Lecture 7: Applications of Supply and Demand

Outline:

1. The incidence of a sales tax

a. Sales tax

b. Sales tax and elasticity

2. Government controlled prices

a. Price floor

b. Price ceiling

3. Examples of government controlled prices:

a. Minimum wage, Agricultural price supports

b. Rent control

4. New Field Guide 2.7.

5. Dollars and Sense #7, 8.

1. The incidence of a sales tax:

Definition:

A sales tax is a tax t charged per unit of a good sold.

* Tax incidence refers to the question of who bears the burden of a tax.

* Tax incidence has nothing to do with whether the government collects the tax directly from consumers or from producers.

* The burden of a tax is distributed between consumers and producers in a way that depends on the relative price elasticities of demand and supply.

Graphically representing the imposition of a sales tax:

Pd is the price that consumers pay for a good and Ps is the price that producers receive for a good

In the absence of a tax : Pd=Ps

When a tax t per unit of the good is imposed: Pd-Ps = t

The effect of the tax can be analyzed by considering a new supply curve - one that lies above the old supply curve by the amount of the tax t.

Explanation: The total amount that consumers must pay to obtain a given quantity of the good from firms, has increased by the amount of the tax t.

Note: Comparing Pd and Ps with the initial equilibrium Pe:

*the price that consumers day after the tax is less than

(Pe+ t)

* the price that producers receive is greater than (Pe-t).

*the consumers and producers have shared the burden of the tax.

Tax incidence and elasticity:

*The share of the tax is born by consumers versus producers depends on the relative elasticities of demand and supply.

*The more inelastic the demand curve is relative to the supply curve - the higher will be the share of the tax paid by consumers.

Question: Why?

*The more elastic the demand curve is relative to the supply curve - the higher will be the share of the tax paid by producers.

Question: Why?

Questions:

Who bears the burden of a sales tax when the demand curve is perfectly inelastic?

Who bears the burden of a sales tax when the supply curve is perfectly inelastic?

2. Government controlled disequilibrium prices:

* In a market where the price is a disequilibrium price, the quantity exchanged will be the lesser of Qd and Qs.

Government controlled prices:

* these are disequilibrium prices that the government maintains through intervention in the market.

Price floor: A minimum price that can be charged for some product.

*To be EFFECTIVE a price floor must be set ABOVE the equilibrium price (Pe)

Consequences of an effective price floor:

* A price floor leads to excess supply/ a surplus in the market.

* Quantity exchanged is equal to Qd

* Quantity exchanged is lower after the price floor than it was at equilibrium.

* A price floor tends to benefit some sellers and hurt buyers.

Note: in some cases the government has set a price floor and has bought up the surplus so that the quantity exchanged equals the Qs.

Price ceiling: A maximum price that can be charged for some product.

* To be EFFECTIVE a price ceiling must be set BELOW the equilibrium price (Pe)

Consequences of an effective price ceiling:

* A price ceiling leads to excess demand/ a shortage in the market.

* Quantity exchanges is equal to Qs

* Quantity exchanged is lower after the price ceiling than it was at equilibrium.

* A price ceiling tends to benefit some consumers and hurt sellers.

Examples of price floors:

Minimum wage:

* Purpose of the minimum wage is to ensure that workers get a minimally acceptable rate of pay for their work.

* If the minimum wage is an effective price floor then it causes unemployment, and fewer people have jobs with the minimum wage than would with the equilibrium wage.

* The argument against increasing the minimum wage presumes (1) that it is an effective price floor and (2) that people are paid according to their productivity.

* In practice there are two arguments in favor of increasing the minimum wage (1) It is not an effective price floor and (2) people are being paid less than their productivity.

* In the end, the issue of the minimum wage is an empirical issue - one experiment would be to increase the minimum wage and see what happens.

* One question which is not frequently asked is - what alternative exists to the minimum wage in terms of ensuring that people receive acceptable wages for their work?

Agricultural price supports:

* Purpose of these was originally to increase the prices of agricultural products in order to support farmers incomes.

* On consequence of the agricultural price supports was large surpluses of agricultural produce.

* In some cases the government bought up the surpluses but was left with the problem of what to do with them:

- distributing them was problematic because if people would otherwise buy the produce, getting it free would lead them to stop buying it

- letting them rot was problematic with so many people in the US going hungry and people in the rest of the world starving

- selling them was problematic because it would work against the price floor and would lower the price.

* Is there are a way of protecting farmers incomes that does not involve the production of surplus agricultural produce? Should farmers incomes be protected by the government?

Example of a price ceiling:

Rent Control:

* Was originally intended as a policy to protect low income renters from rising rental costs and the possibility of becoming homeless.

* In its most liberal form it sets a limit to how much rents can increase per year - the limit is determined by how much costs have increased over the previous year.

* Because price no longer allocates who get rental housing other allocation mechanisms come into play - landlord's preference, black markets, lists, "who you know", etc.

* Current tenants benefit from the policy but landlords and new tenants are hurt by the policy.

* There is less rental housing available than in equilibrium with the difference being determined by the price elasticity of supply.

* Shortages are more severe in the long run than in the short run.

* One question that arises is, what alternatives are there to rent control to help low income renters?