1. Supply, Demand and Government Policies
Chapter 6
Copyright © 2001 by Harcourt, Inc. All rights reserved.   Requests for permission to make copies of any part of the work should be mailed to:
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2. 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. 2 2

3. 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. 3 3

4. Price Ceilings & Price Floors
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. 4 4

5. 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. 5 5

6. A Price Ceiling That Is Not Binding...
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Price Ceiling That Is Not Binding...
Price of
Ice-Cream
Cone
Supply $4
Price
ceiling 3
Equilibrium
price
Demand
100
Quantity of
Ice-Cream
Cones
Equilibrium
quantity 6 7

7. A Price Ceiling That Is Binding...
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Price Ceiling That Is Binding...
Price of
Ice-Cream
Cone
Supply
Equilibrium
price $3 2
Price
ceiling 75
Quantity
supplied
125
Quantity
demanded
Shortage
Demand
Quantity of
Ice-Cream
Cones 7 10

8. 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 11 14

9. What was responsible for the long gas lines?
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.

10. The Price Ceiling on Gasoline Is Not Binding...
Price of
Gasoline
1. Initially, the
price ceiling is not binding...
Supply $4
Price
ceiling P1
Demand
Quantity of
Gasoline Q1 6 7

11. The Price Ceiling on Gasoline Is Binding...
Price of
Gasoline
2. …but when supply falls... S1 P2
Price
ceiling
4. …resulting in a shortage.
3. …the price ceiling becomes binding... P1
Demand
Quantity of
Gasoline Q1 6 7

12. 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.” 2

13. Rent Control in the Short Run...
Rental Price of
Apartment
Supply and demand for apartments are relatively inelastic
Supply
Controlled rent
Shortage
Demand
Quantity of
Apartments 7 10

14. Rent Control in the Long Run...
Because the supply and demand for apartments are more elastic...
Rental Price of
Apartment
Supply
…rent control causes a large shortage
Controlled rent
Shortage
Demand
Quantity of
Apartments 7 10

15. 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. 12 15

16. A Price Floor That Is Not Binding...
Price of
Ice-Cream
Cone
Supply
Equilibrium
price $3
Price
floor 2
Demand
100
Quantity of
Ice-Cream
Cones
Equilibrium
quantity 8 17

17. A Price Floor That Is Binding...
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Price Floor That Is Binding...
Price of
Ice-Cream
Cone
Supply
Surplus $4
Price floor 80
Quantity
demanded
120
Quantity
supplied $3
Equilibrium
price
Demand
Quantity of
Ice-Cream
Cones 8 17

18. 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. 15 24

19. 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 15 25

20. 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.

21. The Minimum Wage A Free Labor Market Labor supply Labor demand Wage
Equilibrium
wage
Equilibrium
employment
Labor
demand
Quantity of
Labor

22. A Labor Market with a Minimum Wage
The Minimum Wage
A Labor Market with a Minimum Wage
Wage
Labor
supply
Labor surplus
(unemployment)
Minimum
wage
Quantity
demanded
Quantity
supplied
Labor
demand
Quantity of
Labor

23. Governments levy taxes to raise revenue for public projects.20 29

24. 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. 22 30

25. 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. 21 31

26. Impact of a 50¢ Tax Levied on Buyers...
Copyright © 2001 by Harcourt, Inc. All rights reserved
Impact of a 50¢ Tax Levied on Buyers...
Price of
Ice-Cream
Cone
Supply, S1 D2
3.00
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50). D1
100
Quantity of
Ice-Cream Cones 23 33

27. Impact of a 50¢ Tax Levied on Buyers...
Copyright © 2001 by Harcourt, Inc. All rights reserved
Impact of a 50¢ Tax Levied on Buyers...
Price of
Ice-Cream
Cone
Supply, S1
$3.30
Price
buyers
pay
Equilibrium without tax
Tax ($0.50)
Price
without
tax
3.00
2.80
Price
sellers
receive
Equilibrium
with tax D1 D2 90
100
Quantity of
Ice-Cream Cones 23 38

28. 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. 22 30

29. Impact of a 50¢ Tax on Sellers...
Copyright © 2001 by Harcourt, Inc. All rights reserved
Impact of a 50¢ Tax on Sellers...
Price of
Ice-Cream
Cone
A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50).
$3.30
Price buyers pay S2
Equilibrium
with tax S1 90
Tax ($0.50)
3.00
Price without tax
Equilibrium without tax
2.80
Price sellers receive
Demand, D1
100
Quantity of
Ice-Cream Cones

30. A Payroll Tax Labor supply Labor demand Wage Wage firms pay Tax wedge
Wage without tax
Wage workers receive
Labor
demand
Quantity of
Labor

31. 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. 29 39

32. Elastic Supply, Inelastic Demand...
Price
1. When supply is more
elastic than demand...
Price buyers pay
Tax
2. ...the
incidence of the
tax falls more
heavily on
consumers...
Supply
Price without tax
3. ...than on
producers.
Price sellers receive
Demand
Quantity 32 44

33. Inelastic Supply, Elastic Demand...
1. When demand is more
elastic than supply...
Price
Supply
Price buyers pay
Tax
3. ...than on consumers.
Price without tax
2. ...the
incidence of
the tax falls more
heavily on producers...
Demand
Price sellers receive
Quantity 32 51

34. 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. 30 41

35. 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.

36. 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.

37. 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.

38. Graphical Review

39. A Price Ceiling That Is Not Binding...
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Price Ceiling That Is Not Binding... $4 3
Quantity of
Ice-Cream
Cones
Price of
Cone
Demand
Supply
Price
ceiling
Equilibrium
price
100
quantity 6 7

40. A Price Ceiling That Is Binding...
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Price Ceiling That Is Binding... $3
Quantity of
Ice-Cream
Cones
Price of
Cone 2
Demand
Supply
Equilibrium
price
Price
ceiling
Shortage
125
Quantity
demanded 75
supplied 7 10

41. The Price Ceiling on Gasoline Is Not Binding...$4 P1
Quantity of
Gasoline
Price of Q1
Demand
Supply
Price
ceiling
1. Initially, the
price ceiling is not binding... 6 7

42. The Price Ceiling on Gasoline Is Binding...
Quantity of
Gasoline
Price of Q1
Demand S1
Price
ceiling S2
2. …but when supply falls... P2
3. …the price ceiling becomes binding...
4. …resulting in a shortage. 6 7

43. Rent Control in the Short Run...
Quantity of
Apartments
Rental Price of
Apartment
Demand
Supply
Controlled rent
Shortage
Supply and demand for apartments are relatively inelastic 7 10

44. Rent Control in the Long Run...
Quantity of
Apartments
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 7 10

45. A Price Floor That Is Not Binding...$3
Quantity of
Ice-Cream
Cones
Price of
Cone
100
Equilibrium
quantity
price
Demand
Supply
Price
floor 2 8 17

46. A Price Floor That Is Binding...
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Price Floor That Is Binding... $3
Quantity of
Ice-Cream
Cones
Price of
Cone
Equilibrium
price
Demand
Supply
Price floor $4
120
Quantity
supplied 80
demanded
Surplus 8 17

47. The Minimum Wage A Free Labor Market supply demand Wage Equilibrium
Quantity of
Labor
Wage
Equilibrium
wage
demand
supply
A Free Labor Market
employment

48. A Labor Market with a Minimum Wage
The Minimum Wage
Minimum
wage
Quantity of
Labor
Wage
demand
supply
Quantity
supplied
demanded
Labor surplus
(unemployment)
A Labor Market with a Minimum Wage

49. Impact of a 50¢ Tax Levied on Buyers...
3.00
Quantity of
Ice-Cream Cones
Price of
Ice-Cream
Cone
100 D1
Supply, S1
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50). D2 23 33

50. Impact of a 50¢ Tax Levied on Buyers...
3.00
Quantity of
Ice-Cream Cones
Price of
Ice-Cream
Cone
100 90
$3.30
Price
buyers
pay D1 D2
Equilibrium
with tax
Supply, S1
Equilibrium without tax
2.80
sellers
receive
without
tax
Tax ($0.50) 23 38

51. Impact of a 50¢ Tax on Sellers...
3.00
Quantity of
Ice-Cream Cones
Price of
Ice-Cream
Cone
100 90 S1 S2
Demand, D1
Price without tax
2.80
Price sellers receive
$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)
Equilibrium
with tax

52. A Payroll Tax supply demand Wage Wage firms pay Tax wedge
Quantity of
Labor
Wage
Wage without tax
demand
supply
Tax wedge
Wage firms pay
Wage workers receive

53. Elastic Supply, Inelastic Demand...
Quantity
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 32 44

54. Inelastic Supply, Elastic Demand...
Quantity
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 32 51