N.

GREGORY MANKIW
PRINCIPLES OF
MICROECONOMICS
Eighth Edition

CHAPTER Supply, Demand, &

6 Government Policies
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V. Andreea CHIRITESCU
Eastern Illinois University
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 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?
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 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
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 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.”

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 EXAMPLE 1: The Market for Apartments

Rental P S
price of Equilibrium
apartments without price
$800 controls

D
Q
300
Quantity
of apartments

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 How Price Ceilings Affect Market Outcomes

P S
A price ceiling Price
$1000
above the ceiling
equilibrium price $800
is not
binding—
has no effect on
the market D
outcome. Q
300

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 How Price Ceilings Affect Market Outcomes

The equilibrium
P S
price ($800) is
above the ceiling
and therefore
illegal. $800
The price ceiling Price
is binding, $500
ceiling
causes a shortage
shortage. D
Q
250 400

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 How Price Ceilings Affect Market Outcomes

In the long run,

P S
supply and
demand of rental
apartments are
more price- $800
elastic. Price
$500
ceiling
So, the shortage shortage
is larger. D
Q
150 450

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 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

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 EXAMPLE 2: The Market for Unskilled Labor

Wage W S
paid to
unskilled Equilibrium
workers without price
$6.00
controls

D
L
500
Quantity of
unskilled workers

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 How Price Floors Affect Market Outcomes

W S
A price floor
below the
equilibrium price
$6.00
is not binding –
has no effect on Price
$5.00
the market floor
outcome.
D
L
500

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 How Price Floors Affect Market Outcomes

The equilibrium wage ($6) labor

is below the floor and W surplus S
therefore illegal. Price
$7.25
The price floor is binding, floor
causes a surplus (i.e.,
unemployment). $6.00

Minimum wage laws do

not affect highly skilled
workers. They do affect
D
teen workers. A 10% L
increase in the minimum 400 550
wage raises teen
unemployment by 1–3%.
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 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.”

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 Active Learning 1 Price controls
The market for hotel The market for
P
140 hotel rooms
rooms is in equilibrium S
as in the graph. 130
120
• Determine the
110
effects of:
100
A. $90 price ceiling 90
B. $90 price floor 80 D
70
C. $120 price floor 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
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 Active Learning 1 A. $90 price ceiling
The market for
P
140 hotel rooms
The price falls to S
$90. (binding price 130
ceiling below the 120
equilibrium) 110
100
Buyers demand Price ceiling
90
120 rooms, sellers
supply 90, leaving a 80 D
shortage = 30
shortage. 70
60
50
40
0 Q
50 60 70 80 90 100 110 120 130
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 Active Learning 1 B. $90 price floor
The market for
P
140 hotel rooms
S
Equilibrium price is 130
above the $90 price 120
floor, so the price 110
floor is not binding. 100
Price floor
P = $100, 90
Q = 100 rooms. 80 D
70
60
50
40
0 Q
50 60 70 80 90 100 110 120 130
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 Active Learning 1 C. $120 price floor
The market for
P
140 hotel rooms
surplus = 60 S
The price rises to 130
$120. (binding price 120
floor above the Price floor
110
equilibrium) 100
Buyers demand 90
60 rooms, sellers 80 D
supply 120, causing 70
a surplus. 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
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 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

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 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)

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 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

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 EXAMPLE 3: The Market for Pizza

P
S1 Equilibrium
without tax
$10.00

D1

Q
500

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 A Tax on Buyers

Effects of a $1.50 per Hence, a tax on buyers

unit tax on buyers shifts the D curve down by
the amount of the tax.
P
The price buyers pay is now
S1
$1.50 higher than the market
$10.00 price P.
Tax
P would have to fall by $1.50
to make buyers willing to buy
$8.50
D1 same Q as before.
D2 • E.g., if P falls from $10.00
Q to $8.50, buyers are still
500
willing to purchase 500
pizzas.
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 A Tax on Buyers

Effects of a $1.50 per New equilibrium:

unit tax on buyers • Q = 450
P • Sellers receive
PS = $9.50
S1
PB = $11.00
Tax
• Buyers pay PB
$10.00 = $11.00
PS = $9.50 Difference
between them =
D1 $1.50 = tax
D2
Q
450 500

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 The Incidence of a Tax:
how the burden of a tax is shared among
market participants

P
In our
S1
example, PB = $11.00
Tax
buyers pay $10.00
$1.00 more, PS = $9.50
sellers get
$0.50 less. D1
D2
Q
450 500

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 A Tax on Sellers
Effects of a $1.50 per
The tax effectively raises
unit tax on sellers
sellers’ costs by $1.50
P per pizza.
S2
$11.50 Sellers will supply 500
Tax S1
pizzas only if P rises to
$10.00 $11.50, to compensate
for this cost increase.
Hence, a tax on sellers
shifts the S curve up by
D1 the amount of the tax.

Q
500

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 A Tax on Sellers

Effects of a $1.50 per

unit tax on sellers New equilibrium:
P • Q = 450
S2 • Buyers pay PB =
S1
PB = $11.00
Tax
$11.00
$10.00
• Sellers receive
PS = $9.50
PS = $9.50
Difference
D1 between them =
$1.50 = tax
Q
450 500

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 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! P
S1
PB = $11.00
Tax
$10.00
A tax drives PS = $9.50
a wedge between
the price buyers D1
pay and the price
sellers receive. 450 500 Q

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 Active Learning 2 Effects of a tax
The market for
The market for hotel P
140 hotel rooms
rooms is in equilibrium S
130
as in the graph.
120
• Suppose the 110
government 100
imposes a tax on
90
buyers of $30 per
80 D
room
70
• Find the new 60
Q, PB, PS, and 50
incidence of tax. 40
0 Q
50 60 70 80 90 100 110 120 130
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 Active Learning 2 Answers
The market for
P
140 hotel rooms
S
• Q = 80 130

• PB = $110 120
PB = 110
• PS = $80 100
Tax
• Incidence 90
PS = 80 D
– buyers: $10 70
– sellers: $20 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
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 Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand

P It’s easier for

sellers than
Buyers’ share PB S buyers to leave
of tax burden the market.
Tax
Price if no tax So buyers bear
most of the
Sellers’ share PS burden of the tax.
of tax burden
D
Q

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

It’s easier for

P
S buyers than
Buyers’ share sellers to leave
of tax burden PB the market.
Sellers bear most
Price if no tax
Tax of the burden of
Sellers’ share the tax.
of tax burden PS
D

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 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

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 CASE STUDY: Who Pays the Luxury Tax?
The market for
yachts
Demand is
P price-elastic.
S
Buyers’ share In the short run,
of tax burden PB
supply is inelastic.
Tax
Hence,
Sellers’ share companies
of tax burden PS that build
D
yachts pay
Q most of
the tax.

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 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?
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 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.
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 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.

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 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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