Supply, Demand, and

6 Government Policies

PRINCIPLES OF

MICROECONOMICS
FOURTH EDITION
In this chapter, look for the answers to
these questions:
 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 does the outcome depend on whether
the tax is imposed on buyers or sellers?
 What is the incidence of a tax?
What determines the incidence?
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
 Government Policies That Alter the
Private Market Outcome
 Price controls
• Price ceiling: a legal maximum on the price
of a good or service. Example: rent control.
• Price floor: a legal minimum on the price of
a good or service. Example: minimum wage.
 Taxes
• The govt can make buyers or sellers pay a
specific amount on each unit bought/sold.

We
We will
will use
use the
the supply/demand
supply/demand model
model to to see
see
how
how each
each policy
policy affects
affects the
the market
market outcome
outcome
(the
(the price
price buyers
buyers pay,
pay, the
the price
price sellers
sellers receive,
receive,
and
and eq’m
eq’m quantity).
quantity).
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
 EXAMPLE 1: The Market for Apartments

Rental P S
price of
apts
$800
Eq’m
Eq’m w/o
w/o
price
price
controls
controls
D
Q
300
Quantity of
apartments
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
How Price Ceilings Affect Market Outcomes

A price ceiling P S
above the Price
eq’m price is $1000
ceiling
not binding –
it has no effect $800
on the market
outcome.

D
Q
300

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

How Price Ceilings Affect Market Outcomes

The eq’m price P S

($800) is above
the ceiling and
therefore illegal.
$800
The ceiling
is a binding Price
$500
constraint ceiling
on the price, shortage
D
and causes Q
250 400
a shortage.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

How Price Ceilings Affect Market Outcomes

In the long run, P S

supply and
demand
are more $800
price-elastic.
Price
So, the $500
ceiling
shortage shortage
is larger. D
Q
150 450

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
EXAMPLE 2: The Market for Unskilled Labor

Wage W S
paid to
unskilled
workers
$4

Eq’m
Eq’m w/o
w/o
price
price
controls
controls
D
L
500
Quantity of
unskilled workers
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
How Price Floors Affect Market Outcomes

A price floor W S
below the
eq’m price is
not binding –
it has no effect $4
on the market Price
outcome. $3
floor

D
L
500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

How Price Floors Affect Market Outcomes
labor
The eq’m wage ($4) W surplus S
is below the floor Price
and therefore $5
floor
illegal.
The floor $4
is a binding
constraint
on the wage,
and causes D
a surplus L
(i.e., 400 550
unemployment).

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 The Minimum Wage
Min wage laws unemp-
do not affect W loyment S
Min.
highly skilled $5
wage
workers.
They do affect $4
teen workers.
Studies:
A 10% increase
in the min wage D
L
raises teen 400 550
unemployment
by 1-3%.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
A C T I V E L E A R N I N G 1:
Price floors The market for
P hotel rooms
& ceilings 140
S
130
Determine 120
effects of: 110
A. $90 price 100
ceiling 90
80 D
B. $90 price
70
floor
60
C. $120 price 50
floor 40
0 Q
50 60 70 80 90 100 110 120 130
13
A C T I V E L E A R N I N G 1:
A. $90 price ceiling The market for
P
140 hotel rooms
S
The price 130
falls to $90. 120
110
Buyers
100
demand Price ceiling
90
120 rooms,
80 D
sellers supply shortage = 30
70
90, leaving a
60
shortage.
50
40
0 Q
50 60 70 80 90 100 110 120 130
14
A C T I V E L E A R N I N G 1:
B. $90 price floor The market for
P
140 hotel rooms
S
Eq’m price is 130
above the floor, 120
so floor is not 110
binding. 100
90
P = $100, Price floor
Q = 100 rooms. 80 D
70
60
50
40
0 Q
50 60 70 80 90 100 110 120 130
15
A C T I V E L E A R N I N G 1:
C. $120 price floor The market for
P
140 hotel rooms
surplus = 60 S
The price 130
rises to $120. 120
Price floor
110
Buyers
100
demand
60 rooms, 90

sellers supply 80 D
120, causing 70
a surplus. 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
16
 Evaluating Price Controls
 Recall one of the Ten Principles:
Markets are usually a good way
to organize economic activity.
 Prices are the signals that guide the allocation of
society’s resources. This allocation is altered
when policymakers restrict prices.
 Price controls are often intended to help the poor,
but they often hurt more than help them:
• The min. wage can cause job losses.
• Rent control can reduce the quantity and quality
of affordable housing.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
 Taxes
 The govt levies taxes on many goods & services
to raise revenue to pay for national defense,
public schools, etc.
 The govt 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.
• For simplicity, we analyze per-unit taxes only.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 EXAMPLE 3: The Market for Pizza

Eq’m
Eq’m
P
w/o
w/o tax
tax
S1

$10.00

D1

Q
500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 A Tax on Buyers
AA tax
tax on
on
buyers Effects of a $1.50 per
buyers shifts
shifts
unit tax on buyers
the
the DD curve
curve P
down
down by by the
the
S1
amount
amount of of PB = $11.00
Tax
the
the tax.
tax. $10.00
PS = $9.50
The
The price
price
buyers
buyers paypay
D1
rises,
rises, the
the
price
price sellers
sellers D2
Q
receive
receive falls,
falls, 430 500
eq’m
eq’m Q 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 = $11.00
Tax
buyers
buyers pay pay
$10.00
$1.00
$1.00 more,
more,
PS = $9.50
sellers
sellers get
get
$0.50
$0.50 less.
less. D1
D2
Q
430 500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

 A Tax on Sellers
AA tax
tax on
on
sellers Effects of a $1.50 per
sellers shifts
shifts
unit tax on sellers
the
the SS curve
curve P
up S2
up by
by the
the
S1
amount
amount of of PB = $11.00
Tax
the
the tax.
tax. $10.00
PS = $9.50
The
The price
price
buyers
buyers paypay
D1
rises,
rises, the
the
price
price sellers
sellers
Q
receive
receive falls,
falls, 430 500
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 = $11.00
Tax
A tax drives $10.00
a wedge PS = $9.50
between the
price buyers D1
pay and the
price sellers
Q
receive. 430 500

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

A C T I V E L E A R N I N G 2:
Effects of a tax The market for
P
140 hotel rooms
Suppose govt S
130
imposes a tax 120
on buyers of 110
$30 per room. 100
90
Find new
80 D
Q, PB, PS,
70
and incidence
60
of tax.
50
40
0 Q
50 60 70 80 90 100 110 120 130
24
A C T I V E L E A R N I N G 2:
Answers The market for
P
140 hotel rooms
S
130
Q = 80
120

PB = $110 PB = 110
100
Tax
PS = $80 90
PS = 80 D
70
Incidence
60
buyers: $10
50
sellers: $20 40
0 Q
50 60 70 80 90 100 110 120 130
25
 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 most
most of of the
the
of tax burden burden
burden of of
Tax
Price if no tax the
the tax.
tax.

Sellers’ share PS
of 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 most
of tax burden PB most of of the
the
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

CASE STUDY: Who Pays the Luxury Tax?

 1990: Congress adopted a luxury tax on yachts,

private airplanes, furs, expensive cars, etc.
 Goal of the tax: to raise revenue from those
who could most easily afford to pay –
wealthy consumers.
 But who really pays this tax?

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

CASE STUDY: Who Pays the Luxury Tax?

The market for yachts Demand

Demand is is
price-elastic.
price-elastic.
P
S
In
In the
the short
short run,
run,
Buyers’ share
of tax burden PB supply
supply is
is inelastic.
inelastic.

Tax Hence,
Hence,
companies
companies
Sellers’ share
that
that build
build
of tax burden PS
D
yachts
yachts pay
pay
most
most ofof
Q the
the tax.
tax.

CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

CONCLUSION: Government Policies and
the Allocation of Resources
 Each of the policies in this chapter affects the
allocation of society’s resources.
• Example 1: a tax on pizza reduces the eq’m
quantity of pizza.
Since the economy is producing fewer pizzas,
some resources (workers, ovens, cheese) will
become available to other industries.
• Example 2: a binding minimum wage causes a
surplus of workers, a waste of resources.
 So, it’s important for policymakers to apply such
policies very carefully.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES
CHAPTER 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 eq’m 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 eq’m 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 eq’m 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.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES