Chapter 6
Supply, Demand, and
Government Policies
Ratna K. Shrestha
Supply, Demand and Govt. Policies
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In a “free”, unregulated market system,
market forces establish equilibrium prices
and quantities.
While equilibrium conditions may be efficient,
not everyone, i.e. buyer or seller, is satisfied.
Hence, government may control the market
to help either buyer or seller (often at the
expense of other).
Examples: (1) Price control and (2) Excise
tax, among others.
(1) Market Price Controls
 Are
usually enacted
when policy-makers
believe that the market
price is unfair either to
buyers or sellers.
 Result in government
policies, i.e. price ceilings
and Price floors.
Price Ceilings & Price Floors
A
Price Ceiling
 is a legally established maximum price
which a seller can charge (or a buyer must
pay).
 Examples: rent ceiling, ceiling on the price
of gasoline in the US in 1970s.
 A Price Floor
 is a legally established minimum price which
a buyer must pay.
 Examples: minimum wage.
Price Ceilings

When the government imposes a price
ceiling two outcomes are possible:
1.
The price ceiling is not binding. In this case
the ceiling has no effect on the market
outcomes.
The price ceiling is a binding constraint on
the market, creating shortages.
2.
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
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
Housing shortages with rent controls
 Non-Price Rationing - An alternative
mechanism for rationing of the good:
Long Lines (first-In-line, friends etc.)
Discrimination criteria set by seller
Black markets
Case Study: Lines At The Gas Pumps in
the US in 1973
S2 (after P of crude
oil increase)
Price
S1
P2
PC
P1
Demand
Shortage
QS
QD Q1
Quantity
Case Study: Rent Control
Short-Run Effect
Price
Supply
With relatively inelastic S
and D, Shortage is smaller.
PC
Shortage
Demand
Quantity of Apts
Case Study: Rent Control
Long-Run Effect
Price
Supply
In the long run, both S
and D become more
elastic and the effect of
rent control can be
much bigger!
PC
Shortage
Demand
Quantity of Apartments
Price Floors
 When
the government imposes a price floor,
two outcomes are possible:
1. The price floor is not binding. It does not
affect the market outcomes. This is the case
when the floor is lower than the equilibrium
price. For example, if the govt. sets
minimum wage at $6 (when the equilibrium
wage is $8), it has no effect at all.
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 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.
 Examples:
Minimum Wage
Agricultural Price Supports
A Binding Price Floor
Creates a Surplus.
Wage
Supply
Wmin
W*
Surplus Or
Unemployment
QD
QE
Demand
QS Quantity of Labor
Evaluating Price Controls
 Policy
makers control prices because they
think the free-market prices are unfair. They
are often aimed at helping the poor.
 Rent control laws try to make housing
affordable for the poor.
 Minimum wage laws are aimed at helping
the unskilled workers.
Evaluating Price Controls
 But
the irony is price controls often hurt those
they are intended to help.
 Rent control discourages landlords from
maintaining their buildings and make
housing hard to find.
 Minimum wage laws cause unemployment
and make it difficult for the unskilled
workers to find jobs. While those who can
maintain their jobs get higher pay, others
can lose the jobs they had before.
Effect of Minimum Wage in Canada
• A law that raises the minimum wage above the
market equilibrium wage creates
unemployment.
• But how much unemployment does it create?
• Until recently, most economists believed that a
10% increase in the minimum wage rate
decreased teenage employment by between 1
and 3 %.
Taxes! Taxes! 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 that is independent of the
price of the product. Example: tax on
gasoline. The tax on gasoline is based on
quantity. No matter what is the price of a liter
of gasoline, the tax/liter is always the same.
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.
Taxes: Impact

Taxes discourage market
activity. The quantity of the
good sold is smaller than
without the tax.


Both buyers and sellers
share the tax burden.
The question is who bears
how much burden?
Taxes: Impact From a 50 Cent Tax
S1
Price
Equilibrium
without tax
$3.00
D1
800
Quantity
Taxes: Impact From a 50 Cent Tax
D1
Price
S1
From the sellers
viewpoint, the tax
causes the
demand curve to
shift down by
50 cents.
$3.00
$2.80
600 800
Quantity
Taxes: Impact From a 50 Cent Tax
Price
D1
S1
The tax increases
the market price to
the buyer…in this
case the price rises
by $0.30 to $3.30.
$3.30
$3.00
$2.80
600 800
Quantity
Taxes: Impact From a 50 Cent Tax
Price
S1
D1
The tax decreases
the return to the
seller as the seller
gets $0.20 less.
$3.30
$3.00
$2.80
600
800
Quantity
Taxes: Impact From a 50 Cent Tax
Price
S1
D1
The tax makes both
the buyer and the
seller worse off!
$3.30
$3.00
$2.80
600
800
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, not on which side of the market it is
imposed.
 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.
Elasticity and Excise Tax Example
Price
A more inelastic demand
and more elastic supply.
Supply
$2.00
Demand
250
Quantity
Elasticity and Excise Tax
S2
Price
Specific Tax $.20
S1
$2.15
$2.00
Demand
200 250
Quantity
Elasticity and Excise Tax
Price
S2
Specific Tax $.20
S1
$2.15
$2.00
$1.95
Producer’s
burden of tax
Demand
200
250
Quantity
Elasticity and Excise Tax
Price
S2
Specific Tax $.20
S1
$2.15
Buyer’s burden
of tax
$2.00
$1.95
Demand
200 250
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.
Hint: The incidence of tax is independent of
which side of the market the tax is imposed!
 How will a $1 tax on land sales be distributed
between the landlord and the land buyer?