Principles of Micro

by Tanya Molodtsova, Fall 2005

Chapter 6: “Supply, Demand and

Government Policies”
 We Will Study:
 the effects of government policies
that fix the price above or below
the equilibrium price

 how a tax on a good affects the

price of the good and the quantity
sold

 how the burden of a tax is split

between buyers and sellers
I. Controls on Prices
 In a free market, market forces
establish equilibrium prices and
quantities.
 It may be true that not everyone is
satisfied in market equilibrium
 Economists use theories to develop
government policies that help change
the world for the better
 Controls on prices are usually enacted
when policymakers believe the market
price is unfair to buyers or sellers.
 They result in government-created
price ceilings and floors.
I. Controls on Prices
 price ceiling: a legal maximum on
the price at which a good can be
sold.
Example: rent-control laws sets
maximum rent that the landlords can
charge
 price floor: a legal minimum on the
price at which a good can be sold.
Example: minimum wage law dictates
the lowest wage that firms may pay
workers
 How Price Ceilings Affect
Market Outcomes
 Two outcomes are possible when
the government imposes a price
ceiling:
1. If the price ceiling is set above
the equilibrium price, it is not
binding and there is no effect on
the price or quantity sold
2. The price ceiling is set below the
equilibrium price, it is binding and
the shortage is created
 A Market With A Price Ceiling
(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
 A Market With A Price Ceiling
(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
 How Price Ceilings Affect
Market Outcomes
 A Binding Price Ceilings Creates:
- shortages because QD > QS
Example: Gasoline shortage of
the 1970s
- mechanism for rationing the good
Example: long lines,
discrimination by sellers
 Not all buyers benefit from a price
ceiling since some will be unable
to purchase the product.
 CASE STUDY: Lines at the Gas
Pump
 In 1973, OPEC raised the price of
crude oil. 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.
The Market for Gasoline with a
Price Ceiling
(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
The Market for Gasoline with a
Price Ceiling
(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
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.”
 Rent Control in the Short-Run
(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
 Rent Control in The Long-Run
(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
 Rent Control in the Short
Run and Long Run
 Since the supply of apartments is fixed
(perfectly inelastic) in the short run and
upward sloping (elastic) in the long
run, the shortage is much larger in the
long run than in the short run.
 Rent controlled apartments are
rationed in a number of ways including
long waiting lists, discrimination
against minorities and families with
children, and even under-the-table
payments to landlords.
 The quality of apartments also suffers
due to rent control.
 How Price Floors Affect
Market Outcomes
 Two outcomes are possible when the
government imposes a price floor:
1. If the price floor is lower than the
equilibrium price, it is not binding and
has no effect on the price or quantity
sold.
2. If the price floor is higher than the
equilibrium price, the floor is a
binding constraint and a surplus is
created.
 A Market With A Price Floor
(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
 A Market With A Price Floor
(b) A Price Floor That Is Binding

Price of
Ice-Cream
Cone Supply

Surplus
$4
Price
floor
3

Equilibrium
price

Demand

0 80 120 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones
How Price Ceilings Affect
Market Outcomes
 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

- the development of a new
mechanism for rationing the good,
using discrimination criteria
CASE STUDY: The Minimum
Wage
 An important example of a price
floor is the minimum wage.
Minimum wage laws dictate the
lowest price for labor that any
employer may pay.
 Consider a labor market in which
the wage adjusts to balance labor
supply and labor demand
 How the Minimum Wage
Affects the Labor Market
Wage

Labor
Supply
Labor surplus
(unemployment)
Minimum
wage

Labor
demand
0 Quantity Quantity Quantity of
demanded supplied Labor
How the Minimum Wage Affects
the Labor Market
 If the minimum wage is above the
equilibrium wage in the labor
market, a surplus of labor will
develop (unemployment).
 The minimum wage will be a
binding constraint only in markets
where equilibrium wages are low.
 Thus, the minimum wage will
have its greatest impact on the
market for teenagers and other
unskilled workers.
 Evaluating Price Controls
 Most economists oppose the use of
price ceilings and floors
Prices balance supply and demand
and thus coordinate economic activity.
If prices are set by laws, they obscure
the signals that efficiently allocate
scarce resources.
 Price ceilings and price floors often
hurt the people they are intended to
help.
- Rent controls create a shortage of
quality housing and provide
disincentives for building maintenance.
- Minimum wage laws create higher
rates of unemployment for teenage and
low skilled workers.
Taxes

 Governments levy taxes to raise

revenue for public projects
 tax incidence: the manner in
which the burden of a tax is
shared among participants in
a market.
How Taxes on Buyers Affect
Market Outcomes
 If the government requires the buyer
to pay a certain amount for each unit
of a good purchased, this will cause a
decrease in demand.
 The demand curve will shift down by
the amount of the tax.
 The quantity of the good sold will
decline.
 Buyers and sellers will share the
burden of the tax; buyers pay more for
the good (including the tax) and
sellers receive less.
How Taxes on Buyers Affect
Market Outcomes
 Two lessons can be learned
here:
1. Taxes discourage market
activity. When the good is
taxed the quantity sold is
smaller than before the tax.
2. Buyers and sellers share the
burden of a tax.
 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
 How Taxes on Sellers Affect
Market Outcomes
 If the government requires the seller to
pay a certain amount for each unit of a
good purchased, this will cause a
decrease in supply.
 The supply curve will shift up by the
amount of the tax.
 The quantity of the good sold will
decline.
 Buyers and sellers will share the
burden of the tax; buyers pay more for
the good and sellers receive less
(because of the tax).
 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
 Elasticity and Tax Incidence

 In what proportions is the burden of

the tax divided?
 The answer to this question
depends on the elasticity of
demand and the elasticity of
supply.
 The burden of a tax falls more
heavily on the side of the
market that is less elastic
 Elasticity and Tax Incidence
 When supply is elastic and demand is
inelastic, the largest share of the tax
burden falls on consumers.
A small elasticity of demand means that
buyers do not have good alternatives to
consuming this product.
 When supply is inelastic and demand is
elastic, the largest share of the tax
burden falls on producers.
A small elasticity of supply means that
sellers do not have good alternatives to
producing this particular good.
 How The Burden of Tax is Divided
(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
 How The Burden of Tax is
Divided (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
 Summary
 Price controls include price ceilings
and price floors.
 A price ceiling is a legal maximum
on the price of a good or service.
An example is rent control.
 A price floor is a legal minimum on
the price of a good or a service.
An example is the minimum wage.
Summary
 Taxes are used to raise revenue
for public purposes.
 When the government levies a tax
on a good, the equilibrium quantity
of the good falls.
 A tax on a good places a wedge
between the price paid by buyers
and the price received by sellers.
 Summary
 The incidence of a tax refers to
who bears the burden of a tax.
 The incidence of a tax does not
depend on whether the tax is levied
on buyers or sellers.
 The incidence of the tax depends
on the price elasticities of supply
and demand.
 The burden tends to fall on the side
of the market that is less elastic.