Sessions 9 & 10

Supply, Demand &

Government Policies

(With inputs from N. Gregory Mankiw: Principles of Economics, 4th Edition, Chapter 6)
Session Objectives:

 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?
Dr. Jaydeep Mukherjee
Ravenshaw University
 An Overview
 In a free, unregulated market system, market forces
establish equilibrium prices and exchange quantities.
 While equilibrium conditions may be efficient, it may
be true that not everyone is satisfied.
 One of the roles of economists is to use their theories
to assist in the development of policies.

Dr. Jaydeep Mukherjee

Ravenshaw University
 Controls on Prices
 Are usually enacted when policymakers believe the
market price is unfair to buyers or sellers.
 Result in government-created price ceilings and
floors.
 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.

Dr. Jaydeep Mukherjee

Ravenshaw University
Price Ceiling: Rent Control
Rental
Consider a common example of Price of S
rent control Apts.

Rent controls are ceilings placed

on the rents that landlords may Rs.1000
charge their tenants.
The goal of rent control policy is
to help the poor by making D
housing more affordable.
500 Quantity
of Apts.
We begin by showing the market for
apartments in equilibrium (before the
government imposes any price
controls).

Dr. Jaydeep Mukherjee

Ravenshaw University
Price Ceiling: Rent Control
A price ceiling above the Rental
equilibrium price is not binding. Price of S
Apts.
The market clears at Rs.1000
and the price ceiling is Rs.1200
ineffective.
Rs.1000

Just because landlords are allowed to charge

Rs.1200 rent doesn’t mean they will – if they
D
do, they won’t be able to rent all of their
apartments – a surplus will result, causing Quantity
downward pressure on the price (rent). 500
of Apts.
There’s no law that prevents the price (rent)
from falling, so it does fall until the surplus is
gone and equilibrium is reached (at P =
Rs.1000 and Q = 500).

Dr. Jaydeep Mukherjee

Ravenshaw University
Price Ceiling: Rent Control
The eq’m price (Rs.1000) is above Rental
the ceiling and therefore illegal. Price of S
Apts.
The ceiling is a binding constraint on
the price, and causes a shortage.
Rs.1000
The actual quantity of apartments
Rs.800
rented equals 250, and there is a
shortage equal to 500 (the difference Shortage D
between the quantity demanded, 750,
and the quantity supplied, 250. 250 500 750 Quantity
of Apts.

Dr. Jaydeep Mukherjee

Ravenshaw University
Price Ceiling: Rent Control
Rental
In the long run, supply and demand Price of S
are more price-elastic. So, the Apts.
shortage is larger. WHY??

Rs.1000
Quick Activity:
Rs.800
For a product, supply and demand Shortage D
functions are estimated as follows:
Qs = 300 + 10P
100 500 900 Quantity
Qd = 500 –15P. of Apts.
If the government fixes a price ceiling of
Rs.15 for the product, then what will be
its impact on the market.

Dr. Jaydeep Mukherjee

Ravenshaw University
 Shortages and Rationing
 With a shortage, sellers must ration the goods
among buyers.
 Some rationing mechanisms: (1) long lines, and (2)
discrimination according to sellers’ biases, and even
under-the-table payments to landlords
 These mechanisms are often unfair, and inefficient:
the goods do not 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).
Dr. Jaydeep Mukherjee
Ravenshaw University
Price Floor: Minimum Wage
W
Now we switch gears and look at the S
effects of a price floor. We illustrate
this concept using the example of the
minimum wage.

The “price” of labor is more Rs.50

commonly known as the wage, which
we measure on the vertical axis of
our supply-demand diagram. Along D
the horizontal axis, we measure the
quantity of labor (number of L
500
workers). The demand for unskilled
labor comes from firms. The supply
comes from workers. We focus on unskilled labor because
the minimum wage is not relevant
for higher skilled, higher wage
workers.
Dr. Jaydeep Mukherjee
Ravenshaw University
Price Floor: Minimum Wage
W
A price floor below the eq’m price is not S
binding – has no effect on the market
outcome.
At a wage of Rs.40, the quantity of unskilled
workers that firms wish to hire exceeds the Rs.50
quantity of unskilled workers that are Rs.40
looking for jobs, resulting in shortages.
But the minimum wage law does not stop D
the wage from rising above Rs.40. So, in
500 L
response to this shortage, the wage will rise
until the shortage disappears – which occurs
at the equilibrium wage of Rs.50. The
equilibrium wage is perfectly legal when the
price floor (i.e. minimum wage) is below it.

Dr. Jaydeep Mukherjee

Ravenshaw University
Price Floor: Minimum Wage
W
Now, the minimum wage exceeds the Surplus S
equilibrium wage. The equilibrium wage
(or any wage below Rs.60) is illegal. Rs.60
In this case, the actual wage will be Rs.60. It
will not be lower, because any lower wage isRs.50
illegal. It will not be higher, because at
any higher wage, the surplus would be even
greater. The actual number of unskilled D
workers with jobs equals 400. 550 want
jobs, but firms are only willing to hire 400, 400 500 550 L
leaving a surplus (i.e. unemployment) of
150 workers.
A surplus of anything – especially labor
represents wasted resources.

Dr. Jaydeep Mukherjee

Ravenshaw University
 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 often intended to help the poor, but often hurt
more than help
 We have seen that the minimum wage can cause job losses, and
rent control can reduce the quantity and quality of affordable
housing. Both policies make the poor worse off
 If prices are set by laws, they obscure the signals that efficiently
allocate scarce resources.

Dr. Jaydeep Mukherjee

Ravenshaw University
 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 % of the good’s price, or a specific amount
for each unit sold.
• For simplicity, we analyze per-unit taxes only.

Tax incidence is the manner in which the burden of

a tax is shared among participants in a market.

Dr. Jaydeep Mukherjee

Ravenshaw University
Taxes on Buyers: Market for Pizza
Price of
Consider the market for pizza Pizza S

Rs.10

We begin by showing the market for D

apartments in equilibrium (before the
government imposes any taxes). 500 Quantity
of Pizza

Dr. Jaydeep Mukherjee

Ravenshaw University
Taxes on Buyers: Market for Pizza
Price of
The government makes buyers pay a
Pizza S
Rs.1.50 on each pizza they purchase.
The new demand curve (in red, labeled
D2) reflects buyers’ demand as a
Pb = Rs.11 Taxes
function of the after-tax price. The
Rs.10
original demand curve (D1) still reflectsP = Rs.9.50
s
buyers’ demand as a function of the
total price – inclusive of the tax.
D1
At each quantity, the height of the original D2
(blue) D curve is still the maximum that Quantity
430 500
buyers will pay for that quantity, while the of Pizza
height of the new (red) D curve is the
maximum that buyers will pay sellers for that
quantity, given that buyers also must pay the
tax. At any Q, the vertical distance between
the blue and red D curves equals the tax.

Dr. Jaydeep Mukherjee

Ravenshaw University
Taxes on Buyers: Market for Pizza
Price of
The price buyers pay rises, the Pizza S
price sellers receive falls, eq’m Q
falls
Pb = Rs.11 Taxes
Rs.10
Ps = Rs.9.50

D1
The burden of a tax is shared among D2
market participants. Because of the tax, 430 500 Quantity
buyers pay Re.1.00 more, sellers get of Pizza
Re.0.50 less.

Dr. Jaydeep Mukherjee

Ravenshaw University
Taxes on Sellers: Market for Pizza
Price of S2
The government makes sellers pay a
Pizza S1
Rs.1.50 on each pizza they sell. The
new supply curve (in red, labeled S2)
reflects sellers’ supply as a function of
Pb = Rs.11 Taxes
the after-tax price.
Rs.10
Ps = Rs.9.50

Making sellers pay a Rs.1.50 tax on each unit

they sell is equivalent to a Rs.1.50 increase D
in the cost of producing each pizza. Anything
that increases production costs causes the S 430 500 Quantity
of Pizza
curve to shift up: In order for sellers to be
willing to supply the same quantity as before,
they must receive a higher price to
compensate them for the increase in their
costs.

Dr. Jaydeep Mukherjee

Ravenshaw University
Taxes on Buyers & Sellers: A Comparison
The Outcome Is the Same in Both Cases!
 Whether the government makes buyers or sellers pay the tax, all of
the effects are the same:
- the price buyers pay rises (in this case to Rs.11)
- the price sellers receive falls (to Rs.9.50)
- the equilibrium quantity falls (to 430)
- the incidence of the tax is the same (here, buyers pay Re.1 of the
tax, while sellers pay Re.0.50 of the tax on each unit)
 The equivalence of taxes on buyers and taxes on sellers means that
we can ignore whether the tax is imposed on buyers or sellers.
 What matters is this: A tax drives a wedge between the price buyers
pay and the price sellers receive.

Dr. Jaydeep Mukherjee

Ravenshaw University
 Tax Incidence and Elasticity

 Tax incidence is not affected by whether the

government makes buyers or sellers pay the tax.
What, then, does determine tax incidence?
 It is elasticity – specifically, the price elasticities of
supply and demand
Two Possibilities:
 supply is more price-elastic than demand
 demand is more price-elastic than supply

Dr. Jaydeep Mukherjee

Ravenshaw University
Case 1:
Supply is more price-elastic than demand
 Sellers are relatively more responsive to changes
in price, and the supply curve is less steep than
the demand curve.
 Buyers have relatively fewer alternatives, so they
have to “eat” most of the price increase caused by
the imposition of the tax.
Result
 Greater burden borne by buyers

Dr. Jaydeep Mukherjee

Ravenshaw University
Case 2:

Demand is more price-elastic than supply

 buyers are relatively more price-sensitive, and the demand
curve is less steep than the supply curve.
 Buyers have relatively more alternatives, so they can avoid
most of the tax. Sellers are less flexible, so they have to
“eat” a greater share of the price increase caused by the
tax.

Result
 Greater burden borne by sellers

Dr. Jaydeep Mukherjee

Ravenshaw University
Final Thoughts
Who pays the luxury tax?
 Demand for Mercedes (and other luxury items) is price-
elastic: if the price of yachts rises, rich consumers can easily
avoid the tax by spending their millions on some other luxury
item.
 Supply of Mercedes is less elastic, especially in the short run.
It is difficult for the companies that build Mercedes to re-tool
their factories and reeducate their workers to produce some
other product.
 Hence, companies that build Mercedes (and companies that
sell other luxury items) pay most of the tax, and the rich pay
relatively little of it.

Dr. Jaydeep Mukherjee

Ravenshaw University