19. Explain how price floors affect market outcomes. Draw the graphs.

How Price Floors Affect Market Outcomes

To examine the effects of another kind of government price control, let’s return to the market for ice cream. Imagine now that the government is persuaded by the pleas of the National Organization of Ice-Cream Makers whose members feel the $3 equilibrium price is too low. In this case, the government might institute a price floor. Price floors, like price ceilings, are an attempt by the government to maintain prices at other than equilibrium levels. Whereas a price ceiling places a legal maximum on prices, a price floor places a legal minimum. 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 cone when the equilibrium price is $3, we obtain the outcome in panel (a) of Figure 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 4 shows what happens when the government imposes a price floor of $4 per cone. 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 toward 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 cones) exceeds the quantity demanded (80 cones). Some people who want to sell ice cream at the going price are unable to. Thus, a binding price floor causes a surplus.

20. Using supply-demand diagrams, show the difference between a non-binding price ceiling and a binding price ceiling in the wheat market.Who benefits from a binding price ceiling? Who is hurt by a binding price ceiling?

The diagrams should look like panels (a) and (b) of Figure 6-1 in the text.

A binding price floor benefits the sellers of the good or service who are still able to sell their product at the higher price. A binding price floor hurts the buyers of the good or service, and those sellers who are no longer able to sell their product at the higher price because of the surplus created by the price floor.

21. The meaning of tax. Explain how taxes on buyers affect market outcomes.

Taxes All governments—from government, to the local governments in small towns—use taxes to raise revenue for public projects, such as roads, schools, and national defense. Because taxes are such an important policy instrument, and because they affect our lives in many ways, we return to the study of taxes several times through.

How Taxes on Buyers Affect Market Outcomes

Now consider a tax levied on buyers of a good. Suppose that our local government passes a law requiring buyers of ice-cream cones to send $0.50 to the government for each ice-cream cone they buy. What are the effects of this law? Again, we apply our three steps. Step One The initial impact of the tax is on the demand for ice cream. The supply curve is not affected because, for any given price of ice cream, sellers have the same incentive to provide ice cream to the market. By contrast, buyers now have to pay a tax to the government (as well as the price to the sellers) whenever they buy ice cream. Thus, the tax shifts the demand curve for ice cream.

Step Two We next determine the direction of the shift. Because the tax on buyers makes buying ice cream less attractive, buyers demand a smaller quantity of ice cream at every price. As a result, the demand curve shifts to the left (or, equivalently, downward) Once again, we can be precise about the size of the shift. Because of the $0.50 tax levied on buyers, the effective price to buyers is now $0.50 higher than the market price (whatever the market price happens to be). For example, if the market price of a cone happened to be $2.00, the effective price to buyers would be $2.50. Because buyers look at their total cost including the tax, they demand a quantity of ice cream as if the market price were $0.50 higher than it actually is. In other words, to induce buyers to demand any given quantity, the market price must now be $0.50 lower to make up for the effect of the tax. Thus, the tax shifts the demand curve downward from D 1 to D2 by the exact size of the tax ($0.50).

Step Three Having determined how the demand curve shifts, we can now see the effect of the tax by comparing the initial equilibrium and the new equilibrium. You can see in the figure that the equilibrium price of ice cream falls from $3.00 to $2.80, and the equilibrium quantity falls from 100 to 90 cones. Once again, the tax on ice cream reduces the size of the ice-cream market. And once again, buyers and sellers share the burden of the tax. Sellers get a lower price for their product; buyers pay a lower market price to sellers than they did previously, but the effective price (including the tax buyers have to pay) rises from $3.00 to $3.30. Implications If you compare Figures 6 and 7, you will notice a surprising conclusion: Taxes levied on sellers and taxes levied on buyers are equivalent. In both cases, the tax places a wedge between the price that buyers pay and the price that sellers receive. The wedge between the buyers’ price and the sellers’ price is the same, regardless of whether the tax is levied on buyers or sellers. In either case, the wedge shifts the relative position of the supply and demand curves. In the new equilibrium, buyers and sellers share the burden of the tax. The only differ ence between taxes on sellers and taxes on buyers is who sends the money to the government.