UMD ECON 200 - Chapter 6: Supply, Demand, and Government Policies

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Chapter 6: Supply, Demand, and Government Policies Controls on Prices- Price ceiling: a legal maximum on the price at which a good can be sold- Price floor: a legal minimum on the price at which a good can be sold - How price ceilings affect market outcomeso 1) If the equilibrium price is below the price ceiling, the price ceiling isnot binding >> market forces will naturally move the economy to the equilibrium and the price ceiling has no effect on the price of the goodo 2) If the equilibrium price is above the price ceiling, the price ceiling isa binding restraint on the market; the forces of supply and demand tend to move the price towards the equilibrium but once the market price hits the price ceiling, it by law can not raise any higher >> at this price there is a shortage (ex: demand=125 cones, supply=75 cones; 50ppl cant buy ice-cream)  Even though a price ceiling was meant to lower prices for the buyers, in the end some buyers are left without ice-cream or have to wait in long lines to get ice-cream o When the government imposes a binding price ceiling on a competitive market, a shortage of the good arises and sellers must ration the scarce goods among the large number of potential buyerso Ex: gas and rent control - How price floors affect market outcomes o 1) If the equilibrium price is above the price floor, then the price floor is not binding >> market forces naturally move the economy to the equilibrium & the price floor has no effecto 2) If the equilibrium price is below the price floor, then the price floor is binding >> market forces tend to move towards the equilibrium price but when it hits the price floor, it can’t drop anymore >> there is a surplus (ex: 120 cones supplied, 80 demanded; some sellers cant sellice-cream) o Ex: minimum wage - Evaluating price controlso One of the 10 principles states that markets are a good way to organize economic activity; gov interference obscures the signals that normally guide the market o Another principle states that gov can sometimes improve market outcomes >> however >> rent control may keep rent low but it discourages landlords from maintaining their buildings and makes housing hard to find, minimum wage laws may raise the incomes of some but also causes unemployment Taxes- Tax incidence: the manner in which the burden of a tax is shared among participants in a market- How taxes on sellers affect market outcomeso Decide whether the law affects the supply or demand curve, decide which way the curve shifts, examine how the shift affects the equilibrium price and quantityo Supply curve shifts to the left (decrease) while demand curve stays the sameo Equilibrium price rises and quantity falls; sellers sell less & buyers buy less so the tax reduces the size of the market o Tax makes buyers and sellers worse offo Summary: taxes discourage market activity, when a good is taxes, the quantity of the good sold is smaller in the new equilibrium, buyers & sellers share the burden of taxes, in the new equilibrium buyers pay more for a good and sellers receive less - How taxes on buyers affect market outcomeso Demand curve shifts to the left (decrease) while supply curve stays the same o Equilibrium price and quantity fallo Tax reduces the size of the market & buyers and sellers share the burden- Taxes levied on sellers and taxes levied on buyers are equivalent- Ex: payroll tax- Elasticity and taxeso When the supply curve is elastic and the demand curve is inelastic, theprice received by sellers falls only slightly while the price paid by buyers rises substantially o When the supply curve is inelastic and the demand curve is elastic, theprice received by sellers falls substantially while the price paid by buyers rises only slightly o A tax burden falls more heavily on the side of the market that is less elastic o Ex: luxury tax o Tax incidence depends on elasticity >> most of the burden falls on the side of the market that is less elastic b/c that side of the market can respond less easily to the tax by changing the quantity sold or


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UMD ECON 200 - Chapter 6: Supply, Demand, and Government Policies

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