Unit 3: The Elasticity of Demand and Supply - Objective 3:
Applying the Principles of Supply and Demand
3.3.1 Price Ceilings and Price Floors
Suppose that the total demand for and supply of eggs per month in Edmonton are as shown
in Table 3.7.
Table 3.7: Supply of and demand for eggs
Thousands Price/ Thousands Surplus (+)
of dozens dozen of dozens or shortage
demanded/ supplied/ (-)/month
90 $1.20 70
85 1.25 72
80 1.30 73
75 1.35 75
70 1.40 77
65 1.45 79
60 1.50 81
55 1.55 83
We can read the equilibrium price and quantity directly from this table. At $1.35 per dozen,
75,000 dozen eggs will be demanded, and 75,000 dozen eggs will be supplied.
We can present this data on a supply/demand graph, as in Figure 3.9, below. Point A marks
the equilibrium price and quantity.
Figure 3.9: Demand and supply curves for eggs Suppose the government decides to put a ceiling price of $1.30 per dozen on eggs (see
Figure 3.10, below).
Figure 3.10: Effect of a price ceiling on the equilibrium price and quantity of eggs
In Figure 3.10, point A is the equilibrium price and quantity determined by the marketplace.
Point B is where the ceiling price ($1.30) intersects the demand curve; it indicates that at
$1.30 per dozen, 80,000 dozen eggs will be demanded. Point C is where the $1.30 price
intersects the supply curve, thus telling us that at $1.30 per dozen, only 73,000 dozen eggs
will be supplied. The ceiling price will therefore lead to a 7,000 dozen shortage.
Now suppose the government decides that the farmers are not receiving a fair return for
their egg–producing efforts, and puts a floor price of $1.45 per dozen on eggs. Figure 3.11
shows what will happen in the egg market.
Figure 3.11: Effect of a floor price on the demand and supply of eggs In Figure 3.11, point A represents the market equilibrium price and quantity. Point B, where
the floor price of $1.45 per dozen intersects the demand curve, indicates that at $1.45 per
dozen, only 65,000 dozen eggs will be demanded. Point C, where the floor price intersects
the supply curve, indicates that at $1.45 per dozen, 79,000 dozen eggs will be supplied. The
floor price has thus led to a surplus of 14,000 dozen eggs.
3.3.2 Price Ceiling
Sometimes governments decide that the equilibrium prices and quantities established by
the price system are undesirable. Under such circumstances, the government will fix the
price at some other level. A price ceiling is a maximum price fixed by government. To be
meaningful, it must be below the market equilibrium. The price ceiling will therefore keep
the market price from going as high as its natural equilibrium. The most familiar example of
a price ceiling today is rent control. We will use our demand/supply model to analyze this
Figure 3.12: Price ceiling In Figure 3.12, P 1nd Q ar1 the
original market equilibrium price and
quantity for rental housing. Now
suppose that the government
imposes a price ceiling (rent control)
at P . From the figure, we can see
that at price P2people will want
Q2units of housing, but suppliers will
only willingly supply Q 3nits of
housing. Imposing a ceiling price will
therefore create a shortage
Q2- Q 3 The rationing function of the market is not allowed to work under conditions of an imposed
price. Ordinarily, a shortage would mean an increase in price, with an appropriate increase
in quantity supplied and some decrease in quantity demanded. Thus, at the natural
equilibrium price, quantity demanded equals quantity supplied. A price ceiling causes a
Some method other than the price mechanism must be found to ration the available supply.
What usually happens is that landlords will pick and choose tenants, and thus do the
allocating themselves. In order to prevent this kind of haphazard distribution, the
government could establish a formal system of rationing, usually with coupons the
government prints and distributes. Those people with coupons get the rationed good.
An illegal or black market can arise if a landlord secretly asks more than P from2someone
who is willing to pay. If the landlord doesn’t want to call this extra charge ―rent,‖ he or she
may call it a damage deposit, and try to get around the price ceiling that way.
In fact, rent controls are a unique form of price control because the commodity, rental
housing, is very durable. This means it provides services to people for a long time after it
has been produced. Because of this, the immediate effects of rent control are different from
the long-term effects. Rent controls are usually imposed with the object of making more
rental housing accessible to people with low incomes.
Figure 3.13: Short- and long-run effects of It takes time for the supply of rental
rent controls housing to change, so for the first while,
when controls are imposed at P , w2
can think of the supply curve as being
vertical (S1in Figure 3.13 at left). The
original equilibrium price is P1, and the
equilibrium quantity is Q . The shortage
initially created by the introduction of
rent control at P 2s equal to Q –2Q . 1s
time goes on, landlords will allow
buildings to deteriorate. No new
buildings will be built, so the quantity
supplied will fall to Q3along a more
elastic, longer-term supply curve, S .
2 The shortage will increase to Q – 2 . 3
At Q 3 the free market price is P ,3which
is even higher than the initial equilibrium
price P 1hat was judged to be too high
in the first place.
As time goes on, it becomes increasingly difficult to remove controls because the rental
increases would be so substantial. Economists usually argue that if the intent is to assist
people with low incomes to obtain rental housing, it is better to give them a direct income
subsidy to be applied to their rent than to use rent control.
3.3.3 Price Floor
Minimum wages are an example of legal prices placed above the equilibrium price.
Figure 3.14: Minimum wage
A legal price placed above the
equilibrium price is called a price
floor. It prevents the market price
from falling to its equilibrium
price. In Figure 3.14, W i1 the
equilibrium price and Q t1e
equilibrium quantity. The
government has imposed a price
floor equal to W 2 At W ,2Q i3 the
quantity of labour demanded, and
Q is the quantity of labour
supplied. Therefore a labour
surplus equal to Q - Q exists.
2 3 Minimum wages are established with the intent of improving the economic position of low-
income earners. Instead, the higher wage may well reduce the demand for labour and cause
unemployment. Only those who are employed at the new higher wage are clearly better off.
As a result of minimum wage legislation, the government may be faced with handling
Even after reaching such conclusions, government may still judge that the legislated price is
desirable, given that the market system does not function perfectly.
The first three columns of Table 3.8 show the before-tax demand and supply schedules for a
certain product, X:
Table 3.8: Supply of and demand for X
Quantity Price/ unit Quantity supplied
unit of time Bef