Governmental Policy
and
Supply and Demand
Price Controls
• Price Ceilings
– Highest legal price of a product or good
– Binding if below market equilibrium
• Leads to shortage
– Non-binding if above
• Price Floor
– Lowest legal price of a product or good
– Binding if above market equilibrium
• Leads to surplus
– Non-binding if below
Price Ceilings
P
D
P
S
D
S
P^
No Effect
P^
Shortage
Q
S*
D*
Q
Examples: Caution-Using a Model
• OPEC limits output, US gov’t places price
ceiling on gas
– Led to shortage, long lines for gas
– Unexpected side effect : small cars boom
• NY rent control
– Short run (inelastic) vs Long run (more elastic)
• SR small shortage, LR large shortage
– Other ways around
• Key deposits, paying finders fees
– Other adverse effects
• People less likely to move, inefficient
• Lower quality housing (less incentive to keep up)
Price Floors
P
P
D
S
D
S
Surplus
P_
No Effect
P_
D*
S*
Q
Q
Example: Caution-Using a Model
• Minimum Wage
– 1938 Fair Labor Standards Act
• Market
– Workers Supply Labor (elastic/inelastic ?)
– Employers Demand Labor (elastic/inelastic ?)
• Impact
– Above equilibrium: surplus (unemployment)
– Higher wages for those with jobs
• Difference by skills
– Skilled Workers unaffected – why?
– Unskilled/youth affected – why?
Subsidies and Taxes
• Subsidy: get paid to buy or get paid to
produce/sell
– Give incentive to participate in market
– Market increases in size
• Tax: have to pay to buy or have to pay to
produce/sell
– Give disincentive to participate in market
– Market decreases in size
• For both change in market size depends on
combined elasticity of supply demand
– More elastic bigger change
Subsidy
• Regardless of subsidize buyer or seller
– Outcome quantity is the same
– Realized buyer/seller price the same
– Market price differs by subsidy (also buyer/seller)
• Both Gain, but:
• Who gains the most from the subsidy (seller
or buyer) depends on who’s curve is most
inelastic
Outcome P, Q, BP, SP
(why shift curves up/down?)
Buyer Gets Subsidy
P
D’
Seller Gets Subsidy
P
D’’
S’
D’
S’
Subsidy
Subsidy
SP=P’’
S’’
SP=P’’+S
P’
P’
BP=P’’
BP=P’’-S
Q’ Q’’
Q
Q’ Q’’
Q
Subsidy Wedge
View
D’
Buyer Gets Subsidy
View
S’
D’
Seller Gets Subsidy
View
D’’
S’
D’
S’’
SP
Subsidy
Wedge
P’
BP
Q’
Q’’
Q’
Q’’
Q’
Q’’
Who Gains? : Price Effect
Supply Curve More Inelastic so
Seller Gains More
S
Demand Curve More Inelastic so
Buyer Gains More
D’’
SP
P’
BP
D’
D’’
S
D’
SP
BP
Effect on Size of Market
Very Inelastic So Small Change
In Quantity
D’’
D’
S
Very Elastic So Large Change
In Quantity
D’’
S
D’
Q’ Q’’
Q’
Q’’
Winners/Losers
• Winners
– Buyers in market
– Sellers in market
• Losers
– Tax payers not in market
– Competitors (trading partners)
Examples
• Farm Subsidies
– Who wins/loses
– Rational
• Home Buying Subsidies (2 kinds)
– Who wins/loses
– Rational
• Ethanol Subsidies
– Who wins/loses
– Rational
Taxes
• Regardless of taxing buyer or seller
– Outcome quantity is the same
– Realized buyer/seller price the same
– Market price differs by tax (also buyer/seller)
• Both Lose, but:
• Who loses the most from the tax (seller or
buyer) depends on who’s curve is most
inelastic
– Tax incident
Outcome P, Q, BP, SP
(why shift curve down/up?)
Buyer Gets Taxed
P
Seller Gets Taxed
P
D’’ D’
S’
D’
S’’
S’
Tax
Tax
BP=P’’+T
P’
SP=P’’
BP=P’’
P’
SP=P’’-T
Q’’ Q’
Q
Q’’ Q’
Q
Who Loses? : Price Effect
Supply Curve More Inelastic so
Seller Loses More
S
Demand Curve More Inelastic so
Buyer Loses More
D’
BP
BP
P’
SP
SP
Tax
D’’
D’
D’’
Tax
S
P’
Effect on Size of Market
Very Inelastic So Small Change
In Quantity
D’
D’’
S
Very Elastic So Large Change
In Quantity
D’
S
D’’
Q’’ Q’
Q’’
Q’
Winners/Losers
• Losers
– Buyers in market
– Sellers in market
• Winners
– Recipients of the tax money
– Competitors (trading partners)
Examples
• Payroll Tax – good is labor supplied by workers
demanded by firms
– Employee and employer both pay half
• True Tax incidence
– Depends on elasticity of supply(workers) and
demand(firms)
• Change in market size
– Depends if markets are elastic or inelastic
Example 2
• Luxury tax introduced in 1990 to tax those
that can most afford to ‘splurge’
– Luxury demand is elastic
– Supply relatively inelastic
• Outcome
– Most of tax incidence fell on suppliers
– So repealed in 1992
Main Points – Subsidies/Taxes
• Tax or subsidy “creates” new hypothetical
supply/demand curve
– Same outcome if put on seller or buyer
• Subsidies increase market, taxes reduce it
– How much depends how elastic market is
• Gain or lose from subsidy/tax split between
buyers and sellers
– Who gets more or pays more depends on who is more
inelastic
• Difference between buyer/seller price is the tax
or subsidy size
Review of Graphs
(Note whose on ‘top’ switches)
Subsidy
and its incidence
Tax
and its incidence
P’
Tax
Wedge
Buyer share
of tax
Seller share
of tax
P’
Seller share
of subsidy
Buyer share
of subsidy
Subsidy
Wedge