Ch. 6: Markets in Action.
 Price ceiling and inefficiencies.
 Price floors (minimum wage) and inefficiency.
 Taxes and inefficiencies
The effect of price ceilings.
• Price ceiling is a maximum price.
– “binding” only if ceiling is below equilibrium price.
– binding price ceiling causes a shortage.
SR & LR effects without price ceiling
Suppose equilibrium price of gasoline is $4 and a
hurricane destroys numerous refineries. Examine
SR & LR effects on price and quantity.
S
$4
D
Compare outcomes with and without a price ceiling
at $4
•Shortage
•Effect on consumer’s surplus
•Effect on producer’s surplus
•Deadweight loss
•Black markets, search costs, enforcement costs
S
$4
S-LR
D
Millions of gallons per day
The effect of price floors
• A price floor is a minimum price
– binding only if it is set above the equilibrium
price
– binding price floor creates a surplus.
Minimum Wage
• Is a price floor on labor.
• Why is there a minimum wage?
• Would a higher minimum wage make
workers better off?
• Efficiency versus equity
The Labor Market and the Minimum Wage
Minimum wage is
a price floor.
Price floor is
“binding” only if it
is above
equilibrium price.
The Labor Market and the Minimum Wage
A “binding” price floor
• reduces consumer
(employer) surplus
•Could increase or
decrease producer
(employee) surplus
•Creates a deadweight loss
• Destroys some of the
producer surplus
(employee) through search
activity.
The Effect of Price Floors
In general, a “binding” price floor will result in:
a. Buyers (employers) are worse off
b. Sellers (employees) could be better or worse off.
c. A deadweight loss.
S
$3
$2
a
b
c
f
e
$1 d
D
500 1000 1500
Taxes
• Tax Incidence
– the division of the burden of a tax between the buyer
and the seller.
– 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, the
buyer pays the tax.
– If the price rises by a lesser amount than the tax, the
buyer and seller share the burden of the tax.
– If the price doesn’t rise at all, the seller pays the tax.
Taxes
• Tax Incidence
– Tax incidence doesn’t depend on tax law.
– The law might impose a tax on the buyer or
the seller, but the outcome will be the same.
– Example: On July 1, 2002, Mayor Bloomberg
upped the cigarette tax in New York City from
almost nothing to $1.50 a pack.
Tax Incidence
.
Taxes
• Tax incidence:
– Buyer: $1
– Seller : $.50
Taxes
• A Tax on Buyers
– suppose that
buyers, not
sellers, are taxed
$1.50 a pack.
• Tax incidence:
– Buyer: $1
– Seller: $.50
Tax Division and Elasticity of Demand
The more inelastic the demand, the larger is the
buyers’ share of the tax.
Taxes
The more elastic the supply, the larger is the
buyers’ share of the tax.
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 of the tax on them.
– Labor has a low elasticity of supply, so the
seller—the worker—pays most of the income
tax and most of the Social Security tax.
Taxes
Taxes create allocative
inefficiency unless S or D
is perfectly inelastic.
• What’s effect of tax on
1.
2.
3.
4.
•
Consumer surplus
Producer surplus
Tax revenue
Deadweight loss
Excess burden of tax


reduction in consumer &
producer surplus minus tax
revenue
Identical to deadweight loss
Subsidies and Quotas
– Fluctuations in the weather bring big
fluctuations in farm output.
– How do changes in farm output affect the
prices of farm products and farm revenues?
– How might farmers be helped by intervention
in markets for farm products?
Stabilizing Farm Revenues
– A poor harvest
decreases supply.
 Effect on total
revenue?
• higher price
• lower quantity
 How would answer
change if demand
were elastic?
Stabilizing Farm Revenues
– A large harvest
increases supply.
– Effect on total
revenue?
• Lower price
• Higher quantity
– How would answer
change if demand
were elastic?
Stabilizing Farm Revenues
Intervention in markets for farm products takes
two main forms:
 Subsidies
a payment made by the government to a producer
that’s in addition to market price received.
 Production quotas
an upper limit on the quantity of a good that may be
produced during a specified period.
Subsidies
Effect of $20 subsidy
• Equilibrium quantity
• Equilibrium price
• Consumer surplus
• Producer surplus
• Cost to taxpayers
• Deadweight loss
Quotas
• Maximum production
allowed.
• Binding only if below equil
quantity
• limits total production to 40
million tons a year.
• Effect on
– Price
– Consumer’s surplus
– Producer’s surplus
– Deadweight loss
– Price of license