USING DEMAND AND SUPPLY Government Policies * ?Ecuador imposes food price controls?; Associated Press, Jan 29, 2008 OVERVIEW / Questions of the Day What happens when the government interferes with the workings of our typical market? Taxes ? used to How will the market react? How will buyers and sellers respond? Who actually pays? How much can the government expect to collect? Price Controls ? used to How will the market react? How will the buyers and sellers respond? Who is helped and how much will they gain? Who is hurt and how much will they lose? * EXCISE TAXES Per-unit taxes on the sale of goods and/or services Can be levied on the buyers or the sellers this is the side that actually ?hands over? the money to the government However, both sides actually pay for the tax- both sides split the cost. (How??) The government cannot control how the buyers and sellers actually split the tax between themselves Tax Incidence ? how the tax burden is shared between the two sides of the market * Selected State Excise Taxes (rank) State Cigarette Tax (cents per pack) Beer Tax (cents per gallon) Gasoline Tax (cents per gallon) New Jersey 275.5 (1st) 12 (38th) 10.5 (46th) South Carolina 7 (50th) 77 (3rd) 16 (41st) Alaska 180 (7th) 107 (1st) 8 (47th) Wyoming 60 (32nd) 2 (50th) 13 (46th) Washington 202.5 (3rd) 26.1 (20th) 34 (1st) Florida 33.9 (45th) 48 (7th) 4 (50th) Tennessee 62 (31st) 14 (37th) 20 (25th) Kentucky 30 (47th) 8 (46th) 18.3 (33rd) National Average 98.5 26 20 Source: Federation of Tax Administrators * Excise Taxes (cont) Consider a simplified version of excise taxes The government has a jar at the counter for tax revenue If a tax is levied on the buyers Buyers pay for the good, then pay the tax (put $ into the jar) If a tax is levied on the sellers Sellers take money from the buyers, then pay the tax (put $ into the jar) The government comes by and collects the jar every week * P 30 15 5 300 Q (CD?s per day) S D Market for CD?s, before any tax P* Q* * Tax on Buyers Buyers now pay for their CD(s), then drop an extra $5 in the jar for each CD they buy Questions to think about What happens to our market (P* and Q*) if we impose a $5 tax (per CD) on buyers? Will buyers now pay effectively $20 for each CD? $15 to the sellers and then $5 to the government? Will they still buy 300 CDs per day? Not quite ? the tax acts like a shifter on the demand curve * Market for CD?s after tax on buyers P 30 15 5 300 Q (CD?s per day) S D Demand shifts ?down? by exactly $5 * Original quantity Original price New equilibrium after tax Tax on Sellers Sellers now take money from the buyers, drop $5 into the jar, and keep the rest Questions to think about What happens to our market (P* and Q*) if we impose a $5 tax (per CD) on sellers? Will sellers now receive effectively $10 for each CD? Get $15 from buyers, then then give $5 to the government? Will they still produce 300 CDs per day Not quite ? the tax acts like a shifter on the supply curve * Market for CD?s after tax on sellers P 30 15 5 300 Q (CD?s per day) S D * Original quantity Supply shifts ?up? by exactly $5 Original price 18 240 Close-up graph ? tax on buyers 18 15 13 S Old D Old P* PB PS P this is the ?sticker? price ? the price that sellers receive * Close-up graph ? tax on sellers 18 15 13 Original S D Old P* PB PS P sticker price is $18; the price buyers pay * Final Effect of the Tax Demand shifts down by the amount of the tax ($5) Q* falls from 300 to 240 Buyers and sellers split the tax Buyers pay $3 more Sellers receive $2 less Govt. collects $1,200 /day $5 per CD * 240 CD?s Supply shifts up by the amount of the tax ($5) Q* falls from 300 to 240 Buyers and sellers split the tax Buyers pay $3 more Sellers receive $2 less Govt. collects $1,200 /day $5 per CD * 240 CD?s Tax on Buyers Tax on Sellers * Tax Effect ? 18 15 13 Old S Old D Old P* PB PS P * Tax Incidence ? CD Market 18 15 13 Old S Old D Old P* PB PS P * Buyers pay Sellers pay Tax Incidence In general, the government cannot It does not matter which side of the market the tax is levied on ? the end result is the same Buyers paid 3/5 of the tax ($3 of the $5) Sellers paid 2/5 of the tax ($2 of the $5) The government can dictate the $5 total, but it cannot determine the split between the buyers and sellers So, if the government cannot control how the tax is split, what does? * Tax Incidence ? Inelastic Demand P Q * D Old P* Buyers pay this portion Sellers pay this portion Tax Incidence ? Inelastic Supply P Q * S D BIG IDEA IN ECONOMICS ELASTICITY OF SUPPLY AND DEMAND DETERMINE HOW the tax burden is split between buyers and sellers The side of the market that is the most inelastic will pay the majority of the tax The side of the market that is the least responsive to price changes will pay the majority of the tax * Market for Textbooks D 90 80 65 75 P ($) Q (in millions) S 110 100 95 55 Suppose in the market for textbooks, the equilibrium price is $100 and quantity is 75 (million). If the government imposes a $15 tax on textbook buyers, what would be the result? Find new PB, PS, Q, and tax incidence. * PRICE CONTROLS Used by the government to artificially set the price higher or lower than the market equilibrium price P* Attempts to deliberately help one side of the market, either the buyers as a group, or the sellers as a group Gainers will always gain at the expense of the losers Price Floors ? attempts by the government to Price Ceilings ? attempts by the government to * Price Floors Price Floor ? (also known as: price supports); a legal minimum price for a good or service This makes it illegal to buy/sell the good for less than the price floor Essentially, the government attempts to maintain a price higher than P* (called a ?binding? price floor) If the price floor is set lower than P*, it is ?non-binding Who is the government trying to help? SELLERS!! * Price Floors (binding and non-binding) S P* P Q D Pfloor Pfloor * Price Floors ? Non-binding S P* P Q D Pfloor A price floor essentially blocks off the market below it * THIS AREA OF THE MARKET IS NO LONGER ACESSIBLE TO BUYERS OR SELLERS So what?? It doesn?t stop the buyers and sellers from finding the equilibrium price P* Price Floor - Binding S P* P Q D This price floor is effective? * It prevents the buyers and sellers from reach equilibrium price P* P floor * S P* P D Q Pfloor Price Floor ? General Outcome Qd Qs At Pf buyers want to buy amount Qd But at Pf, sellers wish to produce amount Qs surplus Application ? Agricultural Price Supports S 3 P ($) D Q (bushels of corn) 4 Pf * x surplus In order to maintain that price, the government usually agrees to purchase the surplus 30 40 Application ? Minimum Wage S (of labor) w* w (P of labor) D (of labor) L (Q of labor) * Surplus of labor (unemployment) Price Ceilings Price Ceiling ? a legal maximum price for a good or service This makes it illegal to buy/sell the good for more than the price ceiling. Essentially, the government attempts to maintain a price lower than P* (called a ?binding? price ceiling) If the price ceiling is set higher than P*, it is ?non-binding Who is the government trying to help? BUYERS!! * Price Ceilings (binding and non-binding) S P* P Q D Pceiling Pceiling * Non-binding or non effective Price Ceilings ? Non-binding S P* P Q D Pceiling The ceiling effectively shuts off this part of the market So what? It doesn?t stop the buyers and sellers from reaching P* * Price Ceilings ? Binding S P* P Q D * The ceiling effectively shuts off this part of the market Price Ceiling ? General Outcome S P* P D Q * But at that low price, buyers wish to buy this much shortage Application ? Rent Ceilings S rent* Rent D Q (apts) (P of Apts.) * shortage BIG IDEA IN ECONOMICS * Economists, in general, are not in favor of price controls Binding price floors set the price above the equilibrium market price and cause surpluses In general, hurts buyers and helps some sellers Binding price ceilings set the price below the equilibrium market price and cause shortages In general, hurts sellers and hurts some buyers KEY CONCEPTS AND TERMS Key Terms Excise Taxes Price Floor Price Ceiling Key Ideas An excise tax on buyers or sellers yields the same outcome Buyers and sellers always split an excise tax Tax incidence is the study of how the tax will be split The split is determined by the elasticities of supply and demand Price controls are a means by which the govt. sets the price artificially higher or lower than the market price Price floors set the price higher than the market price and result in surpluses Price ceilings set the price lower than the market price and result in shortages * Market for Textbooks D 70 85 65 75 P ($) Q (in millions) S 115 100 85 55 95 What would be the effect of: A price ceiling of $115? A price floor of $115? A price ceiling of $85? * The Summer Olympics in 2004 were held in Greece There was widespread reporting of price gouging, which initially kept attendance low One hotel reported went from $210 per night to $860 per night Many Greek business complained that the excessive high prices actually hurt their economy Greek Government Spokesman ?It has become clear that the prices that the hotels were asking were not accepted by the people who were to book a room, but its? nothing for the government to intervene. The government, we?re against price control methods, actually. The policy we?re following is a liberal economic policy and we cannot intervene with the way prices are developing.? * National Public Radio, 8/17/2004
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