1. Economic Analysis for Business Session VIII: Supply Demand and Government Policies-I
Instructor Sandeep Basnyat

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 (Price support): a legal minimum on the price of a good or service. Example: minimum wage.
Taxes and Subsidies
The govt. can make buyers or sellers pay a specific amount on each unit bought/sold.
This slide presents an outline of the chapter.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

3. Price Control Policy : 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.” 2

4. RENT CONTROL: The Market for ApartmentsQ
Rental price of apts S D
$800
300
Eq’m w/o price controls
We start by analyzing the effects of a price ceiling. The most common example is rent control, so we do the analysis in the context of this example.
We begin by showing the market for apartments in equilibrium (before the government imposes any price controls).
Quantity of apartments
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

5. How Price Ceilings Affect Market Outcomes
A price ceiling above the eq’m price is not binding – it has no effect on the market outcome. P Q S
Price ceiling
$1000 D
$800
300
When some students see this for the first time, they wonder why the price ceiling does not result in a surplus.
When the price ceiling is above the equilibrium price, the equilibrium price is still perfectly legal. Just because landlords are allowed to charge $1000 rent doesn’t mean they will – if they do, they won’t be able to rent all of their apartments – a surplus will result, causing downward pressure on the price (rent). There’s no law that prevents the price (rent) from falling, so it does fall until the surplus is gone and equilibrium is reached (at P = $800 and Q = 300).
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

6. How Price Ceilings Affect Market Outcomes
The eq’m price ($800) is above the ceiling and therefore illegal.
The ceiling is a binding constraint on the price, and causes a shortage. P Q S D
$800
Price ceiling
$500
250
400
shortage
In this case, the price ceiling is binding.
In the new equilibrium with the price ceiling, the actual price (rent) of an apartment will be $500. It won’t be more than that, because any higher price is illegal. It won’t be less than $500, because the shortage would be even larger if the price were lower.
The actual quantity of apartments rented equals 250, and there is a shortage equal to 150 (the difference between the quantity demanded, 400, and the quantity supplied, 250.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

7. How Price Ceilings Affect Market OutcomesQ
In the long run, supply and demand are more price-elastic.
So, the shortage is larger. S D
$800
Price ceiling
$500
shortage
In this slide, the equilibrium price ($800) and price ceiling ($500) are the same as on the preceding slides, but supply and demand are more price-elastic than before, and the shortage that results from a binding price ceiling is larger.
150
450
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

8. CASE STUDY: Lines at the Gas Pump
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.

9. The Market for Gasoline with a Price Ceiling
(a) The Price Ceiling on Gasoline Is Not Binding
Price of
Gasoline
Demand
Supply, S1
1. Initially,
the price
ceiling
is not
binding . . .
Price ceiling P1 Q1
Quantity of
Gasoline

10. The Market for Gasoline with a Price Ceiling
(b) The Price Ceiling on Gasoline Is Binding
Price of S2
Gasoline
but when
supply falls . . .
Demand S1 P2 QS QD
Price ceiling
resulting
in a
shortage.
the price
ceiling becomes
binding . . . P1 Q1
Quantity of
Gasoline

11. PRICE FLOOR (PRICE SUPPORT) : The Market for Unskilled LaborW L
Wage paid to unskilled workers S D $4
500
Eq’m w/o price controls
Now we switch gears and look at the effects of a price floor. We illustrate this concept using the common textbook example – the minimum wage.
This may be the first time students have seen a supply-demand diagram of the labor market. It might be useful to note that the “price” of labor is more commonly known as the wage, which we measure on the vertical axis of our supply-demand diagram. Along the horizontal axis, we measure the quantity of labor (number of workers). The demand for unskilled labor comes from firms. The supply comes from workers.
We focus on unskilled labor because the minimum wage is not relevant for higher skilled, higher wage workers.
Quantity of unskilled workers
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

12. How Price Floors Affect Market Outcomes?
A price floor below the eq’m price is not binding – it has no effect on the market outcome. W L S D $4
500
Price floor $3
Some students see this and wonder why the $3 price floor does not cause a shortage. After all, at a wage of $3, the quantity of unskilled workers that firms wish to hire exceeds the quantity of unskilled workers that are looking for jobs.
But the minimum wage law does not stop the wage from rising above $3. So, in response to this shortage, the wage will rise until the shortage evaporates – which occurs at the equilibrium wage of $4. The equilibrium wage is perfectly legal when the price floor (i.e. minimum wage) is below it.
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13. How Price Floors Affect Market Outcomes
labor surplus
The eq’m wage ($4) is below the floor and therefore illegal.
The floor is a binding constraint on the wage, and causes a surplus (i.e., unemployment). W L S
Price floor $5 D
400
550 $4
Now, the minimum wage exceeds the equilibrium wage. The equilibrium wage (or any wage below $5) is illegal.
In this case, the actual wage will be $5. It will not be lower, because any lower wage is illegal. It will not be higher, because at any higher wage, the surplus would be even greater. The actual number of unskilled workers with jobs equals want jobs, but firms are only willing to hire 400, leaving a surplus (i.e. unemployment) of 150 workers.
A surplus of anything – especially labor – represents wasted resources.
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14. Case Study: 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.

15. The Minimum Wage Min wage laws do not affect highly skilled workers.
They do affect teen workers.
Studies: A 10% increase in the min wage raises teen unemployment by 1-3%.
unemp-loyment W L S
Min. wage $5 D
400
550 $4
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

16. Impact of Minimum Wage Laws
Skills and Experience: No effects or not binding because their equilibrium wage rates are well above minimum wage
Teenage labour: Least skilled and least experienced. Minimum wage law hits them hard.
Impact on quantity of labour supplied: Increases the quantity of labor supplied as more teenagers will be interested to work, a result of which they will drop out of schools.

17. Evaluating the Effects of Price Controls
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.
It might be worth reminding students that our analysis has been in the context of a world without market failures. Subsequent chapters (except in the macro split) will introduce situations in which government intervention in the price system can improve on the private market outcome. However, even in such cases, the appropriate policy is usually something other than a direct price control.
The 4th edition adds an excellent new In the News box with an article on rent control from The Economist. Please encourage your students to check it out.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

18. Numerical Problems
Consider a market with Demand curve q = 16 − 10p and Supply curve q = −8 + 20p. (Here q is in millions of kgs and p is in dollars/kg)
Determine the market equilibrium price and quantity and the total revenue in this market.
Calculate the price elasticity of demand and the price elasticity of supply at the market equilibrium.

19. Solved Problems
Consider a market with Demand curve q = 16 − 10p and Supply curve q = −8 + 20p. (Here q is in millions of kgs and p is in dollars per kg.)
(a) Determine the market equilibrium price and quantity and the total revenue in this market.
Simultaneously solving the demand and supply equations:
p = $0.80 per kg. and q = 8 million kgs.
Total revenue is: p x q = 0.8 x 8 = $6.4 millions.
(b) Calculate the price elasticity of demand and the price elasticity of supply at the market equilibrium.
The slope of the demand curve is −10, so the price elasticity of demand at the market equilibrium is −10.(0.8/8) = −1.
Similarly, the slope of the supply curve is 20, so the price elasticity of supply at the market equilibrium is 20.(0.8/8)= 2.

20. Numerical Problems
Consider a market with Demand curve q = 16 − 10p and Supply curve q = −8 + 20p. (Here q is in millions of kgs and p is in dollars/kg)
Suppose the government sets support price of $1 per kg in this market and purchases the surplus at support price. Find the quantity demanded, quantity supplied and government expenditure in this market to implement the policy.
Illustrate in diagram the results obtained in part (c).

21. Numerical Problems Quantity demanded = 16 – 10(1) = 6 million kgs.
Consider a market with Demand curve q = 16 − 10p and Supply curve q = −8 + 20p. (Here q is in millions of kgs and p is in dollars/kg)
Suppose the government sets support price of $1 per kg in this market and purchases the surplus at support price. Find the quantity demanded, quantity supplied and government expenditure in this market to implement the policy.
At, support price of $1/kg,
Quantity demanded = 16 – 10(1) = 6 million kgs.
Quantity Supplied = (1) = 12 million kgs.
There will be a surplus of 6 million kgs in the market.
Total Government expenditure = 6 x 1 = $6 million.

22. (d) Illustration of part c on Price Support Policy
Surplus = 6 million kgs. W L S
Price support (floor) $1 D 6 12
Govt. Spending
$0.8
Now, the minimum wage exceeds the equilibrium wage. The equilibrium wage (or any wage below $5) is illegal.
In this case, the actual wage will be $5. It will not be lower, because any lower wage is illegal. It will not be higher, because at any higher wage, the surplus would be even greater. The actual number of unskilled workers with jobs equals want jobs, but firms are only willing to hire 400, leaving a surplus (i.e. unemployment) of 150 workers.
A surplus of anything – especially labor – represents wasted resources. 8
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23. Thank you