Unit 6 – MORE ON

MARKETS IN ACTION

1. Housing Markets and Rent Ceilings

2. The Labour Market and the Minimum
Wage
3. Taxes
4. Subsidies and Quotas
After studying this unit, you will be able to:
Explain how housing markets work and how price ceilings
create housing shortages and inefficiency
Explain how labour markets work and how minimum wage
laws create unemployment and inefficiency
Explain the effects of a tax
Explain why farm prices and revenues fluctuate and how
production subsidies and quotas influence farm production,
costs, and prices
Explain how markets for illegal goods work
6.1. Housing Markets and Rent Ceilings
6.1.1. Rent Ceilings

A price ceiling is a regulation that makes it illegal to charge a

price higher than a specified level.

A price ceiling applied to

the housing market, is
called a rent ceiling.
The effect of a price (rent)
ceiling depends on whether
it is imposed at a level that
is above or below the
equilibrium price (rent).
 A price ceiling set above the equilibrium price has no
effect. The reason is that the price ceiling does not
constrain the market forces. The force of the law and the
market forces are not in conflict. But a price ceiling below
the equilibrium price has powerful effects on a market. It
prevents the price from regulating the quantities
demanded and supplied and creates inefficiency, namely
a market shortage.
When a rent ceiling creates a housing shortage, two
developments occur. They are: Search activity and Black
markets
Search Activity
Black Markets
1. SEARCH ACTIVITY

The time spent looking for someone with whom to do business is called search
activity. We spend some time in search activity almost every time we buy
something. You want the latest hot CD, and you know four stores that stock it. But
which store has the best deal? You need to spend a few minutes on the telephone
finding out. In some markets, we spend a lot of time searching.
An example is the housing market in which we spend a lot of time checking the
alternatives available before making a choice.
But when a price is regulated and there is a shortage, search activity increases. In
the case of a rent-controlled housing market, frustrated would be renters scan the
newspapers, not only for housing ads but also for death notices! Any information
about newly available housing is useful.
And they race to be first on the scene when news of a possible supplier breaks.

2. BLACK MARKETS

A black market is an illegal parallel market in which the price exceeds the legally
imposed price ceiling. It occurs in rent-controlled housing, and often in ticket sales
for big sporting events and rock concerts. When rent ceilings are in force,
frustrated renters and landlords constantly seek ways of increasing rents. One
common way is for a new tenant to pay a high price for worthless fittings, such as
charging R2 000 for threadbare curtains. Another is for the tenant to pay an
exorbitant price for new locks and keys.
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. But
with strict enforcement, the black market rent is equal to the maximum price that
renters are willing to pay.
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).
Figure 5.9 shows the inefficiency of a rent ceiling. If the rent is fixed at R1 600 per
month, 100 000 units are supplied. Marginal benefit is R2 400 a month. The light
blue triangle above the supply curve below the rent ceiling line shows producer
surplus. Because the quantity of housing is less than the competitive quantity, there
is a deadweight loss, shown by the dark grey triangle. This loss is borne by the
consumers who can’t find housing and by producers who can’t supply housing at
the new lower price. Consumers who do find housing at the controlled rent gain. If
no one incurs search costs, consumer surplus is shown by the sum of the light grey
triangle and the blue rectangle. But search costs might eat up part of the consumer
surplus, possibly as much as the amount shown by the blue rectangle.
Inefficiency of Rent Ceilings
6.2. The Labour Market and the 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.
For each one of us, the labour market is the market that influences the
jobs we get and the wages we earn. Firms decide how much labour to
demand, and the lower the wage rate, the greater is the quantity of
labour demanded. Households decide how much labour to supply, and
the higher the wage rate, the greater is the quantity of labour supplied.
The wage rate adjusts to make the quantity of labour demanded equal to
the quantity supplied.
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. The minimum wage and market forces are not in conflict. 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. Let’s study these
effects by returning to the market for low-skilled labour.
Suppose that with an equilibrium wage of R8 an hour (Figure 5.10a), the
government sets a minimum wage at R10 an hour.

In the short run, there are a given number of people who have a given skill, training, and
experience. The short-run supply of labour describes how the number of hours of labour
supplied by this given number of people changes as the wage rate changes. To get them
to work more hours, they must be offered a higher wage rate. In the long run, people can
acquire new skills and find new types of jobs. The number of people in the low-skilled
labour market depends on the wage rate in this market compared with other opportunities.
If the wage rate of low-skilled labour is high enough, people will enter this market. If the
wage rate is too low, people will leave it. Some will seek training to enter higher-skilled
labour markets, and others will stop working. The long-run supply of labour is the
relationship between the quantity of labour supplied and the wage rate after enough time
has passed for people to enter or leave the low-skilled labour market. If people can freely
enter and leave the low-skilled labour market, the long-run supply of labour is perfectly
elastic.
Figure 5.11 shows the minimum wage as the horizontal blue line labelled
“Minimum wage.” A wage below this level is illegal, in the grey-shaded illegal
region. At the minimum wage rate, 20 million hours of labour are demanded
(point A) and 22 million hours of labour are supplied (point B), so 2 million hours
of available labour are unemployed.
With only 20 million hours demanded, some workers are willing to supply that 20
millionth hour for R6. Frustrated unemployed workers spend time and other
resources searching for hard-to-find jobs.
Inefficiency of Minimum Wage

If a minimum wage is set above the equilibrium wage, the

minimum wage is in conflict with market forces and creates
inefficiency.
The Effect of Minimum Wage Laws

The surplus in the market for labour generates

unemployment.
Taxes

Almost everything you earn and most things you buy are
taxed.
Tax Incidence
Tax incidence is the division of the burden of a tax between
the buyer and the seller.
A Tax On Sellers
When the government imposes a tax on the sale of a good,
the price paid by the buyer might rise by the full amount of the
tax, by a lesser amount, or not at all.
A Tax On Buyers

When a transaction is taxed, there are two prices: the price

paid by buyers, which includes the tax; and the price received
by sellers, which excludes the tax.
Equivalence of Tax On buyers and Sellers

A tax is like a wedge between the buying price and the selling
price.
It is the size of the wedge, not the side of the market on which
the tax is imposed by the government, that determines the
effects of the tax.
Can We Share the Burden Equally?
Value Added Tax
Tax Division and Elasticity of Demand

Perfectly Inelastic Demand

Perfectly Elastic Demand
Tax Division and Elasticity of Supply

Perfectly Inelastic Supply

Perfectly Elastic Supply
Taxes in Practice
Taxes and Efficiency
Subsidies and Quotas

Harvest Fluctuations
A subsidy is a payment made by the government to a
producer.
A subsidy is like a negative tax.
Since a tax is equivalent to an increase in cost, a subsidy is
equivalent to a decrease in cost.
A subsidy brings an increase in supply.
Poor Harvest
Bumper Harvest
Elasticity of Demand
Avoiding a Fallacy of Composition
Subsidies
Production Quotas

A production quota is an upper limit to the quantity of a good

that may be produced in a specified period.

When the government

sets a production quota, it
does not regulate the price.
Market forces determine it.
However, a production
quota is inefficient because
it results in underproduction.
At the quota quantity,
marginal benefit is equal to
the market price and
marginal cost is less than
the market price, so
marginal benefit exceeds
marginal cost.
Markets for Illegal Goods

A Free Market for a Drug

A Market for an Illegal Drug

Penalties on Sellers
Penalties on Buyers
Penalties on Both Sellers
and Buyers
Legalising and Taxing Drugs

Illegal Trading to Evade the Tax

Taxes Versus Prohibition: Some Pros and Cons