Governmental Policyand

Supply and Demand

Price Controls• Price Ceilings– Highest legal price of a product or good– Binding if below market equilibrium• Leads to shortage

– Non-binding if above• Price Floor– Lowest legal price of a product or good– Binding if above market equilibrium• Leads to surplus

– Non-binding if below

Price Ceilings

D SP

Q

D SP

Q

Shortage

S* D*

No Effect

P^

P^

Examples: Caution-Using a Model• OPEC limits output, US gov’t places price

ceiling on gas– Led to shortage, long lines for gas– Unexpected side effect : small cars boom

• NY rent control– Short run (inelastic) vs Long run (more elastic)• SR small shortage, LR large shortage

– Other ways around• Key deposits, paying finders fees

– Other adverse effects• People less likely to move, inefficient • Lower quality housing (less incentive to keep up)

Price Floors

D SP

Q

D SP

Q

Surplus

S*D*

No Effect

P_

P_

Example: Caution-Using a Model• Minimum Wage– 1938 Fair Labor Standards Act

• Market– Workers Supply Labor (elastic/inelastic ?)– Employers Demand Labor (elastic/inelastic ?)

• Impact– Above equilibrium: surplus (unemployment)– Higher wages for those with jobs

• Difference by skills – Skilled Workers unaffected – why?– Unskilled/youth affected – why?

Subsidies and Taxes• Subsidy: get paid to buy or get paid to

produce/sell– Give incentive to participate in market– Market increases in size

• Tax: have to pay to buy or have to pay to produce/sell– Give disincentive to participate in market– Market decreases in size

• For both change in market size depends on combined elasticity of supply demand– More elastic bigger change

Subsidy• Regardless of subsidize buyer or seller– Outcome quantity is the same– Realized buyer/seller price the same– Market price differs by subsidy (also buyer/seller)

• Both Gain, but:• Who gains the most from the subsidy (seller or

buyer) depends on who’s curve is most inelastic

P

P’

Q’ Q

Subsidy

D’’D’

SP=P’’

BP=P’’-S

Q’’

P

P’

Q’ Q

Subsidy

D’

SP=P’’+S

BP=P’’

Q’’

S’’S’S’

Buyer Gets Subsidy Seller Gets Subsidy

Outcome P, Q, BP, SP(why shift curves up/down?)

SubsidyWedge

P’

SP

BP

D’

S’’

S’S’D’’

D’ D’

Subsidy WedgeView

Buyer Gets SubsidyView

Seller Gets SubsidyView

Q’ Q’’ Q’’ Q’’Q’ Q’

P’

D’

D’’ D’

S

D’’S

BP

BP

SPSP

Supply Curve More Inelastic soSeller Gains More

Demand Curve More Inelastic soBuyer Gains More

Who Gains? : Price Effect

SD’’

D’

S

D’’

D’

Q’ Q’’ Q’’Q’

Very Inelastic So Small Change In Quantity

Very Elastic So Large Change In Quantity

Effect on Size of Market

Winners/Losers• Winners– Buyers in market– Sellers in market

• Losers– Tax payers not in market– Competitors (trading partners)

Examples• Farm Subsidies– Who wins/loses– Rational

• Home Buying Subsidies (2 kinds)– Who wins/loses– Rational

• Ethanol Subsidies– Who wins/loses– Rational

Taxes• Regardless of taxing buyer or seller– Outcome quantity is the same– Realized buyer/seller price the same– Market price differs by tax (also buyer/seller)

• Both Lose, but:• Who loses the most from the tax (seller or

buyer) depends on who’s curve is most inelastic– Tax incident

P

Q’’ Q

Tax

D’D’’

P’SP=P’’

Q’

P

P’

Q’’ Q

Tax

D’

SP=P’’-T

BP=P’’

Q’

S’S’’S’

Buyer Gets Taxed Seller Gets Taxed

Outcome P, Q, BP, SP(why shift curve down/up?)

BP=P’’+T

P’

D’

D’’

D’

SD’’

S

BP

BP

SPSP

Supply Curve More Inelastic soSeller Loses More

Demand Curve More Inelastic soBuyer Loses More

Who Loses? : Price Effect

P’

Tax

Tax

SD’

D’’

S

D’

D’’

Q’’ Q’ Q’Q’’

Very Inelastic So Small Change In Quantity

Very Elastic So Large Change In Quantity

Effect on Size of Market

Winners/Losers• Losers– Buyers in market– Sellers in market

• Winners– Recipients of the tax money– Competitors (trading partners)

Examples• Payroll Tax – good is labor supplied by workers

demanded by firms– Employee and employer both pay half

• True Tax incidence– Depends on elasticity of supply(workers) and

demand(firms)• Change in market size– Depends if markets are elastic or inelastic

Example 2• Luxury tax introduced in 1990 to tax those

that can most afford to ‘splurge’– Luxury demand is elastic– Supply relatively inelastic

• Outcome– Most of tax incidence fell on suppliers– So repealed in 1992

Main Points – Subsidies/Taxes

• Tax or subsidy “creates” new hypothetical supply/demand curve– Same outcome if put on seller or buyer

• Subsidies increase market, taxes reduce it– How much depends how elastic market is

• Gain or lose from subsidy/tax split between buyers and sellers– Who gets more or pays more depends on who is more

inelastic• Difference between buyer/seller price is the tax or

subsidy size

TaxWedge

Buyer share of tax

Seller share of tax

Tax and its incidence

Subsidy Wedge

Seller share of subsidy

Buyer share of subsidy

P’ P’

Subsidyand its incidence

Review of Graphs(Note whose on ‘top’ switches)