LECTURE #5: MICROECONOMICSCHAPTER 6

Government InterventionPolicy Objectives

Policy Tools

Government Intervention in the Market

Policy ObjectivesReduce / Increase DemandReduce / Increase Supply

Government Intervention in the Market

Policy ToolsPrice Controls

Rent Controls (increased demand – reduced supply)

Wage Controls (minimum wage laws) – reduced employment

Price Ceilings (may decrease supply)

Credit ControlsInterest rates = cost of credit (borrowing)Money Supply = liquidity

TaxesIncreases tends to reduce demandReduced supplyOn whom does the burden fall? Sellers or Buyers?

Market with a Price Ceiling

4

Price ofIce

CreamCones

Quantity of Ice-Cream Cones 0

Demand

100

(a) A price ceiling that is not binding

In panel (a), the government imposes a price ceiling of $4. Because the price ceiling is above the equilibrium price of $3, the price ceiling has no effect. In panel (b), the government imposes a price ceiling of $2. Because the price ceiling is below the equilibrium price of $3, the market price equals $2. At this price, 125 cones are demanded and only 75 are supplied - a shortage of 50 cones.

(b) A price ceiling that is binding

3

Supply

$4 Price ceiling

Equilibriumprice

Equilibriumquantity

Price ofIce

CreamCones

Quantity of Ice-Cream Cones 0

Demand

$3

Supply

2 Price ceiling

Equilibriumprice

75

Quantitydemanded

Quantitysupplied

125

Shortage

Market With A Price Floor

5

Price ofIce

CreamCone

Quantity of Ice-Cream Cones 0

Demand

100

(a) A price floor that is not binding

In panel (a), the government imposes a price floor of $2. Because this is below the equilibrium price of $3, the price floor has no effect. In panel (b), the government imposes a price floor of $4, which is above the equilibrium price of $3. Therefore, the market price equals $4. Because 120 cones are supplied at this price and only 80 are demanded, there is a surplus of 40 cones.

(b) A price floor that is binding

$3

Supply

2 Price floor

Equilibriumprice

Equilibriumquantity

Price ofIce

CreamCone

Quantity of Ice-Cream Cones 0

Demand

3

Supply

$4Price floor

Equilibriumprice

80

Quantitysupplied

Quantitydemanded

120

Surplus

Tax On Sellers

6

Price ofIce-Cream

Cone

Quantity ofIce-Cream Cones

0

Demand, D1

90

When a tax of $0.50 is levied on sellers, the supply curve shifts up by $0.50 from S1 to S2. The equilibrium quantity falls from 100 to 90 cones. The price that buyers pay rises from $3.00 to $3.30. The price that sellers receive (after paying the tax) falls from $3.00 to $2.80. Even though the tax is levied on sellers, buyers and sellers share the burden of the tax.

S1

S2

100

$3.30

3.00

2.80

Pricebuyers

pay

Pricewithout

tax

Pricesellersreceive

A tax on sellersshifts the supplycurve upwardby the size ofthe tax ($0.50).

Tax($0.50) Equilibrium without tax

Equilibrium with tax

Tax on Buyers

7

Price ofIce-Cream

Cone

Quantity ofIce-Cream Cones

0

D1

90

When a tax of $0.50 is levied on buyers, the demand curve shifts down by $0.50 from D1 to D2. The equilibrium quantity falls from 100 to 90 cones. The price that sellers receive falls from $3.00 to $2.80. The price that buyers pay (including the tax) rises from $3.00 to $3.30. Even though the tax is levied on buyers, buyers and sellers share the burden of the tax.

Supply, S1

100

$3.30

3.00

2.80

Pricebuyers

pay

Pricewithout

tax

Pricesellersreceive

A tax on buyersshifts the demandcurve downwardby the size ofthe tax ($0.50).

Tax($0.50)

Equilibrium without tax

Equilibrium with tax

D2

How Taxes on Buyers Affect Market Outcomes

Buyers and sellers share the burden of the taxSellers get a lower price: Worse offBuyers pay a higher effective price

with taxes: Worse off

Taxes levied on sellers and taxes levied on buyers are equivalent

8

Taxes

Tax burden - falls more heavily on the side of the market that is less elasticSmall elasticity of demand

Buyers do not have good alternatives to consuming this good

Small elasticity of supplySellers do not have good

alternatives to producing this good

9

Homework

Questions for Review: 2, 3, 4, 6Problems and Applications: 1, 2, 3, 6