© 2007 Thomson South-Western
CONTROLS ON PRICES
Controls on Prices are enacted when …
– policymakers believe the market price is unfair to
buyers or sellers
© 2007 Thomson South-Western
CONTROLS ON PRICES
• Price Ceiling
– A legal maximum on the price at which a good can
be sold.
© 2007 Thomson South-Western
A Price Ceiling on Tacos???
Price per Taco
Q of Tacos
Demanded
Q of Tacos
Supplied
1
9
1
2
8
2
3
7
3
4
6
4
5
5
5
6
4
6
7
3
7
8
2
8
9
1
9
10
0
10
© 2007 Thomson South-Western
A Market with a Price Ceiling
Price of
Taco
Supply
Equilibrium
price
$5
3
Price
ceiling
Shortage
Demand
0
3
5
7
Equilibrium Quantity
Quantity
supplied
Quantity
demanded
Quantity of
Tacos
© 2007 Thomson South-Western
Effects of a Price Ceiling
• Shortages
• QD > QS
• Inefficient allocation to consumers
• Missed opportunities
• Wasted resources
Opportunity cost of looking for a taco
• Inefficiently low quality
• Taco suppliers ‘cut corners’ on quality
• Black Market
• Goods bought and sold illegally
© 2007 Thomson South-Western
CASE STUDY: Lines at the Gas Pump
• In 1973, OPEC raised the price of crude oil
in world markets. Crude oil is the major
input in gasoline, so the higher oil prices
reduced the supply of gasoline.
• What was responsible for the long gas lines?
• Economists blame government
regulations that limited the price oil
companies could charge for gasoline.
© 2007 Thomson South-Western
The Market for Gasoline with a Price Ceiling
(b) The Price Ceiling on Gasoline Is Binding
Price of
Gasoline
S2
S1
P2
Price ceiling
P1
Shortage
Demand
0
QS
QD Q1
Quantity of
Gasoline
© 2007 Thomson South-Western
CONTROLS ON PRICES
• Price Floor
– A legal minimum on the price at which a good
can be sold.
© 2007 Thomson South-Western
A Price Ceiling on Tacos???
Price per Taco
Q of Tacos
Demanded
Q of Tacos
Supplied
1
9
1
2
8
2
3
7
3
4
6
4
5
5
5
6
4
6
7
3
7
8
2
8
9
1
9
10
0
10
© 2007 Thomson South-Western
A Market with a Price Ceiling
Price of
Taco
Supply
Equilibrium
price 7
Surplus
Price
floor
$5
Demand
0
3
5
7
Equilibrium Quantity
Quantity
demanded
Quantity
supplied
Quantity of
Tacos
© 2007 Thomson South-Western
Effects of a Price Floor
• Surplus
– QS > QD
• Inefficient allocation of sales among sellers
– Missed opportunities
• Wasted resources
Government may have to buy surplus
• Inefficiently high quality
buyers prefer a lower quality good at a lower price
• Inefficiently low quantity
– Fewer people buying tacos so a loss to society
• Black Market
– Bribes of seller or government officials
© 2007 Thomson South-Western
CASE STUDY: The Minimum Wage
• An important example of a
price floor is the minimum
wage.
• Minimum wage laws dictate
the lowest price possible for
labor that any employer may
pay.
© 2007 Thomson South-Western
How the Minimum Wage Affects the Labor Market
Wage
Labor
Supply
Equilibrium
wage
Labor
demand
0
Equilibrium
employment
Quantity of
Labor
© 2007 Thomson South-Western
How the Minimum Wage Affects the Labor Market
Wage
Labor surplus
(unemployment)
Labor
Supply
Minimum
wage
Labor
demand
0
Quantity
demanded
Quantity
supplied
Quantity of
Labor
© 2007 Thomson South-Western
Quantity Controls - Quotas
A quota is …
•
an upper limit on the quantity of some
good that can be bought or sold.
•
usually controlled by a license
© 2007 Thomson South-Western
Example: Ocean Caught Salmon Market
What controls how many
each salmon boat may
catch?
Licenses are allocated.
Total quota limit reached
=
ocean caught salmon season
is OVER!!!
© 2007 Thomson South-Western
Quota Graph
Quota
S
Pd
Pe
Ps
Qe
D
Q
© 2007 Thomson South-Western
Costs of Quantity Controls
• Inefficiency – missed opportunities
• Incentives for illegal activities - poaching
© 2007 Thomson South-Western
TAXES
• Governments levy taxes to raise revenue for
public projects.
© 2007 Thomson South-Western
How Taxes on Buyers (and Sellers) Affect
Market Outcomes
• Taxes discourage market activity.
• When a good is taxed, the
quantity sold is smaller.
• Buyers and sellers share
the tax burden.
© 2007 Thomson South-Western
How Taxes on Buyers Affect Market
Outcomes
• Elasticity and tax incidence
• Tax incidence is the manner in which the burden of
a tax is shared among participants in a market.
© 2007 Thomson South-Western
How Taxes on Buyers Affect Market
Outcomes
• Elasticity and Tax Incidence
• Tax incidence is the study of who bears the burden
of a tax.
• Taxes result in a change in market equilibrium.
• Buyers pay more and sellers receive less, regardless
of whom the tax is levied on.
© 2007 Thomson South-Western
Figure 6 A Tax on Buyers
Price of
Ice-Cream
Price
Cone
buyers
pay
$3.30
Price
3.00
2.80
without
tax
Price
sellers
receive
Supply, S1
Equilibrium without tax
Tax ($0.50)
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).
Equilibrium
with tax
D1
D2
0
90
100
Quantity of
Ice-Cream Cones
© 2007 Thomson South-Western
Figure 7 A Tax on Sellers
Price of
Ice-Cream
Price
Cone
buyers
pay
$3.30
3.00
Price
2.80
without
tax
S2
Equilibrium
with tax
S1
Tax ($0.50)
A tax on sellers
shifts the supply
curve upward
by the amount of
the tax ($0.50).
Equilibrium without tax
Price
sellers
receive
Demand, D1
0
90
100
Quantity of
Ice-Cream Cones
© 2007 Thomson South-Western
Elasticity and Tax Incidence
• What was the impact of
tax?
• Taxes discourage market
activity.
• When a good is taxed, the
quantity sold is smaller.
• Buyers and sellers share
the tax burden.
© 2007 Thomson South-Western
Figure 8 A Payroll Tax
Wage
Labor supply
Wage firms pay
Tax wedge
Wage without tax
Wage workers
receive
Labor demand
0
Quantity
of Labor
© 2007 Thomson South-Western
Elasticity and Tax Incidence
• In what proportions is the burden of the tax
divided?
• How do the effects of taxes on sellers compare
to those levied on buyers?
• The answers to these questions depend on the
elasticity of demand and the elasticity of
supply.
© 2007 Thomson South-Western
Figure 9 How the Burden of a Tax Is Divided
(a) Elastic Supply, Inelastic Demand
Price
1. When supply is more elastic
than demand . . .
Price buyers pay
Supply
Tax
2. . . . the
incidence of the
tax falls more
heavily on
consumers . . .
Price without tax
Price sellers
receive
3. . . . than
on producers.
0
Demand
Quantity
© 2007 Thomson South-Western
Figure 9 How the Burden of a Tax Is Divided
(b) Inelastic Supply, Elastic Demand
Price
1. When demand is more elastic
than supply . . .
Price buyers pay
Supply
Price without tax
3. . . . than on
consumers.
Tax
Price sellers
receive
0
2. . . . the
incidence of
the tax falls
more heavily
on producers . . .
Demand
Quantity
© 2007 Thomson South-Western
Elasticity and Tax Incidence
So, how is the burden of the tax divided?
The burden of a tax falls more
heavily on the side of the
market that is less elastic.
© 2007 Thomson South-Western