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MARKETS IN ACTION
6
CHAPTER
Objectives
After studying this chapter, you will able to
 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
 Explain why farm prices and farm revenues fluctuate
and how production subsidies and quotas influence farm
production, costs, and prices
 Explain how markets for illegal goods work
Turbulent Times
As more people compete for scarce land, house prices
and rents rise.
As new technologies replace low-skilled labor, the demand
for low-skilled workers falls.
Can governments control prices and wages?
How do taxes affect prices and quantities, and who pays
the tax, the buyer or the seller?
How are farm prices and incomes affected by fluctuations
in harvests?
What happens in a market when trading a good is illegal?
Housing Markets and Rent Ceilings
The 1906 earthquake in San Francisco left 200,000
people—more than half the city—homeless.
By the time the San Francisco Chronicle started publishing
again, a month after the earthquake, there was not a
single mention of a housing shortage.
The classified advertisements listed many more houses
and flats for rent than the advertisements for houses and
flats wanted.
How did the market achieve this outcome?
Housing Markets and Rent Ceilings
The Market Response to a
Decrease in Supply
Figure 6.1 shows the San
Francisco housing market
before the earthquake.
The quantity of housing
was 100,000 units and the
rent was $16 a month at
the intersection of D and
SS.
Housing Markets and Rent Ceilings
The earthquake decreased
the supply of housing and
the supply curve shifted
leftward to SSA.
The rent increased to $20
a month and the quantity
decreased to 72,000 units.
Housing Markets and Rent Ceilings
Long-Run Adjustments
The long-run supply of
housing is perfectly elastic
at $16 a month.
With the rent above $16 a
month, new houses and
apartments are built.
Housing Markets and Rent Ceilings
The building program
increases supply and the
supply curve shifts
rightward.
The quantity of housing
increases and the rent falls
to the pre-earthquake
levels (other things
remaining the same).
Housing Markets and Rent Ceilings
A Regulated Housing Market
A price ceiling is a regulation that makes it illegal to
charge a price higher than a specified level.
When a price ceiling is applied to a housing market it is
called a rent ceiling.
If the rent ceiling is set above the equilibrium rent, it has
no effect. The market works as if there were no ceiling.
But if the rent ceiling is set below the equilibrium rent, it
has powerful effects.
Housing Markets and Rent Ceilings
Figure 6.2 shows the
effects of a rent ceiling that
is set below the equilibrium
rent.
The equilibrium rent is $20
a month.
A rent ceiling is set at $16
a month.
So the equilibrium rent is
in the illegal region.
Housing Markets and Rent Ceilings
At the rent ceiling, the
quantity of housing
demanded exceeds the
quantity supplied and
there is a housing
shortage.
Housing Markets and Rent Ceilings
With a housing shortage,
people are willing to pay
$24 a month.
Because the legal price
cannot eliminate the
shortage, other
mechanisms operate:
 search activity
 black markets
Housing Markets and Rent Ceilings
Search Activity
The time spent looking for someone with whom to do
business is called search activity.
When a price is regulated and there is a shortage, search
activity increases.
Search activity is costly and the opportunity cost of
housing equals its rent (regulated) plus the opportunity
cost of the search activity (unregulated).
Because the quantity of housing is less than the quantity
in an unregulated market, the opportunity cost of housing
exceeds the unregulated rent.
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 and there is a deadweight loss, illustrated in
Figure 6.3 (page 125).
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 and there
is a deadweight loss.
Figure 6.3 illustrates this
loss.
Housing Markets and Rent Ceilings
A rent ceiling decreases
the quantity of rental
housing,
shrinks the producer and
consumer surplus by using
resources is search activity,
and creates a deadweight
loss.
Housing Markets and Rent Ceilings
Are Rent Ceilings Fair
According to the fair rules view, a rent ceiling is unfair
because it blocks voluntary exchange.
According to the fair results view, a rent ceiling is unfair
because it does not generally benefit the poor.
A rent ceiling decreases the quantity of housing and
allocates the scarce housing using:
 Lotteries
 Queues
 Discrimination
Housing Markets and Rent Ceilings
Are Rent Ceilings Fair
A lottery gives scarce housing to the lucky.
A queue gives scarce housing to those who have the
greatest foresight and get their names on the list first.
Discrimination gives scarce housing to friends, family
members, or those of the selected race or sex.
None of these methods leads to a fair outcome.
Housing Markets and Rent Ceilings
Rent Ceilings in Practice
New York, San Francisco, London, Paris, and Boston have
or have had rent ceilings.
Atlanta, Baltimore, Chicago, Dallas, Philadelphia, Phoenix,
and Seattle have never had them.
Comparing cities with and without rent ceilings, we learn:
1. Rent ceilings definitely create a housing shortage.
2. Rent ceilings lower rents for the lucky few and raise
them for everyone else.
Winners are long-standing residents: Losers are mobile
newcomers.
The Labor Market and the Minimum Wage
New, labor-saving technologies become available every
year, which mainly replace low-skilled labor.
Does the persistent decrease in the demand for low-skilled
labor depress the wage rates of these workers?
The immediate effect of these technological advances is a
decrease in the demand for low-skill labor, a fall in the
wage rate, and a decrease in the quantity of labor
supplied.
Figure 6.4 on the next slide illustrates this immediate
effect.
The Labor Market and the Minimum Wage
A decrease in the demand
for low-skill labor is shown
by a leftward shift of the
demand curve.
A new labor market
equilibrium arises at a
lower wage rate and a
smaller quantity of labor
employed.
The Labor Market and the Minimum Wage
In the long run, people get
trained to do higher-skilled
jobs.
The supply of low-skill
labor decreases, which is
shown by a leftward shift
of the short-run supply
curve.
The Labor Market and the Minimum Wage
If long-run supply is
perfectly elastic, the
equilibrium wage rate
returns to its initial level
(other things remaining the
same).
The Labor Market and the 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 the 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
Figure 6.5 on the next slide illustrates these effects.
The Labor Market and the 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 Labor Market and the Minimum Wage
The quantity of labor
employed is the quantity
demanded.
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 the Minimum Wage
Inefficiency of a Minimum
Wage
A 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.
Figure 6.6 illustrates this
loss.
Housing Markets and Rent Ceilings
A minimum wage
decreases the quantity of
labor employed,
shrinks the firms’ and
workers’ surplus by using
resources in job search
activity,
and creates a deadweight
loss.
The Labor Market and the Minimum Wage
The Federal Minimum Wage and its Effects
The United States has passed the Fair Standards Labor
Act, which currently sets the minimum wage at $5.15 per
hour.
This minimum wage has historically fluctuated between 35
percent and 50 percent of the average wage of production
workers.
Most economists believe that minimum wage laws
increase the unemployment rate of low-skilled younger
workers.
The Labor Market and the Minimum Wage
A Living Wage
A living wage has been defined as an hourly wage rate
that enables a person who works a 40 hour week to rent
adequate housing for not more than 30 percent of the
amount earned.
Living wage laws operate in St Louis, St Paul,
Minneapolis, Boston, Oakland, Denver, Chicago, New
Orleans, and New York City.
The effects of a living wage are similar to those of a
minimum wage.
Taxes
Everything you earn and most things you buy are taxed.
Who really pays these taxes?
Income tax and the Social Security tax are deducted from
your pay, and the sales tax is added to the price of the
things you buy, so isn’t it obvious that you pay these
taxes?
Isn’t it equally obvious that your employer pays the
employer’s contribution to the Social Security tax?
You’re going to discover that it isn’t obvious who pays a
tax and that lawmakers don’t decide who will pay!
Taxes
Tax Incidence
Tax incidence is the division of the burden of a tax
between the buyer and the seller.
When an item is taxed, its price might rise by the full
amount of the tax, by a lesser amount, or not at all.
If the price rises by the full amount of the tax, the buyer
pays the tax.
If the price rise by a lesser amount than the tax, the buyer
and seller share the burden of the tax.
If the price doesn’t rise at all, the seller pays the tax.
Taxes
Tax Incidence
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.
To see why, we look at the tax on cigarettes in New York
City.
On July 1, 2002, Mayor Bloomberg upped the cigarette tax
in New York City from almost nothing to $1.50 a pack.
Taxes
A Tax on Sellers
Figure 6.7 shows the
effects of this tax.
Taxes
A Tax on Sellers
Figure 6.7 shows the
effects of this tax.
With no tax, the
equilibrium price is $3 a
pack.
A tax on sellers of $1.50 a
pack is introduced.
The curve S + tax on
seller shows the new
supply curve.
Taxes
The vertical distance
between the original
supply curve and the
supply curve with the tax
is equal to the amount of
the tax--$1.50.
Buyers would have to pay
$4.50 a pack to induce
firms to offer the original
quantity for sale.
Taxes
The tax changes the
equilibrium price and
quantity.
The quantity decreases.
The price paid by the
buyer rises to $4 and the
price received by the
seller falls to $2.50.
Taxes
So buyers pay $1 of the
tax.
Sellers pay the remaining
50¢.
Taxes
A Tax on Buyers
Now suppose that buyers,
not sellers, are taxed
$1.50 a pack.
Again, with no tax, the
equilibrium price is $3 a
pack.
A tax on buyers of $1.50 a
pack is introduced.
The curve D - tax on
buyer shows the new
demand curve.
Taxes
The vertical distance
between the original
demand curve and the
demand curve minus the
tax is equal to the amount
of the tax--$1.50.
Sellers would have to
accept $1.50 a pack to
induce people to buy the
original quantity.
Taxes
The tax changes the
equilibrium price and
quantity.
The quantity decreases.
The price paid by the
buyer rises to $4 and the
price received by the
seller falls to $2.50.
Taxes
So, exactly as before
when the seller was
taxed:
The buyer pays $1 of the
tax.
The seller pays the other
50¢ of the tax.
Tax incidence is the same
regardless of whether the
law says the seller pays or
the buyer pays.
Taxes
The division of the tax between the buyer and the seller
depends on the elasticities of demand and supply.
Tax Division and Elasticity of Demand
To see the effect of the elasticity of demand on the division
of the tax payment, we look at two extreme cases.
 Perfectly inelastic demand: the buyer pays the entire tax.
 Perfectly elastic demand: the seller pays the entire tax.
 The more inelastic the demand, the larger is the buyers’
share of the tax.
Taxes
In this figure, demand is
perfectly inelastic—the
demand curve is vertical.
When a tax is imposed on
this good, the buyer pays
the entire tax.
Taxes
In this figure, demand is
perfectly elastic—the
demand curve is
horizontal.
When a tax is imposed on
this good, the seller pays
the entire tax.
Taxes
Tax Division and Elasticity of Supply
To see the effect of the elasticity of supply on the division
of the tax payment, we again look at two extreme cases.
 Perfectly inelastic supply: the seller pays the entire tax.
 Perfectly elastic supply: the buyer pays the entire tax.
 The more elastic the supply, the larger is the buyers’
share of the tax.
Taxes
In this figure, supply is
perfectly inelastic—the
supply curve is vertical.
When a tax is imposed on
this good, the seller pays
the entire tax.
Taxes
In this figure, supply is
perfectly elastic—the
supply curve is horizontal.
When a tax is imposed on
this good, the buyer pays
the entire tax.
Taxes
Taxes in Practice
Taxes usually are levied on goods and services with an
inelastic demand or an inelastic supply.
Alcohol, tobacco, and gasoline have inelastic demand, so
the buyers of these items pay most the tax on them.
Labor has a low elasticity of supply, so the seller—the
worker—pays most of the income tax and most of the
Social Security tax.
Taxes
Taxes and Efficiency
Except in the extreme
cases of perfectly inelastic
demand or supply when
the quantity remains the
same, imposing a tax
creates inefficiency.
Figure 6.11 shows the
inefficiency created by a
$10 tax on CD players.
Taxes
With no tax, the market is
efficient and the sum of
consumer surplus and
producer surplus is
maximized.
A tax shifts the supply
curve, decreases the
equilibrium quantity, raises
the price to the buyer, and
lowers the price to the
seller.
Taxes
The tax revenue takes part
of the consumer surplus
and producer surplus.
The decreased quantity
creates a deadweight loss.
Subsidies and Quotas
Fluctuations in the weather bring big fluctuations in farm
output.
How do changes in farm output affect the prices of farm
products and farm revenues?
How might farmers be helped by intervention in markets
for farm products?
Stabilizing Farm Revenues
Harvest Fluctuations
Figure 6.12(a) shows the
market for wheat.
Once the crop is planted,
supply is perfectly inelastic
along the momentary
supply curve MS0.
The price is $4 a bushel
and farm total revenue is
$80 billion.
Stabilizing Farm Revenues
A poor harvest decreases
supply.
Farmers lose $20 billion of
total revenue on the
decreased quantity sold.
But they gain $30 billion
from the higher price.
Because demand is
inelastic, total revenue
increases—to $90 billion.
Stabilizing Farm Revenues
Now a bumper harvest
increases supply.
Farmers lose $40 billion of
total revenue on the
original quantity because
the price falls.
They gain only $10 billion
from the increased quantity.
Because demand is
inelastic, total revenue
decreases—to $50 billion.
Stabilizing Farm Revenues
Intervention in markets for farm products takes two main
forms:
 Subsidies
 Production quotas
A subsidy is a payment made by the government to a
producer.
A production quota is an upper limit to the quantity of a
good that may be produced during a specified period.
Stabilizing Farm Revenues
Subsidies
The producers of peanuts,
sugarbeets, milk, wheat,
and many other farm
products receive
subsidies.
Figure 6.13 shows how a
subsidy works.
With no subsidy, the price
is $40 and the quantity is
40 million tons a year
Stabilizing Farm Revenues
Subsidies
A subsidy of $20 a ton is
introduced.
Marginal cost minus
subsidy falls by $20 and
the new supply curve is S
– subsidy.
The new equilibrium is at
60 million tons and $30 a
ton.
Stabilizing Farm Revenues
Subsidies
The equilibrium quantity
increases.
The equilibrium price falls.
The farmer receives more
on each ton sold--$50 a
ton in this example.
Stabilizing Farm Revenues
Production Quotas
The markets for
sugarbeets, tobacco leaf,
and cotton, among others,
are regulated with
production quotas.
Figure 6.14 shows how a
production quota works.
With no quota, the price is
$30 and the quantity is 60
million tons a year.
Stabilizing Farm Revenues
Production Quotas
A production quota limits
total production to 40
million tons a year.
The equilibrium quantity
decreases to this amount.
The price rises to $50 a
ton and marginal cost falls
to $20 a ton.
Markets for Illegal Goods
The U.S. government prohibits trade of some goods, such
as illegal drugs.
Yet, markets exist for illegal goods and services.
How does the market for an illegal good work?
A Free Market for Drugs
To see how the market for an illegal good works, we begin
by looking at a free market and see the changes that occur
when the good is made illegal.
Markets for Illegal Goods
Figure 6.15 shows the
market for a drug such as
marijuana.
The equilibrium is at point
E.
The price is PC and the
quantity is QC.
Markets for Illegal Goods
A Market for Illegal Drugs
Prohibiting transactions in
a good or service raises
the cost of such trading.
If sellers (drug dealers) are
penalized, we must add
the cost of breaking the
law to the minimum supply
price.
Markets for Illegal Goods
If the penalty on the seller
is the amount HK, the
quantity supplied at a
market price of PC is QP.
A new supply curve
passes through point H.
The new equilibrium is at
point F. The price rises and
the quantity decreases.
Markets for Illegal Goods
Starting again at the
equilibrium point E,
suppose that buyers are
penalized (and not sellers).
Now, we must subtract the
cost of breaking the law
from the maximum price
that the buyer is willing to
pay.
Markets for Illegal Goods
If the penalty on the buyer
is the amount JH, the
quantity demanded at a
market price of PC is QP.
A new demand curve
passes through point H.
The new equilibrium is at
point G. The market price
falls and the quantity
decreases.
Markets for Illegal Goods
But the opportunity cost of
buying this illegal good
rises because the buyer
pays the market price plus
the cost of breaking the
law.
Markets for Illegal Goods
Now suppose that both
buyers and sellers are
penalized for trading in the
illegal drug.
We add the cost of
breaking the law to the
minimum supply price and
get a new supply curve.
Markets for Illegal Goods
The new equilibrium is at
point H.
The quantity decreases to
QP .
The market price is PC.
The buyer pays PB and the
seller receives PS.
Markets for Illegal Goods
Legalizing and Taxing Drugs
An illegal good can be legalized and taxed.
A high enough tax rate would decrease consumption to
the level that occurs when trade is illegal.
Arguments that extend beyond economics surround this
choice.
THE END