Introduction to Market Intervention

This study guide covers the effects of government intervention in markets, focusing on sales taxes, price controls (ceilings and floors), and their impact on market efficiency. It also examines real-world applications such as rent controls, agricultural price supports, and minimum wage laws.

How Sales Taxes Affect Market Equilibrium

Sales Tax and Supply Curve

A sales tax is an indirect tax imposed on the sale of goods and services. When a sales tax is introduced, it increases the cost of production for sellers, causing the supply curve to shift upward by the amount of the tax.

• Supply Curve Shift: The supply curve shifts vertically upward by the tax amount, reflecting higher costs for each quantity supplied.

• Market Price: The new equilibrium price paid by consumers (Pconsumer) rises, but not by the full amount of the tax.

• Seller's Price: The price received by sellers (Pseller) is lower than the price paid by consumers, as part of the tax is absorbed by sellers.

Example: If a TV costs $300 and a 10% sales tax is imposed, the price rises to $330 if the entire tax is passed on. In reality, the price increase is less than $30, as the burden is shared.

Tax Incidence and Elasticity

The incidence or burden of a tax refers to how the tax is shared between consumers and producers. The division depends on the relative price elasticity of demand and supply:

• More Elastic Demand: Consumers are sensitive to price changes; sellers bear more of the tax burden.

• More Inelastic Demand: Consumers are less sensitive to price changes; consumers bear more of the tax burden.

Key Formula:

where is the price elasticity of supply and is the price elasticity of demand.

Price Controls and Market Efficiency

Government in the Free Market

• Allocative Efficiency: Resources are allocated to their highest-valued uses; consumers who value the product most receive it.

• Productive Efficiency: Goods are produced at the lowest possible cost.

• Adam Smith's 'Invisible Hand': The free market, without intervention, tends to achieve both types of efficiency.

Types of Price Controls

• Price Ceiling: A legal maximum price set below the equilibrium price (e.g., rent controls, milk prices).

• Price Floor: A legal minimum price set above the equilibrium price (e.g., minimum wage, agricultural price supports).

Market Disequilibrium

• When prices are set above or below equilibrium, excess demand (shortage) or excess supply (surplus) results.

• At any disequilibrium price, the quantity exchanged is the lesser of quantity demanded and supplied.

Rent Controls: A Case Study in Price Ceilings

Characteristics of the Rental Housing Market

• Continuous population growth in limited geographic areas (e.g., Vancouver).

• Inelastic demand: Housing is a necessity.

• Inelastic supply: Slow and difficult to add new housing units.

Effects of Rent Controls

• Short-Run Effects:

  • Increased search activity for apartments.

  • Development of black markets.

  • Non-price discrimination by suppliers (e.g., landlords choose tenants based on criteria other than price).

• Long-Run Effects:

  • Disincentive for developers to build new housing.

  • Slow adjustment to relieve shortages.

Agricultural Price Supports: The Farm Problem

Causes of the Farm Problem

• Technological improvements increase supply over time.

• Price inelastic demand: Consumers do not significantly increase quantity demanded as prices fall.

• Income inelastic demand: Demand for food does not rise much as incomes increase.

• Result: Falling and volatile prices and incomes for farmers.

Government Solutions

1. Purchase Surplus: Government buys excess supply at a set price above equilibrium.

2. Production Quotas: Government restricts the amount produced to keep prices high.

3. Subsidies: Government pays producers to lower prices for consumers while maintaining producer income.

Price Floors: Minimum Wage

Minimum Wage as a Price Floor

• A minimum wage is a price floor set above the equilibrium wage in the labor market.

• Example: Setting minimum wage at $15/hour when equilibrium is $9/hour.

• Creates excess supply of labor (unemployment) if demand and supply are unchanged.

Effects of Minimum Wage

• Traditional theory predicts higher unemployment.

• Empirical evidence (e.g., research by David Card) shows that unemployment does not always rise as minimum wage increases.

• Reason: Higher wages may lead to increased worker productivity as businesses invest in capital, shifting the demand for labor to the right.

Key Formula:

where is the quantity of labor supplied and is the quantity of labor demanded at the minimum wage.

Summary Table: Price Controls and Their Effects

Conclusion

Government intervention through taxes, price ceilings, and price floors can address certain market failures or social goals, but often creates new problems such as shortages, surpluses, or inefficiencies. The actual effects depend on market elasticities and the specific context of intervention.