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Chapter 6:

Chapter 6:. Markets in Action. Objectives. After studying this chapter, you will be able to: Explain how housing markets work and how price ceilings create housing shortages and inefficiency. Explain how labour markets work and how minimum wage laws create unemployment and inefficiency.

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Chapter 6:

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  1. Chapter 6: Markets in Action

  2. Objectives After studying this chapter, you will be able to: • Explain how housing markets work and how price ceilings create housing shortages and inefficiency. • Explain how labour markets work and how minimum wage laws create unemployment and inefficiency. • Explain the effects of a tax. • Explain the effects of a production quota • Explain how markets for illegal goods work.

  3. Housing Markets and Rent Ceilings • Imagine that a tropical cyclone makes landfall at Townsville and that floods destroy 50 per cent of the city’s homes • How would the Townsville housing market cope with such a devastating reduction in the supply of housing?

  4. Housing Markets and Rent Ceilings • The housing market before and after a flood • Figure 6.1 shows the market for housing in Townsville before and after a massive tropical storm floods the city. • D is the demand curve for housing. SS is the short run supply curve and LS the long run supply curve after the market responds to a change in price after enough time has elapsed

  5. After the Flood SSA A Housing Market After a Cyclone Figure 6.1(a) 900 SS 700 Rent (dollars per unit per month) LS 500 D 0 20 30 40 60 Quantity (thousands of units per month)

  6. Long-run adjustment A Housing Market After a Cyclone Figure 6.1(b) SSa 900 SS 700 Rent (dollars per unit per month) LS 500 D 0 20 30 40 60 Quantity (thousands of units per month)

  7. Housing Markets and Rent Ceilings • A regulated housing market • A 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.

  8. Maximum black market rent Rent ceiling Housing shortage A Rent Ceiling Figure 6.2 SSA 900 700 Rent (dollars per unit per month) 500 D 0 20 30 40 Quantity(thousands of units per month)

  9. Housing Markets and Rent Ceilings • Search activity • The 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. It uses time and other resources • A rent ceiling controls the rent portion of the cost of housing, but it does not control the opportunity cost, which might even be higher than the rent in the unregulated market.

  10. Housing Markets and Rent Ceilings • Black markets • A black market is an illegal market in which the price exceeds the legally imposed price ceiling • 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.

  11. Housing Markets and Rent Ceilings • Inefficiency of rent ceilings • A 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. • A rent ceiling is also, usually, unfair. • It does not generally benefit the poor. • It creates an even bigger problem for the housing market.

  12. The Labour Market and theMinimum Wage • New labour-saving technologies become available every year, which mainly replace low-skilled labour. • Does the persistent decrease in the demand for low-skilled labour depress the wage rates of these workers? • The immediate effect of these technological advances is a decrease in the demand for low-skill labour, a fall in the wage rate, and a decrease in the quantity of labour supplied. • Figure 6.4 on the next slide illustrates this immediate effect.

  13. After Intervention LS DA A Market for Low-Skilled Labour Figure 6.4(a) SS 6 Wage Rate (dollars per hour) 5 4 D 3 20 21 22 23 Quantity (millions of hours per year)

  14. SSA Long Run Adjustment A Market for Low-Skilled Labor Figure 6.4(b) SS 6 LS 5 Wage Rate (dollars per hour) 4 D 3 DA 20 21 22 23 Quantity (millions of hours per year)

  15. The Labour Market and theMinimum Wage • 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 labour 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.

  16. The Labour Market and theMinimum Wage • If the minimum wage is set above the equilibrium wage rate, the quantity of labour supplied by workers exceeds the quantity demanded by employers. There is a surplus of labour. • Because employers cannot be forced to hire a greater quantity than they wish, the quantity of labour hired at the minimum wage is less than the quantity that would be hired in an unregulated labour market. • Because the legal wage rate cannot eliminate the surplus, the minimum wage creates unemployment • Figure 6.5 on the next slide illustrates these effects.

  17. Unemployment A B Minimum wage Minimum Wage and Unemployment Figure 6.5 SS 6 Wage Rate (dollars per hour) 5 4 3 DA 20 21 22 23 Quantity (millions of hours per year)

  18. The Labour Market and theMinimum Wage • Inefficiency of the minimum wage • The minimum wage is inefficient. • Unemployed workers are willing to work for less than the minimum wage, and firms are willing to hire them for less than the minimum wage. • The minimum wage law frustrates these transactions that would benefit both workers and the firms that hire them.

  19. Australia’s Wage Regulation and Its Effects • The Commonwealth Arbitration Court established the minimum wage, or basic wage, in 1907 • Historically, minimum wage were awarded to provide families with a living wage and to ensure ‘fair comparability among other occupations • A living wage is defined as an hourly wage rate that enables a person who works a 38 hour work week to provide a family with adequate housing for not more than 3 per cent of the amount earned

  20. Australia’s Wage Regulation and Its Effects • Reforms of the 1990s and 2000s • The Reform Act of 1993, the Workplace Relations Act of 1996, and Workchoices Actof 2005 were designed to make the labour market more competitive and wage rates more responsive to productivity • Studies of the effects of the minimum wage by the Australian Productivity Commission has concluded that large changes in minimum wages do affect employment

  21. Taxes • Tax incidence • Tax incidence is the division of the burden of a tax between the buyer and the seller • When a tax is imposed, the price paid by the buyer may rise by the full amount of the tax, by a lesser amount, or not at all. • If the price rises by the full amount the buyer pays the tax • If the price rises by a lesser amount, the tax is shared between the buyer and the seller. • If the price did not change, the burden of the tax falls entirely on the seller.

  22. Taxes • A tax on sellers • A tax on sellers is like an increase in costs, so it decreases supply • To determine the position of the new supply curve, we add the tax to the minimum price that sellers are willing to accept for each quantity sold.

  23. S + tax on sellers Price paid by buyers $1.50 tax Price with no tax Price received by sellers A Tax on Sellers Figure 6.7 5.00 4.00 3.00 2.50 2.00 1.00 0 S Price (dollars per packet) D 50 75 100 125 150 175 200 225 Quantity (millions of packets per year)

  24. Taxes • A tax on buyers • A tax on buyers will decrease demand and the demand curve shifts leftwards. • To find the new demand curve, the tax is subtracted from the maximum price that buyers are willing to pay for each quantity bought.

  25. Price paid by buyers Price with no tax $1.50 tax Price received by sellers D - tax on buyers A Tax on Buyers Figure 6.8 5.00 4.00 3.00 2.50 2.00 1.50 1.00 0 S Price (dollars per packet) D 50 75 100 125 150 175 200 225 Quantity (millions of packets per year)

  26. Taxes • Equivalence of tax on buyers and sellers • Tax on buyers has the same effects as the tax on sellers • In both cases the equilibrium quantity decreases by the same amount • A tax is like a wedge between the buying price and the selling price, It is the size of the wedge, not the side of the market on which the tax is imposed by the government, that determines the effects of the tax.

  27. Tax Division andElasticity of Demand • The division of the tax burden between buyer and seller depends in part on the elasticity of demand. • Two extremes: • Perfectly elastic demand: buyer pays • Perfectly inelastic demand: seller pays

  28. S + tax Buyer pays entire tax Tax and the Elasticity of Demand Figure 6.9(a) S 2.20 Price (dollars per dose) Perfectly Inelastic Demand 2.00 D 100 Quantity (thousands of doses per day)

  29. S + tax Seller pays entire tax Tax and the Elasticity of Demand Figure 6.9(b) S 1.00 Perfectly Elastic Demand Price (cents per pen) 0.90 1 4 Quantity(thousands of marker pens per week)

  30. Tax Division andElasticity of Demand • In the usual case, demand is neither perfectly inelastic nor perfectly elastic. • This means that the tax is generally split between buyer and seller. • The more inelastic the demand, the more the buyer pays.

  31. Tax Division andElasticity of Supply • The division of the tax burden between the buyer and the seller also depends, in part, on the elasticity of supply. • Two extreme cases: • Perfectly inelastic supply: seller pays • Perfectly elastic supply: buyer pays

  32. Seller pays entire tax Tax and theElasticity of Supply Figure 6.10(a) S Perfectly Inelastic Supply Price (cents per bottle) 50 45 D 100 Quantity (thousands of bottles per week)

  33. Perfectly Elastic Supply S + tax Buyers pays entire tax Tax and theElasticity of Supply Figure 6.10(b) Price (cents per kilogram) 11 10 S D 3 5 Quantity (thousands of kilograms per week)

  34. Tax Division andElasticity of Supply • In the usual case, supply is neither perfectly inelastic nor perfectly elastic. • This means that the tax is generally split between buyer and seller. • The more elastic the supply, the larger is the amount of tax paid by the buyer.

  35. Taxes in Practice • Sales tax is generally applied to items with a low elasticity of demand (alcohol, tobacco, and petrol). • Quantity does not decrease by much, so government collects a large tax revenue • It is unusual to apply sales tax to goods with a high elasticity of demand—tax revenue will be small. • Labour has a low elasticity of supply and a high elasticity of demand. Any tax applied to labour falls mainly on workers.

  36. Taxes and Efficiency • Sales taxes place a wedge between the buyers’ price and the sellers’ price. • The marginal benefit of the buyer does not equal the marginal cost of the seller. This creates inefficiency. • The more inelastic is demand or supply, the smaller the decrease in quantity and so also the smaller the deadweight loss.

  37. S + tax S + tax Consumer surplus Tax Revenue Deadweight loss Producer surplus Taxes and Efficiency Figure 6.11 130 S S Price (dollars per player) 105 100 95 75 D D 0 1 2 3 4 5 6 7 8 9 10 Quantity (thousands of CD players per week)

  38. Production Quotas • A production quota is an upper limit to the quantity of a good or service that may be produced in a specified period • Effects of quota • A quota raises the price, and also lowers the the marginal cost of producing the quota. • Inefficiency of a quota • A production quota is inefficient because it results in underproduction

  39. Markets for Illegal Goods • When a good is illegal, the cost of trading in the good increases. • Penalties and policing increase the cost. • Decreases supply and/or demand

  40. S + CBL Cost per unit of breaking the law... …to buyer F H G …to seller K D - CBL A Market for an Illegal Good Figure 6.12 J PB S Price PC E D PS Q P QC Quantity

  41. A Market for Illegal Drugs • A market for illegal drugs • Penalties on sellers • Penalties on buyer • Penalties on both buyers and sellers

  42. Legalising and Taxing Drugs • Illegal trading to evade the tax • Some pros and cons of taxes versus prohibition. • Tax revenue can be used to make law enforcement more effective • Tax revenue can be used to run a more effective education campaign against drugs • Prohibition will decrease the demand for drugs

  43. END CHAPTER 6

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