CHAPTER 4
WORKING WITH SUPPLY AND DEMAND
MASTERY GOALS
The objectives of this chapter are to:
1. Apply the supply and demand model to actual markets and government policies.
2. Describe the various actions governments take to affect market outcomes.
3. Explain the effect of a price ceiling in a perfectly competitive market and the possible
consequences.
4. Explain the effect of a price #oor in a perfectly competitive market and the possible
consequences.
5. Discuss the effects of an excise tax on buyers and sellers.
6. Discuss the effects of a subsidyon buyers and sellers.
7. Distinguish between a stock variable and a #ow variable.
8. Summarize the application of the supply and demand model to the housing market.
9. Compare the supply curve fo housing to the usual supply curve introduced in the
previous chapter.
10. Use the supply and demand model and the concept of leverage to explain the case of
the housing market, including the housing boom of 1997 – 2006 and the recent housing
bust.
THE CHAPTER IN A NUTSHELL
Governments sometimes intervene in markets, in response to dissatisfaction from some groups
in society, to institute price ceilings or price #oors. Such intervention can have unintended—and
sometimes harmful—consequences.
Taxes enable governments to provide public services, correct income and wealth distribution
inequities, and discourage use of particular goods. A tax on a particular good or service is called
an excise tax. An excise tax shi4s the market supply curve upward by the amount of the tax. The
burden of an excise tax is determined by the shapes of the demand and supply curves.
A subsidy is the opposite of a tax and is used to encourage production of certain goods and
services including medical care for the poor and elderly and college education. A subsidy shi4s
the market demand curve updward by the amount of the subsidy.
The supply and demand model is used to analyze the recent housing boom and bust. The supply
and demand model can be used to show how housing prices rose rapidly from 1997 – 2006 and
then fell sharply in 2007 and beyond.
The appendix details the concept of leverage including its measurements and sample
calculations.
In order presented in chapter.
Price ceiling: A government-imposed maximum price in a market.
Short side of the market: The smaller of quantity supplied and quantity demanded at a
particular price.
Shortage: An excess demand not eliminated by a rise in price, so that quantity demanded
continues to exceed quantity supplied.
Black market: A market in which goods are sold illegally at a price above the legal ceiling.
Rent controls: Government-imposed maximum rents on apartments and homes.
Price oor: A government-imposed minimum price in a market.
Surplus: An excess supply not eliminated by a fall in price, so that quantity supplied continues
to exceed quantity demanded.
Excise tax: A tax on a specific good or service.
Tax incidence: The division of a tax payment between buyers and sellers, determined by
comparing the new (a4er tax) and old (pretax) market equilibriums.
Subsidy: A government payment to buyers or sellers on each unit purchased or sold.
Stock variable: A variable representing a quantity at a moment in time.
Flow variable: A variable representing a process that takes place over some time period.
Supply curve for housing: A vertical line showing the total number of homes in a market
that are available for ownership.
Demand curve for housing: A curve showing, at each price, the total number of homes
that everyone in the market would like to own, given the constraints they face.
Mortgage: A loan given to a home-buyer for part of the purchase price of the home.
Capital gain: The gain to the owner of an asset when it is sold for a price higher than its
original purchase price.
Capital loss: The loss to the owner of an asset when it is sold for a price lower than its
original purchase price.
TEACHING TIPS
1. To demonstrate the problems associated with price #oors, ask your students if they
would like to be millionaires. Ask them to consider what would happen if legislation is
passed requiring employers to pay each worker at least $1 million per year. Discuss the
effects of such legislation on their ability to 6nd work and their actual earnings per year.
Discuss the effect of such legislation on the local unemployment rate. Be sure to explain
that the people who currently earn more than $1 million will keep their jobs. Ask who
some of these people might be. If this scenario seems far-fetched to your students,
describe the massive disemployment effect the initial U.S. minimum wage rate of $0.25
per hour had on the labor market in Puerto Rico, where the average wage was less than
$0.25 per hour—within two years of passage, total employment fell by one-half.
2. To demonstrate the problems associated with price ceilings, mention a relatively
expensive name brand product popular with, although not necessarily affordable by,
your students (such as an A?iction t-shirt retailing for $55). Ask how many students
would buy such a product at $55 each. Then ask how many of these shirts they would
buy at a price of $5 each. Next, have them consider a price ceiling of $5 on this product.
Ask them if they would be able to buy as many as they want at the ceiling price. Discuss
the persistent shortages that result from price ceilings.
3. Have your students demonstrate what would have happened in the housing market had
the government not adopted policies to encourage home ownership in the late 1990s
and the first part of the 21st century. Ask them if the housing bust would have occurred
in such magnitude without these policies.
DISCUSSION STARTERS
1. The Santa Monica, California, city council adopted an ordinance to require employers
with more than 50 employees, located in a designated area of the city, to pay their
employees $10.50/hour, an amount almost twice the state minimum wage rate. Discuss
the expected effects of this price #oor. Discuss why the city council might pass such an
ordinance, given these expected effects.
See “In Santa Monica, Rent Decontrol Brings Surprises,” The Wall Street Journal,
4/28/99, for a discussion of what happens when a price #oor is eliminated.
2. Price support programs make U.S. sugar about twice as expensive as sugar in the rest of
the world. See the following article from Business Week:
hHp://www.businessweek.com/bwdaily/dn#ash/content/aug2009/db20090821_065859
.htm for the effects this policy had on food producers in the U.S.
3. Thousands of Americans die each year while waiting for organ donations (such as
kidneys), in part because it is illegal to sell organs in the U.S. This ban effectively sets a
price ceiling of $0 for organs. Graphically show this ceiling and its effects on the market
for organs. The U.S. Department of Health and Human Services is considering whether
this payment ban should be li4ed. (Search the American Medical Association’s website
at www.ama-assn.org for its policy regarding financial incentives for organ
procurement.) How will this affect the number of organ donations made each year? Will
your answers differ based on which organ is needed? What moral issues are involved?
4. The text points out an important reason for the housing boom were changes to
government policy, among other things. Have your students discuss the pro and cons of
such policies given what they know now a4er we’ve seen the housing bust. Would the
students support the continuation of policies that promote housing ownership?