Econ 2113: Principles of Microeconomics Spring 2009 ECU
Chapter 6 Markets in Action
Efficiency Costs of Policies
Deadweight loss: reduction in total economic surplus that results from the adoption of a policy.
E.g. Price ceilings, price floors (minimum wages), subsidies, taxes
Example: a price ceiling on heating oil P 2.00
S
1.40
1.00 0.80 D 1
2
3
Q (thousands)
Example: a price ceiling on heating oil P 2.00
S Consumer surplus = $900
1.40 Producer surplus = $900 1.00 0.80 D 1
2
3
Q (thousands)
Example: a price ceiling on heating oil
What happens if a maximum price of $1 is imposed on heating oil?
First, the quantity demanded will be higher at the lower price
But the quantity supplied will be lower
Therefore, there will be a shortage of heating oil
Less obvious, but as important, there will be a loss in total surplus, or what we call deadweight loss
Example: a price ceiling on heating oil P 2.00
S Consumer surplus = $900
1.40
Producer surplus = $100 Lost surplus (DWL) = $800
1.00 0.80 D Qs=8
Qs=1 Shortage = 7 units
Q (thousands)
Housing Markets and Rent Ceilings
Because the legal price cannot eliminate the shortage, other mechanisms operate: • Search activity • Black markets
Housing Markets and Rent Ceilings
Black Markets A black market is an illegal market that operates alongside 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 ceiling—and generally above what the rent would have been in an unregulated market.
Housing Markets and Rent Ceilings
Inefficiency of Rent Ceilings A
rent ceiling leads to an inefficient use of resources.
The
quantity of rental housing is less than the efficient quantity, so a deadweight loss arises.
Housing Markets and Rent Ceilings A
rent ceiling decreases the quantity of rental housing.
People use resources in search activity, which decreases producer surplus and consumer surplus. And a deadweight loss increases.
The Labor Market and 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 labor markets, it is called a minimum wage. If the minimum wage is set below the equilibrium wage rate, it has no effect. The market works as if there were no minimum wage. If the minimum wage is set above the equilibrium wage rate, it has powerful effects.
The Labor Market and Minimum Wage If the minimum wage is set above the equilibrium wage rate, the quantity of labor supplied by workers exceeds the quantity demanded by employers. There is a surplus of labor. Because employers cannot be forced to hire a greater quantity than they wish, the quantity of labor hired at the minimum wage is less than the quantity that would be hired in an unregulated labor market. Because the legal wage rate cannot eliminate the surplus, the minimum wage creates unemployment.
The Labor Market and Minimum Wage The
equilibrium wage rate is $4 an hour.
The minimum wage rate is set at $5 an hour. So the equilibrium wage rate is in the illegal region. The quantity of labor employed is the quantity demanded.
The Labor Market and Minimum Wage The
quantity of labor supplied exceeds the quantity demanded.
Unemployment is the gap between the quantity demanded and the quantity supplied.
The Labor Market and Minimum Wage Inefficiency A
of a Minimum Wage
minimum wage leads to an inefficient use of resources. The quantity of labor employed is less than the efficient quantity and there is a deadweight loss.
The Labor Market and Minimum Wage A
minimum wage decreases the quantity of labor employed.
If resources are used in job search activity, workers’ surplus and firms’ surplus decrease. And a deadweight loss arises.
Taxes
A tax on producers raises the cost of production by the amount of the tax.
A tax on consumers lowers the benefit of the good or service by the amount of the tax.
Taxes and efficiency
Generally taxes result in a deadweight loss.
Sometimes taxes correct inefficiencies caused by other market failures (e.g. externalities).
Taxes
Tax Incidence Tax
incidence is the division of the burden of a tax between the buyer and the seller. 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.
The burden of taxes
Equivalence of imposing tax on buyers and sellers. Regardless
of whether the statutory/legal incidence is on the buyer or seller (whether the tax is collected from buyers or sellers) the
price paid by buyers (including tax) the price received by sellers (net of the tax) equilibrium quantity
are the same ! Economic incidence depends on elasticities
A tax levied on producers P
S
P*
D Q*
Q
A tax levied on producers P
S
C.S. P* P.S.
D Qt Q*
Q
A tax levied on producers S+T
P
S Tax
PC P* PS
D Qt Q*
Q
A tax levied on producers S+T
P
S C.S.
Tax
PC P* PS P.S. D Qt Q*
Q
A tax levied on producers S+T
P
S C.S.
Tax
PC Tax P* Revenue PS P.S. D Qt Q*
Q
A tax levied on producers S+T
P
S C.S.
PC Tax P* Revenue PS
Tax Deadweight loss.
P.S. D Qt Q*
Q
A tax levied on consumers P
S
P*
D Q*
Q
A tax levied on consumers P
S
CS P* PS
D Q*
Q
A tax levied on consumers P
S
PC P* PS
D-T Q*
D Q
A tax levied on consumers P
S CS
PC P* PS
PS
D-T Q*
D Q
A tax levied on consumers P
S CS
PC Tax P* Revenue PS PS
D-T Q*
D Q
A tax levied on consumers P
S CS
PC Tax P* Revenue PS PS
Deadweight loss.
D-T Q*
D Q
The incidence of a tax
Who pays? One might think that producers pay the taxes that are levied on producers, and consumers pay the taxes that are levied on consumers… Not so! As we saw in the previous slides, generally taxes reduce both consumer and producer surplus. How much depends on elasticities…
The Impact of Taxes: Summary
Increase in the amount consumers pay. Decrease in the amount sellers receive. Decrease in equilibrium quantity. Deadweight loss. Fall in consumer surplus. Fall in producer surplus.
Taxes and Efficiency
If the elasticity of demand>the elasticity of supply, the burden of the tax is borne primarily by producers.
