Markets in Action

TM 7-2 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain how housing markets work and how price ceilings create housing shortages and inefficiency Explain how labor markets work and how minimum wage laws create unemployment and inefficiency Explain the effects of the sales tax

TM 7-3 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain how markets for illegal goods work Explain why farm prices and revenues fluctuate Explain how speculation limits price fluctuations

TM 7-4 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain how price ceilings create shortages and inefficiency Explain how price floors create surpluses and inefficiency Explain the effects of the sales tax Explain how markets for illegal goods work

TM 7-5 Copyright © 1998 Addison Wesley Longman, Inc. Housing Markets and Rent Ceilings San Francisco Earthquake 1906 How does the market deal with a dramatic reduction in the supply of housing? The destruction of buildings decreases the supply of housing and shifts the short-run supply curve leftward. With sufficient time for new apartments and houses to be constructed, supply increases.

TM 7-6 Copyright © 1998 Addison Wesley Longman, Inc. LS Quantity (thousands of units per month) Rent (dollars per unit per month) D SS The San Francisco Housing Market in 1906 SS a After EarthquakeLong run Adjustment

TM 7-7 Copyright © 1998 Addison Wesley Longman, Inc. A Regulated Housing Market Price ceilings are regulations that make it illegal to charge a price higher than a specified level. Rent ceilings are price ceilings applied to housing markets. How does a rent ceiling affect the housing market?

TM 7-8 Copyright © 1998 Addison Wesley Longman, Inc. A Regulated Housing Market Rent ceilings set above equilibrium have no effect. Rent ceilings set below equilibrium prevents price from regulating the quantities supplied and demanded.

TM 7-9 Copyright © 1998 Addison Wesley Longman, Inc. A Rent Ceiling Quantity (thousands of units per month) Rent (dollars per unit per month) D SS a Housing shortage Maximum black market rent Rent ceiling

TM 7-10 Copyright © 1998 Addison Wesley Longman, Inc. A Regulated Housing Market The ceiling results in two developments: Search activity Black markets

TM 7-11 Copyright © 1998 Addison Wesley Longman, Inc. A Regulated Housing Market Search activity is the time spent looking for someone to do business. It increases when there is a shortage.

TM 7-12 Copyright © 1998 Addison Wesley Longman, Inc. A Regulated Housing Market Black markets are illegal markets in which the price exceeds the legally imposed price ceiling.

TM 7-13 Copyright © 1998 Addison Wesley Longman, Inc. Quantity (thousands of units per month) Rent (dollars per unit per month) D Rent ceiling 30 S Producer surplus Deadweight loss Consumer surplus Inefficiency of Rent Ceilings

TM 7-14 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain how price ceilings create shortages and inefficiency Explain how price floors create surpluses and inefficiency Explain the effects of the sales tax Explain how markets for illegal goods work

TM 7-15 Copyright © 1998 Addison Wesley Longman, Inc. The Labor Market and the Minimum Wage Wage rates adjust to make the quantity demanded of labor equal to the quantity supplied Technology has reduced the demand for low- skilled labor

TM 7-16 Copyright © 1998 Addison Wesley Longman, Inc. The Labor Market and the Minimum Wage Short-run There is a given number of people with a given skill. Wages must be increased in order to increase the number of hours worked.

TM 7-17 Copyright © 1998 Addison Wesley Longman, Inc. The Labor Market and the Minimum Wage Long-run People can acquire new skills and find new types of jobs: If wage rates are too high or low, people will enter or leave this labor market. If people can freely enter and leave the labor market, the long-run supply of labor is perfectly elastic.

TM 7-18 Copyright © 1998 Addison Wesley Longman, Inc. The Labor Market and the Minimum Wage Long-run People can acquire new skills and find new types of jobs (cont.): The longer the period of adjustment, the greater the elasticity of supply of labor.

TM 7-19 Copyright © 1998 Addison Wesley Longman, Inc. A Market for Low-Skilled Labor Quantity (millions of hours per year) Wage Rate (dollars per hour) SS D LS DADA After invention Long-run adjustment

TM 7-20 Copyright © 1998 Addison Wesley Longman, Inc. The Minimum Wage A minimum wage law is a regulation that makes the hiring of labor below a specified wage illegal. If the minimum wage is set below equilibrium it will have no effect. If the minimum wage is set above equilibrium, it prevents price from regulating quantity supplied and demanded.

TM 7-21 Copyright © 1998 Addison Wesley Longman, Inc. Minimum Wage and Unemployment Quantity (millions of hours per year) Wage Rate (dollars per hour) SS DADA Minimum wage a b Unemployment

TM 7-22 Copyright © 1998 Addison Wesley Longman, Inc. Minimum wage USA: Fair Labor Standards Act of 1938 The Federal Minimum $7.25 per hour as of July 24, 2009 Some states like: Georgia ($5.15), Wyoming ($5.15), Arkansas ($6.25) lower wage and others have higher rate: DC ($8.25), California ($8), Alaska ($7.75), Arizona ($7.75), Illinois ($8.25), Massachusetts ($8) The State law excludes from coverage any employment that is subject to the Federal Fair Labor Standards Act when the Federal rate is greater than the State rate.

TM 7-23 Copyright © 1998 Addison Wesley Longman, Inc. Minimum wage UK: there are different levels of NMW, depending on your age and whether you are an apprentice. The current rates are: £ the main rate for workers aged 21 and over ; £ the rate; £ the rate for workers above school leaving age but under 18; £ the apprentice rate, for apprentices under 19 or 19 or over and in the first year of their apprenticeship

TM 7-24 Copyright © 1998 Addison Wesley Longman, Inc. Minimum wage In the 8 out of 27 member states currently have national minimum wages. Many countries, such as Sweden, Finland, Germany, Italy and Cyprus have no minimum wage laws but rely on employer groups and trade unions to set minimum earnings through collective bargaining.collective bargaining France 8.86 (2010); Ireland 7.65 (2011) Japan $ $9.90 (regional basis) Bulgaria 240 lv/monthly

TM 7-25 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain how price ceilings create shortages and inefficiency Explain how price floors create surpluses and inefficiency Explain the effects of the sales tax (or VAT| Explain how markets for illegal goods work

TM 7-26 Copyright © 1998 Addison Wesley Longman, Inc. Taxes Who Pays the Sales Tax (VAT)? Suppose a $10 sales tax (VAT) is imposed on DVD players There are two prices Including the tax buyers respond to this. What they pay. Excluding the tax sellers respond to this. What they receive.

TM 7-27 Copyright © 1998 Addison Wesley Longman, Inc. Tax revenue S + tax The Sales Tax Quantity (thousands of DVD players per week) Price (dollars per player) S DADA $10 tax

TM 7-28 Copyright © 1998 Addison Wesley Longman, Inc. Tax Division and Elasticity of Demand Two Extremes Perfectly inelastic demand--buyer pays Example: Insulin Perfectly elastic demand--seller pays Example: Pink marker pens

TM 7-29 Copyright © 1998 Addison Wesley Longman, Inc. Sales Tax (VAT) and the Elasticity of Demand Quantity (thousands of doses per day) Price (dollars per dose) D S S + tax Buyer pays entire tax Perfectly inelastic demand

TM 7-30 Copyright © 1998 Addison Wesley Longman, Inc. Sales Tax (VAT) and the Elasticity of Demand Quantity (thousands of marker pens per week) SS + tax Seller pays entire tax Price (cents per pen) Perfectly elastic demand

TM 7-31 Copyright © 1998 Addison Wesley Longman, Inc. Tax Division and Elasticity of Demand The division of the tax depends upon elasticity. The more inelastic the demand, the more the buyer pays. The more elastic the demand, the more the seller pays.

TM 7-32 Copyright © 1998 Addison Wesley Longman, Inc. Tax Division and Elasticity of Supply Two Extremes: Perfectly inelastic supply -- seller pays. Example: water from a mineral spring. Perfectly elastic supply -- buyer pays. Example: sand used to make silicon used by computer chip makers.

TM 7-33 Copyright © 1998 Addison Wesley Longman, Inc. Sales Tax (VAT) and the Elasticity of Supply Quantity (thousands of bottles per week) Price (dollars per bottle) S D Seller pays entire tax Perfectly inelastic supply

TM 7-34 Copyright © 1998 Addison Wesley Longman, Inc. Sales Tax (VAT) and the Elasticity of Supply Quantity (thousands of pounds per week) Price (cents per pound) S D S + tax buyer pays entire tax Perfectly Elastic Supply

TM 7-35 Copyright © 1998 Addison Wesley Longman, Inc. Tax Division and Elasticity of Supply The division of the tax depends upon elasticity. The more inelastic the supply, the more the seller pays. The more elastic the supply, the more the buyer pays.

TM 7-36 Copyright © 1998 Addison Wesley Longman, Inc. Sales Taxes (VAT) in Practice Items with low elasticity of demand (alcohol, tobacco, & gasoline) are good sources of tax revenue for the government. Why? Poor source: 1991 Luxury Tax

TM 7-37 Copyright © 1998 Addison Wesley Longman, Inc. Taxes and Efficiency Inefficiency Due to the difference in price paid by the buyer and received by the seller the marginal benefit does not equal the marginal cost. The more inelastic demand or supply, the smaller the decrease in quantity and deadweight loss.

TM 7-38 Copyright © 1998 Addison Wesley Longman, Inc. Taxes and Efficiency Quantity (thousands of DVD players per week) Price (dollars per player) DD S Tax Revenue Consumer surplus Producer surplus S + tax Deadweight loss

TM 7-39 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain how price ceilings create shortages and inefficiency Explain how price floors create surpluses and inefficiency Explain the effects of the sales tax Explain how markets for illegal goods work

TM 7-40 Copyright © 1998 Addison Wesley Longman, Inc. Markets for Illegal Goods When a good is illegal, the cost of trading in the good increases. Penalties and policing increase the cost. Decreasing supply and/or demand

TM 7-41 Copyright © 1998 Addison Wesley Longman, Inc. D - CBL S + CBL A Market for an Illegal Good Quantity Price QcQc PcPc D c S a b Cost per unit of breaking the law... …to buyer …to seller d Q p

TM 7-42 Copyright © 1998 Addison Wesley Longman, Inc. Markets for Illegal Goods Enforcement Price effects depend upon who receives the most severe penalty -- the buyer or seller. Today, penalties on sellers are larger. This causes the equilibrium quantity to decrease and price increases compared to an unregulated market.

TM 7-43 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain why farm prices and revenues fluctuate Explain how speculation limits price fluctuations

TM 7-44 Copyright © 1998 Addison Wesley Longman, Inc. Stabilizing Farm Revenues Farm output fluctuates considerably due to fluctuations in the weather. How do changes in farm output affect farm prices and farm revenues? How can farm revenues be stabilized?

TM 7-45 Copyright © 1998 Addison Wesley Longman, Inc. $20 billion $30 billion $60 billion Quantity (billions of bushels (35.24L) per year) Price (dollar per bushel) MS 0 D Poor harvest MS 1 Harvest, Farm Prices, and Farm Revenues

TM 7-46 Copyright © 1998 Addison Wesley Longman, Inc. Stabilizing Farm Revenues Farm Revenues during a bad harvest Total farm revenue actually increases due to inelastic demand. Some farmers, whose entire crop is destroyed, lose. Others, whose crop is unaffected, earn enormous profits.

TM 7-47 Copyright © 1998 Addison Wesley Longman, Inc. $40 billion $10 billion Quantity (billions of bushels per year) Price (dollar per bushel) MS 0 D MS 2 Bumper Harvest (record high) Harvest, Farm Prices, and Farm Revenues

TM 7-48 Copyright © 1998 Addison Wesley Longman, Inc. Stabilizing Farm Revenues Farm Revenues during a bumper harvest Total farm revenue actually decreases due to inelastic demand.

TM 7-49 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain why farm prices and revenues fluctuate Explain how speculation limits price fluctuations

TM 7-50 Copyright © 1998 Addison Wesley Longman, Inc. Stabilizing Farm Revenues Two institutions designed to stabilize farm revenue Speculative markets in inventories Farm price stabilization policy

TM 7-51 Copyright © 1998 Addison Wesley Longman, Inc Quantity (billions of bushels) S D Price (dollar per bushel) Q1Q1 Inventory Speculation How Inventories Limit Price Changes Q2Q2 5 billion to inventory Production decreases Production increases 5 billion from inventory

TM 7-52 Copyright © 1998 Addison Wesley Longman, Inc. Farm Revenue Speculative markets in inventories do not stabilize farm revenue When price is stabilized, revenue fluctuates as production fluctuates. Bumper crops bring larger revenues than poor harvest do.

TM 7-53 Copyright © 1998 Addison Wesley Longman, Inc. Farm Revenue Farm Price Stabilization Policy Set production limits Set price floors Hold inventories

TM 7-54 Copyright © 1998 Addison Wesley Longman, Inc. Farm Revenue Farm Price Stabilization Policy Production limits Quotas restrict the quantity produced. Can result in higher farm prices. Price floors Set above equilibrium create surpluses. Hold inventories The government must hold inventory to maintain the equilibrium price.