Supply, Demand & Government Policies

Lecture 5

• In a free market system, market forces establish equilibrium prices and exchange quantities.

• One of the roles of economists is to develop theories to assist in the development

of policies.

Controls on Prices

• Buyers always want lower prices, while sellers want higher prices.

• Thus, interests of these two groups conflict.• Controls on prices are usually enacted when

policymakers believe the market price is unfair to buyers or sellers.

• For this government creates price ceilings and price floors.

Controls on PricesCont…

• 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.

Controls on PricesCont…

How Price Ceilings Affect Market Outcomes: • When govt. imposes price ceiling, following

two outcomes are possible:

1. If price is set above the equilibrium price, price ceiling is not binding .

• Price ceiling has no effect on the price or quantity sold .

Price Ceiling that is NOT BINDING

Quantity0

Price

EquilibriumQuantity

P2 PriceCeiling

EquilibriumPrice

Demand

Supply

P1

Q

Controls on PricesCont…

How Price Ceilings Affect Market Outcomes (Cont.):2. If price is set below the equilibrium price,

price ceiling is a binding constraint.• The forces of demand and supply move price

towards equilibrium price.• But when market price hits the ceiling, it can rise

no further.• Thus, market price equals price ceiling.• At this price, quantity demanded exceeds quantity supplied, creating shortage for the good.

Price Ceiling that is BINDING

Quantity0

Price

Demand

Supply

P1 PriceCeilingShortage

Q1

QuantitySupplied

Q2

QuantityDemanded

EquilibriumPrice

P2

Controls on PricesCont…

How Price Ceilings Affect Market Outcomes (Cont.): • Therefore, when government imposes a binding

price ceiling on a market, shortage of the good arises

Controls on PricesCont…

How Price Floors Affect Market Outcomes: • When govt. imposes price floor, following

two outcomes are possible:

1. If price is set below the equilibrium price, price floor is not binding .

• Price floor has no effect on the price or quantity sold .

Price Floor that is NOT BINDING

Quantity0

Price

EquilibriumQuantity

P1

PriceFloor

EquilibriumPrice

Demand

Supply

P2

Q

Controls on PricesCont…

How Price Floors Affect Market Outcomes (Cont.):2. If price is set above the equilibrium price,

price floor is a binding constraint.• The forces of demand and supply move price

towards equilibrium price.• But when market price hits the floor, it can fall no

further.• Thus, market price equals price floor.• At this price, quantity supplied exceeds quantity demanded, causing surplus for the good.

Price Floor that is BINDING

Quantity0

Price

Demand

Supply

P2PriceFloor

Q1

QuantityDemanded

Q2

QuantitySupplied

EquilibriumPrice

Surplus

P1

Taxes

• Governments use taxes to raise revenue for public projects, such as for:– Roads– Schools – National defense

• Taxes affect market activity.• When a good is taxed, the quantity sold is

smaller.

TaxesCont…

Important Question

• When govt. levies tax on a good, who bears the burden of the tax?

Buyers

Or

Sellers

TaxesCont…

• Economists use the term tax incidence to refer to the distribution of tax burden.

• “Tax incidence is the manner in which the burden of a tax is shared among participants in a market”.

TaxesCont…

• Taxes result in a change in market equilibrium.

• Buyers pay more and sellers receive less, regardless of whom the tax is levied on.

TaxesCont…

• What is the impact of tax? – Taxes discourage market activity.– When a good is taxed, the quantity sold is

smaller. – Buyers and sellers share the tax burden.