Supply, Demand and
Government Policies
Chapter 6
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Supply, Demand, and
Government Policies
In a free, unregulated market system,
market forces establish equilibrium prices
and exchange quantities.
One of the things government can do is to
set price controls when the market price is
seen as unfair to either buyers or sellers.
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Price Ceilings & Price Floors
Price Ceiling
A legally established maximum price at which a
good can be sold. (Rent Controls)
Price Floor
A legally established minimum price at which a
good can be sold. (Price Supports for
Agriculture)
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Price Ceilings
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.
Binding means that there is an economic impact.
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A Price Ceiling That Is Binding...
Price of
Ice-Cream
Cone
Supply
Equilibrium
price
$3
2 Price
ceiling
Shortage
Demand
0 75 125 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones
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A Price Ceiling That Is Not Binding...
Price of
Ice-Cream
Cone
Supply
$4 Price
ceiling
Equilibrium
price
Demand
0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones
Effects of Price Ceilings
A binding price ceiling creates ...
shortages because QD > QS.
Example: Gasoline shortage of the
1970s
nonprice rationing
Examples: Long lines, Discrimination
by sellers
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The Price Ceiling on Gasoline Is
Not Binding...
Price of
Gasoline
1. Initially, Supply
the
price ceiling
is not
binding... $4 Price
ceiling
P1
Demand
0 Quantity of
Q1 Gasoline
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The Price Ceiling on Gasoline Is
Binding...
Price of S2 2. …but
Gasoline when supply
falls...
S1
P2
Price
ceiling
P1 3. …the price
ceiling becomes
4. …resulting binding...
in a shortage.
Demand
0 Quantity of
Q1 Gasoline
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Rent Control
Rent controls are ceilings placed on the
rents that landlords may charge their
tenants.
Rent control can make housing more
affordable.
With a price ceiling, you cannot go
above the ceiling.
But what about the landlords?
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Rent Control in the Short Run...
Rental
Price of
Apartment Supply and
Supply demand for
apartments
are relatively
inelastic-Why
is the supply
curve vertical?
Controlled rent
Shortage
Demand
0 Quantity of
Apartments
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Rent Control in the Long Run...
Rental Because the supply
Price of and demand for
Apartment apartments are
more elastic... What
happens in the long
run?
Supply
…rent control Controlled rent
causes a large
shortage
Shortage
Demand
0 Quantity of
Apartments
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Price Floors
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.
Think of price floors as not being able to go
below the floor.
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A Price Floor That Is Not Binding...
Price of
Ice-Cream
Cone
Supply
Equilibrium
price
$3
Price
2
floor
Demand
0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones
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A Price Floor That Is Binding...
Price of
Ice-Cream
Cone
Supply
Surplus
$4 Price floor
$3
Equilibrium
price
Demand
0 80 120 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones
Effects of a Price Floor
A binding price floor causes . . .
a surplus because QS >QD.
nonprice rationing is an alternative
mechanism for rationing the good,
using discrimination criteria.
Examples: The minimum wage, Agricultural
price supports
State Minimum Wages
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The Minimum Wage
A Free Labor Market
Wage
Labor
supply
Equilibrium
wage
Labor
demand
0 Equilibrium Quantity of
employment Labor
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The Minimum Wage
A Labor Market with a
Wage
Minimum Wage
Labor
Labor surplus supply
(unemployment)
Minimum
wage
Labor
demand
0 Quantity Quantity Quantity of
demanded supplied Labor
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What are some potential
impacts of taxes?
Taxes are used to raise
money for the government.
Taxes discourage market
activity.
When a good is taxed, the
quantity sold is smaller.
Buyers and sellers share
the tax burden.
But who bears the burden-
tax incidence.
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Impact of a 50¢ Tax Levied on
Buyers...
Price of
Ice-Cream
Cone Supply, S1
Price
buyers
pay $3.30 Equilibrium without tax
Price 3.00 Tax ($0.50)
without 2.80
tax
Price
Equilibrium
sellers with tax
receive
D1
D2
0 90 100 Quantity of
Ice-Cream Cones
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Impact of a 50¢ Tax on Sellers...
Price of
Ice-Cream
Cone A tax on sellers
Price S2 shifts the
buyers Equilibrium
supply curve
pay with tax
upward by the
$3.30 S1 amount of the
Price 3.00 Tax ($0.50)
tax ($0.50).
without 2.80
tax Equilibrium without tax
Price
sellers
receive
Demand, D1
0 90 100 Quantity of
Ice-Cream Cones
The Incidence of Tax
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 elasticity of demand
and the elasticity of supply.
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Elastic Supply, Inelastic Demand...
Price 1. When supply is more
elastic than demand...
Price buyers pay
Supply
Tax 2. ...the
incidence of the
Price without tax tax falls more
heavily on
Price sellers receive consumers...
3. ...than on Demand
producers.
0 Quantity
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Inelastic Supply, Elastic Demand...
1. When demand is more
Price elastic than supply...
Price buyers pay Supply
Price without tax 3. ...than on consumers.
Tax
Demand
Price sellers receive 2. ...the
incidence of
the tax falls more
heavily on producers...
0 Quantity
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