CH6 Markets in action
Outline
I.
Housing Markets and Rent Ceilings
A. The 1906 San Francisco earthquake in left 200,000 people homeless, yet the housing
shortage vanished in one month.
B. The Market Before and After the Earthquake
1.
The short run supply curve shows
the change in the quantity of
housing supplied as the rent
changes in the short run as the
number of houses and apartments
remains constant. Figure 6.1a
shows that the earth shifted the
short-run supply curve of housing
leftward. After the earthquake, at
the initial rent there was a shortage
of housing.
2.
A new, short run housing market
equilibrium appeared in which the
initial shortage of housing was
eliminated by a rise in rents and an
increase in the quantity of housing
supplied moving up along the new,
short run supply curve.
3.
The long run supply curve reflects
the quantity of housing that is
available when enough time has
elapsed for new housing to be built.
In the long run, the supply of
housing increased and the short-run
supply curve shifted rightward, as
shown in Figure 6.1b.
4.
The long-run supply curve is
perfectly elastic, so the long-run
equilibrium price and quantity are
the same as the pre-earthquake
values (other things remaining the
same).
C. A Regulated Housing Market
1.
A price ceiling is a regulation that makes it illegal to charge a price higher than a
specified level.
2.
When a price ceiling is applied to a housing market it is called a rent ceiling.
a)
If the rent ceiling is set above the equilibrium rental price for housing, the market
attains equilibrium price and quantity as if there were no ceiling.
b) If the rent ceiling is set below the equilibrium rental price for housing, the quantity
of housing demanded by renters exceeds the quantity of housing supplied by
landlords, resulting in a shortage of rental housing.
3.
Because landlords cannot be forced to supply a greater quantity than they wish, the
quantity of housing supplied at the rent ceiling is less than the quantity that would be
supplied in an unregulated market.
4.
Because the legal price cannot eliminate the shortage, other mechanisms operate. This
results in increased search activity and encourages black markets to develop.
D. Search Activity
1.
The time spent looking for someone with whom to do business is called search
activity.
a)
When a price is regulated and
there is a shortage, search activity
necessarily increases.
b) Search activity is costly—the
opportunity cost of housing equals
its rent (regulated) plus the
opportunity cost of the search
activity (unregulated).
2.
Because the quantity of housing is less
than the quantity in an unregulated
market, the opportunity cost of housing
exceeds the unregulated rent—see
Figure 6.2.
E. Black Markets
F.
1.
A black market is an illegal market in which the price exceeds the legally imposed
price ceiling.
2.
A shortage of housing created by a price ceiling results a black market in housing.
3.
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.
Rent Ceilings Are Inefficient
1.
A rent ceiling leads to an inefficient use
of resources.
a)
The quantity of rental housing is less
than the efficient quantity.
b) This results in a deadweight loss to
society, as illustrated in Figure 6.3.
G. Are rent ceilings fair?
1.
Using the “fair rules” criteria, anything
that blocks voluntary exchange is
inherently unfair.
2.
Using the “fair outcomes” rule, it is fair if
it can help the relatively poor and
disadvantaged.
a)
Scarcity has not been eliminated—the resulting shortage from the price ceiling
means that the market mechanism of price is no longer used to allocate housing.
b) Rather, some other mechanism, like a lottery, or queuing, or some other form of
discrimination. None of these methods of distribution favor the poor and
disadvantaged.
H. Rent Ceilings in Practice
1.
Many of the world’s biggest cities use rent ceilings to allocate housing: New York, Paris,
London, San Francisco.
2.
Compared with housing markets in cities that do not use rent ceilings, reveals that in
cities with rent controls:
a)
Housing shortages exist
b) Some renters pay lower rents, but others must pay higher rents.
c)
Those that have lived in the city the longest are usually ones that get the lower rental
rates.
II. The Labor Market and the Minimum Wage
A. New, labor-saving technologies become
available every year, which mainly replace
low-skilled labor.
1.
The market responds with a decrease in
the demand for low-skill labor, shown by
a leftward shift of the demand curve in
Figure 6.4a.
2.
A new labor market equilibrium arises
and the initial surplus of labor is
eliminated by a fall in the wage.
3.
In the long run a decrease in the supply of
low-skill labor occurs as people get
trained to do higher-skilled jobs, resulting
in a leftward shift of the short-run supply
curve shown in Figure 6.4b.
4.
The long-run supply is perfectly elastic,
so the long-run equilibrium wage rate is
the same as the before the technological
level changed (all else remaining the
same).
B. A Minimum Wage
1.
A price floor is a regulation that makes
it illegal to trade at a price lower than a
specified level.
2.
When a price floor is applied to labor
markets, it is called a minimum wage.
a)
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.
b) If the minimum wage is set above the equilibrium wage rate, the quantity of labor
supplied by workers exceeds the quantity demanded by employers. There is a
surplus of labor.
3.
Because employers cannot be forced to hire a greater quantity of labor than they wish,
the quantity of labor hired at the minimum wage is less than the quantity that would be
hired in an unregulated labor market.
4.
Because the legal wage rate cannot
eliminate the surplus, the minimum
wage creates unemployment—Figure
6.5.
D. The Inefficiency of a Minimum Wage
1.
An unregulated market equilibrium
means that everyone who is willing to
work at the going market wage will find
a job.
2.
The minimum wage regulation means
that a labor surplus will arise—some
who are willing to work at the minimum
wage will not be able to find a job.
3.
This outcome creates a dead weight loss
to society, as Figure 6.6 illustrates.
Many people will spend extra time
searching for and not finding work, and they would have been willing to work at the
lower, unregulated wage.
E. The Federal Minimum Wage and Its Effects
1.
The United States has passed the Fair
Standards Labor Act, which currently
sets the minimum wage at $5.15 per
hour.
2.
This minimum wage has historically
fluctuated between 35 percent and 50
percent of the average wage of
production workers.
3.
A study of wage and employment data
by economists David Card and Alan
Krueger (Myth and Measurement: The
New Economics of the Minimum Wage
Law, Princeton: Princeton University
Press, 1995) recently suggested that
minimum wage laws do not cause
unemployment.
4.
Other economists disagree and claim that ceteris paribus conditions were violated
regarding:
a)
the timing of hiring decisions to raises in the minimum wage, or
b) there were significant differences among regions studied.
5.
F.
Most economists believe that minimum wage laws do lead to more unemployment
among unskilled younger workers.
A Living Wage
1.
Despite the likely increase in unemployment caused by a minimum wage, supporter of a
higher minimum wage known as a “living wage” argue that individuals working 40 hours
a week deserve enough pay to afford rental housing that is no more than 30 percent of
their income.
2.
Many city governments such as St. Louis, St. Paul, New Orleans, etc., have already
imposed these laws on their own government employees.
3.
The results will be the same as for the Federal minimum wage law, only with more
intensity and greater deadweight loss.
III. Taxes
A. Who really pays the taxes? Demand and supply analysis shows how much of the tax burden
the buyer and the seller share in the payment of a tax.
1.
Tax incidence is the division of the burden of a tax between the buyer and the seller.
a)
Buyers respond to the price with the tax, because that is the price they must pay.
b) Sellers respond to the price without the tax, because that is the price they receive.
c)
2.
The tax is like a wedge driven between the price paid and price received, altering the
incentives facing both buyers and sellers.
Tax on Sellers: Figure 6.7 shows how a
new sales tax of $1.50 per carton of
cigarettes placed on the sellers of
cigarettes in New York City places a
wedge between the price that buyers must
pay ($4.00 per pack) and the price sellers
actually receive after the tax ($2.50).
a)
The supply curve is shifted leftward.
The vertical distance between the old
and new supply curves is $1.50 at
each and every quantity. This shift
arises because the sellers are only
willing to supply the same amount of
cigarettes if they receive the same
price after the tax is paid.
b) The after-tax price that satisfies both the existing buyer’s demand curve and the new
seller’s supply curve is $4.00 per pack.
c)
The new price is higher than the original price ($3.00 per pack), but not by the full
amount of the tax. As a result, that the quantity of cigarettes sold is less than it was
before the tax.
d) A dead weight loss exists where potential gains from trade would have been enjoyed
by society had the tax not been paid. However, both buyers and sellers bear some of
the burden of the tax.
3.
Tax on Buyers: Figure 6.8 shows how a
new sales tax of $1.50 per carton of
cigarettes placed on the buyers of
cigarettes in New York City places a
similar wedge between the price that
buyers must pay and the price sellers
actually receive after the tax.
a)
This time the demand curve is
shifted leftward. The vertical
distance between the old and new
supply curves is $1.50 at each and every quantity because the buyers are only
willing to purchase the same amount of cigarettes if they can pay the same price
after the tax is paid.
b) The after tax price that satisfies both the existing seller’s supply curve and the new
buyer’s demand curve is at $4.00 per pack, just as before.
c)
Again, the new price is higher than the original price ($3.00 per pack), but not by the
full amount of the tax. This result means that the quantity of cigarettes sold is less
than it was before the tax, just like before.
d) A dead weight loss still exists where potential gains from trade would have been
enjoyed by society had the tax not been paid. Again, both buyers and sellers bear
some of the burden of the tax.
B. Equivalence of Tax on Buyers and Sellers
1.
These two scenarios reveal that the effect of placing a tax on buyers generates the
equivalent result as placing the same tax
on buyers—the new equilibrium price
and quantity are identical.
2.
The tax is not necessarily split evenly
across buyer and seller:
a)
Comparing the old price that buyers
used to pay ($3.00) with the new
price ($4.00), buyers must bear
$1.00 of the tax for each pack sold.
b) Comparing the old price received by
sellers ($3.00) with the new price
they used to receive ($2.50), the
sellers bear only $0.50 of the tax for
each pack.
c)
In this example, it is the buyers who
bear the largest share of the burden
imposed by the tax.
C. Tax Division and Elasticity of Demand
The division of the tax burden between buyer
and seller depends on the elasticities of
demand and supply. In extreme cases, the
seller or the buyer pays the entire tax.
1.
The buyer pays the entire tax if:
a)
Demand is perfectly inelastic (the
demand curve is vertical). Figure
6.9a shows this scenario.
b) Supply is perfectly elastic (the
supply curve is horizontal). Figure
6.9b shows this scenario.
2.
The seller pays the entire tax if:
a)
Demand is perfectly elastic (the demand
curve is horizontal). Figure 6.10a shows
this scenario.
b) Supply is perfectly inelastic (the supply
curve is vertical). Figure 6.10b shows
this scenario.
C. Taxes in Practice
1.
Although no goods or services truly exhibit
perfectly inelastic demand, governments
often levy taxes on goods and services with
very inelastic demand, such as alcohol,
gasoline, or tobacco.
a)
After the tax is imposed in these cases,
the quantity sold declines only
minimally.
b) This means the government can collect
much larger tax revenues because it is
able to place a tax on nearly the same
quantity of goods sold as before the tax
was imposed.
D. Taxes and Efficiency
1.
In general, imposing a tax creates a
deadweight loss.
2.
Figure 6.11 shows the deadweight loss
created from a tax on CD players.
IV. Subsidies and Quotas
A. Harvest Fluctuations
1.
The supply curve for farm products is heavily influenced by natural forces (weather,
insects, etc.) beyond the control of farmers.
2.
Once farmers have harvested their crop, they have no control over the quantity supplied.
They move along the perfectly inelastic momentary supply curve.
3.
These two characteristics combine to make the market for farm products very volatile.
a)
A poor harvest: Poor weather
conditions shift the supply curve to
the left, decreasing equilibrium
quantity and increasing market
price. This raises total farm
revenues. Figure 6.12a shows the
impact on market price and
quantity from a decrease in the
supply of wheat.
b) A bumper crop: Ideal weather
conditions shifts the supply curve
to the right, increasing equilibrium
quantity and decreasing market
price. This decreases total farm
revenues. Figure 6.12b shows the
impact on market price and
quantity from an increase in the
supply of wheat.
4.
The elasticity of demand for farm goods
affects farm revenues:
a)
If the quantity sold and the
revenues collected by farmers
move in the opposite direction, the
demand for wheat is inelastic (as
was the case in the above
example).
b) If the quantity sold and the
revenues collected by farmers
move in the same direction, the
demand for wheat is elastic.
c)
Avoid the fallacy of composition: Even if the total farmer revenues increase during a
poor harvest, not all farmer will see an increase in revenues.
5.
The government uses subsidies to
control for large fluctuations in the
momentary supply curves of farmers.
a)
A subsidy is a payment made by
the government to a producer.
b) Figure 6.13 shows how both the
quantity sold and the price received
by the sellers are higher after the
subsidy. It also shows how the
subsidy drives a wedge between the
marginal benefit and marginal cost
to society, resulting in a surplus of
farm product and a dead weight loss.
6.
The government also uses production
quotas to control for large fluctuations in
farmers’ momentary supply curves.
a)
A production quota is an upper
limit to the quantity of a good that
may be produced in a specific
period of time.
b) Figure 6.14 shows how both the
quantity sold is lower and the price
received by the sellers is higher after
the production quota is in place. It
also shows how the subsidy drives a
wedge between the marginal benefit
and marginal cost to society,
resulting in a surplus of farm
product and a dead weight loss.
V. Markets for Illegal Goods
A. The U.S. government prohibits trade of some
goods, such as illegal drugs. Yet, a market
still exists for these prohibited goods and
services.
B. A Market for Illegal Drugs
1.
Prohibiting transactions in a good or
service raises the cost of such trading
between buyers and sellers. Figure 6.15
shows the demand and supply curves for
illegal drugs.
2.
Compared to an unrestricted market:
a)
If the penalty is levied on the seller,
the penalty is added to the minimum
price required for supplying the good
or service. The supply curve shifts
leftward, so that the vertical distance
between the initial supply curve and the supply curve with the penalty equals the
dollar value of the penalty. In this case, the equilibrium price of the product rises
and the equilibrium quantity decreases.
b) If the penalty is levied on the buyer, the penalty is subtracted from the maximum
willingness to pay for the good. The demand curve shifts leftward, so that the
vertical distance between the initial demand curve with the demand curve with the
penalty equals the dollar value of the penalty. In this case, the equilibrium price of
the product falls and the equilibrium quantity decreases.
c)
3.
If buyers and sellers face penalties, both the demand and supply curves shift
leftward. If the shift in the supply curve is larger, the equilibrium price rises and
quantity decreases; if the shift in the demand curve is larger, the price falls and
quantity decreases; if the shifts are the same magnitude, the price is unchanged and
the quantity decreases.
The impact of the prohibition depends on how effectively the ban is policed and whether
the penalty is levied on the buyer, the seller, or both. The resulting equilibrium quantity
is less than the unregulated market equilibrium quantity.
C. Legalizing and Taxing Drugs
1.
A prohibited good can be legalized and then taxed so that, compared to free and untaxed
trade, the price is higher and the quantity consumed is less.
2.
A high tax rate would likely be necessary to decrease consumption to the level that
occurs when trade is illegal.
3.
A policy of legalizing and taxing a prohibited good or service has advantages and
disadvantages.
a)
An advantage is that the government raises tax revenues, which can be used for
education against the consuming the good or service.
b) A disadvantage is that legalization may signal that use of the good is acceptable,
which could increase demand for the product. In addition, if the demand for the
product were inelastic, it would take a very high tax to reduce consumption to the
same level that occurred with prohibition.