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Supply, Demand,

and Government Policies

CHAPTER

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Premium PowerPoint Slides by:

V. Andreea CHIRITESCU

Eastern Illinois University

N. GREGORY MANKIW PRINCIPLES OF MACROECONOMICS Eighth Edition

This chapter builds on the previous two (supply & demand, elasticity). Students who learned those chapters well usually do not have much difficulty with the material in Chapter 6. This chapter can usually be covered in about 90 minutes of class time.

I have combined the analysis of price ceilings with the rent control example, and I’ve combined the analysis of price floors with the minimum wage example. (In contrast, the textbook presents a generic analysis of price ceilings, then the rent control example in a case study, then a generic analysis of price floors, then the minimum wage example in a case study.) Most students learn new concepts better in the context of a specific example rather than a generic analysis, and combining them in this way saves class time.

Here’s an idea you might consider:

At the end of the class session just prior to the one in which you begin to cover this chapter, ask students to take out a piece of blank paper, and write down whether they think the minimum wage should be increased, and their reason(s). Tell them not to write their names (you want them to be candid), and have them leave their pieces of paper in a pile as they exit the classroom. Later, divide the papers into two groups based on whether they support or oppose increasing the minimum wage. In this PowerPoint file, immediately after this slide, insert two new slides, titling them “Your reasons for raising the minimum wage” and “Your reasons for not raising the minimum wage.” Summarize on each slide the most common reasons students gave. Begin the class session by showing them the results of this impromptu survey (how many students responded each way, and the most common reasons). Tell those students who support a minimum wage increase that their thinking represents that of many educated non-economists. But tell them that economics offers another perspective, and this is something they will learn in this chapter.

If you do this, then I recommend rearranging the slides a bit so that the price floor/minimum wage slides come BEFORE the price ceiling/rent control slides.

Look for the answers to these questions:

What are price ceilings and price floors? What are some examples of each?

How do price ceilings and price floors affect market outcomes?

How do taxes affect market outcomes? How do the effects depend on whether the tax is imposed on buyers or sellers?

What is the incidence of a tax? What determines the incidence?

When we talk about how a policy “affects the market outcome,” we mean the policy’s impact on the price and quantity of the good and therefore on the market’s allocation of resources.

Government Policies That Alter the Private Market Outcome

Price controls

Price ceiling: legal maximum on the price at which a good can be sold

Rent-control laws

Price floor: legal minimum on the price at which a good can be sold

Minimum wage laws

Taxes: government can make buyers or sellers pay a specific amount on each unit

This slide outlines the chapter.

We will use the supply/demand model to see how each policy affects the market outcome (the price buyers pay, the price sellers receive, and eq’m quantity).

ASK THE EXPERTS

Rent Control

“Local ordinances that limit rent increases for some rental housing units, such as in New York and San Francisco, have had a positive impact over the past three decades on the amount and quality of broadly affordable rental housing in cities that have used them.”

This ‘Ask the experts’ feature provides the opportunity for class discussion. If you want, you can move this feature and class discussion after you presented the rent control example on the next few slides.

Start by asking the class what they know about rent control (you may have to explain what rent control is, and tell them that the main goal of this policy is to help the poor by making housing more affordable) .

After showing the statement, you can ask your students to choose one of the options: agree, disagree, or uncertain. You can collect their answers in a variety of ways: show of hands, ballot, clicker system, etc. If time permits, you can allow students to group and discuss some of the reasons they chose their answer.

Ask the students to share with the class their reasons. Their answers will vary.

EXAMPLE 1: The Market for Apartments

Equilibrium without price controls

Rental price of apartments

$800

300

Quantity of apartments

We start by analyzing the effects of a price ceiling. The most common example is rent control, so we do the analysis in the context of this example.

We begin by showing the market for apartments in equilibrium (before the government imposes any price controls).

How Price Ceilings Affect Market Outcomes

A price ceiling above the equilibrium price is not binding— has no effect on the market outcome.

$800

300

Price ceiling

$1000

When some students see this for the first time, they wonder why the price ceiling does not result in a surplus.

When the price ceiling is above the equilibrium price, the equilibrium price is still perfectly legal. Just because landlords are allowed to charge $1000 rent doesn’t mean they will—if they do, they won’t be able to rent all of their apartments, and a surplus will result, causing downward pressure on the price (rent). There’s no law that prevents the price (rent) from falling, so it does fall until the surplus is gone and equilibrium is reached (at P = $800 and Q = 300).

How Price Ceilings Affect Market Outcomes

The equilibrium price ($800) is above the ceiling and therefore illegal.

The price ceiling is binding, causes a shortage.

$800

Price ceiling

$500

250

400

shortage

In this case, the price ceiling is binding.

In the new equilibrium with the price ceiling, the actual price (rent) of an apartment will be $500. It won’t be more than that, because any higher price is illegal. It won’t be less than $500, because the shortage would be even larger if the price were lower.

The actual quantity of apartments rented equals 250, and there is a shortage equal to 150 (the difference between the quantity demanded, 400, and the quantity supplied, 250).

The effects of rent control in the short run (when the supply and demand for housing are inelastic) are: Small shortage and Reduced rents

How Price Ceilings Affect Market Outcomes

In the long run, supply and demand of rental apartments are more price-elastic.

So, the shortage is larger.

$800

150

Price ceiling

$500

450

shortage

In this slide, the equilibrium price ($800) and price ceiling ($500) are the same as on the preceding slides, but supply and demand are more price-elastic than before, and the shortage that results from a binding price ceiling is larger.

The adverse effects of rent control in the long run: large shortage of housing

Landlords: are not building new apartments and are failing to maintain existing ones

People: more people want to find their own apartments and more people to move into a city

Inefficient rationing mechanisms: long waiting lists; preference to tenants without children; discriminate on the basis of race; bribes to building superintendents

Shortages and Rationing

Because of shortage

Sellers must ration the goods among buyers

Some rationing mechanisms:

Long lines

Discrimination according to sellers’ biases

Are often unfair and inefficient

The goods do not necessarily go to the buyers who value them most highly

In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair).

EXAMPLE 2: The Market for Unskilled Labor

Equilibrium without price controls

Wage paid to unskilled workers

$6.00

500

Quantity of unskilled workers

Now we switch gears and look at the effects of a price floor. We illustrate this concept using the common textbook example—the minimum wage.

This may be the first time students have seen a supply–demand diagram of the labor market. It might be useful to note that the “price” of labor is simply the wage, which we measure on the vertical axis of our supply–demand diagram. Along the horizontal axis, we measure the quantity of labor (number of workers). The demand for unskilled labor comes from firms. The supply comes from workers.

We focus on unskilled labor because the minimum wage is not relevant for higher skilled, higher wage workers.

How Price Floors Affect Market Outcomes

A price floor below the equilibrium price is not binding – has no effect on the market outcome.

$6.00

500

Price floor

$5.00

Some students may wonder why the $5 price floor does not cause a shortage. After all, at a wage of $5, the quantity of unskilled workers that firms wish to hire exceeds the quantity of unskilled workers that are looking for jobs.

But the minimum wage law does not stop the wage from rising above $5. So, in response to this shortage, the wage will rise until the shortage disappears – which occurs at the equilibrium wage of $6. The equilibrium wage is perfectly legal when the price floor (i.e. minimum wage) is below it.

How Price Floors Affect Market Outcomes

The equilibrium wage ($6) is below the floor and therefore illegal.

The price floor is binding, causes a surplus (i.e., unemployment).

Minimum wage laws do not affect highly skilled workers. They do affect teen workers. A 10% increase in the minimum wage raises teen unemployment by 1–3%.

$6.00

Price floor

$7.25

400

550

labor surplus

Now, the minimum wage exceeds the equilibrium wage. The equilibrium wage (or any wage below $7.25) is illegal.

In this case, the actual wage will be $7.25. It will not be lower, because any lower wage is illegal. It will not be higher, because at any higher wage, the surplus would be even greater. The actual number of unskilled workers with jobs equals 400. 550 want jobs, but firms are only willing to hire 400, leaving a surplus (i.e. unemployment) of 150 workers.

A surplus of anything – especially labor – represents wasted resources.

ASK THE EXPERTS

The Minimum Wage

“If the federal minimum wage is raised gradually to $15-per-hour by 2020, the employment rate for low-wage U.S. workers will be substantially lower than it would be under the status quo.”

This ‘Ask the experts’ feature provides the opportunity for class discussion.

I think this feature is better suited here, after the discussion of minimum wage as a binding price floor.

Ask the students to share with the class their reasons. Their answers will vary.

Some things from the minimum wage case study in the text are worth mentioning to explain why economists disagree on this issue:

- There is no impact of the minimum wage law on highly skilled and experienced workers because their equilibrium wages are well above the minimum (not binding)

- The minimum wage law affects teenage labor: they are the least skilled and least experienced; have low equilibrium wages; they are willing to accept a lower wage in exchange for on-the-job training (binding minimum wage)

Studies have shown that on the teenage labor market: a 10% increase in the minimum wage depresses teenage employment between 1 and 3%. This is relevant because some teenagers who are still attending high school choose to drop out and take jobs. Moreover, it displaces other teenagers who had already dropped out of school and who now become unemployed.

- Advocates of the minimum wage argue that the law raises the income of the working poor, and indeed workers who earn the minimum wage can afford only a meager standard of living.

- Opponents of the minimum wage say that it is not the best way to combat poverty (leads to unemployment, encourages teenagers to drop out of school, prevents some unskilled workers from getting on-the-job training). It is a poorly targeted policy

The market for hotel rooms

Active Learning 1 Price controls

The market for hotel rooms is in equilibrium as in the graph.

Determine the effects of:

$90 price ceiling

$90 price floor

$120 price floor

A good exercise to break up the lecture, engage students, and assess their learning so far.

The market for hotel rooms

Active Learning 1 A. $90 price ceiling

The price falls to $90. (binding price ceiling below the equilibrium)

Buyers demand 120 rooms, sellers supply 90, leaving a shortage.

shortage = 30

Price ceiling

The market for hotel rooms

Active Learning 1 B. $90 price floor

Equilibrium price is above the $90 price floor, so the price floor is not binding.

P = $100, Q = 100 rooms.

Price floor

The market for hotel rooms

Active Learning 1 C. $120 price floor

The price rises to $120. (binding price floor above the equilibrium)

Buyers demand 60 rooms, sellers supply 120, causing a surplus.

surplus = 60

Price floor

Evaluating Price Controls

Markets are usually a good way to organize economic activity

Economists usually oppose price ceilings and price floors

Prices are not the outcome of some haphazard process

Prices have the crucial job of balancing supply and demand

Coordinating economic activity

Evaluating Price Controls

Governments can sometimes improve market outcomes

Want to use price controls

Because of unfair market outcome

Aimed at helping the poor

Often hurt those they are trying to help

Other ways of helping those in need

Rent subsidies

Wage subsidies (earned income tax credit)

It might be worth reminding students that our analysis has been in the context of a world without market failures. Subsequent chapters (except in the macro split) will introduce situations in which government intervention can improve on the private market outcome. However, even in such cases, the appropriate policy is usually something other than a direct price control.

Taxes

Government uses taxes

To raise revenue for public projects

Roads, schools, and national defense

Tax incidence

Manner in which the burden of a tax is shared among participants in a market

The government can make the seller or the buyer to pay the tax

The tax can be a percentage of the good’s price, or a specific amount for each unit sold. For simplicity, we analyze per-unit taxes only.

EXAMPLE 3: The Market for Pizza

Equilibrium without tax

$10.00

500

A Tax on Buyers

Hence, a tax on buyers shifts the D curve down by the amount of the tax.

The price buyers pay is now $1.50 higher than the market price P.

P would have to fall by $1.50 to make buyers willing to buy same Q as before.

E.g., if P falls from $10.00 to $8.50, buyers are still willing to purchase 500 pizzas.

$10.00

500

Effects of a $1.50 per unit tax on buyers

$8.50

Tax

NOTE: On this and subsequent slides, “PB” denotes the price buyers pay and “PS” denotes the price sellers receive. (The Chapter 8 PowerPoint uses the same notation for the welfare analysis of taxes.)

The government makes buyers pay a $1.50 tax on each pizza they purchase. The new demand curve (in red, labeled D2) reflects buyers’ demand as a function of the after-tax price. The original demand curve (D1) still reflects buyers’ demand as a function of the total price—inclusive of the tax.

Thus, buyers’ demand hasn’t really changed: at each quantity, the height of the original (blue) D curve is still the maximum that buyers will pay for that quantity, while the height of the new (red) D curve is the maximum that buyers will pay sellers for that quantity, given that buyers also must pay the tax. At any Q, the vertical distance between the blue and red D curves equals the tax.

(If this were a percentage tax rather than a per-unit tax, the new D curve would not be parallel to the old one, it would be flatter: a tax of a given percentage would be a larger dollar amount at high prices than at low prices, so the downward shift would be greater in absolute terms when P is high than when it is low. This is the type of complexity we avoid by working with per-unit taxes.)

A Tax on Buyers

New equilibrium:

Q = 450

Sellers receive PS = $9.50

Buyers pay PB = $11.00

Difference between them = $1.50 = tax

$10.00

500

$11.00

PB =

$9.50

PS =

Tax

Effects of a $1.50 per unit tax on buyers

450

How taxes on buyers affect market outcomes:

Buyers and sellers share the burden of tax

Sellers get a lower price, are worse off

Buyers pay a lower market price, are worse off: Effective price (with tax) rises

450

The Incidence of a Tax:

how the burden of a tax is shared among market participants

$10.00

500

$11.00

PB =

$9.50

PS =

Tax

In our example,

buyers pay $1.00 more,

sellers get $0.50 less.

“Market participants” simply means buyers and sellers.

A Tax on Sellers

The tax effectively raises sellers’ costs by $1.50 per pizza.

Sellers will supply 500 pizzas only if P rises to $11.50, to compensate for this cost increase.

Hence, a tax on sellers shifts the S curve up by the amount of the tax.

$10.00

500

Effects of a $1.50 per unit tax on sellers

$11.50

Tax

The government makes sellers pay a $1.50 on each pizza they sell. The new, red supply curve reflects sellers’ supply as a function of the after-tax price.

A Tax on Sellers

New equilibrium:

Q = 450

Buyers pay PB = $11.00

Sellers receive PS = $9.50

Difference between them = $1.50 = tax

$10.00

500

450

$11.00

PB =

$9.50

PS =

Tax

Effects of a $1.50 per unit tax on sellers

The Outcome Is the Same in Both Cases!

The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers!

A tax drives a wedge between the price buyers pay and the price sellers receive.

$10.00

500

450

$9.50

$11.00

PB =

PS =

Tax

Whether the government makes buyers or sellers pay the tax, all of the effects are the same:

- the price buyers pay rises (in this case to $11)

- the price sellers receive falls (to $9.50)

- the equilibrium quantity falls (to 450)

- the incidence of the tax is the same (here, buyers pay $1 of the tax, while sellers pay $.50 of the tax on each unit)

A tax on buyers means buyers will have to pay more, which causes their demand to fall. The fall in demand hurts sellers, forcing them to reduce their price. Similarly, a tax on sellers is like a cost increase, and sellers pass along a portion of that increase to buyers in the form of higher prices.

The equivalence of taxes on buyers and taxes on sellers means that we can ignore whether the tax is imposed on buyers or sellers. All that matters is the size of the tax.

So, in future problems, we can think of the tax as a wedge between the price buyers pay and the price sellers receive. On a supply–demand diagram, this wedge is a vertical line segment (shown in green on this graph). You can think of taking a toothpick the size of the tax and wedging it between the S and D curves. The quantity at which the toothpick fits just snuggly is the new equilibrium quantity. Students will have a chance to practice this in a moment with an exercise.

One last remark: Someone once said “if you want less of something, tax it.” A tax on any good or service causes a fall in its quantity. This is because people respond to incentives: the tax gives buyers an incentive to buy less and gives sellers an incentive to produce less.

The market for hotel rooms

Active Learning 2 Effects of a tax

The market for hotel rooms is in equilibrium as in the graph.

Suppose the government imposes a tax on buyers of $30 per room

Find the new Q, PB, PS, and incidence of tax.

These are the same supply and demand curves used in the previous exercise.

The market for hotel rooms

Active Learning 2 Answers

Q = 80

PB = $110

PS = $80

Incidence

buyers: $10

sellers: $20

Tax

PB =

PS =

First, the equilibrium quantity is the quantity where PB – PS = $30. This quantity is 80.

Next, to find PB, start at Q = 80 and go up to the demand curve to see that PB = $110.

To find PS, start at Q = 80 and go up to the supply curve to see that PS = $80.

To find incidence, just compare PB and PS to the no-tax equilibrium price, $100.

Elasticity and Tax Incidence CASE 1: Supply is more elastic than demand

It’s easier for sellers than buyers to leave the market.

So buyers bear most of the burden of the tax.

Tax

Buyers’ share of tax burden

Sellers’ share of tax burden

Price if no tax

We have just seen that tax incidence is not affected by whether the government makes buyers or sellers pay the tax. So what, then, does determine tax incidence? Turns out it’s elasticity—specifically, the price elasticities of supply and demand.

There are two cases: 1) supply is more price-elastic than demand (this slide), and 2) demand is more price-elastic than supply (next slide).

When supply is more price-elastic than demand, sellers are relatively more responsive to changes in price, and the supply curve is less steep than the demand curve. Buyers have relatively fewer alternatives, so they have to “eat” most of the price increase caused by the imposition of the tax.

As the textbook puts it, sellers can more easily leave the market in response to the tax than can buyers. Thus, buyers are stuck bearing most of the burden of the tax.

Elasticity and Tax Incidence CASE 2: Demand is more elastic than supply

It’s easier for buyers than sellers to leave the market.

Sellers bear most of the burden of the tax.

Tax

Buyers’ share of tax burden

Sellers’ share of tax burden

Price if no tax

The size of the tax is the same in this diagram as in the one on the preceding slide.

When demand is more price-elastic than supply, buyers are relatively more price-sensitive, and the demand curve is less steep than the supply curve. Buyers have relatively more alternatives, so they can avoid most of the tax. Sellers are less flexible, so they have to “eat” a greater share of the price increase caused by the tax.

Tax burden falls more heavily on the side of the market that is less elastic:

Small elasticity of demand: Buyers do not have good alternatives to consuming this good

Small elasticity of supply: Sellers do not have good alternatives to producing this good

Who pays the luxury tax?

1990, Congress adopted a new luxury tax

On yachts, private airplanes, furs, jewelry, expensive cars

Goal: to raise revenue from those who could most easily afford to pay

Luxury items

Demand is quite elastic

Supply is relatively inelastic

This case study shows students an interesting real-world example of the material they just learned.

If you’re pressed for time, it is probably safe to skip it and let students read it on their own. It does not introduce any new concepts, and most students do not find it difficult to read.

CASE STUDY: Who Pays the Luxury Tax?

The market for yachts

Tax

Buyers’ share of tax burden

Sellers’ share of tax burden

Demand is price-elastic.

In the short run, supply is inelastic.

Hence, companies that build yachts pay most of the tax.

Demand for yachts (and other luxury items) is price-elastic: if the price of yachts rises, rich consumers can easily avoid the tax by spending their millions on some other luxury item.

Supply of yachts is less elastic, especially in the short run. It is difficult for the companies that build yachts to re-tool their factories and reeducate their workers to produce some other product.

Hence, companies that build yachts pay most of the tax, and the rich pay relatively little of it.

The same is true for taxes on other luxury items.

Most of the luxury tax was repealed in 1993.

Active Learning 3 The 2011 payroll tax cut

Prior to 2011, the Social Security payroll tax was 6.2% taken from workers’ pay and 6.2% paid by employers (total 12.4%). The Tax Relief Act (2010) reduced the worker’s portion from 6.2% to 4.2% in 2011, but left the employer’s portion at 6.2%.

Should this change have increased the typical worker’s take-home pay by exactly 2%, more than 2%, or less than 2%? Do any elasticities affect your answer? Explain.

FOLLOW-UP QUESTION: Who gets the bigger share of this tax cut, workers or employers? How do elasticities determine the answer?

The Tax Relief Act was signed into law by President Obama in December 2010. It contained several provisions, including a two-year extension of the Bush tax cuts for all income levels and a temporary extension of unemployment insurance benefits. This exercise focuses on the one-year reduction in the Social Security payroll tax.

Active Learning 3 Answers

As long as labor supply and labor demand both have price elasticity > 0, the tax cut will be shared by workers and employers, i.e., workers’ take-home pay will rise less than 2%.

The answer does NOT depend on whether labor demand is more or less elastic than labor supply.

FOLLOW-UP QUESTION :

If labor demand is more elastic than labor supply, workers get more of the tax cut than employers.

If labor demand is less elastic than labor supply, employers get the larger share of the tax cut.

It might be helpful to first remind students that the legal division of the tax (6.2% worker, 6.2% employer) is irrelevant to the economic incidence of the tax. This means that workers’ take-home pay depends only on the total amount of the tax (12.4%), not on the portion that’s collected from workers vs. employers.

To help students understand the answer, have them draw a supply-demand diagram for the labor market, with a tax. Reduce the tax and see what happens to the equilibrium wages paid to workers—they rise, but not by the full amount of the tax cut; employers get a portion of the tax cut.

Then have them consider the follow-up question.

If labor demand is more elastic than labor supply, workers bear most of the burden of the tax. Reducing the tax therefore benefits workers more than employers.

If labor demand is less elastic than supply, the reverse is true.

If your students have trouble with this, have them draw two diagrams, one for each of the two cases.

Summary

A price ceiling is a legal maximum on the price of a good. An example is rent control. If the price ceiling is below the equilibrium price, it is binding and causes a shortage.

A price floor is a legal minimum on the price of a good. An example is the minimum wage. If the price floor is above the equilibrium price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment.

Recall one of the 10 principles from Chapter 1: Markets are usually a good way to organize economic activity. This means that, in absence of market failures (which we will study in later chapters), the allocation of resources resulting from the free market equilibrium is optimal. Hence, government policies that alter this allocation tend to make the economy worse off.

When we study market failures later, we will see that government policies can—in principle—improve on the market’s allocation of resources, and make society better off.

First, though, we need to learn how to measure the impact of government policies like taxes on society’s well-being, as well as define what, exactly, we mean by “well-being.” This field of study, called “welfare economics,” is the topic of the following three chapters.

Summary

A tax on a good places a wedge between the price buyers pay and the price sellers receive, and causes the equilibrium quantity to fall, whether the tax is imposed on buyers or sellers.

The incidence of a tax is the division of the burden of the tax between buyers and sellers, and does not depend on whether the tax is imposed on buyers or sellers.

The incidence of the tax depends on the price elasticities of supply and demand.

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