MARKETS IN ACTION
6
CHAPTER
Objectives
After studying this chapter, you will able to
 Explain how housing markets work and how price
ceilings create housing shortages and inefficiency
 Explain how labor markets work and how minimum
wage laws create unemployment and inefficiency
 Explain the effects of the sales tax
 Explain how markets for illegal goods work
 Explain why farm prices and farm revenues fluctuate
and how speculation and price stabilization agencies
influence farm prices and farm revenues
Turbulent Times
As more people compete for scarce land, house prices
and rents rise. As new technologies replace low-skilled
labor, the demand for low-skilled workers falls. Can
governments control prices and wages?
How do taxes affect prices and quantities, and who pays
the tax, the buyer or the seller?
What happens in a market when a good is made illegal?
How are farm prices and incomes affected by fluctuations
in harvests?
Housing Markets and Rent Ceilings
The 1906 earthquake in San Francisco left 200,000
people—more than half the city—homeless.
By the time the San Francisco Chronicle started publishing
again, a month after the earthquake, there was not a
single mention of a housing shortage.
The classified advertisements listed many more houses
and flats for rent than the advertisements for houses and
flats wanted.
How did the market achieve this outcome?
Housing Markets and Rent Ceilings
The Market Response to a
Decrease in Supply
Figure 6.1 shows the San
Francisco housing market
before the earthquake.
The quantity of housing
was 100,000 units and the
rent was $16 a month at
the intersection of D and
SS.
Housing Markets and Rent Ceilings
The earthquake decreased
the supply of housing and
the supply curve shifted
leftward to SSA.
The rent increased to $20
a month and the quantity
decreased to 72,000 units.
Housing Markets and Rent Ceilings
Long-Run Adjustments
The long-run supply of
housing is perfectly elastic
at $16 a month.
With the rent above $16 a
month, new houses and
apartments are built.
Housing Markets and Rent Ceilings
The building program
increases supply and the
supply curve shifts
rightward.
The quantity of housing
increases and the rent falls
to the pre-earthquake
levels (other things
remaining the same).
Housing Markets and Rent Ceilings
A Regulated Housing Market
A price ceiling is a regulation that makes it illegal to
charge a price higher than a specified level.
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.
Housing Markets and Rent Ceilings
Figure 6.2 shows the
effects of a rent ceiling that
is set below the equilibrium
rent.
The equilibrium rent is $20
a month.
A rent ceiling is set at $16
a month.
So the equilibrium rent is
in the illegal region.
Housing Markets and Rent Ceilings
At the rent ceiling, the
quantity of housing
demanded exceeds the
quantity supplied and
there is a housing
shortage.
Housing Markets and Rent Ceilings
With a housing shortage,
people are willing to pay
$24 a month.
Because the legal price
cannot eliminate the
shortage, other
mechanisms operate:
 search activity
 black markets
Housing Markets and Rent Ceilings
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.
Housing Markets and Rent Ceilings
Black Markets
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.
Housing Markets and Rent Ceilings
Inefficiency of Rent Ceilings
A rent ceiling leads to an inefficient use of resources.
The quantity of rental housing is less than the efficient
quantity and there is a deadweight loss, illustrated in
Figure 6.3 (page 125).
A rent ceiling is also, usually, unfair.
It does not generally benefit the poor.
Rather, it hurts the mobile newcomers and favors the less
mobile, established residents.
Housing Markets and Rent Ceilings
Figure 6.3 shows that a
rent ceiling decreases the
quantity of rental housing,
shrinks the producer and
consumer surplus by using
resources in search activity,
and creates a deadweight
loss.
The Labor Market and the Minimum Wage
New, labor-saving technologies become available every
year, which mainly replace low-skilled labor.
Does the persistent decrease in the demand for low-skilled
labor depress the wage rates of these workers?
The immediate effect of these technological advances is a
decrease in the demand for low-skilled labor, a fall in the
wage rate, and a decrease in the quantity of labor
supplied.
Figure 6.4 on the next slide illustrates this immediate
effect.
The Labor Market and the Minimum Wage
A decrease in the demand
for low-skilled labor is
shown by a leftward shift
of the demand curve.
A new labor market
equilibrium arises at a
lower wage rate and a
smaller quantity of labor
employed.
The Labor Market and the Minimum Wage
In the long run, people get
trained to do higher-skilled
jobs.
The supply of low-skilled
labor decreases, which is
shown by a leftward shift
of the short-run supply
curve.
The Labor Market and the Minimum Wage
If long-run supply is
perfectly elastic, the
equilibrium wage rate
returns to its initial level
(other things remaining the
same).
The Labor Market and the Minimum Wage
The 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 labor markets, it is called a
minimum wage.
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.
The Labor Market and the Minimum Wage
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.
Because employers cannot be forced to hire a greater
quantity 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.
Because the legal wage rate cannot eliminate the surplus,
the minimum wage creates unemployment
Figure 6.5 on the next slide illustrates these effects.
The Labor Market and the Minimum Wage
The equilibrium wage rate
is $4 an hour.
The minimum wage rate is
set at $5 an hour.
So the equilibrium wage
rate is in the illegal region.
The Labor Market and the Minimum Wage
The quantity of labor
employed is the quantity
demanded.
The quantity of labor
supplied exceeds the
quantity demanded.
Unemployment is the gap
between the quantity
demanded and the
quantity supplied.
The Labor Market and the Minimum Wage
The Minimum Wage in Practice
The United States has passed the Fair Standards Labor
Act, which currently sets the minimum wage at $5.15 per
hour.
This minimum wage has historically fluctuated between 35
percent and 50 percent of the average wage of production
workers.
Most economists believe that minimum wage laws
increase the unemployment rate of low-skilled younger
workers.
Taxes
Who Pays a Sales Tax?
Demand and supply analysis shows how the buyer and
the seller share the payment of a tax.
Buyers respond to the price with the tax, because that is
the price they must pay.
Sellers respond to the price without the tax, because that
is the price they receive.
The tax is a wedge between the price paid and price
received, which changes the incentives faced by buyers
and sellers.
Taxes
Figure 6.6 shows the
effects of a sales tax on
CD players.
The equilibrium price with
no tax is $100.
A tax of $10 per CD player
is introduced.
The curve S + tax shows
the new supply curve.
Taxes
The vertical distance
between the original
supply curve and the
supply curve with the tax
is equal to the amount of
the sales tax.
Buyers would have to pay
$110 to induce firms to
offer the original quantity
for sale.
Taxes
The tax changes the
equilibrium price and
quantity.
The quantity decreases.
The price paid by the
buyer rises to $105 and
the price received by the
seller falls to $95.
Taxes
The government collects a
tax revenue on the
decreased quantity.
The buyer and the seller
share the tax payment.
In this example, they share
it equally.
But it doesn’t always turn
out that way.
Taxes
The division of the tax between the buyer and the seller
depends on the elasticities of demand and supply.
Tax Division and Elasticity of Demand
To see the effect of the elasticity of demand on the division
of the tax payment, we look at two extreme cases.
 Perfectly inelastic demand: the buyer pays the entire tax.
 Perfectly elastic demand: the seller pays the entire tax.
 The more inelastic the demand, the larger is the buyers’
share of the tax.
Taxes
In this figure, demand is
perfectly inelastic—the
demand curve is vertical.
When a tax is imposed on
this good, the buyer pays
the entire tax.
Taxes
In this figure, demand is
perfectly elastic—the
demand curve is
horizontal.
When a tax is imposed on
this good, the seller pays
the entire tax.
Taxes
Tax Division 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: the seller pays the entire tax.
 Perfectly elastic supply: the buyer pays the entire tax.
 The more elastic the supply, the larger is the buyers’
share of the tax.
Taxes
In this figure, supply is
perfectly inelastic—the
supply curve is vertical.
When a tax is imposed on
this good, the seller pays
the entire tax.
Taxes
In this figure, supply is
perfectly elastic—the
supply curve is horizontal.
When a tax is imposed on
this good, the buyer pays
the entire tax.
Taxes
Sales Taxes in Practice
Taxes usually are levied on goods and services with an
inelastic demand.
The quantity purchased does not decrease by much after
the tax is imposed.
The government collects relatively larger tax receipts.
Taxes
Taxes and Efficiency
Except in the extreme
cases of perfectly inelastic
demand or supply when
the quantity remains the
same, imposing a tax
creates inefficiency.
Figure 6.9 shows the
inefficiency created by a
$10 tax on CD players.
Taxes
With no tax, the market is
efficient and the sum of
consumer surplus and
producer surplus is
maximized.
A tax shifts the supply
curve, decreases the
equilibrium quantity, raises
the price to the buyer, and
lowers the price to the
seller.
Taxes
The tax revenue takes part
of the consumer surplus
and producer surplus.
The decreased quantity
creates a deadweight loss.
Markets for Illegal Goods
The U.S. government prohibits trade of some goods, such
as illegal drugs.
Yet, markets exist for illegal goods and services.
How does the market for an illegal good work?
A Free Market for Drugs
To see how the market for an illegal good works, we begin
by looking at a free market and see the changes that occur
when the good is made illegal.
Markets for Illegal Goods
Figure 6.10 shows the
market for a drug such as
marijuana.
The equilibrium is at point
E.
The price is PC and the
quantity is QC.
Markets for Illegal Goods
A Market for Illegal Drugs
Prohibiting transactions in
a good or service raises
the cost of such trading.
If sellers (drug dealers) are
penalized, we must add
the cost of breaking the
law to the minimum supply
price.
Markets for Illegal Goods
If the penalty on the seller
is the amount HK, the
quantity supplied at a
market price of PC is QP.
A new supply curve
passes through point H.
The new equilibrium is at
point F. The price rises and
the quantity decreases.
Markets for Illegal Goods
Starting again at the
equilibrium point E,
suppose that buyers are
penalized (and not sellers).
Now, we must subtract the
cost of breaking the law
from the maximum price
that the buyer is willing to
pay.
Markets for Illegal Goods
If the penalty on the buyer
is the amount JH, the
quantity demanded at a
market price of PC is QP.
A new demand curve
passes through point H.
The new equilibrium is at
point G. The market price
falls and the quantity
decreases.
Markets for Illegal Goods
But the opportunity cost of
buying this illegal good
rises because the buyer
pays the market price plus
the cost of breaking the
law.
Markets for Illegal Goods
Now suppose that both
buyers and sellers are
penalized for trading in the
illegal drug.
We add the cost of
breaking the law to the
minimum supply price and
get a new supply curve.
Markets for Illegal Goods
The new equilibrium is at
point H.
The quantity decreases to
QP .
The market price is PC.
The buyer pays PB and the
seller receives PS.
Markets for Illegal Goods
Legalizing and Taxing Drugs
An illegal good can be legalized and 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.
Stabilizing Farm Revenues
An Agricultural Market
The supply of farm products is heavily influenced by
natural forces (weather, insects, etc.) beyond the control of
farmers.
Consumer demand for farm products is inelastic.
These two characteristics combine to make the market for
farm products and farm revenues volatile.
Stabilizing Farm Revenues
Figure 6.11(a) shows the
market for wheat.
Once the crop is planted,
supply is perfectly inelastic
along the momentary
supply curve MS0.
The price is $4 a bushel
and farm total revenue is
$80 billion.
Stabilizing Farm Revenues
A poor harvest decreases
supply.
Farmers lose $20 billion of
total revenue on the
decreased quantity sold.
But they gain $30 billion
from the higher price.
Because demand is
inelastic, total revenue
increases—to $90 billion.
Stabilizing Farm Revenues
Now a bumper harvest
increases supply.
Farmers lose $40 billion of
total revenue on the
original quantity because
the price falls.
They gain only $10 billion
from the increased quantity.
Because demand is
inelastic, total revenue
decreases—to $50 billion.
Stabilizing Farm Revenues
Speculative Markets in Inventories
Speculative markets have developed for the inventories of
those farm products that can be stored over long periods
of time.
Inventory holders speculate by:
 Buying for inventory when the expected future price
exceeds the current price.
 Selling from inventory when the current price exceeds
the expected future price.
Stabilizing Farm Revenues
Figure 6.12 shows how
inventory speculation
changes the outcome.
Supply is now perfectly
elastic at the price
expected by inventory
holders—supply curve S.
A poor harvest decreases
production but inventories
are sold off.
Stabilizing Farm Revenues
A bumper crop increases
production, but some of
the extra output goes into
inventory.
The price is stabilized at
the inventory speculators’
expected price.
Stabilizing Farm Revenues
In reality, speculation decreases but does not completely
eliminate price fluctuations.
While speculation does not stabilize farmers’ revenues, it
changes the effects of bumper harvests and crop failures.
Farmers’ total revenues now increase with bumper crops
and decrease with crop failures.
MARKETS IN ACTION
THE END
6
CHAPTER