Supply, Demand, and

Government Policies

GOVERNMENT INTERVENTION IN MARKETS

• Learning outcomes;
• Use the model of demand and supply to
explain what happens when the government
imposes price floors or price ceilings.
• Discuss the reasons why governments
sometimes choose to control prices and the
consequences of price control policies.
• Evaluate the intent and outcomes of
government stabilisation policies.
 Review
• 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.
How does government interfere in the
market?

Through the imposition of:-

• Tax on goods and services

• Subsidies

• Price controls
 Government controlled prices
• These are policies that attempt to hold
the price at some disequilibrium value.
• If disequilibrium? What determines the
quantity actually traded on the market?
• Any voluntary market transaction
requires both a willing buyer and willing
seller.
 CONTROLLED PRICES
• Are usually enacted when
policymakers believe the market
price is unfair to buyers or sellers.
• Result in government-creating price
ceilings(maximum price) and floors
(minimum price).
 Price Floor
• “ A Price Floor [is] a legal minimum
on the price at which a good can be
sold” (Mankiw, (2019,10th Edition)
• Common in agricultural support
programmes and wage policy.
• Governments often seek to assist
farmers by setting price floors in
agricultural markets.
 Price Floor – Impact if set below equilibrium

Can this be
P S enforced?

The market left

alone, will
P1 gravitate to P1.
Price floor
P2 Setting a minimum
price below is
D ineffective – i.e. it
is not binding.
Q1 Q
 Price Floor – Impact if set above equilibrium
(binding price floor)
P S In this case, the floor is
effective in preventing the
Surplus market price from being
b c Price floor reached.
P2 -permanent surplus is
a created
P1 2........ The consequences of
excess supply.
It differs from product to
product.
a) If product is labour, excess
D translate to
unemployment.
Qd Q1 Qs Q b) If maize, surplus will
accumulate in grain silos.
Why might the government wish to incur these
consequences? ......to improve welfare of sellers.
How successful is this policy in agriculture?
A Market with a Price Floor

(b) A Price Floor That Is Binding

Price of
Maize per
ton Supply

Surplus
$400
Price
floor
200

Equilibrium
price

Demand

0 80 Quantity of
120
Quantity Quantity Maize in tons
demanded supplied
How the Minimum Wage Affects the Labor Market

Wage

Labor
Labor surplus Supply
(unemployment)
Minimum
wage

Labor
demand
0 Quantity Quantity Quantity of
demanded supplied Labor
 Price Ceiling

• “A price ceiling [is] a legal maximum

on the price at which a good can be
sold” (Mankiw, (2019, 10th edition)
• Price ceiling can be defined as the
government imposed restriction on the
pricing of a commodity above a certain
limit.
• How is the ceiling chosen?
• It might be the legal maximum, but under
what circumstances will this maximum not
be charged?
Government goals in setting price ceiling

• To keep specific prices down

• To restrict production: resource allocation

to other uses

• Satisfy notions of equity in consumption of

a product that is temporary in short
supply;
• Eg fuel, food stuff, rentals
 Price Ceiling – Impact if set above
equilibrium
P S

Price ceiling
P2 •Can a price ceiling
P1
set at P2 be
enforced?

•If left alone, the

D market price would
be P1.
Q1 Q

if set above no effect because free market

equilibrium remains attainable
 Price Ceiling – Impact if set below
equilibrium (binding price ceiling)
However if set below, have serious economic consequences

P S
2.........How best to allocate
a product in excess
demand?

a) Sellers preferences- 1st

P3
a
come, 1st served basis
P1 rent
b c Price ceiling b) Rationing using
P2 coupons
However problems are
D
inherent:-
• favouritism
• counterfeit of
Qs Q1 Qd Q coupons
1..if below, there will be Shortage – excess demand
 Price Ceiling
• Two groups of competing buyers emerged
• P2 vs P3
• Black market will crop up
• Black market – market in which goods are sold
illegally at prices that violate a legal price control.
• People buy at P2 and sell at P3 receiving profits
known as rent (P3 – P2)- shaded area on
diagram
• Once price ceiling is accompanied by black
market, it is not clear that desired goals of
government are achieved.
 Price ceiling
• Prices are not kept down, black market prices
will be higher than free market equil P1.
• With active black market, much of the product
will be sold to those who can afford the black
market price.

NB.
1. Price ceiling may result in persistent
shortages
2. No benefit to consumers, instead of paying
market price P2,
they end up paying P3,
3. Thus price ceiling accelerates the rate of
price changes.
 Application of Price Ceilings

Governments sometimes impose price

ceilings on rental properties
Why would the government limit prices on
these properties?
The goal of rent control policy is to help
the poor by making housing more
affordable

What effect does this have in the short run?

Is the impact any different in the long-run?
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

Controlled rent

Shortage
Demand

0 Quantity of
Apartments
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

Controlled rent

Shortage Demand

0 Quantity of
Apartments
 Summary
• Looked at how SS and DD tools can be
used to analyse real world situations.
• Price floors create surpluses by fixing
the price above the equilibrium price. At
the price set by the floor, the quantity
supplied exceeds the quantity
demanded.
• We focused of the direction of change.
• In agriculture, price floors have
created persistent surpluses of a
wide range of agricultural
commodities. Governments
typically purchase the amount of the
surplus or impose production
restrictions in an attempt to reduce
the surplus.
• Price ceilings create shortages by setting the
price below the equilibrium. At the ceiling
price, the quantity demanded exceeds the
quantity supplied.
• Rent controls are an example of a price
ceiling, and thus they create shortages of
rental housing.
• It is sometimes the case that rent controls
create “backdoor” arrangements, ranging
from requirements that tenants rent items that
they do not want to outright bribes, that result
in rents higher than would exist in the
absence of the ceiling.