1. Supply, Demand, and Government Policies6
Supply, Demand, and Government Policies

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.
One of the roles of economists is to use their theories to assist in the development of policies. 2 2

3. PRICE CONTROLS Controls on prices…
are usually enacted when policymakers believe the market price is unfair to buyers or sellers.
Examples: Rental Housing Market, Labour Market
result in government-created price ceilings and floors. 3 3

4. CONTROLS ON PRICES Price Ceiling Price Floor
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. 4 4

5. How Price Ceilings Affect Market Outcomes
Two outcomes are possible when the government imposes a price ceiling:
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. 5 5

6. Figure 1 A Market with a Price Ceiling
(a) A Price Ceiling That Is Not Binding
Price of
Ice-Cream
Cone
Supply
Demand €4
Price
ceiling 3
100
Equilibrium
price
Quantity of
Ice-Cream
Equilibrium
quantity
Cones

7. Figure 1 A Market with a Price Ceiling
(b) A Price Ceiling That Is Binding
Price of
Ice-Cream
Cone
Supply
Demand
Equilibrium
price €3 2
Price
ceiling 75
125
Shortage
Quantity of
Ice-Cream
Quantity
supplied
Quantity
demanded
Cones
Copyright©2011 South-Western

8. How Price Ceilings Affect Market Outcomes
Effects of Price Ceilings
A binding price ceiling creates
shortages because QD > QS.
Example: Rent controls in New York restrict new building
non-price rationing
Examples: Long queues; discrimination by sellers 11 14

9. 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.” 2

10. Figure 2 Rent Control in the Short Run and in the Long Run
(a) Rent Control in the Short Run
(supply and demand are price inelastic)
Rental
Price of
Housing
Units
Supply
Demand
Controlled rent
Shortage
Quantity of
Housing Units
Copyright©2011 South-Western

11. Figure 2 Rent Control in the Short Run and in the Long Run
(b) Rent Control in the Long Run
(supply and demand are price elastic)
Rental
Price of
Housing
Units
Supply
Demand
Controlled rent
Shortage
Quantity of
Housing Units
Copyright©2011 South-Western

12. Effects of Rent Controls
A binding rent control creates…
shortages because QD > QS.
Buyers interested in renting a house cant do so!
search costs associated with shortages.
non-price rationing
Long waiting lists
Discrimination by sellers (race and children)
Black Market
long-run effects: reduction in rental housing 11 14

13. 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. 12 15

14. Figure 3 A Market with a Price Floor
(a) A Price Floor That Is Not Binding
Price of
Ice-Cream
Supply
Cone
Demand
Equilibrium
price €3
100 2
Price
floor
Quantity of
Ice-Cream
Equilibrium
quantity
Cones
Copyright©2011 South-Western

15. Figure 3 A Market with a Price Floor
(b) A Price Floor That Is Binding
Price of
Ice-Cream
Supply
Cone
Demand
Surplus €4
Price
floor 80
120 3
Equilibrium
price
Quantity of
Ice-Cream
Quantity
demanded
Quantity
supplied
Cones
Copyright©2011 South-Western

16. How Price Floors Affect Market Outcomes
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.
Primary result: A binding price floor causes a surplus because QS > QD. 15 24

17. The Minimum Wage
An important example of a price floor is the minimum wage.
Minimum wage laws dictate the lowest price for labour that any employer may pay.
Monthly wage:
1, (2014)

18. Figure 4 How the Minimum Wage Affects the Labour Market
Supply
labour
demand
Equilibrium
employment
wage
Quantity of
labour
Copyright©2011 South-Western

19. Figure 4 How the Minimum Wage Affects the Labour Market
Supply
labour
demand
labour surplus
(unemployment)
Minimum
wage
Quantity
demanded
Quantity
supplied
Quantity of
labour
Copyright©2011 South-Western

20. Effects of Minimum Wages
Consequences of the minimum wage are…
Reduction in employment level
Surplus of labour & Involuntary Unemployment:
Everyone who is willing to sell their labor cant do so!
Non-price rationing: Discrimination
Search costs: Job search is costly and does not guarantee successful results
Effective as anti-poverty tool? Not a consensus in the literature! 15 24

21. TAXES Governments levy taxes to raise revenue for public projects.
Taxes discourage market activity. Why? Taxes = An increase in the costs
When a good is taxed, the quantity sold is smaller.
Buyers and sellers share the tax burden.(i.e. Tax Incidence) 20 29

22. Example: € 0.5 Tax on Ice-cream cones
Suppose that the government levies a €0.5 tax on ice-cream cones.
Moreover, the government states that the tax is payable by the producers of ice-cream cones.
Before the tax, equilibrium price is €3.00 and the equilibrium quantity is 100 cones.
What is the impact of the tax on:
the equilibrium price and quantity?
Consumers and Producers? 21 31

23. Figure 5 A Tax on Sellers Price of Ice-Cream Demand, D1
shifts the supply
curve upward
by the amount of
the tax (€0.50).
Price
buyers
pay
Cone S2
Equilibrium
with tax S1
€3.30 90
Tax (€0.50)
Price
without
tax
3.00
100
Equilibrium without tax
2.80
Price
sellers
receive
Quantity of
Ice-Cream Cones
Copyright©2011 South-Western

24. Figure 6 A Payroll Tax Wage labour supply Wage firms pay Tax wedge
labour demand
Wage firms pay
Tax wedge
Wage without tax
Wage workers
receive
Quantity
of labour
Copyright©2011 South-Western

25. Taxes result in a change in market equilibrium.
Tax Incidence
Tax incidence is the manner in which the burden of a tax is shared among market participants.
Taxes result in a change in market equilibrium.
Buyers pay more and sellers receive less, regardless of whom the tax is levied on. 21 31

26. Figure 5 A Tax on Sellers Price of Ice-Cream Demand, D1
shifts the supply
curve upward
by the amount of
the tax (€0.50).
Price
buyers
pay
Cone S2
Equilibrium
with tax S1
€3.30 90
Tax (€0.50)
Price
without
tax
3.00
100
Equilibrium without tax
2.80
Price
sellers
receive
Quantity of
Ice-Cream Cones
Copyright©2011 South-Western

27. Tax Incidence: Market for Ice-cream cones
Tax incidence is the manner in which the burden of a tax is shared among buyers and sellers.
Before the tax:
Consumers paid: € Producers received: €3.00
After the tax:
Consumers pays: € Producers receives: €2.80
Government collects €0.5 from the producers
Tax Incidence:
Buyers pay €0.3 more: (€ €3.00) (60% of the tax)
Sellers receive €0.2 less: (€ €2.80) (40% of the tax) 21 31

28. Price Elasticity and Tax Incidence
Q: In what proportions is the burden of the tax divided?
A: It depends on the price elasticity of demand and the price elasticity of supply. 29 39

29. Figure 7 How the Burden of a Tax Is Divided
(a) Price Elastic Supply, Price Inelastic Demand
Price
1. When supply is more price elastic
than demand . . .
Demand
Price buyers pay
Tax
the
incidence of the
tax falls more
heavily on
consumers . . .
Supply
Price without tax
than
on producers.
Price sellers
receive
Quantity
Copyright©2011 South-Western

30. Figure 7 How the Burden of a Tax Is Divided
(b) Price Inelastic Supply, Price Elastic Demand
Price
1. When demand is more price elastic
than supply . . .
Demand
Price buyers pay
Supply
Tax
than on
consumers.
Price without tax
the
incidence of
the tax falls
more heavily
on producers . . .
Price sellers
receive
Quantity
Copyright©2011 South-Western

31. ELASTICITY AND TAX INCIDENCE
So, how is the burden of the tax divided?
The burden of a tax falls more heavily on the side of the market that is less price elastic. 30 41