Macroeconomics Price Ceilings/Price Floors/Taxes

September 7, 2017 Law

(Summary of book) Markets In Action Price Ceilings A price ceiling is a government regulation of the maximum price that may be legally charged. To see how a price ceiling works, we’ll examine its effects in a market for rental housing, when it is called a rent ceiling. A Rental Housing Market The demand for and supply of rental housing determine the equilibrium rent and the equilibrium quantity of rental housing available. A rent ceiling tries to change the rent. The effects of a rent ceiling depend crucially on whether the ceiling is binding or not binding.

A rent ceiling is not binding if it is set above the equilibrium rent. A rent ceiling is binding if it set below the equilibrium rent. Let’s see how scarce housing resources get allocated in the face of a binding rent ceiling by examining two groups of mechanisms: -Lottery, queue and discrimination -Black market Lottery, Queue and Discrimination The time spent looking for someone with whom to do business is called search activity. The opportunity cost of a good is equal not only to its price but also to the value of the time spent searching the good. Black Market

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A black market is an illegal market in which the price exceeds the legally imposed price ceiling. Inefficiency of Rent Ceilings Without a rent ceiling, the market determines the equilibrium rent and equilibrium quantity of housing. In this situation, scarce housing resources are allocated efficiently. Marginal social benefit equals marginal social cost. Price Floors A price floor is a regulation that makes it illegal to trade at a price lower than the specified level. Price floors are used in many markets. But when a price floor is applied to labor markets, it is called a minimum wage. A Labor Market

In the labor market, employers are on the demand side and workers are on the supply side. The effects of a minimum wage depend crucially on whether the minimum is binding or not binding. A minimum wage is not binding if it set below the equilibrium wage rate. A minimum wage is binding if it is set above the equilibrium wage. Taxes You’re going to discover that it isn’t obvious who really pays a tax and that lawmakers don’t make that decision. We begin with a definition of tax incidence. Tax Incidence Tax incidence is the division of the burden of a tax between the buyer and the seller.

Tax incidence does not depend on the tax law. The law might impose a tax on sellers or on buyers, but the outcome is the same in either case. Equivalence of Tax on Buyers and Sellers Can We Share the Burden Equally? – The key point is that 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. Buyers respond only to the price that includes the tax because that is the price they pay. Sellers respond only to the price that excludes the tax because that is the price they receive.

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 – demand side or supply side – on which the tax is imposed that determines the effects of the tax. Tax Division and Elasticity of Demand The division of the total tax between buyers and sellers depends partly on the elasticity of demand. There are two extreme cases: -Perfectly inelastic demand – sellers pay -Perfectly elastic demand – buyers pay Taxes in Practice Supply and demand are rarely perfectly elastic or perfectly inelastic. But some items tend towards one of the extremes.

Taxes and Efficiency The price sellers receive is also the sellers’ minimum supply price, which equals marginal cost. So because a tax puts a wedge between the buyers’ price and the sellers’ price, it also puts a wedge between marginal benefit and marginal cost and creates inefficiency. With a higher buyers’ price and a lower sellers’ price, the tax decreases the quantity produced and consumed and a deadweight loss arises. Intervening in Agricultural Markets In this section, we examine agricultural markets and see how the weather and government policies influence them. Harvest Fluctuations

Once farmers have harvested their crop, they have no control over the quantity supplied and supply is inelastic along a momentary supply curve. Poor Harvest – A decrease in supply brings a rise in price and an increase in farm revenue. Bumper Harvest – An increase in supply brings a fall in price and a decrease in farm revenue. Elasticity of Demand – Farm revenue and the quantity produced move in opposite directions because the demand for wheat is inelastic. The percentage change in price exceeds the change in the quantity demanded. If demand is elastic, farm revenue and the quantity produced fluctuate in the same direction.

Avoiding a Fallacy of Composition – Government Intervention Three methods of intervention are used in markets for farm products, often in combination. They are: -Subsidies -Production quotas -Price supports Subsidies – A subsidy is a payment made by the government to a producer. Because the supply curve is the marginal cost curve, and the demand curve is the marginal benefit curve, a subsidy raises marginal cost above marginal benefit and creates a deadweight loss from overproduction. 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. Price Supports – A price support is the government guaranteed minimum price of a good. A price support in an agricultural market operates in a similar way to a price floor in other markets. It creates a surplus. But there is a crucial difference between a price floor and a price support. With a price support, the government buys the surplus and ends up with unwanted inventories. Markets for Illegal Goods The markets for many goods and services are regulated and buying and selling some goods is illegal. (Especially drugs)


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