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99
WHAT’S NEW IN THE EIGHTH EDITION:
There are two new
Ask the Experts
features on “Rent Control” and “The Minimum Wage.”
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
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
demanded exceeds the quantity supplied. Because of the resulting shortage, sellers must in some
way ration the good or service among buyers.
6
SUPPLY, DEMAND, AND
GOVERNMENT POLICIES
100 ❖ Chapter 6/Supply, Demand, and Government Policies
• 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.
• 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.
CHAPTER OUTLINE:
C. How Price Ceilings Affect Market Outcomes
2. If a shortage for a product occurs (and price cannot adjust to eliminate it), a method for
rationing the good must develop.
Figure 1
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.
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.
6.
Ask the Experts
: Rent Control
a. 95 percent of economic experts disagreed that local ordinances allowing 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.
102 ❖ Chapter 6/Supply, Demand, and Government Policies
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.
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
Chapter 6/Supply, Demand, and Government Policies ❖ 103
3.
Ask the Experts
: The Minimum Wage
a. Economic experts’ opinions are split on the effects of an increase in the minimum wage.
E. 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.
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.
This is a good chance to reinforce the principle “Markets are usually a good way to
organize economic activity.”
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
104 ❖ Chapter 6/Supply, Demand, and Government Policies
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.
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.
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
Chapter 6/Supply, Demand, and Government Policies ❖ 105
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
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.
Figure 6
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.
106 ❖ Chapter 6/Supply, Demand, and Government Policies
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.
E. Elasticity and Tax Incidence
Again, be very careful when discussing the “downward” shift of the demand curve.
Describe the effects of the tax on buyers’ willingness to buy.
Figure 7
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
Go through this material slowly. Make sure that students can see how to find the
burden of the tax paid by consumers and the burden of the tax paid by producers
before discussing the effects of elasticity on tax incidence. If you rush through this
material, you will lose them.
Chapter 6/Supply, Demand, and Government Policies ❖ 107
1. When supply is elastic and demand is inelastic, the largest share of the tax burden falls on
consumers.
4.
Case Study: Who Pays the Luxury Tax?
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
Figure 9
108 ❖ Chapter 6/Supply, Demand, and Government Policies
2. With no tax, as shown in Figure 1, the demand curve is
D
1 and the supply curve is
S
. The
If the tax is imposed on car sellers, as shown in Figure 2, the supply curve shifts upward by
the amount of the tax ($1,000) to
S
2. The upward shift in the supply curve leads to a rise in
the price paid by buyers to
P
2 and a decline in the equilibrium quantity to
Q
2. The price paid
Chapter Quick Quiz
1. d
Questions for Review
2. A shortage of a good arises when there is a binding price ceiling. A binding price ceiling is one that is
placed below the market equilibrium price. This leads to a shortage because quantity demanded
Chapter 6/Supply, Demand, and Government Policies ❖ 109
Figure 3
3. When the price of a good is not allowed to bring supply and demand into equilibrium, some
alternative mechanism must allocate resources. If quantity supplied exceeds quantity demanded, so
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
7. The burden of a tax is divided between buyers and sellers depending on the elasticities of demand
and supply. Elasticity represents the willingness of buyers or sellers to leave the market, which in
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
110 ❖ Chapter 6/Supply, Demand, and Government Policies
Figure 4
b. The producers’ complaint that their total revenue has declined is correct if demand is elastic.
With elastic demand, the percentage decline in quantity would exceed the percentage rise in
price, so total revenue would decline.
3. a. The equilibrium price of Frisbees is $8 and the equilibrium quantity is six million Frisbees.
Chapter 6/Supply, Demand, and Government Policies ❖ 111
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.
Figure 5 Figure 6
5. Raising the payroll tax paid by firms and using part of the extra revenue to reduce the payroll tax
paid by workers would not make workers better off, because the division of the burden of a tax
6. The price will rise by less than $500. The burden of any tax is shared by both producers and
consumers⎯the price paid by consumers rises and the price received by producers falls, with the
7. a. It does not matter whether the tax is imposed on producers or consumers⎯the effect will be the
same. With no tax, as shown in Figure 7, the demand curve is
D
1 and the supply curve is
S
1. If
112 ❖ Chapter 6/Supply, Demand, and Government Policies
Figure 7 Figure 8
b. The more elastic the demand curve is, the more effective this tax will be in reducing the quantity
of gasoline consumed. Greater elasticity of demand means that quantity falls more in response to
8. a. Figure 9 shows the effects of the minimum wage. In the absence of the minimum wage, the
market wage would be
w
1 and
Q
1 workers would be employed. With the minimum wage (
w
m)
imposed above
w
1, the market wage is
w
m, the number of employed workers is
Q
2, and the
Chapter 6/Supply, Demand, and Government Policies ❖ 113
b. An increase in the minimum wage would decrease employment. The size of the effect on
employment depends only on the elasticity of demand. The elasticity of supply does not matter,
because there is a surplus of labor.
114 ❖ Chapter 6/Supply, Demand, and Government Policies
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. Solve for the equilibrium price and quantity by setting the quantity supplied equal to the quantity
