2Objectives After studying this chapter, you will able to Explain how housing markets work and how price ceilings create housing shortages and inefficiencyExplain how labor markets work and how minimum wage laws create unemployment and inefficiencyExplain the effects of the sales taxExplain how markets for illegal goods workExplain why farm prices and farm revenues fluctuate and how speculation and price stabilization agencies influence farm prices and farm revenues
3Turbulent TimesAs more people compete for scarce land, house prices and rents rise. As new technologies replace low-skilled labor, the demand for low-skilled workers falls. Can governments control prices and wages?How do taxes affect prices and quantities, and who pays the tax, the buyer or the seller?What happens in a market when a good is made illegal?How are farm prices and incomes affected by fluctuations in harvests?Economics opens our 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, but 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 the fact that issues like apartment rents and relationships with landlords are relevant to their lives and that demand and supply models can reveal how the actions of others influence their decisions.Get them to consider how their responses 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 better citizen-voters through the insights they can gain from this introduction to tax analysis.
4Housing Markets and Rent Ceilings The 1906 earthquake in San Francisco left 200,000 people—more than half the city—homeless.By the time the San Francisco Chronicle started publishing again, a month after the earthquake, there was not a single mention of a housing shortage.The classified advertisements listed many more houses and flats for rent than the advertisements for houses and flats wanted.How did the market achieve this outcome?
5Housing Markets and Rent Ceilings The Market Response to a Decrease in SupplyFigure 6.1 shows the San Francisco housing market before the earthquake.The quantity of housing was 100,000 units and the rent was $16 a month at the intersection of D and SS.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.
6Housing Markets and Rent Ceilings The earthquake decreased the supply of housing and the supply curve shifted leftward to SSA.The rent increased to $20 a month and the quantity decreased to 72,000 units.
7Housing Markets and Rent Ceilings Long-Run AdjustmentsThe long-run supply of housing is perfectly elastic at $16 a month.With the rent above $16 a month, new houses and apartments are built.
8Housing Markets and Rent Ceilings The building program increases supply and the supply curve shifts rightward.The quantity of housing increases and the rent falls to the pre-earthquake levels (other things remaining the same).
9Housing Markets and Rent Ceilings A Regulated Housing MarketA price ceiling is a regulation that makes it illegal to charge a price higher than a specified level.When a price ceiling is applied to a housing market it is called a rent ceiling.If the rent ceiling is set above the equilibrium rent, it has no effect. The market works as if there were no ceiling.But if the rent ceiling is set below the equilibrium rent, it has powerful effects.
10Housing Markets and Rent Ceilings Figure 6.2 shows the effects of a rent ceiling that is set below the equilibrium rent.The equilibrium rent is $20 a month.A rent ceiling is set at $16 a month.So the equilibrium rent is in the illegal region.
11Housing Markets and Rent Ceilings At the rent ceiling, the quantity of housing demanded exceeds the quantity supplied and there is a housing shortage.Explain that because landlords can’t 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.
12Housing Markets and Rent Ceilings With a housing shortage, people are willing to pay $24 a month.Because the legal price cannot eliminate the shortage, other mechanisms operate:search activityblack markets
13Housing Markets and Rent Ceilings Search ActivityThe time spent looking for someone with whom to do business is called search activity.When a price is regulated and there is a shortage, search activity increases.Search activity is costly and the opportunity cost of housing equals its rent (regulated) plus the opportunity cost of the search activity (unregulated).Because the quantity of housing is less than the quantity in an unregulated market, the opportunity cost of housing exceeds the unregulated rent.
14Housing Markets and Rent Ceilings Black MarketsA black market is an illegal market that operates alongside a legal market in which a price ceiling or other restriction has been imposed.A shortage of housing creates a black market in housing.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.
15Housing Markets and Rent Ceilings Inefficiency of Rent CeilingsA rent ceiling leads to an inefficient use of resources.The quantity of rental housing is less than the efficient quantity and there is a deadweight loss, illustrated in Figure 6.3 (page 125).A rent ceiling is also, usually, unfair.It does not generally benefit the poor.Rather, it hurts the mobile newcomers and favors the less mobile, established residents.
16Housing Markets and Rent Ceilings Figure 6.3 shows that a rent ceiling decreases the quantity of rental housing,shrinks the producer and consumer surplus by using resources in search activity,and creates a deadweight loss.
17The Labor Market and the Minimum Wage New, labor-saving technologies become available every year, which mainly replace low-skilled labor.Does the persistent decrease in the demand for low-skilled labor depress the wage rates of these workers?The immediate effect of these technological advances is a decrease in the demand for low-skilled labor, a fall in the wage rate, and a decrease in the quantity of labor supplied.Figure 6.4 on the next slide illustrates this immediate effect.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 labor is work. Households supply it 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.
18The Labor Market and the Minimum Wage A decrease in the demand for low-skilled labor is shown by a leftward shift of the demand curve.A new labor market equilibrium arises at a lower wage rate and a smaller quantity of labor employed.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.
19The Labor Market and the Minimum Wage In the long run, people get trained to do higher-skilled jobs.The supply of low-skilled labor decreases, which is shown by a leftward shift of the short-run supply curve.
20The Labor Market and the Minimum Wage If long-run supply is perfectly elastic, the equilibrium wage rate returns to its initial level (other things remaining the same).
21The Labor Market and the Minimum Wage A price floor is a regulation that makes it illegal to trade at a price lower than a specified level.When a price floor is applied to labor markets, it is called a minimum wage.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.If the minimum wage is set above the equilibrium wage rate, it has powerful effects.
22The Labor Market and the Minimum Wage 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.Because employers cannot be forced to hire a greater quantity 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.Because the legal wage rate cannot eliminate the surplus, the minimum wage creates unemploymentFigure 6.5 on the next slide illustrates these effects.
23The Labor Market and the Minimum Wage The equilibrium wage rate is $4 an hour.The minimum wage rate is set at $5 an hour.So the equilibrium wage rate is in the illegal region.
24The Labor Market and the Minimum Wage The quantity of labor employed is the quantity demanded.The quantity of labor supplied exceeds the quantity demanded.Unemployment is the gap between the quantity demanded and the quantity supplied.
25The Labor Market and the Minimum Wage The Minimum Wage in PracticeThe United States has passed the Fair Standards Labor Act, which currently sets the minimum wage at $5.15 per hour.This minimum wage has historically fluctuated between 35 percent and 50 percent of the average wage of production workers.Most economists believe that minimum wage laws increase the unemployment rate of low-skilled younger workers.Talk about the study of wage and employment data by David Card and Alan Krueger (Myth and Measurement: The New Economics of the Minimum Wage Law, Princeton: Princeton University Press, 1995), which suggests that minimum wage laws do not cause unemployment.Note that other economists disagree and claim that ceteris paribus conditions were violated regarding:the timing of hiring decisionsregional differences
26Taxes Who Pays a Sales Tax? Demand and supply analysis shows how the buyer and the seller share the payment of a tax.Buyers respond to the price with the tax, because that is the price they must pay.Sellers respond to the price without the tax, because that is the price they receive.The tax is a wedge between the price paid and price received, which changes the incentives faced by buyers and sellers.
27Taxes Figure 6.6 shows the effects of a sales tax on CD players. The equilibrium price with no tax is $100.A tax of $10 per CD player is introduced.The curve S + tax shows the new supply curve.
28TaxesThe vertical distance between the original supply curve and the supply curve with the tax is equal to the amount of the sales tax.Buyers would have to pay $110 to induce firms to offer the original quantity for sale.
29Taxes The tax changes the equilibrium price and quantity. The quantity decreases.The price paid by the buyer rises to $105 and the price received by the seller falls to $95.
30Taxes The government collects a tax revenue on the decreased quantity. The buyer and the seller share the tax payment.In this example, they share it equally.But it doesn’t always turn out that way.
31TaxesThe division of the tax between the buyer and the seller depends on the elasticities of demand and supply.Tax Division and Elasticity of DemandTo see the effect of the elasticity of demand on the division of the tax payment, we look at two extreme cases.Perfectly inelastic demand: the buyer pays the entire tax.Perfectly elastic demand: the seller pays the entire tax.The more inelastic the demand, the larger is the buyers’ share of the tax.
32TaxesIn this figure, demand is perfectly inelastic—the demand curve is vertical.When a tax is imposed on this good, the buyer pays the entire tax.
33TaxesIn this figure, demand is perfectly elastic—the demand curve is horizontal.When a tax is imposed on this good, the seller pays the entire tax.
34Taxes Tax Division and Elasticity of Supply To see the effect of the elasticity of supply on the division of the tax payment, we again look at two extreme cases.Perfectly inelastic supply: the seller pays the entire tax.Perfectly elastic supply: the buyer pays the entire tax.The more elastic the supply, the larger is the buyers’ share of the tax.
35TaxesIn this figure, supply is perfectly inelastic—the supply curve is vertical.When a tax is imposed on this good, the seller pays the entire tax.
36TaxesIn this figure, supply is perfectly elastic—the supply curve is horizontal.When a tax is imposed on this good, the buyer pays the entire tax.
37Taxes Sales Taxes in Practice Taxes usually are levied on goods and services with an inelastic demand.The quantity purchased does not decrease by much after the tax is imposed.The government collects relatively larger tax receipts.Taxes and the inelasticity of “sinful” acts. If students understand the basics of taxes, they will become 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.” Provoke the students’ interest in tax policy by showing them 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. (That is, assuming any of us will get anything back for our social security taxes!) Strike three!
38Taxes Taxes and Efficiency Except in the extreme cases of perfectly inelastic demand or supply when the quantity remains the same, imposing a tax creates inefficiency.Figure 6.9 shows the inefficiency created by a $10 tax on CD players.
39TaxesWith no tax, the market is efficient and the sum of consumer surplus and producer surplus is maximized.A tax shifts the supply curve, decreases the equilibrium quantity, raises the price to the buyer, and lowers the price to the seller.
40TaxesThe tax revenue takes part of the consumer surplus and producer surplus.The decreased quantity creates a deadweight loss.
41Markets for Illegal Goods The U.S. government prohibits trade of some goods, such as illegal drugs.Yet, markets exist for illegal goods and services.How does the market for an illegal good work?A Free Market for DrugsTo see how the market for an illegal good works, we begin by looking at a free market and see the changes that occur when the good is made illegal.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.
42Markets for Illegal Goods Figure 6.10 shows the market for a drug such as marijuana.The equilibrium is at point E.The price is PC and the quantity is QC.
43Markets for Illegal Goods A Market for Illegal DrugsProhibiting transactions in a good or service raises the cost of such trading.If sellers (drug dealers) are penalized, we must add the cost of breaking the law to the minimum supply price.
44Markets for Illegal Goods If the penalty on the seller is the amount HK, the quantity supplied at a market price of PC is QP.A new supply curve passes through point H.The new equilibrium is at point F. The price rises and the quantity decreases.
45Markets for Illegal Goods Starting again at the equilibrium point E, suppose that buyers are penalized (and not sellers).Now, we must subtract the cost of breaking the law from the maximum price that the buyer is willing to pay.
46Markets for Illegal Goods If the penalty on the buyer is the amount JH, the quantity demanded at a market price of PC is QP.A new demand curve passes through point H.The new equilibrium is at point G. The market price falls and the quantity decreases.
47Markets for Illegal Goods But the opportunity cost of buying this illegal good rises because the buyer pays the market price plus the cost of breaking the law.
48Markets for Illegal Goods Now suppose that both buyers and sellers are penalized for trading in the illegal drug.We add the cost of breaking the law to the minimum supply price and get a new supply curve.
49Markets for Illegal Goods The new equilibrium is at point H.The quantity decreases to QP.The market price is PC.The buyer pays PB and the seller receives PS.
50Markets for Illegal Goods Legalizing and Taxing DrugsAn illegal good can be legalized and taxed.A high enough tax rate would decrease consumption to the level that occurs when trade is illegal.Arguments that extend beyond economics surround this choice.
51Stabilizing Farm Revenues An Agricultural MarketThe supply of farm products is heavily influenced by natural forces (weather, insects, etc.) beyond the control of farmers.Consumer demand for farm products is inelastic.These two characteristics combine to make the market for farm products and farm revenues volatile.Two nice lessons here:First, inelastic demand means that total revenue fluctuates in the opposite direction to the price. The students know this result from Chapter 4 and the total revenue test. But to see its implication for farm incomes brings the point home and shows its relevance.Second, inventories change the outcome radically. When a good can be stored, it has a perfect substitute—a unit a moment later. Ignoring inventory carrying costs, the perfectly elastic supply at the expected price transforms the predictions. If you want to add the realism of inventory carrying costs, you’ll need a break in the supply curve and two perfectly elastic segments at each side of the break. The price at which the item will be taken into inventory equals the expected selling price minus the inventory carrying cost. The price at which the item will be sold from inventory is the expected price.
52Stabilizing Farm Revenues Figure 6.11(a) shows the market for wheat.Once the crop is planted, supply is perfectly inelastic along the momentary supply curve MS0.The price is $4 a bushel and farm total revenue is $80 billion.
53Stabilizing Farm Revenues A poor harvest decreases supply.Farmers lose $20 billion of total revenue on the decreased quantity sold.But they gain $30 billion from the higher price.Because demand is inelastic, total revenue increases—to $90 billion.
54Stabilizing Farm Revenues Now a bumper harvest increases supply.Farmers lose $40 billion of total revenue on the original quantity because the price falls.They gain only $10 billion from the increased quantity.Because demand is inelastic, total revenue decreases—to $50 billion.
55Stabilizing Farm Revenues Speculative Markets in InventoriesSpeculative markets have developed for the inventories of those farm products that can be stored over long periods of time.Inventory holders speculate by:Buying for inventory when the expected future price exceeds the current price.Selling from inventory when the current price exceeds the expected future price.
56Stabilizing Farm Revenues Figure 6.12 shows how inventory speculation changes the outcome.Supply is now perfectly elastic at the price expected by inventory holders—supply curve S.A poor harvest decreases production but inventories are sold off.
57Stabilizing Farm Revenues A bumper crop increases production, but some of the extra output goes into inventory.The price is stabilized at the inventory speculators’ expected price.
58Stabilizing Farm Revenues In reality, speculation decreases but does not completely eliminate price fluctuations.While speculation does not stabilize farmers’ revenues, it changes the effects of bumper harvests and crop failures.Farmers’ total revenues now increase with bumper crops and decrease with crop failures.