Lect06

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 ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Demand

Supply

Priceceiling

Equilibriumprice

100Equilibrium

quantity

A Price Ceiling That Is Binding...

$3

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

2

Demand

Supply

Equilibriumprice

Priceceiling

Shortage

125Quantity

demanded

75Quantitysupplied

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

The Price Ceiling on Gasoline Is Not Binding...

$4

P1

Quantity ofGasoline

0

Price ofGasoline

Q1

Demand

Supply

Priceceiling

1. Initially, the price ceiling is not binding...

The Price Ceiling on Gasoline Is Binding...

P1

Quantity ofGasoline

0

Price ofGasoline

Q1

Demand

S1

Priceceiling

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 ofApartments

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 ofApartments

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 ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

100Equilibrium

quantity

Equilibrium

price

Demand

Supply

Pricefloor2

A Price Floor That Is Binding...

$3

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Equilibrium

price

Demand

Supply

Price floor$4

120Quantitysupplied

80Quantity

demanded

Surplus

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 . . . 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

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 ofLabor

0

Wage

Equilibrium

wage

Labor demand

Labor supply

A Free Labor Market

Equilibriumemploymen

t

Minimumwage

The Minimum Wage

Quantity ofLabor

0

Wage

Labor demand

Labor supply

Quantitysupplied

Quantitydemanded

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...

3.00

Quantity ofIce-Cream Cones

0

Price ofIce-Cream

Cone

100

D1

Supply, S1

A tax on buyersshifts the demandcurve downwardby the size ofthe tax ($0.50).

D2

3.00

Quantity ofIce-Cream Cones

0

Price ofIce-Cream

Cone

10090

$3.30

Pricebuyers

pay

D1

D2

Equilibriumwith tax

Supply, S1

Equilibrium without tax

Impact of a 50¢ Tax Levied on Buyers...

2.80

Pricesellersreceive

Pricewithout

tax

Tax ($0.50)

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.

3.00

Quantity ofIce-Cream Cones

0

Price ofIce-Cream

Cone

10090

S1

S2

Demand, D1

Impact of a 50¢ Tax on Sellers...

Price without tax

2.80

Price sellers receiv

e

$3.30

Price buyers

pay

Equilibrium without tax

A tax on sellers shifts the supply

curve upward by the

amount of the tax ($0.50).

Tax ($0.50)

Equilibriumwith tax

A Payroll Tax

Quantity ofLabor

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 moreelastic than demand...

2. ...theincidence of thetax falls moreheavily onconsumers...

3. ...than onproducers.

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 moreelastic than supply...

2. ...theincidence 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.