2. • In a free market system, market forces
establish equilibrium prices and
exchange quantities.
• One of the roles of economists is to
develop theories to assist in the
development
of policies.
3. Controls on Prices
• Buyers always want lower prices, while
sellers want higher prices.
• Thus, interests of these two groups conflict.
• Controls on prices are usually enacted when
policymakers believe the market price is
unfair to buyers or sellers.
• For this government creates price ceilings
and price floors.
4. Controls on Prices
Cont…
• Price Ceiling:
– 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.
5. Controls on Prices
Cont…
How Price Ceilings Affect Market Outcomes:
• When govt. imposes price ceiling, following
two outcomes are possible:
1. If price is set above the equilibrium price,
price ceiling is not binding .
• Price ceiling has no effect on the price or
quantity sold .
6. Price Ceiling that is NOT BINDING
Price
Supply
P2 Price
Ceiling
P1
Equilibrium
Price
Demand
0 Q Quantity
Equilibrium
Quantity
7. Controls on Prices
Cont…
How Price Ceilings Affect Market Outcomes (Cont.):
2. If price is set below the equilibrium price,
price ceiling is a binding constraint.
• The forces of demand and supply move price
towards equilibrium price.
• But when market price hits the ceiling, it can rise
no further.
• Thus, market price equals price ceiling.
• At this price, quantity demanded exceeds
quantity supplied, creating shortage for
the good.
9. Controls on Prices
Cont…
How Price Ceilings Affect Market Outcomes (Cont.):
• Therefore, when government imposes a binding
price ceiling on a market, shortage of the good
arises
10. Controls on Prices
Cont…
How Price Floors Affect Market Outcomes:
• When govt. imposes price floor, following
two outcomes are possible:
1. If price is set below the equilibrium price,
price floor is not binding .
• Price floor has no effect on the price or
quantity sold .
11. Price Floor that is NOT BINDING
Price
Supply
Equilibrium
Price
P2
Price
Floor
P1
Demand
0 Q Quantity
Equilibrium
Quantity
12. Controls on Prices
Cont…
How Price Floors Affect Market Outcomes (Cont.):
2. If price is set above the equilibrium price,
price floor is a binding constraint.
• The forces of demand and supply move price
towards equilibrium price.
• But when market price hits the floor, it can fall no
further.
• Thus, market price equals price floor.
• At this price, quantity supplied exceeds
quantity demanded, causing surplus for
the good.
14. Taxes
• Governments use taxes to raise revenue for
public projects, such as for:
– Roads
– Schools
– National defense
• Taxes affect market activity.
• When a good is taxed, the quantity sold is
smaller.
15. Taxes
Cont…
Important Question
• When govt. levies tax on a good, who bears
the burden of the tax?
Buyers
Or
Sellers
16. Taxes
Cont…
• Economists use the term tax incidence to
refer to the distribution of tax burden.
• “Tax incidence is the manner in which the
burden of a tax is shared among participants
in a market”.
17. Taxes
Cont…
• Taxes result in a change in market
equilibrium.
• Buyers pay more and sellers receive less,
regardless of whom the tax is levied on.
18. Taxes
Cont…
• What is the impact of tax?
– Taxes discourage market activity.
– When a good is taxed, the quantity sold is
smaller.
– Buyers and sellers share the tax burden.
