Chapter 6: Supply, Demand, and Government Policies

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Okay, let's unpack this.

Have you ever wondered why the price of an apartment in your city seems frozen or, you know, why there's a minimum wage for certain jobs?

Or maybe you felt the sting of a tax at the checkout counter and pondered who really pays for it.

Right.

These things aren't just random, are they?

Exactly.

They're often the direct result of governments stepping into the marketplace.

Today, we're diving deep into supply, demand, and government policies.

Our mission is to understand how these policies, things like price controls and taxes,

use the fundamental tools of supply and demand to shape market outcomes.

And often with surprising and sometimes unintended effects.

Absolutely.

We'll explore how economists, acting as both scientists and policy advisors, analyze these interventions.

What's fascinating here is how often policymakers, maybe with the best intentions,

enact measures that don't quite achieve what they wanted.

We'll use the powerful lens of supply and demand to sort of cut through the noise and reveal the true impact of these government actions on buyers and sellers alike.

And that raises a big question, doesn't it?

It does.

Can we really legislate away market forces or do they always find a way to, well, reassert themselves?

That's the core tension.

And first up, let's talk about price controls.

These are policies enacted when governments feel that the market price of a good or service is maybe too high for buyers or too low for sellers.

Exactly.

They come in two main flavors, price ceilings and price floors.

Right.

Think of our familiar ice cream market where the equilibrium price naturally settles at, say, $3 per cone.

But what if one group, like the American Association of Ice Cream Eaters, complains the price is too high?

Or the National Organization of Ice Cream Makers argues it's too low.

Precisely.

That's when lobbying begins and governments might consider stepping in with these controls.

So let's start with the first type, price ceilings.

That's a legal maximum on the price at which a good can be sold.

A cap, essentially.

Right, a cap.

Now, imagine the government imposes a price ceiling of $4 per cone,

but our natural equilibrium price is $3.

Well, that $3 is already below the $4 ceiling.

So?

So the ceiling isn't binding.

It has no effect.

The market just goes to its $3 equilibrium.

No drama there.

Okay, simple enough.

But here's where it gets really interesting.

What if the government imposes a price ceiling of $2 per cone?

Our equilibrium is $3, remember?

Ah, now that ceiling is below the equilibrium.

So it is binding.

The market price gets stuck at $2.

It can't legally go higher.

Okay, so the price is held down.

What happens then?

Well,

artificially low price, the quantity demanded, let's say 125 cones, is going to exceed the quantity supplied.

Maybe only 75 cones?

Ah, demand is higher than supply.

Which creates a significant shortage.

Here, 50 cones.

Suddenly, not everyone who wants ice cream at $2 can actually get it.

What does that make you think of?

Well, it means rationing.

Instead of prices doing the work, other, often less desirable mechanisms pop up.

Like what?

We're talking long lines, maybe sellers favoring friends, or even, unfortunately, discriminating based on personal biases.

Exactly.

So while some buyers get a lower price, which was the intention, they might face long waits.

And others get no ice cream at all.

It's a classic example of unintended consequences.

A really stark real world example of this was the 1973 gas crisis.

Oh yeah, I remember hearing about those lines.

When OPEC reduced crude oil production, the supply of gasoline shifted dramatically to the left, now in an unregulated market.

The price would have just gone up, right, to a new higher equilibrium, and there wouldn't have been a shortage, just higher prices.

Precisely.

But the US government had price ceilings on gasoline at the time.

And those ceilings weren't

Correct.

The equilibrium price was below them.

But when OPEC acted, shifting supply left, that existing price ceiling suddenly became binding.

Ah.

So the legal price was now below the new market clearing price.

Exactly.

At the regulated price, consumers wanted to buy far more gasoline than producers were willing to sell.

That led directly to severe shortages and those infamous long lines.

Wow.

Eventually, those regulations were repealed and prices adjusted, right?

They were.

It really shows how preventing prices from inflicting market realities can create major disruptions.

Another widespread example of a price ceiling is rent control.

The stated goal is usually to help the poor by making housing more affordable.

But economists often have, let's say, strong opinions on it.

One even called it the best way to destroy a city other than bombing.

That's quite a statement.

Why such a strong reaction?

Well, this policy's effects often unfold over time, revealing different impacts in the short run versus the long run.

Okay, let's break that down.

Short run first.

In the short run, both the supply and demand for apartments are relatively inelastic.

Landlords can't quickly build new units, right?

And people don't immediately change their living arrangements just because rent changes a bit.

Exactly.

So a rent control law initially causes only a relatively small shortage.

The main effect is just reduced rents for tenants who already have apartments.

Okay, seems okay so far.

But the long run.

Ah, in the long run, both supply and demand become much more elastic.

Landlords facing lower rents have less incentive to build new apartments or even maintain existing ones properly.

Makes sense.

Lower profit means less investment.

And on the demand side, lower rents encourage more people to seek their own apartments, maybe move out from their parents' place or move into the city from elsewhere.

So more demand, less supply incentive.

What does this all mean for the long term?

It means a much, much larger shortage of housing.

Okay.

And then what happens with rationing?

Landlords resort to those undesirable rationing methods again.

Long waiting lists, maybe favoring tenants without children, or even discrimination based on race or other factors.

And I've heard about under -the -table payments too.

Yes.

Essentially bribes or key money, pushing the effective price closer to the true market anyway.

People respond to incentives, right?

Always.

And when landlords can't command higher prices legally, their incentive to keep buildings clean and safe diminishes.

So you often end up with lower quality housing for tenants.

So it raises a big question about who actually benefits and what happens to the overall quality of housing stock.

Exactly.

And while policymakers might try to add more regulations against discrimination or for minimum living conditions.

Those are hard to enforce, I imagine.

Very hard and costly.

Which is why most economists, in fact, strongly disagree that rent control has a positive impact on creating or maintaining affordable housing in the long run.

Okay.

Let's switch gears.

Let's talk about the flip side.

Price floors.

These are a legal minimum on the price at which a good can be sold.

Right.

The opposite of a ceiling.

Back to our ice cream market.

If the government sets a price floor of $2 per cone and the equilibrium price is $3.

Then the floor is below the equilibrium.

So like the non -binding ceiling, it's not binding.

The market naturally settles at $3.

No big deal.

But if the government imposes a price floor of $4 per cone, which is above our $3 equilibrium.

Then this floor is binding.

The market price cannot legally fall below $4.

So what happens now?

Price is held up.

At this higher price, the quantity of ice cream supplied, say 120 cones,

exceeds the quantity demanded.

Perhaps only 80 cones.

Supply is greater than demand now.

Which results in a surplus.

Here, a surplus of 40 cones, sellers now find themselves with excess inventory they can't sell at the legal price.

And just like with shortages leading to non -price rationing.

Surplus is due to, in a way, sellers might appeal to personal biases to move their goods, maybe offer better deals to certain customers under the radar, or just have unsold stock piling up.

It contrasts with the free market where price is the impersonal rationing mechanism, right?

Allowing all sellers who want to sell at the equilibrium price to do so.

Exactly.

So what's the most significant example of a price floor in the real world?

That would have to be the minimum wage.

It dictates the lowest price employers can pay for labor.

Introduced presumably to ensure workers a minimally adequate standard of living.

The federal rate was $7 .25 an hour back in 2018, though many states and cities mandate higher rates now.

Correct.

And in the labor market, workers supply labor and firms demand it.

So if a minimum wage is set above the equilibrium wage for a certain type of labor.

It becomes a binding price floor.

And what does a binding price floor cause?

A surplus.

In the labor market, a surplus of labor means unemployment.

The quantity of labor supplied exceeds the quantity demanded at that wage.

So while some workers who keep their jobs benefit from higher wages.

Others, particularly those with fewer skills or less experience, might find themselves unable to find work at all.

And this largely affects markets for, say, teenage labor, where equilibrium wages might naturally be lower.

That's where much of the research focus is, yes.

Studies typically show that a 10 % increase in the minimum wage can depress teenage employment by maybe 1 to 3 % in the short run.

And potentially larger effects in the long run as firms adjust.

Potentially, yes.

Firms might automate more or adjust their business models.

The debate around the minimum wage is always intense, isn't it?

Absolutely.

Advocates argue it's vital for helping the working poor, pointing out how hard it is to live on minimum wage.

But opponents contend it's a poorly targeted policy.

Why?

They argue it causes unemployment, as we discussed.

It might encourage teenagers to drop out of school for higher -paying jobs they might not keep long term.

And crucially, many minimum wage earners aren't actually from poor households.

You mean like middle -class teenagers working part -time?

Exactly.

They argue the benefits don't necessarily flow to those who need them most.

A 2015 panel of economists showed mixed views on a $15 minimum wage leading to substantially lower employment for low -wage workers,

with a significant portion being uncertain.

Right.

There's debate among economists, too.

Some, like David Newmark, suggest that simply requiring higher wages doesn't work well against broader market forces like technological change and globalization.

And he pointed out that benefits often flow to higher -income families and that credible studies show negative employment effects.

Including something called labor -labor substitution.

Which is?

Where employers, forced to pay a higher minimum, might replace their lowest -skilled workers with slightly higher -skilled workers who they now think are worth the mandated wage.

So this analysis often leads to considering alternatives.

It does.

If we connect this to the bigger picture, many economists suggest policies like the Earned Income Tax Credit, or EITC, are more effective.

How does the EITC work?

It directly targets low -income working families and provides government subsidies added to their earnings.

It encourages work.

Without the potential adverse employment effects of a binding minimum wage.

Because it doesn't raise the cost of labor for employers.

Precisely.

It subsidizes wages rather than mandating a minimum firms must pay.

So evaluating these price controls overall?

Yeah.

What's the takeaway?

One of the core principles of economics is that markets are usually a good way to organize economic activity, right?

Yes.

And prices are the crucial signals in that organization, balancing supply and demand efficiently.

So when policymakers control prices by legal decree.

They obscure those vital signals.

They interfere with the market's natural coordination mechanism.

And while governments can sometimes improve market outcomes, and policymakers are often motivated by fairness.

Price controls frequently end up hurting the very people they intend to help.

Rent control aims for affordability, but leads to less available and lower quality housing.

Minimum wage laws aim to boost incomes but can cause job losses for the least skilled.

Right.

The takeaway seems to be that helping those in need can often be accomplished more effectively through other means.

Like direct rent subsidies instead of rent control.

Or wage subsidies like the EITC instead of minimum wage hikes.

These alternatives address affordability or low income.

Without distorting the market prices and creating those shortages or surpluses or unemployment.

Though it's important to note those subsidies do require government spending and ultimately hire taxes somewhere else.

Right.

Which brings us neatly to our second major topic.

Taxes.

All governments rely on taxes to fund public projects, services, and maybe influence market outcomes too.

Absolutely essential.

But the big question is, when a tax is levied on a good, who actually bears the burden?

Is it the buyers, the sellers, or is it shared?

This is where the concept of tax incidence comes in.

It's all about how the burden of a tax is distributed among the participants in a market.

And you mentioned it's often surprising.

Lawmakers' intentions don't always align with the market reality.

Very often, yes.

The market outcome can be quite different from who is legally assigned to pay the tax.

Okay.

Let's use our ice cream market again.

Suppose the government imposes a $1 .50 tax on sellers for every cone they sell.

How do we analyze this?

We can break it down in three steps.

Like we do with supply and demand shifts.

Step one, which curve is affected?

The immediate impact is on sellers.

The tax is on them.

So the supply curve is affected.

Demand curve stays put for now.

Okay.

Step two, how does the curve shift?

Since the tax raises the cost of selling ice cream, sellers will supply less at every given price.

It makes selling less profitable.

So the supply curve shifts left.

Or, more precisely, you can think of it as shifting upward by the exact amount of the tax, $0 .50.

To be willing to supply any given quantity, sellers now need a market price that's $0 .50 higher to cover the tax and get the same net amount as before.

Got it.

Step three, what's the new equilibrium?

After the supply curve shifts up or left, the equilibrium changes.

The equilibrium price of ice cream rises from, say, $3 to $3 .30.

And the quantity sold?

That falls.

Maybe from 100 cones to 90 cones.

The market for ice cream shrinks because of the tax.

Okay.

So price up, quantity down.

Now, the incidence, who pays?

Right.

Even though sellers are the ones sending the $1 .50 check to the government for each cone.

They don't bear the whole burden.

No.

Both buyers and sellers share the burden.

Look, buyers now pay $3 .30 instead of the original $3 .00.

They're worse off by $1 .30 per cone.

Okay.

Buyers pay $0 .30 more.

What about sellers?

Sellers receive $3 .30 from buyers, but then they have to pay the $1 .50 tax.

So they only get to keep $2 .80 net.

Which is less than the $3 they received before the tax.

Exactly.

They are worse off by $0 .20 per cone, $3 .20.

So in this case, buyers bear $0 .30 of the $0 .20, and sellers bear $0 .20.

It's shared.

This gives us two important lessons, then.

First, taxes discourage market activity the quantity sold went down.

Yep.

Markets shrink.

And second, buyers and sellers share the burden of taxes.

Buyers pay more, sellers receive less net.

That's the key takeaway.

Now, just to drive the point home, what if the tax is legally imposed on buyers instead?

Let's say buyers have to send $1 .50 to the government for every cone they buy.

Okay, same three steps.

Step one, who's immediately impacted?

This time, it's buyers.

So the demand curve is affected.

Supply curve stays put.

Right.

Step two, how does demand shift?

Because the tax makes buying ice cream less attractive, it adds to the count time.

The cost biders will demand a smaller quantity at every market price.

So the demand curve shifts left.

Yes.

Or you could think of it as shifting downward by the exact size of the tax, $0 .50.

To be willing to buy any given quantity, buyers now need the market price to be $1 .50 lower to offset the tax they have to pay.

Their total cost includes the price plus the tax.

Good sense.

Step three, new equilibrium.

With the demand curve shifted down or left, the equilibrium changes again.

The market price falls from $3 to $2 .80.

And the quantity falls.

Also falls, again, from 100 to 90 cones.

The market still shrinks.

Now let's look at the incidents again.

What's the price sellers receive?

Sellers receive the new market price, which is $2 .80.

And what's the total price buyers pay?

Buyers pay the market price of $2 .80.

Plus, they have to send the $1 .50 tax to the government.

So their total cost is $3 .30.

Wait a minute.

Sellers receive $2 .80 net.

Buyers pay $3 .30 total.

The quantity is 90.

That's exactly the same outcome as when the tax was on the sellers.

Precisely.

This is a crucial, often surprising conclusion.

Taxes levied on sellers and taxes levied on buyers are equivalent in terms of their market impact.

Wow.

In both scenarios, the tax creates a $1 .50 wedge between the price buyers ultimately pay, $3 .30, and the price sellers ultimately receive $2 .80.

And the burden is shared in the exact same way.

Dollars and 30 cents on buyers, $2 .20 on sellers in our example.

Regardless of who is legally required to send the money to the government.

The actual economic incidence depends on market forces, not the law specifying who pays.

This principle is clearly illustrated by something like a payroll tax, right?

Like FICA, which funds Social Security and Medicare.

Yes.

Congress legislated that firms and workers each technically pay half.

But our analysis shows that this legal division doesn't determine the true economic burden.

The payroll tax just places that wedge between the wage firms pay and the wage workers receive.

And the actual burden is shared between them based on the underlying elasticities of labor supply and labor demand, not the 50 -50 split written in the law.

Okay.

So we know the burden is shared and it's the same regardless of who the tax is levied on.

But how is it divided?

You said it's rarely 50 -50.

This is where elasticity comes back in.

Exactly.

Elasticity is key to understanding tax incidents.

And there's a general lesson here.

A tax burden falls more heavily on the side of the market that is less elastic.

Less elastic, meaning less responsive to price changes.

Right.

Why?

Because elasticity measures how willing buyers or sellers are to leave the market when conditions become unfavorable, like when a tax makes things more expensive or less profitable.

So the side with fewer alternatives, the side that's kind of stuck in the market.

They can't easily adjust their quantity demanded or supplied in response to the tax, so they end up bearing more of the burden.

The more elastic side can adjust more easily and avoids more of the tax.

Let's try to visualize this.

Imagine supply is very elastic, maybe a nearly flat supply curve, lots of flexibility for sellers,

but demand is relatively inelastic, a steep demand curve.

Maybe it's a necessity.

Okay.

Now, impose a tax.

Because supply is elastic, sellers can easily reduce quantity supplied if the price they receive falls much.

Because demand is inelastic, buyers will continue buying almost as much, even if the price rises significantly.

So the price buyers pay goes up a lot, but the price sellers receive doesn't fall much.

Exactly.

Buyers having fewer alternatives and being less responsive inelastic demand bear most of the tax burden.

Now flip it.

Suppose supply is inelastic, a steep supply curve.

Maybe it's hard for sellers to change production quickly, but demand is very elastic, a flat demand curve, lots of substitutes available for buyers.

Okay.

Inelastic supply, elastic demand, tax time.

Now, buyers have lots of alternatives, elastic demand.

So if the price they pay rises much, they'll just buy something else.

But sellers are stuck inelastic supply.

They can't easily reduce their quantity supplied, even if the price they receive falls.

So the price paid by buyers doesn't rise much.

But the price received by sellers falls substantially.

Here, sellers bear most of the burden because they're the less elastic side.

That makes sense.

Applying this to the payroll tax again.

Most labor economists believe the supply of labor, workers deciding how much to work, is much less elastic than the demand for labor, firms deciding how many workers to hire.

So workers are less responsive to wage changes than firms are.

Generally, yes, especially in the aggregate.

This means that workers rather than firms likely bear most of the burden of the payroll tax despite that legislative attempt at a 50 -50 split.

That's a really important implication.

It is.

And there is a perfect, if unfortunate, illustration of this whole elasticity and tax incidence principle with the 1990 luxury tax.

Ah, yes, I remember that.

On items like yachts, expensive cars, jewelry.

Exactly.

Congress intended to raise revenue from the rich who buy these luxury goods.

Seemed reasonable on the surface.

Tax the rich.

But the outcome was far different.

Think about the elasticities.

Demand for yachts.

Pretty elastic, I'd guess.

A millionaire deciding whether to buy a yacht has plenty of other ways to spend their money if yachts get too expensive.

Exactly.

Demand was quite elastic.

Now, what about the supply of yachts?

Probably relatively inelastic, especially in the short run.

You can't just instantly convert a yacht factory to something else.

And the specialized workers can't easily switch careers.

Precisely.

So we had elastic demand and inelastic supply.

Our analysis predicts.

The tax burden would fall largely on the suppliers, the side that's less elastic.

Which means the firms and workers who build the yachts.

And many of these workers were middle class, skilled laborers, not the wealthy buyers Congress was targeting.

So the tax ended up hurting the industry and its workers far more than the wealthy consumers.

That's exactly what happened.

Demand fell, orders were canceled, workers were laid off.

The tax raised very little revenue and caused significant harm to the industry.

It was largely repealed just a few years later in 1993.

Wow.

A powerful real world lesson about looking beyond intentions to actual economic effects driven by elasticity.

Indeed.

So as we wrap up this deep dive, we've seen how government policies, whether they're price controls or taxes,

fundamentally interact with the powerful laws of supply and demand.

They're common in our economy.

Absolutely.

And their effects are, as we've seen, frequently debated and often complex.

If we connect this to the bigger picture, it's clear that these policies, while often enacted with genuinely good intentions, can lead to complex, sometimes surprising, and even undesirable outcomes like shortages, surpluses, or an unequal distribution of tax burdens that might not match the legal intent.

Understanding the principles of supply and demand, especially elasticity, gives us the tools to analyze and evaluate these policies, revealing that market forces often find a way to make their presence felt, even when constrained by regulation.

It really makes you think about the ripple effects of any intervention, doesn't it?

The elegance of supply and demand as analytical tools can truly illuminate seemingly complex policy questions.

Showing us who might benefit, who might bear the cost, and whether the policy is likely to achieve its stated goals effectively.

We hope this deep dive has given you a clearer picture of how government policies impact markets.

Thank you for joining us.

From the Deep Dive team, we appreciate you tuning in.