Supply, Demand, and

Government Policies

2021/10/19 Supply, Demand, and Government Policies 1

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2021/10/19 Supply, Demand, and Government Policies 2

Review: The Elasticity of Demand
 For a linear demand curve (constant slope), the
price elasticity of demand is also related to the
position on the curve, as

Q / Q Q P
  
P / P P Q
  Inverse of Slope   (position)

2021/10/19 Supply, Demand, and Government Policies 3

Review: Total Revenue & Demand Elasticity
 Total revenue (TR) is the amount paid by buyers
and received by sellers of a good. It is computed
as the price (P) of the good times the quantity (Q)
sold, i.e. TR = P x Q.

 An interesting question arises – does price-

cutting increase total revenue? i.e. Is price-
cutting a good competing strategy?
 It depends!
1. TR decreases with price-cutting when 𝜀 1.
2. TR increases with price-cutting when 𝜀 1.

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2021/10/19 Supply, Demand, and Government Policies 5
Supply, Demand, and Government
Policies
 In a free, unregulated market system, market
forces establish equilibrium prices and exchange
quantities.

 In this chapter, we’ll use the Demand & Supply

tools to study
 the effect of price control, and

 the tax incidence.

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Controls on Prices

 They are usually enacted when policymakers

believe the market price is unfair to buyers or
sellers.
 Result in government-created price ceilings
and floors.
 Price Ceiling: A legal maximum on the price at
which a good can be sold.
 Price Floor: A legal minimum on the price at which
a good can be sold.

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How Price Ceilings Affect Market Outcomes

 Two outcomes are possible when the

government imposes a price ceiling:
 The price ceiling is not binding if set above the
equilibrium price.
 The price ceiling is binding if set below the
equilibrium price, leading to a shortage.

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 (a) A Price Ceiling That Is Not Binding

Price of
Ice-Cream
Cone
Supply

$4 Price
ceiling
3
Equilibrium
price

Demand

0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones

2021/10/19 Supply, Demand, and Government Policies 9

 (b) A Price Ceiling That Is Binding

Price of
Ice-Cream
Cone
Supply

Equilibrium
price

$3

2 Price
Shortage ceiling

Demand

0 75 125 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones

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Effects of Price Ceilings

 A binding price ceiling creates

 shortages because QD > QS.
 Example: Gasoline shortage of the 1970s

 nonprice rationing
 Examples: Long lines, discrimination by sellers

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CASE STUDY: Lines at the Gas Pump

 In 1973, OPEC raised the price of

crude oil in world markets. Crude oil is
the major input in gasoline, so 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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 (a) The Price Ceiling on Gasoline Is Not Binding

Price of
Gasoline

Supply, S1
1. Initially,
the price
ceiling
is not
binding . . . Price ceiling

P1

Demand
0 Q1 Quantity of
Gasoline

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 (b) The Price Ceiling on Gasoline Is Binding

Price of S2
Gasoline 2. . . . but when
supply falls . . .

S1
P2

Price ceiling

P1 3. . . . the price
4. . . . ceiling becomes
resulting binding . . .
in a
shortage. Demand
0 QS QD Q1 Quantity of
Gasoline

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CASE STUDY: Rent Control in the Short Run
and Long Run
 Rent controls are ceilings placed on the rents
that landlords may charge their tenants.

 The goal of rent control policy is to help the

poor by making housing more affordable.

 One economist called rent control “the best

way to destroy a city, other than bombing.”

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

Controlled rent

Shortage
Demand

0 Quantity of
Apartments

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

Supply

Controlled rent

Shortage Demand

0 Quantity of
Apartments

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How Price Floors Affect Market Outcomes

 When the government imposes a price floor,

two outcomes are possible.

 The price floor is not binding if set below the

equilibrium price.

 The price floor is binding if set above the

equilibrium price, leading to a surplus.

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 (a) A Price Floor That Is Not Binding

Price of
Ice-Cream
Cone Supply

Equilibrium
price

$3
Price
floor
2

Demand

0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones

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 (b) A Price Floor That Is Binding

Price of
Ice-Cream
Cone Supply

Surplus
$4
Price
floor
3

Equilibrium
price

Demand

0 80 Quantity of
120
Quantity Quantity Ice-Cream
demanded supplied Cones

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How Price Floors Affect Market Outcomes
 A price floor prevents supply and demand from
moving toward the equilibrium price and quantity.

 When the market price hits the floor, it can fall no

further, and the market price equals the floor price.

 A binding price floor causes . . .

 a surplus because QS > QD.

 nonprice rationing is an alternative mechanism for

rationing the good, using discrimination criteria.
 Examples: The minimum wage, agricultural price supports

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The Minimum Wage

 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.

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 How Minimum Wage Affects Labor Market
Wage

Labor
Supply

Equilibrium
wage

Labor
demand
0 Equilibrium Quantity of
employment Labor

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 How Minimum Wage Affects Labor Market
Wage

Labor
Labor surplus Supply
(unemployment)
Minimum
wage

Labor
demand
0 Quantity Quantity Quantity of
demanded supplied Labor

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Taxes
 Governments levy taxes to raise revenue for
public projects.

 Taxes discourage market activity.

 When a good is taxed, the quantity sold is smaller.

 Buyers and sellers share the tax burden, i.e.

buyers pay more and sellers receive less,
regardless of whom the tax is levied on.

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Elasticity and Tax Incidence

 Tax incidence is the study of who bears the

burden of a tax, or how the burden of a tax is
shared among participants in a market.

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A Tax on Buyers
Price of
Ice-Cream
Price Cone Supply, S1
buyers
pay
$3.30 Equilibrium without tax
Tax ($0.50)
Price 3.00 A tax on buyers
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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 A Tax on Sellers
Price of
Ice-Cream A tax on sellers
Price Cone Equilibrium S2 shifts the supply
buyers with tax curve upward
pay by the amount of
$3.30 S1
Tax ($0.50) the tax ($0.50).
Price 3.00
without 2.80 Equilibrium without tax
tax

Price
sellers
receive

Demand, D1

0 90 100 Quantity of
Ice-Cream Cones

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Elasticity and Tax Incidence

 What was the impact of tax?

 Taxes discourage market activity.

 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

 In what proportions is the burden of the tax

divided?

 How 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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 (a) Elastic Supply, Inelastic Demand

Price
1. When supply is more elastic
than demand . . .
Price buyers pay
Supply

Tax
2. . . . the
incidence of the
Price without tax tax falls more
heavily on
Price sellers consumers . . .
receive

3. . . . than
Demand
on producers.

0 Quantity

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 (b) Inelastic Supply, Elastic Demand

Price
1. When demand is more elastic
than supply . . .
Price buyers pay Supply

Price without tax 3. . . . than on

consumers.
Tax

2. . . . the Demand
Price sellers incidence of
receive the tax falls
more heavily
on producers . . .

0 Quantity

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How is the burden of the tax divided?

 The burden of a tax falls more heavily on the

side of the market that is less elastic.

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