Applied Economics

MODULE
Module No. 3: Week 3: First Quarter
TOPICS: The Law of Demand, The Law of Supply, Supply and Demand Relationship, Equilibrium,
Disequilibrium, Shifts vs. Movement, and Applications of Supply and Demand (*Price-Control and
Rationing *Black Market *Rent Control *Minimum Support Price *Important Results of Price Support
Policy *Incidence of Indirect Taxes)

Learning Competencies
1. Analyze market demand, market supply and market equilibrium.
2. Determine the implications of market pricing on economic decision-making.
Code: Code: ABM_AE12-Ie-h-4-6

Objectives
After reading this module, the learners will be able to
1. explain the law of supply and demand, supply and demand relationship, equilibrium and
disequilibrium, and the shifts vs. movement
2. understand the applications of supply and demand

Let’s Recall

Illustration. Direction: Illustrate the statement below by the use of a simple graph,
the tradeoff between travel bags and wallet. Due to scarcity, choices have to be made
by consumers, businesses and governments.
Every choice we make has a cost associated with it. We simply cannot select one alternative without
forfeiting another. Assume the selection is to produce either a travelling bag or a wallet. If we choose
the traveling bag, we lose the wallet. If we opt for the wallet, we lose the travelling bag. To an
economist, correct costs are what we have to give up to get something. The professional jargon calls
these opportunity costs. Opportunity cost is the value that needs to be sacrificed or given up. They are
also the value of our next option or opportunity. Why? Every time we make a selection, what we
sacrifice is our next best alternative.
Data: Travel Bags Wallet
A 0 800 pieces
B 40 pieces 600 pieces
C 60 pieces 400 pieces
D 80 pieces 200 pieces
E 100 pieces 0

Let’s Understand
Applied Economics Situation

Introduction
In the context of supply and demand discussions, demand refers to the quantity of a good that is
desired by buyers. An important distinction to make is the difference between demand and the quantity

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demanded. The quantity demanded refers to the specific amount of that product that buyers are willing
to buy at a given price. This relationship between price and the quantity of product demanded at that
price is defined as the demand relationship.
Supply is defined as the total quantity of a product or service that the marketplace can offer. The
quantity supplied is the amount of a product/service that suppliers are willing to supply at a given price.
This relationship between price and the amount of a good/service supplied is known as the supply
relationship.
When thinking about demand and supply together, the supply relationship and demand relationship
basically mirror each other at equilibrium. At equilibrium, the quantity supplied and quantity demanded
intersect and are equal. At equilibrium price, suppliers are selling all the goods that they have produced
and consumers are getting all the goods that they demanding. This is the optimal economic condition,
where both consumers and producers of goods and services are satisfied.
Economics Basics: Supply and Demand
Supply and demand are perhaps one of the most fundamental concepts of economics and it is the
backbone of a market economy. Demand refers to how much (quantity) of a product or service is
desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a
certain price; the relationship between price and quantity demanded is known as the demand
relationship. Supply represents how much the market can offer. The quantity supplied refers to the
amount of a certain good producers are willing to supply when receiving a certain price. The correlation
between price and how much of good or service is supplied to the market is known as the supply
relationship. Price, therefore, is a reflection of supply and demand.
The relationship between demand and supply underlie the forces behind the allocation of resources.
In market economy theories, demand and supply theory will allocate resources in the most efficient way
possible. How? Let us take a closer look at the law of demand and the law of supply.
➢ The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a good, the
less people will demand that good. In other words, the higher the price, the lower the quantity demanded.
The amount of a good that buyers purchase at a higher price is less because as the price of a good goes
up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a
product that will force them to forgo the consumption of something else they value more. The graph
under this law, shows that the curve is download slope.
➢ The law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain
price. But unlike the law of demand, the supply relationship shows an upward slope. This means that
the higher the price, the higher the quantity supplied. Producers supply more at a higher price because
selling a higher quantity at a higher price increases revenue.
Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is
important to supply because suppliers must, but cannot always, react quickly to a change in demand or
price. So, it is important to try and determine whether a price change that is caused by demand will be
temporary or permanent.
Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy
season; suppliers may simply accommodate demand by using their production equipment more
intensively. If, however, there is a climate change, and the population will need umbrellas year-round,
the change in demand and price will be expected to be long term; suppliers will have to change their
equipment and production facilities in order to meet the long-term levels of demand.
➢ Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect)
the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient
because the amount of goods being supplied is exactly the same as the amount of goods being
demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic
condition. At the given price, suppliers are selling all the goods that they have produced and consumers
are getting all the goods that they are demanding.
In the real market place equilibrium can only ever be reached in theory, so the prices of goods and
services are constantly changing in relation to fluctuations in demand and supply.

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➢ Disequilibrium
Disequilibrium is a situation where internal and/or external forces prevent market equilibrium from
being reached or cause the market to fall out of balance. This can be a short-term byproduct of a change
in variable factors or a result of long-term structural imbalances. Is also used to describe a deficit or
surplus in a country’s balance of payments.
Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be
allocative inefficiency.
Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so
low, too many consumers want the good while producers are not making enough of it.
➢ Shifts vs. Movement
For economics, the "movements" and "shifts" in relation to the supply and demand curves represent
very different market phenomena.
Movements
A movement refers to a change along a curve. On the demand curve, a movement denotes a change
in both price and quantity demanded from one point to another on the curve. The movement implies
that the demand relationship remains consistent. Therefore, a movement along the demand curve will
occur when the price of the good changes and the quantity demanded changes in accordance to the
original demand relationship. In other words, a movement occurs when a change in the quantity
demanded is caused only by a change in price, and vice versa.
Like a movement along the demand curve, a movement along the supply curve means that the
supply relationship remains consistent. Therefore, a movement along the supply curve will occur when
the price of the good changes and the quantity supplied changes in accordance to the original supply
relationship. In other words, a movement occurs when a change in quantity supplied is caused only by
a change in price, and vice versa.
Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes
even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity
of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts
in the demand curve imply that the original demand relationship has changed, meaning that quantity
demand is affected by a factor other than price. A shift in the demand relationship would occur if, for
instance, beer suddenly became the only type of alcohol available for consumption.
Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to
Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the
supply curve implies that the original supply curve has changed, meaning that the quantity supplied is
affected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural
disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the
same price.
Applications of Supply and Demand
The analysis of price determination in terms of demand and supply is not merely of great theoretical
significance but it has important several practical applications in economic life of a country. This
analysis of demand and supply has been used to explain the implications of price control and rationing,
minimum price fixation, incidence of taxes, several other economic problems and policies.
The market mechanism is allowed to function without interference by the government. But
government in the modern mixed economies interferes with the functioning of the market system to
influence prices so as to promote social welfare when it is felt that free working of market will not
produce desirable results.
The government can interfere with the working of the economy in two main ways. The first
government fixes the maximum price (often called price ceiling) or fixes the minimum price often called
floor price). Price controls of food-grains, rent controls are the examples of fixation of maximum price
or price ceiling above which the sellers cannot charge the price. Agricultural price support programme
is the example of fixation of minimum price to assure minimum remunerative prices to farmers so as to
protect their interests.

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 The second way in which government interferers with the price or market system is working
through the market. In the second way government can impose taxes on the commodities or provide
subsidies. These taxes and subsidies affect the market supply or demand curves which determine prices
of goods and services.
Imposition of heavy excise duties on cigarettes or other drugs and providing subsidies on
agricultural products are examples of interference by government through market. In what follows we
will explain both types of intervention with the functioning of markets by government we begin our
analysis with the imposition of price control and rationing by government.
➢ Price Control and Rationing
In times of war imposition of price control is quite common and was introduced by several countries
during the Second World War. Even in peace time, price controls on essential commodities have been
introduced in several countries to help the poor against inflation.
Under price control the maximum price of a good is fixed above which the sellers cannot charge
from the consumers. Price control is imposed or price-ceiling is set below the equilibrium price. This is
because if the price ceiling is set above the equilibrium price that balances supply and demand, it will
have no effect or in other words, it will not be binding.
Consider Figure 1 where demand and supply balance each other at price P1. At this equilibrium
price both buyers and sellers are satisfied, buyers are getting the quantity of the good they want to buy
at this equilibrium price and the sellers are selling what they want to sell at this price. Therefore, the
higher price P2 than the price P1 fixed by government will have no effect.
When it is realized that the equilibrium price of a commodity is too high and consequently some
buyers go unsatisfied, for they lack the means to pay for it, the Government may pass a law through
which it fixes the maximum price of the commodity at a level below the equilibrium price.
Now, at a price lower than the equilibrium price, quantity demanded will be larger than the quantity
supplied and thus shortage of the commodity will emerge; some consumers who are willing and able to
buy at that price will go unsatisfied. Buyers would, if permitted, bid up the price to the equilibrium
level.
But under price control by the Government, price is not free to move to equate quantity demanded
with the quantity supplied. Thus, when the Government intervenes to fix the maximum price for a
commodity, price loses its important function of a rationing device.

Figure 1: Price ceiling above the equilibrium price Figure 2: Effect of price control (i.e., fixing
is not binding and is ineffective price ceiling below the equilibrium level)
Price control and problems raised by it are graphically illustrated in Figure 2 where demand and
supply curves, DD and SS of sugar are given. As will be seen from this figure that demand and supply
curves intersect at point E and accordingly OP1 is the equilibrium price of sugar.
Suppose that this equilibrium price OP, of sugar is very high so that many poor people are not able
to obtain any quantity of it. Therefore, the Government intervenes and fixes the maximum price of sugar
at the level OP0 which is below the equilibrium price OP1 as will be seen from Figure 2 at the controlled
price OP0 quantity demanded exceeds the quantity supplied. At price OPo, whereas the producers offer
to supply P0R quantity of sugar, the consumers are prepared to buy P0T quantity of it. As a result,
shortage of sugar equal to the amount RT has emerged and some consumers will go unsatisfied.

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As a result, shortage of sugar equal to the amount RT has emerged and some consumers will go
unsatisfied.
In the absence of Government intervention fixing the maximum price at OPj level, the excess
demand equal to RT would have led to rise in the price to the equilibrium level OP, where quantity
demanded is equal to quantity supplied. But, under price control by the government, to charge a price
higher than the legally fixed maximum price OP0 is punishable under the law.
Therefore, the available supply OM at the fixed price OPQ has to be somehow allocated or rationed
between the consumers. The rationing can take many forms. This task of rationing the available supply
OM may be done by the producers or sellers themselves.
Therefore, the available supply OM at the fixed price OPQ has to be somehow allocated or rationed
between the consumers. The rationing can take many forms. This task of rationing the available supply
OM may be done by the producers or sellers themselves.
The sellers may adopt the principle of “first come first served” and distribute the available supply
of sugar among those who are first in the queue before their shops. This system of rationing is therefore
called queue rationing.
The second method of rationing or allocating the scarce supply of the good is to distribute it on the
basis of what has been called, “allocation by seller’s preferences”. Under this, the available supply of
good is sold by the controlled price to their regular Customers. They may also adopt the policy of selling
the available supply to the buyers belonging to certain caste, religion, color etc. and not to others.
If the Government does not like the rationing of a commodity among the population on the basis of
either “first come first served” or arbitrary allocation by sellers’ preferences, it may introduce coupon
rationing of the commodity.
Under the coupon rationing system consumers are given ration coupons just sufficient to buy the
available quantity of the commodity. The number of ration coupons issued to a family may depend on
the age of its members, sex, and the number of family members or on any other criterion considered
desirable.
➢ Black Market
A point worth noting is that price control with or without rationing is likely to give rise to the black
market in the commodity. By black market we mean the sale of a commodity by the producers or sellers
at a price higher than the controlled price.
As mentioned above, at the controlled maximum price fixed below the equilibrium price, the
quantity demanded would exceed the quantity supplied and consequently shortage of the commodity
would develop. It is thus clear that some buyers of the commodity will not be fully satisfied as they will
not be able to get the quantity of the good they wish to buy at the controlled price.
Therefore, they will be prepared to pay a higher price for getting more quantity of the good, but
they can do so only in the black market. Sellers will also be interested in selling the commodity, at least
some quantity of it, in the black market at a higher price as it will fetch them larger profits.
Even when coupon rationing is introduced there will be pressure for the black market to develop.
This is because the consumers are willing to buy more quantity of the commodity than is available at
the controlled price, whereas rationing only distributes the available quantity of the commodity.
Therefore, the consumers who want to procure larger quantity than the rationing amount will be
prepared to pay a higher price to get some quantity in the black market.
There is sufficient evidence in India and abroad to confirm the predictions based on demand and
supply analysis. When price control and rationing system for some commodities which were in shortage
were introduced during the Second World War and after, black markets developed in spite of punitive
measures taken by the authorities.
➢ Rent Control
Rent controls are another example of maximum price that Government fixes on the rental price of
housing units. Under rent control, the Government fixes the rent per month per housing unit of a
standard size which is below the aquarium rent that would otherwise prevail in the market.
The maximum rent fixed by the Government helps the tenants, who generally belong to lower- and
middle-income groups and intend to prevent their exploitation by rich landlords who would charge a
very high market determined rates of rent. Market determined equilibrium rent rate happens to be high
because demand for rental housing tends to be relatively greater than supply of it.

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 Economists often point out the adverse effects of rent control and hold the view that it is highly
inefficient way of helping the poor and lower middle-class people. The adverse effects of rent control
are evident only in the long run because it always takes time to construct new housing units/ apartments
and also for the tenants to adjust to the rent and housing accommodation available on rent.
So, the long-run effect of rent control is different from the short run. In the short run the landlords
have almost a fixed number of housing units/apartments to give on rent. Therefore, the supply curve of
rental units is inelastic in the short-run.
On the other hand, people searching for rental- housing units are also not very responsive in the
short run as it always takes time for them to adjust their housing arrangements. Thus, even demand for
rental housing in relatively inelastic in the short-run.
Therefore, short-run supply curve of housing units is perfectly inelastic at Q0 number of housing
units available for renting. Ds is the short-run demand curve which is also relatively inelastic. If left free
to the market force, rent equal to R0 will be determined at which there is equilibrium between demand
and supply.
Suppose R0 is too high for the poor and middle-class people to pay. To help them, government fixes
ceiling on rent at R1 It will be seen from Figure 3 that at R1 people demand RXL housing units whereas
supply of them remains at R1K or OQ1. Thus, KL shortage of housing units has emerged since the
demand and supply of housing units in the short run is inelastic, shortage caused by rent control is small.
The main effect of rent control in the short-run is to reduce rents.

Figure 3: Effect of rent control in the short run Figure 4: Effect of rent control in the long run
Although in the short run, landlords cannot do much to the lowering of rent through control, further
investment in constructing houses and apartments by them will be reduced causing reduction in the
supply of rental houses in the long run.
In addition to this, the landlords will not spend any money one pairs and maintenance of rental
houses when rents are lowered. These steps will ultimately lead to the poor quality of rental houses and
apartments.
Thus, in the long run, rent control has an important effect on the availability or supply of rental
houses and their quantity. It will be seen from Fig. 4 that at the lower controlled rent OR1 the quantity
demanded of rental housing increases to OQ2 and the quantity supplied of rental housing units falls to
OQ1.
Thus, fixation of lower controlled rent OR1 results in increase in the quantity demanded and
decrease in the quantity supplied of rental houses and thereby leads to the emergence of the large short-
age of rental houses equal to Q1Q2 or KL as will be seen from Fig. 4. The greater the elasticity of supply
and demand for rental housing in the long run, the greater will be the shortage of rental housing units
as a result of imposition of rent control act.
It may be noted that this shortage of rental housing represents the conditions of excess demand for
rental housing. An important question is whether fixation of maximum rent which is lower than the
equilibrium rent can be effectively enforced when conditions of excess demand or shortage of rental
housing units emerges.
Of course, no one can openly or explicitly charge a rent higher than the controlled rate. However,
the emergence of the conditions of excess demand or shortage of rental housing will tend to put upward
pressure on the actual rents received.

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 Due to the excess demand conditions landlords have devised various ways to circumvent the rent
control act and charge higher actual rents. Consider Fig. 4 where it will be seen that at the controlled
rent OR1 of rental housing the quantity supplied of rental housing is OQ1. Further, for OQ rental housing
units tenants are willing to pay rent equal to OR2.
Under these conditions of excess demand and shortage of rental housing units, landlords tend to
extract side payments from tenants, though explicitly they charge controlled rent. For example, in Delhi
and New York, two of the important world cities where rent control law operates, landlords require
tenants to make a large non-refundable pay deposits or a large advance payment adjustable against
monthly rents.
Further, landlords may also require from tenants to make costly fittings or get expensive wood work
done in the rental houses as a condition for rent and further also requiring them to pay for the repairs
and maintenance of the rental housing units. All these ways of evading the rent control act have been
observed.
Unless the law explicitly prohibits such practices, they will be operating and will have the effect of
nullifying the rent control policy. That is tenants will pay controlled rent OR, explicitly but extra
expenditure and payments they are required to incur may add up to R^R0 per month so that the actual
effective monthly rent may amount to the equilibrium rent OR0.
It is evident from above that the consequence of rent control, like that of any other price control, is
the emergence of shortage. However, in case of shortage of rental housing units those who are unable
to get them will make efforts to make other living arrangements.
They may decide to live in other cities or satellite towns which are not covered by rent controls.
Further, the disappointed seekers of rental housing may turn to the construction of their own self-
occupied houses. But this requires a lot of finance which have to be arranged by them.
➢ Minimum Support Price
In the price control we examined the case when the government fixed a price ceiling (that is,
maximum price) to prevent it from rising to the equilibrium level. For many agricultural products the
Government policy has been to fix a price floor, that is, the minimum support price above the
equilibrium level which is considered to be low and un-remunerative to the farmers.
While in case of price control or fixation of price ceiling the Government simply announces the
maximum price above which price cannot be charged by the producers or sellers of a product, in case
of minimum support price, the Government becomes an active buyer of the product in the market.
It is not only in India but also in the developed countries such as the USA that price support policy
for agricultural products is adopted to provide reasonable prices to the farmers and increase their
income. The effects of imposition of minimum support price for wheat, an important agricultural
product.
Illustrated in Figure 5 where demand curve DD and supply curve 55 of wheat intersect at point E.
Thus, if price of wheat is allowed to be determined by the free working of demand for and supply of
wheat, equilibrium price is OP and equilibrium quantity determined is OQ.

Figure 5: Minimum support price for agriculture

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 Now suppose this free market determined equilibrium price OP (= Rs. 500 per quintal) is considered
to be un-remunerative which does not provide incentives to the farmers to produce wheat or expand its
production. Therefore, to promote the interests of the farmers, the Government intervenes and fixes a
higher minimum support price OP, (Rs. 550 per quintal) for wheat.
It will be seen from Figure 5 that at price of, of wheat, the quantity demanded of wheat decreases
to OQ1 (= P1A). On the other hand, at higher price OP1 farmers expand their output and supply a greater
quantity OQ2 (= P1B) of wheat. Thus, at minimum support price OP1 the quantity of wheat supplied by
the fanners exceeds the quantity demanded of it by the consumers in the market.
This means that the imposition of minimum support price of wheat higher than the equilibrium
price OP leads to the emergence of surplus of wheat equal to AB or Q1Q1. If the Government does not
purchase this surplus this will tend to depress the price of wheat.
Therefore, in order to ensure this minimum price of wheat OP, (= Rs. 550 per quintal) to the farmers
the Government will have to purchase the entire surplus AB or Q1Q2 from the farmers. It should be
noted that to purchase the surplus Q1Q2 from the farmers, the Government will have to make
expenditure equal to OP1 x Q1Q2, that is, equal to the area Q1ABQ1. This expenditure on purchase of
wheat surplus may be financed by taxation of the people.
It follows from above that under minimum support price OP1 the farmers sell OQ1, Quantity of
wheat in the free market and quantity Q1Q2 to the Government. At the free market determined
equilibrium price OP and quantity OQ, the total income farmers will be equal to the area OPEQ.
Now, with minimum support price equal to OP, and the total quantity sold equal to OQ2, the income
of the farmers has increased to OP1BQ1. Thus, minimum support price policy has greatly benefited the
farmers both in terms of price they receive for their product and the income they are able to earn.
A major problem facing the Government is how to dispose of the surplus it purchases from the
farmer at the higher minimum support price. If the Government sells it in the market, the price of wheat
in the market will fall which will defeat the purpose of support price policy.
Alternatively, the Government may store the surplus and in this case the Government will incur
storage costs. Besides, the wheat and any other food-grains get rot-toned if kept for longer time in
storage bins. Thus, while to produce surplus requires valuable resources such as labour, fertilizers,
irrigation and other inputs, yet it is quite often left to decay in government warehouses.
In America, one important way of disposing of surplus is to give them to the developing countries
as food aid. But this food aid is not without problems. The American food aid to developing countries
has tended to depress prices of food-grains in these countries and therefore has harmed the interests of
farmers of these developing countries.
The food surpluses are then used for distribution through Public Distribution System (PDS) at a
lower rate. Since Government procures these food grains at a higher rate and sells to the consumers at
lower issue prices, the Government sub-sidises the food-grain consumption and has to incur several
thousand crores on food subsidy annually.
➢ Important Results of Price Support Policy
1. Price paid by the consumers who buy from the open market increases when the minimum support
price of the agricultural product is fixed at a higher level than the equilibrium price. This is because
supply of the agricultural product in the open market decreases as a result of Government purchases of
it from the farmers.
2. Fixation of minimum support price {i.e., price floor) leads to the emergence of wheat surplus which
the Government has to purchase from the farmers. This is quite obvious from the Indian experience
where fixation of higher minimum support price (MSP) has resulted in mountain of food grains with
Food Corporation of India.
3. Taxpayers pay more tax money to finance the Government’s wheat purchases as well as storage costs.
4. How to dispose of the surplus purchased from the farmers poses a big problem. There are several
ways to dispose of the surplus procured. One way is to sell it at subsidized rate to the persons below the
poverty line through public distribution system. Second, the surplus can be used to make a part payment
of wages in terms of food-grains under ‘food for work’ programme. Third, food surplus can be given
to other countries as foreign aid or it can be exported.
5. Incomes of the farmers increase as a result of minimum support price fixed at a higher level than the
free market equilibrium price. As a result of price support, they receive higher price than that which

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would prevail in the free market and also, they produce and sell more than before. They sell a part of
their larger production in the market and a part to the Government.
➢ Incidence of Indirect Taxes
A significant application of demand-supply model is that it explains the problem of incidence of
indirect taxes such as sales tax and excise duty on commodities. By incidence of taxes we mean who
bear the money burden of taxes.
For example, if sale tax is imposed on a commodity the question is whether the producers will bear
the burden of the tax or the consumers who buy the commodity or the money burden of the sales tax
would be distributed in some way between the producers and the consumers. We will confine ourselves
to the explanation of incidence of indirect taxes, that is, taxes which are levied on either production or
sale or purchase of commodities.
It is worthwhile to note that the price of a commodity is determined by demand and supply only
when perfect competition prevails in the market. Supply curve of a commodity slopes upward as it is
assumed that marginal cost of production increases with the increase in output by the firms.
The upward sloping supply curve implies that as the price of a commodity rises the producer would
offer more quantity for sale in the market. If no tax is levied on the commodity, the seller or producer
will receive the whole amount of the price.
Now, if the sales tax is imposed equal to Rs. 5 per unit then the supply price of each unit of the
quantity offered for sale in the market will rise by Rs. 5. In this case, the producer would receive the
market price minus the amount of the tax per unit.
Thus, if the producer is to receive the same amount of price as prior to the imposition of the sales
tax, then; the supply price of each unit of the commodity sold will rise by the full amount of the tax.
This implies that the supply curve of the commodity will now shift upward by the amount of the tax as
a result of the imposition of the sales tax.
Consider figure 6 where demand and supply curves of a commodity are shown. Before the
imposition of any indirect tax, demand and supply curves intersect at point E, and accordingly,
equilibrium price OP and equilibrium amount OM are determined.
Now suppose that the sales tax equal to the amount SS’ is imposed on the commodity. As explained
above, the imposition of the sales tax will shift the supply curve vertically upward. The new supply
curve S’S’ has been drawn which depicts the supply position after the imposition of the sales tax. It will
be seen from the Figure 6 that the new supply curve S’S’ intersects the given demand curve DD at point
E.
Thus, as a result of the imposition of the sales tax the price of the commodity has risen from OP to
OP’. It means that the consumer will have to pay price of a commodity which is higher by the amount
PP’ than before. Obviously, the burden of the tax borne by the consumer is equal to PP'(=E’ H). This is
the incidence of tax fallen on the consumer.

Figure 6: Incidence of tax Figure 7: Incidence of tax in case of

perfectly inelastic demand
It will be seen from the diagram that the quantity sold in the market would now be OM’ and the
Government would receive E’G per unit of it as tax. Since E’ H will be paid by the consumer, the rest
of the tax equal to the amount GH per unit will be borne by the producer or seller.

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 Thus, a part of the tax has been passed on to the consumer through a higher price and a part has
been borne by the producer himself. It is worthwhile to note that the incidence of taxes borne by the
producer and the consumer will depend upon the elasticity of demand as well as elasticity of supply.
The lower the elasticity of demand, the greater will be the incidence of tax borne by the consumer.
If the demand for a commodity is perfectly inelastic the whole of the burden of the commodity tax
will fall on consumer. This is shown in figure 7. In this figure demand curve DD is a vertical straight
line showing that demand for the commodity is completely inelastic.
As a result of the intersection of the demand and supply curves, price OP is determined. If now the
tax equal to SS’ is imposed on the commodity, the supply curve will shift vertically upward to the dotted
position S’S’. It will be seen that the new supply curve S’S’ intersects the demand curve DD at point
EE’ and the new equilibrium price OP’ is determined.
It will be noticed from Fig. 7 that in this case the price of the commodity has risen by PP’ or EE’
which is equal to the full amount of the tax SS’. It means that producers pass on the full tax to the
consumers and they themselves do not bear any incidence. It, therefore, follows that in case of perfectly
in-elastic demand, the whole incidence of the tax falls on the consumer.
On the contrary, if the consumer’s demand for a quantity is perfectly elastic, as is shown by DD
curve in Figure 8 the imposition of the tax on it will not cause any rise in price. In this case, the whole
burden will be borne by the manufacturers or sellers. It will be seen from Fig. 8 that as a result of the
indirect tax by the amount SS’ and the resultant upward shift in supply curve to S’S’ the equilibrium
price remains unchanged at the level OP. Since the price has not risen, the consumer would not bear
any burden of the tax in this case. Therefore, the whole incidence of the tax will fall on the producer,
or seller in case of perfectly elastic demand.

Figure 8: Incidence of tax in case of perfectly Figure 9: Incidence of an indirect tax in case of elastic
elastic demand and inelastic demand
It should be noted that the more inelastic the demand for a commodity, the greater the rise in the
price paid by the consumer and the vice versa. In order to show this clearly, we have drawn two demand
curves—one inelastic and the other relatively more elastic in Figure 9. Supply curve SS has been drawn
which intersects the two demand curves DD and D’ D at the same point F.
Now before the imposition of any tax, the quantity sold and purchased is OM and the price of the
commodity- is OP1. Now, if the sales tax is imposed, supply curve shifts upward to S’S’ by the amount
of tax per unit imposed. It will be noticed from Fig. 9 that the new supply curve S’S’ intersects the
inelastic curve DD at point S according to which equilibrium price OP, is determined.
In this case of inelastic demand price has risen by P1P3 which is the burden borne by the consumers.
Now, the new supply curve S’S’ intersects the relatively elastic demand curve D’D’ at point R according
to which market price OP2 is determined.
Thus, in the case of elastic demand curve D’D’, the rise in price as a result of the same tax, is equal
to P1P2 which smaller than P1P3 borne by the consumer in case of inelastic demand. Therefore, the extent

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to which the incidence of the tax will fall on the consumer depends on their elasticity of the demand for
the commodity in question.
The predictions about the incidence of taxes borne by the consumers and the producers have been
generally found true in the real world situation when the commodities on which taxes are imposed are
sold under competitive conditions.

Let’s Apply
Illustration. Direction. Graph the following statement below.

I. In the graph, supply is illustrated by the upward sloping black line and demand is illustrated by the
downward sloping red line. At a price of P* and a quantity of Q*, the quantity demanded and the supply
demanded intersect at the Equilibrium Price. At equilibrium price, suppliers are selling all the goods
that they have produced and consumers are getting all the goods that they are demanding. This is the
optimal economic condition, were both consumers and producers of goods and services are satisfied.
(Label the graph: Equilibrium)
II. A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation
between quantities demanded (Q) and Price (P). So, at point A, the quantity demanded will be Qı and
the price will be Pı, and so on. The demand relationship curve illustrates the negative relationship
between price and quantity demanded. The higher the price of a good the lower the quantity demanded
(A), and the lower the price, the more the good will be in demand (C). (Label the graph: The Law of
Demand)
III. A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation
between quantities supplied (Q) and price (P). At point B, the quantity supplied will be Q₂ and the price
will be P₂, and so on. (Label the graph: The Law of Supply)

Let’s Analyze
Illustration. Direction. Graph the following statement below.

I. At price P1 the quantity of goods that the producers wish to supply is indicated by Q₂. At Pı, however,
the quantity that the consumers want to consume is at Qı, a quantity much less than Q₂. Because Q₂ is
greater than Qı, too much is being produced and too little is being consumed. The suppliers are trying
to produce more goods, which they hope to sell to increase profits, but those consuming the goods will
find the product less attractive and purchase less because the price is too high. (Label the graph: Excess
Supply)
II. At price Pı, the quantity of goods demanded by consumers at this price is Q₂. Conversely, the
quantity of goods that producers are willing to produce at this price is Qı. Thus, there are too few goods
being produced to satisfy the wants (demand) of the consumers. However, as consumers have to
compete with one another to buy the good at this price, the demand will push the price up, making
suppliers want to supply more and bringing the price closer to its equilibrium. (Label the graph: Excess
Demand)
III. A movement refers to a change along a curve. On the demand curve, a movement denotes a change
in both price and quantity demanded from one point to another on the curve. The movement implies
that the demand relationship remains consistent. Therefore, a movement along the demand curve will
occur when the price of the good changes and the quantity demanded changes in accordance to the
original demand relationship. In other words, a movement occurs when a change in the quantity
demanded is caused only by a change in price, and vice versa. (Label the graph: Movement Along the
Demand Curve)

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 Let’s Try
Illustration. Direction. Graph the following statement below.
I. Like a movement along the demand curve, a movement along the supply curve
means that the supply relationship remains consistent. Therefore, a movement along
the supply curve will occur when the price of the good changes and the quantity
supplied changes in accordance to the original supply relationship. In other words, a movement occurs
when a change in quantity supplied is caused only by a change in price, and vice versa. (Label the
graph: Movement Along the Supply Curve)
II. A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes
even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity
of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts
in the demand curve imply that the original demand relationship has changed, meaning that quantity
demand is affected by a factor other than price. A shift in the demand relationship would occur if, for
instance, beer suddenly became the only type of alcohol available for consumption. (Label the graph:
Shift in Demand for Beer)
III. Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to
Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the
supply curve implies that the original supply curve has changed, meaning that the quantity supplied is
affected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural
disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the
same price. (Label the graph: Shift in Supply for Beer)

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