The Market Strikes Back

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• CHAPTER 4
• The Market Strikes Back

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What you will learn in this chapter

• Why does the government intervene in markets?
• What are the common tools of government
  intervention?
• What happens when the government intervenes?

• Price controls
• Price ceiling
• Price floor
• Quantity controls quota
• Inefficiency

• Excise tax
• Excess burden
• Tax incidence
• Deadweight loss

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The Market for Apartments in the Absence of
Government Controls
Without government intervention, the market for
apartments reaches equilibrium at point E with a
market rent of 1,000 per month and 2 million
apartments rented.
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The Effects of a Price Ceiling
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Price ceilings cause inefficiency!

• A market or an economy is inefficient if there
  are missed opportunities Some people could be
  made better off without making other people worse
  off.
• Price ceilings often lead to inefficiency in the
  forms of
• Inefficient allocation to consumers
• Wasted resources
• Inefficiently low quality
• They also produce black markets.

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So why are there price ceilings?

• Case Rent control in New York
• Price ceilings hurt most residents but give a
  small minority of renters much cheaper housing
  than they would get in an unregulated market.
  (Those who benefit from the controls are
  typically better organized and more influential
  than those who are harmed by them.)
• When price ceilings have been in effect for a
  long time, buyers may not have a realistic idea
  of what would happen without them.
• Government officials often do not understand
  supply and demand analysis!

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The Market for Butter in the Absence of
Government Controls
Without government intervention, the market for
butter reaches equilibrium at a price of 1 per
pound and with 10 million pounds of butter bought
and sold.
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The Effects of a Price Floor
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Price Floors Cause Inefficiency!

• The most familiar price floor is the minimum
  wage. Price floors are also commonly imposed on
  agricultural goods.
• Price floors often lead to inefficiency in the
  forms of
• Inefficient allocation of sales among sellers
• Wasted resources
• Inefficiently high quality
• They can also can provide an incentive for
  illegal activity (Ex. black labor).

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So why are there price floors?

• Price floors benefit some influential sellers.
• Government officials believe that the relevant
  market is poorly described by supply and demand.
• Government officials do not understand the supply
  and demand model.

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Economics in Action

• Case Black Labor in Southern Europe
• Minimum Wage as Price Floor
• In many European countries,
• minimum wages are much higher than in the U.S.,
  and
• employers are required to pay for health and
  retirement benefits.
• This makes the cost of hiring a European worker
  considerably more than the workers paycheck.
• The minimum wage is well above the market
  clearing wage rate
• labor surplus ? unemployment

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Economics in Action

• This high unemployment leads to widespread
  evasion of the law
• workers who are employed by companies that pay
  them less than the legal minimum, fail to provide
  the required health and retirement benefits, or
  both
• ? jobs are simply unreported.
• About a third of the Spains reported unemployed
  are in the black labor marketworking at
  unreported jobs!!

In fact, Spaniards waiting to collect checks from
the unemployment office have been known to
complain about the long lines that keep them from
getting back to work! ?
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Controlling Quantities

• A quantity control, or quota, is an upper limit
  on the quantity of some good that can be bought
  or sold. The total amount of the good that can be
  legally transacted is the quota limit.
• A license gives its owner the right to supply a
  good.
• Example Market for taxi rides in New York City

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The Market for Taxi Rides in the Absence of
Government Controls
Without government intervention, the market
reaches equilibrium with 10 million rides taken
per year at a fare of 5 per ride.
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Effect of a Quota on the Market for Taxi Rides
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• A quota drives a wedge between the demand price
  (the price paid by buyers) and the supply price
  (the price received by sellers) of a good.
• The difference between the demand and supply
  price at the quota limit is the quota rent, the
  earnings that accrue to the license-holder from
  ownership of the right to sell the good. It is
  equal to the market price of the license when the
  licenses are traded.
• Like price controls, quantity controls create
  inefficiencies and encourage illegal activity.

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Excise Taxes

• Excise taxes are taxes on the purchase or sale of
  a good.
• They have effects similar to quotas
• raise the price paid by buyers and
• reduce the price received by sellers,
• and drive a wedge between the two.
• Examples Excise tax levied on sales of taxi
  rides and excise tax levied on purchases of taxi
  rides

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Effect of an Excise Tax Levied on the Sales of
Taxi Rides
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Effect of an Excise Tax Levied on the Purchases
of Taxi Rides
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• The incidence of a tax is a measure of who really
  pays it.
• Who really bears the tax burden (higher prices to
  consumers and lower prices to sellers) does not
  depend on who officially pays the tax. Depending
  on the shapes of supply and demand curves, the
  incidence of an excise tax may be divided
  differently.
• The wedge between the demand price and supply
  price becomes the governments tax revenue.

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The Revenue from an Excise Tax
Area of the shaded rectangle 2 per ride 8
million rides 16 million.
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• Excise taxes also cause inefficiency excess
  burden or deadweight loss.
• This excess burden, or deadweight loss, means
• that the true cost is always larger than the
  amount paid in taxes.
• Excise taxes prevent some mutually beneficial
  transactions.
• They also encourage illegal activity in attempts
  to avoid the tax.

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The End of Chapter 4
coming attractionChapter 5 Elasticity