Supply, Demand,

and Government Policies

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PowerPoint Slides prepared by:

Andreea CHIRITESCU

Eastern Illinois University

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

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Figure 1

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Market with a Price Ceiling

(a) A Price Ceiling That Is Not Binding

In panel (a), the government imposes a price ceiling of $4. Because the price ceiling is above the equilibrium price of $3, the price ceiling has no effect, and the market can reach the equilibrium of supply and demand. In this equilibrium, quantity supplied and quantity demanded both equal 100 cones. In panel (b), the government imposes a price ceiling of $2. Because the price ceiling is below the equilibrium price of $3, the market price equals $2. At this price, 125 cones are demanded and only 75 are supplied, so there is a shortage of 50 cones.

(b) A Price Ceiling That Is Binding

Equilibrium

price

Equilibrium

quantity

Equilibrium

price

Quantity

demanded

Quantity

supplied

Rent control in the short run and the long run

• Price ceiling: rent control
• Local government - ceiling on rents
• Goal: to help the poor
• Making housing more affordable
• In the long run
• Landlords are not building new apartments
• Large shortage of housing
• No maintenance
• Preference to tenants without children
• Discriminate on the basis of race

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Figure 4

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Market with a Price Floor

(A) A Price Floor That Is Not Binding

In panel (a), the government imposes a price floor of $2. Because this is below the equilibrium price of $3, the price floor has no effect. The market price adjusts to balance supply and demand. At the equilibrium, quantity supplied and quantity demanded both equal 100 cones. In panel (b), the government imposes a price floor of $4, which is above the equilibrium price of $3. Therefore, the market price equals $4. Because 120 cones are supplied at this price and only 80 are demanded, there is a surplus of 40 cones.

(B) A Price Floor That Is Binding

Equilibrium

price

Equilibrium

quantity

Equilibrium

price

Quantity

supplied

Quantity

demanded

Figure 5

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How the Minimum Wage Affects the Labor Market

(a) A Free Labor Market

Panel (a) shows a labor market in which the wage adjusts to balance labor supply and labor demand. Panel (b) shows the impact of a binding minimum wage. Because the minimum wage is a price floor, it causes a surplus: The quantity of labor supplied exceeds the quantity demanded. The result is unemployment.

(b) A Labor Market with a

Binding Minimum Wage

The minimum wage

• If minimum wage is above equilibrium
• Unemployment
• Higher income for workers who have jobs
• Highly skilled and experienced workers not affected, their wages are above the minimum

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Taxes

• Tax incidence
• Manner in which the burden of a Government tax is shared among participants in a market

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Figure 6

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A Tax on Sellers

When a tax of $0.50 is levied on sellers, the price that buyers pay rises from $3.00 to $3.30. The price that sellers receive (after paying the tax) falls from $3.00 to $2.80. Even though the tax is levied on sellers, buyers and sellers share the burden of the tax.

Taxes

• Tax levied on sellers of a good
• Buyers and sellers share the burden of tax
• Buyers pay more
• Worse off
• Sellers earn less
• (Get the higher price but pay the tax)
• Worse off
• The tax reduces the size of the market

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Figure 7

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Tax on Buyers

When a tax of $0.50 is levied on buyers, the price that sellers receive falls from $3.00 to $2.80. The price that buyers pay (including the tax) rises from $3.00 to $3.30. Even though the tax is levied on buyers, buyers and sellers share the burden of the tax.

Taxes

• Tax levied on buyers of a good
• Buyers and sellers share the burden of tax
• Sellers get a lower price
• Worse off
• Buyers pay higher
• Effective payment (without tax) falls
• Worse off
• The tax reduces the size of the market

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Taxes

• Taxes levied on sellers, and taxes levied on buyers are equivalent

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Can congress distribute the burden of a payroll tax?

• Payroll taxes
• Deducted from the amount you earned
• By law, the tax burden:
• Half of the tax - paid by firms
• Half of the tax - paid by workers
• Wage received by workers falls
• Wage paid by firms rises
• Workers and firms share the tax burden

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Figure 8

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A Payroll Tax

A payroll tax places a wedge between the wage that workers receive and the wage that firms pay. Comparing wages with and without the tax, you can see that workers and firms share the tax burden. This division of the tax burden between workers and firms does not depend on whether the government levies the tax on workers, levies the tax on firms, or divides the tax equally between the two groups.

Taxes

• Elasticity and tax incidence
• Very elastic supply and relatively inelastic demand
• Sellers – small burden of tax
• Buyers – most of the burden
• Relatively inelastic supply and very elastic demand
• Sellers – most of the tax burden
• Buyers – small burden

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Figure 9

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How the Burden of a Tax Is Divided (a)

In panel (a), the supply curve is elastic, and the demand curve is inelastic. In this case, the price received by sellers falls only slightly, while the price paid by buyers rises substantially. Thus, buyers bear most of the burden of the tax.

(a) Elastic Supply, Inelastic Demand

Figure 9

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How the Burden of a Tax Is Divided (b)

In panel (b), the supply curve is inelastic, and the demand curve is elastic. In this case, the price received by sellers falls substantially, while the price paid by buyers rises only slightly. Thus, sellers bear most of the burden of the tax.

(b) Inelastic Supply, Elastic Demand

Taxes

• Tax burden
• Falls more heavily on the side of the market that is less elastic
• Small elasticity of demand
• Buyers do not have good alternatives to consuming this good
• Small elasticity of supply
• Sellers do not have good alternatives to producing this good

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Who pays the luxury tax?

• 1990 - 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 - quite elastic
• Supply - relatively inelastic

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Who pays the luxury tax?

• Outcome:
• Burden of a tax falls largely on the suppliers
• Relatively inelastic supply
• 1993: most of the luxury tax was repealed

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