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104
WHAT’S NEW IN THE SEVENTH EDITION:
There is a new
In the News
feature on “President Chávez versus the Market.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ the effects of government policies that place a ceiling on prices.
➢ the effects of government policies that put a floor under prices.
➢ how a tax on a good affects the price of the good and the quantity sold.
➢ 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:
Chapter 6 is the third chapter in a three-chapter sequence that deals with supply and demand and how
markets work. Chapter 4 developed the model of supply and demand. Chapter 5 added precision to the
model of supply and demand by developing the concept of elasticity—the sensitivity of the quantity
supplied and quantity demanded to changes in economic conditions. Chapter 6 addresses the impact of
government policies on competitive markets using the tools of supply and demand that you learned in
Chapters 4 and 5.
KEY POINTS:
• A price ceiling is a legal maximum on the price of a good or service. An example is rent control. If the
price ceiling is below the equilibrium price, then the price ceiling is binding, and the quantity
6
SUPPLY, DEMAND, AND
GOVERNMENT POLICIES
Chapter 6/Supply, Demand, and Government Policies ❖ 105
demanded exceeds the quantity supplied. Because of the resulting shortage, sellers must in some
way ration the good or service among buyers.
• When the government levies a tax on a good, the equilibrium quantity of the good falls. That is, a tax
on a market shrinks the size of the market.
• 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.
• The incidence of a tax depends on the price elasticities of supply and demand. Most of the burden
falls on the side of the market that is less elastic because that side of the market cannot respond as
easily to the tax by changing the quantity bought or sold.
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
has no effect on the price or quantity sold.
b. If the price ceiling is lower than the equilibrium price, the ceiling is a binding constraint
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
a. In 1973, OPEC raised the price of crude oil, which led to a reduction in the supply of
gasoline.
b. The federal government put a price ceiling into place and this created large shortages.
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.
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
no effect on the price or quantity sold.
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
a. The market for labor looks like any other market: downward-sloping demand, upward-
sloping supply, an equilibrium price (called a wage), and an equilibrium quantity of labor
hired.
b. If the minimum wage is above the equilibrium wage in the labor market, a surplus of
E.
In the News: President Chávez versus the Market
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.
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.
a. Prices balance supply and demand and thus coordinate economic activity.
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
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
Examples of unit taxes include most government excise taxes on products such as
gasoline, alcohol, and tobacco.
Use this chance to reinforce the three steps learned in Chapter 4. Students should
decide whether this tax law affects the demand curve or the supply curve, decide
which way it shifts, and then examine how the shift affects equilibrium price and
quantity.
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.
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.
2. Subsidy. The farmer offers to sell the ducks for $3. The ducks can then be sold in the
110 ❖ Chapter 6/Supply, Demand, and Government Policies
II. Taxes
A. Definition of tax incidence: the manner in which the burden of a tax is shared among
participants in a market.
B. How Taxes on Sellers Affect Market Outcomes
1. If the government requires the seller to pay a certain dollar amount for each unit of a good
sold, this will cause a decrease in supply.
2. The supply curve will shift left by the exact amount of the tax.
3. The quantity of the good sold will decline.
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.
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.
2. The demand curve will shift left by the exact amount of the tax.
You will want to be very careful when discussing the “upward” shift of the supply
curve given that we encourage students to think of supply and demand curves
shifting “right” and “left.” Make sure to emphasize the effects of the tax on sellers’
willingness to sell.
Figure 6
Chapter 6/Supply, Demand, and Government Policies ❖ 111
3. The quantity of the good sold will decline.
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).
D.
Case Study: Can Congress Distribute the Burden of a Payroll Tax?
1. FICA (Social Security) taxes were designed so that firms and workers would equally share the
burden of the tax.
Figure 7
Again, be very careful when discussing the “downward” shift of the demand curve.
Describe the effects of the tax on buyers’ willingness to buy.
Stress that the outcome of a tax levied on sellers is exactly the same as the outcome
of a tax levied on buyers. When drawing this in class, make sure that the price that
buyers end up paying and the price that sellers end up receiving is the same in both
examples.
Figure 8
112 ❖ Chapter 6/Supply, Demand, and Government Policies
E. Elasticity and Tax Incidence
1. When supply is elastic and demand is inelastic, the largest share of the tax burden falls on
consumers.
2. When supply is inelastic and demand is elastic, the largest share of the tax burden falls on
producers.
3. In general, a tax burden falls more heavily on the side of the market that is less elastic.
a. A small elasticity of demand means that buyers do not have good alternatives to
consuming this product.
b. A small elasticity of supply means that sellers do not have good alternatives to producing
this particular good.
4.
Case Study: Who Pays the Luxury Tax?
a. In 1990, Congress adopted a new luxury tax.
b. The goal of the tax was to raise revenue from those who could most easily afford to pay.
c. Because the demand for luxuries is often relatively more elastic than supply, the burden
of the tax fell on producers and their workers.
Go through this material slowly. Make sure that students can see how to find the
Figure 9
Chapter 6/Supply, Demand, and Government Policies ❖ 113
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. A price ceiling is a legal maximum on the price at which a good can be sold. Examples of
price ceilings include rent controls, price controls on gasoline in the 1970s, and price ceilings
2. With no tax, as shown in Figure 1, the demand curve is
D
1 and the supply curve is
S
. The
equilibrium price is
P
Q
Questions for Review
1. An example of a price ceiling is the rent control system in New York City. An example of a price floor
is the minimum wage. Many other examples are possible.
114 ❖ Chapter 6/Supply, Demand, and Government Policies
2. A shortage of a good arises when there is a binding price ceiling. A binding price ceiling is one that is
Figure 3
3. When the price of a good is not allowed to bring supply and demand into equilibrium, some
4. Economists usually oppose controls on prices because prices have the crucial job of coordinating
5. Removing a tax paid by buyers and replacing it with a tax paid by sellers raises the price that buyers
Quick Check Multiple Choice
Chapter 6/Supply, Demand, and Government Policies ❖ 115
Problems and Applications
1. If the price ceiling of $40 per ticket is below the equilibrium price, then quantity demanded exceeds
2. a. The imposition of a binding price floor in the cheese market is shown in Figure 4. In the absence
of the price floor, the price would be
P
1 and the quantity would be
Q
1. With the floor set at
P
f,
Figure 4
c. If the government purchases all the surplus cheese at the price floor, producers benefit and
116 ❖ Chapter 6/Supply, Demand, and Government Policies
4. a. Figure 5 shows the market for beer without the tax. The equilibrium price is
P
1 and the
equilibrium quantity is
Q
1. The price paid by consumers is the same as the price received by
producers,
P
1.
b. When the tax is imposed, it drives a wedge of $2 between supply and demand, as shown in
5. Raising the payroll tax paid by firms and using part of the extra revenue to reduce the payroll tax
6. The price will rise by less than $500. The burden of any tax is shared by both producers and
Chapter 6/Supply, Demand, and Government Policies ❖ 117
7. a. It does not matter whether the tax is imposed on producers or consumers⎯the effect will be the
d. Workers in the oil industry are hurt by the tax as well. With a lower quantity of gasoline being
118 ❖ Chapter 6/Supply, Demand, and Government Policies
8. a. Figure 9 shows the effects of the minimum wage. In the absence of the minimum wage, the
Figure 9
b. An increase in the minimum wage would decrease employment. The size of the effect on
c. The increase in the minimum wage would increase unemployment. The size of the rise in
d. If the demand for unskilled labor were inelastic, the rise in the minimum wage would increase
Chapter 6/Supply, Demand, and Government Policies ❖ 119
9. Since the supply of seats is perfectly inelastic, the entire burden of the tax will fall on the team’s
owners. Figure 11 shows that the price the buyers pay for the tickets will fall by the exact amount of
the tax.
Figure 11
10. a. The effect of a $0.50 per cone subsidy is to shift the demand curve to the right by $0.50 at each
