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? 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 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. 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? 8 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) 9 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) [...]... 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 25 Government Policies and the Efficiency of Markets Part II Application: The Costs of Taxation... 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. .. 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. .. 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... 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. .. 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... Price Ceilings Affect Market Outcomes The equilibrium price ($800) is above the ceiling ($500) and therefore illegal P S $800 The ceiling is now a binding $500 constraint on the price, causes a shortage shortag e 400 250 Price ceilin g D Q 10 Source: Mankiw (2011) How Price Ceilings Affect Market Outcomes In the long run, supply and demand are more priceelastic So, the shortage is larger P S $800 Price... Application: The Costs of Taxation 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 27 The Effects of a Tax P Equilibrium with no tax: Price... tax on Tax buyers shifts the D curve down by the amount of the tax D1 $10.00 $8.50 D2 500 Q 31 Source: Mankiw (2011) A Tax on Buyers  New equilibrium: P Q = 450 Sellers receive PS = $9.50 Buyers pay PB = $11.00 PB = $11.00 S1 Tax $10.00 PS = $9.50 Difference between them = $1.50 = tax D1 D2 450 500 Q 32 Source: Mankiw (2011) The Incidence of a Tax: Incidence: how the burden of a tax is shared among... goods go to the buyers that value them the most) and impersonal (and thus fair) 12 Example 2: The Market for Unskilled Labor Equilibrium without price controls Wage paid to unskilled workers W S $4 Quantity of unskilled workers D 500 L 13 Source: Mankiw (2011) How Price Floors Affect Market Outcomes A price floor below the equilibrium price is not binding – has no effect on the market outcome W S $4 Price . 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. 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. 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