10/11/2017

Supply, Demand, and Government

Policies
• In a free, unregulated market system, market
forces establish equilibrium prices and
exchange quantities.
• While equilibrium conditions may be efficient,
it may be true that not everyone is satisfied.
Supply, Demand, and • One of the roles of economists is to use their
Government Policies theories to assist in the development of policies.

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CONTROLS ON PRICES CONTROLS ON PRICES

• Are usually enacted when policymakers believe • Price Ceiling
the market price is unfair to buyers or sellers. • A legal maximum on the price at which a good can
• Result in government-created price ceilings and be sold.
floors. • Price Floor
• A legal minimum on the price at which a good can
be sold.

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Figure 1 A Market with a Price Ceiling

How Price Ceilings Affect Market Outcomes
(a) A Price Ceiling That Is Not Binding

• Two outcomes are possible when the Price of

Ice-Cream
government imposes a price ceiling: Cone
Supply
• The price ceiling is not binding if set above the
equilibrium price. $4 Price
ceiling
• The price ceiling is binding if set below the 3
equilibrium price, leading to a shortage. Equilibrium
price

Demand

0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones
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Figure 1 A Market with a Price Ceiling

How Price Ceilings Affect Market Outcomes
(b) A Price Ceiling That Is Binding

Price of • Effects of Price Ceilings

Ice-Cream
Cone
Supply
• A binding price ceiling creates
Equilibrium
• shortages because Q D > Q S.
price • Example: Gasoline shortage of the 1970s
$3 • nonprice rationing
• Examples: Long lines, discrimination by sellers
2 Price
Shortage ceiling

Demand

0 75 125 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones
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Figure 2 The Market for Gasoline with a Price Ceiling

CASE STUDY: Lines at the Gas Pump
(a) The Price Ceiling on Gasoline Is Not Binding

• In 1973, OPEC raised the price of crude Price of

Gasoline
oil in world markets. Crude oil is the
major input in gasoline, so the higher oil
Supply, S1
prices reduced the supply of gasoline. 1. Initially,
• What was responsible for the long gas the price
ceiling
lines? is not
Price ceiling
• Economists blame government binding . . .

regulations that limited the price oil P1

companies could charge for

gasoline.
Demand
0 Q1 Quantity of
Gasoline
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Figure 2 The Market for Gasoline with a Price Ceiling

CASE STUDY: Rent Control in the Short Run
(b) The Price Ceiling on Gasoline Is Binding
and Long Run
Price of S2 • Rent controls are ceilings placed on the rents
Gasoline 2. . . . but when
supply falls . . . that landlords may charge their tenants.
S1 • The goal of rent control policy is to help the
P2
poor by making housing more affordable.
• One economist called rent control “the best way
Price ceiling
3. . . . the price
to destroy a city, other than bombing.”
P1
4. . . . ceiling becomes
resulting binding . . .
in a
shortage. Demand
0 QS QD Q1 Quantity of
Gasoline
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Figure 3 Rent Control in the Short Run and in the Long Run Figure 3 Rent Control in the Short Run and in the Long Run

(a) Rent Control in the Short Run (b) Rent Control in the Long Run
(supply and demand are inelastic) (supply and demand are elastic)
Rental Rental
Price of Price of
Apartment Supply Apartment

Supply

Controlled rent Controlled rent

Shortage Demand
Shortage
Demand

0 Quantity of 0 Quantity of
Apartments Apartments
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Figure 4 A Market with a Price Floor

How Price Floors Affect Market Outcomes
(a) A Price Floor That Is Not Binding

• When the government imposes a price floor, Price of

Ice-Cream
two outcomes are possible. Cone Supply

• The price floor is not binding if set below the Equilibrium

equilibrium price. price

• The price floor is binding if set above the $3

Price

equilibrium price, leading to a surplus. 2

floor

Demand

0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones
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Figure 4 A Market with a Price Floor

How Price Floors Affect Market Outcomes
(b) A Price Floor That Is Binding

Price of • A price floor prevents supply and demand from

Ice-Cream
Cone Supply moving toward the equilibrium price and quantity.
Surplus • When the market price hits the floor, it can fall no
$4 further, and the market price equals the floor price.
Price
floor
3

Equilibrium
price

Demand

0 80 120 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones
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How Price Floors Affect Market Outcomes The Minimum Wage

• A binding price floor causes . . . • An important example of a price floor is the

• a surplus because QS > QD. minimum wage. Minimum wage laws dictate
• nonprice rationing is an alternative mechanism for the lowest price possible for labor that any
rationing the good, using discrimination criteria. employer may pay.
• Examples: The minimum wage, agricultural price
supports

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Figure 5 How the Minimum Wage Affects the Labor Market Figure 5 How the Minimum Wage Affects the Labor Market

Wage Wage

Labor Labor
Supply Labor surplus Supply
(unemployment)
Minimum
wage
Equilibrium
wage

Labor Labor
demand demand
0 Equilibrium Quantity of 0 Quantity Quantity Quantity of
employment Labor demanded supplied Labor

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How Taxes on Buyers (and Sellers) Affect

TAXES Market Outcomes
• Governments levy taxes to raise revenue for • Taxes discourage market activity.
public projects. • When a good is taxed, the
quantity sold is smaller.
• Buyers and sellers share
the tax burden.

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Elasticity and Tax Incidence Elasticity and Tax Incidence

• Tax incidence is the manner in which the • Tax incidence is the study of who bears the
burden of a tax is shared among participants in burden of a tax.
a market. • Taxes result in a change in market equilibrium.
• Buyers pay more and sellers receive less,
regardless of whom the tax is levied on.

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Figure 6 A Tax on Buyers

Elasticity and Tax Incidence
Price of

Price
Ice-Cream
Supply, S1
• What was the impact of tax?
Cone
buyers • Taxes discourage market activity.
pay
$3.30 Equilibrium without tax • When a good is taxed, the quantity sold is smaller.
Tax ($0.50)
Price 3.00 A tax on buyers • Buyers and sellers share the tax burden.
without 2.80
shifts the demand
tax
curve downward
by the size of
Price Equilibrium the tax ($0.50).
sellers with tax
receive

D1
D2

0 90 100 Quantity of
Ice-Cream Cones

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Figure 7 A Tax on Sellers Figure 8 A Payroll Tax

Price of Wage
Ice-Cream A tax on sellers
Price Cone Equilibrium S2 shifts the supply
buyers with tax curve upward Labor supply
pay by the amount of
$3.30 S1
Tax ($0.50) the tax ($0.50).
Price 3.00
without 2.80 Wage firms pay
Equilibrium without tax
tax Tax wedge
Price Wage without tax
sellers
receive Wage workers
receive
Demand, D1

Labor demand

0 90 100 Quantity of 0 Quantity

Ice-Cream Cones of Labor
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Figure 9 How the Burden of a Tax Is Divided

Elasticity and Tax Incidence
(a) Elastic Supply, Inelastic Demand

• In what proportions is the burden of the tax Price

1. When supply is more elastic

divided? Price buyers pay

than demand . . .

• How do the effects of taxes on sellers compare Supply

to those levied on buyers? Tax

2. . . . the

• The answers to these questions depend on the Price without tax

incidence of the
tax falls more

elasticity of demand and the elasticity of supply. Price sellers

heavily on
consumers . . .
receive

3. . . . than
Demand
on producers.

0 Quantity

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Figure 9 How the Burden of a Tax Is Divided

ELASTICITY AND TAX INCIDENCE
(b) Inelastic Supply, Elastic Demand

Price
1. When demand is more elastic
than supply . . . So, how is the burden of the tax divided?
Price buyers pay Supply

Price without tax 3. . . . than on

consumers.
Tax

• The burden of a tax falls more

Price sellers
2. . . . the
incidence of
Demand heavily on the side of the
receive the tax falls
more heavily market that is less elastic.
on producers . . .

0 Quantity

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Summary Summary
• Price controls include price ceilings and price floors. • The incidence of a tax refers to who bears the burden
• A price ceiling is a legal maximum on the price of a of a tax.
good or service. An example is rent control. • The incidence of a tax does not depend on whether the
• A price floor is a legal minimum on the price of a good tax is levied on buyers or sellers.
or a service. An example is the minimum wage. • The incidence of the tax depends on the price
• Taxes are used to raise revenue for public purposes. elasticities of supply and demand.
• When the government levies a tax on a good, the • The burden tends to fall on the side of the market that
equilibrium quantity of the good falls. is less elastic.
• A tax on a good places a wedge between the price paid
by buyers and the price received by sellers.

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