Economics Summaries: Government Actions in Markets PDF

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Government Actions in Markets. A housing market with a rent ceiling   

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Price ceiling/ cap: a government regulation that makes it illegal to charge a price higher than a specified level. A price ceiling set above the equilibrium price has no effect because it does not constrain the market forces. A price ceiling below the equilibrium price has powerful effects on a market because it attempts to prevent the price from regulating the quantities demanded and supplied. Rent ceiling: when a price ceiling is applied to a housing market. A rent ceiling set below the equilibrium rent creates 

A housing shortage  In a housing market, when the rent is at the equilibrium level, the quantity of housing supplied equals the quantity of housing demanded and there is neither a shortage nor a surplus of housing.  Rent set below the equilibrium rate: housing shortage.  When there is a shortage, the quantity available is the quantity supplied, and somehow, this quantity must be allocated among the demanders. Increased search activity  Search activity: the time spent looking for someone with whom to do business with.  When the price is regulated and there is a shortage, search activity increases. A black market  Black market: an illegal market in which the equilibrium price exceeds the price ceiling.  With loose enforcing the black market rent is close to the unregulated rent. With strict enforcement, it is equal to the maximum price that a renter is willing to pay. Inefficiency of a rent ceiling  A rent ceiling set below the equilibrium rent results in an inefficient underproduction of housing services.  The marginal social benefit from housing exceeds its marginal social cost and a deadweight loss shrinks the producer surplus. A labor market with a minimum wage Price floor: a government imposed regulation that makes it illegal to charge a price lower than a specified level.  A price floor set below the equilibrium price has no effect on a market

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A price floor set above the equilibrium price has powerful effects on the market.

Minimum wage: when a price floor is applied to a labor market.  When a minimum wage is set above the equilibrium wage, the quantity of labor supplied exceeds the quantity of labor demanded. (Surplus of labor)  An unregulated labor market allocates the economy’s scarce labor resources to do the jobs in which they are valued most highly. The market is inefficient. Taxes Tax incidence: the division of the burden of a tax between buyers and sellers. When the government imposes a tax on the sale of a good, the price paid by buyers rises by the full amount of the tax , by a lesser amount, or not at all. The employment insurance tax: an example of a tax that the federal government imposes on both buyers of labor (employers) and sellers of labor (employees) Tax incidence and elasticity of demand Perfectly inelastic demand – Buyers pay. Perfectly elastic demand – Sellers pay Tax incidence and elasticity of supply Perfectly inelastic supply – sellers pay Perfectly elastic supply – buyers pay Taxes and fairness The benefits principle  The proposition that people should pay taxes equal to the benefits they receive from the services provided by the government. The ability to pay principle  The proposition that people should pay taxes according to how easily they can bear the burden of the tax. Production quotas  

An upper limit to the quantity of a good that may be produced in a specific period. (Ex. milk, eggs, poultry) A production quota set below the equilibrium quantity has big effects: o A decrease in supply o A rise in price o A decrease in marginal cost o Inefficient underproduction

o An incentive to cheat and overproduce Decrease in supply  Ex. a production quota on milk decreases the supply of milk. Each farmer is assigned a production limit that is less than the amount that would be produced and supplied without the quota.  The total of the farmers’ limits equals the quota and any production of excess of the quota is illegal.  The quantity supplied becomes the amount permitted by the production quota and this quantity is fixed.  The supply of milk becomes perfectly inelastic at the quantity permitted under the quota. Rise in price  Ex. the production quota raises the price of milk. When the government sets a production quota, it leaves market forces free to determine the price.  Because the quota decreases the supply of milk, it raises the price. A decrease in marginal cost  Marginal cost decreases because farmers produce less and stop using the resources with the highest marginal cost. Inefficiency  Marginal social benefit at the quantity produced is equal to the market price, which has increased.  Marginal social cost at the quantity produced has decreased and is less than the market price.  So marginal social benefit exceeds marginal social cost and a deadweight loss arises An incentive to cheat and overproduce  With the quota, the price exceeds marginal cost, so the farmer can get a larger profit by producing one more unit.  To make production effective, farmers must set up a monitoring system to ensure that no one cheats and overproduces. Subsidies Subsidy: a payment made by the government to a producer. Effects of a subsidy:  An increase in supply  A fall in price and increase in quantity produced  An increase in marginal cost  Payments by government to farmers

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Inefficient overproduction. Markets for illegal goods

A free market for a drug  Demand curve: other things remaining the same, the lower the price of the drug, the larger is the quantity of the drug demanded.  Supply curve: other things remaining the same, the lower the price of the drug, the smaller is the quantity supplied A market for an illegal drug  When a good is illegal, the cost of trading in the good increases.  By how much the cost increases and who bears the cost depend on the penalties for violating the law and the degree to which the law is enforced. Penalties on sellers  Drug dealers could serve jail time.  To determine the new supply curve, add the cost of breaking the law to the minimum price that drug dealers are willing to accept. Penalties on buyers  Possession of illegal drugs can result in prison terms and fines.  The cost of breaking the law must be subtracted from the value of the good to determine the maximum price buyers are willing to pay for drugs.  Demand decreases and the demand curve shifts to the left. Penalties on both buyers and sellers  Both supply and demand decrease and both the supply curve and the demand curve shift  The larger the penalties and the greater the degree of law enforcement, the larger is the decrease in demand and/or supply. Legalizing and taxing drugs  Imposing a significantly high tax could decrease the supply, raise the price and achieve the same decrease in the quantity bought as does a prohibition on drugs. Illegal trading to evade the tax  If the penalty for tax law violation is as severe and as effectively policed as drug-dealing laws the quantity of drugs bough would depend on the penalties....