Chapter 5: Using Supply and Demand – Government Intervention and Market Outcomes

Using Supply and Demand

Introduction

This chapter explores how the supply and demand model applies to real-world markets, especially when governments intervene through policies such as price ceilings, price floors, taxes, tariffs, quantity restrictions, and third-party-payer systems. Understanding these interventions is crucial for analyzing market outcomes and predicting changes in equilibrium price and quantity.

Supply and Demand in Real-World Events

Shifts in Supply and Demand

• Supply Curve: Shows the relationship between the price of a good and the quantity supplied.

• Demand Curve: Shows the relationship between the price of a good and the quantity demanded.

• Equilibrium: The point where quantity supplied equals quantity demanded.

• Shifts in supply or demand curves lead to changes in equilibrium price and quantity.

Application: Apples in the United States

• A drought in California caused a significant reduction in apple supply (supply curve shifts left).

• Result: Price of apples rises from $P_0$ to $P_1$, and equilibrium quantity falls from $Q_0$ to $Q_1$.

• Excess demand (shortage) occurs at the original price.

Application: Sand in the United States

• Increased demand for sand (demand curve shifts right) due to higher construction activity.

• Result: Price rises from $P_0$ to $P_1$, and equilibrium quantity increases from $Q_0$ to $Q_1$.

Application: Edible Oils in the World

• Growing middle class in developing countries increases demand for edible oils (demand shifts right).

• Simultaneously, U.S. farmers shift production from soy (source of edible oil) to corn, reducing supply (supply shifts left).

• Result: Price of edible oils increases.

Summary Table: Effects of Changes in Supply and Demand

The following table summarizes the effects of changes in supply and demand on equilibrium price (P) and quantity (Q):

	No change in Supply	Supply increases	Supply decreases
No change in Demand	P same Q same	P down Q up	P up Q down
Demand increases	P up Q up	P ambiguous Q up	P up Q ambiguous
Demand decreases	P down Q down	P down Q ambiguous	P ambiguous Q down

Government Intervention in Markets

Overview

While the 'invisible hand' of the market determines prices and quantities, governments often intervene for social or political reasons. Common interventions include:

• Price ceilings and price floors

• Excise taxes and tariffs

• Quantity restrictions

• Third-party-payer markets

Price Ceilings

A price ceiling is a government-imposed maximum price that can be charged for a good or service. Price ceilings are typically set below the equilibrium price to make goods more affordable for consumers.

• Price ceilings create shortages because the quantity demanded exceeds the quantity supplied at the ceiling price.

• When price is not allowed to rise to equilibrium, non-price rationing mechanisms (such as waiting lists or favoritism) may emerge.

Example: Rent Controls

• After WWII, many cities imposed rent controls (price ceilings) on housing.

• Result: Shortage of apartments, as the quantity demanded exceeds the quantity supplied at the controlled price.

• If rents were allowed to rise to equilibrium, the shortage would disappear.

Price Floors

A price floor is a government-imposed minimum price that must be paid for a good or service. Price floors are typically set above the equilibrium price to benefit suppliers.

• Price floors create surpluses because the quantity supplied exceeds the quantity demanded at the floor price.

Example: Minimum Wage

• The minimum wage is a price floor in the labor market.

• Result: Unemployment (surplus of labor), as more workers are willing to work at the higher wage than firms are willing to hire.

Excise Taxes and Tariffs

An excise tax is a tax levied on a specific good, while a tariff is an excise tax on imported goods. Both increase the cost of supplying the good, shifting the supply curve upward (or to the left).

• Result: Higher equilibrium prices and lower equilibrium quantities.

Example: Luxury Tax on Boats

• A $10,000 excise tax on boats shifts the supply curve up by the amount of the tax.

• The price paid by buyers rises, but by less than the full amount of the tax; the rest is absorbed by sellers.

Quantity Restrictions

Governments may limit the number of firms or individuals allowed to participate in a market by issuing licenses or permits. This restricts supply and can increase prices and wages in the restricted market.

• Result: Higher prices for goods/services and higher earnings for license holders.

Example: NYC Taxi Medallions

• New York City limits the number of taxi licenses (medallions).

• When demand for taxi services increases, wages and the price of medallions rise due to the fixed supply of licenses.

Third-Party-Payer Markets

In third-party-payer markets, the person who receives the good or service is not the person who pays for it (e.g., health care with insurance).

• Consumers pay only a portion of the cost (copayment), leading to higher quantity demanded than if they paid the full price.

• Total spending in the market is higher than what consumers alone would pay.

• Resources may be rationed through non-price mechanisms, such as waiting times or eligibility criteria.

Example: Health Care Markets

• With a copayment, consumers demand more health care units than if they paid the full price.

• Sellers require a higher total payment to supply the increased quantity, resulting in higher total expenditures.

Key Terms and Formulas

• Equilibrium Price and Quantity: The intersection of supply and demand curves.

• Price Ceiling: $P_{ceiling} < P_{equilibrium}$

• Price Floor: $P_{floor} > P_{equilibrium}$

• Excise Tax: Shifts supply curve up by the amount of the tax.

• Tariff: An excise tax on imports, also shifts supply curve up.

• Quantity Restriction: Limits supply, often resulting in higher prices.

• Third-Party-Payer: Consumer pays less than the full price, increasing quantity demanded.

Example Formula: Tax Incidence

• The division of a tax between buyers and sellers depends on the relative elasticities of supply and demand.

• General formula for the price paid by buyers after a tax:

$P_{buyers} = P_{equilibrium} + \frac{E_s}{E_s + |E_d|} \times Tax$

• Where $E_s$ is the price elasticity of supply and $E_d$ is the price elasticity of demand.

Additional info: The above formula is a simplified representation of tax incidence; actual calculations may require more detailed analysis depending on the market structure.