University of Dayton



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Chapter

|6 |markets in action |

Chapter Key Ideas

Turbulent Times

A. As more people compete for scarce land, housing prices and rents rise. As new technologies replace low-skilled labor, the demand for low-skilled workers falls. Can governments control prices and wages and still remain efficient?

B. How do taxes affect market prices and quantities, and who pays the brunt of the tax, the buyer or the seller?

C. What happens in a market when a good is made illegal?

D. How are farm prices and incomes affected by fluctuations in annual harvests?

Outline

I. Housing Markets and Rent Ceilings

A. The 1906 San Francisco earthquake in left 200,000 people homeless, yet the housing shortage vanished in one month.

B. The Market Before and After the Earthquake

1. The short run supply curve shows the change in the quantity of housing supplied as the rent changes in the short run as the number of houses and apartments remains constant. Figure 6.1a shows that the earth shifted the short-run supply curve of housing leftward. After the earthquake, at the initial rent there was a shortage of housing.

2. A new, short run housing market equilibrium appeared in which the initial shortage of housing was eliminated by a rise in rents and an increase in the quantity of housing supplied moving up along the new, short run supply curve.

3. The long run supply curve reflects the quantity of housing that is available when enough time has elapsed for new housing to be built. In the long run, the supply of housing increased and the short-run supply curve shifted rightward, as shown in Figure 6.1b.

4. The long-run supply curve is perfectly elastic, so the long-run equilibrium price and quantity are the same as the pre-earthquake values (other things remaining the same).

C. A Regulated Housing Market

1. A price ceiling is a regulation that makes it illegal to charge a price higher than a specified level.

2. When a price ceiling is applied to a housing market it is called a rent ceiling.

a) If the rent ceiling is set above the equilibrium rental price for housing, the market attains equilibrium price and quantity as if there were no ceiling.

b) If the rent ceiling is set below the equilibrium rental price for housing, the quantity of housing demanded by renters exceeds the quantity of housing supplied by landlords, resulting in a shortage of rental housing.

3. Because landlords cannot be forced to supply a greater quantity than they wish, the quantity of housing supplied at the rent ceiling is less than the quantity that would be supplied in an unregulated market.

4. Because the legal price cannot eliminate the shortage, other mechanisms operate. This results in increased search activity and encourages black markets to develop.

D. Search Activity

1. The time spent looking for someone with whom to do business is called search activity.

a) When a price is regulated and there is a shortage, search activity necessarily increases.

b) Search activity is costly—the opportunity cost of housing equals its rent (regulated) plus the opportunity cost of the search activity (unregulated).

2. Because the quantity of housing is less than the quantity in an unregulated market, the opportunity cost of housing exceeds the unregulated rent—see Figure 6.2.

E. Black Markets

1. A black market is an illegal market in which the price exceeds the legally imposed price ceiling.

2. A shortage of housing created by a price ceiling results a black market in housing.

3. 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.

F. Rent Ceilings Are Inefficient

1. A rent ceiling leads to an inefficient use of resources.

a) The quantity of rental housing is less than the efficient quantity.

b) This results in a deadweight loss to society, as illustrated in Figure 6.3.

G. Are rent ceilings fair?

1. Using the “fair rules” criteria, anything that blocks voluntary exchange is inherently unfair.

2. Using the “fair outcomes” rule, it is fair if it can help the relatively poor and disadvantaged.

a) Scarcity has not been eliminated—the resulting shortage from the price ceiling means that the market mechanism of price is no longer used to allocate housing.

b) Rather, some other mechanism, like a lottery, or queuing, or some other form of discrimination. None of these methods of distribution favor the poor and disadvantaged.

H. Rent Ceilings in Practice

1. Many of the world’s biggest cities use rent ceilings to allocate housing: New York, Paris, London, San Francisco.

2. Compared with housing markets in cities that do not use rent ceilings, reveals that in cities with rent controls:

a) Housing shortages exist

b) Some renters pay lower rents, but others must pay higher rents.

c) Those that have lived in the city the longest are usually ones that get the lower rental rates.

II. The Labor Market and the Minimum Wage

A. New, labor-saving technologies become available every year, which mainly replace low-skilled labor.

1. The market responds with a decrease in the demand for low-skill labor, shown by a leftward shift of the demand curve in Figure 6.4a.

2. A new labor market equilibrium arises and the initial surplus of labor is eliminated by a fall in the wage.

3. In the long run a decrease in the supply of low-skill labor occurs as people get trained to do higher-skilled jobs, resulting in a leftward shift of the short-run supply curve shown in Figure 6.4b.

4. The long-run supply is perfectly elastic, so the long-run equilibrium wage rate is the same as the before the technological level changed (all else remaining the same).

B. A Minimum Wage

1. A price floor is a regulation that makes it illegal to trade at a price lower than a specified level.

2. When a price floor is applied to labor markets, it is called a minimum wage.

a) 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.

b) 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.

3. Because employers cannot be forced to hire a greater quantity of labor 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.

4. Because the legal wage rate cannot eliminate the surplus, the minimum wage creates unemployment—Figure 6.5.

D. The Inefficiency of a Minimum Wage

1. An unregulated market equilibrium means that everyone who is willing to work at the going market wage will find a job.

2. The minimum wage regulation means that a labor surplus will arise—some who are willing to work at the minimum wage will not be able to find a job.

3. This outcome creates a dead weight loss to society, as Figure 6.6 illustrates. Many people will spend extra time searching for and not finding work, and they would have been willing to work at the lower, unregulated wage.

E. The Federal Minimum Wage and Its Effects

1. The United States has passed the Fair Standards Labor Act, which currently sets the minimum wage at $5.15 per hour.

2. This minimum wage has historically fluctuated between 35 percent and 50 percent of the average wage of production workers.

3. A study of wage and employment data by economists David Card and Alan Krueger (Myth and Measurement: The New Economics of the Minimum Wage Law, Princeton: Princeton University Press, 1995) recently suggested that minimum wage laws do not cause unemployment.

4. Other economists disagree and claim that ceteris paribus conditions were violated regarding:

a) the timing of hiring decisions to raises in the minimum wage, or

b) there were significant differences among regions studied.

5. Most economists believe that minimum wage laws do lead to more unemployment among unskilled younger workers.

F. A Living Wage

1. Despite the likely increase in unemployment caused by a minimum wage, supporter of a higher minimum wage known as a “living wage” argue that individuals working 40 hours a week deserve enough pay to afford rental housing that is no more than 30 percent of their income.

2. Many city governments such as St. Louis, St. Paul, New Orleans, etc., have already imposed these laws on their own government employees.

3. The results will be the same as for the Federal minimum wage law, only with more intensity and greater deadweight loss.

III. Taxes

A. Who really pays the taxes? Demand and supply analysis shows how much of the tax burden the buyer and the seller share in the payment of a tax.

1. Tax incidence is the division of the burden of a tax between the buyer and the seller.

a) Buyers respond to the price with the tax, because that is the price they must pay.

b) Sellers respond to the price without the tax, because that is the price they receive.

c) The tax is like a wedge driven between the price paid and price received, altering the incentives facing both buyers and sellers.

2. Tax on Sellers: Figure 6.7 shows how a new sales tax of $1.50 per carton of cigarettes placed on the sellers of cigarettes in New York City places a wedge between the price that buyers must pay ($4.00 per pack) and the price sellers actually receive after the tax ($2.50).

a) The supply curve is shifted leftward. The vertical distance between the old and new supply curves is $1.50 at each and every quantity. This shift arises because the sellers are only willing to supply the same amount of cigarettes if they receive the same price after the tax is paid.

b) The after-tax price that satisfies both the existing buyer’s demand curve and the new seller’s supply curve is $4.00 per pack.

c) The new price is higher than the original price ($3.00 per pack), but not by the full amount of the tax. As a result, that the quantity of cigarettes sold is less than it was before the tax.

d) A dead weight loss exists where potential gains from trade would have been enjoyed by society had the tax not been paid. However, both buyers and sellers bear some of the burden of the tax.

3. Tax on Buyers: Figure 6.8 shows how a new sales tax of $1.50 per carton of cigarettes placed on the buyers of cigarettes in New York City places a similar wedge between the price that buyers must pay and the price sellers actually receive after the tax.

a) This time the demand curve is shifted leftward. The vertical distance between the old and new supply curves is $1.50 at each and every quantity because the buyers are only willing to purchase the same amount of cigarettes if they can pay the same price after the tax is paid.

b) The after tax price that satisfies both the existing seller’s supply curve and the new buyer’s demand curve is at $4.00 per pack, just as before.

c) Again, the new price is higher than the original price ($3.00 per pack), but not by the full amount of the tax. This result means that the quantity of cigarettes sold is less than it was before the tax, just like before.

d) A dead weight loss still exists where potential gains from trade would have been enjoyed by society had the tax not been paid. Again, both buyers and sellers bear some of the burden of the tax.

B. Equivalence of Tax on Buyers and Sellers

1. These two scenarios reveal that the effect of placing a tax on buyers generates the equivalent result as placing the same tax on buyers—the new equilibrium price and quantity are identical.

2. The tax is not necessarily split evenly across buyer and seller:

a) Comparing the old price that buyers used to pay ($3.00) with the new price ($4.00), buyers must bear $1.00 of the tax for each pack sold.

b) Comparing the old price received by sellers ($3.00) with the new price they used to receive ($2.50), the sellers bear only $0.50 of the tax for each pack.

c) In this example, it is the buyers who bear the largest share of the burden imposed by the tax.

C. Tax Division and Elasticity of Demand

The division of the tax burden between buyer and seller depends on the elasticities of demand and supply. In extreme cases, the seller or the buyer pays the entire tax.

1. The buyer pays the entire tax if:

a) Demand is perfectly inelastic (the demand curve is vertical). Figure 6.9a shows this scenario.

b) Supply is perfectly elastic (the supply curve is horizontal). Figure 6.9b shows this scenario.

2. The seller pays the entire tax if:

a) Demand is perfectly elastic (the demand curve is horizontal). Figure 6.10a shows this scenario.

b) Supply is perfectly inelastic (the supply curve is vertical). Figure 6.10b shows this scenario.

C. Taxes in Practice

1. Although no goods or services truly exhibit perfectly inelastic demand, governments often levy taxes on goods and services with very inelastic demand, such as alcohol, gasoline, or tobacco.

a) After the tax is imposed in these cases, the quantity sold declines only minimally.

b) This means the government can collect much larger tax revenues because it is able to place a tax on nearly the same quantity of goods sold as before the tax was imposed.

D. Taxes and Efficiency

1. In general, imposing a tax creates a deadweight loss.

2. Figure 6.11 shows the deadweight loss created from a tax on CD players.

IV. Subsidies and Quotas

A. Harvest Fluctuations

1. The supply curve for farm products is heavily influenced by natural forces (weather, insects, etc.) beyond the control of farmers.

2. Once farmers have harvested their crop, they have no control over the quantity supplied. They move along the perfectly inelastic momentary supply curve.

3. These two characteristics combine to make the market for farm products very volatile.

a) A poor harvest: Poor weather conditions shift the supply curve to the left, decreasing equilibrium quantity and increasing market price. This raises total farm revenues. Figure 6.12a shows the impact on market price and quantity from a decrease in the supply of wheat.

b) A bumper crop: Ideal weather conditions shifts the supply curve to the right, increasing equilibrium quantity and decreasing market price. This decreases total farm revenues. Figure 6.12b shows the impact on market price and quantity from an increase in the supply of wheat.

4. The elasticity of demand for farm goods affects farm revenues:

a) If the quantity sold and the revenues collected by farmers move in the opposite direction, the demand for wheat is inelastic (as was the case in the above example).

b) If the quantity sold and the revenues collected by farmers move in the same direction, the demand for wheat is elastic.

c) Avoid the fallacy of composition: Even if the total farmer revenues increase during a poor harvest, not all farmer will see an increase in revenues.

5. The government uses subsidies to control for large fluctuations in the momentary supply curves of farmers.

a) A subsidy is a payment made by the government to a producer.

b) Figure 6.13 shows how both the quantity sold and the price received by the sellers are higher after the subsidy. It also shows how the subsidy drives a wedge between the marginal benefit and marginal cost to society, resulting in a surplus of farm product and a dead weight loss.

6. The government also uses production quotas to control for large fluctuations in farmers’ momentary supply curves.

a) A production quota is an upper limit to the quantity of a good that may be produced in a specific period of time.

b) Figure 6.14 shows how both the quantity sold is lower and the price received by the sellers is higher after the production quota is in place. It also shows how the subsidy drives a wedge between the marginal benefit and marginal cost to society, resulting in a surplus of farm product and a dead weight loss.

V. Markets for Illegal Goods

A. The U.S. government prohibits trade of some goods, such as illegal drugs. Yet, a market still exists for these prohibited goods and services.

B. A Market for Illegal Drugs

1. Prohibiting transactions in a good or service raises the cost of such trading between buyers and sellers. Figure 6.15 shows the demand and supply curves for illegal drugs.

2. Compared to an unrestricted market:

a) If the penalty is levied on the seller, the penalty is added to the minimum price required for supplying the good or service. The supply curve shifts leftward, so that the vertical distance between the initial supply curve and the supply curve with the penalty equals the dollar value of the penalty. In this case, the equilibrium price of the product rises and the equilibrium quantity decreases.

b) If the penalty is levied on the buyer, the penalty is subtracted from the maximum willingness to pay for the good. The demand curve shifts leftward, so that the vertical distance between the initial demand curve with the demand curve with the penalty equals the dollar value of the penalty. In this case, the equilibrium price of the product falls and the equilibrium quantity decreases.

c) If buyers and sellers face penalties, both the demand and supply curves shift leftward. If the shift in the supply curve is larger, the equilibrium price rises and quantity decreases; if the shift in the demand curve is larger, the price falls and quantity decreases; if the shifts are the same magnitude, the price is unchanged and the quantity decreases.

3. The impact of the prohibition depends on how effectively the ban is policed and whether the penalty is levied on the buyer, the seller, or both. The resulting equilibrium quantity is less than the unregulated market equilibrium quantity.

C. Legalizing and Taxing Drugs

1. A prohibited good can be legalized and then taxed so that, compared to free and untaxed trade, the price is higher and the quantity consumed is less.

2. A high tax rate would likely be necessary to decrease consumption to the level that occurs when trade is illegal.

3. A policy of legalizing and taxing a prohibited good or service has advantages and disadvantages.

a) An advantage is that the government raises tax revenues, which can be used for education against the consuming the good or service.

b) A disadvantage is that legalization may signal that use of the good is acceptable, which could increase demand for the product. In addition, if the demand for the product were inelastic, it would take a very high tax to reduce consumption to the same level that occurred with prohibition.

Reading Between the Lines

A news article discusses the Recording Industry Association of America’s (RIAA) efforts to eliminate “free” downloading of copyrighted music. The analysis points out that when the RIAA goes after the people downloading the music files, it is attempting to decrease the demand for illegally downloaded music.

New in the Seventh Edition

The sections covering rent controls and the minimum wage have been expanded to discuss equity issues more carefully. The analysis of farm subsidies and production quotas has been expanded and refined.

Teaching Suggestions

1. Economics can really open your eyes! This chapter is a reward to the students for mastering the three preceding chapters—demand and supply, elasticity, and efficiency and equity. And the chapter provides you with an opportunity to “sell” economics as a highly valuable perspective on the world.

• Milton Friedman (quoted in Parkin, Economics, first edition, 1990, p. 99) said: “I always say that we economists may not know much, be we know one thing very well, and that’s how to create shortages and surpluses. Just tell us which you want! If you want a shortage, all we have to do is to set a price that’s below the market price and I’ll guarantee you a shortage. If you want a surplus, set the price too high and you’ll have your surplus.”

• Show the students how much they have learned in just a few chapters and how the demand and supply model enables them to understand complex events that affect their daily lives.

• Use to full advantage of the fact that issues like apartment rents and relationships with landlords are relevant to their lives and demand and supply models can reveal how the actions of others influence their decisions.

• Get them to consider how their response to the minimum wage laws are motivating them to act in a way which influences the lives of poor workers in the world of unskilled labor (see additional discussion questions, below).

• Let them see how they can become a better citizen-voter through the insights they can gain from this introduction to tax analysis.

2. Housing Markets and Rent Ceilings: Time and the elasticity of supply. Get the students to recall the different influences on the supply elasticity of the firm from Chapter 4 and remind them how the luxury of time allows sellers to fully respond to changes in their environment. Explain why it is likely that supply is perfectly elastic in the long run for many goods and services.

3. The Labor Market and the Minimum Wage: Labor is work that households supply and firms demand. You might be surprised to find that quite a few students think that the demand for labor is the demand by a household for a job and the supply of labor is the supply of jobs by firms. Of course, they get into a big mess with this mirror image view of the labor market. Try to avoid this all-too-common mistake by being very explicit that households supply labor and firms demand it. Sure, firms provide jobs and people want jobs to earn an income. But it is labor, not jobs, that is supplied and demanded in the labor market.

Time and the elasticity of labor supply. It is easy to get the students to see that the supply of labor can adjust more in the long run than in the short run. This fact is central to understanding why technological change doesn’t bring a permanent fall in the wage rates of low-skilled labor and why it does bring a transitory (but possibly lengthy fall).

4. Taxes and the inelasticity of “sinful” acts. Students who understand the basics of taxation will be more informed citizen voters. Raise a number of provocative issues related to taxation to evoke student interest in understanding why some goods are taxed and others are not:

Taxing the consumer surplus of smokers—“Once, Twice . . . Three times a levy.” Show students how cigarette smokers are “taxed” at least three times for their habit:

• Many believe that smoking is considered to be one of the most addictive, legally available products in the market without a doctor’s prescription. The government recognizes demand for cigarettes is highly inelastic and places a hefty sales tax on each pack of cigarettes. Strike one.

• Many state governments have sued the major tobacco companies for compensation for past and future health care costs arising from the smoking-related illnesses of its citizens. Tobacco companies have recently settled these suits by paying hundreds of billions of dollars in penalties. Students should see that inelastic demand for cigarettes allows tobacco producers to pass on most of these costs to the smoker. (This could explain why the settlement has done little in the long run to depress the stock prices and dividends from these major tobacco companies, relative to the whole market.) Strike two.

• Due to the increased health risk of smoking, the average smoker dies at a much earlier age than the average non-smoker. This means that smokers can expect to receive little, if any, return on all the social security taxes they’ve been paying in throughout their lives. Strike three!

5. Markets for Illegal Goods

Students are always interested in this analysis. The major thing to achieve is an awareness that declaring an activity to be illegal must be backed up with incentives—penalties. And taxes can work as an alternative incentive to achieve an identical outcome in terms of price and quantity. This analysis is another good place to emphasize that the opportunity cost of something is the market price plus any other costs of buying.

The Big Picture

Where we have been:

Chapter 6 uses the demand and supply concepts of Chapter 3, the elasticity concepts of Chapter 4, and the efficiency concepts of Chapter 5, all to study price ceilings and floors, taxes, markets for illegal goods, and markets for farm products. The chapter rounds out the student’s exploration of demand and supply and its application, and should be a fulfilling exercise for putting together the “big picture.”

Where we are going:

We return to demand and supply (and you can jump there whenever you choose after completing this chapter) to study factor markets and the distribution of income in Chapters 17 and 18. We also return to taxes and efficiency issues when we study public choice in Chapter 14 and externalities in Chapter 15. The next block of chapters goes behind the demand curve and the supply curve. Chapter 7 provides an explanation of the derivation of consumer equilibrium and the demand curve using the marginal utility theory. Chapter 8 provides a parallel and optional explanation of the derivation of consumer equilibrium and the demand curve using the indifference curves. Then, in Chapters 9 and 10, we study firms’ costs and lay the foundation for the derivation of the market supply curve in perfect competition in Chapter 11. Chapters 12 and 13 study departures from perfect competition.

Overhead Transparencies

|Transparency |Text figure |Transparency title |

|31 |Figure 6.2 |A Rent Ceiling |

|32 |Figure 6.3 |The Inefficiency of a Rent Ceiling |

|33 |Figure 6.5 |Minimum Wage and Unemployment |

|34 |Figure 6.6 |The Inefficiency of a Minimum Wage |

|35 |Figure 6.11 |Taxes and Efficiency |

|36 |Figure 6.12 |Harvests, Farm Prices, and Farm Revenue |

|37 |Figure 6.15 |A Market for an Illegal Good |

Electronic Supplements

MyEconLab

MyEconLab provides pre- and post-tests for each chapter so that students can assess their own progress. Results on these tests feed an individualized study plan that helps students focus their attention in the areas where they most need help.

Instructors can create and assign tests, quizzes, or graded homework assignments that incorporate graphing questions. Questions are automatically graded and results are tracked using an online grade book.

PowerPoint Lecture Notes

PowerPoint Electronic Lecture Notes with speaking notes are available and offer a full summary of the chapter.

PowerPoint Electronic Lecture Notes for students are available in MyEconLab.

Instructor CD-ROM with Computerized Test Banks

This CD-ROM contains Computerized Test Bank Files, Test Bank, and Instructor’s Manual files in Microsoft Word, and PowerPoint files. All test banks are available in Test Generator Software.

Additional Discussion Questions

1. Does rent control improve the quality of life for university students? A colleague shared the following useful example to make the issue of market price regulation personally relevant for the students. Inform them that the University of California is located in the city of Berkeley, California, where the city government imposes strict rent controls. The University of Florida is located in Gainesville, Florida, where there are no rent controls.

In which city would you expect incoming freshman students to have the least trouble renting an apartment? The students should understand that while apartments with low monthly rents would be very nice, they would also be very scarce due to a market shortage. Emphasize that under a rent control policy, not only are there fewer apartments for lease than if the market were unregulated, there are also many more students looking for an apartment who wouldn’t have even thought about renting at the higher, rental rates of the unregulated market.

Who ultimately gets the apartments? Students should see that the available units must be allocated somehow. Too many students trying to locate too few apartments means a new freshman student will face the following difficulties:

• Significant increase in search costs, like time spent, gasoline consumed, promising leads followed for nothing, etc.

• Greater risk of being rejected by landlords simply for being the “wrong” race or ethnic background; having the “wrong” religious beliefs or sexual orientation; having “too much” body piercing or too many tattoos, etc.

• Unscrupulous landlords requiring huge deposits; charging premiums for electricity or natural gas consumed; gouging the renters for minor maintenance actions; delaying important repairs to air conditioning or heating units or leaking plumbing fixtures.

If rent control laws fail to promote fairness, what about efficiency? Students should see that having a rent control policy means the economy suffers from three sources of inefficiency (meaning net benefits to society are not maximized):

• Those who get an apartment are not always the ones who value it the most.

• Difference in the marginal benefit and marginal cost at the level of housing produced means that too few resources are used for producing rental housing market, creating a deadweight loss.

• Underused resources in the rental housing market imply that too many resources are used in other markets, resulting in the overproduction of goods and services in those markets.

2. What does the “face” of a minimum wage worker look like? Ask students to describe who an unskilled worker is likely to be. They quickly recognize that they themselves often work part-time jobs for minimum wage. Break it to them (gently) that they are not really the utmost of concern to the political supporters of minimum wages. They seek to protect the interests of the uneducated, unskilled heads of households.

What is a “living wage”? Explain to them that minimum wage laws usually are justified as protecting those full time workers who have been denied opportunities for acquiring skills or an education, due to social oppression and poverty. For example, many young black or Hispanic men living in tough, poverty-stricken neighborhoods feel tremendous pressure to drop out of high school while they are still teenagers. These young men must seek out work limited to low-paying jobs for unskilled laborers. Supporters of minimum wage laws state that people like these deserve a second chance in life and can only improve their own future and their children’s future if they can earn a “living wage.”

Will raising the minimum wage help or hurt those who need help the most? This question makes students apply simple demand and supply analysis to discover the counter-intuitive implications from market regulation policies. Point out that minimum wage laws have at least two devastating impacts on the very people that supporters of a “living wage” say need these jobs the very most:

• The higher wage attracts a people with higher qualifications—like college students—to seek unskilled labor jobs that they wouldn’t otherwise seek out at a lower, unregulated wage. This means unskilled laborers who are heads of households are also competing to get jobs against greater numbers of relatively more educated college students with relatively greater human capital.

• Additionally, when employers determine which workers they are going to lay off after the raise in minimum wage takes affect, they are first going to release those employees with the least skills and the least experience. That is precisely the characteristics of many uneducated, minority workers who are in the greatest need of retaining any paying job to ensure a better future.

Students should understand that both of these results are the unintended consequences of trying to manipulate the market forces of supply and demand.

3. Can we list the inefficiencies of agriculture policies that prop up farm prices? Get the students to integrate concepts from many different chapters with the following example of agricultural market regulation. Inform students that the federal government regulates agriculture markets in many ways: i) it pays farmers to not produce output to prop up farm prices; ii) it uses output quotas to limit total farm production; and iii) it imposes price floors and pays farmers for any unsold, surplus quantities arising price floors imposed on many farm commodities markets. This multi-billion dollar annual agricultural support policy was recently given a big boost with the Farm Security Act of 2001. Have the students examine the impact of such market regulation and recognize that:

• Too many resources are used in the agriculture markets, causing a deadweight loss from overproduction. Too few resources are used in other competitive, unregulated markets, causing deadweight loss from underproduction. Remind the students that even if the deadweight losses were not realized, society would still be moving to a lower valued point on the production possibilities frontier.

• The federal government uses additional resources managing the huge surplus agricultural inventories, some of which (milk) is very perishable and requires expensive storage facilities. Much of these perishable farm goods are spoiled before it is decided what could be done with them without depressing the market price. This implies that society is moving towards the interior of the production possibilities frontier.

• The higher prices for food are used to justify increases in food stamp allotments to the poor and disadvantaged, increasing the tax revenues necessary to pay for this program. Higher tax burdens increase the deadweight loss to all markets that are taxed. This implies that society is moving even further to the interior of the production possibilities frontier.

Answers to the Review Quizzes

Page 126

1. When the supply of housing decreases, the short-run supply curve for housing shifts to the left. This causes the equilibrium rental price to increase and the equilibrium quantity of housing units to decrease in the short run.

2. An increase in the rental price for housing units motivates landlords to increase the quantity of housing units available and motivates renters to rent less housing space. If the market is unregulated, the housing units are allocated to those who are willing to pay at least the equilibrium rental rates.

3. If the long-run supply curve for housing units is perfectly elastic, then more housing will eventually be produced and the rental price will return to the original rental rate.

4. A rent ceiling is a specific example of a price ceiling. Rent ceilings are laws that prohibit suppliers (landlords) from charging prices (rental rates) higher than some specified level. If a rent ceiling is set above the equilibrium rental rate, it will have no impact on the equilibrium rental price and quantity of housing.

5. If the rent ceiling is below the equilibrium rental price for housing, the quantity of housing units demanded by renters exceeds the quantity supplied by landlords. Since landlords are not forced to supply more units than the supply curve would indicate for the rent ceiling price, the quantity of housing units actually rented equals the quantity supplied, rather than the quantity demanded. This causes a shortage to develop in the rental housing market.

6. With an effective price ceiling, some means for allocation of housing units (other than by price) becomes necessary. The shortage of housing units causes renters’ search efforts to increase, which imposes an opportunity cost on renters and raises the effective rental price for housing units. Black markets also develop, where housing units are allocated at higher than the regulated rental prices. Over time, those who have lived a long time in the rent-controlled area will benefit, since they will be the households that have acquired housing at the lower price, despite their income-levels. Newcomers will be at a disadvantage.

Page 129

1. Demand for unskilled labor constantly declines because technological advances constantly increase the productivity of skilled workers relative to unskilled workers. In an unregulated labor market, decreases in the demand for unskilled labor causes a short-run decline in wages as the demand curve shifts leftward along a positively sloped, short-run supply curve of labor.

2. If the long run supply of labor is perfectly elastic, wages will eventually return to their original level.

3. When a price floor is applied to the labor market, this is called a minimum wage law. If the minimum wage is set below the equilibrium wage level, then the law has no impact on the labor market equilibrium wage and quantity.

4. If the minimum wage is set above the equilibrium wage level, the ability of the competitive market to allocate resources efficiently is thwarted. In the case of a minimum wage law, a decrease in demand cannot cause the wage to fall, so the quantity supplied of unskilled laborers exceeds the quantity demanded, resulting in unemployment.

Page 134

1. The more elastic the demand curve becomes for a given supply curve: i) the rise in the after tax price paid by the buyer becomes smaller, ii) the deadweight loss to society becomes bigger, and iii) the burden of the tax paid by the buyer becomes smaller. The wedge between the price received by the seller and the price paid by the buyer causes the marginal benefits of the last unit sold to be higher than its marginal cost, and the market will under-produce the good or service being taxed.

2. The more elastic the supply curve becomes for a given demand curve: i) the fall in the after-tax price received by the seller becomes smaller; ii) the deadweight loss to society becomes bigger; and iii) the burden of the tax paid by the seller becomes smaller. The wedge between the price received by the seller and the price paid by the buyer causes the marginal benefits of the last unit sold to be higher than its marginal cost, and the market will under-produce the good or service being taxed.

3. The imposition of a tax on a market causes a wedge to be driven between the price received by the seller and the price paid by the buyer. This causes the marginal benefits of the last unit sold to be higher than its marginal cost, and the market will under-produce the good or service being taxed. If more of the good or service were produced, the marginal benefits gained would be greater than the marginal costs incurred, and net benefits to society would increase.

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1. A bumper crop from ideal weather conditions shifts the momentary supply curve rightward, increasing the equilibrium quantity, lowering the market price, and decreasing total farm revenues. A poor harvest from poor weather conditions shifts the momentary supply curve leftward, decreasing the equilibrium quantity, raising the market price, and raising total farm revenues.

2. A subsidy increases the price received by sellers, shifts the supply curve rightward, and places a wedge between the marginal benefit and marginal cost to society of producing the good. The subsidy creates in a dead weight loss to society, a higher equilibrium quantity sold, over-production of the farm product, and a lower price paid by the consumers. The subsidy increases farm revenues to all farmers.

3. A production quota increases the price paid by buyers, decreases the quantity supplied by sellers, and places a wedge between the marginal benefit and marginal cost to society of producing the good. A production quota results in a dead weight loss to society, a lower equilibrium quantity sold, and a higher price received by the sellers. The production quota increases farm revenues to some farmers and decreases farm revenues to other farmers.

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1. If the penalty is levied on the seller, the penalty is added to the minimum price required for supplying the good or service. The demand curve remains unchanged but the supply curve shifts leftward, so that the vertical distance between the initial supply curve and the supply curve with the penalty equals the dollar value of the penalty. In this case, the equilibrium price of the product rises and the equilibrium quantity decreases.

2. If the penalty is levied on the buyer, the penalty is subtracted from the maximum willingness to pay for the good. The supply curve remains unchanged and the demand curve shifts leftward, so that the vertical distance between the initial demand curve with the demand curve with the penalty equals the dollar value of the penalty. In this case, the equilibrium price of the product falls and the equilibrium quantity decreases.

3. If buyers and sellers face penalties, both the demand and supply curves shift leftward. If the shift in the supply curve is larger, the equilibrium price rises and quantity decreases; if the shift in the demand curve is larger, the price falls and quantity decreases; if the shifts are the same magnitude, the price is unchanged and the quantity decreases.

4. To reduce the consumption of drugs, they can be legalized and taxed. Legalizing and then taxing drugs has the benefit of raising funds for the government that could be used to help educate people about the danger of consuming drugs. However, if very high taxes are necessary to reduce the consumption of illegal drugs to the level of use when they were banned, this will cause buyers and sellers to engage in unreported trade in the black market and avoid the tax through tax evasion. Also, legalizing drugs may signal official approval for its use, shifting the buyers’ demand curve to the right, increasing drug use.

Answers to the Problems

1. a. Equilibrium price is $200 a month and the equilibrium quantity is 10,000 housing units.

b. The quantity rented is 5,000 housing units.

The quantity of housing rented is equal to the quantity supplied at the rent ceiling.

c. The shortage is 10,000 housing units.

At the rent ceiling, the quantity of housing demanded is 15,000, but the quantity supplied is 5,000, so there is a shortage of 10,000 housing units.

d. The maximum price that someone is willing to pay for the 5,000th unit available is $300 a month.

The demand curve tells us the maximum price willingly paid for the 5,000th unit.

2. a. Equilibrium price is $450 a month and the equilibrium quantity is 20,000 housing units.

b. The quantity rented is 10,000 housing units.

The quantity of housing rented is equal to the quantity supplied at the rent ceiling.

c. The shortage of housing is 20,000 housing units.

At the rent ceiling, the quantity of housing demanded is 30,000, but the quantity supplied is 10,000, so there is a shortage of 20,000 housing units.

d. The maximum price that someone is willing to pay for the 10,000th unit available is $600 a month.

The demand curve tells us the maximum price that someone is willing to pay for the 10,000th unit.

3. a. The equilibrium wage rate is $4 an hour, and employment is 2,000 hours a month.

b. Unemployment is zero. Everyone who wants to work for $4 an hour is employed.

c. They work 2,000 hours a month.

A minimum wage rate is the lowest wage rate that a person can be paid for an hour of work. Because the equilibrium wage rate exceeds the minimum wage rate, the minimum wage is ineffective. The wage rate will be $4 an hour and employment is 2,000 hours.

d. There is no unemployment

The wage rate rises to the equilibrium wage—the quantity of labor demanded equals the quantity of labor supplied. So there is no unemployment.

e. At $5 an hour, 1,500 hours a month are employed and 1,000 hours a month are unemployed.

The quantity of labor employed equals the quantity demanded at $5 an hour. Unemployment is equal to the quantity of labor supplied at $5 an hour minus the quantity of labor demanded at $5 an hour. The quantity supplied is 2,500 hours a month, and the quantity demanded is 1,500 hours a month. So 1,000 hours a month are unemployed.

f. The wage rate is $5 an hour, and unemployment is 500 hours a month.

At the minimum wage of $5 an hour, the quantity demanded is 2,000 hours a month and the quantity supplied is 2,500 hours a month. So 500 hours a month are unemployed.

4. a. The equilibrium wage rate is $7.50 an hour, and employment is 7,000 hours a month.

b. Unemployment is zero. Everyone who wants to work for $7.50 an hour is employed.

c. They work 7,000 hours a month.

A minimum wage rate is the lowest wage rate that a person can be paid for an hour of work. Because the equilibrium wage rate exceeds the minimum wage rate, the minimum wage is ineffective. The wage rate will be $7.50 an hour and employment is 7,000 hours.

d. There is no unemployment

The wage rate rises to the equilibrium wage—the quantity of labor demanded equals the quantity of labor supplied. So there is no unemployment.

e. At $8 an hour, 6,000 hours a month are employed and 2,000 hours a month are unemployed.

The quantity of labor employed equals the quantity demanded at $8 an hour. Unemployment is equal to the quantity of labor supplied at $8 an hour minus the quantity of labor demanded at $8 an hour. The quantity supplied is 8,000 hours a month, and the quantity demanded is 6,000 hours a month. So 2,000 hours a month are unemployed.

f. The wage rate is $8 an hour, and unemployment is 4,000 hours a month.

At the minimum wage of $8 an hour, the quantity demanded is 4,000 hours a month and the quantity supplied is 8,000 hours a month. So 4,000 hours a month are unemployed.

5. a. With no tax on brownies, the price is 60 cents a brownie and 4 million a day are consumed.

b. The price is 70 cents a brownie, and 3 million brownies a day are consumed. Consumers and producers each pay 10 cents of the tax on a brownie.

The tax decreases the supply of brownies and raises the price of a brownie. With no tax, producers are willing to sell 3 million brownies a day at 50 cents a brownie. But with a 20 cent tax, they are willing to sell 3 million brownies a day only if the price is 20 cents higher at 70 cents a brownie.

6. a. With no tax on roses, the price is $14 a bunch and 80 bunches a week are bought.

b. The price is $18 a bunch, and 60 bunches a week are bought. Buyers pay $4 of the tax on a bunch of roses and sellers pay $2 of the tax on roses.

The tax decreases the supply of roses and raises the price of a bunch of roses. With no tax, producers are willing to sell 80 bunches a week for $14 a bunch. But with a $6 a bunch tax, they are willing to sell 80 bunches a week only if the price is $6 a bunch higher at $20 a bunch. That is, the price at which producers are willing to sell 40 bunches a week when the tax is $6 a bunch is $16 a bunch; the price at which producers are willing to sell 60 bunches a week when the tax is $6 a bunch is $18 a bunch.

At $18 a bunch, the quantity demanded is 60 bunches a week. $18 a bunch is the price when the tax is $6 a bunch at which they are willing to sell 60 bunches a week. So the quantity sold is 60 bunches a week. The price has risen from $14 a bunch to $18 a bunch, so buyers pay $4 of the $6 tax. Sellers pay the other $2 of tax.

7. With a subsidy on rice, the price is $1.20 a box, the marginal cost $1.50 a box, and the quantity produced is 3,000 boxes a week.

The subsidy of $0.30 lowers the price at which each quantity in the table is supplied. For example, rice farmers will supply 3,000 boxes a week if the price is $1.50 minus $0.30, which is $1.20. With a subsidy, the market equilibrium occurs at $1.20 a box. At this price, the quantity demanded is 3,000 boxes and the quantity supplied is 3,000 boxes. The marginal cost of producing rice is given by the supply schedule. The marginal cost of supplying 3,000 boxes a week is $1.50 a box.

8. With a quota of 2,000 boxes a week, the price is $1.60 a box, the marginal cost $1.30 a box, and the quantity produced is 2,000 boxes a week.

The quota decreases the quantity supplied to 2,000 boxes a week. The price willingly paid for 2,000 boxes a week is $1.60 (given by the demand schedule). The marginal cost of producing 2,000 boxes of rice is given by the supply schedule. The marginal cost of supplying 2,000 boxes a week is $1.30 a box.

Additional Problems

1. The figure shows the demand for and supply of rental housing in Township.

a. What are the equilibrium rent and equilibrium quantity of rental housing?

If a rent ceiling is set at $150 a month, what is

b. The quantity of housing rented?

c. The shortage of housing?

d. The maximum price that someone is willing to pay for the last unit available?

2. The table gives the demand for and supply of labor of high school graduates.

Wage rate Quantity Quantity

(dollars demanded supplied

per hour) (hours per month)

6 9,000 4,000

7 8,000 5,000

8 7,000 6,000

9 6,000 7,000

10 5,000 8,000

a. On a graph, mark in the equilibrium wage rate and level of employment.

b. What is the level of unemployment?

c. If a minimum wage is set at $7 an hour, how many hours do high school graduates work?

d. If a minimum wage is set at $7 an hour, how many hours of labor are unemployed?

e. If a minimum wage is set at $9 an hour, what are employment and unemployment?

f. If the minimum wage is $9 an hour and demand increases by 500 hours a month, what is the wage rate paid to high school graduates and how many hours of their labor are unemployed?

3. The demand and supply schedules for coffee are

Price Quantity Quantity

(dollars per demanded supplied

cup) (cups per hour)

1.50 90 30

1.75 70 40

2.00 50 50

2.25 30 60

2.50 10 70

a. If there is no tax on coffee, what is the price and how much coffee is consumed?

b. If a tax of 75¢ a cup is introduced, what is the price and how much coffee is consumed? Who pays the tax?

Solutions to Additional Problems

1. a. Equilibrium price is $300 a month and the equilibrium quantity is 30,000 housing units.

b. The quantity rented is 10,000 housing units.

The quantity of housing rented is equal to the quantity supplied at the rent ceiling.

c. The shortage of housing is 40,000 housing units.

At the rent ceiling, the quantity of housing demanded is 50,000, but the quantity supplied is 10,000, so there is a shortage of 40,000 housing units.

d. The maximum price that someone is willing to pay for the 10,000th unit available is $450 a month.

The demand curve tells us the maximum price that someone is willing to pay for the 10,000th unit.

2. a. The equilibrium wage rate is $8.50 an hour, and employment is 6,500 hours a month.

b. Unemployment is zero. Everyone who wants to work for $8.50 an hour is employed.

c. They work 6,500 hours a month.

A minimum wage rate is the lowest wage rate that a person can be paid for an hour of work. Because the equilibrium wage rate exceeds the minimum wage rate, the minimum wage is ineffective. The wage rate will be $8.50 an hour and employment is 6,500 hours.

d. There is no unemployment

The wage rate rises to the equilibrium wage—the quantity of labor demanded equals the quantity of labor supplied. So there is no unemployment.

e. At $9 an hour, 6,000 hours a month are employed and 1,000 hours a month are unemployed.

The quantity of labor employed equals the quantity demanded at $9 an hour. Unemployment is equal to the quantity of labor supplied at $9 an hour minus the quantity of labor demanded at $9 an hour. The quantity supplied is 7,000 hours a month, and the quantity demanded is 6,000 hours a month. So 1,000 hours a month are unemployed.

f. The wage rate is $9 an hour, and unemployment is 500 hours a month.

At the minimum wage of $9 an hour, the quantity demanded is 6,500 hours a month and the quantity supplied is 7,000 hours a month. So 500 hours a month are unemployed.

3. a. With no tax on coffee, the price is $2.00 a cup and 50 cups an hour are consumed.

b. The price is $2.25 a cup, and 30 cups an hour are consumed. Consumers pay 25 cents of the tax on a cup of coffee and produces pay 50 cents of the tax on a cup of coffee.

The tax decreases the supply of coffee and raises the price of coffee. With no tax, producers are willing to sell 30 cups an hour at $1.50 a cup. But with a 75 cent tax, they are willing to sell 30 cups an hour only if the price is 75 cents higher at $2.25 a cup.

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