Supply, Demand & Government Policies Chapter 6

In a free market system, market forces establish equilibrium prices and exchange quantities. One of the roles of economists is to develop theories to assist in the development of policies.

Controls on Prices Buyers always want lower prices, while sellers want higher prices. Thus, interests of these two groups conflict. Controls on prices are usually enacted when policymakers believe the market price is unfair to buyers or sellers. For this government creates price ceilings and price floors.

Controls on Prices Cont… 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.

Controls on Prices Cont… How Price Ceilings Affect Market Outcomes: When govt. imposes price ceiling, following two outcomes are possible: 1. If price is set above the equilibrium price, price ceiling is not binding. Price ceiling has no effect on the price or quantity sold.

Price Ceiling that is NOT BINDING Quantity 0 Price Equilibrium Quantity P2 Price Ceiling Equilibrium Price Demand Supply P1 Q

Controls on Prices Cont… How Price Ceilings Affect Market Outcomes (Cont.) : 2.If price is set below the equilibrium price, price ceiling is a binding constraint. The forces of demand and supply move price towards equilibrium price. But when market price hits the ceiling, it can rise no further. Thus, market price equals price ceiling. At this price, quantity demanded exceeds quantity supplied, creating shortage for the good.

Price Ceiling that is BINDING Quantity 0 Price Demand Supply P1 Price Ceiling Shortage Q1 Quantity Supplied Q2 Quantity Demanded Equilibrium Price P2

Controls on Prices Cont… How Price Ceilings Affect Market Outcomes (Cont.) : Therefore, when government imposes a binding price ceiling on a market, shortage of the good arises

Controls on Prices Cont… How Price Floors Affect Market Outcomes: When govt. imposes price floor, following two outcomes are possible: 1. If price is set below the equilibrium price, price floor is not binding. Price floor has no effect on the price or quantity sold.

Price Floor that is NOT BINDING Quantity 0 Price Equilibrium Quantity P1 Price Floor Equilibrium Price Demand Supply P2 Q

Controls on Prices Cont… How Price Floors Affect Market Outcomes (Cont.) : 2.If price is set above the equilibrium price, price floor is a binding constraint. The forces of demand and supply move price towards equilibrium price. But when market price hits the floor, it can fall no further. Thus, market price equals price floor. At this price, quantity supplied exceeds quantity demanded, causing surplus for the good.

Price Floor that is BINDING Quantity 0 Price Demand Supply P2 Price Floor Q1 Quantity Demanded Q2 Quantity Supplied Equilibrium Price Surplus P1

Taxes Governments use taxes to raise revenue for public projects, such as for: –Roads –Schools –National defense Taxes affect market activity. When a good is taxed, the quantity sold is smaller.

Taxes Cont… Important Question When govt. levies tax on a good, who bears the burden of the tax? Buyers Or Sellers

Taxes Cont… Economists use the term tax incidence to refer to the distribution of tax burden. “Tax incidence is the manner in which the burden of a tax is shared among participants in a market”.

Taxes Cont… Taxes result in a change in market equilibrium. Buyers pay more and sellers receive less, regardless of whom the tax is levied on.

Taxes Cont… What is 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.