Supply, Demand and
Government Policies
Chapter 6
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.
One of the roles of economists is to use
their theories to assist in the development
of policies.
Price Controls...
Are usually enacted when
policymakers believe the market
price is unfair to buyers or sellers.
Result in government-created price
ceilings and floors.
Price Ceilings & Price Floors
Price Ceiling
A legally established maximum price at which
a good can be sold.
Price Floor
A legally established minimum price at which
a good can be sold.
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.
The price ceiling is binding if set below the
equilibrium price, leading to a shortage.
A Price Ceiling That Is Not Binding...
$4
3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
Demand
Supply
Price
ceiling
Equilibrium
price
100
Equilibrium
quantity
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Price Ceiling That Is Binding...
$3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
2
Demand
Supply
Equilibrium
price
Price
ceiling
Shortage
125
Quantity
demanded
75
Quantity
supplied
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Effects of Price Ceilings
A binding price ceiling creates ...
¼ shortages because QD > QS.
Example: Gasoline shortage of the
1970s
¼ nonprice rationing
Examples: Long lines, Discrimination
by sellers
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.
The Price Ceiling on Gasoline Is Not
Binding...
$4
P1
Quantity of
Gasoline
0
Price of
Gasoline
Q1
Demand
Supply
Price
ceiling
1. Initially,
the
price ceiling
is not
binding...
The Price Ceiling on Gasoline Is
Binding...
P1
Quantity of
Gasoline
0
Price of
Gasoline
Q1
Demand
S1
Price
ceiling
S2 2. …but
when supply
falls...
P2
3. …the price
ceiling becomes
binding...4. …resulting
in a shortage.
Rent Control
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...
Quantity of
Apartments
0
Rental
Price of
Apartment
Demand
Supply
Controlled rent
Shortage
Supply and
demand for
apartments
are relatively
inelastic
Rent Control in the Long Run...
Quantity of
Apartments
0
Rental
Price of
Apartment
Demand
Supply
Controlled rent
Shortage
Because the
supply and
demand for
apartments are
more elastic...
…rent control
causes a large
shortage
Price Floors
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.
A Price Floor That Is Not Binding...
$3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
100
Equilibrium
quantity
Equilibrium
price
Demand
Supply
Price
floor2
A Price Floor That Is Binding...
$3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
Equilibrium
price
Demand
Supply
Price floor$4
120
Quantity
supplied
80
Quantity
demanded
Surplus
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Effects of a Price Floor
A price floor prevents supply and
demand from moving toward the
equilibrium price and quantity.
When the market price hits the
floor, it can fall no further, and
the market price equals the floor price.
Effects of a Price Floor
A binding price floor causes . . .
¼ a surplus because QS >QD.
¼ nonprice rationing is an alternative
mechanism for rationing the good,
using discrimination criteria.
Examples: The minimum wage, Agricultural
price supports
The Minimum Wage
An important example of a
price floor is the minimum
wage. Minimum wage laws
dictate the lowest price
possible for labor that any
employer may pay.
The Minimum Wage
Quantity of
Labor
0
Wage
Equilibrium
wage
Labor
demand
Labor
supply
A Free Labor Market
Equilibrium
employment
Minimum
wage
The Minimum Wage
Quantity of
Labor
0
Wage
Labor
demand
Labor
supply
Quantity
supplied
Quantity
demanded
Labor surplus
(unemployment)
A Labor Market with a
Minimum Wage
Taxes
Governments levy taxes to
raise revenue for public
projects.
What are some potential impacts
of taxes?
Taxes discourage
market activity.
When a good is
taxed, the quantity
sold is smaller.
Buyers and sellers
share the tax burden.
Taxes
Tax incidence is the study of who
bears the burden of a tax.
Taxes result in a change in market
equilibrium.
Buyers pay more and sellers
receive less, regardless of whom
the tax is levied on.
Impact of a 50¢ Tax Levied on
Buyers...
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
100
D1
Supply, S1
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($).
D2
Copyright © 2001 by Harcourt, Inc. All rights reserved
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
10090
$
Price
buyers
pay
D1
D2
Equilibrium
with tax
Supply, S1
Equilibrium without tax
Impact of a 50¢ Tax Levied on
Buyers...
Price
sellers
receive
Copyright © 2001 by Harcourt, Inc. All rights reserved
Price
without
tax
Tax ($)
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.
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
10090
S1
S2
Demand, D1
Impact of a 50¢ Tax on Sellers...
Price
without
tax
Price
sellers
receive
$
Price
buyers
pay
Equilibrium without tax
Copyright © 2001 by Harcourt, Inc. All rights reserved
A tax on sellers
shifts the
supply curve
upward by the
amount of the
tax ($). Tax ($)
Equilibrium
with tax
A Payroll Tax
Quantity of
Labor
0
Wage
Wage
without tax
Labor
demand
Labor
supply
Tax wedge
Wage firms
pay
Wage workers
receive
The Incidence of Tax
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.
Elastic Supply, Inelastic Demand...
Quantity0
Price
Demand
Supply
Tax
1. When supply is more
elastic than demand...
2. ...the
incidence of the
tax falls more
heavily on
consumers...
3. ...than on
producers.
Price without tax
Price buyers pay
Price sellers receive
Inelastic Supply, Elastic Demand...
Quantity0
Price
Demand
Supply
Price without tax
Tax
1. When demand is more
elastic than supply...
2. ...the
incidence of
the tax falls more
heavily on producers...
3. ...than on consumers.
Price buyers pay
Price sellers receive
So, 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.
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.
Graphical
Review
A Price Ceiling That Is Not Binding...
$4
3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
Demand
Supply
Price
ceiling
Equilibrium
price
100
Equilibrium
quantity
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Price Ceiling That Is Binding...
$3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
2
Demand
Supply
Equilibrium
price
Price
ceiling
Shortage
125
Quantity
demanded
75
Quantity
supplied
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The Price Ceiling on Gasoline Is Not
Binding...
$4
P1
Quantity of
Gasoline
0
Price of
Gasoline
Q1
Demand
Supply
Price
ceiling
1. Initially,
the
price ceiling
is not
binding...
The Price Ceiling on Gasoline Is
Binding...
P1
Quantity of
Gasoline
0
Price of
Gasoline
Q1
Demand
S1
Price
ceiling
S2 2. …but
when supply
falls...
P2
3. …the price
ceiling becomes
binding...4. …resulting
in a shortage.
Rent Control in the Short Run...
Quantity of
Apartments
0
Rental
Price of
Apartment
Demand
Supply
Controlled rent
Shortage
Supply and
demand for
apartments
are relatively
inelastic
Rent Control in the Long Run...
Quantity of
Apartments
0
Rental
Price of
Apartment
Demand
Supply
Controlled rent
Shortage
Because the
supply and
demand for
apartments are
more elastic...
…rent control
causes a large
shortage
A Price Floor That Is Not Binding...
$3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
100
Equilibrium
quantity
Equilibrium
price
Demand
Supply
Price
floor2
A Price Floor That Is Binding...
$3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
Equilibrium
price
Demand
Supply
Price floor$4
120
Quantity
supplied
80
Quantity
demanded
Surplus
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The Minimum Wage
Quantity of
Labor
0
Wage
Equilibrium
wage
Labor
demand
Labor
supply
A Free Labor Market
Equilibrium
employment
The Minimum Wage
Minimum
wage
Quantity of
Labor
0
Wage
Labor
demand
Labor
supply
Quantity
supplied
Quantity
demanded
Labor surplus
(unemployment)
A Labor Market with a
Minimum Wage
Impact of a 50¢ Tax Levied on
Buyers...
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
100
D1
Supply, S1
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($).
D2
Impact of a 50¢ Tax Levied on
Buyers...
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
10090
$
Price
buyers
pay
D1
D2
Equilibrium
with tax
Supply, S1
Equilibrium without tax
Price
sellers
receive
Price
without
tax
Tax ($)
Impact of a 50¢ Tax on Sellers...
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
10090
S1
S2
Demand, D1
Price
without
tax
Price
sellers
receive
$
Price
buyers
pay
Equilibrium without tax
A tax on sellers
shifts the
supply curve
upward by the
amount of the
tax ($). Tax ($)
Equilibrium
with tax
A Payroll Tax
Quantity of
Labor
0
Wage
Wage
without tax
Labor
demand
Labor
supply
Tax wedge
Wage firms
pay
Wage workers
receive
Elastic Supply, Inelastic Demand...
Quantity0
Price
Demand
Supply
Tax
1. When supply is more
elastic than demand...
2. ...the
incidence of the
tax falls more
heavily on
consumers...
3. ...than on
producers.
Price without tax
Price buyers pay
Price sellers receive
Inelastic Supply, Elastic Demand...
Quantity0
Price
Demand
Supply
Price without tax
Tax
1. When demand is more
elastic than supply...
2. ...the
incidence of
the tax falls more
heavily on producers...
3. ...than on consumers.
Price buyers pay
Price sellers receive
