104
WHAT’S NEW IN THE SEVENTH EDITION:
There is a new
In the News
feature on “President Chávez versus the Market.”
LEARNING OBJECTIVES:
the effects of government policies that place a ceiling on prices.
the effects of government policies that put a floor under prices.
that taxes levied on sellers and taxes levied on buyers are equivalent.
how the burden of a tax is split between buyers and sellers.
CONTEXT AND PURPOSE:
Chapters 4 and 5.
The purpose of Chapter 6 is to consider two types of government policies—price controls and taxes.
Price controls set the maximum or minimum price at which a good can be sold while a tax creates a
wedge between what the buyer pays and what the seller receives. These policies can be analyzed within
the model of supply and demand. We will find that government policies sometimes produce unintended
consequences.
KEY POINTS:
6
SUPPLY, DEMAND, AND
GOVERNMENT POLICIES
Chapter 6/Supply, Demand, and Government Policies ❖ 105
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demanded exceeds the quantity supplied. Because of the resulting shortage, sellers must in some
way ration the good or service among buyers.
 A price floor is a legal minimum on the price of a good or service. An example is the minimum wage.
If the price floor is above the equilibrium price, then the price floor is binding, and the quantity
supplied exceeds the quantity demanded. Because of the resulting surplus, buyers’ demands for the
good or service must in some way be rationed among sellers.
 A tax on a good places a wedge between the price paid by buyers and the price received by sellers.
When the market moves to the new equilibrium, buyers pay more for the good and sellers receive
less for it. In this sense, buyers and sellers share the tax burden. The incidence of a tax (that is, the
division of the tax burden) does not depend on whether the tax is levied on buyers or sellers.
CHAPTER OUTLINE:
I. Controls on Prices
A. Definition of price ceiling: a legal maximum on the price at which a good can be sold.
C. How Price Ceilings Affect Market Outcomes
1. There are two possible outcomes if a price ceiling is put into place in a market.
a. If the price ceiling is higher than or equal to the equilibrium price, it is not binding and
and a shortage is created.
Figure 1
106 ❖ Chapter 6/Supply, Demand, and Government Policies
2. If a shortage for a product occurs (and price cannot adjust to eliminate it), a method for
rationing the good must develop.
3. Not all buyers benefit from a price ceiling because some will be unable to purchase the
product.
4.
Case Study: Lines at the Gas Pump
gasoline.
b. The federal government put a price ceiling into place and this created large shortages.
how the gas was rationed).
d. Eventually, the government realized its mistake and repealed the price ceiling.
5.
Case Study: Rent Control in the Short Run and the Long Run
a. The goal of rent control is to make housing more affordable for the poor.
b. Because the supply of apartments is fixed (perfectly inelastic) in the short run and
upward sloping (elastic) in the long run, the shortage is much larger in the long run than
in the short run.
c. Rent-controlled apartments are rationed in a number of ways including long waiting lists,
discrimination against minorities and families with children, and even under-the-table
payments to landlords.
d. The quality of apartments also suffers due to rent control.
D. How Price Floors Affect Market Outcomes
1. There are two possible outcomes if a price floor is put into place in a market.
Figure 2
Figure 3
ALTERNATIVE CLASSROOM EXAMPLE:
Ask students about the rental market in their town. Draw a supply-and-demand graph for
two-bedroom apartments asking students what they believe the equilibrium rental rate is.
Then suggest that the city council is accusing landlords of taking advantage of students and
thus places a price ceiling below the equilibrium price. Make sure that students can see that a
shortage of apartments would result. Ask students to identify the winners and losers of this
government policy.
Chapter 6/Supply, Demand, and Government Policies ❖ 107
a. If the price floor is lower than or equal to the equilibrium price, it is not binding and has
b. If the price floor is higher than the equilibrium price, the floor is a binding constraint and
a surplus is created.
2.
Case Study: The Minimum Wage
hired.
b. If the minimum wage is above the equilibrium wage in the labor market, a surplus of
labor will develop (unemployment).
are low.
d. Thus, the minimum wage will have its greatest impact on the market for teenagers and
other unskilled workers.
Figure 4
ALTERNATIVE CLASSROOM EXAMPLE:
Go through an example with an agricultural price support. Show students that, even though a
price support is not a legal minimum price, its result is exactly the same as a price floor.
Make sure that students can see that a surplus will result. Ask students to identify the
winners and losers of this government policy. Make sure that you also point out the costs of
the program (purchasing the surplus and storing it).
Figure 5
108 ❖ Chapter 6/Supply, Demand, and Government Policies
1. Price ceilings imposed by the government with the intention of aiding the poor can harm rich
and poor people alike due to shortage.
2. This article from
The
New York Times
discussing grocery shortages in Venezuela.
F. Evaluating Price Controls
1. Because most economists feel that markets are usually a good way to organize economic
activity, most oppose the use of price ceilings and floors.
b. If prices are set by laws, they obscure the signals that efficiently allocate scarce
resources.
2. Price ceilings and price floors often hurt the people they are intended to help.
a. Rent controls create a shortage of quality housing and provide disincentives for building
maintenance.
b. Minimum wage laws create higher rates of unemployment for teenage and low skilled
workers.
Be prepared to answer the question, “If price controls have such adverse
consequences, why are they imposed?” You may want to point out that, sometimes,
economic ignorance leads to unintended outcomes. You may also want to point out
that economic analysis serves as only a guide to policymakers. They may choose to
ignore it when forming policy. In addition, it is often interesting to encourage the
students to think about the distributional effects of these government programs.
This is a good chance to reinforce the principle “Markets are usually a good way to
organize economic activity.”
Chapter 6/Supply, Demand, and Government Policies ❖ 109
Activity 1—Ducks in a Row
Type: In-class demonstration
Topics: Price ceilings, subsidies, and unintended consequences
Materials needed: 2 toy ducks, some play money, 3 volunteers
Time: 10 minutes
Class limitations: Works in any size class
Purpose
This demonstration illustrates some common problems of government intervention in
markets.
Instructions
One volunteer plays the role of the government in a poor country. Give the play money to the
“government,” except for $1. The government uses this money to buy ducks from the farmer
and provides the ducks to the shopkeeper. The second volunteer is an urban shopkeeper. The
shopkeeper asks the government for more ducks whenever he or she is sold out. Give the
shopkeeper one duck. The third volunteer is a consumer. The consumer buys ducks. Give the
consumer $1 in play money. The instructor is a duck farmer. The farmer keeps the second
duck.
Explain this background: “Ducks are a staple food in this country but they are expensive at $3
each. The government wants to make food cheap for the urban poor to alleviate hunger.
They calculate people could afford ducks if they were priced at $1. The government decides
to impose a price ceiling of $1; $1 is now the maximum retail price for ducks.”
Start the game. The consumer buys one duck from the shopkeeper. The shopkeeper requests
more ducks from the government. The government comes to the farmer.
Points for Discussion
The instructor, as the duck farmer, controls the game. There are three points to make in this
demonstration:
1. Shortage. The farmer refuses to sell ducks at $1 each. The shopkeeper has no ducks.
of money.
110 ❖ Chapter 6/Supply, Demand, and Government Policies
II. Taxes
participants in a market.
B. How Taxes on Sellers Affect Market Outcomes
2. The supply curve will shift left by the exact amount of the tax.
4. Buyers and sellers will share the burden of the tax; buyers pay more for the good (including
the tax) and sellers receive less.
5. Two lessons can be learned here.
a. Taxes discourage market activity.
C. How Taxes on Buyers Affect Market Outcomes
1. If the government requires the buyer to pay a certain dollar amount for each unit of a good
purchased, this will cause a decrease in demand.
Figure 6
Chapter 6/Supply, Demand, and Government Policies ❖ 111
4. Buyers and sellers will share the burden of the tax; buyers pay more for the good and sellers
receive less (because of the tax).
1. FICA (Social Security) taxes were designed so that firms and workers would equally share the
burden of the tax.
wage the workers will receive.
3. It is true that firms and workers share the burden of this tax, but it is not necessarily 50-50.
Figure 7
Figure 8