Government Actions in Markets

Introduction

Government interventions in markets, such as price controls, taxes, quotas, and subsidies, are designed to address perceived market failures or achieve social objectives. These policies can have significant effects on market outcomes, including prices, quantities, efficiency, and fairness. This study guide explores the microeconomic impacts of these interventions.

Controls on Prices

Price Ceilings and Price Floors

Price controls are government-imposed limits on the prices that can be charged in a market. They come in two main forms:

• Price ceiling: A legal maximum on the price at which a good can be sold.

• Price floor: A legal minimum on the price at which a good can be sold.

These controls are often applied to essential goods and services, such as housing and labor.

A Housing Market with a Rent Ceiling

Definition and Effects

A rent ceiling is a price ceiling applied to the housing market, making it illegal to charge rent above a specified level. The effects depend on the relationship between the ceiling and the equilibrium rent:

• If the rent ceiling is above equilibrium rent, it has no effect.

• If the rent ceiling is below equilibrium rent, it creates:

  • A housing shortage

  • Increased search activity

  • Illegal trading

Housing Shortage

When the rent ceiling is set below equilibrium, the quantity of housing demanded exceeds the quantity supplied, resulting in a shortage.

• Example: If equilibrium rent is $1,200/month and the ceiling is $1,000/month, the market cannot clear, and a shortage arises.

Increased Search Activity

Search activity refers to the time and effort spent looking for housing. When shortages occur due to price ceilings, search activity increases, raising the opportunity cost of housing (regulated rent plus search cost).

Illegal Trading

Rent ceilings may incentivize illegal trading, where renters pay above the legal ceiling to secure housing. This can result in rents higher than those in an unregulated market.

Inefficiency of a Rent Ceiling

Rent ceilings below equilibrium lead to inefficient underproduction of housing services. The marginal social benefit exceeds the marginal social cost, creating a deadweight loss.

• Consumer and producer surplus shrink.

• Potential loss from increased search activity.

Deadweight loss is the loss of total surplus that occurs because the quantity traded is less than the efficient quantity.

Fairness of Rent Ceilings

Rent ceilings are often criticized for being unfair:

• Fair rules view: Unfair because they block voluntary exchange.

• Fair results view: Unfair because they do not generally benefit the poor.

Scarce housing is allocated by lottery, first-come first-served, or discrimination, none of which guarantee a fair outcome.

A Labour Market with a Minimum Wage

Definition and Effects

A minimum wage is a price floor applied to labor markets, making it illegal to pay less than a specified wage. Effects depend on its relation to equilibrium wage:

• If set below equilibrium, no effect.

• If set above equilibrium, creates:

  • Unemployment (labor surplus)

  • Quantity of labor hired is less than in an unregulated market

Minimum Wage and Unemployment

When minimum wage exceeds equilibrium wage, the quantity of labor supplied exceeds the quantity demanded, resulting in unemployment.

• Example: Equilibrium wage is $14/hour, minimum wage is set at $15/hour. Only 20 million hours are demanded, but more are supplied.

Fairness of Minimum Wage

Minimum wage rates vary by province. Most economists believe minimum wage laws increase unemployment among low-skilled, younger workers.

Inefficiency of Minimum Wage

Minimum wage above equilibrium leads to inefficient outcomes:

• Quantity of labor employed is less than efficient quantity.

• Supply of labor measures marginal social cost (leisure forgone).

• Demand for labor measures marginal social benefit (value of goods produced).

• Deadweight loss arises; worker and firm surplus decrease.

Taxes

Tax Incidence

Tax incidence is the division of the burden of a tax between buyers and sellers. The actual burden depends on how prices adjust:

• If price rises by full tax, buyers pay all.

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

• If price does not rise, sellers pay all.

Equivalence of a Tax on Buyers and Sellers

Whether a tax is levied on buyers or sellers, the market outcome is the same. Both shift the supply or demand curve, resulting in a new equilibrium with lower quantity and higher price for buyers.

Tax as a Wedge

A tax creates a wedge between the price buyers pay and the price sellers receive. The equilibrium quantity is where the vertical gap between supply and demand equals the tax size.

Taxes and Efficiency

Except in cases of perfectly inelastic demand or supply, taxes create inefficiency by reducing the quantity traded below the efficient level, resulting in deadweight loss.

• Consumer and producer surplus decrease.

• Tax revenue takes part of the total surplus.

• Decreased quantity creates deadweight loss.

Taxes in Practice

Taxes are often levied on goods with inelastic demand or supply (e.g., alcohol, tobacco, gasoline), so buyers or sellers with less elastic responses bear most of the tax burden.

Taxes and Fairness

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

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

Production Quotas and Subsidies

Production Quotas

A production quota is an upper limit on the quantity of a good that may be produced during a specified period. Quotas reduce supply, raise prices, and can lead to inefficiency and incentives to cheat.

• Example: Quota reduces output from 16 to 14 million kg, price rises from $3 to $5/kg, marginal cost falls to $2/kg.

Inefficiency of Quotas

• Marginal social benefit equals increased market price.

• Marginal social cost decreases.

• Production is inefficient; deadweight loss arises.

Subsidies

A subsidy is a payment made by the government to producers, increasing supply and lowering market price, but raising marginal cost for additional output.

• Example: Subsidy of $20/tonne increases output from 40 to 60 million tonnes, price falls to $30/tonne, but farmers receive $50/tonne (price plus subsidy).

Inefficient Overproduction from Subsidies

• Marginal social benefit equals lower market price.

• Marginal social cost exceeds marginal social benefit.

• Overproduction is inefficient; deadweight loss arises.

Summary Table: Effects of Government Interventions

Key Formulas and Concepts

• Deadweight Loss: Area between demand and supply curves over the range of inefficient quantity.

• Tax Incidence: Determined by relative elasticities of demand and supply.

• Equilibrium with Tax:

• Consumer Surplus:

• Producer Surplus:

Additional info: These notes expand on the slides by providing definitions, examples, and formulas for key microeconomic concepts related to government interventions in markets.