Government Actions in Markets

Introduction

This chapter examines how government interventions such as price ceilings, price floors, taxes, subsidies, and prohibitions affect market outcomes. These policies can lead to unintended consequences, including shortages, surpluses, inefficiency, and the emergence of black markets.

Price Controls

Price Ceilings

A price ceiling is a legal maximum on the price at which a good can be sold. When applied to housing, it is called a rent ceiling.

• Binding Price Ceiling: Set below the equilibrium price, making it illegal to charge higher prices.

• Effects:

  • Creates a shortage: Quantity demanded exceeds quantity supplied.

  • Leads to increased search activity and black markets.

  • Reduces both consumer and producer surplus, causing deadweight loss.

• Example: If the equilibrium rent is $1,400/month and a rent ceiling is set at $1,200/month, a shortage arises as more people want to rent at the lower price, but fewer landlords are willing to supply housing.

Allocation of Scarce Housing

• Lottery: Random allocation to the lucky.

• First-come, first-served: Those with the greatest foresight benefit.

• Discrimination: Landlords may choose tenants based on personal preferences.

• None of these methods guarantee fairness or efficiency.

Inefficiency and Fairness

• Deadweight loss: The loss of total surplus due to underproduction.

• Fair-rules view: Rent ceilings are unfair as they block voluntary exchange.

• Fair-results view: Rent ceilings do not necessarily benefit the poor and may worsen allocation.

Price Floors

A price floor is a legal minimum on the price at which a good can be sold. In labor markets, this is known as the minimum wage.

• Binding Price Floor: Set above the equilibrium price, making it illegal to pay less.

• Effects:

  • Creates a surplus: Quantity supplied exceeds quantity demanded (e.g., unemployment in labor markets).

  • Reduces employment below the efficient level.

  • Increases search time for jobs and may lead to discrimination.

• Example: If the equilibrium wage is $14/hour and the minimum wage is set at $15/hour, fewer workers are hired, and unemployment rises.

Fairness and Inefficiency

• Minimum wage benefits only those who keep their jobs, not all workers.

• Blocks voluntary exchange between firms and workers willing to work for less.

• Leads to deadweight loss and reduced total surplus.

Taxes and Subsidies

Tax Incidence

Tax incidence refers to how the burden of a tax is shared between buyers and sellers, regardless of whom the law says must pay the tax.

• If the price rises by the full amount of the tax, buyers bear the burden.

• If the price rises by less than the tax, the burden is shared.

• If the price does not rise, sellers bear the burden.

Equivalence of Tax on Buyers and Sellers

• Imposing a tax on either side of the market (buyers or sellers) has the same economic effect.

• Example: A $3 tax on cigarettes can be levied on either buyers or sellers; the division of the burden depends on market elasticities.

Tax as a Wedge

• A tax creates a wedge between the price buyers pay and the price sellers receive.

• The equilibrium quantity falls to where the vertical gap between supply and demand equals the tax.

Taxes and Efficiency

• Taxes reduce the quantity traded below the efficient level, creating deadweight loss.

• Marginal social benefit exceeds marginal social cost at the new, lower quantity.

Elasticity and Tax Incidence

• Elasticity of demand: The more inelastic the demand, the greater the burden on buyers.

• Elasticity of supply: The more inelastic the supply, the greater the burden on sellers.

Taxes in Practice

• Taxes are often levied on goods with inelastic demand (e.g., alcohol, tobacco, gasoline) so buyers bear most of the burden.

• Labor supply is relatively inelastic, so workers bear most of payroll taxes.

Principles of Tax Fairness

• Benefits principle: People should pay taxes in proportion to the benefits they receive from government services.

• Ability-to-pay principle: People should pay taxes according to their ability to bear the burden (e.g., higher income, higher taxes).

Production Quotas and Subsidies

Production Quotas

A production quota is an upper limit on the quantity of a good that may be produced. Quotas raise prices, reduce output, and create inefficiency.

• Producers may have an incentive to cheat and exceed the quota.

• Deadweight loss arises due to underproduction.

Subsidies

A subsidy is a payment by the government to producers, lowering their costs and increasing output.

• Leads to overproduction and inefficiency.

• Marginal social cost exceeds marginal social benefit at the new, higher output.

Markets for Illegal Goods

Illegal Markets

When the government prohibits certain goods (e.g., drugs), illegal markets can still emerge.

• Penalties on sellers reduce supply, raising prices and lowering quantity.

• Penalties on buyers reduce demand, lowering prices and quantity.

• Penalties on both sides further reduce quantity traded.

• Legalizing and taxing can achieve similar reductions in consumption as prohibition, but with different social costs.

Costs and Benefits of Prohibition

• Benefits: Reduces undesirable behavior.

• Costs: Enforcement expenses, disrespect for law, disproportionate enforcement, incarceration.

Special Topics: Marriage Market in China and One-Child Policy

Unintended Outcomes of the One-Child Policy

• Imbalanced sex ratios (more males than females).

• Fewer siblings and grandchildren.

• Potential for spoiled children and fewer caretakers for aging parents.

• Distortions in the marriage market: women may marry older, wealthier men; poorer men face difficulty finding spouses.

Key Formulas and Concepts

• Deadweight Loss (DWL): The loss in total surplus due to market inefficiency (e.g., from taxes, price controls).

• Tax Wedge: The difference between what buyers pay and sellers receive due to a tax.

• Elasticity and Tax Incidence:

  • If demand is more inelastic than supply, buyers bear more of the tax burden.

  • If supply is more inelastic than demand, sellers bear more of the tax burden.

Key Equations

• Tax incidence on buyers:

• Tax incidence on sellers:

• Deadweight loss from a tax:

Review Questions (Selected)

• Minimum wage laws set a legal minimum wage, creating unemployment if set above equilibrium.

• Rent controls are price ceilings that can lead to shortages, black markets, and inefficient allocation.

• Tax incidence depends on the relative elasticities of demand and supply, not on whom the tax is legally imposed.

Summary Table: Effects of Government Interventions

Additional info: Some context and examples have been expanded for clarity and completeness, including formulas and summary tables for exam preparation.