Government Influences on Markets CHAPTER 7 If you put the federal government in charge of the Sahara Desert, in 5 years there'd be a shortage of sand.

Government Influences on Markets

CHAPTER7

“If you put the federal government in charge of the

Sahara Desert, in 5 years there'd be a shortage of sand.”

Milton FriedmanNobel Laureate, Economics

(1912 – 2006)

C H A P T E R C H E C K L I S T

When you have completed your study of this chapter, you will be able to

1 Explain how taxes change prices and quantities, are shared by buyers and sellers, and create inefficiency.

2 Explain how a price ceiling works and show how a rent ceiling creates a housing shortage, inefficiency, and unfairness.

3 Explain how a price floor works and show how the minimum wage creates unemployment, inefficiency, and unfairness.

C H A P T E R C H E C K L I S T

4 Explain how a price support in the market for an agricultural product creates a surplus, inefficiency, and unfairness.

7.1 TAXES ON BUYERS AND SELLERS

Tax Incidence

Tax incidence is the division of the burden of a tax between the buyer and the seller.

When a good is taxed, it has two prices:• A price that includes the tax• A price that excludes the tax

Buyers respond to the price that includes the tax.

Sellers respond to the price that excludes the tax.

7.1 TAXES ON BUYERS AND SELLERS

The tax is like a wedge between the two prices.

Suppose that the government puts a $10 tax on MP3 players.

• How does the price paid by the buyer change?• How does the price received by the seller change?• How is the burden of a tax shared between the

buyer and the seller?

1. With no tax, the price is $100 and 5,000 players are bought.

2. A $10 tax on buyers shifts the demand curve to D – tax.

Figure 7.1(a) shows what happens when the government taxes buyers of the MP3 players.

7.1 TAXES ON BUYERS AND SELLERS

3. The buyer’s price rises to $105—an increase of $5 a player.

4. The seller’s price falls to $95—a decrease of $5 a player.

5. The quantity decreases to 2,000 players a week.

6. The government’s tax revenue is $20,000.

7.1 TAXES ON BUYERS AND SELLERS

1. With no tax, the price is $100 and 5,000 players a week are bought.

2. A $10 tax on sellers of MP3 players shifts the supply curve to S + tax.

Figure 7.1(b) shows what happens when the government taxes sellers of the MP3 players.

7.1 TAXES ON BUYERS AND SELLERS

3. The buyer’s price rises to $105—an increase of $5 a player.

4. The seller’s price falls to $95—a decrease of $5 a player.

5. The quantity decreases to 2,000 players a week.

6. The government’s tax revenue is $20,000.

7.1 TAXES ON BUYERS AND SELLERS

A tax places a wedge between the buyers’ price (marginal benefit) and the sellers’ price (marginal cost).

The equilibrium quantity is less than the efficient quantity and a deadweight loss arises.

Taxes and Efficiency

7.1 TAXES ON BUYERS AND SELLERS

In Figure 7.2(a), the market is efficient with marginal benefit equal to marginal cost.

Figure 7.2 shows the inefficiency of taxes.

Total surplus—the sum of2. Consumer surplus and3. Producer surplus—is maximized.

7.1 TAXES ON BUYERS AND SELLERS

A $10 tax shifts the supply curve to S + tax.

3. Consumer surplus and4. Producer surplus shrink.

Figure 7.2(b) shows how taxes create inefficiency.

5. The government collectsits tax revenue.

6. A deadweight loss arises.

1. Marginal benefit exceeds 2. Marginal cost.

7.1 TAXES ON BUYERS AND SELLERS

The loss of consumer surplus and producer surplus is the burden of the tax.

The burden of the tax equals the tax revenue plus the deadweight loss.

7.1 TAXES ON BUYERS AND SELLERS

Excess burden is the deadweight loss from a tax.

The excess burden is (3,000 $10 2), which equals $15,000.

Excess burden is the amount by which the burden of a tax exceeds the tax revenue received by the government.

7.1 TAXES ON BUYERS AND SELLERS

Incidence, Inefficiency, and Elasticity

The incidence of a tax and its excess burden depend on the elasticites of demand and supply:

• For a given elasticity of supply, the buyer pays a larger share of the tax, the more inelastic is the demand for the good.

• For a given elasticity of demand, the seller pays a larger share of the tax, the more inelastic is the supply of the good.

• Excess burden is smaller, the more inelastic is demand or supply.

7.1 TAXES ON BUYERS AND SELLERS

7.1 TAXES ON BUYERS AND SELLERS

Tax Incidence, Inefficiency, and Elasticity of Demand

Perfectly Inelastic Demand: Buyer Pays and Efficient

Perfectly Elastic Demand: Seller Pays and Inefficient

Figures 7.3(a) and 7.3(b) illustrate these two extreme cases.

Figure 7.3(a) shows tax incidence in a market with perfectly inelastic demand—the market for insulin.

A tax of 20¢ a dose raises the price by 20¢, and the buyer pays all the tax.

Marginal benefit equals marginal cost, so the outcome is efficient.

7.1 TAXES ON BUYERS AND SELLERS

Figure 7.3(b) shows tax incidence in a market with perfectly elastic demand—the market for pink pens.

A tax of 10¢ a pink pen lowers the price received by the seller by 10¢, and the seller pays all the tax.

A deadweight loss arises, so the outcome is inefficient.

7.1 TAXES ON BUYERS AND SELLERS

7.1 TAXES ON BUYERS AND SELLERS

Tax Incidence, Inefficiency, and Elasticity of Supply

Perfectly Inelastic Supply: Seller Pays and Efficient

Perfectly Elastic Supply: Buyer Pays and Inefficient

Figures 7.4(a) and 7.4(b) illustrate these two extreme cases.

Figure 7.4(a) shows tax incidence in a market with perfectly inelastic supply—the market for spring water.

A tax of 5¢ a bottle does not change the price paid by the buyer but lowers the price received by the seller by 5¢.

Marginal benefit equals marginal cost, so the outcome is efficient.

The seller pays the entire tax.

7.1 TAXES ON BUYERS AND SELLERS

Figure 7.4(b) shows tax incidence in a market with perfectly elastic supply—the market for sand.

A tax of 1¢ a pound increases the price by 1¢ a pound, and the buyer pays all the tax.

A deadweight loss arises, so the outcome is inefficient.

7.1 TAXES ON BUYERS AND SELLERS

A price ceiling or price cap is a government regulation that places an upper limit on the price at which a particular good, service, or factor of production may be traded.

An example is a price ceiling on housing rents.

Trading above the price ceiling is illegal.

7.2 PRICE CEILINGS

7.2 PRICE CEILINGS

A rent ceiling is a regulation that makes it illegal to charge more than a specified rent for housing.

The effect of a rent ceiling depends on whether it is imposed at a level above or below the market equilibrium rent.

A Rent Ceiling (Rent control)

7.2 PRICE CEILINGS

Figure 7.5 shows a housing market.

1. At the market equilibrium

If a rent ceiling is set above $550 a month, nothing will change.

2. The equilibrium rent is $550 a month and

3. The equilibrium quantity is 4,000 units of housing.

A rent ceiling is imposed at $400 a month, which is below the market equilibrium rent.

1. The quantity of housing supplied decreases to 3,000 units.

2. The quantity of housing demanded increases to 6,000 units.

3. A shortage of 3,000 units arises.

7.2 PRICE CEILINGS

Figure 7.6 shows how a rent ceiling creates a shortage.

7.2 PRICE CEILINGS

When a rent ceiling creates a housing shortage, two developments occur:

• A black market• Increased search activity

A black market is an illegal market that operates alongside a government-regulated market.

Search activity is the time spent looking for someone with whom to do business.

7.2 PRICE CEILINGS

Figure 7.7 shows how a rent ceiling creates a black market and housing search.

With a rent ceiling of $400 a month:

1. 3,000 units of housing are available.

2. Someone is willing to pay $625 a month for the 3,000th unit of housing.

7.2 PRICE CEILINGS

3. Black market rents might be as high as $625 a month and resources get used up in costly search activity.

7.2 PRICE CEILINGS

With a rent ceiling, the outcome is inefficient.

Marginal benefit exceeds marginal cost.

Total surplus—the sum of producer surplus and consumer surplus—shrinks and a deadweight loss arises.

People who can’t find housing and landlords who can’t offer housing at a lower rent lose.

Are Rent Ceilings Efficient?

1. The market is efficient with marginal benefit equal to marginal cost.

7.2 PRICE CEILINGS

Figure 7.8(a) shows an efficient housing market.

2. Consumer surplus plus

3. Producer surplus is as large as possible.

7.2 PRICE CEILINGS

Figure 7.8(b) shows the inefficiency of a rent ceiling.

A rent ceiling restricts the quantity supplied and marginal benefit exceeds marginal cost.

1. Consumer surplus shrinks.

2. Producer surplus shrinks.

7.2 PRICE CEILINGS

3. A deadweight loss arises.

4. Other resources are lost in search activity and evading and enforcing the rent ceiling law .

Resource use is inefficient.

7.2 PRICE CEILINGS

Are the rules fair?

Are the results fair?

Does blocking rent adjustments avoid scarcity?

What mechanisms allocate resources when prices don’t do the job?

Are those non-price mechanisms fair?

Are Rent Ceilings Fair?

7.2 PRICE CEILINGS

Current renters gain and lobby politicians.

More renters than landlords, so rent ceilings can tip an election.

If Rent Ceilings Are So Bad, Why Do We Have Them?

7.3 PRICE FLOORS

A price floor is a government regulation that places a lower limit on the price at which a particular good, service, or factor of production may be traded.

An example is the minimum wage in labor markets.

Trading below the price floor is illegal.

Figure 7.9 shows a market for fast-food servers.

1. The demand for and supply of fast-food servers determine the market equilibrium

7.3 PRICE FLOORS

2. The equilibrium wage rate is $5 an hour.

3. The equilibrium quantity is 5,000 servers.

7.3 PRICE FLOORS

A minimum wage law is a government regulation that makes hiring labor for less than a specified wage illegal.

Firms can pay a wage rate above the minimum wage but they may not pay a wage rate below the minimum wage.

The effect of a minimum wage depends on whether it is set above or below the market equilibrium wage rate.

The Minimum Wage

A minimum wage is set at $7 an hour, above the equilibrium wage.

1. The quantity of labor demanded decreases to 3,000 workers.

2. The quantity of labor supplied increases to 7,000 people.

3. 4,000 people are unemployed.

7.3 PRICE FLOORS

Figure 7.10 shows how a minimum wage creates unemployment.

7.3 PRICE FLOORS

The firms’ surplus and workers’ surplus shrink, and a deadweight loss arises.

Firms that cut back employment and people who can’t find jobs at the higher wage rate lose.

The total loss exceeds the deadweight loss because resources get used in costly job-search activity.

Is the Minimum Wage Efficient?

7.3 PRICE FLOORS

Figure 7.12(a) shows an efficient labor market.

1. At the market equilibrium, the marginal benefit of labor to firms equals the marginal cost of working.

2. The sum of the firms’ and workers’ surpluses is as large as possible.

7.3 PRICE FLOORS

Figure 7.12(b) shows an inefficient labor market with a minimum wage.

The minimum wage restricts the quantity demanded.

1. The firms’ surplus shrinks.

2. The workers’ surplus shrinks.

7.3 PRICE FLOORS

3. A deadweight loss arises.

4. Other resources are used up in job-search activity.

The outcome is inefficient.

7.3 PRICE FLOORS

Is the rule fair?

Is the result fair?

If the wage rate doesn’t allocate labor, what does?

Are non-wage allocation mechanisms fair?

Is the Minimum Wage Fair?

7.3 PRICE FLOORS

The effects of minimum wage on employment might be small, and the effects on poverty rates are smaller.

What would make the effects on employment small?

Why would effect on poverty rates be small?

If the Minimum Wage Is So Bad, Why Do We Have It?