Ch06 7e Lecture

8/11/2019 Ch06 7e Lecture

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2010 Pearson Education Canada


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Even though house prices are falling, some rentsrose by 10 percent in 2007.

Can governments cap rents to help renters?

Can governments make housing more affordableby raising incomes with minimum wage laws?

The government taxes almost everything we buy.

But who actually pays and who benefits when a taxis cut: buyers or sellers?

The government subsidizes some farmers and limitthe quantities that other farmers may produce.

Do subsidies and production limits help to make

markets efficient?


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Skip Market for Illegal Markets

(pp 144 to 145 in the textbook)


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A price ceilingor price capis a regulation that makes itillegal to charge a price higher than a specified level.

When a price ceiling is applied to a housing market it iscalled a rent ceiling.

If the rent ceiling is set abovethe equilibrium rent, it hasno effect. The market works as if there were no ceiling.

But if the rent ceiling is set belowthe equilibrium rent, ithas powerful effects.

A Housing Market with a Rent Ceiling


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Housing Shortage

Figure 6.1 shows theeffects of a rent ceilingthat is set belowthe

equilibrium rent.

The equilibrium rent is$1,000 a month.

A rent ceiling is set at$800 a month.

So the equilibrium rent is

in the illegal region.



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At the rent ceiling,the quantity ofhousing demanded

exceeds the quantitysupplied.

There is a shortageof housing.




Because the legal pricecannot eliminate theshortage, othermechanisms operate:

Search activity

Black markets

With a housingshortage, people arewilling to pay up to$1,200 a month.




Search Activity

The time spent looking for someone with whom to dobusiness is called search activity.

When a price is regulated and there is a shortage, searchactivity increases.

Search activity is costly and the opportunity cost ofhousing equals its rent (regulated) plus the opportunity

cost of the search activity (unregulated).

Because the quantity of housing is less than the quantityin an unregulated market, the opportunity cost of housing

exceeds the unregulated rent.




Black Markets

A black marketis an illegal market that operatesalongside a legal market in which a price ceiling or other

restriction has been imposed.

A shortage of housing creates a black market in housing.

Illegal arrangements are made between renters and

landlords at rents above the rent ceilingand generallyabove what the rent would have been in an unregulatedmarket.




Inefficiency of Rent Ceilings

A rent ceiling set below the equilibrium rent leads to aninefficient underproduction of housing services.

The marginal social benefit from housing services exceedsits marginal social cost and a deadweight loss arises.

Figure 6.2 illustrates this inefficiency.




A rent ceiling decreasesthe quantity of housingsupplied to less than theefficient quantity.

A deadweight loss arises.

Producer surplus shrinks.

Consumer surplus shrinks.

There is a potential lossfrom increased searchactivity.




Are Rent Ceilings Fair?

According to the fair rulesview, a rent ceiling is unfairbecause it blocks voluntary exchange.

According to the fair resultsview, a rent ceiling is unfairbecause it does not generally benefit the poor.

A rent ceiling decreases the quantity of housing and the

scarce housing is allocated byLottery

First-come, first-served

Discrimination




A lotterygives scarce housing to the lucky.

A first-come, first servedgives scarce housing to thosewho have the greatest foresight and get their names on

the list first.

Discriminationgives scarce housing to friends, familymembers, or those of the selected sex, or those without adog.

None of these methods leads to a fair outcome.




A price flooris a regulation that makes it illegal to trade ata price lower than a specified level.

When a price floor is applied to labour markets, it is called

a minimum wage.

If the minimum wage is set belowthe equilibrium wagerate, it has no effect. The market works as if there were nominimum wage.

If the minimum wage is set abovethe equilibrium wagerate, it has powerful effects.

A Labour Market with a Minimum Wage



If the minimum wage is set abovethe equilibrium wagerate, the quantity of labour supplied by workers exceedsthe quantity demanded by employers.

There is a surplus of labour.

The quantity of labour hired at the minimum wage is lessthan the quantity that would be hired in an unregulatedlabour market.

Because the legal wage rate cannot eliminate the surplus,the minimum wage creates unemployment.

Figure 6.3 on the next slide illustrates these effects.




The equilibrium wage rateis $6 an hour.

The minimum wage rate isset at $7 an hour.

So the equilibrium wagerate is in the illegal region.

The quantity of labouremployed is the quantitydemanded.





Minimum Wage Brings

Unemployment

The quantity of labour

supplied exceeds thequantity demanded andunemployment is created.

With only 20 million hours

demanded, some workersare willing to supply the lasthour demanded for $8.



Inefficiency of a Minimum Wage

A minimum wage leads to an inefficient outcome.

The quantity of labour employed is less than the efficientquantity.

The supply of labour measures the marginal social costof labour to workers (leisure forgone).

The demand for labour measures the marginal socialbenefit from labour (value of goods produced).

Figure 6.4 illustrates this inefficient outcome.




A minimum wage setabove the equilibriumwage decreases thequantity of labour

employed.A deadweight loss arises.

The potential loss fromincreased job searchdecreases both workerssurplus and firms surplus.

The full loss is the sum ofthe red and grey areas.




Is the Minimum Wage Fair?

A minimum wage rate in Canada is set by the provincialgovernments.

In 2009, the minimum wage rate ranged from a low of$7.50 an hour in New Brunswick to a high of $10.00 anhour in Nunavut.

Most economists believe that minimum wage lawsincrease the unemployment rate of low-skilled youngerworkers.

A Labour Market with a Minimum

Wage



Taxes

Everything you earn and most things you buy are taxed.

Who reallypays these taxes?

Income tax and the social insurance taxes are deductedfrom your pay, and provincial sales tax and GST areadded to the price of the most of the things you buy, soisnt it obvious that youpay these taxes?

Isnt it equally obvious that your employer pays theemployers contribution to the social insurance tax?

Youre going to discover that it isnt obvious who pays a

tax and that lawmakers dont decide who will pay!



Tax Incidence

Tax incidenceis the division of the burden of a taxbetween buyers and sellers.

When an item is taxed, its price might rise by the fullamount of the tax, by a lesser amount, or not at all.

If the price rises by the full amount of the tax, buyers paythe tax.

If the price rise by a lesser amount than the tax, buyersand sellers share the burden of the tax.

If the price doesnt rise at all, sellers pay the tax.

Taxes


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Tax incidence doesnt depend on tax law!

The law might impose a tax on buyers or sellers, but theoutcome will be the same.

To see why, we look at the tax on cigarettes in Ontario.

On February 1, 2006, Ontario raised the tax on the salesof cigarettes to $3.90 a pack of 25 cigarettes.

What are the effects of this tax?

Taxes


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A Tax on Sellers

Figure 6.5 shows the effectsof this tax.

With no tax, the equilibriumprice is $3.00 a pack.

A tax on sellers of $1.50 apack is introduced.

Supply decreases and thecurve S + tax on sellersshows the new supplycurve.

Taxes


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The market price paid bybuyers rises to $4.00 apack and the quantitybought decreases.

The price received by thesellers falls to $2.50 apack.

So with the tax of $1.50 apack, buyers pay $1.00 apack more and sellersreceive 50 a pack less.

Taxes


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A Tax on Buyers

Again, with no tax, theequilibrium price is $3.00 a

pack.

A tax on buyers of $1.50 apack is introduced.

Demand decreases andthe curve D tax onbuyersshows the newdemand curve.

Taxes


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The price received bysellers falls to $2.50 apack and the quantity

decreases.

So with the tax of $1.50 apack, buyers pay $1.00 apack more and sellersreceive 50 a pack less.

The price paid by buyersrises to $4.00 a pack.

Taxes


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So, exactly as beforewhen sellers were taxed:

Buyers pay $1.00 of the

tax.

Sellers pay the other 50of the tax.

Tax incidence is the sameregardless of whether thelaw says sellers pay orbuyers pay.

Taxes


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Tax Division and Elasticity of Demand

The division of the tax between buyers and sellers dependson the elasticities of demand and supply.

To see how, we look at two extreme cases.

Perfectly inelastic demand: Buyer pay the entire tax.

Perfectly elastic demand: Sellers pay the entire tax.

The more inelastic the demand, the larger is the buyers

share of the tax.

Taxes


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Demand for this good isperfectly inelasticthedemand curve is

vertical.

When a tax is imposedon this good, buyerspay the entire tax.

Taxes


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The demand for thisgood is perfectlyelasticthe demand

curve is horizontal.

When a tax is imposedon this good, sellerspay the entire tax.

Taxes


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Tax Division and Elasticity of Supply

To see the effect of the elasticity of supply on the divisionof the tax payment, we again look at two extreme cases.

Perfectly inelastic supply: Sellers pay the entire tax.

Perfectly elastic supply: Buyers pay the entire tax.

The more elastic the supply, the larger is the buyers share

of the tax.

Taxes


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The supply of this goodis perfectly inelasticthe supply curve isvertical.

When a tax is imposedon this good, sellers paythe entire tax.

Taxes


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The supply of this goodis perfectly elasticthesupply curve is

horizontal.

When a tax is imposedon this good, buyerspay the entire tax.

Taxes


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Taxes in Practice

Taxes usually are levied on goods and services with aninelastic demand or an inelastic supply.

Alcohol, tobacco, and gasoline have inelastic demand, sothe buyers of these items pay most the tax on them.

Labour has a low elasticity of supply, so the sellerthe

workerpays most of the income tax and most of theSocial Security tax.

Taxes


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Taxes and Efficiency

Except in the extreme cases of perfectly inelastic demandor perfectly inelastic supply when the quantity remains the

same, imposing a tax creates inefficiency.

Figure 6.10 shows the inefficiency created by a $20 tax onMP3 players.

Taxes


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With no tax, marginalsocial benefit equalsmarginal social cost andthe market is efficient.

Total surplus (the sum ofconsumer surplus andproducer surplus) ismaximized.

The tax decreases thequantity, raises the buyers

price, and lowers thesellers price.

Taxes


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Marginal social benefitexceeds marginal socialcost and the tax isinefficient.

The tax revenue takespart of the total surplus.

The decreased quantity

creates a deadweightloss.

Taxes


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Taxes and Fairness

Economists propose two conflicting principles of fairnessto apply to a tax system:

The benefits principle

The ability-to-pay principle

Taxes


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The Benefits Principle

The benefits principle is the proposition that people shouldpay taxes equal to the benefits they receive from the

services provided by government.

This arrangement is fair because it means that those whobenefit most pay the most taxes.

Taxes


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The Ability-to-Pay Principle

The ability-to-pay principle is the proposition that peopleshould pay taxes according to how easily they can bear

the burden of the tax.

A rich person can more easily bear the burden than a poorperson can.

So the ability-to-pay principle can reinforce the benefitsprinciple to justify high rates of income tax on highincomes.

Taxes


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Intervention in markets for farm products takes two mainforms:

Production quotas

Subsidies

A production quotais an upper limit to the quantity of agood that may be produced during a specified period.

A subsidyis a payment made by the government to aproducer.

Production Subsidies and Quotas


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Production Quotas

With no quota, the price is$3 a tonne and 16 milliontonnes a year are

produced.

With the production quotaof 14 million tonnes a year,

quantity decreases to 14million tonnes a year.

The market price rises to$5 a tonne and marginal

cost falls to $2 a tonne.



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Subsidies

With no subsidy, the priceis $40 a tonne and 40

million tonnes a year areproduced.

With a subsidy of $20 atonne, marginal cost minus

subsidy falls by $20 atonne and the new supplycurve is Ssubsidy.



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The market price falls to$30 a tonne and farmersincrease the quantity to60 million tonnes a year.

With the subsidy, farmersreceive more on each tonnesoldthe price of $30 atonne plus the subsidy of$20 a tonne, which is $50 atonne.

But farmers marginal cost

increases to $50 a tonne.



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Markets for Illegal Goods (skip)

The Canadian government prohibits trade of some goods,such as illegal drugs.

Yet, markets exist for illegal goods and services.

How does the market for an illegal good work?

To see how the market for an illegal good works, we beginby looking at a free market and see the changes that occur

when the good is made illegal.


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A Free Market for a Drug

Figure 6.13 shows themarket for a drug such asmarijuana.

Market equilibrium is atpoint E.

The price is PC

and thequantity is QC.

Markets for Illegal Goods


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Penalties on Sellers

If the penalty on the selleris the amount HK, then thequantity supplied at a

market price of PCis QP.

Supply of the drugdecreases to S+ CBL.

The new equilibrium is atpoint F.The price rises andthe quantity decreases.



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Penalties on Buyers

If the penalty on the buyeris the amount JH, thequantity demanded at a

market price of PCis QP.

Demand for the drugdecreases to DCBL.

The new equilibrium is atpoint G.The market pricefalls and the quantitydecreases.



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But the opportunity cost ofbuying this illegal goodrises above PCbecause

the buyer pays the marketprice plusthe cost ofbreaking the law.



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Penalties on Both Sellersand Buyers

With both sellers andbuyers penalized for

trading in the illegal drug,

both the demand for thedrug and the supply of thedrug decrease.



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The new equilibrium is atpoint H.

The quantity decreases toQP.

The market price is PC.

The buyer pays PBand theseller receives PS.



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Legalizing and Taxing Drugs

An illegal good can be legalized and taxed.

A high enough tax rate would decrease consumption tothe level that occurs when trade is illegal.

Arguments that extend beyond economics surround thischoice.


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Ch06 7e Lecture

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