Government Actions in Markets

Chapter 6

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Main ideas
After studying this chapter, you will be able to:

• Explain how rent ceilings create housing shortages and inefficiency

• Explain how minimum wage laws create unemployment and inefficiency
• Explain the effects of a tax
• Explain the effects of production quotas and subsidies on production, costs,
and prices
• Explain how markets for illegal goods work

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A Housing Market with a Rent Ceiling
Short-Run Supply
The short-run supply curve shows the change in the quantity of housing supplied as the
rent changes while the number of houses and apartment buildings remains constant
Long-Run Supply
The long-run supply curve shows how the quantity of housing supplied responds to a
change in price after enough time has elapsed for new apartment buildings and houses
to be erected under the government’s proposed scheme to eradicate the housing
shortage
Equilibrium
The equilibrium rent and quantity are determined by demand and short-run supply
Long-Run Adjustments
Figure 6.1(b) shows the long-run adjustment

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A Housing Market with a Rent Ceiling
A Regulated Housing Market
• A price ceiling is a regulation that
makes it illegal to charge a price
higher than a specified level
• When a price ceiling is applied to
housing markets, it is called a
rent ceiling
• When a price ceiling is applied to
housing markets, it is called a
rent ceiling
• A price ceiling set above the
equilibrium price has no effect
• A price ceiling below the
equilibrium price has powerful
effects on a market

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A Housing Market with a Rent Ceiling
• When a rent ceiling creates a housing shortage, two developments occur: search
activity and black markets
Search Activity
• The time spent looking for someone with whom to do business is called search
activity
• When a price is regulated and there is a shortage, search activity increases
• The opportunity cost of a good is equal not only to its price but also to the value of
the search time spent finding the good
Black Markets
• A black market is an illegal parallel market in which the price exceeds the legally
imposed price ceiling
• The level of a black market rent depends on how tightly the rent ceiling is enforced
• With loose enforcement, the black market rent is close to the unregulated rent

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A Housing Market with a Rent Ceiling
Inefficiency of Rent Ceilings
• In an unregulated market, the
market determines the rent at which
the quantity demanded equals the
quantity supplied
• In this situation, scarce resources
are allocated efficiently
• Marginal social benefit equals
marginal social cost (market
demand equals market supply)
Are Rent Ceilings Fair?
• According to the fair rules view,
anything that blocks voluntary
exchange is unfair, so rent ceilings
are unfair
• According to the fair result view, a
fair outcome is one that benefits the
less well off

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A Labour Market with a Minimum Wage
A Minimum Wage
• A price floor is a regulation that
makes it illegal to trade at a price
lower than a specified level
• When a price floor is applied to
labour markets, it is called a
minimum wage
• If a minimum wage is set below the
equilibrium wage, the minimum
wage has no effect
• If a minimum wage is set above the
equilibrium wage, the minimum
wage is in conflict with market
forces and does have some effects
on the labour market

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A Labour Market with a Minimum Wage
Inefficiency of a Minimum Wage
• In an unregulated labour market,
everyone who is willing to work for
the going wage rate gets a job and
the market allocates the economy’s
scarce labour resources accordingly
• The minimum wage frustrates the
market mechanism and results in
unemployment – wasted labour
resources – and an inefficient
amount of job search
• In the labour market, the supply
curve measures the marginal social
cost of labour to workers
• The demand curve measures the
marginal social benefit from labour
• This benefit is the value of the
goods and services produced

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Taxes
• Personal income taxes are deducted
from your earnings and value-added
taxes are added to the bill when you
buy something
Tax Incidence
• Tax incidence is the division of the
burden of a tax between the buyer and
the seller
A Tax on Sellers
• In Figure 6.6, the demand curve is D,
and the supply curve is S
• A tax on sellers is like an increase in
cost, so it decreases supply
• To determine the position of the new
supply curve, we add the tax to the
minimum price that sellers are willing
to accept for each quantity sold
• Equilibrium occurs where the new
supply curve intersects the demand
curve

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Taxes
A Tax on Buyers
• A tax on buyers lowers the amount they
are willing to pay the seller, so it
decreases demand and shifts the
demand curve leftward
• To determine the position of this new
demand curve, we subtract the tax from
the maximum price that buyers are
willing to pay for each quantity bought
Equivalence of Tax on Buyers and
Sellers
Value-Added Tax
• Value-added tax is an example of a tax
that the government imposes equally on
both buyers and sellers
• The division of the burden of a tax
between buyers and sellers depends on
the elasticities of demand and supply

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Taxes
Tax Division and Elasticity of Demand
• The division of the tax between buyers and sellers depends in part on the price
elasticity of demand
o Perfectly price inelastic demand – buyers pay
o Perfectly price elastic demand – sellers pay

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Taxes
Tax Division and Elasticity of Supply
• The division of the tax between buyers and sellers also depends, in part, on the price
elasticity of supply
o Perfectly price inelastic supply – sellers pay
o Perfectly price elastic supply – buyers pay

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Taxes
Taxes and Efficiency
• The price buyers pay is also the buyers’
willingness to pay, which measures
marginal benefit
Taxes and Fairness
The Benefits Principle
• The benefits principle is the proposition
that people should pay taxes equal to the
benefits they receive from the services
provided by government
The Ability-to-Pay Principle
• The ability-to-pay principle is the
proposition that people should pay taxes
according to how easily they can bear
the burden of the tax

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Subsidies and Quotas
Subsidies
• A subsidy is a payment made by the government to a producer
Production Quotas
• A production quota is an upper limit to the quantity of a good that may be produced in
a specified period

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Markets for Illegal Goods
A Market for an Illegal Drug
• When a good is illegal, the cost of trading in the good increases
Penalties on Sellers
• Drug dealers in South Africa face large penalties if their activities are detected
• These penalties are part of the cost of supplying illegal drugs, and they bring a
decrease in supply – a leftward shift in the supply curve
Penalties on Buyers
• Penalties fall on buyers, and the cost of breaking the law must be subtracted from
the value of the good to determine the maximum price buyers are willing to pay for
the drugs
Penalties on Both Sellers and Buyers
• If penalties are imposed on both sellers and buyers, both supply and demand
decrease
• The larger the penalties and the greater the degree of law enforcement, the larger is
the decrease in demand and/or supply

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