Supply, Demand and

Government Policies
Considering the policies that
directly control prices
 Controls on Prices

 Price Ceiling - 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

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 EXAMPLE: The Market for Rice

Price of P S
Rice

42
Eq’m
Eq’m w/o
w/o
price
price
controls
controls
D
Q
20
Quantity of
Rice
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
 How Price Ceilings Affect Market Outcomes

P S
A price ceiling Price
44
above the ceiling
equilibrium price
is 42
not binding –
it has no effect on
the market
outcome. D
Q
20

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 How Price Ceilings Affect Market Outcomes

The equilibrium P S
price (42) above
the ceiling.
The ceiling
is a binding 42
constraint Price
on the price, and 40
ceiling
causes shortage
a shortage. D
Q
15 30

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 How Price Ceilings Affect Market Outcomes

In the long run, P S

supply and
demand
are more
42
price-elastic.
So, the shortage Price
40
is larger. ceiling
shortage
D
Q
15 40

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 Shortages and Rationing
 With a shortage, sellers must ration the goods among buyers.
 Some rationing mechanisms: (1) long lines
(2) discrimination according to sellers’ biases
 These mechanisms are often unfair, and inefficient: the goods
don’t necessarily go to the buyers who value them most highly.
 In contrast, when prices are not controlled,
the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal (and thus fair).

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 How Price Floor Affect Market Outcomes
P S

A Price
Floor that is 42
Not Binding 40
Price
Floor

D
Q
20

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 How Price Floor Affect Market Outcomes

P S
SURPLUS
Price
A Price 44
Floor

-------------------------------

-------------------------------
Floor that is 42 ---------------------------

Binding

D
Q
10 40

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

Taxes
 The government levies taxes on many goods & services to raise revenue to
pay for national defense, public schools, etc.
 The government can make buyers or sellers pay the tax.
 The tax can be a percentage of the good’s price, or a specific amount for
each unit sold.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 EXAMPLE: The Market for Cigarette

P
S1

Equilibrium
Equilibrium $3.00
w/o
w/o tax
tax

D1

Q
20

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

A Tax on Buyers
Effects of a $0.50 per
unit tax on buyers
P
AA tax
tax on
on
S1 buyers
PB = $3.30 buyers shifts
shifts
Tax
the
the DD curve
curve
$3.00 down
down byby the
the
PS = $2.80 amount
amount of of the
the
The
The price
price
buyers tax
tax ($0.50)
($0.50)
buyers paypay
rises, D1
rises, the
the price
price
sellers
sellers receive
receive D2
falls,
falls, equilibrium
equilibrium Q
Q 300 500
Q falls.
falls.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 The Incidence of a Tax:
how the burden of a tax is shared among
market participants
P
Because
Because
of S1
of the
the tax,
tax, PB = $3.30
Tax
buyers
buyers pay pay
$3.00
$0.50
$0.50 more,
more,
PS = $2.80
sellers
sellers get
get
$0.20
$0.20 less.
less. D1
D2
Q
300 500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 A Tax on Sellers
Effects of a $0.50 per
unit tax on sellers
P S2
S1 AA tax
tax on
on
PB = $3.30 sellers
sellers shifts
shifts
Tax
$3.00 the
the SS curve
curve up
up
PS = $2.80 by
by the
the amount
amount
The
The price
price of
of the
the tax.
tax.
buyers
buyers paypay
D1
rises,
rises, the
the
price
price sellers
sellers
Q
receive
receive falls,
falls, 300 500
eq’m
eq’m Q Q falls.
falls.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
 The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!
What matters P
is this: S1
PB = $3.30
Tax
A tax drives
a wedge $3.00
between the PS = $2.80
price buyers
pay and the D1
price sellers
receive. Q
300 500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand

P In
In this
this case,
case,
buyers
buyers bearbear
PB S
Buyers’ share of most
most of of the
the
tax burden burden
burden of of
Tax
Price if no tax the
the tax.
tax.

Sellers’ share of PS
tax burden
D
Q

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply

P In
In this
this case,
case,
S
sellers
sellers bear
bear
Buyers’ share of most
PB most of of the
the
tax burden
burden
burden of of
Price if no tax the
the tax.
tax.
Tax
Sellers’ share of
tax burden PS
D

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 Elasticity and Tax Incidence

 If buyers’ price elasticity > sellers’ price elasticity, buyers can more easily
leave the market when the tax is imposed, so buyers will bear a smaller
share of the burden of the tax than sellers.
 If sellers’ price elasticity > buyers’ price elasticity, the reverse is true.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

CHAPTER 6 SUMMARY

 A price ceiling is a legal maximum on the price of a good. If the price

ceiling is below the equilibrium price, it is binding and causes a
shortage.
 A price floor is a legal minimum on the price of a good. An example is
the minimum wage. If the price floor is above the equilibrium price, it
is binding
and causes a surplus. The labor surplus caused by the minimum wage
is unemployment.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

CHAPTER SUMMARY

 A tax on a good places a wedge between the price buyers pay and the price sellers
receive, and causes the equilibrium quantity to fall, whether the tax is imposed on
buyers or sellers.
 The incidence of a tax is the division of the burden of the tax between buyers and
sellers, and does not depend on whether the tax is imposed on buyers or sellers.
 The incidence of the tax depends on the price elasticity of supply and demand.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES