Demand, Supply and Government Policy

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Topic 5 – Demand, Supply and government policy (Week five Oct 6th – Oct 13th) Outline: 1. Price Ceiling: -- General Analysis; -- Example: Rent Control; 2. Price Floor: -- General Analysis; -- Example: minimum wage law; 3. The Incidence of Sales Tax -- Key Results; -- Numerical Examples: a)Tax levied on sellers; b)Tax levied on buyers; -- Elasticities of demand and supply;

 Price Ceiling
A legal maximum on the price at which a good can be sold 1) General Analysis Price 12 PE 8 Shortage 16 QE Price Ceiling DD Quantity

Price Ceiling
SS

Observation: a).Price ceiling, which is beneath the market clearing price (equilibrium price), creates shortage; b). Principle of voluntary exchange: Q(p) = minimum [QD(p), QS(p)] (Cannot force firm to produce more when they don’t want to; cannot force consumer to demand less when they want to);

c). Non-price rationing: free markets ration goods with price. Markets under price ceiling develop the rationing mechanism that is both inefficient and unfair (discriminative); d).Those who able to buy at the price ceiling could resell to other buyers at the “black market” at price of $12 (black market price)

ECO100Y1-Pesando-Notes edited by Eva Wu

2. Example: Rent Control (introduced into Ontario in 1970s): Rent Price SS

PE Price falls P Shortage Price Ceiling DD QS QE Housing available falls QD Quantity

Economic Concerns with Rent Controls: a). Shortage of available places for rent; b). Incentive effect: -- discourage construction; (shortage worsen in the long run); -- discourage maintenance and other housing services; c) under-table-payments which essentially bring the price up closer to the equilibrium price; Why bother introducing rent control: Political response due to increasing population (election purpose)

 Price Floor
A legal minimum on the price at which a good can be sold General Analysis & Example: Minimum Wage Laws Minimum Wage Price SS Price Floor (minimum wage) Surplus

P Price rises PE

DD: Demand by firms for unskilled workers: SS: Supply of labor by unskilled workers; Observation: a).Minimum wages law increase unemployment (labor surplus); b). Teenagers: Most affected; c). Reduces opportunity for on-the-job training for unskilled workers;

DD QD QE employment falls QS Quantity

Insights on Price Ceiling & Price Floor: 1) government intervention of price is not as helpful. (shortage & surplus) 2) unintended consequences

ECO100Y1-Pesando-Notes edited by Eva Wu

 The Incidence of Sales Tax
-- Refers to the ultimate burden of Tax; -- Measured by higher price paid by buyers and lower price received by sellers; 1. Key Results The incidence of tax: -- does not depend on whether tax is levied on buyers or sellers; -- does depend upon the elasticities of demand and supply 2. Numerical Examples a). Tax Levied on Seller: Tax on Sellers No Tax Price 120 115 110 105 100 95 90 85 80 QD 1 2 3 4 5 6 7 8 9 QS 9 8 7 6 5 4 3 2 1 Sellers pay $10 Tax QD 1 2 3 4 5 6 7 8 9 QS 7 (as $110 when no tax) 6 5 4 3 2 1 --Price ee SS’ SS $105 $100 $95 DD 4 5 quantity $10 Tax

b) tax levied on buyers; before tax: Price paid by buyer = price received by seller = market price; after tax: Price paid by buyers = (price received by sellers + tax) = (market price + tax); Tax on Buyers No Tax $10 tax on buyers Price Price QD 120 115 110 105 100 95 90 85 80 1 2 3 4 5 6 7 8 9 QS 9 8 7 6 5 4 3 2 1 QD --QS 9 8 $105 $100 $95 DD’ 4 5 $10 Tax ee

-- DD unchanged; -- SS shifts upward by $10 because sellers pay the tax, so for sellers to supply a same given quantity as before, price must rise $10

SS

1 (as $120 7 with $10 tax) 2 6 3 4 5 6 7 5 4 3 2 1

DD quantity

-- SS unchanged; -- DD shifts downward by $10 Because buyers pay the tax, so for buyers demand a same given quantity as before, price must decrease $10;

ECO100Y1-Pesando-Notes edited by Eva Wu

c) Summary: Price paid by buyers Price received by sellers Equilibrium quantity Insight: a). both buyers and...
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