Supply, Demand and

Government Policies

Chapter 6

Copyright © 2001 by Harcourt, Inc.

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 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.
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 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.

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 Price Ceilings & Price Floors

Price Ceiling
◆ 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.

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 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.

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 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

Equilibrium
price

Demand

0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones
 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
Shortage
Demand

0 75 125 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones
 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

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 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.
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 The Price Ceiling on Gasoline Is
Not Binding...
Price of
Gasoline

1. Initially, Supply
the
price
ceiling is
not $4 Price
binding... ceiling

P1

Demand

0 Quantity of
Q1 Gasoline
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 The Price Ceiling on Gasoline Is
Binding...
Price of S2 2. …but
Gasoline when
supply
falls...
S1
P2
Price
ceiling

P1 3. …the price
ceiling
4. …resulting becomes
in a binding...
shortage.

Demand

0 Quantity of
Q1 Gasoline
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 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.”
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 Rent Control in the Short Run...
Rental
Price of
Apartme Supply and
nt Supply demand for
apartments
are relatively
inelastic

Controlled rent

Shortage

Demand

0 Quantity of
Apartments
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 Rent Control in the Long Run...
Rental Because the
Price of supply and
Apartme
nt demand for
apartments are
more elastic...

Supply

…rent control Controlled rent

causes a
large
shortage Shortage
Demand

0 Quantity of
Apartments
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 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.

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 A Price Floor That Is Not Binding...
Price of
Ice-Cream
Cone
Supply

Equilibriu
m
price

$3

Price
2
floor

Demand

0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones
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 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

$3

Equilibriu
m
price
Demand

0 80 120 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones
 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.

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 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

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 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.

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 The Minimum Wage
A Free Labor
Wage Market
Labor
supply

Equilibriu
m
wage

Labor
demand
0 Equilibrium Quantity of
employmen Labor
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t
 The Minimum Wage
A Labor Market with a
Wage
Minimum Wage
Labor
Labor surplus supply
(unemployment)
Minimum
wage

Labor
demand
0 Quantity Quantity Quantity of
demanded supplied Labor
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 Taxes

Governments levy taxes to

raise revenue for public
projects.

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 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.

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 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.

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 Copyright © 2001 by Harcourt, Inc. All rights reserved

Impact of a 50¢ Tax Levied on

Buyers...
Price of
Ice-Cream Supply, S1
Cone

3.00 A tax on buyers

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

D1
D
2
0 100 Quantity of
Ice-Cream Cones
 Copyright © 2001 by Harcourt, Inc. All rights reserved

Impact of a 50¢ Tax Levied on

Buyers...
Price of
Ice-Cream
Cone Supply, S1
Price
buyers
pay $3.30 Equilibrium without tax
Price 3.00 Tax
without 2.80 ($0.50)
tax

Price
Equilibrium
sellers with tax
receive
D1
D2

0 90 100 Quantity of
Ice-Cream Cones
 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.

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 Copyright © 2001 by Harcourt, Inc. All rights reserved

Impact of a 50¢ Tax on Sellers...

Price of
Ice-Cream
Cone A tax on
Price S2 sellers shifts
buyers Equilibrium
the supply
pay with tax
curve upward
$3.30 S1 by the
Price 3.00 Tax amount of the
withou 2.80 ($0.50) tax ($0.50).
t tax Equilibrium without tax

Price
sellers
receiv
e
Demand, D1

0 90 100 Quantity of
Ice-Cream Cones
 A Payroll Tax
Wage
Labor
supply

Wage
firms pay

Wage Tax wedge

without
tax
Wage
workers
receive
Labor
demand
0 Quantity of
Labor
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 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.
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 Elastic Supply, Inelastic Demand...

Price 1. When supply is more

elastic than demand...
Price buyers pay
Supply

Tax 2. ...the
incidence of the
Price without tax tax falls more
heavily on
Price sellers receive consumers...

3. ...than on Demand
producers.
0 Quantity

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 Inelastic Supply, Elastic Demand...

1. When demand is more

Price elastic than supply...

Price buyers pay Supply

Price without tax 3. ...than on consumers

Tax

Demand
Price sellers receive 2. ...the
incidence of
the tax falls more
heavily on producers...

0 Quantity

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 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.

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 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.
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 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.
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 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.
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 Graphical
Review

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 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

Equilibrium
price

Demand

0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones
 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
Shortage
Demand

0 75 125 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones
 The Price Ceiling on Gasoline Is
Not Binding...
Price of
Gasoline

1. Initially, Supply
the
price
ceiling is
not $4 Price
binding... ceiling

P1

Demand

0 Quantity of
Q1 Gasoline
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
 The Price Ceiling on Gasoline Is
Binding...
Price of S2 2. …but
Gasoline when
supply
falls...
S1
P2
Price
ceiling

P1 3. …the price
ceiling
4. …resulting becomes
in a binding...
shortage.

Demand

0 Quantity of
Q1 Gasoline
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
 Rent Control in the Short Run...
Rental
Price of
Apartme Supply and
nt Supply demand for
apartments
are relatively
inelastic

Controlled rent

Shortage

Demand

0 Quantity of
Apartments
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
 Rent Control in the Long Run...
Rental Because the
Price of supply and
Apartme
nt demand for
apartments are
more elastic...

Supply

…rent control Controlled rent

causes a
large
shortage Shortage
Demand

0 Quantity of
Apartments
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
 A Price Floor That Is Not Binding...
Price of
Ice-Cream
Cone
Supply

Equilibriu
m
price

$3

Price
2
floor

Demand

0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones
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 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

$3

Equilibriu
m
price
Demand

0 80 120 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones
 The Minimum Wage
A Free Labor
Wage Market
Labor
supply

Equilibriu
m
wage

Labor
demand
0 Equilibrium Quantity of
employmen Labor
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
t
 The Minimum Wage
A Labor Market with a
Wage
Minimum Wage
Labor
Labor surplus supply
(unemployment)
Minimum
wage

Labor
demand
0 Quantity Quantity Quantity of
demanded supplied Labor
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 Impact of a 50¢ Tax Levied on
Buyers...
Price of
Ice-Cream Supply, S1
Cone

3.00 A tax on buyers

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

D1
D
2
0 100 Quantity of
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Ice-Cream Cones
 Impact of a 50¢ Tax Levied on
Buyers...
Price of
Ice-Cream
Cone Supply, S1
Price
buyers
pay $3.30 Equilibrium without tax
Price 3.00 Tax
without 2.80 ($0.50)
tax

Price
Equilibrium
sellers with tax
receive
D1
D2

0 90 100 Quantity of
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Ice-Cream Cones
 Impact of a 50¢ Tax on Sellers...
Price of
Ice-Cream
Cone A tax on
Price S2 sellers shifts
buyers Equilibrium
the supply
pay with tax
curve upward
$3.30 S1 by the
Price 3.00 Tax amount of the
withou 2.80 ($0.50) tax ($0.50).
t tax Equilibrium without tax

Price
sellers
receiv
e
Demand, D1

0 90 100 Quantity of
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Ice-Cream Cones
 A Payroll Tax
Wage
Labor
supply

Wage
firms pay

Wage Tax wedge

without
tax
Wage
workers
receive
Labor
demand
0 Quantity of
Labor
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 Elastic Supply, Inelastic Demand...

Price 1. When supply is more

elastic than demand...
Price buyers pay
Supply

Tax 2. ...the
incidence of the
Price without tax tax falls more
heavily on
Price sellers receive consumers...

3. ...than on Demand
producers.
0 Quantity

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 Inelastic Supply, Elastic Demand...

1. When demand is more

Price elastic than supply...

Price buyers pay Supply

Price without tax 3. ...than on consumers

Tax

Demand
Price sellers receive 2. ...the
incidence of
the tax falls more
heavily on producers...

0 Quantity

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