CHAPTER 4The Market Strikes Back

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What you will learn in this chapter:Why does the government intervene in

markets?What are the common tools of government

intervention?What happens when the government

intervenes?

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Why does the government intervene in markets?

Pressure from buyers. E.g. maximum rental ratePressure from sellers. E.g. minimum wageTools:

Price controls (price ceiling, price floor) Quantity controls (quota, license)

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The Market for Apartments in the Absence of Government Controls

Without government intervention, the market for apartments reaches equilibrium at point E with a market rent of $1,000 per month and 2 million apartments rented.

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The Effects of a Price Ceiling

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A market or an economy is inefficient if there are missed opportunities: Some people could be made better off without making other people worse off.

Price ceilings often lead to inefficiency in the forms of:

Inefficient allocation to consumersWasted resourcesInefficiently low quality

They also produce black markets.

Price ceilings cause inefficiency!

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So why are there price ceilings?Case: Rent control in New York Price ceilings hurt most residents but give a small minority of renters much cheaper housing than they would get in an unregulated market. (Those who benefit from the controls are typically better organized and more influential than those who are harmed by them.) When price ceilings have been in effect for a long time, buyers may not have a realistic idea of what would happen without them. Government officials often do not understand supply and demand analysis!

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The Market for Butter in the Absence of Government Controls

Without government intervention, the market for butter reaches equilibrium at a price of $1 per pound and with 10 million pounds of butter bought and sold.

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The Effects of a Price Floor

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The most familiar price floor is the minimum wage. Price floors are also commonly imposed on agricultural goods.

Price floors often lead to inefficiency in the forms of:

Inefficient allocation of sales among sellers

Wasted resourcesInefficiently high quality

They can also can provide an incentive for illegal activity (Ex.: black labor).

Price Floors Cause Inefficiency!

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So why are there price floors?Price floors benefit some influential sellers.Government officials believe that the relevant market is poorly described by supply and demand.Government officials do not understand the supply and demand model.

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Economics in ActionCase: Black Labor in Southern Europe“Minimum Wage as Price Floor”In many European countries,

minimum wages are much higher than in the U.S., and

employers are required to pay for health and retirement benefits.

This makes the cost of hiring a European worker considerably more than the worker’s paycheck.The minimum wage is well above the market clearing wage rate:

labor surplus unemployment

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This high unemployment leads to widespread evasion of the law:

workers who are employed by companies that pay them less than the legal minimum, fail to provide the required health and retirement benefits, or both:

jobs are simply unreported.

About a third of the Spain’s reported unemployed are in the black labor market—working at unreported jobs!!In fact, Spaniards waiting to collect checks

from the unemployment office have been known to complain about the long lines that keep them from getting back to work!

Economics in Action

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A quantity control, or quota, is an upper limit on the quantity of some good that can be bought or sold. The total amount of the good that can be legally transacted is the quota limit.

A license gives its owner the right to supply a good.

Example: Market for taxi rides in New York City

Controlling Quantities

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The Market for Taxi Rides in the Absence of Government Controls

Without government intervention, the market reaches equilibrium with 10 million rides taken per year at a fare of $5 per ride.

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Effect of a Quota on the Market for Taxi Rides

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A quota drives a wedge between the demand price (the price paid by buyers) and the supply price (the price received by sellers) of a good.

The difference between the demand and supply price at the quota limit is the quota rent, the earnings that accrue to the license-holder from ownership of the right to sell the good. It is equal to the market price of the license when the licenses are traded.

Like price controls, quantity controls create inefficiencies and encourage illegal activity.

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Excise taxes are taxes on the purchase or sale of a good.They have effects similar to quotas:

raise the price paid by buyers and reduce the price received by sellers,

and drive a wedge between the two.

Examples: Excise tax levied on sales of taxi rides and excise tax levied on purchases of taxi rides

Excise Taxes

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Effect of an Excise Tax Levied on the Sales of Taxi Rides

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Effect of an Excise Tax Levied on the Purchases of Taxi Rides

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The incidence of a tax is a measure of who really pays it.

Who really bears the tax burden (higher prices to consumers and lower prices to sellers) does not depend on who officially pays the tax. Depending on the shapes of supply and demand curves, the incidence of an excise tax may be divided differently.

The wedge between the demand price and supply price becomes the government’s tax revenue.

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The Revenue from an Excise Tax

Area of the shaded rectangle: $2 per ride × 8 million rides = $16 million.

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Excise taxes also cause inefficiency: excess burden or deadweight loss.

This excess burden, or deadweight loss, meansthat the true cost is always larger than the amount paid in taxes.

Excise taxes prevent some mutually beneficial transactions.

They also encourage illegal activity in attempts to avoid the tax.

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The End of Chapter 4

coming attraction:Chapter 5: Elasticity