6 Supply, Demand, and

Government Policies

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

In this chapter, look for the answers to
these questions:
▪ What are price ceilings and price floors?
What are some examples of each?
▪ How do price ceilings and price floors affect
market outcomes?
▪ How do taxes affect market outcomes?
How does the outcome depend on whether
the tax is imposed on buyers or sellers?
▪ What is the incidence of a tax?
What determines the incidence?

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 2

 Government Policies That Alter the
Private Market Outcome
▪ Price controls
• Price ceiling: a legal maximum on the price
of a good or service. Example: rent control.
• Price floor: a legal minimum on the price of
a good or service. Example: minimum wage.
▪ Taxes
• The govt can make buyers or sellers pay a
specific amount on each unit bought/sold.

We will use the supply/demand model to see

how each policy affects the market outcome
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 3
 EXAMPLE 1: The Market for Apartments

Rental P S
price of
apts

$800
Eq’m w/o
price
controls
D
Q
300
Quantity of
apartments
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 4
How Price Ceilings Affect Market Outcomes

A price ceiling P S
above the Price
eq’m price is $1000
ceiling
not binding – $800
it has no effect
on the market
outcome.
D
Q
300

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 5

How Price Ceilings Affect Market Outcomes

The eq’m price P S

($800) is above
the ceiling and
therefore illegal.
$800
The ceiling
is a binding Price
$500
constraint ceiling
on the price, shortage
D
and causes Q
250 400
a shortage.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 6

How Price Ceilings Affect Market Outcomes

In the long run, P S

supply and
demand
are more $800
price-elastic.
Price
So, the $500
ceiling
shortage shortage
is larger. D
Q
150 450

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 7

 Shortages and Rationing
▪ With a shortage, sellers must ration the goods
among buyers.
▪ Some rationing mechanisms: (1) long lines
(2) discrimination according to sellers’ biases
▪ These mechanisms are often unfair, and inefficient:
the goods don’t necessarily go to the buyers who
value them most highly.
▪ In contrast, when prices are not controlled,
the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal (and thus fair).
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 8
EXAMPLE 2: The Market for Unskilled Labor

Wage W S
paid to
unskilled
workers
$4

Eq’m w/o
price
controls
D
L
500
Quantity of
unskilled workers
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 9
How Price Floors Affect Market Outcomes

A price floor W S
below the
eq’m price is
not binding –
it has no effect $4
on the market Price
outcome. $3
floor

D
L
500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 10

How Price Floors Affect Market Outcomes
labor
The eq’m wage ($4) W surplus S
is below the floor Price
and therefore $5
floor
illegal.
The floor $4
is a binding
constraint
on the wage,
and causes
D
a surplus L
(i.e., 400 550
unemployment).

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 11

 The Minimum Wage
Min wage laws unemp-
do not affect W loyment S
Min.
highly skilled $5
wage
workers.
They do affect $4
teen workers.
Studies:
A 10% increase
in the min wage D
L
raises teen 400 550
unemployment
by 1-3%.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 12
A C T I V E L E A R N I N G 1:
Price floors The market for
P hotel rooms
& ceilings S
Determine
effects of:
A. $90 price
ceiling
B. $90 price D
floor
C. $120 price
floor
0 Q
13
A C T I V E L E A R N I N G 1:
A. $90 price ceiling The market for
P hotel rooms
S
The price
falls to $90.
Buyers
demand Price ceiling
120 rooms,
D
sellers supply shortage = 30
90, leaving a
shortage.

0 Q
14
A C T I V E L E A R N I N G 1:
B. $90 price floor The market for
P hotel rooms
S
Eq’m price is
above the floor,
so floor is not
binding.
P = $100, Price floor
Q = 100 rooms. D

0 Q
15
A C T I V E L E A R N I N G 1:
C. $120 price floor The market for
P hotel rooms
surplus = 60 S
The price
rises to $120.
Price floor
Buyers
demand
60 rooms,
sellers supply D
120, causing
a surplus.

0 Q
16
 Evaluating Price Controls
▪ Recall one of the Ten Principles:
Markets are usually a good way
to organize economic activity.
▪ Prices are the signals that guide the allocation of
society’s resources. This allocation is altered
when policymakers restrict prices.
▪ Price controls are often intended to help the poor,
but they often hurt more than help them:
• The min. wage can cause job losses.
• Rent control can reduce the quantity and quality
of affordable housing.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 17
 Taxes
▪ The govt levies taxes on many goods & services
to raise revenue to pay for national defense,
public schools, etc.
▪ The govt can make buyers or sellers pay the tax.
▪ The tax can be a percentage of the good’s price,
or a specific amount for each unit sold.
• For simplicity, we analyze per-unit taxes only.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 18

 EXAMPLE 3: The Market for Pizza

Eq’m
P
w/o tax
S1

$10.00

D1

Q
500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 19

 A Tax on Buyers
A tax on
Effects of a $1.50 per
buyers shifts
unit tax on buyers
the D curve P
down by the
S1
amount of PB = $11.00
Tax
the tax.
$10.00
PS = $9.50
The price
buyers pay
D1
rises, the
price sellers D2
Q
receive falls, 430 500
eq’m Q falls.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 20
The Incidence of a Tax:
how the burden of a tax is shared among
market participants
P
Because
of the tax, S1
PB = $11.00
Tax
buyers pay
$10.00
$1.00 more,
PS = $9.50
sellers get
$0.50 less. D1
D2
Q
430 500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 21

 A Tax on Sellers
A tax on
Effects of a $1.50 per
sellers shifts
unit tax on sellers
the S curve P
up by the S2
S1
amount of PB = $11.00
Tax
the tax.
$10.00
PS = $9.50
The price
buyers pay
D1
rises, the
price sellers
Q
receive falls, 430 500
eq’m Q falls.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 22
The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!

What matters P
is this: S1
PB = $11.00
Tax
A tax drives
$10.00
a wedge
PS = $9.50
between the
price buyers
D1
pay and the
price sellers
Q
receive. 430 500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 23

A C T I V E L E A R N I N G 2:
Effects of a tax The market for
P hotel rooms
Suppose govt S
imposes a tax
on buyers of
$30 per room.
Find new
Q, PB, PS, D

and incidence
of tax.

0 Q
24
A C T I V E L E A R N I N G 2:
Answers The market for
P hotel rooms
S
Q = 80

PB = $110 PB =

Tax
PS = $80
PS = D
Incidence
buyers: $10
sellers: $20
0 Q
25
 Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand

P In this case,
buyers bear
PB S
Buyers’ share most of the
of tax burden burden of
Tax
Price if no tax the tax.

Sellers’ share PS
of tax burden
D
Q

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 26

 Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply

P In this case,
S
sellers bear
Buyers’ share most of the
of tax burden PB
burden of
Price if no tax the tax.
Tax
Sellers’ share
of tax burden PS
D

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 27

 Elasticity and Tax Incidence
▪ If buyers’ price elasticity > sellers’ price elasticity,
buyers can more easily leave the market when
the tax is imposed, so buyers will bear a smaller
share of the burden of the tax than sellers.
▪ If sellers’ price elasticity > buyers’ price elasticity,
the reverse is true.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 28

CASE STUDY: Who Pays the Luxury Tax?
▪ 1990: Congress adopted a luxury tax on yachts,
private airplanes, furs, expensive cars, etc.
▪ Goal of the tax: to raise revenue from those
who could most easily afford to pay –
wealthy consumers.
▪ But who really pays this tax?

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 29

CASE STUDY: Who Pays the Luxury Tax?

The market for yachts Demand is

price-elastic.
P
S
In the short run,
Buyers’ share
of tax burden PB supply is inelastic.

Tax Hence,
companies
Sellers’ share
that build
of tax burden PS
D yachts pay
most of
Q the tax.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 30

CONCLUSION: Government Policies and
the Allocation of Resources
▪ Each of the policies in this chapter affects the
allocation of society’s resources.
• Example 1: a tax on pizza reduces the eq’m
quantity of pizza.
Since the economy is producing fewer pizzas,
some resources (workers, ovens, cheese) will
become available to other industries.
• Example 2: a binding minimum wage causes a
surplus of workers, a waste of resources.
▪ So, it’s important for policymakers to apply such
policies very carefully.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 31
CHAPTER SUMMARY
▪ A price ceiling is a legal maximum on the price of
a good. An example is rent control. If the price
ceiling is below the eq’m price, it is binding and
causes a shortage.
▪ A price floor is a legal minimum on the price of a
good. An example is the minimum wage. If the
price floor is above the eq’m price, it is binding
and causes a surplus. The labor surplus caused
by the minimum wage is unemployment.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 32

CHAPTER SUMMARY
▪ A tax on a good places a wedge between the
price buyers pay and the price sellers receive,
and causes the eq’m quantity to fall, whether the
tax is imposed on buyers or sellers.
▪ The incidence of a tax is the division of the
burden of the tax between buyers and sellers,
and does not depend on whether the tax is
imposed on buyers or sellers.
▪ The incidence of the tax depends on the price
elasticities of supply and demand.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 33