[CH.

6] SUPPLY, DEMAND,
AND GOVERNMENT POLICIES

1
LOOK FOR THE ANSWERS TO THESE QUES-
TIONS:

 What are price ceilings and price floors?

What are some examples of each?
 How do price ceilings and price floors affect market outcomes?
 How do taxes affect market outcomes?
How do the effects depend on whether
the tax is imposed on buyers or sellers?
 What is the incidence of a tax?
What determines the incidence?

2
GOVERNMENT POLICIES THAT ALTER THE
PRIVATE MARKET OUTCOME

 Price controls
 Price ceiling: legal maximum on the price at which a good can be sold
– Rent-control laws

 Price floor: legal minimum on the price at which a good can be sold
– Minimum wage laws

 Taxes: Government can make buyers or sellers pay a specific amount on

each unit

3
 ASK THE EXPERTS
RENT CONTROL

“Local ordinances that limit rent increases for some rental housing units, such
as in New York and San Francisco, have had a positive impact over the past
three decades on the amount and quality of broadly affordable rental housing
in cities that have used them.”

4
EXAMPLE 1: THE MARKET FOR APARTMENTS

Rental price of P S Equilibrium

apartments without price
controls

$800

Quantity
of apartments

D
Q
300 5
(A) HOW PRICE CEILINGS AFFECT MARKET OUT-
COMES

P S
Price
A price ceiling $1000
ceiling
above the
equilibrium price is $800
not binding — has
no effect on the
market outcome.

D
Q
300 6
 (A) HOW PRICE CEILINGS AFFECT MARKET OUT-
COMES

P S

The equilibrium price

($800) is above the ceil-
ing and therefore illegal.$800
The price ceiling is bind- Price
ing, causes a shortage. $500 ceiling
shortage
D
Q
250 400 7
 (A) HOW PRICE CEILINGS AFFECT MARKET OUT-
COMES

P S
In the long run, supply
and demand of rental
apartments are $800
more price-elastic.
Price
So, the shortage $500
ceiling
is larger. shortage
D
Q
150 450 8
SHORTAGES AND RATIONING

 Because of shortage
 Sellers must ration the goods among buyers

 Some rationing mechanisms:

– Long lines
– Discrimination according to sellers’ biases

 Are often unfair and inefficient

– The goods do not necessarily go to the buyers who value them most highly

9
EXAMPLE 2: THE MARKET FOR UNSKILLED LABOR

Wage paid W S Equilibrium

to without price
unskilled controls
workers
$6.00
Quantity of unskilled
workers

D
L
500 10
 (B) HOW PRICE FLOORS AFFECT MARKET OUTCOMES

W S

A price floor
below the
equilibrium price is $6.00
not binding – has Price
no effect on the $5.00
floor
market outcome.
D
L
500 11
(B) HOW PRICE FLOORS AFFECT MARKET OUTCOMES

labor
The equilibrium wage ($6) is W surplus S
below the floor and therefore Price
illegal. $7.25
floor
The price floor is binding,
causes a surplus $6.00
(i.e., unemployment).
(cf) Minimum wage laws do not
affect highly skilled workers.
They do affect teen workers.
 A 10% increase in the mini-
mum wage raises teen unemploy- D
ment by 1–3%. 12
L
400 550
 (CF).THE MINIMUM WAGE

“If the federal minimum wage is raised gradually to $15-per-hour by 2020, the employment
rate for low-wage U.S. workers will be substantially lower than it would be under the status
quo.”

13
[EX1.] PRICE CONTROLS
The market for
P
140 hotel rooms
130 S
The market for hotel rooms
is in equilibrium as in the 120
graph. 110
100
• Determine the effects of: 90
A. $90 price ceiling 80 D
70
B. $90 price floor
60
C. $120 price floor 50
40
050 60 70 80 Q 14
90 100 110 120 130
[EX.1] A. $90 PRICE CEILING
The market for
P
140 hotel rooms
130 S
The price falls to $90. 120
(binding price ceiling 110
below the equilibrium) 100
Price ceiling
90
Buyers demand
120 rooms, sellers
80 D
supply 90, leaving a 70 shortage = 30
shortage. 60
50
40
050 60 70 80 Q 15
90 100 110 120 130
[EX.1] B. $90 PRICE FLOOR
The market for
P
140 hotel rooms
130 S
120
Equilibrium price is
110
above the $90 price
100
floor, so the price floor Price floor
is not binding. 90
80 D
P = $100, 70
Q =100 rooms. 60
50
40
050 60 70 80 Q 16
90 100 110 120 130
[EX.1] C. $120 PRICE FLOOR
The market for
P
140 hotel rooms
130 surplus = 60 S
120
Price floor
The price rises to $120. 110
(binding price floor above 100
the equilibrium) 90

Buyers demand 60 rooms, 80 D

sellers supply 120, causing 70
a surplus. 60
50
40
050 60 70 80 Q 17
90 100 110 120 130
*EVALUATING PRICE CONTROLS

 Markets are usually a good way to organize economic activity

 Economists usually oppose price ceilings and price floors
 Prices are not the outcome of some haphazard process
 Prices have the crucial job of balancing supply and demand
– Coordinating economic activity

18
 *EVALUATING PRICE CONTROLS

 Governments can sometimes improve market outcomes

 Want to use price controls
– Because of unfair market outcome
– Aimed at helping the poor

 Often hurt those they are trying to help

 Other ways of helping those in need
– Rent subsidies
– Wage subsidies (earned income tax credit)

19
(1) TAXES

 Government uses taxes

 To raise revenue for public projects
– Roads, schools, and national defense

 Tax incidence
 Manner in which the burden of a tax is shared among participants in a market
– The government can make the seller or the buyer to pay the tax

20
EXAMPLE 3: THE MARKET FOR PIZZA

Equilibrium
P
without tax
S1

$10.00

D1

Q 21
500
 (1-1) A TAX ON BUYERS
Effects of a $1.50 per unit
tax on buyers Hence, a tax on buyers shifts
the D curve down by the
P amount of the tax.
S1 The price buyers pay is now $1.50
higher than the market price P.
$10.00 P would have to fall by $1.50 to make
Tax
buyers willing to buy same Q as be-
fore.
$8.50
D1 • E.g., if P falls from $10.00 to
$8.50, buyers are still willing
D2
to purchase 500 pizzas.
Q
500 22
 (1-1) A TAX ON BUYERS

Effects of a $1.50 per unit

tax on buyers
P New equilibrium:
S1 • Q = 450
PB = $11.00
Tax • Sellers receive PS = $9.50
$10.00
• Buyers pay PB = $11.00
PS = $9.50
Difference between
them = $1.50 = tax
D1

D2
23
Q
450 500
(1-1) THE INCIDENCE OF A TAX:
How the burden of a tax is shared among market participants

P
In our example,
S1
buyers pay PB = $11.00
Tax
$1.00 more,
$10.00
sellers get
PS = $9.50
$0.50 less.

D1
D2
Q
450 500 24
 (1-2) A TAX ON SELLERS
Effects of a $1.50 per unit
tax on sellers
The tax effectively raises
P S2 sellers’ costs by $1.50 per
$11.50 pizza.
Tax S1
Sellers will supply 500 pizza
$10.00 only if P rises to $11.50, to
compensate for this cost
increase.
Hence, a tax on sellers
D1
shifts the S curve up by
the amount of the tax.
Q 25
500
 (1-2) A TAX ON SELLERS
Effects of a $1.50 per unit tax
on sellers
P  New equilibrium:
S2
S1  Q = 450
PB = $11.00
Tax  Buyers pay PB = $11.00
$10.00
 Sellers receive PS = $9.50
PS = $9.50
 Difference between them
= $1.50 = tax
D1

Q
450 500 26
 *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!
P
S1
PB = $11.00
A tax drives Tax
a wedge between the $10.00
price buyers pay and PS = $9.50
the price sellers
receive.
D1

450 500 Q 27
[EX.2] EFFECTS OF A TAX
The market for
P
140 hotel rooms
The market for hotel rooms 130 S
is in equilibrium as in the 120
graph. 110
• Suppose the government 100
imposes a tax on buyers 90
of $30 per room 80 D
70
• Find the new 60
Q, PB, PS, and incidence
50
of tax.
40
050 60 70 80 Q 28
90 100 110 120 130
[EX.2] ANSWERS

The market for

P
140 hotel rooms
• Q = 80 130 S
• PB = $110 120
PB = 110
• PS = $80 100
90 Tax
• Incidence
PS = 80 D
– buyers: $10
70
– sellers: $20 60
50
40 29
050 60 70 80 Q
90 100 110 120 130
ELASTICITY AND TAX INCIDENCE
CASE 1: SUPPLY IS MORE ELASTIC THAN DEMAND

P
It’s easier for
PB sellers than
Buyers’ share S
buyers to leave
of tax burden the market.
Tax
So buyers bear
Price if no tax
most of the
burden of the tax.
Sellers’ share PS
of tax burden
D
30
Q
ELASTICITY AND TAX INCIDENCE
CASE 2: DEMAND IS MORE ELASTIC THAN SUPPLY

P
S
It’s easier for buyers
Buyers’ share than sellers to leave
of tax burden PB
the market.
Price if no tax
Tax Sellers bear most of
the burden of the
Sellers’ share tax.
of tax burden PS
D

Q 31
(CF) WHO PAYS THE LUXURY TAX?

 1990, Congress adopted a new luxury tax

 On yachts, private airplanes, furs, jewelry, expensive cars
 Goal: to raise revenue from those who could most easily afford to pay
 Luxury items
– Demand is quite elastic
– Supply is relatively inelastic

32
 (CF) CASE STUDY: WHO PAYS THE LUXURY
TAX?
The market for yachts
Demand is
P price-elastic.
S
Buyers’ share of
tax burden PB In the short run,
supply is inelastic.
Tax
Sellers’ share of Hence,
tax burden companies that
PS build yachts
D pay most of
the tax. 33

Q
SUMMARY

• A price ceiling is a legal maximum on the price of a good. An

example is rent control. 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.

34
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 elasticities of supply
and demand.

35