Chapter 6
Supply, Demand, and
Government Policies
1. Price Ceiling
2. Price Floor
3. Effect of Taxes
4. Tax Incidence
Objectives
1. Learn the consequences of government
policies that impose a ceiling (maximum)
price on a market
2. learn the consequences of government
policies that impose a floor (minimum)
price on a market
3. Understand how a tax on a good affects
market equilibrium price and quantity
4. Recognize the equivalence of taxes imposed
on buyers and sellers and know how the
burden of a tax is divided between buyers
and sellers
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, i.e. buyer or seller are
satisfied.
Hence, market controls!
Market Price Controls
Are
usually enacted
when policymakers
believe that the market
price is unfair to
buyers and sellers.
Result
in governmental
policies, i.e., price
ceilings and floors.
Price Ceilings & Price Floors
A
–
A
–
Price Ceiling
is a legally established maximum price
which a seller can charge or a buyer must
pay.
Price Floor
is a legally established minimum price
which a seller can charge or a buyer must
pay.
Price Ceilings
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.
Market Impacts of a Price Ceiling
Price
Supply
Equilibrium
Price
Demand
Equilibrium
Quantity
Quantity
A Non-Binding Price Ceiling
Price
Supply
PC
Price
Ceiling
PE
Demand
QE
Quantity
A Binding Price Ceiling
Price
Supply
Price
Ceiling
PE
PC
Demand
QE
Quantity
A Binding Price Ceiling Creates
Shortages.
Price
Supply
PE
PC
Demand
QS
QE
QD
Quantity
A Binding Price Ceiling Creates
Shortages.
Price
Supply
PE
PC
Demand
Shortage
QS
QE
QD
Quantity
Market Impacts of a Price Ceiling
A
–
Binding Price Ceiling creates. . .
Shortages (i.e... Demand > Supply)
Gasoline
–
shortages of the 1970s
Non-Price Rationing - An alternative
mechanism for rationing of the good:
Long
Lines (First-In-Line, Figure 6-2)
Discrimination
criteria set by seller
The Market for Gasoline
with a Price Ceiling
Price of
Gasoline
1. Initially, the price ceiling
is not binding ...
S1
Price ceiling
P1
Demand
0
Q1
Quantity
The Market for Gasoline
with a Price Ceiling
S2
Price of
Gasoline
2. ...but when supply
falls ...
S1
P2
Price ceiling
P1
Demand
0
Q1
Quantity
The Market for Gasoline
with a Price Ceiling
S2
Price of
Gasoline
3. ...the price ceiling
becomes binding ...
S1
P2
Price ceiling
P1
Demand
0
Q1
Quantity
The Market for Gasoline
with a Price Ceiling
S2
Price of
Gasoline
4. Resulting in
a shortage
S1
P2
Price ceiling
Shortage
P1
Demand
0
Qs
QD Q1
Quantity
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
Apartment
Supply
Supply and
demand for
apartments are
relatively
inelastic
Controlled rent
Shortage
Demand
0
Quantity of
Apartments
Rent Control in the Long Run...
Rental
Price of
Apartment
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 (i.e... a legal minimum on the
price at which a good can be sold) two
outcomes are possible:
1
. The price floor is not binding.
2
. The price floor is a binding constraint
on the market, creating Surpluses
A Non-Binding Price Floor
Price
Supply
Price
Floor
PE
PF
Demand
QE
Quantity
A Binding Price Floor
Price
Supply
PF
Price
Floor
PE
Demand
QE
Quantity
Market Impacts of a Price Floor
A
government imposed market price
floor hinders the forces of supply and
demand in 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 a surplus.
A Binding Price Floor Creates a
Surplus.
Price
Supply
PF
PE
Demand
QS
QE
QD
Quantity
A Binding Price Floor Creates a
Surplus.
Price
Supply
PF
PE
Demand
Surplus
QS
QE
QD
Quantity
Market Impacts of a Price Floor
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
A Free Labor Market
Wage
Labor Supply
Equilibrium
Wage
Labor Demand
0
Equilibrium
Unemployment
Quantity of Labor
A Labor Market with a Binding
Minimum Wage
Wage
Labor Supply
Minimum
Wage
Labor Demand
0
Quantity
demanded
Quantity
supplied
Quantity
of Labor
Quick Quiz!
Define
“price ceiling”
and “price floor”
Give
an example
of each.
Which
leads to a
shortage, which a
surplus? Why?
Taxes! Taxes! Taxes!
What
is the purpose of government
imposed taxes?
–
To raise government revenues.
–
To restrict allocation of a product.
What
–
is an excise tax?
A “per-unit” tax that’s independent of
the price of the product.
Taxes! Taxes! 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
Tax
incidence is the study of who
actually bears the burden of taxation
Taxes: Impact
Taxes discourage
market activity. The
quantity of the good
sold is smaller than
without the tax.
Buyers and sellers
share the tax burden.
Taxes: Impact From a 50 Cent Tax
S1
Equilibrium
without tax
$2.00
D1
800
Taxes: Impact From a 50 Cent Tax
S1
From the sellers
viewpoint, the tax
causes the
demand curve to
shift down by
50 cents.
$2.00
$1.80
D1
600 800
Taxes: Impact From a 50 Cent Tax
S1
The tax increases
the market price
to the buyer...
$2.30
$2.00
$1.80
D1
600 800
Taxes: Impact From a 50 Cent Tax
S1
The tax increases
the market price
to the buyer...
...and decreases
demand.
$2.30
$2.00
$1.80
D1
600 800
A Tax on Sellers
Equilibrium with tax
Price
S
Price buyers
pay
2
$3.30
Price w/o
tax
A tax on sellers shifts
the supply curve upward
by the amount of the tax
($.50)
3.00
S
}
1
Tax ($.50)
Equilibrium without tax
2.80
Demand, D1
Price sellers
receive
90
100
Quantity
Figure 6-7
A Payroll Tax
Wage
Labor supply
Wage firms pay
{
Tax Wedge
Wage without tax
Wage workers
receive
Labor demand
0
Quantity
of labor
Figure 6-8
The Burden (incidence) of a Tax is Inversely Related
to the Price Elasticities of Demand and Supply
Price
Supply
}
Price paid by buyers
after the tax = $2.40
relatively elastic
$.50 tax
Price without tax = $2.00
Price received by sellers
after the tax = $1.90
Demand
relatively inelastic
Quantity
The Burden (incidence) of a Tax is Inversely Related
to the Price Elasticities of Demand and Supply
Price
Supply
relatively inelastic
Price paid by buyers
after the tax = $2.10
Price without tax = $2.00
Price received by sellers
after the tax = $1.60
}
$.50 tax
Demand
relatively elastic
Quantity
The Incidence of Tax. . .How is the
burden of the tax distributed?
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.
The Incidence of Tax. . .How is the
burden of the tax distributed?
The burden of a tax
falls on the side
of the market
with the smaller
price elasticity!
Elasticity and Taxes
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.
Elastic Supply, Inelastic Demand...
Price
1. When supply is more
elastic than demand...
Price buyers pay
Supply
Tax
Price without tax
Price sellers receive
3. ...than on
producers.
0
2. ...the
incidence of the
tax falls more
heavily on
consumers...
Demand
Quantity
Inelastic Supply, Elastic Demand...
1. When demand is more
elastic than supply...
Price
Supply
Price buyers pay
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
Quick Quiz
Show
how a tax on car
buyers of $1,000 per
car affects the quantity
of cars sold and the
price of cars.
Show
how a similar tax
on car sellers affects
quantity and price.
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.
Supply, Demand & Government
The
economy is governed by two kinds
of laws:
–
The laws of supply and demand
–
The laws enacted by government.
Price
controls and taxes are common
in various markets in the economy:
–
Price Ceilings
–
Price Floors
–
Excise Tax
Case Studies
1. Lines at gas pump - price ceiling
2. Rent control - price ceiling
3. The minimum wage - price floor
4. Burden of a payroll tax - tax incidence
5. Luxury tax - tax incidence