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LECTURE
5 In this chapter,
look for the answers to these questions:
Supply, Demand, and What are price ceilings and price floors?
Government Policies 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?
1

Government Policies That Alter the EXAMPLE 1: The Market for Apartments
Private Market Outcome
Price controls P
Price ceiling: a legal maximum on the price Rental S
price of
of a good or service Example: rent control
apts
Price floor: a legal minimum on the price of
a good or service Example: minimum wage $800
Eqm w/o
Taxes
price
The govt can make buyers or sellers pay a
controls
specific amount on each unit bought/sold.
D
Q
We will use the supply/demand model to see 300
how each policy affects the market outcome Quantity of
(the price buyers pay, the price sellers receive, apartments
and eqm quantity).
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 2 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 3

How Price Ceilings Affect Market Outcomes How Price Ceilings Affect Market Outcomes
A price ceiling P The eqm price P
above the S S
Price ($800) is above
eqm price is $1000 the ceiling and
ceiling
not binding therefore illegal.
has no effect $800 $800
The ceiling
on the market
is a binding Price
outcome. $500
constraint ceiling
on the price, shortage
D D
Q causes a Q
300 250 400
shortage.

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How Price Ceilings Affect Market Outcomes Shortages and Rationing

With a shortage, sellers must ration the goods
In the long run, P S among buyers.
supply and
demand
Some rationing mechanisms: (1) Long lines
are more
(2) Discrimination according to sellers biases
$800
price-elastic. These mechanisms are often unfair, and inefficient:
Price the goods do not necessarily go to the buyers who
So, the $500
ceiling
shortage value them most highly.
shortage
is larger. D
Q
In contrast, when prices are not controlled,
150 450 the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal (and thus fair).
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 7

EXAMPLE 2: The Market for Unskilled Labor How Price Floors Affect Market Outcomes

W A price floor W
Wage S below the S
paid to
eqm price is
unskilled
workers not binding
$4 has no effect $4
Eqm w/o on the market
Price
outcome. $3
price floor
controls
D D
L L
500 500
Quantity of
unskilled workers
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 8 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 9

How Price Floors Affect Market Outcomes The Minimum Wage

labor Min wage laws unemp-
The eqm wage ($4) W surplus S W loyment S
do not affect
is below the floor Price Min.
$5 highly skilled $5
and therefore floor wage
workers.
illegal.
$4 They do affect $4
The floor
teen workers.
is a binding
constraint Studies:
on the wage, A 10% increase
D in the min wage D
causes a L L
surplus (i.e., 400 550 raises teen 400 550
unemployment). unemployment
by 1-3%.
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ACTIVE LEARNING 1 The market for ACTIVE LEARNING 1

The market for
Price controls hotel rooms in Boracay A. $90 price ceiling hotel rooms in Boracay
P
140 P
140
S The price S
130 falls to $90. 130
Determine
120 120
effects of: Buyers
110 110
A. $90 price 100 demand 100
ceiling 120 rooms, Price ceiling
90 90
B. $90 price 80 D sellers supply 80 D
90, leaving a shortage = 30
floor 70 70
60
shortage. 60
C. $120 price
floor 50 50
40 40
0 Q 0 Q
50 60 70 80 90 100 110 120 130
12 50 60 70 80 90 100 110 120 130
13

ACTIVE LEARNING 1 The market for ACTIVE LEARNING 1 The market for
B. $90 price floor hotel rooms in Boracay C. $120 price floor hotel rooms in Boracay
P
140 The price P
140
Eqm price is S surplus = 60 S
130 rises to $120. 130
above the floor,
120 120
so floor is not Buyers Price floor
110 110
binding. demand
100 100
P = $100, 60 rooms,
90 90
Q = 100 rooms. Price floor sellers supply
80 D 80 D
120, causing a
70 70
surplus.
60 60
50 50
40 40
0 Q 0 Q
50 60 70 80 90 100 110 120 130
14 50 60 70 80 90 100 110 120 130
15

Evaluating Price Controls Taxes

Recall one of the Ten Principles from Chapter 1:
Markets are usually a good way
to organize economic activity.
Prices are the signals that guide the allocation of
societys resources. This allocation is altered
when policymakers restrict prices.
Price controls often intended to help the poor,
but often hurt more than help.
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 % of the goods price,
or a specific amount for each unit sold.
For simplicity, we analyze per-unit taxes only.

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EXAMPLE 3: The Market for Pizza A Tax on Buyers

The price
Hence, buyers
a tax pay
on buyers Effects of a $1.50 per
Eqm is nowthe
shifts $1.50 higher
D curve than
down unit tax on buyers
w/o tax P the market
by the price
amount ofP.
the tax. P
S1 P would have to fall S1
by $1.50 to make
$10.00 buyers willing $10.00
Tax
to buy same Q
as before. $8.50
D1 E.g., if P falls D1
from $10.00 to $8.50, D2
Q buyers still willing to Q
500 500
purchase 500 pizzas.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 18 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 19

A Tax on Buyers The Incidence of a Tax:

how the burden of a tax is shared among
New eqm: Effects of a $1.50 per
unit tax on buyers
market participants
Q = 450 P P
Sellers In our
S1 S1
receive PB = $11.00 example, PB = $11.00
Tax Tax
PS = $9.50 $10.00 buyers pay $10.00
Buyers pay PS = $9.50 $1.00 more, PS = $9.50
PB = $11.00 sellers get
D1 $0.50 less. D1
Difference
between them D2 D2
Q Q
= $1.50 = tax 450 500 450 500

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 20 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 21

A Tax on Sellers A Tax on Sellers

The tax effectively raises Effects of a $1.50 per New eqm: Effects of a $1.50 per
sellers costs by unit tax on sellers unit tax on sellers
P Q = 450 P
$1.50 per pizza. S2 S2
$11.50 Buyers pay
Tax S1 S1
Sellers will supply PB = $11.00 PB = $11.00
Tax
500 pizzas
$10.00 Sellers $10.00
only if
receive PS = $9.50
P rises to $11.50,
to compensate for PS = $9.50
this cost increase. D1 D1
Difference
between them
Hence, a tax on sellers shifts the Q Q
500 = $1.50 = tax 450 500
S curve up by the amount of the tax.

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The Outcome Is the Same in Both Cases! ACTIVE LEARNING 2

The effects on P and Q, and the tax incidence are the Effects of a tax The market for
same whether the tax is imposed on buyers or sellers! P hotel rooms
140
P
Suppose govt S
What matters imposes a tax
130
is this: S1 120
PB = $11.00
Tax
on buyers of
110
A tax drives $30 per room.
$10.00 100
a wedge
PS = $9.50 Find new 90
between the
price buyers Q, PB, PS, 80 D
D1
pay and the and incidence 70
price sellers of tax. 60
Q
receive. 450 500 50
40
0 Q
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 24 50 60 70 80 90 100 110 120 130

ACTIVE LEARNING 2 Elasticity and Tax Incidence

Answers The market for CASE 1: Supply is more elastic than demand
P
140 hotel rooms
S
P
Its easier
130
Q = 80 for sellers
120
PB than buyers
PB = $110 PB = 110 Buyers share S
to leave the
100 of tax burden
PS = $80 Tax Tax market.
90 Price if no tax So buyers
PS = 80 D bear most of
Incidence Sellers share PS
70 the burden
buyers: $10 of tax burden
60 of the tax.
sellers: $20 D
50 Q
40
0 Q
50 60 70 80 90 100 110 120 130 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 27

Elasticity and Tax Incidence CASE STUDY: Who Pays the Luxury Tax?
CASE 2: Demand is more elastic than supply 1990: Congress adopted a luxury tax on yachts,
Its easier private airplanes, furs, expensive cars, etc.
P
S for buyers Goal of the tax: raise revenue from those
Buyers share than sellers who could most easily afford to pay
of tax burden PB to leave the
wealthy consumers.
market.
Price if no tax
Tax Sellers bear But who really pays this tax?
Sellers share most of the
of tax burden PS burden of
D the tax.
Q

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CASE STUDY: Who Pays the Luxury Tax? CONCLUSION: Government Policies and
the Allocation of Resources
The market for yachts Demand is Each of the policies in this chapter affects the
price-elastic. allocation of societys resources.
P
S
In the short run, Example 1: A tax on pizza reduces eqm Q.
Buyers share
of tax burden PB supply is inelastic. With less production of pizza, resources
(workers, ovens, cheese) will become available
Tax Hence, to other industries.
companies
Sellers share
that build Example 2: A binding minimum wage causes
of tax burden PS a surplus of workers, a waste of resources.
D yachts pay
most of So, its important for policymakers to apply such
Q the tax.
policies very carefully.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 30 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 31

CHAPTER SUMMARY CHAPTER SUMMARY

A price ceiling is a legal maximum on the price of a A tax on a good places a wedge between the price
good. An example is rent control. If the price buyers pay and the price sellers receive, and
ceiling is below the eqm price, it is binding and causes the eqm quantity to fall, whether the tax is
causes a shortage. imposed on buyers or sellers.

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 eqm price, it is binding
and causes a surplus. The labor surplus caused
by the minimum wage is unemployment.
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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.
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