Lecture VI: Supply and Demand in Practice

I. Price Controls

A. Price Ceiling

i. in theory Price Ceiling – an upper limit set on a price

Supply Curve (S)

Not binding PC

Excess demand - shortage

Binding PC Demand Curve (D)

QD* QE QS*

- if set above equilibrium, not binding

- if set below equilibrium, it is binding

Binding – a price control is said to be “binding” or effective if it keeps the price in the market from reaching the equilibrium price level

Results of a binding price ceiling is a SHORTAGE

- the government is the economic agency that can legally set price controls and hinder the natural market processes

ii. Application – rent control

IMPACT of Binding Rent Controls

a. - shortage – excess demand

b. - black markets or underground market transactions

c. - entrance fees – people getting kicked out a lot

d. - higher search costs for apartments since there is a shortage

e. - declines in the quality and maintenance of rental housing

f. - large deserted apartment complexes in inner cities

g. - future supply will decline – no incentive for new construction

h. – the creation of a rent control regulator commission

B. Price Floor – a lower limit set on a price

i. in theory

Supply Curve (S)

Binding PF

Excess supply - surplus

Not Binding PF Demand Curve (D)

QD* QE QS*

- if set above equilibrium, binding

Results in a surplus

ii. an application – the minimum wage

8/98 Congress passed a law to raise the minimum wage to $5.25

Impact of Price Floors

II. Excise Taxes – a tax imposed on some specific good

When these taxes are imposed on imported goods they are called tariffs

Tariff – a tax on some specific imported good

Consider a standard supply/demand framework for luxury boats in the US

P (S1)

$70,000 (S0)

$65,000 $10,000

$60,000

(D)

QET QE

- suppose that an excise tax of $10,000 per boat is imposed by the government and collected from the supplier

- the producer will view this tax as a $10,000 increase in the cost of production

- the supply curve will shift up by $10,000, the direction of the price (the vertical axis)

- if the initial equilibrium price is $60,000, the producer would like the new equilibrium price to be $70,000 so they can pass the entire amount of the tax to the consumer

- but with the interaction of supply and demand, the new equilibrium turns out to be at $65,000. This means only half of the tax burden could be passed off to consumers

- the tax results in a higher equilibrium price and a lower equilibrium quantities

III. Quotas – sometimes the gov’t alters the market process by limiting the amount of foreign goods that can be imported into the US

Quota: a quantitative restriction on the amount that one country can export to another

P Quota

(S0)

Surplus (?)

PmE

(D)

QQ QE

A quota acts as a fence that prevents the market from moving to the right on the quantity axis

RESULT:

A higher price than market equilibrium

A lower quantity than market equilibrium