Transcript Why does the government intervene in markets?

CHAPTER 4
The Market Strikes Back
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 rate
Pressure from sellers. E.g. minimum wage
Tools:
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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Price ceilings cause inefficiency!
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 consumers
Wasted resources
Inefficiently low quality
They also produce black markets.
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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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Price Floors Cause Inefficiency!
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 resources
Inefficiently high quality
They can also can provide an incentive for illegal activity
(Ex.: black labor).
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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 Action
Case: 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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Economics in Action
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! 
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Controlling Quantities
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
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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
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
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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, means
that 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
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