1. Chapter 6: “Supply, Demand and Government Policies”
Principles of Micro
by Tanya Molodtsova, Fall 2005
Chapter 6: “Supply, Demand and Government Policies”

2. We Will Study:
the effects of government policies that fix the price above or below the equilibrium price
how a tax on a good affects the price of the good and the quantity sold
how the burden of a tax is split between buyers and sellers

3. I. Controls on Prices
In a free market, market forces establish equilibrium prices and quantities.
It may be true that not everyone is satisfied in market equilibrium
Economists use theories to develop government policies that help change the world for the better
Controls on prices are usually enacted when policymakers believe the market price is unfair to buyers or sellers.
They result in government-created price ceilings and floors.

4. I. Controls on Prices
price ceiling: a legal maximum on the price at which a good can be sold.
Example: rent-control laws sets maximum rent that the landlords can charge
price floor: a legal minimum on the price at which a good can be sold.
Example: minimum wage law dictates the lowest wage that firms may pay workers

5. How Price Ceilings Affect Market Outcomes
Two outcomes are possible when the government imposes a price ceiling:
If the price ceiling is set above the equilibrium price, it is not binding and there is no effect on the price or quantity sold
The price ceiling is set below the equilibrium price, it is binding and the shortage is created

6. A Market With A Price Ceiling
(a) A Price Ceiling That Is Not Binding
Quantity of
Ice-Cream
Cones
Price of
Cone
Equilibrium
quantity $4
Price
ceiling
price
Demand
Supply 3
100

7. A Market With A Price Ceiling
(b) A Price Ceiling That Is Binding
Quantity of
Ice-Cream
Cones
Price of
Cone
Demand
Supply 2
Price
ceiling
Shortage 75
Quantity
supplied
125
demanded
Equilibrium
price $3

8. How Price Ceilings Affect Market Outcomes
A Binding Price Ceilings Creates:
- shortages because QD > QS
Example: Gasoline shortage of the 1970s
- mechanism for rationing the good
Example: long lines, discrimination by sellers
Not all buyers benefit from a price ceiling since some will be unable to purchase the product.

9. CASE STUDY: Lines at the Gas Pump
In 1973, OPEC raised the price of crude oil. 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.

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

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

12. CASE STUDY: 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.”

13. Rent Control in the Short-Run
(a) Rent Control in the Short Run
(supply and demand are inelastic)
Quantity of
Apartments
Supply
Controlled rent
Rental
Price of
Apartment
Demand
Shortage

14. Rent Control in The Long-Run
(b) Rent Control in the Long Run
(supply and demand are elastic)
Rental
Price of
Apartment
Quantity of
Apartments
Demand
Supply
Controlled rent
Shortage

15. Rent Control in the Short Run and Long Run
Since the supply of apartments is fixed (perfectly inelastic) in the short run and upward sloping (elastic) in the long run, the shortage is much larger in the long run than in the short run.
Rent controlled apartments are rationed in a number of ways including long waiting lists, discrimination against minorities and families with children, and even under-the-table payments to landlords.
The quality of apartments also suffers due to rent control.

16. How Price Floors Affect Market Outcomes
Two outcomes are possible when the government imposes a price floor:
If the price floor is lower than the equilibrium price, it is not binding and has no effect on the price or quantity sold.
If the price floor is higher than the equilibrium price, the floor is a binding constraint and a surplus is created.

17. A Market With A Price Floor
(a) A Price Floor That Is Not Binding
Quantity of
Ice-Cream
Cones
Price of
Cone
Equilibrium
quantity 2
Price
floor
price
Demand
Supply $3
100

18. A Market With A Price Floor
(b) A Price Floor That Is Binding
Quantity of
Ice-Cream
Cones
Price of
Cone
Demand
Supply $4
Price
floor 80
Quantity
demanded
120
supplied
Equilibrium
price
Surplus 3

19. How Price Ceilings Affect Market Outcomes
When the market price hits the floor, it can fall no further, and the market price equals the floor price.
A binding price floor causes:
- a surplus because QS > QD
- the development of a new mechanism for rationing the good, using discrimination criteria

20. CASE STUDY: The Minimum Wage
An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price for labor that any employer may pay.
Consider a labor market in which the wage adjusts to balance labor supply and labor demand

21. How the Minimum Wage Affects the Labor Market
Quantity of
Labor
Wage
Supply
Labor surplus
(unemployment)
demand
Minimum
wage
Quantity
demanded
supplied

22. How the Minimum Wage Affects the Labor Market
If the minimum wage is above the equilibrium wage in the labor market, a surplus of labor will develop (unemployment).
The minimum wage will be a binding constraint only in markets where equilibrium wages are low.
Thus, the minimum wage will have its greatest impact on the market for teenagers and other unskilled workers.

23. Evaluating Price Controls
Most economists oppose the use of price ceilings and floors
Prices balance supply and demand and thus coordinate economic activity. If prices are set by laws, they obscure the signals that efficiently allocate scarce resources.
Price ceilings and price floors often hurt the people they are intended to help.
- Rent controls create a shortage of quality housing and provide disincentives for building maintenance.
- Minimum wage laws create higher rates of unemployment for teenage and low skilled workers.

24. Taxes Governments levy taxes to raise revenue for public projects
tax incidence: the manner in which the burden of a tax is shared among participants in a market.

25. How Taxes on Buyers Affect Market Outcomes
If the government requires the buyer to pay a certain amount for each unit of a good purchased, this will cause a decrease in demand.
The demand curve will shift down by the amount of the tax.
The quantity of the good sold will decline.
Buyers and sellers will share the burden of the tax; buyers pay more for the good (including the tax) and sellers receive less.

26. How Taxes on Buyers Affect Market Outcomes
Two lessons can be learned here:
Taxes discourage market activity. When the good is taxed the quantity sold is smaller than before the tax.
Buyers and sellers share the burden of a tax.

27. A Tax on Buyers Quantity of Ice-Cream Cones Price of Ice-Cream Cone
Price of
Ice-Cream
Cone
Price
without
tax
sellers
receive
Equilibrium without tax
Tax ($0.50)
buyers
pay D1 D2
Supply, S1
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).
$3.30 90
Equilibrium
with tax
2.80
3.00
100

28. How Taxes on Sellers Affect Market Outcomes
If the government requires the seller to pay a certain amount for each unit of a good purchased, this will cause a decrease in supply.
The supply curve will shift up by the amount of the tax.
The quantity of the good sold will decline.
Buyers and sellers will share the burden of the tax; buyers pay more for the good and sellers receive less (because of the tax).

29. A Tax on Sellers 2.80 Quantity of Ice-Cream Cones Price of Ice-Cream
Price of
Ice-Cream
Cone
Price
without
tax
sellers
receive
Equilibrium
with tax
Equilibrium without tax
Tax ($0.50)
buyers
pay S1 S2
Demand, D1
A tax on sellers
shifts the supply
curve upward
by the amount of
the tax ($0.50).
3.00
100
$3.30 90

30. Elasticity and Tax Incidence
In what proportions is the burden of the tax divided?
The answer to this question depends on the elasticity of demand and the elasticity of supply.
The burden of a tax falls more heavily on the side of the market that is less elastic

31. Elasticity and Tax Incidence
When supply is elastic and demand is inelastic, the largest share of the tax burden falls on consumers.
A small elasticity of demand means that buyers do not have good alternatives to consuming this product.
When supply is inelastic and demand is elastic, the largest share of the tax burden falls on producers.
A small elasticity of supply means that sellers do not have good alternatives to producing this particular good.

32. How The Burden of Tax is Divided
Quantity
Price
Demand
Supply
Tax
Price sellers
receive
Price buyers pay
(a) Elastic Supply, Inelastic Demand
the
incidence of the
tax falls more
heavily on
consumers . . .
1. When supply is more elastic
than demand . . .
Price without tax
than
on producers.

33. How The Burden of Tax is Divided
Quantity
Price
Demand
Supply
Tax
Price sellers
receive
Price buyers pay
(b) Inelastic Supply, Elastic Demand
than on
consumers.
1. When demand is more elastic
than supply . . .
Price without tax
the
incidence of
the tax falls
more heavily
on producers . . .

34. 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.

35. 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.

36. 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.
The burden tends to fall on the side of the market that is less elastic.