Chapter 6

Chapter 6
 What are price ceilings and price floors?
What are some examples of each?
 How do price ceilings and price floors affect market
outcomes?
 How do taxes affect market outcomes?
How does the outcome depend on whether
the tax is imposed on buyers or sellers?
 What is the incidence (rate/range of
influence/occurrence) of a tax?
What determines the incidence?
SUPPLY, DEMAND, AND GOVERNMENT POLICIES

Government Policies That Alter the
Private Market Outcome
 Price Controls
– Price Ceiling: a legal maximum on the price
of a good or service. Example: rent control.
– Price Floor: a legal minimum on the price of
a good or service. Example: minimum wage.
 Taxes
– The Government can make buyers or sellers pay a specific
amount on each unit bought/sold.


EXAMPLE 1: The Market for Apartments

Rental P S
price of
apartments

$800

Equilibrium
without
price D
Q
controls 300
Quantity of
apartments


How Price Ceilings Affect Market Outcomes
P S
Price
$1000
A price ceiling Ceiling

$800
above the
equilibrium
price is
not binding –
has no effect D
Q
on the market 300
outcome.


P
The equilibrium S
price ($800) is
above the
ceiling and $800
therefore illegal.
Price
The ceiling $500
Ceiling
is a binding Shortage
constraint D
on the price, Q
250 400
causes a
shortage.

P S
In the long
run, supply
and demand $800
are more
price-elastic. $500
Price
Therefore, the Ceiling
Shortage
shortage D
will be larger. Q
150 450


Shortages and Rationing
 With a shortage, sellers must ration the goods among
buyers.
 Some rationing mechanisms: (1) long lines
(2) discrimination 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).

EXAMPLE 2: The Market for Unskilled Labor

Wage W S
paid to
unskilled
workers
$4

Equilibrium
without
D
price L
controls 500
Quantity of
unskilled workers

How Price Floors Affect Market Outcomes
W S
A price floor
below the
equilibrium
price is $4
not binding – Price
$3
has no effect floor
on the market
D
outcome. L
500


How Price Floors Affect Market Outcomes
Labor
The equilibrium W Surplus S
wage ($4) is below Price
$5
the floor and Floor
therefore illegal.
$4
The floor is a
binding constraint
on the wage,
causes a surplus D
(i.e.,unemployment). L
400 550


The Minimum Wage
Unemployment
W S
Minimum
Minimum wage $5 Wage

laws do not affect
highly skilled $4
workers.
Often, they affect
teen workers.
D
L
400 550


Price Floors & Ceilings
The market for
P
140 hotel rooms
Determine S
130
effects of:
120
A. $90 price
110
ceiling
100
B. $90 price
floor 90
80 D
C. $120 price
floor 70
60
50
40
0 Q
50 60 70 80 90 100 110 120 130

A. $90 Price Ceiling The market for
P
140 hotel rooms
S
The price 130
falls to $90. 120
110
Buyers
100
demand Price ceiling
90
120 rooms,
80 D
sellers supply shortage = 30
70
90, leaving a
60
shortage.
50
40
0 Q
50 60 70 80 90 100 110 120 130

B. $90 Price Floor The market for
P
140 hotel rooms
S
130
Equilibrium
price is above 120
the floor, so the 110
floor is not 100
binding. 90
Price floor
P = $100, 80 D
Q = 100 rooms. 70
60
50
40
0 Q
50 60 70 80 90 100 110 120 130

C. $120 price floor The market for
P
140 hotel rooms
surplus = 60 S
130
The price
120
rises to $120. Price floor
110
Buyers
100
demand
60 rooms, 90
sellers supply 80 D
120, causing a 70
surplus. 60
50
40
0 Q
50 60 70 80 90 100 110 120 130

Evaluating Price Controls
 Recall one of the Ten Principles of
Economics:
Markets are usually a good way to organize
economic activity.
 Prices are the signals that guide the allocation of
society’s resources. This allocation is altered
when policymakers restrict prices.
 Price controls often intended to help the poor,
but often hurt more than help.


Taxes
 The Government levies taxes on many goods &
services to raise revenue to pay for national
defense, public schools, etc.
 The Government can make buyers or sellers pay
the tax.
 The tax can be a % of a good’s price, or a specific
amount for each unit sold.
– For simplicity, we will analyze per-unit taxes only.


EXAMPLE 3: The Market for Pizza

Equilibrium P
S1
without tax
$10.00

D1

Q
500


A Tax on Buyers
A tax on
buyers shifts Effects of a $1.50 per
the D curve unit tax on buyers
down by the P
amount of the S1
PB = $11.00
tax. Tax
$10.00
The price PS = $9.50
buyers pay
rises, the price D1
sellers receive D2
falls, Q
430 500
equilibrium Q
falls.

The Incidence of a Tax:
How the burden of a tax is shared among market
participants
P
As a result of S1
PB = $11.00
the tax, Tax
buyers pay $10.00
$1.00 more, PS = $9.50
and sellers
receive D1
$0.50 less. D2
Q
430 500


A Tax on Sellers
A tax on Effects of a $1.50 per
sellers shifts unit tax on sellers
the S curve up P S2
by the amount S1
of the tax. PB = $11.00
Tax
$10.00
PS = $9.50
The price buyers
pay rises, the
price sellers D1
receive falls,
equilibrium Q Q
430 500
falls.


The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!
P
What S1
matters is PB = $11.00
Tax
this: $10.00
A tax drives PS = $9.50

a wedge D1
between the
price buyers Q
pay and the 430 500
price sellers
receive. AND GOVERNMENT POLICIES
SUPPLY, DEMAND,

Effects of a Tax The market for
P
140 hotel rooms
Suppose the S
130
Government 120
imposes a tax 110
on buyers of
100
$30 per room.
90
Find new
Q, PB, PS, 80 D
and incidence of 70
tax. 60
50
40
0 Q
50 60 70 80 90 100 110 120 130

A C T I V E L E A R N I N G 2:
The market for
Answers P
140 hotel rooms
S
130
PB = $110
120
Q = 80 PB = 110
100
Tax
PS = $80 90
PS = 80 D
70
Incidence
60
Buyers: $10
50
Sellers: $20 40
0 Q
50 60 70 80 90 100 110 120 130

Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand
P It is easier for
sellers than buyers
PB S to leave the
Buyers’ share
market.
of tax burden
Tax Therefore, buyers
Price if no tax bear most of the
Sellers’ share burden of the tax.
PS
of tax burden
D
Q


Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply
It is easier for
P buyers than
S
sellers to leave
Buyers’ share
PB the market.
of tax burden
Sellers bear
Price if no tax
Tax most of the
Sellers’ share burden of
of tax burden the tax.
PS
D

Q


CASE STUDY: Who Pays the Luxury Tax?
 1990: Congress adopted a luxury tax on
yachts, private airplanes, furs, expensive cars,
etc.
 Goal of the tax: to raise revenue from those
who could most easily afford to pay –
wealthy consumers.
 But who really pays this tax?


CASE STUDY: Who Pays the Luxury Tax?
The market for yachts Demand is
price-elastic.
P
S
In the short run,
Buyers’ share
of tax burden PB supply is inelastic.

Tax Hence,
companies
Sellers’ share
that build
of tax burden PS
D yachts pay
most of
Q the tax.


CONCLUSION: Government Policies
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 equilibrium Q.
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, and a waste of resources.
 It is important for policymakers to apply such policies
very carefully.


CHAPTER SUMMARY
 A price ceiling is a legal maximum on the price of
a good. An example is rent control. If the price
ceiling is below the equilibrium price, it is binding
and causes a shortage.
 A price floor is a legal minimum on the price of a
good. An example is the minimum wage. If the
price floor is above the equilibrium price, it is
binding and causes a surplus. The labor surplus
caused by the minimum wage is unemployment.


CHAPTER SUMMARY
 A tax on a good places a wedge between the price
buyers pay and the price sellers receive, and causes
the equilibrium 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.


Chapter 6

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Chapter 6