Economics. Supply, Demand, and Government Policies. Principles of. In this chapter, look for the answers to these questions:

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1 N. Gregory Mankiw rinciples of Economics ixth Edition 6 upply, emand, and Government olicies Modified by Joseph Tao-yi Wang remium oweroint lides by Ron Cronovich In this chapter, look for the answers to these questions: What are price s and price s? What are some examples of each? How do price s and price s affect market outcomes? How do taxes affect market outcomes? How do the effects depend on whether the tax is imposed on buyers or sellers? What is the incidence of a tax? What determines the incidence? 1 Government olicies That Alter the rivate Market Outcome rice controls rice : a legal maximum on the price of a good or service Example: rent control rice : a legal minimum on the price of a good or service Example: minimum wage es The govt can make buyers or sellers pay a specific amount on each unit. We will use the supply/demand model to see how each policy affects the market outcome (the price buyers pay, the price sellers receive, and eq m quantity). EXAME 1: The Market for Apartments Eq m w/o price controls Rental price of apts $ uantity of apts 3 How rice Ceilings Affect Market Outcomes How rice Ceilings Affect Market Outcomes A price above the eq m price is not binding has no effect on the market outcome. $00 $ rice The eq m price ($00) is above the and therefore illegal. The is a binding constraint on the price, causes a shortage. $00 $0 shortage rice 4 5 1

2 How rice Ceilings Affect Market Outcomes In the long run, supply and demand are more price-elastic. o, the shortage is larger. $00 $0 150 shortage 450 rice 6 hortages and Rationing With a shortage, sellers must ration the goods among buyers. ome rationing mechanisms: (1) ong lines (2) iscrimination according to sellers biases These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly. In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair). 7 EXAME 2: The Market for Gov t Employee How rice Floors Affect Market Outcomes Eq m w/o price controls Wage of gov t employee $000 W uantity of gov t employee A price below the eq m price is not binding has no effect on the market outcome. $000 $100 W rice 8 9 How rice Floors Affect Market Outcomes The eq m wage W ($,000) is below the and 00 therefore illegal. $000 The is a binding constraint on the wage, causes a surplus (i.e., unemployment). labor surplus rice 10 Min wage laws do not affect highly skilled workers. They do affect $000 unskilled workers (like secretaries). What is the form of unemployment for governmental employees in Taiwan? The Minimum Wage 00 W unemployment Min. wage Everyone takes the exams! 11 2

3 A C T I V E E A R N I N G 1 rice controls etermine effects of: A. $ price B. $ price C. $ price 1 A C T I V E E A R N I N G 1 A. $ price The price falls to $. Buyers demand rooms, sellers supply, leaving a shortage. 1 rice shortage = 30 A C T I V E E A R N I N G 1 B. $ price Eq m price is above the, so is not binding. = $, = rooms. 1 rice A C T I V E E A R N I N G 1 C. $ price The price rises to $. Buyers demand rooms, sellers supply, causing a surplus. 1 surplus = rice Evaluating rice Controls es Recall one of the Ten rinciples from Chapter 1: Markets are usually a good way to organize economic activity. rices are the signals that guide the allocation of society s resources. This allocation is altered when policymakers restrict prices. rice controls often intended to help the poor, but often hurt more than help. The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc. The govt 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

4 EXAME 3: The Market for izza A on Buyers Eq m w/o tax 1 1 The Hence, price a tax buyers on buyers pay is shifts now the $1.50 curve higher down than the by the market amount price of. the tax. would have to fall by $45 to make buyers willing to buy same as before. E.g., if falls from to $255, buyers still willing to purchase pizzas. $255 unit tax on buyers New eq m: = 450 ellers receive = $285 Buyers pay B = A on Buyers B = = $285 ifference between them = $45 = tax 450 unit tax on buyers The Incidence of a : how the burden of a tax is shared among market participants In our example, buyers pay $30 more, sellers get $15 less. B = = $ A on ellers A on ellers The tax effectively raises sellers costs by $45 per pizza. ellers will supply pizzas only if rises to $345, to compensate for this cost increase. $345 Hence, a tax on sellers shifts the curve up by the amount of the tax. unit tax on sellers New eq m: = 450 Buyers pay B = ellers receive = $285 ifference between them = $45 = tax B = = $285 unit tax on sellers

5 The Outcome Is the ame in Both Cases! The effects on and, and the tax incidence are the same whether the tax is imposed on buyers or sellers! What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. B = = $ A C T I V E E A R N I N G 2 Effects of a tax uppose govt imposes a tax on buyers of $30 per room. Find new, B,, and incidence of tax. 1 A C T I V E E A R N I N G 2 Answers = B = $ = $ Incidence buyers: $10 sellers: $ 1 B = = Elasticity and Incidence CAE 1: upply is more elastic than demand Buyers share rice if no tax ellers share B It s easier for sellers than buyers to leave the market. o buyers bear most of the burden of the tax. 27 Elasticity and Incidence CAE 2: emand is more elastic than supply Buyers share rice if no tax ellers share B It s easier for buyers than sellers to leave the market. ellers bear most of the burden of the tax. CAE TUY: Who ays the Cigarette? 06: Taiwan s egislative Yuan increased the cigarette tax by $5. Goal: raise revenue from those evil and wealthy cigarette companies... But who really pays this tax?

6 CAE TUY: Who ays the Cigarette? cigarettes Buyers share ellers share B emand is inelastic. In the short run, supply is elastic. Hence, addicted smokers pay most of the tax. A C T I V E E A R N I N G 3 The 11 payroll tax cut rior to 11, the ocial ecurity payroll tax was 6.2% taken from workers pay and 6.2% paid by employers (total 12.4%). The Relief Act (10) reduces the worker s portion from 6.2% to 4.2% (for 11 only), but leaves the employer s portion at 6.2%. UETION: Will the typical worker s take-home pay rise by exactly 2%, more than 2%, or less than 2%? o any elasticities affect your answer? Explain. 30 A C T I V E E A R N I N G 3 Answers As long as labor supply and labor demand both have price elasticity > 0, the tax cut will be shared by workers and employers, i.e., workers take-home pay will rise less than 2%. The answer does NOT depend on whether labor demand is more or less elastic than labor supply. FOOW-U UETION: Who gets the bigger share of this tax cut, workers or employers? How do elasticities determine the answer? A C T I V E E A R N I N G 3 Answers to follow-up question If labor demand is more elastic than labor supply, workers get more of the tax cut than employers. If labor demand is less elastic than labor supply, employers get the larger share of the tax cut. CONCUION: Government olicies and the Allocation of Resources Each of the policies in this chapter affects the allocation of society s resources. Example 1: A tax on pizza reduces eq m. With less production of pizza, resources (workers, ovens, cheese) will become available to other industries. Example 2: A binding minimum wage causes a surplus of workers, a waste of resources. o, it s important for policymakers to apply such policies very carefully. U M M A R Y A price is a legal maximum on the price of a good. An example is rent control. If the price is below the eq m price, it is binding and causes a shortage. A price is a legal minimum on the price of a good. An example is the minimum wage. If the price is above the eq m price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment. 34 6

7 U M M A R Y rice Control A tax on a good places a wedge between the price buyers pay and the price sellers receive, and causes the eq m 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. rice rice Control emand uantity 37 rice Control rice Control rice Control rice Control 1 1 rice upply rice emand upply uantity 38 uantity 39 rice Control and ation Markets are good? rice control is bad! Homework: Mankiw, Ch. 6, pp , roblem 3, 8, 9, 10, 11, 12 Additional Homework uestions True or False. A price on wheat would cause the price of bread to fall. True or False. ell computers contain hard drivers made by other manufacturers. If ell made its own hard drives, ell computers would be cheaper. 41 7