Ch. 6: Markets in Action.

1. Ch. 6: Markets in Action. • Price ceiling and inefficiencies. • Price floors (minimum wage) and inefficiency. • Taxes and inefficiencies

2. The effect of price ceilings. • Price ceiling is a maximum price. • “binding” only if ceiling is below equilibrium price. • binding price ceiling causes a shortage.

3. SR & LR effects without price ceiling Suppose equilibrium price of gasoline is $4 and a hurricane destroys numerous refineries. Examine SR & LR effects on price and quantity. S $4 D

4. Compare outcomes with and without a price ceiling at $4 • Shortage • Effect on consumer’s surplus • Effect on producer’s surplus • Deadweight loss • Black markets, search costs, enforcement costs S $4 S-LR D Millions of gallons per day

5. The effect of price floors • A price floor is a minimum price • binding only if it is set above the equilibrium price • binding price floor creates a surplus.

6. Minimum Wage • Is a price floor on labor. • Why is there a minimum wage? • Would a higher minimum wage make workers better off? • Efficiency versus equity

7. The Labor Market and the Minimum Wage Minimum wage is a price floor. Price floor is “binding” only if it is above equilibrium price.

8. The Labor Market and the Minimum Wage A “binding” price floor • reduces consumer (employer) surplus • Could increase or decrease producer (employee) surplus • Creates a deadweight loss • Destroys some of the producer surplus (employee) through search activity.

9. The Effect of Price Floors In general, a “binding” price floor will result in: a. Buyers (employers) are worse off b. Sellers (employees) could be better or worse off. c. A deadweight loss.

10. Taxes • Tax Incidence • the division of the burden of a tax between the buyer and the seller. • When an item is taxed, its price might rise by the full amount of the tax, by a lesser amount, or not at all. • If the price rises by the full amount of the tax, the buyer pays the tax. • If the price rises by a lesser amount than the tax, the buyer and seller share the burden of the tax. • If the price doesn’t rise at all, the seller pays the tax.

11. Taxes • Tax Incidence • Tax incidence doesn’t depend on tax law. • The law might impose a tax on the buyer or the seller, but the outcome will be the same. • Example: On July 1, 2002, Mayor Bloomberg upped the cigarette tax in New York City from almost nothing to $1.50 a pack.

12. Tax Incidence .

13. Taxes • Tax incidence: • Buyer: $1 • Seller : $.50

14. Taxes • A Tax on Buyers • suppose that buyers, not sellers, are taxed $1.50 a pack. • Tax incidence: • Buyer: $1 • Seller: $.50

15. Tax Division and Elasticity of Demand The more inelastic the demand, the larger is the buyers’ share of the tax.

16. Taxes • The more elastic the supply, the larger is the buyers’ share of the tax.

17. Taxes • Taxes in Practice • Taxes usually are levied on goods and services with an inelastic demand or an inelastic supply. • Alcohol, tobacco, and gasoline have inelastic demand, so the buyers of these items pay most the tax on them. • Labor has a low elasticity of supply, so the seller—the worker—pays most of the income tax and most of the Social Security tax.

18. Taxes Taxes create allocative inefficiency unless S or D is perfectly inelastic. • What’s effect of tax on • Consumer surplus • Producer surplus • Tax revenue • Deadweight loss • Excess burden of tax • reduction in consumer & producer surplus minus tax revenue • Identical to deadweight loss

19. Subsidies and Quotas • Fluctuations in the weather bring big fluctuations in farm output. • How do changes in farm output affect the prices of farm products and farm revenues? • How might farmers be helped by intervention in markets for farm products?

20. Stabilizing Farm Revenues • A poor harvest decreases supply. • Effect on total revenue? • higher price • lower quantity • How would answer change if demand were elastic?

21. Stabilizing Farm Revenues • A large harvest increases supply. • Effect on total revenue? • Lower price • Higher quantity • How would answer change if demand were elastic?

22. Stabilizing Farm Revenues Intervention in markets for farm products takes two main forms: • Subsidies a payment made by the government to a producer that’s in addition to market price received. • Production quotas an upper limit on the quantity of a good that may be produced during a specified period.

23. Subsidies Effect of $20 subsidy • Equilibrium quantity • Equilibrium price • Consumer surplus • Producer surplus • Cost to taxpayers • Deadweight loss

24. The $20 subsidy would cause consumers to be • $500 million better off • $600 million better off • $400 million better off • $400 million worse off 0% 10

25. Quotas • Maximum production allowed. • Binding only if below equil quantity • limits total production to 40 million tons a year. • Effect on • Price • Consumer’s surplus • Producer’s surplus • Deadweight loss • Price of license