Ch. 6: Markets in Action.

Price ceiling and inefficiencies. Price floors (minimum wage) and inefficiency. Sales tax Volatility of farm prices and revenues How production subsidies and quotas influence

farm production, costs, and prices

The effect of price ceilings.

• Price ceiling is a “maximum” price.• A price ceilinig is “binding” only if ceiling is

below equilibrium price.• A binding price ceiling causes a shortage.

SR & LR effects without price ceiling

S

D

$4S-LR

Suppose equilibrium price of gasoline is $4 and a hurricane destroys numerous refineries. Examine SR & LR effects on price and quantity.

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

D

$4 S-LR

$5

$6

100 200 Millions of gallons per day

Suppose the equilibrium price of gasoline is $5 after the hurricane. Compared to the case where government does not intervene, a price ceiling of $4 would cause

Both pro

ducers

and co...

Produce

rs to

be worse

of..

Consumers

to be w

orse o...

Consumers

to be better o

...

25% 25%25%25%

300%

a) Both producers and consumers to be worse off.

b) Producers to be worse off, but consumers could be better or worse off.

c) Consumers to be worse off, but producers could be better or worse off.

d) Consumers to be better off, but producers to be worse off.

Based on the diagram below, assuming no black markets or search costs, a price ceiling of $4 would make consumers

$50 millionbetter off

$50 millionworse off

$100 millionbetter off

$100 millionworse off

25% 25%25%25%

300% D

$4 S-LR

$5

$6

100 200 Millions of gallons per day

a) $50 million better off

b) $50 million worse off

c) $100 million better off

d) $100 million worse off

Based on the diagram below, assuming no black markets or search costs, a price ceiling of $4 would make prodcuers

$50 millionbe...

$50 millionwo...

$150 millionb...

$150 millionw...

25% 25%25%25%

300% D

$4 S-LR

$5

$6

100 200 Millions of gallons per day

a) $50 million better off

b) $50 million worse off

c) $150 million better off

d) $150 million worse off

Suppose the equilibrium price of gasoline is $4 and a hurricane wipes out some gasoline refineries. The shortage caused by the price ceiling will be greater if the demand for gasoline is

Both pro

ducers

and co...

Produce

rs to

be worse

of..

Consumers

to be w

orse o...

Consumers

to be better o

...

25% 25%25%25%

300%

a) Both producers and consumers to be worse off.

b) Producers to be worse off, but consumers could be better or worse off.

c) Consumers to be worse off, but producers could be better or worse off.

d) Consumers to be better off, but producers to be worse off.

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 isa 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 offb. Sellers (employees) could be better or worse off. c. A deadweight loss.

S

D

1000

$2

500

$1

$3 ab

c

d

ef

1500

Based on the diagram in the previous slide, if a price floor is imposed at $3, there would be

a surp

lus of 5

...

a surp

lus of 1

...

A shorta

ge of ..

.

A shorta

ge of ..

.

25% 25%25%25%

300%

a) a surplus of 500

b) a surplus of 1000

c) A shortage of 500

d) A shortage of 1000

Based on diagram in the previous slide, compared to the case where there is no price floor, a price floor of $3 would make sellers

No better orw...

$250 betterof...

$750 worse off $500 betterof...

25% 25%25%25%

300%

a) No better or worse off

b) $250 better off

c) $750 worse off

d) $500 better off.

Based on diagram in the previous slide, compared to the case where there is no price floor, a price floor of $3 would make buyers

No better orw...

$250 betterof...

$750 worse off $500 worseoff...

25% 25%25%25%

300%

a) No better or worse off

b) $250 better off

c) $750 worse off

d) $500 worse off.

Based on diagram in the previous slide, a price floor of $3 would cause a deadweight loss of:

$0 $250 $500 $750

25% 25%25%25%

300%

a) $0

b) $250

c) $500

d) $750

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.

Income is lower on average among smokers in Mexico than in the U.S. This means that the consumers’ share of a tax on cigarettes would likely be greater in Mexico.

True

False

50%50%

300%

a) True

b) False

The supply of apples is highly inelastic in the short run. Consequently, any tax on apples will be borne primarily by

Apple produce

r...

Apple buyers.

50%50%

300%

a) Apple producers

b) Apple buyers.

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.

– 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 on1. Consumer surplus2. Producer surplus3. Tax revenue4. Deadweight loss

• Excess burden of tax reduction in consumer &

producer surplus minus tax revenue

Identical to deadweight loss

Consider the market for insulin. Suppose demand is perfectly inelastic, equilibrium price per dose is $10, and equilibrium quantity is 1 million per year. If a $2 tax is imposed on each dose, the annual tax revenue would be

$2 million Less than $2 m... More than $2 m...

33% 33%33%

300%

a) $2 million

b) Less than $2 million

c) More than $2 million.

Consider the market for insulin described above. A $2 tax would cause consumer’s surplus to ____.

Not change Decrease $2 mi... Decrease by le...

33% 33%33%

300%

a) Not change

b) Decrease $2 million

c) Decrease by less than $2 million.

Consider the market for insulin described above. A $2 tax would cause producer’s surplus to ____.

Not change Decrease $2 mi... Decrease by le...

33% 33%33%

300%

a) Not change

b) Decrease $2 million

c) Decrease by less than $2 million.

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:

Subsidiesa payment made by the government to a producer

that’s in addition to market price received.

Production quotasan 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

The $20 subsidy would cause consumers to be

$500 millionbetter off

$600 millionbetter off

$400 millionbetter off

$400 millionworse off

25% 25%25%25%

300%

a) $500 million better off

b) $600 million better off

c) $400 million better off

d) $400 million worse off

The $20 subsidy would cause producers to be

$500 millionbetter off

$600 millionbetter off

$400 millionbetter off

$400 millionworse off

25% 25%25%25%

300%

a) $500 million better off

b) $600 million better off

c) $400 million better off

d) $400 million worse off

The $20 subsidy would cost taxpayers

$1000 million $1200 million $500 million $600 million

25% 25%25%25%

300%

a) $1000 million

b) $1200 million

c) $500 million

d) $600 million

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

Suppose that a “binding” quota on peanuts is imposed. This will

Make

consu

mers...

Make

consu

mers...

Make

both co

ns...

Make

both co

ns...

25% 25%25%25%

300%

a) Make consumers worse off, but producers better off.

b) Make consumers worse off, but producers could be better or worse off.

c) Make both consumers and producers worse off.

d) Make both consumers and producers better off.

Markets for Illegal Goods

• How do increased penalties on sellers affect price, quantity?

• How do increased penalties on buyers affect price, quantity?

• Illegal immigration?