Supply, Demand, and
Government Policies
Supply, Demand and
Government Policies
Chapter 6
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Price Controls...
uAre
usually enacted when
policymakers believe the market
price is unfair to buyers or sellers.
uResult in government-created price
ceilings and floors.
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u In a free, unregulated market system,
market forces establish equilibrium prices
and exchange quantities.
u While equilibrium conditions may be
efficient, it may be true that not everyone is
satisfied.
u One of the roles of economists is to use their
theories to assist in the development of
policies.
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Price Ceilings & Price Floors
Price Ceiling
u
A legally established maximum price at which
a good can be sold.
Price Floor
u
A legally established minimum price at which a
good can be sold.
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Price Ceilings
Two outcomes are possible when the
government imposes a price ceiling:
The price ceiling is not binding if set above
the equilibrium price.
u The price ceiling is binding if set below the
equilibrium price, leading to a shortage.
A Price Ceiling That Is Not Binding...
Price of
Ice-Cream
Cone
u
Supply
Price
ceiling
$4
3
Equilibrium
price
Demand
0
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100
Equilibrium
quantity
Quantity of
Ice-Cream
Cones
1
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A Price Ceiling That Is Binding...
Price of
Ice-Cream
Cone
A binding price ceiling creates ...
… shortages because QD > QS.
Supply
Equilibrium
price
u Example:
Price
ceiling
2
Shortage
Demand
75
Quantity
supplied
125
Quantity
demanded
n
n
u Examples:
Long lines, Discrimination
by sellers
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Notice that even though price ceiling was
motivated by a desire to help buyers of
ice cream, not all buyers benefit.
Some buyers do get to pay a lower price,
although they may have to wait in line.
Some buyer do not get the opportunity to
purchase any ice cream.
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Lines at the Gas Pump
In 1973 OPEC raised the price of
crude oil in world markets. Because
crude oil is the major input used to
make gasoline, the higher oil prices
reduced the supply of gasoline.
What was responsible for the long
gas lines?
Economists blame government
regulations that limited the price oil
companies could charge for gasoline.
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The Price Ceiling on Gasoline Is
Not Binding...
Price of
Gasoline
1. Initially,
the
price ceiling
is not
binding...
… nonprice rationing
Quantity of
Ice-Cream
Cones
Effects of Price Ceiling
n
Gasoline shortage of the
1970s
$3
0
Effects of Price Ceilings
The Price Ceiling on Gasoline Is
Binding...
S2
Price of
Gasoline
Supply
2. …but
when supply
falls...
S1
P2
Price
ceiling
$4
Price
ceiling
P1
P1
3. …the price
ceiling becomes
binding...
4. …resulting
in a shortage.
Demand
0
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Q1
Quantity of
Gasoline
Demand
0
Q1
Quantity of
Gasoline
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2
Rent Control in the Short Run...
Rent Control
Rental
Price of
Apartment
u Rent
controls are ceilings placed on the
rents that landlords may charge their
tenants.
Supply
u The
goal of rent control policy is to help
the poor by making housing more
affordable.
Controlled rent
Shortage
u One
economist called rent control “the
best way to destroy a city, other than
bombing.”
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Demand
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How Landlords Ration
Housing
Because the
supply and
demand for
apartments are
more elastic...
Supply
…rent control
causes a large
shortage
Quantity of
Apartments
0
Rent Control in the Long Run...
Rental
Price of
Apartment
Supply and
demand for
apartments
are relatively
inelastic
n
Keep long waiting lists.
n
Give preferences to tenants without children or
pets.
n
They may discriminate on the basis of race.
n
They may take bribes
Controlled rent
Shortage
Demand
Quantity of
Apartments
0
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Price Floors
When the government imposes a
price floor, two outcomes are
possible.
u The price floor is
not binding if set below
the equilibrium price.
u The price floor is binding if set above the
equilibrium price, leading to a surplus.
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A Price Floor That Is Not Binding...
Price of
Ice-Cream
Cone
Supply
Equilibrium
price
$3
Price
floor
2
Demand
0
100
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Equilibrium
quantity
Quantity of
Ice-Cream
Cones
3
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A Price Floor That Is Binding...
Price of
Ice-Cream
Cone
Surplus
Supply
$4
Price floor
$3
Equilibrium
price
Effects of a Price Floor
uA price floor prevents supply and
demand from moving toward the
equilibrium price and quantity.
uWhen the market price hits the
floor, it can fall no further, and the
market price equals the floor price.
Demand
0
80
Quantity
demanded
120
Quantity of
Ice-Cream
Cones
Quantity
supplied
Effects of a Price Floor
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The Minimum Wage
A binding price floor causes . . .
… a surplus because QS >QD.
… nonprice rationing is an alternative
mechanism for rationing the good,
using discrimination criteria.
An important example of a
price floor is the minimum
wage. Minimum wage laws
dictate the lowest price
possible for labor that any
employer may pay.
uExamples: The minimum wage, Agricultural
price supports
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The Minimum Wage
The Minimum Wage
A Free Labor Market
Wage
Labor
supply
Wage
A Labor Market with a
Minimum Wage
Labor surplus
(unemployment)
Labor
supply
Minimum
wage
Equilibrium
wage
Labor
demand
0
Equilibrium
employment
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Quantity of
Labor
Labor
demand
0
Quantity
demanded
Quantity
supplied
Quantity of
Labor
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4
The Minimum Wage
n
n
n
The impact of minimum wage depends on
the skill and experience of the worker.
Workers with high skills are not affected,
because they are making considerably
more than the minimum wage.
The minimum wage has its greatest
impact on the teenage labor market.
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The Minimum Wage
n
Studies have shown that a 10% increase
in the minimum wage causes a 1 to 3
percent drop in teenage employment.
n
Fewer than 1/3 of minimum wage earners
are in families with incomes below the
poverty line.
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Evaluating Price Controls
n
n
“Markets are usually a good way to
organize economic activity.”
Both the rent control and the minimum
wage policies have adverse effects.
Letting the market work itself out may be
a better alternative.
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Taxes
Governments levy taxes to
raise revenue for public
projects.
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Taxes
uTax
incidence is the study of who
bears the burden of a tax.
uTaxes result in a change in market
equilibrium.
uBuyers pay more and sellers receive
less, regardless of whom the tax is
levied on.
Impact of a 50¢ Tax Levied on
Buyers...
Price of
Ice-Cream
Cone
3.00
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).
D1
D2
0
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Supply, S1
100
Quantity of
Ice-Cream Cones
5
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Impact of a 50¢ Tax Levied on
Buyers...
Price of
Ice-Cream
Cone
Price
buyers
pay
$3.30
3.00
2.80
Price
without
tax
Price
sellers
receive
What was the impact of tax?
uTaxes discourage
Supply, S1
market activity.
uWhen a good is taxed,
the quantity sold is
smaller.
uBuyers and sellers
share the tax burden.
Equilibrium without tax
Tax ($0.50)
Equilibrium
with tax
D1
D2
0
90 100
Quantity of
Ice-Cream Cones
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Impact of a 50¢ Tax on Sellers...
Price of
Ice-Cream
Cone
Price
buyers
pay
$3.30
3.00
2.80
Price
without
tax
A tax on sellers
shifts the
supply curve
upward by the
amount of the
tax ($0.50).
S2
Equilibrium
with tax
S1
Tax ($0.50)
Equilibrium without tax
Price
sellers
receive
Demand, D1
0
90 100
Quantity of
Ice-Cream Cones
The Effect of Taxes
n
Taxes on buyers and sellers are
equivalent.
n
Regardless of who is taxed, we end up
with the same result. In this example, the
buyer pays 30 cents of the 50 cent tax and
the seller pays 20 cents of the 50 cent tax.
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A Payroll Tax
Wage
The Incidence of Tax
Labor
supply
Wage firms
pay
Wage
without tax
Tax wedge
Wage workers
receive
Labor
demand
0
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Quantity of
Labor
uIn
what proportions is the burden of
the tax divided?
uHow do the effects of taxes on sellers
compare to those levied on buyers?
The answers to these questions
depend on the elasticity of demand
and the elasticity of supply.
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6
Elastic Supply, Inelastic Demand...
Price
Inelastic Supply, Elastic Demand...
1. When supply is more
elastic than demand...
Price buyers pay
Supply
Tax
Price without tax
Price sellers receive
3. ...than on
producers.
0
2. ...the
incidence of the
tax falls more
heavily on
consumers...
1. When demand is more
elastic than supply...
Price
Supply
Price buyers pay
Price without tax
3. ...than on consumers.
Tax
Demand
2. ...the
incidence of
the tax falls more
heavily on producers...
Price sellers receive
Demand
0
Quantity
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Quantity
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So, how is the burden of the
tax divided?
Summary
uPrice
The burden of a
tax falls more
heavily on the side
of the market that
is less elastic.
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controls include price ceilings
and price floors.
u A price ceiling is a legal maximum on
the price of a good or service. An
example is rent control.
uA price floor is a legal minimum on
the price of a good or a service. An
example is the minimum wage.
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Summary
uTaxes
are used to raise revenue for
public purposes.
uWhen the government levies a tax on
a good, the equilibrium quantity of
the good falls.
uA tax on a good places a wedge
between the price paid by buyers and
the price received by sellers.
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Summary
uThe
incidence of a tax refers to who
bears the burden of a tax.
uThe incidence of a tax does not
depend on whether the tax is levied
on buyers or sellers.
uThe incidence of the tax depends on
the price elasticities of supply and
demand.
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7