Government Actions

6 in Markets

1
 Rental Market For 1 bedroom apartment
TTT illegalregion
3cal 1600
Re 1200
i
800 I
400 0
o 4 to s if Q in thousands
Re 1200
Qe 10
R ceil 1600 is ineffective

20000 S

1600

roo

I
D
do
4 I s

R oeil 800 is effective

not
legal
Éettal market for I bedroom apartment
2000
Demand R 0.594
4000 2r
Ed

R Qs 800
Supply
Qs 12 800

At equilibrium O so
05 209800
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 1
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If Rceil 1800 R ceil is ineffective

1200 R ceil is effective

If Reeil

At 12 1200
Q5 QD

4000 2112007 1600

D QD
Qs 1200 800 400
S

QD Qs Shortage
1000 400 1200
Shortage
At 0 400
 1800 for the last
Someone is willing to pay very
unit of appartment available
I

B
Amaya region
18006
1600

Price
flooring
Labour market minimum
wage
Price W
Ex Wage
Demand W 0.201
20

QD 5W 100

W O 10,5 8
Supply
LS 10W 80

At equilibrium
8 0.29 20
0.19
0.39 12
40
91

0.1140 8 12 W
W
2000 Surp 201

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Minimum is 10
No effectwage

Minimum is 16
wage
effective
not possible at equilibrium
At W 16 QS Qu D

5116 100 204 QLD

10116 80 2 80 Qu S

QS Q unemployment
80 20 60

At 0 20
0111207 8 5110
someone is to work for 10 hour
willing per
 g I
demand 20 units at all
export2 Suppose
rates
Pby wages
80 20 20
Quantitysupplied Quantitydemanded
80 40 40
unemployed

Tax
CommodityCigarette
Demand P 0.29 10 Tat on seller

QD 50
sp supplydecreases

supply
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Qs 40
top
9
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After Tax

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0.11107 4 5 p 8

Tax paid now

bybuyer pricetheypay pricetheypaid
before
8 6 2
Tax
paidby seller
price they
received before
pricereceive
they
G 5 1 now

demand decreases
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Buyer
3 0.29 7
P 0.29 10
S D
0.19 4
after tax
of III YET
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4
 3 10
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Revenuei
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i
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7

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3
80
I producersurplus seller

2 s 5117110

D2
n
5
a
10
a
15 20
n
215 310 135
8
Price paid 8 6 2
bybuyer 6 5 1
Price
paid by seller
Production Quota
Market For Milk

D P 1.5 0.00125 Q

D 1200 800ps

P 0.7 0.000750
5
9333
 S 1333.3 P 933.3
s
1.570.88 55 5 0.00575
eq
0.8 0.002 q
400
p
q pal
underproduction
1,50 MB
MC Shortage
1
i
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i i 300 s
i
Ps
gyps
id i n
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i g
PS
pwt
T i 5110 2

É's quita
oo doo o

Quota at 500 units is ineffective

Quota at 300 units is effective

At 0 300
D P 1.5 0.00125 Q MB
1 5 0.001251300 1.125

5 D 0.7 0.000750
MC
0.7 0.000751300 0,925
Incentive to cheat

s b
dy
subsidy
D P 3g
280

5 P 220 39
238 359
eq 288 38
10 250
60 69 9 p
p

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overproduction

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S
270
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too
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1
2207
g t iz p Ip Q

subsidy
20 2 8 35 288.399
P 220 20
39 69 80
9 13.5
200 39 240
Subsidy p
After studying this chapter you will be able to

 Explain how rent ceilings create housing shortages and

inefficiency
 Explain how minimum wage laws create unemployment
and inefficiency
 Explain the effects of a tax
 Explain the effects of production quotas and subsidies
on production, costs, and prices

2
A Housing Market with a Rent Ceiling
A price ceiling or price cap is a regulation that
makes it illegal to charge a price higher than a
specified level.
frfect
When a price ceiling is applied to a housing
market it is called a rent ceiling.
If the rent ceiling is set above the equilibrium
rent, it has no effect. The market works as if there
were no ceiling.
But if the rent ceiling is set below the equilibrium
rent, it has powerful effects.

effe
it t
Has an

3
A Housing Market with a Rent Ceiling
Housing Shortage
Figure 6.1 shows the
effects of a rent ceiling
that is set below the
equilibrium rent.
The equilibrium rent
is $1,000 a month.
A rent ceiling is set at
$800 a month.
So the equilibrium
rent is in the illegal
region.
4
A Housing Market with a Rent Ceiling
At the rent ceiling,
the quantity of housing
demanded exceeds the
quantity supplied.
There is a shortage of
housing.

100 60 40 thousand
shortage

to

5
A Housing Market with a Rent Ceiling
Because the legal
price cannot
eliminate the
shortage, other
mechanisms operate:
 Increased search
activity
 A black market
With the shortage,
someone is willing to
pay up to $1,200 a
month.

6
A Housing Market with a Rent Ceiling
 Increased Search Activity
The time spent looking for someone with whom to
do business is called search activity.
When a price is regulated and there is a shortage,
search activity increases.
Search activity is costly and the opportunity cost of
housing equals its rent (regulated) plus the
opportunity cost of the search activity
(unregulated).
Because the quantity of housing is less than the
quantity in an unregulated market, the opportunity
cost of housing exceeds the unregulated rent.
7
A Housing Market with a Rent Ceiling
 A Black Market
A black market is an illegal market that operates
alongside a legal market in which a price ceiling or
other restriction has been imposed.
A shortage of housing creates a black market in
housing.
Illegal arrangements are made between renters and
landlords at rents above the rent ceiling—and
generally above what the rent would have been in an
unregulated market.

8
 A Housing Market with a
Rent Ceiling
 Inefficiency of a Rent Ceiling
A rent ceiling set below the equilibrium rent leads
to an inefficient underproduction of housing
services.
The marginal social benefit from housing services
exceeds its marginal social cost and a deadweight
loss arises. D S
Figure 6.2 illustrates this inefficiency.

9
A Housing Market with a Rent Ceiling
A rent ceiling decreases
the quantity of housing
supplied to less than the
efficient quantity.
A deadweight loss
arises.
Producer surplus
shrinks.
Consumer surplus
shrinks.
There is a potential loss
from increased search
activity. 10
 A Housing Market with a
Rent Ceiling
 Are Rent Ceilings Fair?
According to the fair rules view, a rent ceiling is
unfair because it blocks voluntary exchange.
According to the fair results view, a rent ceiling is
unfair because it does not generally benefit the poor.
A rent ceiling decreases the quantity of housing and
the scarce housing is allocated by
 Lottery
 First-come, first-served
 Discrimination
11
 A Housing Market with a
Rent Ceiling
A lottery gives scarce housing to the lucky.
A first-come, first served gives scarce housing to
those who have the greatest foresight and get their
names on the list first.
Discrimination gives scarce housing to friends,
family members, or those of the selected race or
sex.
None of these methods leads to a fair outcome.

12
 A Labour Market with a
Minimum Wage
A price floor is a regulation that makes it illegal to
trade at a price lower than a specified level.
When a price floor is applied to labour markets, it
is called a minimum wage. ___
Effect
If the minimum wage is set below the equilibrium
wage rate, it has no effect. The market works as if
there were no minimum wage.
If the minimum wage is set above the equilibrium
wage rate, it has powerful effects.
Verret

13
A Labour Market with a Minimum Wage
Minimum Wage Brings Unemployment
If the minimum wage is set above the equilibrium
wage rate, the quantity of labour supplied by
workers exceeds the quantity demanded by
employers.
There is a surplus of labour.
The quantity of labour hired at the minimum
wage is less than the quantity that would be hired
in an unregulated labour market.
Because the legal wage rate cannot eliminate the
surplus, the minimum wage creates
unemployment.

14
A Labour Market with a Minimum Wage
The equilibrium wage
rate is $9 an hour.
surplus
The minimum wage rate
is set at $10 an hour.
So the equilibrium wage
rate is in the illegal region.
The quantity of labour
employed is the quantity
demanded.

15
A Labour Market with a Minimum Wage
The quantity of labour
supplied exceeds the
quantity demanded and
unemployment is
created.
With only 20 million
hours demanded, some
workers are willing to
supply the last hour
demanded for $8.

16
 A Labour Market with a
Minimum Wage
 Inefficiency of a Minimum Wage
A minimum wage leads to an inefficient outcome.
The quantity of labour employed is less than the
efficient quantity. unemployment
The supply of labour measures the marginal social
cost of labour to workers (leisure forgone).
The demand for labour measures the marginal
social benefit from labour (value of goods
produced).
Figure 6.4 illustrates this inefficient outcome.
17
A Labour Market with a Minimum Wage
A minimum wage set
above the equilibrium
wage decreases the
quantity of labour
employed.
A deadweight loss arises.
The potential loss from
increased job search
decreases both workers’
surplus and firms’ surplus.
The full loss is the sum of
the red and grey areas.
18
 A Labour Market with a
Minimum Wage
 Is the Minimum Wage Fair?
A minimum wage rate in Canada is set by the
provincial governments.
In 2011, the minimum wage rate ranged from a
low of $8.75 an hour in British Columbia to a high
of $11.00 an hour in Nunavut.
Most economists believe that minimum wage
laws increase the unemployment rate of low-
skilled younger workers.

19
 Taxes
Everything you earn and most things you buy are
taxed.
Who really pays these taxes?
Income taxes and the social security taxes are
deducted from your pay, and HST (or GST) is added
to the price of the things you buy, so isn’t it obvious
that you pay these taxes?
Isn’t it equally obvious that your employer pays the
employer’s contribution to the social security tax?
You’re going to discover that it isn’t obvious who pays
a tax and that lawmakers don’t decide who will pay!
20
 Taxes
 Tax Incidence
Tax incidence is the division of the burden of a
tax between buyers and sellers.
When an item is taxed, its price might rise by the
full amount of the tax, by a lesser amount, or not
at all.
If the price rises by the full amount of the tax,
buyers pay the tax.
If the price rise by a lesser amount than the tax,
buyers and sellers share the burden of the tax.
If the price doesn’t rise at all, sellers pay the tax.

21
Taxes
Tax incidence doesn’t depend on tax law!
The law might impose a tax on buyers or sellers,
but the outcome will be the same.
To see why, we look at the tax on cigarettes in
Ontario.
On February 1, 2006, Ontario raised the tax on
the sales of cigarettes to $3.09 a pack of 25.
What are the effects of this tax?

22
 Taxes
 A Tax on Sellers
Figure 6.5 shows the
effects of tax.
With no tax, the
equilibrium price is $6 a
pack.
A tax on sellers of $3 a
pack is introduced.
Supply decreases and
the curve S + tax on
sellers shows the new
supply curve.

23
Taxes
The market price paid
by buyers rises to $8 a
pack and the quantity
bought decreases.
The price received by
the sellers falls to $5 a
pack.
So with the tax of $3 a
pack, buyers pay $2 a
pack more and sellers
receive $1 a pack less.

24
 Taxes
 A Tax on Buyers
Again, with no tax,
the equilibrium price
is $6 a pack.
A tax on buyers of $3
a pack is introduced.
Demand decreases
and the curve D  tax
on buyers shows the
new demand curve.

25
Taxes
The price received
by sellers falls to $5 a
pack and the quantity
decreases.

The price paid by buyers

rises to $8 a pack.
So with the tax of $3 a
pack, buyers pay $2 a
pack more and sellers
receive $1 a pack less.

26
 Taxes
So, exactly as before
when sellers were taxed:
Buyers pay $2 of the
tax.
Sellers pay the other $1
of the tax.
Tax incidence is the
same regardless of
whether the law says
sellers pay or buyers pay.

27
Taxes
Tax Incidence and Elasticity of Demand
The division of the tax between buyers and sellers
depends on the elasticities of demand and supply.
To see how, we look at two extreme cases.
 Perfectly inelastic demand: Buyers pay the
entire tax.
 Perfectly elastic demand: Sellers pay the entire
tax.
The more inelastic the demand, the larger is the
buyers’ share of the tax.
Demand D S Tax
28
 I Inelastic Demand
Total Tax
paid the
by
buyer

St Tax
S
Elastic Demand
Total tax
paidby
seller

supply g Inelastic
supply
Tax 5 Sellers total
tax
pay

D
 Stat

Elastic
Supply
Total tax
paid by buyer
Taxes
Perfectly Inelastic
Demand
Demand for this
good is perfectly
inelastic—the
demand curve is
vertical.
When a tax is
imposed on this
good, buyers pay the
entire tax.
29
 Taxes
Perfectly Elastic
Demand
The demand for
this good is
perfectly elastic—
the demand curve
is horizontal.
When a tax is
imposed on this
good, sellers pay
the entire tax.

30
Taxes
 Tax Incidence and Elasticity of Supply
To see the effect of the elasticity of supply on the
division of the tax payment, we again look at two
extreme cases.
 Perfectly inelastic supply: Sellers pay the entire
tax.
 Perfectly elastic supply: Buyers pay the entire
tax.
The more elastic the supply, the larger is the
buyers’ share of the tax.

31
Taxes
Perfectly Inelastic
Supply
The supply of this
good is perfectly
inelastic—the
supply curve is
vertical.
When a tax is
imposed on this
good, sellers pay the
entire tax.

32
Taxes
Perfectly Elastic
Supply
The supply of this
good is perfectly
elastic—the supply
curve is horizontal.
When a tax is
imposed on this good,
buyers pay the entire
tax.

33
Taxes
 Taxes in Practice
Taxes usually are levied on goods and services
with an inelastic demand or an inelastic supply.
Alcohol, tobacco, and gasoline have inelastic
demand, so the buyers of these items pay most
the tax on them.
Labour has a low elasticity of supply, so the
seller—the worker—pays most of the income tax
and most of the social security tax.

34
 Taxes
 Taxes and Efficiency
Except in the extreme cases of perfectly inelastic
demand or perfectly inelastic supply when the
quantity remains the same, imposing a tax creates
inefficiency.
Figure 6.10 shows the inefficiency created by a $20
tax on MP3 players.

35
Taxes
With no tax, marginal
social benefit equals
marginal social cost and
the market is efficient.
Total surplus (the sum
of consumer surplus and
producer surplus) is
maximized.
The tax decreases the
quantity, raises the
buyers’ price, and lowers
the sellers’ price.
36
Taxes
Marginal social
benefit exceeds
marginal social cost
and the tax is
inefficient.
The tax revenue takes
part of the total
surplus.
The decreased
quantity creates a
deadweight loss.

37
Production Quotas and Subsidies
Intervention in markets for farm products
takes two main forms:
 Production quotas
 Subsidies
A production quota is an upper limit to the
quantity of a good that may be produced during a
specified period.
A subsidy is a payment made by the government
to a producer.

38
Production Subsidies and Quotas
 Production Quotas
With no quota, the price of
milk is $3 a kg and 16
million kg.s a year are
produced.

With the production quota of

14 million kg.s a year,
quantity decreases to 14
million kg.s a year.

The market price rises to

$5 a kg and marginal cost
falls to $2 a kg. 39
Production Quotas and Subsidies
Inefficiency
At the quantity produced,

 marginal social benefit

equal market price,
which has increased.

 marginal social cost

has decreased.

Production is inefficient
and producers have an
incentive to cheat. 40
Production Subsidies and Quotas
 Subsidies
With no subsidy, the price
of grain is $40 a tonne and
40 million tonnes a year
are produced.

With a subsidy of $20 a

tonne, marginal cost minus
subsidy falls by $20 a
tonne and the new supply
curve is S – subsidy.

41
Production Subsidies and Quotas
The market price falls to
$30 a tonne and farmers
increase the quantity to
60 million tonnes a year.
But farmers’ marginal
cost increases to $50 a
tonne.
With the subsidy, farmers
receive more on each
tonne sold—the price of
$30 a tonne plus the
subsidy of $20 a tonne,
which is $50 a tonne.
42
Production Quotas and Subsidies
Inefficient
Overproduction
At the quantity produced:

 marginal social benefit

equaling the market
demand price has
fallen.

 marginal social cost

has increased and
exceeds marginal
social benefit.
43