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Chapter 6

Supply, Demand,
and Government
Policies

2002 by Nelson, a division of Thomson Canada Limited


In this chapter you will
Examine the effects of government
policies that place a ceiling on prices.
Examine the effects of government
policies that place a floor under prices.
Consider how a tax on a good affects the
price of the good and the quantity sold.
Learn that taxes levied on buyers and
taxes levied on sellers are equivalent.
See how the burden of a tax is split
between buyers and sellers.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 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.
Hencemarket controls!
One of the roles of economists is to use
their theories to assist in the development
of policies.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 3


CONTROLS ON PRICES
Are usually enacted when
policymakers believe the market
price is unfair to buyers or sellers.
Result in government-created price
ceilings and floors.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 4


Price Ceilings and Price Floors
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.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 5


How Price Ceiling Affect Market
Outcomes
When the government imposes a
price ceiling (i.e... a legal maximum
on the price at which a good can be
sold) two outcomes are possible
1) The price ceiling is not binding.
2) The price ceiling is a binding
constraint on the market, creating
Shortages.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 6


Figure 6-1: A Market with a Price Ceiling
(a) A Price Ceiling That is Not Binding (b) A Price Ceiling That is Binding
Price of Price of
Ice-Cream Ice-Cream
Cone Cone

Supply Supply

$4 Equilibrium
Price price
ceiling
$3 $3 Price
ceiling
$2

Equilibrium
price Shortage
Demand Demand

0 100 Quantity of 0 75 125 Quantity of


Equilibrium Ice-Cream Ice-Cream
QS QD
quantity Cones Cones
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 7
How Price Ceiling Affect Market
Outcomes
A binding price ceiling creates
Shortages because QD > QS.
Examples: Gasoline shortage of the
1970s, housing shortages with rent
controls.
Non-price rationing
Examples: Long lines, discrimination by
sellers, black markets.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 8


CASE STUDY: Lines at the Gas Pump

In 1973, OPEC raised the price of crude oil in


world markets. 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.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 9


Figure 6-2: A Market for Gasoline with a
Price Ceiling
(a) A Price Ceiling on Gasoline is Not Binding (b) A Price Ceiling on Gasoline is Binding

Price of
Gasoline
S2

1. Initially
the price
ceiling is S1 2.but when S1
not supply falls
binding

P2

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

0 Q1 Quantity of 0 QS QD Q1 Quantity of
Gasoline Gasoline

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 10


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.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 11


Figure 6-3: Rent Control in the Short Run
and Long Run
(a) Short Run (Supply and Demand are Inelastic) (b) Long Run (Supply and Demand are Elastic)
Rental Rental
Price of Price of
Apartment Apartment

Supply Supply

Controlled Controlled
rent rent

Shortage Demand Shortage Demand

0 Quantity of 0 Quantity of
Apartments Apartments

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 12


How Price Floors Affect Market
Outcomes
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.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 13


Figure 6-4: A Market with a Price Floor
(a) A Price Floor That is Not Binding (b) A Price Floor That is Binding
Price of Price of
Ice-Cream Ice-Cream
Cone Cone

Supply Supply
Surplus

Equilibrium $4
price Price ceiling

$3 $3
Price Floor
$2 Equilibrium
price

Demand Demand

0 100 Quantity of 0 80 120 Quantity of


Equilibrium Ice-Cream Ice-Cream
QD QS Cones
quantity Cones
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 14
How Price Floors Affect Market
Outcomes
A Binding Price Floor creates. . .
Surpluses (i.e. Quantity Supplied >
Quantity Demanded)
Non-Price Rationing - An alternative
mechanism for rationing of the good:
Discrimination Criteria
Examples:
Minimum Wage
Agricultural Price Supports

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 15


CASE STUDY: 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.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 16


Figure 6-5: How the Minimum Wage Affects
the Labour Market
(a) A Free Labour Market (b) A Labour Market with a Binding Minimum Wage

Wage Wage

Labour
Labour Labour surplus supply
supply
(unemployment)

Minimum
wage

Equilibrium
wage

Labour Labour
demand demand

0 Equilibrium Quantity Quantity


Quantity of 0 Quantity of
employment demanded supplied Labour
Labour

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 17


TAXES
What is the purpose of government-
imposed taxes?
To raise government revenues.
To restrict production of a product.
What is an excise tax?
A per-unit tax thats independent of
the price of the product.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 18


TAXES
Who pays the tax on a good? The buyer or the
seller?
How is the burden of a tax divided between
buyer and seller?
When the government levies a tax on a good,
the equilibrium quantity of the good falls. The
size of the market for that good shrinks, shifting
either the demand or supply curve.
Tax incidence: The study of who bears the
burden of taxation.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 19


How Taxes on Buyers (and Sellers) Affect
Market Outcomes
Taxes discourage market activity.
When a good is taxed, the quantity sold
is smaller.
Buyers and sellers share the tax burden.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 20


Figure 6-6: A Tax on Buyers

Price of
Ice-Cream
Cone

S1
Price
buyers
pay

$3.30
Price
Tax ($0.50) Equilibrium without tax
without $3.00
tax A tax on buyers shifts
$2.80 the demand curve
downward by size of
Price the tax ($0.50).
sellers
receive
Equilibrium
with tax
D1

D2

0 90 100 Quantity of Ice-


Cream Cone

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 21


Figure 6-7: A Tax on Sellers

Price of
Ice-Cream
Cone S2

Equilibrium S1
Price
with tax
buyers
A tax on sellers shifts
pay
the supply curve
upward by an amount
of the tax ($0.50).
$3.30
Price
Tax ($0.50) Equilibrium without tax
without $3.00
tax
$2.80
Price
sellers
receive

D1

0 90 100 Quantity of Ice-


Cream Cone

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 22


CASE STUDY: The Burden of a Payroll tax

Example: Employment Insurance.


A payroll tax places a wedge between the
wage the workers receive and the wage
the firm pays.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 23


Figure 6-8: A Payroll Tax

Wage
Labour
supply

Wage firms pay

Tax wedge
Wage without tax

Wage workers
receive

Labour
demand

0 Quantity of
Labour

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 24


Elasticity and Tax incidence
Consider a tax levied on sellers of a
good. What are the effects of this
tax?
How do effects of the tax levied on
the seller compare with those of the
effects imposed on the buyer?
Depends on Elasticity of Demand
and Elasticity of Supply.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 25


Elasticity and Tax incidence
The burden of a tax falls on the side
of the market with the smaller price
elasticity!
The more inelastic the demand and the
more elastic the supply results in the
consumer paying more of the tax.
The more elastic the demand and the
more inelastic the supply results in the
supplier paying more of the tax.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 26


Figure 6-9 a): How the Burden of a Tax is
Divided.
Price
Elastic Supply, Inelastic Demand

1. When supply is more elastic


than demand
Price buyers pay

Supply

Tax

Price without tax


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

Demand
3. than on producers.

Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 27


Figure 6-9 b): How the Burden of a Tax is
Divided
Price 1. When demand is more elastic
than supply Inelastic Supply, Elastic Demand

Supply

Price buyers pay

Price without tax 3. than on consumers.

Tax

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

Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 28


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.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 29


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.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 30


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.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 31


The End

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 6: Page 32