Supply, Demand and Government Policies

January, 2022

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Introduction

This chapter analyzes various types of government policies using tools

of supply and demand.
Examples of important government policies analyzed in this chapter:
How do price ceilings and price floors affect market outcomes?
How do taxes affect market outcomes?
Does it matter whether the tax is imposed on buyer or seller?

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Price Controls

Price Ceiling: a legal maximum on the price at which a good can be

sold. Example: Rent controls.
Price Floor: a legal minimum on the price at which a good can be
sold. Example: Minimum Wages.

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How Price Ceilings Affect Market Outcomes

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How Price Ceilings Affect Market Outcomes...

General result: When the government imposes a binding price ceiling

on a competitive market, a shortage of the good arises, and sellers
must ration the scarce goods among the large number of potential
buyers.
The rationing mechanism in a free, competitive market is both
efficient and impersonal. Free markets ration goods with prices.
The rationing mechanisms that develop under price ceilings tend to
be unfair and inefficient.
Long lines are inefficient because they waste buyers’ time.
Discrimination according to seller bias is both inefficient (because the
good does not necessarily go to the buyer who values it most highly)
and potentially unfair.

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Case Study: Lines at the Gas Pump

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Case Study: Rent Control in the Short Run and the Long
Run

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Case Study: Rent Control in the Short Run and the Long
Run...
Both supply and demand for housing is inelastic in the short run.
Landlords have a fixed number of apartments to rent, and they cannot
adjust this number quickly as market conditions change.
Number of people searching for housing in a city may not be highly
responsive to rents in the short run because people take time to adjust
their housing arrangements.
=⇒ Since both supply and demand are inelastic in the short run, the
initial shortage caused by rent control is small.
Supply and demand for housing is elastic in the long run since the
buyers and sellers of rental housing respond more to market
conditions as time passes.
Landlords respond to low rents by not building new apartments and by
failing to maintain existing ones.
Low rents encourage people to find their own apartments (rather than
living with their parents or sharing apartments with roommates) and
induce more people to move into a city.
=⇒ There is a large shortage of housing due to price control.
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How Price Floors Affect Market Outcomes

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How Price Floors Affect Market Outcomes...

General result: Binding price floor causes a surplus.

In the case of a price floor, some sellers are unable to sell all they
want at the market price.
Just as the shortages resulting from price ceilings can lead to
undesirable rationing mechanisms, so can the surpluses resulting from
price floors.
Sellers who appeal to the personal biases of the buyers, perhaps due to
racial or familial ties, are better able to sell their goods than those who
do not.

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Minimum Wage

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Evaluating Price Controls

Think about ”Markets are usually a good way to organize economic

activity.” in this context.
Prices have the crucial job of balancing supply and demand and,
thereby, coordinating economic activity.
When policymakers set prices by legal decree, they obscure the signals
that normally guide the allocation of society’s resources.
Policymakers are led to control prices because they view the market’s
outcome as unfair.
Price controls are often aimed at helping the poor.
Yet price controls often hurt those they are trying to help. Example:
Negative impact of rent control and minimum wage laws.
It is suggested that targeted rent and wage subsidies may be a better
way to help the poor.

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Taxes

Important Questions:
When the government levies a tax on a good, who actually bears the
burden of the tax?
What determines how the burden is divided?
Can the government simply legislate the division of the burden or is the
division determined by more fundamental market forces?
Tax Incidence: The manner in which the burden of a tax is shared
among participants in a market.

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How Taxes on Sellers Affect Market Outcomes

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How Taxes on Buyers Affect Market Outcomes

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Case Study: Can Congress Distribute the Burden of a
Payroll Tax?

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Elasticity and Tax Incidence

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Elasticity and Tax Incidence...

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Case Study: Who pays the luxury tax?

Demand for luxuries tend to be elastic as consumers can easily switch

to other luxury items when price rises.
Supply of luxury items tend to be relatively inelastic at least in the
short run since the resources employed in the production of luxuries
cannot be easily deployed in alternative uses.
With elastic demand and inelastic supply, the burden of a tax falls
largely on the suppliers.

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References

1 N. Gregory Mankiw (2012), Principles of Economics, 6th edition.

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