Supply, Demand and

Government Policies
Chapter 6

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.

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.

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.

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.

A Price Ceiling That Is Not Binding...

Price of
Ice-Cream
Cone

Supply

Price
ceiling

$4

3
Equilibrium
price

Demand
0

100
Equilibrium
quantity

Quantity of
Ice-Cream
Cones

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
Ice-Cream
Quantity Quantity
Cones
supplied demanded

Effects of Price Ceilings

A binding price ceiling creates ...
shortages because QD > QS.
Example:

Gasoline shortage of the

1970s

nonprice rationing
Examples:

by sellers

Long lines, Discrimination

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.

The Price Ceiling on Gasoline Is

Not Binding...
Price of
Gasoline
1. Initially,
the
price
ceiling is
not
binding...

Supply

Price
ceiling

$4

P1

Demand
0

Q1

Quantity of
Gasoline

The Price Ceiling on Gasoline Is

Binding...
S2

Price of
Gasoline

2. but
when
supply
falls...

S1

P2
Price
ceiling

P1

3. the price
ceiling
becomes
binding...

4. resulting
in a
shortage.

Demand
0

Q1

Quantity of
Gasoline

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.

Rent Control in the Short Run...

Rental
Price of
Apartme
nt

Supply and
demand for
apartments
are relatively
inelastic

Supply

Controlled rent
Shortage

Demand
0

Quantity of
Apartments

Rent Control in the Long Run...

Rental
Price of
Apartme
nt

Because the
supply and
demand for
apartments are
more elastic...

Supply

rent control
causes a
large
shortage

Controlled rent

Shortage

Demand
0

Quantity of
Apartments

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.

A Price Floor That Is Not Binding...

Price of
Ice-Cream
Cone

Supply

Equilibriu
m
price

$3
Price
floor

Demand
0

Quantity of
Equilibrium Ice-Cream
Cones
quantity

100

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 Quantity
demanded supplied

Quantity of
Ice-Cream
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.

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

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.

The Minimum Wage

Wage

A Free Labor
Market

Labor
supply

Equilibriu
m
wage

Labor
demand
0

Equilibrium
employmen
t

Quantity of
Labor

The Minimum Wage

Wage

A Labor Market with a

Minimum Wage
Labor surplus
(unemployment)

Labor
supply

Minimum
wage

Labor
demand
0

Quantity
demanded

Quantity
supplied

Quantity of
Labor

Taxes
Governments levy taxes to
raise revenue for public
projects.

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.

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.

Impact of a 50 Tax Levied on

Buyers...
Price of
Ice-Cream
Cone

Supply, S1

3.00

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

D1
D
2

100

Quantity of
Ice-Cream Cones

Impact of a 50 Tax Levied on

Buyers...
Price of
Ice-Cream
Cone

Price
buyers
pay
Price
without
tax

$3.30
3.00
2.80

Price
sellers
receive

Supply, S1
Equilibrium without tax

Tax
($0.50)

Equilibrium
with tax

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.

Impact of a 50 Tax on Sellers...

Price of
Ice-Cream
Cone
Price
buyers
pay
Price
withou
t tax

A tax on
sellers shifts
S2
the supply
curve upward
S1
by the
amount of the
tax ($0.50).
Equilibrium without tax

Equilibrium
with tax

$3.30
3.00 Tax
2.80 ($0.50)

Price
sellers
receiv
e

Demand, D1

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
Quantity of
Labor

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.

Elastic Supply, Inelastic Demand...

Price

1. When supply is more

elastic than demand...

Price buyers pay

Supply
Tax
Price without tax
Price sellers receive

2. ...the
incidence of th
tax falls more
heavily on
consumers...

3. ...than on Demand
producers.
0

Quantity

Inelastic Supply, Elastic Demand...

1. When demand is more
elastic than supply...

Price

Supply

Price buyers pay

Price without tax

3. ...than on consume
Tax

Price sellers receive

Demand
2. ...the
incidence of
the tax falls more
heavily on producers...
Quantity

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.

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.

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.

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.

Graphical
Review

Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

A Price Ceiling That Is Not Binding...

Price of
Ice-Cream
Cone

Supply

Price
ceiling

$4

3
Equilibrium
price

Demand
0

100
Equilibrium
quantity

Quantity of
Ice-Cream
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
Ice-Cream
Quantity Quantity
Cones
supplied demanded

The Price Ceiling on Gasoline Is

Not Binding...
Price of
Gasoline
1. Initially,
the
price
ceiling is
not
binding...

Supply

Price
ceiling

$4

P1

Demand
0

Q1

Quantity of
Gasoline

The Price Ceiling on Gasoline Is

Binding...
S2

Price of
Gasoline

2. but
when
supply
falls...

S1

P2
Price
ceiling

P1

3. the price
ceiling
becomes
binding...

4. resulting
in a
shortage.

Demand
0

Q1

Quantity of
Gasoline

Rent Control in the Short Run...

Rental
Price of
Apartme
nt

Supply and
demand for
apartments
are relatively
inelastic

Supply

Controlled rent
Shortage

Demand
0

Quantity of
Apartments

Rent Control in the Long Run...

Rental
Price of
Apartme
nt

Because the
supply and
demand for
apartments are
more elastic...

Supply

rent control
causes a
large
shortage

Controlled rent

Shortage

Demand
0

Quantity of
Apartments

A Price Floor That Is Not Binding...

Price of
Ice-Cream
Cone

Supply

Equilibriu
m
price

$3
Price
floor

Demand
0

Quantity of
Equilibrium Ice-Cream
Cones
quantity

100

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 Quantity
demanded supplied

Quantity of
Ice-Cream
Cones

The Minimum Wage

Wage

A Free Labor
Market

Labor
supply

Equilibriu
m
wage

Labor
demand
0

Equilibrium
employmen
t

Quantity of
Labor

The Minimum Wage

Wage

A Labor Market with a

Minimum Wage
Labor surplus
(unemployment)

Labor
supply

Minimum
wage

Labor
demand
0

Quantity
demanded

Quantity
supplied

Quantity of
Labor

Impact of a 50 Tax Levied on

Buyers...
Price of
Ice-Cream
Cone

Supply, S1

3.00

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

D1
D
2

100

Quantity of
Ice-Cream Cones

Impact of a 50 Tax Levied on

Buyers...
Price of
Ice-Cream
Cone

Price
buyers
pay
Price
without
tax

$3.30
3.00
2.80

Price
sellers
receive

Supply, S1
Equilibrium without tax

Tax
($0.50)

Equilibrium
with tax

D1
D2
0

90 100

Quantity of
Ice-Cream Cones

Impact of a 50 Tax on Sellers...

Price of
Ice-Cream
Cone
Price
buyers
pay
Price
withou
t tax

A tax on
sellers shifts
S2
the supply
curve upward
S1
by the
amount of the
tax ($0.50).
Equilibrium without tax

Equilibrium
with tax

$3.30
3.00 Tax
2.80 ($0.50)

Price
sellers
receiv
e

Demand, D1

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
Quantity of
Labor

Elastic Supply, Inelastic Demand...

Price

1. When supply is more

elastic than demand...

Price buyers pay

Supply
Tax
Price without tax
Price sellers receive

2. ...the
incidence of th
tax falls more
heavily on
consumers...

3. ...than on Demand
producers.
0

Quantity

Inelastic Supply, Elastic Demand...

1. When demand is more
elastic than supply...

Price

Supply

Price buyers pay

Price without tax

3. ...than on consume
Tax

Price sellers receive

Demand
2. ...the
incidence of
the tax falls more
heavily on producers...
Quantity