Microeconomics Chapter 6 Government Actions in Markets
Microeconomics Chapter 6 Government Actions in Markets ECON2015
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Date Created: 10/11/16
Chapter 6: Government Actions in Markets Price Ceiling or Price Cap – regulation making it illegal to charge a price higher than a specific level Rent Ceiling – when a price ceiling is applied to a housing market (minimum rent price) If a rent ceiling is set above the equilibrium rent, it has no effect. Market will work as if no ceiling But a rent ceiling below the equilibrium rent creates: housing shortage, increased search activity, black market Figure: equilibrium rent = $1,000/month rent ceiling $800/month = equilibrium rent is in the illegal region @ rent ceiling: Quantity of housing Demanded > Quantity supplied = shortage of housing Legal price can’t eliminate the shortage, so other mechanisms operate: Increased search activity & Black market With the Shortage, someone is willing to pay up to $1,200/month Search Activity – time spent looking for someone to do business with. Regulated price = shortage = search activity increases Search Activity is costly & OC of housing = its rent (regulated) + OC of the search activity (unregulated) Regulated: Q housing is less (bc shortage) than Unregulated Q = OC of housing exceeds unregulated rent Black Market – illegal market operates alongside a legal market when price ceiling(/restrictiimposed. Illegal deals of renter & landlord at rents above rent ceiling & what rent would have been unregulated Shortage of housing = black market in housing Rent Ceiling Inefficiency: a rent ceiling below equilibrium rent: inefficient underproduction of housing services Marginal Social Benefit from housing services > Marginal Social Cost = Deadweight Loss: Producer Surplus shrinks, Consumer Surplus shrinks & potential loss form increased search activity Rent ceiling decreases Quantity housing Supplied to less than efficient Q Fair Rules: rent ceiling is unfair because it blocks voluntary exchange Fair Results: rent ceiling is unfair because it doesn’t generally benefit the poor A rent ceiling decreases the Quantity of housing. The Scarce Housing is allocated by: Lottery – gives scarce housing to the lucky FirstComeFirstServed – gives scarce housing to those who have the greatest foresight & get their names on the list first; also benefits the people who are already renting (by definition first) Discrimination – gives scarce housing to friends, family, or those of the selected race/sex None of these methods leads to a fair outcome!!!! Price Floor – regulation that makes it illegal to trade at a price lower than a specified level Minimum Wage – when a price floor is applied to labor markets. If min. wage is below equilibrium wage, no effect & market works as if there was no min wage If min. wage is above equilibrium wage, powerful effects… o Quantity of labor supplied by workers > Quantity demanded by employers = surplus of labor o Quantity of labor hired at min. wage is less than the Quantity hired if unregulated o The legal wage rate cannot eliminate the surplus, so min wage creates unemployment Equilibrium wage rate = $6/hr Min Wage set= $7/hr Equilibrium wage rate is in illegal region Quantity of labor employed = Quantity Demanded Unemployment when: Supply of workers > Quantity of workers Demanded @ 20 mil hrs demanded, workers willing to supply last hr demanded for $5 Fair Labor Standards Act sets U.S. min wage by federal gov. Some state govs. set min wage above that. Most economists believe that min wage laws increase unemployment rate of lowskilled young workers Min. Wage Inefficiencies: Quantity Labor Employed < Efficiency Quantity = Deadweight Loss Supply of labor measures Marginal Social Cost of labor to workers (leisure forgone) Demand for labor measures Marginal Social Benefit from labor (value of goods produced) The potential loss from increased job search decreases both workers’ surplus & firms’ surplus ~ full loss is sum of red + gray areas Tax Incidence – the diversion of the burden of a tax between buyers & sellers. When items are taxed: Price can rise by the full amount of the tax, so buyers pay the tax Price can rise by a lesser amount than the tax, so buyers and sellers share the burden of the tax Price can not change at all, so sellers pay the tax Tax incidence doesn’t depend on tax law; tax on buyers or sellers = same outcome Tax Incidence is same regardless of law saying seller or buyer pays (Only when “perfectly” inelastic Suppor Demand…) Tax Incidence & Elasticity of Demand The division of the tax between buyers & sellers depends on the elasticities of Demand & Supply Perfectly Inelastic Demand: Buyer pays entire tax Perfectly Elastic Demand: Seller pays entire tax The more INELASTIC the Demand = the larger the buyers’ share of the tax Perfectly Inelastic Demand Perfectly Elastic Demand Vertical Horizontal Tax on this good = Tax on this go od = Buyer pays entire tax Seller pays entire tax Tax Incidence & Elasticity of Supply Perfectly Inelastic Supply: Seller pays entire tax Perfectly Elastic Supply: Buyer pays entire tax The more ELASTIC the Supply = the larger the buyers’ share of the tax Perfectly Inelastic Supply Perfectly Elastic Supply Vertical Horizontal Tax on this good = Tax on this good = Seller pays entire tax Buyer pays entire tax Taxes are usually put on goods with an inelastic demand or supply. Alcohol, tobacco, & gas have inelastic demand, so the buyers pay most of the tax on them Labor has low elasticity of supply, so the seller (the worker) pays most of the income tax & s.s. tax Taxes create inefficiencies (unless “perfectly” inelastic DemandorSupply)… Market is efficient w/o tax if: Marginal Social Benefit = Marginal Social Cost ~ Total Surplus is maximized ~ Adding a tax: Raises Buyer Price Lowers Seller Price Decreases Quantity = Deadweight Loss Marginal Social Benefit > Marginal Social Cost Tax revenue takes part of total surplus Tax is inefficient 2 Conflicting Principles of Fairness Applicable to a Tax System: Benefits Principle – idea that people pay taxes equal to the benefits they receive from government provided services. Fair because those who benefit the most pay the most taxes. AbilitytoPay Principle – idea that people pay taxes according to how easily they can bear the burden of the tax. Rich people can more easily bear the burden than poor people can. AbilitytoPay Principle reinforces Benefits Principle to justify high income tax rates on high incomes. 2 main forms of Intervention in Farm Product Markets: Production Quotas – an upper limit to the quantity of a good that can be produced in a specific period No Quota: Price is $30/ton & 60 mil tons produced/yr Quota of 40 mil tons/yr: Quantity decreases to 40 mil tons/yr Market price rises to $50/ton & Marginal Cost falls to $20/ton At the Quantity produced: Marginal Social Cost has decreased Marginal Social Benefit = Market Price (which has risen) Inefficient Production & Producers have incentive to cheat Subsidies – payments made by the government to producers No Subsidy: Price is $40/ton & 40 mil tons produced/yr Subsidy of $20/ton: Marginal Cost – Subsidy falls by $20/ton New Supply Curve: S – subsidy Farmers increase Q to 60 mil tons/yr Market price falls to $30/ton & Farmers Marginal Cost increase to $50/ton Farmers get more per ton sold price ($30 /tonubsidy $20 /ton $50 )/ton At Quantity produced: Marginal Social Cost has increased (exceeds benefit) Marginal Social Benefit = Market Price (which has fallen) Inefficient Overproduction A Free Market for a Drug Market equilibrium @ point E Price is P c Quantity is Q c Penalties on Sellers If penalty on seller is amount HK, Quantity Supplied at Market Price of P is Qc p Supply of the drug decreases to S + CBL New Equilibrium @ point F Market Price rises & Quantity decreases Penalties on Buyers If penalty on buyer is amount JH, Quantity Demanded at Market Price of P iscQ p Demand for the drug decreases to D – CBL New Equilibrium @ point G Market Price falls & Quantity decreases OC of buying the drug rises above P c bc buyer pays the market price plus the cost of breaking the law Both Sellers & Buyers Penalized Drug’s Supply & Demand both Decrease New Equilibrium @ point H Quantity decreases to Q p Market price is P c Buyer pays P b & Seller receives s ~ If an illegal good is legalized & taxed, a high enough tax rate would decrease consumption to the level that occurs when trade is illegal (arguments that extend beyond economics surround this choice) ~