Ch06 Supply Demand And Government Policies

Chapter 6Chapter 6

Supply, Demand, and Government

Policies

Supply, Demand, and Government

Policies

• Examine the effects of government policies that place a ceiling on prices.

• Examine the effects of government policies that place a floor under prices.

• Consider how a tax on a good affects the price of the good and the quantity sold.

• Learn that taxes levied on buyers and taxes levied on sellers are equivalent.

• See how the burden of a tax is split between buyers and sellers.

• Examine the effects of government policies that place a ceiling on prices.

• Examine the effects of government policies that place a floor under prices.

• Consider how a tax on a good affects the price of the good and the quantity sold.

• Learn that taxes levied on buyers and taxes levied on sellers are equivalent.

• See how the burden of a tax is split between buyers and sellers.

In this chapter you will…In this chapter you will…

• 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.

• Hence…market controls!• One of the roles of economists is to use

their theories to assist in the development of 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.

• Hence…market controls!• One of the roles of economists is to use

their theories to assist in the development of policies.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES SUPPLY, DEMAND, AND

GOVERNMENT POLICIES

• Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.

• Result in government-created price ceilings and floors.

• Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.

• Result in government-created price ceilings and floors.

CONTROLS ON PRICES CONTROLS ON PRICES

• 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.

• 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.

Price Ceilings and Price FloorsPrice Ceilings and Price Floors

• When the government imposes a price ceiling (i.e... a legal maximum on the price at which a good can be sold) two outcomes are possible

1) The price ceiling is not binding.

2) The price ceiling is a binding constraint on the market, creating Shortages.

• When the government imposes a price ceiling (i.e... a legal maximum on the price at which a good can be sold) two outcomes are possible

1) The price ceiling is not binding.

2) The price ceiling is a binding constraint on the market, creating Shortages.

How Price Ceiling Affect Market Outcomes


Quantity of Ice-Cream

Cones

Price of Ice-Cream

Cone

Demand

Supply

Equilibrium price

$3

(a) A Price Ceiling That is Not Binding (b) A Price Ceiling That is Binding

$4Price

ceiling


Cones

100Equilibrium

quantity

Price of Ice-Cream

Cone

Demand

Supply

$2

Price ceiling

$3

75

QS

Equilibrium price

125

QD

Shortage

0 0

Figure 6-1: A Market with a Price CeilingFigure 6-1: A Market with a Price Ceiling

• A binding price ceiling creates– Shortages because QD > QS.

• Examples: Gasoline shortage of the 1970s, housing shortages with rent controls.

– Non-price rationing• Examples: Long lines, discrimination by

sellers, black markets.

• A binding price ceiling creates– Shortages because QD > QS.

• Examples: Gasoline shortage of the 1970s, housing shortages with rent controls.

– Non-price rationing• Examples: Long lines, discrimination by

sellers, black markets.



• 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.

• 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.

CASE STUDY: Lines at the Gas PumpCASE STUDY: Lines at the Gas Pump

Quantity of Gasoline

Price of Gasoline

Demand

S1

(a) A Price Ceiling on Gasoline is Not Binding (b) A Price Ceiling on Gasoline is Binding

Price ceiling

P1

Q10 0

1. Initially the price ceiling is not binding…

Quantity of Gasoline

Demand

S1

Price ceiling

S2

P1

Q1QDQS

P2

4.…resulting in a shortage…

2.…but when supply falls…

3.…the price ceiling becomes binding…

Figure 6-2: A Market for Gasoline with a Price Ceiling

Figure 6-2: A Market for Gasoline with a Price Ceiling

• 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 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.”

CASE STUDY: Rent Control in the Short Run and Long Run

CASE STUDY: Rent Control in the Short Run and Long Run

Quantity of Apartments

Rental Price of

Apartment

Demand

Supply

(a) Short Run (Supply and Demand are Inelastic)

Controlled rent

0 0

(b) Long Run (Supply and Demand are Elastic)

Shortage

Quantity of Apartments

Rental Price of

Apartment

Demand

Supply

Controlled rent

Shortage

Figure 6-3: Rent Control in the Short Run and Long Run

Figure 6-3: Rent Control in the Short Run and Long Run

• 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.

• 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.

How Price Floors Affect Market Outcomes



Cones

Price of Ice-Cream

Cone

Demand

Supply

Equilibrium price

$3

(a) A Price Floor That is Not Binding (b) A Price Floor That is Binding

$2

Price Floor


Cones

100Equilibrium

quantity

Price of Ice-Cream

Cone

Demand

Supply

$4Price ceiling

$3

80

QD

Equilibrium price

120

QS

Surplus

0 0

Figure 6-4: A Market with a Price FloorFigure 6-4: A Market with a Price Floor

• A Binding Price Floor creates. . .– Surpluses (i.e. Quantity Supplied >

Quantity Demanded)– Non-Price Rationing - An alternative

mechanism for rationing of the good: Discrimination Criteria

– Examples: Minimum Wage Agricultural Price Supports

• A Binding Price Floor creates. . .– Surpluses (i.e. Quantity Supplied >

Quantity Demanded)– Non-Price Rationing - An alternative

mechanism for rationing of the good: Discrimination Criteria

– Examples: Minimum Wage Agricultural Price Supports



• 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.

• 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.

CASE STUDY: The Minimum WageCASE STUDY: The Minimum Wage

Labour demand

Labour supply

Quantity of Labour

Wage

Labour demand

Labour supply

Equilibrium wage

(a) A Free Labour Market (b) A Labour Market with a Binding Minimum Wage

Quantity of Labour

Equilibrium employment

Wage

Minimum wage

Labour surplus

(unemployment)

0 0 Quantity demanded

Quantity supplied

Figure 6-5: How the Minimum Wage Affects the Labour Market

Figure 6-5: How the Minimum Wage Affects the Labour Market

• What is the purpose of government- imposed taxes?– To raise government revenues.– To restrict production of a product.

• What is an excise tax?– A “per-unit” tax that’s independent of

the price of the product.

• What is the purpose of government- imposed taxes?– To raise government revenues.– To restrict production of a product.

• What is an excise tax?– A “per-unit” tax that’s independent of

the price of the product.

TAXESTAXES

• Who pays the tax on a good? The buyer or the seller?

• How is the burden of a tax divided between buyer and seller?

• When the government levies a tax on a good, the equilibrium quantity of the good falls. The size of the market for that good shrinks, shifting either the demand or supply curve.

• Tax incidence: The study of who bears the burden of taxation.

• Who pays the tax on a good? The buyer or the seller?

• How is the burden of a tax divided between buyer and seller?

• When the government levies a tax on a good, the equilibrium quantity of the good falls. The size of the market for that good shrinks, shifting either the demand or supply curve.

• Tax incidence: The study of who bears the burden of taxation.

TAXESTAXES

• Taxes discourage market activity.• When a good is taxed, the quantity sold

is smaller. • Buyers and sellers share the tax burden.

• Taxes discourage market activity.• When a good is taxed, the quantity sold

is smaller. • Buyers and sellers share the tax burden.

How Taxes on Buyers (and Sellers) Affect Market Outcomes

How Taxes on Buyers (and Sellers) Affect Market Outcomes

D1

S1

0 Quantity of Ice-Cream Cone

Price of Ice-Cream

Cone

$3.00

100

D2

Equilibrium without tax

90

$2.80

$3.30

Equilibrium with tax

Tax ($0.50)

Price buyers pay

Price without tax

Price sellers receive

A tax on buyers shifts the demand curve downward by size of the tax ($0.50).

Figure 6-6: A Tax on BuyersFigure 6-6: A Tax on Buyers

D1

S1

0 Quantity of Ice-Cream Cone

Price of Ice-Cream

Cone

$3.00

100

Equilibrium without tax

$2.80

Equilibrium with tax

Tax ($0.50)

Price buyers pay

Price without tax


A tax on sellers shifts the supply curve upward by an amount of the tax ($0.50).

S2

90

$3.30

Figure 6-7: A Tax on SellersFigure 6-7: A Tax on Sellers

• Example: Employment Insurance.• A payroll tax places a wedge between the

wage the workers receive and the wage the firm pays.

• Example: Employment Insurance.• A payroll tax places a wedge between the

wage the workers receive and the wage the firm pays.

CASE STUDY: The Burden of a Payroll taxCASE STUDY: The Burden of a Payroll tax

Quantity of Labour

Wage

Labour

demand

Labour supply

Wage without tax

0

Tax wedge

Wage firms pay

Wage workers receive

Figure 6-8: A Payroll TaxFigure 6-8: A Payroll Tax

• Consider a tax levied on sellers of a good. What are the effects of this tax?

• How do effects of the tax levied on the seller compare with those of the effects imposed on the buyer?

• Depends on Elasticity of Demand and Elasticity of Supply.

• Consider a tax levied on sellers of a good. What are the effects of this tax?

• How do effects of the tax levied on the seller compare with those of the effects imposed on the buyer?

• Depends on Elasticity of Demand and Elasticity of Supply.

Elasticity and Tax incidenceElasticity and Tax incidence

• The burden of a tax falls on the side of the market with the smaller price elasticity!

• The more inelastic the demand and the more elastic the supply results in the consumer paying more of the tax.

• The more elastic the demand and the more inelastic the supply results in the supplier paying more of the tax.

• The burden of a tax falls on the side of the market with the smaller price elasticity!

• The more inelastic the demand and the more elastic the supply results in the consumer paying more of the tax.

• The more elastic the demand and the more inelastic the supply results in the supplier paying more of the tax.

Elasticity and Tax incidenceElasticity and Tax incidence

Elastic Supply, Inelastic Demand

Demand

Quantity

Price

Supply

1. When supply is more elastic than demand …

Price buyers pay

Price without tax


Tax

3. …than on producers.

2. …the incidence of the tax falls more heavily on consumers…

Figure 6-9 a): How the Burden of a Tax is Divided.

Figure 6-9 a): How the Burden of a Tax is Divided.

Inelastic Supply, Elastic Demand

Demand

Quantity

Price

Supply

1. When demand is more elastic than supply …

Price buyers pay

Price without tax


Tax

3. …than on consumers.

2. …the incidence of the tax falls more heavily on producers…

Figure 6-9 b): How the Burden of a Tax is Divided

Figure 6-9 b): How the Burden of a Tax is Divided

• 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.

• 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.

SummarySummary

• 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.

• 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.

SummarySummary

• 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.

• 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.

SummarySummary

The EndThe End

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Ch06 Supply Demand And Government Policies