1. Supply, Demand, and Government Policies8
Supply, Demand, and Government Policies
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2. Market Outcomes
In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities.
While equilibrium conditions may be efficient, but they may not always be fair.
Governments seek to influence unfair markets.
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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.
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.
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4. How Price Ceilings Affect Market Outcomes
When the government imposes a price ceiling there are two possible outcomes:
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.
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5. Figure 1 A Market with a Price Ceiling
(a) A Price Ceiling That Is Not Binding
Price of flats per sq m
Supply
Demand
€40
Price
ceiling 30
5 000
Equilibrium
price
Quantity of rental accommodation
(000 sq m)
Equilibrium
quantity

6. Figure 1 A Market with a Price Ceiling
(b) A Price Ceiling That Is Binding
Price of flats per sq m
Supply
Demand
Equilibrium
price
€30 20
Price
ceiling
4 000
6 000
Shortage
Quantity of rental accommodation
(000 sq m)
Quantity
supplied
Quantity
demanded

7. How Price Ceilings Affect Market Outcomes
Effects of Price Ceilings
A binding price ceiling creates
Shortages because QD > QS. Example: Rent controls in a city may restrict new building.
Non-price rationing. Examples: Long queues; discrimination by sellers.
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8. 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.”
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9. Figure 2a. Rent Control in the Short Run and in the Long Run
(supply and demand are price inelastic)
Rental
Price of
Housing
Units
Supply
Demand
Controlled rent
Shortage
Quantity of
Housing Units

10. Figure 2b 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 ]

11. How Price Floors Affect Market Outcomes
When the government imposes a price floor there are two 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.
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12. Figure 3a. A Market with a Price Floor
(a) A Price Floor That Is Not Binding
Price of alcohol per unit (€)
Supply
Demand
Equilibrium
price
€0.35 5
0.25
Price
floor
Quantity of alcohol per unit (millions)
Equilibrium
quantity

13. Figure 3b. A Market with a Price Floor
(b) A Price Floor That Is Binding
Price of alcohol per unit (€)
Supply
Demand
Surplus
€0.45
Price
floor 3 6
0.35
Equilibrium
price
Quantity of alcohol per unit (millions)
Quantity
demanded
Quantity
supplied

14. 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.
A binding price floor causes . . .
a surplus because QS > QD.
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15. Taxes Governments levy taxes to raise revenue for public projects.
However
Taxes discourage market activity.
When a good is taxed, the quantity sold is smaller.
Buyers and sellers share the tax burden.
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16. There Are Many Different Types Of Tax
A direct tax is levied on income and wealth
Indirect tax is levied on the sale of goods and services.
A specific tax is a set amount per unit of expenditure, for example, €0.75 per litre of petrol or €2.50 on a bottle of whisky.
An ad valorem tax is expressed as a percentage, for example a 10 per cent tax.
Tax incidence is the manner in which the burden of a tax is shared among participants in a market.
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17. How Taxes on Sellers Affect Market Outcomes
A Specific Tax where the government requires the seller to pay a certain amount for each good sold.
Supply curve shifts up by the amount of the tax.
Quantity sold falls.
Even though the tax is levied on sellers, buyers and sellers will share the burden of the tax; buyers pay more for the good and sellers receive less (because of the tax)
A tax on sellers places a wedge between the price buyers pay and the price sellers receive.
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18. Figure 4 The Effects of a Specific Tax of €0.50
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19. Figure 5 The Tax Burden on Buyers and Sellers
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20. How Taxes on Sellers Affect Market Outcomes
An ad valorem tax on sellers.
Like the specific tax, the buyers and sellers will share the burden of the tax
Supply curve shifts up but not by a parallel amount.
For example if VAT is introduced at 20% then:
A product costing €20 means the seller pays €4 VAT.
A product costing €50 means the seller pays €10 VAT.
At low prices, the amount of the tax paid is relatively low but 20 per cent of higher prices means the seller has to give more to the government.
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21. Figure 6a. The Effects of an Ad Valorem tax
When a tax of 20 per cent is levied on sellers, the supply curve shifts to the left from S1 to S2.
At low prices, the amount of the tax paid is relatively low
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22. Figure 6b. The Effects of an Ad Valorem tax
At higher prices the seller has to give more to the government.
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23. Elasticity and Tax Incidence
Implications of tax.
Taxes result in a change in market equilibrium. Taxes discourage market activity.
Buyers pay more and sellers receive less, regardless of whom the tax is levied on. Buyers and sellers share the tax burden.
Tax incidence is the manner in which the burden of a tax is shared among market participants.
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24. Price Elasticity and Tax Incidence
The way the burden of the tax divided depends on the price elasticity of demand and the price elasticity of supply.
In general, a tax burden falls more heavily on the side of the market that is less price elastic.
A low price elasticity of demand means buyers do not have good alternatives to consuming the product.
A low price elasticity of supply means sellers do not have good alternatives to producing this good.
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25. Figure 7a. 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
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26. Figure 7b 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
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27. Subsidies A subsidy is the opposite to a tax.
A subsidy is a payment to buyers and sellers to supplement income or lower costs and which thus encourages consumption or provides an advantage to the recipient.
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28. How Subsidies Affect Market Outcomes
Using rail travel as an example then subsidies:
Alter the incentives for people to travel on the train rather than on the roads.
Reduces congestion.
Reduces pollution.
A subsidy is given to railway companies shifts the supply curve outwards and lowers the price to buyers and so increases the amount purchased.
Both buyers and suppliers share the benefit of the subsidy.
There are costs associated with subsidies.
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29. Figure 8 A Subsidy To Railway Companies
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30. 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.
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.
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31. Summary
A tax on a good places a wedge between the price paid by buyers and the price received by sellers.
The incidence of a tax refers to who bears the burden of a tax.
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 price elastic.
The incidence of a tax does not depend on whether the tax is levied on buyers or sellers.
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32. Summary Subsidies are the opposite to taxes.
Subsidies to sellers shift the supply curve to the right, lowers price to buyers and increases the amount purchased.
Both suppliers and buyers gain from subsidies.
Subsidies cost money, usually the taxpayer
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