In this chapter, look for the answers to these
questions:
• What are price ceilings and price floors?
What are some examples of each?
• How do price ceilings and price floors affect
market outcomes?
• How do taxes affect market outcomes?
How does the outcome depend on whether
the tax is imposed on buyers or sellers?
• What is the incidence of a tax?
What determines the incidence?
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Supply, Demand, and Government Policies
CONTROLS ON PRICES
• 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.
• Are usually enacted when policymakers believe
the market price is unfair to buyers or sellers.
• Result in government-created price ceilings and
floors.
• Price Ceiling
– A legal maximum on the price at which a good can
be sold. Example: Rent Control
• Price Floor
– A legal minimum on the price at which a good can
be sold. Example: Minimum Wage
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How Price Ceilings Affect Market
Outcomes
© 2007 Thomson South-Western
Figure 1 A Market with a Price Ceiling
(a) A Price Ceiling That Is Not Binding
• Two outcomes are possible when the
government imposes a price ceiling:
Price of
Ice-Cream
Cone
• 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.
Supply
$4
Price
ceiling
3
The market clears at
$3 and the price
ceiling is ineffective.
Equilibrium
price
Demand
0
100
Equilibrium
quantity
Quantity of
Ice-Cream
Cones
© 2007 Thomson South-Western
© 2007 Thomson South-Western
1
How Price Ceilings Affect Market
Outcomes
Figure 1 A Market with a Price Ceiling
(b) A Price Ceiling That Is Binding
Price of
Ice-Cream
Cone
• Effects of Price Ceilings
• A binding price ceiling creates
Supply
• Shortages because QD > QS.
Equilibrium
price
• Example: Gasoline shortage of the 1970s
• Nonprice rationing
$3
2
• Examples: Long lines, discrimination by sellers
Price
ceiling
Shortage
Demand
0
75
125
Quantity
supplied
Quantity
demanded
Quantity of
Ice-Cream
Cones
© 2007 Thomson South-Western
© 2007 Thomson South-Western
CASE STUDY: Lines at the Gas Pump
Figure 2 The Market for Gasoline with a Price Ceiling
(a) The Price Ceiling on Gasoline Is Not Binding
• 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?
Price of
Gasoline
Supply, S1
• Economists blame government
regulations that limited the price oil
companies could charge for gasoline.
1. Initially,
the price
ceiling
is not
binding . . .
Price ceiling
P1
Demand
0
Q1
Quantity of
Gasoline© 2007 Thomson South-Western
© 2007 Thomson South-Western
Shortages and Rationing
Figure 2 The Market for Gasoline with a Price Ceiling
(b) The Price Ceiling on Gasoline Is Binding
Price of
Gasoline
S2
2. . . . but when
supply falls . . .
S1
P2
• With a shortage, sellers must ration the
goods among buyers.
• Some rationing mechanisms: (1) long
lines
(2) discrimination according to sellers’
biases
Price ceiling
3. . . . the price
ceiling becomes
binding . . .
P1
4. . . .
resulting
in a
shortage.
Demand
0
QS
QD Q1
Quantity of
Gasoline
© 2007 Thomson South-Western
• These mechanisms are often unfair, and
inefficient: the goods don’t necessarily go
to the buyers who value them most highly.
• In contrast, when prices are not controlled,
the rationing mechanism is efficient (the
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2
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.”
Figure 3 Rent Control in the Short Run and in the Long Run
(a) Rent Control in the Short Run
(supply and demand are inelastic)
Rental
Price of
Apartment
Supply
Controlled rent
Shortage
Demand
0
Quantity of
Apartments
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Figure 3 Rent Control in the Short Run and in the Long Run
(b) Rent Control in the Long Run
(supply and demand are elastic)
How Price Floors Affect Market Outcomes
• When the government imposes a price floor,
two outcomes are possible.
Rental
Price of
Apartment
• 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.
Supply
Controlled rent
Demand
Shortage
0
Quantity of
Apartments
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Figure 4 A Market with a Price Floor
Figure 4 A Market with a Price Floor
(a) A Price Floor That Is Not Binding
Price of
Ice-Cream
Cone
Supply
Equilibrium
price
$3
The government
says that icecream cones must
sell for at least $2;
this legislation is
ineffective at the
current market
price.
$4
100
Equilibrium
quantity
Price
floor
Equilibrium
price
Demand
0
Supply
Surplus
3
Price
floor
2
(b) A Price Floor That Is Binding
Price of
Ice-Cream
Cone
Demand
0
Quantity of
Ice-Cream
Cones
© 2007 Thomson South-Western
80
120 Quantity of
Quantity Quantity Ice-Cream
Cones
demanded supplied
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3
How Price Floors Affect Market Outcomes
CASE STUDY: The Minimum Wage
• 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.
• A binding price floor causes . . .
• 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.
• 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
© 2007 Thomson South-Western
Figure 5 How the Minimum Wage Affects the Labor Market
© 2007 Thomson South-Western
Figure 5 How the Minimum Wage Affects the Labor Market
Wage
Wage
Labor
Supply
Labor
Supply
Labor surplus
(unemployment)
Minimum
wage
Equilibrium
wage
Labor
demand
0
Equilibrium
employment
Labor
demand
0
Quantity of
Labor
Quantity
demanded
Quantity
supplied
© 2007 Thomson South-Western
Price floors & ceilings
P
140
Determine
effects of:
A.
$90
price
ceiling
130
The market for
hotel rooms
120
110
100
90
80
B. $90 price
floor
70
C. $120 price
floor
50
© 2007 Thomson South-Western
A. $90 price ceiling
S
D
60
40
0
Q
50 60 70 80 90 100 110 120 130
22
© 2007 Thomson South-Western
Quantity of
Labor
P
140
The price
falls to $90.
Buyers
demand
120 rooms,
sellers
supply 90,
leaving a
shortage.
The market for
hotel rooms
S
130
120
110
100
90
80
70
Price ceiling
D
shortage = 30
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
23
© 2007 Thomson South-Western
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B. $90 price floor
P
140
The market for
hotel rooms
130
Eq’m price is
above the
floor, so floor
is not
binding.
P = $100,
Q = 100
rooms.
C. $120 price floor
S
120
110
100
90
80
Price floor
D
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
The price
rises to
$120.
Buyers
demand
60 rooms,
sellers
supply 120,
causing a
surplus.
P
140
130
120
110
The market for
hotel rooms
surplus = 60
S
Price floor
100
90
D
80
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
24
25
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Evaluating Price Controls
TAXES
• Recall one of the Ten Principles:
Markets are usually a good way to
organize economic activity.
• Governments levy taxes to raise revenue for
public projects.
• Prices are the signals that guide the allocation of
society’s resources. This allocation is altered
when policymakers restrict prices.
• Price controls are often intended to help the
poor, but they often hurt more than help them:
– The min. wage can cause job losses.
– Rent control can reduce the quantity and
quality of affordable housing.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
How Taxes on Buyers (and Sellers) Affect
Market Outcomes
How Taxes on Buyers Affect Market
Outcomes
• Taxes discourage market activity.
• When a good is taxed, the
quantity sold is smaller.
• Buyers and sellers share
the tax burden.
• Elasticity and tax incidence
• Tax incidence is the manner in which the burden of
a tax is shared among participants in a market.
• 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.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
5
Figure 6 A Tax on Buyers
Price of
Ice-Cream
Price
Cone
buyers
pay
$3.30
Price
3.00
2.80
without
tax
Price
sellers
receive
Figure 7 A Tax on Sellers
Supply, S1
Equilibrium without tax
Tax ($0.50)
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).
Equilibrium
with tax
Price of
Ice-Cream
Price
Cone
buyers
pay
$3.30
3.00
Price
2.80
without
A tax on sellers
shifts the supply
curve upward
by the amount of
the tax ($0.50).
S2
Equilibrium
with tax
S1
Tax ($0.50)
Equilibrium without tax
tax
Price
sellers
receive
Demand, D1
D1
D2
0
90
100
Quantity of
Ice-Cream Cones
0
90
100
Quantity of
Ice-Cream Cones
© 2007 Thomson South-Western
Elasticity and Tax Incidence
© 2007 Thomson South-Western
Figure 8 A Payroll Tax
Wage
• What was the impact of
tax?
Labor supply
• Taxes discourage market
activity.
• When a good is taxed, the
quantity sold is smaller.
• Buyers and sellers share
the tax burden.
Wage firms pay
Tax wedge
Wage without tax
Wage workers
receive
Labor demand
0
Quantity
of Labor
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Elasticity and Tax Incidence
Figure 9 How the Burden of a Tax Is Divided
(a) Elastic Supply, Inelastic Demand
• 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.
Price
1. When supply is more elastic
than demand . . .
Price buyers pay
Supply
Tax
2. . . . the
incidence of the
tax falls more
heavily on
consumers . . .
Price without tax
Price sellers
receive
3. . . . than
on producers.
0
Demand
Quantity
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© 2007 Thomson South-Western
6
Elasticity and Tax Incidence
Figure 9 How the Burden of a Tax Is Divided
(b) Inelastic Supply, Elastic Demand
Price
1. When demand is more elastic
than supply . . .
Price buyers pay
So, how is the burden of the tax divided?
Supply
Price without tax
3. . . . than on
consumers.
Tax
Price sellers
receive
0
2. . . . the
incidence of
the tax falls
more heavily
on producers . . .
Demand
The burden of a tax falls more
heavily on the side of the
market that is less elastic.
Quantity
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© 2007 Thomson South-Western
7