Chapter 6 Supply Demand And Government Policies
Effects of gov't policies that place ceiling on prices
Examine effects of gov't policies that put a floor under prices
Consider how a tax on a good affects the price of the good and the quantity sold
Learn that taxes levied on buyers and taxes levied on sellers are equivalent.
See how the burden of a tax split between buyers and sellers.
Economists have two jobs : Scientists and Policy Makers.
Controls on Prices
If gov't enforces legal maximum on the price at which ice cream can be sold: not allowed to rise above
this level: Price Ceiling.
Price Ceiling: A legal maximum on the price at which a good can be sold
Gov't imposes legal minimum on price: price cannot fall below the level: Price Floor.
Price Floor: A legal minimum on a price at which a good can be sold.
How Price Ceilings Affect Market Outcomes
Figure 6.1
Gov't imposes price ceiling of $4 per cone.
Price that balances supply and demand ($3) is below the ceiling, the price ceiling is not binding.
Market forces naturally move economy to the equilibrium. Price ceiling has NO EFFECT on supply and
quantity sold.
Graph 1
Equilibrium price of $3 is above price ceiling: binding constraint on market.
Forces of supply demand can reach equilibrium, but can rise no further once hit ceiling price.
Thus, MARKET PRICE=PRICE CEILING. (Qd exceeds Qs in graph).
Mechanisms drop when shortage of ice cream develops due to price ceiling.
Mechanisms:
long lines
Not all buyers benefit from policy.
Buyers have lower price but wait longer lines inefficient, wastes buyer's time
Thus, Rationing mechanisms that develop under price ceiling are rarely desirable
Rationing mechanisms in a free competitive market is both efficient and impersonal.
When market for ice cream reaches equilibrium: everyone can get a cone.
Free market ration goods with prices.
When the gov't 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 buyers.
Case Study
Lines at Gas Pump
OPEC raised prices of crude oil in world oil markets.
Major input to make gasoline.
higher oil prices reduced supply of gas.
Canada: Price rose, very few shortages.
US: long lines: Blame OPEC for raise of gas prices shortage of gas would not have occured.
Economists blamed U.S gov't regulations that limited the price that oil companies could change for gas.
Graph 6.2
Case Study RENT CONTROL IN THE SHORT RUN AND LONG RUN
Example of price ceiling is rent control.
Provincial gov't places a ceiling on rents that landlords may charge their tenants.
Goal: to help poor by making housing more afforadable.
Arguments: Highly inefficient way to help poor raise standard of living.
Short Run: Landlords have a fixed number of apartments to rent, cannot adjust quickly as market
conditions change.
People take time adjusting their housing arrangements: number of people are not highly responsive to
rents in short run.
6.3 graph.
Short Run effects:
Any binding price ceiling, rent control causes shortages.
Supply and demand are inelastic in short run, the initial shortage caused by rent control is small.
Long run
buyers and sellers of rental housing respond more to market conditions as time passes
Supply side: Landlords respond low to rents by not building new apartments and maintaining existing
ones.
Demand side: Low rents= people find their own apartments (rather than sharing house or being with
parents) and induce people to move in cities.
Both Supply and Demand are thus more elastic in the long run.
6.3 How Price Floors Affect Market Outcomes
Gov't Price controls: Price Flooring: places legal Minimum
Price Ceiling: Legal Maximum
Both attempts by gov't to maintain prices at other than equilibrium prices.
Price Flooring: for example when gov't is persuaded by the pleas of the Canadian Org. of Ice cream
makers.
2 outcomes are possible:
$2 per cone when equilibrium is $3, outcome: a)
Equilibrium above price floor: Price floor is NOT BINDING.
$4 price floor : above equilibrium price $3.
Eq price is below price floor = Price floor is a BINDING CONSTRAINT ON MARKET.
Forces of Supply and Demand move to the price toward equilibrium price.
When market hits floor price, it can fall no further.
MARKET PRICE= PRICE FLOOR
At Price floor: Market Price: $4. 120 cones supplied 80 demanded: Surplus of 40.
Binding price floor causes SURPLUS.
Price ceilings and shortages can lead to undesirable rationing mechanisms as well as Price Floors and
Surpluses.
The seller who appeal to the personal biases of the buyers (racial familial ties) are better able to sell their
goods.
Free market equilibrium serves as the rationing mechanism, and sellers can sell all they want at the
equilibrium.
Case Study
Minimum Wage
example of price floor.
Minimum wage: laws dictate lowest price for labour that any employer may pay. Minimum wage rates
differ in each province and territory Unemployment: minimum wage is above equilibrium level: Quantity of labour exceeds quantity
demanded.
= Min wage raises the incomes of those employed but lowers incomes of those who cannot find jobs.
Economy contains not a single market, but many labour markets for different types of workers.
Experienced skilled workers not affected because equilibrium wages are above minimum.
Minimum wage is NOT BINDING.
Teenage Labour
interns and training
Interns pay nothing so equilibrium does not affect them either (hence existence)
Minimum wage is more binding to teens than other members of labour force.
Increase in Wage: affects job hunting.
Attend schools drop out and take job. New dropouts displace already dropped out teens now unemployed.
Pros:
workers earning MW are poor
poor better off with increase wage
Cons:
Not the best way to combat poverty.
causes unemployment
drop out
prevents unskilled workers getting on trained job they need
poorly targeted policy (not all head of house trying to make $ and feed family)
MANY ARE TEENS FOR EXTRA SPENDING CASH.
Evaluating Price Controls
Markets are usually a good way to organize economic activity (principles)
explain economists opposing price ceiling and flooring
Prices: supply and demand: balance it.
Policymakers set prices by legal decree by allocation's of society's resources.
Gov't can sometimes improve market outcomes
Policy makers control prices because they view market's outcome as unfair.
Price controls aimed to help poor
Often hurt poor
Rent control may keep rents low but it discourages landlords form maintaining their buildings and makes
housing hard to find.
Min wage laws may increase incomes of some workers, cause others to be unemployed.
Alternatives for helping poor instead of price controls: Govt can make housing affordable by paying a fraction of the rent.
This rent subsidies do no reduce quantity of housing supplied and thus do not lead to housing shortages.
Wage subsidies raise living standards of the working poor without discouraging firms from hiring them
Rent and wage subsidies can cost govt money and require higher taxes. :/
Quiz: Price ceiling/ floor? Which leads to surplus? shortage? why?
Taxes
local govt decides to hold annual ice cream celebration.
To raise revenue they to place tax on sale of ice cream cones.
Both lobbying organizations quarrel. (sellers don't want tax consumers
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