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ECON 208 Chapter Notes -Price Ceiling

Course Code
ECON 208
Lee Ohanian

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Adrienne Pacini ECON 208 WEEK: September 29, 2009
Tax Incidence
- When demand is less elastic than supply, the incidence is significantly higher on the
- When demand is more elastic than supply, the incidence is significantly lower on the
o The less elastic is demand relative to supply, the greater the incidence of the tax on
consumers (and the less on suppliers)
Example: the demand for gasoline is inelastic, therefore the tax incidence is
on the consumers
Example: because the inelastic demand of alcohol, the government can
increase taxes (which become the burden of the demander rather than the
For demand: Change in Pd ÷ T = 1/b ÷ 1/b + 1/d (see WebCT)
The bigger the slope of the demand curve relative to the supply curve, the bigger the tax
incidence on consumers. (see the Study Guide) (see Extensions in Theory 4-1)
Other Demand Elasticities
Income Elasticity of Demand
ny = %change in quantity demanded ÷ %change in income
If ny is greater than zero, the good is said to be normal.
If ny is less than zero, the good is said to be inferior.
- The bigger the income elasticity of demand the bigger the shift in the demand curve for any
given change in income
o The bigger is income elasticity the more sensitive the demand for that good to
- Necessities: the more necessary an item is in the consumption patter of consumers, the
lower its income elasticity
o Income elasticities for any one product also vary with the level of a consumer’s
o The distinction between luxuries and necessities also helps to explain differences in
income elasticities between countries
Cross Elasticity of Demand
- nxy = %change in quantity demanded of good X ÷ % change in the price of good Y
- If nxy is greater than zero then X and Y are substitutes
- If nxy is less than zero then X and Y are complements
- (see Study Guide Extension Exercise 4 E-1) (see Extensions in Theory 4-2)
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Adrienne Pacini ECON 208 WEEK: September 29, 2009
- Partial-equilibrium analysis: examines a single market in isolation and ignores feedback
effects from other markets
o In general, this is appropriate when the specific market is quite small relative to the
entire economy
o Most of microeconomics uses partial-equilibrium
- General-equilibrium analysis: more complicated because it involves the analysis of all of the
economy’s markets simultaneously
- Market linkages and interactions: linkages exist with mobile demand and supply
o Joint production linkages: when things are produced together; when one product is
the “by-product” of another
o Input/output linkages: when one product is necessary to produce the other
o Linkages through resource constraints: cause links even between largely unrelated
Politicians give subsidy to an industry in order to increase jobs in a specific
region… but where do these jobs come from?
If on the production possibilities boundary, that must mean that
there will be fewer jobs elsewhere
This causes a shift in the resources to the product being subsidised
Government-Controlled Prices
Price Floors
- Example: minimum wage cannot go below a certain amount
o Shock effect of minimum wage: when firms are hit with a minimum wage, they
must become more efficient so that they will not have to hire as many workers
o This results in a higher demand for jobs
- Price floors make it illegal to sell the product below the controlled price
- A binding price floor must be above the free-market equilibrium price
o Therefore, there will be excess supply
Excess supply can result in unemployment when considering minimum wage
price floors
- Whether spending on the good goes up or down depends on its elasticity of demand
- A black market is any market in which goods are sold at illegal prices
o Example: hiring people for cash at less than minimum wage
o (see Applying Economic Concepts 5-1)
Price Ceilings
- Example: rent controls where the price cannot go above a certain amount
- The maximum price at which a product may be exchanged
o For a price ceiling to have an effect it must be below the market equilibrium price
- A government has one (or more) of three main objectives in imposing a price ceiling:
o Restrict production
o Keep specific prices down
o Satisfy normative notions of equity (fairness)
- The market price will no longer adjust to eliminate excess demand
- Allocation mechanisms:
o First come, first served
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