WEEK 4 - Chapter 6: Supply, Demand and Government Policies

Question 1

Control on prices.

Answer 1

To see how price controls affect market outcomes, let’s look once again at the market for ice-cream. As we saw in chapter 4, if ice-cream is sold in a competitive market free of government regulation, the price of ice-cream adjusts to balance supply and demand – at the equilibrium price, the quantity of ice-cream that buyers want to buy exactly equals the quantity that sellers want to sell. To be concrete, suppose the equilibrium price is $3 per ice-cream.

Some people may not be happy with the outcome of this free-market process. Suppose the Australian Association of Ice-cream Eaters complains that the $3 price is too high for everyone to enjoy an ice-cream a day (their recommended daily allowance). Meanwhile, the National Organisation of Ice-cream Makers complains that the $3 price – the result of ‘cutthroat competition’–is depressing the incomes of its members.

Each of these groups lobbies the government to pass laws that alter the market outcome by directly controlling prices.

Because buyers of any good always want a lower price and sellers want a higher price, the interests of the two groups conflict. If the Ice-cream Eaters are successful in their lobbying, the government imposes a legal maximum on the price at which ice-cream can be sold, called a price ceiling. If the Ice-cream Makers are successful, the government imposes a legal minimum on the price, called a price floor. Let us consider the effects of these policies in turn.

Question 2

What is a price ceiling?

Answer 2

A legal maximum on the price at which a good can be sold.

Eg. Rent controls, home loan interest rates

Effects:
. Lost consumer surplus
. Lost producer surplus 
. Lower quantity traded
. Less consumed 
. Some producer surplus is transferred 
. Most importantly, tends to adversely affect the very people, it is meant to protect! - unintended consequence

Question 3

What is a price floor?

Answer 3

A legal minimum on the price at which a good can be sold.

There will be surplus at the price set by the price floor, because the price is preferred by suppliers, but not by consumers.

Eg. Wool, wheat and butter.

Effects:
. Lost consumer surplus
. Lost producer surplus 
. Lower quantity traded
. Less consumed 
. Some producer surplus is transferred 
. Most importantly, tends to adversely affect the very it is meant to protect! - unintended consequence

Question 4

How price floors affect market outcomes?

Answer 4

2 outcomes:

When the government imposes a price floor on the ice-cream market, two outcomes are possible. If the government imposes a price floor of $2 per ice-cream when the equilibrium price is $3, we obtain the outcome in panel (a) of Figure 6.4.

In this case, because the equilibrium price is above the floor, the price floor is not binding. Market forces naturally move the economy to the equilibrium and the price floor has no effect.

Panel (b) of Figure 6.4 shows what happens when the government imposes a price floor of $4 per ice-cream. In this case, because the equilibrium price of $3 is below the floor, the price floor is a binding constraint on the market. The forces of supply and demand tend to move the price towards the equilibrium price, but when the market price hits the floor, it can fall no further. The market price equals the price floor. At this floor, the quantity of ice-cream supplied (120 ice- creams) exceeds the quantity demanded (80). Some people who want to sell ice-cream at the going price are unable to. Thus, a binding price floor causes a surplus.

Question 5

What about the minimum wage?

Answer 5

Conventional view is that price floor analysis applies to minimum wages - minimum wage should result in a decrease in employment.

This view has been challenged - little evidence on support of this view: minimum wage appears to have no effect on employment.

Perhaps the standard price floor model does not work well in labour markets.

Question 6

Evaluating price controls.

Answer 6

P. 130

Question 7

What is tax incidence?

Answer 7

The study of who bears the burden of taxation.

Question 8

Free Vs Regulated Markets.

Answer 8

. Price ceiling
. Price floors
. Taxes
. Tariffs and subsidies
. Rationing/quotas
. Bans

Essentially dealing with trade-off between equity and efficiency.

Question 9

Rent controls.

Answer 9

Short run effects on owners:
. Don’t make it available
. Use discrimination
. Illegal activities

Long run effect on owners:
. Less investment on repairs and renovations
. Sell and move into commercial property, or other investments

Question 10

Price controls on pharmaceutical drugs.

Answer 10

. Reduces revenue to drug companies
. Less incentive to engage in research and development
- slower pace of innovation
- takes longer for new drugs to be created
- lives lost, greater pain and suffering, etc.

Question 11

Other examples of price controls.

Answer 11

France: a prosperous agricultural nation. However, price controls imposed during the French Revolution in 1973 created widespread food shortages.

Zimbabwe: price controls and imprisoned people who did not comply - food disappears from shop shelves.

Venezuela: food price controls have led to major food crisis.

Question 12

Rationing (quotas).

Answer 12

Supply line begins as normal and then becomes vertical.

Effects of Rationing/
– Transfers surplus from producers to consumers
– Efficiency loss
– Some consumers who value the good highly might miss out and suffer huge surplus loss (Can lead to black markets)
– Some consumers who do not value the good are encouraged to consume it

Question 13

Bans.

Answer 13

. Some markets are illegal 
–Heroin, Marijuana etc
–Prostitution 
–Blood 
–Kidneys

Black Markets form

Question 14

Black markets.

Answer 14

Price controls often force trade underground
• Exchange becomes illegal but some people resort to crime
• Fuels organised crime, corrupts governments

Question 15

Cost of bans.

Answer 15

• 16,151 Australians were waiting for a life-saving transplant and only 308 donations were made last year (Transplant Australia)
• Constant shortage of blood
–No market in blood, so price can’t eliminate the shortage
• Currently rely on altruism but $ might be provide incentive to increase supply

Question 16

Taxes.

Answer 16

Governments levy taxes to:
. Raise revenue for public projects
. Discourage consumption

Whether there is a tax on buyers or sellers, both are impacted. The elasticity of each curve impacts this.

Question 17

Alcohol taxes.

Answer 17

• Alcohol taxation used for three objectives: – Health objective
• 195,000 people die ANNUALLY in the EU • 31,133 died in Australia (1992 to 2001)
– Fiscal objective
– User-pays objective

Question 18

Taxes and market outcomes.

Answer 18

• Taxes discourage market activity
  • When a good is taxed, the quantity sold is smaller
• Buyers and sellers share the tax burden

Deadweight loss, alter consumer and producer surplus, government debt revenue, price buyers pay, price without tax, price sellers receive,

Question 19

A tax on buyers.

Answer 19

A tax on buyers shifts the Demand curve downward by the size of the tax.

Question 20

A tax on sellers.

Answer 20

Shifts the supply curve upward by the amount of the tax.

Question 21

Elasticity and tax incidence.

Answer 21

When supply is more elastic than demand the incidence of the tax falls more heavily on consumers than on producers.

When demand is more elastic than supply the incidence of the tax falls more heavily on producers than on consumers.

Question 22

What is a subsidy?

Answer 22

A payment from government, to consumers or sellers, for each unit of a good that is bought or sold.

A subsidy can be thought of as a negative tax because instead of sending money to the government every time a unit of a good is sold, money is received from the government.

Subsidies are an important public policy tool. There are many examples of subsidies that we encounter every day. The Medicare rebate you may receive when you visit a doctor is a subsidy, as are the payments universities receive to fund the education of Australian citizens and permanent residents.

Examples of subsidies that are commonly found around the world include subsidies on agricultural and motor vehicle production.

Question 23

Price floors and price ceilings.

Answer 23

Remember to imagine them the other way around.

Ceilings are below equilibrium and floors are above equilibrium.

Question 24

What are repugnant markets?

Answer 24

A repugnant market is an area of commerce that is considered by society to be outside the range of market transactions and that bringing this area into the realm of a market would be inherently immoral or uncaring.

Eg. Slavery, organs

Question 25

Tax revenue and deadweight loss.

Answer 25

Government tax revenue is area between the price buyers pay and the price sellers receive. The deadweight loss is to the right of this square.

This deadweight loss represents lost gains from trade.

Question 26

What are tariffs?

Answer 26

A tax or duty on goods produced abroad and sold domestically.

Tariffs raise the price of imported goods above the world price by the amount of the tariff.

Question 27

Impact of free trade VS tariffs on an importing country.

Answer 27

FREE TRADE
. World price (horizontal line underneath equilibrium of domestic supply and domestic demand)
. This lower price can help satisfy more consumers, so consumer surplus fills up the space between the horizontal line the D curve
. Consumer surplus increases whilst domestic producer surplus decreases and total surplus is bigger

TARIFF
. The horizontal line is pushed up
. Consumer surplus decreases and producer surplus increases
. Square space between tariff price and world price is tax revenue
. Triangles beside tax revenue is deadweight loss
. Total surplus is reduced

Question 28

Impact of free trade VS tariffs on an exporting country.

Answer 28

FREE TRADE
. World price (horizontal line above equilibrium of domestic supply and domestic demand)
. This higher price can help satisfy more producers, so producer surplus fills up the space between the horizontal line the S curve
. Consumer surplus decreases and total surplus is bigger
. Triangle between domestic supply, domestic demand and world price is total export

TARIFF
. The horizontal line is pushed up
. Consumer surplus decreases and producer surplus increases
. Square space between tariff price and world price is tax revenue
. Triangles beside tax revenue is deadweight loss
. Total surplus is reduced

Question 29

Second round effects of tariffs.

Answer 29

The negative effect of a tariff doesn’t stop with consumers.

Producers also pay a higher cost for their inputs and hence are adversely affected (if they pass the higher costs on to consumers, consumers suffer further losses).

Encourages investment in unprofitable business. Distorts economic incentives.

Question 30

Reasons for tariffs.

Answer 30

Protect local industry - however, while it protects some industries, it punishes others.

Rent seeking - business and unions lobby governments.

Question 31

Effect of a subsidy.

Answer 31

Sellers now receive a payment from the government for the good they sell, increasing the profitability at any given price – so the supply curve shifts to the right.

Now that we know the supply curve shifts down, we can see the effect of the subsidy by comparing the initial equilibrium and the new equilibrium. Because sellers sell more and buyers buy more in the new equilibrium, the subsidy on the good increases the size of the market.