Chapter 6 (Parkin)Government Actions in MarketsIn this chapter we will study,- Government Intervention in the Market: Price Floors and Price Ceilings - The economic impact of unit taxes. - The economic effects of production quotas and subsidies on production, costs, and prices.- The markets for illegal goods.1Looking at the competitive market is there a way government can more efficiently and/or more fairly allocate resources? We will look at the effects on the market when the government imposes price controlsor taxes on a good/service.What are the effects of a Price Ceiling on a competitive market?Price Ceiling is a legally established maximum price a seller can charge.To illustrate, we will first look at the 1906 San Francisco housing. In this yearan earthquake destroyed the homes for about half of the city’s population.2The Unregulated 1906 San FranciscoHousing Market3BeforeNow let us look at a case when the government imposes a price ceiling (herecalled a rent ceiling)1906 San Francisco Housing MarketThe rent ceiling leads to a housing shortage. The market is not efficient and under produces housing. This results in a deadweight loss.4Rent ceilings lead to search activity and the development of black markets- Search activity is the time spent lookingfor someone with whom to do business.- A _____________ is an illegal market in which the price exceeds the legally imposed price ceiling. In a black market illegal arrangements are made between renters and landlords—often ateffective rental rates that are _______ than would be the case in an unregulated market.Are Rent Ceilings Efficient?Are Rent Ceilings Fair?5What are the effects of a price floor in the market for low skilled labor?A _______ is a government-imposed regulation that makes it illegal to charge a price lower than a specified level. When a price floor is applied to labor markets, it is called a _________. A minimum wage that is set above the equilibrium wage rate creates unemployment.We will first look at a market that does not have a minimum wage and suppose that there is a reduction in the demand for low skilled labor.6The Market for Low Skilled Labor7Let’s see what is expected to happen if we imposed a price floor at $5.The Market for Low Skilled LaborIf a minimum wage is set ______ the equilibrium wage rate, there ________ and this creates _______ and a _________. 8Are Minimum Wages Efficient?- Fewer workers are employed with a minimum wage, so les than the efficient quantity of workers is employed. At the quantity of labor employed, the marginal social benefit of labor exceeds its marginal social cost. - Because the quantity of labor employed is less than the efficiency quantity, there is deadweight loss. In addition to the deadweight loss, there is also increased job search. Higher job search costs borne by workers addto the loss from the minimum wage. Are Minimum Wages Fair?9In general, the minimum wage is unfair based on an evaluation of both the “result” and the “rules” of a minimum wage. What are the impacts of a unit tax on agood or service? Tax incidence is the share of a tax ultimately paid by consumers and sellers.- 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. 10Statutory incidence of a tax indicates who is legally responsible for the tax.11Economic incidence of a tax is the change in the distribution of private real income induced by a tax. (i.e. the amount the suppliers actually pay and theamount the consumers actually pay)For example, suppose there is a $20 tax placed on Hats. We will look at the statutory incidence being placed on the consumer and then the producer. 12Incidence of a unit tax imposed onthe demand sidePer Hat Tax Burden (economic incidence) toConsumes = Per Hat Tax Burden (economic incidence) toProducers =13Incidence of a unit tax imposed on theSupply side Per Hat Tax Burden (economic incidence) toConsumes = Per Hat Tax Burden (economic incidence) toProducers = 14Note that the economic incidence of a unit tax is independent of whether it is levied on consumers or producers.Tax wedge is the tax-induced difference between the price paid by consumers andthe price received by producers.Tax incidence depends on the price elasticities of supply and demand over the relevant price ranges. Let’s see what happens for cases when the price elasticity of the demand curve iseither perfectly inelastic or perfectly elastic over the relevant price range.15Incidence of a $20 unit tax imposed on the Supply side with a perfectly inelasticdemand curve Demand SP = 20 + Ps $70 Ps = 10 + Q/150 $50 Note in this case consumers pay the full amount of the tax.16Incidence of a unit tax imposed on the demand side with a perfectly inelastic supply curve17Taxes and EfficiencyTaxes drive a wedge between the price buyers pay and sellers receive. Taxes put a wedge between marginal benefit and marginal cost and therefore create inefficiency. The quantity produced is less than the efficient quantity.Taxes and Fairness- The Ability-to Pay Principle is the proposition that people should pay taxes according to how easily they can bear the burden on the tax.- The Benefits Principle is the proposition that people should pay taxes equal to the benefits they receive from the services provided by government. 18Production Quotas and SubsidiesA production quota is an upper limit to the quantity of a good that may be produced in a specific period of time. Production quotas will only have an impact if they are set below the equilibrium level of output in a market. - A production quota results in a decreasein quantity supplied, a rise in price, a decrease in marginal cost, inefficiency from underproduction, and an incentiveto cheat and overproduce.Let’s look at two cases and see if a production quota can increase farmers’ total revenue.19If the demand for corn is inelastic over the relevant price range, what will happen to aggregate framer’s total revenue when a quota is imposed? Corn (per Day)Price D0 Quantity20If the demand for corn is elastic over the relevant price range, what will happen to aggregate framer’s total revenue when a quota is imposed?