Chapter 6 Supply, Demand, and Government Policies

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WHATS NEW IN THE THIRD EDITION:

The three-step analysis of the effects of taxes on buyers and sellers is more explicit. The definition of tax incidence has been altered.

LEARNING OBJECTIVES:
By the end of this ch !te"# st$dents sho$%d $nde"st nd: the effects of overnment policies that place a ceilin on prices. the effects of overnment policies that put a floor under prices. ho! a tax on a ood affects the price of the ood and the "uantity sold. that taxes levied on buyers and taxes levied on sellers are e"uivalent. ho! the burden of a tax is split bet!een buyers and sellers.

CONTE&T AND '(R'OSE:

Chapter 6 is the third chapter in a three-chapter se"uence that deals !ith supply and demand and ho! mar#ets !or#. Chapter $ developed the model of supply and demand. Chapter % added precision to the model of supply and demand by developin the concept of elasticity&the sensitivity of the "uantity supplied and "uantity demanded to chan es in economic conditions. Chapter 6 addresses the impact of overnment policies on competitive mar#ets usin the tools of supply and demand that you learned in chapters $ and %. The purpose of chapter 6 is to consider t!o types of overnment policies&price controls and taxes. Price controls set the maximum or minimum price at !hich a ood can be sold !hile a tax creates a !ed e bet!een !hat the buyer pays and the seller receives. These policies can be analy'ed !ithin the model of supply and demand. (e !ill find that overnment policies sometimes produce unintended conse"uences.

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))5 Chapter 66Supply, Demand, and Government Policies

)E* 'OINTS:
). / price ceilin is a le al maximum on the price of a ood or service. /n example is rent control. 4f the price ceilin is belo! the e"uilibrium price, the "uantity demanded exceeds the "uantity supplied. 7ecause of the resultin shorta e, sellers must in some !ay ration the ood or service amon buyers. 5. / price floor is a le al minimum on the price of a ood or service. /n example is the minimum !a e. 4f the price floor is above the e"uilibrium price, the "uantity supplied exceeds the "uantity demanded. 7ecause of the resultin surplus, buyers8 demands for the ood or service must in some !ay be rationed amon sellers. 9. (hen the overnment levies a tax on a ood, the e"uilibrium "uantity of the ood falls. That is, a tax on a mar#et shrin#s the si'e of the mar#et. $. / tax on a ood places a !ed e bet!een the price paid by buyers and the price received by sellers. (hen the mar#et moves to the ne! e"uilibrium, buyers pay more for the ood and sellers receive less for it. 4n this sense, buyers and sellers share the tax burden. The incidence of a tax :that is, the division of the tax burden; does not depend on !hether the tax is levied on buyers or sellers. %. The incidence of a tax depends on the price elasticities of supply and demand. The burden tends to fall on the side of the mar#et that is less elastic because that side of the mar#et can respond less easily to the tax by chan in the "uantity bou ht or sold.

CHA'TER O(TLINE:
4. Controls on Prices /. 7. C. Figure 1 ). There are t!o possible outcomes if a price ceilin is put into place in a mar#et. a. 4f the price ceilin is hi her than or e"ual to the e"uilibrium price, it is not bindin and has no effect on the price or "uantity sold. 4f the price ceilin is lo!er than the e"uilibrium price, the ceilin is a bindin constraint and a shorta e is created. Definition of !"ice cei%in+: +ood c n /e so%d0 Definition of !"ice f%oo": c n /e so%d. %e+ % , -i,$, on the !"ice %e+ % ,ini,$, on the !"ice t .hich +ood

t .hich

<o! Price Ceilin s /ffect .ar#et 1utcomes

b.

Chapter 66Supply, Demand, and Government Policies ))9

5. 9. $. Figure 2

4f a shorta e for a product occurs :and price cannot ad=ust to eliminate it;, a method for rationin the ood must develop. 0ot all buyers benefit from a price ceilin since some !ill be unable to purchase the product. Case Study: Lines at the Gas Pump

a. b. c. d.

4n )>?9, 1P-C raised the price of crude oil, !hich led to a reduction in the supply of asoline. The federal overnment put price ceilin s into place and this created lar e shorta es. .otorists !ere forced to spend lar e amounts of time in line at the as pump :!hich is ho! the as !as rationed;. -ventually, the overnment reali'ed its mista#e and repealed the price ceilin .

ALTERNATIVE CLASSROO1 E&A1'LE: /s# students about the rental mar#et in their to!n. Dra! a supply-and-demand raph for t!o-bedroom apartments as#in students !hat they believe the e"uilibrium rental rate is. Then su est that the city council is accusin landlords of ta#in advanta e of students and thus places a price ceilin belo! the e"uilibrium price. .a#e sure that students can see that a shorta e of apartments !ould result. /s# students to identify the !inners and losers of this overnment policy.

))$ Chapter 66Supply, Demand, and Government Policies

%.

In the News: Does a Drought Need to Cause a Water Shortage? a. b. Durin the summer of )>>>, the east coast of the *nited States experienced a shorta e of !ater. This is an article from the Wall Street Journal su in !hich the shorta e could have been avoided. estin a !ay

6. Figure 3

Case Study: Rent Control in the Short Run and the Long Run

a. b.

The oal of rent control is to ma#e housin more affordable for the poor. Since the supply of apartments is fixed :perfectly inelastic; in the short run and up!ard slopin :elastic; in the lon run, the shorta e is much lar er in the lon run than in the short run. 3ent controlled apartments are rationed in a number of !ays includin lon !aitin lists, discrimination a ainst minorities and families !ith children, and even under-the-table payments to landlords. The "uality of apartments also suffers due to rent control.

c.

d. D. Figure 4 ).

<o! Price @loors /ffect .ar#et 1utcomes

There are t!o possible outcomes if a price floor is put into place in a mar#et. a. b. 4f the price floor is lo!er than or e"ual to the e"uilibrium price, it is not bindin and has no effect on the price or "uantity sold. 4f the price floor is hi her than the e"uilibrium price, the floor is a bindin constraint and a surplus is created.

ALTERNATIVE CLASSROO1 E&A1'LE: Go throu h an example !ith an a ricultural price support. Sho! students that, even thou h a price support is not a le al minimum price, its result is exactly the same as a price floor. .a#e sure that students can see that a surplus !ill result. /s# students to identify the !inners and losers of this overnment policy. .a#e sure that you also point out the costs of the pro ram :purchasin the surplus and storin it;.

Chapter 66Supply, Demand, and Government Policies ))%

5. Figure 5

Case Study: he !inimum Wage

a.

The mar#et for labor loo#s li#e any other mar#etA do!n!ardslopin demand, up!ard-slopin supply, e"uilibrium price :called a !a e;, and e"uilibrium "uantity of labor hired. 4f the minimum !a e is above the e"uilibrium !a e in the labor mar#et, a surplus of labor !ill develop :unemployment;. The minimum !a e !ill be a bindin constraint only in mar#ets !here e"uilibrium !a es are lo!. Thus, the minimum !a e !ill have its reatest impact on the mar#et for teena ers and other uns#illed !or#ers.

b. c. d. -.

-valuatin Price Controls ). 7ecause most economists feel that mar#ets are usually a ood !ay to or ani'e economic activity, most oppose the use of price ceilin s and floors. a. b. Prices balance supply and demand and thus coordinate economic activity. 4f prices are set by la!s, they obscure the si nals that efficiently allocate scarce resources.

5. Price ceilin and price floors oftenB.ar#ets hurt the people theya are intended This is a ood chance to s reinforce the principle are usually to help. ood !ay to or ani'e economic activity.C

))6 Chapter 66Supply, Demand, and Government Policies

7e prepared to ans!er the "uestion, B4f price controls have such adverse a. 3ent controls create a shorta e of "uality housin and provide conse"uences, !hy are they imposedFC ,ou may !ant to point out that, disincentives for buildin maintenance. sometimes, economic i norance leads to unintended outcomes. ,ou may also !ant to point out that economic analysis serves as only a uide to b. .inimum !a e la!s create hi her rates of unemployment for policyma#ers. They may choose to i nore it !hen formin policy. 4n teena e and lo! s#illed !or#ers. addition, it is often interestin to encoura e the students to thin# about the distributional effects of these overnment pro rams. Acti2ity 3 4 D$c5s in Ty!e : To!ics: 1 te"i %s needed: Ti,e: C% ss %i,it tions: Ro.

4n-Class demonstration Price ceilin s, subsidies, and unintended conse"uences 5 toy duc#s, some play money, 9 volunteers )D minutes (or#s in any si'e class

'$"!ose This demonstration illustrates some common problems of overnment intervention in mar#ets. Inst"$ctions 1ne volunteer plays the role of the overnment in a poor country. Give the play money to the B overnment,C except for E). The overnment uses this money to buy duc#s from the farmer and provides the duc#s to the shop#eeper. The second volunteer is an urban shop#eeper. The shop#eeper as#s the overnment for more duc#s !henever it is sold out. Give the shop#eeper ) duc#. The third volunteer is a consumer. The consumer buys duc#s. Give the consumer E) in play money. The instructor is a duc# farmer. The farmer #eeps the second duc#. -xplain this bac# round, BDuc#s are a staple food in this country but they are expensive at E9 each. The overnment !ants to ma#e food cheap for the urban poor to alleviate hun er. They calculate people could afford duc#s if they !ere priced at E). The overnment decides to impose a price ceilin of E)A E) is no! the maximum retail price for duc#s.C Start the ame. The consumer buys one duc# from the shop#eeper. The shop#eeper re"uests more duc#s from the overnment. The overnment comes to the farmer. 'oints fo" Disc$ssion The instructor, as the duc# farmer, controls the ame. There are three points to ma#e in this demonstrationA ). Shorta e. The farmer refuses to sell duc#s at E) each. The shop#eeper has no duc#s. 5. Subsidy. The farmer offers to sell the duc#s for E9. The duc#s can then be sold in the mar#etplace for E). The overnment pays a E5 subsidy to #eep food prices lo!. 9. 7lac# mar#ets. /fter the farmer sells the duc# to overnment for E9, the duc# oes to the shop#eeper for E). The farmer buys bac# the ori inal duc# for E) and resells it to the overnment for E9. This can continue until the overnment runs out of money.

Chapter 66Supply, Demand, and Government Policies ))?

44.

Taxes /. 7. Definition of t - incidence: the , nne" in .hich the /$"den of sh "ed ,on+ ! "tici! nts in , "5et0 <o! Taxes on 7uyers /ffect .ar#et 1utcomes t - is

*se this chance to reinforce the three steps learned in Chapter $. Students should decide !hether this tax la! affects the demand curve or the supply curve, decide !hich !ay it shifts, and then examine ho! the shift affects e"uilibrium price and "uantity. ). 4f the overnment re"uires the buyer to pay a certain dollar amount for each unit of a ood purchased, this !ill cause a decrease in demand.

Figure 6 -xamples of unit taxes include most overnment excise taxes on products such as asoline, alcohol, and tobacco. 5. The demand curve !ill shift do!n by the amount of the tax.

,ou !ill !ant to be very careful !hen discussin the Bdo!n!ardC shift of the demand curve iven that !e encoura e students to thin# of supply and demand curves shiftin Bri htC and Bleft.C 9. $. %. The "uantity of the ood sold !ill decline. 7uyers and sellers !ill share the burden of the taxG buyers pay more for the ood :includin the tax; and sellers receive less. T!o lessons can be learned here. a. b. Taxes discoura e mar#et activity. 7uyers and sellers share the burden of a tax.

))H Chapter 66Supply, Demand, and Government Policies

C. Figure 7

<o! Taxes on Sellers /ffect .ar#et 1utcomes

). 5.

4f the overnment re"uires the seller to pay a certain dollar amount for each unit of a ood purchased, this !ill cause a decrease in supply. The supply curve !ill shift up by the amount of the tax.

/ ain, be very careful !hen discussin the Bup!ardC shift of the supply curve. Students often mista#enly believe that this means that supply is increasin . Point out the increase in the cost of sellin the ood. 4f students understand that an increase in cost leads to a decrease in supply, they !ill be less li#ely to become confused.

Chapter 66Supply, Demand, and Government Policies ))>

9. $.

The "uantity of the ood sold !ill decline. 7uyers and sellers !ill share the burden of the taxG buyers pay more for the ood and sellers receive less :because of the tax;.

Stress that the outcome of a tax levied on sellers is exactly the same as the outcome of a tax levied on buyers. (hen dra!in this in class, ma#e sure that the price that buyers end up payin and the price that sellers end up receivin is the same in both examples. D. Figure 8 ). 5. 9. @4C/ :Social Security; taxes !ere desi ned so that firms and !or#ers !ould exactly share the burden of the tax. This type of payroll tax !ill simply put a !ed e bet!een the !a e the firm pays and the !a e the !or#ers !ill receive. 4t is true that firms and !or#ers share the burden of this tax, but it is not necessarily %D-%D. Case Study: Can Congress Distri"ute the #urden o$ a Payroll a%?

Go throu h this material slo!ly. .a#e sure that students can see ho! to find the burden of the tax paid by consumers and the burden of the tax paid by producers before discussin the effects of elasticity on tax -. -lasticity and Tax 4ncidence incidence. 4f you rush throu h this material, you !ill lose them. ). 5. 9. (hen supply is elastic and demand is inelastic, the lar est share of the tax burden falls on consumers. (hen supply is inelastic and demand is elastic, the lar est share of the tax burden falls on producers. 4n eneral, a tax burden falls more heavily on the side of the mar#et that is less elastic. a. b. / small elasticity of demand means that buyers do not have ood alternatives to consumin this product. / small elasticity of supply means that sellers do not have ood alternatives to producin this particular ood.

Figure 9

)5D Chapter 66Supply, Demand, and Government Policies

$.

Case Study: Who Pays the Lu%ury a%? a. b. c. 4n )>>D, Con ress adopted a ne! luxury tax. The oal of the tax !as to raise revenue from those !ho could most easily afford to pay. 7ecause the demand for luxuries is often relatively more elastic than supply, the burden of the tax fell on producers and their !or#ers.

SOL(TIONS TO TE&T 'ROBLE1S:

6$ic5 6$i77es ). / price ceilin is a le al maximum on the price at !hich a ood can be sold. -xamples of price ceilin s include rent control, price controls on asoline in the )>?Ds, and price ceilin s on !ater durin a drou ht. / price floor is a le al minimum on the price at !hich a ood can be sold. -xamples of price floors include the minimum !a e and farm-support prices. / price ceilin leads to a shorta e, if the ceilin is bindin , because suppliers !on8t produce enou h oods to meet demand unless the price is allo!ed to rise above the ceilin . / price floor leads to a surplus, if the floor is bindin , because suppliers produce more oods than are demanded unless the price is allo!ed to fall belo! the floor. (ith no tax, as sho!n in @i ure ), the demand curve is D) and the supply curve is S. The e"uilibrium price is P) and the e"uilibrium "uantity is &). 4f the tax is imposed on car buyers, the demand curve shifts do!n by the amount of the tax :E)DDD; to D5. The do!n!ard shift in the demand curve leads to a decline in the e"uilibrium price to P5 :the amount received by sellers from buyers; and a decline in the e"uilibrium "uantity to &5. The price received by sellers declines by P) I P5, sho!n in the fi ure

5.

Chapter 66Supply, Demand, and Government Policies )5) as PS. 7uyers pay a total of P5 J E),DDD, an increase in !hat they pay of P5 J E),DDD - P), sho!n in the fi ure as P7.

8i+$"e 3 4f the tax is imposed on car sellers, as sho!n in @i ure 5, the supply curve shifts up by the amount of the tax :E)DDD; to S5. The up!ard shift in the supply curve leads to a rise in the e"uilibrium price to P5 :the amount received by sellers from buyers; and a decline in the e"uilibrium "uantity to &5. The price paid by buyers declines by P) P5, sho!n in the fi ure as P7. Sellers receive P5 and pay taxes of E),DDD, receivin on net P5 - E),DDD, a decrease in !hat they receive by P) - :P5 - E),DDD;, sho!n in the fi ure as PS.

8i+$"e 9

)55 Chapter 66Supply, Demand, and Government Policies

6$estions fo" Re2ie. ). 5. 9. /n example of a price ceilin is the rent control system in 0e! ,or# City. /n example of a price floor is the minimum !a e. .any other examples are possible. / shorta e of a ood arises !hen there is a bindin price ceilin . / surplus of a ood arises !hen there is a bindin price floor. (hen the price of a ood is not allo!ed to brin supply and demand into e"uilibrium, some alternative mechanism must allocate resources. 4f "uantity supplied exceeds "uantity demanded, so that there is a surplus of a ood as in the case of a bindin price floor, sellers may try to appeal to the personal biases of the buyers. 4f "uantity demanded exceeds "uantity supplied, so that there is a shorta e of a ood as in the case of a bindin price ceilin , sellers can ration the ood accordin to their personal biases, or ma#e buyers !ait in line. -conomists usually oppose controls on prices because prices have the crucial =ob of coordinatin economic activity by balancin demand and supply. (hen policyma#ers set controls on prices, they obscure the si nals that uide the allocation of society8s resources. @urther, price controls often hurt those they are tryin to help. / tax paid by buyers shifts the demand curve, !hile a tax paid by sellers shifts the supply curve. <o!ever, the outcome is the same re ardless of !ho pays the tax. / tax on a ood raises the price buyers pay, lo!ers the price sellers receive, and reduces the "uantity sold. The burden of a tax is divided bet!een buyers and sellers dependin on the elasticity of demand and supply. -lasticity represents the !illin ness of buyers or sellers to leave the mar#et, !hich in turns depends on their alternatives. (hen a ood is taxed, the side of the mar#et !ith fe!er ood alternatives cannot easily leave the mar#et and thus bears more of the burden of the tax. nd A!!%ic tions

$.

%. 6. ?.

'"o/%e,s ).

4f the price ceilin of E$D per tic#et is belo! the e"uilibrium price, then "uantity demanded exceeds "uantity supplied, so there !ill be a shorta e of tic#ets. The policy decreases the number of people !ho attend classical music concerts, since the "uantity supplied is lo!er because of the lo!er price. a. The imposition of a bindin price floor in the cheese mar#et is sho!n in @i ure 9. 4n the absence of the price floor, the price !ould be P) and the "uantity !ould be &). (ith the floor set at Pf, !hich is reater than P), the "uantity demanded is &5, !hile "uantity supplied is &9, so there is a surplus of cheese in the amount &9 I &5. The farmers8 complaint that their total revenue has declined is correct if demand is elastic. (ith elastic demand, the percenta e decline in "uantity !ould exceed the percenta e rise in price, so total revenue !ould decline. 4f the overnment purchases all the surplus cheese at the price floor, producers benefit and taxpayers lose. Producers !ould produce "uantity &9 of cheese, and their total revenue !ould increase substantially. 7ut consumers

5.

b.

c.

Chapter 66Supply, Demand, and Government Policies )59 !ould buy only "uantity &5 of cheese, so they are in the same position as before. Taxpayers lose because they !ould be financin the purchase of the surplus cheese throu h hi her taxes.

8i+$"e : 9. a. b. The e"uilibrium price of @risbees is EH and the e"uilibrium "uantity is 6 million @risbees. (ith a price floor of E)D, the ne! mar#et price is E)D since the price floor is bindin . /t that price, only 5 million @risbees are sold, since that8s the "uantity demanded. 4f there8s a price ceilin of E>, it has no effect, since the mar#et e"uilibrium price is EH, belo! the ceilin . So the e"uilibrium price is EH and the e"uilibrium "uantity is 6 million @risbees. @i ure $ sho!s the mar#et for beer !ithout the tax. The e"uilibrium price is P) and the e"uilibrium "uantity is &). The price paid by consumers is the same as the price received by producers.

c.

$.

a.

)5$ Chapter 66Supply, Demand, and Government Policies

8i+$"e ;

8i+$"e < b. (hen the tax is imposed, it drives a !ed e of E5 bet!een supply and demand, as sho!n in @i ure %. The price paid by consumers is P5, !hile the price received by producers is P5 I E5. The "uantity of beer sold declines to & 5.

%.

3educin the payroll tax paid by firms and usin part of the extra revenue to reduce the payroll tax paid by !or#ers !ould not ma#e !or#ers better off, because the division of the burden of a tax depends on the elasticity of supply and demand and not on !ho must pay the tax. Since the tax !ed e !ould be lar er, it is li#ely that both firms and !or#ers, !ho share the burden of any tax, !ould be !orse off. 4f the overnment imposes a E%DD tax on luxury cars, the price paid by consumers !ill rise less than E%DD, in eneral. The burden of any tax is shared by both producers and consumersthe price paid by consumers rises and the price received by producers falls, !ith the difference bet!een the t!o e"ual to the amount of the tax. The only exceptions !ould be if the supply curve !ere perfectly elastic or the demand curve !ere perfectly inelastic, in !hich case consumers !ould bear the full burden of the tax and the price paid by consumers !ould rise by exactly E%DD. a. 4t doesn8t matter !hether the tax is imposed on producers or consumers the effect !ill be the same. (ith no tax, as sho!n in @i ure 6, the demand curve is D) and the supply curve is S). 4f the tax is imposed on producers, the supply curve shifts up by the amount of the tax :%D cents; to S5. Then the e"uilibrium "uantity is &5, the price paid by consumers is P5, and the price received :after taxes are paid; by producers is P5 I %D cents. 4f the tax is instead imposed on consumers, the demand curve shifts do!n by the amount of the tax :%D cents; to D5. The do!n!ard shift in the demand curve :!hen the tax is imposed on consumers; is exactly the same ma nitude as the up!ard shift in the supply curve !hen the tax is imposed on producers. So a ain, the e"uilibrium "uantity is &5, the price paid by consumers is P5 :includin the tax paid to the overnment;, and the price received by

6.

?.

Chapter 66Supply, Demand, and Government Policies )5% producers is P5 I %D cents.

b.

8i+$"e = The more elastic is the demand curve, the more effective this tax !ill be in reducin the "uantity of asoline consumed. Greater elasticity of demand means that "uantity falls more in response to the rise in the price of asoline. @i ure ? illustrates this result. Demand curve D) represents an elastic demand curve, !hile demand curve D5 is more inelastic. To et the same tax !ed e bet!een demand and supply re"uires a reater reduction in "uantity !ith demand curve D) than for demand curve D5.

8i+$"e >

)56 Chapter 66Supply, Demand, and Government Policies c. d. The consumers of asoline are hurt by the tax because they et less asoline at a hi her price. (or#ers in the oil industry are hurt by the tax as !ell. (ith a lo!er "uantity of asoline bein produced, some !or#ers may lose their =obs. (ith a lo!er price received by producers, !a es of !or#ers mi ht decline. @i ure H sho!s the effects of the minimum !a e. 4n the absence of the minimum !a e, the mar#et !a e !ould be w) and &) !or#ers !ould be employed. (ith the minimum !a e :wm; imposed above w), the mar#et !a e is wm, the number of employed !or#ers is &5, and the number of !or#ers !ho are unemployed is &9 - &5. Total !a e payments to !or#ers are sho!n as the area of rectan le /7CD, !hich e"uals wm times &5.

H.

a.

8i+$"e ? b. /n increase in the minimum !a e !ould decrease employment. The si'e of the effect on employment depends only on the elasticity of demand. The elasticity of supply doesn8t matter, because there8s a surplus of labor. The increase in the minimum !a e !ould increase unemployment. The si'e of the rise in unemployment depends on both the elasticities of supply and demand. The elasticity of demand determines the "uantity of labor demanded, the elasticity of supply determines the "uantity of labor supplied, and the difference bet!een the "uantity supplied and demanded of labor is the amount of unemployment. 4f the demand for uns#illed labor !ere inelastic, the rise in the minimum !a e !ould increase total !a e payments to uns#illed labor. (ith inelastic demand, the percenta e decline in employment !ould be less than the percenta e increase in the !a e, so total !a e payments increase. <o!ever, if the demand for uns#illed labor !ere elastic, total !a e payments !ould decline, since then the percenta e decline in employment !ould exceed the percenta e increase in the !a e.

c.

d.

Chapter 66Supply, Demand, and Government Policies )5? >. a. @i ure > sho!s the effect of a tax on un buyers. The tax reduces the demand for uns from D) to D5. The result is a rise in the price buyers pay for uns from P) to P5, and a decline in the "uantity of uns from &) to &5.

8i+$"e @ b. @i ure )D sho!s the effect of a tax on un sellers. The tax reduces the supply of uns from S) to S5. The result is a rise in the price buyers pay for uns from P) to P5, and a decline in the "uantity of uns from &) to &5.

8i+$"e 3A

)5H Chapter 66Supply, Demand, and Government Policies c. @i ure )) sho!s the effect of a bindin price floor on uns. The increase in price from P) to Pf leads to a decline in the "uantity of uns from &) to &5. There is excess supply in the mar#et for uns, since the "uantity supplied : &9; exceeds the "uantity demanded :&5; at the price Pf.

8i+$"e 33 d. @i ure )5 sho!s the effect of a tax on ammunition. The tax on ammunition reduces the demand for uns from D) to D5, because ammunition and uns are complements. The result is a decline in the price of uns from P) to P5, and a decline in the "uantity of uns from &) to &5.

)D.

a.

8i+$"e 39 Pro rams aimed at ma#in the public a!are of the dan ers of smo#in reduce the demand for ci arettes, sho!n in @i ure )9 as a shift from demand curve D) to D5. The price support pro ram increases the price of tobacco, !hich is

Chapter 66Supply, Demand, and Government Policies )5> the main in redient in ci arettes. /s a result, the supply of ci arettes shifts to the left, from S) to S5. The effect of both pro rams is to reduce the "uantity of ci arette consumption from &) to &5.

8i+$"e 3: b. The combined effect of the t!o pro rams on the price of ci arettes is ambi uous. The education campai n reduces demand for ci arettes, !hich tends to reduce the price. The tobacco price supports raise the cost of production of ci arettes, !hich tends to increase the price. The taxation of ci arettes further reduces ci arette consumption, since it increases the price to consumers. /s sho!n in the fi ure, the "uantity falls to & 9. The effect of a ED.%D per cone subsidy is to shift the demand curve up by ED.%D at each "uantity, since at each "uantity a consumerKs !illin ness to pay is ED.%D hi her. The effects of such a subsidy are sho!n in @i ure )$. 7efore the subsidy, the price is P). /fter the subsidy, the price received by sellers is PS and the effective price paid by consumers is PD, !hich e"uals PS minus %D cents. 7efore the subsidy, the "uantity of cones sold is &)G after the subsidy the "uantity increases to &5.

c.

)).

a.

)9D Chapter 66Supply, Demand, and Government Policies 8i+$"e 3; b. 7ecause of the subsidy, consumers are better off, since they consume more at a lo!er price. Producers are also better off, since they sell more at a hi her price. The overnment loses, since it has to pay for the subsidy.