Chapter 6
Supply, Demand,
and Government
Policies
2002 by Nelson, a division of Thomson Canada Limited
In this chapter you will…
• Examine the effects of government
policies that place a ceiling on prices.
• Examine the effects of government
policies that place a floor under prices.
• Consider how a tax on a good affects the
price of the good and the quantity sold.
• Learn that taxes levied on buyers and
taxes levied on sellers are equivalent.
• See how the burden of a tax is split
between buyers and sellers.
Chapter 6: Page 2
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
is satisfied.
• Hence…market controls!
• One of the roles of economists is to use
their theories to assist in the development
of policies.
Chapter 6: Page 3
CONTROLS ON PRICES
• Are usually enacted when
policymakers believe the market
price is unfair to buyers or sellers.
• Result in government-created price
ceilings and floors.
Chapter 6: Page 4
Price Ceilings and Price Floors
• Price Ceiling
– A legal maximum on the price at
which a good can be sold.
• Price Floor
– A legal minimum on the price at
which a good can be sold.
Chapter 6: Page 5
How Price Ceiling Affect Market
Outcomes
• 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.
Chapter 6: Page 6
Figure 6-1: A Market with a Price Ceiling
(a) A Price Ceiling That is Not Binding
(b) A Price Ceiling That is Binding
Price of
Ice-Cream
Cone
Price of
Ice-Cream
Cone
Supply
Supply
$4
Price
ceiling
Equilibrium
price
$3
$3
Price
ceiling
$2
Equilibrium
price
Shortage
Demand
Demand
0
100
Equilibrium
quantity
Quantity of
Ice-Cream
Cones
0
75
125 Quantity of
QS
QD
Ice-Cream
Cones
Chapter 6: Page 7
How Price Ceiling Affect Market
Outcomes
•
A binding price ceiling creates
– Shortages because QD > QS.
•
–
Examples: Gasoline shortage of the
1970s, housing shortages with rent
controls.
Non-price rationing
•
Examples: Long lines, discrimination by
sellers, black markets.
Chapter 6: Page 8
CASE STUDY: Lines at the Gas Pump
•
•
•
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?
Economists blame government regulations that
limited the price oil companies could charge for
gasoline.
Chapter 6: Page 9
Figure 6-2: A Market for Gasoline with a
Price Ceiling
(a) A Price Ceiling on Gasoline is Not Binding
(b) A Price Ceiling on Gasoline is Binding
Price of
Gasoline
S2
1. Initially
the price
ceiling is
not
binding…
2.…but when
supply falls…
S1
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
Gasoline
0
QS
QD
Q1
Quantity of
Gasoline
Chapter 6: Page 10
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.”
Chapter 6: Page 11
Figure 6-3: Rent Control in the Short Run
and Long Run
(a) Short Run (Supply and Demand are Inelastic)
Rental
Price of
Apartment
(b) Long Run (Supply and Demand are Elastic)
Rental
Price of
Apartment
Supply
Supply
Controlled
rent
Shortage
0
Controlled
rent
Shortage
Demand
Quantity of
Apartments
0
Demand
Quantity of
Apartments
Chapter 6: Page 12
How Price Floors Affect Market
Outcomes
• When the government imposes a
price floor, two outcomes are
possible.
• 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.
Chapter 6: Page 13
Figure 6-4: A Market with a Price Floor
(a) A Price Floor That is Not Binding
(b) A Price Floor That is Binding
Price of
Ice-Cream
Cone
Price of
Ice-Cream
Cone
Supply
Supply
Surplus
$4
Equilibrium
price
Price ceiling
$3
$3
Price Floor
Equilibrium
price
$2
Demand
Demand
0
100
Equilibrium
quantity
Quantity of
Ice-Cream
Cones
0
80
120 Quantity of
QD
QS
Chapter 6: Page 14
Ice-Cream
Cones
How Price Floors Affect Market
Outcomes
•
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
Chapter 6: Page 15
CASE STUDY: The Minimum Wage
•
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.
Chapter 6: Page 16
Figure 6-5: How the Minimum Wage Affects
the Labour Market
(a) A Free Labour Market
(b) A Labour Market with a Binding Minimum Wage
Wage
Wage
Labour surplus
Labour
supply
Labour
supply
(unemployment)
Minimum
wage
Equilibrium
wage
Labour
demand
Labour
demand
0
Equilibrium
employment
Quantity of
Labour
0
Quantity
demanded
Quantity
supplied
Quantity of
Labour
Chapter 6: Page 17
TAXES
•
What is the purpose of governmentimposed taxes?
– To raise government revenues.
– To restrict production of a product.
• What is an excise tax?
– A “per-unit” tax that’s independent of
the price of the product.
Chapter 6: Page 18
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: The study of who bears the
burden of taxation.
Chapter 6: Page 19
How Taxes on Buyers (and Sellers) Affect
Market Outcomes
•
•
•
Taxes discourage market activity.
When a good is taxed, the quantity sold
is smaller.
Buyers and sellers share the tax burden.
Chapter 6: Page 20
Figure 6-6: A Tax on Buyers
Price of
Ice-Cream
Cone
S1
Price
buyers
pay
Price
without
tax
$3.30
Tax ($0.50)
$3.00
Equilibrium without tax
A tax on buyers shifts
the demand curve
downward by size of
the tax ($0.50).
$2.80
Price
sellers
receive
Equilibrium
with tax
D1
D2
0
90
100
Quantity of IceCream Cone
Chapter 6: Page 21
Figure 6-7: A Tax on Sellers
Price of
Ice-Cream
Cone
S2
Price
without
tax
S1
Equilibrium
with tax
Price
buyers
pay
A tax on sellers shifts
the supply curve
upward by an amount
of the tax ($0.50).
$3.30
Tax ($0.50)
$3.00
Equilibrium without tax
$2.80
Price
sellers
receive
D1
0
90
100
Quantity of IceCream Cone
Chapter 6: Page 22
CASE STUDY: The Burden of a Payroll tax
•
•
Example: Employment Insurance.
A payroll tax places a wedge between the
wage the workers receive and the wage
the firm pays.
Chapter 6: Page 23
Figure 6-8: A Payroll Tax
Wage
Labour
supply
Wage firms pay
Tax wedge
Wage without tax
Wage workers
receive
Labour
demand
0
Quantity of
Labour
Chapter 6: Page 24
Elasticity and Tax incidence
• 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.
Chapter 6: Page 25
Elasticity and Tax incidence
• The burden of a tax falls on the side
of the market with the smaller price
elasticity!
•
•
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.
Chapter 6: Page 26
Figure 6-9 a): How the Burden of a Tax is
Divided.
Price
Elastic Supply, Inelastic Demand
1. When supply is more elastic
than demand …
Price buyers pay
Supply
Tax
Price without tax
2. …the incidence of the tax falls more
heavily on consumers…
Price sellers
receive
Demand
3. …than on producers.
Quantity
Chapter 6: Page 27
Figure 6-9 b): How the Burden of a Tax is
Divided
Price
1. When demand is more elastic
than supply …
Inelastic Supply, Elastic Demand
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
Quantity
Chapter 6: Page 28
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.
Chapter 6: Page 29
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.
Chapter 6: Page 30
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.
• The burden tends to fall on the side of the
market that is less elastic.
Chapter 6: Page 31
The End
Chapter 6: Page 32