government policies and the efficiency of markets

How do price ceilings and price floors affect market outcomes?. 6 Government Policies That Alter the Private Market Outcome  Price controls – Price ceiling: a legal maximum on the pr

Principles of Economics

Session VI Government Policies and the Efficiency of Markets

Overview

What are price ceilings and price floors?

What are some examples of each?

How do price ceilings and price floors affect market

outcomes?

How do taxes affect market outcomes?

How do the effects depend on whether

the tax is imposed on buyers or sellers?

What is the incidence of a tax?

What determines the incidence?

1

Overview (cont’d)

How does the tax affect consumer surplus, producer

surplus, and total surplus?

What is the deadweight loss of a tax?

What factors determine the size of this deadweight

loss?

How does tax revenue depend on the size of the tax?

2

– how a tax on a good affects the price of the good

and the quantity sold

– that taxes levied on sellers and taxes levied on

buyers are equivalent

3

Learning Objectives (cont’d)

By the end of this session, students should

understand:

– how the burden of a tax is split between buyers and sellers

– how taxes reduce consumer and producer surplus

– the meaning and causes of the deadweight loss from

a tax

– why some taxes have larger deadweight losses than

others

– how tax revenue and deadweight loss vary with the

size of the tax

4

Government Policies and

the Efficiency of Markets

Part I Supply, Demand, and Government Policies

6

Government Policies That Alter the

Private Market Outcome

 Price controls

– Price ceiling: a legal maximum on the price of a good

or service Example: rent control

– Price floor: a legal minimum on the price of a good or

service Example: minimum wage

 Taxes

– Government can make buyers or sellers pay a specific

amount on each unit bought/sold

7

Price Controls

 Price controls are not a new idea

– The first recorded attempt: the Code of Hammurabi –

how much corn a farmer could pay for a cow

– Similar attempts in ancient Egypt, Greece, and Rome

– In the former Soviet Union, as well

– Currently in Venezuela, still similar attempts: refer to an

article in NYTimes “ With Venezuelan Food Shortages, Some

Blame Price Controls”

http://www.nytimes.com/2012/04/21/world/americas/venezuela-faces-shortages-in-grocery-staples.html?pagewanted=all&_r=0

History has shown that price controls generally do not work Why?

of apts

$800

300

Quantity of apartments

Source: Mankiw (2011)

9

How Price Ceilings Affect Market

Outcomes

A price ceiling above the equilibrium price is not

binding – has no effect on the market outcome

g

$1000

Source: Mankiw (2011)

10

How Price Ceilings Affect Market

Outcomes

The equilibrium price ($800) is above the ceiling ($500)

and therefore illegal

11

How Price Ceilings Affect Market

Outcomes

In the long run, supply and demand are more

price-elastic So, the shortage is larger

12

Shortages and Rationing

With a shortage, sellers must ration the goods among

buyers

Some rationing mechanisms: (1) Long lines

(2) Discrimination according to sellers’ biases

These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value

them the most

In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that

value them the most) and impersonal (and thus fair)

$4

500

Quantity of unskilled workers

Source: Mankiw (2011)

14

How Price Floors Affect Market

Outcomes

A price floor below the equilibrium price is not binding –

has no effect on the market outcome

$3

Source: Mankiw (2011)

$5

labor surplus

16

The Minimum Wage

Min wage laws do not affect highly skilled workers, but do

affect teenaged workers

unemp-Source: Mankiw (2011)

Exercise VI-1: Price controls

40 50 60 70 80 90 100 110 120 130 140

Exercise VI-1 Answer A:

Price controls

40 50 60 70 80 90 100 110 120 130 140

18 Source: Mankiw (2011)

Exercise VI-1 Answer B:

Price controls

40 50 60 70 80 90 100 110 120 130 140

above the floor, so

floor is not binding.

Exercise VI-1 Answer C:

Price controls

40 50 60 70 80 90 100 110 120 130 140

Case Study

Fair-Trade Coffee with Price Floor

– Fair-trade coffee is sold through organizations that

purchase directly from growers The coffee is usually sold for a higher price than standard coffee

– The goal is to promote more humane working

conditions for the coffee pickers and growers

– Fair-trade coffee has become more popular but

only accounts for a small portion of all coffee sales,

in large part because it is substantially more expensive to produce

21

Source: Mateer & Coppock (2013)

Case Study (cont’d)

Fair-Trade Coffee with Price Floor

Question:

Suppose that a one-pound bag of standard coffee costs

$8 and that a one-pound bag of fair-trade coffee costs

$12 Congress decides to impose a price floor of $10

per pound Will this policy cause more or fewer

people to buy fair-trade coffee?

22

Case Study : Suggested Answer

Fair-Trade Coffee with Price Floor

Answer:

– Fair-trade producers typically sell their product at a higher price than mass-produced coffee brands

– Therefore, a $10 price floor is binding for

inexpensive brands like Folgers but nonbinding for premium coffees, which include fair-trade sellers

– The price floor will reduce the price disparity b/w

fair-trade coffee and mass-produced coffee

23

Case Study : Suggested Answer

Fair-Trade Coffee with Price Floor

Answer (cont’d):

– A price-floor of $10 reduces the difference b/w the

price of fair-trade coffee and the inexpensive coffee

brands, which now must sell for $10 instead of $8 This lowers the consumer’s opportunity cost of choosing

fair-trade coffee

– Therefore, some consumers of the inexpensive brands

will opt for fair-trade instead As a result, fair-trade

producers will benefit indirectly from the price floor

– Thus more people will buy fair-trade coffee as a result

of this price-floor policy

24

Evaluating Price Controls

Recall one of the Ten Principles:

Markets are usually a good way

to organize economic activity

Prices are the signals that guide the allocation of

society’s resources This allocation is altered when policymakers restrict prices

Price controls are often intended to help the poor, but often hurt more than help

Government Policies and

the Efficiency of Markets

Part II Application:

The Costs of Taxation

27

Taxes

The government levies taxes on many goods &

services to raise revenue to pay for national defense,

public schools, etc

The government can make buyers or sellers pay the

tax

The tax can be a % of the good’s price, or a specific

amount for each unit sold

– For simplicity, we analyze per-unit taxes only

Equilibrium without tax

buyers shifts the D

curve down by the amount of the tax

Tax

Source: Mankiw (2011)

33

The Incidence of a Tax:

Incidence: how the burden of a tax is shared among

The tax effectively

raises sellers’ costs

The effects on P and Q,

and the tax incidence are

the same whether the tax

is imposed on buyers or

sellers!

Source: Mankiw (2011)

Exercise VI-3: Effects of a Tax

40 50 60 70 80 90 100 110 120 130 140

Exercise VI-3 Answer:

Effects of a Tax

40 50 60 70 80 90 100 110 120 130 140

39

Elasticity and Tax Incidence

CASE 1: Supply is more elastic than demand

market

So buyers

bear most of the burden

of the tax

Source: Mankiw (2011)

40

Elasticity and Tax Incidence

CASE 2: Demand is more elastic than supply

Sellers bear most of the burden of the tax

Source: Mankiw (2011)

41

Case Study

Who pays the luxury tax?

– 1990: Congress adopted a luxury tax on yachts,

private airplanes, furs, expensive cars, etc

– Goal of the tax: raise revenue from those who

could most easily afford to pay – wealthy

consumers

– But who really pays this tax?

42

Case Study : Suggested Answer

The market for yachts

In the short run, supply is inelastic

Hence,

companies

that build yachts pay most of the tax

Source: Mankiw (2011)

Government Policies and

the Efficiency of Markets

Part III Deadweight Loss and

Taxation

44

The Effects of a Tax on Welfare

Next, we apply welfare economics to measure the

gains and losses from a tax

We determine consumer surplus (CS),

producer surplus (PS), tax revenue,

and total surplus with and without the tax

Tax revenue can fund beneficial services

(e.g., education, roads, police)

so we include it in total surplus

+ D + E + F

Source: Mankiw (2011)

The tax reduces

total surplus by

C + E

Source: Mankiw (2011)

48

Deadweight Loss of Taxation

Tax on a good levied on buyers

– Demand curve shifts leftward

• By the size of tax

Tax on a good levied on sellers

– Supply curve shifts leftward

• By the size of tax

49

Deadweight Loss of Taxation

Tax on a good levied on buyers or on sellers

– Same outcome: a price wedge

– Price paid by buyers – rises

– Price received by sellers – falls

– Lower quantity sold

50

Deadweight Loss of Taxation

Tax burden

– Distributed between producers and consumers

– Determined by elasticities of supply and demand

Market for the good

– Smaller

Because of the tax,

the units between

Q T and Q E are not

Exercise VI-4: Analysis of Tax

52

A Compute

CS, PS, and total surplus without a tax

B If $100 tax

per ticket, compute

CS, PS, tax revenue, total surplus, and DWL

D

S

0 50 100 150 200 250 300 350 400

Exercise VI-4: Answer B

55

What Determines the Size of the

Dead Weight Loss?

Which goods or services should government tax

to raise the revenue it needs?

One answer: those with the smallest DWL

When is the DWL small vs large?

Turns out it depends on the price elasticities

of supply and demand

Recall:

The price elasticity of demand (or supply) measures

how much Q D (or Q S) changes

when P changes

56

DWL and the Elasticity of Supply

When supply is inelastic ,

it’s harder for firms to

leave the market when

the tax reduces P S

So, the tax only reduces

the easier for firms

to leave the market

when the tax reduces P S,

the greater Q falls

below the

surplus-maximizing quantity,

the greater the DWL

Source: Mankiw (2011)

the tax increases P B,

the more Q falls below

the surplus-maximizing quantity,

and the greater the DWL

Source: Mankiw (2011)

Example VI-5:

Elasticity and the DWL of a Tax

Would the DWL of a tax be larger if the

tax were on:

A Breakfast cereal or sunscreen?

B Hotel rooms in the short run or

hotel rooms in the long run?

C Groceries or meals at fancy restaurants?

60

Example VI-5 Answer A:

Elasticity and the DWL of a Tax

A Breakfast cereal or sunscreen

Breakfast cereal has more close substitutes than

sunscreen, so demand for breakfast cereal

is more price-elastic than demand for sunscreen

So, a tax on breakfast cereal would cause a larger

DWL than a tax on sunscreen

61

Example VI-5 Answer B:

Elasticity and the DWL of a Tax

B Hotel rooms in the short run or long run

From Session IV:

The price elasticities of demand and supply

for hotel rooms are larger in the long run than

in the short run

So, a tax on hotel rooms would cause a larger DWL

in the long run than in the short run

62

Example VI-5 Answer C:

Elasticity and the DWL of a tax

C Groceries or meals at fancy restaurants

From Session IV :

Groceries are more of a necessity and therefore less

price-elastic than meals at

fancy restaurants

So, a tax on restaurant meals would cause a larger

DWL than a tax on groceries

63

Quiz: True or False?

1. A price ceiling set above the equilibrium price is not

binding

2. The more elastic are supply and demand in a market,

the greater are the distortions caused by a tax on that market, and the more likely it is that a tax cut in that market will raise tax revenue

Quiz Answer: True or False?

1. A price ceiling set above the equilibrium price is not

binding  True, To be binding, a price ceiling must

be set below the equilibrium price

Quiz Answer: True or False? (cont’d)

2. The more elastic are supply and demand in a market,

the greater are the distortions caused by a tax on that market, and the more likely it is that a tax cut in that market will raise tax revenue. True,

In the statement above, distortions caused by a tax

mean DWL Namely, a tax on more elastic demand and supply causes larger DWL If both are more

elastic, it is easy for both buyers and sellers to enter the market when the tax cut occurs So the market

quantity increases more due to the tax cut

Summary I

A price ceiling is a legal maximum on the price of a

good An example is rent control If the price ceiling

is below the equilibrium price, it is binding and causes

a shortage

A price floor is a legal minimum on the price of a

good An example is the minimum wage If the price floor is above the equilibrium price, it is binding

and causes a surplus The labor surplus caused by the minimum wage is unemployment

69

Summary II

A tax on a good places a wedge between the price

equilibrium quantity to fall, whether the tax is imposed

on buyers or sellers

on whether the tax is imposed on buyers or sellers

The incidence of the tax depends on the price elasticities

70

Summary III

A tax on a good reduces the welfare of buyers and

sellers This welfare loss usually exceeds the revenue

the tax raises for the government

The fall in total surplus (consumer surplus, producer

surplus, and tax revenue) is called the deadweight loss

A tax has a DWL because it causes consumers to buy

less and producers to sell less, thus shrinking the market below the level that maximizes total surplus

71

Summary IV

The price elasticities of demand and supply measure

how much buyers and sellers respond to price changes Therefore, higher elasticities imply higher DWLs

Evaluation of the Session

Choose the most appropriate words below to fill in the blanks

– ( ) is the legal minimum on the price at which a good can be sold

– ( ) is the legal maximum on the price at which a

good can be sold

– ( ) is the manner in which the burden of a tax is

shared among participants in the market

– ( ) is the fall in total surplus that results from a

market distortion, such as a tax

price ceiling, tax burden, tax incidence, price floor,

dead weight loss 73