The Uses of Supply and Demand in analyzing the Impacts of
Regulation and other Government Policies.
In the United States there is a presumption that markets should be allowed to work to satisfy
our needs. However, for a specific public interest government intervention may be deemed necessary.
Historically legal precedents have been established to define the public interest to include government
interventions to correct market failures such as market power, externalities, information asymmetries,
inequities, and dynamic market failure. When governments intervene they are held to a standard of
finding the least restrictive form of intervention required to correct a market failure. Judging the least
restrictive form of intervention requires an analysis of how the different government interventions
affect markets- the subject of this section.
The Impact of Regulation
Regulation by standards is difficult to illustrate with supply and demand because it generally
involves changes in quality or uncertainty, not quantity. However, two common types of regulationprice regulation and output regulation- can be easily described using supply and demand curves. Price
regulation is represented by a horizontal line at the price controlled price, while output regulation is
represented by a vertical line at the output control. Both types of control may be applied as maximum
or minimum limitations as shown in Figure 2.
Figure 2. Disequilibria (“current price” indicates price to the
Consumer due to Effective control)
(a)
(b)
Current Price
P
Supply
Demand
(c)
Current Price
P
Demand
Supply
(d)
Current Price
P
Demand
P
Supply
Quantity
Quantity
Current Price
Quantity
Demand
Supply
Quantity
Minimum output constraints (Figure 2a) are typically applied by government to provide
necessities to people who would not generally be reached by the market. Attempts to provide universal
service in education, postal service, health care services, telecommunications, water, electricity and
other utilities fall into this type of regulation. Invariably the government must subsidize such service
because at such quantities, people will only be willing to pay what is shown on the demand curve, and
suppliers will need to be paid what is on the supply curve.
Minimum price controls (Figure 2b) are often called “price floors” because they prevent prices
from falling through the floor. (But watch out! A “floor” suggests the price is below the equilibrium, but
it’s not- it’s above the equilibrium, preventing the price from falling to the equilibrium). The price floor
results in queues of goods- called inventories or stockpiles that are expensive and wasteful to store.
They also result in excess capacity which someone must pay for. Market forces will take the form of
businesses (or governments) trying to get rid of the excess between the quantity supplied and the
quantity demanded at the dotted line.
Maximum price controls (Figure 2c), by contrast, are referred to as “price ceilings” because they
prevent prices from rising above the ceiling. The price ceiling results in queues of people, standing in
line waiting for product. Such waiting is a waste of their time and effort and often leads to finding ways
of obtaining a good on an illegal market. Invariably scalpers or smugglers will attempt to meet the
unmet demand and they will do so at a price well above the equilibrium price in the legal market. That
illegal price is often referred to as the “shadow price”- perhaps a better name would be the “shady”
price because illegal markets are created to get around the price ceiling.
Maximum output controls are the prohibitions or quotas that limit production as shown in
figure 2d. In the case of quotas, the shadow price may be legal, but it will still be above the equilibrium
price that would occur if the market were permitted to work without limitation. Invariably illegal
markets will spring up to circumvent such prohibitions or limitations.
Impacts of Other Government Interventions
Many government interventions can be illustrated quite simply with supply and demand curve
shits. Typically the government’s role in opening up information will lower information costs (i.e. price
of resources) and therefore will shift the supply curve rightward or downward. However, when the
government protects information by making it secret or private or if the government otherwise limits
the use of the information, then the supply curve of firms can shift upward or leftward. The government
can lower market power by encouraging entry of new firms into a market (i.e. increasing the number of
sellers). However, if the government favors specific competitors it may actually contribute to the
market power of those specific competitors at the expense of other participants in a market. Taxes and
subsidies are determinants of supply and demand that shift the supply and demand curves. If taxes and
subsidies are made to the buyer then the demand curve shifts. Taxes, like income taxes, shift the
demand curve to the left while subsidies, like social security, given to consumers shift it to the right. If
taxes and subsidies are made to the supplier, then the supply curve shifts. Taxes, like sales taxes on
producers, shift the supply curve upward (to the left) while subsidies shift it downward (to the right).
© copyright 2009 by Michael Tansey