Lecture 5

• Explain how taxes change prices and quantities, are shared between buyers and sellers, and create inefficiency

  1. Explain how a tax on buyers affects prices and quantities

  2. Explain how a tax on sellers affects prices and quantities

  3. Explain how taxes create inefficiency
• Explain how a price ceiling works and show how a rent ceiling creates a housing shortage, inefficiency, and unfairness

  1. Explain how a price ceiling works

  2. Show how a rent ceiling creates a housing shortage

  3. Show how a rent ceiling creates inefficiency

  4. Show how a rent ceiling creates unfairness
• Explain how a price floor works and show how the minimum wage creates unemployment, inefficiency, and unfairness

  1. Explain how a price floor works

  2. Show how the minimum wage creates unemployment

  3. Show how the minimum wage creates inefficiency

  4. Show how the minimum wage creates unfairness
• Explain how a price support in the market for an agricultural product creates a surplus, inefficiency, and unfairness

  1. Explain how a price support creates a surplus

  2. Explain how a price support creates inefficiency

  3. Explain how a price support creates unfairness
• Tax incidence


  The division of a tax burden between the buyer and the seller
• When a good is taxed, it has two prices: a price that includes the tax and a price that excludes the tax
• Buyers respond to the price that includes the tax, sellers respond to the price that excludes the tax
• Tax wedge


  The difference between the price paid by the buyer and the price received by the seller

  
• A $10 tax on MP3 players is imposed


  The buyer's price rises by $5, the seller's price falls by $5, and the quantity decreases

  
• A $10 tax on sellers of MP3 players is imposed


  The buyer's price rises by $5, the seller's price falls by $5, and the quantity decreases

  
• Inefficiency of taxes


  • A tax places a wedge between the buyers' price (marginal benefit) and the sellers' price (marginal cost)
  • The equilibrium quantity is less than the efficient quantity and a deadweight loss arises
• Excess burden

  The deadweight loss from a tax, the amount by which the burden of a tax exceeds the tax revenue received by the government
• Incidence, inefficiency, and elasticity


  The incidence of a tax and its excess burden depend on the elasticities of demand and supply
• For a given elasticity of supply, the buyer pays a larger share of the tax the more inelastic is the demand for the good
• For a given elasticity of demand, the seller pays a larger share of the tax the more inelastic is the supply of the good
• Excess burden is smaller, the more inelastic is demand or supply
• Price ceiling or price cap

  A government regulation that places an upper limit on the price at which a particular good, service, or factor of production may be traded

  
• Rent ceiling

  A regulation that makes it illegal to charge more than a specified rent for housing
• A rent ceiling is imposed below the market equilibrium rent

  A shortage of housing arises
• Effects of a rent ceiling below the market equilibrium

  • Quantity of housing supplied decreases
  • Quantity of housing demanded increases
  • A shortage of housing arises
  • A black market develops
  • Increased search activity occurs
• With a rent ceiling, the outcome is inefficient - marginal benefit exceeds marginal cost, total surplus shrinks, and a deadweight loss arises
• Rent Ceiling

  • Outcome is inefficient
  • Marginal benefit exceeds marginal cost
  • Total surplus shrinks and a deadweight loss arises
  • People who can't find housing and landlords who can't offer housing at a lower rent lose
• The market is efficient with marginal benefit equal to marginal cost
• Consumer surplus plus producer surplus is as large as possible in an efficient housing market
• Inefficiency of Rent Ceiling

  • Consumer surplus shrinks
  • Producer surplus shrinks
  • A deadweight loss arises
  • Other resources are lost in search activity and evading and enforcing the rent ceiling law
• The rules of rent ceilings are not fair as some people cannot buy a house
• The results of rent ceilings are not fair as there is no equal share
• Rent ceilings do not avoid scarcity, they make scarcity work
• If rent ceilings are so bad, they exist because current renters gain and lobby politicians, and there are more renters than landlords
• Price Floor

  A government regulation that places a lower limit on the price at which a particular good, service, or factor of production may be traded

  
• Price Floor

  • Minimum wage in labor markets
• Minimum Wage

  1. Quantity demanded decreases

  2. Quantity supplied increases

  3. People are unemployed

  4. Allocation through increased search activity and illegal hiring
• Inefficiency of Minimum Wage

  • Firms' surplus and workers' surplus shrink, and a deadweight loss arises
  • Firms that cut back employment and people who can't find jobs at the higher wage rate lose
  • Total loss exceeds the deadweight loss because resources get used in costly job-search activity
• The rule of minimum wage is not fair
• The result of minimum wage is not fair
• If the wage rate doesn't allocate labor, non-wage allocation mechanisms may not be fair
• The effects of minimum wage on employment might be small if labor unions lobby for it
• How Governments Intervene in Markets for Farm Products

  • Isolate the domestic market from global competition
  • Introduce a price floor
  • Pay the farmers a subsidy
• Price Supports in Agriculture

  1. Price support is set above the market equilibrium price

  2. Creates a surplus

  3. Government buys the surplus

  4. Provides a subsidy to farmers
• Price support increases farmers' revenue but is inefficient as it creates deadweight loss