eCoNoMiC sTuDiES 2

Price Controls and Tax

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We will now analyze government policy with respect to price controls, and its effects using the supply and demand microeconomic model. Principle of Economics #6: Markets are usually a good way to organize, track, and analyze economic activity.
Governments often wish to influence the market outcome by imposing price ceilings or floors. A price ceiling is the maximum price that businesses may be charged for a product due to external influences, and usually limits the price of a good to reach its free market equilibrium price. Examples can be found in rent controls, gasoline prices, and caps on doctor fees. If the ceiling price is below the equilibrium, it will result in:

1. Lower quantity supplied
2. Higher quantity demanded

This will create a shortage equal to quantity demanded (QD) minus quantity supplied (QS). This effect is larger in the long run because supply is more elastic. If the product is not rationed by price, we must find some other means to allocate. One possible result to this is the black market.
Price floors are minimum prices that artificially raise the equilibrium price of products above the free market point. Examples of price floors are minimum wages, and agricultural marketing boards. If price floors are binding, then it will tend to reduce quantity demanded by citizens, and increase quantity supplied. Naturally, this will cause a surplus in the market since supply will exceed demand.
Most economists believe that minimum wage laws cause some unemployment, especially among teenagers, since businesses need to pay higher wages. It is estimated that a 10% increase in minimum wage generally leads to a 1-3% decline in employment of teenagers.

Taxes and Their Incidence

Who pays taxes levied on products? What happens to the equilibrium price? It depends on the shape of the demand and supply curves, but generally price does not rise as much as the tax rises. Tax drives a wedge between the price paid by the consumer (gross price) and the price received by the producer (net price). Note that "net price" equals "gross price" minus "tax per unit".
Incidence of tax again depends on the relative shape of the curves and is calculated by:

1. Consumers pay gross price - original price.
2. Producers pay original price - net price.

In a perfectly competitive market, it makes no actual difference whether the tax is levied on the consumer or the producer. So what determines the distribution of the tax? If consumers can easily substitute away from the good which is taxed, they will avoid the tax and the producer will pay more (demand is elastic). If consumers cannot easily substitute away from the good which is taxed, they will be forced to buy it anyway and will pay the bulk of the tax (demand is inelastic).
Generally speaking, when demand is more elastic than supply, the producer pays more. When demand is less elastic than supply, the consumer will pay more.