Chapter 6: Supply, Demand, and Government Policies

Price ceilings, established below equilibrium price to protect consumers in markets like housing or energy, generate persistent shortages because the quantity supplied falls below the quantity demanded. These shortages force markets to develop alternative rationing mechanisms including lengthy waiting periods, discriminatory practices, or informal side payments, none of which allocate goods efficiently or fairly. Historical examples such as gasoline shortages during the 1970s energy crisis and the deterioration of rental housing stock under long-term rent control regulations demonstrate why economists largely oppose such policies despite their appeal to those seeking price relief. Price floors operate inversely by setting minimum legal prices above equilibrium, creating surpluses when suppliers cannot sell all they produce. In labor markets, minimum wage laws exemplify this dynamic by establishing wage floors that price some workers out of employment, with empirical evidence indicating teenage employment proves particularly sensitive to wage increases. The chapter contrasts these blunt policy instruments with more targeted alternatives like the Earned Income Tax Credit, which supplements earnings for low-income workers without distorting market quantities. The analysis then shifts to taxation, revealing that taxes create a wedge between what buyers pay and what sellers receive, shrinking market activity below efficient levels. Rather than assuming tax burdens fall on those legally required to remit payments, the chapter introduces tax incidence analysis, which demonstrates that burden distribution depends on the relative price elasticity of supply and demand curves. The side of the market with less elastic responses bears proportionally greater tax burden, a principle illustrated through payroll taxes falling predominantly on workers due to inelastic labor supply, and luxury taxes generating unexpected harm to middle-class producers while leaving wealthy consumers largely unaffected. Throughout, the chapter emphasizes that effective governance requires understanding how policies reshape market incentives and behavior patterns rather than simply assuming intended effects materialize.