Supply Demand and Government policies

Economists have two roles. As scientists, they develop and test theories to explain the world around them. As policy advisers, they use their theories to help change the world for the better. We have seen how supply and demand determining the price of a good and the quantity of the good sold. We have also seen how various events shift supply and demand and thereby change the equilibrium price and quantity.

Here we analyze various types of government policy using only the tools of supply and demand. As you will see, the analysis yields some surprising insights. Policies often have effects that their architects did not intend or anticipate.

We begin by considering policies that directly control prices. For example, rent control laws dictate a maximum rent that landlords may charge tenants. Minimum wage laws dictate the lowest wage that firms may pay workers. Price controls are usually enacted when policy makers believe that the market price of a good or service is unfair to buyers or sellers. Yet, as we will see, these policies can generate inequities of their own.

After our discussion of price controls, we next consider the impact of taxes. Policymakers use taxes both to influence market outcomes and to raise revenue for public purposes. Although the prevalence of taxes in our economy is obvious, their effects are not. For example, when the government levies a tax on the amount that firms pay their workers, do the firms or the workers bear the burden of the tax? The answer is not at all clear until we apply the powerful tools of supply and demand.

Controls on Prices:

To see how price controls affect market outcomes, let’s look at the market for ice cream. If ice cream is sold in a competitive market free of government regulation, the price of ice cream adjusts to balance supply and demand. At the equilibrium price, the quantity of ice cream that buyers want to buy exactly equals the quantity that sellers want to sell. To be concrete, suppose the equilibrium price is $3 per cone.

Not everyone may be happy with the outcome of this free market process. Let’s say the American association of Ice cream Eaters complains that the $3 price is too high for everyone to enjoy a cone a day (their recommended diet). Meanwhile, the National Organization of Ice Cream makers complain that the $3 price – the result of cut throat competition – is too low and is depressing the incomes of its members. Each of these groups lobbies the government to pass laws that alter the market outcome by directly controlling the price of an ice cream cone.

Of course, because buyers of any good always want a lower price while sellers want a higher price, the interests of the two groups conflict. If the Ice cream eaters are successful in their lobbying, the government imposes a legal maximum on the price at which ice cream can be sold. Because the price is not allowed to rise above this level, the legislated maximum is called a price ceiling. By contrast, if the Ice cram makers are successful, the government imposes a legal minimum on the price. Because the price cannot fall below this level, the legislated minimum is called a price floor. Let us consider the effects of these policies.

How Price ceilings affect market outcomes

Price ceilings 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.

When the government, moved by the complaints and campaign contributions of the Ice Cream eaters, imposes a price ceiling on the market for ice cream, two outcomes are possible. If the government imposes a price ceiling of $4 per cone — In this case, because the price that balances supply and demand ($3) is below the ceiling, the price ceiling is not binding. Market forces naturally move the economy to the equilibrium, and price ceiling has no effect on the price or the quantity sold.

When shortage of ice cream develops because of this price ceiling, some mechanism for rationing ice cream will naturally develop. The mechanism could be long lines: Buyers who are willing to arrive early and wait in line get a cone, but those unwilling to wait do not. Alternatively, sellers could ration ice cream according to their own personal biases, selling it only to friends, relatives, or members of their own racial or ethnic group. Notice that even though the price ceiling was motivated by a desire to help buyers of ice cream, not all buyers benefit from the policy. Some buyers do get to pay a lower price, although they may have to wait in line to do so, but other buyers cannot get any ice cream at all.

This example in the market for ice cream shows a general result: when the government imposes a binding price ceiling on a competitive market, a shortage of the good arises, and sellers must ration the scarce good among the large number of potential buyers. The rationing mechanisms that develop under price ceilings are rarely desirable. Long lines are inefficient because they waste buyers’ time. Discrimination according to seller bias is both inefficient (because the good does not necessarily go to the buyer who values it most highly) and potentially unfair. By contrast, the rationing mechanism in a free, competitive market is both efficient and impersonal. When the market for ice cream reaches its equilibrium, anyone who wants to pay the market price can get a cone.