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

S

D

$4

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

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 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

cd

ef

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 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.

TaxesTaxes 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

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 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

The $20 subsidy would cause consumers to be a) $500 million better offb) $600 million better offc) $400 million better offd) $400 million worse

off

10

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