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Supply, Demand andGovernment Policies
Chapter 6
Copyright © 2001 by Harcourt, Inc.
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Supply, Demand, andGovernment Policies
u In a free, unregulated market system,market forces establish equilibrium pricesand exchange quantities.
u One of the things government can do is toset price controls when the market price isseen as unfair to either buyers or sellers.
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Price Ceilings & Price Floors
Price Ceilingu A legally established maximum price at which
a good can be sold. (Rent Controls)
Price Flooru A legally established minimum price at which a
good can be sold. (Price Supports forAgriculture)
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Price Ceilings
Two outcomes are possible when thegovernment imposes a price ceiling:
u The price ceiling is not binding if set abovethe equilibrium price.
u The price ceiling is binding if set below theequilibrium price, leading to a shortage.
u Binding means that there is an economicimpact.
A Price Ceiling That Is Binding...
$3
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
2
Demand
Supply
Equilibriumprice
Priceceiling
Shortage
125Quantity
demanded
75Quantitysupplied
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A Price Ceiling That Is Not Binding...
$4
3
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Demand
Supply
Priceceiling
Equilibriumprice
100Equilibrium
quantity
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Effects of Price Ceilings
A binding price ceiling creates ...º shortages because QD > QS.
u Example: Gasoline shortage of the1970s
º nonprice rationingu Examples: Long lines, Discrimination
by sellers
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The Price Ceiling on Gasoline IsNot Binding...
$4
P1
Quantity ofGasoline
0
Price ofGasoline
Q1
Demand
Supply
Priceceiling
1. Initially,theprice ceilingis notbinding...
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The Price Ceiling on Gasoline IsBinding...
P1
Quantity ofGasoline
0
Price ofGasoline
Q1
Demand
S1
Priceceiling
S2 2. …butwhen supplyfalls...
P2
3. …the priceceiling becomesbinding...4. …resulting
in a shortage.
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Rent Controlu Rent controls are ceilings placed on the
rents that landlords may charge theirtenants.
u Rent control can make housing moreaffordable.
u With a price ceiling, you cannot goabove the ceiling.
u But what about the landlords?
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Rent Control in the Short Run...
Quantity ofApartments
0
RentalPrice of
Apartment
Demand
Supply
Controlled rent
Shortage
Supply anddemand forapartments
are relativelyinelastic-Whyis the supply
curve vertical?
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Rent Control in the Long Run...
Quantity ofApartments
0
RentalPrice of
Apartment
Demand
Supply
Controlled rent
Shortage
Because the supplyand demand forapartments are
more elastic... Whathappens in the long
run?
…rent controlcauses a large
shortage
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Price Floors
When the government imposes aprice floor, two outcomes arepossible.
u The price floor is not binding if set belowthe equilibrium price.
u The price floor is binding if set above theequilibrium price, leading to a surplus.
u Think of price floors as not being able to gobelow the floor.
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A Price Floor That Is Not Binding...
$3
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
100Equilibrium
quantity
Equilibriumprice
Demand
Supply
Pricefloor2
A Price Floor That Is Binding...
$3
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Equilibriumprice
Demand
Supply
Price floor$4
120Quantitysupplied
80Quantity
demanded
Surplus
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Effects of a Price Floor
A binding price floor causes . . .º a surplus because QS >QD.º nonprice rationing is an alternativemechanism for rationing the good,using discrimination criteria.
uExamples: The minimum wage, Agriculturalprice supports
uState Minimum Wages
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The Minimum Wage
Quantity ofLabor
0
Wage
Equilibriumwage
Labor demand
Labor supply
A Free Labor Market
Equilibriumemployment
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Minimumwage
The Minimum Wage
Quantity ofLabor
0
Wage
Labor demand
Labor supply
Quantitysupplied
Quantitydemanded
Labor surplus(unemployment)
A Labor Market with aMinimum Wage
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What are some potentialimpacts of taxes?
u Taxes are used to raisemoney for thegovernment.
u Taxes discourage marketactivity.
u When a good is taxed, thequantity sold is smaller.
u Buyers and sellers sharethe tax burden.
u But who bears theburden-tax incidence.
3.00
Quantity ofIce-Cream Cones
0
Price ofIce-Cream
Cone
10090
$3.30
Pricebuyers
pay
D1
D2
Equilibriumwith tax
Supply, S1
Equilibrium without tax
Impact of a 50¢ Tax Levied onBuyers...
2.80
Pricesellersreceive
Copyright © 2001 by Harcourt, Inc. All rights reserved
Pricewithout
tax
Tax ($0.50)
3.00
Quantity ofIce-Cream Cones
0
Price ofIce-Cream
Cone
10090
S1
S2
Demand, D1
Impact of a 50¢ Tax on Sellers...
Pricewithout
tax2.80
Pricesellersreceive
$3.30
Pricebuyers
pay
Equilibrium without tax
Copyright © 2001 by Harcourt, Inc. All rights reserved
A tax on sellersshifts the
supply curveupward by theamount of thetax ($0.50). Tax ($0.50)
Equilibriumwith tax
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The Incidence of Tax
uIn what proportions is the burden ofthe tax divided?
uHow do the effects of taxes on sellerscompare to those levied on buyers?
The answers to these questionsdepend on the elasticity of demand
and the elasticity of supply.
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Elastic Supply, Inelastic Demand...
Quantity0
Price
Demand
Supply
Tax
1. When supply is moreelastic than demand...
2. ...theincidence of thetax falls moreheavily onconsumers...
3. ...than onproducers.
Price without tax
Price buyers pay
Price sellers receive
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Inelastic Supply, Elastic Demand...
Quantity0
Price
Demand
Supply
Price without tax
Tax
1. When demand is moreelastic than supply...
2. ...theincidence of the tax falls more heavily on producers...
3. ...than on consumers.
Price buyers pay
Price sellers receive
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