Chapter 6 Supply Demand and Government Policies 6 1 Controls on Prices Buyer and seller conflict buyers want lower price sellers want higher price Price ceiling legislated maximum price is not allowed to rise above this level ex rent control Price floor price cannot fall below this level legislated minimum Two outcomes possible after government imposes price ceiling o Not binding price ceiling price set is above equilibrium price Market forces naturally move economy to equilibrium price ceiling has no effect on price or quantity sold o Binding price ceiling price set below equilibrium price market price price ceiling Quantity demanded will exceed quantity supplied creating shortage sellers must ration scarce goods among large number of potential buyers The rationing mechanisms developed under price ceilings are not desirable o Short run supply and demand of housing are relatively inelastic causing a small amount of shortage In the long run suppliers landlords do not build new apartments or maintain existing ones and demanders go out to apartments because of the low rent Multiple ways mechanisms to ration housing bring the total price of an apartment closer to equilibrium price o Price ceilings create Shortages Reduction in product quality To make more profit Wasteful lines and other costs of search Willingness to pay controlled price willingness to pay controlled price cost of time buyers are willing to trade to line up for the good Loss of gains from trade Price ceilings set below market price Q supplied market Q Consumers value good more than cost of its production since Q is relatively low Deadweight loss total of lost consumer producer surplus when all mutually profitable gains from trade are not used o Q supplied is forced on market Q Misallocation of resources Price controls eliminate incentives consumers who value a good most have to pay highest price there is no incentive for producer to supply good to those people o Goods flow to lower valued uses even if there could be higher valued uses Two outcomes possible after government imposes price floor elsewhere loss from trade o Not binding price floor equilibrium price is above floor market forces naturally move economy to o Binding price floor constraint on market forces of supply and demand can t fall further market equilibrium price price floor Binding price floor causes a surplus wasted resources o Minimum wage is more binding for teenagers than others o Price floors create Surplus Lost gains from trade deadweight loss Consumer surplus from having to pay a higher price than market would usually set it as producer surplus lost ability to compete because it has to be kept at the low value don t experience seller surplus Wasteful increases in quality Quality waste section at the higher price floor sellers can create a profit with higher quality but buyers would rather have a lower price price floors encourage sellers to waste resources on creating a higher quality good than buyers are willing to purchase Misallocation of resources Prevention of having low cost firms enter the industry Policy makers set price controls because they think the market outcome is unfair try to help the poor but end up hurting the poor o Subsidies like earned income tax credit may be more helpful 6 2 Taxes Tax incidence how the burden of tax is distributed among buyers and sellers in the market Tax wedge created between price paid by buyers and price received by sellers Taxes on sellers affect market outcomes o Ex government requires sellers of ice cream cones to send 0 50 to government for each cone sold 1 See which curve is affected supply curve 2 See which way curve shifts increase in production cost reduces quantity supplied moves to the left by the size of the tax 0 50 the new effective price received by sellers is 1 50 the sellers will supply a quantity as if price were 0 50 lower to compensate also an increase in what buyers have to pay 3 See how shift affects equilibrium price and quantity there was an overall drop in quantity supplied and increase in price of good size of ice cream market reduced Taxes on buyers affect market outcome o Ex government requires sellers of ice cream to send 0 50 to government for each cone they buy 1 Demand curve is affected 2 Tax on buyers stop buyers from demanding a larger quantity of ice cream demand curve shifts left by amount of tax 0 50 to make up for the effect of tax 3 Everyone is worse off buyers and sellers Tax on either buyers or sellers will always equal but doesn t mean the impact will be shared equally o Tax burden falls more on the less elastic side of market Elastic supply inelastic demand tax burden on buyers Price will change but there won t be much change in quantity demanded Easier for sellers to leave the market Inelastic supply elastic demand tax burden on sellers Easier for buyers to leave market o Elasticity measures willingness of buyers and sellers to leave market when unfavorable Small elasticity of demand buyers do not have good alternatives to consuming this good o When government tries to impose a tax on luxury goods suppliers end up paying for most of it since demanders can leave the market easily but the supply curve is inelastic leads to more unemployment Subsidy reverse tax where government gives money to consumers or producers o Subsidy price received by sellers price paid by buyers Who gets the subsidy doesn t depend on who receives check from government Elasticity affects who benefits from the subsidy Subsidies are paid by taxpayers and are inefficient increases in trade deadweight loss