Chapter 6

Chapter Overview

  • Title: Principles of Microeconomics, Tenth Edition

  • Source: Mankiw, Copyright: 2024 Cengage.

  • Contained: Principles of Microeconomics, Chapter 6: Supply, Demand, and Government Policies

Chapter Objectives

Objectives (1 of 2)

  • By the end of this chapter, you should be able to:

    • Determine the impact of price controls on economic welfare using the supply and demand model.

    • Determine if a price control is a price ceiling or a price floor using the supply and demand model.

    • Determine if a price control is binding using the supply and demand model.

    • Determine the amount of shortage or surplus generated by a price control using the supply and demand model.

Objectives (2 of 2)

  • Additional objectives include:

    • Describe the unintended consequences of rent control using the supply and demand model.

    • Explain how a change in a labor supply determinant impacts labor supply.

    • Identify the tax incidence on consumers and producers for a given market.

    • Determine the impact of a tax on the equilibrium price and quantity in a market.

    • Analyze the relationship between elasticity and tax burden.

Price Controls

  • General Definition:

    • Economists as policy analysts and advisers try to influence real-world opportunities.

    • Policymakers enact price controls when they perceive the market price of a good or service to be excessively high or low.

    • These policies can generate problems instead of solutions.

Types of Price Controls

Price Ceiling

  • Definition:

    • A legal maximum price at which a good can be sold.

  • Example:

    • Rent-control laws.

Price Floor

  • Definition:

    • A legal minimum price at which a good can be sold.

  • Example:

    • Minimum wage laws.

Effects of Price Ceilings on Market Outcomes

Binding vs Non-binding Price Ceilings

  • Non-binding Price Ceiling:

    • Set above the equilibrium price.

    • Has no effect on price or quantity sold.

  • Binding Price Ceiling:

    • Set below the equilibrium price.

    • Market price will reflect the price ceiling.

Active Learning Example

  • Scenario: The Muffin Buyers’ Association lobbies for a price ceiling on muffins.

    • Price Ceiling at $5:

    • Not binding, leads to P = $3, Q = 15.

    • Price Ceiling at $2:

    • Binding, leads to P = $2, Qd = 18, Qs = 10, resulting in a shortage of 8 muffins.

Market Illustration with Price Ceilings

Graphical Analysis:

  • Example: Price Ceiling at $4

    • Above the equilibrium price of $3, no effect on the market; equilibrium quantity is 100 cones.

  • Example: Price Ceiling at $2

    • Below equilibrium price: Quantity demanded is 125, quantity supplied is 75, leading to a shortage of 50 cones.

Challenges of Binding Price Ceilings

  • Outcomes:

    • Shortages arise.

    • Sellers must ration scarce goods among buyers, leading to undesirable rationing mechanisms.

    • Long waiting lines waste time.

    • Bias in seller decisions creates inefficiency, where goods may not go to the highest-value buyer.

Rationing Mechanisms

  • Free, Competitive Market Mechanism:

    • Allows anyone willing to pay the market price access to purchase goods.

    • May seem unfair when prices rise, but it is effective and impersonal.

Price Floors: Impact on Market Outcomes

Binding vs Non-binding Price Floors

  • Non-binding Price Floor:

    • Set below the equilibrium price, leading to no effect on price or quantity sold.

  • Binding Price Floor:

    • Set above the equilibrium price, preventing some sellers from selling their desired quantities.

Graphical Analysis:

  • Example: Price Floor at $2

    • Below equilibrium price of $3, leading to market equilibrium at 100 cones.

  • Example: Price Floor at $4

    • Above equilibrium price of $3, resulting in a surplus of 40 cones (120 supplied vs 80 demanded).

Economic Insights on Minimum Wage

  • Current U.S. Federal Minimum Wage:

    • $7.25 per hour.

    • States can increase this wage, with implications on employment rates for low-wage workers.

Effects in Competitive Labor Markets

  • Graphical Analysis:

    • Wage adjusts to balance supply and demand.

    • Binding minimum wage causes labor supply to exceed labor demand, leading to unemployment.

Evaluating Price Controls

Impact Assessment

  • Markets typically organize economic activities efficiently.

  • Price-setting distorts natural market signals that inform resource allocation.

  • Government interventions can sometimes improve market results if deemed necessary.

  • Unintended Consequences:

    • Price controls may disproportionately harm those they aim to help.

  • Alternative measures like rent or wage subsidies may yield better outcomes.

Tax Incidence

General Overview

  • Taxes

    • Governments impose taxes to generate public revenue.

  • Definition of Tax Incidence:

    • Refers to the distribution of tax burden among market participants.

Effects of Taxes on Sellers

  • Consequences of Tax Imposition:

    • Discourages market operations.

    • Results in reduced equilibrium quantity.

    • Buyers pay more while sellers receive less.

    • Taxes create a necessity for sellers to transfer payment to government entities.

Graphical Example: Tax on Sellers

  • Analysis of Tax Effects:

    • A $0.50 tax raises the supply curve by the same amount.

    • Equilibrium quantity drops from 100 to 90 cones.

    • Buyers’ new price increases from $3.00 to $3.30, while sellers receive $2.80 post-tax.

Effects of Taxes on Buyers

  • Behavioral Effects:

    • Similar to sellers, taxes curtail market activity.

    • Buyers end up paying higher effective prices, despite nominal price drops.

Graphical Example: Tax on Buyers

  • Impact Assessment:

    • A $0.50 tax on buyers shifts the demand curve down by $0.50.

    • The equilibrium quantity again falls from 100 to 90 cones.

    • Sellers receive $2.80 while buyers’ total cost rises from $3.00 to $3.30.

Understanding Tax Incidence

  • Taxes on both sellers and buyers yield similar market outcomes.

  • The tax configuration introduces a wedge between buyer payments and seller receipts.

Elasticity and Tax Burden

Market Elasticity Implications

  • Tax burden distribution largely hinges on market elasticity.

  • Elasticity Measurements:

    • Low elasticity (inelastic demand or supply) indicates minimized options to exit the market under adverse conditions.

    • Resulting structure leads the less elastic market side to bear a heavier tax burden.

Graphical Analysis of Tax Burden

  • Elastic Supply and Inelastic Demand:

    • Sellers receive slightly lower prices, while buyers experience more substantial price increases; hence buyers bear the most burden.

  • Inelastic Supply and Elastic Demand:

    • The inverse scenario occurs where sellers absorb substantial price reductions, and buyers experience minimal price increase; thus sellers take on greater burden.

Conclusion

  • Price controls and tax policies are prevalent across various markets with their implications sparking continuous debate.

  • Supply and demand principles provide foundational tools for analyzing these government measures.

Analytical Reflection

  • Consider implications surrounding a proposed food tax aimed at generating increased revenue. The misconception that tax burdens rest solely on sellers is frequent; analyzing the shared impacts on buyers is essential for accurate assessment.