Supply, Demand, and Government Policies
Price Controls
Price Ceiling:
Definition: A legal maximum on the price of a good or service.
Example: Rent control.
Price Floor:
Definition: A legal minimum on the price of a good or service.
Example: Minimum wage.
Price Ceilings
Policymakers may enact price controls like price ceilings in response to buyers' complaints about prices being "too high."
Price ceilings limit the price sellers can charge for their goods to the maximum price.
Prices cannot legally exceed the ceiling.
Example: Market for Apartments
Equilibrium without price controls: Rental price at 800, Quantity of apartments at 300.
A price ceiling above the equilibrium price is not binding and has no effect on the market outcome.
If the equilibrium price (800) is above the ceiling (500), the ceiling is a binding constraint, causing a shortage.
In the long run, supply and demand are more price-elastic, resulting in a larger shortage.
Five Important Effects of Price Ceilings (below market price):
Shortages
Reduction in Product Quality
Wasteful Lines and Other Costs of Search
Loss of Gains from Trade
Misallocation of Resources
Shortages
When prices are held below the market price, shortages are created.
The shortage is the difference between the quantity demanded (QD) and the quantity supplied (QS) at the controlled price.
The lower the controlled price relative to the market equilibrium price, the larger the shortage.
Example: Vinyl shortage in 1973 forced Capitol Records to melt down slow sellers to press Beatles’ albums.
Reduction of Product Quality
At the controlled price, sellers have more customers than goods.
In a free market, this would be an opportunity to profit by raising prices, but sellers cannot when prices are controlled.
Sellers respond by reducing quality or service.
Wasteful Lines and Other Costs of Search
When shortages occur, not all buyers can purchase the good.
Normally, buyers would compete by offering a higher price.
If the price cannot rise, buyers compete in other ways, like bribes or waiting in line.
Bribes:
Some buyers may bribe sellers to obtain the good.
The highest bribe a buyer would pay is the difference between their maximum price and the price ceiling.
If bribes are common, the total price is the legal price plus the bribe.
Wasteful Lines:
Buyers compete by waiting in line.
The maximum wait time (in monetary terms) is the difference between the maximum price and the price ceiling.
The total price includes the legal price plus the time costs.
Bribes involve a transfer from buyers to sellers, while time spent waiting in line is lost.
Lost Gains from Trade
Price controls reduce gains from trade.
Price ceilings below the market price cause QS to be less than the market Q.
When Q is below the equilibrium market Q, consumers value the good more than the cost of its production.
This represents a gain from trade that would be exploited in a free market.
Deadweight Loss
Deadweight Loss is the total of lost consumer and producer surplus when all mutually profitable gains from trade are not exploited.
Price ceilings create a deadweight loss by forcing Qs below the market Q.
Buyers and sellers would both benefit from trade at a higher price, but cannot because it is illegal.
Deadweight Loss (lost gains from trade) = Lost Consumer Surplus + Lost Producer Surplus
Misallocation of Resources
Price controls distort signals and eliminate incentives, leading to a misallocation of resources.
Consumers who value a good most are prevented from signaling their preference by offering higher prices.
Producers have no incentive to supply the good to the “right” people first.
Goods are misallocated, preventing resources from flowing to their highest-valued uses.
Example: Rent Control
A regulation that prevents rents from rising to equilibrium levels.
Rent control is a price ceiling whose effects worsen over time.
No one wants to build new apartments if the rents will be artificially low.
The shortage is smaller in the Short Run than in the Long Run.
Arguments for Price Controls
The general public may not understand the nasty side-effects of price controls.
Shortages may benefit the ruling elite.
In the former USSR, the communist party elite used Blat to obtain goods.
Blat = having connections that can be used to get favors.
The party elite can use their connections and power to obtain goods for themselves or others.
Without such leverage, their power dissipates.
Price Floors
Definition: A minimum price allowed by law.
They are less common than price ceilings but still important.
Four Common Effects of Price Floors:
Surpluses
Lost gains from trade (deadweight loss)
Wasteful increases in quality
Misallocation of resources
Example: Market for Unskilled Labor
Equilibrium without price controls: Wage at 6.00, Quantity of unskilled workers at 500.
A price floor below the equilibrium price is not binding and has no effect on the market outcome.
If the equilibrium wage (6) is below the floor (7.25), the floor is a binding constraint, causing a surplus (unemployment).
Example: The Minimum Wage.
Minimum wage laws do not affect highly skilled workers but do affect teen workers.
Studies: A 10% increase in the min wage raises teen unemployment by 1–3%.
Surplus
The quantity supplied at the controlled price is greater than quantity demanded at the controlled price, resulting in a surplus.
Lost Gains from Trade
Price floors create a deadweight loss similar to price ceilings.
Deadweight Loss = Lost Consumer Surplus + Lost Producer Surplus
Wasteful Increases in Quality
If sellers can’t lower the price, they will find other ways to compete.
Higher quality raises costs and reduces seller profit.
Buyers get higher quality but would prefer a lower price.
Price floors encourage sellers to waste resources by providing higher quality than buyers are willing to pay for.
Misallocation of Resources
Price controls misallocate resources by:
Allowing high-cost firms to operate.
Preventing low-cost firms from entering the industry.
Example: Regulation prevented Southwest (and 79 other firms) from entering the national market.
Example (1): President Jimmy Carter deregulated the price floors in much of the trucking industry.
Trucks carry almost all of the consumer goods, so almost every time you purchase something, you're paying money to a trucking company.
The price of trucking services fell.
Truckers earned less money.
Consumers saved a lot of money.
Example (2): If the U.S. government sets a price floor on milk, it will not always lead to a surplus because the market price of milk will sometimes rise above the price floor, rendering the price floor irrelevant.
Taxes
The government levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc.
The government can make buyers or sellers pay the tax.
The tax can be a % of the good’s price or a specific amount for each unit sold.
For simplicity, we analyze per-unit taxes only.
Commodity Taxes
Definition: Commodity Tax = A tax on goods.
Some truths about commodity taxation:
Who pays the tax does not depend on who writes the check to the government;
Who pays the tax does depend on the relative elasticities of demand and supply;
Commodity taxation raises revenue and creates lost gains from trade (dead-weight loss)
A Tax on Sellers Shifts the Supply Curve Up by the Tax
Example (Market for Pizza): A Tax on Sellers
Effects of a 1.50 per unit tax on sellers: The tax effectively raises sellers’ costs by 1.50 per pizza.
Sellers will supply 500 pizzas only if the Price rises to 11.50, to compensate for this cost increase.
Hence, the tax on sellers shifts the Supply curve up by the amount of the tax.
New Equilibrium: Q = 450, Buyers pay PB = 11.00, Sellers receive PS = 9.50, Difference between them = 1.50 = tax
Hence, a tax on buyers shifts the Demand curve down by the amount of the tax.
New Equilibrium: Q = 450, Sellers receive PS = 9.50, Buyers pay PB = 11.00, Difference between them = 1.50 = tax
The Incidence of a Tax
Definition: Incidence of Tax = How the burden of a tax is shared among market participants
In the example, buyers pay 1.00 more, sellers get 0.50 less.
What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive.
The effects on Price and Quantity, and the tax incidence are the same whether the tax is imposed on buyers or sellers!
The Tax Wedge
Since it doesn’t matter whether buyers or sellers are taxed, we can graph the tax as a simple “wedge”.
If the tax is 1, the price buyers pay must be 1 more than the price sellers receive.
Who Pays the Tax
Who pays the tax? It depends on the relative elasticities of supply and demand.
The less elastic side of the market will pay the greater share of a tax (bear more of the burden of a tax).
Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand
It’s easier for sellers than buyers to leave the market, so buyers bear most of the burden of the tax.
CASE 2: Demand is more elastic than supply
It’s easier for buyers than sellers to leave the market, so sellers bear most of the burden of the tax.
Case Study: Who Pays the Luxury Tax?
1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc.
Expected tax revenue? 9 billion. Reality? Less than expected
Goal: raise revenue from those who could most easily afford to pay—wealthy consumers.
But who really pays this tax?
Demand is price-elastic. In the short run, supply is inelastic. Hence, companies that build yachts pay most of the tax.
Results
The federal luxury tax was repealed in 1993.
Sales of boats went down 52.7%.
Net loss of 30,000 jobs.
The federal government paid out > 7 million more in unemployment benefits to those workers than it collected in luxury tax revenues.
The Effects of a Tax
A Tax Generates Revenue and Creates a Deadweight Loss
Consumer Surplus- consumers get this
Producer Surplus- producers get this
Tax Revenue- the government gets this
Deadweight Loss- No one gets this
Tax Revenue = 500
Subsidies
Definition: Subsidy = is a reverse tax where the government gives money to consumers (or producers).
Subsidy = Price Received by Sellers – Price Paid by Buyers
Some truths about subsidies:
Who gets the subsidy does not depend on who receives the check from the government
Who benefits from the subsidy does depend on the relative elasticities of demand and supply;
Subsidies must be paid for by taxpayers, and they create inefficient increases in trade (deadweight loss).
The Subsidy Wedge
A subsidy drives a wedge between the price received by sellers and the price paid by the buyers.
*If the subsidy is 1, the price buyers pay must be 1 less than the price sellers receive.
Some Subsidies Have Serious Benefits: Wage Subsidies Increase Employment
A wage subsidy costs the government money but increases employment from Qm to Qs (and reduces welfare payments)
Examples
Example 1
Which of the following statements are true?
I. A 0.50 tax on each fishing lure sold raises the price per lure by 0.50.
II. A tax on sellers is equivalent to a tax on buyers.
III. A tax on buyers is analyzed by shifting the demand curve up by the amount of the tax.
c) II only
Example 2
If demand of some good is more elastic than supply and a tax is imposed on the consumption of the good, who will bear more of the burden of the tax?
a) Producers, because consumers have a greater ability to change their behavior in response to the tax.
Example 3
Junk food has been criticized for being unhealthy and too cheap, enticing the poor to adopt unhealthy lifestyles.
Suppose that the state of Oklakansas imposes a tax on junk food. What needs to be true for the tax to actually deter most of the people from eating junk food: Should junk food demand be elastic or should it be inelastic?
b) Demand should be elastic.
Summary
A price ceiling is a legal maximum on the price of a good. An example is rent control. If the price ceiling is below the equilibrium price, it is binding and causes a shortage.
A price floor is a legal minimum on the price of a good. An example is the minimum wage. If the price floor is above the equilibrium price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment.
A tax on a good places a wedge between the price buyers pay and the price sellers receive and causes the equilibrium quantity to fall, whether the tax is imposed on buyers or sellers.
The incidence of a tax is the division of the burden of the tax between buyers and sellers and does not depend on whether the tax is imposed on buyers or sellers.
The incidence of the tax depends on the price elasticities of supply and demand.