government policies and the efficiency of markets

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?
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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?

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Learning Objectives
By the end of this session, students should
understand:
–the effects of government policies that place a
ceiling on prices.
–the effects of government policies that put a floor

under prices.
–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.
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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.
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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.
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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”
/>shortages-in-grocery-staples.html?pagewanted=all&_r=0
History has shown that price controls generally do not
work. Why?

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Example 1: The Market for
Apartments
Equilibrium without price controls
P
Q
D
S
Rental
price
of apts

$800
300
Quantity of
apartments
Source: Mankiw (2011)
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How Price Ceilings Affect Market
Outcomes
A price ceiling above the equilibrium price is not
binding – has no effect on the market outcome.
P
Q
D
S
$800
300
Price
ceilin
g
$1000
Source: Mankiw (2011)
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How Price Ceilings Affect Market
Outcomes
The equilibrium price ($800) is above the ceiling ($500)
and therefore illegal.
P
Q
D
S

$800
Price
ceilin
g
$500
250
400
shortag
e
The ceiling is
now a binding
constraint on the
price, causes a
shortage.
Source: Mankiw (2011)
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How Price Ceilings Affect Market
Outcomes
In the long run, supply and demand are more price-
elastic. So, the shortage is larger.
P
Q
D
S
$800
150
Price
ceiling
$500
450

shortag
e
Source: Mankiw (2011)
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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).
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Example 2: The Market for
Unskilled Labor
Equilibrium without price controls
W
L
D
S
Wage
paid to
unskilled
workers
$4
500
Quantity of

unskilled workers
Source: Mankiw (2011)
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How Price Floors Affect Market
Outcomes
A price floor below the equilibrium price is not binding –
has no effect on the market outcome.
W
L
D
S
$4
500
Price
floor
$3
Source: Mankiw (2011)
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How Price Floors Affect Market
Outcomes
The equilibrium wage ($4) is below the floor ($5) and
therefore illegal.
W
L
D
S
$4
Price
floor
$5

400 550
labor
surplus
The floor is a
binding
constraint on the
wage, causes a
labor surplus
(i.e.,
unemployment).
Source: Mankiw (2011)
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The Minimum Wage
Min wage laws do not affect highly skilled workers, but do
affect teenaged workers.
W
L
D
S
$4
Min.
wage
$5
400 550
unemp-
loyment
Source: Mankiw (2011)
Exercise VI-1: Price controls
40
50

60
70
80
90
100
110
120
130
140
50 60 70 80 90 100 110 120 130
Q
P
S
0
The market for
hotel rooms
D
Determine
effects of:
A. $90 price
ceiling
B. $90 price
floor
C. $120 price
floor
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Source: Mankiw (2011)
Exercise VI-1 Answer A:
Price controls
40

50
60
70
80
90
100
110
120
130
140
50 60 70 80 90 100 110 120 130
Q
P
S
0
The market for
hotel rooms
D
The price falls to $90.
Buyers demand
120 rooms, sellers
supply 90, leaving a
shortage.
shortage = 30
Price
ceiling
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Source: Mankiw (2011)
Exercise VI-1 Answer B:
Price controls

40
50
60
70
80
90
100
110
120
130
140
50 60 70 80 90 100 110 120 130
Q
P
S
0
D
Equilibrium price is
above the floor, so
floor is not binding.
P = $100,
Q = 100 rooms.
Price floor
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The market for
hotel rooms
Source: Mankiw (2011)
Exercise VI-1 Answer C:
Price controls
40

50
60
70
80
90
100
110
120
130
140
50 60 70 80 90 100 110 120 130
Q
P
S
0
The market for
hotel rooms
D
The price rises to
$120.
Buyers demand 60
rooms, sellers supply
120, causing a
surplus.
surplus = 60
Price floor
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Source: Mankiw (2011)
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.
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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?


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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.


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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


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