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. 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. 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©2010 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.”
Speaking in 1989, Vietnam’s Foreign Minister said: "The Americans couldn't destroy Hanoi, but we have destroyed our city by very low rents. We realized it was stupid and that we must change policy."
Discrimination; big shortages in the long run 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 inelastic)
Rental
Price of
Apartment
Supply
Demand
Controlled rent
Shortage
Quantity of
Apartments
Copyright©2010 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 elastic)
Rental
Price of
Apartment
Supply
Demand
Controlled rent
Shortage
Quantity of
Apartments
Copyright©2010 South-Western

12. Rent controls in New York City, San Francisco, Los Angeles
NYC: over 1 million apartments are rent-regulated
“Rent control limits the price a landlord can charge a tenant for rent and also regulates the services the landlord must provide.”
"Rent control allows some people to stay in artificially cheap apartments, but only by forcing the people who would have rented them into some other, less desirable place.”
“And no one wants to build any new housing except luxury units which will not be controlled.”
Deterioration of quality

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©2010 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©2010 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. 15 24

17. How Price Floors Affect Market Outcomes
A binding price floor causes . . .
a surplus because QS > QD.
non-price rationing is an alternative mechanism for rationing the good, using discrimination criteria.
Examples: The minimum wage, agricultural price supports 15 25

18. 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.

19. Figure 4 How the Minimum Wage Affects the Labour Market
Supply
labour
demand
Equilibrium
employment
wage
Quantity of
labour
Copyright©2010 South-Western

20. 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©2010 South-Western

21. TAXES Governments levy taxes to raise revenue for public projects. 2029

22. 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. 22 30

23. Elasticity and Tax Incidence
Tax incidence is the manner in which the burden of a tax is shared among participants in a market.
Tax incidence is the study of who bears the burden of a tax.
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

24. Figure 5 A Tax on Buyers €3.30 Price of Ice-Cream Price buyers pay
Supply, S1
Cone D1 D2
€3.30 90
Equilibrium without tax
Tax (€0.50)
Price
without
tax
3.00
100
A tax on buyers
shifts the demand
curve downward
by the amount of
the tax (€0.50).
2.80
Equilibrium
with tax
Price
sellers
receive
Quantity of
Ice-Cream Cones
Copyright©2010 South-Western

25. Elasticity and Tax Incidence
What was the impact of tax?
Taxes discourage market activity.
When a good is taxed, the quantity sold is smaller.
Buyers and sellers share the tax burden. 22 30

26. Figure 6 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©2010 South-Western

27. Figure 7 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©2010 South-Western

28. Elasticity and Tax Incidence
In what proportions is the burden of the tax divided?
How do the effects of taxes on sellers compare to those levied on buyers?
The answers to these questions depend on the price elasticity of demand and the price elasticity of supply. 29 39

29. Figure 8 How the Burden of a Tax Is Divided
(a) Elastic Supply, Inelastic Demand
Price
1. When supply is more 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©2010 South-Western

30. Figure 8 How the Burden of a Tax Is Divided
(b) Inelastic Supply, Elastic Demand
Price
1. When demand is more 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©2010 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

32. Luxury tax On yachts, private planes, furs
The D for yachts is quite elastic
The S not so elastic
Burden borne by yacht suppliers

33. Controlling quantities—licensing and import restrictions
Limit the number of firms in a market by the number of business licenses issued.
Taxis, dry cleaners, bars
Import restriction—limit the quantity of a good that can be imported—quota

34. Exercise
In the equilibrium in the powdered milk market, the quantity is 100 million units and the price is $9. The price elasticity of D is .80 and the price elasticity of S is Suppose the gov’t imposes a minimum price (price floor) of $9.90.
Draw a graph to show the effects of price floor
At the price floor, the quantity of powdered milk supplied is___, the Q demanded is___, and the excess supply is_____.

35. Exercise
The equilibrium price of gasoline is $3 and the equilibrium quantity is 100 million gallons. Suppose the government sets a price ceiling of $2.90. For producers, each $0.01 change in price changes quantity supplied by 3 million gallons. For consumers, each $0.01 change in price changes Q demanded by 2 million.
Draw a graph to show the effects of the price ceiling on the gasoline market.
With a price ceiling, find the quantity supplied, Q demanded and the shortage.

36. Medallions in Boston
In 1997 there were 1500 taxi medallions in Boston, each generating a profit of $14000 per year. In 1998 the city announced that it would issue 300 new medallions, auctioning the new medallions to the highest bidders. Even with the new medallions, the number of taxis in the city would still be less than the number in an unregulated market. Your job is to predict the annual profit per medallion after the new medalions are issued.

37. Assume
The cost of providing taxi service is constant at $2 per mile of service
The initial P of taxi service (with 1500 medallions) is $2.14 per mile.
Each taxi (medallion) provides miles of service per year, so 300 new medallions increase the total Q of taxi service from 150 million miles to 180.
The slope of the demand curve is per million miles.
Compute the new price of taxi service
Compute the new profit per medallion.

38. Luxury Boat Tax
Suppose the luxury boat industry employs 1000 workers and produces 100 boats per month. Suppose a tax on luxury boats increases the equilibrium price from $300,000 to 345,000. The price elasticity of demand for luxury boats is 2.0.
The luxury tax increases the equilibrium P of boats by ___%, so it decreases the Q of boats demanded from 100 to___. If builders continue to employ 10 workers per boat, the number of boat workers decreases from 1,000 to___.

39. 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.

40. 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.

41. 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 price elastic.