeq Q
Effective (or binding) Price Floor Ineffective Price Floor
Total goods bought and sold = min(QD, QS) Total goods bought and sold = Qeq
= QD
18
3. Price Floor (PF)
Consequences of price floor
i. Surplus of Goods
– Because effective PF ≥ Peq, amount of goods being bought and sold is
min(QD, QS) = QD (i.e. too much is produced given the elevated price.)
ii. Making consumers unhappy due to higher price.
iii.Not all producers will be happy because only some of them can
sell all their products at higher price.
– For example, the minimum wage law creates a surplus of labor, i.e.
unemployment which is an inefficient allocation of resources.
19
Example 2: Price controls
P
140
The market for hotel The market for S
130 hotel rooms
rooms is in equilibrium as
120
in the graph. 110
100
• Determine the effects
90
of:
80 D
A. $90 price ceiling 70
60
B. $90 price floor 50
40 Q
C. $120 price floor 0
50 60 70 80 90 100 110 120 130
20
Example 2: A. $90 price ceiling
140
P
The market for S
• The price falls to $90. 130
120
hotel rooms
(binding price ceiling
110
below the 100
equilibrium) 90
Price ceiling
80 D
• Buyers demand 70
shortage = 30
120 rooms, sellers 60
supply 90, leaving a 50
40
shortage. 050 60 70 80 90 100 110 120 130
Q
21
Example 2: B. $90 price floor
P
140
130 The market for S
• Equilibrium price is hotel rooms
120
above the $90 price 110
floor, so the price 100
Price floor
90
floor is not binding.
80 D
70
• P = $100,
60
Q = 100 rooms. 50
40
050 60 70 80 90 100 110 120 130
Q
22
Example 2: C. $120 price floor
P
140
surplus = 60 S
• The price rises to 130
120
$120. (binding price Price floor
110
floor above the 100
equilibrium) 90
80 D
• Buyers demand 70
60 rooms, sellers 60 The market for
supply 120, causing a 50 hotel rooms
40
surplus. 050 60 70 80 90 100 110 120 130
Q
23
4. Taxes
• Governments use taxes
– To raise revenue for public projects (e.g., Roads, schools, and national
defense)
– To control price, and (therefore) the market
• When the government levies a tax on a good, who actually bears the
burden of the tax? The buyers or sellers?
– Tax incidence is manner in which the burden of a tax is shared among
participants in a market
• The government can make the seller or the buyer to pay the tax
• If buyers and sellers share the tax burden, what determines how the
burden is divided?
24
Example 3: The Market for Pizza
P
S1
Equilibrium
$10.00
without tax
D1
Q
500
25
4. Taxes: A Tax on Buyers
Effects of a $1.50 per unit tax on • The price buyers pay is now
$1.50 higher than the market
P buyers
price P.
S1 • P would have to fall by $1.50 to
make buyers willing to buy
$10.00 same Q as before.
Tax
• Hence, a tax on buyers shifts
the D curve down by the
$8.50 amount of the tax.
D1
• E.g., if P falls from $10.00 to
D2
$8.50, buyers are still willing to
Q
500 purchase 500 pizzas.
26
4. Taxes: A Tax on Buyers
Effects of a $1.50 per unit tax on
buyers
P
New equilibrium:
S1
PB = $11.00
Tax • Qeq = 450
$10.00
• Sellers receive PS = $9.50
PS = $9.50
• Buyers pay PB = $11.00
D1 • Difference between PS
D2 and PB = $1.50 = tax
450 500 Q
27
4. Taxes: The Incidence of a Tax
How the burden of a tax is shared among
market participants P
In our example, PB = $11.00
S1
Tax
Buyers pay $10.00
$1.00 more, PS = $9.50
Sellers get
$0.50 less. D1
D2
Q
450 500
28
4. Taxes: A Tax on Sellers
Effects of a $1.50 per unit tax on
sellers • The tax effectively raises
P sellers’ costs by $1.50 per
S2
$11.50 pizza.
Tax S1
• Sellers will supply 500 pizzas
only if P rises to $11.50, to
$10.00
compensate for this cost
increase.
• Hence, a tax on sellers shifts
D1
the S curve up by the amount
Q of the tax.
500
29
4. Taxes: A Tax on Sellers
Effects of a $1.50 per unit tax on
sellers
New equilibrium:
P S2
PB = $11.00
S1 • Q = 450
Tax
$10.00 • Buyers pay PB = $11.00
PS = $9.50 • Sellers receive PS =
$9.50
D1
• Difference between PS
Q
and PB = $1.50 = tax
450 500
30
4. Taxes: The Incidence of a Tax 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!
P
S1
PB = $11.00
Tax
A tax drives $10.00
a wedge between the PS = $9.50
price buyers pay and
D1
the price sellers receive.
450 500 Q
31
Example 4: Effects of a tax
P
140
The market for hotel rooms The market for S
130
is in equilibrium as in the hotel rooms
120
graph. 110
• Suppose the government 100
90
imposes a tax on buyers
80 D
of $30 per room 70
• Find the new 60
50
Q, PB, PS, and incidence
40
of tax. 050 60 70 80 90 100 110 120 130
Q
32
Example 4: Effects of a tax
P
140
The market for S
• Q = 80 130
hotel rooms
120
• PB = $110 PB = 110
100
Tax
• PS = $80 90
PS = 80 D
• Incidence 70
60
– buyers: $10 50
40
– sellers: $20 050 60 70 80 90 100 110 120 130
Q
33
Tax Incidence and Elasticity*
• When a good is taxed, buyers and sellers of the good share the
burden of the tax.
• But how exactly is the tax burden divided?
– Only rarely will it be shared equally. It depends on the price elasticity *
of buyers and sellers
– A tax burden falls more heavily on the side of the market that is less
elastic*
• Note:
– Elasticity is the measurement of how responsive of buyers and seller is
to a change in price
• * We will study Elasticity in the lesson 3
34
Tax Incidence and Elasticity*
CASE 1: Supply is more elastic than demand
P
It’s easier for
Buyers’ share of PB S sellers than
tax burden buyers to leave
Tax the market.
Price if no tax
So buyers bear
Sellers’ share of PS most of the
tax burden burden of the
D
tax.
Q
35
Tax Incidence and Elasticity*
CASE 2: Demand is more elastic than supply
P
S • It’s easier for buyers
Buyers’ share of than sellers to leave
tax burden PB
the market.
Price if no tax • Sellers bear most of
Tax
the burden of the
Sellers’ share of
tax burden PS tax.
D
36
Review & Exercise
Effective vs. Ineffective Policies
38
Tax and Tax Incidence
P
S
Buyers’ share of
tax burden PB
Price if no tax
Tax
Sellers’ share of
tax burden PS
D
39
Exercise 1: Price Controls
• Modified from Bresnock’s class materials.
• Suppose we have the following demand‐supply table for toys (where
prices are in USD and quantities in units).
Quantity
Price Quantity Supplied
Demanded
$5 440 240
$10 380 280
$15 320 320
$20 260 360
40
Exercise 1: Price Controls
i. What is the equilibrium price and quantity?
Quantity Quantity
Price
Demanded Supplied
$5 440 240
$10 380 280
$15 320 320
$20 260 360
41
Exercise 1: Price Controls
ii. What would happen if there is an increase in to price from $5
to $10?
Quantity Quantity
Price
Demanded Supplied
$5 440 240
$10 380 280
$15 320 320
$20 260 360
– Movement along the curve (not a shift of the curve) when the
price of the good changes.
– So, quantity demanded falls from 440 to 380 units.
42
Exercise 1: Price Controls
iii. What would happen if the government establishes a legal price of
$10? To be effective, should this legal price be price floor or a price
ceiling?
Quantity Quantity
Price
Demanded Supplied
$5 440 240
$10 380 280
$15 320 320
$20 260 360
– Since Peq = $15 > the legal price of $10
– This must be an effective price ceiling.
43
Exercise 1: Price Controls
iv. If the price ceiling is set at $10, will there be a shortage or surplus? If so,
how much is it? What is the amount of good being bought or sold at the
legal price of $10?
– Recall that a price ceiling suppresses the
Quantity Quantity
Price market price.
Demanded Supplied
$5 440 240 • At P = $10, QD = 380 and QS = 280
$10 380 280 • So, shortage = 380 – 280 = 100 units.
$15 320 320 – Recall we use min(QD, QS) to find the
$20 260 360
amount of good bought/sold.
• At P = $10, QD = 380 and QS = 280
• So, the amount of good bought/sold =
min(380, 280) = 280 units.
44
Exercise 1: Price Controls
• What if the government sets a price ceiling at $20?
Quantity Quantity
Price
Demanded Supplied
$5 440 240
$10 380 280
$15 320 320
$20 260 360
– PC > Peq means that the price ceiling is not effective.
• There will be no shortage or surplus.
– Amount of of goods being bought (or sold) is Qeq = 320 units
at Peq = $15.
45
Exercise 1: Price Controls
• What would happen if demand decreases by 50 units at each
price, while supply increases by 50 units at each price?
– Quantity changes by a fixed amount at each price means that
the curve shifts.
– New demand: old demand – 50 units
– New supply: old supply + 50 units
46
Exercise 1: Price Controls
• What would happen if demand decreases by 50 units at each
price, while supply increases by 50 units at each price?
• Given the new demand and the new supply, can you find out
the new Peq and Qeq?
47
Exercise 2: Price controls and Tax
• Suppose the inverse demand and supply functions for cars are as
follows.
QD = ‐ 2P + 12,000
QS= P + 6,000
Where P is price in thousand baht and Q is quantity of cars/year.
• Find equilibrium price and quantity.
48
Exercise 2: Price controls and Tax
Find equilibrium price and quantity.
• We just need to solve the two equations with QD = QS = Qeq.
– Demand: QD = ‐ 2P + 12,000
– Supply: QS= P + 6,000
• So, we have
– Step 1: ‐ 2P + 12,000 = P + 6,000
– Step 2: 3Peq = 6,000
– Step 3: Peq = 2000 thousand baht = 2 million baht
49
Exercise 2: Price controls and Tax
• Find equilibrium price and quantity.
– To find Qeq, we just need to plug Peq of 2 million baht into either
of the two equations.
Supply: QS= P + 6,000
So, we have
• Step 1: Qeq = – 2,000 + 12,000 OR Peq = 2,000 +6,000
• Step 2: Qeq = 8,000 cars
50
Exercise 2: Price controls and Tax
• If the government sets a price ceiling at 3 million baht, will
there be shortages or surpluses and how much?
– We must check whether the policy is effective or not.
• The price ceiling is effective when PC < Peq.
– But PC = 3 million baht > Peq = 2 million baht, the price ceiling is
NOT effective
– There will be no shortage or surplus.
• The amount of goods being bought/sold is Qeq = 8,000 cars at
Peq = 2 million baht.
51
Exercise 2: Price controls and Tax
• What if the government sets a price ceiling at 1 million baht
instead?
– Again, we must check whether the policy is effective or not.
• The price ceiling is effective when PC < Peq.
• But PC = 1 million baht > Peq = 2 million baht.
– Thus, the price ceiling of 1 million baht is effective.
– There will be shortage.
52
Exercise 2: Price controls and Tax
• What if the government sets a price ceiling at 1 million baht
instead?
– To find QD, and QS, plug PC = 1,000 into:
Demand: QD = – 2P + 12,000 AND Supply: QS= P + 6,000 So, we have
• Step 1: QD = ‐ 2 x 1,000 + 12,000 = 10,000 cars
• Step 2: QS = 1,000 + 6,000 = 7,000 cars
• Shortage = 10,000 – 7,000 = 3,000 cars
• No. of cars being bought/sold = min(10,000, 7,000) = 7,000 cars
53
Exercise 2: Price controls and Tax
• Instead of a price control, the government levies a tax on producers
of 750 thousand baht (Ps = PB ‐ 750)
– As a result, the new supply curve is:
QS= Ps + 6000 = (PB ‐ 750) + 6000 = PB +5250
• Does a shortage or surplus (or neither) develop? What are the price,
quantity supplied, quantity demanded, and size of the shortage or
surplus?
– If the government levies a 1 million baht tax on producers, neither a
shortage nor a surplus develops, but the quantity exchanged is smaller
than without the tax.
54
Exercise 2: Price controls and Tax
– Using the new supply curve QS = PB +5250, we can find new
market equilibrium
– 2PB + 12,000 = QD = Qeq = QS = PB +5250
PB = 2,250 thousand baht = 2.25 million baht. And Ps = 1,500
thousand baht = 1.5 million baht
Qeq = 7,500 cars
– In sum, the price buyers pay is 2.25 million baht. Producers retain 1.5
million baht per car after submitting the 750 thousand baht tax. The
quantity demanded and supplied is 7,500 cars
55