Supply, Demand, and
Government Policy
Controls on Price – Price Ceiling
Legal maximum on the price at which a good can
be sold
• Maximum price for Hamburger
• Intent: to protect consumers
Hamburger market with a price ceiling
Price ceiling that is not binding
Price ceiling that is binding
Price
Price
Supply
Supply
Price ceiling
$4
Equilibrium
price
$3
$3
Equilibrium
price
Price ceiling
$2
Demand
Demand
Shortage
Quantity
supplied
Equilibrium
quantity
0
100
Quantity
0
Quantity
demanded
75
125
Quantity
To the left, the government imposes a price ceiling of $4. Because the price ceiling is above the equilibrium
price of $3, the price ceiling has no effect, and the market can reach the equilibrium of supply and demand.
In this equilibrium, quantity supplied and quantity demanded both equal 100 burgers. To the right, the
government imposes a price ceiling of $2. Because the price ceiling is below the equilibrium price of $3, the
market price equals $2. At this price, 125 burgers are demanded and only 75 are supplied, so there is a
shortage of 50 burgers.
Controls on Price – Price Ceiling
A price ceiling can affect market outcomes
– Not binding
• Above the equilibrium price
• No effect
– Binding constraint
• Below the equilibrium price
• Shortage
• Sellers must ration the scarce goods
– When the rationing mechanisms are not
desirable
Price Ceiling: Gas Price Policy in 1973
In 1973 OPEC managed to raised the price of crude
oil
– by reducing the supply of crude
– thus gas supply lowered
– Long lines at gas stations, why?
– U.S. government regulations: price ceiling on gasoline
• Before OPEC raised the price of crude oil
– Equilibrium price of gas was below the price ceiling: no effect
• When the world price of crude oil rose as OPEC reduced the
supply of gasoline
– Equilibrium price of gas went above price ceiling: shortage
Price Ceiling: Market for gasoline
Gas Price Ceiling is binding
Gas Price Ceiling is not binding
Gas Price
1. Initially, the
price ceiling is
not binding … Supply, S
1
Gas Price
S2
S1
P2
Price ceiling
Price ceiling
3…the price
ceiling becomes
binding…
P1
P1
4. …resulting
in a shortage
Demand
Demand
0
Q1
Quantity of Gas
2…but when
supply falls…
0
QS
QD
Q1
Quantity of Gas
The left illustration shows the gas market when the price ceiling is not binding because the equilibrium price,
P1, is below the ceiling. The right illustration shows the gasoline market after an increase in the price of
crude oil (an input used to make gas) shifts the supply curve to the left from S1 to S2. In an unregulated
market, the price would have risen from P1 to P2. The price ceiling prevents this from happening. At the
binding price ceiling, consumers are willing to buy QD, but producers of gasoline are willing to sell only QS.
The difference between quantity demanded and quantity supplied, QD – QS, measures the gasoline shortage.
Price Ceiling: Rent controls
• Price ceiling: rent control
– Local government puts a ceiling on rents
– Goal: to help the poor (housing more affordable)
– Critique: highly inefficient way to help the poor raise
their standard of living
• Adverse effects of rent control in the short run
– Supply and demand for housing is relatively inelastic
– Initial small shortage at reduced rents
Price Ceiling: Rent controls
• Adverse effects of rent control in the long run
– Supply and demand becomes more elastic
• Landlords will not build new apartments will be less likely
to maintain existing ones
• At the binding rent ceiling more people will want to move
into a city
• Large shortage of housing
– Non-rent rationing mechanisms
• Long waiting lists
• Discrimination (children, pets, race, national origin)
• Bribes to building superintendents
Rent control in the short run and the long run
Rent Control in the Short Run
(supply and demand are inelastic)
Rental
Price of
Apartment
Rent Control in the Long Run
(supply and demand are elastic)
Rental
Price of
Apartment
Supply
Supply
Controlled rent
Controlled rent
Shortage
0
Demand
Quantity of Apartments
Shortage
0
Demand
Quantity of Apartments
The left illustration shows the short-run effects of rent control: Because the supply and demand for
apartments are relatively inelastic, the price ceiling imposed by a rent-control law causes only a small
shortage of housing. The right illustration shows the long-run effects of rent control: Because the supply and
demand for apartments are more elastic, rent control causes a large shortage.
Price Ceiling: Rent controls
• People respond to incentives
– Free markets
• Landlords try to keep their buildings clean and safe
• Higher prices
– Rent control shortages & waiting lists
• Landlords lose their incentive to respond to tenants’
concerns
• Tenants get lower rents & lower-quality housing
• Policymakers: additional regulations
– Difficult and costly to enforce
Controls on Price – Price Floor
Legal minimum on the price at which a good
can be sold
• Minimum legal price for Hamburger
• Why? Supposedly to protect the
Hamburger industry
Price Floor: Hamburger Market
Price floor that is not binding
Price
Price floor that is binding
Price
Supply
Surplus
Supply
$4
Price floor
3
$3
Equilibrium
price
Equilibrium
price
Price floor
2
Demand
Demand
Quantity
demanded
Equilibrium
quantity
0
100
Quantity
0
80
Quantity
supplied
120
Quantity
In the left illustration, government imposes a price floor of $2. Because this is below the equilibrium
price of $3, the price floor has no effect. The market price adjusts to balance supply and demand. At the
equilibrium, quantity supplied and quantity demanded both equal 100 burgers. To the right,
government imposes a price floor of $4, which is above the equilibrium price of $3. Therefore, the
market price equals $4. Because 120 burgers are supplied at this price and only 80 are demanded, there
is a surplus of 40 burgers.
Controls on Price – Price Floor
How price floors affect market outcomes
– Not binding
• Below the equilibrium price
• No effect
– Binding constraint
• Above the equilibrium price
• Surplus
• Some seller are unable to sell what they want
Price Floor: The minimum wage
• Minimum Wage is the lowest price for labor that
any employer may pay
• Fair Labor Standards Act of 1938 to insure
workers a minimally adequate standard of living
• 2007: minimum wage = $5.15 per hour
• 2010: minimum wage = $7.25 per hour
Price Floor: The minimum wage
• Market for labor
– Workers (supply of labor)
– Firms (demand for labor)
• Impact of the minimum wage above equilibrium
– Workers with high skills and much experience
• Not affected: Equilibrium wages are above the minimum
• Minimum wage is not binding
– Teenage labor: least skilled and least experienced
• Low equilibrium wages
• Willing to accept a lower wage in exchange for on-the-job
training
• Minimum wage is binding
Price Floor: Minimum wage and the labor market
A free labor market
A Labor Market with a
Binding Minimum Wage
Wage
Wage
Labor
supply
Labor surplus
(unemployment)
Minimum
wage
Equilibrium
wage
Labor
demand
Labor
demand
0
Labor
supply
Equilibrium
employment
Quantity
of Labor
0
Quantity
demanded
Quantity Quantity
supplied of Labor
The left illustration shows a labor market in which the wage adjusts to balance labor supply and
labor demand. The right illustration shows the impact of a binding minimum wage. Because the
minimum wage is a price floor, it causes a surplus: The quantity of labor supplied exceeds the
quantity demanded. The result is unemployment.
Controls on Prices
Evaluating price controls
• Markets are usually a good way to organize
economic activity
– Economists usually oppose price ceilings and price floors
– Prices coordinate economic activity efficiently
• Governments can sometimes improve market
outcomes
•
•
•
•
because of unfair market outcome
aimed at helping the poor
often hurt those they are trying to help
other ways of helping those in need
• rent subsidies
• wage subsidies
A tax on sellers
Price
Hamburger
Price
buyers
pay
Price
without
tax
Equilibrium with tax
S2
S1
A tax on sellers
shifts the supply
curve upward
by the size of
the tax ($0.50).
$3.30
Tax
($0.50)
3.00
Equilibrium without tax
2.80
Price
sellers
receive
Demand, D1
0
90
100
Quantity of
Hamburger
When a tax of $0.50 is levied on sellers, the supply curve shifts up by $0.50 from S1 to S2. The equilibrium
quantity falls from 100 to 90 hamburgers. The price that buyers pay rises from $3.00 to $3.30. The price
that sellers receive (after paying the tax) falls from $3.00 to $2.80. Even though the tax is levied on sellers,
buyers and sellers share the burden of the tax.
Tax on Sellers
• Tax incidence – a manner in which the burden of a
tax is shared among participants in a market
• How taxes on sellers affect market outcomes
– Immediate impact on sellers
– Supply curve shifts left
– Higher equilibrium price
– Lower equilibrium quantity
– The tax reduces the size of the market
Taxes on Sellers
How taxes on sellers affect market outcomes
– Taxes discourage market activity
– Smaller quantity sold
– Buyers and sellers share the burden of tax
– Buyers pay more
• Worse off
– Sellers receive less
• Collects the higher price but pays the tax
• Overall: effective price falls
• Sellers are worse off
Tax on Buyers
Price
Equilibrium with tax
Price
buyers
pay
Price
without
tax
Supply, S1
Equilibrium without tax
$3.30
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).
Tax
($0.50)
3.00
2.80
Price
sellers
receive
D1
D2
0
90
100
Quantity
When a tax of $0.50 is levied on buyers, the demand curve shifts down by $0.50 from D1 to D2. The
equilibrium quantity falls from 100 to 90 hamburgers. The price that sellers receive falls from $3.00 to
$2.80. The price that buyers pay (including the tax) rises from $3.00 to $3.30. Even though the tax is
levied on buyers, buyers and sellers share the burden of the tax.
Taxes on Buyers
How taxes on buyers affect market outcomes
– Demand curve shifts left
– Higher equilibrium price
– Lower equilibrium quantity
– The tax reduces the size of the market
Tax on Buyers
• How taxes on buyers affect market outcomes
– Buyers and sellers share the burden of the tax
– Sellers get a lower effective price
• Worse off
– Buyers pay a higher market price
• Effective price (with tax) rises
• Worse off
• Tax levied on sellers and tax levied on buyers
are equivalent
Income Tax and Labor Markets
Warning, if you have a weak stomach, you might
want to avoid this slide
Tax rate on this dollar
Earning $200,000 + $1
Federal Income Tax
FICA
Medicare Tax
Kentucky Income Tax
Bowling Green Tax
28.0%
12.4%
2.9%
6.0%
1.85%
51.15%
You keep $1 x 49% = .49 cents
6.2% x 2
1.45% x 2
Income Tax and Labor Markets
Price
Labor Supply
Cost of labor
to business
Size
of tax
Wage without tax
Worker wage
Labor Demand
0
Employment
with tax
Employment
without tax
Quantity
A tax on a good places a wedge between the wage workers receive
and the cost of labor to business. Labor use falls.
The Tax Burden
• Elasticity and tax incidence
• Dividing the tax burden
– Very elastic supply and relatively inelastic
demand
• Sellers – small burden of tax
• Buyers – most of the burden
– Relatively inelastic supply and very elastic
demand
• Sellers – most of the tax burden
• Buyers – small burden
How the burden of a tax is divided
Elastic Supply, Inelastic Demand
Price
1. When supply is more
elastic than demand . . .
Supply
Price buyers pay
Tax
Price without tax
Price sellers
receive
2. . . . The incidence of
the tax falls more heavily
on consumers . . .
3. . . . Than on producers.
Demand
0
Quantity
When he supply curve is elastic, and the demand curve is inelastic. In this case, the price received by
sellers falls only slightly, while the price paid by buyers rises substantially. Thus, buyers bear most of the
burden of the tax.
How the burden of a tax is divided
Inelastic Supply, Elastic Demand
Price
1. When demand is
more elastic than
supply . . .
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
0
Quantity
When the supply curve is inelastic, and the demand curve is elastic. In this case, the price received by
sellers falls substantially, while the price paid by buyers rises only slightly. Thus, sellers bear most of the
burden of the tax.
The Tax Burden
Tax burden falls more heavily on the side of the
market that is less elastic
– Low elasticity of demand
• Buyers do not have good alternatives to
consuming this good
– Low elasticity of supply
• Sellers do not have good alternatives to
producing this good
Who pays the luxury tax?
• The 1990 consumption luxury tax
– Goal: to raise revenue from those who could most
easily afford to pay
– Luxury items
• Demand is usually quite elastic
• Supply is relatively inelastic
• Outcome:
– Burden of a tax falls largely on the suppliers
• The American Yacht industry disappeared
• In 1993 most of the luxury tax was repealed