Chapter 6Supply, Demand and Government Policies

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

Price Floor: Legal minimum on the price at which a good can be sold

Controls on Prices

Two outcomes:1. If price ceiling is higher than or equal to

equilibrium price, it is not binding and has no effect on the price or quantity sold

How Price Ceilings affect Market Outcomes

2. If the price ceiling is lower than the equilibrium price, the ceiling is a binding constraint and a shortage is created

How Price Ceilings Affect Market Outcomes

If shortage occurs (and price can’t be adjusted), a method for rationing the good must be developed

Not all buyers benefit from a price ceiling because some will be unable to purchase the product

Results of Binding Price Ceiling

Lines at the Gas Pump Rent Control in Short Run & Long Run

Case Studies

If price floor is lower than or equal to the equilibrium price, it is not binding and has no effect on the price or quantity sold

Price Floors

If the price floor is higher than the equilibrium price, the floor is a binding constraint and a surplus is created

Price Floors

The Minimum Wage

Case Study

Who bears the burden of taxation?

Tax Incidence

Does it affect supply and/or demand?

Demand curve shifts left/down by the amount of the tax

Amount = tax

Taxes on Buyers

Because market price falls when tax is introduced, sellers receive less than when market worked freely.

Buyers now pay more with the tax, so they are worse off as well.

So… taxes discourage market activity (Q drops) and buyers + sellers share burden of taxes.

Who pays the tax on buyers?

Does it affect supply or demand?

The Supply curve shifts left/upward by exactly the size of the tax

Taxes on Sellers

With upward supply shift, equilibrium quantity will fall and price that buyers pay will go up, but the amount sellers receive after paying the tax will go down.

Thus taxes on buyers and taxes on sellers are equivalent – both buyers & sellers share the burden of the tax

Who pays the tax on sellers?

Payroll Taxes

General rule: Tax burden falls more heavily on the side of the market that is less elastic

Therefore, it is not very likely that a tax will be split 50-50

Elasticity and Tax Incidence

Who really pays the tax?

Luxury Taxes

Using the graph for market X, what would there be if the gov’t imposed an effective price ceiling?

1 2 3 4 5

0% 0% 0%0%0%

1. Shortage of AB2. Surplus of AB3. Shortage of IH4. Surplus of IH5. Shortage of GE

Using the same graph, what would there be if the gov’t imposed an effective price floor on the market?

1 2 3 4 5

0% 0% 0%0%0%

1. Shortage of AB2. Surplus of AB3. Shortage of IH4. Surplus of IH5. Shortage of GE

A tax on producers will:

1 2 3 4 5

0% 0% 0%0%0%

1. Increase demand, causing P & Q to rise

2. Increase supply, causing P & Q to rise

3. Decrease supply, causing P to rise & Q to fall

4. Decrease demand, causing P to rise and Q to fall

5. Decrease supply, causing both P & Q to fall

A tax on consumers will:

1 2 3 4 5

20% 20% 20%20%20%1. Shift supply to the left, raising P & lowering Q

2. Shift demand to right, raising both P & Q

3. Shift demand to the left, lowering both P & Q

4. Shift supply to the right, lowering P & raising Q

5. Shift demand to the left, lowering P & raising Q

The more inelastic the supply curve and the more elastic the demand curve, the:

1 2 3 4 5

20% 20% 20%20%20%1. More of the tax the

producer will pay2. More of the tax the

consumer will pay3. More the tax will be

split equally between the consumer & producer

4. Less likely the tax will have an effect on price

5. None of the above