CHAPTER

2
The Market Forces of
Supply and Demand and Government
Policies

Economics
PRINCIPLES OF

Dr. Nguyen Anh Phuong

PhD, MSc, BA, FHEA

© 2009 South-Western, a part of Cengage Learning, all rights reserved

 Chapter Outline
§ Part 1: Definitions of market and competition
and Demand, Supply and Equilibrium
§ Part 2: Demand and Supply Elasticity
§ Part 3: Government Policies
§ Part 4: Consumer Surplus, Producer Surplus
and Total Surplus

2
PART 3: Government Policies

3
In this part,
look for the answers to these questions:
§ What are price ceilings and price floors?
What are some examples of each?
§ How do price ceilings and price floors affect
market outcomes?
§ How do taxes affect market outcomes?
How do the effects depend on whether
the tax is imposed on buyers or sellers?
§ What is the incidence of a tax?
What determines the incidence?
4
 Government Policies That Alter the
Private Market Outcome
§ Price controls
§ Price ceiling: a legal maximum on the price
of a good or service Example: rent control
§ Price floor: a legal minimum on the price of
a good or service Example: minimum wage
§ Taxes
§ The govt can make buyers or sellers pay a specific
amount on each unit bought/sold.
We will use the supply/demand model to see
how each policy affects the market outcome
(the price buyers pay, the price sellers receive, and
eq’m quantity).
5
EXAMPLE 1: The Market for Apartments

Rental P S
price of
apts

$800
Eq’m w/o
price
controls
D
Q
300
Quantity of
apartments
6
How Price Ceilings Affect Market Outcomes
A price ceiling P S
above the Price
eq’m price is $1000
ceiling
not binding –
has no effect $800
on the market
outcome.

D
Q
300

7
How Price Ceilings Affect Market Outcomes
The eq’m price P S
($800) is above
the ceiling and
therefore illegal.
$800
The ceiling
is a binding Price
$500
constraint ceiling
on the price, shortage
D
causes a Q
250 400
shortage.

8
How Price Ceilings Affect Market Outcomes

In the long run, P S

supply and
demand
are more $800
price-elastic.
Price
So, the $500
ceiling
shortage shortage
is larger. D
Q
150 450

9
 Shortages and Rationing
§ With a shortage, sellers must ration the goods
among buyers.
§ Some rationing mechanisms: (1) Long lines
(2) Discrimination according to sellers’ biases
§ These mechanisms are often unfair, and inefficient:
the goods do not necessarily go to the buyers who
value them most highly.
§ In contrast, when prices are not controlled,
the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal (and thus fair).
10
EXAMPLE 2: The Market for Unskilled Labor

Wage W S
paid to
unskilled
workers
$4

Eq’m w/o
price
controls
D
L
500
Quantity of
unskilled workers
11
 How Price Floors Affect Market Outcomes
A price floor W S
below the
eq’m price is
not binding –
has no effect $4
on the market Price
outcome. $3
floor

D
L
500

12
How Price Floors Affect Market Outcomes
labor
The eq’m wage ($4) W surplus S
is below the floor Price
$5
and therefore floor
illegal.
$4
The floor
is a binding
constraint
on the wage,
D
causes a L
400 550
surplus (i.e.,
unemployment).

13
 The Minimum Wage
Min wage laws unemp-
do not affect W loyment S
Min.
highly skilled $5
wage
workers.
They do affect $4
teen workers.
Studies:
A 10% increase
in the min wage D
L
raises teen 400 550
unemployment
by 1-3%.
14
ACTIVE LEARNING 1
Price controls The market for
P
140 hotel rooms
S
130
Determine
120
effects of:
110
A. $90 price 100
ceiling 90
B. $90 price 80 D
floor 70
60
C. $120 price
floor 50
40
0 Q
50 60 70 80 90 100 110 120 130
15
 Evaluating Price Controls
§ Recall one of the Ten Principles from Chapter 1:
Markets are usually a good way
to organize economic activity.
§ Prices are the signals that guide the allocation of
society’s resources. This allocation is altered
when policymakers restrict prices.
§ Price controls often intended to help the poor,
but often hurt more than help.

16
 Taxes
§ The govt levies taxes on many goods & services
to raise revenue to pay for national defense,
public schools, etc.
§ The govt can make buyers or sellers pay the tax.
§ The tax can be a % of the good’s price,
or a specific amount for each unit sold.
§ For simplicity, we analyze per-unit taxes only.

17
EXAMPLE 3: The Market for Pizza

Eq’m
P
w/o tax
S1

$10.00

D1

Q
500

18
 A Tax on Buyers
The price
Hence, buyers
a tax pay
on buyers Effects of a $1.50 per
is nowthe
shifts $1.50 higher
D curve than
down unit tax on buyers
the market
by the price
amount ofP.
the tax. P
P would have to fall S1
by $1.50 to make
buyers willing $10.00
Tax
to buy same Q
as before. $8.50
E.g., if P falls D1
from $10.00 to $8.50, D2
buyers still willing to Q
500
purchase 500 pizzas.

19
 A Tax on Buyers
New eq’m: Effects of a $1.50 per
unit tax on buyers
Q = 450 P
Sellers S1
receive PB = $11.00
Tax
PS = $9.50 $10.00
Buyers pay PS = $9.50
PB = $11.00
D1
Difference
between them D2
Q
= $1.50 = tax 450 500

20
The Incidence of a Tax:
how the burden of a tax is shared among
market participants
P
In our
S1
example, PB = $11.00
Tax
buyers pay $10.00
$1.00 more, PS = $9.50
sellers get
$0.50 less. D1
D2
Q
450 500

21
 A Tax on Sellers
The tax effectively raises Effects of a $1.50 per
sellers’ costs by unit tax on sellers
P S2
$1.50 per pizza. $11.50
Tax S1
Sellers will supply
500 pizzas
$10.00
only if
P rises to $11.50,
to compensate for
D1
this cost increase.

Hence, a tax on sellers shifts the Q

S curve up by the amount of the tax. 500

22
 A Tax on Sellers
New eq’m: Effects of a $1.50 per
unit tax on sellers
Q = 450 P S2
Buyers pay S1
PB = $11.00 PB = $11.00
Tax
Sellers $10.00
receive PS = $9.50
PS = $9.50
D1
Difference
between them
Q
= $1.50 = tax 450 500

23
The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!

What matters P
is this: S1
PB = $11.00
Tax
A tax drives $10.00
a wedge PS = $9.50
between the
price buyers D1
pay and the
price sellers
Q
receive. 450 500

24
ACTIVE LEARNING 2
Effects of a tax The market for
P
140 hotel rooms
Suppose govt S
130
imposes a tax
120
on buyers of
110
$30 per room.
100
Find new 90
Q, PB, PS, 80 D
and incidence 70
of tax. 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
25
 Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand

P It’s easier
for sellers
PB S than buyers
Buyers’ share
of tax burden
to leave the
Tax market.
Price if no tax So buyers
Sellers’ share PS bear most of
of tax burden the burden
D
of the tax.
Q

26
 Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply

P It’s easier
S for buyers
Buyers’ share than sellers
of tax burden PB to leave the
market.
Price if no tax
Tax Sellers bear
Sellers’ share most of the
of tax burden PS burden of
D the tax.
Q

27
CASE STUDY: Who Pays the Luxury Tax?
§ 1990: Congress adopted a luxury tax on yachts,
private airplanes, furs, expensive cars, etc.
§ Goal of the tax: raise revenue from those
who could most easily afford to pay –
wealthy consumers.
§ But who really pays this tax?

28
CASE STUDY: Who Pays the Luxury Tax?

The market for yachts Demand is

price-elastic.
P
S
In the short run,
Buyers’ share
of tax burden PB supply is inelastic.

Tax Hence,
companies
Sellers’ share
that build
of tax burden PS
D
yachts pay
most of
Q the tax.

29
 CONCLUSION: Government Policies and
the Allocation of Resources
§ Each of the policies in this chapter affects the
allocation of society’s resources.
§ Example 1: A tax on pizza reduces eq’m Q.
With less production of pizza, resources
(workers, ovens, cheese) will become available
to other industries.
§ Example 2: A binding minimum wage causes
a surplus of workers, a waste of resources.
§ So, it’s important for policymakers to apply such
policies very carefully.
30
PART 3’S SUMMARY

§ A price ceiling is a legal maximum on the price of a

good. An example is rent control. If the price
ceiling is below the eq’m price, it is binding and
causes a shortage.
§ A price floor is a legal minimum on the price of a
good. An example is the minimum wage. If the
price floor is above the eq’m price, it is binding
and causes a surplus. The labor surplus caused
by the minimum wage is unemployment.

31
PART 3’S SUMMARY

§ A tax on a good places a wedge between the price

buyers pay and the price sellers receive, and
causes the eq’m quantity to fall, whether the tax is
imposed on buyers or sellers.
§ The incidence of a tax is the division of the burden
of the tax between buyers and sellers, and does
not depend on whether the tax is imposed on
buyers or sellers.
§ The incidence of the tax depends on the price
elasticities of supply and demand.
32
Part 4: Consumer Surplus,
Producer Surplus and Total
Surplus

33
In this part,
look for the answers to these questions:

§ What is consumer surplus? How is it related to the

demand curve?
§ What is producer surplus? How is it related to the
supply curve?
§ Do markets produce a desirable allocation of
resources? Or could the market outcome be
improved upon?

34
 Welfare Economics
§ Recall, the allocation of resources refers to:
§ how much of each good is produced
§ which producers produce it
§ which consumers consume it
§ Welfare economics studies how the allocation
of resources affects economic well-being.
§ First, we look at the well-being of consumers.

35
 Willingness to Pay (WTP)
A buyer’s willingness to pay for a good is the
maximum amount the buyer will pay for that good.
WTP measures how much the buyer values the good.

name WTP Example:

4 buyers’ WTP
Anthony $250
for an iPod
Chad 175
Flea 300
John 125

36
 WTP and the Demand Curve
Q: If price of iPod is $200, who will buy an iPod, and
what is quantity demanded?

A: Anthony & Flea will buy an iPod,

Chad & John will not.
name WTP
Hence, Qd = 2
Anthony $250 when P = $200.
Chad 175
Flea 300
John 125

37
 WTP and the Demand Curve
Derive the
P (price
demand who buys Qd
of iPod)
schedule:
$301 & up nobody 0

name WTP 251 – 300 Flea 1

Anthony $250 176 – 250 Anthony, Flea 2

Chad 175 Chad, Anthony,
126 – 175 3
Flea
Flea 300
John, Chad,
John 125 0 – 125 4
Anthony, Flea

38
 WTP and the Demand Curve
P
$350
P Qd
$300
$250 $301 & up 0

$200 251 – 300 1

$150 176 – 250 2
$100
126 – 175 3
$50
0 – 125 4
$0 Q
0 1 2 3 4
39
 About the Staircase Shape…
P This D curve looks like a staircase
$350 with 4 steps – one per buyer.
$300 If there were a huge # of buyers,
as in a competitive market,
$250
there would be a huge #
$200
of very tiny steps,
$150 and it would look
$100 more like a smooth
curve.
$50
$0 Q
0 1 2 3 4
40
 WTP and the Demand Curve
P At any Q,
Flea’s
$350 WTP the height of
$300 Anthony’s the D curve is
WTP the WTP of the
$250 Chad’s WTP marginal buyer,
John’s
$200 the buyer who
WTP
$150 would leave the
market if P were
$100 any higher.
$50
$0 Q
0 1 2 3 4
41
 Consumer Surplus (CS)
Consumer surplus is the amount a buyer is willing
to pay minus the amount the buyer actually pays:
CS = WTP – P

Suppose P = $260.
name WTP
Flea’s CS = $300 – 260 = $40.
Anthony $250
The others get no CS because
Chad 175
they do not buy an iPod at this
Flea 300 price.
John 125 Total CS = $40.

42
 CS and the Demand Curve
P
Flea’s P = $260
$350 WTP Flea’s CS =
$300 $300 – 260 = $40
$250 Total CS = $40
$200
$150
$100
$50
$0 Q
0 1 2 3 4
43
 CS and the Demand Curve
P
Flea’s Instead, suppose
$350 WTP P = $220
$300 Anthony’s
WTP Flea’s CS =
$250 $300 – 220 = $80
$200 Anthony’s CS =
$250 – 220 = $30
$150
Total CS = $110
$100
$50
$0 Q
0 1 2 3 4
44
 CS and the Demand Curve
P
$350 The lesson:
Total CS equals
$300
the area under
$250 the demand curve
$200 above the price,
from 0 to Q.
$150
$100
$50
$0 Q
0 1 2 3 4
45
CS with Lots of Buyers & a Smooth D Curve
At Q = 5(thousand),
Price P The demand for shoes
the marginal buyer
per pair
$ 60
is willing to pay $50
for pair of shoes. 50
Suppose P = $30. 40
Then his consumer 30
surplus = $20. 1000s of pairs
20 of shoes
10
D
0 Q
0 5 10 15 20 25 30
46
CS with Lots of Buyers & a Smooth D Curve
CS is the area b/w The demand for shoes
P
P and the D curve,
from 0 to Q. $ 60

Recall: area of 50
h
a triangle equals 40
½ x base x height
30
Height =
20
$60 – 30 = $30.
10
So, D
CS = ½ x 15 x $30 0 Q
= $225. 0 5 10 15 20 25 30
47
 How a Higher Price Reduces CS
If P rises to $40,
P
CS = ½ x 10 x $20 1. Fall in CS
60 due to buyers
= $100.
50 leaving market
Two reasons for the
fall in CS. 40
30

2. Fall in CS due to 20
remaining buyers
10
paying higher P D
0 Q
0 5 10 15 20 25 30
48
 ACTIVE LEARNING 1
Consumer surplus demand curve
P
50
A. Find marginal $ 45
buyer’s WTP at 40
Q = 10.
35
B. Find CS for
30
P = $30.
25
Suppose P falls to $20.
20
How much will CS
increase due to… 15
10
C. buyers entering
the market 5
D. existing buyers 0
paying lower price 0 5 10 15 20 Q
25
49
 Cost and the Supply Curve
§ Cost is the value of everything a seller must give
up to produce a good (i.e., opportunity cost).
§ Includes cost of all resources used to produce
good, including value of the seller’s time.
§ Example: Costs of 3 sellers in the lawn-cutting
business.
name cost A seller will produce and sell
the good/service only if the
Jack $10 price exceeds his or her cost.
Janet 20
Hence, cost is a measure of
Chrissy 35 willingness to sell.
50
 Cost and the Supply Curve

P Qs
Derive the supply schedule
from the cost data: $0 – 9 0

10 – 19 1

20 – 34 2
name cost
35 & up 3
Jack $10
Janet 20
Chrissy 35
51
 Cost and the Supply Curve
P
$40 P Qs

$0 – 9 0
$30
10 – 19 1
$20
20 – 34 2

$10 35 & up 3

$0 Q
0 1 2 3
52
 Cost and the Supply Curve
P
At each Q,
$40
Chrissy’ the height of
s the S curve
$30 cost is the cost of the
Janet’s marginal seller,
$20 cost the seller who
would leave
$10 Jack’s cost the market if
the price were
$0 Q any lower.
0 1 2 3
53
 Producer Surplus
P PS = P – cost
$40 Producer surplus (PS):
the amount a seller
$30 is paid for a good
minus the seller’s cost
$20

$10

$0 Q
0 1 2 3
54
 Producer Surplus and the S Curve
P PS = P – cost
$40 Suppose P = $25.
Chrissy’
s Jack’s PS = $15
$30 cost
Janet’s Janet’s PS = $5
$20 cost Chrissy’s PS = $0

$10 Jack’s cost Total PS = $20

Total PS equals the

$0 Q area above the supply
0 1 2 3 curve under the price,
from 0 to Q.
55
PS with Lots of Sellers & a Smooth S Curve
Suppose P = $40.
Price P The supply of shoes
per pair
At Q = 15(thousand), 60
the marginal seller’s
50 S
cost is $30,
40
and her producer
surplus is $10. 30
1000s of pairs
20 of shoes
10
0 Q
0 5 10 15 20 25 30
56
PS with Lots of Sellers & a Smooth S Curve
PS is the area b/w The supply of shoes
P
P and the S curve,
from 0 to Q. 60
50 S
The height of this
triangle is 40
$40 – 15 = $25.
30
So, h
20
PS = ½ x b x h
= ½ x 25 x $25 10
= $312.50 0 Q
0 5 10 15 20 25 30
57
 How a Lower Price Reduces PS
If P falls to $30, P 1. Fall in PS
PS = ½ x 15 x $15 60 due to sellers
= $112.50 50
leaving market S
Two reasons for 40
the fall in PS.
30

2. Fall in PS due to 20
remaining sellers 10
getting lower P
0 Q
0 5 10 15 20 25 30
58
ACTIVE LEARNING 2
Producer surplus supply curve
P
50
A. Find marginal
45
seller’s cost
at Q = 10. 40
35
B. Find total PS for
P = $20. 30
25
Suppose P rises to $30.
20
Find the increase
in PS due to… 15
C. selling 5 10
additional units 5
D. getting a higher price 0
on the initial 10 units 0 5 10 15 20 Q
25
59
 CS, PS, and Total Surplus
CS = (value to buyers) – (amount paid by buyers)
= buyers’ gains from participating in the market

PS = (amount received by sellers) – (cost to sellers)

= sellers’ gains from participating in the market

Total surplus = CS + PS
= total gains from trade in a market
= (value to buyers) – (cost to sellers)

60
The Market’s Allocation of Resources
§ In a market economy, the allocation of resources
is decentralized, determined by the interactions
of many self-interested buyers and sellers.
§ Is the market’s allocation of resources desirable?
Or would a different allocation of resources make
society better off?
§ To answer this, we use total surplus as a measure
of society’s well-being, and we consider whether
the market’s allocation is efficient.
(Policymakers also care about equality, though are
focus here is on efficiency.)
61
 Efficiency
Total
surplus = (value to buyers) – (cost to sellers)

An allocation of resources is efficient if it maximizes

total surplus. Efficiency means:
§ The goods are consumed by the buyers who
value them most highly.
§ The goods are produced by the producers with the
lowest costs.
§ Raising or lowering the quantity of a good
would not increase total surplus.

62
 Evaluating the Market Equilibrium
Market eq’m: P
P = $30
60
Q = 15,000
50 S
Total surplus
= CS + PS 40 CS
Is the market eq’m 30
efficient? PS
20
10
D
0 Q
0 5 10 15 20 25 30
63
 Which Buyers Consume the Good?
Every buyer P
whose WTP is
60
≥ $30 will buy.
50 S
Every buyer
whose WTP is 40
< $30 will not. 30
So, the buyers 20
who value the
10
good most highly D
are the ones who 0 Q
consume it. 0 5 10 15 20 25 30
64
 Which Sellers Produce the Good?
Every seller whose P
cost is ≤ $30 will
60
produce the good.
50 S
Every seller whose
cost is > $30 will 40
not. 30
So, the sellers with 20
the lowest cost
produce the good. 10
D
0 Q
0 5 10 15 20 25 30
65
Does Eq’m Q Maximize Total Surplus?
At Q = 20,
P
cost of producing
60
the marginal unit
is $35 50 S
value to consumers 40
of the marginal unit
is only $20 30
Hence, can increase 20
total surplus
10
by reducing Q. D
This is true at any Q 0 Q
greater than 15. 0 5 10 15 20 25 30
66
Does Eq’m Q Maximize Total Surplus?
At Q = 10,
P
cost of producing
60
the marginal unit
is $25 50 S
value to consumers 40
of the marginal unit
is $40 30
Hence, can increase 20
total surplus
10
by increasing Q. D
This is true at any Q 0 Q
less than 15. 0 5 10 15 20 25 30
67
Does Eq’m Q Maximize Total Surplus?
The market P
eq’m quantity 60
maximizes 50 S
total surplus:
At any other 40
quantity, 30
can increase
20
total surplus by
moving toward 10
D
the market eq’m 0 Q
quantity. 0 5 10 15 20 25 30
68
Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
“Man has almost constant occasion
for the help of his brethren, and it is
vain for him to expect it from their
benevolence only. He will be more
likely to prevail if he can interest their
self-love in his favor, and show them
that it is for their own advantage to do
for him what he requires of them…
It is not from the benevolence of the
butcher, the brewer, or the baker that
Adam Smith,
we expect our dinner, but from their
1723-1790
regard to their own interest….
69
Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
“Every individual…neither intends to
promote the public interest, nor knows
how much he is promoting it….
He intends only his own gain, and he is
in this, as in many other cases, led by
an invisible hand to promote an end
which was no part of his intention.
Nor is it always the worse for the society
that it was no part of it. By pursuing his
own interest he frequently promotes
Adam Smith,
that of the society more effectually than
1723-1790
when he really intends to promote it.”
70
The Free Market vs. Govt Intervention
§ The market equilibrium is efficient. No other
outcome achieves higher total surplus.
§ Govt cannot raise total surplus by changing the
market’s allocation of resources.
§ Laissez faire (French for “allow them to do”):
the notion that govt should not interfere with the
market.

71
The free market vs. central planning
§ Suppose resources were allocated not by the
market, but by a central planner who cares about
society’s well-being.
§ To allocate resources efficiently and maximize total
surplus, the planner would need to know every
seller’s cost and every buyer’s WTP for every
good in the entire economy.
§ This is impossible, and why centrally-planned
economies are never very efficient.

72
 CONCLUSION
§ This chapter used welfare economics to
demonstrate one of the Ten Principles:
Markets are usually a good way to
organize economic activity.
§ Important note:
We derived these lessons assuming
perfectly competitive markets.
§ In other conditions we will study in later chapters,
the market may fail to allocate resources
efficiently…

73
 CONCLUSION
§ Such market failures occur when:
§ a buyer or seller has market power – the ability to
affect the market price.
§ transactions have side effects, called externalities,
that affect bystanders. (example: pollution)
§ We’ll use welfare economics to see how public
policy may improve on the market outcome in such
cases.
§ Despite the possibility of market failure, the analysis
in this chapter applies in many markets, and the
invisible hand remains extremely important.

74
PART 4’S SUMMARY

§ The height of the D curve reflects the value of the

good to buyers—their willingness to pay for it.
§ Consumer surplus is the difference between what
buyers are willing to pay for a good and what they
actually pay.
§ On the graph, consumer surplus is the area
between P and the D curve.

75
PART 4’S SUMMARY

§ The height of the S curve is sellers’ cost of

producing the good. Sellers are willing to sell if the
price they get is at least as high as their cost.
§ Producer surplus is the difference between what
sellers receive for a good and their cost of
producing it.
§ On the graph, producer surplus is the area
between P and the S curve.

76
PART 4’S SUMMARY

§ To measure of society’s well-being, we use

total surplus, the sum of consumer and producer
surplus.
§ Efficiency means that total surplus is maximized,
that the goods are produced by sellers with lowest
cost, and that they are consumed by buyers who
most value them.
§ Under perfect competition, the market outcome is
efficient. Altering it would reduce total surplus.
77
PART 4’S SUMMARY

§ To measure of society’s well-being, we use

total surplus, the sum of consumer and producer
surplus.
§ Efficiency means that total surplus is maximized,
that the goods are produced by sellers with lowest
cost, and that they are consumed by buyers who
most value them.
§ Under perfect competition, the market outcome is
efficient. Altering it would reduce total surplus.
78
 References
§ Mankiw, G. (2015). Principles of
Microeconomics, 6th ed. Cengage

79