Chapter 6 – Government Actions in Markets
A Housing Market with a Rent Ceiling
We spend most of our income on housing than on any other good or service, so it isn’t surprising that
rents can be a political issue.
Price ceiling or price cap – a government regulation that makes it illegal to charge a price higher than a
specified level
The effect of a price ceiling on a market depends on whether it is above or below the equilibrium price
 A price ceiling set above the equilibrium price has no effect. The price does not constrain the
market forces. The force of law and the market forces are not in conflict.
 A price ceiling set below the equilibrium price has a powerful effect on a market. The price
ceiling attempts to prevent the price from regulating the quantities demanded and supplied.
The force of law and the market forces are in conflict.
o Supply and demand intersect above the price ceiling which means there is more
demand and less supply
Rent ceiling – when a price ceiling is applied to a housing market
 A rent ceiling set below the equilibrium rent creates
o A housing shortage
o Increased search activity
o A black market
A housing shortage
At the equilibrium price, the quantity demanded equals the quantity supplied.
 In a housing market when the rent is at the equilibrium level, the quantity of housing supplied
equals the quantity of housing demanded and there is neither a shortage nor a surplus of
housing
 A rent set below the equilibrium rent, the quantity of housing demanded exceeds the quantity
of housing supplied – there is shortage
 The quantity available is the quantity supplied and must be allocated among the demanders
Increased Search Activity
Search Activity – the time spent looking for someone with whom to do business with
When price regulated and there is a shortage, search activity increases.
The opportunity cost of a good is equal not only to the price but also the value of the search time spent
finding the good.
 The opportunity cost of housing is equal to the rent (a regulated price) plus the time and other
resources spent searching for the restricted quantity available.
 A rent ceiling controls only the rent portion of the cost of housing the cost of increased search
activity might end up making the full cost of housing higher than it would be without the a rent
ceiling
A Black Market
Black market – is where illegal trading occurs; an illegal market where the equilibrium price exceeds the
price ceiling.
“key money” – is money that tenants pay for worthless fittings and charges to make the place a home
 With a lose enforcement, the black market rent is close to the unregulated rent
 With a strict enforcement, the black market rent is close to the highest price a renter is willing to
pay
Inefficiency of a Rent Ceiling
A rent ceiling set below the equilibrium price results in an inefficient underproduction of housing
services.
 The marginal social benefit exceeds the marginal cost, and deadweight loss shrinks the producer
surplus and consumer surplus
 Consumer surplus shrinks (green); producer surplus shrinks (blue)
 Pink rectangle loss faced by consumer; deadweight loss arise
Are Rent Ceilings Fair?
According to the first one, it does not block voluntarily exchange so no. According to the 2nd, it would
allocate its resources to the poorest first.
Blocking rent adjustments doesn’t eliminate scarcity but since the rent ceiling decreases the quantity of
housing available it creates an even bigger challenge for the housing market
When rent cannot permit allocation other methods are placed
 A lottery – to those who are lucky , not poor
 First-come, first-served – to those who have the greatest foresight and who get their names on
first
 Discrimination – based on the views and self-interest of the owner of the housing; self-interest
of the bureaucracy that administers the allocation that counts
o Based on friendship, family ties, and criteria such as race, ethnicity, or sex
When rent adjustments are blocked, other methods of allocating scarce housing resources operate that
do not produce a fair outcome
A Labour Market with a Minimum Wage
A labour market influences the jobs we get and the wages we earn.
Firms decide how much labour to demand and the lower the minimum wage the higher the quantity
demanded.
Households decide how much labour to supply and the higher the minimum wage the greater the
quantity labour supplied
Price floor – the government-imposed regulation that makes it illegal to change a price lower than a
specified level is called a price floor
 The price floor set below the equilibrium price has no effect. The price floor does not constrain
the market forces.
o Since firms are willing to pay more for the supply of labour
 The price floor set above the equilibrium price has powerful effects on the market. The price
floor attempts to prevent the price from regulating the quantities demanded and supplied.
o Firms have to pay more for labour then they want to
Minimum wage – the price floor is applied to a labour market.
 A minimum wage above the equilibrium creates unemployment
When the wage rate is at the equilibrium level, the quantity of labour supplied equals the quantity of
labour demanded, neither shortage nor surplus of labour.
When the wage rate is above the equilibrium wage, the quantity supplied exceeds the quantity of labour
demanded – there is a surplus of labour.
The demand of labour determines the number of people employed, the surplus is unemployed
A wage rate below the equilibrium is illegal
Inefficiency of a Minimum Wage
In the labour market, the supply curve measures the marginal social cost of labour to workers, leisure
forgone. The demand curve measures the marginal social benefit from labour. The value of goods and
services produced.
In a unregulated labour market, the labour supplied allocates the economy’s scarce labour resources to
the jobs they are valued most highly. The market is efficient.
The minimum wage frustrates results in unemployment and increased job search.
 The marginal social benefit exceeds the marginal social cost (demand > supply)
o creates a deadweight loss that shrinks the firms’ surplus and the workers’ surplus
Minimum wage is unfair in both views of fairness; it delivers unfair results and imposes unfair rules.
 Only those people who have jobs and keep them benefit from the minimum wage.
 The unemployed end up worse off than they would without minimum wage
When the wage rate doesn’t allocate labour, other mechanisms determine who finds jobs
 Discrimination
 Minimum wage blocks voluntary exchanges , firms want to hire more and people want to work
more but by the minimum wage law they are not permitted to do so
*Always compare charts to equilibrium price
Tax incidence – the division of the burden of a tax between buyers and sellers
 If the price paid by buyers rises by the full amount of the tax , then the burden of the tax falls
entirely on buyers
 If the price paid by buyers rises by a lesser amount than the tax, then the burden falls partly on
buyers and partly on sellers
 If the price paid by buyers doesn’t change at all then the burden of the tax falls entirely on the
seller
A Tax on Sellers
 Increased cost of production which decreases supply
 Supply curve shirts to supply + tax
 Less supply and higher cost , buyers pay $2 of the $3 tax and sellers pay $1
A Tax on Buyers
 Lowers the amount they are willing to pay sellers, so decreases demand
 Shifts the demand curve to the left , demand curve – tax = new position
 Pay $2 of the $3 tax and sellers pay $1
Whether buyers or sellers pay the tax, it has the same affect the equilibrium price changes to its new
position
Equivalence of Tax on Buyers and Sellers
Even if the government imposed that both share equally ($1.50 each), still has the same affect and it
doesn’t change
 Buyers pay $2 of the $3 tax, sellers pay $1 of the $3
 The price paid by buyers which includes the tax
 The price received by sellers which excludes the tax
The Employment Insurance Tax a tax that the federal government imposes on both buyers or labour
(employers) and sellers of labour (employees)
 The market of labour decides how the burden of the Employment Insurance tax is divided
between firms and workers
 In special cases either buyers bear the entire burden or sellers bear it but usually spilt
o The division depends on the elasticities of demand and supply
Tax Incidence and Elasticity of Demand
The division of the tax between buyers and sellers depends in part on the elasticity of demand.
 Perfectly inelastic demand – buyers pay
 Perfectly elastic demand – sellers pay
Perfectly inelastic demand – regardless of the price, vertical demand curve, consumers rather get the
product or service rather than not buy
Ex. insulin , buyers pay the tax since demand doesn’t change (quantity) but supply curve moves to
supply + tax
Perfectly elastic demand – the demand for the object decreases and the supply curve shifts to supply +
tax and makes a new equilibrium price at the new demand. Since there is less demand suppliers usually
pay the entire tax. Demand is horizontal line
Ex. pens , buyers demand decreases and sellers pay tax
The division of tax depends on the elasticity of demand.
 The more inelastic the demand, the larger is the amount of tax paid by the buyers
 The more elastic the demand, the larger is the amount of tax paid by the seller
Tax Incidence and Elasticity of Supply
 Perfectly inelastic supply – sellers pay
 Perfectly elastic supply – buyers pay
Perfectly inelastic supply – no matter what the price is the producer still produces the same amount
 But buyers still only are willing to pay the same
 Ex. water bottles but demand decreases , supply doesn’t change
o 50cents/bottle, tax 5 cents, buyers produce still the same amount and buyers aren’t
willing to pay more so sellers pay the 5 cent and receive 45 cents
Perfectly elastic supply – supply curve changes to supply + tax and buyers pay the entire tax
 Ex. micro chips
The more elastic the supply, the larger is the amount of the tax paid by buyers
Taxes and Efficiency
Buyers willingness to pay measures the marginal social benefit, the price sellers receive is the sellers’
minimum supply-price which is equal to the marginal social cost
 Taxes makes marginal social benefit (demand) > marginal social cost
o Shrinks producer surplus and consumer surplus
o Creates deadweight loss
 The red rectangle is the tax revenue
Only in perfect elastic or in perfect inelastic there is no deadweight loss.
Tax and Fairness
The benefits principle – the proposition that people should pay taxes equal to the benefits they receive
from the services provided by government.
 Fair since people that get the benefits , pay the taxes
The Ability-to-Pay Principle – the proposition that people should pay taxes according to how easily they
can bear the burden of the tax.
 The rich pay more since they obtain higher incomes that they can pay the taxes with.
Production Quotas and Subsidies
Governments intervene in the market for farm products to protect the income and prices of farmers. A
price floor might be used and creates a surplus which is inefficient.
Production Quotas – upper limit to the quantity of a good that may be produced in a specified period
 If the production quota is set above , nothing changes since they are already producing above
 If the production quota is set below the equilibrium quantity has a huge effect
o A decrease in supply
o A rise in price
o Inefficient underproduction
o An incentive to cheat or overproduce
A decrease in supply – each farmer is assigned a production limit, any production excess of the quota is
illegal (without the quota they would produce and supply more)
 This causes the supply to become perfectly inelastic – sellers pay tax and causes a rise in the
prices
 Grey region is illegal; market forces and political forces are in conflict
A rise in price – the market forces free to determine the price because there is lower supply the higher
the price
A decrease in marginal cost – lowers the production cost of milk. Marginal cost decreases since farmers
produce less and stop using the resources with the higher marginal cost
Inefficiency – since there is underproduction, the marginal social benefit exceeds the marginal social
cost which creates a deadweight loss and causes inefficiency
An incentive to Cheat and Overproduce – forces farmers to produce more (cheat) since the price
exceeds marginal cost they can get a larger profit of producing more.
 If farmers produce more than the quota is ineffective and the price falls back to the original
equilibrium price
 To make the quota effective , make a monitoring system to ensure nobody cheats
 Hard to control , monitor , and punish so leave it to the government
Subsidy – a payment made by the government to a producer (negative tax)
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Increase supply
A fall in price and increase in quantity produced
An increase marginal cost
Payments by government to farmers
Ineffective overproduction
Increases supply – since it is like decrease in cost , take the farmer’s minimum supply-price and minus
subsidies you see that the farmer willing to supply less but with the subsidies the farmer supplies more
A fall in price and increase in quantity produced – lowers the price of the product and increase the
quantity produced
An increase in marginal cost –lowers price paid by consumer but increase production price; must turn to
resources that are less ideal for growing grain
Payments by government to farmer – increases production
Inefficient overproduction – marginal social cost exceeds benefit , brings production inefficiency
 Lowers the domestic market price
 Increase supply on the world market lowers the price in the rest of the world
o Farmers in other countries decrease production and receive smaller revenues
A free market for a drug
 The lower the price of the drug, the higher the demand
 The lower the price of the drug, the smaller the quantity supplied
Cost of illegal drugs depend on the penalties for violating the law and the degree of which the law is
enforced
 The larger the penalties and the better the policing, the higher are the costs
 Imposed on seller, buyer, or both
Penalties on sellers – the CBL is added to the minimum price the dealers will accept and supply curve
shifts leftwards; CBL = the cost of breaking the law
Penalties on buyers –the CBL is subtracted from the price buyers are willing to pay for drugs and
demand curve shifts leftward
The larger the penalties and the greater the degree of law enforcement, the larger is the decrease in
demand and/or supply
 If penalties are heavier on seller, supply cure shifts farther than the demand curve and the
market prices rises
 If the penalties are heavier on the buyer, demand shifts farther than the supply curve and the
market price falls
Legalizing drugs
 Decrease in demand and supply
o People would not want to break the law of supplying more than the should
o Also the shift would occur
o People do not want the government to profit from trade of harmful substances
o Influence preferences