Copyright © 2006 Thomson Learning 6 Supply, Demand, and Government Policies.
Supply, Demand & Government Policies
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Transcript of Supply, Demand & Government Policies
Supply, Demand & Government Policies
Lecture 5
• In a free market system, market forces establish equilibrium prices and exchange quantities.
• One of the roles of economists is to develop theories to assist in the development
of policies.
Controls on Prices
• Buyers always want lower prices, while sellers want higher prices.
• Thus, interests of these two groups conflict.• Controls on prices are usually enacted when
policymakers believe the market price is unfair to buyers or sellers.
• For this government creates price ceilings and price floors.
Controls on PricesCont…
• 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.
Controls on PricesCont…
How Price Ceilings Affect Market Outcomes: • When govt. imposes price ceiling, following
two outcomes are possible:
1. If price is set above the equilibrium price, price ceiling is not binding .
• Price ceiling has no effect on the price or quantity sold .
Price Ceiling that is NOT BINDING
Quantity0
Price
EquilibriumQuantity
P2 PriceCeiling
EquilibriumPrice
Demand
Supply
P1
Q
Controls on PricesCont…
How Price Ceilings Affect Market Outcomes (Cont.):2. If price is set below the equilibrium price,
price ceiling is a binding constraint.• The forces of demand and supply move price
towards equilibrium price.• But when market price hits the ceiling, it can rise
no further.• Thus, market price equals price ceiling.• At this price, quantity demanded exceeds quantity supplied, creating shortage for the good.
Price Ceiling that is BINDING
Quantity0
Price
Demand
Supply
P1 PriceCeilingShortage
Q1
QuantitySupplied
Q2
QuantityDemanded
EquilibriumPrice
P2
Controls on PricesCont…
How Price Ceilings Affect Market Outcomes (Cont.): • Therefore, when government imposes a binding
price ceiling on a market, shortage of the good arises
Controls on PricesCont…
How Price Floors Affect Market Outcomes: • When govt. imposes price floor, following
two outcomes are possible:
1. If price is set below the equilibrium price, price floor is not binding .
• Price floor has no effect on the price or quantity sold .
Price Floor that is NOT BINDING
Quantity0
Price
EquilibriumQuantity
P1
PriceFloor
EquilibriumPrice
Demand
Supply
P2
Q
Controls on PricesCont…
How Price Floors Affect Market Outcomes (Cont.):2. If price is set above the equilibrium price,
price floor is a binding constraint.• The forces of demand and supply move price
towards equilibrium price.• But when market price hits the floor, it can fall no
further.• Thus, market price equals price floor.• At this price, quantity supplied exceeds quantity demanded, causing surplus for the good.
Price Floor that is BINDING
Quantity0
Price
Demand
Supply
P2PriceFloor
Q1
QuantityDemanded
Q2
QuantitySupplied
EquilibriumPrice
Surplus
P1
Taxes
• Governments use taxes to raise revenue for public projects, such as for:– Roads– Schools – National defense
• Taxes affect market activity.• When a good is taxed, the quantity sold is
smaller.
TaxesCont…
Important Question
• When govt. levies tax on a good, who bears the burden of the tax?
Buyers
Or
Sellers
TaxesCont…
• Economists use the term tax incidence to refer to the distribution of tax burden.
• “Tax incidence is the manner in which the burden of a tax is shared among participants in a market”.
TaxesCont…
• Taxes result in a change in market equilibrium.
• Buyers pay more and sellers receive less, regardless of whom the tax is levied on.
TaxesCont…
• What is the impact of tax? – Taxes discourage market activity.– When a good is taxed, the quantity sold is
smaller. – Buyers and sellers share the tax burden.