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Markets in Action
Learning Objectives
• Explain how housing markets work and
how price ceilings create housing shortages
and inefficiency
• Explain how labor markets work and how
minimum wage laws create unemployment
and inefficiency
• Explain the effects of the sales tax
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-2
Learning Objectives (cont.)
• Explain how markets for illegal goods work
• Explain why farm prices and revenues
fluctuate
• Explain how speculation limits price
fluctuations
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-3
Learning Objectives
• Explain how price ceilings create shortages
and inefficiency
• Explain how price floors create surpluses
and inefficiency
• Explain the effects of the sales tax
• Explain how markets for illegal goods work
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-4
Housing Markets
and Rent Ceilings
San Francisco Earthquake — 1906
How does the market deal with a dramatic
reduction in the supply of housing?
The destruction of buildings decreases the
supply of housing and shifts the short-run
supply curve leftward.
With sufficient time for new apartments and
houses to be constructed, supply increases.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-5
Rent (dollars per unit per month)
The San Francisco
Housing Market in 1906
SSa
24
SS
20
After Earthquake
Long
run Adjustment
LS
16
D
12
0
Copyright © 1998 Addison Wesley Longman, Inc.
44
72
100
150
Quantity (thousands of units per month)
TM 7-6
A Regulated Housing Market
Price ceilings are regulations that make it
illegal to charge a price higher than a
specified level.
Rent ceilings are price ceilings applied to
housing markets.
How does a rent ceiling affect the housing
market?
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-7
A Regulated Housing Market
Rent ceilings set above equilibrium have no
effect.
Rent ceilings set below equilibrium
prevents price from regulating the quantities
supplied and demanded.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-8
Rent (dollars per unit per month)
A Rent Ceiling
Maximum black
market rent
24
SSa
20
Rent
ceiling
16
Housing
shortage
12
0
Copyright © 1998 Addison Wesley Longman, Inc.
44
D
72
100
150
Quantity (thousands of units per month)
TM 7-9
A Regulated Housing Market
The ceiling results in two developments:
Search activity
Black markets
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-10
A Regulated Housing Market
Search activity is the time spent looking for
someone to do business.
It increases when there is a shortage.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-11
A Regulated Housing Market
Black markets are illegal markets in which
the price exceeds the legally imposed price
ceiling.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-12
Rent (dollars per unit per month)
Inefficiency of Rent Ceilings
Consumer
surplus
30
S
24
Deadweight
loss
20
Rent
ceiling
16
12
Producer
surplus
0
Copyright © 1998 Addison Wesley Longman, Inc.
44
D
72
100
150
Quantity (thousands of units per month)
TM 7-13
Learning Objectives
• Explain how price ceilings create shortages
and inefficiency
• Explain how price floors create surpluses
and inefficiency
• Explain the effects of the sales tax
• Explain how markets for illegal goods work
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-14
The Labor Market
and the Minimum Wage
Wage rates adjust to make the quantity
demanded of labor equal to the quantity
supplied
Technology has reduced the demand for lowskilled labor
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-15
The Labor Market
and the Minimum Wage
Short-run
There is a given number of people with a
given skill.
Wages must be increased in order to increase
the number of hours worked.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-16
The Labor Market
and the Minimum Wage
Long-run
People can acquire new skills and find new
types of jobs:
• If wage rates are too high or low, people will
enter or leave this labor market.
• If people can freely enter and leave the labor
market, the long-run supply of labor is perfectly
elastic.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-17
The Labor Market
and the Minimum Wage
Long-run
People can acquire new skills and find new
types of jobs (cont.):
The longer the period of adjustment, the greater
the elasticity of supply of labor.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-18
Wage Rate (dollars per hour)
A Market for Low-Skilled Labor
SS
6
LS
5
After invention
Long-run
adjustment
4
D
3
DA
20
21
22
23
Quantity (millions of hours per year)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-19
The Minimum Wage
A minimum wage law is a regulation that
makes the hiring of labor below a specified
wage illegal.
If the minimum wage is set below
equilibrium it will have no effect.
If the minimum wage is set above
equilibrium, it prevents price from
regulating quantity supplied and demanded.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-20
Wage Rate (dollars per hour)
Minimum Wage and Unemployment
SS
6
Unemployment
5
a
b
Minimum
wage
4
3
DA
20
21
22
23
Quantity (millions of hours per year)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-21
Minimum wage
USA: Fair Labor Standards Act of 1938
The Federal Minimum $7.25 per hour as of July 24, 2009
Some states like: Georgia ($5.15), Wyoming ($5.15),
Arkansas ($6.25) lower wage and others have higher rate:
DC ($8.25), California ($8), Alaska ($7.75), Arizona
($7.75), Illinois ($8.25), Massachusetts ($8)
• The State law excludes from coverage any employment
that is subject to the Federal Fair Labor Standards Act
when the Federal rate is greater than the State rate.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-22
Minimum wage
• UK: there are different levels of NMW, depending
on your age and whether you are an apprentice.
The current rates are:
• £5.93 - the main rate for workers aged 21 and
over ; £4.92 - the 18-20 rate; £3.64 - the 16-17 rate
for workers above school leaving age but under
18; £2.50 - the apprentice rate, for apprentices
under 19 or 19 or over and in the first year of their
apprenticeship
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-23
Minimum wage
• In the 8 out of 27 member states currently have national
minimum wages. Many countries, such as Sweden,
Finland, Germany, Italy and Cyprus have no minimum
wage laws but rely on employer groups and trade unions to
set minimum earnings through collective bargaining.
• France € 8.86 (2010); Ireland € 7.65 (2011)
• Japan $7.75 - $9.90 (regional basis)
• Bulgaria 240 lv/monthly
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-24
Learning Objectives
• Explain how price ceilings create shortages
and inefficiency
• Explain how price floors create surpluses
and inefficiency
• Explain the effects of the sales tax (or VAT|
• Explain how markets for illegal goods work
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-25
Taxes
Who Pays the Sales Tax (VAT)?
Suppose a $10 sales tax (VAT) is imposed on
DVD players
There are two prices
Including the tax — buyers respond to this.
• What they pay.
Excluding the tax — sellers respond to this.
• What they receive.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-26
Price (dollars per player)
The Sales Tax
S + tax
S
110
$10 tax
105
100
Tax
revenue
95
DA
3
4
5
6
Quantity (thousands of DVD players per week)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-27
Tax Division and
Elasticity of Demand
Two Extremes
Perfectly inelastic demand--buyer pays
Example: Insulin
Perfectly elastic demand--seller pays
Example: Pink marker pens
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-28
Price (dollars per dose)
Sales Tax (VAT) and the
Elasticity of Demand
S + tax
Buyer pays
entire tax
S
2.20
Perfectly inelastic
demand
2.00
D
100
Quantity (thousands of doses per day)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-29
Price (cents per pen)
Sales Tax (VAT) and the
Elasticity of Demand
S + tax
S
1.00
0.90
Perfectly elastic
demand
Seller
pays
entire
tax
1
4
Quantity (thousands of marker pens per week)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-30
Tax Division and
Elasticity of Demand
The division of the tax depends upon
elasticity.
The more inelastic the demand, the more the
buyer pays.
The more elastic the demand, the more the
seller pays.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-31
Tax Division and
Elasticity of Supply
Two Extremes:
Perfectly inelastic supply -- seller pays.
Example: water from a mineral spring.
Perfectly elastic supply -- buyer pays.
Example: sand used to make silicon used by
computer chip makers.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-32
Price (dollars per bottle)
Sales Tax (VAT) and the
Elasticity of Supply
S
Perfectly inelastic
supply
50
Seller pays
entire tax
45
D
100 Quantity (thousands of bottles per week)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-33
Price (cents per pound)
Sales Tax (VAT) and the
Elasticity of Supply
Perfectly Elastic
Supply
S + tax
11
buyer pays
entire tax
10
S
D
3
Copyright © 1998 Addison Wesley Longman, Inc.
5
Quantity (thousands of pounds per week)
TM 7-34
Tax Division and
Elasticity of Supply
The division of the tax depends upon
elasticity.
The more inelastic the supply, the more the
seller pays.
The more elastic the supply, the more the buyer
pays.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-35
Sales Taxes (VAT) in Practice
Items with low elasticity of demand
(alcohol, tobacco, & gasoline) are good
sources of tax revenue for the government.
Why?
Poor source: 1991 Luxury Tax
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-36
Taxes and Efficiency
Inefficiency
Due to the difference in price paid by the
buyer and received by the seller the
marginal benefit does not equal the
marginal cost.
The more inelastic demand or supply, the
smaller the decrease in quantity and
deadweight loss.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-37
Price (dollars per player)
Taxes and Efficiency
130
105
100
95
Consumer
surplus
S
Tax Revenue
75
0
S + tax
Deadweight
loss
D
Producer
surplus
1
2
3
4
5
6
7
8
9
10
Quantity (thousands of DVD players per week)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-38
Learning Objectives
• Explain how price ceilings create shortages
and inefficiency
• Explain how price floors create surpluses
and inefficiency
• Explain the effects of the sales tax
• Explain how markets for illegal goods work
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-39
Markets for Illegal Goods
When a good is illegal, the cost of trading in
the good increases.
Penalties and policing increase the cost.
Decreasing supply and/or demand
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-40
Price
A Market for an Illegal Good
Pc
S + CBL
Cost per unit
of breaking
the law...
…to
buyer
…to
seller
a
d
S
c
b
D
D - CBL
Qp
Copyright © 1998 Addison Wesley Longman, Inc.
Qc
Quantity
TM 7-41
Markets for Illegal Goods
Enforcement
Price effects depend upon who receives the
most severe penalty -- the buyer or seller.
Today, penalties on sellers are larger.
This causes the equilibrium quantity to decrease
and price increases compared to an unregulated
market.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-42
Learning Objectives (cont.)
• Explain why farm prices and revenues
fluctuate
• Explain how speculation limits price
fluctuations
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-43
Stabilizing Farm Revenues
Farm output fluctuates considerably due to
fluctuations in the weather.
How do changes in farm output affect farm
prices and farm revenues?
How can farm revenues be stabilized?
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-44
Price (dollar per bushel)
Harvest, Farm Prices,
and Farm Revenues
MS1
MS0
8
Poor harvest
6
$30 billion
4
2
$60 billion
0
5
10
$20
billion
15
D
20
25
Quantity (billions of bushels (35.24L) per year)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-45
Stabilizing Farm Revenues
Farm Revenues during a bad harvest
Total farm revenue actually increases due to
inelastic demand.
Some farmers, whose entire crop is
destroyed, lose.
Others, whose crop is unaffected, earn
enormous profits.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-46
Price (dollar per bushel)
Harvest, Farm Prices,
and Farm Revenues
MS0
MS2
8
6
Bumper
Harvest
(record high)
4
$40 billion
2
$40 billion
0
Copyright © 1998 Addison Wesley Longman, Inc.
5
10
D
$10
billion
15
20
25
Quantity (billions of bushels per year)
TM 7-47
Stabilizing Farm Revenues
Farm Revenues during a bumper harvest
Total farm revenue actually decreases due to
inelastic demand.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-48
Learning Objectives (cont.)
• Explain why farm prices and revenues
fluctuate
• Explain how speculation limits price
fluctuations
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-49
Stabilizing Farm Revenues
Two institutions designed to stabilize farm
revenue
Speculative markets in inventories
Farm price stabilization policy
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-50
Price (dollar per bushel)
How Inventories Limit Price Changes
Q1
Q2
Inventory
Speculation
8
6
4
2
0
Copyright © 1998 Addison Wesley Longman, Inc.
5
S
Production
decreases
Production
increases
5 billion from
inventory
5 billion to
inventory
10
D
15
20
25 Quantity
Inventory
(billions of bushels)
TM 7-51
Farm Revenue
Speculative markets in inventories do not
stabilize farm revenue
When price is stabilized, revenue fluctuates as
production fluctuates.
Bumper crops bring larger revenues than poor
harvest do.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-52
Farm Revenue
Farm Price Stabilization Policy
• Set production limits
• Set price floors
• Hold inventories
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-53
Farm Revenue
Farm Price Stabilization Policy
Production limits
Quotas restrict the quantity produced.
Can result in higher farm prices.
Price floors
Set above equilibrium create surpluses.
Hold inventories
The government must hold inventory to maintain the
equilibrium price.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 7-54